1025953--3/15/2006--NOVASTAR_FINANCIAL

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Risks Related to Our Borrowing and Securitization 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. Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations. Financing with warehouse repurchase agreements may lead to margin calls if the market value of our mortgage assets declines. We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities. Competition in the securitization market may negatively affect our net income. 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. Changes in accounting standards might cause us to alter the way we structure or account for securitizations. Risks Related to Interest Rates and Our Hedging Strategies Changes in interest rates may harm our results of operations. Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available 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 would result in higher loan losses. 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. Our Option ARM mortgage product exposes us to greater credit risk 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 reduce our earnings, dividends, cash flows, access to liquidity and 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. To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses. Uninsured losses due to the Gulf State hurricanes could adversely affect our financial condition and results of operations. 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 mortgage loans, which could harm our earnings. If lenders are prohibited from originating loans in the State of Illinois with fees in excess of 3% where the interest rate exceeds 8%, this could force us to curtail operations in Illinois. We are no longer able to rely on the Alternative Mortgage Transactions Parity Act to preempt certain state law restrictions on prepayment penalties, which could harm our earnings. 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 fail to maintain REIT status, we would be subject to tax 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. 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. Past issuances of our common stock pursuant to our 401(k) plan and our Direct Stock Purchase and Dividend Reinvestment Plan may not have complied with the registration requirements of the securities laws. 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 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. Our inability to realize cash proceeds from loan sales and securitizations in excess of the loan acquisition cost could harm our financial position. Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs. 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. 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 stockholders to sell their common stock at favorable prices.

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1025953--3/15/2006--NOVASTAR_FINANCIAL_INC