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 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 and early 2008, 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 during 2008 and 2009 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") during the third quarter of 2008 and Advent Financial Services, LLC ("Advent") during the second quarter of 2009. StreetLinks is a national residential appraisal management company. StreetLinks collects a fee for appraisal services from lenders and borrowers and 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 during 2009, 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.

The Company's condensed consolidated financial statements as of September 30, 2009 and for the nine and three months ended September 30, 2009 and 2008 are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the condensed consolidated financial statements.

The Company's condensed consolidated financial statements should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto, included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Going Concern Considerations - As of September 30, 2009, the Company's total liabilities exceeded its total assets under GAAP, resulting in a shareholders' deficit. The Company's losses, negative cash flows, shareholders' deficit, and lack of significant operations raise substantial doubt about the Company's ability to continue as a going concern and, therefore, may not realize its assets and discharge its liabilities in the normal course of business. There is no assurance that cash flows will be sufficient to meet the Company's obligations. The Company's 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. The Company's condensed consolidated financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should the Company be unable to continue as a going concern.

Impact of Recently Issued Accounting Pronouncements

Accounting Pronouncements Adopted in 2009

Accounting standards codification - In June 2009, the Financial Accounting Standards Board ("FASB") issued an accounting pronouncement establishing the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities. This pronouncement was effective for financial statements issued for interim and annual periods ending after September 15, 2009, for most entities. On the effective date, all non-SEC accounting and reporting standards will be superceded. The Company adopted this new accounting pronouncement for the quarterly period ended September 30, 2009, as required, and adoption did not have a material impact on the Company's financial statements taken as a whole.

Consolidation of variable interest entities - In June 2009, the FASB issued variable interest entity guidance, 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 the previous guidance, as well as qualifying special-purpose entities ("QSPEs") that are currently excluded from the previous guidance. This guidance 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 this guidance will have on its financial condition and results of operation upon adoption.

Accounting for transfers of financial assets - In June 2009, the FASB issued guidance relating to the transfers of financial assets. This guidance amends the derecognition accounting and disclosure requirements of previous guidance. It also eliminates the exemption from consolidation for QSPEs and also requires a transferor to evaluate all existing QSPEs to determine whether it must be consolidated. This guidance 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 this guidance will have on its financial condition and results of operation upon adoption.

Strategy - Management is focused on building the operations of StreetLinks and Advent. If and when opportunities arise, we intend to use available cash resources 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 -Key Performance Metrics
(dollars in thousands; except per share amounts)

                                                              September 30,       December 31,
                                                                  2009                2008
Cash and cash equivalents, including restricted cash          $     19,112       $     30,836

                                                                 For the Nine Months Ended
                                                                       September 30,
                                                                  2009                2008
Net loss available to common shareholders, per diluted share  $     (17.98 )     $     (67.92 )

Liquidity - During the nine months ended September 30, 2009, we received $16.4 million in cash on our securities portfolio. We received $20.8 million in cash relating to appraisal fee income. We used cash to repay interest on borrowings, pay for current operating and administrative costs, invest in StreetLinks and Advent and pay for costs related to our legacy mortgage lending and servicing operations. As of September 30, 2009, we had $19.1 million in cash, cash equivalents and restricted cash, a decrease of $11.7 million from December 31, 2008. As of November 12, 2009, we have $18.6 million in cash and cash equivalents (including restricted cash of $4.3 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 are focused 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 continue to decrease in the next several months as the underlying mortgage loans are repaid and could be significantly less than the current projections if future market conditions are not as projected. While StreetLinks is generating significant revenues, it is using all cash generated in building its infrastructure to sustain growth and is not profitable. We have significant outstanding obligations under our subordinated debt agreements. Our liquidity consists solely of cash and cash equivalents.

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 September 30, 2009 as Compared to December 31, 2008

The following provides explanations for material changes in the components of our balance sheet when comparing amounts from September 30, 2009 and December 31, 2008.

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

Mortgage Loans - Held-in-Portfolio. Mortgage loans - held-in-portfolio consist of subprime mortgage loans which have been securitized and are owned by three separate trusts - NHES 2006-1, NHES 2006MTA-1 and NHES 2007-1. We consolidate these trusts for GAAP reporting.

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 worsen and borrowers' repayment performance continues to be poor. Specifically, during recent months, the loss severity rate on foreclosed and liquidated loans has increased. Therefore, we continue to increase the allowance for losses as a percentage of loan principal. The allowance has decreased from $776.0 as of December 31, 2008 to $746.7 million as of September 30, 2009 due to the loan principal balances declining by a greater amount which was mainly due to borrower repayments and foreclosures. Additionally, the balance of mortgage loans - held-in-portfolio has decreased due to regular borrower repayments. During the nine months ended September 30, 2009 the trusts received repayments of the mortgage loans totaling $74.4 million. These balances will continue to decline either through normal borrower repayments or through continued devaluation as delinquencies, foreclosures and losses occur.

Mortgage loans - held-in-portfolio are serviced by a third party entity. During the nine months ended September 30, 2009, the servicer modified loans totaling $210.0 million in principal with weighted-average interest rates of 8.41% and 4.75% before and after modification, respectively. Generally, the modifications are offered to borrowers experiencing financial difficulties and serve to reduce monthly payments and/or defer unpaid interest. The Company's estimates for the allowance for loan losses and related provision include the projected impact of the modified loans.

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 nine months ended September 30, 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 continue to decline. We have consistently written the value of our securities down over the past two years and will likely continue to write them down as their economic value declines.