The following discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the "Company", "NovaStar Financial", "NFI", "we" or "us") and the notes thereto as well as NovaStar Financial's Annual Report to Shareholders and Annual Report on Form 10-K, as amended, for the fiscal year ended December 31, 2008.

Executive Overview

Corporate Overview, Background and Strategy - We are a Maryland corporation formed on September 13, 1996. Prior to significant changes in our business during 2007 and the first quarter of 2008, we originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage securities. We retained, through our mortgage securities investment portfolio, significant interests in the nonconforming loans we originated and purchased, and through our servicing platform, serviced all of the loans in which we retained interests. During 2007, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in the closing of our servicing operations.

Because of severe declines in housing prices and national and international economic crises, we have suffered significant losses since 2007 because of declining values of our investments in mortgage loans and securities. Liquidity constraints forced us to reduce operations and administrative staff and take other measures to conserve cash.

Management's focus is building its newly acquired operating businesses, reducing corporate operating cash needs, clearing follow-on matters arising from our legacy lending and servicing operations and evaluating investment opportunities.

Management made significant steps in the rebuilding process by investing in StreetLinks National Appraisal Services, LLC ("StreetLinks") and Advent Financial Services, LLC ("Advent"). StreetLinks is a national residential appraisal management company. A fee for appraisal services is collected from lenders and borrowers and StreetLinks passes most of the fee through to an independent residential appraiser. StreetLinks retains a portion of the fee to cover its costs of managing the process of fulfilling the appraisal order. Management believes that StreetLinks is situated to take advantage of growth opportunities in the residential appraisal management business. We have added significant new customers for StreetLinks, which have produced significant increases in revenue for StreetLinks during 2009. Advent is in its start-up phase and will provide access to tailored banking accounts, small dollar banking products and related services to meet the needs of low and moderate income level individuals. Advent is currently developing systems and a network of business partners for the distribution of its services.

Going Concern Considerations - If the cash flows from our mortgage securities are less than currently anticipated, and if we are unable to generate positive cash flow and earnings from our operations and/or restructure our contractual obligations, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws. Due to the fact that we have a negative net worth, and that we do not currently have ongoing significant business operations that are profitable, it is unlikely that we will be able to obtain additional equity or debt financing on favorable terms, or at all, for the foreseeable future. To the extent we require additional liquidity and cannot obtain it, we will be forced to file for bankruptcy.

Our condensed consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. There is substantial doubt that we will be able to continue as a going concern and, therefore, may be unable to realize our assets and discharge our liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts nor to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.

Impact of Recently Issued Accounting Pronouncements - In June 2009, the FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R)" ("SFAS 167"), which amends the consolidation guidance applicable to variable interest entities ("VIEs"). The amendments to the consolidation guidance affect all entities currently within the scope of FIN 46(R), as well as qualifying special-purpose entities ("QSPEs") that are currently excluded from the scope of FIN 46(R). SFAS 167 is effective as of the beginning of the first fiscal year that begins after November 15, 2009. The Company is continuing to evaluate the impact that SFAS 167 would have on its financial condition and results of operation upon adoption.

In June 2009, the FASB issued SFAS No. 166, "Accounting for Transfers of Financial Assets - an amendment of FASB Statement No. 140" ("SFAS 166"). SFAS 166 amends the derecognition accounting and disclosure guidance relating to SFAS
140. SFAS 166 eliminates the exemption from consolidation for QSPEs, it also requires a transferor to evaluate all existing QSPEs to determine whether it must be consolidated in accordance with SFAS 167. SFAS 166 is effective for financial asset transfers occurring after the beginning of an entity's first fiscal year that begins after November 15, 2009. The Company is continuing to evaluate the impact that SFAS 166 would have on its financial condition and results of operation upon adoption.

In June 2008, the FASB issued FASB Staff Position No. EITF 03-6-1 "Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities" ("FSP EITF 03-6-1"). FSP EITF 03-6-1 was issued to clarify that instruments granted in share-based payment transactions can be participating securities prior to the requisite service having been rendered. The guidance in FSP EITF 03-6-1 applies to the calculation of Earnings Per Share ("EPS") under Statement 128 for share-based payment awards with rights to dividends or dividend equivalents. Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. FSP EITF 03-6-1 is effective January 1, 2009. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of FSP EITF 03-6-1. The adoption of FSP EITF 03-6-1 required the Company to include certain restricted stock shares in its earnings per share calculations but did not have a significant impact on the Company's financial statements.

In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities" ("SFAS 161"). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity's financial position, financial performance, and cash flows. It is effective for the Company as of January 1, 2009. Since SFAS No. 161 only requires certain additional disclosures, it did not have an effect on the Company's financial statements. See Note 10 for further information regarding these disclosures.

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS 160"), which requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and non-controlling interest. SFAS 160 is effective January 1, 2009. The adoption of SFAS 160 required the Company to present the noncontrolling interests on the condensed consolidated balance sheet, statement of operations, and statement of shareholders deficit.

In December 2007, FASB issued Statement of Financial Accounting Standards No.
141 (R), "Business Combinations" ("SFAS 141(R)"). In summary, SFAS 141(R) requires the acquirer of a business combination to measure at fair value the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, with limited exceptions. In addition, this standard will require acquisition costs to be expensed as incurred. The standard is effective for fiscal years beginning after December 15, 2008, and is to be applied prospectively, with no earlier adoption permitted. The Company adopted SFAS 141(R) effective January 1, 2009. The adoption of this standard may have an impact on the accounting for certain costs related to any future acquisitions.

Strategy - Management is focused on building the operations of StreetLinks and Advent. If and when opportunities arise, available cash resources will be used to invest in or start businesses that can generate income and cash. Additionally, management will attempt to renegotiate and/or restructure the components of our equity in order to realign the capital structure with our current business model.

The key performance measures for executive management are:

º maintaining and/or generating adequate liquidity to sustain us and allow us to take advantage of investment opportunity, and
º generating income for our shareholders.

The following selected key performance metrics are derived from our condensed consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and with the disclosure included elsewhere in "Management's Discussion and Analysis of Financial Condition and Results of Operations." Management's Discussion and Analysis of Financial Condition and Results of Operations, along with other portions of this report, are designed to provide information regarding our performance and these key performance measures.

Table 1 - Summary of Financial Highlights and Key Performance Metrics
(dollars in thousands; except per share amounts)
                                                                 March 31,       December 31,
                                                                    2009             2008
Cash and cash equivalents, including restricted cash             $   26,067       $     21,684

                                                                     For the Quarter Ended
                                                                           March 31,
                                                                    2009             2008
Net loss available to common shareholders, per diluted share     $   (10.18 )    $      (30.63 )

Liquidity - During the first quarter of 2009, we received $6.1 million in cash on our securities portfolio. We received $1.7 million in gross appraisal fee income. We used cash to pay for current operating and administrative costs, invest in StreetLinks and pay for costs related to our legacy mortgage lending and servicing operations. As of March 31, 2009, we had $26.1 million in cash, cash equivalents and restricted cash, a decrease of $4.8 million from December 31, 2008. As of July 10, 2009, we have $20.7 million in cash and cash equivalents (including restricted cash of $6.1 million). See "Liquidity and Capital Resources" for further discussion of our liquidity position and steps we have taken to preserve liquidity levels.

As part of our near-term future strategy, we will focus on building our operating businesses, minimizing losses, preserving liquidity and, if and when cash is available, investing in opportunities that can contribute positively to our liquidity position. Our mortgage securities are a primary source of new cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. While StreetLinks is generating significant cash, it is using all cash generated in building its infrastructure to sustain growth. We have no outstanding lending facilities available for liquidity purposes. We have significant outstanding obligations relating to our discontinued operations, as well as payment obligations with respect to unsecured debt. Our liquidity consists solely of cash and cash equivalents.

Significant Recent Events - In April 2009, we restructured our junior subordinated debenture. See Note 6 to the condensed consolidated financial statements for discussion of the restructuring. As discussed above, subsequent to March 31, 2009, we acquired a majority ownership in Advent Financial Services
LLC. On June 30, 2009, the Company executed a settlement agreement with EHD whereby the Company is released from all past and future obligations under its lease agreement and paid $5 million to EHD in July 2009. EHD and the Company also agreed to take the necessary steps for the dismissal of all legal proceedings related to the lease agreement.

Impact of Consolidation of Securitized Mortgage Assets on Our Financial Statements

The discussions of our financial condition and results of operation below provide analysis for the changes in our balance sheet and income statement as presented using Generally Accepted Accounting Principles in the United States of America ("GAAP"). Mortgage loans - held-in-portfolio and certain of our mortgage securities - trading are owned by trusts established when those assets were securitized. The trusts issued asset-backed bonds to finance the assets. In accordance with GAAP, we have consolidated these trusts. Due to significant events that have occurred subsequent to the securitization of these assets, we no longer have a significant economic benefit from these assets. We have provided additional disclosure in "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Assets and Liabilities of Consolidated Securitization Trusts" to demonstrate the impact of the trusts on our consolidated financial statements.

Financial Condition as of March 31, 2009 as Compared to December 31, 2008

The following provides explanations in material changes in the components of our balance sheet when comparing amounts from March 31, 2009 and December 31, 2008.

Cash and Cash Equivalents. See "Liquidity and Capital Resources" for discussion of our cash and cash equivalents.

The mortgage loans - held-in-portfolio balance has declined as their value has decreased significantly. The value is dependent largely in part on their credit quality and the borrowers' repayment performance. The credit quality of the portfolio continues to decline. Specifically, during recent months, the loss severity rate on foreclosed and liquidated loans has increased. Therefore, we continue to increase the allowance for losses on these loans. The allowance has increased from $776.0 as of December 31, 2008 to $793.7 million as of March 31, 2009. Additionally, the balance of mortgage loans - held-in-portfolio has decreased due to regular borrower repayments. During the first quarter of 2009 the trusts received repayments of the mortgage loans totaling $25.6 million. These balances will continue to decline either through normal borrower repayments or through continued devaluation as delinquencies, foreclosures and losses occur.

As discussed under the heading "Assets and Liabilities of Consolidated Securitization Trusts", these assets have no economic benefit to us and we have no control over these assets. We have also provided the assets and liabilities of the trusts on a separate and combined basis.

Mortgage Securities - Trading and Available-for-Sale. During the first quarter of 2009, the value of the securities continued to decline as the estimated future cash flow from the securities is decreasing. The decrease is attributable largely to the continued poor credit quality and repayment performance of the mortgage loans underlying these securities. In general, the default rate on the underlying loans has increased dramatically over the past two years. Defaults are the result of national economic conditions that have led to job losses, severe declines in housing prices and the inability for credit-challenged individuals to refinance mortgage loans. In many cases, the securities we own have ceased to generate cash flow and, for the securities generating cash, we expect cash flow to decline during the coming year. We have consistently written the value of our securities down over the past two years.

The following tables provide details of our mortgage securities.