| NOVASTAR FINANCIAL INC Item 1A Risk Factors Risk Factors You should carefully consider the risks described below before investing in our publicly traded securities |
| The risks described below are not the only ones facing us |
| Our business is also subject to the risks that affect many other companies, such as competition, inflation, technological obsolescence, labor relations, general economic conditions and geopolitical events |
| Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity |
| Risks Related to Our Borrowing and Securitization Activities Our growth is dependent on leverage, which may create other risks |
| Our success is dependent, in part, upon our ability to grow our assets through the use of leverage |
| Leverage creates an opportunity for increased net income, but at the same time creates risks |
| For example, leveraging magnifies changes in our net worth |
| We will incur leverage only when there is an expectation that it will enhance returns |
| Moreover, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our ability to make expected minimum REIT dividend requirements to shareholders will be adversely affected |
| Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our common shareholders |
| An interruption or reduction in the securitization market or our ability to access this market would harm our financial position |
| We are dependent on the securitization market because we securitize loans directly to finance our loan origination business and many of our whole loan buyers purchase our loans with the intention to securitize |
| A disruption in the securitization market could prevent us from being able to sell loans at a favorable price or at all |
| Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, a terrorist attack, an outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization |
| In addition, poor performance of our previously securitized loans could harm our access to the securitization market |
| In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a company to whom they provided financing and underwriting services |
| In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the business or charge more for their services, all of which could have a negative impact on our ability to securitize the loans we originate and the securitization market in general |
| A decline in our ability to obtain long-term funding for our mortgage loans in the securitization market in general or on attractive terms or a decline in the market’s demand for our loans could harm our results of operations, financial condition and business prospects |
| Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations |
| We are currently dependent upon several warehouse purchase agreements to provide short term financing of our mortgage loan originations and acquisitions |
| These warehouse purchase agreements contain numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants |
| If we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds |
| In addition, if we breach a covenant contained in any warehouse agreement, the lenders under all existing warehouse agreements could demand immediate payment of all outstanding amounts because all of our warehouse agreements contain cross-default provisions |
| Any failure to renew or obtain adequate funding under these financing arrangements for any reason, or any demand by warehouse lenders for immediate payment of outstanding balances could harm our lending operations and have a material adverse effect on our results of operations, financial condition and business prospects |
| In addition, an increase in the cost of warehouse financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distribution to our shareholders |
| In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization |
| At that time, we faced significant liquidity constraints which harmed our business and our profitability |
| Financing with warehouse repurchase agreements may lead to margin calls if the market value of our mortgage assets declines |
| We use warehouse repurchase agreements to finance our acquisition of mortgage assets in the short-term |
| Generally, the 13 ______________________________________________________________________ [35]Table of Contents repurchase agreements we enter into provide 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 95prca to 100prca of the asset market value with respect to mortgage loans and 65prca to 80prca of the asset market value with respect to mortgage securities—available-for-sale |
| When, in a lender’s opinion, asset market values decrease for any reason, including a rise in interest rates or general concern about the value or liquidity of the assets, we are required to repay the margin or difference in market value, or post additional collateral |
| If cash or additional collateral is unavailable to meet margin calls, we may default on our obligations under the applicable repurchase agreement |
| In that event, the lender retains the right to liquidate the collateral we provided it to settle the amount due from us |
| In addition to obtain cash, we may be required to liquidate assets at a disadvantageous time, which would cause us to incur losses and could change our mix of investments, which in turn could jeopardize our REIT status or our ability to rely on certain exemptions under the Investment Company Act |
| We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities |
| When we sell whole loans or securitize loans, we have potential credit and liquidity exposure for loans that are the subject of fraud, that have irregularities in their documentation or process, or that result in our breaching the representations and warranties in the contract of sale |
| In addition, when we sell loans to the whole loan market we have exposure for loans that default |
| In these cases, we may be obligated to repurchase loans at principal value, which could result in a significant decline in our available cash |
| When we purchase loans from a third party that we sell into the whole loan market or to a securitization trust, we obtain representations and warranties from the counter-parties that sold the loans to us that generally parallel the representations and warranties we provided to our purchasers |
| However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use cash resources to repurchase loans, which could adversely affect our liquidity |
| Competition in the securitization market may negatively affect our net income |
| Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field |
| Increased competition could reduce our securitization margins if we have to pay a higher price for the long-term funding of these assets |
| To the extent that our securitization margins erode, our results of operations, financial condition and business prospects will be negatively impacted |
| Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities—available-for-sale could adversely affect our financial position |
| Currently, our securitizations of mortgage loans are structured to be treated as sales for financial reporting purposes and, therefore, result in gain recognition at closing |
| As of December 31, 2005, we had mortgage securities – available for sale with a fair value of dlra505dtta6 million on our balance sheet |
| Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities—available-for-sale |
| It is extremely difficult to validate the assumptions we use in determining the amount of gain on sale and the value of our mortgage securities – available for sale |
| If our actual experience differs materially from the assumptions that we use to determine our gain on sale or the value of our mortgage securities—available-for-sale, our future cash flows, our financial condition and our results of operations could be negatively affected |
| Changes in accounting standards might cause us to alter the way we structure or account for securitizations |
| Changes could be made to the current accounting standards, which could affect the way we structure or account for securitizations |
| For example, if changes were made in the types of transactions eligible for gain on sale treatment, we may have to change the way we account for securitizations, which may harm our results of operations or financial condition |
| Risks Related to Interest Rates and Our Hedging Strategies Changes in interest rates may harm our results of operations |
| Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates |
| Interest rate changes could affect us in the following ways: • a substantial or sustained increase in interest rates could harm our ability to originate or acquire mortgage loans in expected volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expense levels; 14 ______________________________________________________________________ [36]Table of Contents • interest rate fluctuations may harm our earnings as the spread between the interest rates we pay on our borrowings and the interest rates we receive on our mortgage assets narrows; • mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in anticipated prepayment rates may harm our earnings; and • when we securitize loans, the value of the residual and subordinated securities we retain and the income we receive from them are based primarily on the London Inter-Bank Offered Rate, or LIBOR, and an increase in LIBOR reduces the net income we receive from, and the value of, these securities |
| Any of the foregoing results from changing interest rates may adversely affect our results from operations |
| Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders |
| We may enter into interest rate cap or swap agreements or pursue other interest rate hedging strategies |
| Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, and other changing market conditions |
| Interest rate hedging may fail to protect or could adversely affect us because, among other things: • interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; • hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any US or foreign governmental authorities; consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions, and the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements; • available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought; • the duration of the hedge may not match the duration of the related liability or asset; • the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; • the party owing money in the hedging transaction may default on its obligation to pay, which may result in the loss of unrealized profits; and • we may not be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risks |
| Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders |
| Unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions |
| Complying with REIT requirements may limit our ability to hedge effectively |
| We attempt to minimize exposure to interest rate fluctuations by hedging |
| The REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25prca of our gross income |
| The interest rate hedges that we generally enter into will not be counted as a qualified asset for the purposes of satisfying this requirement |
| In addition, under the Code, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5prca of our annual gross income |
| As a result, we may have to limit our use of advantageous hedging techniques |
| This could result in greater risks associated with changes in interest rates than we would otherwise want to incur |
| In addition, if it is ultimately determined that certain of our interest rate hedging transactions are non-qualified under the 15 ______________________________________________________________________ [37]Table of Contents Code, we may have more than 5prca of our annual gross income from non-qualified sources |
| If we violate the 5prca or 25prca limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability |
| In addition, if we fail to observe these limitations, we could lose our REIT status unless our failure was due to reasonable cause and not due to willful neglect |
| Risks Related to Credit Losses and Prepayment Rates Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and default rates which would result in higher loan losses |
| Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow |
| Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses |
| Delinquency interrupts the flow of projected interest income from a mortgage loan, and default can ultimately lead to a loss if the net realizable value of the real property securing the mortgage loan is insufficient to cover the principal and interest due on the loan |
| Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan |
| We bear the risk of delinquency and default on loans beginning when we originate them |
| In whole loan sales, our risk of delinquency and default typically only extends to the first payment but can extend up to the third payment |
| When we securitize any of our loans, we continue to be exposed to delinquencies and losses, either through our residual interests for securitizations structured as sales or through the loans still recorded on our balance sheet for securitizations structured as financings |
| We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase |
| Any failure by us to adequately address the delinquency and default risk associated with nonconforming lending could harm our financial condition and results of operations |
| Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans and, as a result, our results of operations may be affected |
| There are many aspects of credit that we cannot control and our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults and losses |
| Our comprehensive underwriting process may not be effective in mitigating our risk of loss on the underlying loans |
| Further, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions, natural disasters, over-leveraging of the borrower, and reduction in personal incomes |
| The frequency of defaults and the loss severity on loans upon default may be greater than we anticipated |
| Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve higher than expected delinquencies and defaults |
| Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses |
| Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs |
| To the extent that unforeseen or uncontrollable events increase loan delinquencies and defaults, our results of operations may be adversely affected |
| Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses |
| We use mortgage insurance to mitigate our risk of credit losses |
| Our decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends |
| Mortgage insurance coverage on our new mortgage loan production may not be available at rates that we believe are economically viable for us or at all |
| We also face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons |
| Any of those events could increase our credit losses and thus adversely affect our results of operations and financial condition |
| Our Option ARM mortgage product exposes us to greater credit risk There has been an increase in production of our loan product which is characterized as an option ARM loan |
| There have been recent announcements by federal regulators concerning interest-only loan programs, option ARM loan programs and other ARM loans with deeply discounted initial rates and/or negative amortization features |
| Federal banking regulators have expressed serious concerns with these programs and an intent to issue guidance shortly concerning offerings of these products |
| In addition, already one rating agency (Standard & Poors) has required greater credit enhancements for securitization pools that are backed by option ARMs |
| The combination of these events could lead to the loan product becoming a less available financing option and hence this could have a material affect on the value of such products |
| 16 ______________________________________________________________________ [38]Table of Contents Our interest-only loans may have a higher risk of default than our fully-amortizing loans |
| For the year ended December 31, 2005, originations of interest-only loans totaled dlra2dtta0 billion, or 22prca, of total originations |
| These interest-only loans require the borrowers to make monthly payments only of accrued interest for the first 24, 36 or 120 months following origination |
| After such interest-only period, the borrower’s monthly payment is recalculated to cover both interest and principal so that the mortgage loan will amortize fully prior to its final payment date |
| The interest-only feature may reduce the likelihood of prepayment during the interest-only period due to the smaller monthly payments relative to a fully-amortizing mortgage loan |
| Because no principal payments may be made on such mortgage loans for an extended period following origination, if the borrower defaults, the unpaid principal balance of the related loans would be greater than otherwise would be the case for a fully-amortizing loan, increasing the risk of loss on these loans |
| Current loan performance data may not be indicative of future results |
| When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience with mortgage loans |
| Actual results and the timing of certain events could differ materially in adverse ways from those projected, due to factors including changes in general economic conditions, fluctuations in interest rates, fluctuations in mortgage loan prepayment rates and fluctuations in losses due to defaults on mortgage loans |
| These differences and fluctuations could rise to levels that may adversely affect our profitability |
| Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, access to liquidity and results of operations |
| The economic returns we expect to earn from most of the mortgage assets we own are affected by the rate of prepayment of the underlying mortgage loans |
| Adverse changes in cash flows from a mortgage asset resulting from accelerated prepayments would likely reduce the asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings |
| Changes in loan prepayment patterns can affect us in a variety of other ways that can be complex and difficult to predict |
| In addition, our exposure to prepayment changes over time |
| As a result, changes in prepayment rates will likely cause volatility in our financial results in ways that are not necessarily obvious or predictable and that may adversely affect our results of operations |
| Geographic concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas, especially in California and Florida |
| Over-concentration of loans we originate or purchase in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area |
| Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgages which in turn may increase the risk of delinquency, foreclosure, bankruptcy, or losses from those loans |
| To the extent that a large number of loans are impaired, our financial condition and results of operations may be adversely affected |
| To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses |
| Standard homeowner insurance policies generally do not provide coverage for natural disasters, such as hurricanes and floods |
| Furthermore, nonconforming borrowers are not likely to have special hazard insurance |
| To the extent that borrowers do not have insurance coverage for natural disasters, they may not be able to repair the property or may stop paying their mortgages if the property is damaged |
| A natural disaster that results in a significant number of delinquencies could cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters, and that in turn could harm our financial condition and results of operations |
| Uninsured losses due to the Gulf State hurricanes could adversely affect our financial condition and results of operations |
| The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and Wilma, has affected the value of our portfolio of mortgage loans held-for-sale and the mortgage loan portfolio we service which underlies our mortgage securities – available-for-sale by impairing the ability of certain borrowers to repay their loans |
| At present, we are unable to predict the ultimate impact of the Gulf State hurricanes on our future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricanes adversely affect the ability of borrowers to repay their 17 ______________________________________________________________________ [39]Table of Contents loans, and the cost to us of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers |
| Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in areas where properties may have suffered little, if any, damage or may not yet have been inspected |
| We currently have a mortgage protection insurance policy, which protects us from uninsured losses as a result of these hurricanes up to a maximum of dlra5 million in aggregate losses with a deductible of dlra100cmam000 per hurricane |
| To the extent that losses exceed the dlra5 million aggregate loss insurance coverage, our financial condition and results of operations could be adversely affected |
| Additionally, there is no guarantee the insurance company will pay our claims, which could adversely affect our results of operations |
| A prolonged economic slowdown or a decline in the real estate market could harm our results of operations |
| A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities—available-for-sale evidencing interests in single-family mortgage loans |
| Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns |
| Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to sell loans, the prices we receive for our loans, the values of our mortgage loans held for sale or our residual interests in securitizations, which could harm our financial condition and results of operations |
| In addition, any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults |
| In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the extent not covered by third-party credit enhancement |
| Risks Related to the Legal and Regulatory Environment in Which We Operate Various legal proceedings could adversely affect our financial condition or results of operations |
| In the course of our business, we are subject to various legal proceedings |