The following discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the "Company" ,"NovaStar Financial", "NFI" , "we" or "us") and the notes thereto as well as NovaStar Financial's annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2005.

Safe Harbor Statement

Statements in this report regarding NovaStar Financial, Inc. and its business, which are not historical facts, are "forward-looking statements" that involve risks and uncertainties. Forward looking statements are those that predict or describe future events and that do not relate solely to historical matters. Certain matters discussed in this quarterly 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 timing of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including our ability to generate sufficient liquidity on favorable terms; the size, frequency and structure of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or default rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations or opinions of counsel relating thereto and the impact of new local, state or federal legislation or regulations, or opinions of counsel relating thereto, or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of overhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are outlined from time to time in our filings with the Commission, including this report on Form 10-Q. Other factors not presently identified may also cause actual results to differ. This document only speaks as of its date and we expressly disclaim any duty to update the information herein.

Executive Overview of Performance

The following selected key performance metrics are derived from our condensed consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and "Management's Discussion and Analysis of Financial Condition and Results of Operations."

Table 1 - Summary of Financial Highlights and Key Performance Metrics

(dollars in thousands; except per share amounts)



                                                For the Nine Months               For the Three Months
                                                Ended September 30,               Ended September 30,
                                               2006             2005             2006             2005
Net income available to common
shareholders                                $    80,689      $   106,026      $    25,252      $    34,630
Net income available to common
shareholders, per diluted share             $      2.40      $      3.60      $      0.73      $      1.12
Estimated taxable net income available
to common shareholders (A)                  $   154,450      $   219,689      $    59,130      $    62,105
Estimated taxable net income available
to common shareholders, per share (A)       $      4.25      $      7.14      $      1.63      $      2.02
Cash dividends declared per common share    $      5.60      $      4.20      $      2.80      $      1.40
Nonconforming originations and purchases
(B)                                         $ 7,587,290      $ 7,084,799      $ 2,935,879      $ 2,779,316
Weighted average coupon of nonconforming
originations and purchases (B)                     8.74 %           7.58 %           8.93 %           7.50 %
Nonconforming loans securitized             $ 4,265,688      $ 5,889,460      $ 2,174,900      $ 2,140,171
Nonconforming loans sold to third
parties                                     $ 1,486,832      $   717,262      $   693,776      $   490,067
Gains on sales of mortgage assets           $    51,027      $    60,462      $    27,709      $     9,691
Net interest yield on assets (C)                   1.25 %           1.63 %           1.12 %           1.81 %
Net yield on mortgage securities (D)              27.97 %          30.57 %          24.39 %          34.28 %
Weighted average whole loan price used
in the initial valuation of residual
interests                                        102.07           102.22           102.20           101.66
Costs of wholesale production, as a
percent of principal (E)                           1.90 %           2.43 %           1.79 %           2.18 %

(B) Does not include bulk purchased MTA loans during the period.

(C) This metric is defined in Table 3.

(D) This metric is defined in Table 2.

(E) This metric is defined in Table 9.

Nine Months Ended September 30, 2006 as Compared to the Nine Months Ended September 30, 2005

Net income available to common shareholders declined by approximately $25.3 million during the nine months ended September 30, 2006 as compared to the same period of 2005. The following factors contributed to the decline:

• Shift in securitization strategies to add qualified assets to our balance sheet to insure our status as a real estate investment trust ("REIT"). This decision ultimately resulted in a decrease in securitization sales transaction volume from $5.9 billion for the nine months ended September 30, 2005 to $4.3 billion for the same period of 2006. During the second quarter of 2006, we structured the NHES Series 2006-1 securitization as well as the NHES 2006-MTA1 securitization as financing transactions instead of our typical sales transactions. As a result of the decline in the volume of loans securitized in sales transactions, our gains on sales of mortgage assets declined to $51.0 million during the nine months ended September 30, 2006 from $60.5 million during the same period of 2005.

• The increase in the provision for credit losses for the nine months ended September 30, 2006 from the same period in 2005. We increased our provision for credit losses by approximately $18.8 million for the nine months ended September 30, 2006 from the same period in 2005 due to $2.7 billion of securitizations structured as financing transactions we executed in 2006. Our provision for credit losses significantly offset the positive impact to interest income yielded by these transactions.

• Higher expected credit losses due to housing appreciation concerns contributed to impairments increasing by $3.2 million in 2006 from 2005. As can be seen by our increase in credit loss assumptions as well as our high provision for credit losses, we are beginning to see the effects of a cooling housing market on mortgage credit quality.

• The rise in short-term interest rates in 2006 was much less than 2005. This resulted in a $5.4 million decrease in the gains we recognized on derivative instruments which did not qualify for hedge accounting during the nine months ended September 30, 2006 compared to the same period of 2005.

Three Months Ended September 30, 2006 as Compared to the Three Months Ended September 30, 2005

Net income available to common shareholders declined by approximately $9.4 million during the three months ended September 30, 2006 as compared to the same period of 2005. The following factors contributed to the decline:

• The increase in the provision for credit losses for the three months ended September 30, 2006 from the same period in 2005. We increased our provision for credit losses by approximately $10.0 million for the three months ended September 30, 2006 from the same period in 2005 due to $2.7 billion of securitizations structured as financing transactions we executed in 2006. Our provision for credit losses significantly offset the positive impact to interest income yielded by these transactions.

• The rise in short-term interest rates in 2006 was much less than 2005. This resulted in a $13.4 million decrease in the gains we recognized on derivative instruments which did not qualify for hedge accounting during the three months ended September 30, 2006 compared to the same period of 2005.

Dividends

On September 11, 2006, the Board of Directors of NovaStar announced the declaration of remaining common and preferred dividends for 2006:

• a common stock dividend of $1.40 per share, payable November 30, 2006, to shareholders of record as of November 20, 2006

• a common stock dividend of $1.40 per share, payable December 29, 2006, to shareholders of record as of December 19, 2006

• a quarterly dividend of $.55625 per share on our 8.90% Class C Cumulative Redeemable Preferred Stock, payable January 2, 2007, to holders of record as of December 5, 2006

We anticipate these common dividends will result in a distribution of 100% distribution of our 2005 taxable income. The payment of the common dividend in December represents an acceleration of the fourth quarter payment. Historically, this dividend has been declared in December and paid in January.

Our fourth quarter 2006 preferred dividend is payable in January of 2007, and would typically reduce income available to common shareholders in the fourth quarter. Because we declared this dividend in the third quarter, it is reflected in our third quarter results and reduces income available to common shareholders for the third quarter by $1.7 million, or approximately $0.05 per diluted share. Also, it should be noted that in the fourth quarter we do not anticipate a reduction to net income available to common shareholders for preferred dividends.

The early declaration of our common dividend had a similar effect on ending shareholders' equity in the third quarter. In the normal course of business, we accrue for our anticipated quarterly common dividend distribution. As such, our ending book value reflects our financial position as if the corresponding quarterly dividend had been declared in the quarter. However, given the early declaration of our fourth quarter 2006 common dividend, ending shareholders' equity for the third quarter includes a reduction of $50.8 million for our estimated fourth quarter dividend distribution.

Industry Overview and Known Material Trends

Described below are some of the marketplace conditions and known material trends that may impact our future results of operations.

As we move into the fourth quarter of 2006, we believe the nonconforming mortgage market continues to offer a mix of opportunities and challenges. The following trends have become evident in the business environment in which we operate and could have a significant impact on our financial condition, results of operations and cash flows:

• Various industry publications predict that growth in the nonconforming origination market will be relatively flat for the remainder of 2006 and beginning of 2007 with some publications predicting a decline. Our ability to increase the size of our securitized mortgage loan portfolio, which drives our mortgage securities portfolio, at growth rates experienced in recent years, could be impaired under these tighter conditions. We continue to pursue opportunities to increase our market share in the nonconforming market, including through development of new business or acquisitions of existing businesses. To the extent that we acquire an existing business we may be required to incur additional debt or sell additional equity securities, which could be dilutive to our shareholders.

• Mortgage banking profit margins have lowered as a result of interest rates rising faster than the coupons on newly originated mortgage loans. The spread between funding costs and loan coupons has narrowed by more than 200 basis points since 2004. Some relief was evident in the first half of 2006 as the industry began to raise coupons on new originations, and we began to see more attractive whole loan prices. However, margins could continue to tighten if short-term interest rates increase and competitive pressures hold coupons on mortgage loans flat. If we sell our mortgage loans either in whole pools to third parties or in securitizations, we could continue to experience depressed gains and even losses on sales of mortgage loans. Additionally, the mortgage securities we are currently adding to our portfolio are yielding lower returns than our older securities as a result of these compressed margins. Increasing the size of our portfolio is one of our top priorities but not at the expense of long-term risk-adjusted returns or risk management.

• Rising home prices have begun to cool along with housing growth rates after a multiyear boom. Increasing prices have been fueling the volume of home refinancing, as well as, reducing the risk of existing mortgage loans by improving loan-to-value ratios. For the remainder of 2006, many economists are expecting slower home-price growth, perhaps even declines in some markets which had experienced substantial growth. This could have a significant impact on origination growth in our mortgage lending segment, as well as, prepayment speed and credit loss assumptions on the mortgage securities held by our mortgage portfolio management segment.

While we continue to believe our best economic execution is realized from structuring a securitization as a sale for both GAAP and tax purposes, the current economic environment has made it necessary to add additional qualified assets to our REIT balance sheet. To provide qualifying income and assets to the REIT for purposes of these tests, we structured our NHES Series 2006-1 and NHES 2006-MTA1 securitizations as financing transactions at the REIT level instead of our typical sales transactions at the taxable REIT subsidiary level. The mortgage loans securitized under this structure came from our normal origination and purchase channels as well as from our MTA bulk loan purchases of approximately $1.0 billion which occurred in the first quarter of 2006. The MTA bulk loan purchase was, and future whole pool purchases could be, much larger in size as compared to our typical correspondent purchases. We would also expect these purchases to be eligible for financing through our warehouse repurchase agreements until they are securitized. See "Financial Condition - Short-term Borrowings" as well as "Liquidity and Capital Resources" for discussion of our financing facilities and other liquidity sources.

We generally expect to execute most of our future securitizations as sales transactions but we may continue to execute financing transactions from time to time depending on future economic as well as general business conditions.

In a securitization structured as a financing, no gain is recognized at the time of securitization, the mortgage loans remain on the balance sheet and the asset-backed bonds issued to third parties are recorded as debt on the balance sheet. These are clearly much different accounting dynamics than our historical securitizations structured as sales. In a sale, a gain is recognized at the time of securitization, the mortgage loans are removed from the balance sheet and new mortgage securities (retained interests) are recorded. Net income for any quarter in which we structure a securitization as a financing generally will be significantly lower than if the securitization were structured as a sale because there is no gain recognition associated with a financing. This initial difference in net income will reverse itself over the remaining life of the securitization resulting in no significant difference in net income recognized under either structure over the life of the securitization.

Additionally, structuring a securitization as a financing generally gives rise to excess inclusion income. If we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A shareholder's share of excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the shareholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. The amounts of excess inclusion income in any given year from these transactions could be significant. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Another strategy we executed in the first quarter of 2006 to ensure we maintain our REIT qualification was the contribution of certain bonds from the REIT to NFI Holding Corporation, a wholly-owned subsidiary of NFI, and its subsidiaries (collectively known as the "TRS"). Certain of the residual securities that historically have been held at the REIT generate interest income based on cash flows received from excess interest spread, prepayment penalties and derivatives (i.e., interest rate swap and cap contracts). The cash flows received from the derivatives does not represent qualified income for the REIT income tests requirements of the Code. The Code limits the amount of income from derivative income together with any income not generated from qualified REIT assets to no more than 25% of our gross income. In addition, under the Code, we must limit our aggregate income from derivatives (that are non-qualified tax hedges) and from other non-qualifying sources to no more than 5% of our annual gross income. Because of the magnitude of the derivative income projected for 2006 it was highly likely that we would not satisfy the REIT income tests. In order to resolve this REIT qualification issue, we isolated cash flows received from the residual securities and created a separate security for certain of the bonds that generate derivative income (the "CT Bonds") and then contributed the CT Bonds from the REIT to our taxable REIT subsidiary. This transaction may add volatility to future reported GAAP earnings because both the interest only residual bonds ("IO Bonds") and CT Bonds will be evaluated separately for impairment. Historically, the CT Bonds have acted as an economic hedge for the IO Bonds that are retained at the REIT, thus mitigating the impairment risk to the IO Bonds in a rising interest rate environment. As a result of transferring the CT Bonds to the TRS, the IO and CT Bonds will be valued separately creating the risk of earnings volatility resulting from other-than-temporary impairment charges. For example, in a rising rate environment, the IO bond will generally decrease in value while the CT Bond will increase in value. If the decrease in value of the IO Bond is deemed to be other than temporary in nature, we would record an impairment charge through the income statement for such decrease. At the same time, any increase in value of the CT Bond would be recorded in accumulated other comprehensive income. See Table 8 for a summary of impairments on our mortgage securities - available-for-sale.

During late 2005 and the first three quarters of 2006 we have retained various subordinate investment-grade securities from our securitization transactions that were previously held in the form of overcollateralization bonds. We have also purchased subordinated securities from other asset-backed securities ("ABS") issuers. We will continue to retain, acquire and aggregate various types of ABS as well as synthetic assets with the intention of securing non-recourse term financing through securitizations while retaining the risk of the underlying securities by investing in the equity and subordinated debt pieces of the collateralized debt obligation ("CDO"). CDO equity securities bear the first-loss and second-loss credit risk with respect to the securities owned by the securitization entity. Our goal is to leverage our extensive portfolio management experience for shareholders by purchasing securities that are higher in the capital structure than our residual securities and executing CDOs for long-term non-recourse financing, thereby generating good risk-adjusted returns for shareholders. We anticipate executing our first CDO in the late 2006 to early 2007 timeframe depending on market conditions and we have not yet determined how these transactions will be structured for GAAP and tax purposes.

During the third quarter of 2006 our primary loan origination unit, NovaStar Mortgage Inc. entered into an agreement to acquire up to 21 retail mortgage lending locations and certain other assets of Oak Street Mortgage LLC. NMI will create a new retail division and expand its retail mortgage lending business beyond the current focus on customer retention programs. The transaction is expected to close late in the fourth quarter of 2006. We expect this expansion into the retail market to enable us to substantially increase our loan production. While Oak Street's retail channel is already an efficient loan origination operation, the elimination of duplicate overhead should further reduce our cost of production.

Company Overview

We operate as a specialty finance company that originates, purchases, securitizes, sells, invests in and services residential nonconforming loans. We offer a wide range of mortgage loan products to borrowers, commonly referred to as "nonconforming borrowers," who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including United States of America government-sponsored entities such as Fannie Mae or Freddie Mac.

We operate three core businesses:

• Mortgage portfolio management

• Mortgage lending

• Loan servicing

We no longer include our branch operations as a core business as it was discontinued as of June 30, 2006.

Mortgage Portfolio Management

We operate as a long-term mortgage securities and mortgage loan portfolio investor. We invest in assets generated primarily from our originations and purchases of nonconforming, single-family, residential mortgage loans. These assets we invest in consist primarily of beneficial interests we retain from our securitization transactions accounted for as sales as well as mortgage loans we have classified as held-in-portfolio related to our securitizations treated as financings.

Our portfolio of mortgage securities includes interest-only, prepayment penalty, overcollateralization securities retained from our securitizations (collectively, the "residual securities"), subordinated mortgage securities also retained from our securitizations as well as bonds we have purchased from other issuers (collectively, the "subordinated securities"). We finance our investment in these mortgage securities by issuing asset-backed bonds ("ABB"), debt and capital stock and entering into repurchase agreements.

The long-term mortgage loan portfolio on our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated as financings from 1998 (NHES Series 1998-1 and NHES Series 1998-2) as well as two securitizations completed in the second and third quarters of 2006 (NHES Series 2006-1 and NHES Series 2006-MTA1). We have financed our investment in these loans by issuing ABB.

Our mortgage portfolio management operations generate earnings primarily from the return on our mortgage securities and mortgage loan portfolio.

A significant risk relating to our mortgage portfolio management segment is interest rate risk - the risk that interest rates on the mortgage loans which underly our mortgage securities will not adjust at the same times or in the same amounts that interest rates on the liabilities adjust. Most of the loans in our portfolio have fixed rates of interest for a period of time ranging from 2 to 30 years. Our funding costs generally adjust monthly off the one-month LIBOR rate. We use derivative instruments to mitigate the risk of our cost of funding increasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).

In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to protect the third-party bondholders from interest rate risk and to decrease the volatility of future cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our . . .