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NOVASTAR FINL INC (NFI)

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NYSE \ Financial \ Mortgage Investment

NovaStar (NFI) is a non-prime mortgage lender that is organized as a REIT (Real Estate Investment Trust)*. NovaStar specializes in home equity loans to borrowers who do not fit traditional lending guidelines. Many of these borrowers are small business owners unable to document income. Other borrowers have relatively high interest rate credit card debt and use Novastar mortgages to consolidate their debt load and improve their cash flow by accessing the tax-deductible equity in their homes. Typically, mortgage loans are $140K - $150K, on homes priced below $200K.

They have refined a number of innovations which have resulted in extraordinary growth, and enabled them to take market share from their competitors. First, they divide up the mortgages into two segments � principal, and interest. They pool the principal portion of the loans into $1.5- $2.5 billion bundles, and sell bonds collateralized by them to institutions. The money from the principal then goes to the institutions, and NFI collects 1/2 a percent of the total annually to service the loans. They sell limited time instruments (18 to 24 month duration) called NIMs which are collateralized by the interest portion of the loans, and for that time period the interest portion of the payments goes to the NIM holders. At the end of 18/24 months, the cash keeps coming in, but there are no more NIMs, so it's all cash for the company, free and clear. This unique method of self-financing enables them to turn over their money quickly, which has enabled their phenomenal growth.

NovaStar�s unique and ultra-conservative method of mortgage securitization is what sets NovaStar apart from its competitors. These innovations convert relatively risky mortgages into Moody�s AAA-rated bonds, greatly mitigating both the risk of borrower default and the risk of interest rate fluctuations. NovaStar�s conservative management, growing market share and steady dividends are attracting increasing numbers of both individual and institutional investors seeking stable, reliable income.

NovaStar�s business process is detailed in NFI Deal Flow. A simplified version follows:

Newly originated loans are "bundled" and securitized on a quarterly basis. The bundled mortgages are divided into two segments � principal, and interest. NovaStar pools and securitizes the principal portion into multi-billion dollar lots, and sells the resultant AAA-rated bonds to institutions, collecting 0.5% of the total annually to service the loans. The interest only (IO) portion of the loan bundles is collateralized and sold as limited-time instruments (18 to 24 month duration) called NIMs. For that time period, the IO cash generated goes to the NIM holders. When the NIM�s expire, the remaining IO income is retained by NovaStar, contributing towards Total Earnings. This unique method of loan management provides NovaStar with superior safety margins and efficiency, enabling their phenomenal growth.

Unlike many REITs, gradually rising higher interest rates are favorable for NovaStar. There are two reasons for this: Firstly, when mortgage rates increase, the portfolio, primarily adjustable rate mortgages, also incrementally and correspondingly goes up in value. Secondly, pre-payment of mortgages historically slows down when rates increase. This decline in loan pre-payments causes the IO loan bundles to pay income over a longer period of time, greatly increasing their value to NFI and shareholders.

NovaStar�s loan portfolio is growing rapidly. Monthly portfolio growth equals the difference between loan originations and pay-downs. Therefore, if NovaStar originates $800 million of loans per month and pay-downs are $300 million then the loan portfolio increases by $500 million. Portfolio growth is projected to flatten out as the portfolio size approaches $50 billion.

Any evaluation of NovaStar is incomplete without taking the time to listen to periodic conference calls and/or shareholder meetings. Listeners should note corporate earnings and dividend projections versus what is actually delivered. Shareholder�s of NovaStar find that the company consistently "under-promises and over-delivers". Missouri-style integrity and ethics are an integral part of the NovaStar culture. NovaStar�s managers are recognized as some of the sharpest minds in the mortgage finance industry ^{[citation needed]}

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Today

Max

Funds w/ NFI:	12
Rank:	340 / 351

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Company Analysis

NFI earns its revenues in 4 primary ways:

Interest it collects from mortgages it securitizes/collaterizes Sale of bonds from its securitizations Sales of loans in the wholesale markets From and off its portfolio servicing fees. The company doubled in growth and profit in 2002, and more than doubled again in 2003. 2004 also looks to be good for a 60-80%+ growth. On the negative side, a large portion of NFI's stock has been sold short, commening in July 2002 when popular wisdom had it that the business was headed south. Turns out that was in error, and now the large hedge fund who is short can't get out without causing a huge runup in the price. Creates lots of volatility, but the long-term trend is up. Click here for an excellent post on the Yahoo boards that explains NFI's business in a nutshell.

NFI has built a system to generate loans to add to a portfolio of highest-quality (AAA rated) captured interest rate spread. That system is growing, and even if it didn't, the portfolio would keep growing for the next 4 or 5 years. If you look carefully at how they do this, you'll see that they basically return to the branch owners the normal profits of originating loans, taking only a small fee for the company. Even the reported profits in the mortgage company are mostly from interest rate spread thrown off by mortgages waiting to be securitized.

Over the long haul, all that really matters is the interest rate on the loans minus the interest rate on the CMO bonds, and how many loans are "feeding" the earnings. The recent popularity of LIBOR-based loans is terrific, because issuing LIBOR-based bonds keeps the classic interest rate risk from hitting the NFI portfolio, even when rates rise. Keep that in mind the next time rates go up � your earnings will basically NOT go down, not even as much as the earnings will drop with traditional ARM mortgages that other lenders hold. In fact, if the new loans being added outweigh the old loans rolling off, your dividends will keep going up even though rates are rising.

Here are the top 15 reasons why so many shareholders consider NFI to be a great investment:

16 consecutive quarters of management exceeding expectations and forecasts. $5.60 annual dividend level. See Yahoo! NovaStar Dividend History and NovaStar's Dividend Information. Honest management. Underpromises and overdelivers. Key execs have their net worth in stock and continue buying. Portfolio value increased from approximately $2 billion end of 2002 to roughly $7.2 Billion value end of 2003, to $12.1 billion by end of 2004. On track to hit grow to $15 billion+ by year end 2005. Originations continue to grow, in all interest rate environments Housing and Mortgage Sector remains bright spot in the economic turnaround. S&P rates NFI's non-prime servicer rating 'strong'. Proprietary web-based origination system reduces transaction time and increases efficiency for their originators. Large short interest means guaranteed buyers for millions of shares. They have to cover sometime. Stock price appreciated over 300% in 2003. Dividend more than doubled in 2002 and 2003. Unique business model allows continuous income from I/O strips to hit the bottom line (and thus, dividends) for up to thirty years. See Commonly Used Terms for a description of Interest Only (I/O) strips. Company remains undervalued to its peers due to short selling pressure. Industry average <8% yield on forward earnings, NFI currently 12+% yield on trailing earnings. Great buying opportunity with plenty of upside growth potential. Growth primarily driven by increasing market share. NFI tiny (3% of total $250 billion non-prime market) but growing aggressively, beating own plan. Deferred Taxable Income, which creates a cushion for the current dividend. It also helps increase the company's future earnings further with a minimum of dilution. In addition, the deferred Taxable Income for any particular year has to be paid by the date of the final tax return filing in each subsequent year in addition to regular dividends, thus providing a more reliable and increasing dividend payout. And the final reason�every quarter hard cash shows up in our accounts from the dividend, lowering our cost basis and enabling us to accumulate more. This has resulted in tremendous wealth being built by many longer term holders. This is simply the best investment we know of, and among the best we�ve ever owned. ^{[citation needed]}

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News Feed

06/06/08 12:06 pm	Judge drops class-action suit against NovaStar (at bizjournals.com)
06/05/08 4:06 pm	NovaStar says creditors could prompt bankruptcy (at bizjournals.com)
01/15/08 7:01 am	[$$] This Time the Customers Won (at RealMoney by TheStreet.com)
01/14/08 3:01 pm	NOVASTAR FINANCIAL INC Files SEC form 8-K, Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Stan (EDGAR Online)
01/11/08 1:01 pm	NOVASTAR FINANCIAL INC Files SEC form 8-K, Costs Associated with Exit or Disposal Activities (EDGAR Online)
01/10/08 5:01 pm	NOVASTAR FINANCIAL INC Files SEC form 8-K/A, Change in Directors or Principal Officers, Financial Statements and Exhi (EDGAR Online)
01/10/08 5:01 pm	NOVASTAR FINANCIAL INC Files SEC form 8-K, Entry into a Material Definitive Agreement, Termination of a Material Defi (EDGAR Online)
01/08/08 5:01 pm	NOVASTAR FINANCIAL INC Files SEC form 8-K, Change in Directors or Principal Officers, Financial Statements and Exhibi (EDGAR Online)
01/02/08 8:01 pm	2007 Small-Cap Winners And Losers (at Forbes.com)
01/02/08 11:01 am	What Happens When the Boom Goes Bust? (at Motley Fool)