Subprime lender NovaStar Financial Inc. will cut 17 percent of its workforce, laying off 350 workers at its Kansas City, Mo., headquarters, and at operations centers in California and Ohio.

The job cuts, to be completed by the second quarter, target NovaStar’s wholesale loan originations and do not affect loan servicing, the company said. The layoffs are expected to cost the company up to $3.1 million this quarter but reduce long-term costs.

In their annual report to shareholders, NovaStar executives said performance of its 2006 loans had dropped to “unacceptable levels,” blaming the downturn in the housing market and the company’s own underwriting guidelines and tolerance for inflated appraisals. The company reported profits declined from $132.5 million in 2005 to $66.3 million in 2006.

NovaStar has been subject to increased repurchase demands as a result of borrower fraud and early payment defaults, the company said. The lender said it was tightening underwriting guidelines, stepping up its review of appraisals, and working to identify loans with unacceptable levels of risk.

“While we have taken steps to enhance our underwriting policies and procedures, there can be no assurance that these steps will be effective,” the company said. Those steps were also expected to reduce NovaStar’s loan origination and purchase volumes.

Most of NovaStar’s loan production is securitized and sold to Wall Street investors, who have the right to demand that the lender repurchase loans with defects in the loan origination process, such as misrepresentations by borrowers or loan officers. At the end of 2006, the outstanding balance of loans NovaStar had sold loans that were subject to such demands was $12.6 billion.

NovaStar also sold $2.2 billion in loans to third parties in 2006 that were subject to repurchase demands, up from $1.1 billion in 2005. NovaStar paid $21.3 million to repurchase loans sold to third parties in 2006, compared with $2.3 million in 2005. The company maintained reserves of $24.8 million at the end of the year for loan buybacks.

Cash-out refinance loans made up about 65 percent of NovaStar’s loan production in 2006, the company said, a business that suffers when interest rates rise and home prices decline, the company warned investors.

NovaStar originated and purchased 62,747 nonconforming loans in 2006 totaling $11.2 billion, up from $9.3 billion in 2005. The average loan-to-value ratio was 82 percent, the average FICO score was 633, and 62 percent included prepayment penalties.

The $1.4 billion in interest-only loans originated in 2006 accounted for 13 percent of the lender’s total originations. Those loans allow borrowers to put off paying principal for two, three or 10 years. The likelihood that NovaStar will incur a loss on such loans increases in a declining real estate market, the company said.

Some 12 percent of NovaStar’s total originations were pay-option ARMs or negative-amortization loans, with rates that begin adjusting after one to three months. Borrowers can avoid paying the full interest payment for at least one year. NovaStar said its underwriting standards include a requirement that borrowers be able to pay the loans back at the fully indexed rate.

Friday’s announcement of job cuts came the same week the company announced bonuses for top executives.

CEO Scott F. Hartman and President and Chief Operating Officer W. Lance Anderson were each compensated $1.6 million in 2006, including $474,534 in bonuses and stock options and awards valued at $442,605. David A. Pazgan, chief executive officer of subsidiary NovaStar Mortgage, was paid $1.05 million, including a $300,000 bonus and stock options and awards valued at $348,171.

In addition, seven executives were granted options to buy 492,204 shares of stock at $4.18 per share. The stock was trading Monday afternoon near its $5.90 Friday closing price.

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