1025953--3/1/2007--NOVASTAR_FINANCIAL

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Risks Related to Securitization, Loan Sale, and Borrowing Activities Our growth is dependent on leverage, which may create other risks. An interruption or reduction in the securitization market or our ability to access this market would harm our financial position. We may not be able to continue to sell our mortgage loans on terms and conditions that are profitable to us. Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our business. A decline in the market value of mortgage assets financed under our warehouse finance arrangements may result in margin calls or similar obligations, which may require that we liquidate assets at a disadvantageous time. We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could harm our liquidity, results of operations and financial condition. Our investments in mortgage securities and loans are subject to changes in credit spreads which could adversely affect our ability to realize gains on the sale of such investments and may subject us to margin calls or similar liquidity requirements. We retain and assume credit risk under a variety of mortgage securities and similar assets in connection with and as a result of our securitization activities. Significant losses on these assets reduce our earnings, negatively affect our liquidity, and otherwise negatively affect our business. Credit results with respect to mortgage assets underlying our securitizations may negatively affect our access to the securitization market on favorable terms, which in turn would harm our financial condition and prospects. Competition in the securitization market may erode our securitization margins, which in turn may adversely affect or harm our financial condition and prospects. Differences in our actual experience compared to the assumptions that we use to determine the value of our residual mortgage securities could adversely affect our financial position. Changes in accounting standards might cause us to alter the way we structure or account for securitizations. The rate at which we are able to acquire eligible mortgage loans or mortgage securities and changes in market conditions during asset accumulation may adversely affect our anticipated returns from the securitization of these assets. Market factors may limit our ability to originate and acquire mortgage assets at yields that are favorable relative to costs. We have recently imposed stricter mortgage loan and borrower requirements, which may result in a decrease in our mortgage loan origination and purchase volumes and, consequently, our loan sale and securitization volumes. Risks Related to Interest Rates and Our Hedging Strategies Changes in interest rates may harm our results of operations and equity value. Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for operations and for distribution to our shareholders. Complying with REIT requirements may limit our ability to hedge effectively. Risks Related to Credit Losses and Prepayment Rates Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and default rates which will result in higher loan losses. We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other third parties. Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be harmed if the demand for this type of refinancing declines. 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. Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses. Investments in diverse types of assets and businesses could expose us to new, different, or increased risks. The federal banking agencies final guidance on nontraditional mortgage products may impact our ability to originate, buy, or sell certain nontraditional mortgage loans. Our interest-only loans may have a higher risk of default than our fully-amortizing loans. Current loan performance data may not be indicative of future results. Changes in prepayment rates of mortgage loans could adversely affect the return that we are able to achieve on our assets. Geographic concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas. To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses. A prolonged economic slowdown or a decline in the real estate market could harm our results of operations. 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. We are subject to the risk that provisions of our loan agreements may be unenforceable. We are exposed to the risk of environmental liabilities with respect to properties to which we take title. Regulation as an investment company could harm our business; efforts to avoid regulation as an investment company could limit our operations. Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to, mortgage lending, loan servicing, broker compensation programs, or other aspects of our business could harm our operations and profitability. New legislation could restrict our ability to make, finance and sell mortgage loans, could increase our compliance and origination costs, and could expose us to lawsuits and compliance actions, any of which could harm our earnings and business prospects. We are subject to significant legal and reputational risks and expenses under federal and state laws concerning privacy, use, and security of customer information. New regulatory actions affecting the mortgage industry may increase our costs and decrease our mortgage acquisition. Changes in Internal Revenue Service regulations regarding the timing of income recognition and/or deductions could materially adversely affect the amount of our dividends. If we do not maintain our REIT status, we would be subject to tax as a regular corporation and would otherwise operate as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements. Our cash balances and cash flows may become limited relative to our cash needs, which may ultimately affect our REIT status or solvency. The tax imposed on REITs engaging in prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing loans, which would be treated as sales for federal income tax purposes. Even if we qualify as a REIT, the income earned by our taxable REIT subsidiaries will be subject to federal income tax and we could be subject to an excise tax on non-arm s-length transactions with our taxable REIT subsidiaries. We may be harmed by changes in tax laws applicable to REITs or the reduced 15% tax rate on certain corporate dividends may harm us. We may be unable to comply with the requirements applicable to REITs or compliance with such requirements could harm our financial condition. We could lose our REIT status if more than 20% of the value of our total assets are represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter. Risks Related to Our Capital Stock Investors in our common stock may experience losses, volatility and poor liquidity, and we may reduce or delay payment of our dividends in a variety of circumstances. We may not pay common stock dividends to stockholders. Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities. The market price of our common stock and trading volume may be volatile, which could result in substantial losses for our shareholders. Our common stock may become illiquid if an active public trading market cannot be sustained, which could adversely affect the trading price and your ability to transfer our common stock. We may issue additional shares that may cause dilution and may depress the price of our common stock. Other Risks Related to our Business Intense competition in our industry may harm our financial condition. If we are unable to maintain and expand our network of independent brokers, our loan origination business will decrease. Our reported GAAP financial results differ from the taxable income results that drive our common stock dividend distributions, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret. If we attempt to make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits. The inability to attract and retain qualified employees could significantly harm our business. The success and growth of our business will depend upon our ability to adapt to and implement technological changes. Our business could be adversely affected if we experienced an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive. We may enter into certain transactions at the REIT in the future that incur excess inclusion income that will increase the tax liability of our shareholders. Some provisions of our charter, bylaws and Maryland law may deter takeover attempts, which may limit the opportunity of our shareholders to sell their common stock at favorable prices. Strategies undertaken to comply with REIT requirements under the Code may create volatility in future reported GAAP earnings.

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1025953--3/1/2007--NOVASTAR_FINANCIAL_INC