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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10 -K
/X/ Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the year ended December 31, 1999
OR
/ / Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
Commission file number: 001-13417
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND 13-3950486
(State or other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
90 WEST STREET, SUITE 2210, NEW YORK, NY 10006
(Address of principal executive offices) (Zip Code)
(212) 732-5086
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.01 Par Value per Share - American Stock Exchange
Warrants - American Stock Exchange
Units - American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
---
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. / /
The aggregate market value of common stock held by nonaffiliates of the
registrant as of March 17, 2000 was approximately $20,394,000 (based on closing
sales price of $3.50 per share of common stock as reported for the American
Stock Exchange) on March 17, 2000.
The registrant had 5,826,899 shares of common stock outstanding as of
March 17, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement to be delivered to shareholders in
connection with the Annual Meeting of Shareholders to be held May 18, 2000 are
incorporated by reference into Part III.
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HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED DECEMBER 31, 1999
INDEX
PART I PAGE
----
Item 1. Business.................................................................................. 2
Item 2. Properties................................................................................ 27
Item 3. Legal Proceedings......................................................................... 27
Item 4. Submission of Matters to a Vote of Security Holders....................................... 27
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters..................... 28
Item 6. Selected Financial Data................................................................... 30
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..... 31
Item 7a. Quantitative and Qualitative Disclosure About Market Risk................................. 51
Item 8. Financial Statements and Supplementary Data............................................... 54
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures..... 54
PART III
Item 10. Directors and Executive Officers of the Registrant........................................ 55
Item 11. Executive Compensation.................................................................... 55
Item 12. Security Ownership of Certain Beneficial Owners and Management............................ 55
Item 13. Certain Relationships and Related Transactions............................................ 55
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 56
Signatures ......................................................................................... 57
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PART I
ITEM 1: BUSINESS
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") is a real estate investment
trust (also referred to as a "REIT") which is focused on the single-family
mortgage market. Hanover invests in single-family mortgage loan pools and
subordinate mortgage-backed securities and provides consulting and due diligence
services through its unconsolidated subsidiary, Hanover Capital Partners Ltd.
("HCP"). Additionally, Hanover is developing an internet-based mortgage whole
loan trading exchange through its unconsolidated subsidiary, HanoverTrade.com,
Inc. ("HTC"). Hanover is a Maryland corporation formed on June 10, 1997. Hanover
owns a 97% ownership interest (representing a 100% ownership of non-voting
preferred stock) in each of HCP and HTC.
The principal business strategy of Hanover and its wholly-owned subsidiaries
(together referred to as the "Company") is to (i) acquire primarily
single-family mortgage loans that are at least twelve months old or that were
intended to be of certain credit quality but that do not meet the originally
intended market parameters due to errors or credit deterioration, (ii)
securitize the mortgage loans and retain subordinated interests therein and
(iii) acquire subordinated mortgage backed securities ("MBS") similar in nature
to the retained interests generated from internal securitizations. The Company
acquires single-family mortgage loans through a network of sales representatives
targeting financial institutions throughout the United States.
The principal business strategy of the Company's primary unconsolidated
subsidiary, HCP, is to generate consulting and other fee income by (i)
performing loan file due diligence reviews for third parties, (ii) performing
loan sale advisory services, (iii) brokering and trading portfolios of loans,
and (iv) providing mortgage loan assignment services for third parties. Until
June 30, 1999, HCP was also engaged in the business of originating multifamily
and commercial loans. This business was discontinued in the quarter ended June
30, 1999 and substantially all charges associated with its discontinuance were
recognized in the quarter.
The principal business strategy of HanoverTrade.com, Inc. ("HTC") is to leverage
HCP's market position as a broker of whole-loan mortgage portfolios to develop a
real-time, internet-based trading exchange through which major participants in
the secondary mortgage market will be able to trade bulk pools of mortgage loans
among themselves.
The Company's third unconsolidated subsidiary, Hanover Capital Partners 2, Inc.
("HCP-2") was formed in October 1998 in connection with a securitization
transaction. The Company wrote off its investment in HCP-2 in September, 1999
and does not expect any material future revenue or expenses associated with
HCP-2.
The Company's principal business objective is to generate net interest income on
its portfolio of mortgage loans and mortgage securities, and to generate fee
income through HCP and HTC.
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The Company's principal executive offices are located at 90 West Street, Suite
2210, New York, New York 10006.
INVESTMENT PORTFOLIO
General
The primary business of the Company is investing, generally on a long-term
basis, in first lien single-family mortgage loans and mortgage-backed securities
secured by or representing an interest in mortgage loans. While the Company has
not done so to date, it may in the future also invest in multifamily mortgage
loans and commercial mortgage loans (single-family mortgage loans, mortgage
securities, multifamily mortgage loans and commercial mortgage loans
collectively referred to as the "Investment Portfolio"). The percentage of the
Company's mortgage-related assets which is invested in various sectors of the
Investment Portfolio may vary significantly from time to time depending upon the
availability of mortgage loans and mortgage securities.
The Company believes that its sales and due diligence organization and its
mortgage industry expertise gives it certain advantages over other mortgage
market participants. The Company uses its sales force to source mortgage loan
pools, and uses its due diligence organization to analyze the credit risk
characteristics of those pools. In addition, the Company acquires subordinate
mortgage backed securities that bear the credit risk of specific mortgage loan
pools. The Company uses its due diligence organization and industry expertise to
analyze the credit risk characteristics of these mortgage loan pools in order to
price these securities efficiently.
Trends and Recent Developments
Purchase of Subordinate MBS. As a result of the continued evolution of the
mortgage loan and MBS markets in which the Company operates, market conditions
in 1999 dictated a shift in the Company's strategy of acquiring mortgage loans
and mortgage-backed securities, as compared to 1997 and 1998. Whereas the
Company had previously focused primarily on acquiring seasoned mortgage loans,
in 1999 the Company focused primarily on acquiring subordinate MBS with
characteristics similar to the subordinate MBS that the Company created in its
first four securitizations.
Prior to 1999, the Company had primarily invested its funds in mortgage whole
loans, which were subsequently securitized. When the mortgage whole loans were
securitized, the Company retained a subordinate interest in the loans. These
subordinate interests are referred to as subordinate MBS. Other issuers also
create subordinate MBS, and these subordinate MBS trade in organized markets.
Historically, the Company invested only in subordinate MBS that were created by
the Company.
The market for subordinate MBS changed dramatically at the end of 1998 and in
early 1999, resulting in a substantial buying opportunity for the Company. As a
result of the market disruption, the Company found that it could purchase
subordinate MBS created by third party securitizers at very attractive yields.
In some cases these yields were higher than the yields the Company could obtain
by its previous practice of purchasing whole loans, securitizing them and
retaining the resulting subordinate MBS. Additionally, the Company's costs to
acquire
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subordinate MBS created by other issuers is substantially lower than the cost of
creating its own subordinate MBS.
As a result of these changes in the market, the Company attempted to take
advantage of the new market dynamic by curtailing its purchase of mortgage whole
loans and purchasing existing subordinate MBS instead. In 1999, the Company
purchased 12 subordinate MBS with an aggregate principal balance of $6,155,000,
at a net purchase price of $3,668,000. In addition, the Company's affiliate,
HCP, purchased 17 subordinate MBS with an aggregate principal balance of
$33,518,000, at a net purchase price of $14,123,000. The Company receives 97% of
the income attributable to the subordinate MBS purchased by its affiliate.
Third Quarter Charges. The Company also recognized $14,061,000 of charges and
expenses in the third quarter of 1999, the majority of which was the result of a
securitization transaction that the Company executed during substantial market
turmoil in October 1998. These charges are detailed in Note 17 to the financial
statements. The Company believes that these charges primarily resulted from the
unusual market conditions of October 1998.
Portfolio Composition
At December 31, 1999, the Company had invested $270,084,000 or 73.9% of the
Company's total assets in single-family mortgage loans classified as held for
sale, held to maturity and collateral for collateralized mortgage obligations
("CMOs"), and $62,686,000 or 17.2% of its total assets in single-family
mortgage-backed securities classified as available for sale, held to maturity or
held for trading. The composition of the investment portfolio is described in
detail in Notes 3 and 4 to the Company's audited financial statements. The
revenues, operating profit and loss from the Company's investing activity is
reflected on the Company's consolidated statement of operations.
In 1999, the Company experienced $58,000 of mortgage loan losses on its mortgage
loan portfolio (held for sale, held to maturity and collateral for CMOs), and
the Company did not experience any mortgage loan credit losses on its
mortgage-backed securities portfolio (available for sale, held to maturity and
trading). The Company experienced no mortgage loan losses during 1998.
Notwithstanding the low level of losses actually incurred, the Company recorded
a provision of $446,000 and $356,000 in 1999 and 1998.
In December 1997, the Company purchased 15 government agency adjustable rate
mortgage ("Agency ARM") securities from various "Wall Street" dealers and in
March of 1998 purchased a fixed rate FNMA certificate from another dealer firm.
The ARM securities were purchased at a price of 103.72% of par value or
$349,186,000 and the FNMA fixed rate mortgage security was purchased at a price
of 105.125% of par or $4,333,000. In October 1998, due to (1) market
dislocation, (2) desire to increase liquidity and decrease leverage and (3)
rapid prepayments experienced on the Agency ARM securities, the Company sold all
of its Agency ARM securities at a loss of $5,989,000. As of December 31, 1999,
the Company has not invested in any agency ARM securities.
The mortgage loans, created mortgage securities and, to a lesser extent, the
purchased mortgage securities held in the Investment Portfolio generally will be
held on a long-term basis, so that the returns will be earned over the lives of
the mortgage loans and mortgage securities rather than from sales of the
investments.
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Securitization Activity
In March 1999, the Company completed its third securitization transaction, the
"1999-A" securitization, and thereby transferred $138,357,000 (par value) of
mortgage loans to CMO collateral. In August 1999, the Company completed its
fourth securitization transaction, the "1999-B" securitization, and thereby
transferred $111,575,000 (par value) of mortgage loans to CMO collateral.
In April 1998, the Company completed its first securitization, the "1998-A"
securitization, and thereby transferred $103 million (par value) of mortgage
loans to CMO collateral. In August 1998, the Company converted approximately $17
million (par value) of adjustable rate mortgage loans into FNMA mortgage
securities, and in October and December the Company converted $56 million and
$55 million (par value) of fixed rate mortgage loans into FNMA mortgage
securities. In October 1998, the Company completed a $318 million (par value)
securitization accomplished as a real estate mortgage investment conduit
("REMIC") structure through a taxable subsidiary of the Company, HCP-2.
Simultaneously, the Company acquired from HCP-2 in exchange for all of the
preferred stock of HCP-2, through two newly created REIT qualified subsidiaries,
all of the investment grade securities, (except for the "AAA" rated securities),
the unrated securities, the interest-only securities and the principal only
securities from the security transaction.
The table below summarizes the Company's securitization transactions (dollars in
thousands):
SECURITIZATION TRANSACTIONS
Mortgage Principal Mortgage
Month Balance on Transaction Security
Completed Transaction Date Type Created
April 1998 $102,977 CMO structured as a REMIC Private Placement
August 1998 17,404 Swap FNMA
October 1998 317,764 REMIC Private Placement
October 1998 55,650 Swap FNMA
December 1998 55,208 Swap FNMA
March 1999 138,357 CMO Private Placement
August 1999 111,575 CMO Private Placement
Subordinate Mortgage Backed Securities Purchases
In analyzing subordinate MBS for purchase, the Company focuses primarily on
subordinated interests ("tranches") in pools of whole single-family mortgage
loans that do not fit into the large government-sponsored (FHA, FHLMC or GNMA)
conduits, typically because the principal balance of the mortgages exceeds the
maximum amount permissible in a government-agency guaranteed MBS. The Company
generally purchases subordinate MBS collateralized by "A" quality mortgages
originated by several of the largest non-government mortgage conduits in the
market. All of the Company's acquisitions of subordinate MBS to date have been
fixed rate.
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The subordinate tranches that the Company purchases are generally structured so
that they will absorb the credit losses resulting from a specified pool of
mortgages. Since these tranches could potentially absorb credit losses, the
tranches of securities the Company purchases are generally either not rated or
are rated below investment grade (generally "BB" or "B"). These tranches are
generally purchased at a substantial discount to their principal balance. This
discount provides a cushion against potential future losses, and, to the extent
that losses on the mortgage loans are less than the discount, the discount
provides a yield enhancement.
The Company primarily purchases subordinate MBS from "Wall Street" dealer firms,
although the Company also is attempting to develop direct relationships with the
larger issuers of subordinate MBS. For the foreseeable future, the Company
believes that there will be an adequate supply of subordinate MBS available in
the market.
At December 31, 1999, the Company (together with its affiliate, HCP) had
purchased since inception in excess of $39,673,000 (principal balance) of
subordinate MBS from third parties, representing subordinate interests in
approximately $6,887,000,000 (principal balance) of single-family mortgage loan
pools. The aggregate purchase price of these MBS was $17,781,000.
One of the Company's unconsolidated subsidiaries, HCP, has a due diligence and
consulting staff, located in Edison, New Jersey, consisting of approximately
thirty-four full-time employees and access to a part-time pool of employees in
excess of 600. The due diligence staff contributes to the subordinate MBS
acquisition process by providing expertise in the analysis of many
characteristics of the underlying single-family mortgage loans.
Because there are a number of regular issuers of subordinate MBS, the Company is
not dependent upon any one source. Note 5 to the financial statements describes
the concentration of the Company's portfolio by issuer. Management believes that
the loss of any single financial institution from which the Company purchases
subordinate MBS would not have any detrimental effect on the Company.
Prior to making an offer to purchase a subordinate MBS, HCP employees conduct an
extensive investigation and evaluation of the loans collateralizing the
security. This examination typically consists of analyzing the information made
available by the seller (generally, an outline of the portfolio with the credit
and collateral files for each loan in the pool), reviewing other relevant
material that may be available, analyzing the underlying collateral (including
reviewing the Company's single-family mortgage loan database which contains,
among other things, listings of property values and loan loss experience in
local markets for similar assets), and in certain instances obtaining opinions
of value from third parties. The Company's senior management determines the
amount to be offered for the security using a proprietary stratification and
pricing system which focuses on, among other things, rate, term, location,
credit scores and types of the loans. The Company also reviews information on
the local economy and real estate markets (including the amount of time and
procedures legally required to foreclose on real property) where the loan
collateral is located.
By examining the mortgage pool loan data, a prepayment speed is selected based
primarily upon the gross coupons and seasoning of the subject pool. The Company
also determines a "base case" default scenario and several alternative scenarios
based on the Public Securities Association's standard default assumption
("SDA"). The default scenarios reflect the
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Company's estimate of the most likely range of potential losses on the
underlying mortgage loans, taking into consideration the credit analysis
described above.
After determination of a prepayment speed and a base case SDA assumption, the
pools' cash flow stream is modeled. The proposed purchase price is calculated as
the present value of the base case cash flow stream, discounted by the current
market rate for securities with similar product type and credit characteristics.
The Company then examines the yield of the security under various alternative
SDA and prepayment assumptions, and if necessary, adjusts the proposed purchase
price so that it will receive an acceptable yield under a variety of possible
scenarios.
Single Family Mortgage Operations
Single-Family Mortgage Loans. In 1999, the Company did not purchase any mortgage
whole loans. However, the Company continues to monitor the relative value
available in the mortgage whole loan market vis-a-vis the subordinate MBS
market. To the extent that the Company is able to purchase and securitize
mortgage whole loans at attractive prices, the Company would attempt to do so,
creating attractive yields on the resulting subordinate MBS.
In analyzing potential whole loan pools for purchase, the Company focuses on
pools of whole single-family mortgage loans that do not fit into the large
government-sponsored (FHA, FHLMC or GNMA) or private conduit programs.
Single-family mortgage loans generally are acquired in pools from a wide variety
of sources, including private sellers such as banks, thrifts, finance companies,
mortgage companies and governmental agencies. The majority (77%) of the
Company's acquisitions of single-family mortgage loan pools to date have been
fixed rate loans, with the balance made up of adjustable rate mortgage ("ARM")
loans.
The Company uses five sales representatives from HCP, located in Illinois,
Minnesota, Massachusetts and New York, to source single-family mortgage loan
products. For the foreseeable future, the Company believes that there will be an
adequate supply of mortgage loan product that can be sourced by the existing HCP
sales force.
At December 31, 1999, the Company had purchased since inception in excess of $1
billion of single-family mortgage loan pools. Also, at December 31, 1999 the
Company did not have any commitments outstanding to purchase single-family
mortgage pools.
Because mortgage loan pools can be purchased from virtually any bank, insurance
company or financial institution, the Company is not dependent upon any one
source. During 1999, the Company did not purchase any mortgage loan pools.
During 1998, the Company purchased approximately 22% of the Company's
single-family mortgage loan portfolio from one source (Residential Funding
Corporation). Management believes that the loss of any single financial
institution from which the Company purchases mortgage loans would not have any
detrimental effect on the Company. The Company does not service its
single-family mortgage loans. The servicing is outsourced to unrelated third
parties specializing in single-family loan servicing.
Single-family mortgage loan pools are usually acquired through competitive bids
or negotiated transactions. The competition for larger single-family mortgage
loan portfolios is generally more intense, while there is less competition for
smaller single-family mortgage loan portfolios. Management believes that the
Company's funding flexibility, personnel, proprietary due
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diligence software and single-family mortgage loan trading relationships provide
it with certain advantages over competitors in pricing and purchasing certain
single-family mortgage loan portfolios.
The Company purchases mortgages in bulk, after its bid has been accepted,
subject to the Company's due diligence work. Prior to making an offer to
purchase a single-family mortgage loan portfolio, HCP employees conduct an
extensive investigation and evaluation of the loans in the portfolio. This
examination typically consists of analyzing the information made available by
the portfolio seller (generally, an outline of the portfolio with the credit and
collateral files for each loan in the pool), reviewing other relevant material
that may be available, analyzing the underlying collateral (including reviewing
the Company's single-family mortgage loan database which contains, among other
things, listings of property values and loan loss experience in local markets
for similar assets), and obtaining opinions of value from third parties (and, in
some cases, conducting site inspections). The Company's senior management
determines the amount to be offered for the portfolio using a proprietary
stratification and pricing system which focuses on, among other things, rate,
term, location, credit scores and types of the loans. The proprietary
stratification and pricing system identifies pool characteristics and segments
loans by product type (i.e., fixed or adjustable rate, interest rate change
frequency, ARM index, etc.). The segments are then further divided by credit
quality using a logic program, which uses credit bureau scores and other
criteria to grade loans within numerous categories. These categories include
subdivisions such as loans eligible for sale/securitization to Fannie Mae or
Freddie Mac (the "Agencies"), and further subdivisions of loans that only meet
some Agency requirements, loans without mortgage insurance, loans with certain
LTV and delinquency characteristics, etc.
Upon completion of the product segmentation and loan grading phase, the
resulting pools are individually priced and totaled to determine an overall
portfolio value. The effective pricing would require information on gross
weighted average coupon, servicing fee, original term, weighted average
maturity, remittance data, settlement data and ARM data (i.e., index, margin,
rate and payment reset frequency, etc.).
By examining the mortgage pool loan data, a prepayment speed is selected based
primarily upon the gross coupons and seasoning of the subject pool. After
determination of a prepayment speed, the pool's cash flow stream is modeled. The
present value of the cash flow stream is determined by discounting the cash flow
by the current market rate for loans with similar product type and credit
characteristics.
The Company also reviews information on the local economy and real estate
markets (including the amount of time and procedures legally required to
foreclose on real property) where the loan collateral is located.
HCP's due diligence staff contributes to the single-family mortgage loan
acquisition process by providing expertise in the analysis of many
characteristics of the single-family mortgage loans. It has been Management's
experience that buyers generally discount the price of a single-family mortgage
loan if there is a lack of information. By accumulating additional information
on loan pools through its due diligence operations, the Company believes it is
better able to assess the value of loan pools.
In conducting due diligence operations, HCP often discovers non-conforming
elements of single-family mortgage loans, such as: (i) problems with documents,
including missing or lost
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documentation, errors on documents, nonstandard forms of documents and
inconsistent dates between documents, (ii) problems with the real estate,
including inadequate initial appraisals, deterioration in property values or
economic decline in the general geographic area, and (iii) miscellaneous
problems, including poor servicing, poor credit history of the borrower, poor
payment history by the borrower and current delinquency status. The price paid
for such loans is adjusted to compensate for these non-conforming elements.
The Company maintains a process to improve the value of its single-family
mortgage loan portfolio, including updating data, obtaining lost note affidavits
in the event that a note has been misplaced, updating property values with new
appraisals, assembling historical records, obtaining mortgage insurance if the
value of a loan is in question, grouping similar loans in packages for
securitization, and segmenting portfolios for different buyers. However,
Management believes, in most cases, any value created will be extracted by
financing or securitizing the single-family mortgage loans and then realizing
the enhanced spread on the retained pool, as opposed to recognizing a gain on
sale of the single-family mortgage loan portfolio.
Single-Family Market Trends. The Company focuses on purchasing its mortgage
loans, which are generally available in bulk, from loan originators such as
mortgage bankers, banks and thrifts that originate primarily for sale and from
mortgage portfolio holders as they restructure their holdings.
Single-Family Acquisition Strategy. The Company believes that it can continue to
acquire single-family mortgage loans that have a relatively high yield when
compared to the applicable risk of loss. In many cases, portions of a pool may
be made eligible for inclusion in Agency pools, which will raise the credit
level of the Investment Portfolio, while preserving the higher yield obtained at
the time of purchase. In addition, the Company may securitize a single-family
mortgage loan pool. In structuring a securitization, the Company generally
retains subordinated or other interests (including, for example, interest only
tranches and principal only tranches). The investment grade tranches typically
are not retained.
Single-Family Underwriting Guidelines. The Company has developed an underwriting
approval policy to maintain uniform control over the quality of the
single-family mortgage loans it purchases. This policy sets forth a three step
review process: (i) collateral valuation, (ii) credit review, and (iii) property
valuation. Prior to final purchase of a portfolio, a senior manager of the
Company reviews the results of all three underwriting evaluations. The
collateral valuation entails a check on the collateral documents (i.e., the
note, mortgage, title policy and assignment chain). The documents are examined
for conformity among the documents and adherence to secondary market standards.
The credit review involves an analysis of the credit of the borrower, including
an examination of the origination and credit documents, credit report and
payment history. For more seasoned single-family mortgage loans, the analysis
may be more directed at payment histories and credit scores. The property
valuation involves an analysis of the loan-to-value of the collateral, including
an examination of the original appraisal in the context of the current regional
property market conditions and often a drive-by valuation of the subject
property and review of recent comparable sales.
Single-Family Servicing. Pools of single-family mortgage loans are purchased
with servicing retained or released by the seller. In the case of pools
purchased with servicing retained by the seller, the Company considers the
reputation and the servicing capabilities of the servicer. In
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some instances, the Company requires a master servicer to provide the assurance
of quality required. A master servicer provides oversight of its subservicers
and stands ready, and is contractually obligated, to take over the servicing if
there is a problem with the subservicer. In the case of pools purchased with
servicing released, the Company places the servicing with a qualified servicer.
In some cases, the Company may retain the servicing and contract with a
qualified servicer to provide subservicing. In this case, the Company keeps the
risk of ownership of the servicing with respect to any change in value as a
result of prepayment of the underlying single-family mortgage loans or other
factors. If the Company contracts out to a servicer the servicing of a mortgage
loan pool, the servicer's responsibilities would include collection of the
borrower's remittances, proper application of the borrower's remittances to
principal, interest and escrow, remitting collections to the master servicer and
remitting advances to the master servicer on delinquent loans (for principal and
interest only). The master servicer would then remit funds and loan level
documentation to the Company, or if the loan is securitized - to the trustee.
The trustee would then distribute the funds to the certificate holders. Neither
the Company nor any of its affiliates are involved in any single-family
servicing operations.
Commercial Mortgage Loans and Multifamily Mortgage Loans
The Company discontinued its commercial and multifamily mortgage origination
business in the second quarter of 1999. HCP's wholly-owned subsidiary, Hanover
Capital Mortgage Corporation ("HCMC"), has retained the relevant licenses
necessary to originate these mortgages, and may at some point decide to re-enter
this market. HCMC was one of the first commercial mortgage banking operations to
originate multifamily mortgage loans for sale to conduits, which are financial
firms (generally "Wall Street" firms) that purchase loans on real estate with
the specific intention to convert the underlying mortgages to securities in the
form of bonds.
Commercial and Multifamily Mortgage Loan Servicing. The Company continues to
service a very limited number of multifamily and commercial mortgages. HCMC, as
servicer, will have the risks associated with operating a mortgage servicing
business as well as the risk of ownership of the servicing.
HCMC serviced approximately $13 million and $46 million of multifamily mortgage
loans at December 31, 1999 and December 31, 1998. The servicing of mortgage
loans involves processing and administering the mortgage loan payments for a
fee. It involves collecting mortgage payments on behalf of investors, reporting
information to investors and maintaining escrow accounts for the payment of
principal and interest to investors and property taxes and insurance premiums on
behalf of borrowers.
The primary risk of operating a servicing business is failing to service the
loans in accordance with the servicing contracts, which exposes the servicer to
liability for possible losses suffered by the owner of the loans. The
operational requirements include proper handling and accounting for all payment
and escrow amounts, proper borrower and periodic credit reviews, proper value
and property reviews and proper payment of all monies due to third parties, such
as real estate taxing authorities and insurance companies.
The primary risks of ownership of servicing rights include the loss of value
through faster than anticipated loan prepayments (even though there may be
prepayment penalties) or improper servicing as outlined above.
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Commercial Market Trends. The market for commercial and multifamily mortgage
loans has undergone dramatic changes in recent years with the advent of
securitizations. Financing of income-producing property has evolved from a
traditional two-party lending relationship, with the borrower obtaining funding
from a traditional lending institution, to a market in which lenders with
expertise in the creation of mortgage-backed securities offer borrowers an
alternative source of competitive financing. Securitization involves multiple
parties, each with specialized roles and responsibilities creating profitable
lending opportunities for those with experience in commercial mortgage finance
and the capital markets. Securitizations of commercial and multifamily mortgage
loans have grown rapidly during the 1990's.
INVESTMENT PORTFOLIO ACQUISITIONS
The Company's core business strategy is to acquire or create subordinate
mortgage backed securities collateralized primarily by single-family mortgage
loans. The Company either acquires the mortgage backed securities outright, or
it acquires mortgage loans, securitizes the mortgage loans and retain the
subordinate mortgage backed securities created thereby. The process for
identifying possible mortgage backed securities or mortgage loan pools in the
secondary market for acquisition, bidding, due diligence and closing is time
consuming. Once a bid is accepted, the process to conclude a successful purchase
generally takes 30-60 days depending upon the complexity of each purchase.
During the accumulation period (ramp up period subsequent to Hanover's initial
public offering (IPO) in September 1997 to full investment of the proceeds of
the IPO) the Company could not invest exclusively in mortgage loans and
subordinate mortgage backed securities and instead chose to invest a portion of
its leveraged capital in Agency ARM securities. At December 31, 1997 the Company
had invested $348,131,000 or 67.3% of the Company's total assets in Agency ARM
securities, and $160,970,000 or 31.1% of the Company's total assets in mortgage
loans.
In October 1998, the Company sold off all of its Agency ARM securities at a loss
of $5,989,000. The sale of these mortgage securities was part of an action plan
taken by Management to reduce leverage and increase liquidity in response to the
severe unanticipated dislocation in the financial markets at that time. These
ARM mortgage securities, never the core business of the Company, suffered from
historically high prepayments, causing accelerated premium amortization and
depressed market pricing.
HANOVER CAPITAL PARTNERS LTD.
The Company conducts due diligence and consulting operations through HCP for
commercial banks, government agencies, mortgage banks, credit unions and
insurance companies. The operations consist of the underwriting of credit,
analysis of loan documentation and collateral, and analysis of the accuracy of
the accounting for mortgage loans serviced by third party servicers. The due
diligence analyses are performed on a loan by loan basis. Audits of the accuracy
of the interest charged on adjustable rate mortgage loans are frequently a part
of the due diligence services provided to customers. Consulting services include
loan sale advisory work and brokering of mortgage loans for third parties. HCP
also performs due diligence on mortgage loans acquired by the Company.
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HCP owns a licensed mortgage banker, HCMC, and a licensed broker-dealer, Hanover
Capital Securities, Inc. ("HCS"). Although HCP maintains these companies'
licenses in good standing, neither of these companies currently conduct any
material ongoing business. As noted above, HCMC originated multifamily mortgage
loans until June 1999, when this activity was discontinued, and continues to
service a small number of multifamily loans.
In January 2000, HCP hired all of the former management of Document Management
Network, Inc. ("DMN"), and is continuing DMN's business as the Document
Management Network division of HCP. DMN provides mortgage assignment services
for many of the same customers serviced by HCP. Whenever an institution
purchases a mortgage loan in the secondary market, the purchaser is required to
submit paperwork (called an "assignment of mortgage") to the local county or
city jurisdiction in which the mortgaged property is located in order to record
the new institution's interest in the mortgaged property. DMN employees prepare
and process this paperwork for third party institutions.
FINANCING
General
The Company's purchases of mortgage related assets are initially financed
primarily with equity and short-term borrowings through reverse repurchase
agreements until long-term financing is arranged or the assets are securitized.
Generally, upon repayment of each borrowing in the form of a reverse repurchase
agreement, the mortgage asset used to collateralize the financing will
immediately be pledged to secure a new reverse repurchase agreement or some form
of long term financing. The Company had established committed and uncommitted
mortgage asset financing agreements from various financial institutions at
December 31, 1999.
Reverse Repurchase Agreements
A reverse repurchase agreement ("repo"), although structured as a sale and
repurchase obligation, is a financing transaction in which the Company pledges
its mortgage assets as collateral to secure a short-term loan. Generally, the
other party to the agreement will loan an amount equal to a percentage of the
market value of the pledged collateral, typically 80% to 97%. At the maturity of
the reverse repurchase agreement, the Company is required to repay the loan and
correspondingly receives back its collateral. Under reverse repurchase
agreements, the Company generally retains the incidents of beneficial ownership,
including the right to distributions on the collateral and the right to vote on
matters as to which certificate holders vote. If the Company defaults in a
payment obligation under such agreements, the lending party may liquidate the
collateral.
In the event of the insolvency or bankruptcy of the Company, certain reverse
repurchase agreements may qualify for special treatment under the United States
Bankruptcy Code, which permits the creditor to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral without
delay. In the event of the insolvency or bankruptcy of a lender during the term
of a reverse repurchase agreement, the lender may be permitted, under the
Bankruptcy Code, to repudiate the contract, and the Company's claim against the
lender for damages therefrom may be treated simply as that of an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970 or an insured depository institution
subject to the Federal Deposit Insurance Act, the Company's ability to
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exercise its rights to recover its mortgage assets under a reverse repurchase
agreement or to be compensated for damages resulting from the lender's
insolvency may be limited by those laws. The effect of these various statutes
is, among other things, that a bankrupt lender, or its conservator or receiver,
may be permitted to repudiate or disaffirm its reverse repurchase agreements,
and the Company's claims against the bankrupt lender may be treated as an
unsecured claim. Should this occur, the Company's claims would be subject to
significant delay and, if and when paid, could be in an amount substantially
less than the damages actually suffered by the Company.
To reduce its exposure to the credit risk of reverse repurchase agreements, the
Company enters into arrangements with several different parties. The Company
monitors its exposure to the financial condition of its reverse repurchase
agreement lenders on a regular basis, including the percentage of its mortgage
loans that are the subject of reverse repurchase agreements with a single
lender. Notwithstanding these measures, no assurance can be given that the
Company will be able to avoid such third party risks.
The reverse repurchase borrowings bear short-term fixed (one year or less)
interest rates varying from LIBOR to LIBOR plus 238 basis points depending on
the credit of the related mortgage assets. Generally, the borrowing agreements
require the Company to deposit additional collateral in the event the market
value of existing collateral declines, which, in dramatically rising
interest-rate markets, could require the Company to sell assets to reduce the
borrowings.
There exists a risk during the initial holding of the mortgage loan assets, when
the mortgage loan assets are financed with repo agreements, that adverse
developments in the mortgage market could cause the repo lenders to reduce the
mark to market on the mortgage loans collateralizing the repo agreements. A
reduction in the repo lender's market value calculations could result in margin
calls that could be in excess of the Company's liquid assets. In this situation,
the Company might be forced to sell other portfolio assets to meet the repo
lender's margin call. There also exists a risk during the initial holding period
of the mortgage loan assets that there might be no demand or very limited demand
for the creation of new mortgage securitizations. If this situation were to
exist for an extended time period, the Company might be forced to maintain repo
financing on its mortgage assets for a longer than intended period, which might
cause repo financing availability to become more scarce and might cause repo
financing terms to become more onerous for the Company.
SECURITIZATION AND SALE PROCESS
General
When the Company acquires a sufficient volume of mortgage loans with similar
characteristics, generally $50 million to $100 million or more, the Company
normally securitizes the mortgage loans through the issuance of mortgage-backed
securities. Such securitization generally will be in the form of collateralized
mortgage obligations but may also be in the form of REMICs. Alternatively, to a
lesser extent and to the extent consistent with the Company's qualification as a
REIT, the Company may resell loans in bulk whole loan sales. The length of time
from when the Company commits to purchase a mortgage loan to when it sells or
securitizes the loan will generally range from 30 days to one year or more,
depending on certain factors, including the length of the purchase commitment
period, the amount and type of the mortgage loan, and the
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securitization process. Any decision by the Company to issue CMOs or REMICs or
to sell mortgage loans in bulk will be influenced by a variety of factors.
For accounting and tax purposes, mortgage loans financed through the issuance of
CMOs are treated as assets of the Company, and the CMOs are treated as debt of
the Company. The Company earns the net interest spread between the interest
income on the mortgage loans and the interest and other expenses associated with
the CMO financing. The net interest spread will be directly affected by
prepayments of the underlying mortgage loans and, to the extent the CMOs have
variable interest, may be affected by changes in short-term interest rates.
The Company may from time to time issue REMICs. REMIC transactions are generally
accounted for as sales of the mortgage loans for tax purposes and can be
accounted for as sales or financing for accounting purposes depending upon
various criteria. REMIC securities consist of one or more classes of "regular
interests" and a single "residual interest". The regular interests are tailored
to the needs of investors and may be issued in multiple classes with varying
maturities, average lives and interest rates. These regular interests are
predominantly senior securities but, in conjunction with providing credit
enhancement, may be subordinated to the rights of other regular interests. The
residual interest represents the remainder of the cash flows from the underlying
mortgage loans over the amounts required to be distributed on the regular
interests. In some cases, the regular interests may be structured so that there
is no significant residual cash flow. In such a REMIC transaction, the Company
sells its entire interest in the mortgage loans, and all of the capital
originally invested in the mortgage loans may be reinvested. The Company may
retain regular and residual interests on a short-term or long-term basis. Gain
on sale income from the issuance of REMICs may not qualify as acceptable REIT
income for tax purposes. Accordingly, REMIC issuances are not Hanover's primary
securitization technique and will generally be undertaken through the taxable
subsidiaries.
The Company expects that its retained interests in securitizations will be
subordinated to the securities issued to third party investors with respect to
losses of principal and interest on the underlying mortgage loans. Accordingly,
any such losses on underlying mortgage loans will be applied first to reduce the
remaining amount of the Company's retained interest, until reduced to zero. Any
retained regular interest may include "principal only" or "interest only"
securities or other interest rate or prepayment sensitive securities or
investments. Any retained securities may subject the Company to credit, interest
rate and/or prepayment risks. The Company anticipates it will retain securities
only on terms which it believes are sufficiently attractive to compensate it for
assuming the associated risks.
The Company may also retain subordinated mortgage backed securities, with
ratings ranging from AA to unrated, generally fixed-rate. The fixed-rate
securities generally evidence interests in 30-year single-family mortgage loans.
Securities backed by multifamily mortgage loans and commercial loans are
generally interests in 7 or 10 year balloon loans with 25 or 30 year
amortization schedules. In general, subordinated classes bear all losses prior
to the related senior classes. Losses in excess of losses anticipated at the
time subordinated securities are purchased would adversely affect the Company's
yield on the securities and could result in the failure of the Company to recoup
its initial investment.
Except in the case of breach of the representations and warranties made by the
Company when mortgage loans are securitized, the securitization of mortgage
loans will be non-recourse to the Company. As a result, the Company is able to
maintain the economic benefit of financing the
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mortgage assets and earning a positive net interest spread, while limiting its
potential risk of credit loss to its investment in the subordinated or residual
securities (generally approximately 5% to 10% of the loan pool amount). A second
advantage to the CMO structure is that it is permanent financing and, therefore,
not subject to margin calls during periods in which the value of the pool assets
is declining due to increases in interest rates.
The Company may also pay a monoline bond insurer a monthly fee to assume a
portion of the credit risk in a pool of mortgage loans. The monoline insurer
would generally require the issuer to retain a portion of the credit risk and
over-collateralize a particular pool of mortgage loans.
Proceeds from securitizations will be available to support new loan originations
and acquisitions. In addition to providing relatively less expensive long-term
financing, Management believes that the Company's securitizations will reduce
the Company's interest rate risk on mortgage assets held for long-term
investment.
Credit Enhancement
CMOs or REMICs created by the Company are structured so that one or more of the
classes of the securities are rated investment grade by at least one nationally
recognized rating agency. The ratings for the Company's mortgage assets will be
based on the rating agency's view of the perceived credit risk of the underlying
mortgage loans, the structure of the mortgage assets and the associated level of
credit enhancement. Credit enhancement is designed to provide protection to the
holders of the securities in the event of borrower defaults and other losses,
including reductions in the principal or interest as required by law or a
bankruptcy court. The Company can utilize multiple forms of credit enhancement,
including special hazard insurance, monoline insurance, reserve funds, letters
of credit, surety bonds and subordination or any combination thereof. A decline
in the credit quality of the mortgage loans backing any mortgage securities or
of any third party providing credit enhancement, or adverse developments in
general economic trends affecting real estate values or the mortgage industry,
could result in ratings being downgraded.
In determining whether to provide credit enhancement, the Company takes into
consideration the costs associated with each method. The Company generally
provides credit enhancement through the issuance of mortgage-backed securities
in senior/subordinated structures or by over-collateralization of its mortgage
assets. The need for additional collateral or other credit enhancements will
depend upon factors such as the type of collateral provided and the interest
rates paid thereon, the geographic concentration of the mortgaged property and
other criteria established by the rating agency. The pledge of additional
collateral would reduce the capacity of the Company to raise additional funds
through short-term secured borrowings or additional CMOs and will diminish the
ability of the Company to expand its Investment Portfolio. Accordingly,
collateral would be pledged for CMOs only in the amount required to obtain the
highest rating category of a nationally-recognized rating agency. The
subordinated mortgage securities may be sold, retained by the Company or
accumulated for sale in subsequent transactions.
Other Mortgage-Backed Securities
As an additional alternative for the financing of the Investment Portfolio, the
Company may cause to be issued other mortgage-backed securities if the issuance
of such other securities is
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advantageous and consistent with the Company's qualification as a REIT. In
particular, mortgage pass-through certificates representing undivided interests
in pools of mortgage loans formed by the Company may prove to be attractive
vehicles for raising funds.
The holders of mortgage pass-through certificates receive their pro rata share
of the principal payments made on a pool of mortgage loans and interest at a
pass-through interest rate that is fixed at the time of the offering. The
Company intends to retain significant portions of the undivided interests in the
mortgage loans underlying pass-through certificates. The retained interest may
also be subordinated so that, in the event of a loss, payments to certificate
holders will be made before the Company receives its payments. Unlike the
issuance of CMOs, the issuance of mortgage pass-through certificates will not
create an obligation of the Company to security holders in the event of a
borrower default. However, as in the case of CMOs, the Company may be required
to obtain credit enhancement in order to obtain a rating for the mortgage
pass-through certificates in one of the top two rating categories established by
a nationally-recognized rating agency.
CAPITAL ALLOCATION GUIDELINES (CAG)
The Company has adopted capital allocation guidelines ("CAG") in order to strike
a balance between the under-utilization of leverage and excess dependence on
leverage, which could reduce the Company's ability to meet its obligations
during adverse market conditions. Modifications to the CAG require the approval
of a majority of the Company's Board of Directors. The CAG are intended to keep
the Company's leverage balanced by (i) matching the amount of leverage to the
riskiness (return and liquidity) of each mortgage asset, and (ii) monitoring the
credit and prepayment performance of each mortgage asset to adjust the required
capital. This analysis takes into account the Company's various hedging and
other risk containment programs discussed below. In this way, the use of balance
sheet leverage is optimized through the implementation of the CAG controls. The
lender haircut indicates the minimum amount of equity the lender requires with a
mortgage asset. There is some variation in haircut levels among lenders from
time to time. From the lender's perspective, the haircut is a "cushion" to
protect capital in case the borrower is unable to meet a margin call. The size
of the haircut depends on the liquidity and price volatility of each mortgage
asset. Agency securities are very liquid, with price volatility in line with the
fixed income markets, which means a lender requires a smaller haircut, typically
3%. On the other extreme, securities rated below "AAA" and securities not
registered with the Securities and Exchange Commission are substantially less
liquid, and have more price volatility than Agency securities, which results in
a lender requiring a larger haircut (5% to 40% depending on the rating).
Particular securities that are performing below expectations would also
typically require a larger haircut. The haircut for residential whole loan pools
will generally range between 3% and 5% depending on the documentation and
delinquency characteristics of the pool. Certain whole loan pools may have
haircuts which may be negotiated with lenders in excess of 5% due to other
attributes of the pool (delinquencies, aging, liens etc.).
Implementation of the CAG -- Mark to Market Accounting
Each quarter, for financial management purposes, the Company marks its mortgage
assets to market. This process consists of (i) valuing the Company's mortgage
assets acquired in the secondary market, and (ii) valuing the Company's
non-security investments, such as retained interests in securitizations. For the
purchased mortgage assets, the Company obtains benchmark
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market quotes from traders who make markets in securities similar in nature to
the mortgage assets. The Company then adjusts for the difference in pricing
between securities and whole loan pools. Market values for the Company's
retained interests in securitizations are calculated internally using market
assumptions for losses, prepayments and discount rates.
The face amount of the financing used for the securities and retained interests
is subtracted from the current market value of the mortgage assets. This is the
current market value of the Company's equity positions. This value is compared
to the required capital as determined by the CAG. If the actual equity of the
Company falls below the capital required by the CAG, the Company must prepare a
plan to bring the actual capital above the level required by the CAG.
Periodically, Management presents to the Board of Directors the results of the
CAG compared to actual equity. Management may propose changing the capital
required for a class of investments or for an individual investment based on its
prepayment and credit performance relative to the market and the ability of the
Company to predict or hedge the risk of the mortgage asset.
As a result of these procedures, the leverage of the balance sheet will change
with the performance of the Company's mortgage assets. Good credit or prepayment
performance may release equity for purchase of additional mortgage assets,
leading to increased earnings. Poor credit or prepayment performance may cause
additional equity to be allocated to existing investments, forcing a reduction
in mortgage assets on the balance sheet and lower future earnings. In either
case, the constant mortgage asset performance evaluation, along with the
corresponding leverage adjustments, should help to maintain the maximum
acceptable leverage (and earnings) while protecting the capital base of the
Company.
RISK MANAGEMENT
The Company believes that its portfolio income is subject to three primary
risks: credit risk, interest rate risk and prepayment risk.
Credit Risk Management
The Company reduces credit risk through (i) the review of each mortgage-backed
security or mortgage loan prior to purchase to ensure that it meets the
guidelines established by the Company, (ii) use of early intervention,
aggressive collection and loss mitigation techniques in the servicing process,
(iii) use of insurance in the securitization process, (iv) maintenance of
appropriate capital and reserve levels, and (v) obtaining representations and
warranties, to the extent possible, from originators. Although the Company does
not set specific geographic diversification requirements, the Company closely
monitors the geographic dispersion of the mortgage loans and makes decisions on
a portfolio by portfolio basis about adding to specific concentrations.
Single-family mortgage loans are generally purchased in bulk pools of $2 million
to $100 million. The credit underwriting process varies depending on the pool
characteristics, including seasoning, loan-to-value ratios and payment
histories. For a new pool of single-family mortgage loans, a full due diligence
review is undertaken, including a review of the documentation, appraisal reports
and credit underwriting. Where required, an updated property valuation is
obtained. The bulk of the work is performed by employees in the due diligence
operations of HCP.
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Interest Rate Risk Management
For accounting purposes, the Company has three basic types of mortgage loans and
three basic types of MBS. Mortgage loans are classified as (i) mortgage loans
held for sale, (ii) mortgage loans held to maturity, or (iii) collateral for
CMOs. MBS are classified as (i) available for sale, (ii) held to maturity, or
(iii) held for trading. Fixed rate mortgage loans and MBS held for sale,
available for sale or held for trading are generally hedged. A variety of
hedging instruments may be used, depending on the asset or liability to be
hedged and the relative price of the various hedging instruments. Possible
hedging instruments include forward sales of mortgage securities, and may also
include interest rate futures or options, interest rate swaps, and caps and
floor agreements. Mortgage loans held in securitized form are generally financed
in a manner designed to maintain a consistent spread in a variety of interest
rate environments and therefore do not require any hedging.
The Company may purchase interest rate caps, interest rate swaps and similar
instruments to attempt to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its mortgage assets
during a period of rising interest rates. The Company generally hedges as much
of the interest rate risk as management determines is reasonable, given the cost
of such hedging transactions and the need to maintain the Company's status as a
REIT, among other factors. The Company may also, to the extent consistent with
its qualification as a REIT and Maryland law, utilize financial futures
contracts, options and forward contracts and other instruments as a hedge
against future interest rate changes. See "Business - Hedging."
Prepayment Risk Management
Prepayment risk is monitored by senior management and through periodic review of
the impact of a variety of prepayment scenarios on the Company's revenues, net
earnings, dividends, cash flow and net balance sheet market value.
Although the Company believes it has developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks, no strategy can completely insulate the Company from the
effects of interest rate changes, prepayments and defaults by counterparties.
Further, certain of the Federal income tax requirements that the Company must
satisfy to qualify as a REIT limit the Company's ability to fully hedge its
interest rate and prepayment risks.
HEDGING
Investment Portfolio
The Company's primary method of addressing interest rate risk on its mortgage
loans is through its strategy of securitizing mortgage loans with collateralized
mortgage obligation ("CMO") borrowings or REMIC financing, which are designed to
provide long term financing while maintaining a consistent spread in a variety
of interest rate environments. The Company believes that its primary interest
rate risk relates to MBS and mortgage loans that are financed with reverse
repurchase agreements and are held for securitization.
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The Company uses certain hedging strategies in connection with the management of
the Investment Portfolio. To the extent consistent with the Company's REIT
status, the Company follows a hedging program intended to protect against
interest rate changes and to enable the Company to earn net interest income in
periods of generally rising, as well as declining or static, interest rates.
Specifically, the goal of the hedging program is to offset the potential adverse
effects of changes in interest rates relative to the interest rates of the
mortgage assets held in the Investment Portfolio. As part of its hedging
program, the Company also monitors prepayment risks that arise in fluctuating
interest rate environments.
The Company may use a variety of instruments in its hedging program. One example
currently used is an interest rate cap. In a typical interest rate cap
agreement, the cap purchaser makes an initial lump sum cash payment to the cap
seller in exchange for the seller's promise to make cash payments to the
purchaser on fixed dates during the contract term if prevailing interest rates
exceed the rate specified in the contract. The Company may also use, but as yet
has not used, mortgage derivative securities. Mortgage derivative securities can
be used as effective hedging instruments in certain situations as the value and
yields of some of these instruments tend to increase as interest rates rise and
to decrease as interest rates decline, while the experience for others is the
converse. The Company will limit its purchases of mortgage derivative securities
to investments that meet REIT requirements. To a lesser extent, the Company may
also enter into, but again has not entered into, interest rate swap agreements,
financial futures contracts and options on financial futures contracts, and
forward contracts. However, the Company will not invest in these instruments
unless the Company is exempt from the registration requirements of the Commodity
Exchange Act or otherwise complies with the provisions of that Act. The REIT
rules may restrict the Company's ability to purchase certain instruments and may
restrict the Company's ability to employ other strategies. In all its hedging
transactions, the Company deals only with counterparties that the Company
believes are sound credit risks.
In connection with securitizations of mortgage loans, the Company is subject to
the risk of rising mortgage interest rates between the time it commits to a
fixed price purchase and the time it sells or securitizes the mortgage loans. To
mitigate this risk, the Company currently utilizes interest rate caps and
forward sales of Agency mortgage securities and may utilize other hedging
strategies, including mandatory and optional forward selling of mortgage loans
or mortgage-backed securities, interest rate floors, and buying and selling of
futures and options on futures. The nature and quantity of these hedging
transactions is determined by the management of the Company based on various
factors, including market conditions and expected volume of mortgage loan
purchases.
The Company also enters into interest rate hedge mechanisms (interest rate caps)
to manage its interest rate exposure on certain reverse repurchase agreement
financing. The cost of the interest rate caps is amortized over the life of the
interest rate cap and is reflected as a portion of interest expense in the
consolidated statement of operations.
Costs and Limitations
The Company believes that it has implemented a cost-effective hedging policy to
provide an adequate level of protection against interest rate risks. However,
maintaining an effective hedging strategy is complex, and no hedging strategy
can completely insulate the Company from interest rate risks. Moreover, as noted
above, certain of the REIT rules limit the Company's ability to fully hedge its
interest rate risks. The Company monitors carefully, and may have to
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limit, its hedging strategies to assure that it does not violate the REIT rules,
which could result in disqualification and/or payment of penalties.
In addition, hedging involves transaction and other costs, which can increase
dramatically as the period covered by the hedge increases and also increase in
periods of rising and fluctuating interest rates. Therefore, the Company may be
prevented from effectively hedging its interest rate risks without significantly
reducing the Company's return on equity.
SERVICING RIGHTS
Whether servicing is purchased by the Company (along with purchased
single-family mortgage loans or purchased multifamily mortgage loans and
commercial mortgage loans) or created by HCMC (by the origination of multifamily
mortgage loans and commercial mortgage loans), a value is placed on the
servicing as a purchased mortgage servicing right ("PMSR") or an originated
mortgage servicing right ("OMSR"), as the case may be, and recorded as an asset
on the books of the respective entity.
The valuation of a PMSR and an OMSR includes an analysis of the characteristics
of the size, rate, escrow amounts, type, maturity, etc. of the loan, as well as
an estimate of the mortgage loan's remaining life. To the extent the
characteristics change or the estimate of remaining life changes, the value of
the PMSR or OMSR will be adjusted. For example, if mortgage loans are repaid
more quickly than originally forecasted (increased speed), the value of the OMSR
or PMSR will be reduced.
REGULATION
Although HCMC does not currently originate mortgage loans, HCMC continues to
service a small number of loans and has retained its mortgage-banking licenses
in several states. In addition, the Company's activities are subject to the
rules and regulations of HUD. Mortgage operations also may be subject to
applicable state usury and collection statutes.
HCP's wholly owned subsidiary, Hanover Capital Securities, Inc., is a registered
broker/dealer with the Securities and Exchange Commission.
COMPETITION
The Company participates on a national level in the mortgage market, which is
estimated at $4.4 trillion for single-family mortgage loans and $1.0 trillion
for multifamily mortgage loans and commercial loans. In purchasing mortgage
loans and MBS and issuing mortgage-backed securities, the Company competes with
other REITs, established mortgage conduit programs, investment banking firms,
savings and loan associations, banks, thrift and loan associations, finance
companies, mortgage bankers, insurance companies, other lenders and other
entities purchasing mortgage assets. In addition, there are several mortgage
REITs similar to the Company and others may be organized in the future.
Continued consolidation in the mortgage banking industry may reduce the number
of sellers of mortgage loans, which would reduce the Company's potential
customer base and result in the Company purchasing a larger percentage of
mortgage loans from a smaller number of sellers. These changes could negatively
impact the Company. As an issuer of mortgage securities, the Company will face
competition for investors from other investment opportunities.
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Increasingly, mortgage lending is being conducted by mortgage lenders who
specialize in the origination and servicing of mortgage loans and then sell
these loans to other mortgage investment institutions, such as the Company. The
Company believes it has a competitive advantage because of the low cost of its
operations relative to traditional mortgage investors such as banks and savings
and loans. Like traditional financial institutions, the Company seeks to
generate income for distribution to its shareholders primarily from the
difference between the interest income on its mortgage assets and the financing
costs associated with carrying the mortgage assets.
EMPLOYEES
The Company had five employees (the "Principals") at December 31, 1999. The
Company engages the services of HCP to provide management expertise, product
sourcing, due diligence support, and general and administrative services to
assist the Company in accomplishing its business objectives. At December 31,
1999, HCP employed 34 people on a full-time basis and 24 people on a part-time
basis. HCP periodically hires additional employees on a temporary basis to
perform due diligence and consulting service work on specific engagements. HCP
maintains a database of approximately 600 individuals that can be employed for
due diligence and consulting engagements. To date, the Company and its
subsidiaries believe they have been successful in their efforts to recruit
qualified employees, but there is no assurance that it will continue to be
successful in the future. None of the employees are subject to collective
bargaining agreements.
TRADEMARKS
HCP owns two registered trademarks that have been registered with the United
States Patent and Trademark Office, each of which expires in the year 2003.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the Company's investment and operating
policies, which can be revised only with the approval of the Board of Directors,
including a majority of the unaffiliated directors. Except as otherwise
restricted, the Board of Directors may revise the policies without the consent
of stockholders if the Board of Directors determines that the change is in the
best interests of stockholders. Developments in the market which affect the
policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and financing strategies.
The Company has elected to qualify as a REIT for tax purposes (see "Federal
Income Tax Considerations"). The Company has adopted certain compliance
guidelines which include restrictions on the acquisition, holding and sale of
assets. Prior to the acquisition of any asset, the Company determines whether
the asset meets REIT requirements. Substantially all of the assets that the
Company has acquired and will acquire for investment are expected to qualify as
REIT assets. This requirement limits the Company's investment strategies.
The Company closely monitors its purchases of mortgage assets and the sources of
its income, including from its hedging strategies, to ensure at all times that
it maintains its qualifications as a REIT. The Company has developed certain
accounting systems and testing procedures to
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facilitate its ongoing compliance with the REIT provisions of the Code. No
changes in the Company's investment policies and operating strategies, including
credit criteria for mortgage asset investments, may be made without the approval
of the Company's Board of Directors, including a majority of the unaffiliated
directors.
The Company intends to conduct its business so as not to become regulated as an
investment company under the Investment Company Act of 1940. The Investment
Company Act exempts entities that are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate" ("Qualifying Interests"). Under current interpretation of the staff
of the Securities and Exchange Commission, in order to qualify for this
exemption, the Company must maintain at least 55% of its assets directly in
Qualifying Interests. In addition, unless certain mortgage securities represent
all the securities issued with respect to an underlying pool of mortgages, the
securities may be treated as securities separate from the underlying mortgage
pool and, thus, may not be considered Qualifying Interests for purposes of the
55% requirement. The Company closely monitors its compliance with this
requirement and intends to maintain its exempt status. As of this date, the
Company has been able to maintain its exemption through the purchase of mortgage
loan pools and certain whole pool government Agency securities that qualify for
the exemption.
A REIT is subject to a 100% tax on the net income from prohibited transactions.
The only "prohibited transaction" is the sale or disposition of property, that
is not foreclosure property, held primarily for sale to customers in the
ordinary course of a trade or business. Management believes that none of the
1998 or 1999 sales transactions would be classified as prohibited transactions.
RELATIONSHIPS WITH AFFILIATES AND PRIOR BUSINESS
HCP has rendered asset management services in connection with the short-term
trading of seasoned (more than one year since origination) single-family
mortgage loans since 1995. In managing mortgage activities, HCP typically
targeted mortgage loan pools containing single-family mortgage loans with
deficiencies that could be corrected so as to permit resales on favorable terms.
In managing sale activities, HCP generally had pursued a strategy of selling
single-family mortgage loans within eighteen months after their acquisition. The
Company, on the other hand, generally holds mortgage loans on a long-term basis,
so that returns are earned over the lives of mortgage loans rather than from
their sales.
In the past, HCP has engaged in single-family mortgage loan acquisition,
financing, hedging and sale activities pursuant to private management
arrangements with (i) Alpine Associates, a Limited Partnership ("Alpine
Associates"), (ii) a limited liability company formed by HCP, Alpine Associates
and an affiliate of Bankers Trust New York Corp. and (iii) certain affiliates of
Bankers Trust New York Corp. The objective in each of those arrangements was to
profit from purchasing and reselling mortgage loans rather than, as in the case
of the Company, from holding, financing and securitizing mortgage loans.
After the closing of the initial public offering in September 1997, the Company
acquired an Investment Portfolio, the composition of which has changed over
time. HCP has continued to conduct the due diligence and consulting operations
and, in addition, support the Company's acquisition and investment activities by
providing due diligence services to the Company. HCS facilitates the Company's
trading activities by acting as a broker/dealer.
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Management Agreement
Effective as of January 1, 1998, Hanover entered into a Management Agreement
(the "Management Agreement") with HCP. Under this agreement, HCP, subject to the
direction and control of Hanover's Board of Directors, provides certain services
for Hanover, including, among other things: (i) serving as Hanover's consultant
with respect to formulation of investment criteria and preparation of policy
guidelines by the Board of Directors; (ii) assisting Hanover in developing
criteria for the purchase of mortgage assets that are specifically tailored to
Hanover's investment objectives; (iii) representing Hanover in connection with
the purchase and commitment to purchase or sell mortgage assets; (iv) arranging
for the issuance of mortgage securities from a pool of mortgage loans; (v)
furnishing reports and statistical and economic research to Hanover regarding
Hanover's activities and the services performed for Hanover by HCP; (vi)
monitoring and providing to the Board of Directors on an ongoing basis price
information and other data; (vii) investing or reinvesting any money of Hanover
in accordance with its policies and procedures and the terms and conditions of
the Management Agreement; (viii) providing the executive and administrative
personnel office space and services required in rendering such services to
Hanover; and (ix) administering the day-to-day operations of Hanover. For these
services, Hanover each month pays HCP an amount equal to the sum of: (a) the
wages and salaries of the personnel employed by HCP and/or its affiliates (other
than independent contractors and other third parties rendering due diligence
services in connection with the acquisition of any mortgage assets) apportioned
to Hanover for such month; plus (b) twenty-five percent (25%) of (a). Hanover is
also required to pay HCP each month an amount equal to the sum of: (c) the
expenses of HCP for any services provided to the Company; plus (d) three percent
(3%) of (c). Effective July 1, 1999, the Management Agreement was amended to
define HCP's monthly expenses related to services provided to the Company to
include: rent; telephone; utilities; office furniture; equipment; machinery; and
other office expenses of HCP required for the Company's day-to-day operations,
including bookkeeping, clerical and back-office services provided by HCP. Any
amount that may become payable by HCP to Hanover for any services provided by
Hanover to HCP, including the services of the Principals, is offset against
amounts payable to HCP.
Subject to other contractual limitations, the Management Agreement does not
prevent HCP from acting as an investment advisor or manager for any other
person, firm or corporation. The term of the Management Agreement continues
until December 31, 2000 and is automatically renewed for successive one year
periods unless the unaffiliated directors resolve to terminate the Management
Agreement.
FEDERAL INCOME TAX CONSIDERATIONS
General
Hanover has elected to be treated as a REIT for tax purposes, pursuant to the
Internal Revenue Code of 1986, as amended (sometimes referred to as the "Code").
In brief, if certain detailed conditions imposed by the REIT provisions of the
Code are met, entities that invest primarily in real estate investments and
mortgage loans, and that otherwise would be taxed as corporations are, with
certain limited exceptions, not taxed at the corporate level on their taxable
income that is currently distributed to their shareholders. This treatment
eliminates most of the "double taxation" (at the corporate level and then again
at the shareholder level when the income is
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distributed) that typically results from the use of corporate investment
vehicles. In the event that Hanover does not qualify as a REIT in any year, it
would be subject to Federal income tax as a domestic corporation and the amount
of Hanover's after-tax cash available for distribution to its shareholders would
be reduced. Hanover believes it has satisfied the requirements for qualification
as a REIT since commencement of its operations in September 1997. Hanover
intends at all times to continue to comply with the requirements for
qualification as a REIT under the Code, as described below.
Requirements for Qualification as a REIT
To qualify for tax treatment as a REIT under the Code, Hanover must meet certain
tests which are described briefly below.
Ownership of Common Stock
For all taxable years after its first taxable year, Hanover's shares of capital
stock must be held by a minimum of 100 persons for at least 335 days of a 12
month year (or a proportionate part of a short tax year). In addition, at any
time during the second half of each taxable year, no more than 50% in value of
the capital stock of Hanover may be owned directly or indirectly by five or
fewer individuals. Hanover is required to maintain records regarding the actual
and constructive ownership of its shares, and other information, and to demand
statements from persons owning above a specified level of the REITs shares (if
Hanover has 200 or fewer shareholders of record, from persons holding 0.5% or
more of Hanover's outstanding shares of capital stock) regarding their ownership
of shares. Hanover must keep a list of those shareholders who fail to reply to
such a demand. Hanover is required to use (and does use) the calendar year as
its taxable year for income tax reporting purposes.
Nature of Assets
On the last day of each calendar quarter, Hanover must satisfy three tests
relating to the nature of its assets. First, at least 75% of the value of
Hanover's assets must consist of mortgage loans, certain interests in mortgage
loans, real estate, certain interests in real estate (the foregoing, "Qualified
REIT Assets"), government securities, cash and cash items. Hanover expects that
substantially all of its assets will continue to be Qualified REIT Assets.
Second, not more than 25% of Hanover's assets may consist of securities that do
not qualify under the 75% asset test. Third, of the investments in securities
not included in the 75% asset test, the value of any one issuer's securities may
not exceed 5% by value of Hanover's total assets, and Hanover may not own more
than 10% of any one issuer's outstanding voting securities.
On December 17, 1999, as part of a larger bill, the President signed into law
the REIT Modernization Act ("RMA"). Effective January 1, 2001, the RMA will
amend the tax rules relating to the composition of REIT's assets. Under current
law, a REIT is precluded from owning more than 10% of the outstanding voting
securities of any one issuer, other than a wholly owned subsidiary or another
REIT. Beginning in 2001, a REIT will remain subject to the current restriction
and be precluded from owning more than 10% of the value of all classes of
securities of any one issuer.
There is an exception to this prohibition. A REIT will be allowed to own up to
100% of the securities of a taxable REIT subsidiary ("TRS"). However, no more
than 20% of the value of a
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REIT's total assets may be represented by securities of one or more TRSs. The
amount of debt and rental payments from a TRS to a REIT will be limited to
ensure that a TRS is subject to an appropriate level of corporate tax. The new
10% asset test will not apply to certain arrangements (including third party
subsidiaries) in place on July 12, 1999, provided that the subsidiary does not
engage in a "substantial" new line of business, its existing business does not
increase, and a REIT does not acquire any new securities in the subsidiary.
Under the RMA, a third party subsidiary will be able to convert tax free into a
TRS.
Pursuant to its compliance guidelines, Hanover intends to monitor closely the
purchase and holding of its assets in order to comply with the above asset
tests.
Sources of Income
Hanover must meet the following two separate income-based tests each year:
1. 75% INCOME TEST. At least 75% of Hanover's gross income for the taxable year
must be derived from Qualified REIT Assets including interest on obligations
secured by mortgages on real property or interests in real property. During the
first year of operations certain temporary investment income will also qualify
under the 75% income test. The investments that Hanover has made and will
continue to make will give rise primarily to mortgage interest qualifying under
the 75% income test.
2. 95% INCOME TEST. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of Hanover's gross income for
the taxable year must be derived from those sources, or from dividends, interest
or gains from the sale or disposition of stock or other securities that are not
dealer property. Hanover intends to limit substantially all of the assets that
it acquires to Qualified REIT Assets. The policy of Hanover to maintain REIT
status may limit the types of assets, including hedging contracts and other
securities, that Hanover otherwise might acquire.
Distributions
Hanover must distribute to its shareholders on a pro rata basis each year an
amount equal to at least (i) 95% of its taxable income before deduction of
dividends paid and excluding net capital gains, plus (ii) 95% of the excess of
the net income from foreclosure property over the tax imposed on such income by
the Code, less (iii) certain "excess noncash income". Hanover intends to make
distributions to its shareholders in sufficient amounts to meet this 95%
distribution requirement.
Pursuant to the REIT Modernization Act ("RMA"), effective January 1, 2001, the
distribution of taxable income requirement a REIT will be reduced from 95% to
90%.
Taxation of Hanover's Shareholders
For any taxable year in which Hanover is treated as a REIT for Federal income
tax purposes, amounts distributed by Hanover to its shareholders out of current
or accumulated earnings and profits will be includable by the shareholders as
ordinary income for Federal income tax purposes unless properly designated by
Hanover as capital gain dividends. Distributions of Hanover will not be eligible
for the dividends received deduction for corporations. Shareholders
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may not deduct any net operating losses or capital losses of Hanover. Any loss
on the sale or exchange of shares of the common stock of Hanover held by a
shareholder for six months or less will be treated as a long-term capital loss
to the extent of any capital gain dividends received on the common stock held by
such shareholder.
If Hanover makes distributions to its shareholders in excess of its current and
accumulated earnings and profits, those distributions will be considered first a
tax-free return of capital, reducing the tax basis of a shareholder's shares
until the tax basis is zero. Such distributions in excess of the tax basis will
be taxable as gain realized from the sale of Hanover's shares. Hanover will
withhold 30% of dividend distributions to shareholders that Hanover knows to be
foreign persons unless the shareholder provides Hanover with a properly
completed IRS form claiming a reduced withholding rate under an applicable
income tax treaty.
Under the Code, if a portion of Hanover's assets were treated as a taxable
mortgage pool or if Hanover were to hold REMIC residual interests, a portion of
Hanover's dividends would be treated as unrelated business taxable income
("UBTI") for pension plans and other tax exempt entities. Hanover believes that
it has not engaged in activities that would cause any portion of Hanover's
income to be taxable as UBTI for pension plans and similar tax exempt
shareholders. Hanover believes that its shares of stock will be treated as
publicly offered securities under the plan asset rules of the Employment
Retirement Income Security Act ("ERISA") for Qualified Plans.
The provisions of the Code are highly technical and complex and are subject to
amendment and interpretation from time to time. This summary is not intended to
be a detailed discussion of all applicable provisions of the Code, the rules and
regulations promulgated thereunder, or the administrative and judicial
interpretations thereof. Hanover has not obtained a ruling from the Internal
Revenue Service with respect to tax considerations relevant to its organization
or operations.
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ITEM 2: PROPERTIES
The Company's and its unconsolidated subsidiaries operations are conducted in
several leased office facilities throughout the United States. A summary of the
office leases is shown below:
OFFICE MINIMUM
SPACE ANNUAL EXPIRATION
LOCATION (SQ. FT.) RENTAL DATE OFFICE USE
-------- --------- ------ ---- ----------
New York, New York (a) 7,863 $216,233 February 2010 Executive, Administration,
Accounting, Investment
Operations
Edison, New Jersey 5,834 78,874 June 2002 Accounting, Administration, Due
Diligence Operations, Mortgage
Loan Servicing, Investment
Operations
Chicago, Illinois 1,151 22,397 January 2004 Due Diligence Operations,
Investment Operations
Rockland, Massachusetts 300 6,000 Month to Month Investment Operations
St. Paul, Minnesota 150 4,200 August 2000 Investment Operations
------ --------
Total: 17,487 $343,400
====== ========
(a) HCP entered into an amendment to the existing office lease in December
1998 to relocate from its former office space (2,328 sq. ft.) to larger
office space (7,863 sq. ft.) in the same office building. Hanover took
occupancy of the new office space in November 1999.
Management of the Company believes that these facilities are adequate for the
Company's and its unconsolidated subsidiaries foreseeable office space needs and
that lease renewals and/or alternate space at comparable rental rates is
available, if necessary.
ITEM 3: LEGAL PROCEEDINGS
The Company is not engaged in any material legal proceeding.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
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PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In September 1997, Hanover raised net proceeds of approximately $79 million in
its initial public offering (the "IPO"). In the IPO, Hanover sold 5,750,000
units (each unit consists of one share of common stock, par value $.01 and one
stock warrant) including 750,000 units sold pursuant to the underwriters'
over-allotment option, which was exercised in full. Each warrant entitled the
holder to purchase one share of common stock at the original issue price -
$15.00. The strike price of the warrant was subsequently reset to $14.56. The
warrants became exercisable on March 19, 1998 and expire on September 15, 2000.
As of December 31, 1999, there were 5,917,878 warrants outstanding, including
172,500 warrants issued pursuant to the underwriters' over-allotment option.
Hanover utilized substantially all of the net proceeds of the IPO to fund
leveraged purchases of mortgage assets.
On September 19, 1997, the units began trading on the American Stock Exchange
under the trading symbol HCM.U or HCM/U. Commencing March 19, 1998, the warrants
became detachable from the common stock, and commencing March 20, 1998, the
common stock and warrants began trading separately on the American Stock
Exchange under the trading symbols HCM and HCM.WS, respectively. As of March 17,
2000, Hanover had 5,826,899 shares of common stock issued and outstanding, which
was held by 73 holders of record and approximately 1,839 beneficial owners.
The following tables set forth, for the periods indicated, the high, low and
closing sales price of Hanover's securities as reported on the American Stock
Exchange in 1998 and 1999.
UNIT PRICES
-----------
High Low Close
---- --- -----
Quarter Ended March 31, 1998 21 7/8 16 1/4 19 1/16
Quarter Ended June 30, 1998 20 13/16 10 5/8 10 5/8
Quarter Ended September 30, 1998 11 3/4 7 1/4 7 1/4
Quarter Ended December 31, 1998 7 1/4 3 1/2 4 3/16
Quarter Ended March 31, 1999 5 1/4 4 1/4 4 1/2
Quarter Ended June 30, 1999 5 5/8 4 3/8 5 1/4
Quarter Ended September 30, 1999 5 1/4 4 3/8 4 3/8
Quarter Ended December 31, 1999 4 3/8 3 3 1/8
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COMMON STOCK
------------
High Low Close
---- --- -----
Quarter Ended March 31, 1998 (a) 16 1/2 16 1/8 16 1/4
Quarter Ended June 30, 1998 17 3/8 9 1/2 9 1/2
Quarter Ended September 30, 1998 10 3/8 6 7/8 6 7/8
Quarter Ended December 31, 1998 6 7/8 3 1/2 4
Quarter Ended March 31, 1999 5 7/16 4 1/4 4 7/16
Quarter Ended June 30, 1999 6 4 1/8 5 3/8
Quarter Ended September 30, 1999 5 3/8 4 4
Quarter Ended December 31, 1999 4 3/8 3 1/4 3 5/8
WARRANTS
------------
High Low Close
---- --- -----
Quarter Ended March 31, 1998 (a) 3 7/8 3 1/8 3 1/8
Quarter Ended June 30, 1998 3 1/4 1 1/8 1 1/8
Quarter Ended September 30, 1998 1 3/8 3/16 3/16
Quarter Ended December 31, 1998 3/8 5/16 1/8
Quarter Ended March 31, 1999 1/4 1/16 1/8
Quarter Ended June 30, 1999 3/16 1/16 1/8
Quarter Ended September 30, 1999 1/8 1/32 1/16
Quarter Ended December 31, 1999 3/64 1/64 1/64
The following table sets forth, for the periods indicated, Hanover's dividends
declared for each quarter for the two most recent fiscal years:
DIVIDENDS
DECLARED
--------
Quarter Ended March 31, 1998 $0.21
Quarter Ended June 30, 1998 $0.21
Quarter Ended September 30, 1998 $0.17
Quarter Ended December 31, 1998 $0.11
Quarter Ended March 31, 1999 $0.20
Quarter Ended June 30, 1999 $0.10
Quarter Ended September 30, 1999 $0.10
Quarter Ended December 31, 1999 $0.10
(a) Common stock and warrants were first listed on the American Stock
Exchange on March 20, 1998.
Hanover intends to pay quarterly dividends and other distributions to its
shareholders of all or substantially all of its taxable income in each year in
order to qualify for the tax benefits accorded to a REIT under the Code. To the
extent that Hanover records capital gain income in future years, this income
does not need to be distributed as dividends to shareholders to the extent of
unutilized capital losses recorded (more than $6,500,000 as of December 31,
1999). All distributions will be made by Hanover at the discretion of the Board
of Directors and will depend on the earnings of Hanover, financial condition of
Hanover, maintenance of REIT status and such other factors as the Board of
Directors deems relevant.
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ITEM 6: SELECTED FINANCIAL DATA
The following selected financial data are derived from audited consolidated
financial statements of Hanover for the years ended December 31, 1999, December
31, 1998 and for the period from June 10, 1997 (inception) to December 31, 1997.
The selected financial data should be read in conjunction with the more detailed
information contained in the Consolidated Financial Statements and Notes thereto
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Form 10-K (dollars in thousands, except
per share data):
Period from
STATEMENT OF OPERATIONS HIGHLIGHTS Year Ended Year Ended June 10 (inception)
December 31, 1999 December 31, 1998 to December 31, 1997
----------------- ----------------- --------------------
Net interest income $ 4,408 $ 6,623 $ 1,676
Loan loss provision (446) (356) (18)
Gain (loss) on sale and mark-to-market (5,831) (5,704) 35
Provision for loss on unconsolidated subsidiary (4,793) -- --
----------- ----------- -----------
Total revenues (loss) (6,662) 563 1,693
Expenses 4,191 4,064 940
----------- ----------- -----------
Operating income (loss) (10,853) (3,501) 753
Equity in (loss) of unconsolidated subsidiaries (1,774) (1,433) (254)
----------- ----------- -----------
Net income (loss) $ (12,627) $ (4,934) $ 499
=========== =========== ===========
Basic earnings (loss) per share $ (2.12) $ (0.77) $ 0.15
=========== =========== ===========
Diluted earnings (loss) per share $ (2.12) $ (0.77) $ 0.14
=========== =========== ===========
Dividends declared per share $ 0.50 $ 0.70 $ 0.16
=========== =========== ===========
BALANCE SHEET HIGHLIGHTS December 31, December 31, December 31,
1999 1998 1997
---- ---- ----
Mortgage loans $ 270,084 $ 407,994 $ 160,970
Mortgage securities 62,686 78,478 348,131
Cash and cash equivalents 18,022 11,837 4,022
Other assets 14,694 17,861 4,420
----------- ----------- -----------
Total assets $ 365,486 $ 516,170 $ 517,543
=========== =========== ===========
Reverse repurchase agreements $ 55,722 $ 370,090 $ 435,138
CMO Borrowings 254,963 77,305 --
Other liabilities 4,443 2,995 4,307
----------- ----------- -----------
Total liabilities 315,128 450,390 439,445
----------- ----------- -----------
Stockholders' equity 50,358 65,780 78,098
----------- ----------- -----------
Total liabilities and stockholders' equity $ 365,486 $ 516,170 $ 517,543
=========== =========== ===========
Number of common shares outstanding 5,826,899 6,321,899 6,466,677
=========== =========== ===========
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland
on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to
operate as a specialty finance company. The principal business strategy of
Hanover and its wholly-owned subsidiaries (together referred to as the
"Company") is to (i) acquire primarily single-family mortgage loans that are at
least twelve months old or that were intended to be of certain credit quality
but that do not meet the originally intended market parameters due to errors or
credit deterioration, (ii) securitize the mortgage loans and retain interests
therein and (iii) acquire subordinated mortgage securities similar in nature to
the retained interests generated from internal securitizations. The principal
business strategy of the Company's primary unconsolidated subsidiary, Hanover
Capital Partners Ltd. ("HCP"), is to generate consulting fee income by (i)
performing loan file due diligence reviews for third parties, (ii) performing
loan sale advisory services and (iii) brokering and trading portfolios of loans.
Until recently, HCP was also engaged in the business of originating multifamily
and commercial loans. This business was discontinued in the quarter ended June
30, 1999.
The Company's principal business objective is to generate net interest income on
its portfolio of mortgage loans and mortgage securities, and to generate fee
income through HCP. The Company acquires single-family mortgage loans through a
network of sales representatives targeting financial institutions throughout the
United States. Hanover operates as a tax-advantaged REIT and is generally not
subject to Federal and state income tax to the extent that it distributes its
earnings to its stockholders and maintains its qualification as a REIT. Taxable
affiliates of Hanover, however, are subject to Federal and state income tax.
Hanover has engaged HCP to render due diligence, asset management and
administrative services pursuant to a Management Agreement.
The Company's generation of net income is dependent upon (i) the spread between
interest earned on its investment portfolio and the cost of borrowed funds to
finance the investment portfolio; and (ii) the aggregate amount of the
investment portfolio on the Company's balance sheet. The Company strives to
create a diversified portfolio of investments that in the aggregate generates
increasing net income in a variety of interest rate and prepayment rate
environments and preserves the equity base of the Company. The Company's primary
strategy for its mortgage loan investment portfolio entails (1) efficient
acquisition pricing of mortgage loans, (2) financing in the short term by
reverse repurchase agreements or lines of credit, (3) hedging in the short term
to offset potential adverse effects of changes in interest rates, (4)
stratifying and segregating mortgage loans in securitizations to replace short
term financing with collateralized mortgage obligations (CMO), real estate
mortgage investment conduits (REMIC) or other types of long term debt financing,
thereby eliminating the majority of refinancing and interest rate risk and (5)
retaining certain residual interests of the securitization resulting in
increased yields.
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RESULTS OF OPERATIONS
(dollars in thousands, except per share data)
Quarter Ended Year
----------------------------------------------------- Ended
Mar 31 Jun 30 Sept 30 Dec 31 Dec 31
1999 1999 1999 1999 1999
------- ------- -------- ------- --------
Net interest income (expense) $ 2,051 $ 1,733 $ (884) $ 1,508 $ 4,408
Loan loss provision (119) (113) (107) (107) (446)
Gain on sale of servicing rights 342 2 196 -- 540
Gain (loss) on sale of mortgage assets 163 -- (17) -- 146
Gain (loss) on mark to market of mortgage
securities and mortgage loans, net of
associated hedge -- -- (6,534) 17 (6,517)
Provision for (loss) on disposition of
unconsolidated subsidiary -- -- (4,793) -- (4,793)
------- ------- -------- ------- --------
Total revenues (loss) 2,437 1,622 (12,139) 1,418 (6,662)
Expenses 825 860 1,304 1,202 4,191
------- ------- -------- ------- --------
Operating income (loss) 1,612 762 (13,443) 216 (10,853)
Equity in (loss) of unconsolidated subsidiaries (876) (704) (551) 357 (1,774)
------- ------- -------- ------- --------
Net income (loss) $ 736 $ 58 $(13,994) $ 573 $(12,627)
======= ======= ======== ======= ========
Basic earnings (loss) per share $ 0.12 $ 0.01 $ (2.40) $ 0.10 $ (2.12)
======= ======= ======== ======= ========
Dividends declared per share (a) $ 0.20 $ 0.10 $ 0.10 $ 0.10 $ 0.50
======= ======= ======== ======= ========
Quarter Ended Year
----------------------------------------------------- Ended
Mar 31 Jun 30 Sept 30 Dec 31 Dec 31
1998 1998 1998 1998 1998
------- ------- -------- ------- --------
Net interest income (expense) $ 2,159 $ 774 $ 1,692 $ 1,998 $ 6,623
Loan loss provision (51) (97) (130) (78) (356)
Gain on sale of servicing rights -- -- -- -- --
Gain (loss) on sale of mortgage assets -- (49) -- (5,655) (5,704)
Gain (loss) on mark to market of mortgage
securities and mortgage loans, net of
associated hedge -- -- -- -- --
------- ------- -------- ------- --------
Provision for (loss) on disposition of
unconsolidated subsidiary -- -- -- -- --
------- ------- -------- ------- --------
Total revenues (loss) 2,108 628 1,562 (3,735) 563
Expenses 854 978 928 1,304 4,064
------- ------- -------- ------- --------
Operating income (loss) 1,254 (350) 634 (5,039) (3,501)
Equity in (loss) of unconsolidated subsidiaries (6) (294) (288) (845) (1,433)
------- ------- -------- ------- --------
Net income (loss) $ 1,248 $ (644) $ 346 $(5,884) $ (4,934)
======= ======= ======== ======= ========
Basic earnings (loss) per share $ 0.19 $ (0.10) $ 0.05 $ (0.93) $ (0.77)
======= ======= ======== ======= ========
Dividends declared per share (a) $ 0.21 $ 0.21 $ 0.17 $ 0.11 $ 0.70
======= ======= ======== ======= ========
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(a) The dividends relating to the three months ended December 31, 1999 were
declared on December 21, 1999.
The Company recorded a net loss of ($12,627,000) or ($2.12) per share based on
5,942,403 weighted shares of common stock outstanding for the year ended
December 31, 1999 compared to a net loss of ($4,934,000) or ($0.77) per share
based on 6,418,305 weighted shares of common stock outstanding for 1998. Total
revenues for the year ended December 31, 1999 were negative ($6,662,000)
compared to a positive $563,000 in 1998.
The 1999 revenues were negatively impacted by charges for (1) provision for loss
on the disposition of an unconsolidated subsidiary, Hanover Capital Partners 2,
Inc. ("HCP-2") of $4,793,000, (2) mark to market adjustments on mortgage
securities acquired from the Hanover 1998-B securitization of $3,537,000, (3)
mark to market adjustments on mortgage loans securitized in the August 1999
Hanover 1999-B securitization of $2,997,000 and (4) adjustments to the
investment portfolio's net interest income resulting primarily from cumulative
prepayment speed adjustments affecting amortization totaling $2,178,000. The
1999 revenues before these charges were $6,844,000.
By comparison, 1998 revenues of $563,000 included a loss of $5,989,000 on the
sale of adjustable rate mortgage securities in October, 1998. Revenues for 1998
before this loss were $6,552,000.
The Company's equity in losses of Hanover Capital Partners Ltd. ("HCP"), its
consulting subsidiary, declined from a loss of $1,039,000 in 1998 to a loss of
$443,000 in 1999. The Company believes that its increased focus on building fee
income revenue in HCP is beginning to bear fruit. Third party consulting and
loan brokering revenues at HCP increased from $3,500,000 in 1998 to $5,036,000
in 1999, and the Company recorded a profit of $383,000 from its equity in HCP in
the fourth quarter of 1999.
During 1999, the Company reflected equity in losses of HCP-2 of $1,300,000
compared to $394,000 in 1998. As noted above, the Company took a provision of
$4,793,000 in the quarter ended September 30, 1999 and recorded certain other
operating expenses in connection with its decision to sell HCP-2.
HCP-2 is an unconsolidated mortgage finance subsidiary that was organized in
October 1998 to execute a REMIC financing securitization for the Company. The
financing structure required certain costs of the securitization (net premiums,
hedging and deferred financing costs) to be capitalized in this subsidiary.
Substantially all of HCP-2's net equity ($4,473,000 at September 30, 1999)
consisted of these capitalized expenses. These deferred financing costs were
being amortized through net interest income (expense) over the anticipated life
of the respective mortgage loans and recorded by the Company in its economic
ownership percentage (99%) of this net loss through September 30, 1999. As a
result of the provision for the expected sale of HCP-2, the Company believes it
will not record future losses from HCP-2.
Also included in the equity in loss of unconsolidated subsidiaries is a $31,000
loss from a newly organized subsidiary - HanoverTrade.com, Inc. ("HTC"). HTC was
organized in June 1999 to develop an E-commerce business to broker mortgage loan
pools to financial institutions and other finance companies via the internet.
33
35
Operating expenses for the year ended December 31, 1999 were $4,191,000,
compared to $4,064,000 in 1998. The Company did not purchase any mortgage loans
during 1999, compared to 1998 when the Company purchased in excess of
$749,000,000 of mortgage loan pools. Accordingly, the Company incurred only a
fraction of the due diligence and commission expenses in 1999 ($124,000) as
compared to 1998 ($973,000) and experienced significantly lower financing and
commitment fees ($404,000 vs $836,000). Offsetting these cost savings were
substantial increases in legal and professional expenses ($1,201,000 vs
$545,000) and personnel expenses ($1,230,000 vs $712,000). Legal and
professional expenses increased substantially in 1999 compared to 1998 as a
result of increased regulatory filings and the negotiation of credit lines to
replace lines that were wound down during the liquidity crunch at the end of
1998. The increase in personnel expenses results primarily from the reallocation
of certain personnel expenses from HCP to the Company to better reflect the
proper allocation of the affected individuals' time, and from the addition of a
new chief financial officer in 1999.
The Management Agreement by and between Hanover and HCP, whereby HCP provides
Hanover due diligence, asset management and administrative services, was amended
in September 1999 (retroactive to July 1, 1999). The amendment reallocated
certain asset management and administrative service expenses between Hanover and
HCP to more accurately reflect current top management personnel expense and
certain other occupancy related charges. As a result of this amendment, the
Company recorded additional personnel and occupancy expenses that were
previously allocated to HCP. Hanover will continue to record similar expenses in
future periods. Also included in personnel expense in the third quarter of 1999
is approximately $103,000 of additional compensation expense paid to certain
employees of Hanover, relating to the provision for the forgiveness of certain
of their loans in connection with the write-off of HCP-2.
The Company's third quarter 1999 and 1998 operating expenses did not include any
incentive bonus compensation pursuant to the Company's incentive bonus plan. In
order for the eligible participants to earn incentive bonus compensation, the
rate of return on shareholders' investment must exceed the average ten-year U.S.
Treasury rate during the year plus 4.0%.
34
36
The table below highlights the Company's historical trends and components of
return on average equity.
COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY (1)
Gain (loss) on Other Equity in
Net Interest Sale of Gains or Operating Earnings (Loss) Annualized
For the Income/ Assets/ (Losses)/ Expenses/ of Subsidiaries/ Return on
Quarter Ended Equity Equity Equity Equity Equity Equity
------------- ------ ------ ------ ------ ------ ------
June 30, 1997 (2) 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
September 30, 1997 (3) 4.85% 0.00% 0.00% 3.59% 0.97% 2.23%
December 31, 1997 7.71% 0.18% 0.00% 4.26% (1.41%) 2.22%
March 31, 1998 10.78% 0.00% 0.00% 4.37% (0.03%) 6.38%
June 30, 1998 3.47% (0.25%) 0.00% 5.00% (1.50%) (3.28%)
September 30, 1998 8.23% 0.00% 0.00% 4.89% (1.52%) 1.82%
December 31, 1998 11.12% (32.76%) 0.00% 7.55% (4.89%) (34.08%)
March 31, 1999 11.36% 2.97% 0.00% 4.85% (5.15%) 4.33%
June 30, 1999 9.89% 0.01% 0.00% 5.25% (4.30%) 0.35%
September 30, 1999 (6.57%) 1.19% (75.10%) 8.65% (3.65%) (92.78%)
December 31, 1999 11.01% 0.00% 0.13% 9.46% 2.81% 4.51%
(1) Average equity excludes unrealized loss on investments available for
sale.
(2) The Company was organized on June 10, 1997, but did not begin
operations until September 19, 1997.
(3) Average equity for this period is based on the equity balance at
September 19, 1997 (IPO date) and the equity balance at September 30,
1997, excluding unrealized loss on investments available for sale.
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37
The following table reflects the average balances for each major category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities with the corresponding effective rate of interest annualized for the
periods shown below (dollars in thousands):
INTEREST EARNING ASSETS AND RELATED LIABILITIES
Quarter Ended Quarter Ended Quarter Ended Quarter Ended
March 31, 1999 June 30, 1999 September 30, 1999 December 31, 1999
Average Effective Average Effective Average Effective Average Effective
Balance Rate (1) Balance Rate (1) Balance Rate (1) Balance Rate (1)
------- -------- ------- -------- ------- -------- ------- --------
Interest earning assets:
Mortgage loans $246,329 7.092% $123,945 7.010% $ 41,034 2.704% $ 251 (9.243%)
CMO collateral 124,784 6.825% 204,469 7.076% 262,666 6.781% 279,928 7.202%
FNMA MBS 57,552 6.783% 53,619 6.930% 49,968 6.724% 46,930 6.979%
Private placement notes 18,334 15.069% 17,261 14.414% 18,643 (22.958%) 16,401 17.492%
-------- ------ -------- ------ -------- ------ -------- ------
446,999 7.306% 399,294 7.353% 372,311 4.835% 343,510 7.650%
-------- ------ -------- ------ -------- ------ -------- ------
Interest bearing liabilities:
Reverse repurchase borrowings on
mortgage loans 225,835 6.432% 113,125 6.150% 37,031 6.258% -- --
CMO borrowings 98,357 6.879% 191,858 6.791% 232,132 6.894% 262,354 6.960%
Reverse repurchase borrowings on:
CMO collateral 18,194 5.956% 1,518 6.379% 15,361 7.054% 3,366 8.030%
FNMA MBS 56,420 5.069% 52,559 5.388% 47,888 5.822% 38,534 5.890%
Private placement notes 4,037 5.455% 5,836 5.826% 4,243 5.845% 4,605 6.687%
-------- ------ -------- ------ -------- ------ -------- ------
402,843 6.319% 364,896 6.373% 336,655 6.701% 308,859 6.855%
-------- ------ -------- ------ -------- ------ -------- ------
Net interest earning assets $ 44,156 $ 34,398 $ 35,656 $ 34,651
======== ======== ======== ========
Net interest spread 0.986% 0.980% (1.866%) 0.796%
====== ====== ====== ======
Yield on net interest earning
assets (2) 16.303% 17.519% (12.598%) 15.176%
====== ====== ====== ======
Quarter Ended Quarter Ended Quarter Ended Quarter Ended
March 31, 1998 June 30, 1998 September 30, 1998 December 31, 1998
Average Effective Average Effective Average Effective Average Effective
Balance Rate (1) Balance Rate (1) Balance Rate (1) Balance Rate (1)
------- -------- ------- -------- ------- -------- ------- --------
Interest earning assets:
Mortgage loans $216,275 7.410% $370,811 7.371% $566,456 7.489% $465,445 7.392%
CMO collateral -- -- 92,272 7.158% 91,980 7.071% 86,477 6.230%
FNMA MBS 334,722 6.116% 281,933 3.992% 243,299 4.528% 59,492 5.446%
Private placement notes -- -- -- -- -- -- 13,446 16.662%
-------- ------ -------- ------ -------- ------ -------- ------
550,997 6.624% 745,016 6.066% 901,735 6.648% 624,860 7.246%
-------- ------ -------- ------ -------- ------ -------- ------
Interest bearing liabilities:
Reverse repurchase borrowings on
mortgage loans 166,882 6.318% 332,424 6.452% 523,403 6.377% 447,915 6.422%
CMO borrowings -- -- 88,069 6.901% 87,524 6.916% 80,522 6.926%
Reverse repurchase borrowings on:
CMO collateral -- -- 1,076 7.031% 203 6.145% 1,760 6.616%
FNMA MBS 324,305 5.597% 272,176 5.616% 241,388 5.826% 55,548 5.754%
Private placement notes -- -- -- -- -- -- 2,784 5.729%
-------- ------ -------- ------ -------- ------ -------- ------
491,187 5.842% 693,745 6.241% 852,518 6.364% 588,529 6.535%
-------- ------ -------- ------ -------- ------ -------- ------
Net interest earning assets $ 59,810 $ 51,271 $ 49,217 $ 36,331
======== ======== ======== ========
Net interest spread 0.782% (0.175%) 0.284% 0.711%
====== ====== ====== ======
Yield on net interest earning
assets (2) 13.046% 3.700% 11.562% 18.769%
====== ====== ====== ======
(1) Loan loss provisions are excluded in the above calculations.
(2) Yield on net interest earning assets is computed by dividing the
applicable net interest income by the average daily balance of net
interest earning assets.
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38
NET INTEREST INCOME (EXPENSE)
Net interest income for the year ended December 31, 1999 was $4,408,000 compared
to net interest income of $6,623,000 for 1998. The following table reflects net
interest income (expense) generated for each period (dollars in thousands):
NET INTEREST INCOME (EXPENSE) IN 1999
Quarter Ended
------------------------------------------------------------
March 31, June 30, September 30, December 31, Total
1999 1999 1999 1999 1999
------ ------- ------- ------- -------
Mortgage loans $ 736 $ 413 $ (314) $ (6) $ 829
CMO collateral 166 335 181 396 1,078
FNMA MBS 261 221 143 251 876
Private placement notes 637 537 (1,132) 640 682
Other 251 227 238 227 943
------ ------- ------- ------- -------
Total net interest income $2,051 $ 1,733 $ (884) $ 1,508 $ 4,408
====== ======= ======= ======= =======
NET INTEREST INCOME (EXPENSE) IN 1998
Quarter Ended
------------------------------------------------------------
March 31, June 30, September 30, December 31, Total
1998 1998 1998 1998 1998
------ ------- ------- ------- -------
Mortgage loans $1,371 $ 1,412 $ 2,076 $ 1,251 $ 6,110
CMO collateral -- 113 109 (77) 145
FNMA MBS 580 (1,050) (762) 11 (1,221)
Private placement notes -- -- -- 519 519
Other 208 299 269 294 1,070
------ ------- ------- ------- -------
Total net interest income $2,159 $ 774 $ 1,692 $ 1,998 $ 6,623
====== ======= ======= ======= =======
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39
Mortgage Loans Held for Sale and Held to Maturity
Net interest income generated from investments in mortgage loans (classified as
held for sale and held to maturity) during the years ended December 31, 1999 and
1998, respectively, is detailed below (dollars in thousands):
Mortgage Loans Held for Sale and Held to Maturity
Quarter Ended
-------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1999 1999 1999 1999
-------- -------- --------- ---------
Average asset balance $246,329 $123,945 $ 41,034 $ 251
Average repo borrowing balance 225,835 113,125 37,031 --
-------- -------- --------- ---------
Net interest earning assets $ 20,494 $ 10,820 $ 4,003 $ 251
Average leverage ratio 91.680% 91.270% 90.245% --
Effective interest income rate 7.092% 7.010% 2.704% (9.243%)
Effective interest expense rate 6.432% 6.150% 6.258% --
-------- -------- --------- ---------
Net interest spread 0.660% 0.860% (3.554%) (9.243%)
Interest income $ 4,367 $ 2,172 $ 278 $ (6)
Interest expense 3,631 1,759 592 --
-------- -------- --------- ---------
Net interest income (loss) $ 736 $ 413 $ (314) $ (6)
======== ======== ========= =========
Yield on net interest earning assets 14.369% 15.282% (31.376%) (9.243%)
Quarter Ended
-------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1998 1998 1998 1998
-------- -------- --------- ---------
Average asset balance $216,275 $370,811 $ 566,455 $ 465,445
Average repo borrowing balance 166,882 332,424 523,403 447,915
-------- -------- --------- ---------
Net interest earning assets $ 49,393 $ 38,387 $ 43,052 $ 17,530
Average leverage ratio 77.161% 89.648% 92.400% 96.234%
Effective interest income rate 7.410% 7.371% 7.489% 7.392%
Effective interest expense rate 6.318% 6.452% 6.377% 6.422%
-------- -------- --------- ---------
Net interest spread 1.092% 0.919% 1.112% 0.970%
Interest income $ 4,006 $ 6,833 $ 10,606 $ 8,602
Interest expense 2,635 5,421 8,530 7,351
-------- -------- --------- ---------
Net interest income $ 1,371 $ 1,412 $ 2,076 $ 1,251
======== ======== ========= =========
Yield on net interest earning assets 11.099% 14.712% 19.285% 28.543%
In 1999, the Company securitized substantially all of its remaining inventory of
mortgage loans. These loans were transferred from the held for sale category to
the CMO collateral category. Accordingly, the Company's net interest income from
mortgage loans held for sale and held to maturity declined to $829,000 in 1999
compared to $6,110,000 in 1998. The Company did not purchase any mortgage loans
in 1999. In 1998 the Company purchased in excess of $850,000,000 of mortgage
loans.
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40
Mortgage Loans - CMO Collateral
Net interest income generated from the Mortgage Loans - CMO collateral during
1999 and 1998 is detailed below (dollars in thousands):
Mortgage Loans - CMO Collateral
Quarter Ended
-------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1999 1999 1999 1999
-------- -------- --------- ---------
Average asset balance $124,784 $204,469 $ 262,666 $ 279,298
Average CMO borrowing balance 98,357 191,858 232,132 262,354
Average repo balance 18,194 1,518 15,361 3,366
-------- -------- --------- ---------
Net interest earning assets $ 8,233 $ 11,093 $ 15,173 $ 13,578
Average leverage ratio 93.402% 94.575% 94.223% 95.138%
Effective interest income rate 6.825% 7.076% 6.781% 7.202%
Effective interest expense rate 6.737% 6.789% 6.904% 6.974%
-------- -------- --------- ---------
Net interest spread 0.088% 0.287% (0.123%) 0.228%
Interest income $ 2,129 $ 3,617 $ 4,453 $ 5,029
Interest expense 1,963 3,282 4,272 4,633
-------- -------- --------- ---------
Net interest income $ 166 $ 335 $ 181 $ 396
======== ======== ========= =========
Yield on net interest earning assets 8.065% 12.080% 4.772% 11.659%
Quarter Ended
-------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1998 1998 1998 1998
-------- -------- --------- ---------
Average asset balance $ -- $ 92,272 $ 91,980 $ 86,477
Average CMO borrowing balance -- 88,069 87,524 80,522
Average repo balance -- 1,076 203 1,760
-------- -------- --------- ---------
Net interest earning assets $ -- $ 3,127 $ 4,253 $ 4,195
Average leverage ratio -- 95.445% 95.155% 93.113%
Effective interest income rate -- 7.158% 7.071% 6.230%
Effective interest expense rate -- 6.903% 6.915% 6.919%
-------- -------- --------- ---------
Net interest spread -- 0.255% 0.156% (0.689%)
Interest income $ -- $ 1,651 $ 1,625 $ 1,346
Interest expense -- 1,538 1,516 1,423
-------- -------- --------- ---------
Net interest income (expense) $ -- $ 113 $ 109 $ (77)
======== ======== ========= =========
Yield on net interest earning assets -- 14.413% 10.291% (7.346%)
In 1999, the Company securitized $249,932,000 (par value) of mortgage loans in
two securitizations. The securitizations were accomplished in a grantor/owner
trust format (CMO) through a wholly-owned subsidiary, Hanover SPC-A, Inc. The
transactions were accounted for as financings for both GAAP and tax accounting
purposes. In 1998, the company securitized $102,977,000 in a REMIC CMO format.
This transaction was accounted for as a financing for GAAP and a sale for tax.
In a GAAP financing, the Company continues to record 100% of the interest
income, net of servicing and other fees, generated by the mortgage loans. The
primary source of financing for these mortgage loans was the CMO borrowing.
These financings represent the liability for
39
41
certain investment grade mortgage notes issued by the Company. The interest
expense on this financing represents the coupon interest amount to be paid to
those note holders.
The Company's net equity in these transactions was leveraged through reverse
repurchase financing. At December 31, 1999 the Company had $3,366,000 of reverse
repurchase financing against its net equity in these transactions.
Interest expense includes the interest on CMO borrowings, interest on the
related reverse repurchase agreements and amortization of certain deferred
financing costs and interest rate caps.
40
42
FNMA Mortgage Securities
Net interest income in 1999 and 1998 generated from investments in FNMA mortgage
securities is detailed below (dollars in thousands):
FNMA Mortgage Securities
Quarter Ended
--------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1999 1999 1999 1999
-------- --------- --------- --------
Average asset balance $ 57,552 $ 53,619 $ 49,968 $ 46,930
Average repo borrowing balance 56,420 52,559 47,888 38,534
-------- --------- --------- --------
Net interest earning assets $ 1,132 $ 1,060 $ 2,080 $ 8,396
Average leverage ratio 98.033% 98.023% 95.837% 82.110%
Effective interest income rate 6.783% 6.930% 6.724% 6.979%
Effective interest expense rate 5.069% 5.388% 5.822% 5.890%
-------- --------- --------- --------
Net interest spread 1.714% 1.542% 0.902% 1.089%
Interest income $ 976 $ 929 $ 840 $ 819
Interest expense 715 708 697 568
-------- --------- --------- --------
Net interest income $ 261 $ 221 $ 143 $ 251
======== ========= ========= ========
Yield on net interest earning assets 92.226% 83.396% 27.500% 11.974%
Quarter Ended
--------------------------------------------------------------------
March 31, June 30, September 30, December 31,
1998 1998 1998 1998
-------- --------- --------- --------
Average asset balance $334,722 $ 281,933 $ 243,299 $ 59,492
Average repo borrowing balance 324,305 272,176 241,388 55,548
-------- --------- --------- --------
Net interest earning assets $ 10,417 $ 9,757 $ 1,911 $ 3,944
Average leverage ratio 96.888% 96.539% 99.215% 93.371%
Effective interest income rate 6.116% 3.992% 4.528% 5.446%
Effective interest expense rate 5.597% 5.616% 5.826% 5.754%
-------- --------- --------- --------
Net interest spread 0.519% (1.624%) (1.298%) (0.308%)
Interest income $ 5,118 $ 2,814 $ 2,754 $ 810
Interest expense 4,538 3,864 3,516 799
-------- --------- --------- --------
Net interest income $ 580 $ (1,050) $ (762) $ 11
======== ========= ========= ========
Yield on net interest earning assets 22.271% (43.054%) (159.498%) 1.116%
In August 1998, the Company exchanged $17.4 million of adjustable rate mortgage
loans for a like amount of mortgage securities in the form of five FNMA
certificates. All of these mortgage certificates were subsequently sold with
recourse in October 1998. In December 1998, the Company exchanged $55.2 million
of fixed rate mortgage loans (without recourse) for a like amount of mortgage
securities in the form of 31 FNMA certificates. In March 1998, the Company
purchased $4,122,000 of FNMA passthrough certificates from a Wall Street dealer
firm.
Interest expense includes the interest on the related reverse repurchase
agreements and amortization of deferred financing costs and interest rate caps.
41
43
Private Placement MBS
Net interest income (expense) generated from private placement mortgage-backed
securities is detailed below (dollars in thousands):
Private Placement MBS
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
1999 1999 1999 1999
------- ------- -------- -------
Average asset balance $18,334 $17,261 $ 18,643 $16,401
Average repo borrowing balance 4,037 5,836 4,243 4,605
------- ------- -------- -------
Net interest earning assets $14,297 $11,425 $ 14,400 $11,796
Average leverage ratio 22.019% 33.810% 22.759% 28.077%
Effective interest income rate 15.069% 14.414% (22.958%) 17.492%
Effective interest expense rate 5.455% 5.826% 5.845% 6.687%
------- ------- -------- -------
Net interest spread 9.614% 8.588% (28.803%) 10.805%
Interest income (expense) $ 692 $ 622 $ (1,070) $ 717
Interest expense 55 85 62 77
------- ------- -------- -------
Net interest income (expense) $ 637 $ 537 $ (1,132) $ 640
======= ======= ======== =======
Yield on net interest earning assets 17.784% 18.801% (31.444%) 21.710%
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
1998 1998 1998 1998
------- ------- -------- -------
Average asset balance $ -- $ -- $ -- $13,446
Average repo borrowing balance -- -- -- 2,784
------- ------- -------- -------
Net interest earning assets $ -- $ -- $ -- $10,662
Average leverage ratio -- -- -- 20.707%
Effective interest income rate -- -- -- 16.662%
Effective interest expense rate -- -- -- 5.729%
------- ------- -------- -------
Net interest spread -- -- -- 10.933%
Interest income $ -- $ -- $ -- $ 560
Interest expense -- -- -- 41
------- ------- -------- -------
Net interest income $ -- $ -- $ -- $ 519
======= ======= ======== =======
Yield on net interest earning assets -- -- -- 19.484%
The Private Placement MBS category includes (1) subordinate MBS, interest only
notes, and principal only notes that the Company created in its second
securitization, 1998-B, and (2) starting in June 1999, subordinate MBS that the
company purchased in the open market.
In October 1998, the Company completed its second private placement REMIC
securitization transaction, the 1998-B securitization. Hanover contributed
certain mortgage loan collateral to its newly organized unconsolidated
subsidiary, HCP-2. This had the effect of removing the mortgage loan collateral
from Hanover's balance sheet for GAAP and tax accounting purposes.
42
44
HCP-2 accounted for the transaction as a financing for GAAP and as a sale for
tax accounting purposes.
The Company's investment in 1998-B private placement MBS at December 31, 1999
includes a $13,567,000 investment in six investment grade ("AA", "A" and "BBB"),
six interest only notes, six below investment grade notes and three principal
only notes. The Company's investment in 1998-B private placement MBS at December
31, 1998 includes a $18,883,000 investment in the same securities plus three
additional investment grade subordinate MBS and three additional below
investment grade subordinate MBS.
The 1998-B interest only notes will be adversely affected more than other notes
by higher than expected prepayment speeds on underlying mortgage loans with
interest rates in excess of the net coupon rate. In all likelihood, mortgages
with higher interest rates will be repaid more rapidly than mortgages with lower
interest rates.
In the second quarter of 1999, the Company purchased twelve below investment
grade subordinate MBS from third parties. At December 31, 1999, these securities
had an aggregate book of value of $3,640,000.
Other interest income
Interest income generated during 1999 and 1998 from non-mortgage assets is
detailed below (dollars in thousands):
QUARTER ENDED Year
----------------------------------------------- Ended
Mar 31, Jun 30, Sept 30, Dec 31, Dec 31,
1999 1999 1999 1999 1999
---- ---- ---- ------ ------
Cash margin $ -- $ -- $ -- $ -- $ --
Overnight investing 199 169 146 84 598
Related party notes 52 58 92 143 345
---- ---- ---- ------ ------
$251 $227 $238 $ 227 $ 943
==== ==== ==== ====== ======
QUARTER ENDED Year
----------------------------------------------- Ended
Mar 31, Jun 30, Sept 30, Dec 31, Dec 31,
1998 1998 1998 1998 1998
---- ---- ---- ------ ------
Cash margin $109 $157 $173 $ -- $ 439
Overnight investing 81 82 3 209 375
Related party notes 18 60 93 85 256
---- ---- ---- ------ ------
$208 $299 $269 $ 294 $1,070
==== ==== ==== ====== ======
Interest income on cash deposited as additional cash collateral (cash margin)
pursuant to reverse repurchase financing agreements with certain lenders in 1998
earned interest at the respective borrowing rate charged by the lender. There
was no such activity in 1999.
Interest income recorded on overnight investing was generated for the most part
from investing excess cash in Federal Home Loan Bank discount notes and, to a
much lesser extent, investments in the highest rated commercial paper and
savings accounts. Interest rates on overnight investments ranged from 3.65% to
5.13%.
43
45
The Company had maintained a significantly higher liquidity balance in the first
three quarters of 1999 as compared to 1998. (Cash and cash equivalent balances
at December 31, 1999 and 1998 were $18,022,000 and $11,837,000, respectively.)
Accordingly, interest income generated from overnight investing was considerably
higher than in 1998. In the fourth quarter of 1999, excess cash was applied to
reduce borrowings against FNMA collateral.
Notes receivable due from HCP earn interest at the prime rate less one percent.
The balance due from HCP at December 31, 1999 and 1998 was $4,896,000 and
$713,000, respectively. Notes receivable due from Principals earn interest at
the lowest applicable Federal rate in effect at the time of the loan. The
balance due from Principals at December 31, 1999 and 1998 was $3,050,000 and
$3,180,000, respectively.
In September 1999 Hanover advanced $3,041,000 to HCP to fund the purchase of
certain third party private placement notes by HCP. This advance is included in
the notes receivable due from HCP at December 31, 1999.
TAXABLE INCOME
Hanover's taxable income for year ended December 31, 1999 is estimated at
$2,367,000. Taxable income differs from GAAP net (loss) for the year ended
December 31, 1999 due to various recurring and one time book/tax differences.
The following table details the major book/tax differences in arriving at the
estimated taxable income for the year ended December 31, 1999 (dollars in
thousands):
GAAP net (loss) $(12,627)
- ---------------
Recurring adjustments:
- ----------------------
Add: Equity in loss of unconsolidated
subsidiaries 1,774
Loan loss provision, net of realized losses 405
Difference in recognition on sales of
servicing rights and mortgage loans
and mortgage securities 230
Less: Tax amortization of net premiums
on mortgages, CMO collateral and
mortgage securities and interest accrual
in excess of GAAP amortization and
interest accrual (447)
Other (99)
Adjustments related to third quarter charges:
- ---------------------------------------------
Add: Realized loss on mark to market of
mortgage securities and mortgage loans 6,517
Provision for loss on disposition of
unconsolidated subsidiary (HCP-2) 4,793
Catch up amortization of net premiums
and deferred costs on CMO collateral
and mortgage securities 1,821
--------
Estimated taxable income $ 2,367
- ------------------------ ========
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As a REIT, Hanover is required to declare dividends amounting to 85% of each
year's taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of Hanover's taxable income for each year by the time
Hanover files its Federal tax return. Therefore, a REIT generally passes through
substantially all of its earnings to shareholders without paying Federal income
tax at the corporate level.
LIQUIDITY
With the completion of the 1999-B securitization and the concomitant reduction
of mortgage loans held for sale to close to zero, the Company believes it has
substantially reduced its exposure to liquidity events. The Company expects to
meet its future short-term and long-term liquidity requirements generally from
its existing working capital, cash flow provided by operations, reverse
repurchase agreements and other possible sources of financing, including CMOs
and REMICs. The Company considers its ability to generate cash to be adequate to
meet operating requirements both short-term and long-term.
The Company's remaining exposure to market-driven liquidity events is limited to
the short-term reverse repurchase financing it has in place against its
mortgage-backed securities. If a significant decline in the market value of the
Company's mortgage-backed securities portfolio should occur, the Company's
available liquidity from existing sources and ability to access additional
sources of credit may be reduced. As a result of such a reduction in liquidity,
the Company may be forced to sell certain investments in order to maintain
liquidity. If required, these sales could be made at prices lower than the
carrying value of such assets, which could result in losses.
The Company had two committed reverse repurchase agreement lines of credit in
place at December 31, 1999 and four uncommitted lines of credit. Management may
add additional committed and uncommitted lines of credit in the future.
Net cash provided by operating activities for the year ended December 31, 1999
was $2,676,000 compared to a net loss of ($12,627,000) for the year ended
December 31, 1999. Significant non-cash charges and expenses included $6,517,000
of non cash losses from mark-to-market of certain securities and mortgage loans;
$4,793,000 provision for loss on sale of HCP-2 subsidiary; and $4,300,000 in
amortization of premium and deferred costs. The most significant use of cash not
reflected in net income were loans to related parties of $4,294,000, consisting
primarily of loans to HCP which were used to fund purchases by HCP of
subordinate MBS.
Net cash provided by investing activities amounted to $145,515,000 during the
year ended December 31, 1999. The majority of cash proceeds from investing
activities was generated from (1) principal payments received on collateral for
CMOs of $61,613,000, mortgage loans available for sale of $44,429,000 and
mortgage securities of $12,895,000; and (2) proceeds from sale of mortgage loans
of $28,789,000, offset by the purchase of twelve below investment grade mortgage
securities for $3,668,000 in the second quarter. (In addition, HCP purchased
seventeen below investment grade mortgage securities in the third quarter. The
cash used for this purchase ($3,041,000) was provided by the Company in the form
of a note receivable from HCP, which is reflected in the increase in loans to
related parties described in the preceding paragraph.)
Cash flows from financing activities used $142,006,000 during the year ended
December 31, 1999. During the year ended December 31, 1999, the Company made net
repayments to its
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reverse repurchase lenders of $314,368,000 and had net borrowings on CMOs (net
of principal repayments) of $177,624,000. The Company also paid dividends of
$3,026,000 and purchased an additional 495,000 shares of its common stock for
$2,235,000 during this period.
CAPITAL RESOURCES
The Company had no significant capital expenditure during 1999 and management
does not anticipate the need for any material capital expenditures in the near
future.
YEAR 2000 (Y2K) DISCLOSURE
The Y2K issue is the result of computer systems that use two digits rather than
four to define the applicable year, which may prevent such systems from
accurately processing dates ending in the year 2000 and thereafter. This could
result in system failures or in miscalculations causing disruption of
operations, including, but not limited to, an inability to process transactions,
to send and receive electronic data, or to engage in routine activities and
operations.
The Company did not experience any material Y2K issues. Nevertheless, there
still remain some future dates that could potentially cause computer systems
problems.
The following information is provided relating to the Company's preparation for
Y2K issues in the year ended December 31, 1999:
1. Y2K-Readiness- The Company reviewed the status of all of its information
technology ("IT") systems and determined that all of its computer hardware
is Y2K compliant. In addition, the Company received satisfactory
certification from virtually all of its third party vendors and/or verified
to its satisfaction that their IT systems were Y2K compliant as of December
31, 1999.
Key Third Party Vendors Services Provided
----------------------- -----------------
Securities dealer firms Financing, facilitate purchase and
sale of mortgage assets, etc.
Information processing firms Accounting, word processing, database
software systems
Mortgage loan servicers Mortgage loan servicing
Communications firms Telephone, modems, fax, financial
software, internet, postage
Facilities firms Office space, storage, security
General Legal and accounting, office supplies,
etc.
The Company did not incur any significant costs associated with Y2K
non-compliance by the third party vendors. The Company does not own any
non-IT systems (i.e. elevator
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systems, building air management systems, security and fire control
systems). The Company received written and/or verbal confirmation that the
non-IT systems located in the Company's principal leased facilities are all
Y2K compliant.
2. Y2K-Costs - The Company did not incur any material costs related to its Y2K
issues and believes its total Y2K costs to date have been less than
$25,000. It does not anticipate any material costs will be incurred on as
yet unidentified Y2K issues.
3. Y2K-Risks- The Company's most reasonably likely worst case scenario related
to the Y2K issue would have occurred if any of the companies which service
its mortgage asset portfolios had Y2K problems that prohibited such
companies from either (1) collecting and remitting funds or (2) providing
the related loan data to the Company on a timely basis. To the Company's
knowledge, neither of these scenarios occurred.
4. Y2K-Contingency Plans- The Company developed contingency plans to handle
the most reasonably likely worst case Y2K scenario. The Y2K contingency
plans identified individuals within the Company to contact in the event of
a Y2K problem, as well as the availability of back-up systems.
OTHER MATTERS
REIT Requirements
Hanover has elected to be taxed as a REIT under the Code. Hanover believes that
it was in full compliance with the REIT tax rules as of December 31, 1999 and
intends to remain in compliance with all REIT tax rules. If Hanover fails to
qualify as a REIT in any taxable year and certain relief provisions of the Code
do not apply, Hanover will be subject to Federal income tax as a regular,
domestic corporation, and its stockholders will be subject to tax in the same
manner as stockholders of a regular corporation. Distributions to its
stockholders in any year in which Hanover fails to qualify as a REIT would not
be deductible by Hanover in computing its taxable income. As a result, Hanover
could be subject to income tax liability, thereby significantly reducing or
eliminating the amount of cash available for distribution to its stockholders.
Further, Hanover could also be disqualified from re-electing REIT status for the
four taxable years following the year during which it became disqualified.
Investments in Certain Mortgage Assets
The Company takes certain risks in investing in subprime single-family mortgage
loans and securities collateralized by such loans. If these mortgage loans are
missing relevant documents, such as the original note, they may be difficult to
enforce. These mortgage loans may also have inadequate property valuations. In
addition, if a single-family mortgage loan has a poor payment history, it is
more likely to have future delinquencies because of poor borrower payment habits
or a continuing cash flow problem.
Defaults on Mortgage Assets
The Company makes long-term investments in mortgage assets and securities.
During the time it holds mortgage assets for investment, the Company is subject
to the risks of borrower defaults and bankruptcies and hazard losses (such as
those occurring from earthquakes or floods) that are
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not covered by insurance. If a default occurs on any mortgage loan held by the
Company or on any mortgage loan collateralizing below investment grade in BS
held by the Company, the Company will bear the risk of loss of principal to the
extent of any deficiency between the value of the mortgaged property, plus any
payments from an insurer or guarantor, and the amount owing on the mortgage
loan.
If the Company were to invest in commercial mortgage loans, the Company may be
subject to certain additional risks. Commercial properties tend to be unique and
more difficult to value than single-family residential properties. Commercial
mortgage loans often have shorter maturities than single-family mortgage loans
and often have a significant principal balance or "balloon" due on maturity. A
balloon payment creates a greater risk for the lender because the ability of a
borrower to make a balloon payment normally depends on its ability to refinance
the loan or sell the related property at a price sufficient to permit the
borrower to make the payment. Commercial mortgage lending is generally viewed as
exposing the lender to a relatively greater risk of loss than single-family
mortgage lending because it usually involves larger mortgage loans to single
borrowers or groups of related borrowers and the repayment of the loans is
typically dependent upon the successful operation of the related properties. As
of December 31, 1999, the Company did not have any commercial mortgage loan
investments. However, the Company may elect to make such investments.
Negative Effects of Fluctuating Interest Rates
Changes in interest rates may impact the Company's earnings in various ways.
While the Company anticipates that over the long term less than 25% of its
mortgage loans will be adjustable rate mortgages ("ARMs"), rising short term
interest rates may negatively affect the Company's earnings in the short term.
Increases in the interest rate on an ARM loan are generally limited to either 1%
or 2% per adjustment period. ARM loans owned by the Company are subject to such
limitations, while adjustments in the interest rate on the Company's borrowings
are not correspondingly limited. As a result, in periods of rising interest
rates, the Company's net interest income could temporarily decline.
The rate of prepayment on the Company's mortgage loans may increase if interest
rates decline, or if the difference between long-term and short-term interest
rates diminishes. Increased prepayments would cause the Company to amortize any
premiums paid on the acquisition of its mortgage loans faster than currently
anticipated, resulting in a reduced yield on its mortgage loans. Additionally,
to the extent proceeds of prepayments cannot be reinvested at a rate of interest
at least equal to the rate previously earned on the prepaid mortgage loans, the
Company's earnings may be adversely affected.
Insufficient Demand for Mortgage Loans and the Company's Loan Products
The availability of mortgage loans that meet the Company's criteria depends on,
among other things, the size of and level of activity in the residential,
multifamily and commercial real estate lending markets. The size and level of
activity in these markets, in turn, depends on the level of interest rates,
regional and national economic conditions, inflation and deflation in property
values and the general regulatory and tax environment as it relates to mortgage
lending. If the Company can not obtain sufficient mortgage loans or mortgage
securities that meet its criteria, its business will be adversely affected.
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Investment Company Act
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act. If the
Company were to become regulated as an investment company, the Company's use of
leverage would be substantially reduced. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on interest in real estate" ("Qualifying
Interests"). Under current interpretation of the staff of the Securities and
Exchange Commission, in order to qualify for this exemption, the Company must
maintain at least 55% of its assets directly in Qualifying Interests. As of
December 31, 1999, Management calculates that the Company is in compliance with
this requirement.
Clinton Administration Proposal
The Clinton's administration for the fiscal year 2001 budget proposal was
announced on February 1, 2000. The proposed budget would amend the tax rules
relating to the distribution of a REIT's income. Under current law, a REIT is
required to distribute at least 85% of its ordinary income and 95% of its
capital gains during a taxable year in order to avoid a 4% excise tax on the
undistributed amount. Under the Clinton Administration proposal, a REIT would be
required to distribute 98% of both ordinary income and capital gain net income
to avoid the excise tax. If this proposal was enacted, it would be effective for
calendar years beginning after December 31, 2000.
As in previous Clinton Administration proposals, the administration proposes a
"closely held REIT" ownership test, under which no "person" (i.e., a
corporation, partnership or trust, including a pension or profit sharing trust)
could own stock of a REIT possessing 50% or more the total combined voting power
of all classes of voting stock or 50% or more of the total value of shares of
all classes of stock. This 2001 proposal contains an exception for REITs owning
more than 50% of another REIT. Further, there is a newly proposed "limited
look-through rule" for partnerships that own REITs. There is no exception for
publicly traded REITs. This proposal, if enacted, would be effective for
entities electing REIT status for taxable years beginning on or after the date
of first committee action (an entity that has elected REIT status prior to this
date will avoid these restrictions so long as it has sufficient business assets
or activities as of such date). It is presently uncertain whether these REIT
proposals, or any other proposals regarding REITs, will be enacted.
State and Local Taxes
Hanover and its shareholders may be subject to state or local taxation in
various jurisdictions, including those in which it or they transact business or
reside. The state and local tax treatment of Hanover and its shareholders may
not conform to federal income tax consequence discussed above. Consequently,
prospective shareholders should consult their own tax advisors regarding the
effect of state and local tax laws on an investment in Hanover shares.
IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
The preceding section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and other sections of this Quarterly
Report contain various "forward-looking statements" within the meaning of
Section 27A of the Securities Exchange Act of 1933,
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as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
These forward-looking statements represent the Company's expectations or beliefs
concerning future events, including, without limitation, statements containing
the words "believes," "anticipates," "expects" and words of similar import; and
also including, without limitation, the following: statements regarding the
Company's continuing ability to target and acquire mortgage loans; expected
availability of the master reverse repurchase agreement financing; the
sufficiency of the Company's working capital, cash flows and financing to
support the Company's future operating and capital requirements; results of
operations and overall financial performance; the expected dividend distribution
rate; and the expected tax treatment of the Company's operations. Such
forward-looking statements relate to future events and the future financial
performance of the Company and the industry and involve known and unknown risks,
uncertainties and other important factors which could cause actual results,
performance or achievements of the Company or industry to differ materially from
the future results, performance or achievements expressed or implied by such
forward-looking statements.
Investors should carefully consider the various factors identified in
"Management's Discussion and Analysis of Financial Condition and Results of
Operation - Other Matters," and elsewhere in this Report that could cause actual
results to differ materially from the results predicted in the forward-looking
statements. Further, the Company specifically cautions investors to consider the
following important factors in conjunction with the forward-looking statements:
the possible decline in the Company's ability to locate and acquire mortgage
loans; the possible adverse effect of changing economic conditions, including
fluctuations in interest rates and changes in the real estate market both
locally and nationally; the effect of severe weather or natural disasters; the
effect of competitive pressures from other financial institutions, including
other mortgage REIT's; and the possible changes, if any, in the REIT rules.
Because of the foregoing factors, the actual results achieved by the Company in
the future may differ materially from the expected results described in the
forward-looking statements.
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ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
During 1999 the Company used certain derivative financial instruments (for
purposes other than trading) as hedges of anticipated transactions relating to
its investment portfolio.
The Company from time to time enters into interest rate hedge mechanisms
(forward sales of Agency mortgage securities) to manage its exposure to market
pricing changes in connection with the purchase, holding of, securitization and
sale of its fixed rate mortgage loan portfolio and certain mortgage securities.
The Company generally closes out the hedge position to coincide with the related
sale or securitization transactions and recognizes the results of the hedge
transaction in determining the amount of the related gain or loss for loans or
securities sold, or as a basis adjustment to loans held to maturity.
At December 31, 1999 the Company had forward commitments to sell $6 million (par
value) of Agency mortgage securities that had not yet settled. This forward sale
was entered into to hedge the expected sale of approximately $6 million of AA
and A rated subordinate mortgage-backed securities held in a trading account.
The Company generally hedges its "held for sale" fixed rate mortgage loan pools
by selling short similar coupon and duration matched Agency securities, usually
for 30 to 60 day periods. This hedging of mortgage assets should, if properly
executed, adjust the carrying value of the hedged fixed mortgage loan pools to
reflect current market pricing. The costs or gains of the individual hedging
transactions can vary greatly depending upon market conditions. Net hedging
gains on the fixed rate mortgage pools were $86,000 during 1999.
The primary risk associated with selling short Agency securities relates to
changes in interest rates. Generally, as market interest rates increase, the
market value of the hedged asset (fixed rate mortgage loans) will decrease. The
net effect of increasing interest rates will generally be a favorable or gain
settlement on the forward sale of the Agency security; this gain should offset a
corresponding decline in the value of the hedged assets. Conversely, if interest
rates decrease, the market value of the hedged asset will generally increase.
The net effect of decreasing interest rates will generally be an unfavorable or
loss settlement on the forward sale of the Agency security; this loss should be
offset by a corresponding gain in value of the hedged assets. To mitigate
interest rate risk an effective matching of Agency securities with the hedged
assets needs to be monitored closely. Senior Management continually monitors the
changes in weighted average duration and coupons of the hedged assets and will
appropriately adjust the amount, duration and coupon of future forward sales of
Agency securities.
The Company also enters into interest rate hedge mechanisms (interest rate caps)
to manage its interest rate exposure on certain reverse repurchase agreement
financing and floating rate CMOs. The cost of the interest rate caps is
amortized over the life of the interest rate cap and is reflected as a portion
of interest expense in the consolidated statement of operations.
At December 31, 1999 the Company had the following interest rate caps in effect
(dollars in thousands):
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NOTIONAL AMOUNT INDEX STRIKE % MATURITY DATE
--------------- ----- -------- -------------
$ 29,741 3 Month LIBOR 5.75% March, 2001
28,823 3 Month LIBOR 5.75% April, 2001
75,000 1 Month LIBOR 7.25% August, 2002
35,000 1 Month LIBOR 7.75% August, 2004
--------
$168,564
========
In addition, the Company's affiliate, HCP, had the following interest rate caps
in effect at December 31, 1999:
NOTIONAL AMOUNT INDEX STRIKE % MATURITY DATE
--------------- ----- -------- -------------
$ 11,000 3 month LIBOR 7.695% October, 2003
The primary risk associated with interest rate caps relates to interest rate
increases. The interest rate caps provide a cost of funds hedge against interest
rates that exceed the strike rate, subject to the limitation of the notional
amount of financing.
INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repo Financing
At December 31, 1999, the Company owned a de minimus amount of mortgage loans
held for sale. If the Company resumes its strategy of purchasing mortgage loans,
it would finance these assets during the initial period (the time period during
which management analyzes the loans in detail and corrects deficiencies where
possible before securitizing the loans) with reverse repurchase agreement
("repo") financing or with equity alone in certain instances. In this scenario,
the Company would be exposed to the mismatch between the cost of funds on its
repo financing and the yield on the mortgage loans. The Company's repo financing
agreements at December 31, 1999 were indexed to LIBOR plus a spread of 125 to
238 basis points. This financing generally is rolled and matures every 30 to 90
days. Accordingly, any increases in LIBOR will tend to reduce net interest
income and any decreases in LIBOR will tend to increase net interest income.
The Company also has floating rate reverse repurchase financing for certain
fixed-rate mortgage backed securities. At December 31, 1999, the Company had a
total of $52,356,000 of floating rate reverse repo financing compared to
$62,686,000 of fixed rate mortgage-backed securities investments, and the
Company's affiliate, HCP, had $10,842,000 of such financing against $14,180,000
of fixed-rate securities. The Company has attempted to hedge this exposure by
using the interest rate caps described above.
Price Risk
The market value of mortgage loans and mortgage securities will fluctuate with
changes in interest rates. In the case of mortgage loans held for sale and
mortgage securities available for sale or held for trading, the Company will be
required to record changes in the market value of such assets. In the case of
mortgage loans held for sale and mortgage securities held in trading, the
Company generally attempts to hedge these changes through the short sale of
mortgage securities, described above. At December 31, 1999, the Company did not
have any significant
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mortgage loans held for sale. The mortgage securities held in trading were
hedged with the short sale of mortgage securities described above.
In the case of mortgage loans held for sale, hedging gains and losses and other
related hedging costs are deferred and are recorded as an adjustment of the
hedged assets or liabilities. The hedging gains ("Hedging Gains") and losses
("Hedging Costs") along with the other related hedging costs are amortized over
the estimated life of the asset or liability. This hedging of mortgage assets
should, if properly executed, adjust the carrying value of the fixed mortgage
loan pools to reflect current market pricing. The costs of the individual
hedging transactions can vary greatly depending upon the market conditions. Net
Hedging Gains on fixed mortgage pools were $86,000 through the first three
quarters of 1999.
Prepayment Risk
Interest income on the mortgage loan and mortgage securities portfolio is also
negatively affected by prepayments on mortgage loan pools or MBS purchased at a
premium and positively impacted by prepayments on mortgage loan pools or MBS
purchased at a discount. The Company assigns an anticipated prepayment speed to
each mortgage pool and MBS at the time of purchase and records the appropriate
amortization of the premium or discount over the estimated life of the mortgage
loan pool or MBS. To the extent the actual prepayment speeds vary significantly
from the anticipated prepayment speeds for an extended period of time, the
Company will adjust the anticipated prepayment speeds and amortization of the
premium or discount accordingly. This will negatively (in the case of
accelerated amortization of premiums or decelerated amortization of discounts)
or positively (in the case of decelerated amortization of premiums or
accelerated amortization of discounts) impact net interest income.
Delinquency and Default Risk
Increases in delinquency rates and defaults by borrowers on their mortgages can
also negatively impact the Company's net interest income. The Company monitors
delinquencies and defaults in its mortgage loan portfolio in three categories:
government, conventional and uninsured. It adjusts its loan loss provision
policy and non-interest accrual policy in accordance with changes in the
delinquency and default trends.
Securitized Mortgage Loan Assets
With respect to the match funding of assets and liabilities, the CMO collateral
relating to the 1998-A, 1999-A and 1999-B securitizations reflect $176,751,000
of fixed rate mortgage loans and $93,082,000 of adjustable rate mortgage loans
at December 31, 1999. The primary financing for this asset category is the CMOs
($254,963,000) and to a much lesser extent repo agreements ($3,366,000). The
repo financing, which is indexed to LIBOR, is subject to interest rate
volatility as the repo agreement matures and is extended. The financing provided
by the CMOs for the 1998-A and 1999-A securitizations lock in long-term fixed
financing and thereby eliminates most interest rate risk. The financing for the
1999-B securitization is indexed to LIBOR. Accordingly, the Company has hedged
this interest rate risk through the purchase of interest rate caps. The Company
purchased amortizing interest rate caps with notional balances of $110 million
in August 1999 to hedge the 1999-B securitization.
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Mortgage Securities
At December 31, 1999 the Company owned certain fixed rate Agency and private
placement mortgage securities and certain interest only and principal only
private placement mortgage securities ($62,686,000). The coupon interest rates
on the fixed rate mortgage securities would not be affected by changes in
interest rates. The interest only notes remit monthly interest generated from
the underlying mortgages after deducting all service fees and the coupon
interest rate on the applicable notes. The interest rate on each of the interest
only notes is based on a notional amount (the principal balance of those
mortgage loans with an interest rate in excess of the related note coupon
interest rate). The notional amounts decline each month to reflect the related
normal principal amortization, curtailments and prepayments for the related
underlying mortgage loans. Accordingly, net interest income on the mortgage
securities portfolio would be negatively affected by prepayments on mortgage
loans underlying the mortgage securities and would further be negatively
affected to the extent that higher rated coupon mortgage loans paid off more
rapidly than lower rated coupon mortgage loans.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together with the
Independent Auditors' Report thereon beginning on page F-1 of this Form 10-K.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated herein by reference to the Company's definitive proxy statement to
be filed with the Securities and Exchange Commission.
ITEM 11: EXECUTIVE COMPENSATION
Incorporated herein by reference to the Company's definitive proxy statement to
be filed with the Securities and Exchange Commission.
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated herein by reference to the Company's definitive proxy statement to
be filed with the Securities and Exchange Commission.
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference to the Company's definitive proxy statement to
be filed with the Securities and Exchange Commission.
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PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
See Part II, Item 8 hereof.
(2) Financial Statements and Auditors' Reports
All schedules omitted are inapplicable or the information required is
shown in the Financial Statements or notes thereto. The auditors'
reports of Deloitte & Touche LLP with respect to the Financial
Statements begin on page F-1 of this Form 10-K.
(3) Exhibits
Exhibits required to be attached by Item 601 of Regulation S-K are
listed in the Exhibit Index attached hereto, which is incorporated
herein by this reference.
(b) Reports on Form 8-K
Hanover filed no reports on Form 8-K during 1999.
(c) Exhibits
See Item 14(a) 3 above.
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TABLE OF CONTENTS TO FINANCIAL STATEMENTS
PAGE
----
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
Independent Auditors' Report...................................................................... F-2
Consolidated Financial Statements as of December 31, 1999 and December 31, 1998
and for the Years Ended December 31, 1999 and 1998 and for the Period from June
10, 1997 (inception) through December 31, 1997:
Balance Sheets.......................................................................... F-3
Statements of Operations................................................................ F-4
Statements of Stockholders' Equity...................................................... F-5
Statements of Cash Flows................................................................ F-6
Notes to Consolidated Financial Statements.............................................. F-7
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
Independent Auditors' Report...................................................................... F-38
Consolidated Financial Statements as of December 31, 1999 and December 31, 1998
and for each of the Three Years in the Period Ended December 31, 1999:
Balance Sheets.......................................................................... F-39
Statements of Operations................................................................ F-40
Statements of Stockholders' Equity...................................................... F-41
Statements of Cash Flows................................................................ F-42
Notes to Consolidated Financial Statements.............................................. F-43
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
Independent Auditors' Report...................................................................... F-57
Consolidated Financial Statements as of December 31, 1999 and December 31, 1998
and for the Year Ended December 31, 1999 and for the Period from October 7, 1998
(inception) through December 31, 1998:
Balance Sheets.......................................................................... F-58
Statements of Operations................................................................ F-59
Statements of Stockholders' Equity...................................................... F-60
Statements of Cash Flows................................................................ F-61
Notes to Consolidated Financial Statements.............................................. F-62
59
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Mortgage Holdings, Inc. and Subsidiaries
New York, New York
We have audited the accompanying consolidated balance sheets of Hanover Capital
Mortgage Holdings, Inc. and Subsidiaries (the "Company") as of December 31, 1999
and 1998, and the related consolidated statements of operations, stockholders'
equity and cash flows for the years ended December 31, 1999 and 1998 and for the
period from June 10, 1997 (inception) through December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing standards
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Hanover
Capital Mortgage Holdings, Inc. and Subsidiaries as of December 31, 1999 and
1998, and the consolidated results of their operations and their cash flows for
the years ended December 31, 1999 and 1998 and for the period from June 10, 1997
(inception) through December 31, 1997 in conformity with generally accepted
accounting principles in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 17, 2000
F-2
60
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
DECEMBER 31, DECEMBER 31,
ASSETS 1999 1998
--------- ---------
Mortgage loans:
Held for sale $ 251 $ 256,833
Held to maturity -- 69,495
Collateral for CMOs 269,833 81,666
Mortgage securities:
Available for sale 48,529 74,000
Held to maturity 8,238 4,478
Trading 5,919 --
Cash and cash equivalents 18,022 11,837
Accrued interest receivable 2,926 3,940
Equity investments
Operating (Hanover Capital Partners Ltd.) 1,466 1,761
Mortgage Finance (Hanover Capital Partners 2, Inc.) -- 5,728
Other (HanoverTrade.com, Inc.) (30) --
Notes receivable from related parties 8,187 3,893
Due from related parties 232 313
Other receivables 151 1,621
Prepaid expenses and other assets 1,910 605
--------- ---------
TOTAL ASSETS $ 365,634 $ 516,170
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 55,722 $ 370,090
CMO borrowing 254,963 77,305
Accrued interest payable 2,433 1,394
Dividends payable 583 695
Due to related party 88 --
Accrued expenses and other liabilities 1,339 906
--------- ---------
TOTAL LIABILITIES 315,128 450,390
--------- ---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01
authorized, 10 million shares, issued
and outstanding, -0- shares
Common stock, par value $.01
authorized, 90 million shares, 5,826,899 and
6,321,899 shares outstanding at December 31, 1999
and December 31, 1998, respectively 58 65
Additional paid-in-capital 75,840 78,069
Retained earnings (deficit) (25,496) (9,955)
Accumulated other comprehensive (loss) 104 (2,399)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 50,506 65,780
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 365,634 $ 516,170
========= =========
See notes to consolidated financial statements
F-3
61
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
PERIOD FROM
YEAR ENDED YEAR ENDED JUNE 10 (INCEPTION)
DECEMBER 31, DECEMBER 31, TO DECEMBER 31,
1999 1998 1997
-------- -------- -------
REVENUES:
Interest income $ 27,505 $ 47,799 $ 4,880
Interest expense 23,097 41,176 3,204
-------- -------- -------
Net interest income 4,408 6,623 1,676
Loan loss provision 446 356 18
-------- -------- -------
Net interest income
after loan loss provision 3,962 6,267 1,658
Gain on sale of servicing rights 540 -- --
Gain (loss) on sale of mortgage assets 146 (5,704) 35
Gain (loss) on mark to market of mortgage
assets, net of associated hedge (4,292) -- --
Impairment charge on mortgage securities (2,225)
Provision for (loss) on unconsolidated
subsidiary (4,793) -- --
-------- -------- -------
Total revenue (loss) (6,662) 563 1,693
EXPENSES:
Personnel 1,230 712 --
Management and administrative 894 733 400
Due diligence 119 687 266
Commissions 5 286 61
Legal and professional 1,201 545 138
Financing/commitment fees 404 836 32
Other 338 265 43
-------- -------- -------
Total expenses 4,191 4,064 940
-------- -------- -------
Operating income (loss) (10,853) (3,501) 753
Equity in income/(loss) of unconsolidated
subsidiaries
Hanover Capital Partners Ltd. (443) (1,039) (254)
Hanover Capital Partners 2, Inc. (1,300) (394) --
HanoverTrade.com, Inc. (31) -- --
-------- -------- -------
NET INCOME (LOSS) $(12,627) $ (4,934) $ 499
======== ======== =======
BASIC EARNINGS (LOSS) PER SHARE $ (2.12) $ (0.77) $ 0.15
======== ======== =======
DILUTED EARNINGS (LOSS) PER SHARE $ (2.12) $ (0.77) $ 0.14
======== ======== =======
See notes to consolidated financial statements
F-4
62
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1999 AND 1998 AND
PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(in thousands except share data)
ACCUMULATED
COMMON STOCK ADDITIONAL RETAINED OTHER
------------ PAID-IN COMPREHENSIVE EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) (LOSS) TOTAL
------ ------ ------- ------ --------- ------ -----
Issuance of Stock 6,466,677 $ 65 $ 79,411 $ 79,476
Comprehensive (loss):
Net income $ 499 $ 499 499
Other comprehensive (loss):
Unrealized (loss) (842) $ (842) (842)
---------
Comprehensive
(loss) $ (343)
=========
Dividends declared (1,035) (1,035)
--------- --------- --------- --------- --------- --------
BALANCE,
DECEMBER 31, 1997 6,466,677 65 79,411 (536) (842) 78,098
Adjustment of initial public
offering expenses 11 11
Exercise of
Warrants 2,122 32 32
Costs associated
with registration
of warrants (40) (40)
Repurchase of
common stock (146,900) (1,345) (1,345)
Comprehensive (loss):
Net (loss) (4,934) (4,934) (4,934)
Other comprehensive (loss):
Change in net
unrealized gain (loss)
on securities available
for sale (1,557) (1,557) (1,557)
---------
Comprehensive (loss) $ (6,491)
=========
Dividends declared (4,485) (4,485)
--------- --------- --------- --------- --------- --------
BALANCE,
DECEMBER 31, 1998 6,321,899 65 78,069 (9,955) (2,399) 65,780
Repurchase of common stock (495,000) (2,236) (2,236)
Treasury stock par value
re-class (7) 7 --
Comprehensive (loss):
Net (loss) (12,627) (12,627) (12,627)
Other comprehensive (loss):
Change in net
unrealized gain (loss)
on securities available
for sale, net of
reclassification
adjustment 2,355 2,355 2,355
Equity in other comprehensive
income of unconsolidated
subsidiary 148 148 148
---------
Comprehensive (loss) $ (10,124)
=========
Dividends declared (2,914) (2,914)
--------- --------- --------- --------- --------- --------
BALANCE,
DECEMBER 31, 1999 5,826,899 $ 58 $ 75,840 $ (25,496) $ 104 $ 50,506
========= ========= ========= ========= ========= ========
See notes to consolidated financial statements
F-5
63
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
PERIOD FROM
JUNE 10
YEAR ENDED YEAR ENDED (INCEPTION) TO
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (12,627) $ (4,934) $ 499
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Amortization of net premium and deferred costs 4,300 6,594 361
Loan loss provision 446 356 18
(Gain) on sale of servicing rights (540) -- --
(Gain) loss on sale of mortgage assets (146) 5,705 (35)
Loss on mark to market of mortgage assets 4,292 -- --
Impairment charge on mortgage securities 2,225
Provision for loss on sale of unconsolidated subsidiary 4,793 -- --
Equity in loss of unconsolidated subsidiaries 1,774 1,433 254
(Increase) decrease in accrued interest receivable 1,014 (343) (3,597)
(Increase) in loans to related parties (4,294) (3,411) (482)
(Increase) decrease in other receivables 1,104 (1,621) --
(Increase) in prepaid expenses and other assets (1,305) (364) (241)
Increase (decrease) in accrued interest payable 1,039 842 2,250
Increase (decrease) in due to related parties 169 (782) 540
Increase in accrued expenses and other liabilities 432 423 482
--------- --------- ---------
Net cash provided by operating activities 2,676 3,898 49
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage loans (1,449) (863,324) (349,287)
Purchase of Agency mortgage securities -- (4,333) (163,030)
Purchase of private placement mortgage securities (3,668) (21,523) --
Principal payments received on mortgage securities 12,895 150,543 --
Principal payments received on collateral for CMOs 61,613 23,165 --
Principal payments received on mortgage loans held for sale 44,429 123,098 1,995
and held to maturity
Proceeds from sale of mortgage assets 30,909 276,582 35
Proceeds from sale of mortgage servicing 786 -- --
--------- --------- ---------
Net cash provided by (used in) investing activities 145,515 (315,792) (510,287)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from (repayment of) reverse repurchase (314,368) 243,218 435,138
agreements
Net borrowing from CMOs 238,962 100,675 --
Payments on CMOs (61,338) (23,370) --
Net proceeds of initial public offering -- 11 79,122
Exercise of stock warrants - net -- (8) --
Equity investments in subsidiaries (1) (2,700) --
Dividends received - unconsolidated subsidiary -- 8,054 --
Payment of dividends (3,026) (4,826) --
Repurchase of common stock (2,235) (1,345) --
--------- --------- ---------
Net cash provided by (used in) financing activities (142,006) 319,709 514,260
--------- --------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 6,185 7,815 4,022
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 11,837 4,022 --
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 18,022 $ 11,837 $ 4,022
========= ========= =========
See notes to consolidated financial statements
F-6
64
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1999 AND 1998 AND PERIOD FROM JUNE 10 (INCEPTION) TO
DECEMBER 31, 1997
1. ORGANIZATION AND BASIS OF PRESENTATION
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland
on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to
operate as a specialty finance company. The principal business strategy of
Hanover and its wholly-owned subsidiaries, (together referred to as the
"Company") is to (i) acquire primarily single-family mortgage loans that are at
least twelve months old or that were intended to be of certain credit quality
but that do not meet the originally intended market parameters due to errors or
credit deterioration, (ii) securitize the mortgage loans and retain interests
therein and (iii) acquire subordinated mortgage securities similar in nature to
the retained interests generated from internal securitizations. The principal
business strategy of the Company's primary unconsolidated subsidiary, Hanover
Capital Partners Ltd. ("HCP"), is to generate consulting and other fee income by
(i) performing loan file due diligence reviews for third parties, (ii)
performing loan sale advisory services and (iii) brokering and trading
portfolios of loans. Until recently, HCP was also engaged in the business of
originating multifamily and commercial loans. This business was discontinued in
the quarter ended June 30, 1999 and substantially all charges associated with
its discontinuance were recognized in the quarter. The Company's principal
business objective is to generate net interest income on its portfolio of
mortgage loans and mortgage securities, and to generate fee income through HCP.
The Company acquires single-family mortgage loans through a network of sales
representatives targeting financial institutions throughout the United States.
CAPITALIZATION
In September 1997, Hanover raised net proceeds of approximately $79 million in
its initial public offering (the "IPO"). In the IPO, Hanover sold 5,750,000
units (each unit consisting of one share of common stock, par value $.01 and one
stock warrant) at $15.00 per unit including 750,000 units sold pursuant to the
underwriters' over-allotment option, which was exercised in full. Each warrant,
as adjusted on January 1, 1999, entitles the holder to purchase 1.0302 shares of
common stock at the adjusted price of $14.56 per share of common stock. The
warrants became exercisable on March 19, 1998 and expire on September 15, 2000.
The Company utilized substantially all of the net proceeds of the IPO to fund
leveraged purchases of mortgage loans and mortgage backed securities ("MBS"). As
of December 31, 1999, there were 6,217,877 warrants outstanding, including
172,500 warrants issued pursuant to the underwriters over-allotment option.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Hanover Capital
Mortgage Holdings, Inc. and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated.
F-7
65
BASIS OF PRESENTATION
The consolidated financial statements of the Company are prepared on the accrual
basis of accounting in accordance with generally accepted accounting principles
("GAAP") and in conformity with the rules and regulations of the Securities and
Exchange Commission. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation
have been included.
USE OF ESTIMATES; RISKS AND UNCERTAINTIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amount of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. The Company's estimates and
assumptions primarily arise from risks and uncertainties associated with
interest rate volatility, credit exposure and regulatory changes. Although
management is not currently aware of any factors that would significantly change
its estimates and assumptions in the near term, future changes in market trends
and conditions may occur which could cause actual results to differ materially.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand, overnight investments deposited
with banks and government securities with maturities less than 30 days.
MORTGAGE LOANS
The Company's policy is to classify each of its mortgage loans as held for sale
as they are purchased and each asset is monitored for a period of time,
generally four to nine months, prior to making a determination as to whether the
asset will be classified as held to maturity. Mortgage loans that are
securitized in a collateralized mortgage obligation ("CMO") are classified as
collateral for CMOs as of the closing date of the CMO. All mortgage loans
designated as held for sale are reported at the lower of cost or market, with
unrealized losses reported as a charge to earnings in the current period.
Mortgage loans designated as held to maturity and CMO collateral are reported at
the lower of the original cost of the mortgaged loans or the market value of the
mortgage loans as of the date they were designated as CMO collateral or held to
maturity.
Premiums, discounts and certain deferred costs associated with the purchase of
mortgage loans are amortized into interest income over the lives of the mortgage
loans using the effective yield method adjusted for the effects of estimated
prepayments. Mortgage loan transactions are recorded on the date the mortgage
loans are purchased or sold. Purchases of new mortgage loans are recorded when
all significant uncertainties regarding the characteristics of the mortgage
loans are removed, generally on or shortly before settlement date. Realized
gains and losses on mortgage loan transactions are determined on the specific
identification basis.
The accrual of interest on impaired loans is discontinued when, in management's
opinion, the borrower may be unable to meet payments as they become due. When
interest accrual is discontinued, all unpaid accrued interest income is
reversed. Interest income is subsequently recognized only to the extent cash
payments are received.
F-8
66
The Company has limited its exposure to credit losses on its portfolio of
mortgage loans by performing an in-depth due diligence on every loan purchased.
The due diligence encompasses the borrower's credit, the enforceability of the
documents, and the value of the mortgage property. In addition, many mortgage
loans are guaranteed by an agency of the federal government or private mortgage
insurance. The Company monitors the delinquencies and losses on the underlying
mortgages and makes a provision for known losses as well as unidentified
potential losses in its mortgage loan portfolio if the impairment is deemed to
be other than temporary. The provision is based on management's assessment of
numerous factors affecting its portfolio of mortgage loans including, but not
limited to, current and projected economic conditions, delinquency status,
losses to date on mortgages and remaining credit protection.
MORTGAGE SECURITIES
The Company's policy is to generally classify mortgage securities as available
for sale as they are acquired. Each available for sale mortgage security is
monitored for a period of time prior to making a determination whether the asset
will be classified as held to maturity or trading. Management reevaluates the
classification of the mortgage securities on a quarterly basis.
Mortgage securities designated as available for sale are reported at fair value,
with unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity.
Mortgage securities designated as trading are reported at fair value. Gains and
losses resulting from changes in fair value are recorded as income or expense
and included in earnings.
Mortgage securities classified as held to maturity are carried at the fair value
of the security at the time the designation is made. Any fair value adjustment
is reflected as a separate component of stockholders' equity and as a cost
adjustment of the mortgage security as of the date of the classification and is
amortized into interest income as a yield adjustment.
The Company makes periodic evaluations of all mortgage securities to determine
whether an other than temporary impairment is considered to have occurred. If a
decline in the fair value is judged to be other than temporary, the cost basis
of the mortgage security will be marked to fair value, resulting in a current
period loss in the consolidated statement of operations. The new cost basis
shall not be changed for further increases in market value; however, further
increases in market value will be reflected separately in the equity section of
the Company's balance sheet. In the quarter ended September 30, 1999, the
Company determined that six interest only notes were impaired. See Note 13,
"Certain Charges and Expenses in the Quarter Ended September 30, 1999".
Premiums, discounts and certain deferred costs associated with the acquisition
of mortgage securities are amortized into interest income over the lives of the
securities using the effective yield method adjusted for the effects of
estimated prepayments. Mortgage securities transactions are recorded on the date
the mortgage securities are purchased or sold. Purchases of new issue mortgage
securities are recorded when all significant uncertainties regarding the
characteristics of the mortgage securities are removed, generally on or shortly
before settlement date. Realized gains and losses on mortgage securities
transactions are determined on the specific identification basis.
The Company purchases both investment grade and below investment grade mortgage
backed securities. Below investment grade MBS have the potential to absorb
credit losses caused by delinquencies and defaults on the underlying mortgage
loans. When purchasing below investment grade MBS, the Company leverages HCP's
due diligence operations and management's substantial mortgage credit
F-9
67
expertise to make a thorough evaluation of the underlying mortgage loan
collateral. The Company monitors the delinquencies and defaults on the
underlying mortgages of its mortgage securities and, if an impairment is deemed
to be other than temporary, makes a provision for known losses as well as
unidentified potential losses. The provision is based on management's assessment
of numerous factors affecting its portfolio of mortgage securities including,
but not limited to, current and projected economic conditions, delinquency
status, credit losses to date on underlying mortgages and remaining credit
protection. The provision is made by reducing the cost basis of the individual
security and the amount of such write-down is recorded as a realized loss,
thereby reducing earnings. Provisions for credit losses do not reduce taxable
income and therefore do not affect the dividends paid by the Company to
stockholders in the period the provisions are taken. Actual losses realized by
the Company reduce taxable income in the period the actual loss is realized and
may affect the dividends paid to stockholders for that tax year.
EQUITY INVESTMENTS
Hanover records its investment in Hanover Capital Partners Ltd. ("HCP"), Hanover
Capital Partners 2, Inc. ("HCP-2"), and HanoverTrade.com, Inc. ("HTC") on the
equity method. Accordingly, Hanover records 97% of the earnings or losses of HCP
and HTC, and, until September 30, 1999, 99% of the earnings or losses of HCP-2
through its ownership of all of the non-voting preferred stock of HCP, HTC and
HCP-2, respectively. After writing off its investment in HCP-2 in September,
1999, Hanover stopped recording earnings or losses of HCP-2. Hanover believes
that HCP-2 has no value.
Hanover generally has no right to control the affairs of HCP, HCP-2 or HTC
because Hanover's investment in those companies is based solely on ownership of
non-voting preferred stock. Even though Hanover has no right to control the
affairs of these companies, management believes that Hanover has the ability to
exert significant influence over these companies and therefore these investments
are accounted for on the equity method.
REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts, plus accrued interest.
FINANCIAL INSTRUMENTS
The Company from time to time enters into interest rate hedge mechanisms
(forward sales of Agency mortgage securities) to manage its exposure to market
pricing changes in connection with the purchase, holding of, securitization and
sale of its mortgage loan and mortgage securities portfolio. The Company
generally closes out the hedge position to coincide with the related sale or
securitization transactions. Gains and losses on mortgage loan hedge positions
are either (i) deferred as an adjustment to the carrying value of the related
loans until the loan has been funded and securitized, after which the gains or
losses will be amortized into income over the remaining life of the loan using a
method that approximates the effective yield method, or (ii) deferred until such
time as the related loans are sold. Gains or losses on hedge positions
associated with mortgage securities held in a trading account are recognized as
income or loss in each period.
The Company also enters into interest rate caps to manage its interest rate
exposure on certain reverse repurchase agreement and CMO financing. The cost of
the interest rate caps is amortized over the life of the interest rate cap and
is reflected as a portion of interest expense in the consolidated statement of
F-10
68
operations. Any payments received under the interest rate cap agreements are
recorded as a reduction of interest expense on the reverse repurchase agreement
financing.
For derivative financial instruments designated as hedge instruments, the
Company periodically evaluates the effectiveness of these hedges against the
financial instrument being hedged under various interest rate scenarios. The
Company utilized hedge deferral accounting procedures in accounting for its
hedging program so long as there is adequate correlation between the hedged
results and the change in value of the hedged financial instrument. If the hedge
instrument performance does not result in adequate correlation between the
changes in value of the hedge instrument and the related hedged financial
instrument, the Company will terminate hedge deferral accounting and mark the
carrying value of the hedge instrument to market. If a hedge instrument is sold
or matures, or the criteria that was anticipated at the time the hedge
instrument was entered into no longer exists, the hedge instrument is no longer
accounted for as a hedge. Under these circumstances, the accumulated change in
the market value of the hedge is recognized in current period income or loss to
the extent that the effects of interest rate or price changes of the hedged item
have not offset the hedged results.
In accordance with SFAS No.107, Disclosure about Derivative Financial
Instruments, and SFAS No. 119, Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments, the Company has provided fair value
estimates and information about valuation methodologies. The estimated fair
value amounts have been determined using available market information or
appropriate valuation methodologies. However, considerable judgment is required
in interpreting market data to develop estimates of fair value, so the estimates
are not necessarily indicative of the amounts that would be realized in a
current market exchange. The effect of using different market assumptions and/or
estimation methodologies may materially impact the estimated fair value amounts.
INCOME TAXES
Hanover has elected to be taxed as a real estate investment trust ("REIT") and
intends to comply with the provisions of the Internal Revenue Code of 1986, as
amended (the "Code") with respect thereto. Accordingly, Hanover will not be
subject to Federal or state income tax to the extent that its annual
distributions to stockholders are equal to at least 95% of its taxable income
and as long as certain asset, income and stock ownership tests are met.
Effective January 1, 2001, the distribution requirement will be reduced from 95%
to 90%.
During 1998, Hanover distributed dividends in excess of its accumulated and
current taxable income. Consequently, the distributions in excess of accumulated
and current taxable income were treated as a return of capital to the
stockholders.
EARNINGS PER SHARE
Basic earnings or loss per share excludes dilution and is computed by dividing
income or loss available to common stockholders by the weighted average number
of common shares outstanding during the period. Diluted earnings or loss per
share reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock
that then shared in earnings and losses. Shares issued during the period and
shares reacquired during the period are weighted for the period they were
outstanding.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available for sale
securities, are reported as a separate component of the equity section of the
consolidated balance sheets, such items, along with net income, are components
of comprehensive income.
F-11
69
RECLASSIFICATION
The 1998 financial statements have been reclassified to conform to the 1999
financial statement presentation.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
The FASB issued SFAS 133 Accounting for Derivative Instruments and Hedging
Activities ("SFAS 133") in June 1998. SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. Management's preliminary evaluation of
SFAS 133 indicates the implementation of SFAS 133 will not result in any
material changes to the Company's consolidated statement of operations. SFAS
137, issued in June 1999, delayed the effective date of SFAS 133 to make it
effective for quarters in fiscal years beginning after June 15, 2000.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENT
The FASB issued SFAS No. 134 Accounting For Mortgage-Backed Securities Retained
after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking
Enterprise ("SFAS 134") in October 1998. SFAS 134 amends FAS 65 Accounting for
Certain Mortgage Banking Activities, and FAS 115 Accounting for Certain
Investments in Debt and Equity Securities to require that after the
securitization of mortgage loans held for sale, an entity engaged in mortgage
banking activities classify the resulting mortgage-backed securities or other
retained interests based on its ability and intent to sell or hold those
investments. SFAS 134 is effective for fiscal quarters beginning after December
15, 1998. The Company adopted SFAS 134 effective January, 1, 1999. The adoption
of SFAS 134 had no affect on the Company's consolidated financial statements.
3. MORTGAGE LOANS
At December 31, 1999 management had made the determination that $251,000 of
mortgage loans were held for sale. No mortgage loans were designated as held to
maturity and $269,833,000 of mortgage loans were held as collateralized mortgage
obligation ("CMO") collateral.
HELD FOR SALE
The following table summarizes certain characteristics of the Company's
single-family mortgage loan pools, held for sale portfolio which are carried at
the lower of cost or market (dollars in thousands):
DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- -----------------
Fixed Adjustable Fixed Adjustable
Rate Rate (a) Total Rate Rate (a) Total
---- -------- ----- ---- -------- -----
Principal amount of mortgage loans $ 45 $ 206 $ 251 $ 93,615 $ 159,901 $ 253,516
Net premium and deferred cost -- -- -- 2,305 1,262 3,567
Loan loss allowance -- -- -- (157) (93) (250)
--------- --------- --------- --------- --------- ---------
Carrying cost of mortgage loans $ 45 $ 206 $ 251 $ 95,763 $ 161,070 $ 256,833
Mix 17.93% 82.07% 100.00% 37.290% 62.710% 100.00%
Weighted average net coupon 9.261% 8.125% 8.329% 8.545% 7.542% 7.912%
Weighted average maturity 141 194 184 187 264 235
F-12
70
The Company had one adjustable rate mortgage loan at December 31, 1999 with a
one year constant maturity treasury ("CMT") reference rate index with a 12 month
repricing period and a net life cap of 13.50%.
The adjustable rate mortgage loans at December 31, 1998 had various reference
rate indexes with a weighted average 13 month repricing period and a weighted
average net life cap of 13.23%.
(a) The adjustable rate mortgage loans include $ -0- and $31,857,000 of
hybrid mortgage loans at December 31, 1999 and December 31, 1998
respectively, which allow the coupon interest rate to change at one
specified time during the life of the loan.
(b) Weighted average maturity reflects the number of months until maturity.
HELD TO MATURITY
The Company did not have any mortgage loans held to maturity at December 31,
1999. The following table summarizes certain characteristics of the Company's
single-family mortgage loans, held to maturity which are carried at cost at
December 31, 1998 (dollars in thousands):
DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- -----------------
Fixed Adjustable Fixed Adjustable
Rate Rate (a) Total Rate Rate (a) Total
---- -------- ----- ---- -------- -----
Principal amount of mortgage loans -- -- -- $ 67,515 $ 144 $ 67,659
Net premium and deferred cost -- -- -- 1,874 4 1,878
Loan loss allowance -- -- -- (39) (3) (42)
--------- --------- --------- --------- --------- ---------
Carrying cost of mortgage loans -- -- -- $ 69,350 $ 145 $ 69,495
========= ========= =========
Mix -- -- -- 99.79% 0.21% 100.00%
Weighted average net coupon -- -- -- 8.707% 7.625% 8.705%
Weighted average maturity -- -- -- 253 302 253
The adjustable rate mortgage loans had a 1 year CMT based reference rate with a
12 month repricing period and a net life cap of 10.25%.
The average effective yield, which includes the amortization of net premium,
discounts and certain deferred costs for the periods shown below on the combined
held for sale and held to maturity mortgage loan portfolio were as follows:
1999 1998
-------- --------
Quarter ended March 31 7.092% 7.410%
Quarter ended June 30 7.010% 7.371%
Quarter ended September 30 2.704% 7.489%
Quarter ended December 31 (9.243%) 7.392%
-------- --------
6.620% 7.424%
======== ========
F-13
71
COLLATERAL FOR CMOS
In April 1998, the Company issued its first CMO securitization transaction,
Hanover Capital SPC, Inc. Series 1998-A ("1998-A"). $102,977,000 (par value) of
single family fixed rate residential mortgage loans were assigned as collateral
for the 1998-A securitization. In March 1999, the Company completed its second
CMO securitization transaction, Hanover Grantor Trust 1999-A ("1999-A").
$138,357,000 (par value) of single family fixed and adjustable rate residential
loans were assigned as collateral for the 1999-A securitization. In August 1999,
the Company completed its third CMO securitization transaction, Hanover Capital
Trust 1999-B ("1999-B"). $111,575,000 (par value) of single family fixed and
adjustable rate residential loans were assigned as collateral for the 1999-B
securitization. The Company has limited exposure to credit risk retained on
loans it has securitized through the issuance of CMOs.
The following table summarizes the Company's single-family fixed and adjustable
rate mortgage loan pools held as CMO collateral (dollars in thousands):
DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- -----------------
Fixed Adjustable Fixed Adjustable
Rate Rate (a) Total Rate Rate (a) Total
---- -------- ----- ---- -------- -----
Principal amount of mortgage loans $ 174,761 $ 93,419 $ 268,180 $ 79,812 $ -- $ 79,812
Net premium (discount)
and deferred costs 2,361 (165) 2,196 1,934 -- 1,934
Loan loss allowance (371) (172) (543) (80) -- (80)
---------- --------- --------- --------- --------- ---------
Carrying cost of mortgage loans $ 176,751 $ 93,082 $ 269,833 $ 81,666 $ -- $ 81,666
========= ========= ========= ========= ========= =========
Mix 65.50% 34.50% 100.00% 100.00% -- 100.00%
Weighted average net coupon 8.310% 7.180% 7.916% 7.787% -- 7.787%
Weighted average maturity 221 249 231 231 -- 231
The adjustable rate mortgage loans assigned as CMO collateral at December 31,
1999 had 18 reference rate indexes with a weighted average 4 month repricing
period and a weighted average net life cap of 13.82%.
The average effective yield, which includes the amortization of net premiums,
discounts and certain deferred costs, for the periods shown below on the CMO
collateral were as follows:
1999 1998
-------- --------
Quarter ended March 31 6.825% N/A
Quarter ended June 30 7.076% 7.158%
Quarter ended September 30 6.781% 7.071%
Quarter ended December 31 7.201% 6.230%
-------- --------
6.991% 6.832%
======== ========
4. MORTGAGE SECURITIES
At December 31, 1999, the Company had $45,479,000 of fixed rate FNMA
mortgage-backed securities, all classified as available for sale, and
$17,207,000 of fixed rate private-placement mortgage-backed securities,
classified as available for sale, held to maturity, and trading, as shown in the
table below.
F-14
72
FIXED RATE FNMA MORTGAGE-BACKED SECURITIES
DECEMBER 31, 1999 DECEMBER 31, 1998
------------------------------------------ ------------------------------------------
Available Held Available Held
For to For to
Sale (a) Maturity Trading Total Sale (a) Maturity Trading Total
-------- -------- ------- ----- -------- -------- ------- -----
Principal balance of mortgage securities $ 46,156 $ -- $ -- $ 46,156 $ 58,462 $ -- $ -- $ 58,462
Net premium and deferred costs 863 -- -- 863 1,179 -- -- 1,179
-------- ------ ------ -------- -------- -------- ------- --------
Total amortized cost of mortgage securities 47,019 -- -- 47,019 59,641 -- -- 59,641
Gross unrealized loss (1,540) -- -- (1,540) (46) -- -- (46)
-------- ------ ------ -------- -------- -------- ------- --------
Carrying cost of mortgage securities $ 45,479 $ -- $ -- $ 45,479 $ 59,595 $ -- $ -- $ 59,595
Mix 100% -- -- 100% 100% -- -- 100%
Weighted average net coupon 7.451% -- -- 7.451% 7.548% -- -- 7.548%
Weighted average maturity 246 -- -- 246 251 -- -- 251
FIXED RATE PRIVATE PLACEMENT MORTGAGE-BACKED SECURITIES
DECEMBER 31, 1999
-------------------------------------------------
Available Held
For to
Sale (b) Maturity (c) Trading (d) Total
-------- ------------ ----------- -----
Principal balance of mortgage securities $ -- $ 13,735 $ 7,105 $ 20,840
Net premium (discount) and deferred costs 1,554 (5,241) (1,186) (4,822)
-------- ---------- -------- ----------
Total amortized cost of mortgage securities $ 1,554 $ 8,494 $ 5,919 $ 16,018
Loan loss allowance -- (256) -- (256)
Gross unrealized gain/(loss) 1,496 -- -- 1,445
-------- ---------- -------- ----------
Carrying cost of mortgage securities $ 3,050 $ 8,238 $ 5,919 $ 17,207
Mix 17.73% 47.87% 34.40% 100.00%
Principal balance of mortgage loans $208,447 $1,271,860 $208,447 $1,480,307
Weighted average net coupon 0.768% 5.932% 6.597% 1.147%
Weighted average maturity 295 303 295 300
FIXED RATE PRIVATE PLACEMENT MORTGAGE-BACKED SECURITIES
DECEMBER 31, 1998
-----------------------------------------------
Available Held
For to
Sale (b) Maturity (c) Trading (d) Total
-------- ------------ ----------- -----
Principal balance of mortgage securities $ 14,279 $ 3,816 -- $ 18,095
Net premium (discount) and deferred costs 2,479 662 -- 3,141
-------- -------- -------- --------
Total amortized cost of mortgage securities $ 16,758 $ 4,478 $ -- $ 21,236
Loan loss allowance -- -- -- --
Gross unrealized gain/(loss) (2,353) -- -- (2,353)
-------- -------- -------- --------
Carrying cost of mortgage securities $ 14,405 $ 4,478 $ -- $ 18,883
Mix 76.29% 23.71% -- 100.00%
Principal balance of mortgage loans $297,682 $297,682 -- $297,682
Weighted average net coupon 0.987% 5.038% -- 1.058%
Weighted average maturity 307 307 -- 307
The Company also has substantially all of the economic benefit and risks
associated with $14,180,000 of fixed rate private-placement subordinate mortgage
backed securities held by its affiliate, HCP. Although HCP's balance sheet is
not consolidated in the Company's consolidated balance sheet, the Company
receives 97% of HCP's income and has guaranteed HCP's debts associated with
these securities. See Note 7 "Equity Investments."
FIXED RATE PRIVATE PLACEMENT MORTGAGE-BACKED SECURITIES
(HELD BY AFFILIATE)
-------------------
DECEMBER 31, 1999 DECEMBER 31, 1998
--------------------------------------------- --------------------------------------
Available Held Available Held
For to For to
Sale (e) Maturity Trading Total Sale Maturity Trading Total
-------- -------- ------- ----- ---- -------- ------- -----
Principal balance of mortgage securities $ 33,401 $ -- $ -- $ 33,401 $ -- $ -- $ -- $ --
Net (discount) and deferred costs (19,175) -- -- (19,175) -- -- -- --
---------- -------- ------- ---------- ------- ------- ------ ------
Total amortized cost of mortgage securities $ 14,226 $ -- $ -- $ 14,226 -- -- -- --
Loan loss provision (285) -- -- (285) -- -- -- --
Gross unrealized gain 239 -- -- 239 -- -- -- --
---------- -------- ------- ---------- ------- ------- ------ ------
Carrying cost of mortgage securities $ 14,180 $ -- $ -- $ 14,180 $ -- $ -- $ -- $ --
Mix 100% -- -- 100% -- -- -- --
Principal balance of mortgage loans $5,171,979 -- -- $5,171,979 -- -- -- --
Weighted average net coupon 6.520% -- -- 6.520% -- -- -- --
Weighted average maturity 345 -- -- 345 -- -- -- --
F-15
73
(a) Represents 31 fixed rate FNMA pass-through certificates that the Company
received in exchange for a like amount of fixed rate mortgage loans in
December 1998, and one FNMA pass-through certificate purchased from a
"Wall Street" dealer firm. The coupon interest rates range from 6.00% to
10.50%. These certificates generate normal principal and interest
remittances to the Company on a monthly basis.
(b) At December 31, 1999, represents six interest only notes purchased from an
affiliate, Hanover Capital Partners 2, Inc. ("HCP-2"), in a private
placement in October 1998 in connection with the 1998-B securitization. At
December 31, 1998, represented nine investment grade ("AA", "A" and "BBB")
subordinate mortgage-backed securities ("MBS") and six interest only notes
purchased from HCP-2 in such private placement. At September 30, 1999
management reclassified four investment grade subordinate MBS ("AA and
"A") to the trading category and two investment grade subordinate MBS
("BBB") to the held to maturity category. These MBS were transferred at
their fair market value which was lower than their cost basis by
$1,312,000. This decrease in market value was recorded as a one-time
charge in the consolidated statements of operations. See Note 17, "Certain
Charges and Expenses in the Quarter Ended September 30, 1999".
The interest rates on the investment grade subordinate MBS are fixed and
range from 6.25% to 6.75%. These bonds generate normal principal and
interest remittances to the Company on a monthly basis.
The interest only notes generate monthly interest remittances to the
Company (subject to the availability of funds) from the excess interest
generated from the underlying mortgages after deducting all service fees
and the coupon interest rate on the applicable notes. The interest rate on
each of the interest only notes is based on a notional amount (the
principal balance of those mortgage loans with an interest rate in excess
of the related note coupon interest rate). The notional amounts decline
each month to reflect the related normal principal amortization,
curtailments and prepayments for the related underlying mortgage loans.
The interest only notes are divided into two major categories: at December
31, 1999, the first group had an effective weighted average interest rate
of 1.055% on a notional balance of $177,641,000; and the second group had
an effective weighted average interest rate of 0.25% on a notional balance
of $98,071,000. At December 31, 1998, the first group had an effective
weighted average interest rate of 1.166% on a notional balance of
$259,861,000; and the second group had an effective weighted average
interest rate of 0.25% on a notional balance of $143,366,000.
(c) At December 31, 1999, represents twelve below investment grade subordinate
MBS purchased from third parties in the second quarter of 1999; and two
investment grade ("BBB") subordinate MBS, six below investment grade
subordinate MBS and three investment grade ("AAA") principal only notes
purchased from HCP-2 in October 1998 in connection with the 1998-B
securitization. At December 31, 1998, represents six below investment
grade subordinate MBS and three and three investment grade ("AAA")
principal only notes, all purchased from HCP-2 in October 1998 in
connection with the 1998-B securitization.
The coupon interest rates on the below investment grade subordinate MBS
purchased from third parties are fixed and range from 6.25% to 6.68%.
These notes generate normal principal and interest remittances to the
Company on a monthly basis. These notes represented a $6,094,000
(principal balance) subordinated interest in $1,063,413,000 of mortgage
loans at December 31, 1999. These notes were carried at $3,640,000 at
December 31, 1999.
F-16
74
The coupon interest rates on the 1998-B subordinate MBS are fixed and
range from 6.50% to 6.75%. These notes generate normal principal and
interest remittances to the Company on a monthly basis. The 1998-B
subordinate MBS represented a $6,360,000 (principal balance) subordinated
interest in $208,447,000 of mortgage loans at December 31, 1999 and a
$3,546,000 subordinated interest in $297,682,000 of mortgage loans at
December 31, 1998. These notes were carried at $4,597,000 at December 31,
1999 and at $3,106,000 at December 31, 1998.
The 1998-B principal only notes do not pay interest. These notes generate
principal remittances, and are carried at a discount to face value. The
difference between the carrying value and the face amount is accreted into
income on the constant yield method. These notes had a principal balance
of $1,281,000 and $1,676,000 at December 31, 1999 and 1998, and were
carried at $1,052,000 and at $1,370,000 at December 31, 1999 and 1998.
(d) Represents four investment grade subordinate MBS ("AA" and "A") purchased
from HCP-2, in October 1998 in connection with the 1998-B securitization.
The coupon interest rates on the investment grade notes are fixed and
range from 6.50% to 6.75%. These notes generate normal principal and
interest remittances to the Company on a monthly basis. These notes are
carried at fair value.
(e) At December 31, 1999, represents seventeen below investment grade
subordinate MBS purchased from third parties in the third quarter of 1999.
The coupon interest rates on these notes are fixed and range from 6.25% to
6.75%. These notes generate normal principal and interest remittances to
the Company on a monthly basis. These notes represented a $33,401,000
(principal balance) subordinated interest in $5,171,979,000 of mortgage
loans at December 31, 1999. These notes were carried at $14,180,000 at
December 31, 1999 on the balance sheet of HCP. Although HCP's balance
sheet is not consolidated in the Company's consolidated balance sheet, the
Company receives 97% of HCP's income and has guaranteed HCP's debts
associated with these securities. See Note 7 "Equity Investments."
The carrying value at December 31, 1999 of the Company's mortgage securities by
contractual maturity dates are presented below (dollars in thousands):
Available for Sale Held to Maturity Trading
Carrying Value Carrying Value Carrying Value
-------------- -------------- --------------
Due after ten years $48,529 $8,238 $5,919
As mentioned above, actual maturities may differ from stated maturities because
borrowers usually have the right to prepay certain obligations, often times
without penalties. Maturities of mortgage securities depend on the repayment
characteristics and experience of the underlying mortgage loans.
The average effective yield, which includes amortization of net premiums,
(discounts) and deferred costs, for the periods shown below on the combined
available for sale, held to maturity and trading mortgage securities portfolio
(excluding securities owned by HCP) were as follows:
F-17
75
1999 1998
-------- --------
Quarter ended March 31 8.784% 6.116%
Quarter ended June 30 8.752% 3.992%
Quarter ended September 30 (1.335%) 4.528%
Quarter ended December 31 9.701% 7.520%
-------- --------
6.494% 5.170%
======== ========
The proceeds, gross realized gains and losses from sales of available for sale
mortgage securities in 1999 and 1998 were as follows (dollars in thousands):
1999
REALIZED
PROCEEDS GAIN (LOSS)
-------- -----------
Hanover Capital 1998-B Subordinate MBS (a) 2,232 146
1998
REALIZED
PROCEEDS GAIN (LOSS)
-------- -----------
Adjustable rate FNMA and FHLMC
Certificates (b) $ 189,057 $ (5,989)
Adjustable rate FNMA certificates (c) 17,172 (161)
Fixed rate FNMA certificates (d) 56,740 495
--------- ---------
$ 262,969 $ (5,655)
========= =========
(a) relates to the sale in March 1999 of six subordinate MBS acquired in
connection with the 1998-B securitization in October 1998.
(b) relates to the sale in October 1998 of eight FNMA certificates and seven
FHLMC certificates purchased in December 1997
(c) relates to the sale in October 1998 of five FNMA certificates acquired from
a swap of mortgage loans in August 1998
(d) relates to the sale in October 1998 of nineteen FNMA certificates acquired
from a swap of mortgage loans in October 1998
5. CONCENTRATION OF CREDIT RISK
MORTGAGE LOANS
The Company's exposure to credit risk associated with its investment activities
is measured on an individual customer basis as well as by groups of customers
that share similar attributes. In the normal course of its business, the Company
has concentrations of credit risk in its mortgage portfolio for the loans in
certain geographic areas. At December 31, 1999 and 1998, the percent of total
principal amount of loans outstanding in any one state, exceeding 5% of the
principal amount of mortgage loans are as follows:
F-18
76
AT DECEMBER 31, 1999 AT DECEMBER 31, 1998
Mortgage Loans Mortgage Loans
-------------------- ------------------------------------------------------
Collateral for Collateral for
CMOs Held for Sale Held to Maturity CMOs
---- ------------- ---------------- ----
California 13% 13% 17% 11%
Texas 9 7 13 --
Florida 15 10 8 26
Missouri -- -- 6 --
Illinois -- 5 -- --
South Carolina -- -- -- --
Ohio 6 -- -- 12
Hawaii -- -- -- 6
Maryland 5 -- -- --
Total 48% 35% 44% 55%
==== ==== ==== ====
The Company did not have any material concentrations of credit risk in its held
for sale and held to maturity categories at December 31, 1999.
The Company did not purchase any mortgage loans in 1999. During 1998 the Company
purchased approximately 75.2% of its total principal amount of mortgage loans
from six financial institutions, the largest of which represented approximately
21.7% of the total principal amount of mortgage loans purchased in 1998.
Management believes that the loss of any single financial institution from which
the Company purchased mortgage loans would not have any material detrimental
effect on the Company.
MORTGAGE SECURITIES
The Company's exposure to credit risk associated with its investment activities
is measured on an individual security basis as well as by groups of securities
that share similar attributes. In certain instances, the Company has
concentrations of credit risk in its mortgage securities portfolio for the
securities of certain issuers. Management believes exposure to credit risk
associated with purchased Agency mortgage securities is minimal due to the
guarantees provided by FNMA.
CONCENTRATION OF CREDIT RISK BY ISSUER
DECEMBER 31, 1999
Hanover
Capital
Hanover Capital Mortgage Holdings, Inc. Partners Ltd. Total
------------------------------------------------------- ------------- -----
Available Held Available
for to for
Issuer Sale Maturity Trading Total Sale
- ------ ---- -------- ------- ----- ----
FNMA $45,479 $ -- $ -- $45,479 $ -- $45,479
Hanover Capital 1998-B 3,050 4,597 5,919 13,566 -- 13,567
Issuer 1 -- -- -- -- 7,387 7,387
Issuer 2 -- -- -- -- 6,793 6,793
Issuer 3 -- 2,220 -- 2,220 -- 2,220
Issuer 4 -- 706 -- 706 -- 706
Issuer 5 -- 715 -- 715 -- 714
------- ------- ------- ------- ------- -------
Total $48,529 $ 8,238 $ 5,919 $62,686 $14,180 $76,866
======= ======= ======= ======= ======= =======
F-19
77
CONCENTRATION OF CREDIT RISK BY ISSUER
DECEMBER 31, 1998
Hanover
Capital
Hanover Capital Mortgage Holdings, Inc. Partners Ltd. Total
------------------------------------------------------- ------------- -----
Available Held Available
for to for
Issuer Sale Maturity Trading Total Sale
- ------ ---- -------- ------- ----- ----
FNMA $59,595 $ -- -- $59,595 $ -- $59,595
Hanover Capital 1998-B 14,405 4,478 -- 18,883 $ -- 18,883
------- ------- ------- ------- ------- -------
Total $74,000 $ 4,478 -- $78,478 $ -- $78,478
======= ======= ======= ======= ======= =======
The Company has cash and cash equivalents in a major financial institution which
is insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000.
At December 31, 1999, the Company had amounts on deposit with the financial
institution in excess of FDIC limits. At December 31, 1999, the Company had
overnight investments of $18,000,000 in Federal Home Loan Bank discount notes.
The Company limits its risk by placing its cash and cash equivalents in a high
quality financial institution, Federal Agency notes or in the highest rated
commercial paper.
6. LOAN LOSS ALLOWANCE
The provision for loan loss charged to expense is based upon actual credit loss
experience and management's estimate and evaluation of potential losses in the
existing mortgage loan and mortgage securities portfolio, including the
evaluation of impaired loans. The following table summarizes the activity in the
loan loss allowance for the following periods (dollars in thousands):
YEAR ENDED YEAR ENDED PERIOD FROM JUNE 10
DECEMBER 31, DECEMBER 31, (INCEPTION) TO
1999 1998 DECEMBER 31, 1997
---- ---- -----------------
Balance, beginning of period $ 372 $ 18 $ - 0 -
Loan loss provision 446 356 18
Transfers/sales 39 (2) --
Charge-offs (110) -- --
Recoveries 52 -- --
----- ----- -----
Balance, end of period $ 799 $ 372 $ 18
===== ===== =====
7. EQUITY INVESTMENTS
Hanover owns 100% of the non-voting preferred stock of Hanover Capital Partners
Ltd. ("HCP"), which entitles Hanover to receive 97% of the earnings or losses of
HCP and its wholly owned subsidiaries. Hanover also owns 100% of the non-voting
preferred stock of Hanover Capital Partners 2, Inc. ("HCP-2"), which entitles
Hanover to receive 99% of the earnings or losses of HCP-2 and its wholly owned
subsidiary. In June 1999, the Company acquired 100% of the non-voting preferred
stock of HanoverTrade.com, Inc. ("HTC") which entitles Hanover to receive 97% of
the earnings or losses of HTC.
F-20
78
Hanover currently conducts substantially all of its taxable consulting
operations (i.e. due diligence consulting, loan sale advisory, and loan
brokering and trading) through HCP. HCP-2 was organized in October 1998 to
facilitate the securitization of $318 million of fixed and adjustable rate
residential mortgage loans in connection with the issuance of the 1998-B
security. HCP-2 does not conduct any ongoing business. The Company wrote off its
remaining investment in HCP-2 in September, 1999. HTC was organized in June 1999
to develop an E-commerce business to broker mortgage loan pools to financial
institutions via the internet.
HCP and its subsidiaries operate as a specialty finance company which is
principally engaged in performing due diligence, consulting and mortgage
investment banking services. A wholly-owned subsidiary of HCP, Hanover Capital
Mortgage Corporation, is a servicer of multifamily mortgage loans and, prior to
June 1999, was an originator of multifamily and commercial loans. HCMC's
origination operations were discontinued in June 1999. Another wholly-owned
subsidiary of HCP, Hanover Capital Securities, Inc. is a registered
broker/dealer with the Securities and Exchange Commission.
HCP-2 was organized in October, 1998 to acquire single-family residential
mortgage loans from Hanover pursuant to its formation transaction and to finance
the purchase of these mortgage loans through a REMIC securitization, 1998-B.
Hanover contributed $324.2 million of fixed rate mortgage loans (with a par
value of $318 million) subject to $310 million of reverse repurchase agreement
financing to HCP-2 in exchange for a 99% economic ownership of HCP-2
(representing a 100% ownership of the non-voting preferred stock in HCP-2).
HCP-2 issued a REMIC mortgage security and sold all of the REMIC mortgage
securities except the AAA notes to two newly created wholly-owned subsidiaries
of Hanover (Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B, Inc.). Hanover
recorded its investment in HCP-2 on the equity method. The Board of Directors
has approved the sale or disposition of the Company's preferred stock investment
in HCP-2 and has recorded a one-time charge to the consolidated statement of
operations for a loss on the sale of HCP-2 of $4,428,000. See Note 17, "Certain
Charges and Expenses in the Three Months Ended September 30, 1999".
Until September 30, Hanover recorded 99% of the earnings or losses of HCP-2
through its ownership of all the non-voting preferred stock of HCP-2. After
September 30, Hanover has not recorded earning or losses of HCP-2
The table below reflects the activity recorded in Hanover's equity investments
for the following periods (dollars in thousands):
PERIOD FROM
YEAR ENDED YEAR ENDED JUNE 10 (INCEPTION)
DECEMBER 31, DECEMBER 31, TO DECEMBER 31,
1999 1998 1997
--------------------------------------------- --------------------------------- -------------------
HCP HCP-2 HTC Total HCP HCP-2 Total HCP Total
--- ----- --- ----- --- ----- ----- --- -----
Beginning balance $ 1,761 $ 5,728 $ -- $ 7,489 $ 100 $ -- $ 100 $ -- $ --
Applicable % of net (loss) (443) (1,300) (31) (1,774) (1,039) (394) (1,433) (254) (254)
Applicable % of
comprehensive gain 148 -- -- 148 -- -- -- -- --
Capital contribution -- -- 1 1 2,700 -- 2,700 -- --
Formation transaction -- -- -- -- -- 14,176 14,176 354 354
Dividends received (a) -- -- -- -- -- (8,054) (8,054) -- --
Write off of investment -- (4,428) -- (4,428) -- -- -- -- --
-------- -------- -------- -------- -------- -------- -------- -------- ------
Ending Balance $ 1,466 $ -- $ (30) $ 1,436 $ 1,761 $ 5,728 $ 7,489 $ 100 $ 100
======== ======== ======== ======== ======== ======== ======== ======== ======
(a) represents a return of capital
F-21
79
8. NOTES RECEIVABLE FROM RELATED PARTIES
In connection with Hanover's original formation transactions in September 1997,
Hanover agreed to lend a maximum of $1,750,000 collectively, to four
officer/stockholders (collectively referred to as the "Principals") to enable
the Principals to pay personal income taxes on the gains they must recognize
upon contributing their HCP preferred stock to the Company for shares of
Hanover's common stock. The loans are secured solely by 116,667 shares of
Hanover's common stock owned by the Principals, collectively. The loans bear
interest at the lowest applicable Federal tax rate during the month the loans
are made. At December 31, 1999 Hanover had loaned the Principals the full
$1,750,000. These loans bear interest at 6.02% (on $482,600 of loans) and 5.70%
(on $1,267,400 of loans) at December 31, 1999.
In March 1998, Hanover agreed to lend up to an additional $1,500,000 in
unsecured loans to the Principals, in lieu of incurring the costs and expenses
Hanover was required to pay associated with the registration of 100,000 shares
of Hanover's common stock owned by the Principals. Pursuant to such agreement,
Hanover loaned the Principals an additional $1,203,880 in April 1998. These
additional loans are due and payable on March 31, 2001 and bear interest at
5.51%.
In November 1998, Hanover agreed to lend an additional $226,693 in unsecured
loans to the Principals. These loans are due and payable in November 2002 and
bear interest at 4.47% (the lowest applicable Federal tax rate in November
1999). A portion of these loans ($69,148) was repaid in February 1999, and
another portion ($61,837) was forgiven on January 28, 2000. The Company reserved
for this forgiveness on September 30, 1999. At December 31, 1999, the balance of
these loans, net of the reserved amount, was $95,708.
During 1999 Hanover advanced funds to HCP pursuant to an unsecured loan
agreement. These loans to HCP bear interest at 1.00% below the prime rate. At
December 31, 1999 the loans outstanding to HCP totaled $4,896,046.
Amounts due from related parties and due to related parties are detailed below
(dollars in thousands):
INTERCOMPANY BALANCES
---------------------
DECEMBER 31, DECEMBER 31,
1999 1998
---- ----
Due from HTC $121 $ --
Due from HCP-2 -- 305
Due from HCP 6 --
Due to HCP 88 --
F-22
80
NOTES RECEIVABLE
----------------
DECEMBER 31, DECEMBER 31,
1999 1998
---- ----
Principals (a) (b) (c) $3,049 $3,180
HCP (d) 4,869 713
(a) The Principals are John A. Burchett, George J. Ostendorf, Irma N. Tavares
and Joyce S. Mizerak, the four most senior officers/stockholders of
Hanover.
(b) In March 1999, Hanover agreed to amend certain notes receivable
(aggregating $1,203,880) from the Principals that had a scheduled maturity
date of March 31, 1999, by extending the maturity date for two additional
years. The notes were also modified to provide for accelerated repayment by
a Principal in the event of such Principals' voluntary termination of
employment.
(c) Pursuant to the note agreements, the Company loaned the Principals $143,000
to purchase common stock in HCP-2 in order to complete the 1998-B
securitization transaction. The Principals subsequently made payments on
the loans totaling $69,000. In September 1999, the Company reserved for an
expected forgiveness of $62,000 of these loans. This amount was
subsequently forgiven on January 28, 2000. Summarized below is the change
in Principals loans during 1999:
Balance at January 1, 1999 $ 3,180
Loan repayments (69)
Provision for loan forgiveness (62)
-------
Balance at December 31, 1999 $ 3,049
=======
(d) In September 1999 the Company advanced $3,041,000 to HCP to fund the
purchase of certain subordinated mortgage securities pursuant to an
unsecured loan agreement.
9. REVERSE REPURCHASE AGREEMENTS
At December 31, 1999 the Company had a total of $250 million of committed and
uncommitted mortgage asset reverse repurchase agreement financing available
pursuant to master reverse repurchase agreements with two lenders. All
borrowings pursuant to the master reverse repurchase agreements are secured by
mortgage loans or other securities.
The reverse repurchase agreements collateralized by mortgage loans are short
term borrowings with interest rates that vary from LIBOR plus 125 basis points
to LIBOR plus 238 basis points. The lender will typically finance an amount
equal to 80% to 97% of the market value of the pledged collateral (mortgage
loans) depending on certain characteristics of the collateral (delinquencies,
liens, aging, etc.). The reverse repurchase agreement financing rates for
mortgage securities, accomplished through individual Public Securities
Association (PSA) agreements and through existing reverse repurchase agreements,
bear interest rates that vary from LIBOR to LIBOR plus 288 basis points. The
lender will typically finance an amount equal to 60% to 97% of the market value
of the mortgage securities, depending on the nature of the collateral.
F-23
81
At December 31, 1999 the Company had no outstanding borrowings on mortgage loans
under the above mentioned reverse repurchase agreements.
At December 31, 1999, the Company had outstanding borrowings on retained CMO
securities of $3,366,000 with a weighted average borrowing rate of 8.16% and a
weighted average remaining maturity of three months. Retained CMO securities
represent the Company's net investment in the CMOs issued by the Company. The
reverse repurchase financing agreements at December 31, 1999 were collateralized
by securities with a cost basis of $7,201,152.
At December 31, 1999, the Company had outstanding reverse repurchase agreement
financing for mortgage securities (other than retained CMO securities) of
$52,356,000 with a weighted average borrowing rate of 6.05% and a remaining
maturity of less than one month. These mortgage securities are mortgage
securities that the Company has purchased or created in transactions other than
CMOs. The repurchase agreement financing at December 31, 1999 was collateralized
by securities with a cost basis of $60,465,000.
The table below details the scheduled maturities of the Company's committed and
uncommitted master reverse repurchase agreements at December 31, 1999:
Committed Uncommitted Maturity Date
--------- ----------- -------------
$ 50 million -- March 2000
100 million $100 million March 2000
Information pertaining to reverse repurchase agreement financing as of and for
the years ended December 31, 1999 and 1998 is summarized as follows (dollars in
thousands):
REVERSE REPO FINANCING
YEAR ENDED DECEMBER 31, 1999
OTHER
MORTGAGE RETAINED CMO MORTGAGE
REVERSE REPURCHASE AGREEMENTS LOANS SECURITIES SECURITIES
- ----------------------------- ----- ---------- ----------
Balance of borrowing at end of period -- $ 3,366 $ 52,356
Average borrowing balance during the
period $ 93,998 $ 2,244 $ 53,638
Average interest rate during the period 6.364% 7.164% 5.510%
Maximum month-end borrowing balance $283,837 $ 3,393 $ 61,559
during the period
COLLATERAL UNDERLYING THE AGREEMENTS
------------------------------------
Balance at end of period - carrying value -- $ 7,201 $ 60,465
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82
YEAR ENDED DECEMBER 31, 1998
OTHER
MORTGAGE RETAINED CMO MORTGAGE
REVERSE REPURCHASE AGREEMENTS LOANS SECURITIES SECURITIES
- ----------------------------- ----- ---------- ----------
Balance of borrowing at end of period $306,239 $ 1,911 $ 61,940
Average borrowing balance during the $367,656 $ 760 $224,050
period
Average interest rate during the period 6.511% 6.853% 5.695%
Maximum month - end borrowing balance $659,319 $ 2,331 $249,450
during the period
COLLATERAL UNDERLYING THE AGREEMENTS
------------------------------------
Balance at end of period - carrying value $320,759 $ 2,542 $ 64,938
Additional information pertaining to individual reverse repurchase agreement
lenders at December 31, 1999 is summarized as follows (dollars in thousands):
Weighted
Reverse Average
Repurchase Accrued Total Underlying Maturity
Lender Type of Collateral Financing Interest Financing Collateral Date
- ------ ------------------ --------- -------- --------- ---------- ----
Lender A (committed) Retained CMO Securities $ 3,366 $ 21 $ 3,387 $ 7,201 March 31, 2000 (a)
Lender B (committed) Mortgage Securities 5,000 3 5,003 9,793 March 31, 2000 (b)
Lender C Mortgage Securities 37,481 360 37,841 37,337 January 25, 2000 (c)
Lender D Mortgage Securities 8,975 92 9,067 9,352 January 23, 2000 (c)
Lender E Mortgage Securities 463 -- 463 705 January 26, 2000 (c)
Lender F Mortgage Securities 437 -- 437 713 January 28, 2000 (c)
------- ------- ------- -------
Total $55,722 $ 476 $56,198 $65,101
======= ======= ======= =======
(a) The Company expects that the lender will renew this facility for an
additional year.
(b) The maturity date of this facility was extended to April 30, 1999 and the
Company expects that the lender will renew this facility for an additional
year.
(c) These borrowings are pursuant to uncommitted lines of credit which are
typically renewed monthly.
10. CMO BORROWING
The Company issued its first CMO (also referred to as mortgage-backed bonds
borrowing) secured by fixed rate mortgage loans in April 1998, and issued
subsequent CMO borrowings secured by fixed rate and adjustable rate mortgage
loans in March 1999 and August 1999. For GAAP purposes, the mortgage loans
financed through the issuance of CMOs are treated as assets of the Company and
the CMOs are treated as debt of the Company. Borrower remittances received on
the CMO collateral are used to make payments on the CMOs. The obligations of the
CMO are payable solely from the underlying mortgage loans collateralizing the
debt and otherwise are non-recourse to the Company. The maturity of each class
of CMO is directly affected by principal prepayments on the related CMO
collateral. Each class of CMO is also subject to redemption according to
specific terms of the respective indenture agreements. As a result, the actual
maturity of any class of CMO is likely to occur earlier than its stated
maturity.
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Information pertaining to the CMOs as of and for the year ended December 31,
1999 is summarized as follows (dollars in thousands):
1999-B 1999-A 1998-A
SECURITIZATION SECURITIZATION SECURITIZATION TOTAL
-------------- -------------- -------------- -----
Balance of borrowing at end of period $ 94,718 $105,993 $ 54,252 $254,963
Average borrowing balance during the period $ 98,658 $108,977 $ 57,634 $265,270
Average interest rate during the period 6.250% 7.063% 6.670% 6.675%
Interest rate at end of period 6.380% 7.131% 6.947% 6.813%
Maximum month-end borrowing balance
during the period $ 99,973 $110,513 $ 59,088 $269,575
CMO collateral
- --------------
Balance at end of period - carrying balance $ 98,507 $113,662 $ 57,664 $269,833
Information pertaining to the CMOs as of and for the year ended December 31,
1998 is summarized as follows (dollars in thousands):
1998-A
SECURITIZATION
--------------
Balance of borrowing at end of period $77,305
Average borrowing balance during the $63,764
period
Average interest rate during the period 6.914%
Interest Rate at end of period 6.940%
Maximum month - end borrowing balance $98,391
during the period
CMO collateral
- --------------
Balance at end of period - carrying value $81,666
Aggregate annual repayments of mortgage backed bonds based upon contractual
amortization of the underlying mortgage loan collateral at December 31, 1999
were as follows (dollars in thousands):
YEAR AMOUNT
---- ------
2000 $ 14,719
2001 10,751
2002 11,332
2003 11,400
2004 11,384
Thereafter 195,377
--------
Total $254,963
========
11. COMMON STOCK REPURCHASES
In July 1998, the Board of Directors of the Company authorized a share
repurchase program pursuant to which the Company was authorized to repurchase up
to 646,880 shares of the Company's outstanding
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84
common stock. The repurchases were made from time to time in open market
transactions. During the year ended December 31, 1998, the Company repurchased a
total of 146,900 shares of its common stock at an average price of $9.16 per
share for a total cost of $1,345,000. During the year ended December 31, 1999,
the Company repurchased a total of 495,000 shares at an average price of $4.51
per share for a total cost of $2,236,000. Through December 31, 1999 the Company
had repurchased a total of 641,900 shares at an average price of $5.58 per share
for a total of $3,580,000. In October, 1999, the Board of Directors of the
Company authorized a second share repurchase program pursuant to which the
Company was authorized to repurchase up to 1,000,000 shares of its outstanding
common stock from time to time in open market transactions. Through December 31,
1999, the Company had not repurchased any shares pursuant to the second program.
12. EMPLOYEE BENEFIT PLANS
401(K) PLAN
The Company participates in the HCP non-contributory retirement plan ("401(k)
Plan"). The 401(k) plan is available to all full-time company employees with at
least six months of service. The 401(k) Plan is designed to be tax deferred in
accordance with provisions of Section 401(k) of the Internal Revenue Code. The
401(k) Plan provides that each participant may contribute 15.0% of his or her
salary subject to the maximum allowable each fiscal year ($10,000 in 1999 and
$10,000 in 1998). Under the 401(k) Plan, an employee may elect to enroll on
January 1, or July 1, provided that the employee has met the six month
employment service requirement.
COMPANY STOCK OPTION PLANS
The Company has adopted two stock option plans: (1) the 1997 Executive and
Non-Employee Director 1997 Stock Option Plan (the "1997 Stock Option Plan"); and
(2) the 1999 Equity Incentive Plan (the "1999 Equity Incentive Plan", together
with the 1997 Stock Option Plan, "the Stock Option Plans"). The purpose of the
Stock Option Plans is to provide a means of performance-based compensation in
order to attract and retain qualified personnel and to afford additional
incentive to others to increase their efforts in providing significant services
to the Company.
1997 Stock Option Plan
The 1997 Stock Option Plan provides for the grant of qualified incentive stock
options ("ISOs") which meet the requirements of Section 422 of the Internal
Revenue Code, stock options not so qualified ("NQSOs"), deferred stock,
restricted stock, performance shares, stock appreciation and limited stock
awards ("Awards"), and dividend equivalent rights ("DERs"). The 1997 Stock
Option Plan authorizes the grant of options to purchase, and Awards of, an
aggregate of up to 325,333 shares of the Company's Common Stock. If an option
granted under the Stock Option Plan expires or terminates, or an Award is
forfeited, the shares subject to any unexercised portion of such option or Award
will again become available for issuance under the Stock Option Plan.
Unless previously terminated by the Board of Directors, the 1997 Stock Option
Plan will terminate ten years from the date of approval (or five years in the
case of ISOs granted to an employee who owns in excess of 10% of the combined
voting power of the Company's outstanding equity stock) and no options or Awards
may be granted under the 1997 Stock Option Plan thereafter, but existing options
or Awards remain in effect until the options are exercised or the options or the
Awards are terminated by their terms. The aggregate fair market value
(determined as of the time of grant) of the shares with respect to
F-27
85
which ISOs are exercisable for the first time by an employee during any calendar
year may not exceed $100,000.
All stock options granted by the Compensation Committee pursuant to the Stock
Option Plan are contingent and may vest, subject to other vesting requirements
imposed by the Compensation Committee, in full or in part on any September 30
beginning with September 30, 1998 and ending with September 30, 2002 (each, an
"Earn-Out Measuring Date"). No vesting occurred on the first Earn-Out Measuring
Date (September 30, 1998) and the second Earn-Out Measuring Date (September 30,
1999) because the Company did not meet or exceed the vesting requirements.
Vesting occurs when the return on a unit (a unit is composed of one common stock
certificate and one warrant certificate) is at least equal to the initial public
offering price of the unit. In addition, subject to any other vesting
restrictions, one-third of any outstanding stock options will vest as of any
Earn-Out Measuring Date through which the return on a unit is at least equal to
a 20% annualized return on the initial public offering price of the unit.
The return on a unit is determined by adding (i) the appreciation in the value
of the unit since the closing of the initial public offering and (ii) the amount
of distributions made by the Company on the share of Common Stock included in
the unit since the closing of the initial public offering. The appreciation in
the value of a unit as of any Earn-Out Measuring Date is the average difference,
during the 30 day period that ends on the Earn-Out Measuring Date, between the
market price of the shares of Common Stock included in the unit and the initial
public offering price of the unit multiplied by two to take into account the
value of the warrant included in the unit. In determining whether such stock
options have vested, appropriate adjustments will be made for stock splits,
recapitalizations, stock dividends and transactions having similar effects.
1999 Stock Option Plan
The Company adopted the 1999 Equity Incentive Plan (the "1999 Stock Option
Plan"), which provides for the grant of stock options which are not intended to
be "qualified incentive stock options" pursuant to Section 422 of the Internal
Revenue Code. The 1999 Stock Option Plan authorizes the grant of options of up
to 550,710 shares of the Company's Common Stock. If an option granted under the
1999 Stock Option Plan expires or terminates, or an Award is forfeited, the
shares subject to any unexercised portion of such option or Award will again
become available for the issuance of further options or Awards under the 1999
Equity Incentive Plan. The maximum number of Common Stock that any eligible
participant may receive under the 1999 Stock Option Plan for any year may not
exceed 50,000.
Unless terminated earlier by the Board of Directors, the 1999 Stock Option Plan
will terminate ten years from its approval date. When the 1999 Stock Option Plan
ends, no options or Awards may be granted under the 1999 Stock Option Plan, but
existing options or Awards remain in effect until they are exercised or
terminated. Each option must terminate no more than ten years from the date it
is granted. Options may be granted on terms providing for exercise either in
whole or in part at any time or times during their restrictive terms, or only in
specified percentages at stated time periods or intervals during the term of the
option. One third of the option vests one year after the grant of the option,
another third of the option vests two years after the grant, and after three
years the option may be exercised in full.
F-28
86
A summary of the status of the Company's 1997 and 1999 Stock Option Plans as of
December 31, 1999 and changes during the periods from September 19, 1997 to
December 31, 1997 and for the years ended December 31, 1998 and 1999 is
presented below:
1997 Plan 1999 Plan
# of # of Weighted
Options for Options for Average
Stock Option Activity - 1997 Shares Shares Exercise Price Exercise Price
- ---------------------------- ------ ------ -------------- --------------
Granted - September 19, 1997 162,664 $ 15.00
Granted - September 28, 1997 160,660 15.75
Cancelled (3,000) 15.75
-------
Outstanding at Dec. 31, 1997 320,324 $ 15.37
======= ========
Stock Option Activity - 1998
- ----------------------------
Granted - January 14, 1998 2,000 $ 15.94
Granted - March 9, 1998 2,000 18.13
Cancelled (1,750) 15.75
-------
Outstanding at Dec. 31, 1998 322,574
-------
Stock Option Activity - 1999
- ----------------------------
Granted - August 29, 1999 282,750 $ 4.625
Cancelled (27,250) 15.75
Cancelled (12,500) 4.625
------- -------- -------- --------
Outstanding at Dec. 31, 1999 295,324 $ 15.35
======= ========
270,250 $ 4.625
======== ========
No shares were exercisable at December 31, 1999, 1998 and 1997.
The per share weighted average fair value of stock options granted during the
period ended December 31, 1999 and 1998 was $0.49 and $0.95, respectively at the
date of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
1999 1998
---- ----
Expected life (years) 10 9
Risk-free interest rate 6.27% 5.10%
Volatility 61.4% 60.0%
Expected dividend yield 12.3% 10.0%
The Company applies APB opinion No. 25 in accounting for its 1997 and 1999 Stock
Option Plan and, accordingly, no compensation cost has been recognized for its
stock options in the financial statements for 1999, 1998 and 1997. Had the
Company determined compensation cost based on the fair value at the grant date
for its stock options under Statements of Financial Accounting Standards No.
123, Accounting For Stock-Based Compensation, the Company's net income would
have been reduced to the pro forma amounts for the period indicated below
(dollars in thousands, except per share data):
F-29
87
PERIOD FROM JUNE 10
YEAR ENDED YEAR ENDED (INCEPTION) TO
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
Net earnings (loss):
As reported ($12,627) ($4,934) $ 499
Pro forma ($12,766) ($4,938) $ 417
Earnings (loss) per share - basic:
As reported ($ 2.12) ($ 0.77) $0.15
Pro forma ($ 2.15) ($ 0.77) $0.13
Earnings (loss) per share - diluted:
As reported ($ 2.12) ($ 0.77) $0.14
Pro forma ($ 2.14) ($ 0.77) $0.11
Bonus Incentive Compensation Plan
A bonus incentive compensation plan was established in 1997, whereby an annual
bonus will be accrued for eligible participants of the Company. The annual bonus
will be paid one-half in cash and (subject to ownership limits) one-half in
shares of common stock in the following year. The Company must generate annual
net income before bonus accruals that allows for a return of equity to
stockholders in excess of the average weekly ten-year U.S. Treasury rate plus
4.0% before any bonus accrual is recorded. No such accrual was recorded in 1999
and 1998.
13. AFFILIATED PARTY TRANSACTIONS
The Company engaged HCP pursuant to a Management Agreement to render among other
things, due diligence, asset management and administrative services.
The 1999 consolidated statement of operations of the Company includes management
and administrative expenses of $809,000, due diligence expenses of $119,000 and
commission expenses of $5,000 relating to billings from HCP. The 1998
consolidated statement of operations of the Company includes management and
administrative expenses of $733,000, due diligence expenses of $687,000 and
commission expenses of $286,000 relating to billings from HCP. The 1999 and 1998
consolidated statement of operations also reflects a reduction in personnel
expenses for a portion of salaries allocated (and billed) to HCP.
During 1999 and 1998 the Company recorded $175,000 and $129,000 of interest
income generated from loans to the Principals and $168,000 and $126,000 of
interest income from loans to HCP. The term of the Management Agreement
continues until December 31, 2000 with subsequent renewal.
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88
14. EARNINGS PER SHARE
Calculations for earnings (loss) per share are shown below (dollars in
thousands, except per share data):
PERIOD FROM
YEAR ENDED YEAR ENDED JUNE 10 (INCEPTION)
DECEMBER 31, DECEMBER 31, TO DECEMBER 31,
1999 1998 1997
----------- ----------- -----------
EARNINGS (LOSS) PER SHARE BASIC:
Net income (loss) [numerator] $ (12,627) $ (4,934) $ 499
=========== =========== ===========
Average common shares
outstanding [denominator] 5,942,403 6,418,305 3,296,742
=========== =========== ===========
Per share $ (2.12) $ (0.77) $ 0.15
=========== =========== ===========
EARNINGS (LOSS) PER SHARE DILUTED:
Net income (loss) [numerator] $ (12,627) $ (4,934) $ 499
=========== =========== ===========
Average common shares
outstanding 5,942,403 6,418,305 3,296,742
=========== =========== ===========
Add: Incremental shares from
assumed conversion of
warrants 27,016 -0- 374,943
----------- ----------- -----------
Dilutive potential common shares 27,016 -0- 374,943
----------- ----------- -----------
Adjusted weighted average shares
outstanding [denominator] 5,969,419 6,418,305 3,671,685
=========== =========== ===========
Per share $ (2.12) $ (0.77) $ 0.14
=========== =========== ===========
15. STOCK WARRANTS AND STOCK OPTIONS
In November 1998 Hanover entered into a short term financing agreement (that has
since terminated) with Residential Funding Corporation ("RFC"). In connection
with that financing arrangement, Hanover in April 1999 executed a Warrant
Agreement to issue to RFC warrants to purchase 299,999 shares of Hanover's
common stock. The warrants are exercisable at a price per share equal to the
closing price of Hanover's common stock on the American Stock Exchange on the
date of the November agreement, which was $4.00 per share. The warrants expire
after five years, in April 2004.
16. GAIN ON SALE OF SERVICING RIGHTS
On March 31, 1999 Hanover entered into an agreement to sell the servicing rights
on $148 million of single-family mortgage loans. The total income from the sale
of mortgage servicing rights was $566,000. The gain on sale of mortgage
servicing rights was $540,000 and the balance of the income ($26,000) relating
to mortgage loans classified as held for sale, was deferred and was amortized
into
F-31
89
interest income in 1999 over the lives of the mortgage loans using the effective
yield method until the mortgage loans were securitized in August 1999.
17. CERTAIN CHARGES AND EXPENSES IN THE THREE MONTHS ENDED SEPTEMBER 30, 1999
For the three-month period ended September 30, 1999 the Company recorded certain
charges and expenses totaling $14,061,000. These charges and expenses are
summarized as detailed below (dollars in thousands):
Realized (loss) on mark to
market of mortgage securities $ 1,312 (a)
Impairment charge on mortgage securities 2,225 (b)
Realized (loss) on mark to
market of mortgage loans 2,997 (c)
Provision for (loss) on disposition of
unconsolidated subsidiary (HCP-2) 4,793 (d)
Additional operating expenses relating
to the provision for (loss) on sale of
unconsolidated subsidiary (HCP-2) 153 (d)
Loss from unconsolidated subsidiary
(HCP-2) 403 (d)
Catch-up premium, (discount), deferred
financing adjustments on certain
CMOs and mortgage securities 1,821 (e)
Mortgage loan net interest
income adjustment 357 (f)
-------
$14,061
=======
(a) The realized (loss) on mark to market of mortgage securities resulted from
the September 30, 1999 mark to market adjustment recorded on six 1998-B
notes transferred from the available for sale category to the held to
maturity and the trading categories.
(b) The impairment charge on mortgage securities resulted from the mark down of
six 1998-B interest only notes to market value.
(c) The realized (loss) from mark to market resulted from a mark to market
adjustment of $2,997,000 at the time of transfer of mortgage loans from the
held for sale category to the collateral for CMOs category (in connection
with the 1999-B securitization transaction).
(d) The financing structure for the 1998-B securitization resulted in the
organization of HCP-2 in October 1998. HCP-2 was capitalized with a
non-cash contribution from Hanover in the form of mortgage pools net of
related reverse repurchase agreement financing in exchange for 100% of the
non-voting preferred stock of HCP-2 (99% economic interest in HCP-2) and
cash contributions from the Principals (which were loaned to the Principals
from Hanover) in exchange for all of the common stock of HCP-2 (1% economic
interest in HCP-2). The financing structure required certain costs of the
securitization (net premium, hedging and deferred financing costs) to be
capitalized in the subsidiary, HCP-2. Substantially all of Hanover's
investment in HCP-2 consists of these capitalized costs. The capitalized
costs are amortized on HCP-2's books over the anticipated life of the
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90
respective mortgage loans and passed through to Hanover each period as
Hanover's equity ownership (99%) in HCP-2. HCP-2 will continue to generate
losses as these capitalized costs are amortized.
In September 1999, the Company decided to sell HCP-2. A provision for a
loss on the disposition of this investment has been reflected as follows:
100% of the balance of the
investment in HCP-2 $4,428,000
Advances to HCP-2 365,000
----------
Total provision $4,793,000
==========
The Company reserved for the expected forgiveness of $62,000 of loans that
Hanover advanced to the Principals in October 1998 that the Principals used
to invest in HCP-2. These loans were forgiven on January 28, 2000. In
addition, the Company reserved for additional compensation ($41,000) to the
Principals equal to the anticipated income tax consequences attributable to
the forgiveness of the notes. The total compensation costs related to the
provision for forgiveness of Principals' notes ($103,000) and an estimate
of costs relating to the disposition of HCP-2 (legal and other) of $50,000
are reflected as additional operating expenses in the consolidated
statement of operations for 1999.
Also reflected in the above is the $403,000 loss for the three month period
ended September 30, 1999 from an unconsolidated subsidiary (HCP-2). Because
the Company has no basis in its investment in HCP-2 at September 30, 1999
the Company does not expect to record any future losses from HCP-2.
(e) At September 30, 1999 management reviewed the actual prepayment speeds as
compared to the projected prepayment speeds on all of its investment
portfolios. The review resulted in a cumulative adjustment of premiums,
(discount), deferred costs and deferred financing amortization of
$1,821,000 on certain of the Company's investment portfolio. The following
cumulative income adjustments were recorded in the three month period ended
September 30, 1999:
Mortgage securities - 1998-B $1,606,000
Collateral for CMO - 1998-A 138,000
Collateral for CMO - 1999-A 58,000
Mortgage securities - swapped
FNMA certificates 19,000
----------
$1,821,000
==========
(f) An adjustment to mortgage loan net interest income of $357,000 was
reflected in the three month period ended September 30, 1999 in connection
with the 1999-B securitization. This adjustment reduced the Company's
outstanding accrued interest receivable on loans included in the
securitization to the amount specified in the securitization documentation.
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91
18. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands except share data):
PERIOD FROM JUNE 10
YEAR ENDED YEAR ENDED (INCEPTION) TO
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
Cash paid during the period for
Interest $22,058 $39,876 $844
======= ======= ====
Supplemental Schedule of Noncash Activities
Dividends of $583,000 and $695,000 were declared in December 1999 and December
1998 but not paid until February 2000 and January 1999, respectively.
Acquisition of a 99% economic ownership in Hanover Capital Partners 2, Inc. in
October 1998 from the contribution of $324,210 (book value) of mortgage
loans net of $309,963 of reverse repurchase agreement financing less funds
to be returned to Hanover of $71.
Acquisition of a 97% economic ownership in Hanover Capital Partners Ltd. in
September 1997 from the issuance of 716,667 shares of Hanover's common
stock.
19. COMMITMENTS AND CONTINGENCIES
Hanover entered into employment agreements with the Principals in 1997. Such
agreements are for five year terms which expire in 2002, and provide for initial
aggregate annual base salaries of $975,000 (subject to cost of living
increases). A portion of the aggregate base salaries was allocated to one of
Hanover's taxable subsidiaries, HCP, based on management's actual and estimated
time involved with the subsidiary's activities.
As additional consideration to the Principals for their contribution of their
HCP preferred stock to Hanover, Hanover has agreed to (1) issue to the
Principals up to 216,667 additional shares of Hanover's common stock and (2)
forgive a maximum of $1,750,000 in loans made to the Principals if certain
financial returns to stockholders are met, at certain Earn-Out Measuring Dates
as described in Hanover's IPO Prospectus dated September 15, 1997.
Hanover has guaranteed a one year reverse repurchase financing agreement for
HCP. The amount of reverse repurchase financing outstanding at December 31, 1999
was $10,842,000.
Hanover has guaranteed the obligations of HCP with respect to an amendment to an
office lease entered into by HCP. The office lease (effective November 1999) is
for a period of 10 years and 3 months and obligates HCP for $2,162,300 of base
rental expense plus escalation, electric and other billings over the lease term.
Pursuant to a short-term (3 month) reverse repurchase financing agreement
entered into in November 1998, Hanover agreed to issue and deliver to the lender
warrants to purchase 299,999 shares of Hanover's common stock. The warrants are
exercisable at $4.00 per share. In addition, Hanover agreed to (1) retain and
compensate the lender as an underwriter on certain future mortgage loan
securitization deals, (2) have HCMC offer the lender the right to purchase any
originated commercial loans through November 2000 on the same terms and
conditions as it would offer such to a third party and (3) offer the lender the
opportunity to act as master servicer on any mortgage loan securitization
effected by the Company through November 2000 on the same terms and conditions
as it would offer such to a third party. The lender in turn will offer HCP the
opportunity to undertake due diligence services for portfolio transactions or
for securitization transactions in which the lender is not undertaking or is
otherwise
F-34
92
contracting with third parties for such due diligence services on the
same terms and conditions as it would offer such to a third party through
November 2000.
In March 1999, Hanover entered into a one-year reverse repurchase financing
agreement. Pursuant to the terms of the agreement, Hanover agreed to pay at
least $500,000 in underwriting fees to the lender during the term of the
agreement. As of December 31, 1999, Hanover had not paid any such fees to the
lender. The Company expects that this commitment will be applied towards a
securitization transaction that is scheduled for April 2000.
In October 1998, the Company sold 15 adjustable rate FNMA certificates and 19
fixed rate FNMA certificates that the Company received in a swap for certain
adjustable rate and fixed rate mortgage loans. These securities were sold with
recourse. Accordingly, the Company retains credit risk with respect to the
principal amount of these mortgage securities.
At December 31, 1999 the Company had forward commitments to sell $6 million (par
value) of Agency mortgage securities that had not yet settled. This forward sale
was entered into to hedge the expected sale of approximately $6 million of AA
and A rated subordinate mortgage-backed securities held in a trading account.
20. FINANCIAL INSTRUMENTS
The estimated fair value of the Company's assets and liabilities classified as
financial instruments and off-balance sheet financial instruments at December
31, 1999 and 1998 are as follows (dollars in thousands):
DECEMBER 31, 1999 DECEMBER 31, 1998
--------------------------------- ------------------------------------
Carrying Notional Fair Carrying Notional Fair
Amount Amount Value Amount Amount Value
------ ------ ----- ------ ------ -----
Assets:
Mortgage loans $270,084 $263,624 $407,994 $407,694
Mortgage securities, available for sale 48,529 48,529 74,000 74,000
Mortgage Securities, held to maturity 8,238 7,379 4,478 4,473
Mortgage Securities, trading 5,919 5,919 -- --
Interest Rate Caps 1,072 $166,266 1,139 394 $ 69,939 200
Cash and cash equivalents 18,022 18,022 11,837 11,837
Accrued interest receivable 3,015 3,015 3,940 3,940
Notes receivable 7,946 7,946 3,893 3,893
-------- -------- -------- -------- -------- --------
Total $362,825 $166,266 $355,574 $506,536 $ 69,939 $506,037
======== ======== ======== ======== ======== ========
Liabilities:
Reverse repurchase agreements $ 55,722 $ 55,722 $370,090 $370,090
CMO borrowing 254,963 250,906 77,305 77,831
Accrued interest payable 2,433 2,433 1,394 1,394
Other liabilities 2,513 2,513 1,601 1,601
-------- -------- -------- --------
Total $315,631 $311,574 $450,390 $450,916
======== ======== ======== ========
Off-Balance Sheet:
Forward commitments to sell mortgage securities $ 68 $ 6,000 $ 68 $ -- $ 51,457 $ 51,409
======== ======== ======== ======== ======== ========
F-35
93
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Mortgage loans - The fair values of these financial instruments are based upon
actual prices received upon recent sales of loans and securities to investors
and projected prices which could be obtained through investors considering
interest rates, loan type, and credit quality.
Mortgage securities - The fair values of these financial instruments are based
upon either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investors, estimates considering interest rates, loan type, quality and
discounted cash flow analysis based on prepayment and interest rate assumptions
used in the market place for similar securities with similar credit ratings.
Cash and cash equivalents, accrued interest receivable, notes receivable,
reverse repurchase agreements, accrued interest payable, other liabilities - The
fair value of these financial instruments was determined to be their carrying
value due to their short-term nature.
CMO Borrowing - The fair values of these financial instruments are based upon
either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investor estimates considering interest rates, loan type, quality and discounted
cash flow analysis based on prepayment and interest rate assumptions used in the
market place for similar securities with similar credit ratings.
Forward commitments to sell securities - The Company has outstanding forward
commitments to sell mortgage securities into mandatory delivery contracts with
investment bankers, private investors and agency-backed securities. The fair
value of these financial instruments was determined through review of published
market information associated with similar instruments. These commitment
obligations are considered in conjunction with the Company's lower of cost or
market valuation of its loans held for sale.
Interest rate caps - The fair values of these financial instruments are
estimated based on dealer quotes and is the estimated amount the Company would
pay to execute a new agreement with similar terms.
21. SUBSEQUENT EVENTS
On February 1, 2000 a $0.10 cash dividend previously declared by the Board of
Directors was paid to stockholders of record as of December 31, 1999.
On January 28, 2000 the Company forgave $62,000 of loans to Principals.
On January 27, February 18 and February 25, 2000, the Company's affiliate, HCP,
purchased $819,000, $1,000,000 and $3,851,000 (principal balance) of subordinate
mortgage backed securities at purchase prices of $458,000, $538,000 and
$2,112,000. HCP funded these purchases with a loan of $1,297,000 from the
Company and with loans of $1,838,000 from the dealers who sold such securities.
Hanover guaranteed the dealer loans.
F-36
94
22. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data are as follows (dollars in thousands, except
per share data):
Three Months Three Months Three Months Three Months
Ended Ended Ended Ended
December 31, September 30, June 30, March 31,
1999 1999 1999 1999
--------- --------- --------- ---------
Net interest income $ 1,509 $ (884) $ 1,733 $ 2,051
========= ========= ========= =========
Net income (loss) $ 573 $ (13,994) $ 58 $ 736
========= ========= ========= =========
Basic earnings (loss) per share (2) $ 0.10 $ (2.40) $ 0.01 $ 0.12
========= ========= ========= =========
Diluted earnings (loss) per share (2) $ 0.10 $ (2.38) $ 0.01 $ 0.11
========= ========= ========= =========
Dividends declared $ 0.10 $ 0.10 $ 0.10 $ 0.10
========= ========= ========= =========
Three Months Three Months Three Months Three Months
Ended Ended Ended Ended
December 31, September 30, June 30, March 31,
1998 1998 1998 1998
--------- --------- --------- ---------
Net interest income $ 1,998 $ 1,692 $ 774 $ 2,159
========= ========= ========= =========
Net income (loss) $ (5,884) $ 346 $ (644) $ 1,248
========= ========= ========= =========
Basic earnings (loss) per share (2) $ (0.93) $ 0.05 $ (0.10) $ 0.19
========= ========= ========= =========
Diluted earnings (loss) per share (2) $ (0.93) $ 0.05 $ (0.10) $ 0.17
========= ========= ========= =========
Dividends declared $ 0.11 $ 0.17 $ 0.21 $ 0.21
========= ========= ========= =========
Three Months Three Months June 10, 1997
Ended Ended Through
December 31, September 30, June 30,
1997 1997 (1) 1997 (1)
--------- --------- ---------
Net interest income $ 1,548 $ 128 $ 0
========= ========= =========
Net income $ 440 $ 59 $ 0
========= ========= =========
Basic earnings per share (2) $ 0.07 $ 0.07 $ 0.00
========= ========= =========
Diluted earnings per share (2) $ 0.07 $ 0.07 $ 0.00
========= ========= =========
Dividends declared $ 0.16 $ 0.00 $ 0.00
========= ========= =========
(1) - the Company was organized on June 10, 1997, however operations did not
begin until the IPO date - September 19, 1997
(2) - earnings per share are computed independently for each of the quarters
presented; therefore the sum of the quarterly earnings per share do not
equal the earnings per share total for the year.
******
F-37
95
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Partners Ltd.
New York, New York
We have audited the accompanying consolidated balance sheets of Hanover Capital
Partners Ltd. and Subsidiaries (the "Company") as of December 31, 1999 and 1998,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 1999.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing standards
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the consolidated financial position of Hanover Capital
Partners Ltd. and Subsidiaries at December 31, 1999 and 1998, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1999 in conformity with generally
accepted accounting principles in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 17, 2000
F-38
96
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
ASSETS 1999 1998
------------ -----------
CURRENT ASSETS:
Cash $ 514,804 $ 635,484
Investment in marketable securities 19,055 17,992
Accounts receivable 668,993 517,245
Receivables from related parties 186,969 213,779
Accrued interest receivable 181,471 --
Accrued revenue on contracts in progress 761,923 247,100
Prepaid expenses and other current assets 170,201 192,580
------------ -----------
Total current assets 2,503,416 1,824,180
PROPERTY AND EQUIPMENT - Net 56,601 141,459
NET INVESTMENT IN MORTGAGE SECURITIES
AVAILABLE FOR SALE 14,180,184 --
DEFERRED TAX ASSET 856,143 801,351
OTHER ASSETS 175,633 128,572
INCOME TAX RECEIVABLE -- 219,563
------------ -----------
TOTAL ASSETS $ 17,771,977 $ 3,115,125
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Reverse repurchase agreement $ 10,842,000 $ --
Accrued appraisal and subcontractor costs 13,582 20,730
Accounts payable and accrued expenses 508,975 466,697
Deferred revenue -- 89,625
Notes payable to related parties 4,896,046 712,824
------------ -----------
Total current liabilities 16,260,603 1,289,876
------------ -----------
TOTAL LIABILITIES 16,260,603 1,289,876
------------ -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000
shares authorized, 97,000 shares outstanding
at December 31, 1999 and 1998 970 970
Common stock:
Class A: $.01 par value, 5,000
authorized at 3,000 shares
outstanding at December 31, 1999 and 1998 30 30
Additional paid-in capital 2,839,947 2,839,947
Retained earnings (deficit) (1,471,884) (1,015,698)
Accumulated other comprehensive income 142,311 --
------------ -----------
TOTAL STOCKHOLDERS' EQUITY: 1,511,374 1,825,249
------------ -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 17,771,977 $ 3,115,125
============ ===========
See notes to consolidated financial statements.
F-39
97
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1997
----------- ----------- -----------
REVENUES:
Due diligence fees $ 5,530,307 $ 5,001,047 $ 4,058,609
Mortgage sales and servicing 229,557 701,574 826,486
Loan brokering/asset management fees 789,003 654,748 3,027,319
Interest income on mortgage 384,642 -- --
backed securities, net of interest
expense of $547,636 in 1999
Other income (loss) 125,809 (12,609) 58,151
----------- ----------- -----------
Total revenues 7,059,318 6,344,760 7,970,565
----------- ----------- -----------
EXPENSES:
Personnel expense 3,954,622 4,364,725 5,373,331
Subcontractor expense 1,950,946 1,537,294 1,386,979
Occupancy expense 477,937 578,512 495,285
Travel and subsistence 390,318 555,382 302,936
General and administrative expense 378,407 532,006 419,543
Appraisal, inspection and other 155,609 223,262 618,059
professional fees
Interest expense 252,144 155,128 117,894
Depreciation and amortization 107,583 107,971 117,675
Reversal of reserve for IRS assessment -- -- (23,160)
----------- ----------- -----------
Total expenses 7,667,566 8,054,280 8,808,542
----------- ----------- -----------
(LOSS) BEFORE INCOME TAX (BENEFIT) (608,248) (1,709,520) (837,977)
INCOME TAX (BENEFIT) (152,062) (661,524) (325,959)
----------- ----------- -----------
NET (LOSS) $ (456,186) $(1,047,996) $ (512,018)
=========== =========== ===========
BASIC (LOSS) PER SHARE $ (152.07) $ (349.33) $ (525.79)
=========== =========== ===========
See notes to consolidated financial statements.
F-40
98
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997
Common Stock Common Stock
Preferred Stock New Class A Old Class A Additional
--------------- --------------- ---------------- Paid-In
Shares Amount Shares Amount Shares Amount Capital
------ ------ ------ ------ ------ ------ -------
BALANCE, DECEMBER 31, 1996 166.424 $ 2 $ 57,440
Agreement and plan of recapitalization:
Exchange of old Class A Shares for new
Class A Shares and Series A Preferred
Stock 97,000 $ 970 3,000 $ 30 (166.424) (2) (998)
Comprehensive (loss):
Net (loss)
Comprehensive (loss)
Dividends (noncash)
------ ----- ----- ---- ------- ------- ----------
BALANCE, DECEMBER 31, 1997 97,000 $ 970 3,000 $ 30 -- -- 56,442
Capital Contributions 2,783,505
Comprehensive (loss):
Net (loss)
Comprehensive (loss)
------ ----- ----- ---- ------- ------- ----------
BALANCE, DECEMBER 31, 1998 97,000 $ 970 3,000 $ 30 -- -- 2,839,947
Comprehensive (loss):
Net (loss)
Other comprehensive income:
Change in net unrealized gain on
securities available for sale,
net of income tax effect
Comprehensive (loss)
------ ----- ----- ---- ------- ------- ----------
BALANCE, DECEMBER 31, 1999 97,000 $ 970 3,000 $ 30 -- -- $2,839,947
====== ===== ===== ==== ======= ======= ==========
Accumulated
Retained Other
Comprehensive Earnings Comprehensive
(Loss) (Deficit) Gain Total
------ --------- ---- -----
BALANCE, DECEMBER 31, 1996 $ 617,448 $ 674,890
Agreement and plan of recapitalization:
Exchange of old Class A Shares for new
Class A Shares and Series A Preferred
Stock
Comprehensive (loss):
Net (loss) $ (512,018) (512,018) (512,018)
----------
Comprehensive (loss) (512,018)
==========
Dividends (noncash) (73,132) (73,132)
---------- ---------- ----------
BALANCE, DECEMBER 31, 1997 32,298 -- 89,740
Capital Contributions 2,783,505
Comprehensive (loss):
Net (loss) (1,047,996) (1,047,996) (1,047,996)
----------
Comprehensive (loss) (1,047,996)
========== ---------- ---------- ----------
BALANCE, DECEMBER 31, 1998 (1,015,698) -- 1,825,249
Comprehensive (loss):
Net (loss) (456,186) (456,186) (456,186)
Other comprehensive income:
Change in net unrealized gain on
securities available for sale,
net of income tax effect 142,311 142,311 142,311
----------
Comprehensive (loss) $ (313,875)
========== ----------- ---------- ----------
BALANCE, DECEMBER 31, 1999 $(1,471,884) $ 142,311 $1,511,374
=========== ========== ==========
F-41
99
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR YEAR YEAR
ENDED ENDED ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1997
------------ ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $ (456,186) $(1,047,996) $ (512,018)
Adjustments to reconcile net (loss) to net cash
(used in) operating activities:
Amortization of net premium (204,010) -- --
Loan loss provision 289,297 -- --
Depreciation and amortization 107,583 107,971 117,675
Gain on sale of mortgage servicing rights -- (371,977) (16,916)
Reversal of reserve for IRS assessment -- -- (23,160)
IRS payroll tax settlement -- -- (99,240)
Loss on disposal of property and equipment 14,588 -- 35,696
Loss on disposal of securities -- 100,750 --
Purchase of trading securities (1,063) (598) (951)
Changes in assets - (increase) decrease:
Accounts receivable (151,748) (383,416) 3,550,036
Receivables from related parties 26,810 597,371 (315,097)
Accrued interest receivable (181,471) -- --
Accrued revenue on contracts in progress (514,823) (211,687) 514,368
Income tax receivable 219,563 73,322 (292,885)
Prepaid expenses and other current assets 22,379 (74,028) 24,474
Deferred tax asset -- (781,270) (20,081)
Other assets (47,062) 37,348 (12,254)
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs (7,148) (111,248) (2,675,194)
Accounts payable and accrued expenses 42,278 132,106 (343,799)
Income taxes payable -- -- (89,477)
Deferred income taxes (152,062) -- (12,993)
Deferred revenue (89,625) (15,325) (89,384)
Minority interest -- (616) 366
------------ ----------- -----------
Net cash (used in) operating activities (1,082,700) (1,949,293) (260,834)
------------ ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (38,598) (33,841) (43,060)
Sale of property and equipment 1,285 -- --
Proceeds from sale of mortgage servicing rights -- 418,974 34,446
Purchase of securities -- (100,000) --
Capitalization of mortgage servicing rights -- -- (43,783)
Purchase of private placement mortgage securities (14,110,858) -- --
Principal payments received on mortgage securities 84,969 -- --
------------ ----------- -----------
Net cash (used in) provided by investing activities (14,063,202) 285,133 (52,397)
------------ ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (repayment of) note payable to bank -- (1,405,000) 360,000
Net proceeds from note payable to related party 4,183,222 712,824 --
Capital contributions -- 2,783,505 --
Net borrowings from reverse repurchase agreements 10,842,000 -- --
------------ ----------- -----------
Net cash provided by financing activities 15,025,222 2,091,329 360,000
------------ ----------- -----------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (120,680) 427,169 46,769
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 635,484 208,315 161,546
------------ ----------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 514,804 $ 635,484 $ 208,315
============ =========== ===========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $7,165,000, $13,930,000, and $25,649,378 were originated by HCMC
and funded by investors in 1999, 1998 and 1997, respectively
Noncash dividends of $73,132, were distributed to the Company's
stockholders on September 19, 1997
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for:
Income taxes $ 5,350 $ 5,671 $ 129,359
============ =========== ===========
Interest $ 323,851 $ 689,779 $ 116,993
============ =========== ===========
See notes to consolidated financial statements.
F-42
100
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. BUSINESS DESCRIPTION
Hanover Capital Partners Ltd. ("HCP") and its subsidiaries operate as a
specialty finance company which is principally engaged in performing due
diligence services, asset management services, and mortgage and investment
banking services for third parties and for its affiliate, Hanover Capital
Mortgage Holdings, Inc. A wholly-owned subsidiary of HCP, Hanover Capital
Mortgage Corporation ("HCMC"), is a servicer of multifamily mortgage loans and
until June 30, 1999 was an originator of multifamily mortgage loans. HCMC is
approved by the U.S. Department of Housing and Urban Development (HUD) as a
Title II Nonsupervised Mortgagee under the National Housing Act. Another
wholly-owned subsidiary of HCP, Hanover Capital Securities, Inc. ("HCS") is a
registered broker/dealer with the Securities and Exchange Commission.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of HCP and its
wholly-owned subsidiaries (the "Company"). The wholly-owned subsidiaries include
HCMC and HCS. All significant intercompany accounts and transactions have been
eliminated.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the required amounts of revenues and expenses during
the reporting period.
INVESTMENTS IN LIMITED LIABILITY COMPANIES
Minority ownership interests in limited liability companies are accounted for by
the equity method of accounting. HCP's investments in limited liability
companies are classified as other assets in the accompanying consolidated
balance sheets. The ownership of each limited liability company at December 31,
1999 and 1998 is detailed below:
1999 1998
---- ----
Alpine/Hanover, LLC 1.0% 1.0%
ABH-I, LLC 1.0% 1.0%
REVENUE RECOGNITION
Revenues from due diligence contracts in progress are recognized for the
services provided as they are earned and billed.
F-43
101
LOAN ORIGINATION FEES AND COSTS
Loan origination fees and costs are deferred until the sale of the loan. The
Company sells all originated loans to investors at the time of origination, and
accordingly, recognizes loan origination fees at that time. Direct loan
origination costs and loan origination fees are offset and included in mortgage
sales and servicing.
LOAN SERVICING FEES
Loan servicing fees consist of fees paid by investors for the collection of
monthly mortgage payments, maintenance of required escrow accounts, remittance
to investors, and ancillary income associated with those activities. The Company
recognizes loan servicing fees as payments are collected.
DEFERRED REVENUE
Cash advances received for certain service contracts are recorded in the
accompanying consolidated balance sheets as deferred revenue and are recognized
during the period the services are provided and the related revenue is earned.
INCOME TAXES
The Company files a consolidated Federal income tax return. The Company has not
been subject to an examination of its income tax returns by the Internal Revenue
Service. The Company's tax sharing policy provides that each member of the
Federal consolidated group receive an allocation of income taxes as if each
filed a separate Federal income tax return. HCP, HCMC and HCS generally file
their state income tax returns on a separate company basis. Deferred income
taxes are provided for the effect of temporary timing differences between the
tax basis of an asset or liability and its reported amount in the consolidated
financial statements.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost less accumulated depreciation.
Depreciation is computed on the straight-line method over the estimated useful
lives of the assets, generally three to seven years. Leasehold improvements are
depreciated over the terms of the respective leases or their estimated useful
lives, whichever is shorter.
INVESTMENT IN MARKETABLE SECURITIES
Investment in marketable securities which the Company has classified as trading
securities are reported in the accompanying consolidated balance sheets at
market value at December 31, 1999 and 1998.
CASH AND CASH EQUIVALENTS
For cash flow purposes, the Company considers highly liquid investments,
purchased with an original maturity of three months or less, to be cash
equivalents.
F-44
102
MORTGAGE SERVICING RIGHTS
Effective January 1, 1997, the Company adopted Statement of Financial Accounting
Standards No. 125, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities ("SFAS 125"). Under SFAS 125, after the
transfer of a financial asset, the Company recognizes the financial assets it
controls and the liabilities it has incurred. Furthermore, the Company no longer
recognizes the financial assets for which control has been surrendered and
liabilities have been extinguished. The adoption of SFAS 125 did not have an
effect on the financial position or results of operations of the Company.
For purposes of assessing impairment, the lower of carrying value or fair value
of servicing rights is determined on an individual loan basis. Capitalized
servicing rights are amortized in proportion to projected net servicing revenue.
The fair value of servicing rights is determined using a discounted cash flow
method.
MORTGAGE SECURITIES
The Company's policy is to generally classify mortgage securities as available
for sale as they are acquired. Each available for sale mortgage security is
monitored for a period of time prior to making a determination whether the asset
will be classified as held to maturity or trading. Management reevaluates the
classification of the mortgage securities on a quarterly basis.
Mortgage securities designated as available for sale are reported at fair value,
with unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity.
Mortgage securities designated as trading are reported at fair value. Gains and
losses resulting from changes in fair value are recorded as income or expense
and included in earnings.
Mortgage securities classified as held to maturity are carried at the fair value
of the security at the time the designation is made. Any fair value adjustment
is reflected as a separate component of stockholders' equity and as a cost
adjustment of the mortgage security as of the date of the classification and is
amortized into interest income as a yield adjustment.
The Company makes periodic evaluations of all mortgage securities to determine
whether an other than temporary impairment is considered to have occurred. If a
decline in the fair value is judged to be other than temporary, the cost basis
of the mortgage security will be marked to fair value, resulting in a current
period loss in the consolidated statement of operations. The new cost basis
shall not be changed for further increases in market value; however, further
increases in market value will be reflected separately in the equity section of
the Company's consolidated balance sheet.
Premiums, discounts and certain deferred costs associated with the acquisition
of mortgage securities are amortized into interest income over the lives of the
securities using the effective yield method adjusted for the effects of
estimated prepayments. Mortgage securities transactions are recorded on the date
the mortgage securities are purchased or sold. Purchases of new issue mortgage
securities are recorded when all significant uncertainties regarding the
characteristics of the mortgage securities are removed, generally on or shortly
before settlement date. Realized gains and losses on mortgage securities
transactions are determined on the specific identification basis.
F-45
103
The Company purchases both investment grade and below investment grade mortgage
backed securities ("MBS"). Below investment grade MBS have the potential to
absorb credit losses caused by delinquencies and defaults on the underlying
mortgage loans. When purchasing below investment grade MBS, the Company
leverages off of its due diligence operations and management's substantial
mortgage credit expertise to make a thorough evaluation of the underlying
mortgage loan collateral. The Company monitors the delinquencies and defaults on
the underlying mortgages of its mortgage securities and, if an impairment is
deemed to be other than temporary, makes a provision for known losses as well as
unidentified potential losses. The provision is based on management's assessment
of numerous factors affecting its portfolio of mortgage securities including,
but not limited to, current and projected economic conditions, delinquency
status, credit losses to date on underlying mortgages and remaining credit
protection. The provision is made by reducing the cost basis of the individual
security and the amount of such write-down is recorded as a realized loss,
thereby reducing earnings. Provisions for credit losses do not reduce taxable
income and therefore do not affect the dividends paid by the Company to
stockholders in the period the provisions are taken. Actual losses realized by
the Company reduce taxable income in the period the actual loss is realized and
would affect the dividends paid to stockholders for that tax year.
REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts, plus accrued interest.
FINANCIAL INSTRUMENTS
The Company from time to time enters into interest rate hedge mechanisms
including short sales and interest rate caps to manage its exposure to market
pricing changes and/or changes in costs of match funded liabilities in
connection with the purchase, holding, permanent financing or sale of its
mortgage securities portfolio. The Company generally closes out the hedge
position to coincide with the related sale or permanent financing transactions.
Gains and losses on hedge positions are either (i) deferred as an adjustment to
the carrying value of the related securities until the security has been sold or
permanently financed, after which the gains or losses will be amortized into
income over the remaining life of the security or financing using a method that
approximates the effective yield method, or (ii) deferred until such time as the
related securities are sold. Gains or losses on hedge positions associated with
mortgage securities held in a trading account are recognized as income or loss
in each period.
The Company also enters into interest rate caps to manage its interest rate
exposure on certain reverse repurchase agreement and CMO financing. The cost of
the interest rate caps is amortized over the life of the interest rate cap and
is reflected as a portion of interest expense in the consolidated statement of
operations. Any payments received under the interest rate cap agreements are
recorded as a reduction of interest expense on the reverse repurchase agreement
financing.
For derivative financial instruments designated as hedge instruments, the
Company periodically evaluates the effectiveness of these hedges against the
financial instrument being hedged under various interest rate scenarios. The
Company utilizes hedge deferral accounting procedures in accounting for its
hedging program so long as there is adequate correlation between the hedged
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results and the change in value of the hedged financial instrument. If the hedge
instrument performance does not result in adequate correlation between the
changes in value of the hedge instrument and the related hedged financial
instrument, the Company will terminate hedge deferral accounting and mark the
carrying value of the hedge instrument to market. If a hedge instrument is sold
or matures, or the criteria that was anticipated at the time the hedge
instrument was entered into no longer exists, the hedge instrument is no longer
accounted for as a hedge. Under these circumstances, the accumulated change in
the market value of the hedge is recognized in current period income or loss to
the extent that the effects of interest rate or price changes of the hedged item
have not offset the hedged results.
In accordance with SFAS No.107, Disclosure about Derivative Financial
Instruments, and SFAS No. 119, Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments, the Company has provided fair value
estimates and information about valuation methodologies. The estimated fair
value amounts have been determined using available market information or
appropriate valuation methodologies. However, considerable judgment is required
in interpreting market data to develop estimates of fair value, so the estimates
are not necessarily indicative of the amounts that would be realized in a
current market exchange. The effect of using different market assumptions and/or
estimation methodologies may materially impact the estimated fair value amounts.
BASIC EARNINGS PER SHARE
Basic earnings per share is computed by dividing income available to common
stockholders by the weighted average number of common shares outstanding during
the period. Shares issued during the period and shares reacquired during the
period are weighted for the portion of time they were outstanding.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses,
gains and losses be included in net income. Although certain changes in assets
and liabilities, such as unrealized gains and losses on available for sale
securities, are reported as a separate component of the equity section of the
consolidated balance sheets, such items, along with net income, are components
of comprehensive income.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
The FASB issued SFAS 133 Accounting for Derivative Instruments and Hedging
Activities ("SFAS 133") in June 1998. SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. Management's preliminary evaluation of
SFAS 133 indicates the implementation of SFAS 133 will not result in any
material changes to the Company's consolidated statement of operations. SFAS
137, issued in June 1999, delayed the effective date of SFAS 133 to make it
effective for quarters in fiscal years beginning after June 15, 2000.
3. PAYROLL TAX SETTLEMENT
In 1994, the Internal Revenue Service ("IRS") began an examination of the
Company's payroll tax withholding practices with respect to independent
contractors who provided services to HCP's due diligence business.
Pursuant to the IRS Classification Settlement Program ("CSP"), HCP settled all
disputed payroll taxes relating to the IRS examination of HCP's payroll
withholding practices with respect to independent contractors. In October 1997,
management agreed to the terms of the CSP which required HCP to pay the United
States Government $99,240 in full discharge of any federal
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105
employment tax liability and to further treat the workers as employees (rather
than independent contractors) on a prospective basis effective April 1, 1998.
At December 31, 1995, HCP had recorded an accrual of $400,000 for payroll
withholding tax for independent contractors. HCP recorded a reversal of reserve
of $23,160 and $277,600 for the payroll tax matter in the accompanying
consolidated statements of operations for the years ended December 31, 1997 and
1996, respectively, to adjust the previously established reserve to the actual
and expected settlement amounts.
4. CONCENTRATION RISK
REVENUES FROM CERTAIN CUSTOMERS
For the years ended December 31, 1999, 1998 and 1997, the Company received
revenues from certain customers, which are subject to change annually, which
exceeded 10% of total revenues as follows:
1999 1998 1997
---- ---- ----
Major Customer # 1 22% 28% 24%
Major Customer # 2 13% 13% 18%
MORTGAGE SECURITIES
The Company's exposure to credit risk associated with its investment activities
is measured on an individual security basis as well as by groups of securities
that share similar attributes. In certain instances, the Company has
concentrations of credit risk in its mortgage securities portfolio for the
securities of certain issuers. The following table sets forth the concentrations
of the Company's credit risk by issuer at December 31, 1999. The Company did not
own any mortgage securities at December 31, 1998.
CONCENTRATION OF CREDIT RISK BY ISSUER
DECEMBER 31, 1999
Carrying
Value of
Mortgage
Issuer Securities
------ ----------
Private Issuer 1 $ 7,386,525
Private Issuer 2 6,793,659
-----------
Total $14,180,184
===========
5. MORTGAGE SERVICING
The Company, through its wholly-owned subsidiary, HCMC, services multifamily
mortgage loans on behalf of others. Loan servicing consists of the collection of
monthly mortgage payments on behalf of investors, reporting information to those
investors on a monthly basis and
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maintaining custodial escrow accounts for the payment of principal and interest
to investors and property taxes and insurance premiums on behalf of borrowers.
As of December 31, 1999 and 1998, HCMC was servicing 6 and 13 loans,
respectively, with unpaid principal balances of $13,388,037 and $46,329,000
including loans subserviced for others of $10,690,537 and $27,533,700
respectively. Escrow balances maintained by HCMC were $212,528 and $1,316,400 at
December 31, 1999 and 1998, respectively. The aforementioned servicing portfolio
and related escrow accounts are not included in the accompanying consolidated
balance sheets as of December 31, 1999 and 1998.
Activity in mortgage servicing rights for the years ended December 31, 1998
was as follows:
1998
----
Beginning balance $ 49,449
Capitalization --
Sales (46,997)
Scheduled amortization (2,452)
--------
$ --
========
6. MORTGAGE OPERATIONS
In September 1998, the Company purchased a portfolio of single family mortgage
loans with a principal balance of $101,586,036. This balance was comprised of
fixed rate loans ($22,752,341) and adjustable rate loans ($78,833,695). The
mortgage loan portfolio was purchased at 101.395% of par value. The Company sold
this portfolio of loans at book value to Hanover Capital Mortgage Holdings, Inc.
During the period in which the Company owned the loan portfolio, net interest
income of $121,585 was recognized and is reported as a component of other income
(loss) in the 1998 consolidated statement of operations.
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7. RELATED PARTY TRANSACTIONS
Receivables from related parties at December 31, 1999 and 1998 consist of the
following:
1999 1998
-------- --------
Due from Hanover Capital Mortgage Holdings, Inc. (1) $150,027 $ 82,782
Due from ABII-I, LLC (includes $9,005 and $9,005 of asset
management fees at December 31, 1999 and 1998,
respectively) (2) 9,005 16,015
Due from Hanover Mortgage Capital Corporation (3) 6,727 9,342
Due from AGR Financial, LLC (4) -- 44,192
Due from Hanover Investment Fund (3) 125 2,250
Due from Hanover Capital Partners 2, Inc. (6) -- 5,150
Due from HanoverTrade.com (7) 14,274 --
-------- --------
Due from related entities 180,158 159,731
Due from officers (5) 6,811 54,048
-------- --------
Receivables from related parties $186,969 $213,779
======== ========
(1) The Company entered into a Management Agreement in 1998 to provide, among
other services, due diligence, asset management and administrative services
to Hanover Capital Mortgage Holdings, Inc. ("HCHI") in connection with
acquiring single-family mortgage loan pools and managing and servicing
HCHI's investment portfolio. The term of the Management Agreement continues
until December 31, 2000 with automatic annual renewal.
(2) Amounts due from entities that the Company had a minority ownership
interest in represent receivables resulting primarily from fees generated
from asset management services and out-of-pocket expenses. The Company
ceased providing asset management services to these entities in September
1997. Asset management fees are recognized in the period earned and
amounted to $2,446,000 for the year ended December 31, 1997.
(3) Amounts due from entities that are owned by certain of the Company's
officers/owners represent receivables resulting primarily from accounting
fees and out-of-pocket expenses.
(4) Amounts due from AGR Financial, LLC represent unpaid billings for services
that the Company provides to AGR Financial, LLC pursuant to an agreement
dated August 1996. The services include but are not limited to providing
AGR Financial, LLC with software operating systems, processing
capabilities, payroll services and accounting services.
(5) Amounts due from officers at December 31, 1998 include $53,766 from the
Company's President, which was repaid in August 1999.
(6) Amounts due reflect certain costs that the Company paid for Hanover Capital
Partners 2, Inc. in connection with a security transaction completed by
Hanover Capital Partners 2, Inc. in October 1998.
(7) Amounts due reflect certain costs that the Company paid for
HanoverTrade.com. These expenses incurred relate to start-up costs of
HanoverTrade.com.
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8. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 1999 and 1998 consists of the following:
1999 1998
--------- ---------
Office machinery and equipment $ 229,133 $ 415,032
Furniture and fixtures 4,745 111,246
Leasehold improvements -- 68,553
--------- ---------
233,878 594,831
Less accumulated depreciation (177,277) (453,372)
--------- ---------
Property and equipment - net $ 56,601 $ 141,459
========= =========
Depreciation expense for the years ended December 31, 1999, 1998 and 1997 was
$107,583, $105,519, and $110,284, respectively.
9. MORTGAGE SECURITIES
At December 31, 1999, the Company had $14,180,184 of fixed rate
private-placement mortgage-backed securities, classified as available for sale,
as shown on the table below. The Company did not have any such securities at
December 31, 1998.
FIXED RATE PRIVATE PLACEMENT MORTGAGE-BACKED SECURITIES
DECEMBER 31, 1999
-------------------------------------------------------------------------------
Available Held
For to
Sale (a) Maturity Trading Total
-------- -------- ------- -----
Principal balance of mortgage securities $ 33,400,795 $ -- $ -- $ 33,400,795
Net (discount) and deferred costs (19,174,902) -- -- (19,174,902)
--------------- ------------ ------------- ---------------
Total amortized cost of mortgage securities 14,225,893 -- -- 14,225,893
Loan loss allowance (285,290) -- (285,290)
Gross unrealized gain 239,581 -- -- 239,581
--------------- ------------ ------------- ---------------
Carrying cost of mortgage securities $ 14,180,184 $ -- $ -- $ 14,180,184
Mix 100% -- -- 100%
Principal balance of mortgage loans $ 5,171,979,000 -- -- $ 5,171,979,000
Weighted average net coupon 6.520% -- -- 6.520%
Weighted average maturity 345 -- -- 345
(a) At December 31, 1999, represents seventeen below investment grade
subordinate MBS purchased from third parties in the third quarter of 1999.
The coupon interest rates on these notes are fixed and range from 6.25% to
6.75%. These notes generate normal principal and interest remittances to
the Company on a monthly basis. These notes represented a $33,400,795
(principal balance) subordinated interest in $5,171,979,000 of mortgage
loans at December 31, 1999. These notes were carried at $14,180,184 at
December 31, 1999.
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The carrying value at December 31, 1999 of the Company's mortgage securities by
contractual maturity dates are presented below:
AVAILABLE FOR SALE HELD TO MATURITY TRADING
CARRYING VALUE CARRYING VALUE CARRYING VALUE
-------------- -------------- --------------
Due after ten years $14,180,184 -- --
As mentioned above, actual maturities may differ from stated maturities because
borrowers usually have the right to prepay certain obligations, often times
without penalties. Maturities of mortgage securities depend on the repayment
characteristics and experience of the underlying mortgage loans.
The average effective yield, which includes amortization of net premiums,
(discounts) and deferred costs, for the periods shown below on the combined
available for sale, held to maturity and trading mortgage securities portfolio
were as follows:
1999
------
Quarter ended March 31 --
Quarter ended June 30 --
Quarter ended September 30 20.218%
Quarter ended December 31 19.696%
------
22.527%
======
10. LOAN LOSS ALLOWANCE
The provision for loan loss charged to expense is based upon actual credit loss
experience and management's estimate and evaluation of potential losses in the
existing mortgage securities portfolio, including the evaluation of impaired
loans. The following table summarizes the activity in the loan loss allowance
for the year ended December 31, 1999. There was no loan loss reserve prior to
January 1, 1999 as the Company did not invest in mortgage securities prior to
January 1, 1999.
YEAR ENDED
DECEMBER 31, 1999
-----------------
Balance beginning of period $ --
Loan loss provision 289,297
Transfers/sales --
Charge-offs (4,006)
---------
Balance end of period $ 285,291
=========
11. REVERSE REPURCHASE AGREEMENTS
At December 31, 1999 the Company had a total of $10,842,000 of uncommitted
borrowings pursuant to a master reverse repurchase agreement with one lender.
All borrowings pursuant to the master reverse repurchase agreement are secured
by mortgage securities.
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The reverse repurchase agreements bear interest rates that vary from LIBOR plus
90 to LIBOR plus 130 basis points. The lender will typically finance an amount
equal to 60% to 80% of the market value of the mortgage securities, depending on
the nature of the collateral.
The weighted average borrowing rate under the agreement was 7.111% at December
31, 1999. The weighted average maturity was eight months. The reverse repurchase
financing agreements at December 31, 1999 were collateralized by securities with
a cost basis of $14,180,184.
Information pertaining to reverse repurchase agreement financing as of and for
the year ended December 31, 1999 is summarized as follows:
REVERSE REPO FINANCING
YEAR ENDED DECEMBER 31, 1999
----------------------------
MORTGAGE
REVERSE REPURCHASE AGREEMENTS SECURITIES
----------------------------- ----------
Balance of borrowing at end of period $10,842,000
Accrued interest at end of period $ 66,572
Average borrowing balance during the
period $11,022,000
Average interest rate during the period 6.874%
Maximum month-end borrowing balance
during the period $11,082,000
COLLATERAL UNDERLYING THE AGREEMENTS
------------------------------------
Balance at end of period - carrying value $14,180,184
12. INCOME TAXES
The components of deferred income taxes as of December 31, 1999 and 1998 are as
follows:
1999 1998
----------- -----------
Deferred tax assets $ 986,625 $ 813,003
Deferred tax liabilities (130,482) (11,652)
----------- -----------
Net deferred tax assets $ 856,143 $ 801,351
=========== ===========
The items resulting in significant temporary differences for the years ended
December 31, 1999 and 1998 that generate deferred tax assets and liabilities
relate primarily to the recognition of revenue and accrued liabilities for
financial reporting purposes.
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The components of the income tax (benefit) for the years ended December 31,
1999, 1998 and 1997 consist of the following:
1999 1998 1997
--------- --------- ---------
Current - Federal, state and local $ -- $ -- $(292,885)
Deferred - Federal, state and local (152,062) (661,524) (33,074)
--------- --------- ---------
Total $(152,062) $ 661,524 $(325,959)
========= ========= =========
The income tax (benefit) differs from amounts computed at statutory rates, as
follows:
1999 1998 1997
--------- --------- ---------
Federal income taxes (benefit) at statutory rate $(206,804) $(595,554) $(285,167)
State and local income taxes provision (benefit) (40,145) (76,256) (59,486)
Unconsolidated subsidiary's net income (loss) -- -- 1,177
Meals and entertainment 6,486 6,002 4,052
Officer's life insurance -- 4,273 9,613
Adjustment of deferred tax asset 88,401 -- --
Other, net -- 11 3,852
--------- --------- ---------
Total $(152,062) $(661,524) $(329,811)
========= ========= =========
The Company has a Federal taxable net operating loss carryforward of
approximately $1.9 million which begins to expire in the year 2012.
13. STOCKHOLDERS' EQUITY
On September 19, 1997, the Company entered into an Agreement and Plan of
Recapitalization ("Agreement") with its four stockholders to recapitalize the
Company. The Agreement provided for the tax-free exchange of the stockholders'
166.424 Class A "old" common stock shares for 3,000 shares of "new" Class A
common stock shares, $0.01 par value (representing a 3% economic interest in the
Company) and 97,000 shares of Series A preferred stock, $0.01 par value
(representing a 97% economic interest in the Company). The preferred stock has
no dividend rate or preference over the common stock. Dividend distributions
will be made in the same amount on a per share basis of the common stock as for
the preferred stock. Dividend distributions will be made to the common
stockholders and the preferred stockholders in proportion to the number of
outstanding shares. The preferred stockholder has the right to
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112
receive $10,750,005 upon liquidation of the Company before common stockholders
receive any liquidating distributions.
14. NOTE PAYABLE TO BANK
HCP had a $2.0 million Line of Credit Facility Agreement ("Line") with a bank
that expired December 31, 1999 and was not renewed. There was no outstanding
balance at December 31, 1999 and 1998.
15. NOTE PAYABLE TO RELATED PARTY
At December 31, 1999 the Company had a principal balance outstanding on a note
payable to Hanover Capital Mortgage Holdings, Inc. in the amount of $4,896,046.
The note bears interest at the prime rate minus 1% and interest is calculated on
the daily principal balance outstanding. At December 31, 1999 the interest rate
in effect was 7.5%. Included in the 1999 consolidated statement of operations is
interest expense in the amount of $167,955 related to this note payable.
16. COMMITMENTS AND CONTINGENCIES
The Company has noncancelable operating lease agreements for office space.
Future minimum rental payments for such leases are as follows:
YEAR AMOUNT
---- ------
2000 $ 321,703
2001 317,551
2002 278,114
2003 238,677
2004 218,103
Thereafter 991,068
----------
Total $2,365,216
==========
Rent expense for the years ended December 31, 1999, 1998 and 1997 amounted to
$217,413, $250,684, and $310,814 respectively.
HCHI has guaranteed the obligations of the Company with respect to an amendment
to an office lease entered into by the Company. The office lease (beginning
November 4, 1999) is for a period of 10 years and 3 months and obligates the
Company for $2,162,300 of base rental expense plus escalation, electric and
other billings over the lease term.
17. FINANCIAL INSTRUMENTS
The estimated fair value of the Company's assets and liabilities classified as
financial instruments and off-balance sheet financial instruments at December
31, 1999 and 1998 are as follows:
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113
DECEMBER 31, 1999 DECEMBER 31, 1998
----------------------------- -----------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Assets:
Mortgage securities, available for sale $14,180,184 $14,180,184 -- --
Interest rate caps 135,609 245,000 -- --
Cash and cash equivalents 515,804 514,804 $ 635,484 $ 635,484
Marketable securities 19,055 19,055 17,992 17,992
Accrued interest receivable 181,471 181,471 -- --
----------- ----------- ----------- -----------
Total $15,032,123 $15,140,514 $ 653,476 $ 653,476
=========== =========== =========== ===========
Liabilities:
Reverse repurchase agreements $10,842,000 $10,842,000 -- --
----------- ----------- ----------- -----------
Total $10,842,000 $10,842,000 -- --
=========== =========== =========== ===========
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Mortgage securities - The fair values of these financial instruments are based
upon either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investors, estimates considering interest rates, loan type, quality and
discounted cash flow analysis based on prepayment and interest rate assumptions
used in the market place for similar securities with similar credit ratings.
Cash and cash equivalents, accrued interest receivable, reverse repurchase
agreements - The fair value of these financial instruments was determined to be
their carrying value due to their short-term nature.
Marketable securities - The fair values of these financial instruments are based
on quotes obtained from third parties.
Interest rate caps - The fair values of these financial instruments are
estimated based on dealer quotes and is the estimated amount the Company would
pay to execute a new agreement with similar terms.
18. SUBSEQUENT EVENTS
On January 1, 2000, the Company hired the five most senior employees of Document
Management Network, Inc. ("DMN") and purchased all of DMN's assets for a nominal
sum. These employees have become the DMN division of the Company. DMN prepares
documentation (primarily assignments of mortgage loans ) for third parties on a
contract basis.
On January 27, February 18 and February 25, 2000, the Company purchased
$819,000, $1,000,000 and $3,851,000 (principal balance) of subordinate mortgage
backed securities at purchase prices of $458,000, $538,000 and $2,112,000. The
Company funded these purchases with a loan of $1,270,000 from the Company's
affiliate, Hanover Capital Mortgage Holdings, Inc. and with loans of $1,838,000
from the dealers who sold such securities.
******
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114
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Partners 2, Inc.
New York, New York
We have audited the accompanying consolidated balance sheets of Hanover Capital
Partners 2, Inc. and Subsidiary (the "Company") as of December 31, 1999 and 1998
and the related consolidated statements of operations, stockholders' equity and
cash flows for the year ended December 31, 1999, and for the period from October
7, 1998 (inception) through December 31, 1998. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audits in accordance with generally accepted auditing standards
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Hanover Capital
Partners 2, Inc. and Subsidiary as of December 31, 1999 and 1998, and the
results of their consolidated operations and their consolidated cash flows for
the year ended December 31, 1999, and for the period from October 7, 1998
(inception) through December 31, 1998 in conformity with generally accepted
accounting principles in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 17, 2000
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115
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
ASSETS DECEMBER 31, DECEMBER 31,
1999 1998
--------- ---------
Mortgage loans:
Collateral for CMOs $ 210,578 $ 300,599
Cash and cash equivalents -- 143
Accrued interest receivable 1,267 1,868
Deferred financing costs 2,336 3,191
--------- ---------
TOTAL ASSETS $ 214,181 $ 305,801
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
CMO Borrowings $ 208,448 $ 297,682
Accrued interest payable 1,267 1,868
Due to related parties 364 310
Accrued expenses and other liabilities -- 154
--------- ---------
TOTAL LIABILITIES 210,079 300,014
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01
authorized, 9,900 shares, issued
and outstanding, 9,900 shares -- --
Common stock, par value $.01
authorized, 100 shares, issued and
outstanding, 100 shares -- --
Additional paid-in-capital 14,319 14,319
Retained (deficit) (10,217) (8,532)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 4,102 5,787
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $ 214,181 $ 305,801
========= =========
See notes to consolidated financial statements.
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116
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
PERIOD FROM
OCTOBER OF 1998
YEAR ENDED (INCEPTION) TO
DECEMBER 31, DECEMBER 31,
1999 1998
----------- -----------
REVENUES:
Interest income $ 16,841 $ 5,611
Interest expense 18,521 5,965
----------- -----------
Net interest expense (1,680) (354)
Loan loss provision -- 38
----------- -----------
Net interest expense after loan loss
provision (1,680) (392)
----------- -----------
EXPENSES:
Operating 5 5
----------- -----------
NET (LOSS) $ (1,685) $ (397)
=========== ===========
BASIC (LOSS) PER SHARE $(16,851.72) $ (3,974.00)
=========== ===========
See notes to consolidated financial statements.
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117
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands, except share data)
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------- ------------------- PAID-IN- RETAINED
SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) TOTAL
------ ------ ------ ------ ------- --------- -----
Issuance of
common stock -- -- 100 -- $ 143 $ 143
Issuance of
preferred stock 9,900 -- -- -- 14,176 14,176
Net (loss) $ (397) (397)
Dividends declared (8,135) (8,135)
----- ------- --- ----- -------- -------- --------
BALANCE,
DECEMBER 31, 1998 9,900 -- 100 -- $ 14,319 $ (8,532) $ 5,787
===== ======= === ===== ======== ======== ========
Net (loss) (1,685) (1,685)
Dividends declared -- --
----- ------- --- ----- -------- -------- --------
BALANCE
DECEMBER 31, 1999 9,900 -- 100 -- $ 14,319 $(10,217) $ 4,102
===== ======= === ===== ======== ======== ========
See notes to consolidated financial statements.
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118
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, except share data)
PERIOD FROM
OCTOBER 7, 1998
YEAR ENDED (INCEPTION) TO
DECEMBER 31, DECEMBER 31,
1999 1998
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $ (1,685) $ (397)
Adjustments to reconcile net (loss) to
net cash (used in) provided by operating activities:
Amortization of net premium and deferred costs 797 353
Loan loss provision (38) 38
Decrease in deferred financing 855 --
(Increase) decrease in accrued interest receivable 601 (1,868)
(Increase) in prepaid and other assets (1) --
Increase (decrease) in accrued interest payable (601) 1,868
Decrease (increase) in accrued expenses and other liabilities (73) 73
Increase in due to related parties 55 241
--------- ---------
Net cash (used in) provided by operating activities (90) 308
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments received on collateral for
mortgage backed bonds 89,235 20,082
Transfer of premium and deferred hedge 27 3,320
--------- ---------
Net cash provided by investing activities 89,262 23,402
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from CMOs -- 317,764
Payoff of reverse repurchase agreements -- (309,963)
Payments on CMOs (89,234) (20,082)
Deferred financing costs -- (3,375)
Capital contributions -- 143
Payment of dividends (81) (8,054)
--------- ---------
Net cash (used in) financing activities (89,315) (23,567)
--------- ---------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (143) 143
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 143 --
--------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ -- $ 143
========= =========
SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES
9,900 shares of preferred stock were issued in exchange for $324,210 (book value) of
mortgage loans, net of $309,963 of reverse repurchase financing in October 1998.
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for interest $ -- $ 3,913
========= =========
See notes to consolidated financial statements
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HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS DESCRIPTION
GENERAL
Hanover Capital Partners 2, Inc. (the"Company") was incorporated in Delaware on
October 7, 1998. The Company was formed to acquire single-family residential
mortgage loans from Hanover Capital Mortgage Holdings, Inc. pursuant to its
formation transaction and to finance the purchase of these mortgage loans
through a REMIC securitization.
Hanover SPC-2, Inc., a wholly owned subsidiary of the Company, was incorporated
in Delaware on October 9, 1998 for the sole purpose of selling certain
investment grade and subordinated securities to Hanover Capital Mortgage
Holdings, Inc., through its wholly-owned subsidiaries, Hanover QRS-1 98-B, Inc.
and Hanover QRS-2 98-B, Inc.
CAPITALIZATION
At the time of incorporation, the Company was authorized to issue 9,900 shares
of preferred stock at $.01 per share and 100 shares of common stock at $.01 per
share
In October 1998, the Company received $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing from Hanover Capital Mortgage Holdings, Inc. in
exchange for the issuance of 9,900 shares of non-voting preferred stock
(representing a 99% economic ownership of the Company). In October 1998, the
Company also received cash proceeds of $143,189 for the issuance of 100 shares
of common stock (representing a 1% economic ownership of the Company).
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Hanover Capital
Partners 2, Inc. and its wholly-owned subsidiary, Hanover SPC-2, Inc. All
significant inter-company accounts and transactions have been eliminated.
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RISKS AND UNCERTAINTIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. The
Company's estimates and assumptions primarily arise from risks and uncertainties
associated with interest rate volatility, credit exposure and regulatory
changes. Although management is not currently aware of any factors that would
significantly change its estimates and assumptions in the near term, future
changes in market trends and conditions may occur which could cause actual
results to differ materially.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents may include cash on hand, overnight investments
deposited with banks and government securities with maturities of less than 30
days.
REVENUE RECOGNITION
Mortgage loan interest income is recognized on the accrual method based on the
net coupon after deducting service fees.
DEFERRED FINANCING COSTS
Deferred financing costs incurred ($3,375,000) in connection with the
securitization were capitalized and are being amortized as part of interest
expense over the life of the CMOs.
EARNINGS PER SHARE
Basic earnings or losses per share excludes dilution and is computed by dividing
income or loss available to common stockholders by the weighted average number
of common shares outstanding during the period. Shares issued during the period
and shares reacquired during the period are weighted for the period they were
outstanding.
3. MORTGAGE LOANS
COLLATERAL FOR CMOs
In October 1998 the Company issued its first real estate mortgage investment
conduit ("REMIC") security. $317,764,000 of par value single family fixed rate
residential mortgage loans were assigned as collateral for the Company's CMOs
(REMIC) security. The Company has limited exposure to credit risk retained on
loans it has securitized through the issuance of collateralized bonds. All
mortgage loans held as collateral for CMOs are reported at cost. Premiums,
discounts and all deferred costs associated with the mortgage loans held as
collateral for CMOs are amortized into interest income over the lives of the
mortgage loans using the effective yield method adjusted for the effects of
prepayments.
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The following table summarizes the Company's single-family fixed rate mortgage
loan pools classified as held to maturity (and held as collateral for CMOs),
which are carried at cost (dollars in thousands):
1999 1998
--------- ---------
Fixed rate $ 208,447 $ 297,682
Net premiums, and
deferred costs 2,131 2,955
Loan loss provision -- (38)
--------- ---------
Carrying value $ 210,578 $ 300,599
========= =========
The following table summarizes certain characteristics of the Company's
single-family fixed rate mortgage loans held as collateral for CMOs at December
31, 1999 and 1998 (dollars in thousands):
Carrying Value Principal Amount Weighted Weighted
of Collateral of Collateral Average Average
for CMOs for CMOs Net Coupon Maturity (1)
-------- -------- ---------- ------------
1999 $210,578 $208,447 7.474% 222
======== ======== ===== ========
1998 $300,599 $297,682 7.549% 307
======== ======== ===== ========
(1) weighted average maturity reflects the number of months remaining until
maturity.
The average effective yield after amortization of net premiums, discounts and
deferred costs for 1999 and 1998 on the collateral for the mortgage backed bond
portfolio was 6.930% and 7.004%.
4. CONCENTRATION OF CREDIT RISK
The Company's exposure to credit risk associated with its investment activities
is measured on an individual customer basis as well as by groups of customers
that share similar attributes. In the normal course of its business, the Company
has concentrations of credit risk in its mortgage portfolio for loans in certain
geographic areas. At December 31, 1999 and 1998, the percent of total principal
amount of loans outstanding in any one state, exceeding 5% of the principal
amount of mortgage loans are as follows:
State 1999 1998
----- ---- ----
Illinois 25% 18%
California 10 10
Florida 12 10
Ohio 6 8
Indiana -- 7
Texas -- 6
Arizona 8 6
Kentucky 6 6
--- ---
67% 71%
=== ===
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5. AFFILIATED PARTY TRANSACTIONS
In October 1998, the Company received $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing from Hanover Capital Mortgage Holdings, Inc. in
exchange for the issuance of 9,900 shares of non-voting preferred stock
(representing a 99% economic ownership of the Company).
At December 31, 1999 and 1998 the Company reflected amounts due to Hanover
Capital Mortgage Holdings, Inc. of $364,600 and $304,800 and Hanover Capital
Partners Ltd. of $0 and $5,200 for the payment of operating expenses and
securitization costs.
6. COLLATERALIZED MORTGAGE OBLIGATIONS
The Company, through a wholly owned subsidiary, Hanover SPC-2, Inc. has issued
non-recourse debt in the form of CMOs. Borrower remittances received on the
collateral for CMOs are used to make payments on the CMOs. The obligations under
the CMOs are payable solely from the collateral for CMOs and are otherwise
non-recourse to the Company. The maturity of the CMOs is directly affected by
the rate of principal prepayments on the related collateral. The CMOs are
subject to redemption according to specific terms of the respective indentures,
generally when the remaining balance of the bonds equals 20% or less of the
original principal balance of the bonds. As a result, the actual maturity of any
class of CMOs is likely to occur earlier than its stated maturity.
Information pertaining to CMOs financing for 1999 and 1998 is summarized as
follows (dollars in thousands):
CMO
Borrowing
---------
1999 1998
---- ----
Balance at period-end $208,448 $297,682
Average balance during the period $242,003 $307,843
Average interest rate during the period 7.653% 7.512%
Interest rate at period-end 7.760% 7.543%
Maximum month-end balance during the period $282,329 $317,764
Collateral for CMOs
--------------------------------------
Balance at period-end - carrying value $210,578 $300,599
Aggregate annual repayments of CMOs based upon contractual amortization of the
underlying mortgage loan collateral at December 31, 1999 were as follows
(dollars in thousands):
Year Amount
---- ------
2000 $ 15,452
2001 11,398
2002 11,696
2003 11,603
2004 11,648
Thereafter 146,651
---------
Total $ 208,448
=========
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7. INCOME TAXES
The Company and its wholly owned subsidiary file a consolidated Federal income
tax return. They each file separate state income tax returns. Deferred income
taxes are provided for the effects of temporary differences between the basis of
an asset or liability and its reported amount in the financial statements. The
significant differences between the statutory income tax rate result primarily
from state income taxes and the recording of a valuation allowance for the
entire tax benefit including the deferred tax asset. The significant differences
giving rise to deferred tax assets and liabilities result primarily from the
treatment of the REMIC transaction as a sale for income tax purposes.
The Company had a net deferred tax asset of approximately $1,542,000 in 1999 and
1998 which is fully reserved by a valuation allowance. This deferred tax asset
is substantially the result of a capital loss carryforward in the amount of
$3,800,000 which expires in the year 2013 for Federal income tax purposes.
8. FINANCIAL INSTRUMENTS
In accordance with SFAS No. 107, Disclosure about Derivative Financial
Instruments, and SFAS No. 119, Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments, the Company has provided fair value
estimates and information about valuation methodologies. The estimated fair
value amounts have been determined using available market information or
appropriate valuation methodologies. However, considerable judgment is required
in interpreting market data to develop estimates of fair value, so the estimates
are not necessarily indicative of the amounts that would be realized in a
current market exchange. The effect of using different market assumptions and/or
estimation methodologies may materially impact the estimated fair value amounts.
The estimated fair value of the Company's assets and liabilities classified as
financial instruments at December 31, 1999 and 1998 is as follows (dollars in
thousands):
DECEMBER 31, 1999 DECEMBER 31, 1998
------------------------- -------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
Assets:
Mortgage loans
Collateral for CMOs $210,578 $200,179 $300,599 $297,367
Cash and cash equivalents -- -- 143 143
Accrued interest receivable 1,267 1,267 1,868 1,868
-------- -------- -------- --------
Total $211,845 $201,446 $302,610 $299,378
======== ======== ======== ========
Liabilities:
CMO borrowing $208,448 $200,179 $297,682 $297,367
Accrued interest payable 1,267 1,267 1,868 1,868
Other liabilities 365 365 464 464
-------- -------- -------- --------
Total $210,080 $201,811 $300,014 $299,699
======== ======== ======== ========
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The Company had no off-balance sheet financial instruments at December 31, 1999.
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Collateral for CMOs - The fair values of these mortgage loans are based upon
actual prices received upon recent sales of loans and securities to investors
and projected prices which could be obtained through investors considering
interest rates, loan type, and credit quality. Cash and cash equivalents,
accrued interest receivable, accrued interest payable, other liabilities - The
fair value of these instruments was determined to be their carrying value due to
their short-term nature.
CMO Borrowing - The fair values of these financial instruments are based upon
either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investor estimates considering interest rates, loan type, quality and discounted
cash flow analysis based on prepayment and interest rate assumptions used in the
market place for similar securities with similar credit ratings.
*******
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, on March 30, 2000.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By /s/ Thomas P. Kaplan
------------------------
Thomas P. Kaplan
Managing Director and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of Registrant and the
capacities indicated on March 30, 2000.
SIGNATURE TITLE
/s/ John A. Burchett Chairman of the Board of Directors
----------------------- and Chief Executive Officer
John A. Burchett
/s/ Irma N. Tavares Senior Managing Director and a Director
-----------------------
Irma N. Tavares
/s/ Joyce S. Mizerak Senior Managing Director, Secretary and a Director
-----------------------
Joyce S. Mizerak
/s/ George J. Ostendorf Senior Managing Director and a Director
-----------------------
George J. Ostendorf
/s/ John A. Clymer Director
-----------------------
John A. Clymer
/s/ Joseph J. Freeman Director
-----------------------
Joseph J. Freeman
/s/ James F. Stone Director
-----------------------
James F. Stone
/s/ Saiyid T. Naqvi Director
-----------------------
Saiyid T. Naqvi
/s/ John N. Rees Director
-----------------------
John N. Rees
/s/ Thomas P. Kaplan Managing Director and Chief Financial
----------------------- Officer (Principal Financial and Accounting
Thomas P. Kaplan Officer)
126
EXHIBIT INDEX
3.1* Articles of Incorporation of the Company, as amended
3.2* By-Laws of the Company
4.1* Specimen Common Stock Certificate
4.2* Warrant Agreement pursuant to which Warrants were issued
(including form of Warrant)
4.3* Representatives' Warrant Agreement pursuant to which the
Representatives' Warrants were issued
4.4* Specimen Unit Certificate
10.3* Registration Rights Agreement
10.4* Shareholders' Agreement of HCP
10.5* Agreement and Plan of Recapitalization
10.6* Bonus Incentive Compensation Plan
10.7* 1997 Executive and Non-Employee Director Stock Option Plan
10.7.1 1999 Equity Incentive Plan
10.8* Employment Agreement by and between the Company and John A.
Burchett
10.9* Employment Agreement by and between the Company and Irma N.
Tavares
10.10* Employment Agreement by and between the Company and Joyce S.
Mizerak
10.11* Employment Agreement by and between the Company and George J.
Ostendorf
10.12* Standard Form of Office Lease, dated as of May 6, 1991, by and
between Irwin Kahn and HCP, as amended by the First Amendment
of Lease, dated as of July 1, 1996
10.12.1 Second Amendment of lease, dated as of December 22, 1998, by
and between FGP 90 West Street, Inc., successor to Irwin Kahn,
and HCP.
127
10.13* Office Lease Agreement, dated as of March 1, 1994, by and
between Metroplex Associates and HCMC, as amended by the First
Modification and Extension of Lease Amendment, dated as of
February 28, 1997.
10.14 Office Lease Agreement, dated as of February 1, 1999, between
La Salle-Adams, LLC and HCP.
10.16* Office Lease and Service Agreement, dated as of August 28,
1995 by and between Federal Deposit Insurance Receiver for
Merchants Bank and HCP
10.17 Agreement of Lease, dated as of July 27, 1999 by and between
Saint Paul Executive Office Suites, Inc., d.b.a. LesWork Inc.
and HCP.
10.25* Contribution Agreement
10.26* Participation Agreement
10.27* Loan Agreement
10.29** Management Agreement, dated as of January 1, 1998, by and
between the Company and HCP
10.30 Amendment Number One to Management Agreement, dated as of
September 30, 1999
10.31 Amended and Restated Master Loan and Security Agreement by and
between Greenwich Capital Financial Products, Inc. and Hanover
Capital Mortgage Holdings, Inc., dated November 23, 1998, as
amended by Amendment Number One, Amendment Number Two and
Amendment Number Three thereto
10.32 Warehousing Credit and Security Agreement, dated as of April
30, 1999, by and between Bank United and the Company, as
amended by the First Amendment and Second Amendment thereto
21 Subsidiaries of the Company
27 Financial Data Schedule
- ----------
* Incorporated herein by reference to the Company's Registration
Statement No. 333-29261, as amended, as filed with the Securities and
Exchange Commission.
** Incorporated herein by reference to the Company's Form 10-K for the
year ended December 31, 1997, as filed with the Securities and Exchange
Commission.