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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2001
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From to
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Commission File Number 001-13533
NOVASTAR FINANCIAL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 74-2830661
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1901 W. 47th Place, Suite 105, Westwood, KS 66205
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (913) 362-1090
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
Common Stock, $0.01 par value New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/
The aggregate market value of voting stock held by non-affiliates of the
registrant as of March 5, 2002 was approximately $186,201,725 as reported by the
New York Stock Exchange Composite Transactions on such date.
The number of shares of the Registrant's Common Stock outstanding on March 5,
2002 was 10,356,047.
DOCUMENTS INCORPORATED BY REFERENCE
Items 10, 11, 12, and 13 of Part III are incorporated by reference to the
NovaStar Financial, Inc. definitive proxy statement to shareholders, which will
be filed with the Commission no later than 120 days after December 31, 2001.
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NOVASTAR FINANCIAL, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
TABLE OF CONTENTS
PART I
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . 13
PART II
Item 5. Market For Registrant's Common Equity and Related Stockholder Matters . . . . . . . . . 14
Item 6. Selected Consolidated Financial Data and Other Data . . . . . . . . . . . . . . . . . . 14
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . 40
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
PART III
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . 66
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . . . . . . . . . . 66
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . 66
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . . 67
1
PART I
ITEM 1. BUSINESS
OVERVIEW
We are a Maryland corporation formed on September 13, 1996 as an investor
in mortgage assets, with a focus on non-conforming mortgage loans. We also
originate single-family non-conforming loans in the name of NovaStar Mortgage,
Inc. (NovaStar Mortgage), our subsidiary.
Management believes the tax-advantaged structure of a real estate
investment trust (REIT) maximizes the after-tax returns from mortgage assets. We
must meet numerous rules established by the Internal Revenue Service to retain
our status as a REIT. In summary, they require us to:
o Restrict investments to certain real estate related assets,
o Avoid certain investment trading and hedging activities, and
o Distribute virtually all taxable income to stockholders.
As long as we maintain our REIT status, distributions to stockholders will
generally be deductible by us for income tax purposes. This deduction
effectively eliminates corporate level income taxes. Management believes it has
and will continue to meet the requirements to maintain our REIT status.
2001 IN REVIEW
During 2001, we originated $1.3 billion in non-conforming loans. We
continue to become more efficient in underwriting and funding wholesale mortgage
loans through the use of our Internet Underwriter(R), or "IU", a webbased
automated underwriting system used by selected customers for non-conforming
residential mortgage loans. Our cost to originate a loan decreased from 3.4% in
2000 to 2.4% in 2001.
Loans are primarily sold through securitization transactions completed by
NovaStar Mortgage. Included in net gains on sales of mortgage assets for the
year ended December 31, 2001 are $21.7 million in gains recognized in two
transactions securitizing a total of $1.2 billion in loans. In addition, we sold
loans aggregating $73.3 million to unrelated third parties for cash, recognizing
net gains of $954,000 with an average price to par of 102.1%.
NovaStar Mortgage retains the servicing rights to loans securitized. During
2001 the loan-servicing portfolio increased from $1.0 billion to $2.0 billion.
During 2001, we expanded our net branch product using the name NovaStar
Home Mortgage, Inc. (NovaStar Home Mortgage). Loan brokers/officers can open a
branch facility under the NovaStar Home Mortgage name. NovaStar provides a
license, loan investors and administrative services to the branch.
Administrative services include accounting, payroll and human resource support.
Branch management must adhere to lending policies we have established. Net
branch income-broker fee income less branch expenses and the administrative fees
paid to NovaStar Home Mortgage-are profits earned by the branch manager.
While the branch is free to broker loans for any approved investor, many of
the loans produced by our branches are funded by NovaStar Mortgage. This
arrangement serves to reduce our overall cost of lending and provides for
enhanced fee income.
At the beginning of 2001, we had 63 branches open. As of December 31, 2001
there were 123 branches in operation located in 32 states.
We have obtained committed financing facilities to fund our mortgage loan
operations. As of December 31, 2001, combined lending arrangements under these
agreements totaled $960 million. Cash and availability under these committed
facilities were $81.1 million.
During the year ended December 31, 2001, we recorded net income of $32.3
million, $3.02 per diluted share. The earnings include a gain of $14.9 million
from the sale of mortgage securities, executed through a securitization
transaction. Our operating results are discussed further under "Management's
Discussion and Analysis of Financial Condition and Results of Operations" of
this annual report.
2
ORGANIZATIONAL STRUCTURE AND OPERATIONS
Historically, REITs were generally limited to holding non-voting preferred
stock in taxable affiliates. As of January 1, 2001, REITs were permitted to hold
taxable affiliates as wholly-owned subsidiaries. The value of all taxable
subsidiaries of a REIT is limited to 20% of the total value of the REIT's
assets. We acquired all of the common stock of NFI Holding Corporation (NFI
Holding) from Scott Hartman and Lance Anderson, our two founders, on January 1,
2001. As a result of this purchase, we own 100% of the common stock of NFI
Holding, which owns 100% of the common stock of NovaStar Mortgage and NovaStar
Home Mortgage. The details of the purchase transaction are described fully in
Note 9 to the consolidated financial statements.
Following is a diagram of the industry in which we operate and our loan
production during 2001 (in thousands). Following the diagram is further
description of our business.
[GRAPH TO BE INSERTED]
MORTGAGE LENDING
We originate and invest in non-conforming residential mortgage loans. We
lend to individuals who generally do not qualify for agency/conventional lending
programs because of a lack of available documentation or previous credit
difficulties, but generally have substantial equity in their homes. Often, these
are individuals or families who have built high-rate consumer debt and are
attempting to use the equity in their home to consolidate debt and lower their
total monthly payments.
Our sales force, which includes 112 account executives, develops and
maintains relationships with a network of independent retail brokers. In 1997
and in much of 1998, we retained our mortgage loans. Since 1998, we have
operated as a seller of whole loans to independent third parties. Two primary
avenues were used for selling mortgage loans: 1) directly to independent, third
parties for cash and 2) through securitization transactions that are treated for
tax and accounting purposes as loan sales. Through these channels, we sold $1.3
billion in loans netting gains of $22.7 million in 2001.
We underwrite, process, fund and service the mortgage loans sourced through
our broker network. Further details regarding the loan originations are
discussed under "Mortgage Originations" section of "Management's Discussion and
Analysis of Financial Condition and Results of Operations".
On a short-term basis, we finance mortgage loans using warehouse lines of
credit and repurchase agreements. In addition, we have access to facilities
secured by our mortgage securities. Details regarding available financing
3
arrangements and amounts outstanding under those arrangements are included in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and Note 5 to the consolidated financial statements.
For long-term financing, we fund our mortgage loans using asset-backed
bonds (ABB). Primary bonds-AAA through BBB rated-are issued to the public. We
retain the interest only bonds and prepayment penalty bonds, which are AAA
rated. We also retain the right to service the mortgage loans and retain
non-rated, subordinated interests.
Prior to 1999, ABB transactions were executed and 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 consolidated balance sheets, and no gain is recorded.
Beginning in 1999, our securitization transactions have been structured to
qualify as sales for accounting and income tax purposes. The loans and related
bond liability are not recorded in our consolidated financial statements. We do
record the value of the securities and servicing rights we retain, however.
Details regarding ABBs we issued can be found in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and in Notes 3 and 5
to our consolidated financial statements.
LOAN SERVICING
Loan servicing remains a critical part of our business operation. In the
opinion of management, maintaining contact with our borrowers is critical in
managing credit risk and in borrower retention. Non-conforming borrowers are
more prone to late payments and are more likely to default on their obligations
than conventional borrowers. By servicing our loans, we strive to identify
problems with borrowers early and take quick action to address problems.
Borrowers may be motivated to refinance their mortgage loans either by improving
their personal credit or due to a decrease in interest rates. By keeping in
close touch with borrowers, we can provide them with information about company
products to entice them to refinance with us.
LOAN BROKERING BY AFFILIATED BRANCHES
In 1999, we opened our retail mortgage broker business operating under the
name NovaStar Home Mortgage. Branch offices offer conforming and non-conforming
loans to potential borrowers. Loans are brokered for approved investors,
including NovaStar Mortgage. The branches must adhere to a strict set of
established policies regarding their operations. Net income of the branch is
returned to the branch "owner/manager." Administrative functions, including
accounting, payroll and human resources, investor relations and licensing, are
conducted by our central corporate office staff. As of December 31, 2001 we have
123 active branches in 32 states.
MARKET IN WHICH NOVASTAR OPERATES AND COMPETES
We face intense competition in the business of originating, purchasing,
selling and securitizing nonconforming mortgage loans. The number of market
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 compete for non-conforming borrowers with
consumer finance companies, conventional mortgage bankers, commercial banks,
credit unions and thrift institutions. We also compete 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 resources than we do.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, amount and term of the loan, customer service,
marketing/distribution channels, loan origination fees and interest rates. To
the extent any competitor significantly expands their activities in the
non-conforming and subprime market, we could be materially adversely affected.
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. Standard and Poor's assigned our servicing department
an "Above Average" overall rating and designated NovaStar as a Special Servicer.
During 2001, the branches brokered $1.1 billion in residential mortgage
loans. That volume places us in the top 10 of mortgage brokers, based on volume.
While the branches are free to broker loans for any approved investor, the
investor of choice is often NovaStar Mortgage. This integrated relationship adds
another competitive advantage for us.
4
In addition, regulated mortgage lenders, such as savings and loans and
banks, are subject to regulatory review and must pay for the costs incurred by
the regulator in their examinations. We incur no such regulation fees or costs
and are, therefore, competitively advantaged.
We are also competitively successful due to our:
o experienced management team;
o use of technology to enhance customer service and reduce operating
costs;
o tax advantaged status as a REIT;
o vertical integration-we broker and/or originate, fund, service and
manage mortgage loans;
o access to capital markets to securitize our assets.
RISK MANAGEMENT
Management recognizes the following primary risks associated with the
business and industry in which it operates.
o Credit
o Prepayment
o Liquidity
o Interest Rate/Market
CREDIT RISK
Credit risk is the risk that we will not fully collect the principal we
have invested in mortgage loans or securities. Non-conforming mortgage loans
comprise substantially all of our mortgage loan portfolio and serve as
collateral for our mortgage securities. Our non-conforming borrowers include
individuals who do not qualify for agency/conventional lending programs because
of a lack of available documentation or previous credit difficulties, but have
considerable equity in their homes. Often, they are individuals or families who
have built up high-rate consumer debt and are attempting to use the equity in
their home to consolidate debt and reduce the amount of money it takes to
service their monthly debt obligations.
Our 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.
Underwriting staff work under the supervision of our Chief Credit Officer.
Underwriters are given approval authority only after their work has been
reviewed for a period of at least two weeks. Thereafter, the Chief Credit
Officer re-evaluates the authority levels of all underwriting personnel on an
ongoing basis. All loans in excess of $350,000 currently require the approval of
an underwriting supervisor. Loans in excess of $500,000 must be approved by our
Chief Credit Officer or our President.
The underwriting guidelines take into consideration the number of times the
potential borrower has recently been late on a mortgage payment and whether that
payment was 30, 60 or 90 days past due. Delinquency on consumer/revolving debt
isalso considered. Discharged bankruptcy filings are allowed under all credit
ratings, however, to obtain an "A" or "B" grade, the borrower must have at least
a one-year seasoning on a discharged Chapter 13 filing and two years for a
Chapter 7 filing. The credit grade that is assigned to the borrower is a
reflection of the borrower's historical credit and the loan-to-value determined
by the amount of documentation the borrower can produce to support income.
Maximum loan-to-value ratios for each credit grade depend on the level of income
documentation provided by the potential borrower. In some instances, when the
borrower exhibits strong compensating factors, exceptions to the underwriting
guidelines may be approved.
Key to our successful underwriting process is the use of IU, our automated
underwriting system. IU provides more consistency in underwriting loans and
allows underwriting personnel to focus more of their time on loans that are not
initially accepted by the IU system.
Table 1 of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" sets forth our mortgage loan portfolio by credit grade,
all of which are non-conforming.
5
A tool for managing credit risk is to diversify the markets in which we
originate and own mortgage loans. Presented in Table 2 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
section of this annual report is a breakdown of the geographic diversification
our loans. Detail regarding loan delinquencies and loans charged off are
disclosed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations" under the heading "Provisions for Credit Losses".
We have purchased mortgage insurance on substantially all loans that are
held in our portfolio-on the balance sheet and those that serve as collateral
for our mortgage securities. Our mortgage insurance provides for coverage to a
loan-to-value of 50%, which serves to substantially limit our exposure to credit
risk. The use of mortgage insurance is discussed under "Premiums Paid on
Mortgage Insurance" in "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
PREPAYMENT RISK
The majority of our securities are "interest-only" in nature. These
securities represent the net cash flow-interest income-on the underlying loans
in excess of the cost to finance the loans. When borrowers repay the principal
on their mortgage loans early, the effect is to shorten the period over which
interest is earned, and therefore, reduce the cash flow and yield on our
securities.
We mitigate prepayment risk by originating loans that are originated with a
penalty if the borrower repays the loan in the early months of the loan's life.
For the majority of our loans, a prepayment penalty is charged equal to 80% of
six months interest on the principal balance that is to be paid in full. Table 6
of "Management's Discussion and Analysis of Financial Condition and Results of
Operations" is a summary of the loans originated by NovaStar Mortgage
demonstrating the nature of prepayment penalties. As of December 31, 2001, 46%
of our loans had a prepayment penalty. Of the loans that serve as collateral for
our mortgage securities, 87% had prepayment penalties as of December 31, 2001.
During 2001, 82% of the loans we originated had prepayment penalties. Table 6 of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" detail, prepayment speeds.
LIQUIDITY RISK
See the "Liquidity and Capital Resources" section of "Management's
Discussion and Analysis of Financial Condition and Results of Operations" for a
discussion of liquidity risks and resources available to us.
INTEREST RATE/MARKET RISK
Our investment policy sets the following general goals:
(1) Maintain the net interest margin between assets and liabilities, and
(2) Diminish the effect of changes in interest rate levels on our market
value
LOAN PRICE VOLATILITY. Under our current mode of operation, we depend
heavily on the market for wholesale non-conforming mortgage loans. To conserve
capital, we may sell loans we originate. Financial results will depend, in part,
on the ability to find purchasers for the loans at prices that cover origination
expenses. Exposure to loan price volatility is reduced as when we acquire and
retain mortgage loans.
INTEREST RATE RISK. When interest rates on our assets do not adjust at the
same rates as our liabilities or when the assets have fixed rates and the
liabilities are adjusting, future earnings potential is affected. We express
this interest rate risk as the risk that the market value of assets will
increase or decrease at different rates than that of the liabilities. Expressed
another way, this is the risk that net asset value will experience an adverse
change when interest rates change. We assess the risk based on the change in
market values given increases and decreases in interest rates. We also assess
the risk based on the impact to net income in changing interest rate
environments.
Management primarily uses financing sources where the interest rate resets
frequently. As of December 31, 2001, borrowings under all financing arrangements
adjust daily, monthly, or quarterly. On the other hand, very few of the mortgage
assets we own, 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 is significantly affected, as the
asset rate resets would lag the borrowing rate resets.
6
To assess interest sensitivity 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.
The following are summaries of the analysis.
INTEREST RATE SENSITIVITY-INCOME
(DOLLARS IN THOUSANDS)
BASIS POINT INCREASE (DECREASE) IN INTEREST RATE (A)
------------------------------------------------------------
AS OF DECEMBER 31, 2001 (200)(D) (100) BASE 100 200
- ----------------------- ---------- --------- --------- --------- ---------
Income (expense) from:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N/A $ 133,173 $ 135,196 $ 136,598 $ 141,106
Liabilities (B) . . . . . . . . . . . . . . . . . . . . . . . . . N/A (35,336) (51,896) (68,801) (86,099)
Interest rate agreements . . . . . . . . . . . . . . . . . . . . . N/A (21,647) (14,636) (7,624) (612)
---------- --------- --------- --------- ---------
Net interest income . . . . . . . . . . . . . . . . . . . . . . . N/A $ 76,190 $ 68,664 $ 60,173 $ 54,395
========== ========= ========= ========= =========
Percent change in net interest income from base . . . . . . . . . N/A 11.0% - (12.4)% (20.8)%
========== ========= ========= ========= =========
Percent change of capital (C) . . . . . . . . . . . . . . . . . . N/A 5.8% - (6.5)% (11.0)%
========== ========= ========= ========= =========
AS OF DECEMBER 31, 2000
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Income (expense) from:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 89,542 $ 91,334 $ 93,189 $ 95,138 $ 96,946
Liabilities (B) . . . . . . . . . . . . . . . . . . . . . . . . . (52,263) (60,327) (68,686) (77,207) (85,914)
Interest rate agreements . . . . . . . . . . . . . . . . . . . . . (1,587) (1,587) (1,424) (119) 2,577
---------- --------- --------- --------- ---------
Net interest income . . . . . . . . . . . . . . . . . . . . . . . $ 35,692 $ 29,420 $ 23,079 $ 17,812 $ 13,609
========== ========= ========= ========= =========
Percent change in net interest income from base . . . . . . . . . 54.7% 27.5% - (22.8)% (41.0)%
========== ========= ========= ========= =========
Percent change of capital (C) . . . . . . . . . . . . . . . . . . 11.7% 5.9% - (4.9)% (8.8)%
========== ========= ========= ========= =========
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(A) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down 1% and 2%.
(B) Includes debt issuance costs, amortization of loan premiums, mortgage
insurance premiums and provisions for credit losses.
(C) Total change in estimated spread income as a percent of total stockholders'
equity as of December 31, 2001 and December 31, 2000.
(D) A decrease in interest rates by 200 basis points (2%) would imply rates on
liabilities at or below zero.
7
INTEREST RATE SENSITIVITY-MARKET VALUE
(DOLLARS IN THOUSANDS)
BASIS POINT INCREASE (DECREASE) IN INTEREST RATE (A)
--------------------------------------------------------
AS OF DECEMBER 31, 2001 (200)(C) (100) 100 200
- ----------------------- ---------- --------- --------- ---------
Change in market values of:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N/A $ 13,158 $ (28,771) $ (67,162)
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . N/A (2,245) 2,382 6,414
Interest rate agreements . . . . . . . . . . . . . . . . . . . . . N/A (15,505) 15,218 30,236
Cumulative change in market value . . . . . . . . . . . . . . . . . N/A $ (4,592) $ (11,171) $ (30,512)
Percent change of market value portfolio equity (B) . . . . . . . . N/A 3.0% (7.3)% (19.8)%
AS OF DECEMBER 31, 2000
- -----------------------
Change in market values of:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,908 $ 2,448 $ (9,763) $ (25,723)
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,975) (1,624) 1,865 3,818
Interest rate agreements . . . . . . . . . . . . . . . . . . . . . . (591) (524) 2,220 6,479
Cumulative change in market value . . . . . . . . . . . . . . . . . $ 9,342 $ 300 $ (5,678) $ (15,426)
Percent change of market value portfolio equity (B) . . . . . . . . 9.5% 0.3% (5.7)% (15.6)%
- ---------------
(A) Change in market value of assets, liabilities or interest rate agreements
in a parallel shift in the yield curve, up and down 1% and 2%.
(B) Total change in estimated market value as a percent of market value
portfolio equity as of December 31, 2001 and December 31, 2000.
(C) A decrease in interest rates by 200 basis points (2%) would imply rates on
liabilities at or below zero.
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, 2001. The values under the headings "100",
"200", "(100)" and "(200)" 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 and 200 basis points, or 1 and 2 percent
higher and lower. The cumulative change in income or market value 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 our interest rate sensitivity and
hedged position quarterly. Although management also evaluates the portfolio
using interest rate increases and decreases less than and greater than one
percent, management focuses on the one percent increase.
ASSUMPTIONS USED IN INTEREST RATE SENSITIVITY ANALYSIS. Management uses a
variety of estimates and assumptions in determining the income and market value
of assets, liabilities and interest rate agreements. 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, 2001.
Management's analysis for assessing interest rate sensitivity on its
mortgage loans relies significantly on estimates for prepayment speeds. A
prepayment model has been internally developed based upon four main factors:
o Refinancing incentives (the interest rate of the mortgage compared
with the current mortgage rates available to the borrower)
o Borrower credit grades
o Loan-to-value ratios
o Prepayment penalties, if any
8
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 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 because 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 non-conforming mortgage
origination industry. Actual results may differ from the estimates and
assumptions used in the model and the projected results as shown in the
sensitivity analyses.
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, loan to value, gross margin, weighted average maturity
and lifetime and periodic caps and floors. This prepayment curve is also
multiplied by a factor of 60% on average for periods when a prepayment penalty
is in effect on the loan. Prepayment assumptions are also multiplied by a factor
of greater than 100% during periods around rate resets and prepayment penalty
expirations. These assumptions change with levels of interest rates. The actual
historical speeds experienced on our loans shown in Table 6 are weighted average
speeds of all loans in each deal.
As shown above, 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. 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.
HEDGING. 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 mortgage assets and the differences between interest rate
adjustment indices and interest rate adjustment periods of adjustable-rate
mortgage loans and related borrowings.
We use interest rate cap and swap contracts to mitigate the risk of the
cost of variable rate liabilities increasing at a faster rate than the earnings
on 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 our
best interest, given the cost of hedging transactions and the need to maintain
REIT status.
We seek to build a balance sheet and undertake an interest rate risk
management program that is likely, in management's view, to enable us 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 us and a third
party firm or "counter-party". The counterparty agrees to make payments to us in
the future should the one- or three-month LIBOR interest rate rise above the
strike rate specified in the contract. We make either quarterly premium payments
or have chosen to pay the premiums at the beginning 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. When the referenced LIBOR interest rate
rises above the contractual strike rate, we earn cap income. Payments on an
annualized basis equal the contractual notional face amount times the difference
between actual LIBOR and the strike rate. Interest rate swaps have similar
characteristics. However, interest rate swap agreements allow us to pay a fixed
rate of interest while receiving a rate that adjusts with one-month LIBOR.
OTHER RISK FACTORS
Although management considers the risk components set forth above to be its
primary business risks, the following are other risks that should be considered
by our investors. Further information regarding these risks is included in our
registration statements filed with the Commission.
o 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 capital markets faced
9
a liquidity crisis with respect to the availability of short-tem
borrowings from major lenders and long-term borrowings through
securitization. We faced significant liquidity constraints.
o 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 have incurred
significant net losses in 1999 and 1998.
o 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.
o CHANGES IN INTEREST RATES MAY ADVERSELY AFFECT RESULTS OF OPERATION.
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.
o INTEREST RATE FLUCTUATIONS MAY ADVERSELY AFFECT THE VALUE OF MORTGAGE
LOANS HELD-FOR-SALE OR SECURITIZATION. Declines and increases in
interest rates will cause the value of a loan to rise and fall,
respectively, if the yield spread, or basis, between the loan and the
duration-matched treasury remains the same. The basis does fluctuate
over time, however, and we may experience mark-to-market gains and
losses on our unsecuritized portfolio even though interest rates may
have remained stable. This may effect the value of future
securitizations if the decrease in market value on loans was caused by
basis widening in the securitization market, which would make
long-term, non-recourse financing more expensive. Basis changes may
not have an effect on future securitizations if, for example, there
was simply an over supply in the whole loan market and securitization
spreads had remained constant.
o FINANCING WITH REPURCHASE AGREEMENTS MAY LEAD TO MARGIN CALLS IF THE
MARKET VALUE OF MORTGAGE ASSETS DECLINE.We use repurchase agreements
to finance the acquisition of mortgage assets in the short-term. 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 entered into stipulate that we must repurchase the asset
in 30 days. For financial accounting purposes, these arrangements are
treated as secured financings. We retain the assets on our balance
sheet and record an obligation to repurchase the asset. The amount we
may 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 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 due from us.
o INTENSE COMPETITION IN THE NON-CONFORMING MORTGAGE INDUSTRY MAY RESULT
IN REDUCED NET INCOME OR IN REVISED UNDERWRITING STANDARDS WHICH WOULD
ADVERSELY AFFECT OPERATIONS. We face intense competition from
commercial banks, savings and loans, other independent mortgage
lenders and brokers, and certain other mortgage REITs. In addition,
Fannie Mae and Freddie Mac are expanding their participation in the
non-conforming mortgage loan market we serve. Any increase in the
competition among lenders to originate or purchase non-conforming
mortgage loans may result in either reduced interest income on
mortgage loans compared to present levels or revised underwriting
standards permitting higher loan-to-value ratios on properties
securing non-conforming mortgage loans.
o CURRENT LOAN PERFORMANCE DATA MAY NOT BE INDICATIVE OF FUTURE RESULTS.
Management uses estimates and assumptions based on actual experience
with the mortgage loans. Actual results and the time of certain events
could differ materially from those projected, due to factors including
general economic conditions, fluctuations in interest rates,
fluctuations in prepayment speeds, and fluctuations in losses due to
defaults on mortgage loans. These fluctuations could rise to levels
that would adversely affect profitability.
o 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 limited number of primary
credit facilities for funding 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.
10
o 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 Internal Revenue Code ("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.
o WE FACE LOSS EXPOSURE DUE TO THE UNDERLYING REAL ESTATE. A substantial
portion of our mortgage assets consists of single family mortgage
loans or mortgage securities evidencing interests in single family
mortgage loans. We will be subject to the risk of loss on mortgage
assets arising from borrower defaults to the extent not covered by
third-party credit enhancement.
o 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.
o 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 these restrictions.
o MORTGAGE INSURERS MAY NOT PAY CLAIMS RESULTING IN INCREASED CREDIT
LOSSES OR MAY IN THE FUTURE CHANGE THEIR PRICING OR UNDERWRITING
GUIDELINES.We have placed reliance on mortgage insurance to mitigate
the risk of credit losses. However there can be no assurance that the
mortgage insurers will continue to have the financial ability to pay
all claims presented. In addition, insurers have the right to deny a
claim if the loan is not properly serviced or has been defectively
originated. We also have the risk that mortgage insurance providers
will revise their guidelines to an extent where we will no longer be
able to acquire coverage on all of our new production.
o ACCESS TO ADDITIONAL CAPITAL MAY ULTIMATELY CURTAIL GROWTH. Cash is
required to fund loans we originate as financing arrangements allow us
to borrow a percentage, typically 98%, of the mortgage note amount. If
we are unable to obtain sufficient cash resources, we may not sustain
asset growth. Liquidity and capital resources are discussed further
under the "Liquidity and Capital Resources" section presented
elsewhere in this report.
o OUR FAILURE TO COMPLY WITH FEDERAL, STATE OR LOCAL REGULATION OF
MORTGAGE LENDING, OF BROKER COMPENSATION PROGRAMS OR OF OUR LOCAL
BRANCH OPERATIONS COULD ADVERSELY AFFECT OUR OPERATIONS AND
PROFITABILITY. As a mortgage lender, we are subject to many laws and
regulations. Any failure to comply with these rules and their
interpretations or with any future interpretations or judicial
decisions could cause a material adverse impact on our profitability
or a change in the way we do business. For example, several lawsuit
have been filed challenging payments made by a lender to a broker,
similar to payments we make to our independent brokers. Similarly, in
our branch operations, we allow our branch managers considerable
autonomy which could result in greater exposure to third-party claims
where our otherwise effective compliance programs are not strictly
adhered to.
FEDERAL INCOME TAX CONSEQUENCES
GENERAL.We believe we have complied, and intend to comply in the future,
with the requirements for qualification as a REIT under the Code. To the extent
that we qualify as a REIT for federal income tax purposes, we generally will not
be subject to federal income tax on the amount of income or gain that is
distributed to shareholders. However, origination and broker operations are
conducted through NovaStar Mortgage and NovaStar Home Mortgage, which are owned
by NFI Holding - a taxable REIT subsidiary. Consequently, all of the taxable
income of NFI Holding is subject to federal and state corporate income taxes.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, its activities be passive rather than active and it
distribute annually to our shareholders substantially all of its taxable income.
We could be subject to a number of taxes if we failed to satisfy those rules or
if we acquired certain types of
11
income-producing real property through foreclosure. Although no complete
assurance can be given, we do not expect that we will be subject to material
amounts of such taxes.
Failure to satisfy certain Code requirements could cause loss of REIT
status. If we fail to qualify as a REIT for any taxable year, we would be
subject to federal income tax (including any applicable minimum tax) at regular
corporate rates and would not receive deductions for dividends paid to
shareholders. As a result, the amount of after-tax earnings available for
distribution to shareholders would decrease substantially. While we intend to
operate in a manner that will enable it to qualify as a REIT in future taxable
years, there can be no certainty that such intention will be realized. Loss of
REIT status would reduce the amount of any distributions by taxes due, but the
character of such distributions for tax purposes should be unaffected.
QUALIFICATION AS A REIT. Qualification as a REIT requires that we satisfy a
variety of tests relating to income, assets, distributions and ownership. The
significant tests are summarized below. We will make available more detailed
information regarding our compliance with the REIT rules upon request.
SOURCES OF INCOME.We must satisfy two tests with respect to the sources of
income: the 75% income test, and the 95% income test. The 75% income test
requires that we derive at least 75% of gross income, excluding gross income
from prohibited transactions, from certain real estate-related sources.
Management believes that income qualified for both of the income tests during
2001.
In order to satisfy the 95% income test, at least an additional 20% of
gross income for the taxable year must consist either of income that qualifies
under the 75% income test or dividends and interest.
NATURE AND DIVERSIFICATION OF ASSETS. As of the last day of each calendar
quarter, we must meet three asset tests. Under the 75% of assets test, at least
75% of the value of our total assets must represent cash or cash items
(including receivables), government securities or real estate assets. Under the
10% asset test, we may not own more than 10% of the outstanding securities of
any single non-governmental issuer, if these securities do not qualify under the
75% asset test. There is an exception for electing corporations of which we own
at least 35% of the outstanding securities. We intend to make this election.
Under the 5% asset test, ownership of any stocks or securities that do not
qualify under the 75% asset test must be limited, in respect of any single
non-governmental issuer, to an amount not greater than 5% of the value of our
total assets. The definition of security for this purpose includes financial
contracts and instruments that we acquire in the normal course of business.
If we inadvertently fail to satisfy one or more of the asset tests at the
end of a calendar quarter, such failure would not cause us to lose our REIT
status. We still could avoid disqualification by eliminating any discrepancy
within 30 days after the close of the calendar quarter in which the discrepancy
arose. Management believes that we complied with the asset tests for all
quarters during 2001.
OWNERSHIP OF COMMON STOCK. Our capital stock must be held by a minimum of
100 persons for at least 335 days of each year. In addition, at all times during
the second half of each taxable year, no more than 50% in value of our capital
stock may be owned directly or indirectly by 5 or fewer individuals. We use the
calendar year as our taxable year for income tax purposes. The Code requires us
to send annual information questionnaires to specified shareholders in order to
assure compliance with the ownership tests. Management believes that we have
complied with these stock ownership tests for 2001.
DISTRIBUTIONS.We must distribute at least 90% of our taxable income and any
after-tax net income from certain types of foreclosure property less any
non-cash income. No distributions are required in periods in which there is no
income.
TAXABLE INCOME. We use the calendar year for both tax and financial
reporting purposes. However, there may be differences between taxable income and
income computed in accordance with accounting principles generally accepted in
the United States of America (GAAP). These differences primarily arise from
timing and character differences in the recognition of revenue and expense and
gains and losses for tax and GAAP purposes. Additionally, taxable income does
not include the taxable income of our taxable subsidiary, although the
subsidiary's operating results are included in our GAAP results.
PERSONNEL
As of December 31, 2001, we employed 970 people. Of these, our affiliated
branches employed 594; 347 were employed in our wholesale lending and servicing
operations the remainder in our portfolio management and administrative
functions.
12
ITEM 2. PROPERTIES
Our executive and administrative offices are located in Westwood, Kansas,
and consist of approximately 7,000 square feet of leased office space. The lease
agreements on the premises expire through January 2007. The current annual rent
for these offices is approximately $161,000.
We lease office space for our mortgage lending operations in Orange County,
California and Independence, Ohio. Currently, these offices consist of
approximately 30,000 square feet. The lease on the premise expires January 2006,
and the current annual rent is approximately $553,000.
We also lease office space for our mortgage servicing operation in
Westwood, Kansas. The square footage on these premises is approximately 24,000,
with annual rent of approximately $344,000, and a lease scheduled to expire in
January 2005.
NovaStar Home Mortgage leases space for its net branch operation in
Westwood, Kansas. The square footage for this space is approximately 11,000
square feet. The lease of this space expires December 2004, and the current
annual rent is approximately $228,000.
ITEM 3. LEGAL PROCEEDINGS
We occasionally become involved in litigation arising in the normal course
of business. Management believes that any liability with respect to such legal
actions, individually or in the aggregate, will not have a material adverse
effect on its financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
13
PART II
ITEM 5. A. MARKET FOR REGISTRANT'S COMMON EQUITY
The common stock of NovaStar Financial is traded on the NYSE under the
symbol "NFI". 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 PRICES CASH DIVIDENDS(A)
- ------------------------------------------- ------------------------------------------------------
CLASS OF PAID OR AMOUNT
HIGH LOW STOCK DECLARED PAYABLE PER SHARE
-------- ------- ------------ ------------ ----------- -------------
1/1/00 to 3/31/00 . . . . $ 4.38 $ 3.13 Preferred 4/26/00 5/10/00 $0.12
4/1/00 to 6/30/00 . . . . 4.19 2.88 Preferred 7/26/00 8/10/00 0.12
7/1/00 to 9/30/00 . . . . 4.06 2.88 Preferred 10/25/00 11/10/00 0.12
10/1/00 to 12/31/00 . . . 4.31 3.56 Preferred 12/20/00 1/10/01 0.12
1/1/01 to 3/31/01 . . . . 6.20 3.75 Preferred 4/27/01 5/10/01 0.12
4/1/01 to 6/30/01 . . . . 8.50 5.55 Preferred and 7/26/01 8/10/01 0.13
Common
7/1/01 to 9/30/01 . . . . 11.80 8.05 Preferred and 10/25/01 11/10/01 0.36
Common
10/1/01 to 12/31/01 . . . . 18.10 10.35 Preferred 12/19/01 1/10/02 0.47
Common 12/19/01 1/14/02 0.47
- ---------------
(A) We did not declare dividends on common stock during 1999 and 2000.
(B) We issued the class B 7% convertible preferred stock in March 1999, which
converted to common stock in February 2002.
As of March 5, 2002, more than 2,000 stockholders held our 10,356,047
shares of common stock as provided by third party brokers and transfer agent
reports.
We intend to make distributions to stockholders of all or substantially all
of 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 at the discretion of the Board of Directors and will depend on earnings,
financial condition, maintenance of REIT status and other factors as the Board
of Directors may deem relevant.
B. RECENT SALES OF UNREGISTERED SECURITIES
None.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
The following selected consolidated financial data are derived from our
audited consolidated financial - statements 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 annual report. Operating results are not
necessarily indicative of future performance.
14
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------
2001(A) 2000 1999 1998 1997
----------- -------- -------- -------- --------
CONSOLIDATED STATEMENT OF OPERATIONS DATA
Interest income . . . . . . . . . . . . . . . . . . . $ 58,069 $ 47,627 $ 66,713 $100,747 $ 36,961
Interest expense . . . . . . . . . . . . . . . . . . 28,588 34,696 46,758 80,794 28,185
Net interest income before
provision for credit losses . . . . . . . . . . . . 29,481 12,931 19,955 19,953 8,776
Provision for credit losses . . . . . . . . . . . . . 3,773 5,449 22,078 7,430 2,453
Equity in net income (loss)-
NFI Holding . . . . . . . . . . . . . . . . . . . . - 1,123 88 (2,984) 28
Gain (loss) on derivative instruments
and sales of mortgage assets . . . . . . . . . . . 34,616 (826) 351 (14,962) 51
General and administrative expenses . . . . . . . . . 49,443 3,017 3,590 4,379 3,451
Income (loss) before cumulative effect
of change in accounting principle . . . . . . . . . 34,014 5,626 (7,092) (21,821) (1,135)
Cumulative effect of change in
accounting principle(B) . . . . . . . . . . . . . . (1,706) - - - -
Net income (loss) . . . . . . . . . . . . . . . . . . 32,308 5,626 (7,092) (21,821) (1,135)
Basic earnings (loss) per share . . . . . . . . . . . $ 3.22 $ 0.51 $ (1.08) $ (2.71) $ (0.26)
Diluted earnings (loss) per share . . . . . . . . . . $ 3.02 $ 0.50 $ (1.08) $ (2.71) $ (0.26)
AS OF DECEMBER 31,
-----------------------------------------------------
2001 2000 1999 1998 1997
----------- -------- -------- -------- ----------
Consolidated Balance Sheet Data
Mortgage Assets:
Mortgage loans . . . . . . . . . . . . . . . . . . $ 365,560 $375,927 $620,406 $945,798 $ 574,984
Mortgage securities . . . . . . . . . . . . . . . . 71,584 46,650 6,775 - 517,246
Total assets . . . . . . . . . . . . . . . . . . . . 512,380 494,482 689,427 997,754 1,126,252
Borrowings . . . . . . . . . . . . . . . . . . . . . 362,398 382,437 586,868 891,944 1,002,560
Stockholders' equity . . . . . . . . . . . . . . . . 129,997 107,919 100,161 82,808 116,489
FOR THE YEAR ENDED DECEMBER 31,
-----------------------------------------------------
2001 2000 1999 1998 1997
----------- -------- -------- -------- ----------
OTHER DATA
Loans originated, principal . . . . . . . . . . . . . $ 1,338,476 $719,341 $452,554 $878,871 $ 409,974
Branches, end of year . . . . . . . . . . . . . . . . 123 63 1 - -
Loans brokered through branches . . . . . . . . . . . $ 1,087,971 $193,191 - - -
Annualized return on assets . . . . . . . . . . . . . 6.03% 0.97% (0.83)% (1.66)% (0.01)%
Annualized return on equity . . . . . . . . . . . . . 27.04% 5.50% (6.71)% (20.71)% (0.06)%
Taxable income (loss) . . . . . . . . . . . . . . . . $ 5,242 $ 525 $ (90) $ (2,628) $ 1,434
Taxable income (loss) per share . . . . . . . . . . . $ 0.91 $ - $ (.01) $ (0.32) $ 0.18
Dividends declared per common share . . . . . . . . . $ 0.96 $ - $ - $ 1.00 $ 0.28
Dividends declared per preferred share . . . . . . . $ 1.08 $ 0.49 $ 0.37 $ - $ 0.18
Number of account executives . . . . . . . . . . . . 112 85 47 63 36
- --------------------
(A) Includes the assets, liabilities, equity and results of operations for NFI
Holding Corporation. We acquired the common stock of NFI Holding
Corporation on January 1, 2001. Details of this transaction are discussed
in Note 9 to our consolidated financial statements.
(B) Implementation of Statement of Financial Accounting Standards, No. 133 as
discussed in Note 1 to our consolidated financial statements.
15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
consolidated financial statements of NovaStar Financial and the notes thereto
included elsewhere in this report.
SAFE HARBOR STATEMENT
"Safe Harbor" statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding NovaStar Financial, Inc.
(NovaStar Financial) and its business, which are not historical facts, are
"forward-looking statements" that involve risks and uncertainties. Certain
matters discussed in this report may constitute forward-looking statements
within the meaning of the federal securities laws that inherently include
certain risks and uncertainties. Actual results and the time of certain events
could differ materially from those projected in or contemplated by the
forward-looking statements due to a number of factors, including general
economic conditions, fluctuations in interest rates, fluctuations in prepayment
speeds, fluctuations in losses due to defaults on mortgage loans, the
availability of non-conforming residential mortgage loans, the availability and
access to financing and liquidity resources, and other risk factors outlined in
the section title "Risk Management." Other factors not presently identified may
also cause actual results to differ. Management continuously updates and revises
these estimates and assumptions based on actual conditions experienced. It is
not practicable to publish all revisions and, as a result, no one should assume
that results projected in or contemplated by the forward-looking statements will
continue to be accurate in the future.
DESCRIPTION OF BUSINESSES
INVESTMENT PORTFOLIO
o We invest in assets generated primarily from our wholesale origination
of non-conforming, single-family, residential mortgage loans.
o We operate as a long-term portfolio investor.
o Financing is provided by issuing asset-backed bonds and entering into
reverse repurchase agreements.
o Earnings are generated from return on mortgage securities and spread
income on the mortgage loan portfolio.
RESIDENTIAL MORTGAGE LENDING AND SERVICING
o Our primary customer is the retail mortgage broker who deals with the
borrower.
o Our borrowers generally are individuals or families who do not qualify
for agency/conventional lending programs because of a lack of
available documentation or previous credit difficulties.
o We finance our loans through short-term warehouse and repurchase
facilities.
o Loans we originate are held-for-sale in either outright sales for cash
or in securitization transactions.
o We service the loans we originate.
AFFILIATED BRANCHES
o Retail mortgage branches that broker loans for 200 investors,
including NovaStar Mortgage, Inc.
o Branches operate under policies we established.
o The net operating income for the branch is returned as compensation to
the branch "owner/manager."
PRESENTATION
On January 1, 2001, we purchased the voting common shares of NFI Holding.
Previously, two members of management owned these securities. Prior to January
1, 2001, the assets and liabilities and operating results of NFI Holding were
not consolidated with that of NovaStar Financial. Beginning January 1, 2001, the
financial statements of NFI Holding are consolidated with those of NovaStar
Financial. For comparative purposes, we have presented
16
prior period information as if the financial results of NFI Holding had been
consolidated with those of NovaStar Financial in relevant analyses that follow.
In these cases, we have marked the pro forma information accordingly. Note 9 of
the consolidated financial statements presents pro forma consolidated operating
results.
SIGNIFICANCE OF ESTIMATES AND CRITICAL ACCOUNTING POLICIES
We prepare our consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America and,
therefore, are required to make estimates regarding the values of our assets and
in recording income and expenses. These estimates are based, in part, on our
judgment and assumptions regarding various economic conditions that we believe
are reasonable based on facts and circumstances existing at the time of
reporting. The result of these estimates affect reported amounts of assets at
the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the periods presented. The following summarizes the
components of our consolidated financial statements where understanding
accounting policies is critical to understand and evaluate our reported
financial results, especially given the significant estimates used in applying
the policies.
MORTGAGE SECURITIES. Our mortgage securities primarily consist of the right
to receive the future cash flow from a pool of securitized mortgage loans. Our
interest in these securities consist of:
- The interest spread between the coupon on the underlying loans and the
cost of financing.
- Prepayment penalties received from borrowers who payoff their loans
early in their life.
- Overcollateralization, which is designed to protect the primary
bondholder from credit loss on the underlying loans.
The cash flow we receive is highly dependent upon interest rate
environment. The cost of financing for the securitized loans is indexed to
short-term interest rates, while the loan coupons are less interest sensitive.
As a result, as rates rise and fall, our cash flow will fall and rise, which in
turn will increase or decrease the value of our mortgage securities. Likewise,
increasing or decreasing cash flow will increase or decrease the yield on our
securities. We adjust our yield (rate of income recognition) prospectively based
on the expectation for cash flow on the securities.
In estimating the value of our mortgage securities and in establishing the
rate of income recognition from the securities, management uses assumptions
regarding economic conditions, including interest rates, principal payment and
prepayment and loan defaults. The rate used to discount the projected cash flow
is critical in the evaluation of our mortgage securities. Information regarding
the assumption we used in the preparation of our consolidated financial
statements is discussed under "Mortgage Securities" in the following discussion
and in Note 3 to our consolidated financial statements.
TRANSFERS OF ASSETS (LOAN SECURITIZATION) AND RELATED GAINS.We combine the
mortgage loans we originate and mortgage securities in pools to serve as
collateral for asset-backed bonds that are issued to the public. The loans or
securities are transferred to a trust designed to serve only for the purpose of
holding the collateral. The owners of the asset-backed bonds have no recourse to
us in the event the collateral does not perform as planned. When these transfers
are executed in a manner such that we have no control over the collateral, the
transfer is accounted for as a sale. We do retain the right to service the
underlying mortgage loans and we also retain certain mortgage securities issued
by the trust (see Mortgage Securities above). A gain on the sale is recorded.
These gains represent a significant portion of our operating results. When we do
have the ability to exert control over the transferred collateral, the assets
remain on our financial records and a liability is recorded for the related
asset-backed bonds.
The gain recognized upon securitization depends on, among other things, the
fair value of the components of the securitization-the loans or securities
transferred, the securities retained and the mortgage servicing rights. The
value of these components is estimated at the time of the securitization. In
estimating these values, management uses assumptions regarding economic
conditions and the make-up of the collateral, including interest rates,
principal payment and prepayment and loan defaults. The rate used to discount
the cash flow projections is critical in the evaluation of our mortgage
securities. Information regarding the assumption we used is discussed under
"Mortgage Securities" in the following preceding discussion and in Note 3 to our
consolidated financial statements.
MORTGAGE LOANS, ALLOWANCE FOR CREDIT LOSSES AND ASSETS ACQUIRED THROUGH
FORECLOSURE. Mortgage loans that are not available-for-sale are recorded at
their cost, adjusted for the amortization of deferred costs and for credit
losses inherent in the portfolio. An allowance is maintained for credit losses.
17
Assets acquired through foreclosure are carried at the lower-of-cost or
estimated fair value less estimated selling costs. The carrying value of the
loan is adjusted at the time of foreclosure using a charge to the allowance for
credit losses.
The allowance, and therefore the related charges to income, is based on the
assessment by management of various factors affecting our mortgage loan
portfolio, including current and projected economic conditions, the makeup of
the portfolio based on credit grade, loan-to-value, delinquency status, mortgage
insurance we purchase and other relevant factors. The allowance is maintained
through ongoing provisions charged to operating income. Significant changes in
the portfolio, our ability to obtain mortgage insurance and/or economic
conditions may affect the allowance for credit losses and net income. The
make-up of our mortgage loan portfolio is discussed below under "Mortgage Loans"
and in Note 2 to our consolidated financial statements. The allowance for credit
losses is discussed below under that heading. We discuss purchased mortgage
insurance under the heading "Premiums Paid for Mortgage Insurance."
FINANCIAL CONDITION OF NOVASTAR FINANCIAL AS OF DECEMBER 31, 2001 AND 2000
MORTGAGE LOANS. Our balance sheet consists primarily of mortgage loans we
have originated. We classify our mortgage loans into two categories:
held-for-sale and held-in-portfolio. A majority of our loans serve as collateral
for asset-backed bonds we have issued and are classified as held-in-portfolio.
The carrying value of held-in-portfolio mortgage loans as of December 31, 2001
was $226 million compared to $376 million as of December 31, 2000.
Loans we have originated, but have not yet sold or securitized, are
classified as "held-for-sale." We expect to sell these loans outright in third
party transactions or in securitization transactions that will be, for tax and
accounting purposes, recorded as sales. We use warehouse lines of credit and
mortgage repurchase agreements to finance our held-for-sale loans.
Premiums are paid on substantially all mortgage loans. Premiums are
amortized as a reduction of interest income over the estimated lives of the
assets. Tables 3 and 6 provide information to analyze the impact of principal
payments on amortization.
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 repay their mortgage principal balances earlier
than is required by the terms of their mortgages. Non-conforming borrowers, as
they update their credit rating, are more likely to refinance their mortgage
loan to obtain a lower interest rate. To mitigate the effect of prepayments on
interest income from mortgage loans, we strive to originate mortgage loans with
prepayment penalties.
Prepayment rates in Table 6 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. This information has not been presented for heldfor- sale
loans as we do not expect to own the loans for a period long enough to
experience material repayments.
Characteristics of the mortgage loans we own are provided in Tables 1
through 6. The operating performance of our mortgage loan portfolio, including
net interest income, allowances for credit losses and effects of hedging, are
discussed under "Results of Operations" and "Interest Rate/Market Risk." Gains
on the sales of mortgage loans, including impact of securitizations treated as
sales, is also discussed under "Results of Operations."
18
TABLE 1
MORTGAGE LOANS BY CREDIT GRADE
(DOLLARS IN THOUSANDS)
DECEMBER 31,
-------------------------------------------------------------
2001 2000
----------------------------- ------------------------------
WEIGHTED WEIGHTED
ALLOWED MAXIMUM WEIGHTED AVERAGE WEIGHTED AVERAGE
CREDIT MORTGAGE LOAN-TO- CURRENT AVERAGE LOAN-TO- CURRENT AVERAGE LOAN-TO-
GRADE LATES (A) VALUE PRINCIPAL COUPON VALUE PRINCIPAL COUPON VALUE
- ----- --------- ----- --------- ------ ----- --------- ------ -----
Held-in-portfolio:
AA . . . . . . . . . . . 0 x 30 95 $ 35,922 9.59% 82.1% $ 56,463 10.17% 82.6%
A . . . . . . . . . . . 1 x 30 90 90,775 10.05 79.1 152,621 10.66 79.4
A- . . . . . . . . . . . 2 x 30 90 53,971 10.52 81.5 88,617 11.30 81.7
B . . . . . . . . . . . 3 x 30, 1 x 60 85 28,400 11.05 77.4 51,001 11.80 78.1
5 x 30, 2 x 60
C . . . . . . . . . . . . 1 x 90 75 15,122 11.53 72.3 22,902 12.30 72.8
D . . . . . . . . . . . . 6 x 30, 3 x 60, 2 x 90 65 2,770 12.15 64.8 4,268 13.13 63.8
-------- --------
$226,960 10.34% 79.3% $375,872 11.02% 79.7%
======== ===== ==== ======== ===== ====
Held-for-sale:
Alt A . . . . . . . . . . 0 x 30 95 $ 11,662 8.74% 85.8%
AAA . . . . . . . . . . . 0 x 30 97(B) 28,892 8.70 74.5
AA . . . . . . . . . . . 0 x 30 95 32,352 9.14 78.9
A . . . . . . . . . . . . 1 x 30 90 25,218 9.21 79.1
A- . . . . . . . . . . . 2 x 30 90 10,964 9.21 79.1
B . . . . . . . . . . . . 3 x 30, 1 x 60, 85 8,828 9.33 74.8
5 x 30, 2 x 60
C . . . . . . . . . . . . 1 x 90 75 599 11.77 75.1
Other . . . . . . . . . . Varies 97 19,713 9.33 94.1
--------
$138,228 9.08% 80.2%
======== ==== ====
- -----------------
(A) Represents the number of times a prospective borrower is allowed to be late
more than 30, 60 or 90 days. For instance, a 3 x 30, 1 x 60 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) 97% on fixed-rate only; all other maximum of 95%.
TABLE 2
MORTGAGE LOANS BY GEOGRAPHIC CONCENTRATION
PERCENT OF CURRENT PRINCIPAL AS OF DECEMBER 31, 2001
HELD-IN-PORTFOLIO HELD-FOR-SALE
----------------- -------------
COLLATERAL LOCATION
Florida . . . . . . . . . . . . . . . 16% 11%
California . . . . . . . . . . . . . . 13 23
Washington . . . . . . . . . . . . . . 6 1
Oregon . . . . . . . . . . . . . . . . 5 2
Texas . . . . . . . . . . . . . . . . 5 3
Michigan . . . . . . . . . . . . . . . 3 7
Ohio . . . . . . . . . . . . . . . . . 4 5
Nevada . . . . . . . . . . . . . . . . 4 2
Tennessee . . . . . . . . . . . . . . 4 2
All other states . . . . . . . . . . . 40 44
--- ---
Total . . . . . . . . . . . . . . . 100% 100%
=== ===
19
TABLE 3
CARRYING VALUE OF MORTGAGE LOANS BY PRODUCT/TYPE
(DOLLARS IN THOUSANDS)
DECEMBER 31,
-----------------------------------
PRODUCT/TYPE 2001 2000
- ------------ ------------- ------------
Held-in-portfolio:
30/15-year fixed and balloon . . . . . . . . . . $128,299 $185,817
Two and three-year fixed . . . . . . . . . . . . 85,145 166,627
Six-month LIBOR and one-year CMT . . . . . . . . 13,516 23,428
-------- --------
Outstanding principal . . . . . . . . . . . . . 226,960 375,872
Deferred broker premium and costs . . . . . . . 4,630 7,745
Allowance for credit losses . . . . . . . . . . (5,557) (7,690)
-------- --------
Carrying value . . . . . . . . . . . . . . . . . $226,033 $375,927
-------- --------
Carrying value as a percent of principal . . . . 99.59% 100.01%
======== ========
Held-for-sale:
30/15-year fixed and balloon . . . . . . . . . . $ 49,013
Two and three-year fixed . . . . . . . . . . . . 89,215
--------
Outstanding principal . . . . . . . . . . . . . 138,228
Deferred broker premium and costs . . . . . . . 1,453
Allowance for credit losses . . . . . . . . . . (154)
--------
Carrying value . . . . . . . . . . . . . . . . . $139,527
========
Carrying value as a percent of principal . . . . 100.94%
========
TABLE 4
MORTGAGE CREDIT ANALYSIS-HELD-IN-PORTFOLIO LOANS
DECEMBER 31, 2001 (DOLLARS IN THOUSANDS)
DEFAULTS AS PERCENT OF CURRENT PRINCIPAL
CREDIT ORIGINAL CURRENT WEIGHTED AVERAGE LOAN- 60-89 90 DAYS AND FORECLOSURE
GRADE BALANCE PRINCIPAL TO-VALUE RATIO DAYS GREATER AND REO TOTAL
- ----- ------- --------- -------------- ---- ------- ------- -----
NOVASTAR HOME EQUITY SERIES 1997-1:
A . . . . . $ 117,904 $ 12,946 73.1 - 2.8 4.3 7.1
A- . . . . 73,499 9,119 77.3 0.2 8.2 12.1 20.5
B . . . . . 53,812 5,445 72.7 1.5 3.1 16.0 20.6
C . . . . . 23,065 2,903 70.7 - 0.9 - 0.9
D . . . . . 9,021 923 69.4 - - - -
NOVASTAR HOME EQUITY SERIES 1997-2:
AA . . . . $ 3,153 $ 347 86.4 - - - -
A . . . . . 104,582 14,520 79.3 1.2 0.8 9.9 11.9
A- . . . . 63,660 9,384 83.0 0.7 1.4 4.2 6.3
B . . . . . 36,727 4,996 79.0 4.3 0.7 15.7 20.7
C . . . . . 11,354 2,376 69.7 - - 6.3 6.3
D . . . . . 1,529 422 60.4 - - 8.4 8.4
NOVASTAR HOME EQUITY SERIES 1998-1:
AA . . . . $ 59,213 $ 12,633 83.3 2.5 0.5 12.1 15.1
A . . . . . 113,457 25,397 80.7 2.8 2.4 11.6 16.8
A- . . . . 63,100 13,666 82.0 1.0 0.7 13.3 15.0
B . . . . . 38,249 7,464 78.4 4.7 2.5 11.5 18.7
C . . . . . 23,029 4,469 75.4 2.6 1.9 17.6 22.1
D . . . . . 5,495 739 63.6 - 25.5 6.4 31.9
NOVASTAR HOME EQUITY SERIES 1998-2:
AA . . . . $ 64,851 $ 22,942 81.5 2.0 0.4 3.2 5.6
A . . . . . 113,557 37,912 80.6 1.4 1.3 9.5 12.2
A- . . . . 70,399 21,802 83.2 1.1 4.0 7.1 12.2
B . . . . . 40,818 10,495 80.0 3.1 1.7 20.8 25.6
C . . . . . 22,335 5,374 72.5 2.3 1.9 14.6 18.8
D . . . . . 2,951 686 61.5 - - 7.6 7.6
---------- --------
Total . . . $1,115,760 $226,960
========== ========
20
TABLE 5
LOSS ANALYSIS-HELD-IN-PORTFOLIO LOANS
DECEMBER 31, 2001
(DOLLARS IN THOUSANDS)
LOANS REPURCHASED FROM TRUSTS
CUMULATIVE LOSSES AS -------------------------------
REPORTED, AS PERCENT OF LOSS AS A % OF
ORIGINAL BALANCE LOSS AMOUNT ORIGINAL BALANCE TOTAL LOSSES
----------------------- ------------- ------------------ --------------
NHES 1997-1 . . . . . . . . 1.78% $3,522 1.27% 3.05%
NHES 1997-2 . . . . . . . . 2.01 6,299 2.85 4.86
NHES 1998-1 . . . . . . . . 2.16 7,685 2.54 4.70
NHES 1998-2 . . . . . . . . 2.03 2,425 0.77 2.80
TABLE 6
MORTGAGE LOAN COUPON AND PREPAYMENT ANALYSIS
(DOLLARS IN THOUSANDS)
REMAINING
PREPAYMENT
PENALTY CONSTANT PREPAYMENT RATE
PERCENT WITH PERIOD (IN YEARS) (ANNUAL PERCENT)
ORIGINAL CURRENT PREPAYMENT FOR LOANS WITH THREE- TWELVE-
ISSUE DATE PRINCIPAL PRINCIPAL PREMIUM PENALTY COUPON PENALTY MONTH MONTH LIFE
---------- --------- --------- ------- ------- ------ ------- ----- ----- ----
AS OF DECEMBER 31, 2001
HELD-IN-PORTFOLIO-SERVING AS
COLLATERAL FOR NOVASTAR HOME EQUITY
SERIES ASSET BACKED BONDS:
Series 1997-1 October 1, 1997 $ 277,301 $ 31,336 $ 1,453 19% 10.90% 0.09 26 37 39
Series 1997-2 December 11, 1997 221,005 32,045 652 22 10.79 0.18 23 37 37
Series 1998-1 April 30, 1998 302,543 64,368 1,050 24 10.45 0.29 34 40 33
Series 1998-2 August 18, 1998 314,911 99,211 1,475 31 10.18 0.48 39 37 28
---------- --------- -------
Total $1,115,760 $ 226,960 $ 4,630 26% 10.34% 0.33
========== ========= ======= == ===== ====
Held-for-sale: $ 138,228 $ 1,453 79% 9.08% 2.35
========= ======= == ===== ====
AS OF DECEMBER 31, 2000
HELD-IN-PORTFOLIO-SERVING AS
COLLATERAL FOR NOVASTAR HOME EQUITY
SERIES ASSET BACKED BONDS:
Series 1997-1 October 1, 1997 $ 277,301 $ 52,282 $ 2,494 25% 11.80% 0.30 37 40 40
Series 1997-2 December 11, 1997 221,005 53,727 1,040 16 11.55 0.28 45 46 36
Series 1998-1 April 30, 1998 302,543 114,367 1,877 33 11.03 0.46 34 41 30
Series 1998-2 August 18, 1998 314,911 155,496 2,334 60 10.57 0.85 38 33 24
---------- --------- -------
Total $1,115,760 $ 375,872 $ 7,745 40% 11.02% 0.57
========== ========= ======= == ===== ====
MORTGAGE SECURITIES-AVAILABLE-FOR-SALE. During 2001, 2000 and 1999, $1.2
billion, $570 million, and $165 million in loans we originated were pooled in
securitization transactions. These transactions were treated as sales for
accounting and tax purposes. We service the loans sold in these securitizations
and we retained the AAA-rated interest-only, prepayment penalties and other
subordinated securities issued in the securitizations. The December 31, 2001
value of the AAA-rated interest-only, prepayment penalties and other
subordinated interests retained in 2001 securitizations was $59.6 million. Under
the section "Mortgage Loan Sales" we discuss the details of the loan
securitization transactions.
21
During the third quarter of 2001, we resecuritized our NMFT 2000-1 and
2000-2 AAA-rated interest-only and prepayment penalty securities and issued
NovaStar CAPS Certificates 2001-C1 (CAPS 2001-C1) in the amount of $29.3
million. A gain of $14.9 million was recognized on this transaction. We retained
a $8.2 million subordinated interest, which entitles us to the remaining cash
flows once the primary bonds of the CAPS 2001-C1 are paid in full.
As of December 31, 2001 and December 31, 2000, the fair value of mortgage
securities was $71.6 million and $46.7 million, respectively. This amount
represents the present value of the securities' cash flows that we expect to
receive over their lives, considering estimated prepayment speeds and credit
losses of the underlying loans, discounted at an appropriate risk-adjusted
market rate of return. The cash flows are realized over the life of the loan
collateral as cash distributions are received from the trust that owns the
collateral. In estimating the fair value of our mortgage securities, management
must make assumptions regarding the future performance and cash flow of the
mortgage loans collateralizing the securities. These estimates are based on
management's judgements about the nature of the loans. We believe the value of
the securities is fair, 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 income of future
periods. Table 7 summarizes our mortgage securities and the underlying
collateral and senior asset-backed bonds. Table 8 provides a summary of the
critical assumptions used in estimating the cash flows of the collateral and the
resulting estimated fair value of the mortgage securities.
22
TABLE 7
MORTGAGE SECURITIES
(DOLLARS IN THOUSANDS)
ASSET-BACKED BONDS MORTGAGE LOANS
ESTIMATED ---------------------- ----------------------------------------
FAIR VALUE WEIGHTED AVERAGE
OF MORTGAGE REMAINING INTEREST REMAINING ESTIMATED
SECURITIES PRINCIPAL RATE PRINCIPAL COUPON MONTHS TO CALL
---------- ----------- ---------- ----------- -------- ----------------
DECEMBER 31, 2001
NMFT 1999-1
- -----------
Subordinated securities
(non-investment grade) . . . . . . $ 3,661 $ 58,738 4.49% $ 62,665 10.23% 46
NMFT 2000-1
- -----------
Interest only (AAA-rated) . . . . . . . -(A)
Prepayment penalty (AAA-rated) . . . . . -(A)
Subordinated securities
(non-investment grade) . . . . . . . 560
----------
560 145,538 2.18 149,400 10.16 44
NMFT 2000-2
- -----------
Interest only (AAA-rated) . . . . . . . -(A)
Prepayment penalty (AAA-rated) . . . . . -(A)
Subordinated securities
(non-investment grade) . . . . . . . 997
----------
997 252,995 2.18 259,037 10.59 41
NMFT 2001-1
- -----------
Interest only (AAA-rated) . . . . . . . 14,132
Prepayment penalty (AAA-rated) . . . . . 3,648
Subordinated securities
(non-investment grade) . . . . . . . 1,016
----------
18,796 367,468 2.28 373,949 10.35 50
NMFT 2001-2
- -----------
Interest only (AAA-rated). . . . . . . . 31,428
Prepayment penalty (AAA-rated) . . . . . 6,130
Subordinated securities
(non-investment grade) . . . . . . . 1,813
----------
39,371 772,296 2.09 784,617 9.70 61
CAPS 2001-C1
- ------------
Subordinated securities
(non-investment grade) . . . . . . . 8,199 19,241 7.25 -(A) -(A) -(A)
---------- ---------- ----------
Total . . . . . . . . . . . . . . . . . $ 71,584 $1,616,276 $1,629,668
========== ========== ==========
DECEMBER 31, 2000
NMFT 1999-1
- -----------
Subordinated securities
(non-investment grade) . . . . . . . $ 6,900 $ 96,521 6.23 $ 103,968 10.66 64
NMFT 2000-1
- -----------
Interest only (AAA-rated) . . . . . . . 11,697
Prepayment penalty (AAA-rated) . . . . . 2,533
Subordinated securities
(non-investment grade) . . . . . . . 720
----------
14,950 210,261 6.11 216,216 10.18 62
NMFT 2000-2
- -----------
Interest only (AAA-rated) . . . . . . . 19,745
Prepayment penalty (AAA-rated) . . . . . 3,729
Subordinated securities
(non-investment grade) . . . . . . . 1,326
----------
24,800 328,025 6.12 333,865 10.57 58
---------- ---------- ----------
Total . . . . . . . . . . . . . . . . . $ 46,650 $ 634,807 $ 654,049
========== ========== ==========
- ------------------
(A) Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment
penalty mortgage securities of NMFT 2000- 1 and 2000-2. The performance of
the mortgage loan collateral underlying these securities, as presented in
this table, directly affects the performance of the CAPS 2001-C1 security.
23
TABLE 8
CHARACTERISTICS OF LOAN COLLATERAL, VALUATION OF INDIVIDUAL MORTGAGE
SECURITIES AND ASSUMPTIONS
(DOLLARS IN THOUSANDS)
DECEMBER 31, 2001 DECEMBER 31, 2000
------------------------------------------------------------ --------------------------------
NOVASTAR MORTGAGE CAPS
FUNDING TRUST SERIES: 1999-1 2000-1 2000-2 2001-1 2001-2 2001-C1 TOTAL 1999-1 2000-1 2000-2 TOTAL
------ ------ ------ ------ ------ ------- ----- ------ ------ ------ -----
Discount rate (%) . . . . . . 25 40 40 25 25 40 17 17 17
Constant prepayment rate (%) 30 41 44 39 31 43 32 32 32
As a percent of mortgage
loan principal (%):
Delinquent loans
(30 days and greater) . 8.8 3.7 1.9 2.2 - (A) 17.0 5.7 1.1
Loans in foreclosure . . . 6.0 2.8 2.6 1.1 - (A) 5.5 1.6 0.3
Real estate owned . . . . 5.5 1.7 0.8 0.1 - (A) 4.2 0.1 -
Cumulative losses (as reported) 1.8 0.1 - - - (A) 1.0 - -
Cost basis of individual
mortgage securities:
Interest only (AAA- rated) $ - $ - $ - $ 9,272 $26,783 $ - $36,055 $ - $8,961 $15,607 $24,568
Prepayment penalty
(AAA- rated) . . . . . . . - - - 3,325 4,640 - 7,965 - 1,912 3,758 5,670
Subordinated securities
(non-investment grade) 5,366 413 661 619 421 3,094 10,574 5,265 338 642 6,245
Unrealized gain (loss) . (1,705) 147 336 5,580 7,527 5,105 16,990 1,635 3,739 4,793 10,167
------- ------- ------- ------- ------- ------- ------- ------ ------- ------- -------
Total . . . . . . . . $ 3,661 $ 560 $ 997 $18,796 $39,371 $ 8,199 $71,584 $6,900 $14,950 $24,800 $46,650
======= ======= ======= ======= ======= ======= ======= ====== ======= ======= =======
- ------------------------
(A) Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment
penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of
the mortgage loan collateral underlying these securities, as presented in
this table, directly effects the performance of the CAPS 2001-C1 security.
Prepayment assumptions used for each transaction have generally risen as
market interest rates and funding costs havedecreased. Discount rates have been
increased to reflect the market appetite for our securities. While interest
rates are declining and the cash flow from our securities are increasing, the
market place has not recognized the value of these securities, especially given
the minimal credit risk of the securities. The discount rate assumption and
other assumptions used for valuing the CAPS 2001-C1 security are discussed in
the "Sales of Mortgage Assets" section of this document.
The performance of the loans serving as collateral for our mortgage
securities is critical to the return our mortgage securities will generate.
Credit quality and prepayment experience characteristics of the loan collateral,
among others, are important to properly analyze the performance of our mortgage
securities. We have presented characteristics of the loans collateralizing our
mortgage securities in Tables 9 through 14. The operating performance of our
mortgage securities portfolio, including net interest income and effects of
hedging are discussed under "Results of Operations" and "Interest Rate/Market
Risk."
24
TABLE 9
LOANS COLLATERALIZING MORTGAGE SECURITIES CREDIT GRADE
(DOLLARS IN THOUSANDS)
DECEMBER 31,
---------------------------------------------------------------
2001 2000
------------------------------- ------------------------------
WEIGHTED WEIGHTED
ALLOWED MAXIMUM WEIGHTED AVERAGE WEIGHTED AVERAGE
CREDIT MORTGAGE LOAN-TO- CURRENT AVERAGE LOAN-TO- CURRENT AVERAGE LOAN-TO-
GRADE LATES (A) VALUE PRINCIPAL COUPON VALUE PRINCIPAL COUPON VALUE
- ----- --------- -------- ---------- ------ -------- --------- ------ --------
AAA . . . . . . . . 0 x 30 97(B) $ 319,360 9.64% 81.0% $143,673 9.71% 80.9%
AA . . . . . . . . 0 x 30 95 482,718 10.17 83.9 175,068 10.25 83.5
A . . . . . . . . . 1 x 30 90 302,271 10.36 81.6 130,237 10.54 81.2
A- . . . . . . . . 2 x 30 90 190,054 10.52 81.0 86,660 10.65 81.3
B . . . . . . . . . 3 x 30, 1 x 60, 85 124,052 10.85 78.0 44,487 11.16 79.3
5 x 30, 2 x 60
C . . . . . . . . . 1 x 90 75 29,549 11.43 68.4 18,398 11.69 70.1
D . . . . . . . . . 6 x 30, 3 x 60, 2 x 90 65 1,425 12.29 62.3 1,568 12.69 61.6
Other . . . . . . . Varies 97 180,239 11.51 93.5 53,958 11.44 92.7
---------- ----- -------- -----
$1,629,668 10.25 $654,049 10.45
========== ===== ======== =====
- -----------------
(A) Represents the number of times a prospective borrower is allowed to be late
more than 30, 60 or 90 days. For instance, a 3 x 30, 1 x 60 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) 97% on fixed-rate purchases; all other maximum of 95%.
TABLE 10
LOANS COLLATERALIZING MORTGAGE SECURITIES
PERCENT OF CURRENT PRINCIPAL AS OF DECEMBER 31, 2001
COLLATERAL LOCATION
FloridaS . . . . . . . . . . . . . . . . . . . . . . . . . . . 14%
California . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Michigan . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Ohio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Nevada . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Tennessee . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Arizona . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Washington . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Colorado . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
All other states . . . . . . . . . . . . . . . . . . . . . . . 35
---
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . 100%
===
TABLE 11
LOANS COLLATERALIZING MORTGAGE SECURITIES
CARRYING VALUE OF LOANS BY PRODUCT/TYPE
(IN THOUSANDS)
DECEMBER 31,
-----------------------
PRODUCT/TYPE 2001 2000
---------- ----------
Two and three-year fixed . . . . . . . . . . . . . . $1,236,328 $ 465,976
Six-month LIBOR and one-year CMT . . . . . . . . . . 2,607 2,492
30/15-year fixed and balloon . . . . . . . . . . . . 390,733 185,581
---------- ----------
Outstanding principal . . . . . . . . . . . . . . . $1,629,668 $ 654,049
========== ==========
Mortgage securities retained . . . . . . . . . . . . $ 71,584 $ 46,650
========== ==========
25
TABLE 12
LOANS COLLATERALIZING MORTGAGE SECURITIES
MORTGAGE LOAN COUPON AND PREPAYMENT PENALTIES
(DOLLARS IN THOUSANDS)
REMAINING CONSTANT PREPAYMENT RATE
PERCENT PREPAYMENT (ANNUAL PERCENT)
WITH PENALTY PERIOD (IN ------------------------
ORIGINAL CURRENT PREPAYMENT YEARS) FOR LOANS THREE- TWELVE-
ISSUE DATE PRINCIPAL PRINCIPAL PENALTY COUPON WITH PENALTY MONTH MONTH LIFE
---------- ---------- --------- ------- ------ ------------ ----- ----- ----
DECEMBER 31, 2001
NOVASTAR MORTGAGE FUNDING TRUST SERIES:
1999-1 . . . . January 29, 1999 $ 164,995 $ 62,665 42 10.23% 0.76 37 37 27
2000-1 (A) . . March 31, 2000 230,138 149,400 88 10.16 1.65 35 30 21
2000-2 (A) . . September 28, 2000 339,688 259,037 93 10.59 1.71 31 22 18
2001-1 . . . . March 31, 2001 415,067 373,949 89 10.35 2.02 18 - 11
2001-2 . . . . September 25, 2001 800,033 784,617 86 9.70 2.25 7 - 6
---------- ----------
Total. . . . . $1,949,921 $1,629,668 87% 10.25% 2.20
========== ========== === =====
DECEMBER 31, 2000
NOVASTAR MORTGAGE FUNDING TRUST SERIES:
1999-1 . . . . January 29, 1999 $ 164,995 $ 103,968 64 10.66 1.23 38 28 21
2000-1 . . . . March 31, 2000 230,138 216,216 94 10.18 2.43 10 - 8
2000-2 . . . . September 28, 2000 339,688 333,865 90 10.57 2.49 5 - 5
---------- ----------
Total. . . . . $ 734,821 $ 654,049 87% 10.45% 2.27
========== ========== === =====
- -----------------
(A) Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment
penalty mortgage securities of NMFT 2000- 1 and 2000-2. The performance of
the mortgage loan collateral underlying these securities, as presented in
this table, directly effects the performance of the CAPS 2001-C1 security.
26
TABLE 13
LOANS COLLATERALIZING MORTGAGE SECURITIES
MORTGAGE CREDIT ANALYSIS
DECEMBER 31, 2001
DEFAULTS AS PERCENT
OF CURRENT PRINCIPAL
---------------------------------------------------
CREDIT ORIGINAL CURRENT WEIGHTED AVERAGE 60-89 90 DAYS AND FORECLOSURE
GRADE BALANCE PRINCIPAL LOAN-TO-VALUE RATIO DAYS GREATER AND REO TOTAL
- ----- --------- --------- ----------------------- ------- ------------- ------------- -------
NOVASTAR MORTGAGE FUNDING TRUST SERIES 1999-1:
AAA $ 4,024 $ 2,071 78.3 - 2.9 - 2.9
AA 30,772 12,437 85.3 0.8 1.6 5.3 7.7
A 50,693 19,018 83.8 3.9 1.8 6.3 12.0
A- 38,953 15,076 82.4 0.9 1.2 10.8 12.9
B 23,135 8,581 79.5 2.6 10.4 17.2 30.1
C 12,959 4,759 71.3 3.3 1.9 28.4 33.6
C- 47 - - - - - -
D 4,412 723 62.8 - - 13.1 13.1
NOVASTAR MORTGAGE FUNDING TRUST SERIES 2000-1: (A)
AAA $ 85,222 $ 55,395 80.6 - 1.4 3.2 4.6
AA 55,874 37,708 83.2 3.0 - 4.6 7.5
A 36,422 24,730 80.9 3.0 2.3 7.1 12.3
A- 23,329 14,329 80.4 1.3 - 5.4 6.7
B 13,089 7,277 80.0 - - 10.9 10.9
C 5,922 3,446 68.6 1.7 - 18.0 19.7
C- 335 - - - - - -
D 51 48 58.0 - - - -
Other 9,894 6,467 92.0 1.6 0.8 2.4 4.8
NOVASTAR MORTGAGE FUNDING TRUST SERIES 2000-2: (A)
AAA $ 57,846 $ 43,593 81.2 2.4 0.2 1.3 3.9
AA 103,454 80,428 83.9 0.6 0.9 5.2 6.7
A 60,735 45,658 81.5 2.0 0.8 4.4 7.3
A- 39,939 29,522 81.4 1.5 5.2 6.7
B 19,843 15,387 77.0 0.7 - 4.9 5.6
C 4,275 3,094 67.1 - - 10.1 10.1
C- 388 532 74.7 - - - -
Other 53,208 40,823 92.8 0.7 4.3 5.0
NOVASTAR MORTGAGE FUNDING TRUST SERIES 2001-1: