<PAGE>
Rule 424(b)(3)
Form S-11 Registration Statement
(Registration No. 333-77375)
Prospectus
NovaStar Financial, Inc.
[LOGO OF NOVASTAR]
4,285,714 Shares Class B Convertible Preferred Stock
13,013,425 Shares Common Stock
5,177,712 Stock Purchase Warrants
Consider carefully the
risk factors beginning on
page 11 of this
prospectus, including the
following:
. limited operating
history
. significant losses in
1999 and 1998
. dependence upon short-
term borrowings from
major lenders
. dependence upon long-
term borrowings
through
securitizations
. impact of unexpected
or rapid changes in
interest rates
. restrictions on
ownership and
transferability of our
stock
This prospectus relates to:
. 4,285,714 shares of our preferred stock held by selling securityholders;
. 3,549,999 shares of our common stock held by selling securityholders;
. 5,177,712 stock purchase warrants held by selling securityholders, each
warrant exercisable for common stock at various exercise prices; and
. 9,463,426 shares of common stock issuable upon the exercise of warrants
and conversion of preferred stock.
Under some circumstances, the selling securityholders and any broker-dealers
that act in connection with the sales may be deemed to be "underwriters" within
the meaning of Section 2(11) of the Securities Act, and any commissions or
discounts and other compensation paid to such persons may be deemed to be
underwriting discounts and commissions under the Securities Act.
We will not receive any proceeds from the sale of securities by the selling
securityholders. We will receive the proceeds from the issuance and sale of
common stock pursuant to the exercise of the warrants. If all warrants
outstanding as of the date of this prospectus are exercised at the price
issued, we would receive proceeds, before expenses, of $66,360,925.00.
Our common stock is listed on the New York Stock Exchange under the symbol
"NFI". On April 13, 2000, the last reported sale price was $3 5/8 per share.
Our warrants trade through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's bulletin board service. There can be no
assurance as to the development or liquidity of a market for our preferred
stock.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is accurate or complete. Any representation to the contrary is
a criminal offense.
May 18, 2000
<PAGE>
TABLE OF CONTENTS
<TABLE>
<S> <C>
PROSPECTUS SUMMARY........................................................ 4
Overview of NovaStar Financial, Inc...................................... 4
The Offering............................................................. 5
Securities Offered....................................................... 5
Use of Proceeds.......................................................... 5
The Structure of Our Company and Principal Affiliates.................... 5
Recent Developments...................................................... 6
Summary Risk Factors..................................................... 7
Summary Financial and Other Data......................................... 9
RISK FACTORS.............................................................. 10
Overall Enterprise of NovaStar Financial, Inc. .......................... 10
Our dependence upon borrowings can result in significant liquidity
constraints............................................................. 10
We have a limited operating history and incurred significant net losses
in 1999 and 1998........................................................ 10
Forgivable notes may adversely affect results of operations.............. 10
We depend on key personnel for successful operations..................... 10
We need additional equity financing to support future growth............. 10
Should we fail to maintain REIT status, we would be subject to tax as a
regular corporation..................................................... 11
We lack voting control of our taxable affiliate NovaStar Mortgage........ 11
Failure to qualify for Investment Company Act exemption may adversely
affect our ability to use leverage and to conduct our business.......... 11
Future revisions in policies and strategies at the discretion of Board of
Directors may adversely affect operations............................... 11
Mortgage Lending Operation............................................... 12
Changes in interest rates may adversely affect results of operations..... 12
Intense competition in the mortgage loan industry may result in reduced
net income or in revised underwriting standards which would adversely
affect operations....................................................... 12
Higher loan-to-value ratios increase the risk that we may not recover, on
default, full amounts due on mortgage loans............................. 12
Loans made to non-conforming mortgage borrowers entail higher delinquency
and loss rates.......................................................... 13
Failure to renew or obtain adequate funding under warehouse facilities
and repurchase agreements may materially adversely impact our lending
operations.............................................................. 13
Financing with repurchase agreements may lead to margin calls if the
market value of mortgage assets declines................................ 13
Interest rate fluctuations may adversely affect the value of our mortgage
loans in process or held for sale or securitization..................... 13
Competition with other prospective purchasers of mortgage loans for
business with independent brokers and lenders may result in fluctuations
in volume and cost of acquiring mortgage loans.......................... 14
New laws and regulations, new administrative or judicial interpretations
or our failure to comply with existing federal, state, and local
legislation or regulation could adversely affect our operations......... 14
Failure to comply with future regulatory interpretations or judicial
decisions regarding broker compensation programs may adversely affect
results of operations................................................... 14
Contamination of properties securing mortgage loans by hazardous
substances would result in our facing environmental liabilities......... 15
Acquisition and Management of a Portfolio of Mortgage Assets............. 15
General economic and financial conditions in mortgage and financial
markets may affect our results of operations............................ 15
</TABLE>
<TABLE>
<S> <C>
Interest rate fluctuations may result in a decrease in net interest
income.................................................................. 15
Interest rates on our borrowings adjust differently than those on related
adjustable rate mortgages which may adversely affect our net interest
income.................................................................. 16
Interest rate caps on adjustable rate mortgages may adversely affect our
net interest income..................................................... 16
Changes in anticipated prepayment rates may adversely affect net interest
income.................................................................. 17
Failure to hedge effectively against interest rate changes may adversely
affect results of operations............................................ 17
Limitations on effective hedging may adversely affect attempts to
mitigate risk of variable rate liabilities.............................. 18
Hedging poses a credit risk.............................................. 18
Hedging poses a legal risk............................................... 18
Hedging poses a basis risk............................................... 18
We face loss exposure on single family mortgage assets................... 19
We face loss exposure due to the credit risks of non-conforming mortgage
loans................................................................... 19
We face loss exposure due to the underlying real estate.................. 19
Market factors may limit our ability to acquire mortgage assets at yields
which are favorable relative to borrowing costs......................... 20
We face substantial leverage and potential net interest and operating
losses in connection with borrowings.................................... 20
Our failure to refinance outstanding borrowings on favorable terms may
affect results of operations............................................ 20
Decline in market value of mortgage assets may limit our ability to
borrow, result in lenders initiating margin calls and require us to sell
mortgage assets in adverse market conditions............................ 21
Adverse changes in the securitization market could impair our ability to
acquire and finance mortgage loans through securitizations on a
favorable or timely basis............................................... 21
Mortgage loan performance may adversely affect future results............ 21
Illiquidity of investments restricts resale of mortgage securities....... 22
Lack of geographic diversification of properties underlying mortgage
assets may subject such mortgage assets to greater risk of default in
event of hazards that affect such region................................ 22
Investment in the Securities in the Offering............................. 22
Restrictions on ownership of capital stock may inhibit market activity
and the resulting opportunity for holders of our capital stock and
warrants to receive a premium for their securities...................... 22
Future sales of securities may dilute the equity of our stockholders or
reduce the price of shares of our common stock.......................... 22
There is no assurance of an active public trading market................. 23
Possible volatility of stock price may adversely impact the liquidity of
our common stock and may result in losses to stockholders who sell
shares of common stock.................................................. 23
NOVASTAR FINANCIAL, INC................................................... 24
USE OF PROCEEDS........................................................... 25
DIVIDEND POLICY AND DISTRIBUTIONS......................................... 25
DIVIDEND REINVESTMENT PLAN................................................ 26
CAPITALIZATION............................................................ 26
MARKET PRICES AND DIVIDEND DATA........................................... 27
SELECTED FINANCIAL AND OTHER DATA......................................... 28
</TABLE>
2
<PAGE>
TABLE OF CONTENTS--(Continued)
<TABLE>
<S> <C>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS................................................................ 29
Safe Harbor Statement..................................................... 29
Information............................................................... 29
Basis of Presentation..................................................... 29
Recent Developments....................................................... 30
Notes Receivable from Founders............................................ 30
Financial Condition of NovaStar Financial, Inc. as of December 31, 1999
and December 31, 1998.................................................... 31
Results of Operations of NovaStar Financial, Inc.--Year Ended December 31,
1999 Compared to the Year Ended December 31, 1998........................ 38
Net Income............................................................... 38
Net Interest Income...................................................... 38
Prepayment Penalty Income................................................ 40
Gain or Loss on Sales of Assets and Loss on Termination of Interest Rate
Agreements.............................................................. 40
Mortgage Insurance....................................................... 40
Provisions for Credit Losses............................................. 41
Loan Servicing Fees Paid to NovaStar Mortgage, Inc. ..................... 43
General and Administrative Expenses...................................... 44
Equity in Earnings or Loss of NFI Holding Corporation.................... 45
Results of Operations of NovaStar Financial, Inc.--Year Ended December 31,
1998 Compared to the Year Ended December 31, 1997........................ 45
Net Income............................................................... 45
Net Interest Income...................................................... 46
Prepayment Penalty Income................................................ 47
Gain or Loss on Sales of Assets and Loss on Termination of Interest Rate
Agreements.............................................................. 47
Provisions for Credit Losses and Premium for Mortgage Loan Insurance..... 47
Loan Servicing Fees Paid to NovaStar Mortgage, Inc. and Other Loan
Servicing Fees.......................................................... 47
General and Administrative Expenses...................................... 48
Equity in Earnings or Loss of NFI Holding Corporation.................... 48
Taxable Income or Loss................................................... 49
NFI Holding Corporation................................................... 49
Financial Condition of NFI Holding as of December 31, 1999 and December
31, 1998................................................................. 49
Results of Operations of NFI Holding, Inc.--Year Ended December 31, 1999
Compared to the Year Ended December 31, 1998............................. 53
Results of Operations of NFI Holding, Inc.--Year Ended December 31, 1998
Compared to the Year Ended December 31, 1997............................. 54
Liquidity and Capital Resources........................................... 54
Interest Rate/Market Risk................................................. 56
BUSINESS................................................................... 60
Mortgage Lending Operation ............................................... 60
Market Overview........................................................... 60
Competition............................................................... 61
Loan Origination.......................................................... 62
Marketing and Production Strategy......................................... 63
Underwriting and Quality Control Strategy................................. 65
Mortgage Loan Servicing Strategy.......................................... 68
Portfolio Management...................................................... 69
Types of Mortgage Assets.................................................. 69
Asset Acquisition Policies................................................ 71
Financing for Mortgage Lending Operations and Mortgage Security
Acquisitions............................................................. 72
Mortgage Loans Held as Collateral for Structured Debt..................... 72
Credit Risk Management Policies........................................... 73
Interest Rate Risk Management............................................. 74
</TABLE>
<TABLE>
<S> <C>
Prepayment Risk Management................................................ 75
Taxable Affiliates........................................................ 75
Properties................................................................ 76
Legal Proceedings......................................................... 76
MANAGEMENT................................................................. 77
Directors and Executive Officers.......................................... 77
Directors and Executive Officers.......................................... 77
Other Senior Officers..................................................... 78
Terms of Directors and Officers........................................... 79
Committees of the Board................................................... 80
Compensation of Directors................................................. 80
Compensation Committee Interlocks......................................... 80
Executive Compensation.................................................... 81
REPORT ON REPRICING OF OPTIONS............................................. 85
10 YEAR OPTION REPRICINGS.................................................. 85
PRINCIPAL SECURITYHOLDERS.................................................. 87
Beneficial Ownership of Common Stock by Large Securityholders............. 87
Beneficial Ownership of Common Stock by Directors and Management.......... 88
CERTAIN TRANSACTIONS....................................................... 89
Transactions with Management.............................................. 89
Indebtedness of Management................................................ 90
Certain Business Relationships with Large Securityholders................. 91
Conflict of Interest Policy............................................... 92
SELLING SECURITYHOLDERS.................................................... 93
A. Selling Securityholders for 1999 Warrants.............................. 93
B. Selling Securityholders for 1996 Warrants.............................. 94
FEDERAL INCOME TAX CONSEQUENCES............................................ 103
General................................................................... 103
Opinion of tax counsel.................................................... 103
Qualification as a REIT................................................... 104
Taxation of NovaStar Financial............................................ 107
Taxation of Taxable Affiliates............................................ 108
Termination or Revocation of REIT Status.................................. 108
Taxation of the Company's Stockholders.................................... 109
Redemption and Conversion of Preferred Stock.............................. 109
Warrants.................................................................. 110
Taxation of Tax-Exempt Entities........................................... 111
Foreign Investors......................................................... 111
Recordkeeping Requirement................................................. 111
Backup Withholding........................................................ 112
State and Local Taxes..................................................... 112
ERISA Investors........................................................... 112
DESCRIPTION OF CAPITAL STOCK............................................... 114
General................................................................... 114
Historical Capital Structure.............................................. 114
Preferred Stock........................................................... 114
Common Stock.............................................................. 117
Registration Rights....................................................... 118
Private Placement Purchase Terms Agreement................................ 119
Repurchase of Shares and Restriction on Transfer.......................... 119
Indemnification........................................................... 121
Limitation of Liability................................................... 122
Business Acquisitions Statutes............................................ 122
Control Share Acquisitions................................................ 122
Transfer Agent and Registrar.............................................. 123
DESCRIPTION OF WARRANTS.................................................... 124
PLAN OF DISTRIBUTION....................................................... 127
LEGAL MATTERS.............................................................. 127
EXPERTS.................................................................... 127
WHERE YOU CAN FIND MORE INFORMATION........................................ 128
GLOSSARY................................................................... 129
FINANCIAL STATEMENTS....................................................... F-1
</TABLE>
3
<PAGE>
PROSPECTUS SUMMARY
This summary highlights selected information from this prospectus and does
not contain all of the information that you need to consider in making your
investment decision. You should read this entire prospectus carefully to
understand all of the terms of the offering. We include a glossary beginning on
page 129.
Overview of NovaStar Financial, Inc.
We are a specialty finance company which:
. acquires single family residential non-conforming mortgage loans,
primarily from our affiliate NovaStar Mortgage;
. borrows money to finance its assets using warehouse facilities, including
repurchase agreements;
. issues collateralized debt obligations to finance its non-conforming
mortgage loans in the long-term;
. purchases mortgage securities; and
. manages the resulting combined portfolio of mortgage loans and securities
in a tax-advantaged real estate investment trust structure.
NovaStar Mortgage originates non-conforming residential mortgage loans.
NovaStar Mortgage has developed a nationwide network of wholesale loan brokers
and mortgage lenders who submit mortgage loans to NovaStar Mortgage. These
brokers and mortgage lenders are independent from any of the NovaStar entities.
NovaStar Mortgage underwrites these mortgage loans and funds approved mortgage
loans. During 1999, NovaStar Mortgage originated $453 million in non-conforming
mortgage loans. Throughout 1999, NFI operated principally as a seller of whole
loans through NFI Holding, a taxable subsidiary of NovaStar Financial.
Generally the people to whom NovaStar Mortgage lends money have substantial
equity in the property securing the mortgage loan. NovaStar considers "non-
conforming" borrowers to be individuals who have impaired or limited credit
profiles or higher debt-to-income ratios than traditional mortgage lenders
allow. These borrowers also include individuals who, due to self-employment or
other circumstances, have difficulty verifying their income. These types of
borrowers are generally willing to pay higher mortgage loan origination fees
and interest rates than those charged by conventional lending sources. Because
these borrowers typically use the proceeds of the mortgage loans to consolidate
and refinance debt and to finance home improvements, education and other
consumer needs, loan volume is less dependent on general levels of interest
rates or home sales and therefore less cyclical than conventional mortgage
lending.
We have elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended. As a result, our earnings are generally not subject to
federal income tax to the extent that we distribute our earnings to
stockholders and maintain our qualification as a REIT. We believe the REIT
structure is the most desirable for owning mortgage loans and mortgage
securities due to the elimination of corporate-level income taxation. We are
self-advised and self-managed. We have neither an outside advisor to provide
portfolio investment advice nor an outside manager to take care of the day-to-
day administration of our business operations. We believe that this is a
structure that distinguishes us from many other mortgage REITs.
4
<PAGE>
The Offering
Securities Offered
This prospectus covers offerings of up to:
. 4,285,714 shares of issued and outstanding preferred stock held by the
selling securityholders;
. 3,549,999 shares of our common stock held by selling securityholders;
. 5,177,712 warrants that are owned by the selling securityholders; and
. 9,463,426 shares of common stock that may be subsequently acquired by the
selling securityholders from us upon the exercise of warrants and
conversion of preferred stock.
Each share of preferred stock:
. is convertible, at the option of the holder, into one share of common
stock;
. has a cumulative dividend payable at the rate of 7.0% per annum; and
. may be redeemed at a price of $7.00 by NovaStar Financial at any time
after March 31, 2002.
The warrants consist of:
. 350,000 warrants expiring February 12, 2002 issued with an exercise price
of $6.9375;
. 812,731 warrants expiring October 13, 2003 issued with an exercise price
of $4.5625; and
. 4,014,981 warrants expiring February 3, 2001 issued with an exercise
price of $15.00. Pursuant to their anti-dilution provisions, each warrant
exercised at $15.00 will currently purchase 1.29 shares of common stock,
which represents an effective price of $11.62 per share. The anti-
dilution provisions mean that at present an additional 1,164,344 shares
of common stock are issuable upon the exercise of warrants. As of the
date of this prospectus, 181 warrants have been exercised.
Use of Proceeds
We will receive no proceeds from the sale of preferred stock or warrants by
the selling securityholders. We will use the net proceeds from the issuance of
common stock pursuant to the exercise of the warrants to fund the acquisition
of mortgage loans, as described in this prospectus and, pending such use, to
reduce borrowings.
The Structure of Our Company and Principal Affiliates
Scott Hartman and Lance Anderson own 100 percent of the voting common stock
of NFI Holding. NFI Holding was capitalized through the purchase of voting
common stock by Scott Hartman and Lance Anderson in the amount of $20,000 and
the purchase of non-voting preferred stock by NovaStar Financial in the amount
of $1,980,000. Additional capital was contributed to NFI Holding in 1999
(NovaStar Financial $6,930,000; Scott Hartman and Lance Anderson $70,000) and
1998 (NovaStar Financial $990,000; Scott Hartman and Lance Anderson $10,000).
Mr. Hartman and Mr. Anderson receive one percent of the economic benefits
derived from dividends and distributions of NFI Holding as a result of their
common stock ownership. We receive 99 percent of the economics of NFI Holding
as a result of our preferred stock ownership. Accordingly, we indirectly
receive 99 percent of the economics of NovaStar Mortgage by virtue of our
ownership interest in NFI Holding. In addition, Mr. Hartman and Mr. Anderson
serve as the sole directors of both NFI Holding and NovaStar Mortgage.
Recently adopted legislation will allow REITs to own directly all of the
stock of taxable subsidiaries beginning in the tax year 2001. At present, REITs
are generally limited to holding non-voting preferred stock in taxable
affiliates. The value of all taxable subsidiaries of a REIT will be limited to
20% of the total value of the REIT's assets. Accordingly, NFI expects to
acquire all of the common stock of NFI Holding from Scott Hartman and Lance
Anderson during 2001. This federal tax legislation change is discussed further
under "Federal Income Tax Consequences" of this prospectus.
5
<PAGE>
In contracts with us, NovaStar Mortgage has agreed to:
. pay interest on amounts borrowed from us;
. pay guaranty fees on loans sold by NovaStar Financial in which NovaStar
Financial has guaranteed the performance of NovaStar Mortgage;
. service our non-conforming mortgage loans; and
. provide administrative services to us.
Without voting control of NovaStar Mortgage, there can be no assurance that
these contracts, which are subject to renewal, will continue indefinitely. In
addition, while Messrs. Hartman and Anderson have entered into an agreement of
shareholders, which contains management and control provisions and restrictions
on transfer of NFI Holding common stock, there can be no assurance that the
agreement will be enforced in a timely manner against the individuals, their
heirs or representatives.
[ORGANIZATION CHART OF NOVASTAR FINANCIAL, INC. APPEARS HERE]
During December 1999, Management and the Board authorized the purchase of up
to $5 million of outstanding shares of NovaStar Financial common stock. Under
this stock repurchase plan, NovaStar Financial repurchased 673,400 shares
through December 31, 1999 and an additional 217,300 shares through March 16,
2000.
Recent Developments
As of March 31, 2000, we securitized $128 million in non-conforming loans as
part of the first close of securitization 2000-1, recognizing a gain of $1.5
million. For the issuance of the asset backed bond of $226,320,000, we will
combine an additional $102 million in non-conforming loans in a second closing.
The primary (A-class) bonds were sold to third parties independent of us and
our affiliates. We purchased the subordinated (B-class) and interest-only bonds
and retained the residual. No active trading market for the purchase and sale
of the B-class, interest-only and residual classes of securities exists.
Therefore, management estimates the value of the security by discounting the
expected future cash flow of the collateral and bonds.
During December 1999, Management and the Board authorized the purchase of up
to $5 million of outstanding shares of NovaStar Financial common stock. Under
this stock repurchase plan, NovaStar Financial repurchased 673,400 shares
through December 31, 1999 and an additional 477,700 shares through April 13,
2000.
6
<PAGE>
Summary Risk Factors
Prior to making an investment decision, prospective investors should
carefully consider all of the information set forth in this prospectus and, in
particular, should evaluate the factors set forth in "Risk Factors." These risk
factors include:
. Our dependence upon borrowings can result in significant liquidity
constraints. Our profitability is dependent upon our ability to borrow
money on favorable terms. In October 1998, the subprime mortgage loan
market faced a liquidity crisis with respect to the availability of
short-term borrowings from major lenders and long-term borrowings through
securitization. We faced significant liquidity constraints.
. We have a limited operating history and incurred significant net losses
in 1999 and 1998. We have not yet developed an extensive earnings history
or experienced a wide variety of interest rate or market conditions.
Historical operating performance may be of limited relevance in
predicting future performance. We incurred significant net losses in 1999
and 1998.
. Forgivable notes may adversely affect results of operations. In our
private placement, Messrs. Hartman and Anderson each acquired units paid
for with promissory notes. Principal due on the notes will be forgiven if
the return to private placement investors meets benchmarks. The non-cash
charge against earnings resulting from forgiveness of the notes could
have a material adverse effect on our results of operations and dividends
paid to stockholders during periods forgiven.
. We depend on key personnel for successful operations. Our operations and
those of NovaStar Mortgage depend heavily upon the contributions of Scott
Hartman and Lance Anderson, both of whom would be difficult to replace.
The loss of either of these individuals could have a material adverse
effect upon our businesses and results of operations.
. Should we fail to maintain REIT status, we would be subject to tax as a
regular corporation. If we fail to maintain our qualification as a REIT,
we would be subject to federal income tax as a regular corporation. We
intend to conduct our business at all times in a manner consistent with
the REIT provisions of the Code.
. Changes in interest rates may adversely affect results of operations. Our
results of operations are likely to be adversely affected during any
period of unexpected or rapid changes in interest rates. For example, a
substantial or sustained increase in interest rates could adversely
affect our ability to acquire mortgage loans in expected volumes
necessary to support our fixed overhead expense levels.
. Intense competition in the non-conforming mortgage loan industry may
result in reduced net income or in revised underwriting standards which
would adversely affect operations. We face intense competition, primarily
from commercial banks, savings and loans, other independent mortgage
lenders, and other mortgage REITs. Any increase in the competition among
lenders to originate or purchase non-conforming mortgage loans may result
in either reduced interest income on such mortgage loans compared to
present levels or revised underwriting standards permitting higher loan-
to-value ratios on properties securing non-conforming mortgage loans.
. Loans made to non-conforming mortgage borrowers entail higher delinquency
and loss rates. Lenders in the non-conforming mortgage banking industry
make loans to borrowers who have impaired or limited credit histories,
limited documentation of income and higher debt-to-income ratios than
traditional mortgage lenders allow. Mortgage loans made to non-conforming
mortgage loan borrowers generally entail a higher risk of delinquency and
foreclosure than mortgage loans made to borrowers with better credit and
may result in higher levels of realized losses. Any failure by us to
adequately address the risks of non-conforming lending would have a
material adverse impact on our results of operations, financial condition
and business prospects.
. Historical mortgage loan performance data inhibits prediction of future
results. We use historical mortgage loan performance data to estimate the
level of allowances for credit losses on our mortgage loan
7
<PAGE>
portfolio. The delinquency, foreclosure and loss experience of the
mortgage loans to date may not be indicative of future results. Actual
experience that is different from our estimates may have a material
adverse impact on our results of operations and financial results.
. Failure to renew or obtain adequate funding under warehouse facilities
and repurchase agreements may materially adversely impact our lending
operations. We are currently dependent upon a few lenders to provide the
primary credit facilities for funding of our mortgage loan originations
and acquisitions. Any failure to renew or obtain adequate funding under
these financing arrangements could have a material adverse effect on our
lending operations and our overall performance.
. Interest rate fluctuations may result in a decrease in net interest
income. Interest rate fluctuations may affect our earnings as a result of
potential changes in the spread between the interest rates on our
borrowings and the interest rates on our mortgage assets. In addition,
mortgage prepayment rates vary depending on such factors as mortgage
interest rates and market conditions. Changes in anticipated prepayment
rates may adversely affect our earnings.
. Failure to hedge effectively against interest rate changes may adversely
affect results of operations. Asset/liability management hedging
strategies involve risk and may not be effective in reducing our exposure
to interest rate changes. Moreover, compliance with the REIT provisions
of the Code may prevent us from effectively implementing the strategies
that we determine, absent such compliance, would best insulate us from
the risks associated with changing interest rates.
. We face loss exposure due to the underlying real estate. A substantial
portion of our mortgage assets consists of (1) single family mortgage
loans or (2) mortgage securities evidencing interests in single family
mortgage loans. We will be subject to the risk of loss on such mortgage
assets arising from borrower defaults to the extent not covered by third-
party credit enhancement.
. Market factors may limit our ability to acquire mortgage assets at yields
which are favorable relative to borrowing costs. Despite management's
experience in the acquisition of mortgage assets and its relationships
with various mortgage suppliers, there can be no assurance that we will
be able to acquire sufficient mortgage assets from mortgage suppliers at
spreads above our cost of funds.
. Restrictions on ownership of capital stock may inhibit market activity
and the resulting opportunity for holders of our capital stock and
warrants to receive a premium for their securities. In order for us to
meet the requirements for qualification as a REIT, our charter generally
prohibits any person from acquiring or holding, directly or indirectly,
shares of common stock in excess of 9.8% of the outstanding shares. This
restriction may inhibit market activity and the resulting opportunity for
the holders of our common stock to receive a premium for their stock that
might otherwise exist in the absence of such restrictions.
. There is no assurance of an active public trading market. There is no
assurance that an active public trading market for the common stock will
be sustained. Our common stock's trading volume is relatively low
compared to many other securities listed on the New York Stock Exchange.
Our warrants trade through market makers, such as Stifel, Nicolaus &
Company, Incorporated, using the NASD's bulletin board service. Shares of
preferred stock are available for trading by qualified institutional
buyers as defined in Rule 144A through the PORTAL market. There can be no
assurance as to the development or liquidity of a market for the
preferred stock, which will not be listed on a national securities
exchange and will not be authorized for quotation on Nasdaq. The
transferability of both the warrants and the preferred stock may be
extremely limited.
8
<PAGE>
Summary Financial and Other Data
(dollars in thousands, except per share amounts)
<TABLE>
<CAPTION>
For the Year Ended For the
December 31, Period Ended
------------------------------- December 31,
1999 1998 1997 1996(1)
-------- -------- --------- ----------------
<S> <C> <C> <C> <C>
Statement of Operations Data
Interest income............ $ 66,713 $100,747 $ 36,961 $ 155
Interest expense........... 46,758 80,794 28,185 --
Net interest income........ 19,955 19,953 8,776 155
Provision for credit
losses.................... 22,078 7,430 2,453 --
Equity in net income
(loss)--NFI Holding
Corporation............... 88 (2,984) 28 --
Gain (loss) on sales of
mortgage assets........... 351 (14,962) 51 --
General and administrative
expenses.................. 3,735 7,062 7,101 457
Net loss................... (7,092) (21,821) (1,135) (302)
Basic and diluted loss per
share (2)................. (1.08) (2.71) (0.26) (0.08)
<CAPTION>
As of December 31,
--------------------------------------------------
1999 1998 1997 1996
-------- -------- --------- ----------------
<S> <C> <C> <C> <C>
Balance Sheet Data
Mortgage Assets:
Mortgage loans............. $620,406 $945,798 $ 589,318 $ --
Mortgage securities........ 6,775 -- 517,246 13,239
Total assets............... 690,510 997,754 1,126,252 59,811
Borrowings................. 586,868 909,944 1,005,560 --
Stockholders' equity....... 101,314 82,808 116,489 46,380
<CAPTION>
As of or for the As of or for the
Year Ended December 31, Period Ended
------------------------------- December 31,
1999 1998 1997 1996(1)
-------- -------- --------- ----------------
<S> <C> <C> <C> <C>
Other Data
Loans originated by NFI
Holding Corporation:
Principal at purchase...... $452,554 $878,871 $ 409,974 $ --
Average principal balance
per loan.................. $ 101 $ 94 $ 130 $ --
Weighted average interest
rate:
Adjustable rate mortgage
loans.................... 9.9% 10.0% 10.1% --
Fixed rate mortgage
loans.................... 10.0% 9.9% -- --
Loans with prepayment
penalties................. 90% 74% 73% --
Weighted average prepayment
period (in years) (3)..... 2.5 2.4 2.4 --
Annualized return on
assets.................... (0.83)% (1.66)% (0.01)% (0.50)%
Annualized return on
equity.................... (6.71)% (20.71)% (0.06)% (0.65)%
Taxable income (loss)...... $ -- $ (2,628) $ 1,434 $ (173)
Taxable income (loss) per
share..................... $ -- $ (0.32) $ 0.18 $ (0.05)
Dividends declared per
common share (4).......... $ -- $ 1.00 $ 0.28 $ --
Dividends declared per
preferred share........... $ 0.37 $ -- $ 0.18 $ --
Number of account
executives................ 47 63 36 --
</TABLE>
- --------
(1) NovaStar Financial, Inc. was formed on September 13, 1996. Operations began
in substance after the initial closing of the private placement on December
9, 1996.
(2) Diluted loss per share is based on the weighted average shares of common
stock and preferred stock outstanding, and includes the effect of warrants
and options.
(3) Includes only those mortgage loans with a prepayment penalty.
(4) The level of quarterly common stock dividends is determined by the Board of
Directors based upon its consideration of a number of factors and should
not be deemed indicative of taxable income for the quarter in which
declared or future quarters, or of income calculated in accordance with
generally accepted accounting principles.
9
<PAGE>
RISK FACTORS
Overall Enterprise of NovaStar Financial, Inc.
Our dependence upon borrowings can result in significant liquidity
constraints.
Our profitability is dependent upon our ability to borrow money on favorable
terms. In October 1998, the subprime mortgage market faced a liquidity crisis
with respect to the availability of short-term borrowings from major lenders
and long-term borrowings through securitization. We faced significant liquidity
constraints and we entered into a short-term financing arrangement for
approximately $18 million. In the event the long-term securitization market
remains constrained, NovaStar Financial's ability to increase its portfolio and
earnings will be adversely affected.
We have a limited operating history and incurred significant net losses in
1999 and 1998.
We began operations in December 1996 after the closing of a private
placement. Our affiliate, NovaStar Mortgage, began its mortgage lending
operation in late January 1997 and began servicing loans on July 15, 1997.
Because we have not developed an extensive earnings history nor experienced a
wide variety of interest rate or market conditions, our historical operating
performance may not predict our future performance. Although we generated net
income in the first three quarters of 1998, we incurred significant net losses
for the fourth quarter of 1998 due to certain events that occurred early in the
fourth quarter of 1998. During the year ended December 31, 1999, we recorded a
significant net loss, principally a result of increased provisions for credit
losses. Please read further in the "Management's Discussion and Analysis of
Financial Condition and Results of Operations" section of this prospectus for
more details.
Forgivable notes may adversely affect results of operations.
Messrs. Hartman and Anderson each acquired 108,333 units at the price of
$15.00 per unit in our initial private placement of preferred stock. Hartman
and Anderson paid for the units by delivering promissory notes to us. Each
promissory note was in the amount of $1,624,995, bearing interest at eight
percent per annum, and was secured by the units acquired. The principal amount
of the notes was divided into three equal parts which we refer to as
"tranches." We will forgive principal due if the return to private placement
investors meets benchmarks as follows: one tranche will be forgiven if we
generate a total return to the private placement investors equal to or greater
than 15% in any one fiscal year; all tranches will be forgiven if the total
cumulative return to private placement investors reaches 100% prior to December
31, 2001. Return to investors includes dividends paid and any appreciation in
the average price per share of the common stock and the related warrant during
the period. For each tranche forgiven, we will recognize a non-cash charge
against earnings of $1,083,330 for the related accounting period. Incentive
targets were met and one tranche was forgiven in 1997. Incentive targets were
not met in 1998 or 1999 and, therefore, debt was not forgiven. The charges
against earnings resulting from forgiveness of the notes could have a material
adverse effect on the results of our operations and on the dividends paid to
shareholders, including investors in this offering, during periods forgiven.
We depend on key personnel for successful operations.
Our operations and the operations of NovaStar Mortgage depend heavily on the
contributions of Scott Hartman and Lance Anderson. Both Mr. Hartman and Mr.
Anderson would be difficult to replace. The loss of either of these individuals
could materially adversely effect our business and operating results.
We need additional equity financing to support future growth.
To fully implement our strategy to grow our portfolio of mortgage assets, we
will need to raise additional capital periodically. Accordingly, we expect to
undertake both future equity offerings and long-term securitized debt
offerings. There is no assurance that we will successfully and economically
raise the capital we will require through such offerings.
10
<PAGE>
Should we fail to maintain REIT status, we would be subject to tax as a
regular corporation.
We intend to operate so as to qualify as a REIT for federal income tax
purposes. In order to maintain our classification as a REIT for federal income
tax purposes, we must satisfy tests with respect to the sources of our income,
the nature and type of our assets, the amount of our distributions to
stockholders, and concentration of the ownership of our stock. If we fail to
qualify as a REIT in any taxable year and the relief provisions of the Code do
not apply, we would be subject to federal income tax on our taxable income as a
regular, domestic corporation and our stockholders would be subject to the same
tax treatment as stockholders of such corporation. Distributions to
stockholders in any year in which we fail to qualify as a REIT would not be
deductible in computing our taxable income. As a result, we could be subject to
income tax liability and the cash available for distribution to our
stockholders would be significantly reduced or eliminated. Further, we could
also be disqualified from re-electing REIT status for the four taxable years
following the year we became disqualified.
There is no assurance that future legislation, regulations, administrative
interpretations or court decisions will not significantly change the tax laws
with respect to our qualification as a REIT or with respect to the federal
income tax consequences of such qualification. Any such changes may reduce or
eliminate our competitive advantage over non-REIT competitors.
We lack voting control of our taxable affiliate NovaStar Mortgage.
We formed NFI Holding to serve as a holding company for our taxable
affiliates in order to legally separate the mortgage loan origination operation
and other lines of business from the REIT entity. This was done for regulatory,
tax, risk management and other reasons. Scott Hartman and Lance Anderson own
100% of the voting common stock of NFI Holding while we own 100% of NFI
Holding's non-voting preferred stock. The common stock is entitled to 1% of
dividend distributions of NFI Holding and the preferred stock is entitled to
99% of such distributions. NFI Holding wholly owns NovaStar Mortgage, and the
REIT thus owns a beneficial interest in 99% of any future dividend
distributions from NovaStar Mortgage. NovaStar Mortgage has contracted with us
to: sell subprime mortgage loans it originates to us; service subprime mortgage
loans for us; and provide administrative services to us. Without voting control
of NovaStar Mortgage, we cannot assure you that our contracts with NovaStar
Mortgage, which are subject to renewal, will continue indefinitely. In
addition, while Messrs. Hartman and Anderson have entered into an agreement of
shareholders which contains management and control provisions and restrictions
on transfer of the common stock, we cannot assure you that the agreement will
be enforced in a timely manner against the individuals, their heirs or
representatives. Due to recently adopted legislation, as described in the
summary and elsewhere in this prospectus, we anticipate acquiring the NFI
Holding common stock from Messrs. Anderson and Hartman in the year 2001.
Failure to qualify for Investment Company Act exemption may adversely affect
our ability to use leverage and to conduct our business.
We conduct our business so as not to become regulated as an investment
company under the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate." If we
fail to qualify for exemption from registration as an investment company, our
ability to use leverage would be substantially reduced and we would be unable
to conduct our business. Any such failure to qualify for such exemption could
have a material adverse effect on us.
Future revisions in policies and strategies at the discretion of Board of
Directors may adversely affect operations.
Management has established our operating policies and strategies set forth in
this prospectus. These policies and strategies may be modified or waived by the
Board of Directors, subject in some cases to approval by a majority of the
independent directors, without stockholder approval. The ultimate effect of
these changes may adversely affect our operations.
11
<PAGE>
Mortgage Lending Operation
Changes in interest rates may adversely affect results of operations.
Any period of unexpected or rapid changes in interest rates is likely to
adversely affect results of our operations. For example, a substantial or
sustained increase in interest rates could adversely affect our ability to
acquire non-conforming mortgage loans in expected volumes necessary to support
fixed overhead expense levels. Decrease in interest rates generally cause
mortgage loans in the portfolio to prepay more quickly. This could result in
our amortizing more of the premium we paid for the mortgage loans and would,
therefore, decrease net interest income.
Intense competition in the mortgage loan industry may result in reduced net
income or in revised underwriting standards which would adversely affect
operations.
NovaStar Financial and NovaStar Mortgage face intense competition, primarily
from commercial banks, savings and loans, other independent mortgage lenders,
and other mortgage REITs. We face competition from lenders with established
positions in the national market and particular geographic markets in which we
operate. Competition can take place on various levels, including convenience in
obtaining a loan, service, marketing, origination channels and pricing.
The non-conforming market is currently undergoing substantial changes. There
are new entities leaving and entering into the market creating a changing
competitive environment. Furthermore, some large national finance companies and
prime mortgage originators have begun to implement plans to adapt their prime
mortgage loan origination programs and to allocate resources to the origination
of non-conforming mortgage loans. Some of these larger mortgage companies and
commercial banks have begun to offer products similar to those which are
offered by NovaStar Mortgage and have begun to target customers similar to
those targeted by NovaStar Mortgage. In the future, NovaStar Mortgage may also
face competition from government sponsored entities, such as Fannie Mae and
Freddie Mac, formerly known as FNMA and FHLMC, respectively. For example,
Freddie Mac has issued securities collateralized by non-conforming mortgage
loans originated by a financial institution.
The entrance of these competitors into NovaStar Mortgage's market could have
a material adverse effect on our operating results and on our financial
condition. Increased competition could result in either reduced net interest
income on non-conforming mortgage loans compared to present levels or in
revised underwriting standards permitting higher loan-to-value ratios on
properties securing non-conforming mortgage loans. Increased competition may
also increase the demand for NovaStar Mortgage's experienced personnel and the
potential that such personnel will leave NovaStar for its competitors. There is
no assurance that NovaStar Mortgage will be able to compete successfully in
this market environment. Any failure in this regard could have a material
adverse effect on our operating results and on our financial condition.
Fluctuations in interest rates and general and localized economic conditions
may also affect the competition NovaStar Mortgage faces. Competitors with lower
costs of capital have a competitive advantage over us. During periods of
declining rates, competitors may solicit our customers to refinance their
loans. In addition, during periods of economic slowdown or recession, our
borrowers may face financial difficulties and be more receptive to the offers
of our competitors to refinance their mortgage loans.
Higher loan-to-value ratios increase the risk that we may not recover, on
default, full amounts due on mortgage loans.
Our current underwriting guidelines allow for the acquisition of originated
loans with up to a 95% loan-to-value ratio. The higher the loan-to-value ratio,
the greater the risk that we may be unable to recover full amounts due on our
mortgage loans when a borrower defaults and we foreclose and sell the
underlying collateral. As of December 31, 1999, the average loan-to-value ratio
of our mortgage loan portfolio was 80.0%. Our failure to adequately address the
risk of high loan-to-value products would have a material adverse effect on our
operating results, our financial condition and our business prospects.
12
<PAGE>
Loans made to non-conforming mortgage borrowers entail higher delinquency and
loss rates.
Lenders in the non-conforming mortgage banking industry make loans to
borrowers who have impaired or limited credit histories, limited documentation
of income and higher debt-to-income ratios than traditional mortgage lenders
allow. Mortgage loans made to non-conforming mortgage borrowers generally
entail a higher risk of delinquency and foreclosure than mortgage loans made to
borrowers with better credit and may result in higher levels of realized loss.
Most of our mortgage loans are made to borrowers who do not qualify for
mortgage loans from conventional mortgage lenders. As of December 31, 1999,
6.9% of our mortgage loan portfolio was comprised of mortgage loans made to
borrowers graded "C" and 1.2% of our portfolio was comprised of mortgage loans
made to borrowers graded "D", "C" and "D" being our two lowest credit grade
classifications. There is no assurance that our underwriting criteria or
methods will afford adequate protection against the higher risks associated
with mortgage loans made to non-conforming mortgage loan borrowers. Our failure
to adequately address the risk of non-conforming lending would have a material
adverse impact on our operating results, our financial condition and our
business prospects.
Failure to renew or obtain adequate funding under warehouse facilities and
repurchase agreements may materially adversely impact our lending operations.
We finance substantially all of our mortgage loans through interim financing
facilities including our bank warehouse credit line and repurchase agreements,
and with equity. These borrowings have been and will be repaid with the net
proceeds we receive from financing mortgage loans through securitization or
sales for cash. We are dependent upon a few lenders to provide the primary
credit facilities for our mortgaging loan originations and acquisitions. Any
failure to renew or obtain adequate funding under these financing arrangements,
find buyers for mortgage loan originations or issue asset-backed bonds could
have a material adverse impact on our lending operations.
Financing with repurchase agreements may lead to margin calls if the market
value of mortgage assets declines.
In a repurchase agreement, we sell an asset and agree to repurchase the same
asset at some period in the future. Generally, the repurchase agreements we
enter into stipulate that we must repurchase the asset in 30 days. These
arrangements are treated as secured financings. The amount we can borrow under
these arrangements is generally 96% to 98% of the asset market value. When
asset market values decrease, we are required to repay the margin, or
difference in the market value. To the extent the market values of assets
financed with repurchase agreements decline rapidly, we will be required to
meet cash margin calls. If cash is unavailable, we may be forced to default
under the terms of the repurchase agreement. In that event, the lender retains
the right to liquidate the collateral to settle the amount we then owe.
Interest rate fluctuations may adversely affect the value of our mortgage
loans in process or held for sale or securitization.
Changes in interest rates can have a variety of effects on our mortgage loan
origination business. The market value of fixed-rate mortgage loans has a
greater sensitivity to changes in market interest rates than adjustable rate
mortgage loans. To the extent an interest rate is established for a mortgage
loan in process prior to the time such mortgage loan is funded, a gain or loss
on the sale of the mortgage loan may result from changes in interest rates
during the period between the time the interest rate is established and the
time the mortgage loan is committed for sale. A sharp rise in interest rates or
increasing market concern about the value or liquidity of a type or types of
mortgage loans being held by us will reduce the market value of the mortgage
loans. This may cause lenders to require additional collateral. Even with
stable or declining interest rates, the market value of the type of mortgage
loans we hold could decrease, making long term securitization expensive or
unavailable. In addition, our results of operations from our origination of
mortgage loans can be adversely affected to the extent rising interest rates
decrease the volume of mortgage loan originations and the revenue derived
therefrom.
13
<PAGE>
Competition with other prospective purchasers of mortgage loans for business
with independent brokers and lenders may result in fluctuations in volume and
cost of acquiring mortgage loans.
NovaStar Financial and NovaStar Mortgage depend in large part upon
independent mortgage loan brokers and mortgage lenders for originations and
purchases of new mortgage loans. Our competitors also seek to establish
relationships with brokers and mortgage lenders. Our future results may become
more exposed to fluctuations in the volume and cost of acquiring our mortgage
loans resulting from competition from other prospective purchasers of mortgage
loans.
New laws and regulations, new administrative or judicial interpretations or
our failure to comply with existing federal, state, and local legislation or
regulation could adversely affect our operations.
Members of Congress and government officials from time to time have suggested
the elimination of the mortgage interest deduction for federal income tax
purposes, either entirely or, in part, based on borrower income, type of
mortgage loan or principal amount. Because many of our mortgage loans will be
made to borrowers for the purpose of consolidating consumer debt or financing
other consumer needs, the competitive advantages of tax deductible interest,
when compared with alternative sources of financing, could be eliminated or
seriously impaired by such government action. Accordingly, the reduction or
elimination of these tax benefits could have a material adverse effect on the
demand for mortgage loans offered by us.
The Clinton Administration's 2001 year budget includes a proposal that would
increase the amount of a REIT's taxable income that must be distributed during
the year in order to avoid imposition of the 4% excise tax from the current 85%
to 98%. The Administration also proposed a provision that would bar any entity
from electing REIT status if 50% or more of its stock were owned by another
corporation. Management does not believe that these proposals will have a
material effect on NovaStar Financial's business and operations.
The businesses of NovaStar Financial and NovaStar Mortgage are subject to
extensive regulation, supervision and licensing by federal, state and local
governmental authorities. They are also subject to various laws and judicial
and administrative decisions imposing requirements and restrictions on all or
part of the businesses' operations. There can be no assurance that we will
maintain compliance with these requirements in the future without additional
expenses, or that more restrictive local, state or federal laws, rules and
regulations will not be adopted or that existing laws and regulations will not
be interpreted in a more restrictive manner, which would make compliance more
difficult for us. Failure to comply with these requirements can lead to loss of
approved status, termination or suspension of servicing contracts without
compensation to the servicer, demands for indemnifications or mortgage loan
repurchases, rights of rescission for mortgage loans, class action lawsuits and
administrative enforcement actions, all of which could cause a material adverse
impact on our profitability.
These laws and regulations are subject to legislative, administrative and
judicial interpretation, and some have been infrequently interpreted or only
recently enacted, all of which can result in ambiguity with respect to
permitted conduct. Any ambiguity under the regulations to which we are subject
may lead to regulatory investigations or enforcement actions and private causes
of action, such as class action law suits, with respect to our compliance with
the applicable laws and regulations. As a mortgage lender, NovaStar Mortgage
will be subject to regulatory enforcement actions and private causes of action
from time to time with respect to its compliance with applicable laws and
regulations.
Failure to comply with future regulatory interpretations or judicial decisions
regarding broker compensation programs may adversely affect results of
operations.
Future regulatory interpretations or judicial decisions may require us to
change our broker compensation programs or else face material monetary
judgments or other penalties. Any such changes or penalties may have a material
adverse effect on our operating results, financial condition and on our
business prospects. Several law suits have been filed against a number of
mortgage lenders alleging that such lenders have violated the Real Estate
14
<PAGE>
Settlement Procedures Act, commonly called RESPA, by making payments to
independent mortgage brokers. These lawsuits have generally been filed on
behalf of a purported nationwide class of borrowers and allege that payments
made by a lender to a broker in addition to payments made by the borrower to a
broker are prohibited by the Real Estate Settlement Procedure Act, and are
therefore illegal. Several federal district courts construing RESPA in these
cases have reached conflicting results. In 1998, the United States Court of
Appeals for the Eleventh Circuit ruled in two decisions in Culpepper v. Inland
Mortgage Corporation that the payment by the lender to the broker in the
circumstance of that particular case constituted a prohibited referral fee
under the Real Estate Settlement Procedure Act. The case was remanded to the
district court for further proceedings. If the pending cases on lender payments
to brokers are ultimately resolved against the lenders, it may cause an
industry-wide change in the way independent mortgage brokers are compensated.
Our broker compensation programs currently utilize such payments.
Contamination of properties securing mortgage loans by hazardous substances
would result in our facing environmental liabilities.
Properties securing mortgage loans may be contaminated by hazardous
substances. As a result, the value of the real property may be diminished. In
the event that we are forced to foreclose on a defaulted mortgage loan on that
property, we may be subject to environmental liabilities regardless of whether
we were responsible for the contamination. While we intend to exercise due
diligence to discover potential environmental liabilities prior to the
acquisition of any property through foreclosure, hazardous substances or
wastes, contaminants, pollutants or sources thereof may be discovered on
properties during our ownership or after a sale thereof to a third party. If
such hazardous substances are discovered on properties, we may be required to
remove those substances or sources and clean up the property. The company may
also be liable to tenants and other users of neighboring properties. Such
clean-up costs and liabilities may be extensive and may materially and
adversely affect our results of operations. In addition, we may find it
difficult or impossible to sell the property prior to or following any such
clean-up.
Acquisition and Management of a Portfolio of Mortgage Assets
General economic and financial conditions in mortgage and financial markets
may affect our results of operations.
The results of our mortgage assets portfolio operation are affected by
various factors, many of which are beyond our control. The performance of our
mortgage assets portfolio depends on, among other things, the level of net
interest income generated by our mortgage assets, the market value of such
mortgage assets and the supply and demand for such mortgage assets. Our net
interest income varies primarily as a result of changes in short-term interest
rates, borrowing costs and prepayment rates, the behavior of which involve
various risks and uncertainties as set forth below. Prepayment rates, interest
rates, borrowing costs and credit losses depend upon the nature and terms of
the mortgage assets, the geographic location of the properties securing the
mortgage loans included in or underlying the mortgage assets, conditions in
financial markets, the fiscal and monetary policies of the U.S. government and
the Board of Governors of the Federal Reserve System, international economic
and financial conditions, competition and other factors, none of which can be
predicted with any certainty. Because changes in interest rates may
significantly affect our activities, our operating results depend, in large
part, upon our ability to manage our interest rate and prepayment risks while
maintaining our status as a REIT. Prolonged failure to manage such risks would
adversely affect our results of operations.
Interest rate fluctuations may result in a decrease in net interest income.
Our adjustable rate mortgage loans bear adjustable interest or pass-through
rates based on short-term interest rates, and substantially all of our
borrowings bear interest at short-term rates and have maturities of less than
one year. Consequently, changes in short-term interest rates may significantly
influence our net interest income. While rising short-term interest rates
generally increase the yields on our adjustable rate mortgage
15
<PAGE>
loans, rising short-term interest rates also increase the cost of our
borrowings which are utilized to fund the mortgage loans. To the extent such
costs escalate more rapidly than the yields, our net interest income may be
reduced or a net loss may result. Conversely, falling short-term interest rates
may decrease the interest cost on our borrowings more rapidly than the yields
on the mortgage loans and hence may increase our net interest income. There is
no assurance as to the amount or timing of changes in interest rates or their
effect on our mortgage assets or net interest income.
As of December 31, 1999, 62.4% of our mortgage loans, $386.4 million, had
adjustable rate characteristics. Adjustable rate mortgage loans, commonly
called ARMs, are inherently riskier than fixed rate mortgage loans. These loans
have interest rates that may rise, resulting in higher mortgage payments for
the borrower. Adjustable rate mortgage loans are usually underwritten at a
higher interest rate, to ensure that the borrower has the ability to make
mortgage payments as the rate on the mortgage loan increases. An increasing
interest rate environment will force the borrower to make higher mortgage
payments, which could result in higher delinquencies, foreclosures and losses.
Interest rates on our borrowings adjust differently than those on related
adjustable rate mortgages which may adversely affect our net interest income.
A substantial portion of all mortgage loans we own have adjustable terms
today or are fixed today, but will adjust at some point in the future. Interest
rates on our borrowings are and generally will be based on short-term indices.
To the extent any of our mortgage loans are financed with borrowings bearing
interest based on or varying with an index different from that used for the
related mortgage assets, so-called "basis" interest rate risk will arise. In
this event, if the index used for the mortgage assets is a "lagging" index,
such as the 11th District Cost of Funds, that reflects market interest rate
changes on a delayed basis, and the rate borne by the related borrowings
reflects market rate changes more rapidly, our net interest income will be
adversely affected in periods of increasing market interest rates.
Additionally, our adjustable rate mortgage loans will be subject to periodic
rate adjustments which may be more or less frequent than the increases or
decreases in rates borne by the borrowings or financing we utilize.
Accordingly, in a period of increasing interest rates, we could experience a
decrease in net interest income or a net loss because the interest rates on
borrowings could adjust faster than the interest rates on our adjustable rate
mortgages or mortgage assets backed by adjustable rate mortgages.
As of December 31, 1999, 62.4% of our mortgage loans bear rates that adjust
semiannually, annually or are fixed for two or three years and adjust annually
thereafter. All of our borrowings bear variable rates of interest. Rates on our
repurchase agreements are variable based on the terms to maturity of individual
agreements. As of December 31, 1999, these repurchase agreements were tied to
one-month LIBOR. The rate on our warehouse line of credit adjusts based upon
the federal funds rate.
Interest rate caps on adjustable rate mortgages may adversely affect our net
interest income.
Adjustable rate mortgage loans are typically subject to periodic and lifetime
interest rate caps that limit the amount an adjustable rate mortgage interest
rate can change during any given period. Our borrowings will not be subject to
similar restrictions. Hence, in a period of rapidly increasing interest rates,
we could also experience a decrease in net interest income or a net loss in the
absence of effective hedging because the interest rates on borrowings could
increase without limitation while the interest rates on our adjustable rate
mortgages and mortgage assets backed by adjustable rate mortgages would be
limited by caps. Further, some adjustable rate mortgages may be subject to
periodic payment caps that result in some portion of the interest accruing on
the adjustable rate mortgage being deferred and added to the principal
outstanding. This could result in our receipt of less cash income on our
adjustable rate mortgages than is required to pay interest on the related
borrowings, which will not have such payment caps.
16
<PAGE>
Changes in anticipated prepayment rates may adversely affect net interest
income.
Prepayment rates vary from time to time and may cause changes in the amount
of our net interest income. Prepayments of adjustable rate mortgages and
mortgage assets backed by adjustable rate mortgages usually can be expected to
increase when mortgage interest rates fall below the then-current interest
rates on such adjustable rate mortgages and decrease when mortgage interest
rates exceed the then-current interest rate on adjustable rate mortgages,
although such effects are not predictable. Prepayment experience may also be
affected by the geographic location of the property securing the mortgage
loans, the assumability of the mortgage loans, conditions in the housing and
financial markets and general economic conditions. In addition, prepayments on
adjustable rate mortgages are affected by the ability of the borrower to
convert an adjustable rate mortgage to a fixed-rate mortgage loan by conditions
in the fixed-rate mortgage market. If the interest rate on adjustable rates
mortgage increase at a rate greater than the interest rate on fixed-rate
mortgage loans, prepayments on adjustable rate mortgages may tend to increase.
In periods of fluctuating interest rates, interest rates on adjustable rate
mortgages may exceed interest rates on fixed-rate mortgage loans, which may
tend to cause prepayments on adjustable rate mortgages to increase at a rate
greater than anticipated. We will seek to minimize prepayment risk through a
variety of means to the extent they are available to us at reasonable cost at
various points in time. These means may include structuring a diversified
portfolio with a variety of prepayment characteristics, investing in mortgage
assets with prepayment prohibitions and penalties and investing in mortgage
security structures which have prepayment protection. In addition, we may
purchase interest-only strips to a limited extent. The basis risk that will
exist between an interest-only strips and the other assets in the portfolio
could increase our risk in interest rate environments where interest-only strip
would amortize quickly.
Changes in anticipated prepayment rates of mortgage assets could affect us in
several adverse ways. Faster than anticipated prepayment of any mortgage asset
that we purchased at a premium would generally result in a faster than
anticipated write-off of any remaining capitalized premium amount and
consequent reduction of our net interest income by such amount. A portion of
the adjustable-rate single family mortgage loans which we may acquire, either
directly as mortgage loans or through mortgage securities backed by adjustable
rate mortgages, will generally bear initial interest rates which are lower than
their "fully-indexed" rates. In the event that such an asset prepays faster
than anticipated prior to or soon after the time of adjustment to a fully-
indexed rate, we will have experienced an adverse effect on our net interest
income during the time we held such adjustable rate mortgage compared with
holding a fully-indexed adjustable rate mortgage and will have lost the
opportunity to receive interest at the fully-indexed rate over the expected
life of the adjustable rate mortgage
Subprime borrowers are frequently in a unique position to receive economic
gain from refinancing due to improving their mortgage and consumer credit
profiles through timely payments on outstanding loans. As a result, a subprime
borrower may be able to lower the rate on their home loan without a change in
interest rates.
Failure to hedge effectively against interest rate changes may adversely
affect results of operations.
Our operating strategy subjects us to interest rate risks. We follow an
asset/liability management program intended to protect against interest rate
changes and prepayments. Nevertheless, developing an effective asset/liability
management strategy is complex and no strategy can completely insulate us from
risks associated with interest rate changes and prepayments. In addition, there
is no assurance that our hedging activities will have the desired beneficial
impact on our operating results or financial condition. Hedging typically
involves costs, including transaction costs, which increase dramatically as the
period covered by the hedge increases and which also increase during periods of
rising and volatile interest rates. We may increase our hedging activity, and
thus increase our hedging costs, during such periods when interest rates are
volatile or rising and hedging costs have increased. Moreover, federal tax laws
applicable to REITs may substantially limit our ability to engage in
asset/liability management transactions. Such federal tax laws may prevent us
from effectively implementing hedging strategies that we determine, absent such
restrictions, would best insulate us from the risks associated with changing
interest rates and prepayments.
17
<PAGE>
Limitations on effective hedging may adversely affect attempts to mitigate
risk of variable rate liabilities.
We purchase interest rate caps and interest rate swaps to attempt to mitigate
the risk of variable rate liabilities increasing at a faster rate than the
earnings on its assets during a period of rising interest rates. In this way,
we intend generally to hedge as much of the interest rate risk as we determine
is in our best interests given the cost of such hedging transactions and the
need to maintain our status as a REIT. In this regard, the amount of income we
may earn from interest rate swaps and caps is subject to substantial
limitations under the REIT provisions of the Code. We may hedge the risk of our
borrowing costs on our variable rate liabilities increasing faster than our
income, due to the effect of the periodic and lifetime caps on our mortgage
assets, through the acquisition of
. qualified REIT assets, such as interest-only REMIC regular interests,
that function in a manner similar to hedging instruments;
. qualified hedges, the income from which qualifies for the 95% income
test, but not the 75% income test for REIT qualification purposes; and
. other hedging instruments, whose income qualifies for neither the 95%
income test nor the 75% income test.
The latter form of hedging may be accomplished through one of our taxable
affiliates.This determination may result in our election to bear a level of
interest rate risk that could otherwise be hedged when we believe, based on all
relevant facts, that bearing such risk is advisable.
Hedging poses a credit risk.
In the event that we purchase interest rate caps or other interest rate
agreements to hedge against lifetime and periodic rate or payment caps, and the
provider of interest rate agreements becomes financially unsound or insolvent,
we may be forced to unwind our interest rate agreements with such provider and
may take a loss on such interest rate agreements. Although we intend to
purchase interest rate agreements only from financially sound institutions and
to monitor the financial strength of such institutions on a periodic basis,
there is no assurance that we can avoid such third party risks.
Hedging poses a legal risk.
We accept legal risk in entering into interest rate swap and cap agreements.
No assurance can be given as to the enforceability of these agreements. An
agreement that is not enforceable may subject us to unexpected interest rate
risk and have a material adverse affect on results of operations.
Hedging poses a basis risk.
We also accept basis risk in entering into interest rate swap and cap
agreements. Basis risk occurs as the performance of hedged financing sources
vary from expectations and differ from the performance of the hedging
instrument. For instance, we hedge our borrowing to mitigate interest rate risk
of mortgage assets that are fixed or we reprice at different times or based on
different indices. Although the hedging item may reduce interest rate risk,
borrowers may prepay at speeds which vary from initial expectation. Absent
proper monitoring, we could have a hedging instrument in place without an
underlying financing source. The consequence of which may be a material adverse
effect on results of operations.
We are not regulated in regards to our hedging activities. However, in order
to maintain our exemption from the registration requirements of the Commodities
Exchange Act, we are limited with respect to investments in futures contracts,
options on futures contracts and options on commodities.
18
<PAGE>
We face loss exposure on single family mortgage assets.
A substantial portion of our investment portfolio consists of single family
mortgage loans or mortgage assets evidencing interests in single family
mortgage loans. We will generally bear the risk of loss on any such mortgage
assets we purchase in the mortgage market or through our mortgage lending
business. To the extent third parties have been contracted to provide the
credit enhancement, we are dependent in part upon the credit worthiness and
claims-paying ability of the insurer and the timeliness of reimbursement in the
event of a default on the underlying obligations. Further, the insurance
coverage for various types of losses is limited in amount and losses in excess
of the limitation would be borne by us.
Accordingly, during the time we hold such mortgage loans, we will be subject
to risks of borrower defaults and bankruptcies and special hazard losses that
are not covered by standard hazard insurance, such as those occurring from
earthquakes or floods. In the event of a default on any single family mortgage
loan held by us, including, without limitation, resulting from higher default
levels as a result of declining property values and worsening economic
conditions, among other factors, we would bear the risk of loss of principal to
the extent of any deficiency between the value of the related real property,
plus any payments from an insurer or guarantor, and the amount owing on the
mortgage loan. Defaulted mortgage loans would also cease to be eligible
collateral for borrowings and would have to be financed by us out of other
funds until ultimately liquidated, resulting in increased financing costs and
reduced net income or a net loss.
We may pool and finance or sell through securitizations a substantial portion
of the single family mortgage loans we acquire. In securitizations, we continue
to bear risk of loss on the underlying mortgage loans.
We face loss exposure due to the credit risks of non-conforming mortgage
loans.
Credit risks associated with non-conforming mortgage loans may be greater
than those associated with prime mortgage loans that conform to Fannie Mae and
Freddie Mac guidelines. The principal difference between non-conforming
mortgage loans and conforming mortgage loans include the applicable loan-to-
value ratios, the credit and income histories of the borrowers, the
documentation required for approval of the borrowers, the types of properties
securing the mortgage loans, loan sizes and the borrowers occupancy status with
respect to the mortgaged property. As a result of these and other factors, the
interest rates charged on non-conforming mortgage loans are often higher than
those charged for conforming mortgage loans. The combination of different
underwriting criteria and higher rates of interest may lead to higher
delinquency rates and/or credit losses for non-conforming as compared to
conforming mortgage loans and could have an adverse effect on us to the extent
that we invest in those mortgage loans or securities secured by such mortgage
loans.
We face loss exposure due to the underlying real estate.
Many of the risks of holding subprime mortgage loans and retaining, after
securitization, credit risk derived therefrom reflect the risks of investing
directly in the real estate securing the underlying mortgage loans. This may be
especially true in the case of a relatively small or less diverse pool of
subprime mortgage loans. In the event of a default on the underlying mortgage
loan, the ultimate extent of the loss, if any, may only be determined after a
foreclosure of the mortgage encumbering the property and, if the lender takes
title to the property, upon liquidation of the property. Factors such as the
title to the property or its physical condition, including environmental
considerations, may make a third party unwilling to purchase the property at a
foreclosure sale or for a price sufficient to satisfy the obligations with
respect to the related mortgage securities. Foreclosure laws in various states
may extend the foreclosure process. In addition, the condition of a property
may deteriorate during the pendency of foreclosure proceedings. Some borrowers
on underlying mortgages may become subject to bankruptcy proceedings, in which
case the amount and timing of amounts due may be materially adversely affected.
19
<PAGE>
Market factors may limit our ability to acquire mortgage assets at yields
which are favorable relative to borrowing costs.
Our net income depends, in large part, on our ability to acquire mortgage
assets at favorable spreads over our borrowing costs. In acquiring mortgage
assets, we compete with other REITs, securities dealers, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, other
lenders, Ginnie Mae, Fannie Mae, Freddie Mac and other entities purchasing
mortgage assets. In addition, there are several mortgage REITs similar to us,
and others may be organized in the future. The effect of the existence of
additional REITs may be to increase competition for the available supply of
mortgage assets suitable for our purchase.
Despite management's experience in the acquisition of mortgage assets and its
relationships with various mortgage suppliers, there is no assurance that we
will be able to acquire sufficient mortgage assets from mortgage suppliers at
spreads above our cost of funds. We will also face competition for financing
sources, and the effect of the existence of additional mortgage REITs may be to
deny us access to sufficient funds to carry out our business strategy and/or to
increase the cost of funds to us.
We face substantial leverage and potential net interest and operating losses
in connection with borrowings.
We employ a financing strategy to increase the size of our mortgage asset
portfolio by borrowing a substantial portion of the market value of our
mortgage assets. The portion borrowed may vary depending upon the mix of the
mortgage assets in our portfolio and the application of our policies with
respect to such mix of mortgage assets. If the returns on the mortgage assets
purchased with borrowed funds fail to cover the cost of the borrowings, we will
experience net interest losses and may experience net losses. In addition, due
to increases in haircuts, i.e., the discount from face value applied by a
lender or purchaser with respect to our mortgage securities, decreases in the
market value of our mortgage assets, increases in interest rate volatility,
availability of financing in the market, circumstances then applicable in the
lending market and other factors, we may not be able to achieve the degree of
leverage we believe to be optimal. This may cause us to be less profitable than
we might be otherwise. As of December 31, 1999, our equity represented 14.7% of
assets.
Our failure to refinance outstanding borrowings on favorable terms may affect
results of operations.
Additionally, our ability to achieve our investment objectives depends not
only on our ability to borrow money in sufficient amounts and on favorable
terms but also on our ability to renew or replace on a continuous basis our
maturing short-term borrowings. Our business strategy relies on short-term
financing agreements to fund mortgage asset originations and purchases. We have
not at the present time entered into any commitment agreements under which a
lender would be required to enter into new borrowing agreements during a
specified period of time; however, we may enter into one or more of such
commitment agreements in the future if deemed favorable. In the event we are
not able to renew or replace maturing borrowings, we could be required to sell
mortgage assets under adverse market conditions and could incur losses as a
result. In addition, in such event, we may be required to terminate hedge
positions, which could result in further costs to us. An event or development
such as a sharp rise in interest rates or increasing market concern about the
value or liquidity of a type or types of mortgage assets in which our portfolio
is concentrated will reduce the market value of the mortgage assets, which
would likely cause lenders to require additional collateral. At the same time,
the market value of the mortgage assets in which our liquidity capital is
invested may have decreased. A number of such factors in combination may cause
us difficulties, including a possible liquidation of a major portion of our
mortgage assets at disadvantageous prices with consequent losses, which could
have a materially adverse effect on our profitability and our solvency.
A majority of our borrowings are collateralized borrowings, primarily in the
form of reverse repurchase agreements and similar borrowings, the availability
of which are based on the market value of the mortgage assets pledged to secure
the specific borrowings, availability of financing in the market, circumstances
then applicable in the lending market and other factors. The cost of borrowings
under reverse repurchase agreements
20
<PAGE>
generally corresponds to LIBOR or the federal funds rate plus a spread. The
cost of borrowings under other sources of funding which we may use may refer or
correspond to other short-term indices, plus a margin. The margins on such
borrowings over or under LIBOR, the federal funds rate or such other short-term
indices vary depending upon the lender, the nature and liquidity of the
underlying collateral, the movement of interest rates, the availability of
financing in the market and other factors. If the actual cash flow
characteristics are other than as expected, we may experience reduced net
interest income.
Decline in market value of mortgage assets may limit our ability to borrow,
result in lenders initiating margin calls and require us to sell mortgage
assets in adverse market conditions.
A decline in the market value of our portfolio of mortgage assets may limit
our ability to borrow or result in lenders initiating margin calls. A lender's
margin call requires a pledge of cash or additional mortgage assets to re-
establish the ratio of the amount of the borrowing to the value of the
collateral. This remains true despite the employment of hedging strategies. We
could be required to sell mortgage assets under adverse market conditions in
order to maintain liquidity. Such sales may be effected by management when
deemed by it to be necessary in order to preserve our capital base. If these
sales were made at prices lower than the amortized cost of the mortgage assets,
we would experience losses. A default by us under our collateralized borrowings
could also result in a liquidation of the collateral, including any cross-
collateralized assets, and a resulting loss of the difference between the value
of the collateral and the amount borrowed. Additionally, in the event of our
bankruptcy, reverse repurchase agreements may qualify for special treatment
under the bankruptcy laws, the effect of which is, among other things, to allow
the creditors under such agreements to avoid the automatic stay provisions of
the bankruptcy laws and to liquidate the collateral under such agreements
without delay. Conversely, in the event of the bankruptcy of a party with whom
we had a reverse repurchase agreement, we might experience difficulty
recovering the collateral subject to such agreement if the agreement were to be
repudiated and our claim against the bankrupt lender for any resulting damages
were to be treated simply as one of an unsecured creditor. Should this occur,
our claims would be subject to significant delay. In addition, recoveries, if
and when received, may be substantially less than the damages we actually
suffered. There is no assurance that we will be able to avoid such third-party
risks.
To the extent that we are compelled to liquidate mortgage assets that are
qualified REIT assets to repay borrowings, we may be unable to comply with the
REIT provisions of the Code regarding assets and sources of income
requirements. This could ultimately jeopardize our status as a REIT or could
result in the imposition of substantial taxes and penalties.
Adverse changes in the securitization market could impair our ability to
acquire and finance mortgage loans through securitizations on a favorable or
timely basis.
Any impairment to the securitization market could have a material adverse
effect on our operating results and financial condition. In addition, in order
to gain access to the securitization market, we generally expect to rely upon
credit enhancements provided by one or more monoline insurance carriers. Any
substantial reductions in the size or availability of the securitization market
for our mortgage loans, or the unwillingness of insurance companies to provide
credit enhancement for our mortgage securities could have a material adverse
effect on our operating results and financial condition.
Mortgage loan performance may adversely affect future results.
The delinquency, foreclosure and loss experience to date of the mortgage
loans we have purchased may not be indicative of future results. We do maintain
reserves based on estimated delinquency, foreclosure and loan loss rates.
Actual results may differ from the estimates which may adversely affect our
results of operation.
21
<PAGE>
Illiquidity of investments restricts resale of mortgage securities.
We may invest in mortgage securities, which have been sold in private
placements and have not been registered under the Securities Act. Unregistered
mortgage securities may be subject to restrictions on resale that may limit our
ability to sell them when it might be most desirable to do so. Some of our
investments may lack a regular trading market and may be illiquid. In addition,
during turbulent market conditions, the liquidity of all of our mortgage assets
may be adversely impacted. There is no limit in the percentage of our
investments that may be invested in illiquid mortgage assets.
Lack of geographic diversification of properties underlying mortgage assets
may subject such mortgage assets to greater risk of default in event of
hazards that affect such region.
We seek geographic diversification of the properties underlying our mortgage
assets and have established a diversification policy. Nevertheless, properties
underlying such mortgage assets may be located in the same or a limited number
of geographical regions. For example, as of December 31, 1999, 16% and 14% of
our mortgage loan portfolio was comprised of loans secured by California and
Florida real estate, respectively. To the extent that properties underlying
such mortgage assets are located in the same geographical region, such mortgage
assets may be subject to a greater risk of default than other comparable
mortgage assets in the event of adverse economic, political or business
developments and natural hazard risks that may affect such region and,
ultimately, the ability of property owners to make payments of principal and
interest on the underlying mortgages.
Investment in the Securities in the Offering
Restrictions on ownership of capital stock may inhibit market activity and the
resulting opportunity for holders of our capital stock and warrants to receive
a premium for their securities.
Our charter authorizes the Board of Directors to reclassify any of the
unissued shares of authorized capital stock into a class or classes of
preferred stock. The issuance of preferred stock could have the effect of
making an attempt to gain control of NovaStar Financial more difficult by means
of a merger, tender offer, proxy contest or otherwise. The preferred stock, if
issued, could have a preference on dividend payments over our common stock
which could affect our ability to make dividend distributions to the holders of
our common stock.
In order that we may meet the requirements for qualification as a REIT at all
times, the charter generally prohibits any person from acquiring or holding,
directly or indirectly, shares of capital stock in excess of 9.8% of the
outstanding shares of capital stock.
These provisions may inhibit market activity and the resulting opportunity
for the holders of our capital stock and warrants to receive a premium for
their securities that might otherwise exist in the absence of such provisions.
Such provisions also may make us an unsuitable investment vehicle for any
person seeking to obtain ownership of more than 9.8% of the outstanding shares
of capital stock.
In addition, provisions of Maryland law relating to "business combinations"
and a "control share acquisition" and of our charter and bylaws, e.g.,
staggered terms for directors, may also have the effect of delaying, deterring
or preventing a takeover attempt or other change in control which would be
beneficial to shareholders and might otherwise result in a premium over then
prevailing market prices.
Future sales of securities may dilute the equity of our stockholders or reduce
the price of shares of our common stock.
We expect to increase our capital resources by making additional offerings of
equity and debt securities, including classes of preferred stock, common stock,
commercial paper, medium-term notes, mortgage-backed obligations and senior or
subordinated debt. All debt securities and classes of preferred stock will be
senior to the common stock in the event of our liquidation. Additional equity
offerings may dilute the equity of our
22
<PAGE>
stockholders or reduce the price of shares of our common stock, or both. We are
unable to estimate the amount, timing or nature of additional offerings as they
will depend upon market conditions and other factors.
As of December 31, 1999, options to purchase 357,720 shares of common stock
were outstanding under our stock option plan, which will vest on various dates
extending through July 31, 2003. We filed a Form S-8 registration statement to
permit shares issued pursuant to the exercise of options to be sold.
There is no assurance of an active public trading market.
There is no assurance that an active public trading market for the common
stock will be sustained. Our common stock's trading volume is relatively low
compared to many other securities listed on the New York Stock Exchange. Our
warrants trade through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's bulletin board service. Shares of preferred
stock are available for trading by qualified institutional buyers as defined in
Rule 144A through the PORTAL market. There can be no assurance as to the
development or liquidity of a market for the preferred stock, which will not be
listed on a national securities exchange and will not be authorized for
quotation on Nasdaq. The transferability of both the warrants and the preferred
stock may be extremely limited.
Possible volatility of stock price may adversely impact the liquidity of our
common stock and may result in losses to stockholders who sell shares of
common stock.
In the active trading market for the common stock, the market price of our
common stock may experience fluctuations unrelated to our operating
performance. In particular, the price of our common stock may be affected by
general market price movements as well as developments specifically related to
the finance industry such as interest rate movements and credit quality trends.
It is likely that the market price of our common stock will be influenced by
any variation between the net yield on our mortgage assets and prevailing
market interest rates and by the markets perception of our ability to achieve
earnings growth. Our earnings will be derived primarily from any positive
spread between the yield on our mortgage assets and the cost of our borrowings.
During the period immediately following our receipt of net proceeds from an
offering or other source, prior to the time we have fully implemented our
financing strategy to employ such net proceeds, our earnings and levels of
dividend distributions may be lower than if the financing strategy were fully
implemented, which may affect the market value of our common stock. In
addition, the positive spread between the yield on our mortgage assets and the
cost of borrowings will not necessarily be larger in high interest rate
environments than in low interest rate environments regardless of our business
strategy to achieve such result. Accordingly, in periods of high interest
rates, our net income and, therefore, the dividend yield on our common stock
may be less attractive compared with alternative investments, which could
negatively impact the price of our common stock. If the anticipated or actual
net yield on our mortgage assets declines or if prevailing market interest
rates rise, thereby decreasing the positive spread between the net yield on the
mortgage assets and the cost of our borrowings, the market price of our common
stock may be materially adversely affected. In addition, if the market price of
other REIT stocks decline for any reason, or there is a broad-based decline in
real estate values or in the value of our portfolio of mortgage assets, the
market price of the common stock may be adversely affected. During any period
when the market price of our common stock has been adversely affected due to
any of the foregoing reasons, the liquidity of our common stock may be
negatively impacted and stockholders who may desire or be required to sell
their shares of common stock may experience losses.
23
<PAGE>
NOVASTAR FINANCIAL, INC.
We were founded by Scott Hartman and Lance Anderson and incorporated in the
State of Maryland on September 13, 1996. We have elected to be a REIT for
federal income tax purposes. As a result of our REIT status, we will be
permitted to deduct dividend distributions to stockholders, thereby effectively
eliminating the "double taxation" that generally results when a corporation
earns income and distributes that income to stockholders in the form of
dividends.
NFI Holding, Inc. was incorporated in the State of Delaware on February 6,
1997. Our founders own equally 100% of the voting common stock of NFI Holding.
We own 100% of the non-voting preferred stock of NFI Holding, for which we
receive 99% of dividends paid by NFI Holding. NFI Holding owns NovaStar
Mortgage, NovaStar Capital, NovaStar Mortgage Funding Corporation II, NovaStar
REMIC Financing Corporation, and NovaStar Home Mortgage. NovaStar Mortgage was
incorporated in the State of Virginia on May 16, 1996. Although NovaStar
Mortgage was formed in 1996, substantial operations did not commence until
January 1997. NovaStar Capital, a Delaware corporation, was incorporated on
September 29, 1998. In February 2000, NovaStar Capital discontinued operations.
NovaStar Mortgage Funding Corporation II and NovaStar REMIC Financing
Corporation were incorporated in the State of Delaware on January 25, 1999.
NovaStar Home Mortgage was created in May of 1999 to provide administrative
services to a select group of brokers. On October 1, 1997, we founded NovaStar
Assets Corporation, a wholly-owned, REIT-qualifying subsidiary, in conjunction
with our first issuance of a collateralized mortgage obligation, and on
December 3, 1997, we founded NovaStar Certificates Financing Corporation, a
second wholly-owned REIT-qualifying subsidiary. NovaStar Capital Access
Corporation, an inactive corporation organized in Delaware on February 26,
1998, is also one of our wholly-owned REIT-qualifying subsidiaries.
As discussed further under "Federal Income Tax Consequences" of this
prospectus, recently adopted legislation will allow REITs to own directly all
of the stock of taxable subsidiaries beginning in the tax year 2001. At
present, REITs are generally limited to holding non-voting preferred stock in
taxable affiliates. The value of all taxable subsidiaries of a REIT will be
limited to 20% of the total value of the REIT's assets. As a result, we expect
to acquire all of the common stock of NFI Holding from Scott Hartman and Lance
Anderson during January 2001.
Our basic function is to manage our mortgage assets. NovaStar Mortgage serves
as a source for loan origination--a primary source of our mortgage loans. In
addition, NovaStar Mortgage services our loans. Through June 30, 1998, we
purchased substantially all of NovaStar Mortgage's loan originations. Beginning
July 1, 1998, NovaStar Mortgage began retaining the loans it originates to be
sold in the open market. During 1999 and 1998, $390.8 million and $133.7
million, respectively, in mortgage loans were sold to unrelated third parties
for cash, recognizing net gains of $10.2 million and $3.0 million,
respectively. Also included in net gains on sales is a $1.6 million gain
recognized in NovaStar Mortgage's securitization transaction in 1999. This
securitization was treated as a sale for accounting and tax purposes.
We are self-advised and self-managed. Our management oversees our day-to-day
operations, subject to supervision by our Board of Directors. Our management
team has considerable expertise in the origination, acquisition and management
of mortgage loans and securities and asset/liability management. The principal
executive offices of NovaStar Financial and NovaStar Mortgage are at
1901 W. 47th Place, Suite 105, Westwood, Kansas 66205, telephone (913) 514-
3500. Novastar Mortgage operates a loan origination facility at 23046 Avenue De
La Carlota, Laguna Hills, California 92653.
24
<PAGE>
USE OF PROCEEDS
We will receive no proceeds from the sale of the preferred stock or warrants
by the selling securityholders, but we will receive the net proceeds from the
sale of common stock underlying the warrants. Net proceeds from the sale of the
underlying common stock will be used to purchase mortgage assets and for
working capital and general corporate purposes. Pending these uses, the net
proceeds may be temporarily invested to the extent consistent with the REIT
provisions of the Code, or alternatively, may be used to temporarily pay down
warehouse borrowing facilities. We anticipate that we will fully invest our net
proceeds in mortgage loans or securities as soon as reasonably practicable upon
receipt of such proceeds. No mortgage assets have been specifically identified
in which to invest our net proceeds of this offering.
DIVIDEND POLICY AND DISTRIBUTIONS
We generally intend to distribute substantially all of our taxable income
each year to our stockholders so as to comply with the REIT provisions of the
Code. Taxable income does not ordinarily equal net income as calculated in
accordance with generally accepted accounting principles. We generally intend
to make dividend distributions quarterly. We intend to distribute any taxable
income remaining after the distribution of the final regular quarterly dividend
each year together with the first regular quarterly dividend payment of the
following taxable year or in a special dividend distributed prior thereto. The
dividend policy is subject to revision at the discretion of the Board of
Directors. All distributions will be made at the discretion of the Board of
Directors. Dividends will depend on taxable income, our financial condition,
maintenance of REIT status and other factors as the Board of Directors deems
relevant.
Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by us as
capital gain or may constitute a tax-free return of capital. We will annually
furnish to each of our stockholders a statement setting forth distributions
paid during the preceding year and their characterization as ordinary income,
capital gains, or return of capital.
No dividends will be paid or set apart for payment on shares of common stock
unless full cumulative dividends have been paid on the preferred stock.
Dividends are payable on the preferred stock quarterly at the rate of 7% per
annum and are cumulative from the date of original issuance in March 1999.
In 1999, we declared dividends of $0.37 per share on preferred stock. No
dividends were declared on common stock in 1999. We declared dividends on
common stock in the amount of $0.28 per share and $1.00 per share during 1997
and 1998, respectively.
25
<PAGE>
DIVIDEND REINVESTMENT PLAN
We may adopt a dividend reinvestment plan for stockholders who wish to
reinvest all or part of their distributions in additional shares of common
stock. Generally, under a dividend reinvestment plan dividends paid with
respect to shares of capital stock are automatically invested in additional
shares of stock at a discount to the then current market price.
Stockholders who own more than a specified number of shares of common stock
will be eligible to participate in the dividend reinvestment plan following the
effectiveness of the registration of securities issuable thereunder. This
offering is not related to the proposed dividend reinvestment plan, nor have we
prepared or filed a registration statement with the SEC registering the shares
to be issued under the dividend reinvestment plan. Prior to buying shares
through the dividend reinvestment plan, participants will be provided with a
dividend reinvestment plan prospectus, which will constitute a part of such
dividend reinvestment plan registration statement. Our transfer agent will act
as the trustee and administrator of the dividend reinvestment plan.
Stockholders will not be automatically enrolled in the dividend reinvestment
plan. Each stockholder desiring to participate in the dividend reinvestment
plan must complete and deliver to the agent an enrollment form, which will be
sent to each eligible stockholder following the effectiveness of the
registration of the shares to be issued under the dividend reinvestment plan.
Participation in the dividend reinvestment plan will commence with all
dividends and distributions payable after receipt of a participant's
authorization, provided that the authorization must be received by the agent at
least two business days prior to the record date for any dividends in order for
any stockholder to be eligible for reinvestment of such dividends.
CAPITALIZATION
The table below sets forth our capitalization as of December 31, 1999 and as
adjusted to give effect to the exercise of all warrants and conversion of
preferred stock.
<TABLE>
<CAPTION>
As of December 31, 1999
------------------------
Actual As Adjusted(1)
-------- --------------
(in thousands)
<S> <C> <C>
Stockholders' Equity:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Common Stock; 8,130,069 (actual) and
13,943,496 (as adjusted) shares issued and
outstanding.................................. $ 81 $ 176
Class B, convertible preferred stock, 4,285,714
shares issued and outstanding.................. 43 --
Additional paid-in capital...................... 151,173 217,439
Accumulated deficit............................. (41,502) (41,502)
Accumulated other comprehensive income.......... 242 242
Cost of treasury stock, 673,400 shares.......... (1,877) (1,877)
Forgivable notes receivable from founders....... (6,846) (6,846)
-------- --------
Total....................................... $101,314 $167,632
======== ========
</TABLE>
- --------
(1) Does not include 357,720 shares of common stock options outstanding under
our stock option plan, of which 187,500 are outstanding to executive
officers and directors. We refer you to "Management--Executive
Compensation."
26
<PAGE>
MARKET PRICES AND DIVIDEND DATA
The common stock of NovaStar Financial is traded on the NYSE under the symbol
"NFI". NovaStar Financial's warrants trade through market makers, such as
Stifel, Nicolaus & Company, Incorporated, using the NASD's bulletin board
service. The following table sets forth, for the periods indicated, the high
and low sales prices per share of common stock on the NYSE and the cash
dividends paid or payable per share of capital stock.
Common Stock
<TABLE>
<CAPTION>
Common Stock
Prices Cash Dividends(1)
----------------- -----------------------------
Date Date Paid Amount
High Low Declared or Payable Per Share
-------- -------- -------- ---------- ---------
<S> <C> <C> <C> <C> <C>
1/1/98 to 3/31/98 21 1/8 15 15/16 12/19/97 1/27/98 $0.10
4/1/98 to 6/30/98 21 16 3/8 3/25/98 4/14/98 $0.30
7/1/98 to 9/30/98 17 13/16 11 3/8 6/23/98 7/14/98 $0.35
10/1/98 to 12/31/98 12 7/8 3 9/22/98 4/15/99 $0.35
1/1/99 to 3/31/99 7 1/4 5 5/8 -- -- --
4/1/99 to 6/30/99 7 1/16 5 5/8 -- -- --
7/1/99 to 9/30/99 6 1/2 3 1/8 -- -- --
10/1/99 to 12/31/99 3 3/4 2 5/8 -- -- --
1/1/00 to 3/31/00 4 3/8 3 1/8 -- -- --
4/1/00 to 4/13/00 4 3 -- -- --
</TABLE>
- --------
(1) NovaStar Financial did not declare dividends on its common stock in 1999.
Preferred Stock(2)
<TABLE>
<CAPTION>
Cash Dividends
--------------------
Date Date Paid Amount
Declared or Payable Per Share
-------- ---------- ---------
<S> <C> <C> <C>
1/1/99 to 3/31/99 4/21/99 5/10/99 $0.01
4/1/99 to 6/30/99 7/21/99 8/10/99 $0.12
7/1/99 to 9/30/99 10/20/99 11/10/99 $0.12
10/1/99 to 12/31/99 12/21/99 1/10/00 $0.12
</TABLE>
- --------
(2) NovaStar Financial issued the class B 7% convertible preferred stock in
March 1999.
Reports provided by NovaStar Financial's third party broker, Corporate
Investors Communication Inc., and transfer agent, UMB Bank, indicate that as of
March 16, 2000, over 2,000 stockholders held NovaStar Financial's 7,245,932
shares of common stock.
NovaStar Financial intends to make distributions to its stockholders of all
or substantially all of its taxable income in each year, subject to certain
adjustments, so as to qualify for the tax benefits accorded to a REIT under the
Code. All distributions will be made by NovaStar Financial at the discretion of
the board of directors and will depend on the earnings of NovaStar Financial,
financial condition of NovaStar Financial, maintenance of REIT status and such
other factors as the board of directors may deem relevant from time to time.
27
<PAGE>
SELECTED FINANCIAL AND OTHER DATA
(dollars in thousands, except per share amounts)
The following selected consolidated financial data are derived from the
audited consolidated financial statements of NovaStar Financial for the periods
presented and should be read in conjunction with the more detailed information
therein and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included elsewhere in this prospectus. Operating results
are not necessarily indicative of future performance.
<TABLE>
<CAPTION>
For the Year Ended December 31, For the Period Ended
------------------------------- December 31, 1996(1)
1999 1998 1997 --------------------
<S> <C> <C> <C> <C>
Consolidated Statement
of Operations Data
Interest income........ $ 66,713 $ 100,747 $ 36,961 $ 155
Interest expense....... 46,758 80,794 28,185 --
Net interest income.... 19,955 19,953 8,776 155
Provision for credit
losses................ 22,078 7,430 2,453 --
Equity in net income
(loss)--NFI Holding
Corporation........... 88 (2,984) 28 --
Gain (loss) on sales of
mortgage assets....... 351 (14,962) 51 --
General and
administrative
expenses.............. 3,735 7,062 7,101 457
Net loss............... (7,092) (21,821) (1,135) (302)
Basic and diluted loss
per share(2).......... (1.08) (2.71) (0.26) (0.08)
<CAPTION>
As of December 31,
----------------------------------------------------------
1999 1998 1997 1996
<S> <C> <C> <C> <C>
Consolidated Balance
Sheet Data
Mortgage Assets:
Mortgage loans......... $ 620,406 $ 945,798 $ 589,318 $ --
Mortgage securities.... 6,775 -- 517,246 13,239
Total assets........... 690,510 997,754 1,126,252 59,811
Borrowings............. 586,868 909,944 1,005,560 --
Stockholders' equity... 101,314 82,808 116,489 46,380
<CAPTION>
As of or for the Year As of or for
Ended December 31, the Period Ended
----------------------------------- December 31, 1996(1)
1999 1998 1997 --------------------
<S> <C> <C> <C> <C>
Other Data
Loans originated by NFI
Holding Corporation:
Principal at purchase.. $ 452,554 $ 878,871 $ 409,974 $ --
Average principal
balance per loan...... $ 101 $ 94 $ 130 $ --
Weighted average
interest rate:
Adjustable rate
mortgage loans....... 9.9% 10.0% 10.1% --
Fixed rate mortgage
loans................ 10.0% 9.9% --
Loans with prepayment
penalties............. 90% 74% 73% --
Weighted average
prepayment period (in
years)(3)............. 2.5 2.4 2.4 --
Annualized return on
assets................ (0.83)% (1.66)% (0.01)% (0.50)%
Annualized return on
equity................ (6.71)% (20.71)% (0.06)% (0.65)%
Taxable income (loss).. $ -- $ (2,628) $ 1,434 $ (173)
Taxable income (loss)
per share............. $ -- $ (0.32) $ 0.18 $ (0.05)
Dividends declared per
common share(4)....... $ -- $ 1.00 $ 0.28 $ --
Dividends declared per
preferred share....... $ 0.37 $ -- $ 0.18 $ --
Number of account
executives............ 47 63 36 --
</TABLE>
- --------
(1) NovaStar Financial, Inc. was formed on September 13, 1996. Operations began
in substance after the initial closing of the private placement on December
9, 1996.
(2) Diluted earnings (loss) per share is based on the weighted average shares
of common stock and preferred stock outstanding, and includes the effect of
warrants and options.
(3) Includes only those mortgage loans with a prepayment penalty.
(4) The level of quarterly common stock dividends is determined by the Board of
Directors based upon its consideration of a number of factors and should
not be deemed indicative of taxable income for the quarter in which
declared or future quarters, or of income calculated in accordance with
generally accepted accounting principles.
28
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the preceding
Selected Consolidated Financial and Other Data and the Consolidated Financial
Statements of NovaStar Financial, Inc. and the Notes thereto, included
elsewhere in this prospectus as well as the annual report on Form 10K of
NovaStar Financial, Inc for the fiscal year ended December 31, 1999.
Safe Harbor Statement
"Safe Harbor" statement under the Private Securities Litigation Reform Act of
1995: Statements in this discussion regarding NovaStar Financial, Inc. and its
business, which are not historical facts, are "forward-looking statements" that
involve risks and uncertainties. Risks and uncertainties, which could cause
results to differ from those discussed in the forward-looking statements
herein, are listed in the "Risk Factors" section of this prospectus. In
addition, there are many important factors that could cause actual results to
differ materially from those indicated in the forward-looking statements. These
factors include, but are not limited to, general economic conditions, interest
rate levels and risk, prepayment speeds, delinquency and loss rates, changes in
the asset securitization industry or the REIT provisions of the Internal
Revenue Code, demand for services and products offered by NovaStar, the impact
of covenants in loan agreements, the degree to which NovaStar Financial is
leveraged, the needs for and availability of financing, access to capital and
other risks identified in NovaStar Financial's Securities and Exchange
Commission filings. In addition, it should be noted that past financial and
operational performance of NovaStar Financial is not necessarily indicative of
future financial and operational performance.
Information
Management intends to provide extensive information about the financial
position and results of operations of NovaStar Financial in a format that is
clear and easy to understand. This report and other published documents are
designed to provide a framework for understanding NovaStar Financial's business
and the associated risks. The manner in which management conducts business and
assesses risks will determine future performance. By providing detailed
information to this extent, investors will be able to evaluate NovaStar
Financial as an investment option and to compare NovaStar Financial with its
competition.
Basis of Presentation
NovaStar Financial owns 100% of the common stock of NovaStar Assets
Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage
Funding Corporation. These entities were established as special purpose
entities used in issuance of collateralized mortgage obligations. The
consolidated financial statements of NovaStar Financial include the financial
condition and results of operations of these entities.
NovaStar Financial also owns 100% of the non-voting preferred stock of NFI
Holding Corporation for which it receives 99% of any dividends paid by NFI
Holding. A significant component of the financial results of NovaStar Financial
are derived from the operations of NovaStar Mortgage, Inc. Scott Hartman and
Lance Anderson, the founders of NovaStar Financial, own the voting common stock
of NFI Holding and receive 1% of any dividends paid by NFI Holding. NovaStar
Mortgage, Inc. and NovaStar Capital are wholly owned subsidiaries of NFI
Holding. Key officers of NovaStar Financial serve as officers of NFI Holding,
NovaStar Mortgage and NovaStar Capital, Inc. The founders are the only members
of the Board of Directors of NFI Holding, NovaStar Mortgage and NovaStar
Capital. NovaStar Home Mortgage, Inc. was created in May of 1999 to provide
administrative services to a select group of brokers. NovaStar Mortgage owns
100% of NovaStar Mortgage Funding Corporation II and NovaStar REMIC Financing
Corporation. Both of these special purpose entities were created in January
1999 for the issuance of real estate mortgage investment conduits
29
<PAGE>
commonly known as REMICs. NovaStar Financial accounts for its investment in NFI
Holding using the equity method.
Recent Developments
Securitization. As of March 31, 2000, we securitized $128 million in non-
conforming loans as part of the first close of securitization 2000-1,
recognizing a gain of $1.5 million. For the issuance of the asset backed bond
of $226,320,000, we will combine an additional $102 million in non-conforming
loans in a second closing. The primary (A-class) bonds were sold to third
parties independent of us and our affiliates. We purchased the subordinated (B-
class) and interest-only bonds and retained the residual. No active trading
market for the purchase and sale of the B-class, interest-only and residual
classes of securities exists. Therefore, management estimates the value of the
security by discounting the expected future cash flow of the collateral and
bonds.
Servicing. On October 20, 1999, NovaStar Mortgage was notified that its
servicing department had received an "Above Average" Residential Servicer
rating from Standard & Poors. An "Above Average" rating signifies a high degree
of efficiency and competency in managing portfolios. In addition, Standard &
Poors approved NovaStar Mortgage as a designated "Special Servicer".
Lending Agreements. NovaStar Financial executed several new lending
arrangements during December 1999. The Company renewed its backup liquidity
line with First Union secured by residual interests in securitized loans. The
facility was increased from $20 million to $25 million and renewed for a
committed two-year period through December 2001. Two committed warehouse
facilities aggregating $250 million with First Union National Bank were renewed
through June 1, 2000. In addition, NovaStar Financial entered into a
$50 million committed warehouse financing arrangement with GMAC/Residential
Funding Corporation (GMAC/RFC). This new facility has a one-year maturity with
terms and conditions similar to that of the First Union warehouse line.
Federal Tax Legislation. Recently adopted legislation will allow REITs to own
directly all of the stock of taxable subsidiaries beginning in the tax year
2001. At present, REITs are generally limited to holding non-voting preferred
stock in taxable affiliates. The value of all taxable subsidiaries of a REIT
will be limited to 20% of the total value of the REIT's assets. Accordingly,
NFI expects to acquire all of the common stock of Novastar Holding, Inc. from
Scott Hartman and Lance Anderson after the beginning of the year 2001.
Also, effective beginning with the 2001 tax year, the minimum dividend
distributions of a REIT will have to equal 90% of taxable income, down from 95%
of taxable income under current law. This provision will also first be
effective beginning with the 2001 tax year. These and other federal tax
legislation changes and proposals are discussed further in NovaStar Financial's
Annual Report on Form 10K under "Federal Income Tax Consequences".
Notes Receivable from Founders
The founders of NovaStar Financial purchased 216,666 units in the Company's
1996 private placement in exchange for forgivable promissory notes. A unit
consisted of one share of convertible preferred stock and one common stock
warrant. Principal on these notes is divided into three equal parts, called
"tranches", and is forgiven if certain incentive performance targets are
achieved. The incentive tests relate to the return generated to investors in
the private placement, including the appreciation in stock price, the value of
the warrants, and dividends paid. One tranche will be forgiven for each fiscal
year NovaStar Financial generates a return of 15% to investors in the private
placement. All three tranches will be forgiven if a return of 100% is generated
within five years.
During the period from the closing of the private placement through December
31, 1997, NovaStar Financial's stock price averaged $17.08 per share, dividends
of $0.28 were declared and the value of each warrant was $2.08. The combination
of these produced a return to investors in the private placement exceeding
30
<PAGE>
15%. As a result, the first tranche of these notes was forgiven resulting in a
non-cash charge of $1,083,000 during the fourth quarter of 1997. NovaStar
Financial did not recognize any forgiveness of the second tranche in 1999 or
1998 as the incentive performance targets were not met.
In March 1998, the founders exercised options to acquire 289,332 shares of
common stock by executing notes payable to NovaStar Financial. The notes bear
interest at one month LIBOR plus 1% are collateralized by the common stock
issued, and are non-recourse in nature which means that NovaStar Financial's
recourse is limited to the collateral. These notes and accrued interest are
classified as part of the contra-equity account, notes receivable from
founders. Unpaid principal on the notes was $4,340,000 as of December 31, 1999
and 1998 while accrued interest on these notes was $339,000 and $142,000,
respectively.
Financial Condition of NovaStar Financial, Inc. as of December 31, 1999 and
December 31, 1998
NovaStar Financial's balance sheets consist primarily of securitized mortgage
loans originated by and purchased from NovaStar Mortgage, which serve as
collateral on its collateralized mortgage obligations. The carrying value of
mortgage loans as of December 31, 1999 was $620 million versus $946 million as
of December 31, 1998. The carrying value of collateralized mortgage obligations
as of December 31, 1999 was $587 million compared with $892 million as of
December 31, 1998. The decline in both balance sheet items is primarily a
result of principal paydowns that occurred during 1999.
31
<PAGE>
Mortgage loans. Table 1 is a presentation of loans as of December 31, 1999
and 1998 and their credit grades. Table 2 is a summary of all mortgage loans
owned by NovaStar Financial as of December 31, 1999 and 1998 by state.
Table 1
Mortgage Loans by Credit Grade
(dollars in thousands)
<TABLE>
<CAPTION>
December 31, 1999 December 31, 1998
--------------------------- ---------------------------
Maximum Weighted Weighted
Allowed Loan- Weighted Average Weighted Average
Credit Mortgage to- Current Average Loan-to- Current Average Loan-to-
Grade Lates(A) value Principal Coupon value Principal Coupon value
------ ---------------------- ------- --------- -------- -------- --------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
AA 0 X 30 95(B) $ 85,476 9.50% 83.2% $120,427 9.51% 83.4%
A 1 X 30 90 244,187 10.06 80.1 366,913 9.84 79.7
A- 2 X 30 90 149,248 10.45 81.8 220,591 10.31 81.3
B 3 X 30, 1 X 60
5 X 30, 2 X 60 85 89,477 10.86 78.4 142,346 10.62 77.9
C 1 X 90 75 42,766 11.35 72.5 64,529 11.13 72.3
D 6 X 30, 3 X 60, 2 x 90 65 7,668 12.16 62.1 13,697 12.14 62.2
-------- --------
Total $618,822 10.31% 80.0% $928,503 10.15% 79.5%
======== ===== ==== ======== ===== ====
</TABLE>
- --------
(A) Represents the number of times a prospective borrower is allowed to be late
more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would
afford the prospective borrower to be more than 30 days late on three
separate occasions and 60 days late no more than one time.
(B) Fixed purchases; all other maximum of 90%.
Table 2
Mortgage Loans by State
Percent of Portfolio
(based on current principal balance)
<TABLE>
<CAPTION>
December 31,
-------------
Collateral Location 1999 1998
------------------- ---- ----
<S> <C> <C>
California............................................... 16% 18%
Florida.................................................. 14 12
Washington............................................... 7 8
Oregon................................................... 5 5
All other states......................................... 58 57
------ ------
Total.................................................. 100% 100%
====== ======
</TABLE>
32
<PAGE>
Table 3 provides a summary of NovaStar Financial's mortgage loans by type and
carrying value as of December 31, 1999 and 1998.
Table 3
Carrying Value of Loans by Product/Type
December 31, 1999 and 1998
(in thousands)
<TABLE>
<CAPTION>
December 31
------------------
Product/Type 1999 1998
------------ -------- --------
<S> <C> <C>
Two and three-year fixed.............................. $343,193 $526,044
Six-month LIBOR and one-year CMT...................... 43,178 91,430
30/15-year fixed and balloon.......................... 232,451 311,029
-------- --------
Outstanding principal............................... 618,822 928,503
Premium............................................... 12,689 20,868
Allowance for credit losses........................... (11,105) (3,573)
-------- --------
Carrying Value...................................... $620,406 $945,798
======== ========
Carrying value as a percent of principal.............. 100.26% 101.86%
======== ========
</TABLE>
Substantially all of mortgage assets are acquired at a premium. Premiums are
amortized as a reduction of interest income over the estimated lives of the
assets. See Tables 4, 5, 6 and 7 for the impact of principal payments on
amortization. To mitigate the effect of prepayments on interest income from
mortgage loans, NovaStar Financial generally strives to acquire mortgage loans
that have some form of prepayment penalty. During 1999, prepayment penalties
collected from borrowers totaled $3.1 million in comparison with $2.0 million
for the same period of 1998. Table 4 is an analysis of mortgage loans and
prepayment penalties.
Table 4
Mortgage Loan Prepayment Penalties
December 31, 1999 and 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Weighted Average
----------------------------------
Percent Remaining
with Loan- Prepayment Penalty
Current Prepayment to- Period (in years)--
Principal Premium Penalty Coupon value Loans with Penalty
--------- ------- ---------- ------ ----- -------------------
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1999
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $ 85,015 $ 3,942 32% 11.04% 75.5% 0.51
1997-2................ 101,031 1,917 35 10.90 79.3 0.55
1998-1................ 195,170 3,205 63 10.08 81.1 0.93
1998-2................ 237,223 3,606 74 9.97 81.1 1.51
All other loans......... 383 19 6 11.96 77.6 0.10
-------- -------
Total................... $618,822 $12,689 58% 10.31% 80.0% 1.03
======== =======
</TABLE>
33
<PAGE>
<TABLE>
<CAPTION>
Weighted Average
------------------------------------
Percent Remaining
with Prepayment Penalty
Current Prepayment Loan-to- Period (in years)--
Principal Premium Penalty Coupon value Loans with Penalty
--------- ------- ---------- ------ -------- -------------------
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $170,118 $ 7,975 65% 10.57% 75.1% 0.89
1997-2................ 170,363 3,403 72 10.37 78.5 1.10
1998-1................ 275,673 4,651 69 10.01 81.1 1.51
1998-2................ 306,586 4,703 71 9.95 81.1 2.09
All other loans......... 5,763 136 65 9.91 80.0 1.59
-------- -------
Total................... $928,503 $20,868 70% 10.15% 79.5% 1.52
======== ======= === ===== ==== ====
</TABLE>
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a better interest rate. Even in rising rate
environments, borrowers tend to collectively repay their mortgage principal
balances earlier than is required by the terms of their mortgages. This is
particularly true for non-conforming borrowers who are seeking to upgrade their
credit rating to obtain a lower interest rate.
Prepayment rates in the table below represent the annualized principal
prepayment rate in the most recent one, three and twelve month periods and over
the life of the pool of loans.
Table 5
Prepayment Speeds
<TABLE>
<CAPTION>
Weighted
Average Age Constant Prepayment Rate (Annual
Current of Loans at Percent)
Principal Inception ---------------------------------------
Issue Date Balance (in months) One-month Three-month Twelve-month Life
----------------- --------- ----------- --------- ----------- ------------ ----
<S> <C> <C> <C> <C> <C> <C> <C>
As of December 31, 1999
NovaStar Home Equity
Series:
1997-1................ October 1, 1997 $ 85,015 7 44 42 50 40
1997-2................ December 11, 1997 101,031 3 64 58 42 32
1998-1................ April 30, 1998 195,170 3 47 36 29 23
1998-2................ August 18, 1998 237,223 3 26 21 21 18
As of December 31, 1998
NovaStar Home Equity
Series:
1997-1................ October 1, 1997 $170,118 7 44 36 33 31
1997-2................ December 11, 1997 170,363 3 42 32 22 21
1998-1................ April 30, 1998 275,673 3 20 17 -- 12
1998-2................ August 18, 1998 306,586 3 18 10 -- 9
</TABLE>
34
<PAGE>
Table 8 summarizes mortgage asset activity during 1999 and 1998 and Table 9
details the amount of premium as a percent of principal at quarter end for 1999
and 1998.
Table 6
Mortgage Assets Activity
(in thousands)
<TABLE>
<CAPTION>
Mortgage
Mortgage Loans Securities Total
------------------ ------------------ -------------------
Principal Premium Principal Premium Principal Premium
--------- ------- --------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31,
1997................... $559,436 $17,861 $ 504,847 $ 8,205 $1,064,283 $26,066
Acquisitions............ 207,976 3,758 270,059 3,806 478,035 7,564
Principal repayments and
amortization........... (27,224) (1,160) (63,892) (731) (91,116) (1,891)
Dispositions............ -- -- (310,113) (5,294) (310,113) (5,294)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1998................... 740,188 20,459 400,901 5,986 1,141,089 26,445
Acquisitions............ 290,350 5,148 80,237 823 370,587 5,971
Principal repayments and
amortization........... (43,849) (1,506) (47,201) (451) (91,050) (1,957)
Dispositions............ (2,843) (53) -- -- (2,843) (53)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1998.. 983,846 24,048 433,937 6,358 1,417,783 30,406
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (54,745) (1,442) (38,925) (493) (93,670) (1,935)
Dispositions............ (4,666) (56) (7,781) (107) (12,447) (163)
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1998................... 924,435 22,550 387,231 5,758 1,311,666 28,308
Acquisitions............ 42,298 458 -- -- 42,298 458
Principal repayments and
amortization........... (62,953) (2,135) (15,215) (173) (78,168) (2,308)
Adjustment(A)........... 25,101 -- -- -- 25,101 --
Dispositions............ (378) (5) (372,016) (5,585) (372,394) (5,590)
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1998................... 928,503 20,868 -- -- 928,503 20,868
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (70,883) (1,830) -- -- (70,883) (1,830)
Dispositions............ (4,446) (79) -- -- (4,446) (79)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1999................... 853,174 18,959 -- -- 853,174 18,959
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (77,650) (2,289) -- -- (77,650) (2,289)
Dispositions............ (364) (12) -- -- (364) (12)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1999.. 775,160 16,658 -- -- 775,160 16,658
Acquisitions............ -- -- 7,243 -- 7,243 --
Principal repayments and
amortization........... (84,772) (2,248) (290) -- (85,062) (2,248)
Dispositions............ -- -- -- -- -- --
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1999................... 690,388 14,410 6,953 -- 697,341 14,410
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (71,566) (1,721) (421) -- (71,987) (1,721)
Dispositions............ -- -- -- -- -- --
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1999................... $618,822 $12,689 $ 6,532 $ -- $ 625,354 $12,689
======== ======= ========= ======= ========== =======
</TABLE>
- --------
(A) Adjustment due to balance sheet reclassifications that were made in 1999
and 1998. See the "Financial Condition of NovaStar Financial as of December
31, 1999 and December 31, 1998" section of this document for a description
of the reclassifications that were made to better match the timing of
principal and interest payments of NovaStar Financial's securitized
mortgage loan portfolio with the principal and interest payments of
collateralized mortgage obligations.
35
<PAGE>
Table 7
Premium as a Percent of Principal
<TABLE>
<CAPTION>
Total
Mortgage Mortgage Mortgage
Loans Securities Assets
-------- ---------- --------
<S> <C> <C> <C>
As of:
December 31, 1999.......................... 2.05% -- % 2.05%
September 30, 1999......................... 2.09 -- 2.09
June 30, 1999.............................. 2.15 -- 2.15
March 31, 1999............................. 2.22 -- 2.22
December 31, 1998.......................... 2.25 -- 2.25
September 30, 1998......................... 2.44 1.49 2.16
June 30, 1998.............................. 2.44 1.47 2.14
March 31, 1998............................. 2.76 1.49 2.32
December 31, 1997.......................... 3.19 1.63 2.45
</TABLE>
Mortgage securities available-for-sale. In September 1999, NovaStar Financial
purchased NovaStar Mortgage's residual interests in the NovaStar Mortgage
Funding Trust Series 99--01 securitization transaction. The NovaStar Mortgage
Funding Trust Series 99--01 transaction is discussed further under the
"Mortgage Loan Sales" section of this document and Note 3 of the consolidated
financial statements. As the owner of the residual certificate, NovaStar
Financial receives the net cash flow of the NovaStar Mortgage Funding Trust
Series 99--01 securitization, which represents the right to receive, over the
life of the securitization, the excess of the weighted average coupon on the
loans securitized over the sum of the interest rate on the bonds, a normal
servicing fee, a trustee fee, an insurance fee and the credit losses relating
to the loans securitized. As of December 31, 1999, the carrying value of the
residual interests was $6.8 million. This value represents the present value of
the residual cashflows that NovaStar Financial expects to receive over the life
of the securitization, taking into consideration estimated prepayment speeds
and credit losses, and is discounted at a rate which management believes is an
appropriate risk-adjusted market rate of return for the residual asset. The
residual cashflows are realized over the life of the securitization as cash
distributions are received from the trust. NovaStar Financial believes its
residual asset is fairly valued as of December 31, 1999 but can provide no
assurance that future prepayment and loss experience or changes in the required
market discount rate will not require write-downs of the residual asset. Write-
downs would reduce the income of future periods and could cause NovaStar
Financial to report net losses.
Some key statistics of the NovaStar Mortgage Funding Trust Series 99--1
mortgage loan collateral and bond as of December 31, 1999 are included in Note
3 of the consolidated financial statements. Delinquency statistics of the 99--1
securitization are disclosed in Tables 20 and 21 of "Financial Condition of NFI
Holding as of December 31, 1999 and December 31, 1998."
Assets Acquired through Foreclosure. As of December 31, 1999, NovaStar
Financial had 192 loans in real estate owned with a carrying value of $16.9
million (principal of $24.4 million) compared to 126 loans with a carrying
value of $10.6 million (principal of $14.5 million) as of December 31, 1998.
Short-term and Long-term Financing Arrangements. Mortgage loan originations
are funded with various financing facilities prior to securitization. Loans
originated have typically been funded initially through a $75 million committed
warehouse line with First Union National Bank under which NovaStar Financial,
NovaStar Mortgage and NovaStar Capital are co-borrowers. These entities
executed a $50 million committed warehouse facility with GMAC/RFC in December
1999 to diversify their funding sources. NovaStar entities also use repurchase
agreements as a means of warehousing loans prior to securitization. At December
31, 1999, First Union provided a $175 million committed facility for such
purposes. In addition, First Union provides a $25 million committed facility
secured by residual interests in asset-backed bonds that is committed through
December 2001. As of December 31, 1999, NovaStar Financial had no borrowings
outstanding under this residual interest facility.
36
<PAGE>
As of December 31, 1998, NovaStar Financial had a short-term financing
arrangement with GMAC/RFC secured by residual interests in NovaStar Financial's
CMOs. In 1998, NovaStar Financial borrowed $15 million from GMAC/RFC, which
included a $3 million financing fee. NovaStar Financial had no other short-term
borrowings outstanding as of December 31, 1998. In February of 1999, NovaStar
Financial used financing sources at First Union to pay this debt in full.
On a long-term basis, NovaStar Financial finances its mortgage loans using
collateralized mortgage obligations commonly called CMOs. Investors in CMOs are
repaid based on the performance of the mortgage loans collateralizing the CMOs.
These non-recourse financing arrangements match the loans with the financing
arrangement for long periods of time, as compared to repurchase agreements that
mature frequently with interest rates that reset frequently and have liquidity
risk in the form of margin calls. Under the terms of its CMOs, NovaStar
Financial is entitled to repurchase the mortgage loan collateral and repay the
remaining CMO when their aggregate principal balance falls below 35% for issue
97-01 and 25% for issues 97-02, 98-01 and 98-02. Subprime mortgage loans are
not readily obtainable financial assets. As a result, NovaStar Financial
retains effective control over the transferred assets as defined in paragraph
9c. of Statement of Financial Accounting Standards (SFAS) No. 125, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities and further clarified by paragraph 30 of SFAS No. 125. Accordingly,
NovaStar Financial records its CMO transactions as secured borrowings, rather
than sales of the transferred loans.
Under its CMOs, NovaStar Financial retains the mortgage loans and incurs the
obligation to pay the CMO bondholders. NovaStar Financial earns the net spread
between the interest income on the loans and the interest expense on the bonds.
The spread earned also is reduced by credit losses on the portfolio.
Prepayments on the mortgage loans serve to reduce the term over which interest
spread is earned. The longer the mortgage collateral is outstanding, the longer
the period of cash flow. To the extent the borrowers prepay, it shortens the
life of the CMO and the period over which cash flow is received. The cash flow
will change when interest rates on the bonds fluctuate at amounts or times that
are different from the mortgage loan collateral, thereby subjecting NovaStar
Financial to interest rate risk. The carrying value of CMOs as of December 31,
1999 was $587 million compared with $892 million as of December 31, 1998. The
decline in carrying value is primarily a result of principal paydowns that
occurred during 1999.
Further details regarding NovaStar Financial's short-term and long-term
borrowing arrangements are located in Note 4 to the consolidated financial
statements.
Stockholders' equity. The increase in NovaStar Financial's stockholders'
equity as of December 31, 1999 compared with 1998 is a result of the following:
. $30 million increase as a result of the issuance of 4,285,714 shares of
Class B 7% cumulative convertible preferred stock in March 1999.
. $242,000 increase as a result of NovaStar Financial's purchase of the
economic residual interests in NovaStar Mortgage's January 1999 asset
backed bond transaction which for accounting and tax purposes was treated
as a sale. The residual interests in those transactions have been
classified as available-for-sale securities and the unrealized gain is
recognized as a component of accumulated other comprehensive income.
. $7.1 million decrease due to NovaStar Financial's net loss recognized for
the year ended December 31, 1999.
. $1.9 million decrease as a result of the repurchases of common stock.
NovaStar Financial's Board of Directors amended its stock repurchase
program during the third quarter of 1999 to increase the amount of common
stock authorized to be acquired up to an aggregate purchase price of $5
million. Stock repurchases may be made in the open market, in block
purchase transactions, through put options or through privately
negotiated transactions. The timing of repurchases and the number of
shares ultimately repurchased will depend upon market conditions and
corporate requirements. As of December 31, 1999, NovaStar Financial had
repurchased 673,400 shares of its common stock. The number of shares
repurchased by NovaStar Financial has increased to 890,700 through March
16, 2000.
37
<PAGE>
Results of Operations of NovaStar Financial, Inc.--Year Ended December 31, 1999
Compared to the Year Ended December 31, 1998
Net Income
During the year ended December 31, 1999, NovaStar Financial recorded a net
loss of $7.1 million, $1.08 per diluted share, compared with net loss of $21.8
million, $2.71 per diluted share, for the year ended December 31, 1998.
NovaStar Financial's net loss for 1999 is principally a result of increased
provisions for credit losses that aggregated $22.1 million in 1999 versus $7.4
million in 1998. This increase is discussed further under "Provisions for
Credit Losses and Premium for Mortgage Loan Insurance". In 1998, NovaStar
Financial recognized losses aggregating $23.4 million when it sold all of its
agency securities and terminated various interest rate agreements as a result
of the liquidity crisis faced by the capital markets in the fourth quarter of
1998.
NovaStar Financial's primary sources of revenue are interest earned on its
securitized mortgage loan portfolio and prepayment penalty income. In addition,
results indirectly reflect gains from the sale of whole loans to third parties
and securitization transactions executed by NovaStar Mortgage.
Net Interest Income
Table 8 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, 1999 and 1998.
Table 8
Interest Analysis (dollars in thousands)
<TABLE>
<CAPTION>
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Year ended December 31, Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
1999 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- ----------------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $709,371 $66,324 9.35% $ 2,357 $ 389 16.50% $ 711,728 $ 66,713 9.37%
======== ======= ======= ========
Interest-bearing
liabilities
Collateralized mortgage
obligations........... $785,547 $43,963 5.60% -- -- -- $ 785,547 $ 43,963 5.60%
Other borrowings....... 4,206 541 12.86 -- -- -- 4,206 541 12.86
-------- ----- ----------
Cost of derivative
financial instruments
hedging liabilities... 2,254 2,254
------- --------
Total borrowings....... $789,753 $46,758 5.92% $ -- $ -- -- % $ 789,753 $ 46,758 5.92%
======== ======= ===== ======== ======= ===== ========== ======== =====
Net interest income.... $19,566 $ 389 $ 19,955
======= ======= ========
Net interest spread.... 3.43% 16.50% 3.45%
===== ===== =====
Net yield.............. 2.76% 16.50% 2.80%
===== ===== =====
<CAPTION>
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Year ended December 31, Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
1998 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- ----------------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $822,180 $76,751 9.34% $375,222 $23,996 6.40% $1,197,402 $100,747 8.41%
======== ======= ===== ======= ===== ======== =====
Interest-bearing
liabilities
Repurchase agreements.. $118,380 $ 7,817 6.60% $392,859 $21,891 5.57% $ 511,239 $ 29,708 5.81%
Collateralized mortgage
obligations........... 703,328 43,287 6.15 -- -- -- 703,328 43,287 6.15
Other borrowings....... 18,936 4,908 25.92 -- -- -- 18,936 4,908 25.92
-------- -------- ------- ----------
Cost of derivative
financial instruments
hedging liabilities... 2,162 729 2,891
------- ------- --------
Total borrowings....... $840,644 $58,174 6.92% $511,460 22,620 5.76% $1,233,503 $ 80,794 6.55%
======== ======= ===== ======== ======= ===== ========== ======== =====
Net interest income.... $18,577 $ 1,376 $ 19,953
======= ======= ========
Net interest spread.... 2.42% 0.64% 1.86%
===== ===== =====
Net yield.............. 2.26% 0.37% 1.67%
===== ===== =====
</TABLE>
38
<PAGE>
Interest income. NovaStar Financial's average interest-earning assets consist
primarily of mortgage loans for the year ended December 31, 1999. For 1998,
interest-earning assets included mortgage loans (70%) and of lower-yielding
agency securities (30%). Mortgage securities income for 1999 consists of
earnings on residual interests that NovaStar Financial purchased from NovaStar
Mortgage in September 1999. During 1999, mortgage loans earned $66.3 million,
or a yield of 9.4%, compared with $76.8 million, or a yield of 9.3% for the
same period of 1998. In total, assets earned $66.7 million, or a yield of 9.4%
for the year ended December 31, 1999. During 1998, assets earned $100.7 million
or an 8.4% yield. As discussed in "Financial Condition of NovaStar Financial,
Inc. as of December 31, 1999 and December 31, 1998", NovaStar Financial sold
all of its agency securities in October 1998 to meet short-term liquidity needs
faced in the fourth quarter of 1998. Agency securities earned $24.0 million for
the year ended December 31, 1998, or a yield of 6.4%. As noted in Table 9,
interest income is a function of volume and rates. Increasing the volume of
assets will cause future increases in interest income, while declining balances
will reduce interest income. Market interest rates will also affect future
interest income.
Interest expense. Average interest-bearing liabilities for the year ended
December 31, 1999 consisted entirely of financing costs on mortgage loans,
compared with 1998 when mortgage loans represented 70% and agency securities
were 30%. During the fourth quarter of 1998, NovaStar Financial sold all of its
agency securities. The cost of borrowed funds for mortgage loans was $46.8
million for 1999, or 5.9% of average borrowings compared with $58.2 million, or
6.9% for 1998. The cost of financing agency securities was $22.6 million during
1998, or 5.8% of average borrowings. The composition of interest expense is
significantly different for the year ended December 31, 1999 compared with the
same period of 1998 due to the following factors:
. The majority of mortgage loans serve as collateral on collateralized
mortgage obligations as of December 31, 1999. During 1998, mortgage loans
secured debt consisting of collateralized mortgage obligations and
warehouse facilities. The change in financing composition is due to the
fact that NovaStar Financial discontinued purchasing mortgage loans from
NovaStar Mortgage during the last half of 1998. Prior to that point in
time, NovaStar Financial had purchased 100% of NovaStar Mortgage's loan
production upon origination. During that time, NovaStar Financial
reimbursed NovaStar Mortgage for warehousing costs incurred prior to
sale. Repurchase and warehouse facility costs for 1998 are included under
repurchase agreements and other borrowings in Table 9.
. NovaStar sold all of its agency securities in October 1998 and paid off
all related borrowings. No agency securities have been purchased since
that time.
. In connection with capital markets liquidity crisis that occurred in the
last quarter of 1998, NovaStar Financial executed a short-term liquidity
line with GMAC/Residential Funding Corporation that was secured by
mortgage interests in NovaStar's asset-backed bonds. This facility
carried a substantially higher interest cost than other borrowing
arrangements. This debt was paid off in February 1999 with funds from a
similar facility provided by First Union National Bank. The First Union
line was repaid in full with proceeds from convertible preferred stock
issued in March 1999. The interest on these facilities during the year
ended December 31, 1999 and 1998 is included as a component of other
borrowings in Table 9.
Advances under the warehouse line of credit bear interest based on the
federal funds rate plus a spread. Advances under the master repurchase
agreement bear interest at rates based on LIBOR, plus a spread. During the year
ended December 31, 1999, one-month LIBOR averaged 5.25 percent compared with
5.57 percent for the year ended December 31, 1998. Because the Federal Reserve
increased the targeted Federal Funds interest rate in 1999, effective borrowing
costs have been higher for the second half of 1999. As with interest income,
the cost of funds in the future will largely depend on market conditions, most
notably levels of short-term interest rates. Rates on other borrowings
generally fluctuate with short-term market interest rates, such as LIBOR or the
federal funds rate.
39
<PAGE>
Net interest income and spread. Net interest income on mortgage loans for
1999 was $19.6 million, or 2.8% of average interest-earning mortgage loans,
compared with $18.6 million, or 2.3% for 1998. Net interest spread on mortgage
loans was 3.4% and 2.4%, respectively, for 1999 and 1998. Net interest income
on mortgage securities (economic residual interests) during 1999 was $389,000,
or 16.5% of average interest-earning mortgage securities compared with net
interest income of $1.4 million, or 0.4% for 1998. Net interest spread on
mortgage securities was 16.5% for 1999 compared with 0.6% for 1998. The
significant increase in net margin and spread during 1999 compared with 1998 is
due to the change in NovaStar Financial's asset and liability composition.
During the latter part of 1998, NovaStar Financial sold all agency securities
and paid off related financing. NovaStar Financial has not purchased any more
of these lower-yielding mortgage assets. Net interest income and the spread are
functions of asset yields relative to its costs of funds. The volume of assets
and liabilities and how well the spread between earnings on assets and the cost
of funds is managed will dictate future net interest income.
Impact of interest rate agreements. NovaStar Financial has entered into
interest rate agreements designed to mitigate exposure to interest rate risk.
Interest rate cap agreements require NovaStar Financial to pay a monthly fixed
premium while allowing it to receive a rate that adjusts with LIBOR, when rates
rise above a certain agreed-upon rate. These agreements are used to alter, in
effect, the interest rates on funding costs to more closely match the yield on
interest-earning assets.
During the years ended December 31, 1999 and 1998, net interest expense
incurred on hedging agreements was $2.3 million and $2.9 million, respectively,
which is included as a component of interest expense. In 1998, NovaStar
Financial recognized losses aggregating $8.0 million due to the termination of
all swap agreements during the liquidity crisis faced by the subprime market in
the latter part of 1998. These agreements were related to the financing for
disposed mortgage loans and securities. NovaStar Financial's interest rate
agreements as of December 31, 1999 and 1998 are further detailed in Footnote 5
of the consolidated financial statements.
Prepayment Penalty Income
NovaStar Financial strives to purchase loans that have some form of
prepayment penalty fee to mitigate exposure to prepayment risk. Prepayment
penalties totaled $3.1 million during 1999 compared with $2.0 million for 1998.
This increase is attributable to larger prepayments in the securitized mortgage
loan portfolio in 1999.
Gain (Loss) on Sales of Assets and Loss on Termination of Interest Rate
Agreements
For the year ended December 31, 1999, NovaStar Financial recognized $319,000
in net gains on the sale of real estate properties. In 1998, NovaStar Financial
recognized losses aggregating $15.4 million and $8.0 million on the sale of
agency securities and termination of related swap agreements. Also, in the 1998
net gains of $305,000 were recognized on the sale of $7.9 million of mortgage
loans.
Mortgage Insurance
In August of 1998, NovaStar Financial and NovaStar Mortgage executed an
agreement whereby insurance coverage is provided on selected mortgage loans.
The use of mortgage insurance is one method of managing the credit risk in the
mortgage asset portfolio. Going forward, management expects that it will
evaluate the cost-benefit of securing lender paid mortgage insurance for each
securitization transaction.
As of December 31, 1999 and 1998, approximately 39% and 26% of the loans
owned by NovaStar Financial are covered under this agreement, including loans
serving as collateral for NMFT 99-01. The loans collateralizing NMFT are not
recorded as loans of NovaStar Financial, but the performance of NovaStar's
investment in the residual interest of NMFT 99-01 is dependent on the credit
losses of the underlying collateral.
40
<PAGE>
Premiums for mortgage insurance on loans maintained on the balance sheet of
NovaStar Financial are recorded as a portfolio cost and included in the income
statement under the caption "Mortgage Loan Insurance." During the year ended
December 31, 1999, total premiums paid by NovaStar totaled $1.7 million
compared with $744,000 for the same period of 1998. The monthly premiums paid
on loans serving as collateral for NMFT 99-01 reduce NovaStar Financial's
monthly residual cashflow receipt.
Provisions for Credit Losses
NovaStar Financial owns loans where the borrower possesses credit risk higher
than that of conforming borrowers. Under this business model, delinquent loans
and losses are expected to occur. Most of the loans owned by NovaStar Financial
were underwritten and funded by NovaStar Mortgage. NovaStar Mortgage uses
several different techniques to mitigate the credit losses, including pre-
funding audits by quality control personnel and in-depth appraisal reviews.
Another loss mitigation technique allows a borrower to sell their property for
less than the outstanding loan balance prior to foreclosure in transactions
known as short sales, when it is believed that the resulting loss is less than
what would be realized through foreclosure. Loans are charged off in full when
the cost of pursuing foreclosure and liquidation outweigh recorded balances.
While short sales have served to reduce the overall severity of losses
incurred, they also accelerate the timing of losses.
As discussed further under the caption "Mortgage Insurance", lender paid
mortgage insurance is used as a means of managing credit risk exposure.
Generally, the exposure to credit loss on insured loans is considered minimal.
Management also believes aggressive servicing is an important element to
managing credit risk.
Provisions for credit losses are made in amounts considered necessary to
maintain the allowance at a level sufficient to cover probable losses inherent
in the loan portfolio. Charge-offs are recognized at the time of foreclosure by
recording the value of real estate owned property at its estimated realizable
value. Subsequent gains or losses on dispositions, if any, are recorded in
operations. One of the principal methods used to estimate expected losses is a
delinquency migration analysis. This analysis takes into consideration
historical information regarding foreclosure and loss severity experience and
applies that information to the portfolio at the reporting date.
During 1999, NovaStar Financial made provisions for losses of $22.1 million
and incurred net charge-offs of $14.5 million, compared to $7.4 million and
$6.2 million during 1998. Charge-offs in 1999 include $1.9 million resulting
from short sale transactions and loans charged off in full.
The level and trend of charge-offs in 1999 led management to conclude that
total losses on securitized mortgage loans will be higher, and will occur
earlier, than originally projected. The provisions during 1999 and resulting
allowance as of December 31, 1999 reflect the increased loss activity. In the
opinion of management, the allowance for credit losses as of December 31, 1999
is adequate to cover losses inherent in the portfolio at that date. If losses
do not develop in accordance with current expectations, future provisions will
be increased or decreased as necessary. Management also believes that internal
processes involving quality control, appraisal review and servicing that have
been made as a result of experience to-date, will result in lower losses being
incurred on loans currently being originated.
41
<PAGE>
Table 9 is a rollforward of the activity in the allowance for credit losses
during 1999 and 1998.
Table 9
Rollforward of Allowance for Credit Losses
<TABLE>
<CAPTION>
1999 1998
------------------------------------------ ------------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Beginning balance....... $ 5,370 $ 3,573 $ 3,492 $ 3,573 $ 2,757 $ 3,341 $2,871 $2,313
Provision for credit
losses................ 10,579 5,634 3,566 2,299 4,030 1,179 1,145 1,076
Amounts charged off,
net of recoveries..... (4,844) (3,837) (3,485) (2,380) (3,214) (1,763) (675) (518)
------- ------- ------- ------- ------- ------- ------ ------
Ending Balance.......... $11,105 $ 5,370 $ 3,573 $ 3,492 $ 3,573 $ 2,757 $3,341 $2,871
======= ======= ======= ======= ======= ======= ====== ======
</TABLE>
The following tables provide details regarding the delinquencies, defaults,
and loss statistics of NovaStar Financial's mortgage loan portfolio.
Table 10
Loan Delinquencies (90 days and greater) (A)
1999 and 1998
<TABLE>
<CAPTION>
1999 1998
----------------------------------------- -----------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans
collateralizing
NovaStar Home Equity
series (CMO):
1997-1
(Issued October 1,
1997)................. 5.63% 6.32% 5.13% 4.37% 5.45% 5.97% 5.86% 4.39%
1997-2
(Issued December 11,
1997)................. 6.24 4.92 4.03 5.38 5.62 4.97 4.72 2.23
1998-1
(Issued April 30,
1998)................. 4.42 5.32 4.13 4.64 4.44 2.06 -- --
1998-2
(Issued August 18,
1998)................. 5.38 4.06 3.94 3.72 2.35 0.40 -- --
</TABLE>
- --------
(A)Includes loans in foreclosure or bankruptcy.
42
<PAGE>
Table 11
Delinquencies, Defaults and Losses
December 31, 1999 and 1998
(dollars in thousands)
<TABLE>
<CAPTION>
NovaStar Home Equity Series
----------------------------------
December 31, 1999 1997-1 1997-2 1998-1 1998-2 Warehouse All Loans
- ----------------- ------- ------- ------- ------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Allowance for Credit
Losses:
Balance, January 1,
1999................. $ 816 $ 1,049 $ 1,163 $ 346 $ 199 $ 3,573
Provision for credit
losses............... 4,317 5,436 8,194 4,065 66 22,078
Amounts charged off,
net of recoveries.... (2,798) (3,624) (5,143) (2,726) (255) (14,546)
------- ------- ------- ------- ------- --------
Balance, December 31,
1999................. $ 2,335 $ 2,861 $ 4,214 $ 1,685 $ 10 $ 11,105
======= ======= ======= ======= ======= ========
Defaults as a percent of
loan servicing
Delinquent loans(A)... 8.03% 9.89% 6.38% 7.50% 91.75% 6.60%
======= ======= ======= ======= ======= ========
Loans in foreclosure.. 4.73 4.32 3.75 4.02 6.76 3.43
======= ======= ======= ======= ======= ========
Real estate owned..... 3.85 4.88 3.61 2.62 47.00 3.51
======= ======= ======= ======= ======= ========
<CAPTION>
NovaStar Home Equity Series
----------------------------------
December 31, 1998 1997-1 1997-2 1998-1 1998-2 Warehouse All Loans
- ----------------- ------- ------- ------- ------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Allowance for Credit
Losses:
Balance, January 1,
1998................. $ 1,063 $ 967 $ -- $ -- $ 283 $ 2,313
Provision for credit
losses............... 1,895 2,257 1,878 222 1,178 7,430
Amounts charged off,
net of recoveries.... (2,142) (2,175) (715) 124 (1,262) (6,170)
------- ------- ------- ------- ------- --------
Balance, December 31,
1998................. $ 816 $ 1,049 $ 1,163 $ 346 $ 199 $ 3,573
======= ======= ======= ======= ======= ========
Defaults as a percent of
loan servicing.........
Delinquent loans(A)... 6.45% 5.95% 4.89% 4.06% 98.68% 5.17%
======= ======= ======= ======= ======= ========
Loans in foreclosure.. 2.63 2.96 3.60 2.06 8.82 2.80
======= ======= ======= ======= ======= ========
Real estate owned..... 3.54 2.76 1.01 0.09 86.11 1.56
======= ======= ======= ======= ======= ========
</TABLE>
- --------
(A)Includes loans delinquent 30 days or greater
Loan Servicing Fees Paid to NovaStar Mortgage, Inc.
Loan servicing fees paid to NovaStar Mortgage, Inc. include the 50 basis
point fee charged by NovaStar Mortgage for servicing the loans owned by
NovaStar Financial serving as collateral on CMOs. The fee charged is based on
the collected loan principal balance of the mortgage loans serviced.
43
<PAGE>
General and Administrative Expenses
General and administrative expenses for the years ended December 31, 1999 and
1998 are provided in Table 12. Table 13 displays the relationship of portfolio
expenses to net interest income during 1999 and 1998 by quarter.
Table 12
General and Administrative Expenses
(dollars in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------
1999 1998
------------------- -------------------
Percent of Percent of
Net Interest Net Interest
Income Income
------------ ------------
<S> <C> <C> <C> <C>
Compensation and benefits............. $1,804 9.0% $1,785 8.9%
Professional and outside services..... 801 4.0 1,117 5.6
Office administration................. 804 4.0 903 4.5
Other................................. 181 0.9 574 2.9
------ ---- ------ ----
Total portfolio-related expenses...... 3,590 17.9% 4,379 21.9%
==== ====
Fees for services provided by NovaStar
Mortgage, Inc. ...................... 145 2,683
------ ------
Total general and administrative
expenses............................. $3,735 $7,062
====== ======
Efficiency Ratio (A).................. 15.4% 29.9%
==== ====
</TABLE>
- --------
(A) The efficiency ratio is calculated by dividing general and administrative
expenses by the sum of net interest income, prepayment penalty income, gain
(loss) on sales of securities and mortgage loans and other income.
Table 13
Portfolio Related Expenses as a
Percent of Net Interest Income
1999 and 1998
<TABLE>
<CAPTION>
Percent of
Interest Efficiency
Income Ratio
---------- ----------
<S> <C> <C>
1999:................................................ 17.9% 15.4%
Fourth quarter....................................... 24.9 16.3
Third quarter........................................ 19.2 12.1
Second quarter....................................... 11.5 0.5
First quarter........................................ 18.5 30.7
1998:................................................ 21.9% 30.0%
Fourth quarter....................................... 89.7 36.8
Third quarter........................................ 22.3 1.8
Second quarter....................................... 19.3 46.2
First quarter........................................ 14.8 44.2
</TABLE>
The increase in portfolio related expenses in 1999 compared with 1998 is
attributable in part to increased general and administrative costs incurred
during the capital markets liquidity crisis of 1998. Also, in 1998, fees were
paid for portfolio management related services prior to the hiring of
additional personnel to this department in 1998.
44
<PAGE>
The fees paid to (received from) NovaStar Mortgage during 1999 and 1998 are
further detailed in Footnote 9 of NovaStar Financial's consolidated financial
statements. The significant decline in these fees for the year ended December
31, 1999 compared with 1998 is due to the net effect of the following:
. The decline in the administrative fees paid to NovaStar Mortgage is due
to the cancellation of this agreement on March 31, 1999, since NovaStar
Financial is no longer purchasing loans from NovaStar Mortgage.
. The decrease in purchase commitment fees is due to the discontinuance of
this intercompany agreement beginning January 1, 1999.
. The increase in interest income received from NovaStar Mortgage is due to
this intercompany agreement went into effect April 1, 1999.
Equity in Earnings (Loss) of NFI Holding Corporation
For the years ended December 31, 1999, NFI Holding recorded net income of
$89,000 compared with a net loss of $3.0 million for the same period of 1998.
NovaStar Financial records its portion of the earnings (loss) as equity in net
earnings (loss) of NFI Holding in its income statement. NFI Holding's net
earnings (loss) include the net earnings (loss) of NovaStar Mortgage and
NovaStar Capital, subsidiaries of NFI Holding as discussed under "Basis of
Presentation". NFI Holding's financial position and results of operation for
the years ended December 31, 1999 and 1998 are discussed further under the
heading "NFI Holding Corporation".
Results of Operations of NovaStar Financial, Inc.--Year Ended December 31, 1998
Compared to the Year Ended December 31, 1997.
Net Income
During the year ended December 31, 1998, NovaStar Financial recorded a net
loss of $21.8 million, $2.71 per diluted share, compared with a net loss of
$1.1 million, $0.26 per diluted share, for the year ended December 31, 1997.
NovaStar Financial's net loss in 1998 was primarily a result of the $23.4 loss
recognized on the sale of all agency securities and termination of interest
agreements due to the liquidity crisis faced by the subprime mortgage industry
in the latter part of 1998. The results for the year ended December 31, 1997
reflect the significant cost of developing operations. During most of 1997,
NovaStar Financial focused on the hiring of key employees and developing
policies and procedures. NovaStar Financial's 1997 operational results also
include the $1.1 million forgiveness of the first tranche of the forgivable
founders' notes receivable. Excluding the forgiveness of the notes receivable
from founders, NovaStar Financial incurred a net loss of $52,000, or $0.01 per
share.
45
<PAGE>
Net Interest Income
Table 14 presents a summary of the average interest-earnings assets, average
interest-bearing liabilities and the related yields and rates thereon for the
years ended December 31, 1998 and 1997.
Table 14
Interest Analysis
Years Ended December 31, 1998 and 1997
(dollars in thousands)
<TABLE>
<CAPTION>
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Year ended December 31, Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
1998 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- ----------------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $822,180 $76,751 9.34% $375,222 $23,996 6.40% $1,197,402 $100,747 8.41%
======== ======= ===== ======== ======= ==== ========== ======== =====
Interest-bearing
liabilities
Repurchase agreements.. $118,380 $ 7,817 6.60% $392,859 $21,891 5.57% $ 511,239 $ 29,708 5.81%
Collateralized mortgage
obligations........... 703,328 43,287 6.15 -- -- -- 703,328 43,287 6.15
Other borrowings....... 18,936 4,908 25.92 -- -- -- 18,936 4,908 25.92
-------- ------- ----- -------- ------- ---------- -------- -----
Cost of derivative
financial Instruments
hedging liabilities.... 2,162 729 2,891
------- ------- --------
Total borrowings....... $840,644 $58,174 6.92% $511,460 22,620 5.76% $1,233,503 $ 80,794 6.55%
======== ======= ===== ======== ======= ==== ========== ======== =====
Net interest income.... $18,577 $ 1,376 $ 19,953
======= ======= ========
Net interest spread.... 2.42% 0.64% 1.86%
===== ==== =====
Net yield.............. 2.26% 0.37% 1.67%
===== ==== =====
<CAPTION>
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Year ended December 31, Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
1998 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- ----------------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $294,111 $25,154 8.55% $182,140 $11,807 6.48% $ 476,251 $ 36,961 7.76%
======== ======= ===== ======== ======= ==== ========== ======== =====
Interest-bearing
liabilities
Repurchase agreements.. $170,344 $12,020 7.06% $172,829 $10,383 6.01% $ 343,173 $ 22,403 6.53%
Collateralized mortgage
obligations........... 74,511 4,736 6.36 -- -- -- 74,511 4,736 6.36
Other borrowings....... -- -- -- -- -- -- -- -- --
-------- -------- ---------- --------
Cost of derivative
financial Instruments
hedging liabilities.... 534 512 1,046
------- ------- --------
Total borrowings....... $244,855 $17,290 7.06% $172,829 $10,895 6.30% $ 417,684 $ 28,185 6.75%
======== ======= ===== ======== ======= ==== ========== ======== =====
Net interest income.... $ 7,864 $ 912 $ 8,776
======= ======= ========
Net interest spread.... 1.49% 0.18% 1.01%
===== ==== =====
Net yield.............. 2.67% 0.50% 1.84%
===== ==== =====
</TABLE>
Average interest-earning assets were $1.2 billion during 1998, including
$822.2 million of mortgage loans and $375.2 million of mortgage securities
compared with average interest-earning assets of $476.3 million during 1997.
During 1998, mortgage loans earned $76.8 million, or a yield of 9.3 percent,
compared with $25.2 million, or a yield of 8.6 percent for 1997. Mortgage
securities earned $24.0 million for 1998, or a yield of 6.4 percent, compared
with $11.8 million, or a yield of 6.5 percent for 1997. In total, assets earned
$100.7 million, or an 8.4 percent yield for 1998. During 1997, assets earned
$37.0 million or a 7.8 percent yield.
The cost of borrowed funds was $80.8 million during 1998, or 6.6 percent of
average borrowings, compared with $28.2 million for 1997, or 6.8 percent of
average borrowings. NovaStar Financial's cost of
46
<PAGE>
funds remained relatively low and stable during most of 1998 and 1997. During
the fourth quarter of 1998, NovaStar Financial experienced increasing costs of
funds associated with impaired liquidity resources. Special interest costs of
$4 million were incurred to obtain a short-term financing arrangement from
GMAC/RFC.
Net interest income during 1998 was $20.0 million or 1.7 percent of average
interest-earning assets, compared with $8.8 million, or 1.8 percent of average
interest-earning assets during 1997. Net interest spread was 1.9 percent during
the year ended December 31, 1998 compared with 1.0 percent during 1997.
During the years ended December 31, 1998 and 1997, net interest expense on
hedging agreements was $2.9 million and $1.0 million, respectively, and is
included as a component of interest expense.
Prepayment Penalty Income
Prepayment penalties of $2.0 million were recognized in 1998 compared with
$414,000 during 1997. The increase in prepayment penalties in 1998 is due to an
increase in NovaStar Financial's mortgage loan prepayments compared with 1997.
Gain (Loss) on Sales of Securities and Assets and Loss on Termination of
Interest Rate Agreements
During 1998, NovaStar recognized net losses on the sales of securities and
assets of $15.0 million and $8.0 million in termination losses of interest rate
agreements. In the latter part of 1998, NovaStar Financial sold all investment
securities and terminated all swap agreements as a result of the 1998 capital
markets liquidity crisis recognizing losses aggregating $23.4 million. During
1997, NovaStar Financial recognized $51,000 in net gains on sales of mortgage
securities with a principal balance of $108 million.
Provisions for Credit Losses and Premium for Mortgage Loan Insurance
During the year ended December 31, 1998, NovaStar Financial provided $7.4
million to the allowance for credit losses, compared with $2.5 million during
the same period of 1998. Net charge-offs during 1998 were $6.2 million compared
with $140,000 during the same period of 1997. The increase in charge-offs was
due principally to losses occurring earlier in the overall life of the loans
than originally anticipated. See discussion of "Provisions for Credit Losses
and Premiums for Mortgage Loan Insurance" under "Results of Operations of
NovaStar Financial, Inc.--Year Ended December 31, 1999 Compared to the Year
Ended December 31, 1998."
Premiums for mortgage loan insurance include the premiums paid to Radian
Guaranty, Inc. The agreement with Radian was executed in the third quarter of
1999. Accordingly, no expense was incurred in 1997 or 1998.
Loan Servicing Fees Paid to NovaStar Mortgage, Inc. and Other Loan Servicing
Fees
Loan servicing fees paid to NovaStar Mortgage, Inc. include the fifty basis
point fee that NovaStar Mortgage charges NovaStar Financial for the loans
collateralizing the CMOs. This fee is based on the collected principal balance
of the mortgage loans serviced. The increase in the fee charged in 1998
compared with 1997 is because NovaStar Mortgage did not begin servicing
Novastar Financial's loans until July 15, 1997. Prior to this point in time
NovaStar Financial's mortgage loans were serviced by an outside servicer while
NovaStar Mortgage developed its servicing operation infrastructure during the
first half of the year. The fees paid to this outside servicer are included as
component of the other loan servicing fees.
47
<PAGE>
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 1998 and
1997 are provided in Table 15.
Table 15
General and Administrative Expenses
(dollars in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------
1998 1997
------------------- -------------------
Percent of Percent of
Net Interest Net Interest
Income Income
------------ ------------
<S> <C> <C> <C> <C>
Compensation and benefits.............. $1,785 8.9% $ 839 9.6%
Professional and outside services...... 1,117 5.6 676 7.7
Office administration.................. 903 4.5 299 3.4
Other.................................. 574 2.9 554 6.3
------ ---- ------ -----
Total portfolio-related expenses....... $4,379 21.9% $2,368 27.0%
====== ==== ====== =====
Forgiveness of notes receivable from
founders.............................. -- 1,083
Fees for services provided by NovaStar
Mortgage, Inc......................... 2,683 3,650
------ ------
Total general and administrative
expenses............................ $7,062 $7,101
====== ======
Efficiency Ratio (A)................... 29.9% 74.5 %
==== =====
</TABLE>
- --------
(A) The efficiency ratio is calculated by dividing general and administrative
expenses by the sum of net interest income, prepayment penalty income, gain
(loss) on sales of securities and mortgage loans (excluding the 1998
securities losses due to the liquidity crisis) and other income.
The increase in portfolio-related expenses in 1998 compared with 1997 is due
to the addition of portfolio management and finance staff in 1998 as well as
general company growth. 1997 portfolio-related expenses reflect costs of
developing operations and hiring of key personnel.
The fees for services provided by NovaStar Mortgage, Inc. represent
compensation for certain services, including the development of loan products,
underwriting, funding, quality control, and servicing. NovaStar Mortgage pays a
commitment fee to NovaStar Financial when originated loans are not sold to
NovaStar Financial. No fee is paid if NovaStar Financial is unable or unwilling
to purchase the mortgage loans originated by NovaStar Mortgage. The increase in
this fee for 1998 compared with 1997 is primarily a result of an increase in
the extent of services required and the increase in loan volume. These fees are
discussed in greater detail in Note 9 to consolidated financial statements.
In 1997, NovaStar Financial, Inc. forgave the first tranche of forgivable
notes receivable from founders due to certain incentive targets were met in
1997. The terms of these notes are further defined in the "Notes Receivable
From Founders" section of "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Note 7 of the consolidated financial
statements.
Equity in Earnings (Loss) of NFI Holding Corporation
For the year ended December 31, 1998, NFI Holding recorded a net loss of $3.0
million compared with net income of $28,000 for the period of inception
(February 6, 1997) to December 31, 1997. NFI Holding's financial position and
results of operation for the these periods are discussed further under the
heading "NFI Holding Corporation."
48
<PAGE>
Taxable Income (Loss)
Income reported for financial reporting purposes as calculated in accordance
with generally accepted accounting principles (GAAP) differs from income
computed for income tax purposes. This distinction is important as dividends
paid are based on taxable income. Table 17 is a summary of the differences
between net income or loss reported for GAAP and taxable income for 1999 and
1998.
Table 16
Taxable Income (Loss)
1999 and 1998 (in thousands)
<TABLE>
<CAPTION>
1999 1998 1997
-------- -------- -------
<S> <C> <C> <C>
Net loss.......................................... $ (7,092) $(21,821) $(1,135)
Use of net operating loss carryforward............ (2,628) -- --
Results of NFI Holding and subsidiaries........... (88) 2,984 (28)
Provision for credit losses....................... 22,078 7,430 2,453
Loans charged-off................................. (14,546) (6,170) (140)
Capital losses.................................... -- 14,963 --
Other, net........................................ (200) (14) 284
-------- -------- -------
Estimated taxable income (loss)................... $ (2,476) $ (2,628) $ 1,434
======== ======== =======
</TABLE>
NovaStar Financial has a net operating loss carryforward of approximately
$2.5 million available to offset taxable income in 2000, and thereby reduce the
amount of required distributions under REIT guidelines. In addition, dividends
paid on convertible preferred stock serve to reduce the amount of required
distributions to common shareholders.
NFI Holding Corporation
Since NovaStar Financial discontinued purchasing loans from NovaStar Mortgage
and holding them in portfolio in the latter part of 1998, NovaStar Mortgage has
had a larger impact on NovaStar Financial's operational results. Instead of
selling loans to NovaStar Financial, NovaStar Mortgage has sold loans to
outside third parties. Through its indirect equity ownership of NFI Holding,
NovaStar Financial has shared in the profits of NovaStar Mortgage's loan sales.
Condensed consolidated financial statements for NFI Holding are presented in
Note 12 to the consolidated financial statements. NFI Holding's balance sheet
consists primarily of the assets, liabilities, and operational results of
NovaStar Mortgage and NovaStar Capital; accordingly, the discussion that
follows focuses on these two entities.
Financial Condition of NFI Holding as of December 31, 1999 and December 31,
1998
Mortgage Loan Originations. NFI Holding originated 4,495 non-conforming
residential mortgage loans during the year ended December 31, 1999 with an
aggregate principal amount of $453 million. Virtually all of NFI Holding's
mortgage assets as of December 31, 1999 and December 31, 1998 consist of non-
conforming mortgage loans that will be sold directly to independent buyers of
whole loans or through securitization transactions that are treated for tax and
accounting purposes as sales.
49
<PAGE>
Table 17 is a summary of NFI Holding's wholesale loan originations for 1999
and 1998. Table 18 presents a summary of mortgage loan sales of NFI Holding
during 1999 and 1998. Table 19 is a summary of wholesale loan origination costs
of production.
Table 17
1999 and 1998 Quarterly Wholesale Loan Originations--NFI Holding, Inc.
(dollars in thousands)
<TABLE>
<CAPTION>
Weighted Average
---------------------- Percent
Number Average Price Loan with
of Loan Paid to to Credit Prepayment
Loans Principal Balance Broker Value Rating(A) Coupon Penalty
------ --------- ------- ------- ----- --------- ------ ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1999:
Fourth quarter........ 1,265 $130,288 $103 101.0 82% 5.30 10.04% 91%
Third quarter......... 1,204 125,140 104 100.8 82 5.28 9.87 91
Second quarter........ 1,161 114,631 99 101.1 82 5.14 9.82 89
First quarter......... 865 82,495 95 100.5 80 4.95 9.85 89
----- -------- ---- ----- --- ---- ----- ---
1999 total.......... 4,495 $452,554 $101 100.9 82% 5.19 9.90% 90%
===== ======== ==== ===== === ==== ===== ===
1998:
Fourth quarter........ 1,526 $136,659 $ 90 100.8 81% 4.76 9.76% 87%
Third quarter......... 2,622 239,933 92 101.4 81 4.38 10.07 79
Second quarter........ 3,133 294,303 94 101.3 81 4.43 9.95 71
First quarter......... 2,033 207,976 102 101.4 81 4.45 9.93 65
----- -------- ---- ----- --- ---- ----- ---
1998 total.......... 9,314 $878,871 $ 94 101.3 81% 4.47 9.95% 74%
===== ======== ==== ===== === ==== ===== ===
</TABLE>
- --------
(A) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
Table 18
Mortgage Loan Sales to Third Parties--NFI Holding, Inc.
Years Ended December 31, 1999 and 1998
(dollars in thousands)
<TABLE>
<CAPTION>
Weighted
Average
Principal Net Gain Price To
Amount Recognized Par
--------- ---------- --------
<S> <C> <C> <C>
1999:
Fourth quarter.................................. $109,443 $ 2,583 104.1%
Third quarter................................... 110,512 3,075 104.2
Second quarter.................................. 98,048 2,911 104.4
First quarter................................... 73,743 1,593 103.6
-------- -------
1999 total.................................... $391,746 $10,162 104.1
======== ======= =====
1998:
Fourth quarter.................................. $108,800 $ 1,985 103.6%
Third quarter................................... 18,133 826 106.0
Second quarter.................................. 6,742 173 106.0
First quarter................................... -- -- --
-------- -------
1998 total.................................... $133,675 $ 2,984 104.0
======== ======= =====
</TABLE>
50
<PAGE>
Table 19
Wholesale Loan Costs of Production
Years Ended December 31, 1999 and 1998
(dollars in thousands)
<TABLE>
<CAPTION>
Premium paid to
Gross Loan broker, net of fees Total
Production collected Acquisition Cost
---------- ------------------- ----------------
<S> <C> <C> <C>
Costs as a percent of
principal:
1999:
1999........................ 4.2% 0.4% 4.6%
=== === ===
Fourth quarter.............. 3.1% 0.5% 3.6%
=== === ===
Third quarter............... 3.8% 0.4% 4.2%
=== === ===
Second quarter.............. 4.2% 0.5% 4.7%
=== === ===
First quarter............... 6.2% 0.2% 6.4%
=== === ===
1998:
1998........................ 2.4% 1.0% 3.4%
=== === ===
Fourth quarter.............. 5.3% 0.5% 5.8%
=== === ===
Third quarter............... 2.3% 1.2% 3.5%
=== === ===
Second quarter.............. 1.6% 1.0% 2.6%
=== === ===
First quarter............... 1.9% 1.0% 2.9%
=== === ===
</TABLE>
Table 20 is a summary of loans originated by NovaStar Mortgage and NovaStar
Capital by state for 1999 and 1998 by quarter. As of December 31, 1999,
NovaStar Mortgage had 47 account executives 45 covering states.
Table 20
Mortgage Loan Originations by State--NovaStar Mortgage, Inc. and NovaStar
Capital, Inc.
1999 and 1998
<TABLE>
<CAPTION>
Percent of Total Originations during Quarter
(based on original principal balance)
---------------------------------------------------
1999 1998
------------------------- -------------------------
Collateral Location Fourth Third Second First Fourth Third Second First
- ------------------- ------ ----- ------ ----- ------ ----- ------ -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Florida..................... 12% 15% 12% 15% 21% 17% 16% 12%
Michigan.................... 12 10 10 12 6 5 5 5
California.................. 10 10 8 6 7 7 9 15
Arizona..................... 8 5 7 4 2 3 2 3
Ohio........................ 8 12 10 8 9 4 5 2
Tennessee................... 6 4 6 9 6 4 4 4
Washington.................. 4 4 5 3 4 5 6 7
Texas....................... 2 2 1 2 4 5 3 3
North Carolina.............. 1 1 1 2 6 5 3 2
All other states............ 34 33 36 35 33 41 44 45
</TABLE>
NFI Holding's loan originations are funded through warehouse and repurchase
facilities at First Union and are discussed further in footnote 4 of the
consolidated financial statements.
Mortgage Loan Sales. In a securitization executed by NovaStar Mortgage during
the first quarter of 1999, $165 million in loans were sold to a Special Purpose
Entity (SPE), of which $26 million settled in April 1999. Proceeds of the bonds
issued by the SPE, $160 million, were used to pay for the mortgage loans
acquired from NovaStar Mortgage. The loans were sold without recourse by
NovaStar Mortgage. NovaStar Mortgage retained a residual certificate issued by
the SPE. In September 1999, NovaStar Financial purchased the economic
51
<PAGE>
residual interests. NovaStar Mortgage also retained loan servicing rights for
the loans sold to the SPE. The value of the retained interests in the mortgage
servicing rights has been recorded as an asset and the loans sold have been
removed from the balance sheet of NovaStar Mortgage.
NovaStar Mortgage allocated its basis in the mortgage loans between the
portion of the mortgage loans sold and the retained assets based on the
relative fair values of those portions at the time of sale. The values of these
assets were determined by discounting estimated future cash flows using the
cash out method. Footnote 3 of the consolidated financial statements detail the
significant values and assumptions used in determining the values of the assets
sold and values of the resulting retained assets.
Of the aggregate gain recognized in the securitization, $355,000 was recorded
upon the April closing.
NFI Holding also sold $391.7 million of its whole loan portfolio to unrelated
third parties for cash at a net gain of $10.2 million at an average price of
104.1 during 1999. Table 20 of "Financial Condition of NFI Holding, Inc. as of
December 31, 1999 and 1998" provides a quarterly analysis of NovaStar
Mortgage's and NovaStar Capital's mortgage loan sales to third parties.
Mortgage loan servicing. Loan servicing is a critical part of NovaStar
Mortgage's business. The majority of the loans serviced by NovaStar Mortgage
are owned by NovaStar Financial. In the opinion of management, maintaining
contact with borrowers is vital in managing credit risk and in borrower
retention. Non-conforming borrowers are prone to late payments and are more
likely to default on their obligations than conventional borrowers. NovaStar
Mortgage strives to identify issues and trends with borrowers early and take
quick action to address such matters.
Table 21 provides summaries of delinquencies and default statistics of
NovaStar Mortgage's mortgage loan portfolio as of December 31, 1999 and 1998 by
quarter. The information presented in both tables include mortgage loans owned
by NovaStar Financial and its affiliates. Other information regarding the
credit quality of NovaStar Financial's mortgage loans is provided in Table 1.
Table 21
Delinquencies and Defaults
<TABLE>
<CAPTION>
1999 1998
----------------------------------------------- --------------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ---------- ---------- ----------- ------------ -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Loan servicing
portfolio.............. $897,572 $969,343 $1,032,065 $1,072,393 $1,179,967 $1,178,861 $995,428 $742,075
======== ======== ========== ========== ========== ========== ======== ========
Total defaults:
Delinquent loans (A)... 6.28% 4.75% 5.21% 4.12% 4.40% 2.95% 1.95% 1.92%
======== ======== ========== ========== ========== ========== ======== ========
Loans in foreclosure... 3.62 3.79 3.36 3.39 2.25 2.02 2.28 2.29
======== ======== ========== ========== ========== ========== ======== ========
Real estate owned...... 2.71 2.24 2.20 1.66 1.21 0.81 0.52 0.24
======== ======== ========== ========== ========== ========== ======== ========
</TABLE>
- --------
(A) Includes loans delinquent 30 days or greater
52
<PAGE>
The following table presents a summary of the mortgage loan activity of NFI
Holding for 1999 and 1998 as a percent of the respective quarter's beginning
principal of mortgage loans held in portfolio and loan origination principal.
Table 22
Mortgage Loan Activity--NFI Holding, Inc.
(dollars in thousands)
<TABLE>
<CAPTION>
Percent Sold Percent
to Sold to Percent Sold Percent
NovaStar Third in Held in Percent of
Financial, Inc. Parties Securitizations Portfolio Prepayments Total
--------------- ------- --------------- --------- ----------- -----
<S> <C> <C> <C> <C> <C> <C>
1999
Fourth quarter........ % 52% % 46% 2% 100%
Third quarter......... -- 54 -- 44 2 100
Second quarter........ -- 32 13 54 1 100
First quarter......... -- 25 45 29 1 100
1998
Fourth quarter........ % 30% 11% 58% 1% 100%
Third quarter......... -- 5 -- 94 1 100
Second quarter........ 99 1 -- -- -- 100
First quarter......... 100 -- -- -- -- 100
</TABLE>
Results of Operations of NFI Holding, Inc.--Year Ended December 31, 1999
Compared to the Year Ended December 31, 1998
For the year ended December 31, 1999 NFI Holding recorded net income of
$89,000 compared with a net loss of $3.0 million during 1998. Note 9 of the
consolidated financial statements presents a summarized income statement of NFI
Holding, Inc.
The following summarizes reasons impacting operating results of NFI Holding
for 1999 compared with 1998:
. Effective July 1998, NovaStar Mortgage began retaining its mortgage loan
production to sell to third parties or securitize versus its previous
practice of selling 100% of originations directly to NovaStar Financial.
Accordingly, NovaStar Mortgage recognized $5.5 million of net interest
income on loans in warehouse for the year ended December 31, 1999
compared with $4.3 million during 1998. The net interest income
recognized in 1998 also includes interest earned on agency securities.
NovaStar Mortgage sold all of its agency securities during the latter
part of 1998.
. Provisions for credit losses in 1999 were $860,000 versus $210,000 in
1998. The increase in the provisions is partly due to the effects of
maintaining warehouse loans as well as increases made to the provisions
for credit losses in 1999 as discussed under "Provisions for Credit
Losses and Premiums for Mortgage Loan Insurance".
. The administrative fee agreement between NovaStar Financial and NovaStar
Mortgage was cancelled on April 1, 1999. These fees are included in
services provided to NovaStar Financial, Inc.
. During 1999, NovaStar Mortgage recognized net gains of $11.8 million from
the sale of whole loans. Of that amount, $1.6 million of the gains
recognized were a result of the closing of NovaStar Mortgage's first
securitization transaction. The remainder of the gain resulted from
various whole loan sales to third parties for cash. During 1998, NovaStar
Mortgage recognized gains of $3.0 million on sales of whole loans and
$164,000 from selling mortgage securities.
53
<PAGE>
. NovaStar Mortgage's wholesale origination operation did not operate at
full capacity during 1999. The cost of loan production as a percent of
principal averaged 4.7% in 1999 versus 3.4% during 1998, the details of
which are presented in Table 19. As a result, NovaStar Mortgage
capitalized a lower percentage of origination costs during 1999--which
under GAAP are amortized as an adjustment of the yield over the life of
the loan versus expensed in the period incurred.
Results of Operations of NFI Holding, Inc.--Year Ended December 31, 1998
Compared to the Year Ended December 1997
For the year ended December 31, 1998 NFI Holding recorded a net loss of $3.0
million compared with net income of $28,000 for the period from February 6,
1997 (inception) to December 31, 1997. The significant increase in the net loss
of NFI Holding in 1998 compared with the same period of 1997 is largely due to
the commitment fees paid to NovaStar Financial, Inc. when NovaStar Mortgage did
not sell its wholesale loan production to NovaStar Financial, Inc. as discussed
in Note 9 of the consolidated financial statements. During the last half of
1998, NovaStar Mortgage retained its mortgage loan production versus selling
them to NovaStar Financial. Prior to this point in time, NovaStar Financial,
Inc. had acquired 100% of NovaStar Mortgage's mortgage loan production. As a
result, NovaStar Mortgage paid NovaStar Financial, commitment fees aggregating
$5.1 million in 1998. No commitment fees were paid to NovaStar Financial for
the same period of 1997. Also, during the fourth quarter of 1998 production
volumes were significantly lower than prior quarters as a result of
circumstances affecting the subprime industry as described in "Events of the
Fourth Quarter". As the origination side of the business was not functioning at
full capacity during the latter part of 1998, NovaStar Mortgage's costs of loan
production as a percent of principal averaged 2.1% in 1998 versus 1.4% during
1997 as detailed in Table 3. These additional costs incurred by NovaStar
Mortgage in 1998 were offset to a degree by net gains of $1.0 million on the
sale of $25 million of subprime residential mortgage loans to independent third
parties. NovaStar Mortgage did not sell any of its mortgage assets to outside
parties during the same period of 1997.
Liquidity and Capital Resources
Liquidity means the need for, access to and uses of cash. The primary needs
for cash include the acquisition of mortgage loans, principal repayment and
interest on borrowings, operating expenses and dividend payments. Substantial
cash is required to support the operating activities of the business,
especially the mortgage origination operation. Mortgage asset sales, principal,
interest and fees collected on mortgage assets and residual interests on CMOs
will serve to support cash needs. Drawing upon various borrowing arrangements
typically satisfies major cash requirements. During the first nine months of
1999, NovaStar Financial also improved its equity and liquidity positions
significantly by:
. Securing lending facilities with First Union National Bank and GMAC/RFC.
. Raising additional capital through the issuance of 4 million shares of
Class B 7% cumulative convertible preferred stock in March 1999; gross
proceeds aggregating $30 million.
NovaStar Mortgage requires substantial cash to fund loan originations and
operating costs. As of December 31, 1999, NovaStar Mortgage and NovaStar
Capital owned $107.9 million of subprime mortgage loans. NovaStar Mortgage and
NovaStar Capital provide financing for these loans through warehouse and
repurchase credit facilities at First Union. In December 1999, a $50 million
warehouse financing arrangement with GMAC/RFC was executed that will provide an
additional financing source for funding loans. Loans financed with warehouse
and repurchase credit facilities are subject to changing market valuation and
margin calls. Management expects to continue selling loans originated by
NovaStar Mortgage and NovaStar Capital or securitizing those loans at a profit
to meet the significant cash needs of the wholesale loan operation. Management
believes NovaStar Financial can operate indefinitely in this manner, provided
that the level of loan originations are at or near the capacity of its
production infrastructure.
54
<PAGE>
Table 23 is a summary of financing arrangements and available borrowing
capacity under those arrangements as of December 31, 1999:
Table 23
Liquidity Resources
December 31, 1999 (dollars in thousands)
<TABLE>
<CAPTION>
Maximum
Borrowing Value of
Resource Limit Collateral Borrowings Availability
-------- --------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
Cash.............................. $ 3,861
First Union National Bank (A):
Committed warehouse line of
credit......................... $ 75,000 $ 58,001 $33,382 $24,619
Committed secured whole loan
repurchase Agreement........... $175,000 $ 45,066 $45,066 $ --
Committed residual financing
available under CMOs........... $ 25,000 (B) --
-------
GMAC/Residential Funding
Corporation (A):
Committed warehouse line of
credit......................... $ 50,000 $ -- $ -- --
-------- -------- ------- -------
Total......................... $325,000 $103,082 $78,448 $28,480
======== ======== ======= =======
Total availability as a percent
of:
Total assets.................. 4.127 %
=======
Total stockholders' equity.... 28.126 %
=======
</TABLE>
- --------
(A) Value of collateral and borrowings include amounts for NovaStar Financial,
NovaStar Mortgage and NovaStar Capital as they are co-borrowers under the
arrangements with First Union National Bank and GMAC/RFC.
(B) Management estimates the value of the residuals range from $55 to $70
million and does not include the value of mortgage servicing rights.
Management believes the liquidity resources available are sufficient to cover
expected future production of NovaStar Mortgage and NovaStar Capital.
Cash activity during the years ended December 31, 1999, 1998 and 1997 are
presented in the consolidated statement of cash flows.
The capital of NovaStar Financial has come from
. a private placement offering of preferred stock, raising net proceeds of
$47 million.
. an initial public offering of common stock, raising net proceeds of $67
million, and
. a private offering of convertible preferred stock, raising net proceeds
of $29 million.
NovaStar Financial uses capital when financing loans on a long-term basis.
Under short-term financing arrangements, NovaStar can borrow up to 98% of the
market value of the loans it owns. In long-term financing (i.e. in the form of
asset-backed bonds) NovaStar can finance approximately 95% of the market value
of the loans. NovaStar must use its own capital resources to "finance" the
difference between the financed portion and the full loan cost.
During 1999, most of the loans originated by NovaStar Mortgage were sold to
third parties. In doing so, NovaStar does not use capital. In fact, if the
sales prices are above the full cost to originate loans, this method of
operation will generate capital for NovaStar.
During 2000, management expects to finance half of the loans produced by
NovaStar Mortgage. The remainder will be sold to third parties. NovaStar
currently has excess capital available to support this mode of operation during
2000. When NovaStar Financial fully deploys its capital, management expects to
either raise more equity from the capital markets or sell enough loans, so that
it operates without the need for additional capital.
55
<PAGE>
Interest Rate/Market Risk
Loan Price volatility. Under its current mode of operation, NovaStar
Financial depends heavily on the market for wholesale subprime mortgage loans.
To conserve capital, NovaStar Mortgage and NovaStar Capital may sell loans it
originates. The financial results of NovaStar Financial will depend, in part,
on the ability to find purchasers for the loans at prices that cover
origination expenses. Exposure to loan price volatility will be reduced as
NovaStar Financial resumes acquisition and retention of its subprime mortgage
loans.
Interest rate risk. Interest rate risk is the risk that the interest rate of
NovaStar Financial's mortgage assets will increase or decrease at different
rates than the interest rate cost of its liabilities. Expressed another way,
this is the risk that NovaStar Financial's net asset value will experience an
adverse change when interest rates change. When interest rates on the assets do
not adjust at the same rates as the liabilities or when the assets are fixed
rates and the liabilities are adjusting, future earnings potential is affected.
Management primarily uses financing sources where the interest rate resets
frequently. As of December 31, 1999, borrowings under all financing
arrangements adjust daily, monthly, or quarterly. On the other hand, very few
of the mortgage assets owned by NovaStar Financial, as of December 31, 1999,
adjust on a monthly or daily basis. Most of the mortgage loans contain features
where their rates are fixed for some period of time and then adjust frequently
thereafter. For example, one of our loan products is the " 2/28" loan. This
loan is fixed for its first two years and then adjusts every six months
thereafter.
While short-term borrowing rates are low and long-term asset rates are high,
this portfolio structure produces good results. However, if short-term interest
rates rise rapidly, earning potential could be significantly affected as the
asset rate resets would "lag" borrowing rate resets. The converse can be true
when sharp declines in short-term interest rates cause interest costs to fall
faster than asset rate resets, thereby increasing earnings.
In its assessment of the interest sensitivity and as an indication of
exposure to interest rate risk, management relies on models of financial
information in a variety of interest rate scenarios. Using these models, the
fair value and interest rate sensitivity of each financial instrument, or
groups of similar instruments is estimated, and then aggregated to form a
comprehensive picture of the risk characteristics of the balance sheet. The
risks are analyzed on both an income and market value basis.
Table 24 is a summary of the analysis as of December 31, 1999 and 1998.
Table 24
Interest Rate Sensitivity-Income
December 31, 1999 and 1998
<TABLE>
<CAPTION>
Basis Point Increase
(Decrease) in Interest
Rate(A)
-------------------------
As of December 31, 1999 (100) Base(B) 100
- ----------------------- ------- ------- -------
<S> <C> <C> <C>
Income from:
Assets............................................ $61,610 $64,419 $66,954
Liabilities(B).................................... 42,173 47,803 53,442
Interest rate agreements.......................... (1,379) (1,379) 1,122
------- ------- -------
Net spread income................................... $18,058 $15,237 $14,634
======= ======= =======
Cumulative change in income from base(C)............ $ 2,821 -- $ (603)
Percent change from base spread income(D)........... 18.5% -- (4.0)%
======= ======= =======
Percent change of capital(E)........................ 2.8% -- (0.6)%
======= ======= =======
</TABLE>
56
<PAGE>
<TABLE>
<CAPTION>
Basis Point Increase
(Decrease) in Interest
Rate(A)
-------------------------
As of December 31, 1999 (100) Base(B) 100
- ----------------------- ------- ------- -------
<S> <C> <C> <C>
Income from: Assets................................. $80,507 $82,310 $83,966
Costs of: Liabilities(B)............................ 47,546 55,259 63,233
Costs of: Interest rate agreements.................. (2,244) (2,244) 107
------- ------- -------
Net spread income................................... $30,717 $24,807 $20,840
======= ======= =======
Cumulative change in income from base(C)............ $ 5,910 -- $ 3,967
Percent change from base spread income(D)........... 23.8% -- (16.0)%
======= ======= =======
Percent change of capital(E)........................ 6.8% -- (4.5)%
======= ======= =======
</TABLE>
- --------
(A) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down 1%.
(B) Includes deal expenses, loan premium amortization, mortgage insurance
premiums and provisions for credit losses.
(C) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income as of December 31.
(D) Total change in estimated spread income, as a percent, from base.
(E) Total change in estimated spread income as a percent of total stockholders'
equity as of December 31.
Table 25
Interest Rate Sensitivity--Market Value
December 31, 1999 and 1998
<TABLE>
<CAPTION>
Basis Point
Increase
(Decrease) in
Interest Rate(A)
-----------------
As of December 31, 1999 (100) 100
- ----------------------- ------- --------
<S> <C> <C>
Change in market values of:
Assets.................................................... $ 9,112 $(11,340)
Liabilities............................................... (2,068) 2,376
Interest rate agreements.................................. (2,809) 4,723
------- --------
Cumulative change in market value........................... $ 4,235 $ (4,241)
======= ========
Percent change of market value portfolio equity(B).......... 3.5% (3.6)%
======= ========
<CAPTION>
Basis Point
Increase
(Decrease) in
Interest Rate(A)
-----------------
As of December 31, 1999 (100) 100
- ----------------------- ------- --------
<S> <C> <C>
Change in market values of:
Assets.................................................... $13,216 $(14,896)
Liabilities............................................... (714) 713
Interest rate agreements.................................. (923) 2,775
------- --------
Cumulative change in market value from base................. $11,579 $(11,408)
Percent change of market value portfolio equity(B).......... 12.4% (12.2)%
======= ========
</TABLE>
- --------
(A) Change in market value of assets, liabilities or interest rate agreements
in a parallel shift in the yield curve, up and down 1%.
(B) Total change in estimated market value as a percent of market value
portfolio equity as of December 31.
Interest rate sensitivity analysis. The values under the heading "Base" are
management's estimates of spread income for assets, liabilities and interest
rate agreements on December 31, 1999 and December 31, 1998. The values under
the headings "100" and "(100)" are management's estimates of the income and
change in market value of those same assets, liabilities and interest rate
agreements assuming that interest rates were 100 basis points, or 1 percent
higher and lower. The cumulative change in income or market value
57
<PAGE>
represents the change in income or market value of assets, net of the change in
income or market value of liabilities and interest rate agreements.
The interest sensitivity analysis is prepared monthly. If the analysis
demonstrates that a 100 basis point shift, up or down in interest rates would
result in 25 percent or more cumulative decrease in income from base, or a 10%
cumulative decrease in market value from base, policy requires management to
adjust the portfolio by adding or removing interest rate cap or swap
agreements. The Board of Directors reviews and approves NovaStar Financial's
interest sensitivity and hedged position quarterly.
Assumptions used in interest rate sensitivity analysis. Management uses
estimates in determining the income and market value of assets, liabilities and
interest rate agreements. The estimation process is dependent upon a variety of
assumptions, especially in determining the income and market 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, 1999 and 1998.
Management's analysis for assessing interest rate sensitivity on its subprime
mortgage loans relies significantly on estimates for prepayment speeds. A
prepayment model has been internally developed based upon four main factors:
. Refinancing incentives (the interest rate of the mortgage compared with
the current mortgage rates available to the borrower)
. Borrower credit grades
. Loan-to-value ratios
. Prepayment penalties, if any
Generally speaking, when market interest rates decline, borrowers are more
likely to refinance their mortgages. The higher the interest rate a borrower
currently has on his or her mortgage the more incentive he or she has to
refinance the mortgage when rates decline. In addition, the higher the credit
grade, the more incentive there is to refinance when credit ratings improve.
When a borrower has a low loan-to-value ratio, he or she is more likely to do a
"cash-out" refinance. Each of these factors presumably increases the chance for
higher prepayment speeds during the term of the loan. On the other hand,
prepayment penalties serve to mitigate the risk that loans will prepay, under
the assumption that the penalty is a deterrent to refinancing.
These factors are weighted based on management's experience and an evaluation
of the important trends observed in the subprime mortgage origination industry.
Actual results may differ from the estimates and assumptions used in the model
and the projected results as shown in the above table.
NovaStar Financial's projected prepayment rates in each interest rate
scenario start at a prepayment speed less than 5% in month one and increase to
a long-term prepayment speed in nine to 18 months, to account for the seasoning
of the loans. The long-term prepayment speed ranges from 20% to 40% and depends
on the characteristics of the loan which include type of product (ARM or fixed
rate), note rate, credit grade, LTV, gross margin, weighted average maturity
and lifetime and periodic caps and floors. This prepayment curve is also
multiplied by a factor of 60% on average for periods when a prepayment penalty
is in effect on the loan. These assumptions change with levels of interest
rates. The actual historical speeds experienced on NovaStar Financial's loans
shown in Table 7 are weighted average speeds of all loans in each deal.
As shown in Table 7, actual prepayment rates on loans that have been held in
portfolio for shorter periods are slower than long term prepayment rates used
in the interest rate sensitivity analysis. However, this table also indicates
that as pools of loans held in portfolio season, the actual prepayment rates
are more consistent with the long term prepayment rates used in the interest
sensitivity analysis.
58
<PAGE>
The investment policy for NovaStar Financial sets the following general
goals:
(1) Maintain the net interest margin between assets and liabilities, and
(2) Diminish the effect of changes in interest rate levels on the market
value of NovaStar Financial.
Although management evaluates the portfolio using interest rate increases and
decreases greater than one percent, management focuses on the one percent
increase. The investment policy for NovaStar Financial allows for no more than
a 25 percent decrease in the spread income of the portfolio and for no more
than a 10% decrease in the market value of the portfolio when interest rates
rise or fall by one percent.
Sensitivity as of December 31, 1999 and 1998. As shown in the above table, if
interest rates were to decrease one percent (-100 basis points), the spread
income would increase by an estimated 2.8% and 6.8% as of December 31, 1999 and
December 31, 1998, respectively. If interest rates rise by one percent (+100
basis points), the spread income would decrease by an estimated 0.6% and 4.5%
as of December 31, 1999 and 1998, respectively. If interest rates were to
decrease one percent, the market value of portfolio equity would increase by an
estimated 3.5% and 12.4% as of December 31, 1999 and 1998, respectively. If
interest rates rise by one percent, the market value of portfolio equity would
decrease by an estimated 3.6% and 12.2% as of December 31, 1999 and 1998,
respectively.
Hedging with off-balance-sheet financial instruments. In order to address a
mismatch of assets and liabilities, the hedging section of the investment
policy is followed, as approved by the Board. Specifically, the interest rate
risk management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on its mortgage
assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate mortgage loans and
related borrowings.
NovaStar Financial uses interest rate cap and swap agreements and financial
futures contracts to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its assets during
a period of rising rates. In this way, management intends generally to hedge as
much of the interest rate risk as determined to be in the best interest of
NovaStar Financial, given the cost of hedging transactions and the need to
maintain REIT status.
NovaStar Financial seeks to build a balance sheet and undertake an interest
rate risk management program that is likely, in management's view, to enable
NovaStar Financial to maintain an equity liquidation value sufficient to
maintain operations given a variety of potentially adverse circumstances.
Accordingly, the hedging program addresses both income preservation, as
discussed in the first part of this section, and capital preservation concerns.
Interest rate cap agreements are legal contracts between NovaStar Financial
and a third party firm or "counter-party". The counter-party agrees to make
payments to NovaStar Financial in the future should the one- or three-month
LIBOR interest rate rise above the strike rate specified in the contract.
NovaStar Financial either makes quarterly premium payments or has chosen to pay
the premiums upfront to the counterparties under contract. Each contract has a
fixed notional face amount, on which the interest is computed, and a set term
to maturity. Should the reference LIBOR interest rate rise above the
contractual strike rate, NovaStar Financial will earn cap income. Payments on
an annualized basis equal the contractual notional face amount times the
difference between actual LIBOR and the strike rate.
59
<PAGE>
BUSINESS
Generally, we invest in and manage a portfolio of mortgage loans, primarily
non-conforming, and mortgage securities. A substantial portion of the mortgage
loans we acquired have been originated by our affiliate, NovaStar Mortgage,
Inc. Mortgage securities were acquired in the open marketplace.
NovaStar Mortgage continues to originate loans for sale to third parties and
we consider that function integral to our business. During 2000, we expect to
finance half of the loans produced by NovaStar Mortgage. The remainder will be
sold to third parties. NovaStar currently has excess capital available to
support this mode of operation in 2000. After our excess capital is fully
deployed, we expect to raise additional equity through capital markets or by
selling loans. We continue to own and manage a portfolio of mortgage loans that
are, substantially, financed with long-term, non-recourse asset-backed bonds.
Following are summaries of the lending operation and our portfolio management
strategy.
Mortgage Lending Operation
Market Overview
During 1999, total mortgage loan originations were approximately $1,300
billion. Approximately 85% of these loans were classified as "prime" mortgages
which generally means they have credit quality and documentation sufficient to
qualify for a guarantee by GNMA, FNMA or FHLMC. More than $190 billion of the
total mortgage loans originated in 1999 were classified as "non-conforming" as
published by Mortgage Bankers Association of America.
We believe there is strong national demand by borrowers for non-conforming
mortgage loans. Across the country, many borrowers have suffered dislocation
and temporary unemployment, resulting in negative entries on their credit
reports. Erratic market and economic conditions and other factors have resulted
in high ratios of debts to assets and high levels of credit card and other
installment debt for these individuals. In addition, more borrowers are
choosing to become self-employed. These are some of the circumstances, which
create the market for non-conforming mortgage loans.
One of the significant differences between the conforming and non-conforming
mortgage loan markets has been the comparative dependence upon the overall
level of interest rates. Generally, the non-conforming mortgage loan market's
historical performance has been more consistent without regard to interest
rates. This is evident by the growth in non-conforming originations from 1993
through 1997. While the prime market experienced a decline in originations due
primarily to an increase in interest rates, mortgage loan originations in the
non-conforming market continued to grow.
The size of the non-conforming mortgage loan market in 1999 was approximately
$190 billion in annual originations. Historically, the non-conforming 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 non-conforming mortgage business, we believe the non-
conforming mortgage market is still highly fragmented, with no single
competitor having more than a 6% market share. The growth and profitability of
the non-conforming mortgage loan market, the demise of numerous financial
institutions in the late 1980s which had served this market, and reduced
profits and mortgage loan volume at traditional financial institutions have
together drawn new participants and capital to the non-conforming mortgage loan
market. We believe the non-conforming mortgage loan market requires more
business judgement from underwriters in evaluating borrowers with previous
credit problems. Non-conforming lending is also generally a lower volume/higher
profit margin business rather than the generally higher volume/lower profit
margin conforming mortgage loan business to which traditional mortgage bankers
have become accustomed. Non-conforming mortgage lending is also more capital
intensive than the conforming 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.
60
<PAGE>
We believe that the non-conforming mortgage market will continue to grow and
to generate relatively attractive risk-adjusted returns over the long term due
in part to the following reasons:
. growth in the number of existing homeowners with negative entries on
their credit reports;
. growth in the number of immigrants with limited credit histories who are
in the prime home buying ages of 25 to 34;
. growth in the number of self-employed individuals who have sources of
income which are inconsistent and difficult to document;
. growth in consumer debt levels which are causing many borrowers to have
higher debt/income ratios; and
. growth in consumer bankruptcy filings which cause borrowers to be
classified as subprime.
We expect more competitors to attempt to enter the market. While this may
cause profit margins to narrow, we believe that the non-conforming mortgage
market will be able to sustain relatively attractive profit margins due to
certain barriers to entry which include:
. the capital intensive nature of the business as issuers of securities
backed by non-conforming mortgage loans are required to retain the credit
and prepayment risks;
. the higher level of expertise required to underwrite the mortgage loans;
. the higher cost to service the mortgage loans due to the additional
emphasis required on collections and loss mitigation; and
. the highly fragmented nature of business due to the difficulty of
sourcing the mortgage loans.
Competition
In the November 15, 1999 issue of the National Mortgage News, competitors in
the top 40 of third quarter 1999 non-conforming mortgage loan originations
ranged from $3.3 billion to $148 million. NovaStar Mortgage's mortgage loan
origination volume for the third quarter of 1999 was $125 million. Based on
market capitalization, as published in national Mortgage News on November 15,
1999, NovaStar Financial ranked 14 of 22 publicly traded non-conforming
lenders. Management's research of the asset size of the companies indicates
NovaStar Financial ranks number 10 of 22.
We face intense competition in the business of originating, purchasing,
selling and securitizing non-conforming 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 non-conforming market. In addition to
other residential mortgage REITs, we are in competition for non-conforming
borrowers with consumer finance companies, conventional mortgage bankers,
commercial banks, credit unions and thrift institutions. We compete for holding
mortgage loans with life insurance companies, institutional investors and other
well-capitalized publicly-owned mortgage lenders. Many of these competitors are
substantially larger than we are and have considerably greater financial,
technical and marketing resources than we do.
Competition among industry participants can take many forms, including
convenience in obtaining a mortgage loan, amount and term of the loan, customer
service, marketing/distribution channels, loan origination fees and interest
rates. To the extent any competitor significantly expands its activities in the
non-conforming mortgage loan market, we could be materially adversely affected.
We believe that one of our key competitive strengths is our employees and the
level of service they are able to provide our borrowers. By servicing our loan
portfolio directly, we are able to stay in close contact with our borrowers and
identify potential problems early. NovaStar Mortgage's servicing staff is
comprised of seasoned mortgage professionals with significant experience in the
non-conforming mortgage loan marketplace.
61
<PAGE>
We effectively compete due to our:
. experienced management team;
. tax advantaged status as a REIT;
. vertical integration through our relationship with NovaStar Mortgage,
which originates and services mortgage loans;
. direct access to capital markets to securitize our assets; and
. cost-efficient operations.
Prior to 1999, our CMO transactions were designed to meet accounting rules
that resulted in securitizations being treated as financing transactions. The
mortgage loans and related debt continue to be presented on our balance sheet,
and no gain is recorded. Securitization transactions may also be structured as
sales for accounting and tax purposes. NovaStar Mortgage completed this type of
securitization in January of 1999. Details regarding CMOS issued by us and the
securitization transaction issued by NovaStar Mortgage can be found in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and Notes 3 and 4 to our consolidated financial statements.
We believe we have an advantage over other mortgage REITs through our
infrastructure that allows us to acquire wholesale loan production through our
taxable affiliate, NovaStar Mortgage, at a total cost lower than purchasing
those mortgage loans in the secondary market. Moreover, the relationship we
have with NovaStar Mortgage results in a vertically integrated organization.
Because of this integration, there are no material conflicts between the
interests of the mortgage lending operation and the portfolio management
operation. Conflicts may arise in REITs where the incentives and interest of
management are dependent on asset size rather than return on equity or
stockholder returns. Conflict may arise in entities that have external
management contracts or situations where management's compensation is not
directly related to the company's performance or return to stockholders. Our
primary management incentive programs are dependent on return on equity, in the
annual bonus plan, and stock price appreciation for forgivable loans to
founders and the stock option plan.
We file our own income tax return, while NFI Holding files consolidated
income tax returns that include NovaStar Mortgage. This structure is designed
to legally separate the mortgage loan origination operation from our
operations, i.e., the REIT entity. This structure also allows for activities
and transactions to be entered into by NovaStar Mortgage, while preserving our
REIT status. These activities include such items as the sale of assets, hedging
techniques and forms of indebtedness. NFI Holding was formed in order to
provide an efficient means of adding additional taxable affiliates to the
organization. We refer you to the "Federal Income Tax Consequences--
Qualification as a REIT" section of this prospectus for further information on
recently adopted legislation.
NovaStar is competitively disadvantaged because of its youth and relatively
low production volume. NovaStar Mortgage has been in the business of
originating non-conforming mortgage loans for three years and is still
developing its lending network. Until the infrastructure is completely refined
and developed, NovaStar Mortgage will not have the high volume/low cost per
loan production experienced by its competition. In addition, NovaStar Financial
requires significant capital to acquire assets and maximize earnings potential.
Many competitors of NovaStar Financial have larger market capitalization. A
larger market capitalization generally affords larger trading volume, more
recognition in the marketplace and, therefore, greater ability to raise
capital.
Loan Origination
As discussed in the following sections, NovaStar Mortgage originates and
services non-conforming mortgage loans. NovaStar Mortgage has agreed to service
the mortgage loans owned by NovaStar Financial. NovaStar Financial pays an
administrative outsourcing fee to NovaStar Mortgage as compensation for
mortgage loan development, underwriting, funding and quality control services.
We have entered into other agreements with NovaStar Mortgage in which NovaStar
Mortgage has agreed to pay us interest on amounts
62
<PAGE>
borrowed from us as well as pay us guaranty fees on loans sold by us in which
we have guaranteed their performance.
The historical amounts and nature of these intercompany fees are further
described under the "Fees from NovaStar Mortgage, Inc." and "General and
Administrative Expenses" categories in "Management's Discussion and Analysis of
Financial Condition and Results of Operations". Intercompany fees are also
disclosed in the consolidated financial statements of NovaStar Financial and
the notes thereto.
Loans originated by NovaStar Mortgage are primarily non-conforming mortgage
loans, generally secured by first liens on single family residential
properties. Non-conforming mortgage lending involves lending to individuals
whose borrowing needs are generally not being served by traditional financial
institutions due to poor credit history and/or other factors which make it
difficult for them to meet prime mortgage loan underwriting criteria. NovaStar
Mortgage targets as potential customers individuals with relatively significant
equity value in their homes, but who have impaired credit profiles, are self-
employed, tend to experience some volatility in their income or have difficult-
to-document sources of income, or are otherwise unable to qualify for
traditional conforming mortgage loans. Mortgage loan proceeds are used by
borrowers for a variety of purposes such as to consolidate consumer credit card
and other installment debt, to finance home improvements and to pay educational
expenses. These borrowers are often seeking to lower their monthly payments by
reducing the rate of interest they would otherwise pay or extending their debt
amortization period or doing both. Customer service is emphasized by providing
prompt responses and flexible terms to broker-initiated customer borrowing
requests. Through this approach, NovaStar Mortgage expects to originate new
mortgage loans and purchase closed mortgage loans with relatively higher
interest rates than are typically charged by lenders for prime mortgage loans
while having comparable or lower loan-to-value ratios. The pricing differential
between typical prime non-conforming mortgage loans and non-conforming mortgage
loans is often as much as 300 basis points. With proper management of the
credit risk, most of this additional spread may become additional profit for
the owner of these mortgage loans.
Originations have primarily been made for debt consolidation purposes, with
the remainder of our origination either rate/term refinances or purchase money
loans. Given the borrowers needs, non-conforming mortgage lending tends to be
less interest rate sensitive than the prime mortgage purchase market or
rate/term refinance market, since borrowings secured by real estate are
generally less expensive than credit card or installment debt. Non-conforming
borrowers are also generally more willing to accept a prepayment penalty since
they have fewer options for obtaining financing then the typical conforming
mortgage loan borrower. During 1999, 90% of the mortgage loans originated by
NovaStar Mortgage had a prepayment penalty.
Marketing and Production Strategy
General. NovaStar Mortgage's competitive strategy is to build efficient
channels of production for originating non-conforming mortgage loans. NovaStar
Mortgage has generated mortgage product through two distinctive production
channels:
. direct origination through a wholesale broker network; and
. bulk acquisitions from originators.
NovaStar Mortgage's long-term strategy is to emphasize production through the
wholesale broker network. We believe that production channels that allow us to
get closer to the customer and eliminate as many intermediaries as possible
will generally be the most efficient over the long-term and that by developing
the direct origination channel through a mortgage broker network, we will be
able to differentiate ourselves from other end investors who purchase their
production in bulk from other originators. From time to time, we may
participate in the bulk acquisition market depending on market conditions and
the availability of capital.
We believe that non-conforming mortgage loans provide a relatively attractive
net earnings profile, producing higher yields without commensurately higher
credit risks when compared to prime mortgage loans.
63
<PAGE>
With the proper focus on underwriting, appraisal, management and servicing of
non-conforming mortgage loans, we believe we can be successful in developing a
profitable business in this segment of the market. While many new competitors
have recently entered the non-conforming mortgage loan market, We believe that
the experience of our management in this industry and the infrastructure, which
has been established, allows it to effectively compete in this segment.
Mortgage Products. NovaStar Mortgage offers a broad menu of products in order
to serve our customers. These products are comprised of both fixed rate and
adjustable-rate mortgages. During 1999, the percentage of fixed rate and
adjustable rate loans originated by NovaStar Mortgage is 36% and 64%,
respectively. NovaStar Mortgage categorizes the mortgage loans that it
originates into one of six different credit risk classifications. Mortgage
loans are assigned a credit classification based on several factors consisting
of such things as loan-to-value ratios, the credit history of the borrower,
debt ratios of the borrower and other characteristics. NovaStar Mortgage
provides loans up to a maximum loan-to-value ratio of 97% based on the credit
risk classification and the loan amount. For loans originated in 1999, the
average loan-to-value ratio is 82% and the average loan amount was $101,000.
Wholesale Channel. NovaStar Mortgage's wholesale origination consists of a
network of brokers and mortgage lenders that offer our line of mortgage
products. We believe that our wholesale channel allows NovaStar Mortgage to
originate mortgage loans at a lower cost, including the cost to originate the
loan, than it could purchase the loan in the market. For example, assume the
price to purchase a loan in bulk is 104% of the face amount. If NovaStar
Mortgage can originate the same loan at 101% of face amount and incurs
origination costs of 1% of par, the wholesale loan would be 2% less expensive
than the mortgage loan purchased in bulk.
The wholesale origination infrastructure consists of a sales force to call on
mortgage loan brokers, two underwriting and processing centers to underwrite,
close and fund mortgage loans and systems to process data. As of December 31,
1999, we had a staff of 47 account executives, located in offices nationwide,
whose job is to call on brokers. Supporting the sales force is a staff of 72 in
Orange County, California. We believe we can originate loans through the
wholesale channel at a price 1.5 to 2.0% lower than the cost of acquiring
mortgage loans in bulk when our mortgage lending operation is running at full
capacity.
We believe we have been, and will continue to be, successful in competing in
the wholesale business for several reasons. First, we are vertically integrated
with our wholesale originator. Management believes this approach will provide a
competitive advantage over many competitors who either only originate loans or
only act as end investors because of the elimination of redundancy in
separating the two functions. Second, we believe our REIT status gives us a
pricing advantage over non-REIT mortgage investors. Third, NovaStar Mortgage
assembled a mortgage loan production staff with extensive experience and
contacts in the non-conforming mortgage loan market. We believe that important
factors influencing success or failure in the wholesale channel are offering
competitive prices, consistent application of underwriting guidelines, and
responsive service.
During the third quarter of 1999, we released Internet Underwriter, or "IU",
a web-based automated underwriting system used by selected customers for non-
conforming residential mortgage loans. IU serves to provide customers with the
ability to obtain underwriting approval and a loan purchase commitment in a
manner of minutes. All loans are subject to our underwriting guidelines
described below.
Bulk Acquisitions. The bulk acquisition channel was the first channel
developed by us as it required the least infrastructure to operate and it
allowed us to acquire non-conforming mortgage loans very quickly. Although it
generally carries a lower margin than the wholesale channel, from time to time
we may still acquire mortgage loans through this channel. In bulk acquisitions,
pools of mortgage loans ranging in size from $2 million to in excess of $25
million are acquired from large originators of mortgage loans.
Due diligence with respect to bulk acquisitions may be performed from time to
time by contract underwriters under the guidance of our Chief Credit Officer.
The Chief Credit Officer personally reviews the
64
<PAGE>
resumes of each contract underwriter prior to the performance of the due
diligence process. Any exceptions to our underwriting guidelines must be
approved by the Chief Credit Officer. Only the Chief Credit Officer and the
President can make the ultimate decision to approve a loan when the borrower
has an open bankruptcy. Personnel for this channel are centralized in the
mortgage operations headquarters with the only field personnel consisting of
the sales force strategically located in select markets. Through this
production channel, capital quickly invested in pools of non-conforming
mortgage loans.
Retail Channel. Neither NovaStar Mortgage nor NovaStar Financial has yet
established a retail or direct origination channel to the consumer. This is the
typical finance company model with a local office in a strip center and
commissioned loan originators. Retail origination is the most expensive and
potentially the most profitable origination channel. The overhead cost to
originate retail mortgage loans can be as high as four to 6% of the face amount
of the loan. However, the gross profit on such a mortgage loan can be as high
as 10% of the face amount of the mortgage loan and the prepayment risk is
mitigated due to the loan being funded at a discount to par. Success in retail
origination often times depends on the branch's ability to generate leads,
access to an outlet to sell mortgage loan products which are attractive to
borrowers, and flexible, common sense underwriting. This segment of the
mortgage industry remains highly fragmented and dominated by local brokers.
While NovaStar Mortgage or NovaStar Financial do not have plans to implement a
retail production channel initially, it may test a variety of direct consumer
marketing strategies in the future.
Profitability and Capital Allocation by Production Channel. In general, we
believe that the closer it gets to the consumer in the mortgage process chain,
the more profitable the production channel will be due to the elimination of
unnecessary intermediaries. While over the long term we believe this to be
true, there may be times when market conditions are such that the bulk
acquisition channel, the furthest from the customer, is the most profitable. In
order to properly manage the allocation of capital, we will measure the
profitability of each channel on a stand-alone basis. Direct expenses will be
tracked by channel and measured against mortgage loans originated via each
channel.
By measuring each channel independently, we intend to avoid supporting a
channel, which has been unprofitable over time. In addition, by knowing the
profitability of each channel at any given point in time, as well as on average
over a specified time period, we can make the proper decisions in deciding
where to invest our capital to obtain the best return for stockholders.
Underwriting and Quality Control Strategy
Underwriting Guidelines. We purchase loans in accordance with its
underwriting guidelines. These underwriting guidelines were developed by our
senior management utilizing their experience in the industry. The underwriting
guidelines are intended to evaluate the credit history of the potential
borrower, the capacity and willingness of the borrower to repay the loan and
the adequacy of the collateral securing the loan. NovaStar Mortgage originates
loans only in compliance with NovaStar Financial's underwriting guidelines.
NovaStar Mortgage underwrites all mortgage loans it originates through its
wholesale channel. Loans acquired by the Company in bulk pools are subject to
the same underwriting guidelines as established for NovaStar Mortgage
production. NovaStar Mortgage has hired experienced underwriters who work under
the supervision of the Chief Credit Officer. The underwriters hired by NovaStar
Mortgage all have substantial experience in the underwriting of subprime
mortgage loans.
Underwriters are given approval authority only after their work has been
reviewed by the Chief Credit Officer for a period of at least two weeks.
Thereafter, the Chief Credit Officer re-evaluates the authority levels of all
underwriting personnel on an ongoing basis. All mortgage loans in excess of
$350,000 currently require the approval of the Chief Credit Officer. In
addition, the President approves all mortgage loans in excess of $450,000.
On a case-by-case basis, exceptions to the underwriting guidelines are made
where compensating factors exist. Compensating factors may consist of factors
like length of time in residence, lowering of the borrower's
65
<PAGE>
monthly debt service payments, the loan to value ratio on the mortgage loan or
other criteria that in the judgment of the underwriter warrants an exception.
The Chief Credit Officer and the President have the authority to approve a
mortgage loan when the potential borrower has an open bankruptcy.
Each loan applicant completes an application that includes information with
respect to the applicant's income, assets, liabilities and employment history.
A credit report is also submitted by the broker along with the loan application
which provides detailed information concerning the payment history of the
borrower on all of their debts. Prior to issuing an approval on the mortgage
loan, the underwriter runs an independent credit report to verify that the
information submitted by the broker is still accurate and up-to-date. An
appraisal is also required on all mortgage loans and in many cases a review
appraisal or second appraisal may be required depending on the value of the
property and the underwriters comfort with the original valuation. All
appraisals are required to conform to the Uniform Standards of Professional
Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal
Foundation and are generally on forms acceptable to FNMA and FHLMC.
The underwriting guidelines include three levels of applicant documentation
requirements, referred to as "full documentation", "limited documentation", and
"stated income". Under the full documentation program applicants generally are
required to submit two written forms of verification of stable income for at
least 12 months. Under the limited documentation program, verification of
income is not required. However, personal or business bank statements for the
most recent 12 months are required as evidence of cash flows. Under the stated
income documentation program, an applicant may be qualified based on monthly
income as stated in the loan application.
66
<PAGE>
Our categories and criteria for grading the credit history of potential
borrowers and the maximum loan to value ratios allowed for each category are
shown below.
<TABLE>
<CAPTION>
AAA Risk AA Risk A Risk A- Risk B Risk C Risk D Risk
------------- ------------- ------------- ------------- ------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C> <C>
Mortgage No mortgage No mortgage Maximum one Maximum two Maximum three Maximum five Maximum six
History........ lates allowed lates allowed 30-day late 30-day lates 30 day lates 30 day 30 day lates,
within the within the and no 60-day and no 60-day and one 60 lates, and and three 60
last 24 last 12 lates within lates within day late two 60 day day lates and
months months the last the last within the lates, and two 90 day
12 months 12 months last one 90 day lates within
12 months late within the last 12
the last months. Must be
12 months current at time
of origination
Other Credit.... Limited 30 Limited 30 Limited 30 Limited 30 Limited 60 Limited 90 Discretionary--
day lates. day lates day lates day lates day lates day lates credit is
Generally within the within the within the within the within the generally
paid as last 24 last 12 last 12 last 12 last 12 expected to be
agreed months. months. months months months late pay
Generally Generally
paid as paid
agreed as agreed
Bankruptcy Chapter 13 Chapter 13 Chapter 13 Chapter 13 Chapter 13 Chapter 13 Chapter 13 and
Filings........ must be must be must be must be must be no seasoning 7 no seasoning
discharged discharged discharged discharged discharged required on required on
minimum of 2 minimum of minimum of minimum of minimum of discharge discharge with
years with 2 years with 2 years with 1 year with 1 year with with evidence of
reestablished reestablished reestablished reestablished reestablished evidence of satisfactory
credit; credit; credit; credit; credit; satisfactory discharge
Chapter 7 Chapter 7 Chapter 7 Chapter 7 Chapter 7 discharge;
must be must must must must Chapter 7
discharged be discharged be discharged be discharged be discharged minimum
minimum of 3 minimum of minimum of minimum of minimum of 18 discharge of
years with 3 years with 3 years with 2 years with months with 1 year
reestablished reestablished reestablished reestablished reestablished
credit credit credit credit credit
Debt Service
Ratio.......... 45% 45% 45% 50% 50% 55% 55%
Maximum Loan-to-
Value Ratio:
Full documenta-
tion........... 97% 95% 90% 90% 85% 75% 65%
Limited
documentation.. 90% 90% 85% 80% 80% 70% NA
Stated income... 90% 85% 80% 75% 75% 65% NA
</TABLE>
Loan Portfolio by Credit Risk Category. Table 1 of the Management's
Discussion and Analysis of Financial Condition and Results of Operations sets
forth our mortgage loan portfolio by credit grade as of December 31, 1999 and
1998, all of which are non-conforming.
Geographic Diversification. Close attention is paid to geographic
diversification in managing our credit risk. We believe one of the best tools
for managing credit risk is to diversify the markets in which we originate and
purchase mortgage loans. We have established a diversification policy to be
followed in managing this credit risk which states that no one market can
represent a percentage of total mortgage loans we own higher than twice that
market's percentage of the total national market share. While there generally
is some geographic concentration in mortgage loans originated through the bulk
acquisition channel, over time our mortgage lending operation plans to
diversify our credit risk by selecting target markets through the wholesale
channel. Presented in Table 2 of the "Management's Discussion and Analysis of
Financial Condition and Results of Operations" section of this prospectus is a
breakdown of our current geographic diversification as of December 31, 1999 and
1998.
Collateral Valuation. Collateral valuation also receives close attention in
our underwriting of our mortgage loans. Given that we primarily lend to non-
conforming borrowers, we place great emphasis on the ability of collateral to
protect against losses in the event of default by borrowers. We have
established an appraisal policy as part of our underwriting guidelines. This
policy includes requiring second and/or review appraisals on properties in
order to verify the value of the property.
67
<PAGE>
Quality Control. Quality control reviews are conducted to ensure that all
mortgage loans, whether originated or purchased, meet established quality
standards. The type and extent of the reviews depend on the production channel
through which the mortgage loan was obtained and the characteristics of the
mortgage loan. Reviews are performed on a high percentage of mortgage loans
with principal balances in excess of $350,000, high loan to value, limited
documentation, or those made for "cash out" refinance purposes. Appraisal
reviews and compliance reviews are also performed as part of the quality
control process to ensure adherence to appraisal policies and state and federal
regulations.
Regulation. We are regulated with respect to mortgage loan origination
marketing efforts, credit application and underwriting activities, maximum
finance and other charges, disclosure to customers, rights of rescission on
mortgage loans, closing and servicing mortgage loans, collection and
foreclosure procedures, qualification and licensing requirements for doing
business in various jurisdictions and other trade practices. Mortgage loan
origination activities are subject to the laws and regulations in each of the
states in which those activities are conducted. Activities as a lender are also
subject to various federal laws. The Truth in Lending Act, and Regulation Z
promulgated thereunder, contain disclosure requirements designed to provide
consumers with uniform, understandable information with respect to the terms
and conditions of loans and credit transactions so consumers have the ability
to compare credit terms. The Truth in Lending Act also guarantees consumers a
three-day right to cancel credit transactions. The Truth in Lending Act also
imposes disclosure, underwriting and documentation requirements on mortgage
loans with (1) total points and fees upon origination in excess of eight
percent of the mortgage loan amount or (2) an annual percentage rate of more
than ten percentage points higher than comparably maturing U.S. treasury
securities. We are also required to comply with the Equal Credit Opportunity
Act of 1974, as amended, which prohibits creditors from discriminating against
applicants on the basis of race, color, sex, age or marital status. Regulation
B promulgated under the Equal Credit Opportunity Act restricts creditors from
obtaining information from loan applicants. It also requires certain
disclosures by the lender regarding consumer rights and requires lenders to
advise applicants of the reasons for any credit denial. In instances where the
applicant is denied credit or the rate or charge for a loan increases as a
result of information obtained from a consumer credit agency, the Fair Credit
Reporting Act of 1970, as amended, requires the lender to supply the applicant
with a name and address of the reporting agency. We will also be subject to the
Real Estate Settlement Procedures Act and the Debt Collection Practices Act
pursuant to the Home Mortgage Disclosure Act. We will also be subject to the
rules and regulations of, and examinations by, the Government National Mortgage
Association, HUD and state regulatory authorities with respect to originating,
processing, underwriting, selling and servicing loans.
Mortgage Loan Servicing Strategy
Overview. We plan to acquire the large majority of mortgage loans we purchase
on a servicing released basis and thereby acquire the servicing rights. Through
July 14, 1997, Advanta Mortgage Corp. USA was acting as sub-servicer for the
mortgage loans we acquired. Effective, July 15, 1997, NovaStar Mortgage began
servicing our mortgage loans. The servicing operation is located in the
Westwood, Kansas office. Servicing includes collecting and remitting loan
payments, making required advances, accounting for principal and interest,
holding escrow or impound funds for payment of taxes and insurance, making
required inspections of the property, contacting delinquent borrowers and
supervising foreclosures and property disposition in the event of unremedied
defaults in accordance with company guidelines.
NovaStar Mortgage's focus for the servicing of our non-conforming mortgage
loans is based on effective credit risk. NovaStar Mortgage intends to employ
the proper resources to mitigate the losses on the mortgage loans serviced. We
also believe we can better manage prepayment risk by servicing our mortgage
loans through our affiliate. Through our servicing function, we intend to pre-
select borrowers that have an incentive to refinance and retain those mortgage
loans by soliciting the borrowers directly rather than losing them to another
mortgage lender. Although it is not a primary focus, we estimate that NovaStar
Mortgage will be able to effectively service our loans at a cost less than the
cost to outsource this to an unrelated company.
68
<PAGE>
Procedures. We have prescribed procedures for servicing our mortgage loans
which are to be followed by NovaStar Mortgage. In servicing non-conforming
mortgage loans, NovaStar Mortgage uses collection procedures that are generally
more stringent than those typically employed by a servicer of conforming
mortgage loans consistent with applicable laws. We believe one of the first
steps in effectively servicing non-conforming mortgage loans is to establish
contact with the borrower prior to any delinquency problems. To achieve this
objective, each borrower is telephoned ten days prior to the first payment due
date on the mortgage loan. With this telephone call,
. NovaStar Mortgage ensures it has the proper telephone number for the
borrower;
. the borrower will be aware of who is servicing the loan, where payment is
to be made, and has a contact to call in the event of any questions; and
. NovaStar Mortgage is able to stress to the borrower the importance of
making payments in a complete and timely manner.
The first 30 days of a delinquency are, in our view, the crucial period for
resolving the delinquency. At a minimum, all borrowers who have not made their
mortgage payment by the 10th day of the month in which it is due receive a call
from a collector. Borrowers whose payment history exhibits signs that the
borrower may be having financial difficulty receive more attention. For
example, any borrowers who made their previous months payment after the late
charge date, generally the 15th of the month, receive a call from a collector
no later than the second business day of the current month if their payment has
not yet been received. This allows NovaStar Mortgage to be more aggressive with
those borrowers who need the most attention and also focuses the efforts of the
collection staff of NovaStar Mortgage on the higher risk borrowers.
For accounts that have become 60 days or more delinquent, the collection
follow-up is increased and a full financial analysis of the borrower is
performed, a Notice of Intent to Foreclose is filed, and efforts to establish a
work out plan with the borrower are instituted.
Our policy allows for reasonable discretion to extend appropriate relief to
borrowers who encounter hardship and who are cooperative and demonstrate proper
regard for their obligation. NovaStar Mortgage is available to offer some
guidance and make personal contact with delinquent borrowers as often as
possible to seek to achieve a solution that will bring the mortgage loan
current. However, no relief will be granted unless there is reasonable
expectation that the borrower can bring the mortgage loan current within 180
days following the initial default.
If properly managed from both an underwriting and a servicing standpoint,
management believes it will be able to keep the level of delinquencies and
losses in our mortgage loans in line with industry standards.
Portfolio Management
We build our mortgage asset portfolio from two sources--loans originated in
the mortgage lending operation of NovaStar Mortgage and purchases in the
mortgage and securities markets. Initially, the portfolio was comprised of
purchased mortgage assets. As NovaStar Mortgage has developed its
infrastructure of non-conforming mortgage lending, we have relied less on
purchasing mortgage loans in bulk and more on wholesale origination.
Ultimately, management expects a substantial portion of our portfolio to
consist of retained interests in wholesale loans originated by NovaStar
Mortgage collateralizing our structured debt instruments.
Types of Mortgage Assets
The mortgage assets we purchased are principally single family mortgage loans
and mortgage securities backed by single family mortgage loans, as well as from
time to time multifamily mortgage loans and mortgage securities backed by
multifamily mortgage loans and commercial mortgage loans and mortgage
securities backed by commercial mortgage loans. Single family mortgage loans
are mortgage loans secured solely by first mortgages or deeds of trust on
residences with one-to-four units. Multifamily mortgage loans are mortgage
loans
69
<PAGE>
secured solely by first mortgages or deeds of trust on residential properties
with more than four units. Commercial mortgage loans are secured by commercial
properties. Substantially all of our mortgage assets bear adjustable interest
rates or have a fixed-rate coupon that has been paired with an interest rate
cap, so that we have the proper matching of assets and liabilities.
In September 1999, we purchased the subordinated (B-class) and interest-only
bonds of NovaStar Mortgage Funding Trust, Series 99-01, issued by NovaStar
Mortgage, our taxable-affiliate. In addition, as discussed above we may create
a variety of different types of assets, including the types mentioned in this
paragraph, through the normal process of securitization of our own mortgage
assets. Other than our taxable affiliates, we will not acquire or retain any
REMIC residual interest that may give rise to excess inclusion income as
defined under Section 860E of the Code. Excess inclusion income realized by a
taxable affiliate is not passed through to our stockholders.
Single Family Mortgage Loans. In future periods, we may acquire conforming
mortgage loans--those that comply with the requirements for inclusion in a loan
guarantee program sponsored by other FHLMC or FNMA. To date, we have acquired
only nonconforming mortgage loans. We also may acquire FHA Loans or VA Loans,
which qualify for inclusion in a pool of mortgage loans guaranteed by GNMA. To
date, no loans insured by FHA or VA have been originated or owned. Under
current regulations, the maximum principal balance allowed on conforming
mortgage loans ranges from $240,000 for one-unit to $461,300 for four-unit
residential loans. For properties located in either Alaska or Hawaii, the
maximum principal balance allowed ranges from $360,000 for one-unit to $691,950
for four-unit residential loans. Nonconforming single family mortgage loans are
single family mortgage loans that do not qualify in one or more respects for
purchase by FNMA or FHLMC. We expect that a majority of the nonconforming
mortgage loans it purchases will be nonconforming because they have original
principal balances which exceed the requirements for FHLMC or FNMA programs or
generally because they vary in certain other respects from the requirements of
such programs including the requirements relating to creditworthiness of the
mortgagors. A substantial portion of our nonconforming mortgage loans meet the
requirements for sale to national private mortgage conduit programs which focus
upon the non-conforming mortgage lending market. As of December 31, 1999, 87.1%
of our mortgage loans were collateralized by single family residential
properties.
Multifamily Mortgage Loans. Generally, we do not acquire multifamily mortgage
loans. Multifamily mortgage loans generally involve larger principal amounts
per loan than single family mortgage loans and require more complex credit and
property evaluation analysis. Multifamily mortgage loans share many of the
characteristics and risks associated with commercial mortgage loans and are
often categorized as commercial loans rather than residential loans. For
example, the credit quality of a multifamily mortgage loan typically depends
upon the existence and terms of underlying leases, tenant credit quality and
the historical and anticipated level of vacancies and rents on the mortgaged
property and on the competitive market condition of the mortgaged property
relative to other competitive properties in the same region, among other
factors. Multifamily mortgage loans, however, constitute "qualified mortgages"
for purposes of the REMIC regulations and the favorable tax treatment
associated therewith and, when securitized, certain of the resulting rated
classes of multifamily mortgage securities qualify as "mortgage-related
securities" and for the favorable treatment accorded such securities under the
Secondary Mortgage Market Enhancement Act of 1984. As of December 31, 1999,
3.7% of our mortgage loans were collateralized by multifamily residential
property.
Mortgage Securities. Mortgage securities we owned as of and during the period
since inception and through December 31, 1998, have consisted of mortgage
securities issued by corporations sponsored by the United States government,
including FNMA, GNMA and FHLMC. Securities issued by FHLMC and FNMA are not
guaranteed by the full faith and credit of the U.S. Government. In October
1998, we sold all securities owned by NovaStar Financial and NovaStar Mortgage
and paid off the related repurchase agreement financing, recognizing an
aggregate loss of $15.4 million.
70
<PAGE>
Mortgage assets purchased by us in the future may include mortgage securities
as follows:
(1) Single Family and Multifamily Privately Issued Certificates. Single
family and multifamily privately issued certificates are issued by
originators of, investors in, and other owners of mortgage loans, including
savings and loan associations, savings banks, commercial banks, mortgage
banks, investment banks and special purpose "conduit" subsidiaries of such
institutions. Single family and multifamily privately issued certificates
are generally covered by one or more forms of private, i.e., non-
governmental, credit enhancements. Forms of credit enhancements include,
but are not limited to, surety bonds, limited issuer guarantees, reserve
funds, private mortgage guaranty pool insurance, over-collateralization and
subordination.
(2) Agency Certificates. At present, all GNMA certificates are backed by
single family mortgage loans. FNMA certificates and FHLMC certificates may
be backed by pools of single family or multifamily mortgage loans. The
interest rate paid on agency certificates may be fixed rate or adjustable
rate.
(3) Commercial Mortgage Securities. To the extent we will seek to acquire
any mortgage assets either backed by or secured by commercial property, we
intend to favor the acquisition of mortgage securities backed by commercial
mortgage loans rather than direct acquisition of commercial mortgage loans.
These mortgage securities generally have been structured as pass-through
certificates with private, i.e., non-governmental, credit enhancements or
as collateralized mortgage obligations. Because of the great diversity in
characteristics of the commercial mortgage loans that secure or underlie
these mortgage securities, such securities will also have diverse
characteristics. Although many are backed by large pools of commercial
mortgage loans with relatively small individual principal balances, these
mortgage securities may be backed by commercial mortgage loans
collateralized by only a few commercial properties or a single commercial
property. Because the risk involved in single commercial property financing
is highly concentrated, single commercial property mortgage securities to
date have tended to be limited to extremely desirable commercial properties
with excellent values and/or lease agreements with extremely creditworthy
and reliable tenants, such as major corporations.
Commercial Mortgage Loans. We will only acquire commercial mortgage loans
when we believe we have the necessary expertise to evaluate and manage them and
only if they are consistent with our capital asset guidelines. Commercial
mortgage loans are secured by commercial properties, such as industrial and
warehouse properties, office buildings, retail space and shopping malls, hotels
and motels, hospitals, nursing homes and senior living centers. Commercial
mortgage loans have certain distinct risk characteristics: commercial mortgage
loans generally lack standardized terms, which may complicate their structure,
although some of the new conduits are introducing standard form documents for
use in their programs; commercial mortgage loans tend to have shorter
maturities than single family mortgage loans; they may not be fully amortizing,
meaning that they may have a significant principal balance or "balloon" due on
maturity; and commercial properties, particularly industrial and warehouse
properties, are generally subject to relatively greater environmental risks
than non-commercial properties and the corresponding burdens and costs of
compliance with environmental laws and regulations. To date, we have not
acquired commercial mortgage loans. As of December 31, 1999, we had no loans
collateralized by commercial property.
Asset Acquisition Policies
We acquire only those mortgage assets that we believe we have the necessary
expertise to evaluate and manage and which are consistent with our risk
management objectives. Our strategy is to focus primarily on the acquisition of
single family mortgage loans, single family mortgage securities, multifamily
mortgage loans and multifamily mortgage securities. We focus primarily on the
acquisition of floating-rate and adjustable-rate assets, so that assets and
liabilities remain matched. Our asset acquisition strategy will change over
time as market conditions change and as we evolve.
Our investment policy allows for the acquisition of mortgage assets and
certain other liquid investments, such as federal agency securities and
commercial paper. We do not presently intend to invest in real estate,
interests in real estate, or interests in persons primarily engaged in real
estate activities.
71
<PAGE>
We may also purchase the stock of other mortgage REITs or similar companies
when we believe that such purchases will yield attractive returns on capital
employed. We have not, nor do we presently intend to invest in the securities
of other issuers for the purpose of exercising control or to underwrite
securities of other issuers. We have not and we presently have no intention to
repurchase or otherwise reacquire our shares or other securities. Although we
have not, we may in the future acquire mortgage assets by offering our debt or
equity securities in exchange for mortgage assets.
We generally intend to hold mortgage assets to maturity. In addition, the
REIT provisions of the Code limit our ability to sell mortgage assets. We may
decide to sell assets from time to time, however, for a number of reasons,
including, without limitation, to dispose of a mortgage asset as to which
credit risk concerns have arisen, to reduce interest rate risk, to substitute
one type of mortgage asset for another to improve yield or to maintain
compliance with the 55% requirement under the Investment Company Act, and
generally to restructure the balance sheet when we deem such action advisable.
We will select any mortgage assets to be sold according to the particular
purpose such sale will serve. The Board of Directors has not adopted a policy
that would restrict our authority to determine the timing of sales or the
selection of mortgage assets to be sold.
Financing for Mortgage Lending Operations and Mortgage Security Acquisitions
We finance our mortgage loan purchases through interim financing facilities
such as repurchase agreements. A repurchase agreement is a borrowing device
evidenced by an agreement to sell securities or other assets to a third-party
and a simultaneous agreement to repurchase them at a specified future date and
price, the price differential constituting interest on the borrowing.
A non-conforming mortgage lending operation is a capital intensive business.
Depending on the type of product originated and the production channel, the
amount of capital required as a percentage of the balance of mortgage loans
originated may range from 6% to 12%. For illustration purposes only, based on a
hypothetical monthly volume of $25 million, this will equate to a capital
requirement of $1.5 to $3 million per month, and on a hypothetical volume of
$50 million, this requirement doubles to $3 to $6 million per month. Our non-
conforming mortgage lending operation is managed through a taxable affiliate,
which provides us the flexibility to sell our mortgage loan production as whole
loans or in the form of pass-through securities in the event it encounters
restrictions in accessing the capital markets.
To mitigate interest rate risk, we enter into transactions designed to hedge
interest rate risk, which may include mandatory and optional forward selling of
mortgage loans or mortgage assets, interest rate caps, floors and swaps, buying
and selling of futures and options on futures, and acquisition of interest-only
REMIC regular interests. The nature and quantity of these hedging transactions
will be determined by us based on various factors, including market conditions
and the expected volume of mortgage loan purchases. We believe our strategy of
issuing long-term structured debt securities will also assist us in managing
interest rate risk.
Acquisitions of mortgage securities are generally financed using repurchase
agreements.
Mortgage Loans Held as Collateral for Structured Debt
We intend to securitize the non-conforming mortgage loans produced by the
mortgage lending operation as part of our overall asset/liability strategy.
Securitization is the process of pooling mortgage loans and issuing equity
securities, such as mortgage pass throughs, or debt securities, such as
collateralized mortgage obligations. We intend to securitize by issuing
structured debt. Under this approach, for accounting purposes the mortgage
loans securitized remain on the balance sheet as assets and the collateralized
mortgage debt obligations appear as liabilities. A securitization results only
in rearranging our borrowings, as proceeds from the structured debt issuance
are applied against preexisting borrowings. The proceeds repay advances under
the warehouse line of credit or borrowings under repurchase agreements. Issuing
structured debt in this matter serves to lock in less expensive, non-recourse
long-term financing that better matches the terms of the loans serving as
collateral for the debt.
72
<PAGE>
Proceeds from securitizations have been used to support new mortgage loan
originations. Securitizations are long-term financing and are not subject to a
margin call if a rapid increase in rates would reduce the value of the
underlying mortgages.
Our investment in retained interests under securitizations, as discussed
above, reflects the excess of the mortgage loan collateral over the related
liabilities on the balance sheet. The resulting stream of expected "spread"
income will be recognized over time through the tax-advantaged REIT structure.
Other forms of securitizations may also be employed from time to time under
which a "sale" of interests in the mortgage loans occurs and a resulting gain
or loss is reflected for accounting purposes at the time of sale. This form of
securitization was employed in September of 1999 by NovaStar Mortgage. See
further discussion of this sales transaction in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and Notes 3 and 4 to
our Consolidated Financial Statements. Under this form, only the net retained
interest in the securitized mortgage loans remains on the balance sheet. We
anticipate these sales will generally be made through one or more of our
taxable affiliates. We may conduct securitization activities through one or
more taxable affiliates or qualified REIT subsidiaries formed for such purpose.
We expect our retained interests in our securitizations, regardless of the
form used, will be subordinated to the classes of securities issued to
investors in such securitizations with respect to losses of principal and
interest on the underlying mortgage loans. Accordingly, any such losses
incurred on the underlying mortgage loans will be applied first to reduce the
remaining amount of our retained interest, until reduced to zero. Thereafter,
any further losses would be borne by the investors or, if used, the monoline
insurers in such securitizations rather than us.
We will structure our securitizations so as to avoid the attribution of any
excess inclusion income to our stockholders. NovaStar management is experienced
in the securitization of non-conforming and other single family residential
mortgage loans.
We have financed our retained interests in our securitizations through a
combination of equity and secured debt financings.
Credit Risk Management Policies
Mortgage Loans. With respect to our mortgage loan portfolio, we attempt to
control and mitigate credit risk through:
. ensuring that established underwriting guidelines are followed;
. geographic diversification of our loan portfolio;
. the use of early intervention, aggressive collection and loss mitigation
techniques in servicing our mortgage loans;
. the use of insurance and the securitization process to limit the amount
of credit risk that it is exposed to on our retained interests in
securitizations; and
. maintenance of appropriate capital reserve levels.
A summary of the credit quality and diversification of our loan portfolio as
of December 31, 1999 and 1998 is presented in Table 1 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
Acquisitions. With respect to the mortgage assets we purchase, we review the
credit risk associated with each investment and determine the appropriate
allocation of capital to apply to such investment under our capital allocation
guidelines. Because the risks presented by single family, multifamily and
commercial mortgage assets are different, we analyze the risk of loss
associated with such mortgage assets separately. In addition, we attempt to
diversify our portfolio to avoid undue geographic, issuer, industry and certain
other types of concentrations. We attempt to obtain protection against some
risks from sellers and servicers through
73
<PAGE>
representations and warranties and other appropriate documentation. The Board
of Directors will monitor the overall portfolio risk and determine appropriate
levels of provision for losses.
With respect to our purchased mortgage assets, we are exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying mortgage assets and the nature and level of credit enhancements
supporting such securities. Credit loss protection for privately issued
certificates is achieved through the subordination of other interests in the
pool to the interest held by us and/or through pool insurance. The degree of
credit protection varies substantially among the privately issued certificates
held by us. While privately issued certificates held by us will have some
degree of credit enhancement, the majority of such assets are, in turn,
subordinated to other interests. Thus, should such a privately issued
certificate experience credit losses, such losses could be greater than our pro
rata share of the remaining mortgage pool, but in no event could exceed our
investment in such privately issued certificate.
With respect to purchases of mortgage assets in the form of mortgage loans,
we have developed a quality control program to monitor the quality of loan
underwriting at the time of acquisition and on an ongoing basis. We will
conduct a legal document review of each mortgage loan acquired to verify the
accuracy and completeness of the information contained in the mortgage notes,
security instruments and other pertinent documents in the file. As a condition
of purchase, we will select a sample of mortgage loans targeted to be acquired,
focusing on those mortgage loans with higher risk characteristics, and submit
them to a third party, nationally recognized underwriting review firm for a
compliance check of underwriting and review of income, asset and appraisal
information. In addition, we or our agents will underwrite all multifamily and
commercial mortgage loans. During the time it holds mortgage loans, we will be
subject to risks of borrower defaults and bankruptcies and special hazard
losses, such as those occurring from earthquakes or floods, that are not
covered by standard hazard insurance. We will generally not obtain credit
enhancements such as mortgage pool or special hazard insurance for our mortgage
loans, although individual loans may be covered by FHA insurance, VA guarantees
or private mortgage insurance and, to the extent securitized into agency
certificates, by such government sponsored entity obligations or guarantees.
In August 1998, NovaStar Financial and NovaStar Mortgage executed an
agreement whereby lender-paid mortgage insurance coverage is purchased on
selected mortgage loans. The use of mortgage insurance is one method of
managing the credit risk in the mortgage asset portfolio. Going forward,
management expects that it will evaluate the cost-benefit of securing lender
paid mortgage insurance for each securitization transaction.
Interest Rate Risk Management
The investment policy for NovaStar Financial sets the following general
goals:
(1) Maintain the net interest margin between assets and liabilities, and
(2) Diminish the effect of changes in interest rate levels on the market
value of NovaStar Financial.
Loan Price Volatility. Under its current mode of operation, NovaStar
Financial depends heavily on the market for wholesale non-conforming mortgage
loans. To conserve capital, NovaStar Mortgage may sell loans it originates. The
financial results of NovaStar Financial will depend, in part, on the ability to
find purchasers for the loans at prices that cover origination expenses.
Exposure to loan price volatility will be reduced as NovaStar Financial resumes
acquisition and retention of mortgage loans.
Interest Rate Risk. Interest rate risk is the risk that the interest rate on
NovaStar Financial's mortgage assets will increase or decrease at different
rates than that of the liabilities. Expressed another way, this is the risk
that NovaStar Financial's net asset value will experience an adverse change
when interest rates change. When interest rates on the assets do not adjust at
the same rates as the liabilities or when the assets are fixed rates and the
liabilities are adjusting, future earnings potential is affected. Management
primarily uses financing sources where the interest rate resets frequently. As
of December 31, 1999, borrowings under all financing arrangements adjust daily,
monthly, or quarterly. On the other hand, very few of the mortgage assets owned
by
74
<PAGE>
NovaStar Financial, as of December 31, 1999, adjust on a monthly or daily
basis. Most of the mortgage loans contain features where their rates are fixed
for some period of time and then adjust frequently thereafter. For example, one
of our loan products is the "2/28" loan. This loan is fixed for its first two
years and then adjusts every six months thereafter.
While short-term borrowing rates are low and long-term asset rates are high,
this portfolio structure produces good results. However, if short-term interest
rates rise rapidly, earning potential could be significantly affected as the
asset rate resets would lag the borrowing rate resets. The converse can be true
when sharp declines in short-term interest rates cause interest costs to fall
faster than asset rate resets, thereby increasing earnings.
In its assessment of the interest sensitivity and as an indication of
exposure to interest rate risk, management relies on models of financial
information in a variety of interest rate scenarios. Using these models, the
fair value and interest rate sensitivity of each financial instrument, or
groups of similar instruments is estimated, and then aggregated to form a
comprehensive picture of the risk characteristics of the balance sheet. The
risks are analyzed on both an income and market value basis. We refer you to
the discussion and analysis of interest rate risk presented in the
"Management's Discussion and Analysis of Financial Condition and Results of
Operation--Interest Rate/Market Risk" section of this prospectus for further
information.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated
prepayment rates in our mortgage assets portfolio by acquiring mortgage loans
with prepayment penalties, utilizing various financial instruments and the
production of new mortgage loans as a hedge against prepayment risk, and
capturing through our servicing of the mortgage loans and our portfolio
retention department a large portion of those loans which are refinanced. Under
certain state laws, prepayment charges may not be imposed or may be limited as
to amount or period of time they can be imposed. Prepayment risk is monitored
by management and through periodic review of the impact of a variety of
prepayment scenarios on our revenues, net earnings, dividends, cash flow and
the market value of portfolio equity.
Although we believe we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks, no strategy can completely insulate us from the effects of
interest rate changes, prepayments and defaults by counterparties. Further,
certain of the federal income tax requirements that we must satisfy to qualify
as a REIT may, at times, limit our ability to fully hedge our interest rate and
prepayment risks.
Taxable Affiliates
We have currently implemented, and will continue to implement, portions of
our business strategy from time to time through one of our taxable affiliates.
Other taxable affiliates may be used to implement future business strategies.
The REIT is entitled to up to 99% of dividends distributed by such taxable
affiliate. The voting common stock of such corporation, however, is owned by
persons other than the REIT due to the provisions of the Code limiting
ownership by REITs of the voting stock of non-REIT qualifying entities. In our
case, the voting common stock of NFI Holding, our taxable affiliate holding
company, is held by Messrs. Hartman and Anderson. Such common stock currently
has at least one percent of the dividends and liquidation rights of NFI
Holding. We hold a class of preferred stock of the taxable affiliate holding
company, which preferred stock is entitled to up to 99% of the dividends and
liquidation proceeds distributable from NFI Holding. Recently adopted
legislation will allow REITs to own directly all of the stock of taxable
subsidiaries beginning in the tax year 2001. At present, REITs are generally
limited to holding non-voting preferred stock in taxable affiliates. The value
of all taxable subsidiaries of a REIT will be limited to 20% of the total value
of the REIT's assets. Accordingly, NFI will have to acquire all of the common
stock of NFI Holding from Scott Hartman and Lance Anderson during 2001. This
federal tax legislation change is discussed further under "Federal Income Tax
Consequences" of this prospectus.
75
<PAGE>
Taxable affiliates are not qualified REIT subsidiaries and would be subject
to federal and state income taxes. In order to comply with the nature of asset
tests applicable to us as a REIT, as of the last day of each calendar quarter,
the value of the securities of any such affiliate held by us must be limited to
less than five percent of the value of our total assets and no more than ten
percent of the voting securities of any such affiliate may be owned by us.
Taxable affiliates have not elected REIT status and distribute any net profit
after taxes to us and our other stockholders. Any dividend income received by
us from any such taxable affiliate, combined with all other income generated
from our assets, other than qualified REIT assets, must not exceed 25% of our
gross income. Before we form any additional taxable affiliate corporations, we
will obtain an opinion of counsel to the effect that the formation and
contemplated method of operation of such corporation will not cause us to fail
to satisfy the nature of assets and sources of income tests applicable to it as
a REIT.
The Clinton Administration's fiscal year 2001 budget includes a proposal that
would increase the amount of a REIT's taxable income that must be distributed
during the year in order to avoid imposition of the 4% excise tax from the
current 85% to 98%. The Administration also proposed a provision that would bar
an entity from electing REIT status if 50% or more of its stock were owned by
another corporation. We do not anticipate that the Administration's budget
proposal would have an adverse effect on our operations, including those of
NovaStar Mortgage.
Properties
Our executive and administrative offices are located in Westwood, Kansas, and
consist of approximately 11,000 square feet. The leases on the premises expire
December 2002 and December 2004. The current annual rent for these offices is
approximately $228,000.
NovaStar Mortgage leases space for its mortgage lending operations in Orange
County, California. Currently, these offices consist of approximately 16,000
square feet, respectively. The lease on the Orange County premises expires
January 2004, and the current annual rent is approximately $414,000.
NovaStar Mortgage also leases space for its mortgage servicing operation in
Westwood, Kansas. The square footage on these premises is approximately 24,000,
with annual rent of approximately $260,000, and a lease scheduled to expire in
January 2005.
Legal Proceedings
We occasionally become involved in litigation arising in the normal course of
business. We believe that any liability with respect to such legal actions,
individually or in the aggregate, will not have a material adverse effect on
our financial position or results of operations.
76
<PAGE>
MANAGEMENT
Directors and Executive Officers
Our directors and executive officers and their positions are as follows:
<TABLE>
<CAPTION>
Name Position
---- --------
<S> <C>
Scott F. Hartman(1)........ Chairman of the Board, Secretary and
Chief Executive Officer
W. Lance Anderson(1)....... Director, President and Chief Operating Officer
Michael L. Bamburg......... Senior Vice President and Chief Investment Officer
Rodney E. Schwatken........ Vice President, Treasurer and
Controller (Chief Accounting Officer)
Edward W. Mehrer(2)(3)(4).. Director
Gregory T. Barmore(2)(4)... Director
Bart Johnson(2)(3)(5)...... Director
</TABLE>
- --------
(1) Founder of the Company.
(2) Independent director.
(3) Member of the Audit Committee.
(4) Member of the Compensation Committee.
(5) Mr. Johnson resigned from GE Capital Corporation, and consequently from his
position as a Director of NovaStar Financial, as of March 29, 2000.
Information regarding the background and experience of our directors and
officers follows:
Directors and Executive Officers
Scott F. Hartman, age 40, is our co-founder, Chairman of the Board of
Directors and Chief Executive Officer and has been a member of the Board of
Directors since 1996. His main responsibilities are to manage our portfolio of
investments, interact with the capital markets and oversee the securitization
of our mortgage loan production. Mr. Hartman most recently served as Executive
Vice President of Dynex Capital, Inc., (Dynex) formerly Resource Mortgage
Capital, Inc., a New York Stock Exchange listed REIT. His responsibilities
while at Dynex included managing the investment portfolio, overseeing the
securitization of mortgage loans originated through Dynex's mortgage operation
and the administration of the securities issued by Dynex. Mr. Hartman left
Dynex in June 1996 to pursue this opportunity. Prior to joining Dynex in
February 1995, Mr. Hartman served as a consultant to Dynex for three years
during which time he was involved in designing and overseeing the development
of Dynex's analytical and securities structuring system. Mr. Hartman also
serves as a director and Vice Chairman of NovaStar Mortgage.
W. Lance Anderson, age 39, is our co-founder, President and Chief Operating
Officer and has been a member of the Board of Directors since 1996. His main
responsibility is to manage our mortgage origination and servicing operations.
Mr. Anderson most recently served as Executive Vice President of Dynex Capital,
Inc., formerly Resource Mortgage Capital, Inc., a NYSE-listed REIT. In
addition, Mr. Anderson was President and Chief Executive Officer of Dynex's
single family mortgage operation, Saxon Mortgage. In this role he was
responsible for the origination, underwriting, servicing, quality control and
pricing functions for Saxon. He served in this capacity for two years prior to
which he was Executive Vice President in charge of production for the single
family operation. Mr. Anderson served from October 1989 at Dynex where he was
responsible for the startup of the single family operation. Mr. Anderson was
also responsible for re-focusing the conduit on the subprime mortgage market in
late 1993. Mr. Anderson also serves as Chairman of the Board of Directors,
President and Chief Executive Officer of NovaStar Mortgage.
Michael L. Bamburg, age 37, is Senior Vice President and Chief Investment
Officer of NovaStar Financial and NovaStar Mortgage. Mr. Bamburg is responsible
for managing our portfolio of investments,
77
<PAGE>
interacting with the capital markets, overseeing the securitization of our
mortgage loan production, and developing new business lines for us. Mr. Bamburg
most recently served as a Principal of Smith Breeden Associates, a financial
institution consulting and money management firm specializing in the evaluation
and hedging of mortgage backed securities. Mr. Bamburg spent over 11 years with
Smith Breeden where he analyzed and traded hundreds of millions of dollars of
mortgage backed securities and consulted with various financial institutions
regarding investments and asset/liability management issues. During the last 3
years with Smith Breeden, Mr. Bamburg spent most of his time marketing Smith
Breeden's money management products.
Rodney E. Schwatken, age 36, is Vice President, Treasurer and Controller of
NovaStar Financial and NovaStar Mortgage. Mr. Schwatken is responsible for all
accounting and finance functions, including management of financial
relationships, management and shareholder reporting and compliance with REIT
regulations. From June 1993 to March 1997, when he joined NovaStar Financial,
Mr. Schwatken was Accounting Manager with U.S. Central Credit Union, a $30
billion dollar investment, liquidity and technology resource for the credit
union industry. From January 1987 to June 1994, Deloitte & Touche LLP in Kansas
City, Missouri employed Mr. Schwatken, most recently as an audit manager.
Edward W. Mehrer, age 60, has been a member of the Board of Directors since
1996. He is presently Chief Financial Officer of Cydex, a pharmaceutical
company based in Overland Park, Kansas. Mr. Mehrer was previously associated
with Hoechst Marion Roussel, formerly Marion Merrell Dow, Inc., an
international pharmaceutical company, for approximately ten years until his
retirement in December 1995. From December 1991, he served as Executive Vice
President, Chief Financial Officer and a director of Marion. Prior to that
position, he served in a number of financial and administrative positions.
Prior to joining Marion, Mr. Mehrer was a partner with the public accounting
firm of Peat Marwick Mitchell & Co., a predecessor firm to KPMG LLP, in Kansas
City, Missouri.
Gregory T. Barmore, age 58, was most recently Chairman of the Board of GE
Capital Mortgage Corporation, a subsidiary of GE Capital Corporation
headquartered in Raleigh, North Carolina. He has served on the Board of
Directors since 1996. He was responsible for overseeing the strategic
development of GE Capital Mortgage Corporation's residential real estate-
affiliated financial businesses, including mortgage insurance, mortgage
services and mortgage funding. Prior to joining GE Capital Mortgage Corporation
in 1986, Mr. Barmore was Chief Financial Officer of Employers Reinsurance
Corporation, one of the nation's largest property and casualty reinsurance
companies and also a subsidiary of GE Capital Corporation. Prior to his
appointment at Employers Reinsurance Corporation, he held a number of financial
and general management positions within GE. Mr. Barmore was selected to serve
on our Board as an independent director without regard to the GE Capital
Corporation investment and accordingly there are no arrangements with GE
Capital Corporation or our affiliates regarding his term of office or other
aspects of his service on the Board.
Bart O. Johnson, age 51, had been a member of the Board since 1998 as the GE
Capital Corporation nominee. He was President of GE Capital Residential
Connections, a division of GE Capital Mortgage Corporation, and is a 25-year
mortgage industry veteran. Immediately prior to joining GE in 1997, Mr. Johnson
served as Chief Financial Officer and National Residential Production Manager
at Mellon Bank's Mortgage Banking Group beginning in 1989. Mr. Johnson resigned
from GE Capital Corporation, and consequently from his position as a Director
of NovaStar Financial, as of March 29, 2000.
Other Senior Officers
James H. Anderson, age 36, is Senior Vice President and National Sales
Manager of NovaStar Mortgage. His primary responsibilities include overseeing
the overall marketing efforts of NovaStar Mortgage, including managing the
sales force of account executives. Prior to joining NovaStar in November 1996,
Mr. Anderson was President of his own marketing consulting business. From
August 1992 through September 1996, Mr. Anderson was employed by Saxon, where
he served as Vice President of Marketing, in charge of the Western Region of
the United States. In addition, Mr. Anderson was in charge of Saxon's national
sales force for correspondent lending.
78
<PAGE>
Scott A. Hebdon, age 31, is Senior Vice President and Chief Credit Officer
for NovaStar Mortgage. Mr. Hebdon has primary responsibility for all
processing, underwriting, and funding activities of the Company. In addition,
Mr. Hebdon chairs the Company's Credit Committee. Prior to joining NovaStar, he
served as a Vice President and Regional Manager for Security Pacific Financial
Services and a District Manager for Commercial Credit. In these positions, Mr.
Hebdon was responsible for all origination, underwriting, and collection
activities of regional loan centers located in Washington, Oregon, and Los
Angeles/Orange County, CA. Prior to this, Mr. Hebdon held various positions
with Norwest Financial.
Christopher S. Miller, age 34, is Senior Vice President and Servicing Manager
of NovaStar Mortgage. Mr. Miller is a former Vice President of Option One
Mortgage Corporation, a subsidiary of Fleet Mortgage Corporation. From July
1995 to March 1997, Mr. Miller's responsibilities included managing the
Collections Department, Customer Service Department, Escrow Analysis, Payoff
Department, and Reconveyance. Prior to his tenure at Option One Mortgage in
1995, Mr. Miller spent over seven years at Novus Financial Corporation, a
subsidiary of Dean Witter Financial Services, where he managed multiple
servicing departments. Mr. Miller brings to NovaStar a diverse servicing
background with an emphasis on default management.
Terms of Directors and Officers
Our Board of Directors consists of such number of persons as shall be fixed
by the Board of Directors from time to time by resolution to be divided into
three classes, designated Class I, Class II and Class III, with each class to
be as nearly equal in number of directors as possible. Currently there are four
directors. Mr. Mehrer is a Class I director, Mr. Anderson and Mr. Barmore are
Class II directors and Mr. Hartman is a Class III director. Class I, Class II
and Class III directors will stand for reelection at the annual meetings of
stockholders held in 2000, 2001 and 2002, respectively. At each annual meeting,
the successors to the class of directors whose term expires at that time are to
be elected to hold office for a term of three years, and until their respective
successors are elected and qualified, so that the term of one class of
directors expires at each such annual meeting. We intend to maintain the
composition of the Board so that there will be no more than six directors, with
a majority of independent directors at all times, each of whom shall serve on
the Audit and/or Compensation Committees. Mr. Johnson was the GE Capital
Corporation nominee serving as a Class III director with a term running until
the 2002 annual meeting of stockholders. Mr. Johnson resigned from GE Capital
Corporation, and consequently from his position as a director of NovaStar
Financial, as of March 29, 2000. In the case of any vacancy on the Board of
Directors, including a vacancy created by an increase in the number of
directors, the vacancy may be filled by election of the Board of Directors or
the stockholders, with the director so elected to serve until the next annual
meeting of stockholders, if elected by the Board of Directors, or for the
remainder of the term of the director being replaced, if elected by the
stockholders; any newly-created directorships or decreases in directorships are
to be assigned by the Board of Directors so as to make all classes as nearly
equal in number as possible. Directors may be removed only for cause and then
only by vote of a majority of the combined voting power of stockholders
entitled to vote in the election for directors. Subject to the voting rights of
the holders of preferred stock, our charter may be amended by the vote of a
majority of the combined voting power of stockholders, provided that amendments
to the article dealing with directors may only be amended if it is advised by
at least two-thirds of the Board of Directors and approved by vote of at least
two-thirds of the combined voting power of stockholders. The effect of the
foregoing as well as other provisions of our charter and bylaws may discourage
takeover attempts and make more difficult attempts by stockholders to change
management. Prospective investors are encouraged to review our charter and
bylaws in their entirety.
Our bylaws provide that, except in the case of a vacancy, a majority of the
members of the Board of Directors will at all times be independent directors.
Independent directors are defined as directors who are not officers or our
employees or any affiliate or our subsidiary. GE Capital Corporation and our
affiliates are expressly deemed not to be our affiliates for this purpose.
Vacancies occurring on the Board of Directors among the independent directors
may be filled by a vote of a majority of the remaining directors, including a
majority of the remaining independent directors. Officers are elected annually
and serve at the discretion of the Board of Directors. There are no family
relationships between the executive officers or directors.
79
<PAGE>
Committees of the Board
Audit Committee. We have established an Audit Committee composed of two
independent directors. The Audit Committee makes recommendations concerning the
engagement of independent public accountants, reviews with the independent
public accountants, the plans and results of any audits, reviews other
professional services provided by the independent public accountants, reviews
the independence of the independent public accountants, considers the range of
audit and non-audit fees and reviews the adequacy of our internal accounting
controls.
Compensation Committee. We have established a Compensation Committee composed
of two independent directors. The Compensation Committee determines the
compensation of our executive officers.
Other Committees. The Board of Directors may establish other committees as
deemed necessary or appropriate from time to time, including, but not limited
to, an Executive Committee of the Board of Directors.
Compensation of Directors
We pay independent directors $10,000 per year plus $500 for each meeting
attended in person. Each independent director has been granted options to
purchase 5,000 shares of common stock at the fair market value of the common
stock upon becoming a director and options to purchase 2,500 shares at the fair
market value of the common stock on the day after each annual meeting of
stockholders. However, as the GE Capital Corporation nominee and pursuant to GE
Capital Corporation's internal policy, Mr. Johnson did not receive any
compensation, whether fees or stock options, for his service on the Board of
Directors. None of our directors have received any separate compensation for
service on the Board of Directors or on any committee. In addition, Mr. Barmore
and Mr. Mehrer were granted options to purchase 5,000 shares of common stock at
$18 per share in connection with the 1997 initial public offering of common
stock. All directors receive reimbursement of reasonable out-of-pocket expenses
incurred in connection with meetings of the Board of Directors. No director who
is our employee will receive separate compensation for services rendered as a
director.
Compensation Committee Interlocks
No interlocking relationship exists between our Board of Directors or
officers responsible for compensation decisions and the board of directors or
compensation committee of any other company, nor has any such interlocking
relationship existed in the past.
80
<PAGE>
Executive Compensation
Executive Officer Summary Compensation Table
<TABLE>
<CAPTION>
Long-term
Compensation
--------------------
Securities
Other Annual Underlying All Other
Name and Position Year Salary Bonus Compensation Options(#) DER's(6) Compensation
- ----------------- ---- -------- -------- ------------ ---------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Scott F. Hartman........ 1999 $280,000 -- -- -- -- $50,633(1)
Chairman of the Board, 1998 $185,000 -- -- -- -- $94,033(1)
Secretary and Chief 1997 $130,833 -- $549,635(2) 40,000 -- --
Executive Officer
W. Lance Anderson....... 1999 $280,000 -- -- -- -- $50,633(1)
President and Chief 1998 $185,000 -- -- -- -- 94,033(1)
Operating Officer 1997 $130,833 -- $549,635(2) 40,000 -- --
Mark J. Kohlrus(3) 1999 $170,000 $ 89,250 -- 20,000(7) -- --
Senior Vice President, 1998 $120,000 $ 86,500 -- 10,000 $3,300 --
Treasurer and 1997 $100,000 $ 90,000 -- -- -- --
Chief Financial Officer
Michael L. Bamburg(4)... 1999 $190,000 $114,000 -- 30,000(7) -- --
Senior Vice President 1998 $128,333 $105,000 -- 20,000 -- --
and
Chief Investment 1997 -- -- -- -- -- --
Officer
Rodney Schwatken(5)..... 1999 $ 80,000 $ 22,800 -- 6,000(7) -- --
Vice President, 1998 $ 75,000 $ 16,875 -- 4,500 -- --
Treasurer and
Controller
1997 $ 62,500 $ 18,750 -- -- -- --
</TABLE>
- --------
(1) Represents dividend payments on 144,666 shares of common stock, each owned
by Mr. Hartman and Mr. Anderson, serving as collateral on non-recourse
promissory notes issued in 1998 upon the exercise of options. The dividend
payments are treated as compensation for personal income tax purposes.
(2) Represents forgiveness of one tranche of founders' forgivable debt.
(3) Mr. Kohlrus was employed by NovaStar Financial from December 16, 1996
through March 15, 2000.
(4) Mr. Bamburg's employment with NovaStar Financial began in February 1998 and
provided for an annual salary of $140,000 through December 31, 1998. Mr.
Bamburg is eligible to receive an annual bonus of up to 75% of his annual
salary.
(5) Mr. Schwatken's employment with NovaStar Financial began on March 20, 1997
and provided for an annual salary of $75,000.
(6) 1996 options granted to Mr. Hartman and Mr. Anderson which vested on the
closing of the initial public offering were granted without dividend
equivalent rights or DERs. Options granted to Mr. Kohlrus which began to
vest in December 1997 were granted with DERs. None of the 1997, 1998 and
1999 options listed were granted with DERs.
(7) Pursuant to resolutions of the Compensation Committee dated December 21,
1999, certain options issued to employees were repriced to $7.00 per share.
Options "granted" in 1999 replace 1997 options "canceled" for Messrs.
Kohlrus and Schwatken and 1998 options "canceled" for Mr. Bamburg. The
repricing is described under the heading "Report on Repricing of Options".
81
<PAGE>
Bonus Incentive Compensation Plan. A bonus incentive compensation plan was
established for certain executive and key officers of NovaStar Financial and
its affiliates, effective commencing with the fiscal year beginning January 1,
1998. The annual bonus pursuant to the bonus incentive compensation plan will
be paid one-half in cash and one-half in shares of common stock, annually,
following receipt of the audit for the related fiscal year. This program will
award bonuses annually to those officers out of a total pool determined by
stockholder return on equity ("ROE") as follows:
<TABLE>
<CAPTION>
ROE(1) in Excess of Base Bonus as percent of Average
Rate(2) By: Net Worth(3) Outstanding
------------------------ ---------------------------
<S> <C>
Zero or less 0%
Greater than 0% but less 10% x (Actual ROE--Base
than 6% Rate)
Greater than 6% (10% x 6%) + 15% x (Actual
ROE--(Base Rate + 6%))
</TABLE>
Of the amount so determined, one-half will be deemed contributed to the total
pool in cash and the other half deemed contributed to the total pool in the
form of shares of common stock, with the number of shares to be calculated
based on the average price per share during the preceding year. The total pool
may not exceed $1 million for fiscal years ending December 31, 1998, and
December 31, 1999. For 1998 and 1999, NovaStar did not contribute to this pool
and no bonuses were awarded.
- --------
(1) "ROE" is determined for the fiscal year by averaging the monthly ratios
calculated each month by dividing the monthly net income (adjusted to an
annual rate) by its average net worth for such month. For such
calculations, the "net income" means the net income or net loss determined
according to GAAP, but after deducting any dividends paid or payable on
preferred stock that may be issued before giving effect to the bonus
incentive compensation or any valuation allowance adjustment to
stockholders' equity. The definition "ROE" is used only for purposes of
calculating the bonus incentive compensation payable pursuant to the bonus
incentive compensation plan and is not related to the actual distributions
received by stockholders. The bonus payments will be an operating expense
of NovaStar Financial.
(2)"Base rate" is the average for each month of the ten-year U.S. Treasury
rate, plus 4%.
(3)"Average net worth" for any month means the arithmetic average of the sum of
(1) the net proceeds from all offerings of equity securities since formation
including exercise of warrants and stock options and pursuant to the
proposed Dividend Reinvestment Plan (but excluding any offerings of
preferred stock in the future), after deducting any underwriting discounts
and commissions and other expenses and costs relating to the offerings, plus
(2) the retained earnings (without taking into account any losses incurred
in prior fiscal years, after deducting any amounts reflecting taxable income
to be distributed as dividends and without giving effect to any valuation
allowance adjustment to stockholders' equity) computed by taking the daily
average of such values during such period.
Units Acquired with Forgivable Debt. Messrs. Hartman and Anderson each
acquired 108,333 units, each unit consisting of one share of preferred stock
which converted to common stock at the closing of the initial public offering
and one warrant, which were acquired at the price of $15 per unit on December
9, 1996. Payment for such units was made by delivering to NovaStar Financial
promissory notes, each in the amount of $1,624,995, bearing interest at 8% per
annum compounded annually and secured by the units being acquired. Interest
began accruing during the first year and is added to principal due under the
note. Thereafter, interest became payable quarterly and upon forgiveness or at
maturity of the notes, which is at the end of the fifth fiscal period.
The principal amount of the notes is divided into three equal tranches.
Payment of principal on each tranche will be forgiven, if the following
incentive performance tests are achieved:
. During the first five fiscal periods after issuance of the notes:
--One tranche will be forgiven for each fiscal period as to which
NovaStar Financial generates a total return to investors in units
equal to or greater than 15%. The debt on the first tranche was
82
<PAGE>
forgiven and NovaStar Financial recognized a non-cash charge against
earnings of $1,083,330 for the fiscal period ending December 31, 1997.
--At the end of each of the five fiscal periods, all remaining tranches
will be forgiven if NovaStar Financial has generated a total
cumulative return to investors in units (from date of initial issuance
of the notes) equal to or greater than 100%.
. For purposes of calculating the returns to such investors:
--The term "fiscal period" will refer to each of five periods. The first
period commenced with the closing of the private placement on December
9, 1996, and ended on December 31, 1997, and, thereafter, each
succeeding fiscal period extends for twelve months and ends on each
December 31.
. The term "return" for each fiscal period will mean the sum of (on a per
unit basis) (a) all cash dividends paid during (or declared with respect
to) such fiscal period per share of preferred stock (or per share of
common stock following conversion of the preferred stock upon completion
of the initial public offering), (b) any increase or decrease in the
price per share of preferred stock (or resulting common stock) during
such fiscal period, measured by using the price per unit to investors in
the private placement as the starting price ($15.00), and using the
average public trading price during the last 90 days of each succeeding
fiscal period for such succeeding periods (except such shorter period as
the common stock was traded in 1997), and (c) any increase or decrease in
the price per warrant during such fiscal period, determined in the same
manner as in (b). For purposes of the fiscal period 15% return test, the
total return for a given period will be equal to the sum of (a), (b) and
(c) during the period, and for purposes of the cumulative 100% return
test, the amounts in (a), (b) and (c) will all be measured from the
beginning of the first fiscal period. The amount of that "return" will
then be measured as a percentage of the investor's investment in the
units (on a per unit basis) without regard to timing of receipt of
dividends or timing of increases in per share or per warrant prices.
. If one of the incentive tests is met, the amount of loan forgiveness for
each tranche will be the principal amount of such tranche of the note. In
addition, a loan will be made by NovaStar Financial to Messrs. Hartman
and Anderson in the amount of (1) personal tax liability resulting from
the forgiveness of debt, and (2) interest accrued during the first year
of the forgiven tranches. The note will bear interest at a floating
market rate, will be secured by that proportionate number of shares that
had secured the forgiven tranche of the note and will mature upon the
earlier of the sale of those shares or the termination of the officer's
employment. Messrs. Hartman and Anderson have issued notes payable to
NovaStar Financial for the repayment of the tax liability and interest
accrued on forgivable notes through December 31, 1997 and notes payable
for the founders' contributions to capital of NFI Holding in 1999. For
further discussion on these notes see "Indebtedness of Management".
Stock Option Plan. NovaStar Financial's 1996 stock option plan provides for
the grant of qualified incentive stock options or ISOs, non-qualified stock
options or NQSOs, deferred stock, restricted stock, performance shares, stock
appreciation and limited stock awards, and dividend equivalent rights or DERs.
ISOs may be granted to the officers and employees. NQSOs and awards may be
granted to the directors, officers, employees, agents and consultants. Unless
previously terminated by the Board of Directors, the plan will terminate on
September 1, 2006.
All options have been granted at exercise prices greater than or equal to
the estimated fair value of the underlying stock. Outstanding options vest
over four years and expire ten years after the date of grant.
83
<PAGE>
The following table sets forth information concerning stock options granted
during 1999 for each of the directors and executive officers.
<TABLE>
<CAPTION>
Individual Grants
------------------------------------------
Percent of Potential Realizable
Total Value at Assumed
Options Exercise Annual Rates of
Granted to Price or Stock Price Appreciation
Employees Base forOption Term(2)
No. During the Price Expiration -------------------------
Name Granted Year ($/Share) Date 5% 10%
---- ------- ---------- --------- ---------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Michael L. Bamburg...... 30,000(1) 25% $7.00 1/28/08 $ 139,440 $ 203,290
Gregory T. Barmore...... 2,500 2% 6.75 6/9/09 26,999 42,991
Edward W. Mehrer........ 2,500 2% 6.75 6/9/09 26,999 42,991
Mark J. Kohlrus......... 20,000(1) 17% 7.00 11/4/07 91,909 132,552
Rodney E. Schwatken..... 6,000(1) 5% 7.00 11/4/07 27,573 39,766
------- ---
Total to Directors and
Executive Officers... 61,000 51%
======= ===
Total options
granted.............. 119,000
=======
</TABLE>
- --------
(1) Certain 1998 and 1997 stock options repriced in 1999 as discussed in the
"Report on Repricing of Options". The original stock options were treated
as cancelled and the options repriced at $7.00 per share were treated as
granted in 1999.
(2) Options granted to non-employee directors were priced at the market price
of NovaStar Financial's common stock on the NYSE at the date of grant.
Repriced options were priced in excess of the then current market price of
$3.13 per share. In each case, the assumed annual rates represent the
potential appreciation in value over the exercise price.
The following table sets forth certain information with respect to the value
of the options as of December 31, 1999 held by the named directors and
executive officers.
Fiscal Year End Option Value
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options as
Options as of of December 31,
Shares December 31, 1999 1999(2)(3)
Acquired on ------------------------- -------------------------
Name Exercise Value Realized(1) Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ----------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Scott F. Hartman........ -- -- 20,000 20,000 -- --
W. Lance Anderson....... -- -- 20,000 20,000 -- --
Gregory T. Barmore...... 1,250 4,363 3,125 8,125 -- $3,900
Edward W. Mehrer........ -- -- 6,875 8,125 $11,700 3,900
Michael L. Bamburg...... -- -- 12,500 37,500 -- --
Rodney E. Schwatken..... -- -- 4,125 6,375 -- --
</TABLE>
- --------
(1) The "value realized" represents the difference between the exercise price
of the option shares and the market price of the option shares on the date
the option was exercised. The value realized was determined without
considering any taxes which may have been owed.
(2) "In-the-money" options whose exercise was less than the market price of
common stock at December 31, 1999.
(3) Assuming a stock price of $3.13 per share, which was the closing price of a
share of common stock reported for the New York Stock Exchange on December
31, 1999.
84
<PAGE>
Report on Repricing of Options
On December 21, 1999, the Compensation Committee changed the exercise price
for 104,000 stock options issued to employees to $7.00 per share. Of these,
69,000 were originally issued in 1997 with an exercise price of $18.00 per
share and 35,000 in 1998 at an exercise price of $17.01 per share. The New York
Stock Exchange closing price on that date was $3.13 per share. The $7.00
options are considered granted and the $18.00 and $17.01 options are considered
cancelled during 1999. No changes were made to the vesting periods or
expiration dates. The Compensation Committee adopted the following report on
repricing of options:
The Compensation Committee finds that the repricing is necessary because
equity incentives are a significant component of the total compensation
package and play a substantial role in NovaStar Financial's ability to
retain the services of individuals essential to NovaStar Financial's long-
term financial success. Prior to the implementation of the program, the
market price of NovaStar Financial's common stock had fallen as a result of
market factors which adversely impacted NovaStar Financial's financial
results and which did not necessarily reflect the optionees' contributions
to NovaStar Financial's progress. The Compensation Committee finds that
NovaStar Financial's ability to retain key employees would be significantly
impaired unless value is restored to their options through repricing. The
Compensation Committee believes that the program strikes an appropriate
balance between the interests of the option holders and those of the
shareowners. The lower exercise price, although in excess of current fair
market value, make those options valuable once again to the optionees.
Compensation Committee
Gregory T. Barmore
Edward W. Mehrer
10-Year Option Repricings
<TABLE>
<CAPTION>
Market Length of
Option Value at Exercise Original Option
Date of Shares Time of Price at Time New Exercise Term at Time of
Name Repricing Repriced Repricing of Repricing Price Repricing
---- --------- -------- --------- ------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
Scott F. Hartman........ -- -- -- -- -- --
Chairman of the Board,
Secretary and Chief
Executive Officer
W. Lance Anderson....... -- -- -- -- -- --
President and Chief
Operating Officer
Gregory T. Barmore...... -- -- -- -- -- --
Director
Edward W. Mehrer........ -- -- -- -- -- --
Director
Mark J. Kohlrus......... 12/21/99 20,000 $3.13 $18.00 $7.00 7 yrs 318 days
Senior Vice President
and Chief Financial
Officer
Michael L. Bamburg...... 12/21/99 30,000 3.13 17.01 7.00 8 yrs 38 days
Senior Vice President
and Chief Investment
Officer
Rodney E. Schwatken..... 12/21/99 6,000 3.13 18.00 7.00 7 yrs 318 days
Vice President,
Treasurer
and Controller
</TABLE>
Employment Agreements. NovaStar Financial has entered into employment
agreements with the founders, Mr. Hartman and Mr. Anderson. Each employment
agreement provides for a term through December 31, 2001, and will be
automatically extended for an additional year at the end of each year of the
agreement, unless either party provides a prescribed prior written notice to
the contrary. Each employment agreement
85
<PAGE>
provides for the annual base salary described above and for participation by
the subject officer in the bonus incentive compensation plan. Each employment
agreement provides for the subject officer to receive his annual base salary
and bonus compensation to the date of the termination of employment by reason
of death, disability or resignation and to receive base compensation to the
date of the termination of employment by reason of a termination of employment
for cause as defined in the agreement. Each employment agreement also provides
for the subject officer to receive, if the subject officer resigns for "good
reason" or is terminated without cause after a "change in control" as those
terms are defined in the agreement, an amount, 50% payable immediately and 50%
payable in monthly installments over the succeeding twelve months, equal to
three times such officer's combined maximum base salary and actual bonus
compensation for the preceding year, subject in each case to a maximum amount
of 1% of the book equity value (exclusive of valuation adjustments) and a
minimum of $360,000. In that instance, the subject officer is prohibited from
competing with NovaStar Financial for a period of one year. In addition, all
outstanding options granted to the subject officer under the 1996 stock option
plan shall immediately vest. Section 280G of the Code may limit the
deductibility of the payments to such officer for federal income tax purposes.
"Change of control" for purposes of the agreements would include a merger or
consolidation of NovaStar Financial, a sale of all or substantially all of the
assets of NovaStar Financial, changes in the identity of a majority of the
members of the Board of Directors of NovaStar Financial (other than due to the
death, disability or age of a director) or acquisitions of more than 25% of the
combined voting power of NovaStar Financial's capital stock, subject to certain
limitations. Absent a "change in control," if NovaStar Financial terminates the
officer's employment without cause, or if the officer resigns for "good
reason," the officer receives an amount, payable immediately, equal to such
officer's combined maximum base salary and actual bonus compensation for the
preceding year, subject in each case to a maximum amount of 1% of book value
(exclusive of valuation adjustments) and a minimum of $120,000. If the officer
resigns for any other reason, there is no severance payment and the officer is
prohibited from competing with NovaStar Financial for a period of one year
following the resignation.
86
<PAGE>
PRINCIPAL SECURITYHOLDERS
Beneficial Ownership of Common Stock by Large Securityholders
The following table sets forth the information we have with respect to
beneficial ownership of our common stock as of April 1, 2000, by each person
other than members of management known to us to beneficially own more than 5%
of our common stock. Unless otherwise indicated in the footnotes to the table,
the beneficial owners named have, to our knowledge, sole voting and investment
power with respect to the shares beneficially owned, subject to community
property laws where applicable.
<TABLE>
<CAPTION>
Beneficial Ownership
of Common Stock(1)
----------------------
Name and Address of Beneficial Owner Shares Percent
- ------------------------------------ ----------- ----------
<S> <C> <C>
Wallace R. Weitz & Company(2)............................ 6,372,262 48.99%
1125 South 103rd Street, Suite 600
Omaha, NE 68124-6008
General Electric Capital Corporation(3).................. 1,333,332 15.16%
260 Long Ridge Road
Stamford, CT 06927
Lindner Dividend Fund(4)................................. 1,216,567 13.83%
7711 Carondolet Avenue, Suite 700
St. Louis, MO 63104
GMAC/Residential Funding Corporation(5).................. 1,177,713 12.65%
8400 Normandale Lake Blvd., Suite 600
Minneapolis, MN 55437
McCarthy Group, Inc.(6).................................. 814,285 9.21%
1125 South 103rd Street, Suite 450
Omaha, NE 68124
First Union Corporation(7)............................... 536,667 6.33%
One First Union Center, TW9
Charlotte, NC 28288-0610
First Financial Fund(8).................................. 450,700 5.54%
c/o Wellington Management Company
75 State Street
Boston, MA 02109
</TABLE>
- --------
(1) Assuming no exercise of warrants or conversion of preferred stock except by
the securityholder named, separately, and no purchases by any of the listed
securityholders in this offering.
(2) Includes 1,305,000 shares of common stock issuable upon the exercise of
warrants and 3,571,429 shares of common stock issuable upon conversion of
preferred stock.
(3) Includes 666,666 shares of common stock issuable upon the exercise of
warrants.
(4) Includes 666,667 shares of common stock issuable upon the exercise of
warrants.
(5) Includes 1,177,713 shares of common stock issuable upon the exercise of
warrants.
(6) Includes 714,285 shares of common stock issuable upon conversion of
preferred stock.
(7) Includes 350,000 shares of common stock issuable upon the exercise of
warrants.
(8) Consists of shares of common stock currently outstanding.
87
<PAGE>
Beneficial Ownership of Common Stock by Directors and Management
The following table sets forth information we have with respect to beneficial
ownership of our common stock as of April 1, 2000, by (1) each director, (2)
our executive officers, and (3) all directors and executive officers as a
group. Unless otherwise indicated in the footnotes to the table, the beneficial
owners named have, to our knowledge, sole voting and investment power with
respect to the shares beneficially owned, subject to community property laws
where applicable.
<TABLE>
<CAPTION>
Beneficial
Ownership
of Common
Stock(1)
-----------------
Name of Beneficial Owner Number Percent
- ------------------------ --------- -------
<S> <C> <C>
Scott F. Hartman(2)...................................................... 529,065 6.40
W. Lance Anderson(3)..................................................... 539,465 6.52
Edward W. Mehrer(4)...................................................... 39,750 *
Gregory T. Barmore(5).................................................... 1,250 *
Bart O. Johnson.......................................................... -- --
Michael L. Bamburg(6).................................................... 76,988 *
Mark J. Kohlrus(7)....................................................... 16,305 *
Rodney Schwatken......................................................... 6,425 *
All Directors and Executive Officers as a Group (7 persons).............. 1,202,823 14.57
</TABLE>
- --------
* Less than one percent.
(1) Assuming no exercise of the warrants and exercisable options, except by the
listed securityholder named separately.
(2) Consists of 390,732 shares of common stock and 128,333 warrants, including
224,066 of common stock and 20,000 of warrants owned jointly with his wife,
and 10,000 shares of common stock issuable upon the exercise of options.
(3) Consists of 395,932 shares of common stock and 133,533 warrants, including
287,599 of common stock and 25,200 of warrants owned jointly with his wife,
and 10,000 shares of common stock issuable upon the exercise of options.
(4) Consists of 24,000 shares of common stock and 12,000 of warrants, including
2,000 of each owned by his wife, and 3,750 shares of common stock issuable
upon the exercise of options.
(5) Consists of 1,250 shares of common stock issuable upon the exercise of
options.
(6) Consists of 46,188 shares of common stock and 23,300 warrants, including
1,228 shares of common stock owned by his wife, 300 warrants owned by his
wife, 20,110 warrants owned jointly with his wife, and 7,500 shares of
common stock issuable upon the exercise of options.
(7) Includes 9,805 shares of common stock and 1,500 warrants, all of which are
owned jointly with his wife, except for 550 shares of common stock which
are controlled by Mr. Kohlrus as custodian for his children, and 5,000
shares of common stock issuable upon the exercise of options.
88
<PAGE>
CERTAIN TRANSACTIONS
Transactions with Management. In May 1996, Messrs. Hartman and Anderson
formed NovaStar Mortgage, Inc. for the purpose of engaging in the non-
conforming lending business. Following NovaStar Financial's private placement,
NovaStar Mortgage began obtaining required licenses and permits, developing
guidelines for the origination of mortgage loans through its wholesale lending
channel and hiring critical senior personnel to put in place the infrastructure
for its mortgage lending and servicing operations.
Following the close of the private placement in December 1996, NovaStar
Financial moved to implement the portion of its business strategy to be
conducted through taxable affiliates. In February 1997, NFI Holding Corporation
was formed to serve as a holding company for such taxable affiliates. In March
1997, Messrs. Hartman and Anderson acquired all of the outstanding voting
common stock of NFI Holding for a total price of $20,000 and NovaStar Financial
acquired all of the outstanding non-voting preferred stock of NFI Holding for a
total price of $1,980,000. NFI Holding was additionally capitalized with
NovaStar Financial and Messrs. Hartman and Anderson contributing $6,930,000 and
$70,000, respectively, in 1999 and $990,000 and $10,000, respectively, in 1998.
The voting common stock is entitled to 1% of the dividend distributions of NFI
Holding and the preferred stock is entitled to 99% of such distributions. At
the time of acquisition of the common stock, Messrs. Hartman and Anderson
entered into an agreement of shareholders, to which NovaStar Financial is a
party, which contains certain management and control provisions and
restrictions on transfer of the common stock. The obligations of Messrs.
Hartman and Anderson under the agreement of shareholders are secured by the
pledge of their common stock in NFI Holding.
In February 1997, NFI Holding acquired all of the outstanding common stock of
NovaStar Mortgage from Messrs. Hartman and Anderson. NovaStar Mortgage thereby
became a wholly-owned subsidiary of Holding. Through NFI Holding, NovaStar
Financial owns a beneficial interest in 99% of the future dividend
distributions attributable to NovaStar Mortgage.
NovaStar Financial and NovaStar Mortgage also entered into a loan
subservicing agreement under which NovaStar Mortgage agrees to service mortgage
loans for NovaStar Financial initially for a fixed dollar fee per loan based on
the fee in comparable subservicing arrangements. The subservicing agreement
became effective with the commencement of NovaStar Mortgage's servicing
operation in July 1997. Separate agreements have been executed for each pool of
loans serving as collateral for NovaStar Financial's collateralized mortgage
obligations.
NovaStar Financial and NovaStar Mortgage further entered into an
administrative services outsourcing agreement, dated June 30, 1997, pursuant to
which NovaStar Mortgage provides to NovaStar Financial on a fee basis certain
administrative services, including consulting with respect to the development
of mortgage loan products, loan underwriting, loan funding and quality control.
Effective April 1, 1999, NovaStar Financial entered an intercompany loan and
guarantee agreement with NovaStar Mortgage. Under the terms of this agreement,
NovaStar Mortgage pays interest on amounts it borrows from NovaStar Financial.
As of December 31, 1999 and 1998, NovaStar Mortgage had $27,663,000 and
$48,486,000 in borrowings from NovaStar Financial outstanding. Interest on the
borrowings accrues at the federal funds rate plus 1.75%. In addition, NovaStar
Mortgage is required to pay guaranty fees in the amount 0.25% of the loans sold
by NovaStar Mortgage for which NovaStar Financial has guaranteed the
performance of NovaStar Mortgage.
89
<PAGE>
Following is a summary of the fees, in thousands, which NovaStar Financial
paid to and received from NovaStar Mortgage:
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------------
1999 1998 1997
-------- -------- -------
<S> <C> <C> <C>
Amounts paid to NovaStar Mortgage:
Loan servicing fees.............................. $ 3,886 $ 3,803 $ 505
======== ======== =======
Administrative fees.............................. $ 1,258 $ 7,800 $ 3,650
Amounts received from NovaStar Mortgage:
Intercompany interest income..................... (1,113) -- --
Purchase commitment fees......................... -- (5,117) --
-------- -------- -------
Net fees paid.................................. $ 145 $ 2,683 $ 3,650
======== ======== =======
</TABLE>
Indebtedness of Management. In connection with the initial formation and
capitalization of NovaStar Financial, Mssrs. Hartman and Anderson acquired
216,666 shares of common stock and warrants to acquire 216,666 additional
shares for $15.00 in exchange for forgivable promissory notes. Pursuant to the
terms of the original warrant agreement, the effective exercise price of the
warrants was reduced to $11.62 upon NovaStar Financial's subsequent issuance of
warrants to unrelated entities at exercise prices lower than $15.00. The notes
bear interest at 8% and are secured by the shares and warrants. Interest is
payable quarterly and the notes mature December 31, 2001. The principal is
payable in three equal tranches. Payment of principal on each tranche will be
forgiven if NovaStar Financial meets certain incentive targets. During 1997,
the first incentive target was met resulting in the forgiveness of one-third of
the note and the recognition of compensation expense in 1997 of $1,083,000. The
incentive targets were not met in 1998 or 1999 and, accordingly, no debt
forgiveness occurred in those years.
During 1998, the founders exercised options to acquire 289,332 shares of
common stock in exchange for non-recourse promissory notes aggregating
$4,340,000. The notes bear interest at one-month LIBOR plus 1%, are secured by
the shares of common stock and mature at the earlier of the founders'
employment termination or the sale of the stock.
The notes have been recorded in the consolidated balance sheets as a contra-
equity account. Accrued interest related to the forgivable notes is recorded as
amounts due from founders. The accrued interest related to the non-recourse
notes is recorded as an additional component of the contra-equity account. The
following table summarizes amounts of these notes as of December 31 (in
thousands).
<TABLE>
<CAPTION>
1999 1998
------ ------
<S> <C> <C>
Notes receivable from founders:
Forgivable.................................................. $2,167 $2,167
Non-recourse................................................ 4,340 4,340
Accrued interest............................................ 339 142
------ ------
Total..................................................... $6,846 $6,649
====== ======
</TABLE>
90
<PAGE>
NovaStar Financial advanced funds to the founders for the payment of their
personal tax liability arising from the forgiveness of the first tranche of the
forgivable notes, as discussed above. The founders have issued notes payable to
NovaStar Financial for the repayment of the tax liability, interest accrued on
the forgivable notes through December 31, 1997 and notes payable for the
founders' contributions to NFI Holding capital in 1999. Amounts due from
founders outstanding as of December 31, 1999 and 1998 are shown below (in
thousands).
<TABLE>
<CAPTION>
1999 1998
------ ----
<S> <C> <C>
Amounts due from founders:
Founders' personal tax liability................................. $ 584 $584
Interest on notes receivable from founders through December 31,
1997............................................................ 260 260
Accrued interest on amounts due from founders.................... 239 117
Advances for capitalization of NFI Holding....................... 70 --
------ ----
Amounts due from founders.......................................... $1,153 $961
====== ====
</TABLE>
Interest income recorded by NovaStar Financial related to the notes
aggregated $496,000, $441,000 and $260,000 in 1999, 1998 and 1997,
respectively. Interest paid by the founders aggregated $177,000 and $199,000 in
1999 and 1998, respectively.
Certain Business Relationships with Large Securityholders. In connection with
a commitment from General Electric Capital Corporation to purchase units in the
private placement of units in 1996, NovaStar Financial agreed that so long as
GE Capital owns at least 10% of the outstanding common stock, assuming full
exercise of all warrants, GE Capital will have the right to appoint one
director (of up to six authorized directors) or, alternatively, to have board
observation rights so long as it maintains more than 20% of its initial
investment in NovaStar Financial. The director most recently serving pursuant
to these provisions was Bart Johnson, who replaced Jenne K. Britell in 1998. GE
Capital's common stock ownership is currently below the 10% threshold.
On February 12, 1999, NovaStar Financial entered into several lending
arrangements with First Union National Bank for one year. The warehouse line of
credit and master repurchase agreements with First Union allow NovaStar
Financial to borrow up to $75 million and $300 million, respectively, and are
secured by mortgage loans. At the same time, two additional lending
arrangements were executed with First Union whereby NovaStar Financial can
borrow up to $20 million secured by the residual interests of asset-backed
bonds. NovaStar Financial issued First Union 350,000 warrants to purchase
common stock at $6.9375 per share, the closing price on February 11, 1999, in
exchange for 186,667 existing warrants at $15.00 per share.
On December 17, 1999, NovaStar Financial amended several lending arrangements
with First Union Corporation, including the Mortgage Loan Warehousing Agreement
dated as of February 20, 1997 between NovaStar Financial, NovaStar Mortgage,
Inc. and First Union Corporation, the Master Repurchase Agreement, dated as of
February 12, 1999, between NovaStar Financial, NovaStar Mortgage, Inc. and
First Union Corporation, together with the Addendum thereto dated as of
February 12, 1999, and the Master Repurchase Agreement, dated as of February
12, 1999, between NovaStar Certificates Financing Corporation and First Union
Corporation, together with the Addendum thereto dated as of February 12, 1999.
These amendments extended existing warehouse and securitization facilities
beyond the February 12, 2000 maturity date to June 1, 2000, reduced the
securitization facility from $300 million to $175 million and resulted in an
increased commitment to $25 million on the residential financing facility with
a term of two years.
On March 29, 1999, NovaStar Financial completed the private placement and
issuance of 4,285,714 shares of Class B 7% Cumulative Convertible Preferred
Stock at a price of $7.00 per share, resulting in total proceeds of
approximately $30 million, which includes approximately $25 million acquired by
Wallace R. Weitz & Company. Weitz's present beneficial ownership of NovaStar
Financial is 52% which includes 1.5 million shares of common stock outstanding,
1.3 million of the 1996 warrants and over 3.5 million shares of
91
<PAGE>
convertible preferred stock. Each share of the preferred stock is convertible,
at the option of the holder, into one share of common stock and is redeemable
at par by NovaStar Financial at any time after March 31, 2002.
On March 10, 1999, NovaStar Financial issued to GMAC/Residential Funding
Corporation 812,731 warrants to purchase NovaStar Financial common stock at a
price of $4.5625 per share, the closing price of NovaStar Financial's common
stock on October 12, 1998. These warrants were issued pursuant to the terms of
a credit facility entered into on October 13, 1998. These warrants will expire
on October 13, 2003. In connection with this same warrant agreement, NovaStar
Financial issued to GMAC/Residential Funding Corporation 364,982 warrants to
purchase NovaStar Financial common stock at the effective price of the 1996
warrants, which is $11.62 per share, which are exercisable until February 3,
2001.
On December 29, 1999, NovaStar Financial entered into certain lending
arrangements with GMAC/Residential Funding Corporation secured by mortgage
loans and pledged securities. Under the terms of all the agreements required
in connection with a one-year Revolving Warehouse Line of Credit, NovaStar
Financial and NovaStar Mortgage, with NFI Holding as guarantor, can borrow $50
million to finance the acquisition of residential mortgage loans. Obligations
under this arrangement bear interest at a rate indexed to one-month LIBOR.
Conflict of Interest Policy
On January 27, 1999, the Board of Directors of NovaStar Financial adopted a
conflict of interest policy which includes, among others, the following
provisions:
If a director or officer has an interest that may conflict with those of
NovaStar Financial, he or she must immediately disclose the matters and
discuss them fully and frankly with the Board of Directors. An interested
director or officer may participate in the discussion of the transaction and
his or her presence may be counted for purposes of determining a quorum.
However, he or she must not vote on any resolution or motion that authorizes,
approves or ratifies a contract or transaction in which that director or
officer may have a conflict of interest.
Specifically, no director or officer shall:
. Accept or seek on behalf of himself/herself, or any immediate family
member, any financial advantage or gain of other than nominal value
offered as a result of the individual's affiliation with NovaStar
Financial;
. Disclose any confidential information that is available solely as a
result of the director or officer's affiliation with NovaStar Financial
to any person not authorized to receive such information, or use to the
disadvantage of NovaStar Financial any such confidential information,
without the express authorization of NovaStar Financial; or
. Knowingly take any action or make any statement intended to influence the
conduct of NovaStar Financial in such a way to confer any financial
benefit on such person or on any corporation or entity in which the
individual has a significant interest or affiliation.
92
<PAGE>
SELLING SECURITYHOLDERS
The following tables set forth information known to NovaStar Financial at the
date of this prospectus, with respect to the number of shares of common stock,
preferred stock and warrants which may be offered pursuant to this prospectus
by the selling securityholders. In addition, at the date of this prospectus,
none of the underlying common stock is currently held by the selling
securityholders but may be issued to them pursuant to the conversion of the
preferred stock or the exercise of warrants, all of which underlying common
stock, to the extent acquired by such selling securityholders, may be offered
pursuant to this prospectus.
A. Selling Securityholders for 1999 Warrants
<TABLE>
<CAPTION>
Beneficial Securities Covered by Beneficial
Ownership Before Shelf Registration Ownership After
Offering Statement Offering
------------------- ------------------------ -------------------
No. Shares
No. Shares Outstanding No. Shares
Outstanding Preferred No. Warrants Outstanding
Common or Common or Common Common
Name Stock Percent Stock(1) Stock(1) Stock Percent
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Wallace R. Weitz &
Company (2)............ 1,498,533 8.5 3,571,429 -- 1,498,533 8.5
McCarthy Group, Inc.
(3).................... 883,600 5.0 714,285 -- 883,600 5.0
First Union Corporation
(4).................... 186,667 1.1 -- 350,000 186,667 1.1
GMAC/Residential Funding
Corporation............ -- -- -- 1,177,713 -- --
---------- ----- --------- --------- ---------- -----
Subtotal............... 2,568,800 14.6 4,285,714 1,527,713 2,568,800 14.6
Shareholders not
subject to this
filing................ 15,024,695 85.4 -- 3,649,999 15,024,695 85.4
---------- ----- --------- --------- ---------- -----
Total................. 17,593,495 100.0 4,285,714 5,177,712 17,593,495 100.0
========== ===== ========= ========= ========== =====
</TABLE>
- --------
(1) Reflects shares of common stock issuable to the holder upon the conversion
of preferred stock or the exercise of warrants.
(2) Includes securities owned by funds managed by Wallace R. Weitz & Company,
including Weitz Series Fund, Inc.--Value Portfolio, Weitz Series Fund,
Inc.--Hickory Portfolio, Weitz Series Fund, Inc.--Partners Value Fund and
Weitz Partners III--Limited Partnership.
(3) Includes securities owned by funds managed by McCarthy Group, Inc.,
including Fulcrum Capital Partners, LLC and McCarthy Group Asset
Management, Inc.
(4) Includes securities owned by First Union Corporation and its subsidiary,
First Fidelity Incorporated.
93
<PAGE>
B. Selling Securityholders for 1996 Warrants
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ----------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Cede & Co.
c/o The Depository Trust
Company
as beneficial owner
for:
Eugene Whitney Harris
Revocable Trust....... 2,500 -- 2,500 2,500 -- --
L. Rothschild, Jr. & L.
Rothschild III, TTEE
Edith Rothschild Tr.
DTD 12/11/89 FBO L.
Rothschild, Jr. &
L. Rothschild III..... 3,000 -- 3,000 3,000 -- --
L. Rothschild, Jr. & L.
Rothschild III, TTEE
Louis Rothschild Tr.
DTD 12/11/89 FBO L.
Rothschild, Jr. &
L. Rothschild III..... 2,000 -- 2,000 2,000 -- --
NACLE Distributors,
Inc. PSP, U/A DTD
01/01/83. W. Chris
Elcan TTEE............ 2,000 -- 2,000 2,000 -- --
Ilma Glaser Isaac...... 2,000 -- 2,000 2,000 -- --
Actor's Fund of
America............... 7,000 -- 7,000 7,000 -- --
Acceptance Insurance
Company............... 100,000 0.6 100,000 100,000 -- --
National Automobile &
Casualty Insurance
Co. .................. 33,333 0.2 33,333 33,333 -- --
General Electric
Capital Corporation... 666,666 3.8 666,666 666,666 -- --
Lindner Dividend Fund.. -- -- 666,667 666,667 -- --
First Financial Fund,
Inc. ................. 466,700 2.7 466,700 466,700 -- --
Wellington Management
Co. .................. 275,000 1.6 -- -- 275,000 1.6
Bay Pond Partners,
L.P. ................. 200,000 1.1 200,000 200,000 -- --
Wallace Weitz & Co. ... 250,000 1.4 -- -- 250,000 1.4
Weitz Series Fund,
Inc.--Hickory
Portfolio............. 520,000 3.0 260,000 260,000 520,000 3.0
Weitz Partners, Inc.--
Partners Value Fund... 367,300 2.1 370,000 370,000 367,300 2.1
Weitz Series Fund,
Inc.--Value
Portfolio............. 475,000 2.7 350,000 350,000 475,000 2.7
Weitz Partners III
Limited Partnership... 132,633 0.8 325,000 325,000 132,633 0.8
UMB F/B/O/ John Adams
M.D. IRA R/O.......... 3,000 -- 3,000 3,000 -- --
United Missouri Bank
N.A. Cust. Agent for
Technical Products
Supply Inc. P/S RJ.
BJORSETH 37 8022-02-
4..................... 2,000 -- 2,000 2,000 -- --
--------- ---- ------------- ------------- --------- ----
Cede & Co. Subtotal... 3,510,132 20.0 3,461,866 3,461,866 2,019,933 11.5
First Fidelity
Incorporated
c/o First Union Capital
Market Groups.......... 186,667 1.1 186,667 186,667 -- --
Allis & Co. ............ 10,000 -- 10,000 10,000 -- --
Lynne K. Anderson IRA... 200 -- 200 200 -- --
Walter Lance Anderson(2)
and Rania Habiby
Anderson............... 16,700 0.1 16,700 16,700 -- --
</TABLE>
94
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stifel, Nicolaus & Co.
William Anderson IRA
Acct. No. 1163-3334.... 1,200 -- 1,200 1,200 -- --
Willliam M. Anderson and
Lynne K. Anderson...... 1,300 -- 1,300 1,300 -- --
Stifel, Nicolaus & Co.
(3), C/F William G. Ash
IRA R/O Account No.
1220-4030.............. 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus, &
Julie Bamburg(18)
Spousal IRA Acct. No.
1313-3336.............. 943 -- 300 300 643 --
Michael L. Bamburg(19).. 23,600 0.1 11,100 11,100 12,500 0.2
Marianthe Mewkill, TEE
Smith Breeden Profit
Sharing Plan DTD
12/29/83, FBO Michael
Lee Bamburg(19)........ 5,645 -- 1,900 1,900 3,745 --
Stifel, Nicolaus & Co.,
C/F Stuart Beath IRA
Acct. No. 1419-6385.... 6,600 -- 6,600 6,600 -- --
Larry Bender............ 4,253 -- 4,253 4,253 -- --
Stifel, Nicolaus & Co.,
C/F W. Coleman Biting
IRA Acct. No. 1574-
1789................... 3,400 -- 3,400 3,400 -- --
W. Coleman Biting(4) and
Jean M. Biting......... 8,700 -- 6,700 6,700 2,000 --
Martin J. Bloom, TTEE
Martin J. Bloom Family
Trust, U/A DTD
8/18/93................ 6,500 -- 6,500 6,500 -- --
Ivan Bowen.............. 2,000 -- 2,000 2,000 -- --
George W. Bull.......... 5,000 -- 5,000 5,000 -- --
Juan O. Carden, TTEE
Juan O. Carden
Revocable Living Trust
7/17/95................ 2,000 -- 2,000 2,000 -- --
Steven R. Carrico and
Tammy M. Carrico....... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus Cust.
for William S. Carter.. 6,600 -- 6,600 6,600 -- --
Craig J. Cerny.......... 1,635 -- 1,625 1,625 -- --
Marianthe Mewskill, TTEE
Smith Breeden Profit
Sharing and 401K Plan
U/A 12/29/93, FBO Craig
Cerny (401K)4.......... 875 -- 875 875 -- --
Stifel, Nicolaus & Co.,
C/F Henry W. Clever,
Jr. IRA R/O Acct.
No. 2243-5082.......... 2,000 -- 2,000 2,000 -- --
Victor G. Clever, Sr. &
Maureen Clever, TTEES
Victor G. Clever. Sr.
REV Tr. U/A Dtd 2/9/96;
FBO Victor G.
Clever, Sr. ........... 2,000 -- 2,000 2,000 -- --
William C. Cohen........ 2,000 -- 2,000 2,000 -- --
Marcus T. Cohn and
Francine M. Cohn....... 6,000 -- 4,000 4,000 2,000 --
Stifel, Nicolaus & Co.,
C/F John Steven Cole
IRA Acct. No. 2293-
8436................... 2,000 -- 2,000 2,000 -- --
Richard P. Conerly and
Iva J. Conerly......... 4,000 -- 4,000 4,000 -- --
Stella A. Corley, TTEE
or Her Successors Under
Ind. Trust DTD 6/16/88,
Stella A. Corley,
Grantor................ 2,000 -- 2,000 2,000 -- --
Leslie M. Cruvant....... 6,600 -- 6,600 6,600 -- --
Marilyn Joyce Dame...... 2,000 -- 2,000 2,000 -- --
Robert V. Dawson........ 2,000 -- 2,000 2,000 -- --
</TABLE>
95
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Daniel C. Dektar and
Nancy I. Kalow......... 23,333 0.1 13,333 13,333 10,000 --
Walter DeVries and Cora
DeVries, Joint
Tenants................ 2,000 -- 2,000 2,000 -- --
Robert M. Dolgin and
Deborah R. Dolgin...... 3,300 -- 3,300 3,300 -- --
Stifel, Nicolaus & Co.,
C/F Douglas G. Draper
IRA Acct. No. 2850-
0523................... 11,400 0.1 11,400 11,400 -- --
David P. Dunlap......... 6,000 -- 6,000 6,000 -- --
E.K.S. Investments,
L.P. .................. 10,000 -- 3,000 3,000 7,000 --
Stephen A. Eason and
Kathryn Ellis Eason,
Tenants in Common...... 7,000 -- 7,000 7,000 -- --
David R. Eidelman....... 2,500 -- 2,500 2,500 -- --
Jack R. Eidelman,
Trustee Jack R.
Eidelman Rev. Trust dtd
4/18/80................ 4,000 -- 2,000 2,000 2,000 --
Rachel Eidelman, TTEE
FBO Eidelman Family
Trust, U/W/O Jacob Reby
DTD 6/3/91............. 2,000 -- 2,000 2,000 -- --
David G. Estes(5) and
Astrid G. Estes........ 2,000 -- 2,000 2,000 -- --
David S. Evans.......... 6,000 -- 6,000 6,000 -- --
Elton P. Evans Jr.,
Trustee FBO The Elton
P. Evans Jr.
Declaration of Trust
DTD 6/28/96............ 3,500 -- 3,500 3,500 -- --
William S. Fagan IRA
(Separate Property),
Bear Stearns Securities
Corp., Custodian....... 5,500 -- 5,500 5,500 -- --
Sharon E. Frankhauser
and Jamie S.
Frankhauser............ 2,000 -- 2,000 2,000 -- --
David L. Farris(20)..... 23,045 0.1 6,666 6,666 16,379 0.1
Stifel, Nicholaus & Co.,
C/F Robert M. Feibel
IRA Acct. No. 3135-
0587................... 2,000 -- 2,000 2,000 -- --
Bernard H. Feinstein,
Trustee for Bernard H.
Feinstein Rev. Living
Trust 5/17/95.......... 2,000 -- 2,000 2,000 -- --
Stifel, Nicholaus,
Custodian for Leon A.
Felman Keogh Profit
Sharing Plan........... 22,300 0.1 12,800 12,800 9,500 --
Martha B. Fisher........ 3,000 -- 2,000 2,000 1,000 --
Stifel, Nicholaus & Co.,
Robert J. Fleming IRA
R/O Acct. No. 3257-
4805................... 6,600 -- 6,600 6,600 -- --
Jeremiah T. Flowers..... 5,000 -- 5,000 5,000 -- --
Jeffery Gendelman, TTEE
Jeffery Gendleman
Revocable Trust DTD
5/7/91................. 2,700 -- 2,700 2,700 -- --
Margaret A. Gerber and
William J. Gerber...... 2,000 -- 2,000 2,000 -- --
Everett N. Gertsen and
Carol E. Gertsen....... 3,300 -- 3,300 3,300 -- --
Michael J. Giaria and
Ellen H. Michelson..... 27,000 0.2 3,000 3,000 24,000 0.1
Mark Glass.............. 2,000 -- 2,000 2,000 -- --
Marion Glicksberg....... 3,300 -- 3,300 3,300 -- --
</TABLE>
96
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Guenter Goldsmith & Ann
Goldsmith TTEE Guenter
& Ann Goldsmith
Revocable Living Trust
DTD 5/30/88............ 2,000 -- 2,000 2,000 -- --
Selma K. Goldstein,
Trustee for Selma K.
Goldstein 2/29/84...... 2,000 -- 2,000 2,000 -- --
Sidney Guller........... 4,000 -- 4,000 4,000 -- --
Ann Robin Gwozdz and
Michael J. Gwozdz...... 1,250 -- 700 700 550 --
Douglas B. Hansen....... 2,000 -- 2,000 2,000 -- --
Scott F. Hartman(6) and
Cathleen A. Hartman.... 20,000 -- 20,000 20,000 -- --
Peter T. Healy(5)....... 5,000 -- 5,000 5,000 -- --
Lore Herzberg, TTEE UAD
DTD 11/3/89; FBO Lore
Herzberg............... 4,000 -- 2,000 2,000 2,000 --
Craig R. Hildreth and
Elizabeth C. Hildreth.. 2,000 -- 1,000 1,000 1,000 --
Frank Hoffman........... 7,000 -- 7,000 7,000 -- --
R. Russell Hogan........ 2,000 -- 2,000 2,000 -- --
Homebaker Brand Profit
Sharing Plan; Leon A.
Folman TTEE............ 5,900 -- 5,900 5,900 -- --
Insurance Management
Associates, Inc. ...... 6,000 -- 6,000 6,000 -- --
Stifel, Nicholaus & Co.,
C/F Gerald A. Jabaay
IRA R/O Acct. No. 4434-
9290................... 6,700 -- 6,700 6,700 -- --
James Lee Johnson III,
Trustee James Leon
Johnson III Revocable
Trust, Dated 5/4/85.... 3,000 -- 3,000 3,000 -- --
Matthew E. Just, Jr. ... 6,666 -- 6,666 6,666 -- --
Paul Just............... 4,000 -- 4,000 4,000 -- --
Philip G. Kaplan and
Judith A. Kaplan....... 2,000 -- 2,000 2,000 -- --
Dr. Bruce A. Kauk and
Janet L. Kauk.......... 2,000 -- 2,000 2,000 -- --
Michael F. Kickham, TTEE
Michael F. Kickham Tr
Dtd 9/5/90............. 4,000 -- 2,000 2,000 2,000 --
Myron Klevens, Trustee
Myron J. Klevens Trust
DTD 9/15/94............ 2,000 -- 2,000 2,000 -- --
Jean R. Kluge, Trustee,
Jean K. Kluge Living
Trust U/I 11/18/87..... 2,000 -- 2,000 2,000 -- --
Mark J. Kohlrus(7) and
Lisa M. Kohlrus........ 4,200 -- 1,500 1,500 2,700 --
Bernard G. Kohm and
Barbara Kohm(8)........ 2,000 -- 2,000 2,000 -- --
Mark J. Koster(9)....... 2,650 -- 2,650 2,650 -- --
Matthew J. Koster....... 4,400 -- 2,400 2,400 2,000 --
Patrick R. Koster(10)... 4,000 -- 4,000 4,000 -- --
Stribling Koster........ 2,000 -- 2,000 2,000 -- --
Stifel. Nicolaus & Co.,
C/F Ken Kranzborg IRA
Spousal Acct. No. 4932-
9221................... 2,000 -- 2,000 2,000 -- --
Joel A. Kunin........... 2,000 -- 2,000 2,000 -- --
William M. LaWarre...... 15,333 0.1 13,333 13,333 2,000 --
Arnold J. Levin and
Roslyn J. Levin........ 2,000 -- 2,000 2,000 -- --
</TABLE>
97
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stephen Levin and Amy
Levin.................. 4,000 -- 4,000 4,000 -- --
Michael Litwack
Revocable Trust DTD
3/8/83................. 5,000 -- 2,000 2,000 3,000 --
Brent R. Locke.......... 2,000 -- 2,000 2,000 -- --
David S. Lundeen........ 3,000 -- 3,000 3,000 -- --
Gerald J. Madigan....... 4,000 -- 4,000 4,000 -- --
Lawrence A. Manica(4)
and Charla M. Manica... 2,500 -- 2,000 2,000 500 --
Rickey E. Maples(4) and
Laurie H. Maples....... 10,000 -- 10,000 10,000 -- --
Charlotte C. Mehrer..... 2,000 -- 2,000 2,000 -- --
Edward W. Mehrer,
Jr.(12)................ 22,000 0.3 10,000 10,000 12,000 0.1
F. Jack Meyering, TTEE
F. Jack Meyering Trust
DTD 11/27/89........... 10,000 -- 10,000 10,000 -- --
Theodore Miedema, TTEE
Theodore Miedema Trust
DTD 10/9/93............ 2,000 -- 2,000 2,000 -- --
Jacob C. Mol............ 3,400 -- 3,400 3,400 -- --
Kevin M. Moore and
Kimberly A. Moore...... 13,300 0.1 13,300 13,300 -- --
Eugene J. McCabe,
M.D. .................. 2,000 -- 2,000 2,000 -- --
Kenneth K. Newton....... 3,000 -- 3,000 3,000 -- --
Harold W. Nicholas...... 2,000 -- 2,000 2,000 -- --
NorDruk Partners
Investment Co.(13)..... 2,000 -- 2,000 2,000 -- --
Bruce P. Novak.......... 6,600 -- 6,600 6,600 -- --
Charles D. O'Kieffe III,
TTEE Charles D.
O'Kieffe III Trust U/A
DTD 2/2/96............. 10,000 -- 10,000 10,000 -- --
Aaron Oshevow, Trustee
for The Oshevow Trust,
Dated 9/11/89 (314)
726-3288............... 2,000 -- 2,000 2,000 -- --
Louis Pechersky and
Sarah Pechersky........ 2,000 -- 2,000 2,000 -- --
David P. Peterson
Revocable Trust........ 6,700 -- 6,700 6,700 -- --
Douglas L. Phillips
Inter Vivos Trust dtd
8/19/88, Douglas L.
Phillips, Trustee...... 2,000 -- 2,000 2,000 -- --
Janelle Phillips........ 2,000 -- 2,000 2,000 -- --
Richard P. Proctor,
Jr..................... 5,000 -- 2,000 2,000 3,000 --
William F. Quinn........ 2,700 -- 2,700 2,700 -- --
Melvin Rabushka, Trustee
Melvin Rabushka Rev Tr
DT 9-29-92............. 2,000 -- 2,000 2,000 -- --
Adele Reby.............. 2,000 -- 2,000 2,000 -- --
Robert E. Ribbe, TTEE
Robert E. Ribbe Trust
DTD 3/15/91............ 4,000 -- 2,000 2,000 2,000 --
Edward A. Roach,
Trustee, Edward A.
Roach M.D., Trust DTD
9/28/89................ 3,000 -- 2,000 2,000 1,000 --
Helene B. Roberson...... 3,300 3,300 3,300 -- --
William C. Rosenbaum,
Jr..................... 7,666 -- 6,666 6,666 1,000 --
Kenneth J. Rosenthal,
Trustee, Kenneth J.
Rosenthal Revocable
Trust Dtd 6/3/93....... 3,300 -- 3,300 3,300 -- --
Louis G. Rothschild
III.................... 2,000 -- 2,000 2,000 -- --
Timothy D. Rowe......... 10,000 -- 10,000 10,000 -- --
</TABLE>
98
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Zsoit Rumy.............. 8,000 -- 8,000 8,000 -- --
Fred R. Sale & Susan W.
Sale TTEE Fred R. Sale
Tr. UA 8/5/83.......... 2,000 -- 2,000 2,000 -- --
Julian Seeherman,
Trustee of the Julian
Seeherman Revocable
Trust, FBO Julian
Seeherman, DTD
2/26/90................ 10,000 -- 10,000 10,000 -- --
Odis E. Shoaf, Jr.(14).. 2,000 -- 2,000 2,000 -- --
Charles W. Smith........ 3,000 -- 2,000 2,000 1,000 --
Forrest M. Smith(10).... 200 -- 100 100 100 --
Kenneth Smith(9) and
Lawerence Guillot-
Smith.................. 2,000 -- 2,000 2,000 -- --
David Soshnik(4),
Trustee for David
Soshnik Trust, DTD
8/2/93................. 2,000 -- 2,000 2,000 -- --
Joseph A. Stieven(4) and
Mary K. Stieven........ 7,000 -- 7,000 7,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Richard A. Baldwin III
IRA.................... 500 -- 319 319 181 --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Robert G. Brackett IRA
R/O #2 Acct. No. 1725-
7881................... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
James J. Brennan....... 3,334 -- 3,334 3,334 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for A.
Ray Cercle(10) IRA
SPSL................... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Robert L. Desmond
I.R.A. ................ 6,666 -- 6,666 6,666 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian
for Raymond J.
Ellingsworth IRA Acct.
No. 2992-4481.......... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Leon A. Folman IRA
Rollover............... 4,300 -- 4,300 4,300 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Milton Goldenberg IRA
R/O.................... 4,000 -- 4,000 4,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Girard A. Munsch,
Jr.(4) IRA Acct. No.
6099-6176.............. 3,000 -- 3,000 3,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Michael A. Murphy(4)
IRA Rollover........... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Paul E. Pazdan IRA
R/O.................... 3,400 -- 3,400 3,400 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Frederick W. Sammons
IRA R/O................ 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Stephen I. Schneider(4)
IRA.................... 2,500 -- 2,500 2,500 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Michael L. Sklar IRA
Spousal................ 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Julia S. Sylvester
IRA.................... 2,000 -- 2,000 2,000 -- --
</TABLE>
99
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- ------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stifel, Nicolaus & Co.,
Inc., Custodian for
Carl W. Webb IRA....... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Earl J. Wipfler, Jr.
IRA Rollover Acct. No.
8800-7061.............. 4,000 -- 4,000 4,000 -- --
Mike Straneva........... 300 -- 300 300 -- --
Robert L. Suffian and
Carolyn C. Suffian..... 2,000 -- 2,000 2,000 -- --
Russell E. Tackett and
Terry D. Tackett....... 2,000 -- 2,000 2,000 -- --
Daryl Ter Harr and
Patricia Ter Harr...... 2,000 -- 2,000 2,000 -- --
Thomas A. Thoma TTEE U/A
DTD 03/31/90 by Thomas
A. Thoma............... 2,000 -- 2,000 2,000 -- --
Michael J. Tompkins..... 13,300 0.1 13,300 13,300 -- --
Stifel, Nicolaus & Co.,
C/F Jerrold Vesper IRA
Acct. No. 8368-5961.... 2,000 -- 2,000 2,000 -- --
Garry Vicker IRA........ 2,000 -- 2,000 2,000 -- --
Mary G. VonGontard, TTRE
Mary G. VonGontard Liv
Trust Dtd 10/12/93..... 2,000 -- 2,000 2,000 -- --
George H. Walker
III(15)................ 5,000 -- 2,000 2,000 3,000 --
Bertha L. Wallbrunn..... 1,000 -- 1,000 1,000 -- --
Stephen S. Wasserman(4)
& Judith B. Wasserman,
TTEES Stephen S.
Wasserman Rev Tr DTD
3/26/94................ 2,000 -- 2,000 2,000 -- --
Nancy N. Weaver, TTEE
Nancy N. Weaver Rev.
Trust DTD 7/24/95...... 3,000 -- 3,000 3,000 -- --
Christopher J. Whybrow
and Cynthia C.
Whybrow................ 2,000 -- 2,000 2,000 -- --
Peter Douglas Wierenga.. 2,000 -- 2,000 2,000 -- --
R. Keith Wilson(16) and
Barbara A. Wilson...... 2,000 -- 2,000 2,000 -- --
Woodsmill Limited....... 2,000 -- 2,000 2,000 -- --
W. Lance Anderson(2) and
Rania H. Anderson...... 8,500 -- 8,500 8,500 -- --
Phillip R. Pollock(17).. 1,000 -- 1,000 1,000 -- --
Scott F. Hartman(6)..... 36,111 0.4 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.4 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 36,111 36,111 -- --
Stanley Edelstein and
Susan G. Edelstein,
TTEES Stanley M.
Edelstein Revocable
Trust U/A DTD 5/4/95... 2,000 -- 2,000 2,000 -- --
Julius Weissman, TTEE
FBO Julius Weissman U/A
DTD 11/30/89........... 2,000 -- 2,000 2,000 -- --
William Walbrunn........ 1,000 -- 1,000 1,000 -- --
</TABLE>
100
<PAGE>
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership Before Securities Covered by Shelf Ownership After
Offering Registration Statement Offering
------------------- ------------------------------- -------------------
No. Shares No. Shares
Outstanding No. Shares No. Warrants Outstanding
Common Outstanding or Common Common
Name Stock Percent Common Stock Stock(1) Stock Percent
- ---- ----------- ------- -------------- -------------- ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stifel Warrant
Recipients(18)
W. Coleman Biting(4)... -- -- -- 5,000 -- --
W. Coleman Biting(4)... -- -- -- 5,000 -- --
W. Coleman Biting(4)... -- -- -- 5,000 -- --
Ricky E. Maples(4)..... -- -- -- 6,819 -- --
Ricky E. Maples(4)..... -- -- -- 6,819 -- --
Ricky E. Maples(4)..... -- -- -- 6,820 -- --
Patrick R. Koster(10).. -- -- -- 1,581 -- --
Patrick R. Koster(10).. -- -- -- 1,581 -- --
Patrick R. Koster(10).. -- -- -- 1,582 -- --
Kenneth C. Smith(9).... -- -- -- 741 -- --
Kenneth C. Smith(9).... -- -- -- 741 -- --
Kenneth C. Smith(9).... -- -- -- 742 -- --
Mark J. Ross........... -- -- -- 741 -- --
Mark J. Ross........... -- -- -- 741 -- --
Mark J. Ross........... -- -- -- 742 -- --
Shelly Swan............ -- -- -- 33 -- --
Shelly Swan............ -- -- -- 33 -- --
Shelly Swan............ -- -- -- 34 -- --
Stifel, Nicolaus &
Company,
Incorporated.......... -- -- -- 55,250 -- --
---------- ----- -------------- ------------- ---------- -----
Stifel, Nicolaus &
Company, Incorporated
Subtotal............. -- -- -- 100,000 -- --
---------- ----- -------------- ------------- ---------- -----
Transferees unknown to
NovaStar Financial... -- -- -- (971,667) -- --
---------- ----- -------------- ------------- ---------- -----
Subtotal.............. 1,189,417 6.7 1,059,619 187,952 129,798 0.7
---------- ----- -------------- ------------- ---------- -----
Subtotal.............. 4,699,549 26.7 3,549,818 3,649,818 2,149,731 12.2
Warrants exercised.... 181 181
Shareholders not
subject to this
filing............... 12,893,946 73.3 (3,549,999) 1,527,713 15,443,764 87.8
---------- ----- -------------- ------------- ---------- -----
Total................. 17,593,495 100.0% 3,549,999 5,177,712 17,593,495 100.0%
========== ===== ============== ============= ========== =====
</TABLE>
- --------
(1) Reflects shares of common stock issuable to such holder upon the exercise
of warrants at the exercise price of $15.00 as required pursuant to the
terms of the warrants.
(2) Co-founder, Director, President and Chief Operating Officer of NovaStar
Financial, Inc.
(3) Stifel, Nicolaus & Company, Inc., was the placement agent for the private
placement offering of units.
(4) Senior Vice President of Stifel.
(5) Attorney at O'Melveny & Myers LLP, counsel to Stifel.
(6) Co-founder, Chairman of the Board, Secretary and Chief Executive Officer
of NovaStar Financial, Inc.
(7) Former Senior Vice President, Treasurer and Chief Financial Officer of
NovaStar Financial, Inc. and wife.
(8) Vice President of Stifel and his spouse.
(9) Assistant Vice President of Stifel.
(10) First Vice President of Stifel.
101
<PAGE>
(11) Senior Vice President of Stifel and his spouse.
(12) Independent director of NovaStar Financial, Inc.
(13) A subsidiary of Stifel.
(14) Former employee of Stifel.
(15) Chairman of the Board of Stifel.
(16) Vice President of Stifel.
(17) Attorney at Tobin & Tobin, counsel to NovaStar Financial, Inc.
(18) Warrants issued to Stifel pursuant to the terms of the Purchase Terms
Agreement and subsequently divided by Stifel among the employees shown.
(19) Senior Vice President and Chief Investment Officer of NovaStar Financial,
Inc. or his spouse.
(20) Vice President of NovaStar Financial, Inc.
102
<PAGE>
FEDERAL INCOME TAX CONSEQUENCES
The following discussion summarizes the material federal income tax
consequences that may be relevant to a prospective purchaser of securities.
This discussion is based on current law. The following discussion is not
exhaustive of all possible tax consequences. It does not give a detailed
discussion of any state, local or foreign tax consequences, nor does it discuss
all of the aspects of federal income taxation that may be relevant to a
prospective investor in light of such investor's particular circumstances or to
special classes of investors, including insurance companies, tax-exempt
entities, financial institutions, broker/dealers, foreign corporations and
persons who are not citizens or residents of the United States, subject to
particular treatment under federal income tax laws.
Each prospective purchaser of the securities is urged to consult with his or
her own tax advisor regarding the specific consequences to him or her of the
purchase, ownership and sale of the securities, including the federal, state,
local, foreign and other tax consequences of such purchase, ownership and sale
and the potential changes in applicable tax laws.
General
The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to NovaStar Financial as a REIT for federal income tax
purposes and to its stockholders in connection with their ownership of shares
of stock of NovaStar Financial. However, it is impractical to set forth in this
prospectus all aspects of federal, state, local and foreign tax law that may
have tax consequences with respect to an investor's purchase of the common
stock. The discussion of various aspects of federal taxation contained herein
is based on the Code, administrative regulations, judicial decisions,
administrative rulings and practice, all of which are subject to change. In
brief, if detailed conditions imposed by the Code are met, entities that invest
primarily in real estate assets, including mortgage loans, and that otherwise
would be taxed as corporations are, with limited exceptions, not taxed at the
corporate level on their taxable income that is currently distributed to their
stockholders. This treatment eliminates most of the "double taxation", at the
corporate level and then again at the stockholder level when the income is
distributed, that typically results from the use of corporate investment
vehicles. A qualifying REIT, however, may be subject to certain excise and
other taxes, as well as normal corporate tax, on taxable income that is not
currently distributed to its stockholders.
NovaStar Financial elected to be taxed as a REIT under the Code commencing
with its taxable year ended December 31, 1996.
Opinion of tax counsel
Jeffers, Shaff & Falk, LLP, tax and ERISA counsel to NovaStar Financial, has
advised NovaStar Financial in connection with the formation of NovaStar
Financial, the private placement, our initial public offering, this offering
and NovaStar Financial's election to be taxed as a REIT. Based on existing law
and factual representations made to tax counsel by NovaStar Financial, tax
counsel is of the opinion that NovaStar Financial, exclusive of any taxable
affiliates, operated in a manner consistent with its qualifying as a REIT under
the Code since the beginning of its taxable year ended December 31, 1996
through December 31, 1999, the date of the unaudited balance sheet and income
statement made available to tax counsel, and the organization and contemplated
method of operation of NovaStar Financial are such as to enable it to continue
to so qualify throughout the balance of 2000 and in subsequent years. However,
whether NovaStar Financial will in fact so qualify will depend on actual
operating results and compliance with the various tests for qualification as a
REIT relating to its income, assets, distributions, ownership and
administrative matters, the results of which may not be reviewed by tax
counsel. Moreover, some aspects of operations have not been considered by the
courts or the Internal Revenue Service. There can be no assurance that the
courts or the Internal Revenue Service will agree with this opinion. In
addition, qualification as a REIT depends on future transactions and events
that cannot be known at this time. In the opinion of tax counsel, this section
of the
103
<PAGE>
prospectus identifies and fairly summarizes the federal income tax consequences
that are likely to be material to a holder of the common stock and to the
extent such summaries involve matters of law, such statements of law are
correct under the Code. Tax counsel's opinions are based on various assumptions
and on the factual representations of NovaStar Financial concerning its
business and assets.
The opinions of tax counsel are also based upon existing law including the
Code, existing Treasury Regulations, Revenue Rulings, Revenue Procedures,
proposed regulations and case law, all of which is subject to change either
prospectively or retroactively. Moreover, relevant laws or other legal
authorities may change in a manner that could adversely affect NovaStar
Financial or its stockholders.
In the event NovaStar Financial does not qualify as a REIT in any year, it
will be subject to federal income tax as a domestic corporation and its
stockholders will be taxed in the same manner as stockholders of ordinary
corporations. To the extent NovaStar Financial would, as a consequence, be
subject to potentially significant tax liabilities, the amount of earnings and
cash available for distribution to its stockholders would be reduced.
Qualification as a REIT
To qualify for tax treatment as a REIT under the Code, NovaStar Financial
must meet certain tests which are described immediately below.
Ownership of Stock. For all taxable years after the first taxable year for
which a REIT election is made, NovaStar Financial shares of stock must be
transferable and must be held by a minimum of 100 persons for at least 335 days
of a 12 month year or a proportionate part of a short tax year. Since the
closing of its private placement, NovaStar Financial has had more than 100
shareholders of record. NovaStar Financial must, and does, use the calendar
year as its taxable year. In addition, at all times during the second half of
each taxable year, no more than 50% in value of the shares of any class of the
stock of NovaStar Financial may be owned directly or indirectly by five or
fewer individuals. In determining whether NovaStar Financial shares are held by
five or fewer individuals, the attribution rules apply. NovaStar Financial's
charter imposes certain repurchase provisions and transfer restrictions to
avoid more than 50% by value of any class of stock being held by five or fewer
individuals, directly or constructively, at any time during the last half of
any taxable year. Such repurchase and transfer restrictions will not cause the
stock not to be treated as "transferable" for purposes of qualification as a
REIT. NovaStar Financial has satisfied and intends to continue satisfying both
the 100 stockholder and 50%/5 stockholder individual ownership limitations
described above for as long as it seeks qualification as a REIT.
Nature of Assets. On the last day of each calendar quarter at least 75% of
the value of assets owned by NovaStar Financial must consist of qualified REIT
assets, government securities, cash and cash items, the "75% of assets test".
NovaStar Financial expects that substantially all of its assets, other than
qualified hedges and the preferred stock of NFI Holding, will be "qualified
REIT assets." Qualified REIT assets include interests in real property,
interests in mortgage loans secured by real property and interests in REMICs.
NovaStar Financial has complied with the 75% of assets test for each quarter
since inception of its REIT election. Qualified hedges generally are financial
instruments that a REIT enters into or acquires to protect against interest
rate risks on debt incurred to acquire qualified REIT assets.
On the last day of each calendar quarter, of the investments in securities
not included in the 75% of assets test, the value of any one issuer's
securities may not exceed 5% by value of total assets and NovaStar Financial
may not own more than 10% of any one issuer's outstanding voting securities.
Pursuant to its compliance guidelines, NovaStar Financial intends to monitor
closely, on not less than a quarterly basis, the purchase and holding of assets
in order to comply with the above assets tests. In particular, as of the end of
each calendar quarter NovaStar Financial intends to limit and diversify its
ownership of securities of any taxable affiliate, hedging contracts and other
mortgage securities that do not constitute qualified REIT assets to less than
25%, in the aggregate, by value of its portfolio, to less than 5% by value as
to any single issuer, including the stock of
104
<PAGE>
any taxable affiliate, and to less than 10% of the voting stock of any single
issuer, collectively the "25% of assets limits". If such limits are ever
exceeded, NovaStar Financial intends to take appropriate remedial action to
dispose of such excess assets within the 30 day period after the end of the
calendar quarter, as permitted under the Code. As of December 31, 1999,
NovaStar Financial complied with the tests described in this paragraph.
After December 31, 2000 (i.e., beginning with the 2001 tax year), REITs will
be able to own directly all of the stock of taxable subsidiaries. At present,
REITs are generally limited to holding non-voting preferred stock in taxable
affiliates. The value of all taxable subsidiaries of a REIT will be limited to
20% of the total value of the REIT's assets. Existing taxable subsidiaries will
have to be converted to qualified taxable REIT subsidiaries after December 31,
2000. In addition, a REIT will be subject to a 100% penalty tax equal to any
rents or charges that the REIT imposed on the taxable subsidiary in excess of
the arm's length price for comparable services. NFI expects to acquire all of
the common stock of Novastar Holding, Inc. from Scott Hartman and Lance
Anderson after the beginning of the year 2001.
When purchasing mortgage-related securities, NovaStar Financial may rely on
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent
those securities and the income therefrom constitute qualified REIT assets and
income for purposes of the 75% of assets test and the source of income tests.
If NovaStar Financial invests in a partnership, NovaStar Financial will be
treated as receiving its share of the income and loss of the partnership and
owning a proportionate share of the assets of the partnership and any income
from the partnership will retain the character that it had in the hands of the
partnership.
Sources of Income. NovaStar Financial must meet two separate income-based
tests each year in order to qualify as a REIT.
1. The 75% Test. At least 75% of gross income, the "75% of income test" for
the taxable year must be derived from the following sources among others:
. interest on, other than interest based in whole or in part on the income
or profits of any person, and commitment fees to enter into obligations
secured by mortgages on real property;
. gains from the sale or other disposition of interests in real property
and real estate mortgages, other than gain from property held primarily
for sale to customers in the ordinary course of business; and
. income from the operation, and gain from the sale, of property acquired
at or in lieu of a foreclosure of the mortgage secured by such property
or as a result of a default under a lease of such property.
The investments that NovaStar Financial intends to make will give rise
primarily to mortgage interest qualifying under the 75% of income test. As of
December 31, 1999, NovaStar Financial complied with the 75% income test on an
annualized basis.
2. The 95% Test. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of gross income for the
taxable year must be derived from those sources, or from dividends, interest or
gains from the sale or disposition of stock or other securities that are not
dealer property, the "95% of income test". Income attributable to assets other
than qualified REIT assets, such as income from or gain on the disposition of
qualified hedges, dividends on stock including any dividends from a taxable
affiliate, interest on any other obligations not secured by real property, and
gains from the sale or disposition of stock or other securities that are not
qualified REIT assets will constitute qualified income for purposes of the 95%
of income test only, and will not be qualified income for purposes of the 75%
of income test. Income from mortgage servicing, loan guarantee fees or other
contracts under which NovaStar Financial would earn fees for performing
services and hedging other than from qualified REIT assets will not qualify for
either the 95% or 75% of income tests. NovaStar Financial intends to severely
limit its acquisition of any assets or investments
105
<PAGE>
the income from which does not qualify for purposes of the 95% of income test.
Moreover, in order to help ensure compliance with the 95% of income test and
the 75% of income test, NovaStar Financial intends to limit substantially all
of the assets that it acquires, other than the shares of the preferred stock of
any taxable affiliate and qualified hedges, to qualified REIT assets. The
policy of NovaStar Financial to maintain REIT status may limit the type of
assets, including hedging contracts, that NovaStar Financial otherwise might
acquire. As of December 31, 1999, NovaStar Financial complied with the 95%
income test on an annualized basis.
For purposes of determining whether NovaStar Financial complies with the 75%
of income test and the 95% of income test detailed above, gross income does not
include gross income from "prohibited transactions." A "prohibited transaction"
is one involving a sale of dealer property, other than foreclosure property.
Net income from "prohibited transactions" is subject to a 100% tax.
NovaStar Financial intends to maintain its REIT status by carefully
monitoring its income, including income from hedging transactions, futures
contracts and sales of Mortgage Assets to comply with the 75% of income test
and the 95% of income test. In order to help insure its compliance with the
REIT requirements of the Code, NovaStar Financial has adopted guidelines the
effect of which will be to limit its ability to earn certain types of income,
including income from hedging, other than hedging income from qualified REIT
assets and from qualified hedges.
Failure to satisfy one or both of the 75% or 95% of income tests for any year
may result in either (a) a 100% tax on the greater of the amounts of income by
which it failed to comply with the 75% test of income or the 95% of income
test, reduced by estimated related expenses, assuming such failure was for
reasonable cause and not willful neglect, or (b) loss of REIT status. There can
be no assurance that NovaStar Financial will always be able to maintain
compliance with the gross income tests for REIT qualification despite periodic
monitoring procedures. Moreover, there is no assurance that the relief
provisions for a failure to satisfy either the 95% or the 75% of income tests
will be available in any particular circumstance.
Distributions. NovaStar Financial must distribute to its stockholders on a
pro rata basis each year an amount equal to
. 95% of its taxable income before deduction of dividends paid and
excluding net capital gain, plus
. 95% of the excess of the net income from foreclosure property over the
tax imposed on such income by the Code, less
. any "excess noncash income."
NovaStar Financial intends to make distributions to its stockholders in
amounts sufficient to meet this 95% distribution requirement. Such
distributions must be made in the taxable year to which they relate or, if
declared before the timely filing of the tax return for such year and paid not
later than the first regular dividend payment after such declaration, in the
following taxable year. Effective for the 2001 tax year, the minimum dividend
distributions of a REIT will have to equal 90% of the taxable income, down from
95% of taxable income under current law. Under this provision, TFR will be able
to retain a greater percentage of its after-tax earnings if desired.
A nondeductible excise tax, equal to 4% of the excess of such required
distributions over the amounts actually distributed will be imposed for each
calendar year to the extent that dividends paid during the year, or declared
during the last quarter of the year and paid during January of the succeeding
year, are less than the sum of
. 85% of NovaStar Financial's "ordinary income,"
. 95% of NovaStar Financial's capital gain net income, and
. income not distributed in earlier years.
106
<PAGE>
The Clinton Administration's 2001 budget contains a provision that would
impose the 4% excise on a REIT if the REIT has failed to distribute 98% of
ordinary income during the taxable year.
If NovaStar Financial fails to meet the 95% distribution test as a result of
an adjustment to tax returns by the Internal Revenue Service, NovaStar
Financial by following certain requirements set forth in the Code may pay a
deficiency dividend within a specified period which will be permitted as a
deduction in the taxable year to which the adjustment is made. NovaStar
Financial would be liable for interest based on the amount of the deficiency
dividend. A deficiency dividend is not permitted if the deficiency is due to
fraud with intent to evade tax or to a willful failure to file a timely tax
return. NovaStar Financial generally distributes dividends equal to 100% of its
taxable income to eliminate corporate level tax.
Taxation of NovaStar Financial
In any year in which NovaStar Financial qualifies as a REIT, it generally
will not be subject to federal income tax on that portion of its taxable income
or net capital gain which is distributed to its stockholders. NovaStar
Financial will, however, be subject to tax at normal corporate rates upon any
net income or net capital gain not distributed. NovaStar Financial intends to
distribute substantially all of its taxable income to its stockholders on a pro
rata basis in each year.
In addition, NovaStar Financial will also be subject to a tax of 100% of net
income from any prohibited transaction and will be subject to a 100% tax on the
greater of the amount by which it fails either the 75% or 95% of income tests,
reduced by approximated expenses, if the failure to satisfy such tests is due
to reasonable cause and not willful neglect and if certain other requirements
are met. NovaStar Financial may be subject to the alternative minimum tax on
certain items of tax preference.
If NovaStar Financial acquires any real property as a result of foreclosure,
or by a deed in lieu of foreclosure, it may elect to treat such real property
as foreclosure property. Net income from the sale of foreclosure property is
taxable at the maximum federal corporate rate, currently 35%. Income from
foreclosure property will not be subject to the 100% tax on prohibited
transactions. NovaStar Financial will determine whether to treat such real
property as foreclosure property on the tax return for the fiscal year in which
such property is acquired. NovaStar Financial expects to so elect.
NovaStar Financial securitizes mortgage loans and sells such mortgage loans
through one or more taxable affiliates. However, if NovaStar Financial itself
were to sell such mortgage assets on a regular basis, there is a substantial
risk that it would be deemed "dealer property" and that all of the profits from
such sales would be subject to tax at the rate of 100% as income from
prohibited transactions. Such taxable affiliate will not be subject to this
100% tax on income from prohibited transactions, which is only applicable to
REITs.
NovaStar Financial will also be subject to the nondeductible four percent
excise tax discussed above if it fails to make timely dividend distributions
for each calendar year. NovaStar Financial generally will declare its fourth
regular annual dividend during the final quarter of the year and make such
dividend distribution no later than thirty-one (31) days after the end of the
year in order to avoid imposition of the excise tax. Such a distribution would
be taxed to the stockholders in the year that the distribution was declared,
not in the year paid. Imposition of the excise tax on NovaStar Financial would
reduce the amount of cash available for distribution to stockholders.
As a publicly held corporation, NovaStar Financial will not be allowed a
deduction for applicable employee remuneration with respect to any covered
employee in excess of $1 million per year. The million dollar limit on
deductibility is subject to certain exceptions, including the exception for
"performance based compensation" meeting each of the following criteria:
. the agreement must have been approved by the corporation's stockholders;
107
<PAGE>
. the agreement must have been approved by a compensation committee
consisting solely of two or more non-employee directors of the
corporation; and
. the performance based compensation payable to the employee must be based
on objective performance criteria and the meeting of these criteria must
have been certified by the compensation committee.
Based on certain representations of NovaStar Financial, counsel is of the
opinion that it is more likely than not that the deduction for compensation to
the officers under the agreements would not be disallowed under the million
dollar limit.
Taxation of Taxable Affiliates
NovaStar Financial has caused, and will continue to cause, the creation and
sale of mortgage assets or conduct certain hedging activities through one or
more taxable affiliates. To date, NovaStar Financial has caused the formation
of NFI Holding and NovaStar Mortgage, the wholly owned subsidiary of NFI
Holding. NovaStar Financial owns all of the preferred stock issued by NFI
Holding. The common stock is the sole class of voting stock of NFI Holding,
although NovaStar Financial would be entitled to vote on any matter that could
adversely affect the rights of its preferred stock in NFI Holding. The assets
of NFI Holding consist of the issued capital stock of NovaStar Mortgage and a
nominal amount of cash.
In order to ensure that NovaStar Financial will not violate the prohibition
on ownership of more than 10% of the voting stock of a single issuer and the
prohibition on investing more than 5% of the value of its assets in the stock
or securities of a single issuer, NovaStar Financial will primarily own only
shares of nonvoting preferred stock of NFI Holding and will not own any of the
NFI Holding's common stock. NovaStar Financial will monitor the value of its
investment in NFI Holding on a quarterly basis to limit the risk of violating
any of the tests that comprise the 25% of assets limits. In addition, the
dividends that NFI Holding pays to NovaStar Financial will not qualify as
income from qualified REIT assets for purposes of the 75% of income test, and
in all events would have to be limited, along with other interest, dividends,
gains on the sale of securities, hedging income, and other income not derived
from qualified REIT assets to less than 25% of gross revenues in each year. NFI
Holding will not elect REIT status, will be subject to income taxation on its
net earnings and will generally be able to distribute only its net earnings to
its stockholders, including NovaStar Financial, as dividend distributions. If
NFI Holding creates a taxable mortgage pool, such pool itself will constitute a
separate taxable subsidiary of NFI Holding. NFI Holding would be unable to
offset the income derived from such a taxable mortgage pool with losses derived
from any other activities.
As discussed under "Nature of Assets" above, after December 31, 2000 (i.e.,
beginning with the 2001 tax year), REITs will be able to own directly all of
the stock of taxable subsidiaries. Novastar Financial expects to acquire all of
the stock of NFI Holding.
Termination or Revocation of REIT Status
The election to be treated as a REIT will be terminated automatically if
NovaStar Financial fails to meet the requirements described above. In that
event, NovaStar Financial will not be eligible again to elect REIT status until
the fifth taxable year which begins after the year for which the election was
terminated unless all of the following relief provisions apply:
. NovaStar Financial did not willfully fail to file a timely return with
respect to the termination taxable year;
. inclusion of incorrect information in such return was not due to fraud
with intent to evade tax; and
. NovaStar Financial establishes that failure to meet requirements was due
to reasonable cause and not willful neglect.
108
<PAGE>
NovaStar Financial may also voluntarily revoke its election, although it has
no intention of doing so, in which event NovaStar Financial will be prohibited,
without exception, from electing REIT status for the year to which the
revocation relates and the following four taxable years.
Failure to qualify for taxation as a REIT in any taxable year, and the relief
provisions do not apply, NovaStar Financial would be subject to tax, including
any applicable alternative minimum tax, on its taxable income at regular
corporate rates. Distributions to stockholders with respect to any year in
which NovaStar Financial fails to qualify as a REIT would not be deductible by
NovaStar Financial nor would they be required to be made. Failure to qualify as
a REIT would result in a reduction of its distributions to stockholders in
order to pay the resulting taxes. If, after forfeiting REIT status, NovaStar
Financial later qualifies and elects to be taxed as a REIT again, NovaStar
Financial could face significant adverse tax consequences.
Taxation of the Company's Stockholders
General. For any taxable year in which NovaStar Financial is treated as a
REIT for federal income purposes, amounts distributed by NovaStar Financial to
its stockholders out of current or accumulated earnings and profits will be
includible by the stockholders as ordinary income for federal income tax
purposes unless properly designated by NovaStar Financial as capital gain
dividends. In the latter case, the distributions will be taxable to the
stockholders as long-term capital gains.
Distributions will not be eligible for the dividends received deduction
available for non-REIT corporations. Stockholders may not deduct any net
operating losses or capital losses of NovaStar Financial.
Any loss on the sale or exchange of shares of the stock held by a stockholder
for six months or less will be treated as a long-term capital loss to the
extent of any capital gain dividend received on the stock held by such
stockholders.
If NovaStar Financial makes distributions to its stockholders in excess of
its current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a
stockholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of shares.
NovaStar Financial, exclusive of its taxable affiliates, does not expect to
acquire or retain residual interests issued by REMICs. Such residual interests,
if acquired by a REIT, would generate excess inclusion income to shareholders
of the REIT. Excess inclusion income cannot be offset by net operating losses
of a stockholder. If the stockholder is a tax-exempt entity, the excess
inclusion income is fully taxable as unrelated trade or business income as
defined in Section 512 of the Code. If allocated to a foreign stockholder, the
excess inclusion income is subject to Federal income tax withholding without
reduction pursuant to any otherwise applicable tax treaty. Excess inclusion
income realized by a taxable affiliate is not passed through to stockholders.
Potential investors, and in particular tax exempt entities, are urged to
consult with their tax advisors concerning this issue.
NovaStar Financial will notify stockholders after the close of the taxable
year as to the portions of the distributions which constitute ordinary income,
return of capital and capital gain. Dividends and distributions declared in the
last quarter of any year payable to stockholders of record on a specified date
in such month will be deemed to have been received by the stockholders and paid
on December 31 of the record year, provided that such dividends are paid before
February 1 of the following year.
Redemption and Conversion of Preferred Stock
Cash Redemption of Preferred Stock. A cash redemption of shares of the
preferred stock will be treated under section 302 of the Code as a distribution
taxable as a dividend, to the extent of NovaStar's current and accumulated
earnings and profits, at ordinary income rates unless the redemption satisfies
one of the tests set
109
<PAGE>
forth in the Code for treatment as a sale or exchange of the redeemed shares.
The cash redemption will be treated as a sale or exchange if it (1) is
"substantially disproportionate" with respect to the holder, (2) results in a
"complete termination" of the holder's stock interest in NovaStar, or (3) is
"not essentially equivalent to a dividend" with respect to the holder. In
determining whether any of these tests have been met, shares of capital stock,
including common stock and other equity interests in NovaStar, considered to be
owned by the holder by reason of certain constructive ownership rules set forth
in the Code, as well as shares of capital stock actually owned by the holder,
must generally be taken into account. In general, a non-prorata redemption of
preferred stock from a shareholder who owns only preferred stock is treated as
a sale or exchange and not a dividend. Nevertheless, because the determination
as to whether any of the alternative tests for capital gain treatment as a
redemption will be satisfied with respect to any particular holder of the
preferred stock depends upon the facts and circumstances at the time that the
determination must be made, prospective holders of the preferred stock are
advised to consult their own tax advisors to determine such tax treatment.
If a cash redemption of shares of the preferred stock is not treated as a
distribution taxable as a dividend to a particular holder, it will be treated,
as to that holder, as a taxable sale or exchange. As a result, such holder will
recognize gain or loss for federal income tax purposes in an amount equal to
the difference between (1) the amount of cash and the fair market value of any
property received, less any portion thereof attributable to accumulated and
declared but unpaid dividends, which will be able as a dividend to the extent
of NovaStar's current and accumulated earnings and profits, and (2) the
holder's adjusted basis in the shares of the preferred stock for tax purposes.
Such gain or loss will be capital gain or loss if the shares of the preferred
stock have been held as a capital asset, and will be long-term gain or loss if
such shares have been held for more than one year.
If a redemption of shares of the preferred stock is treated as a distribution
taxable as a dividend, the amount of the distribution will be measured by the
amount of cash and the fair market value of any property received by the
holder. The holder's adjusted basis in the redeemed shares of the preferred
stock for tax purposes will be transferred to the holder's remaining shares of
capital stock in NovaStar, if any. A redemption of shares of the preferred
stock for shares of common stock will be treated as a conversion of the
preferred stock into common stock.
Conversion of Preferred Stock into Common Stock. In general, no gain or loss
will be recognized for federal income tax purposes upon conversion of the
preferred stock solely into shares of common stock. The basis that a holder
will have for tax purposes in the shares of common stock received upon
conversion will be equal to the adjusted basis for the holder in the shares of
preferred stock so converted, and provided that the shares of preferred stock
were held as a capital asset, the holding period for the shares of common stock
received would include the holding period for the shares of preferred stock
converted. A holder will, however, generally recognize gain or loss on the
receipt of cash in lieu of fractional shares of common stock in an amount equal
to the difference between the amount of cash received and the holder's adjusted
basis for tax purposes in the preferred stock for which cash was received.
Furthermore, under certain circumstances, a holder of shares of preferred stock
may recognize gain or dividend income to the extent that there are dividends in
arrears on the shares at the time of conversion into common stock.
Adjustments to Conversion Price. Adjustments in the conversion price, or the
failure to make such adjustments, pursuant to the anti-dilution provisions of
the preferred stock or otherwise may result in constructive distributions to
the holders of preferred stock that could, under certain circumstances, be
taxable to them as dividends pursuant to section 305 of the Code, If such a
constructive distribution were to occur, a holder of preferred stock could be
required to recognize ordinary income for tax purposes without receiving a
corresponding distribution of cash.
Warrants
Upon the exercise of a warrant, a holder will not recognize gain or loss and
will have a tax basis in the common stock received equal to the tax basis in
such holder's warrant plus the exercise price of the warrant.
110
<PAGE>
The holding period for the common stock purchased pursuant to the exercise of a
warrant will begin on the day following the date of exercise and will not
include the period that the holder held the warrant.
Upon a sale or other disposition of a warrant, a holder will recognize
capital gain or loss in an amount equal to the difference between the amount
realized and the holder's tax basis in the warrant. Such a gain or loss will be
long-term if the holding period is more than one year. In the event that a
warrant lapses unexercised, a holder will recognize a capital loss in an amount
equal to his tax basis in the warrant. Such loss will be long-term if the
warrant has been held for more than one year.
Taxation of Tax-Exempt Entities
In general, a tax-exempt entity that is a stockholder of NovaStar Financial
is not subject to tax on distributions. The Internal Revenue Service has ruled
that amounts distributed by a REIT to an exempt employees' pension trust do not
constitute unrelated trade or business income and thus should be nontaxable to
such a tax-exempt entity. Tax counsel is of the opinion that indebtedness
incurred by NovaStar Financial in connection with the acquisition of real
estate assets such as mortgage loans will not cause dividends paid to a
stockholder that is a tax-exempt entity to be unrelated trade or business
income, provided that the tax-exempt entity has not financed the acquisition of
its stock with "acquisition indebtedness" within the meaning of the Code. Under
some conditions, if a tax-exempt employee pension or profit sharing trust were
to acquire more than 10% of the stock of NovaStar Financial, a portion of the
dividends on such stock could be treated as unrelated trade or business income.
For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17) and
(c)(20), respectively, income from an investment in NovaStar Financial will
constitute unrelated trade or business income unless the organization is able
to properly deduct amounts set aside or placed in reserve for certain purposes
so as to offset the unrelated trade or business income generated by its
investment. Such entities should review Code Section 512(a)(3) and should
consult their own tax advisors concerning these "set aside" and reserve
requirements.
Foreign Investors
The preceding discussion does not address the federal income tax consequences
to foreign investors, non-resident aliens and foreign corporations as defined
in the Code, of an investment in NovaStar Financial. In general, foreign
investors will be subject to special withholding tax requirements on income and
capital gains distributions attributable to their ownership of NovaStar
Financial stock. Foreign investors should consult their own tax advisors
concerning the federal income tax consequences to them of a purchase of shares
of NovaStar Financial stock including the federal income tax treatment of
dispositions of interests in, and the receipt of distributions from, REITs by
foreign investors. In addition, federal income taxes must be withheld on
certain distributions by a REIT to foreign investors unless reduced or
eliminated by an income tax treaty between the United States and the foreign
investor's country. A foreign investor eligible for reduction or elimination of
withholding must file an appropriate form with NovaStar Financial in order to
claim such treatment.
Recordkeeping Requirement
A REIT is required to maintain records regarding the actual and constructive
ownership of its shares, and other information, and within 30 days after the
end of its taxable year, to demand statements from persons owning above a
specified level of the REIT's shares, e.g., if NovaStar Financial has over 200
but fewer than 2,000 stockholders of record, from persons holding 1% or more of
outstanding shares of stock and if NovaStar Financial has 200 or fewer
stockholders of record, from persons holding 1/2% or more of the stock,
regarding their ownership of shares. NovaStar Financial must maintain, as part
of its records, a list of those persons failing or refusing to comply with this
demand. Stockholders who fail or refuse to comply with the demand
111
<PAGE>
must submit a statement with their tax returns setting forth the actual stock
ownership and other information. NovaStar Financial maintains the records and
demand statements as required by these regulations.
Backup Withholding
The Code imposes a modified form of "backup withholding" for payments of
interest and dividends. This withholding applies only if a stockholder, among
other things,
. fails to furnish NovaStar Financial with a properly certified taxpayer
identification number;
. fails properly to report interest or dividends from any source; or
. under certain circumstances fails to provide NovaStar Financial or the
stockholder's securities broker with a certified statement, under penalty
of perjury, that he or she is not subject to backup withholding.
The backup withholding rate is 31% of "reportable payments," which include
dividends. Stockholders should consult their tax advisors as to the procedure
for insuring that distributions to them will not be subject to backup
withholding.
NovaStar Financial will report to its stockholders and the Internal Revenue
Service the amount of dividends paid during each calendar year and the amount
of tax withheld, if any.
State and Local Taxes
State and local tax laws may not correspond to the federal income tax
principles discussed in this section. Accordingly, prospective stockholders
should consult their tax advisers concerning the state and local tax
consequences of an investment in NovaStar Financial's stock.
ERISA Investors
A fiduciary of a pension, profit-sharing plan, stock bonus plan or individual
retirement account, including a plan for self-employed individuals and their
employees or any other employee benefit plan subject to the prohibited
transaction provisions of the Code or the fiduciary responsibility provisions
of the Employee Retirement Income Security Act of 1974, commonly called
"ERISA," should consider
. whether the ownership of NovaStar Financial's stock is in accordance with
the documents and instruments governing the plan;
. whether the ownership of NovaStar Financial's stock is consistent with
the fiduciary's responsibilities and satisfies the requirements of Part 4
of Subtitle A of Title I of ERISA, if applicable, and, in particular, the
diversification, prudence and liquidity requirements of Section 404 of
ERISA;
. the prohibitions under ERISA on improper delegation of control over, or
responsibility for, "plan assets" and ERISA's imposition of co-fiduciary
liability on a fiduciary who participates in, or permits, by action or
inaction, the occurrence of, or fails to remedy, a known breach of duty
by another fiduciary with respect to plan assets; and
. the need to value the assets of the plan annually.
As to the "plan assets" issue noted in the third bullet point above in
connection with the Class B preferred stock, the responsibility for "plan
assets," in the case of a plan's investment in an equity interest of an entity,
such as the preferred stock, which is a class of securities that are not
publicly-offered securities, the plan's assets include both the equity interest
and an undivided interest in each of the underlying assets of the entity,
unless it is established that, in the context of NovaStar Financial, that
equity participation in the preferred stock by plan investors is not
"significant." Equity participation is not "significant" if the aggregate
ownership by plans of any class of equity interests issued by NovaStar
Financial is at all times less than 25%.
112
<PAGE>
NovaStar Financial has represented that it will not permit any of its Class B
preferred stock to be sold to a plan if such sale would cause ownership by
plans of such class of preferred stock to equal or exceed 25% until such time
as such class of preferred stock is, in the opinion of tax counsel, a publicly
offered security under ERISA. NovaStar Financial will use reasonable efforts to
maintain the ownership interest in the preferred stock held by plan investors
at a level below the 25% limit. NovaStar Financial will be able to reject a
potential investor that would cause aggregate ownership by plans to equal or
exceed 25% of any class of stock that is not a publicly-offered security,
excluding from such class any shares held by certain affiliates of NovaStar.
Based on such representations, tax and ERISA counsel believes that NovaStar
Financial's Class B preferred stock, and not the underlying assets of NovaStar
Financial, will be considered the assets of a plan investing in the Class B
preferred stock of NovaStar Financial.
Based on certain representations of NovaStar Financial, tax and ERISA counsel
is of the opinion that the common stock will qualify as "publicly offered
securities" within the meaning of the regulations defining "plan assets" and
therefore, in most circumstances, the common stock, and not the underlying
assets of NovaStar Financial, will be considered the assets of a plan investing
in the common stock.
113
<PAGE>
DESCRIPTION OF CAPITAL STOCK
General
Our authorized capital stock will consist of 46,450,000 shares of common
stock, of which 12,430,069 shares will be outstanding, and 3,550,000 shares of
unclassified capital stock, none of which will be outstanding.
Historical Capital Structure
Our authorized capital stock consists of 50,000,000 shares of capital stock,
$0.01 par value. These shares of capital stock were initially classified as
common stock. Our charter authorizes the Board of Directors to reclassify any
of the unissued shares of authorized capital stock into other classes or series
of capital stock, including classes or series of preferred stock. On December
6, 1996, we supplemented our charter to divide and classify 3,550,000 shares of
our capital stock into a class of preferred stock. The Class A preferred stock
had the rights and privileges of, and was subject to the conditions and terms
set forth in, articles supplementary. On December 9, 1996, we issued (1)
3,333,333 shares of preferred stock as part of the units sold in our private
placement, each unit consisting of one share of preferred stock and one
warrant; and (2) 216,666 shares of preferred stock as part of the units
acquired by the founders with forgivable debt. Effective on the closing of our
initial public offering in December 1997, such shares of outstanding Class A
preferred stock automatically converted to common stock. Shares of the
preferred stock which we received upon the conversion and all remaining
authorized shares of preferred stock were restored to the status of authorized
but unissued shares of capital stock, without designation as to class.
Preferred Stock
On March 24, 1999, articles supplementary were filed to divide and classify
4,300,000 shares of our capital stock into shares of the Class B preferred
stock. Additional preferred stock may be issued from time to time in one or
more classes or series, with such distinctive designations, rights and
preferences as shall be determined by the Board of Directors. Additional
preferred stock would be available for possible future financing of, or
acquisitions by, NovaStar Financial and for general corporate purposes without
any legal requirement that further stockholder authorization for issuance be
obtained. The issuance of preferred stock could have the effect of making more
difficult any attempt to gain control of NovaStar Financial by means of a
merger, tender offer, proxy contest or otherwise. Additional preferred stock,
if issued, could have a preference on dividend payments. This would affect our
ability to make dividend distributions to the holders of our common stock or
our Class B preferred stock.
The rights and preferences of the Class B 7% Cumulative Convertible Preferred
Stock, including the priority of cumulative dividends, conversion rights,
liquidation preference, redemption options, voting rights and ranking, as set
forth in articles supplementary are as follows:
Dividends. The holders of Class B preferred stock shall be entitled to
receive, when and as declared by the Board of Directors out of funds legally
available for that purpose, cumulative dividends payable in cash in an amount
per share equal to the greater of (1) the base dividend of $0.1225 per quarter
or (2) the cash dividends declared on the number of shares of common stock, or
portion thereof, into which a share of preferred stock is convertible.
Dividends are payable, with respect to each calendar quarter in arrears on the
same basis as the common stock on the following January 10, May 10, August 10
and November 10 of each year, commencing May 10, 1999. Holders of preferred
stock shall not be entitled to any dividends, whether payable in cash, property
or stock, in excess of cumulative dividends, as herein provided, on the
preferred stock. No interest, or sum of money in lieu of interest, shall be
payable in respect of any dividend payment or payments on the preferred stock
that may be in arrears. No dividends will be paid or set apart for payment on
shares of common stock unless full cumulative dividends have been paid on the
preferred stock.
114
<PAGE>
Conversion. Holders of shares of preferred stock shall have the right to
convert all or a portion of such shares into shares of common stock, at such
holder's option, at any time, in whole or in part, into the number of fully
paid and non-assessable shares of authorized but previously unissued shares of
common stock per each share of preferred stock obtained by dividing the
liquidation preference, excluding any accumulated, accrued and unpaid
dividends, per share by the conversion price, by surrendering such shares to be
converted; provided, however, that the right to convert shares of preferred
stock called for redemption shall terminate at the close of business on the
call date fixed for redemption, unless NovaStar Financial shall default in
making payment of cash upon such redemption. Holders of shares of preferred
stock at the close of business on a dividend payment record date shall be
entitled to receive the dividend payable on such shares on the corresponding
dividend payment date notwithstanding the conversion thereof following such
dividend payment record date and prior to such dividend payment date. Except as
provided above, NovaStar Financial shall make no payment or allowance for
unpaid dividends, whether or not in arrears, on converted shares or for
dividends on the shares of common stock issued upon such conversion. Each
conversion shall be deemed to have been effected immediately prior to the close
of business on the date on which the certificates for shares of preferred stock
shall have been surrendered and such notice received by NovaStar Financial. If
more than one share shall be surrendered for conversion at one time by the same
holder, the number of full shares of common stock issuable upon conversion
thereof shall be computed on the basis of the aggregate number of shares of
preferred stock so surrendered. The conversion price shall be adjusted from
time to time if NovaStar:
. shall after the issue date pay a dividend or make a distribution on its
capital stock in shares of common stock, subdivide its outstanding common
stock into a greater number of shares; combine its outstanding common
stock into a smaller number of shares or issue any shares of capital
stock by reclassification of its outstanding common stock;
. shall issue after the issue date rights, options or warrants to all
holders of common stock entitling them, for a period expiring within 45
days after the record date, to subscribe for or purchase common stock at
a price per share less than the fair market value per share of the common
stock on the record date for the determination of stockholders entitled
to receive such rights, options or warrants;
. shall after the issue date make a distribution on its common stock other
than in cash or shares of common stock, including any distribution in
securities other than rights, options or warrants.
No adjustment in the conversion price shall generally be required unless such
adjustment would require a cumulative increase or decrease of at least 1% in
such price.
If NovaStar Financial shall be a party to any transaction, including without
limitation a merger, consolidation, statutory share exchange, issuer or self
tender offer for all or a substantial portion of the shares of common stock
outstanding, sale of all or substantially all of NovaStar Financial's assets or
recapitalization of the common stock, in each case as a result of which shares
of common stock shall be converted into the right to receive stock, securities
or other property, including cash or any combination thereof, each share of
preferred stock which is not converted into the right to receive stock,
securities or other property in connection with such transaction shall
thereupon be convertible into the kind and amount of shares of stock,
securities and other property, including cash or any combination thereof,
receivable upon such consummation by a holder of that number of shares of
common stock into which one share of preferred stock was convertible
immediately prior to such transaction.
There shall be no adjustment of the conversion price in case of the issuance
of any capital stock of NovaStar Financial in a reorganization, acquisition or
other similar transaction except as specifically set forth in this section. If
NovaStar Financial shall take any action affecting the common stock, other than
action described in this section, that in the opinion of the Board of Directors
would materially adversely affect the conversion rights of the holders of
preferred stock, the conversion price for the preferred stock may be adjusted,
to the extent permitted by law, in such manner, if any, and at such time as the
Board of Directors, in its sole discretion, may determine to be equitable under
the circumstances. NovaStar Financial covenants that any shares of common stock
issued upon conversion of the shares of preferred stock shall be validly
issued,
115
<PAGE>
fully paid and nonassessable. NovaStar Financial shall use its best efforts to
list the shares of common stock required to be delivered upon conversion of the
shares of preferred stock, prior to such delivery, upon each national
securities exchange, if any, upon which the outstanding shares of common stock
are listed at the time of such delivery.
Liquidation Preference. In the event of any liquidation, dissolution or
winding up of NovaStar Financial, whether voluntary or involuntary, before any
payment or distribution of NovaStar Financial, whether capital or surplus,
shall be made to or set apart for the holders of junior stock, the holders of
shares Class B Preferred Stock shall be entitled to receive $7.00 per share,
plus an amount equal to all dividends, whether or not earned or declared,
accumulated, accrued and unpaid thereon to the date of final distribution to
such holders; but such holders shall not be entitled to any further payment.
Until the holders of the preferred stock have been paid in full, plus an amount
equal to all dividends, whether or not earned or declared, accumulated, accrued
and unpaid thereon to the date of final distribution to such holders, no
payment will be made to any holder of junior stock upon the liquidation,
dissolution or winding up of NovaStar Financial. If, upon any liquidation,
dissolution or winding up of NovaStar Financial, the assets of NovaStar
Financial, or proceeds thereof, distributable among the holders of preferred
stock and any class or series of parity stock shall be insufficient to pay in
full the preferential amount aforesaid and liquidating payments on any other
shares of any class or series of parity stock, then such assets, or the
proceeds thereof, shall be distributed among the holders of preferred stock and
any such other parity stock ratably in the same proportion as the respective
amounts that would be payable on such preferred stock and any such other parity
stock if all amounts payable thereon were paid in full.
Redemption at the Option of NovaStar Financial. Shares of Class B Preferred
Stock shall not be redeemable by NovaStar Financial prior to March 31, 2002.
The shares may be redeemed, in whole or in part, at the option of NovaStar
Financial at any time on or after March 31, 2002 out of funds legally available
therefor at a redemption price payable in cash equal to $7.00 per share, plus
all accumulated, accrued and unpaid dividends as provided below. NovaStar
Financial shall pay in cash all cumulative, accrued and unpaid dividends for
all dividend periods ending prior to the dividend period in which the
redemption occurs, plus the dividend, determined by reference to the base rate
if the call date precedes the date on which the dividend on the common stock is
declared for such dividend period, accrued from the beginning of the dividend
period in which the redemption occurs and ending on the call date; provided,
however, that if such call date is on or after the record date for such
dividend period, each holder of preferred stock at the close of business on
such dividend record date shall be entitled to the dividend payable on such
shares on the corresponding dividend payment date notwithstanding the
redemption of such shares prior to such dividend payment date. Except as
provided above, NovaStar Financial shall make no payment or allowance for
accumulated or accrued dividends on shares of preferred stock called for
redemption or on the shares of common stock issued upon such redemption. The
call date shall be selected by NovaStar Financial, shall be specified in the
notice of redemption and shall be not less than 30 days nor more than 60 days
after the date notice of redemption is sent by NovaStar Financial.
Stock To Be Retired. All shares of Class B Preferred Stock which shall have
been issued and reacquired in any manner by NovaStar Financial shall be
restored to the status of authorized, but unissued shares of common stock, par
value $.01 per share. NovaStar Financial may also retire any unissued shares of
preferred stock, and such shares shall then be restored to the status of
authorized but unissued shares of common stock, par value $.01 per share.
Ranking. Any class or series of capital stock of NovaStar Financial shall be
deemed to rank:
. prior or senior to the preferred stock, as to the payment of dividends
and as to distribution of assets upon liquidation, dissolution or winding
up, if the holders of such class or series shall be entitled to the
receipt of dividends or of amounts distributable upon liquidation,
dissolution or winding up, as the case may be, in preference or priority
to the holders of preferred stock;
116
<PAGE>
. on a parity with the preferred stock, as to the payment of dividends and
as to distribution of assets upon liquidation, dissolution or winding up,
whether or not the dividend rates, dividend payment dates or redemption
or liquidation prices per share thereof be different from those of the
preferred stock, if the holders of such class of stock or series and the
preferred stock shall be entitled to the receipt of dividends and of
amounts distributable upon liquidation, dissolution or winding up in
proportion to their respective amounts of accrued and unpaid dividends
per share or liquidation preferences, without preference or priority one
over the other or parity stock; and
. junior to the preferred stock, as to the payment of dividends or as to
the distribution of assets upon liquidation, dissolution or winding up,
if such stock or series shall be common stock or if the holders of
preferred stock shall be entitled to receipt of dividends or of amounts
distributable upon liquidation, dissolution or winding up, as the case
may be, in preference or priority to the holders of shares of such class
or series or junior stock.
Voting. Except as otherwise expressly required by applicable law or NovaStar
Financial's Articles of Incorporation or as described below, the holders of the
preferred stock will not be entitled to vote on any matter and will not be
entitled to notice of any meeting of shareholders of NovaStar Financial. If at
any time NovaStar Financial falls in arrears in the payment of dividends on the
preferred stock in an aggregate amount equal to the full accrued dividends for
six quarterly dividend periods, or upon failure of NovaStar Financial to
maintain consolidated shareholders' equity, determined in accordance with
generally accepted accounting principles and giving any effect to any
adjustment for the net unrealized gain or loss on assets available for sale, of
at least 150 % of the sum of (a) the aggregate issue price of the then
outstanding preferred stock and (b) the aggregate original issue price of any
then outstanding parity stock, as defined below, the number of NovaStar
Financial's directors will be increased, if not already increased by reason of
similar types of provisions with respect to any parity stock, by two and the
holders of the preferred stock, together with holders of all classes of parity
stock, voting together as a single class, will have the right to elect two
directors to fill the positions created, and such right will continue until all
dividends in arrears shall have been paid, or such shareholders' equity has
been restored to at least 150% of the sum of (a) the aggregate issue price of
the then outstanding preferred stock and (b) the aggregate original issue price
of any then outstanding parity stock, as the case may be. If any other class of
parity stock with which the preferred is entitled to vote as a single class is
entitled to elect two directors as a result of a failure to maintain a
specified level of consolidated shareholders' equity, then, when such
entitlement to vote is triggered, the separate entitlement of the preferred
stock to vote for directors described in this paragraph shall be suspended.
For purposes of the foregoing provisions and all other voting rights, each
share of preferred stock shall have one (1) vote per share, except that when
any class or series of parity stock shall have the right to vote with the
preferred stock as a single class on any matter, then the preferred stock and
such other class or series shall have with respect to such matters one (1) vote
per $7.00 of stated liquidation preference. Except as otherwise required by
applicable law or as set forth in this prospectus, the preferred stock shall
not have any relative, participating, optional or other special voting rights
and powers other than as set forth in this prospectus, and the consent of the
holders thereof shall not be required for the taking of any corporate action.
Common Stock
The following summary of the rights of the common stock is qualified in its
entirety by reference to our charter. A copy of our charter has been filed with
the SEC as an exhibit to the shelf registration statement of which this
prospectus is a part.
Voting. Each holder of common stock is entitled to one vote for each share
of record on each matter submitted to a vote of holders of our capital stock.
Our charter does not provide for cumulative voting. Accordingly, the holders of
a majority of the outstanding shares of capital stock have the power to elect
all directors to be elected each year.
117
<PAGE>
We hold annual meetings of our stockholders. Special meetings may be called
by any member of the Board of Directors, by the President or generally by
stockholders holding at least 20% of the outstanding shares of capital stock
entitled to be voted at the meeting. Our charter may be amended in accordance
with Maryland law, subject to limitations set forth in the charter.
Dividends; Liquidation; Other Rights. The holders of shares of our common
stock are entitled to receive dividends when, as, and if declared by the Board
of Directors out of funds that are legally available, subject to the rights of
the holders of the preferred stock or any other class or series of preferred
stock that may be issued in the future. In the event of liquidation,
dissolution or winding up of NovaStar Financial, the holders of our common
stock will share ratably in all the assets of NovaStar Financial remaining
after the payment of liabilities and after payment of the liquidation
preference of any shares, classes or series of preferred stock that may be
issued and outstanding. There are no preemptive or other subscription rights,
conversion rights or redemption or sinking fund provisions with respect to
shares of common stock. The common stock is nonassessable.
Registration Rights
Each purchaser of units in our 1996 private placement is entitled to rights
with respect to registration under the Securities Act. With respect to the
shares of our common stock into which the shares of our Class A preferred stock
have been converted, the 1996 warrants and the shares of underlying common
stock, there is a registration rights agreement. In accordance with the 1996
registration rights agreement, we have filed with the Commission, within six
months after the closing of our initial public offering, and then used our best
efforts to effectuate, a shelf registration statement. We also agreed to use
our best efforts to have the shares of common stock, upon the effectiveness of
the initial public offering, and the 1996 warrants, upon the effectiveness of
the shelf registration agreement, approved for quotation on the NYSE. We are
required to keep the shelf registration statement effective until the sooner of
three years or such time as, in the written opinion of our counsel, such
registration is not required for the unrestricted resale of shares of common
stock or warrants entitled to registration rights under the registration rights
agreement. In addition, with respect to each investor who purchased 5% or more
of the units sold in the private placement, a "5% purchaser", we have agreed to
include with each registration statement we file that relates to a new issuance
of common stock during the term of the registration rights agreement, shares of
common stock of such 5% purchaser resulting from the conversion of the
preferred stock or the exercise of warrants, subject to certain conditions.
Such conditions provide, among other things, that the managing underwriter in
any offering being so registered may determine that all of such shares of
common stock proposed to be included in the offering cannot be sold. If this is
the case, the number of such shares included will be reduced pro rata among
such 5% purchasers proposing to participate according to the number of such
shares proposed to be sold. Provided, however, that with respect to our first
two public offerings of common stock exceeding a $50 million threshold, such
purchasers will be entitled to participate pro rata in any amount that can be
sold in excess of $50 million per offering. Following the end of the
effectiveness of the shelf registration statement, each 5% purchaser shall have
two demand registration rights, unless, in a written opinion of our counsel
which is reasonably acceptable to such purchaser, such registration is not
necessary for such 5% purchaser to sell its shares in the manner contemplated
in compliance with applicable securities laws. If requested by any
participating 5% purchaser, our management will conduct road shows to assist
such 5% purchaser in selling its shares under either the shelf registration
statement or the demand registrations.
Messrs. Hartman and Anderson, as holders of the 216,666 shares of currently
outstanding common stock, are entitled to rights with respect to registration
under the Securities Act of such common stock. Under the terms of a founders
registration rights agreement, such holders are entitled to include shares of
our common stock held by such holders, subject to conditions and limitations,
within any of our proposed registration statements under the Securities Act
with respect to a firm commitment underwritten public offering of common stock,
either for its own account or for the account of other security holders.
118
<PAGE>
Our warrant agreements with First Union and GMAC/Residential Funding
Corporation contain anti-dilution protections and registration rights for
warrantholders. We have also entered into a registration rights agreement for
the benefit of the holders of the preferred stock. We have agreed to file a
shelf registration statement with the SEC covering the warrants and the
preferred stock. This prospectus is a part of that shelf registration
statement.
Private Placement Purchase Terms Agreement
According to a purchase terms agreement between NovaStar Financial and the
placement agent in our private placement, we agreed to a number of provisions
for the benefit of the purchasers of units. The purchase terms agreement
included, among other covenants, the following:
(1) financial reporting and information requirements prior to our initial
public offering;
(2) approval by a majority of independent directors of material increases
in management compensation;
(3) restrictions on affiliated transactions, excluding transactions with GE
Capital Corporation and its affiliates;
(4) prohibitions on entering unrelated lines of business, including, but
not limited to, investments in commercial and multifamily mortgage and
mortgage-backed securities or other REITs;
(5) maintenance of key man life insurance on Messrs. Hartman and Anderson
for five years;
(6) maintenance of our status as a REIT;
(7) changes in the capital allocation guidelines and hedge policies;
(8) undertaking to carry out a liquidation of NovaStar Financial upon the
vote of a majority of the stockholders recommending such action; and
(9) prohibition on grants of stock options or other awards under our 1996
Stock Option Plan prior to our initial public offering other than those
stock options described in "Management--Executive Compensation."
Since our 1997 initial public offering or, in the case of clauses (4) and (5)
above, for one year following our 1997 initial public offering, the provisions
of clauses (2) through (7) above may be modified or waived by a majority of
independent directors. During such one-year period, clauses (4) and (5) may be
waived by a unanimous vote of the Board of Directors. Clauses (8) and (9)
terminated upon the closing of our 1997 initial public offering.
Repurchase of Shares and Restriction on Transfer
Two of the requirements of qualification for the tax benefits accorded by the
REIT provisions of the Code are that (1) during the last half of each taxable
year not more than 50% in value of the outstanding shares may be owned directly
or indirectly by five or fewer individuals, which is the "50%/5 stockholder
test", and (2) there must be at least 100 stockholders on 335 days of each
taxable year of 12 months.
In order that we may meet these requirements at all times, the charter
prohibits any person from acquiring or holding, directly or indirectly, shares
of capital stock in excess of 9.8% in value of the aggregate of the outstanding
shares of capital stock or in excess of 9.8%, in value or in number of shares,
whichever is more restrictive, of the aggregate of the outstanding shares of
our common stock. For this purpose, the term "ownership" is defined in
accordance with the REIT provisions of the Code and the constructive ownership
provisions of Section 544 of the Code, as modified by Section 856(h)(1)(B) of
the Code.
For purposes of the 50%/5 stockholder test, the constructive ownership
provisions applicable under Section 544 of the Code attribute ownership of
securities owned by a corporation, partnership, estate or trust
119
<PAGE>
proportionately to its stockholders, partners or beneficiaries. These code
provisions also attribute ownership of securities owned by family members and
partners to other members of the same family. Further these code provisions
treat securities with respect to which a person has an option to purchase as
actually owned by that person. Finally, the code provisions set forth rules as
to when securities constructively owned by a person are considered to be
actually owned for the application of such attribution provisions i.e.,
"reattribution". Thus, for purposes of determining whether a person holds
shares of capital stock in violation of the ownership limitations set forth in
our charter, many types of entities may own directly more than the 9.8% limit
because such entities shares are attributed to its individual stockholders. On
the other hand, a person will be treated as owning not only shares of capital
stock actually or beneficially owned, but also any shares of capital stock
attributed to such person under the attribution rules. Accordingly, under some
circumstances, shares of capital stock owned by a person who individually owns
less than 9.8% of the shares outstanding may nevertheless be in violation of
the ownership limitations set forth in our charter. Ownership of shares of our
capital stock through such attribution is generally referred to as constructive
ownership. The 100 stockholder test is determined by actual, and not
constructive, ownership. We have greater than 100 shareholders of record.
Under the constructive ownership provisions of Section 544 of the Code, a
holder of a warrant will be treated as owning the number of shares of capital
stock into which such warrant may be converted.
Our charter further provides that if any transfer of shares of capital stock
occurs which, if effective, would result in any person beneficially or
constructively owning shares of capital stock in excess or in violation of the
above transfer or ownership limitations, then that number of shares of capital
stock the beneficial or constructive ownership of which otherwise would cause
such person to violate such limitations, rounded to the nearest whole shares,
shall be automatically transferred to the trustee of a trust for the exclusive
benefit of one or more charitable beneficiaries, and the intended transferee
shall not acquire any rights in such shares. Shares held by the trustee shall
be issued and outstanding shares of capital stock. The intended transferee
shall not benefit economically from ownership of any shares held in the trust,
shall have no rights to dividends, and shall not possess any rights to vote or
other rights attributable to the shares held in the trust. The trustee shall
have all voting rights and rights to dividends or other distributions with
respect to shares held in the trust, which rights shall be exercised for the
exclusive benefit of the charitable beneficiary. Any dividend or other
distribution paid to the intended transferee prior to our discovery that shares
of common stock have been transferred to the trustee shall be paid with respect
to such shares to the trustee by the intended transferee upon demand and any
dividend or other distribution authorized but unpaid shall be paid when due to
the trustee. Our Board of Directors, in their discretion, may waive these
requirements on owning shares in excess of the ownership limitations.
Within 20 days of receiving notice from us that shares of capital stock have
been transferred to the trust, the trustee shall sell the shares held in the
trust to a person, designated by the trustee, whose ownership of the shares
will not violate the ownership limitations set forth in the charter. Upon such
sale, the interest of the charitable beneficiary in the shares sold shall
terminate and the trustee shall distribute the net proceeds of the sale to the
intended transferee and to the charitable beneficiary as follows. The intended
transferee shall receive the lesser of (1) the price paid by the intended
transferee for the shares or, if the intended transferee did not give value for
the shares in connection with the event causing the shares to be held in the
trust, e.g., in the case of a gift, devise or other such transaction, the
market price of the shares on the day of the event causing the shares to be
held in the trust and (2) the price per share received by the trustee from the
sale or other disposition of the shares held in the trust. Any net sales
proceeds in excess of the amount payable to the intended transferee shall be
immediately paid to the charitable beneficiary. In addition, shares of capital
stock transferred to the trustee shall be deemed to have been offered for sale
to NovaStar Financial, or our designee, at a price per share equal to the
lesser of (1) the price per share in the transaction that resulted in such
transfer to the trust, or, in the case of a devise or gift, the market price at
the time of such devise or gift and (2) the market price on the date we, or our
designee, accept such offer. We shall have the right to accept such offer until
the trustee has sold shares held in the trust. Upon such a sale to NovaStar
Financial, the interest of the
120
<PAGE>
charitable beneficiary in the shares sold shall terminate and the trustee shall
distribute the net proceeds of the sale to the intended transferee.
The term "market price" on any date shall mean, with respect to any class or
series of outstanding shares of our stock, the closing price for such shares on
such date. The "closing price" on any date shall mean the last sale price for
such shares, regular way, or, in case no such sale takes place on such day, the
average of the closing bid and asked prices, regular way, for such shares. In
either case as reported in the principal consolidated transaction reporting
system with respect to securities listed or admitted to trading on the NYSE or,
if such shares are not listed or admitted to trading on the NYSE, as reported
on the principal consolidated transaction reporting system with respect to
securities listed on the principal national securities exchange on which such
shares are listed or admitted to trading or, if such shares are not listed or
admitted to trading on any national securities exchange, the last quoted price,
or, if not so quoted, the average of the high bid and low asked prices in the
over-the-counter market, as reported by the National Association of Securities
Dealers, Inc. Automated Quotation System or, if such system is no longer in
use, the principal other automated quotation system that may then be in use or,
if such shares are not quoted by any such organization, the average of the
closing bid and asked prices as furnished by a professional market maker making
a market in such shares selected by the Board of Directors or, in the event
that no trading price is available for such shares, the fair market value of
the shares, as determined in good faith by the Board of Directors.
Every owner of more than 5% or such lower percentage as required by the Code
or the regulations promulgated thereunder of all classes or series of our
stock, within 30 days after the end of each taxable year, is required to give
us written notice stating the name and address of such owner, the number of
shares of each class and series of our stock beneficially owned and a
description of the manner in which such shares are held. Each such owner shall
provide us with such additional information as we may request in order to
determine the effect, if any, of such beneficial ownership on our status as a
REIT and to ensure compliance with the ownership limitations.
Subject to some limitations, our Board of Directors may increase or decrease
the ownership limitations. In addition, to the extent consistent with the REIT
provisions of the Code, our Board of Directors may waive the ownership
limitations for and at the request of purchasers in this offering or subsequent
purchasers.
The provisions described above may inhibit market activity and the resulting
opportunity for the holders of our capital stock and warrants to receive a
premium for their shares or warrants that might otherwise exist in the absence
of such provisions. Such provisions also may make us an unsuitable investment
vehicle for any person seeking to obtain ownership of more than 9.8% of the
outstanding shares of capital stock.
Indemnification
Our charter obligates us to indemnify our directors and officers and to pay
or reimburse expenses for such individuals in advance of the final disposition
of a proceeding to the maximum extent permitted from time to time by Maryland
law. Maryland law permits a corporation to indemnify its present and former
directors and officers, among others, against judgments, penalties, fines,
settlements and reasonable expenses actually incurred by them in connection
with any proceeding to which they may be made a party by reason of their
service in those or other capacities, unless it is established that
. the act or omission of the director or officer was material to the matter
giving rise to the proceeding and (1) was committed in bad faith, or (2)
was a result of active and deliberate dishonesty;
. the director or officer actually received an improper personal benefit in
money, property or services; or
. in the case of any criminal proceeding, the director or officer had
reasonable cause to believe that the act or omission was unlawful.
121
<PAGE>
Limitation of Liability
Maryland law permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholder for money damages, except to the extent that
(1) it is proved that the person actually received an improper benefit or
profit in money, property or services, or (2) a judgment or other final
adjudication adverse to the person is entered in a proceeding based on a
finding that the person's action, or failure to act, was the result of active
and deliberate dishonesty and was material to the cause of action adjudicated
in the proceeding. Our charter contains a provision providing for elimination
of the liability of our directors and officers to NovaStar Financial or our
stockholders for money damages to the maximum extent permitted by Maryland law
as amended or interpreted.
Business Acquisitions Statutes
Under Maryland law, "business combinations", including a merger,
consolidation, share exchange, or, in circumstances, an asset transfer or
issuance or reclassification of equity securities, between a Maryland
corporation and any person who beneficially owns 10% or more of the voting
power of the corporations shares or an affiliate of the corporation which, at
any time within the two-year period prior to the date in question, was the
beneficial owner of 10% or more of the voting power of the then-outstanding
voting stock of the corporation, an "interested stockholder", or an affiliate
thereof, are prohibited for five years after the most recent date on which the
interested stockholder became an interested stockholder. Thereafter, any such
business combination must be recommended by the board of directors of such
corporation and approved by the affirmative vote of at least (a) 80% of the
votes entitled to be cast by holders of outstanding voting shares of the
corporation and (b) two-thirds of the votes entitled to be cast by holders of
outstanding voting shares of the corporation other than shares held by the
interested stockholder with whom the business combination is to be effected,
unless, among other things, the corporation's stockholders receive a minimum
price, as defined by Maryland law, for their shares and the consideration is
received in cash or in the same form as previously paid by the interested
stockholder for its shares. These provisions of Maryland law do not apply,
however, to business combinations that are approved or exempted by the board of
directors of the corporation prior to the time that the interested stockholder
becomes an interested stockholder. Our Board of Directors has adopted a
resolution to the effect that the foregoing provisions of Maryland law shall
not apply to any future business combination with any purchaser of units in the
private placement, or an affiliate thereof, or to any other future business
combination with NovaStar Financial. No assurance can be given that such
provision will not be amended or eliminated at any point in the future with
respect to business combinations not involving a purchaser of units.
Control Share Acquisitions
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on the
matter, excluding shares of stock owned by the acquiror or by officers or
directors who are employees of the corporation. "Control shares" are voting
shares of stock which, if aggregated with all other shares of stock owned by
such a person, would entitle the acquiror to exercise voting power in electing
directors within one of the following ranges of voting power:
. one-fifth or more but less than one third;
. one-third or more but less than a majority; or
. a majority or more of all voting power.
"Control shares" do not include shares of stock the acquiring person is then
entitled to vote as a result of having owned stockholder approval. A "control
share acquisition" means, subject to exceptions, the acquisition of, ownership
of, or the power to direct the exercise of voting power with respect to,
control shares.
122
<PAGE>
A person who has made or proposes to make a "control share acquisition," upon
satisfaction of conditions including an undertaking to pay expenses, may compel
the Board of Directors to call a special meeting of stockholders to be held
within 50 days of demand to consider the voting rights of the shares. If no
request for a meeting is made, the corporation may itself present the question
at any stockholders' meeting. If voting rights are not approved at the meeting
or if the acquiring person does not deliver an acquiring person statement as
permitted by the statute, then, subject to conditions and limitations, the
corporation may redeem any or all of the "control shares," except those for
which voting rights have previously been approved, for fair value determined,
without regard to absence of voting rights, as of the date of the last control
share acquisition or of any meeting of stockholders at which the voting rights
of such shares are considered and not approved. If voting rights for "control
shares" are approved at a stockholders meeting and the acquiror becomes
entitled to vote a majority of the shares entitled to vote, all other
stockholders may exercise appraisal rights. The fair value of the stock, as
determined for purposes of such appraisal rights may not be less than the
highest price per share paid in the control share acquisition, and certain
limitations and restrictions otherwise applicable to the exercise of dissenters
rights do not apply in the context of "control share acquisitions."
The "control share acquisition" statute does not apply to stock acquired in a
merger, consolidation or share exchange if the corporation is a party to the
transaction, or to acquisitions approved or exempted by a provision of the
articles of incorporation or bylaws of the corporation adopted prior to the
acquisition of the shares. We have adopted a provision in our bylaws that
exempts our shares of capital stock from application of the control share
acquisition statute. No assurance can be given, however, that such bylaw
provision may not be removed at any time by amendment of the bylaws.
Transfer Agent and Registrar
We have appointed UMB Bank N.A. as transfer agent and registrar with respect
to the common stock and the warrants.
123
<PAGE>
DESCRIPTION OF WARRANTS
The warrants were issued pursuant to warrant agreements. The following
summary of the warrant agreements is not complete and is qualified in its
entirety by reference to the warrant agreements including the definitions
therein of terms used below. A copy of each warrant agreement is filed with the
SEC.
On December 9, 1996, we entered into a warrant agreement with a warrant agent
whereby 3,649,999 warrants were originally issued as part of the units, each
unit consisting of one share of preferred stock and one warrant. An aggregate
of 3,333,333 Units, each Unit consisting of one share of Class A Convertible
Preferred Stock and one Stock Purchase Warrant were sold to approximately 180
accredited investors; and additional 216,666 Units were sold to the two
founders of NovaStar Financial for forgivable notes. The warrants were
represented by the preferred stock, which have an endorsement representing
beneficial ownership of the related warrants on deposit with the warrant agent
as custodian for the registered holders of the warrant. Prior to conversion,
transfer of a share of preferred stock to which the related warrant has not
been exercised constituted transfer of a holder's beneficial interest in the
related warrant. Upon closing of our initial public offering, each share of
preferred stock and the registered holder of the preferred stock received a
stock certificate representing the common stock and a certificate from the
warrant agent evidencing a separately transferable warrant. Warrants issued to
the placement agent are evidenced by warrant certificates issued at that time.
The warrants and the underlying common stock were previously registered under a
shelf registration statement. Holders of the warrants have registration rights.
Each warrant, when exercised, will entitle its holder to receive one share of
our common stock at the exercise price. The warrants were originally issued at
an exercise price of $15.00. Pursuant to their anti-dilution provisions, each
warrant exercised at $15.00 will currently purchase 1.29 shares of common
stock, which represents an effective exercise price of $11.62 per share. The
registered owner of the warrants may exercise, in whole or in part, but not as
to a fractional share of common stock, the purchase rights represented by the
warrant at any time prior to February 3, 2000.
On February 12, 1999, we entered into a warrant agreement with First Union
Corporation whereby we agreed to issue to First Union Corporation 350,000
warrants by two separate warrant certificates, one warrant certificate in the
amount of 230,000 warrants and the other warrant certificate in the amount of
120,000 warrants, to purchase common stock at $6.9375 per share, the closing
price on February 11, 1999, in exchange for 186,667 existing 1996 warrants at
$15.00 per share. The registered holder of the warrant certificates may
exercise, in whole or in part, but not as to a fractional share of common
stock, the purchase rights represented by the warrant at any time prior to
February 12, 2002.
On March 10, 1999, we entered into a warrant agreement with GMAC/Residential
Funding Corporation whereby we agreed to issue to GMAC/Residential Funding
Corporation (1) a guaranty warrant to acquire 812,731 warrants for the purchase
of our common stock at a price of $4.5625 per share, the closing price of the
common stock on October 12, 1998 and (2) a tag along warrant to acquire 364,982
shares of our common stock at $15.00 per share, the price in effect on our
December 9, 1996 warrants. Pursuant to anti-dilution provisions, each warrant
exercised at $15.00 will currently purchase 1.29 shares of common stock, which
represents an effective exercise price of $11.62 per share. The registered
holder of the guaranty warrant may exercise, in whole or in part, but not as to
a fractional share of common stock, the purchase rights represented by the
warrant at any time prior to October 13, 2003. The registered holder of the tag
along warrant may exercise, in whole or in part, but not as to a fractional
share of common stock, the purchase rights represented by the warrant at any
time and from time to time after March 10, 1999 up to and including the
expiration date of the 1996 warrants, which is February 3, 2001.
The warrants will be deemed to be exercised when NovaStar Financial has
received:
. a completed exercise agreement, executed by the person exercising all or
part of the purchase rights represented by the warrant;
. the warrant;
124
<PAGE>
. if the warrant is not registered in the name of the purchaser, an
assignment or assignments evidencing the assignment of the warrant to the
purchaser; and
. either (1) a check payable to the NovaStar Financial in an amount equal
to the product of the exercise price multiplied by the number of shares
of common stock being purchased upon such exercise, (2) the surrender to
NovaStar Financial of debt or equity securities of NovaStar Financial or
any of its wholly owned subsidiaries having a market price equal to the
aggregate exercise price of the common stock being purchased upon such
exercise, provided that the market price of any note or other debt
security or any preferred stock shall be deemed to be equal to the
aggregate outstanding principal amount or liquidation value thereof plus
all accrued and unpaid interest thereon or accrued or declared and unpaid
dividends thereon or (3) a written notice to NovaStar Financial that the
purchaser is exercising the warrant, or a portion thereof, by authorizing
NovaStar Financial to withhold from issuance a number of shares of common
stock issuable upon such exercise of the warrant which when multiplied by
the market price of the common stock is equal to the aggregate exercise
price and such withheld shares shall no longer be issuable under the
warrant.
NovaStar Financial will deliver certificates for shares of common stock
purchased upon exercise of the warrant to the purchaser within three business
days, or five business days in the case of warrants exercised under the First
Union warrant agreement. Unless the warrant has expired or all of the purchase
rights represented have been exercised, NovaStar Financial shall prepare a new
warrant, representing the rights which have not been exercised and shall within
such three or five day period deliver such new warrant to the person designated
in the exercise agreement.
The common stock issuable upon the exercise of the warrant shall be deemed to
have been issued to the purchaser at the opening of business on the date on
which the exercise time occurs, and the purchaser shall be deemed for all
purposes to have become the record holder of such common stock at the exercise
time. The issuance of certificates for shares of common stock upon exercise of
the warrant shall be made without charge to the registered holder or the
purchaser for any issuance tax or other cost incurred by NovaStar Financial in
connection with exercise and the related issuance of shares of common stock.
NovaStar Financial will at all times reserve and keep available out of its
authorized but unissued shares of common stock, solely for the purpose of
issuance upon the exercise of the warrants, the number of shares of common
stock then issuable upon the exercise of all outstanding warrants. All shares
of common stock which are so issuable shall, when issued upon payment of the
exercise price, be duly and validly issued, fully paid and nonassessable and
free from all taxes, liens and charges. NovaStar Financial shall take all
actions as may be necessary to assure that all shares of common stock may be so
issued without violation of any applicable law or governmental regulation or
any requirements of any domestic securities exchange upon which shares of
common stock may be listed. NovaStar Financial shall not take any action which
would cause the number of authorized but unissued shares of common stock to be
less than the number of shares required to be reserved for issuance upon
exercise of the warrants.
No fractional shares will be issued upon exercise of the warrants. The
holders of the warrants have no right to vote on matters submitted to our
stockholders and no right to receive dividends. The holders of warrants not yet
exercised are not entitled to share in the assets of NovaStar Financial in the
event of our liquidation, dissolution or the winding up of our affairs. There
are no statutory, or to the best of NovaStar's knowledge, contractual
stockholder preemptive rights or rights of first refusal with respect to the
issuance of the warrants or the issuance of the common stock upon exercise of
the warrants or any other issuance of common stock.
In order to prevent dilution of the rights granted under the guaranty
warrant, the exercise price of the guaranty warrants will be subject to
adjustment from time to time and the number of shares of common stock
obtainable upon exercise of the guaranty warrant will be subject to adjustment
from time to time. If and whenever on or after the date of issuance NovaStar
Financial issues or sells, or is deemed to have issued or
125
<PAGE>
sold, any share of common stock for a consideration per share less than the
greater of (1) $4.5625 and (2) the market price per share of such common stock,
then immediately upon such issue or sale the exercise price shall be reduced to
the exercise price determined by multiplying (A) the exercise price in effect
immediately prior to such issue or sale by (B) a fraction, the numerator of
which shall be the sum of (x) the number of shares of common stock deemed
outstanding immediately prior to such issue or sale and (y) the number of
shares that could be purchased at the base rate from the aggregate proceeds to
NovaStar Financial from the issuance of such new shares of common stock, and
the denominator of which shall be the number of shares of common stock deemed
outstanding immediately after such issue or sale. Upon each adjustment of the
exercise price, the number of shares of common stock acquirable upon exercise
of the warrant shall be adjusted to the number of shares determined by
multiplying the exercise price in effect immediately prior to the adjustment by
the number of shares of common stock acquirable upon exercise of the warrant
immediately prior to the adjustment and dividing the product thereof by the
exercise price resulting from the adjustment.
So long as they are outstanding, if NovaStar Financial reprices, adjusts or
amends in any manner the warrants issued pursuant to the warrant agreement
dated as of December 9, 1996 between NovaStar Financial and the holders of such
warrants, NovaStar Financial shall offer to make an identical change to the tag
along warrant.
Pursuant to the warrant agreement with First Union the exercise price will be
appropriately adjusted if we:
. Pay a dividend or make a distribution on our common stock in shares of
our common stock;
. Subdivide our outstanding shares of our common stock into a greater
number of shares;
. Combine our outstanding shares of our common stock into a smaller number
of shares;
. Issue by reclassification of our common stock any shares of our capital
stock; or
. Issue shares of capital stock, as to the First Union warrants, at a price
below the greater of (a) 6.9375 or (b) fair market value.
In case of consolidations or mergers of NovaStar Financial, or our
liquidation or the sale of all or substantially all of our assets to another
corporation, each warrant will thereafter be deemed exercised for the right to
receive the kind and amount of shares of stock or other securities or property
to which such holder would have been entitled as a result of such
consolidation, merger or sale had the warrants been exercised immediately prior
thereto and into shares of our common stock, less the exercise price.
126
<PAGE>
PLAN OF DISTRIBUTION
The offered preferred stock, the warrants and the underlying common stock
subsequently acquired by the selling securityholders pursuant to the exercise
of outstanding warrants or conversion of preferred stock, may be offered for
sale from time to time by the selling securityholders named in this prospectus,
or by their pledgees, donees, transferees or other successors in interest, to
or through underwriters or directly to other purchasers or through agents in
one or more transactions in the over-the-counter market, in one or more private
transactions, or in a combination of such methods of sale, at prices and on
terms then prevailing, at prices related to such prices, or at negotiated
prices. Under some circumstances, the selling securityholders and any broker-
dealers that act in connection with the sale of such securities may be deemed
to be "underwriters" within the meaning of Section 2(11) of the Securities Act,
and any commissions or discounts and other compensation paid to such persons
may be deemed to be underwriting discounts and commissions under the Securities
Act. At any time a particular offer of offered common stock, warrants or
underlying common stock is made, if required, a prospectus supplement will be
distributed that will set forth the aggregate amount of such securities being
offered and the terms of the offering, including the name or names of any
underwriters, dealers or agents, any discounts, commissions and other items
constituting compensation from the selling securityholders and any discounts,
commissions or concessions allowed or reallowed or paid to dealers. Such
prospectus supplement and, if necessary, a post-effective amendment to the
shelf registration statement of which this prospectus is a part, will be filed
with the SEC to reflect the disclosure of additional information with respect
to the distribution of such securities.
The underlying common stock offered hereby will be sold directly by us to the
warrantholder at the exercise price of the warrants and pursuant to the terms
and conditions of the warrant agreement governing the warrants, a copy of which
has been filed as an exhibit to the shelf registration statement of which this
prospectus is a part.
To comply with the securities laws of different jurisdictions, the securities
offered hereby may be offered or sold in such jurisdictions only through
registered or licensed brokers or dealers. In addition, in different
jurisdictions the securities offered hereby may not be offered or sold unless
they have been registered or qualified for sale in such jurisdictions or an
exemption from registration or qualification is available and is complied with.
The holders of the securities covered by this prospectus have agreed not to
effect any public sale or distribution of our securities in periods surrounding
underwritten public offerings by NovaStar Financial.
LEGAL MATTERS
The validity of the common stock offered hereby and legal matters will be
passed upon by Tobin & Tobin, a professional corporation, San Francisco,
California. Tax matters will be passed on by Jeffers, Shaff & Falk, LLP,
Irvine, California.
EXPERTS
Our consolidated balance sheets as of December 31, 1999 and 1998 and our
statements of consolidated operations, stockholders' equity and cash flows for
each of the years in the three year period ended December 31, 1999, have been
incorporated herein, in reliance on the report of KPMG LLP, independent
accountants, given on the authority of that firm as experts in accounting and
auditing.
127
<PAGE>
WHERE YOU CAN FIND MORE INFORMATION
We file annual, quarterly and special reports, proxy statements and other
information with the SEC. Our SEC filings are available to the public over the
Internet at the SEC's web site at http://www.sec.gov. You may also read and
copy any document we file at the SEC's public reference rooms in Washington,
D.C., New York, New York and Chicago, Illinois. Please call the SEC at 1-800-
SEC-0300 for further information on the public reference rooms.
The SEC allows us to "incorporate by reference" the information we file with
them, which means that we can disclose important information to you by
referring you to those documents. The information incorporated by reference is
an important part of this prospectus, and information that we file later with
the SEC will automatically update and supersede this information. We
incorporate by reference the documents listed below and any future filings made
with the SEC under Sections 13(a), 13(c), 14 and 15(d) of the Securities
Exchange Act of 1934 until we sell all of the securities.
. Annual Report on Form 10-K for the year ended December 31, 1999; and
. Current Reports on Form 8-K, filed July 6, 1998, October 12, 1998,
October 13, 1998, October 15, 1998, December 22, 1998, February 23, 1999,
and April 6, 1999.
You may request a copy of these filings at no cost, by writing or telephoning
us at the following address:
Corporate Secretary
NovaStar Financial, Inc.
1901 West 47th Place, Suite 105
Westwood, Kansas 66205
(913) 514-3500
You should rely only on the information incorporated by reference or provided
in this prospectus. We have not authorized anyone else to provide you with
different information. We are not making an offer of these securities in any
state where the offer is not permitted. You should not assume that the
information in this prospectus is accurate as of any date other than the date
on the front of the document.
128
<PAGE>
GLOSSARY
As used in this Prospectus, the capitalized and other terms listed below have
the meanings indicated.
"agency" means FNMA, FHLMC or GNMA.
"agency certificates" means pass-through certificates guaranteed by FNMA,
FHLMC or GNMA.
"agency securities" means securities issued or guaranteed by FNMA, FHLMC or
GNMA.
"adjustable-rate mortgage" or "ARM" means a mortgage loan (including any
mortgage loan underlying a mortgage security) that features adjustments of the
underlying interest rate at predetermined times based on an agreed margin to an
established index. An ARM is usually subject to periodic interest rate and/or
payment caps and a lifetime interest rate cap.
"capital stock" means the shares of capital stock issuable by NovaStar
Financial under its charter, and includes common stock and preferred stock.
"collateralized mortgage obligations" or "CMOs" means adjustable or short-
term fixed-rate debt obligations or bonds, that are collateralized by mortgage
loans or pass-through certificates issued by private institutions or issued or
guaranteed by GNMA, FNMA or FHLMC.
"Code" means the Internal Revenue Code of 1986, as amended.
"conforming mortgage loans" means mortgage loans that either comply with
requirements for inclusion in credit support programs sponsored by FHLMC or
FNMA or are FHA or VA Loans, all of which are secured by first mortgages or
deeds of trust on single family (one to four units) residences.
"dividend equivalent rights" or "DERs" means an element of our 1996 stock
option plan, which are granted together with certain stock options.
"ERISA" means the Employee Retirement Income Security Act of 1974.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"FHA" means the United States Federal Housing Administration.
"FHLMC" means Freddie Mac, previously the Federal Home Loan Mortgage
Corporation.
"founders" means Scott F. Hartman and W. Lance Anderson.
"FNMA" means Fannie Mae, previously the Federal National Mortgage
Association.
"GAAP" means generally accepted accounting principles.
"GNMA" means Ginnie Mae, previously the Government National Mortgage
Association.
"independent directors" means a director of NovaStar Financial who is not an
officer or employee of NovaStar Financial or any affiliate (excluding GE
Capital and its affiliates) or subsidiary of NovaStar Financial.
"IPO" means NovaStar Financial's initial public offering, which closed on
December 1, 1997.
"incentive stock options" or "ISOs" means stock options granted under our
1996 stock option plan which meet the requirements of Section 422 of the Code.
129
<PAGE>
"loan-to-value" or "LTV" ratio is the percentage obtained by dividing the
principal amount of a loan by the lower of the sales price or appraised value
of the mortgaged property when the loan is originated.
"Maryland GCL" means the general corporation laws of the State of Maryland,
the state in which NovaStar Financial, Inc. is incorporated.
"mortgage assets" means (1) mortgage loans, and (2) mortgage securities, and
(3) other qualified REIT assets.
"mortgage securities" means (1) pass-through certificates and (2) CMOs.
"net interest spread" means the difference between the annual yield earned on
interest-earning assets and the rate paid on borrowings.
"NFI Holding" means NFI Holding Corporation, a taxable affiliate of NovaStar
Financial.
"NovaStar Mortgage" means NovaStar Mortgage, Inc., a taxable affiliate of
NovaStar Financial, Inc.
"non-qualified stock options" or "NQSOs", are an element of our 1996 Stock
Option Plan, which are not treated as ISOs pursuant to Section 422 of the Code.
"NYSE" means the New York Stock Exchange.
"pass-through certificates" means securities (or interests therein) which are
qualified REIT assets evidencing undivided ownership interests in a pool of
mortgage loans, the holders of which receive a "pass-through" of the principal
and interest paid in connection with the underlying mortgage loans in
accordance with the holders' respective undivided interests in the pool.
"private placement" means NovaStar Financial's private placement of units
which closed December 9, 1996. Each unit consisted of one share of convertible
preferred stock and one warrant to purchase one share of common stock.
"qualified hedge" means any interest rate swap or cap agreement, option,
futures contract, forward rate agreement, or any similar financial instrument,
entered into by NovaStar Financial in a transaction to reduce NovaStar
Financial's interest rate risk with respect to indebtedness (including NovaStar
Financial's reverse repurchase obligations) incurred or to be incurred by
NovaStar Financial to acquire and carry mortgage assets or other real estate
assets.
"qualified REIT assets" means pass-through certificates, mortgage loans,
agency certificates and other assets of the type described in Code Section
856(c)(6)(B).
"real estate asset" means interests in real property, interests in mortgages
on real property, and regular or residual interests in REMICs.
"REIT" means real estate investment trust as defined under Section 856 of the
Code.
"REMIC" means real estate mortgage investment conduit as defined under
Section 860D of the Code.
"reverse repurchase agreement" means a secured borrowing device evidenced by
an agreement to sell securities or other assets to a third party and a
simultaneous agreement to repurchase them at a specified future date and price,
the price difference constituting the interest on the borrowing.
"SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.
"Securities Act" means the Securities Act of 1933, as amended.
130
<PAGE>
"single family" means, with respect to mortgage loans, loans secured by one-
to four-unit residential property.
"tax-exempt entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh Plans, bank commingled trust funds for
such plans, IRAs and other similar entities intended to be exempt from federal
income taxation.
"taxable income" means for any year the taxable income of NovaStar Financial
for such year (excluding any net income derived either from property held
primarily for sale to customers or from foreclosure property) subject to
certain adjustments provided in Section 857 of the Code.
"tranches" means one of three equal parts that the principal amount of
forgivable notes are divided into.
"VA" means the United States Department of Veterans Affairs.
131
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
December 31, 1999
NOVASTAR FINANCIAL, INC.
Audited Financial Statements:
Consolidated Balance Sheets.............................................. F-2
Consolidated Statements of Operations.................................... F-3
Consolidated Statements of Stockholders' Equity.......................... F-4
Consolidated Statements of Cash Flows.................................... F-5
Notes to Consolidated Financial Statements............................... F-6
Independent Auditors' Report............................................... F-20
</TABLE>
F-1
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
<TABLE>
<CAPTION>
December 31,
------------------
1999 1998
-------- --------
<S> <C> <C>
Assets
Cash and cash equivalents................................ $ 2,395 $ --
Mortgage loans........................................... 620,406 945,798
Mortgage securities--available-for-sale.................. 6,775 --
Accrued interest receivable.............................. 12,452 17,608
Assets acquired through foreclosure...................... 16,891 10,583
Advances to and investment in NFI Holding Corporation.... 29,208 20,650
Amounts due from founders................................ 1,153 961
Other assets............................................. 1,230 2,154
-------- --------
Total assets......................................... $690,510 $997,754
======== ========
Liabilities and Stockholders' Equity
Liabilities:
Borrowings............................................. $586,868 $909,944
Dividends payable...................................... 525 2,845
Accounts payable and other liabilities................. 1,803 2,157
-------- --------
Total liabilities.................................... 589,196 914,946
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares
authorized:
Class B, convertible preferred stock, 4,285,714 shares
issued and outstanding as of December 31, 1999....... 43 --
Common stock, 8,130,069 shares issued; 7,460,523 and
8,130,069 shares outstanding, respectively........... 81 81
Additional paid-in capital............................. 151,173 122,180
Accumulated deficit.................................... (41,502) (32,804)
Accumulated other comprehensive income................. 242 --
Cost of treasury stock, 673,400 as of December 31,
1999.................................................. (1,877) --
Notes receivable from founders......................... (6,846) (6,649)
-------- --------
Total stockholders' equity........................... 101,314 82,808
-------- --------
Total liabilities and stockholders' equity........... $690,510 $997,754
======== ========
</TABLE>
See notes to consolidated financial statements.
F-2
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
For the Year Ended
December 31,
---------------------------
1999 1998 1997
-------- -------- -------
<S> <C> <C> <C>
Interest income:
Mortgage loans................................... $ 66,324 $ 76,751 $25,154
Mortgage securities.............................. 389 23,996 11,807
-------- -------- -------
Total interest income.............................. 66,713 100,747 36,961
Interest expense................................... 46,758 80,794 28,185
-------- -------- -------
Net interest income................................ 19,955 19,953 8,776
Prepayment penalty income.......................... 3,143 1,985 414
Provision for credit losses........................ (22,078) (7,430) (2,453)
Premiums for mortgage loan insurance............... (1,731) (744) --
Loan servicing fees paid to NovaStar Mortgage,
Inc............................................... (3,886) (3,803) (505)
Other loan servicing fees.......................... -- -- (635)
-------- -------- -------
Net portfolio income (loss)........................ (4,597) 9,961 5,597
Gain (loss) on sales of mortgage assets............ 351 (14,962) 51
Loss on termination of interest rate agreements.... -- (7,977) --
Other income....................................... 801 1,203 290
Equity in net income (loss) of NFI Holding
Corporation....................................... 88 (2,984) 28
General and administrative expenses:
Compensation and benefits........................ 1,804 1,785 839
Office administration............................ 804 903 299
Professional and outside services................ 801 1,117 676
Net fees for other services provided by NovaStar
Mortgage........................................ 145 2,683 3,650
Other............................................ 181 574 554
Forgiveness of notes receivable from founders.... -- -- 1,083
-------- -------- -------
Total general and administrative expenses...... 3,735 7,062 7,101
-------- -------- -------
Net loss........................................... $ (7,092) $(21,821) $(1,135)
======== ======== =======
Dividends on preferred shares...................... $ 1,606 -- --
========
Net loss available to common shareholders.......... $ (8,698) $(21,821) $(1,135)
======== ======== =======
Basic and diluted loss per share................... $ (1.08) $ (2.71) $ (0.26)
======== ======== =======
Weighted average basic and diluted shares
outstanding....................................... 8,032 8,057 4,430
======== ======== =======
</TABLE>
See notes to consolidated financial statements.
F-3
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
Forgivable
Accumulated Notes
Convertible Additional Other Receivable Total
Preferred Common Paid-in Accumulated Comprehensive Treasury from Stockholders'
Stock Stock Capital Deficit Income Stock Founders Equity
----------- ------ ---------- ----------- ------------- -------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1,
1997.................... $ 36 $ 2 $ 49,910 $ (302) $ (16) $ -- $(3,250) $ 46,380
Private placement
issuance costs.......... -- -- (48) -- -- -- (48)
Proceeds from initial
public offering of
common stock, net of
issuance costs of
$5,848.................. (36) 76 67,216 -- -- -- -- 67,256
Exercise of stock
options................. -- -- 6 -- -- -- -- 6
Dividends on convertible
preferred stock ($0.18
per share).............. -- -- -- (639) -- -- -- (639)
Dividends on common
stock ($0.10 per
share).................. -- -- -- (783) -- -- -- (783)
Forgiveness of founders'
notes receivable........ -- -- -- -- -- -- 1,083 1,083
---- ---- -------- -------- ------- ------- ------- --------
Comprehensive income
(loss):
Net loss............... (1,135) -- (1,135)
Other comprehensive
income (loss)--change
in unrealized gain
(loss) on available-
for-sale securities,
net of reclassification
adjustments of $51 for
gains included in net
loss................... -- 4,369 4,369
-------- ------- --------
Total comprehensive
income (loss)......... (1,135) 4,369 3,234
-------- ------- --------
Balance, December 31,
1997.................... -- 78 117,084 (2,859) 4,353 -- (2,167) 116,489
Initial public offering
of common stock issuance
costs................... -- -- (88) -- -- -- -- (88)
Exercise of stock
options and warrants.... -- 3 5,184 -- -- -- (4,350) 837
Interest accrued on
notes receivable from
founders, net of
payments................ -- -- -- -- -- -- (132) (132)
Dividends on common
stock ($1.00 per
share).................. -- -- -- (8,124) -- -- -- (8,124)
---- ---- -------- -------- ------- ------- ------- --------
Comprehensive loss:
Net loss............... (21,821) -- (21,821)
Other comprehensive
loss--change in
unrealized gain (loss)
on available-for-sales
securities, net of
reclassification
adjustments of $15,268
for losses included in
net loss............... -- (4,353) (4,353)
-------- ------- --------
Total comprehensive
loss.................. (21,821) (4,353) -- (26,174)
-------- ------- --------
Balance, December 31,
1998.................... -- 81 122,180 (32,804) -- -- (6,649) 82,808
Proceeds from preferred
stock issuance, net of
costs of $1,323......... 43 -- 28,635 -- -- -- -- 28,678
Exercise of stock
options and warrants.... -- -- 8 -- -- -- -- 8
Warrants issued......... -- -- 350 -- -- -- -- 350
Treasury stock purchase,
630,400 shares.......... -- -- -- -- -- (1,877) -- (1,877)
Interest accrued on
notes receivable from
founders, net of
payments................ -- -- -- -- -- -- (197) (197)
Dividends on preferred
stock ($0.37 per
share).................. -- -- -- (1,606) -- -- -- (1,606)
---- ---- -------- -------- ------- ------- ------- --------
Comprehensive income
(loss):
Net loss............... (7,092) -- (7,092)
Other comprehensive
income--change in
unrealized gain (loss)
on available-for-sales
securities............. -- 242 242
-------- ------- --------
Total comprehensive
income (loss)......... (7,092) 242 (6,850)
-------- ------- --------
Balance, December 31,
1999.................... $ 43 $ 81 $151,173 $(41,502) $ 242 $(1,877) $(6,846) $101,314
==== ==== ======== ======== ======= ======= ======= ========
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>
For the Year Ended December 31,
---------------------------------
1999 1998 1997
--------- --------- -----------
<S> <C> <C> <C>
Cash flow from operating activities:
Net loss..................................... $ (7,092) $ (21,821) $ (1,135)
Adjustments to reconcile net loss to cash
provided by (used in) operating activities:
Amortization of premiums on mortgage
assets..................................... 8,088 7,620 3,440
Amortization of deferred debt costs......... 2,271 4,562 93
Provision for credit losses................. 22,078 7,430 2,453
Forgiveness of notes receivable from
founders................................... -- -- 1,083
Equity in net loss (income) of NFI Holding
Corporation................................ (88) 2,984 (28)
Losses (gains) on sales of mortgage assets.. (351) 14,962 (51)
Loss on terminations of interest rate
agreements................................. -- 7,977 --
Change in:
Accrued interest receivable................ 5,156 (6,807) (10,772)
Other assets............................... 73 (1,638) (3,780)
Other liabilities.......................... (300) (9,219) 3,223
--------- --------- -----------
Net cash provided by (used in) operating
activities............................... 29,835 6,050 (5,474)
Cash flow from investing activities:
Mortgage loans purchased from NovaStar
Mortgage, Inc.............................. -- (556,158) (417,752)
Mortgage loans purchased from others........ -- -- (219,995)
Mortgage loans sold to others............... 4,932 8,307 --
Mortgage loan repayments.................... 260,109 161,237 43,287
Sales of assets acquired through
foreclosure................................ 24,228 6,815 --
Purchases of available-for-sale securities.. -- (375,051) (659,415)
Settlement of amounts due to brokers........ -- -- (13,255)
Proceeds from sales of available-for-sale
securities................................. -- 705,906 110,067
Proceeds from paydowns on available-for-sale
securities................................. 882 165,233 48,694
Investment in NFI Holding Corporation....... (7,000) (990) (1,980)
Net change in advances to NFI Holding
Corporation................................ (8,127) (15,868) (2,653)
--------- --------- -----------
Net cash provided by (used in) investing
activities............................... 275,024 99,431 (1,113,002)
Cash flow from financing activities:
Proceeds from issuance of collateralized
mortgage obligations....................... -- 665,000 424,674
Payments on collateralized mortgage
obligations................................ (307,318) (179,851) (13,596)
Debt issuance costs paid on collateralized
mortgage obligations....................... -- (2,821) (2,304)
Change in short-term borrowings............. (18,029) (581,693) 596,693
Proceeds from issuance of capital stock and
exercise of equity instruments, net of
offering costs............................. 28,686 (54) 67,214
Treasury stock purchases.................... (1,877) -- --
Dividends paid on preferred stock........... (1,081) -- --
Dividends paid on common stock.............. (2,845) (6,062) (639)
--------- --------- -----------
Net cash provided by (used in) financing
activities............................... (302,464) (105,481) 1,072,042
---------
Net increase (decrease) in cash and cash
equivalents................................. 2,395 -- (46,434)
========= ========= ===========
Cash and cash equivalents, beginning of
year........................................ -- -- 46,434
========= ========= ===========
Cash and cash equivalents, end of year....... $ 2,395 $ -- $ --
========= ========= ===========
Supplemental disclosure of cash flow
information:
Cash paid for interest...................... $ 48,397 $ 80,604 $ 27,436
========= ========= ===========
Note received in exchange for options
exercised by founders...................... $ -- $ 4,591 $ --
========= ========= ===========
Issuance of warrants........................ $ 350 $ 813 $ --
========= ========= ===========
Dividends payable........................... $ 525 $ 2,845 $ 783
========= ========= ===========
Assets acquired through foreclosure......... $ 30,966 $ 17,242 $ 156
========= ========= ===========
</TABLE>
See notes to consolidated financial statements.
F-5
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999
Note 1. Summary of Significant Accounting Policies
NovaStar Financial, Inc. (the Company) is a Maryland corporation formed on
September 13, 1996. The Company manages a portfolio of mortgage assets
primarily consisting of non-conforming mortgage loans.
Financial Statement Presentation The Company's financial statements have been
prepared in conformity with generally accepted accounting principles and
prevailing practices within the financial services industry. The preparation of
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of income and expense during the
period. The Company uses estimates and employs the judgments of management in
determining the amount of its allowance for credit losses, amortizing premiums
or accreting discounts on its mortgage assets, and establishing the fair value
of its mortgage securities. While the financial statements and footnotes
reflect the best estimates and judgments of management at the time, actual
results could differ from those estimates. For example, it is possible that
credit losses or prepayments could rise to levels that would adversely affect
profitability if those levels were sustained for more than brief periods.
The Company owns 100% of the common stock of three special purpose entities--
NovaStar Assets Corporation, NovaStar Mortgage Funding Corporation and NovaStar
Certificates Financial Corporation. The Company formed these entities in
connection with the issuance of collateralized mortgage obligations. The
consolidated financial statements of the Company include the accounts of these
entities. Significant intercompany accounts and transactions have been
eliminated in consolidation.
The Company also owns 100% of the nonvoting preferred stock of NFI Holding
Corporation, for which it receives 99% of any dividends paid by NFI Holding
Corporation. The founders of the Company own 100% of the common stock of NFI
Holding Corporation and serve as officers and directors of NFI Holding
Corporation and its subsidiaries. The Company accounts for its investment in
NFI Holding Corporation using the equity method. The preferred stock was
purchased in February 1997 for $1,980,000 and the Company contributed
$7,000,000 and $990,000 of capital to NFI Holding Corporation during 1999 and
1998, respectively.
NFI Holding Corporation owns 100% of the outstanding common stock of NovaStar
Mortgage. NovaStar Mortgage originated a substantial portion of the non-
conforming residential mortgage loans owned by the Company and services all of
the loans owned by the Company.
Cash and Cash Equivalents The Company considers investments with maturities
of three months or less at the date of purchase to be cash equivalents.
Mortgage Loans Mortgage loans include loans acquired from NovaStar Mortgage
and in bulk pools from other originators and securities dealers. Mortgage loans
are generally purchased at a premium over the outstanding principal balance and
are stated at amortized cost. Premiums are amortized and discounts accreted as
yield adjustments over the estimated lives of the loans using a method that
approximates the interest method. Amortization includes the effect of
prepayments.
Interest is recognized as revenue when earned according to the terms of the
mortgage loans and when, in the opinion of management, it is collectible. The
accrual of interest on loans is discontinued when, in management's opinion, the
interest is not collectible in the normal course of business, but in no case
beyond when a loan becomes ninety days delinquent. Interest collected on non-
accrual loans is recognized as income upon receipt.
The Company maintains an allowance for probable credit losses inherent in the
portfolio at the balance sheet date. The allowance is based upon the assessment
by management of various factors affecting its
F-6
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
mortgage loan portfolio, including current and projected economic conditions,
the makeup of the portfolio based on credit grade, loan to value, delinquency
status, Company purchased mortgage insurance and other factors deemed to
warrant consideration. The allowance is maintained through ongoing provisions
charged to operating income and is reduced by loans that are charged off.
Mortgage Securities The Company classifies all of its mortgage securities as
available-for-sale and, therefore, reports them at their estimated fair value
with unrealized gains and losses reported as a separate component of
stockholders' equity. Premiums are amortized and discounts are accreted as
yield adjustments over the estimated lives of the securities using a method
that approximates the interest method. Amortization includes the effect of
prepayments. Gains or losses on sales of securities are recognized using the
specific identification method.
Effective January 1, 1999, the Company adopted the provisions of Statement of
Financial Accounting Standards (SFAS) No. 134, Accounting for Mortgage-Backed
Securities Retained after the Securitization of Mortgage Loans Held for Sale by
a Mortgage Banking Enterprise. SFAS No. 134 amends SFAS No. 65 and 115, and
requires entities to classify retained mortgage-backed securities after the
securitization of mortgage loans held for sale in accordance with SFAS No. 115.
However, a mortgage banking enterprise must classify retained mortgage-backed
securities that it commits to sell before or during the securitization process
as trading securities. The adoption of SFAS No. 134 did not result in an
adjustment to assets, liabilities, stockholders' equity or net loss.
Assets Acquired Through Foreclosure Real estate owned, which consists of
residential real estate acquired in satisfaction of loans, is carried at the
lower of cost or estimated fair value less estimated selling costs. Adjustments
to the loan carrying value required at time of foreclosure are charged to the
allowance for credit losses. Losses or gains from the ultimate disposition of
real estate owned are charged or credited to operating income.
Transfers of Assets The Company uses the financial components approach when
accounting for transfers of mortgage loans in repurchase and securitization
transactions. When the Company retains control over the loans, repurchase and
securitization transactions are accounted for as secured borrowings rather than
as sales. The borrowings under repurchase agreements and collateralized
mortgage obligations included in the accompanying consolidated balance sheets
represent the remaining principal amount of funds received in the transfer.
Stock-based Compensation Compensation expense for services the Company
receives as consideration for stock issued through its employee stock option
plans is measured by the quoted market price of the stock at the measurement
date less the amount, if any, that the employee is required to pay.
Income Taxes The Company intends to operate and qualify as a Real Estate
Investment Trust (REIT) under the requirements of the Internal Revenue Code.
Therefore, the Company, and its qualified REIT subsidiaries, will generally not
be subject to federal income taxes at the corporate level on taxable income
distributed to stockholders. Requirements for qualification as a REIT include
various restrictions on common stock ownership and the nature of assets and
sources of income. In addition, a REIT must distribute at least 95% of its
annual taxable income to its stockholders. If in any tax year, the Company does
not qualify as a REIT, it will be taxed as a corporation and distributions to
stockholders will not be deductible in computing taxable income. If the Company
fails to qualify as a REIT in any tax year, it will not be permitted to qualify
for the succeeding four years. The most significant difference between GAAP
earnings and taxable income relates to provisions made allowance for credit
losses, which are not deductible for income tax purposes. NFI Holding
Corporation has not elected REIT-status and files a consolidated federal income
tax return with its subsidiaries.
F-7
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Loss Per Share Basic loss per share excludes dilution and is computed by
dividing loss available to common stockholders by the weighted-average number
of common shares outstanding for the period. 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 all options and warrants on the Company's common stock have
been exercised and the convertible preferred stock is converted, unless the
exercise would be anti-dilutive.
Financial Instruments with Off-balance-sheet Risk The Company has entered
into interest rate swap and cap agreements designed to, in effect, alter the
interest rates on its funding costs to more closely match the yield on
interest-earning assets. Net income earned from or expense incurred on interest
rate swap and cap agreements is accounted for on the accrual method and is
recorded as an adjustment of interest expense. The gain or loss on early
termination, sale or disposition of an interest rate swap or cap agreement is
recognized in current earnings if the matched funding source is also
extinguished. If the matched funding source is not extinguished, the unrealized
gain or loss on the related interest rate swap or cap agreement is deferred and
amortized as a component of interest expense over the remaining term of the
matched funding source. Unmatched swap or cap agreements are recorded at fair
value with changes in the unrealized gains or losses recorded in current
earnings.
Segment Information Effective January 1, 1998, the Company adopted the
provisions of SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information. SFAS No. 131 requires public business enterprises to
report financial and descriptive information about its reportable operating
segments. Operating segments are components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision-maker in deciding how to allocate resources and in
assessing performance. Generally, financial information is required to be
reported on the basis that it is used internally for evaluating segment
performance and deciding how to allocate resources to segments. The Company has
one reportable operating segment. The adoption of SFAS No. 131 did not result
in an adjustment to assets, liabilities, stockholders' equity or net loss.
New Accounting Pronouncements During 1998, the Financial Accounting Standards
Board (FASB) issued SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities. SFAS No. 133 standardizes the accounting for derivative
instruments, including certain instruments embedded in other contracts, by
requiring that an entity recognize those items as assets or liabilities in the
balance sheet and measure them at fair value. If certain conditions are met, an
entity may elect to designate a derivative instrument either as a cash flow
hedge, a fair value hedge or a hedge of foreign currency exposure. Generally,
SFAS No. 133 provides for matching the timing of gain or loss recognition on
the hedging instrument with the recognition of the changes in the fair value of
hedge asset or liability that is attributable to the hedge risk or the earnings
effect of the hedge forecasted transaction. SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133 an amendment of FASB Statement No. 133 was issued in
June 1999 and postponed the effective date of SFAS No. 133 to fiscal years
beginning after June 15, 2000. Management does not expect the adoption of SFAS
No. 133 to have a material impact on the financial statements of the Company.
Reclassifications Certain reclassifications of prior year amounts have been
made to conform to current year presentation.
F-8
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Note 2. Mortgage Loans
Mortgage loans, all of which are secured by residential properties, consisted
of the following as of December 31 (in thousands).
<TABLE>
<CAPTION>
1999 1998
-------- --------
<S> <C> <C>
Outstanding principal.................................. $618,822 $928,503
Net unamortized premium................................ 12,689 20,868
-------- --------
Amortized cost......................................... 631,511 949,371
Allowance for credit losses............................ (11,105) (3,573)
-------- --------
$620,406 $945,798
======== ========
</TABLE>
Activity in the allowance for credit losses is as follows, for the three
years ended December 31, 1999 (in thousands).
<TABLE>
<CAPTION>
1999 1998 1997
------- ------ ------
<S> <C> <C> <C>
Balance, January 1................................ $ 3,573 $2,313 $ --
Provision for credit losses....................... 22,078 7,430 2,453
Amounts charged off, net of recoveries............ (14,546) (6,170) (140)
------- ------ ------
Balance, December 31.............................. $11,105 $3,573 $2,313
======= ====== ======
</TABLE>
All mortgage loans serve as collateral for various borrowing arrangements as
discussed in Note 4. The weighted-average interest rate on these loans at
December 31, 1999 and 1998 was 10.3% and 10.2%, respectively.
Collateral for 16%, 14% and 7% of the mortgage loans outstanding as of
December 31, 1999 was located in California, Florida and Washington,
respectively. The Company has no other significant concentration of credit
risk.
Note 3. Mortgage and Other Securities
As of December 31, 1999, available-for-sale mortgage securities consisted of
the Company's investment in the subordinated and interest-only bond portions of
NovaStar Mortgage Funding Trust, Series 99-01 (NMFT 99-01). NovaStar Mortgage
issued NMFT 99-01, a Real Estate Mortgage Investment Conduit, during January
1999. The primary (A-class) bonds were sold to parties independent of the
Company or its affiliates. The Company purchased the subordinated (B-class) and
interest-only bonds from NovaStar Mortgage in September 1999. For the issuance
of NMFT 99-01, NovaStar Mortgage combined $165 million in non-conforming
mortgage loans and issued $160 million in asset-backed bonds. No active trading
market for the purchase and sale of residuals exists. Therefore, management
estimates the value the security by discounting the expected future cash flow
of the collateral and bonds.
The original estimated fair value of the interests retained by NovaStar
Mortgage was $9,700,000. In estimating the value of the retained interests,
management assumed prepayment rates ranging from 35 to 45 CPR, an annual
constant default rate of 70 basis points and a discount rate of 16.5%. The
original securitization generated a gain for NovaStar Mortgage of $1,600,000.
As of December 31, 1999, the fair value of the residual interest owned by the
Company was estimated using annual constant prepayment rates ranging from 35 to
45, an annual constant default rate of 70 basis points and a discount rate of
20%.
F-9
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Before December 31, 1998, the Company owned mortgage-backed securities issued
by government agencies and corporate bonds. Gross gains and losses on sales of
these securities were as follows (in thousands).
<TABLE>
<CAPTION>
Year Ended
December 31,
--------------
1998 1997
-------- ----
<S> <C> <C>
Gross gains............................................... $ 222 $51
Gross losses.............................................. 15,490 --
-------- ---
Gains (losses) on the sale of mortgage and other
securities............................................... $(15,268) $51
======== ===
</TABLE>
Note 4. Borrowings
Collateralized Mortgage Obligations (CMOs) The Company issued CMOs secured by
its mortgage loans as a means for long-term financing. For financial reporting
and tax purposes, the mortgage loans held as collateral for CMOs are recorded
as assets of the Company and the CMOs are recorded as debt. Interest and
principal on each CMO is payable only from principal and interest on the
underlying mortgage loans collateralizing the CMO. Interest rates reset monthly
and are indexed to one-month LIBOR. The estimated weighted-average months to
maturity is based on estimates and assumptions made by management. The actual
maturity may differ from expectations. However, the Company retains the option
to repay the CMO, and reacquire the mortgage loans, when the remaining unpaid
principal balance of the underlying mortgage loans falls below 35 % of their
original amounts for issue 97-01 and 25% on 97-02, 98-01 and 98-02. Following
is a summary of outstanding CMOs (dollars in thousands):
<TABLE>
<CAPTION>
Collateralized
Mortgage Obligation Mortgage Loans
----------------------- ---------------------------------
Estimated
Remaining Weighted Weighted
Remaining Interest Principal Average Average
Principal Rate (A) Coupon Months to Call
----------- --------- --------- -------- --------------
<S> <C> <C> <C> <C> <C>
As of December 31, 1999:
NovaStar Home Equity
Series:
Issue 1997-1.......... $ 75,580 6.94% $ 87,534 11.04% --
Issue 1997-2.......... 95,053 6.72 104,851 10.90 12
Issue 1998-1.......... 186,493 6.55 200,625 10.08 22
Issue 1998-2.......... 231,969 6.71 244,109 9.97 29
Unamortized debt
issuance costs, net.. (2,227)
-----------
$ 586,868
===========
As of December 31, 1999:
NovaStar Home Equity
Series:
Issue 1997-1.......... $ 163,419 5.88% $174,516 10.56% 11
Issue 1997-2.......... 164,496 5.88 173,858 10.37 24
Issue 1998-1.......... 268,152 5.69 277,776 10.01 34
Issue 1998-2.......... 300,161 5.74 306,807 9.95 41
Unamortized debt
issuance costs, net.. (4,284)
-----------
891,944
===========
</TABLE>
- --------
(A) Includes assets acquired through foreclosure.
F-10
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Short-term Financing Arrangements The Company is a co-borrower with NovaStar
Mortgage under warehouse lending and master repurchase agreements with First
Union National Bank. The Company and NovaStar Mortgage can borrow up to $75
million under the warehouse lending agreement and $175 million under the master
repurchase agreement ($300 million as of December 31, 1998). As of December 31,
1999 and 1998, the Company had no borrowings outstanding and NovaStar Mortgage
had borrowings of $78,448,000 and $203,341,000 outstanding under these
arrangements, respectively. Borrowings under these arrangements are secured by
mortgage loans owned by NovaStar Mortgage. The interest rate on borrowings
under the warehouse lending arrangement is indexed to the Federal funds rate.
Under the master repurchase agreement, borrowings are indexed to one-month
LIBOR. These agreements expire on June 1, 2000. Upon expiration, the Company
expects to renew these arrangements on substantially the same terms.
Under the terms of two additional repurchase agreements entered in February
1999, the Company and/or NovaStar Mortgage can borrow up to $25 million from
First Union National bank secured by residual interests in CMOs issued by the
Company, its affiliates or subsidiaries. Borrowings under these arrangements
bear interest at one-month LIBOR plus 5%. These agreements expire on December
17, 2001. No amounts were outstanding under these agreements as of December 31,
1999. In connection with the execution of the financing agreements with First
Union, the Company issued First Union warrants for the purchase of the
Company's stock (see Note 7).
The Company is also a co-borrower under a warehouse lending agreement with
GMAC/Residential Funding Corporation (GMAC/RFC). The Company and/or NovaStar
Mortgage can borrow up to $50 million under this agreement. No amounts were
outstanding under this agreement as of December 31, 1999. Future borrowings
will be secured by mortgage loans owned by the Company or NovaStar Mortgage and
will bear interest at a rate indexed to one-month LIBOR. The agreement expires
on December 27, 2000.
As of December 31, 1998, the Company had a short-term financing arrangement
with GMAC/RFC secured by residual interests in the Company's CMOs. In 1998, the
Company borrowed $15 million from GMAC/RFC. The $15 million in principal and a
$3 million fee are included in borrowings in the accompanying December 31, 1998
consolidated balance sheet. As discussed in Note 7, in connection with the
agreement, the Company issued warrants to GMAC/RFC for the purchase of the
Company's stock. The financing fee and the estimated value of the warrants
($813,000) were recognized as additional interest expense in 1998. All amounts
were repaid in February 1999.
Average daily balances for short-term borrowings of the Company were as
follows (in thousands).
<TABLE>
<CAPTION>
1999 1998
------ --------
<S> <C> <C>
Repurchase agreements secured by mortgage loans........... $ -- $118,380
Borrowings under warehouse lines of credit................ -- 14,991
Other short-term borrowings............................... 4,206 3,945
Repurchase agreements secured by mortgage securities...... -- 392,859
</TABLE>
All short-term financing arrangements require the Company and NovaStar
Mortgage to maintain minimum tangible net worth, meet equity ratio tests and
comply with other customary debt covenants. The Company and NovaStar Mortgage
comply with all debt covenants.
Note 5. Financial Instruments with Off-balance-sheet Risk
The Company's interest rate cap agreements 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.
F-11
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Credit Risk The Company's exposure to credit risk on interest rate cap
agreements is limited to the cost of replacing contracts should the
counterparty fail. The Company seeks to minimize credit risk through the use of
credit approval and review processes, the selection of only the most
creditworthy counterparties, continuing review and monitoring of all
counterparties, exposure reduction techniques and through legal scrutiny of
agreements. Before engaging in negotiated derivative transactions with any
counterparty, the Company has in place fully executed written agreements.
Agreements with counterparties also call for full two-way netting of payments.
Under these agreements, on each payment exchange date all gains and losses of
counterparties are netted into a single amount, limiting exposure to the
counterparty to any net positive value.
Market Risk The potential for financial loss due to adverse changes in market
interest rates is a function of the sensitivity of each position to changes in
interest rates, the degree to which each position can affect future earnings
under adverse market conditions, the source and nature of funding for the
position, and the net effect due to offsetting positions. The synthetic product
of these transactions is a "matched" position for the Company. The combination
of off-balance-sheet instruments with on-balance-sheet liabilities leaves the
Company in a market risk position that is designed to be a better position than
if the derivative had not been used in interest rate risk management.
Derivatives instruments used in matched transactions as described above are
classified as derivatives held for purposes other than trading. No derivatives
were held for trading purposes during the three years ended December 31, 1999.
Other Risk Considerations The Company is cognizant of the risks involved with
financial derivatives. The Company's policies and procedures seek to mitigate
risk associated with the use of financial derivatives in ways appropriate to
its business activities, considering its risk profile as a limited end-user.
Information regarding the Company's financial instruments with off-balance-
sheet risk is as follows (dollars in thousands).
<TABLE>
<CAPTION>
Unrealized
------------
Weighted
Notional Days to Cap
Value Gains Losses Maturity Rate
-------- ----- ------ -------- ----
<S> <C> <C> <C> <C> <C>
As of December 31, 1999:
Interest rate cap agreements............. $430,000 $778 $ -- 578 6.45%
======== ==== ======
As of December 31, 1998:
Interest rate cap agreements............. $625,000 $-- $2,483 734 6.27%
======== ==== ======
</TABLE>
During the three years ended December 31, 1999, the Company recognized
$2,254,000, $2,891,000 and $1,047,000, respectively, in interest expense
relating to off-balance-sheet financial instruments. In 1998, the Company
terminated interest rate agreements with an aggregate notional value of $469
million because of the sale of the Company's portfolio of mortgage securities
and repayment of the related financing under repurchase agreements, incurring
net losses of $7,977,000.
Note 6. Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments
presents amounts that have been determined using available market information
and appropriate valuation methodologies. However, considerable judgment is
required to interpret market data to develop the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of
the amounts that could be realized in a current market exchange. The use of
different market assumptions or estimation methodologies could have a material
impact on the estimated fair value amounts.
F-12
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The estimated fair values of the Company's financial instruments are as
follows as of December 31 (in thousands).
<TABLE>
<CAPTION>
1999 1998
------------------- -------------------
Carrying Carrying
Value Fair Value Value Fair Value
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
Financial assets:
Mortgage loans....................... $620,406 $612,144 $945,798 $950,808
Mortgage securities.................. 6,775 6,775 -- --
Financial liabilities:
Collateralized mortgage
obligations....................... 586,868 587,245 891,944 883,000
Other borrowings................... -- -- 18,000 18,000
Off-balance-sheet financial
instruments....................... 594 1,372 1,157 (1,326)
</TABLE>
Market quotations were used to estimate the fair value of mortgage
securities. The fair value of all other financial instruments is estimated by
discounting projected future cash flows, including projected prepayments for
mortgage assets, at current market rates. The fair value of cash and cash
equivalents and accrued interest receivable and payable approximates its
carrying value.
Note 7. Stockholders' equity
On December 1, 1997, the Company completed an initial public offering of its
common stock issuing 4,059,000 shares and receiving net proceeds of $67
million. In connection with the initial public offering, 3,649,999 shares of
previously issued convertible preferred stock were converted into a like number
of shares of common stock.
On March 29, 1999, the Company completed a private placement of preferred
stock by issuing 4,285,714 shares of class B, 7% cumulative convertible
preferred stock for $7 per share and received net proceeds of $28.7 million.
Each share of preferred stock is convertible, at the option of the holder, into
one share of common stock and is redeemable for $7 per share by the Company any
time after March 31, 2002.
As of December 31, 1999, the Company has the following warrants outstanding
for the purchase of Company common stock.
<TABLE>
<CAPTION>
Exercise Expiration
Quantity Price Date
--------- -------- ----------
<S> <C> <C>
4,014,800 $15.00 2001
350,000 6.94 2002
812,731 4.56 2003
---------
5,177,531
=========
</TABLE>
The founders of the Company were issued 261,866 of the warrants expiring in
2001 (see Note 8.) The warrants that expire in 2002 and 2003 were issued to
First Union and GMAC/RFC, respectively, in connection with the execution of
short-term financing arrangements as discussed in Note 4.
Note 8. Transactions with Founders
In connection with the initial formation and capitalization of the Company,
its founders acquired 216,666 shares of common stock and warrants to acquire
216,666 additional shares for $15.00 in exchange for forgivable promissory
notes. Pursuant to the terms of the original warrant agreement, the exercise
price of the
F-13
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
warrants was reduced to $11.62 upon the Company's subsequent issuance of
warrants to unrelated entities at exercise prices lower than $15.00. The notes
bear interest at 8% and are secured by the shares and warrants. Interest is
payable quarterly and the notes mature December 31, 2001. The principal is
payable in three equal tranches. Payment of principal on each tranche will be
forgiven if the Company meets certain incentive targets. During 1997, the first
incentive target was met resulting in the forgiveness of one-third of the note
and the recognition of compensation expense in 1997 of $1,083,000. The
incentive targets were not met in 1998 or 1999 and, accordingly, no debt
forgiveness incurred in those years.
During 1998, the founders exercised options to acquire 289,332 shares of
common stock in exchange for non-recourse promissory notes aggregating
$4,340,000. The notes bear interest at one-month LIBOR plus 1%, are secured by
the shares of common stock and mature at the earlier of the founders'
employment termination or the sale of the stock.
The notes have been recorded in the accompanying consolidated balance sheets
as a contra-equity account. Accrued interest related to the forgivable notes is
recorded as amounts due from founders. The accrued interest related to the non-
recourse notes is recorded as an additional component of the contra-equity
account. The following table summarizes amounts of these notes as of December
31 (in thousands).
<TABLE>
<CAPTION>
1999 1998
------ ------
<S> <C> <C>
Notes receivable from founders:
Forgivable................................................ $2,167 $2,167
Non-recourse.............................................. 4,340 4,340
Accrued interest.......................................... 339 142
------ ------
Total..................................................... $6,846 $6,649
====== ======
</TABLE>
The Company advanced funds to the founders for the payment of their personal
tax liability arising from the forgiveness of the first tranche of the
forgivable notes, as discussed above. The founders have issued notes payable to
the Company for the repayment of the tax liability, interest accrued on the
forgivable notes through December 31, 1997 and notes payable for the founders'
contributions to NFI Holding capital in 1999. Amounts due from founders
outstanding as of December 31, 1999 and 1998 are shown below (in thousands).
<TABLE>
<CAPTION>
1999 1998
------ ----
<S> <C> <C>
Amounts due from founders:
Founders' personal tax liability........................... $ 584 $584
Interest on notes receivable from founders through December
31, 1997.................................................. 260 260
Accrued interest on amounts due from founders.............. 239 117
Advances for capitalization of NFI Holding................. 70 --
------ ----
Amounts due from founders.................................... $1,153 $961
====== ====
</TABLE>
Interest income recorded by the Company related to the notes aggregated
$496,000, $441,000 and $260,000 in 1999, 1998 and 1997, respectively. Interest
paid by the founders aggregated $177,000 and $199,000 in 1999 and 1998,
respectively.
Note 9. Stock Option Plan
The Company's 1996 Stock Option Plan (the Plan) provides for the grant of
qualified incentive stock options (ISOs), non-qualified stock options (NQSOs),
deferred stock, restricted stock, performance shares, stock appreciation and
limited stock awards, and dividend equivalent rights (DERs). ISOs may be
granted to the
F-14
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
officers and employees of the Company. NQSOs and awards may be granted to the
directors, officers, employees, agents and consultants of the Company or any
subsidiaries. Under the terms of the Plan, the number of shares available for
issuance is equal to 10% of the Company's outstanding common. Unless previously
terminated by the Board of Directors, the Plan will terminate on September 1,
2006.
All options have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Outstanding
options vest over four years and expire ten years after the date of grant. The
following table summarizes option activity under the 1996 Plan for 1999, 1998
and 1997, respectively:
<TABLE>
<CAPTION>
1999 1998 1997
------------------ ------------------ -----------------
Weighted Weighted Weighted
Average Average Average
Shares Price Shares Price Shares Price
-------- -------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at the
beginning of year...... 384,060 $13.37 557,472 $15.22 334,332 $13.24
Granted................. 119,000 6.94 148,000 9.38 225,640 18.00
Exercised............... (3,750) 1.67 (300,582) 14.51 (2,500) 2.50
Canceled................ (141,590) 16.39 (20,830) 18.00 -- --
-------- -------- -------
Outstanding at the end
of year................ 357,720 $10.16 384,060 $13.37 557,472 $15.22
======== ====== ======== ====== ======= ======
Exercisable at the end
of year................ 141,890 $11.10 61,685 $15.70 298,082 $14.61
======== ====== ======== ====== ======= ======
</TABLE>
Pursuant to a resolution of the Company's compensation committee of the Board
of Directors dated December 21, 1999, the exercise price for 104,000 stock
options issued to employees was decreased to $7.00. These options are included
in the granted and canceled amounts during 1999 in that above table. Of these,
69,000 were issued originally in 1997 with an exercise price of $18.00 per
share and 35,000 in 1998 at an exercise price of $17.01 per share. No changes
were made to the vesting periods or expiration dates. The market price of the
Company's stock was below the adjusted exercise price of the options as of the
adjustment date and through December 31, 1999. Therefore, no compensation
expense was recorded. If the price of the Company's stock exceeds $7.00 per
share in future periods, the Company will record compensation expense.
Certain options granted during 1998 and 1997 were granted with DERs. Under
the terms of the DERs, a recipient is entitled to receive additional shares of
stock upon the exercise of options. The DERs accrue at a rate equal to the
number of options outstanding times the dividends per share amount at each
dividend date. The accrued DERs convert to shares based on the stock's fair
value on the dividend declaration date. Certain of the options exercised in
1999 and 1998 had DERs attached to them. As a result of these exercises, an
additional 104 and 641 shares of common were issued in 1999 and 1998,
respectively. No DERs were converted to common stock upon the exercise of
options in 1997. As discussed in Note 8, the Company's two founders exercised
options to acquire 289,332 shares of common stock in 1998.
The following table presents information on stock options outstanding as of
December 31, 1999.
<TABLE>
<CAPTION>
Outstanding Exercisable
------------------------------- -----------------
Weighted
Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Exercise Price Quantity Life (years) Price Quantity Price
-------------- -------- ------------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
$0.01-$2.50................ 22,500 6.86 $ 1.81 13,750 $ 1.82
$5.88-7.00................. 217,000 8.53 6.69 67,750 6.78
$18.00-$20.81.............. 118,220 7.87 18.12 60,390 18.06
------- -------
357,720 8.20 $10.16 141,890 $11.10
======= ==== ====== ======= ======
</TABLE>
F-15
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In accordance with generally accepted accounting principles, the Company has
chosen to not record the fair value of stock options at their grant date. If
the expense had been recorded the Company's diluted loss per share for the
three years ended December 31, 1999 would have been $(1.10), $(2.72) and
$(0.26). The following table summarizes the weighted average fair value of the
granted options, determined using the Black-Scholes option pricing model and
the assumptions used in their determination.
<TABLE>
<CAPTION>
1999 1998 1997
----- ----- ----
<S> <C> <C> <C>
Weighted average:
Fair value............................................. $2.39 $4.47 $--
Expected life in years................................. 7 7 7
Annual risk-free interest rate......................... 6.0% 5.1% 6.5%
Volatility............................................. 4.1 4.0 --
Dividend yield......................................... 5.0% 5.0% 8.0%
</TABLE>
Note 10. Income Taxes
The Company has elected to be taxed as a REIT and accordingly has deducted
for income tax purposes, all dividends paid on its common and preferred stock.
Because the Company has paid or will pay dividends in amounts approximating its
taxable income or has incurred net operating losses, 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.
Note 12. Transactions With and Condensed Financial Statements of NFI Holding
Corporation and Subsidiaries
NFI Holding Corporation and its subsidiaries had no operations, revenues or
expenses before February 1997, when NovaStar Mortgage began originating
subprime mortgage loans through a network of wholesale brokers and
correspondents. Effective July 15, 1997, NovaStar Mortgage began servicing
mortgage loans on behalf of the Company.
Under the terms of loan servicing agreements, NovaStar Mortgage services
loans owned by the Company. Individual agreements have been executed for each
pool of loans serving as collateral for the Company's CMOs. A separate
agreement exists between the Company and NovaStar Mortgage for those loans that
do not serve as collateral for CMOs.
Under the terms of an administrative outsourcing services agreement, the
Company paid NovaStar Mortgage a fee for providing certain services, including
the development of loan products and information systems, underwriting,
funding, and quality control. The agreement was terminated effective March 31,
1999.
Effective April 1, 1999, the Company entered an intercompany loan and
guarantee agreement with NovaStar Mortgage. Under the terms of this agreement,
NovaStar Mortgage pays interest on amounts it borrows from the Company. As of
December 31, 1999 and 1998, NovaStar Mortgage had $27,663,000 and $48,486,000
in borrowings from the Company outstanding, respectively. Interest on the
borrowings accrues at the Federal funds rate plus 1.75%. In addition, NovaStar
Mortgage is required to pay guaranty fees in the amount 0.25% of the loans sold
by NovaStar Mortgage for which the Company has guaranteed the performance of
NovaStar Mortgage.
F-16
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
During, 1997 and 1998, the Company and NovaStar Mortgage were parties to a
mortgage loan purchase and sale agreement. Under the terms of the agreement,
the Company purchased mortgage loans originated by NovaStar Mortgage at prices
that varied with the nature and terms of the underlying mortgage loans. The
agreement was modified effective January 1, 1998 to include a purchase
commitment fee. If NovaStar Mortgage chose to retain the mortgage loans it
originated or sold them to third parties, it paid a fee to the Company for not
delivering its loan production under the purchase commitment. During 1998,
NovaStar Mortgage originated loans with a principal amount of $870 million, of
which the Company acquired $541 million. During 1997, NovaStar Mortgage
originated loans with a principal amount of $735 million, all acquired by the
Company.
Following is a summary of the fees, in thousands, paid to and received from
NovaStar Mortgage.
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------------
1999 1998 1997
-------- -------- -------
<S> <C> <C> <C>
Amounts paid to NovaStar Mortgage:
Loan servicing fees........................... $ 3,886 $ 3,803 $ 505
======== ======== =======
Administrative fees, net of guaranty fees..... 1,258 7,800 3,650
Amounts received from NovaStar Mortgage:
Intercompany interest income.................. (1,113) -- --
Purchase commitment fee....................... -- (5,117) --
-------- -------- -------
$ 145 $ 2,683 $ 3,650
======== ======== =======
</TABLE>
F-17
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NFI Holding Corporation has no operations of its own and, therefore, its
consolidated financial statements generally reflect the operations of NovaStar
Mortgage. Following are the condensed consolidated balance sheet and statement
of operations of NFI Holding Corporation (in thousands):
NFI Holding Corporation
Condensed Consolidated Balances Sheets
<TABLE>
<CAPTION>
December 31,
-----------------
1999 1998
-------- --------
<S> <C> <C>
Assets
Cash and cash equivalents.................................... $ 1,466 $ 5,759
Mortgage loans............................................... 107,916 216,839
Other assets................................................. 10,061 6,608
-------- --------
Total assets........................................... $119,443 $229,206
======== ========
Liabilities and Stockholders' Equity
Liabilities:
Borrowings............................................... $ 78,448 $203,341
Due to NovaStar Financial, Inc........................... 22,161 20,637
Accounts payable and other liabilities................... 11,787 5,215
-------- --------
Total liabilities...................................... 112,396 229,193
Stockholders' equity..................................... 7,047 13
-------- --------
Total liabilities and stockholders' equity............. $119,443 $229,206
======== ========
</TABLE>
F-18
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NFI Holding Corporation
Condensed Consolidated Statements of Operations
<TABLE>
<CAPTION>
For the period from
Year Ended December 31, February 6, 1997
----------------------- (inception) to
1999 1998 December 31, 1997
----------- ----------- -------------------
<S> <C> <C> <C>
Interest income................... $ 11,473 $ 11,812 $1,136
Interest expense.................. 5,942 7,501 945
----------- ----------- ------
Net interest income............. 5,531 4,311 191
Provision for credit losses....... 860 210 --
----------- ----------- ------
Net interest income after
provision for credit losses...... 4,671 4,101 191
Other income:
Fees from third parties......... 905 2,829 1,271
Fees received from, net of paid
to, NovaStar Financial, Inc.... 4,032 6,486 4,155
Net gain on sales of mortgage
assets......................... 11,767 3,148 --
----------- ----------- ------
Total other income............ 16,704 12,463 5,426
General and administrative
expenses......................... 21,286 19,579 5,569
----------- ----------- ------
Net income (loss) before taxes.... 89 (3,015) 48
Income tax expense................ -- -- 20
----------- ----------- ------
Net income (loss)................. $ 89 $ (3,015) $ 28
=========== =========== ======
</TABLE>
Note 13. Condensed Quarterly Financial Information (unaudited)
Following is condensed consolidated operating results for the Company (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
1999 Quarters 1998 Quarters
------------------------------ -----------------------------
First Second Third Fourth First Second Third Fourth
------ ------ ------- ------- ------ ------ ------ --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net interest income..... $6,341 $5,447 $ 4,489 $ 3,678 $5,472 $6,026 $6,709 $ 1,746
Provision for credit
losses................. 2,299 3,566 5,634 10,579 1,076 1,146 1,179 4,029
Net income (loss)....... 1,726 1,845 (1,537) (9,126) 1,279 1,894 2,394 (27,388)
Dividends on preferred
stock.................. 31 525 525 525 -- -- -- --
Net income (loss)
available to common
shareholders........... 1,695 1,320 (2,062) (9,651) 1,279 1,894 2,394 (27,388)
Earnings (loss) per
share.................. 0.20 0.15 (0.25) (1.25) 0.15 0.21 0.29 (3.36)
</TABLE>
F-19
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
NovaStar Financial, Inc.:
We have audited the accompanying consolidated balance sheets of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1999 and 1998 and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the years in the three-year period ended December 31, 1999.
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, 1999 and 1998 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1999 in conformity with generally accepted
accounting principles.
KPMG LLP
Kansas City, Missouri
February 23, 2000
F-20
<PAGE>
- --------------------------------------------------------------------------------
You should rely only on
the information contained
or incorporated by
reference in this
prospectus. We have not
authorized anyone to
provide you with different
information.
We are not offering the
securities in any state
where the offer is not
permitted.
We do not claim that the
information in this
prospectus is accurate as
of any date other than the
date stated on the cover.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
4,285,714 Shares
NovaStar Financial, Inc.
Convertible Preferred Stock
13,013,425 Shares
NovaStar Financial, Inc.
Common Stock
5,177,712
NovaStar Financial Inc.
Stock Purchase Warrants
[LOGO OF NOVASTAR FINANCIAL, INC.]
---------------
Prospectus
May 18, 2000
---------------
- --------------------------------------------------------------------------------
