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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, 2000
OR
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
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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
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 1, 2001 was approximately $26,586,000 (based on closing
sales price of $6.15 per share of common stock as reported for the American
Stock Exchange) on March 1, 2001.
The registrant had 4,322,944 shares of common stock outstanding as of
March 1, 2001.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the notice of Annual Stockholder's Meeting and Proxy Statement, to
be filed within 120 days after the end of registrant's fiscal year, 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, 2000
INDEX
PART I PAGE
Item 1. Business............................................................ 2
Item 2. Properties.......................................................... 23
Item 3. Legal Proceedings................................................... 23
Item 4. Submission of Matters to a Vote of Security Holders................. 23
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters............................................................. 24
Item 6. Selected Financial Data............................................. 27
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................... 28
Item 7a. Quantitative and Qualitative Disclosure About Market Risk.......... 49
Item 8. Financial Statements and Supplementary Data......................... 51
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure............................................ 51
PART III
Item 10. Directors and Executive Officers of the Registrant................. 52
Item 11. Executive Compensation............................................. 52
Item 12. Security Ownership of Certain Beneficial Owners and Management..... 52
Item 13. Certain Relationships and Related Transactions..................... 52
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.... 53
Signatures ................................................................. 54
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PART I
ITEM 1: BUSINESS
This Annual Report on Form 10-K contains, in addition to historical
information, forward-looking statements that involve risks and uncertainty. The
Company's actual results could differ significantly from the results discussed
in the forward-looking statements. Factors that could cause or contribute to
such differences include those discussed in "Management's Discussion and
Analysis of Financial Condition and Results of Operations," as well as those
discussed elsewhere in this Annual Report on Form 10-K.
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. Hanover has two primary unconsolidated
subsidiaries: Hanover Capital Partners Ltd. ("HCP") and HanoverTrade.com, Inc.
("HTC"). When we refer to the "Company," we mean Hanover together with its
consolidated and unconsolidated subsidiaries.
The Company is engaged in three principal businesses, which are conducted
through its three primary operating units: Hanover, HCP and HTC. The principal
business strategy of Hanover is to invest in mortgage backed securities ("MBS")
and, to a lesser extent, in mortgage loans. The principal business strategy of
HCP is to generate consulting and other fee income by performing loan file and
operational due diligence reviews for third parties, performing advisory
services for third parties, and preparing and or processing documentation
(primarily assignments of mortgage loans) for third parties on a contract basis.
The principal business activity of HTC is to generate fee income by operating an
online world-wide web-based exchange for trading loan pools (primarily mortgage
loan pools) and by performing loan sale advisory services for third parties.
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.
The Company's principal executive offices are located at 90 West Street, Suite
2210, New York, New York 10006.
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INVESTMENT PORTFOLIO
General
Hanover's primary business is investing in mortgage backed securities which are
secured by single family mortgage loans. Hanover generally targets so-called
"subordinate" mortgage backed securities. The subordinate mortgage backed
securities bear all of the credit losses on the related pool of mortgage loans.
Because of this feature, these securities are generally rated below investment
grade by the major statistical rating organizations, such as Moody's Investors
Service, Standard & Poor's Ratings Group, or Fitch Investor Service.
Hanover has in the past, and may in the future, invest directly in mortgage
loans. Hanover has issued mortgage backed securities collateralized by these
loans, and has retained the subordinate securities from these transactions.
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 and 2000 the Company focused primarily on acquiring subordinate MBS with
characteristics similar to the subordinate MBS that the Company created in its
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.
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. The
pricing shifts experienced in early 1999 have remained consistent to-date. As a
result of the change in relative pricing, the Company found that it could
purchase subordinate MBS created by third party securitizers at very attractive
yields. Additionally, the Company's costs to acquire 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 took advantage of the
new market conditions by curtailing its purchase of mortgage whole loans and
purchasing existing MBS instead. In 2000, the Company purchased ten subordinate
MBS with an aggregate principal balance of $9,273,000,
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at a net purchase price of $5,941,000. The Company also purchased three MBS
issued by agencies of the Federal government ("Agency") with an aggregate
principal balance of $4,257,000 at a net purchase price of $4,626,000. In
addition, the Company's affiliate, HCP, purchased twenty-seven subordinate MBS
with an aggregate principal balance of $15,191,000, at a net purchase price of
$8,451,000. All of the MBS purchased by HCP were either sold or transferred to
Hanover in June 2000. The Company receives 97% of the income attributable to the
subordinate MBS purchased by its affiliate.
Portfolio Composition
At December 31, 2000, the Company had invested $222,124,000 or 81.4% of the
Company's total assets in single-family mortgage loans classified as held for
sale, held to maturity or collateral for collateralized mortgage obligations
("CMOs"), and $25,846,000 or 9.5% 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 included
in this Annual Report on Form 10-K. The revenues, operating profit and loss from
the Company's investing activity is reflected on the Company's consolidated
statement of operations.
In 2000, the Company experienced $16,000 of mortgage loan losses on its mortgage
loan portfolio (held for sale, held to maturity and collateral for CMOs), and
$70,000 of losses on its mortgage-backed securities portfolio (available for
sale, held to maturity and trading). The Company experienced $58,000 of mortgage
loan losses during 1999 on its mortgage loan portfolio and no losses on its
mortgage-backed securities portfolio. Notwithstanding the low level of losses
actually incurred, the Company recorded a provision for anticipated credit
losses of $875,000 and $446,000 in 2000 and 1999.
The mortgage loans and created 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. The mortgage securities that the Company
purchased may be held or sold from time to time depending on market conditions
Securitization Activity
In June 2000, the Company issued $13,222,000 of CMO borrowings at a discount of
$2,013,000 for net proceeds before expenses of $11,209,000. The "Hanover 2000-A"
CMO securities carry a fixed interest rate of 6.50%. The Hanover 2000-A
securities are collateralized by $25,588,000 principal balance of the retained
portions of Hanover's previous CMO borrowings, Hanover 98-A, Hanover 99-A and
Hanover 99-B and certain retained mortgage backed securities from Hanover 98-B.
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
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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
Collateral 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
June 2000 25,588 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 (FNMA, 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.
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.
As of December 31, 2000, the Company and its affiliates had purchased since
inception approximately $64,317,000 (principal balance) of subordinate MBS from
third parties at an aggregate purchase price of $32,174,000. As of the same
date, the Company had sold approximately $28,192,000 (principal balance) of such
securities. At December 31, 2000 the Company owned $35,212,000 (principal
balance) of subordinate MBS purchased from third parties, representing a
subordinate interest in $5,401,000,000 of
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single-family mortgage loan pools. The aggregate carrying value of these MBS at
December 31, 2000 was $19,518,000.
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.
One of the Company's unconsolidated subsidiaries, HCP, has a due diligence and
consulting staff, located in Edison, New Jersey, consisting of approximately 33
full-time employees and access to a part-time pool of employees in excess of
500. 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.
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
information 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 property specific
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 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 2000, 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.
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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 (FNMA, 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.
At December 31, 2000, the Company had purchased since inception in excess of $1
billion of single-family mortgage loan pools. Also, at December 31, 2000 the
Company did not have any commitments outstanding to purchase single-family
mortgage pools.
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 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.
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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 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 that 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 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 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
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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 $10 million and $13 million of multifamily mortgage
loans at December 31, 2000 and December 31, 1999. 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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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 loan sale advisory assignments,
the underwriting of credit, analysis of loan documentation and collateral,
analysis of the accuracy of the accounting for mortgage loans serviced by third
party servicers, and the preparation of documentation to facilitate the transfer
of mortgage loan. The due diligence analyses are performed on a loan by loan
basis. Consulting services include loan sale advisory work for government
agencies such as the Small Business Administration and Federal Deposit
Insurance Corporation as well as private sector financial institutions. HCP also
performs due diligence on mortgage loans acquired by the Company.
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. and is continuing DMN's business as the Assignment Division of
HCP. The Assignment Division 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. The Assignment Division employees prepare
and process this paperwork for third party institutions.
HANOVERTRADE.COM, INC.
The Company conducts loan brokering and trading, and loan sale advisory services
through HTC. HTC operates an online world wide web-based exchange for trading
loan pools (primarily mortgage loan pools) and performs loan sale advisory
services for third parties. HTC was incorporated on May 28, 1999. In the third
quarter of 2000, the loan brokering and trading activities of HCP were combined
with the HTC activities. HTC officially launched its web-site on October 29,
2000.
In January of 2000, HTC hired all of the former employees and acquired all of
the assets of Pamex Capital Partners, LLC. (We refer to this as "Pamex.") Prior
to its acquisition, Pamex was a traditional broker of pools of mortgage loans
and consumer loans. With the acquisition of Pamex and subsequent reassignments,
HTC has 9 full-time salespeople. These salespeople attempt to maintain regular
contact with all of the major buyers and sellers of mortgage and consumer whole
loans.
As of January 31, 2001, registered members of the site accounted for
approximately 51% of the domestic US mortgage origination market.
HTC arranges for the sale of pools of mortgage loans, consumer loans and
commercial mortgage loans to institutional purchasers. HTC arranges for such
sales through its web site as well as through traditional channels, including
telephone contact and e-mail.
Typically, HTC attempts to utilize its web site to assist in the process of
selling larger pools of mortgage loans that conform to industry recognized
underwriting standards. For smaller pools, or pools that do not conform to
industry recognized standards, HTC will attempt to sell these pools using more
traditional means. To assist in the sales process of these pools, HTC may
prepare marketing materials and marketing analyses for sellers of pools.
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, 2000.
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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, ranging from 50% to 97% depending on the
credit quality of the collateral pledged. 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 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 such 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 (one year or less) fixed
interest rates varying from LIBOR to LIBOR plus 288 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 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,
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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
During periods when the Company is acquiring mortgage whole loans, the Company
normally securitizes the mortgage loans through the issuance of mortgage-backed
securities after acquiring a sufficient volume of mortgage loans with similar
characteristics, generally $50 million to $100 million or more. 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 several factors, including the length of the purchase commitment
period, the amount and type of the mortgage loan, and the securitization
process.
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 financings 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 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.
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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, in extreme circumstances, 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 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-collaterization 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 diminish the
potential expansion of the Investment Portfolio.
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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 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 investment, and (ii) monitoring the
credit and prepayment performance of each investment to adjust the required
capital. This analysis takes into account the Company's various hedging and
other risk containment programs discussed below. The minimum amount of equity
the lender requires with a mortgage asset is generally referred to as the lender
haircut. There is some variation in haircut levels among lenders from time to
time. From the lender's perspective, the haircut is a "cushion" to provide
additional protection if the value of or cash flow from an asset pool declines.
The size of the haircut depends on the liquidity and price volatility of each
investment. 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 50% 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.).
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Implementation of the CAG -- Mark to Market Accounting
Each quarter, for financial management purposes, the Company marks its
investments to market. This process consists of (i) valuing the Company's
investments acquired in the secondary market, and (ii) valuing the Company's
non-security investments, such as retained interests in securitizations. For the
first category, the Company obtains benchmark market quotes from traders who
make markets in securities similar in nature to the Company's investments. 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 investments. 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 investments.
As a result of these procedures, the leverage of the balance sheet will change
with the performance of the Company's investments. Good credit or prepayment
performance may release equity for purchase of additional investments. Poor
credit or prepayment performance may cause additional equity to be allocated to
existing investments, forcing a reduction in investments on the balance sheet.
In either case, the periodic investments performance evaluation, along with the
corresponding leverage adjustments, is intended to 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 seeks to reduce 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 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.
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Where required, an updated property valuation is obtained. The bulk of the work
is performed by employees in the due diligence operations of HCP.
Interest Rate Risk Management
For accounting purposes, the Company has three basic types of mortgage loans and
four 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, (iii)
held for trading or (iv) collateral for CMOs. 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 intended to maintain a consistent spread in a variety of interest
rate environments and therefore are not hedged.
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 credit, interest
rate and prepayment risks, no strategy can completely insulate the Company from
the effects of credit risk, 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.
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
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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. Two
examples currently used are interest rate caps and short sales of so called
"TBA" securities. 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 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. "TBA" securities (which stands for
"to be announced") are commitments to deliver mortgage securities which have not
yet been created. When the Company short sells a TBA security, it ordinarily
covers the short sale within a month by agreeing to buy a similar TBA security.
The Company would then sell another TBA security and cover that sale in the
following month and so on. The changes in market prices from such short sales
are intended to offset changes in interest rates that could offset either the
market price or the net interest margin earned on the Company's investment
portfolio. 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.
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 limit, its
hedging strategies to
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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 $5 trillion for single-family mortgage 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.
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
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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
Hanover had five employees (the "Principals") at December 31, 2000. Hanover
engages the services of HCP to provide management expertise, product
sourcing, due diligence support, and general and administrative services to
assist Hanover in accomplishing its business objectives. At December 31,
2000, HCP employed 33 people on a full-time basis and 31 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. Nine
of these 33 people devote substantially all their time to HTC. HTC does not have
a separate payroll. HCP maintains a database of approximately 500 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. HTC
is in the process of registering one trademark with the United States Patent and
Trademark office.
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 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
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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
1999 or 2000 sales transactions would be classified as prohibited transactions.
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FEDERAL INCOME TAX CONSIDERATIONS
General
Hanover has elected to be treated as a REIT for income 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 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
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23
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 REIT's 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 amended
tax rules relating to the composition of REITs assets. Under prior law, a REIT
was 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 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 expects to
continue to make will give rise primarily to mortgage interest qualifying under
the 75% income test.
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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) 90% of its taxable income before deduction of
dividends paid and excluding net capital gains, plus (ii) 90% 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 90%
distribution requirement.
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 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 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
Edison, NJ(1) 5,200 137,800 April 2005 Executive, Administration,
Accounting Operations
Chicago, Illinois 1,151 22,397 January 2004 Marketing
Rockland, Massachusetts 300 6,000 Month to Month Marketing
St. Paul, Minnesota 150 9,060 Month to Month Marketing
------ --------
Total: 20,498 $470,364
====== ========
(1) This office lease will be assumed by HanoverTrade.com, Inc., in connection
with it's acquisition of all of the assets of Pamex Capital Partners, L.L.C.
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 expired on September 15, 2000.
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. With the
expiration of the warrants on September 15, 2000 the units and warrants stopped
trading on September 14, 2000. As of March 1, 2001, Hanover had 4,322,944 shares
of common stock issued and outstanding, which was held by 108 holders of record
and approximately 1,500 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, 1999 and 2000.
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
Quarter Ended March 31, 2000 3 7/8 3 5/16 3 11/16
Quarter Ended June 30, 2000 4 1/2 3 5/8 4 1/2
Quarter Ended September 30, 2000 5 7/16 4 3/8 5
Quarter Ended December 31, 2000 5 9/16 4 9/16 5 1/4
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
Quarter Ended March 31, 2000 3 7/8 3 1/8 3 3/8
Quarter Ended June 30, 2000 4 3/16 3 1/4 4 1/8
Quarter Ended September 30, 2000 4 3/4 4 (1)
Quarter Ended December 31, 2000 (1) (1) (1)
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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
Quarter Ended March 31, 2000 1/16 .252/64 1/16
Quarter Ended June 30, 2000 1/16 .252/64 1/64
Quarter Ended September 30, 2000 1/64 1/64 (1)
Quarter Ended December 31, 2000 (1) (1) (1)
(1) The warrants expired on September 15, 2000 and the warrants and units
stopped trading on September 14, 2000.
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
Quarter Ended March 31, 2000 $0.12
Quarter Ended June 30, 2000 $0.14
Quarter Ended September 30, 2000 $0.20
Quarter Ended December 31, 2000 $0.20
(a) Common stock and warrants were first listed on the American Stock Exchange
on March 20, 1998.
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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 $8,944,000 as of December 31,
2000). 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, 2000, 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
June 10
STATEMENT OF OPERATIONS HIGHLIGHTS Year Ended Year Ended Year Ended (inception) to
December 31, December 31, December 31, December 31,
2000 1999 1998 1997
---- ---- ---- ----
Net interest income $ 6,663 $ 4,408 $ 6,623 $ 1,676
Loan loss provision (875) (446) (356) (18)
Gain (loss) on sale and mark-to-market 1,250 (5,831) (5,704) 35
Provision for loss on unconsolidated subsidiary -- (4,793) -- --
---------- ---------- ---------- ----------
Total revenues (loss) 7,038 (6,662) 563 1,693
Expenses 3,136 4,191 4,064 940
---------- ---------- ---------- ----------
Operating income (loss) 3,902 (10,853) (3,501) 753
Equity in income (loss) of unconsolidated
subsidiaries
Hanover Capital Partners Ltd. 455 (443) (1,039) (254)
Hanover Capital Partners 2, Inc. -- (1,300) (394) --
HanoverTrade.com, Inc. (1,495) (31) -- --
---------- ---------- ---------- ----------
(1,040) (1,774) (1,433) (254)
---------- ---------- ---------- ----------
Net income (loss) $ 2,862 $ (12,627) $ (4,934) $ 499
========== ========== ========== ==========
Basic earnings (loss) per share $ .56 $ (2.12) $ (0.77) $ 0.15
========== ========== ========== ==========
Diluted earnings (loss) per share $ .56 $ (2.12) $ (0.77) $ 0.14
========== ========== ========== ==========
Dividends declared per share $ .66 $ 0.50 $ 0.70 $ 0.16
========== ========== ========== ==========
BALANCE SHEET HIGHLIGHTS December 31, December 31, December 31, December 31,
2000 1999 1998 1997
---- ---- ---- ----
Mortgage loans $ 212,247 $ 270,084 $ 407,994 $ 160,970
Mortgage securities 35,723 62,686 78,478 348,131
Cash and cash equivalents 9,958 18,022 11,837 4,022
Other assets 14,880 14,694 17,861 4,420
---------- ---------- ---------- ----------
Total assets $ 272,808 $ 365,486 $ 516,170 $ 517,543
========== ========== ========== ==========
Reverse repurchase agreements $ 14,760 $ 55,722 $ 370,090 $ 435,138
CMO Borrowings 210,374 254,963 77,305 --
Other liabilities 3,650 4,443 2,995 4,307
---------- ---------- ---------- ----------
Total liabilities 228,784 315,128 450,390 439,445
---------- ---------- ---------- ----------
Stockholders' equity 44,024 50,358 65,780 78,098
---------- ---------- ---------- ----------
Total liabilities and stockholders' equity $ 272,808 $ 365,486 $ 516,170 $ 517,543
========== ========== ========== ==========
Number of common shares outstanding 4,322,944 5,826,899 6,321,899 6,466,677
========== ========== ========== ==========
Book value per common share $ 10.18 $ 8.64 $ 10.41 $ 12.08
========== ========== ========== ==========
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Hanover is a real estate investment trust ("REIT"), formed to operate as a
specialty finance company. The principal business strategy of Hanover is to
invest in mortgage backed securities and to a lesser extent mortgage loans and
to earn net interest income on these investments. The Company has two principal
unconsolidated subsidiaries, HCP and HTC. The principal business strategy of HCP
is to generate consulting and other fee income by performing loan file and
operational due diligence reviews for third parties, performing advisory
services for third parties, and preparing and/or processing documentation
(primarily assignments of mortgage loans) for third parties on a contract basis.
The principal business activity of HTC is to generate fee income by operating an
online world-wide web-based exchange for trading loan pools (primarily mortgage
loan pools) and by performing loan sale advisory services for third parties.
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 investment portfolio entails (1) efficient acquisition pricing
of mortgage loans and securities, (2) financing securities and loans by reverse
repurchase agreements or lines of credit, (3) hedging in the short term to
offset potential adverse effects of changes in interest rates, and (4) for
mortgage loans, stratifying and segregating them 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
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
2000 2000 2000 2000 2000
---- ---- ---- ---- ----
Net interest income $ 1,484 $ 1,425 $ 2,081 $ 1,673 $ 6,663
Loan loss provision (103) (99) (385) (288) (875)
Gain on sale of mortgage assets -- -- -- 819 819
Gain on mark to market of mortgage securities
and mortgage loans, net of associated hedge 199 316 -- (84) 431
-------- -------- -------- -------- --------
Total revenues 1,580 1,642 1,696 2,120 7,038
Expenses 980 959 502 695 3,136
-------- -------- -------- -------- --------
Operating income 600 683 1,194 1,425 3,902
Equity in income (loss) of unconsolidated subsidiaries
Hanover Capital Partners Ltd 114 98 125 118 455
Hanover Capital Partners 2, Inc. -- -- -- -- --
HanoverTrade.com, Inc. (24) (46) (592) (833) (1,495)
-------- -------- -------- -------- --------
Net income $ 690 $ 735 $ 727 $ 710 $ 2,862
======== ======== ======== ======== ========
Basic earnings per share $ 0.12 $ 0.14 $ 0.15 $ 0.16 $ 0.56
======== ======== ======== ======== ========
Dividends declared per share (a) $ 0.12 $ 0.14 $ 0.20 $ 0.20 $ 0.66
======== ======== ======== ======== ========
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) $ 1,509 $ 4,409
Loan loss provision (119) (113) (107) (108) (447)
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 1,203 4,192
-------- -------- -------- -------- --------
Operating income (loss) 1,612 762 (13,443) 215 (10,854)
Equity in income(loss) of unconsolidated subsidiaries
Hanover Capital Partners Ltd. (407) (276) (142) 383 (442)
Hanover Capital Partners 2, Inc. (469) (428) (403) -- (1,300)
HanoverTrade.com, Inc. -- -- (6) (25) (31)
-------- -------- -------- -------- --------
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
======== ======== ======== ======== ========
(a) The dividends relating to the three months ended December 31, 2000 were
declared on December 22, 2000. The dividends relating to the three months
ended December 31, 1999 were declared on December 21, 1999.
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32
YEARS ENDED DECEMBER 31, 2000 AND 1999.
The Company recorded net income of $2,862,000 or $0.56 per share based on
5,102,563 weighted shares of common stock outstanding for the year ended
December 31, 2000 compared to a net loss of $12,627,000 or $2.12 per share based
on 5,942,403 weighted shares of common stock outstanding for 1999. Total
revenues for the year ended December 31, 2000 were $7,038,000 compared to a
negative $6,662,000 in 1999.
The 1999 revenues were negatively impacted by charges in the third quarter 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.
Net interest income increased to $6,663,000 in 2000 compared to $4,408,000 in
1999. Net interest income in 1999 was $6,587,000 before giving effect to the
third quarter amortization expense described above.
Net interest income in the first and second quarter of 2000 of $1,484,000 and
$1,425,000 was significantly lower than in the comparable quarters of 1999
($2,051,000 and $1,733,000.) Net interest income declined for these periods as a
result of (1) an increase in amortization expense for whole loans as a result of
increases in assumed prepayment speeds and (2) a reduction in the principal
balance of the company-sponsored securitizations of whole loans partially offset
by a corresponding reduction in the principal balance of CMO borrowings against
such whole loans.
Net interest income in the third quarter of 2000 was $2,081,000 compared to a
negative $884,000 in the third quarter of 1999. The 2000 figure includes a
positive $205,000 of amortization adjustment reflecting a slowing of assumed
prepayment speeds, and also includes $306,000 of net revenue from subordinate
MBS that were transferred from HCP to the Company on July 1, 2000. The 1999
figure includes a negative $2,178,000 reflecting an increase in assumed
prepayment speeds.
Net interest income for the fourth quarter of 2000 was $1,673,000 compared to
$1,509,000 for the same period in 1999. The increase resulted from the
repositioning of the Company's investment portfolio during 2000 towards more
high yielding subordinate mortgage-backed securities purchased from third
parties. At December 31, 1999 the Company's direct investment in such securities
totaled $3,640,000 as compared to $19,518,000 at December 31, 2000. At December
31, 1999 the Company's unconsolidated subsidiary, HCP, owned $14,180,000 of such
securities and recorded the net interest income earned thereon. All of these
securities were either sold or transferred to the Company on July 1, 2000.
The Company's provision for loan losses increased from $447,000 in 1999 to
$875,000 in 2000, primarily as a result of the Company's increased investment in
subordinate mortgaged-backed securities. Provision for losses on Hanover
sponsored securitizations decreased from $331,000 for the year ended December
31, 1999 to $319,000 for 2000. Provision for loan losses on subordinate
securities purchased from third parties increased from $39,000 for the year
ended December 31, 1999 to $555,000 for the similar 2000 period. The average
balance of subordinate securities purchased from third parties in 1999 was
$2,133,000, compared to $11,973,000 in 2000.
The Company sold nine subordinate mortgage-backed MBS with proceeds of
$5,882,000 and a gain of $1,248,000 and 32 Agency MBS with proceeds of
$39,881,000 and a loss of $429,000 during 2000. The
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33
Company sold six subordinate MBS created in the Hanover 1998B securitization for
proceeds of $2,232,000 and a gain of $146,000 during 1999.
The Company held subordinate mortgage-backed securities from Hanover 1998B
classified as trading during the year ended December 31, 2000 and recorded mark
to market gains totaling $515,000 net of the associated hedge. These securities
were transferred to CMO collateral as part of the Hanover 2000A securitization
in June 2000. In addition, net hedging activity on subordinate MBS available for
sale, net of related realized marks of the hedged securities totaled a loss of
$84,000 in the fourth quarter of 2000.
The Company's equity in income (losses) of HCP, its consulting subsidiary,
improved from a loss of $443,000 in 1999 to income of $455,000 in 2000. Total
revenue at HCP increased $1,654,000 or 23% to $8,713,000 in 2000 from $7,059,000
in 1999. Due diligence fees increased $1,486,000 or 27% from $5,530,000 in 1999
to $7,016,000 in 2000. Assignment fees contributed $631,000 of revenue in 2000,
the first year of activity in this area. The portfolio of subordinate mortgage
backed securities contributed $954,000 of net interest income and gains on sale
in 2000 compared to $385,000 of net interest income in 1999. This portfolio was
transferred from HCP to the Company in July of 2000. Loan brokering and asset
management fees declined to $30,000 in 2000 from $789,000 in 1999. This activity
was transferred to HTC in July of 2000.
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.
The Company recognized equity in losses of HTC, its world wide web based
exchange for loan pool trading and loan sale advisory, of $1,495,000 for 2000
and $31,000 for 1999. HTC was organized in May 1999 to develop an E-commerce
business to broker mortgage loan pools to financial institutions and other
finance companies via the internet. HTC recorded revenue of $141,000 for the
year ended December 31, 2000 and $0 for 1999. HTC operating expenses for the
year ended December 31, 2000 totaled $1,683,000 and $32,000 for the similar
period in 1999. The 2000 expenses included personnel expense of $790,000,
technology expense for web hosting and web graphics of $230,000 and premises
expense of $130,000. Depreciation and amortization of $151,000 for 2000 includes
$149,000 of amortization of capitalized software costs. Travel and entertainment
expense of $175,000 includes $42,000 to introduce the HTC web site at the
Mortgage Bankers Association Conference.
Operating expenses for the year ended December 31, 2000 were $3,136,000,
compared to $4,191,000 in 1999, a reduction of $1,055,000. Legal and
professional fees declined to $555,000 in 2000 from $1,201,000 in 1999 as a
result of decreases in legal and other professional fees. Financing fees
declined to $281,000 in 2000 from $404,000 in 1999 reflecting reduced committed
lines of credit and lower levels of activity. Due diligence expenses in 1999
resulted from the Company's two 1999 securitizations. There were no similar
expenses in 2000. Management and administrative expenses included office
overhead in 1999 but do not in 2000 resulting in a decrease of $135,000. Office
expenses are paid directly in 2000
31
34
and recorded in the other expense category causing an increase of $186,000 from
the prior year. In addition, $103,000 of premises related expenses were billed
to HTC in 2000 to reflect activity on behalf of HTC. There were no similar
billings in 1999. The Company also billed personnel related expenses totaling
$369,000 to HTC and $136,000 to HCP during 2000. These billings reduce personnel
related expenses of the Company and similar billings are expected in future
periods. There were no similar billings to HTC in 1999 and HCP was billed
$180,000 in 1999.
The Company's 2000 and 1999 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%.
YEARS ENDED DECEMBER 31, 1999 AND 1998
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 HCP, its consulting subsidiary, declined
from a loss of $1,039,000 in 1998 to a loss of $443,000 in 1999. 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.
32
35
Also included in the equity in loss of unconsolidated subsidiaries in 1999 is a
$31,000 loss from a newly organized subsidiary -- HanoverTrade.com, Inc. HTC was
organized in May 1999 to develop an E-commerce business to broker mortgage loan
pools to financial institutions and other finance companies via the internet.
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 $973,000 in 1998 and experienced significantly lower financing and
commitment fees, $404,000 in 1999 compared to $836,000 in 1998. Offsetting
these cost savings were substantial increases in legal and professional
expenses, $1,201,000 for 1999 compared to $545,000 in 1998, and personnel
expenses of $1,230,000 in 1999 compared to $712,000 for 1998. 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.
33
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%
March 31, 2000 10.91% 1.57% 0.00% 7.74% .71% 5.45%
June 30, 2000 10.99% 2.62% 0.00% 7.95% .43% 6.09%
September 30, 2000 13.40% 0.00% 1.16% 4.31% (4.01)% 6.24%
December 31, 2000 12.435 6.61% 0.00% 6.24% (6.41) 6.39%
(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.
34
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, 2000 June 30, 2000 September 30, 2000 December 31, 2000
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 $ 334 251.64% $ 354 4.10% $ 282 21.17% $ 231 60.32%
CMO collateral 262,909 7.13% 251,775 7.47% 246,268 7.82% 230,449 7.45%
Agency MBS 44,515 7.04% 42,500 7.19% 40,911 7.78% 36,361 7.11%
Private placement notes 17,390 15.97% 16,313 17.13% 24,513 16.86% 22,849 17.26%
-------- ----- -------- ------- -------- ----- -------- -----
325,148 7.84% 310,942 7.94% 311,974 8.56% 289,890 8.22%
-------- ------ -------- ------- -------- ----- -------- -----
Interest bearing liabilities:
Reverse repurchase borrowings on
mortgage loans - - - - - - - -
CMO borrowings 247,655 7.36% 236,373 7.49% 233,548 7.52% 217,796 7.61%
Reverse repurchase borrowings on:
CMO collateral 3,346 7.43% 3,335 8.31% 3,622 8.05% 3,758 6.12%
Agency MBS 33,957 5.93% 33,522 5.99% 25,695 5.53% 22,908 5.19%
Private placement notes 4,292 6.54% 2,463 6.98% 12,653 8.01% 10,770 8.27%
-------- ------ -------- ------- -------- ----- -------- -----
289,250 7.18% 275,693 7.31% 275,518 7.36% 255,232 7.40%
-------- ------ -------- ------- -------- ----- -------- -----
Net interest earning assets $ 35,898 $ 35,249 $ 36,456 $ 34,658
======== ======== ======== ========
Net interest spread 0.66% 0.62% 1.17% 0.82%
====== ====== ===== =====
Yield on net interest earning
assets (2) 13.17% 12.80% 17.40% 14.29%
====== ====== ===== =====
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 7.02% $123,945 6.93% $ 41,034 2.64% $ 251 (9.56%)
CMO collateral 124,784 6.75% 204,469 7.00% 262,666 6.72% 279,928 7.13%
Agency MBS 57,552 6.78% 53,619 6.93% 49,968 6.72% 46,930 6.97%
Private placement notes 18,334 13.98% 17,261 13.21% 18,643 (24.22%) 16,401 16.13%
-------- ------ -------- ----- -------- ------ -------- ------
446,999 7.20% 399,294 7.23% 372,311 4.71% 343,510 7.53%
-------- ------ -------- ------ -------- ------ -------- ------
Interest bearing liabilities:
Reverse repurchase borrowings on
mortgage loans 225,835 6.43% 113,125 6.15% 37,031 6.32% - -
CMO borrowings 98,357 6.88% 191,858 6.79% 232,132 7.22% 262,354 6.96%
Reverse repurchase borrowings on:
CMO collateral 18,194 5.96% 1,518 6.32% 15,361 7.05% 3,366 8.08%
Agency MBS 56,420 5.07% 52,559 5.39% 47,888 5.82% 38,534 5.89%
Private placement notes 4,037 5.45% 5,836 5.83% 4,243 5.85% 4,605 6.69%
-------- ------ -------- ----- -------- ------ -------- ------
402,843 6.32% 364,896 6.37% 336,655 6.70% 308,859 6.86%
-------- ------ -------- ----- -------- ------ -------- ------
Net interest earning assets $ 44,156 $ 34,398 $ 35,656 $ 34,651
======== ======== ======== ========
Net interest spread 0.99% 0.98% (1.87%) 0.80%
====== ===== ====== ======
Yield on net interest earning
assets (2) 16.30% 17.52% (12.60%) 15.18%
====== ===== ====== ======
(1) Loan loss provisions are included in the above calculations.
(2) Yield on net interest earning assets is computed by dividing the applicable
net interest income after loan loss provision 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, 2000 was $6,663,000 compared
to net interest income of $4,408,000 for 1999. The following table reflects net
interest income (expense) generated for each period (dollars in thousands):
NET INTEREST INCOME (EXPENSE) IN 2000
Quarter Ended
---------------------------------------------------------------------------------
March 31, 2000 June 30, 2000 September 30, 2000 December 31, 2000 Total
-------------- ------------- ------------------ ----------------- -----
Net Loan Net Loan Net Loan Net Loan Loan
Interest Loss Interest Loss Interest Loss Interest Loss Interest Loss
Income Provision Income Provision Income Provision Income Provision Income Provision
Mortgage Loans $ 210 $ -- $ 4 $ -- $ 15 $ -- $ 35 $ -- $ 264 $ --
CMO Collateral 119 (48) 253 (50) 427 (78) 164 (73) 963 (249)
Agency MBS 280 -- 261 -- 440 -- 349 -- 1,330 --
Private placement MBS 679 (54) 705 (49) 1,088 (308) 978 (215) 3,450 (626)
Other 196 -- 202 -- 111 -- 147 -- 656 --
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total net interest income $1,484 $ (102) $1,425 $ (99) $2,081 $ (386) $1,673 $ (288) $6,663 $ (875)
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
NET INTEREST INCOME (EXPENSE) IN 1999
Quarter Ended
---------------------------------------------------------------------------------
March 31, 1999 June 30, 1999 September 30, 1999 December 31, 1999 Total
-------------- ------------- ------------------ ----------------- -----
Net Loan Net Loan Net Loan Net Loan Loan
Interest Loss Interest Loss Interest Loss Interest Loss Interest Loss
Income Provision Income Provision Income Provision Income Provision Income Provision
Mortgage Loans $ 736 $ (45) $ 413 $ (24) $ (314) $ (7) $ (6) $ -- $ 829 $ (76)
CMO Collateral 166 (23) 335 (37) 181 (41) 396 (51) 1,078 (152)
Agency MBS 261 -- 221 -- 143 -- 251 -- 876 --
Private placement MBS 637 (51) 537 (52) (1,132) (59) 640 (56) 682 (218)
Other 251 -- 227 -- 238 -- 227 -- 943 --
------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total net interest income $ 2,051 $ (119) $ 1,733 $ (113) $ (884) $ (107) $ 1,508 $ (107) $ 4,408 $ (446)
======= ======= ======= ======= ======= ======= ======= ======= ======= =======
MORTGAGE LOANS HELD FOR SALE
Net interest income generated from investments in mortgage loans (classified as
held for sale and held to maturity) during the years ended December 31, 2000 and
1999, respectively, is detailed below (dollars in thousands):
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39
Mortgage Loans Held for Sale
Quarter Ended
--------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
---- ---- ---- ----
Average asset balance $ 334 $ 354 $ 282 $ 231
Average repo borrowing balance -- -- -- --
------- ------- ------- -------
Net interest earning assets $ 334 $ 354 $ 282 $ 231
Average leverage ratio 0.00% 0.00% 0.00% 0.00%
Effective interest income rate 251.64% 4.10% 21.17% 60.32%
Effective interest expense rate 0.00% 0.00% 0.00% 0.00%
------- ------- ------- -------
Net interest spread 251.64% 4.10% 21.17% 60.32%
Interest income $ 210 $ 4 $ 15 $ 35
Interest expense -- -- -- --
------- ------- ------- -------
Net interest income before loan loss provision 210 4 15 35
Loan loss provision -- -- -- --
------- ------- ------- -------
Net interest income after loan loss provision $ 210 $ 4 $ 15 $ 35
======= ======= ======= =======
Yield on net interest earning assets
after loan loss provision 251.64% 4.10% 21.17% 60.32%
======= ======= ======= =======
Mortgage Loans Held for Sale
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 91.68% 91.27% 90.25% --
Effective interest income rate 7.09% 7.01% 2.70% (9.24%)
Effective interest expense rate 6.43% 6.23% 6.39% --
------- -------- ------- -------
Net interest spread 0.66% 0.79% (3.69%) (9.24%)
Interest income $ 4,367 $ 2,172 $ 278 $ (6)
Interest expense 3,631 1,759 592 --
------- -------- ------- -------
Net interest income before loan loss provision 736 413 (314) (6)
Loan loss provision (45) (24) (7) --
------- -------- ------- -------
Net interest income after loan loss provision $ 691 $ 389 $ (321) $ (6)
======= ======== ======= =======
Yield on net interest earning assets after
loan loss provision 13.49% 14.39% (32.10%) (9.56%)
======= ======== ======= =======
The Company did not purchase any mortgage loans in 2000 or 1999. 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.
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40
CMO COLLATERAL
Net interest income generated from the CMO collateral (including mortgage loans
and mortgage-backed securities pledged to CMOs) during 2000 and 1999 is detailed
below (dollars in thousands):
CMO Collateral
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
---- ---- ---- ----
Average asset balance $ 262,909 $ 251,775 $246,268 $230,449
Average CMO borrowing balance 247,655 236,373 233,548 217,796
Average repo balance 3,346 3,335 3,621 3,758
--------- --------- -------- --------
Net interest earning assets $ 11,908 $ 12,067 $ 9,099 $ 8,895
Average leverage ratio 95.47% 95.21% 96.31% 96.14%
Effective interest income rate 7.21% 7.55% 7.95% 7.58%
Effective interest expense rate 7.36% 7.49% 7.52% 7.61%
Effective interest expense rate - Repo 7.43% 8.31% 8.05% 6.12%
--------- --------- -------- --------
Net interest spread (0.15%) 0.06% 0.43% (0.03%)
Interest income $ 4,736 $ 4,749 $ 4,892 $ 4,368
Interest expense 4,556 4,427 4,392 4,146
Interest expense - Repo 62 69 73 57
--------- --------- -------- --------
Net interest income before loan loss
provision 118 253 427 165
Loan loss provision (48) (50) (78) (73)
--------- --------- -------- --------
Net interest income after loan loss
provision $ 70 $ 203 $ 349 $ 92
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 2.34% 6.75% 15.36% 4.09%
========= ========= ======== ========
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 93.40% 94.58% 94.22% 95.14%
Effective interest income rate 6.83% 7.08% 6.78% 7.20%
Effective interest expense rate 6.88% 6.79% 7.29% 6.97%
Effective interest expense rate - Repo 5.96% 6.32% 1.93% 8.08%
--------- --------- -------- --------
Net interest spread (0.05%) 0.29% (0.51%) 0.23%
Interest income $ 2,129 $ 3,617 $ 4,453 $ 5,029
Interest expense 1,692 3,258 4,230 4,565
Interest expense - Repo 271 24 42 68
--------- --------- -------- --------
Net interest income before loan loss
provision 166 335 181 396
Loan loss provision (23) (37) (41) (51)
--------- --------- -------- --------
Net interest income after loan loss
provision $ 143 $ 298 $ 140 $ 345
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 6.95% 10.75% 3.69% 10.16%
========= ========= ======== ========
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41
In 2000, the Company issued $13,222,000 of CMO borrowings at a discount of
$2,013,000 for net proceeds before expenses of $11,209,000. The "Hanover 2000-A"
CMO securities carry a fixed interest rate of 6.50%. The Hanover 2000-A
securities are collateralized by $25,588,000 principal balance of the retained
portions of Hanover's previous CMO borrowings, Hanover 98-A, Hanover 99-A and
Hanover 99-B and certain retained mortgage-backed securities from Hanover 98-B.
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 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 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, 2000 the Company had $3,627,000 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.
AGENCY MORTGAGE SECURITIES
Net interest income in 2000 and 1999 generated from investments in Agency
mortgage securities is detailed below (dollars in thousands):
Agency Mortgage Securities
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
---- ---- ---- ----
Average asset balance $ 44,515 $ 42,500 $ 40,911 $ 36,361
Average repo borrowing balance 33,957 33,522 25,695 22,908
--------- --------- -------- --------
Net interest earning assets $ 10,558 $ 8,978 $ 15,216 $ 13,453
Average leverage ratio 76.28% 78.88% 62.81% 63.00%
Effective interest income rate 7.04% 7.19% 7.78% 7.11%
Effective interest expense rate 5.93% 5.99% 5.53% 5.19%
--------- --------- -------- --------
Net interest spread 1.11% 1.20% 2.25% 1.92%
Interest income $ 783 $ 764 $ 796 $ 646
Interest expense 503 503 356 297
--------- --------- -------- --------
Net interest income before loan loss
provision 280 261 440 349
Loan loss provision -- -- -- --
--------- --------- -------- --------
Net interest income after loan loss
provision $ 280 $ 261 $ 440 $ 349
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 10.62% 11.64% 11.58% 10.37%
========= ========= ======== ========
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42
Agency Mortgage Securities
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
1999 1999 1999 1999
---- ---- ---- ----
Average asset balance $ 57,552 $ 53,618 $ 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 98.03% 98.02% 95.84% 82.11%
Effective interest income rate 6.78% 6.93% 6.72% 6.98%
Effective interest expense rate 5.07% 5.39% 5.82% 5.89%
--------- --------- -------- --------
Net interest spread 1.71% 1.54% 0.90% 1.09%
Interest income $ 976 $ 929 $ 840 $ 819
Interest expense 715 708 697 568
--------- --------- -------- --------
Net interest income before loan loss
provision 261 221 143 251
Loan loss provision -- -- -- --
Net interest income after loan loss
provision $ 261 $ 221 $ 143 $ 251
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 92.23% 83.40% 27.50% 11.97%
========= ========= ======== ========
In November 2000, the Company purchased $1.9 million of GNMA securities. In
December 2000, the Company sold 31 FNMA Certificates, totaling $36.9 million of
principal.
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.
Interest expense includes the interest on the related reverse repurchase
agreements and amortization of deferred financing costs and interest rate caps.
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43
PRIVATE PLACEMENT MBS
Net interest income (expense) generated from private placement mortgage-backed
securities excluding securities pledged as collateral for CMO is detailed below
(dollars in thousands):
Private Placement MBS
Quarter Ended
---------------------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
Average asset balance $ 17,390 $ 16,313 $ 24,513 $ 22,849
Average repo borrowing balance 4,292 2,463 12,653 10,770
--------- --------- -------- --------
Net interest earning assets $ 13,098 $ 13,850 $ 11,860 $ 12,079
Average leverage ratio 24.68% 15.10% 51.62% 47.13%
Effective interest income rate 17.23% 18.33% 21.88% 21.02%
Effective interest expense rate 6.54% 6.98% 8.01% 8.27%
--------- --------- -------- --------
Net interest spread 10.69% 11.35% 13.87% 12.75%
Interest income (expense) $ 749 $ 748 $ 1,341 $ 1,201
Interest expense 70 43 253 223
--------- --------- -------- --------
Net interest income before loan loss
provision 679 705 1,088 978
Loan loss provision (54) (49) (308) (215)
--------- --------- -------- --------
Net interest income after loan loss
provision $ 625 $ 656 $ 780 $ 763
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 19.06% 18.94% 26.30% 25.28%
========= ========= ======== ========
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 22.02% 33.81% 22.76% 28.08%
Effective interest income rate 15.10% 14.41% (22.96%) 17.49%
Effective interest expense rate 5.45% 5.82% 5.84% 6.69%
--------- --------- -------- --------
Net interest spread 9.65% 8.59% (28.80%) 10.80%
Interest income (expense) $ 692 $ 622 $ (1,070) $ 717
Interest expense 55 85 62 77
--------- --------- -------- --------
Net interest income before loan loss
provision 637 537 (1,132) 640
Loan loss provision (51) (52) (59) (56)
--------- --------- -------- --------
Net interest income after loan loss
provision $ 586 $ 485 $ (1,191) $ 584
========= ========= ======== ========
Yield on net interest earning assets after
loan loss provision 16.40% 16.98% (33.08%) 19.81%
========= ========= ======== ========
41
44
The Private Placement MBS category includes (1) 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. 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, 2000
includes a $12,345,000 investment in six investment grade ("AA", "A" and "BBB"),
six interest only notes, six below investment grade notes and three principal
only notes.
The 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 pass through rate on the Securitization. In all
likelihood, mortgages with higher interest rates will be repaid more rapidly
than mortgages with lower interest rates.
The Company's investment in private placement MBS at December 31, 2000 includes
an investment of $1.6 million carrying value in 1998-B interest only notes, an
investment of $0.9 million carrying value in 1998-B principal only notes and an
investment of $19.5 million carrying value in below investment grade subordinate
MBS classified as held to maturity, available for sale or trading.
During 2000 the Company purchased $6.0 million of below investment grade MBS
from third parties, sold $5.9 million of below investment grade MBS to third
parties, purchased $13.8 million of below investment grade subordinate MBS from
HCP, and transferred $9.9 million of investment grade and below investment grade
subordinate MBS from the Company's 1998-B CMO to Collateral for the 2000-A CMO.
During 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.
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OTHER INTEREST INCOME
Interest income generated during 2000 and 1999 from non-mortgage assets is
detailed below (dollars in thousands):
QUARTER ENDED Year
--------------------------------------------------- Ended
Mar 31, Jun 30, Sept 30, Dec 31, Dec 31,
2000 2000 2000 2000 2000
---- ---- ---- ---- ----
Overnight investing $ 52 $ 28 $ 14 $ 29 123
Related party notes 144 174 97 117 532
---- ---- ---- ---- ----
$196 $202 $111 $146 $655
==== ==== ==== ==== ====
QUARTER ENDED Year
--------------------------------------------------- Ended
Mar 31, Jun 30, Sept 30, Dec 31, Dec 31,
1999 1999 1999 1999 1999
---- ---- ---- ---- ----
Overnight investing $199 $169 $146 $ 84 $598
Related party notes 52 58 92 143 345
---- ---- ---- ---- ----
$251 $227 $238 $227 $943
==== ==== ==== ==== ====
Interest income recorded on overnight investing was generated for the most part
from investing excess cash in Federal Agency Discount Notes, mutual funds of
Treasury and Agency securities and, to a lesser extent, investments in the
highest rated commercial paper and savings accounts. Interest rates on overnight
investments ranged from 4.80% to 6.29%.
The Company applied excess cash to reduce borrowing against Agency Collateral
during 2000 and the fourth quarter of 1999.
Notes receivable due from HCP and HTC earn interest at the prime rate less one
percent. The balance due from HCP at December 31, 2000 and 1999 was $1,704,000
and $4,896,000, respectively. The balance due from HTC at December 31, 2000 and
December 31, 1999 was $2,904,000 and $0 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, 2000 and 1999
was $3,279,000 and $3,050,000, 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. The outstanding balance
of this advance was repaid when the private placement notes were transferred to
the Company in July of 2000.
43
46
TAXABLE INCOME
Hanover's taxable income for the year ended December 31, 2000 is estimated at
$2,732,000. Taxable income differs from GAAP net income for the year ended
December 31, 2000 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, 2000 (dollars in
thousands):
GAAP NET INCOME $2,862
RECURRING ADJUSTMENTS:
Add: Equity in loss of unconsolidated
subsidiaries 1,041
Loan loss provision, net of realized losses 789
Less: Tax amortization of net premiums
on mortgages, CMO collateral and
mortgage securities and interest accrual
in excess of GAAP amortization and
interest accrual (1,197)
Difference in recognition on sales of
mortgage securities (697)
Other (66)
----------
ESTIMATED TAXABLE INCOME $ 2,732
==========
As a REIT, Hanover is required to pay dividends amounting to 85% of each year's
taxable income by the end of each calendar year and to have declared dividends
amounting to 90% 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 2000-A securitization in June 2000, 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, 2000 and seven uncommitted lines of credit. At December
31, 2000 the Company had available capacity to borrow $21 million under the
first committed line and $50 million under the second. Management may add
additional committed and uncommitted lines of credit in the future.
44
47
Net cash used in operating activities for the year ended December 31, 2000 was
$3,906,000 compared to net income of $2,682,000 for the year. Significant
non-cash charges and expenses included $1,041,000 of equity in income and loss
of unconsolidated subsidiaries and loan loss provision of $875,000, partially
offset by gain on mark to market of mortgage securities of $816,000. Purchase of
trading securities used $7,634,000, partially offset by sale of trading
securities of $2,709,000.
Net cash provided by investing activities amounted to $91,551,000 during the
year ended December 31, 2000. The majority of cash proceeds from investing
activities was generated from (1) principal payments received on collateral for
CMOs of $57,254,000, (2) proceeds from the sale of mortgage assets of
$43,054,000 and (3) principal payments received on mortgage securities of
$8,001,000. These were offset by cash payments to purchase mortgage securities
from third parties of $2,934,000 and cash used to purchase mortgage securities
from HCP of $13,845,000.
Cash flows from financing activities used $95,709,000 during the year ended
December 31, 2000. The Company made net repayments to its reverse repurchase
lenders of $40,962,000 and had net repayment on CMO borrowings (net of
borrowings of $11,209,000) of $45,685,000. The Company also paid dividends of
$2,822,000 and purchased an additional 1,503,955 shares of its common stock for
$7,309,000 during this period.
CAPITAL RESOURCES
The Company regularly invests its capital in mortgage backed securities through
Hanover, its primary investment vehicle. Hanover has also invested a limited
amount of its capital in HTC. From the inception of HTC in May 1999 until
December 31, 2000, Hanover advanced $2,904,000 in the form of a loan, and
$390,000 in the form of an inter-company advance, to HTC. The Company believes
that HTC will continue to have significant capital needs for the remainder of
2001. The Company is attempting to raise outside capital to address HTC's
capital budget. However, if the Company is unable to raise outside capital on
acceptable terms, the Company expects to continue to advance funds from Hanover
to HTC for the remainder of 2001.
HTC has a limited operating history and has not been profitable to date.
Although the Company currently expects that HTC will not need substantial
capital investments after the end of 2001, there can be no assurances that HTC
will generate sufficient revenues to cover its own capital costs and operating
costs at that time. If future revenues are insufficient to cover such costs,
HTC would require additional advances from Hanover in order to remain as a
going concern.
YEAR 2000 (Y2K) DISCLOSURE
The Company did not experience any material Y2K issues. Nevertheless, there
still remain some future dates that could potentially cause computer systems
problems.
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.
RISK FACTORS
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, 2000 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.
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48
Investments in Certain Mortgage Assets
The Company takes certain risks in investing in non-standard 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 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 MBS 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, 2000, the Company did not have any commercial mortgage loan
investments. However, the Company may elect to make such investments in the
future.
Negative Effects of Fluctuating Interest Rates
Changes in interest rates may impact the Company's earnings in various ways.
Approximately one third of the Company's mortgage loans held as collateral for
CMOs are adjustable rate mortgages ("ARMs"). Therefore, 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 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.
46
49
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.
Investment in Subsidiary
As of Dec. 31, 2000, Hanover had provided $2,904,000 to HTC in the form of
loans, and Hanover anticipates that HTC will continue to borrow substantial
amounts of money from Hanover in the future. Since its inception, HTC has not
generated revenues, and there can be no assurance that in the future HTC will
generate sufficient revenues or be successful enough to repay such loans to
Hanover or provide Hanover with any other returns on its investment.
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, 2000, the Company believes that it is in compliance with this
requirement.
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 consequences 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.
47
50
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 Annual Report
on Form 10K contain various "forward-looking statements" within the meaning of
Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21E
of the Securities Exchange Act of 1934, as amended. These forward-looking
statements represent the Company's current expectations, intent 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 - Risk Factors," and elsewhere in this Annual Report on Form 10K 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 or mortgage backed securities; 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. The Company undertakes no obligation to update or revise the
information contained herein, whether as a result of new information, future
events or circumstances, or otherwise.
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ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
During 2000 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, 2000 the Company had forward commitments to sell $11.3 million
(par value) of Agency mortgage securities that had not yet settled. Of this
amount, $4.5 million was entered into to hedge the expected sale of
approximately $3,921,000 million principal balance of subordinate
mortgage-backed securities held in a trading account. The balance of $6.8
million was entered into as a partial hedge for the Company's mortgage
securities available for sale
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 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, 2000 the Company had the following interest rate caps in effect
(dollars in thousands):
NOTIONAL AMOUNT INDEX STRIKE % MATURITY DATE
- ---------------------------- -------------------------- -------------------------- --------------------------
$ 23,922 3 Month LIBOR 5.75% March, 2001
23,097 3 Month LIBOR 5.75% April, 2001
11,000 3 Month LIBOR 7.70% October 2003
50,000 1 Month LIBOR 7.25% August, 2002
25,000 1 Month LIBOR 7.75% August, 2004
--------
$133,019
========
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.
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INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repo Financing
At December 31, 2000, 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, 2000 were indexed to LIBOR plus a spread of 0 to 288
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, 2000, the Company had a
total of $11,134,000 of floating rate reverse repo financing compared to
$35,723,000 of fixed rate mortgage-backed securities investments. 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 for trading, the
Company generally attempts to hedge these changes through the short sale of
mortgage securities, described above. At December 31, 2000, the Company did not
have any significant mortgage loans held for sale. The mortgage securities held
for 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.
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
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53
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 insured and conventional uninsured. It adjusts its loan
loss provision policy and interest non-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, 1999-B and 2000-A securitizations reflect
$142,330,000 of fixed rate mortgage loans and $69,687,000 of adjustable rate
mortgage loans and $9,877,000 of mortgage securities at December 31, 2000. The
primary financing for this asset category is the CMO debt of $210,374,000 and to
a much lesser extent repo agreements of $3,627,000. 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,
1999-A and 2000-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. The remaining notional balance of these caps
is $75 million at December 31, 2000.
Mortgage Securities
At December 31, 2000 the Company owned certain fixed rate Agency and private
placement mortgage securities and certain interest only and principal only
private placement mortgage securities with an aggregate carrying value of
$25,846,000. 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 within 120 days after the
end of the Company's fiscal year.
ITEM 11: EXECUTIVE COMPENSATION
Incorporated herein by reference to the Company's definitive proxy statement to
be filed with the Securities and Exchange Commission within 120 days after the
end of the Company's fiscal year.
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 within 120 days after the
end of the Company's fiscal year.
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 within 120 days after the
end of the Company's fiscal year.
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PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, 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
The Company did not file any current reports on Form 8-K during the last
quarter of 2000.
53
56
EXHIBIT INDEX
3.1(1) Articles of Incorporation of the Company, as amended
3.2(1) By-Laws of the Company
4.1(1) Specimen Common Stock Certificate
4.2(1) Warrant Agreement pursuant to which Warrants were issued
(including form of Warrant)
4.3(1) Representatives' Warrant Agreement pursuant to which the
Representatives' Warrants were issued
4.4(1) Specimen Unit Certificate
10.3*(1) Registration Rights Agreement
10.4*(1) Shareholders' Agreement of Hanover Capital Partners Ltd.
10.4.1*(6) Termination of Shareholders' Agreement of
Hanover Capital Partners Ltd.
10.5*(1) Agreement and Plan of Recapitalization
10.6*(1) Bonus Incentive Compensation Plan
10.7*(1) 1997 Executive and Non-Employee Director Stock Option Plan
10.7.1*(3) 1999 Equity Incentive Plan
10.8*(1) Employment Agreement by and between the Company and John A.
Burchett
10.8.1* First Amendment to Employment Agreement by and between the
Company and John A. Burchett
10.9*(1) Employment Agreement by and between the Company and Irma N.
Tavares
10.9.1* First Amendment to Employment Agreement by and between the
Company and Irma N. Tavares
10.10*(1) Employment Agreement by and between the Company and Joyce S.
Mizerak
10.10.1* First Amendment to Employment Agreement by and between the
Company and Joyce S. Mizerak
10.11*(1) Employment Agreement by and between the Company and George J.
Ostendorf
10.11.1* First Amendment to Employment Agreement by and between the
Company and George J. Ostendorf
10.11.2* Employment Agreement by and between the Company and Thomas P.
Kaplan
10.12(1) 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(3) Second Amendment of lease, dated as of December 22, 1998, by and
between FGP 90 West Street, Inc., successor to Irwin Kahn, and
HCP.
10.13(1) 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(3) Office Lease Agreement, dated as of February 1, 1999, between La
Salle-Adams, LLC and HCP.
57
10.16(1) Office Lease and Service Agreement, dated as of August 28, 1995
by and between Federal Deposit Insurance Receiver for Merchants
Bank and HCP
10.25*(1) Contribution Agreement
10.26*(1) Participation Agreement
10.27*(1) Loan Agreement
10.29(2) Management Agreement, dated as of January 1, 1998, by and
between the Company and HCP
10.30(3) Amendment Number One to Management Agreement, dated as of
September 30, 1999
10.31(4) Amended and Restated Master Loan and Security Agreement by and
between Greenwich Capital Financial Products, Inc. and Hanover
Capital Mortgage Holdings, Inc. and Hanover Capital Partners
Ltd., dated March 27, 2000
10.32(3) 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
10.32.1(4) Third Amendment to Warehousing Credit and Security Agreement
dated as of April 30, 1999 by and between Bank United and the
Company
10.32.2(6) Fourth Amendment to Warehousing Credit and Security Agreement
dated as of May 31, 2000 by and between Bank United and the
Company
10.33(5) Stockholder Protection Rights Agreement
10.34 Asset Purchase Agreement dated as of January 19, 2001 by and
among HanoverTrade.com, Inc., Hanover Capital Mortgage Holdings,
Inc., Pamex Capital Partners, L.L.C. and the Members of Pamex
Capital Partners, L.L.C.
21 Subsidiaries of the Company
- --------------------------------------------------------------------------------
(1) Incorporated herein by reference to the Company's Registration Statement
No. 333-29261, as amended, as filed with the Securities and Exchange
Commission.
(2) 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.
(3) Incorporated herein by reference to the Company's Form 10-K for the year
ended December 31, 1999, as filed with the Securities and Exchange
Commission.
(4) Incorporated herein by reference to the Company's Form 10-Q for the
quarter ended March 31, 2000, as filed with the Securities and Exchange
Commission.
(5) Incorporated herein by reference to the Company's Report on Form 8-K
filed with the Securities and Exchange Commission on April 29, 2000.
(6) Incorporated herein by reference to the Company's Form 10-Q for the
quarter ended June 30, 2000, as filed with the Securities and Exchange
Commission.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to Item 601 of Regulation S-K.
58
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, 2000 and December 31, 1999 and for the Years
Ended December 31, 2000, 1999 and 1998:
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-40
Consolidated Financial Statements as of December 31, 2000 and December 31, 1999 and the Years
Ended December 31, 2000, 1999 and 1998:
Balance Sheets ........................................................................ F-41
Statements of Operations .............................................................. F-42
Statements of Stockholders' Equity .................................................... F-43
Statements of Cash Flows .............................................................. F-44
Notes to Consolidated Financial Statements ............................................ F-45
HANOVERTRADE.COM, Inc.
Independent Auditors' Report .................................................................... F-59
Consolidated Financial Statements as of December 31, 2000 and December 31,
1999 and for the Year Ended December 31, 2000 and for the Period from May 28,
1999 (inception) through December 31, 1999:
Balance Sheets ........................................................................ F-60
Statements of Operations .............................................................. F-61
Statements of Stockholders' Equity .................................................... F-62
Statements of Cash Flows .............................................................. F-63
Notes to Consolidated Financial Statements ............................................ F-64
F-1
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, 2000
and 1999, and the related consolidated statements of operations, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 2000. 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 auditing standards generally accepted
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 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, 2000 and
1999, and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 31, 2000 in conformity with
accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 27, 2001
F-2
60
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
DECEMBER 31, DECEMBER 31,
ASSETS 2000 1999
--------- ---------
Mortgage loans:
Held for sale $ 230 $ 251
Collateral for CMOs 212,017 269,833
Mortgage securities pledged as collateral
for reverse repurchase agreements:
Available for sale 11,785 48,529
Held to maturity 1,384 3,618
Trading 1,743 5,919
Mortgage securities pledged as
collateral for CMOs 9,877 --
Mortgage securities, not pledged:
Available for sale 4,744 --
Held to maturity 3,133 4,620
Trading 3,057 --
Cash and cash equivalents 9,958 18,022
Accrued interest receivable 2,466 2,926
Equity investments
Hanover Capital Partners Ltd. 1,765 1,466
HanoverTrade.com, Inc. (1,526) (30)
Notes receivable from related parties 7,887 8,187
Due from related parties 237 232
Other receivables 911 151
Prepaid expenses and other assets 3,140 1,910
--------- ---------
TOTAL ASSETS $ 272,808 $ 365,634
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 14,760 $ 55,722
CMO borrowing 210,374 254,963
Accrued interest payable 1,796 2,433
Dividends payable 865 583
Due to related party -- 88
Accrued expenses and other liabilities 989 1,339
--------- ---------
TOTAL LIABILITIES 228,784 315,128
--------- ---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01, 10 million
shares authorized, -0- issued and outstanding
Common stock, par value $.01, 90 million shares
authorized, 4,322,944 and 5,826,899 shares
outstanding at December 31, 2000 and December
31, 1999, respectively 43 58
Additional paid-in capital 68,546 75,840
Retained earnings (deficit) (25,737) (25,496)
Accumulated other comprehensive income 1,172 104
---------
TOTAL STOCKHOLDERS' EQUITY 44,024 50,506
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 272,808 $ 365,634
========= =========
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)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
------------ ------------ ------------
REVENUES:
Interest income $ 26,692 $ 27,505 $ 47,799
Interest expense 20,029 23,097 41,176
-------- -------- --------
Net interest income 6,663 4,408 6,623
Loan loss provision 875 446 356
-------- -------- --------
Net interest income
after loan loss provision 5,788 3,962 6,267
Gain on sale of servicing rights -- 540 --
Gain (loss) on sale of mortgage assets 819 146 (5,704)
Gain (loss) on mark to market of mortgage
assets, net of associated hedge 431 (4,292) --
Impairment charge on mortgage securities -- (2,225)
Provision for (loss) on unconsolidated
subsidiary -- (4,793) --
-------- -------- --------
Total revenue (loss) 7,038 (6,662) 563
EXPENSES:
Personnel 1,013 1,230 712
Management and administrative 759 894 733
Due diligence -- 119 687
Commissions 4 5 286
Legal and professional 555 1,201 545
Financing/commitment fees 281 404 836
Other 524 338 265
-------- -------- --------
Total expenses 3,136 4,191 4,064
-------- -------- --------
Operating income (loss) 3,902 (10,853) (3,501)
Equity in income (loss) of unconsolidated
subsidiaries
Hanover Capital Partners Ltd. 455 (443) (1,039)
Hanover Capital Partners 2, Inc. -- (1,300) (394)
HanoverTrade.com, Inc. (1,495) (31) --
-------- -------- --------
NET INCOME (LOSS) $ 2,862 $(12,627) $ (4,934)
======== ======== ========
BASIC EARNINGS (LOSS) PER SHARE $ 0.56 $ (2.12) $ (0.77)
======== ======== ========
DILUTED EARNINGS (LOSS) PER SHARE $ 0.56 $ (2.12) $ (0.77)
======== ======== ========
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, 2000, 1999 AND 1998
(in thousands except share data)
ACCUMULATED
COMMON STOCK ADDITIONAL COMPREHENSIVE RETAINED OTHER
------------ PAID-IN INCOME EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) INCOME (LOSS) TOTAL
---------- ------ ------- ------------- ---------- ------------- -------
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 13, 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 income
Change in net unrealized gain on
securities available for sale, net of
reclassification adjustments 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
Repurchase of common stock (1,503,955) (15) (7,294) (7,309)
Comprehensive income:
Net income 2,862 2,862 2,862
Other comprehensive income:
Change in net unrealized gain on
securities available for sale 1,216 1,216 1,216
Equity in other comprehensive loss of
unconsolidated subsidiary (148) (148) (148)
-------
Comprehensive income: $ 3,930
=======
Dividends declared (3,103) (3,103)
---------- ------ ------- --------- ------------- -------
BALANCE, DECEMBER 31, 2000 4,322,944 $ 43 $ 68,546 $ (25,737) $ 1,172 $44,024
========== ====== ======= ========= ============= =======
See notes to consolidated financial statements
F-5
63
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 2000 DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- ----------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 2,862 $ (12,627) $ (4,934)
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Amortization of net premium and deferred costs 203 4,300 6,594
Loan loss provision 875 446 356
(Gain) on sale of servicing rights -- (540) --
(Gain) loss on sale of mortgage assets (873) (146) 5,705
(Gain) loss on mark to market of mortgage assets (816) 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 1,041 1,774 1,433
Purchase of Trading Securities (7,634) -- --
Sales of Trading Securities 2,709 -- --
(Increase) decrease in accrued interest receivable 460 1,014 (343)
(Increase) decrease in loans to related parties 300 (4,294) (3,411)
(Increase) decrease in other receivables (761) 1,104 (1,621)
(Increase) in prepaid expenses and other assets (1,230) (1,305) (364)
Increase (decrease) in accrued interest payable (637) 1,039 842
Increase (decrease) in due to related parties (93) 169 (782)
Increase (decrease) in accrued expenses and other liabilities (312) 432 423
--------- --------- ---------
Net cash provided by (used in) operating activities (3,906) 2,676 3,898
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage loans -- (1,449) (863,324)
Purchase of mortgage securities (2,934) (3,668) (25,856)
Purchase of mortgage securities from affiliate (13,845) -- --
Principal payments received on mortgage securities 8,001 12,895 150,543
Principal payments received on collateral for CMOs 57,254 61,613 23,165
Principal payments received on mortgage loans held
for sale and held to maturity 21 44,429 123,098
Proceeds from sale of mortgage assets 43,054 30,909 276,582
Proceeds from sale of servicing rights -- 786 --
--------- --------- ---------
Net cash provided by (used in) investing activities 91,551 145,515 (315,792)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from (repayment of) reverse
repurchase agreements (40,962) (314,368) 243,218
Net (repayment of) borrowing from CMOs (45,685) 177,624 77,305
Increase in CMO discount 1,069
Net proceeds of initial public offering -- 11
Exercise of stock warrants - net -- (8)
Equity investments in subsidiaries (1) (2,700)
Dividends received - unconsolidated subsidiary -- 8,054
Payment of dividends (2,822) (3,026) (4,826)
Repurchase of common stock (7,309) (2,235) (1,345)
--------- --------- ---------
Net cash provided by (used in) financing activities (95,709) (142,006) 319,709
--------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS (8,064) 6,185 7,815
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 18,022 11,837 4,022
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 9,958 $ 18,022 $ 11,837
========= ========= =========
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, 2000, 1999 AND 1998
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. Hanover has two primary unconsolidated
subsidiaries: Hanover Capital Partners Ltd. ("HCP") and HanoverTrade.com, Inc.
("HTC"). When we refer to the "Company," we mean Hanover together with its
consolidated and unconsolidated subsidiaries.
The Company is engaged in three principal businesses, which are conducted
through its three primary operating units: Hanover, HCP and HTC. The principal
business strategy of Hanover is to invest in mortgage backed securities ("MBS")
and, to a lesser extent, in mortgage loans. The principal business strategy of
HCP is to generate consulting and other fee income by performing loan file and
operational due diligence reviews for third parties, performing advisory
services for third parties, and preparing and or processing documentation
(primarily assignments of mortgage loans) for third parties on a contract basis.
The principal business activity of HTC is to generate fee income by operating an
online worldwide web-based exchange for trading loan pools (primarily mortgage
loan pools) and by performing loan sale advisory services for third parties.
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.
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.
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. When necessary, reclassifications have been made to conform
to current period presentation.
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
F-7
65
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.
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.
F-8
66
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 16,
"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 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
F-9
67
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 HCP, Hanover Capital Partners 2, Inc.
("HCP-2"), and 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 changes
in interest rates 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 long-term
securitization financing transaction or with any sale. Gains and losses on 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
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
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
F-10
68
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 90% of its taxable income
and as long as certain asset, income and stock ownership tests are met.
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.
RECLASSIFICATION
The 1999 financial statements were reclassified to conform to the 2000 financial
statement presentation.
F-11
69
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board ("FASB") issued Statement of Financial
Accounting Standards ("SFAS") 133, Accounting for Derivative Instruments and
Hedging Activities in June 1998. SFAS 133 establishes accounting and reporting
standards for derivative instruments and hedging activities. 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. SFAS 138, issued in June
2000, amends certain technical provisions of SFAS 133. The Company implemented
SFAS 133, SFAS 137 and SFAS 138 on January 1, 2001. See Note 20, "Subsequent
Events".
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101 - Revenue Recognition in Financial Statements. The Staff
Accounting Bulletin summarizes certain of the staff's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. The staff is providing this guidance, due, in part, to the large
number of revenue recognition issues that registrants encounter. Implementation
of Staff Accounting Bulletin No. 101 must occur no later than the fourth fiscal
quarter of fiscal years beginning after December 15, 1999. The Company adopted
SAB 101 effective October 1, 2000. The adoption of SAB 101 did not have an
impact on the Company's financial statements.
In September 2000, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 140, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB
Statement No. 125 ("SFAS 140"). SFAS 140 replaces FASB Statement No. 125,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities ("SFAS 125"). It revises the standards for accounting for
securitizations and other transfers of financial assets and collateral and
requires certain disclosures, but it carries over most of SFAS 125's provisions
without reconsideration. SFAS 140 provides accounting and reporting standards
for transfers and servicing of financial assets and extinguishments of
liabilities. Those standards are based on consistent application of a financial
components approach that focuses on control. Under that approach, after a
transfer of financial assets, an entity recognizes the financial and servicing
assets it controls and the liabilities it has incurred, derecognizes financial
assets when control has been surrendered, and derecognizes liabilities when
extinguished. SFAS 140 provides consistent standards for distinguishing
transfers of financial assets that are sales from transfers that are secured
borrowings. SFAS 140 is effective for transfers and servicing of financial
assets and extinguishments of liabilities occurring after March 31, 2001. SFAS
140 is effective for recognition and reclassification of collateral and for
disclosures relating to securitization transactions and collateral for fiscal
years ending after December 15, 2000. The adoption of SFAS 140 did not have an
impact on the Company's financial statements, except for the requirement of
additional disclosure with respect to certain mortgage-backed securities
retained in connection with one of the Company's securitization transactions.
This disclosure is displayed in Note 10. CMO Borrowing and Securitized Sale.
3. MORTGAGE LOANS
At December 31, 2000 management had made the determination that $230,000 of
mortgage loans were held for sale. No mortgage loans were designated as held to
maturity and $212,017,000 of mortgage loans were held as collateralized mortgage
obligation ("CMO") collateral.
F-12
70
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, 2000 DECEMBER 31, 1999
--------------------------------- ---------------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
----- ---------- ----- ----- ---------- -----
Principal amount of mortgage loans $ 31 $199 $230 $ 45 $206 $251
Net premium and deferred cost -- -- -- -- -- --
Loan loss allowance -- -- -- -- -- --
---- ---- ---- ---- ---- ----
Carrying cost of mortgage loans $ 31 $199 $230 $ 45 $206 $251
==== ==== ==== ==== ==== ====
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. In June 2000, the Company completed its fourth CMO
securitization transaction, Hanover Capital Trust 2000-A ("2000-A"). The Company
assigned all of its interests in 1999-A and 1999-B securitizations and certain
mortgage securities from its 1998-A and 1998-B securitizations as collateral for
the 2000-A 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, 2000 DECEMBER 31, 1999
--------------------------------------- ---------------------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
--------- ---------- --------- --------- ---------- ---------
Principal amount of mortgage loans $ 140,867 $ 70,059 $ 210,926 $ 174,761 $ 93,419 $ 268,180
Net premium (discount)
and deferred costs 1,952 (159) 1,793 2,361 (165) 2,196
Loan loss allowance (489) (213) (702) (371) (172) (543)
--------- --------- --------- --------- --------- ---------
Carrying cost of mortgage loans $ 142,330 $ 69,687 $ 212,017 $ 176,751 $ 93,082 $ 269,833
========= ========= ========= ========= ========= =========
4. MORTGAGE SECURITIES
At December 31, 2000, the Company had $3,860,000 of fixed rate Agency
mortgage-backed securities, $19,519,000 of fixed rate subordinate
mortgage-backed securities, and $2,467,000 of interest only and principal only
derivatives, created in the Company's 1998-B securitization. These securities
are freely marketable and are classified as available for sale, held to
maturity, or trading, as shown in the tables below.
F-13
71
In addition, the Company had $9,877,000 of fixed-rate subordinate
mortgage-backed securities which have been permanently pledged to support CMO
borrowings. The Company is prohibited by the terms of the CMO from selling or
otherwise transferring these securities.
The following tables summarize the Company's Agency mortgage-backed securities,
fixed rate subordinate mortgage-backed securities, and derivatives (dollars in
thousands):
FIXED RATE AGENCY MORTGAGE-BACKED SECURITIES
DECEMBER 31, 2000 DECEMBER 31, 1999
------------------ -----------------
AVAILABLE HELD AVAILABLE HELD
FOR TO FOR TO
SALE MATURITY TRADING TOTAL SALE MATURITY TRADING TOTAL
--------- -------- ------- -------- --------- -------- ------- --------
Principal balance of mortgage securities $ 2,047 $-- $ 1,681 $ 3,728 $ 46,156 $-- $-- $ 46,156
Net premium and deferred costs 105 -- 65 170 863 -- -- 863
-------- --- -------- -------- -------- --------
Total amortized cost of mortgage securities 2,152 -- 1,746 3,898 47,019 -- -- 47,019
Gross unrealized loss (35) -- (3) (38) (1,540) -- -- (1,540)
-------- --- -------- -------- -------- --- --- --------
Carrying cost of mortgage securities $ 2,117 $-- $ 1,743 $ 3,860 $ 45,479 $-- $-- $ 45,479
======== === ======== ======== ======== === === ========
FIXED RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
DECEMBER 31, 2000
-----------------
AVAILABLE HELD COLLATERAL
FOR TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- -------- ---------- --------
Principal balance of mortgage securities $ 25,305 $ 5,986 $ 3,921 $ 13,234 $ 48,446
Net (discount) and deferred costs (12,857) (2,281) (913) (3,035) (19,086)
-------- -------- -------- -------- --------
Total amortized cost of mortgage securities 12,448 3,705 3,008 10,199 29,360
Loan loss allowance (595) (105) -- (322) (1,022)
Gross unrealized gain (loss) 1,009 -- 49 -- 1,058
-------- -------- -------- -------- --------
Carrying cost of mortgage securities $ 12,862 $ 3,600 $ 3,057 $ 9,877 $ 29,396
======== ======== ======== ======== ========
DECEMBER 31, 1999
-----------------
AVAILABLE HELD
FOR TO
SALE MATURITY TRADING TOTAL
--------- -------- -------- --------
Principal balance of mortgage securities $-- $ 12,454 $ 7,105 $ 19,559
Net (discount) and deferred costs -- (5,012) (1,135) (6,147)
--- -------- -------- --------
Total amortized cost of mortgage securities -- 7,442 5,970 13,412
Loan loss allowance -- (256) -- (256)
Gross unrealized gain (loss) -- -- (51) (51)
--- -------- -------- --------
Carrying cost of mortgage securities -- $ 7,186 $ 5,919 $ 13,105
=== ======== ======== ========
DERIVATIVE MORTGAGE-BACKED SECURITIES
DECEMBER 31, 2000 DECEMBER 31, 1999
----------------- -----------------
INTEREST PRINCIPAL INTEREST PRINCIPAL
ONLY STRIPS ONLY STRIPS ONLY STRIPS ONLY STRIPS
AVAILABLE HELD AVAILABLE HELD
FOR TO FOR TO
SALE MATURITY TRADING TOTAL SALE MATURITY TRADING TOTAL
-------- -------- ------- ------- -------- -------- ------- -------
Principal balance of mortgage securities $ -- $ 1,111 $-- $ 1,111 $ -- $ 1,281 $-- $ 1,281
Net premium (discount) and deferred costs 1,170 (194) -- 976 1,553 (229) -- 1,324
------- ------- --- ------- ------- ------- --- -------
Total amortized cost of mortgage securities 1,170 917 -- 2,087 1,553 1,052 -- 2,605
Loan loss allowance -- -- -- -- -- -- -- --
Gross unrealized gain 380 -- -- 380 1,496 -- -- 1,496
------- ------- --- ------- ------- ------- --- -------
Carrying cost of mortgage securities $ 1,550 $ 917 $-- $ 2,467 $ 3,049 $ 1,052 $-- $ 4,101
======= ======= === ======= ======= ======= === =======
December 31, 1999 the Company also had 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. The
securities were transferred to the Company on June 30, 2000.
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72
FIXED RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(HELD BY AFFILIATE)
DECEMBER 31, 1999
AVAILABLE HELD
FOR TO
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 allowance (285) -- -- (285)
Gross unrealized gain 239 -- -- 239
-------- --------- -------- --------
Carrying cost of mortgage securities $ 14,180 $ -- $ -- $ 14,180
======== ========= ======== ========
The carrying value at December 31, 2000 of the Company's mortgage securities by
average life dates are presented below (dollars in thousands):
AVAILABLE FOR SALE HELD TO MATURITY TRADING COLLATERAL
AVERAGE LIFE CARRYING VALUE CARRYING VALUE CARRYING VALUE FOR CMOs
- ------------ ------------------ ---------------- -------------- ----------
One to five years $ 1,551 $ 613 -- --
Five to ten years 4,753 2,721 $1,743 --
More than ten years 10,226 1,183 3,057 $9,877
-------- ------ ------ ------
$ 16,529 $4,517 $4,800 $9,877
======== ====== ====== ======
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 proceeds, gross realized gains and losses from sales of available for sale
mortgage securities in 2000, 1999 and 1998 were as follows (dollars in
thousands):
2000
REALIZED
PROCEEDS GAIN (LOSS)
--------- -----------
Sale of Subordinate MBS $ 5,882 $ 1,248
Sale of Agency Pass-Through MBS 39,881 (429)
--------- --------
$ 45,763 $ 819
========= ========
1999
REALIZED
PROCEEDS GAIN (LOSS)
--------- -----------
Hanover Capital 1998-B Subordinate MBS $ 2,232 $ 146
F-15
73
1998
REALIZED
PROCEEDS GAIN (LOSS)
--------- -----------
Adjustable rate FNMA and FHLMC
Certificates $ 189,057 $ (5,989)
Adjustable rate FNMA certificates 17,172 (161)
Fixed rate FNMA certificates 56,740 495
--------- ----------
$ 262,969 $ (5,655)
========= ==========
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, 2000 and 1999, 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:
AT DECEMBER 31, 2000 AT DECEMBER 31, 1999
MORTGAGE LOANS MORTGAGE LOANS
---------------------- ----------------------
COLLATERAL FOR COLLATERAL FOR
CMOs CMOs
---- ----
Florida 16% 15%
California 13 13
Texas 9 9
Ohio 5 6
Maryland 5 5
--- ---
Total 48% 48%
=== ===
The Company did not have any material concentrations of credit risk in its held
for sale and held to maturity categories at December 31, 2000.
The Company did not purchase any mortgage loans in 2000 or 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.
F-16
74
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 the Agency.
CONCENTRATION OF CREDIT RISK BY ISSUER
DECEMBER 31, 2000
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
---------------------------------------------
AVAILABLE HELD COLLATERAL
FOR TO FOR
ISSUER SALE MATURITY TRADING CMOs TOTAL
- ------ --------- -------- ------- ---------- -------
FNMA $ 2,117 $ -- $ -- $ -- $ 2,117
GNMA -- -- 1,743 -- 1,743
Hanover Capital 1998-B 1,550 917 -- 9,877 12,344
Issuer 1 3,428 -- -- -- 3,428
Issuer 2 1,946 -- -- -- 1,946
Issuer 3 2,407 2,216 -- -- 4,623
Issuer 4 -- 712 -- -- 712
Issuer 5 3,580 672 -- -- 4,252
Issuer 6 1,501 -- -- -- 1,501
Issuer 7 -- -- 3,057 -- 3,057
------- ------- ------- ------- -------
Total $16,529 $ 4,517 $ 4,800 $ 9,877 $35,723
======= ======= ======= ======= =======
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 -- 13,566
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 -- 715
------- ------- ------- ------- ------- -------
Total $48,529 $ 8,238 $ 5,919 $62,686 $14,180 $76,866
======= ======= ======= ======= ======= =======
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75
CASH AND OVERNIGHT INVESTMENTS
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, 2000, the Company had amounts on deposit with the financial
institution in excess of FDIC limits. At December 31, 2000, the Company had
overnight investments of $9,796,000 in mutual funds of treasury securities. The
Company limits its risk by placing its cash and cash equivalents in a high
quality financial institution, Federal Agency notes, mutual funds of treasury
securities 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 YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
------------ ------------ ------------
Balance, beginning of period $ 799 $ 372 $ 18
Loan loss provision 875 446 356
Transfers from related company 729 39 (2)
Sales (593) -- --
Charge-offs (92) (110) --
Recoveries 6 52 --
------- ------- -------
Balance, end of period $ 1,724 $ 799 $ 372
======= ======= =======
7. EQUITY INVESTMENTS
Hanover owns 100% of the non-voting preferred stock of 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 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 HTC which entitles Hanover to receive 97% of the
earnings or losses of HTC.
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 and HTC. 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.
F-18
76
The principal business activity of HTC is to generate fee income by operating an
online world-wide web-based exchange for trading loan pools (primarily mortgage
loan pools) and by performing loan sale advisory services for third parties.
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.
The table below reflects the activity recorded in Hanover's equity investments
for the following periods (dollars in thousands):
YEAR ENDED YEAR ENDED
DECEMBER 31, 2000 DECEMBER 31, 1999
------------------- -------------------
HCP HCP-2 HTC TOTAL HCP HCP-2 HTC TOTAL
------- ------- ------- ------- ------- ------- ------- -------
Beginning balance $ 1,466 $ -- $ (30) $ 1,436 $ 1,761 $ 5,728 $ -- $ 7,489
Applicable % of net (loss) 455 -- (1,496) (1,041) (443) (1,300) (31) (1,774)
Applicable % of
comprehensive gain (156) -- -- (156) 148 -- -- 148
Capital contribution -- -- -- -- -- -- 1 1
Formation transaction -- -- -- -- -- -- -- --
Dividends received (a) -- -- -- -- -- -- -- --
Write off of investment -- -- -- -- -- (4,428) -- (4,428)
------- ------- ------- ------- ------- ------- ------- -------
Ending Balance $ 1,765 $ -- $(1,526) $ 239 $ 1,466 $ -- $ (30) $ 1,436
======= ======= ======= ======= ======= ======= ======= =======
YEAR ENDED
DECEMBER 31,
1998
------------------------------------
HCP HCP-2 TOTAL
-------- -------- --------
Beginning balance $ 100 $ -- $ 100
Applicable % of net (loss) (1,039) (394) (1,433)
Applicable % of
comprehensive gain -- -- --
Capital contribution 2,700 -- 2,700
Formation transaction -- 14,176 14,176
Dividends received (a) -- (8,054) (8,054)
-------- -------- --------
Ending Balance $ 1,761 $ 5,728 $ 7,489
======== ======== ========
(a) represents a return of capital
8. NOTES RECEIVABLE AND DUE 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, 2000 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, 2000.
F-19
77
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, $69,149, was repaid in February 1999, another
portion, $61,837, was forgiven on January 28, 2000 and $12,202 was repaid in
April 2000. The Company reserved for this forgiveness on September 30, 1999. At
December 31, 2000, the balance of these loans, was $83,505.
During 2000 Hanover advanced funds to HCP and HTC pursuant to unsecured loan
agreements. These loans to HCP and HTC bear interest at 1.00% below the prime
rate. At December 31, 2000 the loan outstanding to HCP totaled $1,704,342 and
the loan outstanding to HTC totaled $2,903,758.
Accrued interest receivable from related parties was $172,000 at December 31,
2000 and $121,000 at December 31, 1999.
Amounts due from related parties and due to related parties are detailed below
(dollars in thousands):
INTERCOMPANY BALANCES
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Due from HTC $ 51 $121
Due from HCP 14 6
---- ----
$ 65 $127
==== ====
Due to HCP $ -- $ 88
==== ====
NOTES RECEIVABLE
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Principals (a) (b) (c) (e) (f) $3,279 $3,049
Hanover Capital Partners (d) 1,704 4,869
HanoverTrade.com 2,904 --
(a) Amounts reported for 2000 include John A. Burchett, George J. Ostendorf,
Irma N. Tavares, Joyce S. Mizerak and Tom Kaplan, the five most senior
officers/stockholders of Hanover. Amounts reported for 1999 include loans
to John A. Burchett, George J. Ostendorf, Irma N. Tavares and Joyce S.
Mizerak.
(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.
F-20
78
(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 $81,000. 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 2000:
Balance at January 1, 2000 $3,291
Loan repayments (12)
---------
Balance at December 31, 2000 $3,279
=========
(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. An additional advance of $2,847,000 was made
during the first six months of 2000 to fund the purchase of certain
subordinated securities. The advances were repaid when the subordinated
securities were sold to the Company in July 2000.
(e) In September 1999 the Company loaned Mr. Kaplan $242,000 to purchase stock
in the Company. The loan bears interest at 5.29% and is secured by the
stock purchased. Mr. Kaplan's loan was re-classed to principal loans
January 1, 2000.
(f) In March 2000, the Company amended the terms of the notes due from Mr.
Burchett, Ms. Mizerak, Mr. Ostendorf and Ms. Tavares to provide that the
notes would be forgiven in the event of certain changes in control.
9. REVERSE REPURCHASE AGREEMENTS
At December 31, 2000 the Company had a total of $75 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 95% 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 50% to 97% of the market value
of the mortgage securities, depending on the nature of the collateral. At
December 31, 2000 the Company had no outstanding borrowings on mortgage loans
under the above mentioned reverse repurchase agreements.
At December 31, 2000, the Company had outstanding borrowings on retained CMO
securities of $3,627,000 with a weighted average borrowing rate of 7.47% 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, 2000 were collateralized
by securities with a cost basis of $11,545,000.
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At December 31, 2000, the Company had outstanding reverse repurchase agreement
financing for mortgage securities (other than retained CMO securities) of
$11,134,000 with a weighted average borrowing rate of 6.14% 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, 2000 was collateralized
by securities with a cost basis of $14,912,000.
The table below details the scheduled maturities of the Company's committed and
uncommitted master reverse repurchase agreements at December 31, 2000:
COMMITTED MATURITY DATE
---------- -------------
$50 million May 2001
$25 million March 2001
Information pertaining to reverse repurchase agreement financing as of and for
the years ended December 31, 2000 and 1999 is summarized as follows (dollars in
thousands):
YEAR ENDED DECEMBER 31, 2000
OTHER
MORTGAGE RETAINED CMO MORTGAGE
LOANS SECURITIES SECURITIES
REVERSE REPURCHASE AGREEMENTS -------- ------------ ----------
Balance of borrowing at end of period -- $ 3,627 $11,134
Average borrowing balance during the period -- $ 3,515 $36,565
Average interest rate during the period -- 7.47% 6.14%
Maximum month-end borrowing balance during
the period -- $ 3,815 $39,177
COLLATERAL UNDERLYING THE AGREEMENTS
Balance at end of period - carrying value -- $11,545 $14,912
REVERSE REPO FINANCING
YEAR ENDED DECEMBER 31, 1999
OTHER
MORTGAGE RETAINED CMO MORTGAGE
LOANS SECURITIES SECURITIES
-------- ------------ ----------
REVERSE REPURCHASE AGREEMENTS
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
during the period $283,837 $ 3,393 $ 61,559
COLLATERAL UNDERLYING THE AGREEMENTS
Balance at end of period - carrying value -- $ 7,201 $ 60,465
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Additional information pertaining to individual reverse repurchase agreement
lenders at December 31, 2000 is summarized as follows (dollars in thousands):
REVERSE WEIGHTED AVERAGE
REPURCHASE UNDERLYING MATURITY
LENDER TYPE OF COLLATERAL FINANCING COLLATERAL DATE
- ------ ----------------------- --------- ----------- --------------------
Lender A (committed) Retained CMO Securities $3,627 $11,545 March 28, 2001 (a)
Lender A Mortgage Securities 952 1,486 January 4, 2001 (b)
Lender B Mortgage Securities 2,940 3,892 January 5, 2001 (b)
Lender C Mortgage Securities 1,672 1,743 January 8, 2001 (b)
Lender D Mortgage Securities 3,691 5,297 January 31, 2001 (b)
Lender E Mortgage Securities 1,034 1,331 January 29, 2001 (b)
Lender F Mortgage Securities 516 712 January 30, 2001 (b)
Lender G Mortgage Securities 328 454 January 16, 2001 (b)
--------- -----------
Total $14,760 $26,460
========= ===========
(a) The Company does not intend to renew this facility.
(b) These borrowings are pursuant to uncommitted lines of credit which are
typically renewed monthly.
10. CMO BORROWING AND SECURITIZED SALE
The Company has executed five securitization transactions since April 1998. Four
of these transactions were structured as financings, and one of these
transactions ("Hanover 1998-B") was structured as a sale transaction. In the
financing transactions, the company pledged mortgage loans to secure
collateralized mortgage obligations ("CMOs"). These mortgage loans are treated
as assets of the Company and the CMOs are treated as debt of the Company. In
contrast, the mortgage loans financed through the issuance of Hanover 1998-B
were treated as having been sold, and the corresponding debt is not treated as
debt of the Company.
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS)
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.
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. In June 2000, the Company issued
$13,222,000 of CMO borrowings at a discount of $2,013,000 for net proceeds
before expenses of $11,209,000 (the "Hanover 2000-A" CMO). The Hanover 2000-A
CMO securities carry a fixed interest rate of the 6.50%. The Hanover 2000-A
securities are collateralized by $25,588,000 principal balance of the retained
portions of Hanover's previous CMO borrowings, Hanover 98-A, Hanover 99-A and
Hanover 99-B, and by certain retained mortgage backed securities from Hanover
98-B.
Information pertaining to the CMOs as of and for the year ended December 31,
2000 is summarized as follows (dollars in thousands):
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81
2000-A 1999-B 1999-A 1998-A
SECURITIZATION SECURITIZATION SECURITIZATION SECURITIZATION TOTAL
-------------- -------------- -------------- -------------- --------
Balance of borrowing at end of period $11,095 $71,462 $85,843 $41,974 $210,374
Average borrowing balance during the period 5,894 83,207 96,388 48,354 233,843
Average interest rate during the period 9.76% 7.96% 7.18% 6.89% 7.49%
Interest rate at end of period 9.48% 8.37% 7.32% 6.95% 7.72%
Maximum month-end borrowing balance
during the period 11,183 91,795 103,997 53,365 260,340
CMO COLLATERAL
Balance at end of period - carrying balance $10,839 $75,221 $91,824 $44,972 $222,856
Aggregate annual repayments of mortgage backed bonds based upon the expected
amortization of the underlying mortgage loan collateral at December 31, 2000
were as follows (dollars in thousands):
YEAR AMOUNT
---- --------
2001 $ 57,321
2002 42,457
2003 30,946
2004 22,135
2005 15,955
Thereafter 42,534
--------
Total $211,348
========
SECURITIZED SALE
In October 1998, the Company completed the Hanover 1998-B securitization. The
Company sold mortgage loans to an unconsolidated affiliate, HCP-2, which
simultaneously issued a Real Estate Mortgage Investment Conduit (REMIC)
structured as a CMO. The mortgage loans were transferred to HCP-2 at cost. HCP-2
recorded the transaction as a financing. HCP-2 sold the most highly rated
securities and transferred the remaining securities to the Company. The purchase
of the retained REMIC securities was recorded at cost. No gain or loss was
recognized in connection with the transaction.
The Company does not service any of the loans in the Hanover 1998-B
securitization. At the time of the transaction, the Company was not subject to
any restrictions that would limit its ability to transfer the securities
retained in the securitization. However, certain of these securities were later
pledged to support borrowings under the Hanover 2000-A CMO transaction. The
Company did not provide any recourse in the 1998-B securitization. However, the
securities initially retained by the Company will bear all of the losses
incurred on the related mortgage loans.
At December 31, 2000, the Company had a remaining investment of $12,344,000 in
securities retained from Hanover 1998-B. Of this amount, $9,877,000 were
subordinate mortgage backed securities classified as collateral for CMOs,
$1,550,000 were interest only strips classified as available for sale, and
$917,000 were principal only strips classified as held to maturity. These
securities had a fair value of $11,716,000. The Company determines the fair
value of these securities by obtaining market quotes from a third party dealer
firm. In providing these quotes, the dealer firm used the following assumptions
for the Hanover 1998-B securities:
F-24
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TYPE OF CREDIT DISCOUNT PREPAYMENT AVERAGE
SECURITY RATING SPREAD RATE SPEED LIFE
-------- ------ ------ ---- ----- ----
Subordinate AA/AAA 300 bp 8.12% 175 PSA 10 years
Subordinate A/AA+ 400 9.12 175 PSA 10
Subordinate BBB/A+ 675 11.87 175 PSA 10
Subordinate BB/BB+ 1125 16.37 175 PSA 10
Subordinate B/B 1875 23.87 175 PSA 10
Subordinate unrated -- 60.00 175 PSA 10
Interest only AAA/AAA -- 0.00 40 CPR 1
Principal only AAA/AAA 200 7.00 6 CPR 3-8
Discount rates in the market for subordinate securities are typically quoted
based on the assumption that the securities will not incur any losses,
notwithstanding the fact that market makers expect that these securities will
incur losses. The exposure of these securities to credit losses is reflected in
the quoted discount rates. Although dealer firms do not typically quote credit
loss assumptions, the Company monitors and projects the credit losses on its
portfolio. The Company assumes that the mortgage loans in the Hanover 1998-B
securitization will default at an annual rate of 0.30% per year, and the Company
will recover 75% of the principal balance of the defaulted mortgage loans. Using
these assumptions, the quoted prices for the unrated subordinate securities
result in an annualized yield of 49% - 57%. This default rate assumption results
in projected cumulative losses of $743,000, or 0.23% of the original principal
balance of the mortgage loans in the Hanover 1998-B securitization.
The following tables shows the impact of a change of each of the foregoing
assumptions on the fair value of the related securities:
SENSITIVITY TO DISCOUNT RATE
CHANGE IN DECLINE
TYPE OF DISCOUNT IN
SECURITY RATE VALUE
-------------- -------- ---------
Subordinate +100 bp $ 518,000
+200 bp 992,000
Interest Only +500 bp $ 230,000
+1000 bp 421,000
Principal Only +25 bp $ 8,000
+50 bp 16,000
SENSITIVITY TO PREPAYMENT SPEED
DECLINE
TYPE OF PREPAYMENT IN
SECURITY SPEED VALUE
-------------- ---------- ---------
Subordinate 175 PSA $ --
150 PSA 60,000
100 PSA 196,000
Interest Only 40 CPR $ --
50 CPR 668,000
60 CPR 1,146,000
Principal Only 6 CPR $ --
4 CPR 30,000
2 CPR 63,000
F-25
83
SENSITIVITY TO LOSS ASSUMPTION
ANNUAL DECLINE
TYPE OF DEFAULT CUMULATIVE IN
SECURITY RATE LOSSES VALUE
----------- ------- ---------- ---------
Subordinate 0.30% 0.23% $ --
0.90% 0.66% 81,000
3.00% 1.99% 979,000
The foregoing sensitivity analysis is designed to assist the reader in
evaluating the impact that changes in interest rates, prepayment speeds or
default rates would have on the value of the securities retained in the Hanover
1998-B securitization. This analysis is based on projected cashflows. The
projections were prepared based on a number of simplifying assumptions,
including but not limited to the following: (i) all of the loans will prepay at
the indicated speeds; (ii) all borrowers pay a full month's interest if they
prepay their loans; (iii) there are no delinquencies on the underlying mortgage
loans; and (iv) the securities are not called. Actual results will differ from
projected results.
Managed Mortgage Whole Loans
The following table presents certain information relating to all mortgage loans
securitized by the Company or owned by the Company at December 31, 2000.
MANAGED ASSETS
PRINCIPAL BALANCE OF MANAGED ASSETS PRINCIPAL BALANCE
- ----------------------------------- -----------------
Mortgage loans held for sale $ 230,000
Mortgage loans collateralizing on-balance sheet CMOs 210,926,000
Mortgage loans collateralizing off-balance sheet
securitization executed by the Company 172,947,000
---------------
Total mortgage loans purchased and managed by the Company $ 384,103,000
===============
DELINQUENCY RATES OF MANAGED ASSETS
- -----------------------------------
30-59 days delinquent 6.73%
60-89 days delinquent 1.33%
90 or more days delinquent 1.88%
Loans in foreclosure 0.75%
Real estate owned 0.42%
The Company realized credit losses of $56,000 on the foregoing assets during the
year ended December 31, 2000.
11. 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 3 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 ($10,500 in 2000 and
$10,000 in 1999). Under the 401(k) Plan, an employee may elect to enroll on the
first of the month, provided that the employee has met the 3
F-26
84
month employment service requirement. The Company can, at its option, make a
discretionary matching contribution to the plan. In January 2001 the Company
made a matching contribution of 1/2 of the employee's contribution up to a
maximum of 2% of the employee's 2000 base salary
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 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
F-27
85
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, 2000 and changes during the periods from September 19, 1997 to
December 31, 1997 and for the years ended December 31, 1998, 1999 and 2000 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 $15.39
------- ======
STOCK OPTION ACTIVITY - 1999
Granted - July 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
------- ======
STOCK OPTION ACTIVITY - 2000
Granted - May 18, 2000 282,210 $3.875
Cancelled (6,250) 15.75
Cancelled (2,000) 15.94
Cancelled (13,750) 3.875
Cancelled (17,500) 4.625
-------
Outstanding at Dec. 31, 2000 287,074 $15.34
======= ------- ======
521,210 $ 4.24
======= ======
No shares were exercisable at December 31, 1998 and 1997.
At December 31, 2000, 90,250 shares were exercisable at a weighted exercise
price of $4.58. At December 31, 1999, 2000 shares were exercisable at a weighted
exercise price of $4.625.
The per share weighted average fair value of stock options granted during the
period ended December 31, 2000 and 1999 was $0.17 and $0.49, respectively at the
date of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
F-29
87
2000 1999
---- ----
Expected life (years) 10 10
Risk-free interest rate 6.54% 6.27%
Volatility 42.1% 61.4%
Expected dividend yield 12.6% 12.3%
The Company applies APB opinion No. 25 in accounting for its 1997 and 1999 Stock
Option Plans and, accordingly, no compensation cost has been recognized for its
stock options in the financial statements for 2000, 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):
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 2000 DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- ----------------- -----------------
Net earnings (loss):
As reported $2,862 ($12,627) ($4,934)
Pro forma $2,814 ($12,766) ($4,938)
Earnings (loss) per share - basic:
As reported $ 0.56 ($2.12) ($0.77)
Pro forma $ 0.55 ($2.15) ($0.77)
Earnings (loss) per share - diluted :
As reported $ 0.56 ($2.12) ($0.77)
Pro forma $ 0.55 ($2.14) ($0.77)
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 2000,
1999 and 1998.
12. AFFILIATED PARTY TRANSACTIONS
The Company engaged HCP pursuant to a Management Agreement to render among other
things, due diligence, asset management and administrative services.
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88
The 2000 consolidated statement of operations of the Company includes
management and administrative expenses of $634,000 and commission expense of
$4,000 relating to billings from HCP.
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 2000, 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 2000, 1999 and 1998 the Company recorded $185,000, $175,000 and $129,000
of interest income generated from loans to the Principals, $265,000, $168,000
and $126,000 of interest income from loans to HCP and $81,000, $0, and $0 of
interest income from loans to HTC.
The term of the Management Agreement continues until December 31, 2001 with
subsequent renewal.
13. EARNINGS PER SHARE
Calculations for earnings (loss) per share are shown below (dollars in
thousands, except per share data):
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
----------- ----------- -----------
EARNINGS (LOSS) PER SHARE BASIC:
Net income (loss) (numerator) $ 2,862 $ (12,627) $ (4,934)
=========== =========== ===========
Average common shares
outstanding (denominator) 5,102,563 5,942,403 6,418,305
=========== =========== ===========
Per share $ 0.56 $ (2.12) $ (0.77)
=========== =========== ===========
EARNINGS (LOSS) PER SHARE DILUTED:
Net income (loss) (numerator) $ 2,862 $ (12,627) $ (4,934)
=========== =========== ===========
Average common shares
outstanding 5,102,563 5,942,403 6,418,305
=========== =========== ===========
Add: Incremental shares from
assumed conversion of
warrants and exercise of options 24,577 27,016 -0-
----------- ----------- -----------
Dilutive potential common shares 24,577 27,016 -0-
----------- ----------- -----------
Adjusted weighted average shares
outstanding (denominator) 5,127,140 5,969,419 6,418,305
=========== =========== ===========
Per share $ 0.56 $ (2.12) $ (0.77)
=========== =========== ===========
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14. STOCKHOLDERS' EQUITY
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. The warrants
became exercisable on March 19, 1998 and expired 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.
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 common stock. 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.
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
in April 2004.
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. 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.
In August 2000, the Board of Directors of the Company authorized a third share
repurchase program pursuant to which the Company is authorized to repurchase up
to 1,000,000 shares of its outstanding common stock from time to time in open
market transactions at a total cost not to exceed $3,000,000. During the year
ended December 31, 2000, the Company repurchased 1,503,955 shares at an average
price of $4.86 per share for a total cost of $7,309,055 pursuant to the share
repurchase programs.
As of December 31, 2000, the Company has repurchased 646,880 shares pursuant to
the 1998 share repurchase program, 1,000,000 shares pursuant to the 1999 share
repurchase program, and 498,975 shares at an average price of $5.74 for a total
cost of $2,863,000 pursuant to the 2000 share repurchase program. As of such
date, the Company had remaining authority to purchase up to 501,025 shares for
not more than $137,000.
15. 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 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.
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16. 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
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.
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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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92
17. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands except share data):
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 2000 DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- ----------------- -----------------
Cash paid during the
period for interest
$3,234 $22,058 $39,876
====== ======= =======
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES
Dividends of $865,000, $583,000 and $695,000 were declared in December 2000,
December 1999 and December 1998 but not paid until February 2001, 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.
18. COMMITMENTS AND CONTINGENCIES
Hanover entered into employment agreements with the Principals in 1997 and Mr.
Kaplan in August 2000. The terms of the agreements were amended in August 2000.
Such agreements are for five year terms, and provide for initial aggregate
annual base salaries of $1,200,000 (subject to cost of living increases).
Pursuant to the amendments, the term of each contract is automatically extended
on its anniversary, unless either party gives notice to the contrary. A portion
of the aggregate base salaries was allocated to Hanover's principal taxable
subsidiaries, HCP and HTC, 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 the obligations of HCP with respect to an amendment to an
office lease entered into by HCP. At December 31, 2000 the remaining term of the
lease is 9 years and 2 months and obligates HCP for $1,982,000 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 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, 2000 the Company had forward commitments to sell $11.3 million
(par value) of Agency mortgage securities that had not yet settled. This forward
sale was entered into to hedge the
F-35
93
expected sale of approximately $19.6 million, principal balance, of purchased
subordinate mortgage-backed securities held in a trading account and classified
as available for sale.
19. 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, 2000 and 1999 are as follows (dollars in thousands):
DECEMBER 31, 2000 DECEMBER 31, 1999
------------------ -----------------
CARRYING NOTIONAL FAIR CARRYING NOTIONAL FAIR
AMOUNT AMOUNT VALUE AMOUNT AMOUNT VALUE
--------- --------- --------- -------- -------- --------
Assets:
Mortgage loans
Held for sale $ 230 $ 230 $ 251 $ 251
Collateral for CMOs 212,017 207,741 269,833 263,373
Mortgage securities pledged as
collateral for reverse
repurchase agreements:
Available for sale 11,785 11,785 48,529 48,529
Held to maturity 1,384 1,392 3,618 3,345
Trading 1,743 1,743 5,919 5,919
Mortgage securities pledged
as collateral for CMOs 9,877 9,340 -- --
Mortgage securities not pledged:
Available for sale 4,744 4,744 -- -
Held to maturity 3,133 3,033 4,620 4,034
Trading 3,057 3,057 -- --
Interest rate caps 619 134,362 206 1,072 166,266 1,139
Forward commitments to sell
mortgage securities (103) 11,300 (103) 68 6,000 68
Cash and cash equivalents 9,958 9,958 18,022 18,022
Accrued interest receivable 2,466 2,466 3,015 3,015
Notes receivable 7,887 7,887 7,946 7,946
--------- --------- --------- --------- -------- --------
Total $ 268,797 $ 145,662 $ 263,479 $ 362,893 $172,266 $355,641
========= ========= ========= ========= ======== ========
Liabilities:
Reverse repurchase agreements $ 14,760 $ 14,760 $ 55,722 $ 55,722
CMO borrowing 210,374 209,331 254,963 250,906
Accrued interest payable 1,796 1,796 2,433 2,433
Other liabilities 989 989 2,513 2,513
--------- --------- --------- --------
Total $ 227,919 $ 226,876 $ 315,631 $311,574
========= ========= ========= ========
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
F-36
94
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.
20. SUBSEQUENT EVENTS
On January 1, 2001, the Company implemented Statements of Financial Accounting
Standards ("SFAS") 133, 137 and 138. SFAS 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES, issued in June 1998, establishes accounting
and reporting standards for derivative instruments and hedging activities. 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. SFAS 138,
issued in June 2000, amends certain technical provisions of SFAS 133. The impact
of this implementation will be reflected in the Company's quarterly financial
statements for the period ending March 31, 2001.
In connection with the implementation of these financial standards, the Company
adopted a hedging policy on January 1, 2001. Certain of the hedges that the
Company had in place as of December 31, 2000 were designated as Fair Value
Hedges, and certain of the hedges that the Company had in place were designated
as Cash Flow Hedges.
In future financial statements, changes in the values of Fair Value Hedges will
be reflected in income, and an offsetting amount reflecting changes in value of
the related hedged assets will also be reflected in income. The effect of this
treatment will be to reflect in income any ineffective portion of such hedges.
The Company's Fair Value Hedges as of December 31, 2000 consisted of short sales
of $11.3 million of FNMA agency mortgage-backed securities. As of December 31,
2000, both the hedge and the hedged assets were carried at fair value. This
treatment will not materially change as a result of the adoption of SFAS 133,
137 and 138.
Changes in the value of Cash Flow Hedges will be reflected as other
comprehensive income or loss, but only to the extent that the hedging
relationship is expected to be highly effective. The Company's Cash Flow Hedges
at December 31, 2000 consisted of five interest rate caps in effect at December
31, 2000 with an aggregate book value of $619,000 and an aggregate market value
of $206,000.
F-37
95
Two of these hedges with an aggregate book value of $480,000 were designated as
hedges for floating rate borrowings. The Company expects that these Cash Flow
Hedges will be highly effective. These hedges had a fair value at January 1,
2001 of $72,000. The carrying value of these hedges was adjusted to fair value
at January 1, 2001. The difference between the carrying value and the fair value
of these hedges, or $408,000, was recorded as an unrealized loss, and will be
reported as a component of "other comprehensive income" in the Company's
financial statements for the period ending March 31, 2001. The Company considers
this loss to be part of the cumulative effect of the adoption of SFAS 133.
Two of these hedges with an aggregate book value of $40,000 had been designated
as hedges for floating rate borrowings that were repaid in the fourth quarter of
2000. These hedges had a fair value at January 1, 2001 of $123,000. The carrying
value of these hedges was adjusted to fair value at January 1, 2001. The
difference between the carrying value and the fair value of these hedges, or
$83,000, was recorded as a realized gain, and will be reported as a component of
income in the Company's financial statements for the period ending March 31,
2001. The Company considers this gain to be part of the cumulative effect of the
adoption of SFAS 133.
On January 1, 2001, the Company reclassified $1,874,000 of mortgage securities
from "held to maturity" to "trading" in connection with the adoption of SFAS
133. These securities were sold on January 31, 2001 for $2,047,000, resulting in
a gain on sale of $173,000. The Company considers this gain to be part of the
cumulative effect of the adoption of SFAS 133.
Also on January 1, 2001, the Company reclassified $1,725,000 of mortgage
securities from "held to maturity" to "available for sale" in connection with
the adoption of SFAS 133. In connection with this transfer, the carrying value
of these securities was adjusted to fair value. These securities had a fair
value of $1,681,000 as of January 1, 2001. The $44,000 difference between the
carrying value at December 31, 2000 and the fair value at January 1, 2001 was
recorded as an unrealized loss, and will be reported as a component of "other
comprehensive income" in the Company's financial statements for the period
ending March 31, 2001. The Company considers this loss to be part of the
cumulative effect of the adoption of SFAS 133.
On February 1, 2001 a $0.20 cash dividend previously declared by the Board of
Directors was paid to stockholders of record as of December 31, 2000.
On January 19, 2001 the Company's affiliate, HanoverTrade.com, Inc. purchased
all the assets of Pamex Capital Partners, L.L.C. ("Pamex") a whole loan mortgage
broker and hired 18 Pamex employees. The purchase price consisted of $850,000 in
cash paid at closing plus an earn out of between $1,250,000 and $1,500,000,
payable over three years in shares of Hanover. Included in the purchase was
Pamex Securities, L.L.C. a licensed securities broker dealer registered with the
Securities Exchange Commission and the National Association of Securities
Dealers. The combined sales force will market HanoverTrade.com product and
continue to broker whole loans through traditional channels.
At the February 2, 2001 meeting of the board of directors, the loans to the
principals totaling $3,279,000 due on March 31, 2001 were extended to March 31,
2003.
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96
21. 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,
2000 2000 2000 2000
------------------- ------------------ ------------------- ------------------
Net interest income $1,673 $2,081 $1,425 $1,484
=================== ================== =================== ==================
Net income $ 710 $ 727 $ 735 $ 690
=================== ================== =================== ==================
Basic earnings per share (2) $ .16 $ .15 $ .14 $ .12
=================== ================== =================== ==================
Diluted earnings per share $ .15 $ .15 $ .14 $ .12
(2)
=================== ================== =================== ==================
Dividends declared $ .20 $ .20 $ .14 $ .12
=================== ================== =================== ==================
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 $ 0.10 $ (2.38) $ 0.01 $ 0.11
(2)
=================== ================== =================== ==================
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 $ 0.07 $0.07 $0.00
(2)
=================== ================== ==================
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 does not
equal the earnings per share total for the year.
******
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97
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, 2000 and 1999,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 2000.
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 auditing standards generally accepted
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, 2000 and 1999, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2000 in conformity with accounting
principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 27, 2001
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98
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
ASSETS 2000 1999
---- ----
CURRENT ASSETS:
Cash $ 493,711 $ 514,804
Investment in marketable securities 3,300 19,055
Accounts receivable 2,302,211 668,993
Receivables from related parties 532,115 186,969
Accrued interest receivable -- 181,471
Accrued revenue on contracts in progress 1,347,566 761,923
Prepaid expenses and other current assets 26,556 170,201
------------ ------------
Total current assets 4,705,459 2,503,416
PROPERTY AND EQUIPMENT - Net 86,717 56,601
NET INVESTMENT IN MORTGAGE SECURITIES
AVAILABLE FOR SALE -- 14,180,184
DEFERRED TAX ASSET 340,731 856,143
OTHER ASSETS 13,730 175,633
------------ ------------
TOTAL ASSETS $ 5,146,637 $ 17,771,977
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Reverse repurchase agreement $ -- $ 10,842,000
Accrued appraisal and subcontractor costs 36,779 13,582
Accounts payable and accrued expenses 1,541,328 508,975
Deferred revenue 5,276 --
Notes payable to related parties 1,704,342 4,896,046
Income tax payable 21,508 --
------------ ------------
Total current liabilities 3,309,233 16,260,603
------------ ------------
TOTAL LIABILITIES 3,309,233 16,260,603
------------ ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000 shares authorized,
97,000 shares outstanding at December 31, 2000 and 1999 970 970
Common stock: Class A: $.01 par value, 5,000 authorized,
3,000 shares outstanding at December 31, 2000 and 1999 30 30
Additional paid-in capital 2,839,947 2,839,947
Retained earnings (deficit) (1,003,543) (1,471,884)
Accumulated other comprehensive income -- 142,311
------------ ------------
TOTAL STOCKHOLDERS' EQUITY: 1,837,404 1,511,374
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 5,146,637 $ 17,771,977
============ ============
See notes to consolidated financial statements
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99
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
----------- ----------- -----------
REVENUES:
Due diligence fees $ 7,016,435 $ 5,530,307 $ 5,001,047
Mortgage sales and servicing 27,825 229,557 701,574
Assignment fees 631,093 -- --
Loan brokering/asset management fees 30,234 789,003 654,748
Interest income on mortgage backed securities,
net of interest expense of $962,485 and $547,636
in 2000 and 1999 respectively 513,391 384,642 --
Gain on sale of mortgage securities 440,639 -- --
Other income (loss) 54,041 125,809 (12,609)
----------- ----------- -----------
Total revenues 8,713,658 7,059,318 6,344,760
----------- ----------- -----------
EXPENSES:
Personnel expense 3,309,860 3,954,622 4,364,725
Subcontractor expense 2,924,021 1,950,946 1,537,294
Occupancy expense 453,372 477,937 578,512
Travel and subsistence 215,959 390,318 555,382
General and administrative expense 309,926 378,407 532,006
Appraisal, inspection and other professional fees 257,495 155,609 223,262
Interest expense 90,054 252,144 155,128
Depreciation and amortization 52,908 107,583 107,971
----------- ----------- -----------
Total revenues 7,613,595 7,667,566 8,054,280
----------- ----------- -----------
INCOME (LOSS) BEFORE INCOME TAX PROVISION (BENEFIT) 1,100,063 (608,248) (1,709,520)
INCOME TAX PROVISION (BENEFIT) 631,722 (152,062) (661,524)
----------- ----------- -----------
NET INCOME (LOSS) $ 468,341 $ (456,186) $(1,047,996)
=========== =========== ===========
BASIC EARNINGS (LOSS) PER SHARE $ 156.12 $ (152.07) $ (349.33)
=========== =========== ===========
See notes to consolidated financial statements
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100
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
Preferred Stock Common Stock
---------------- ----------------
Shares Amount Shares Amount
------ ------ ------ ------
BALANCE, DECEMBER 31, 1997 97,000 $ 970 3,000 $ 30
Capital Contributions
Comprehensive (loss):
Net (loss)
Comprehensive (loss)
------ ----- ------ -----
BALANCE, DECEMBER 31, 1998 97,000 970 3,000 30
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
Comprehensive income:
Net income
Other comprehensive income
(loss):
Change in net unrealized
gain on securities
available for sale,
net of income tax effect
Comprehensive income
------ ----- ------ -----
BALANCE, DECEMBER 31, 2000 97,000 $ 970 3,000 $ 30
====== ===== ====== =====
Accumulated
Additional Comprehensive Retained Other
Paid-In Income Earnings Comprehensive
Capital (Loss) (Deficit) Gain Total
------- ------ --------- ---- -----
BALANCE, DECEMBER 31, 1997 $ 56,442 $ 32,298 -- $ 89,740
Capital Contributions 2,783,505 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 2,839,947 (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 2,839,947 (1,471,884) 142,311 1,511,374
Comprehensive income:
Net income $ 468,341 468,341 468,341
Other comprehensive income
(loss):
Change in net unrealized
gain on securities
available for sale,
net of income tax effect (142,311) (142,311) (142,311)
----------
Comprehensive income $ 326,030
---------- ========== ----------- --------- -----------
BALANCE, DECEMBER 31, 2000 $2,839,947 $(1,003,543) $ -- $ 1,837,404
========== =========== ========= ===========
See notes to consolidated financial statements
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101
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS CASH FLOWS
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 468,341 $ (456,186) $ (1,047,996)
Adjustments to reconcile net income (loss) to net cash
(used in) operating activities:
Amortization of net premium (374,961) (204,010) --
Loan loss provision 478,330 289,297 --
Depreciation and amortization 42,798 107,583 107,971
Gain on sale of mortgage servicing rights -- -- (371,977)
Gain on sale of mortgage backed securities (440,639) -- --
(Gain) Loss on disposal of property and equipment (2,700) 14,588 --
Loss on disposal of securities -- -- 100,750
Sale (Purchase) of trading securities 15,755 (1,063) (598)
Changes in assets - (increase) decrease:
Accounts receivable (1,633,218) (151,748) (383,416)
Receivables from related parties (345,146) 26,810 597,371
Accrued interest receivable 181,471 (181,471) --
Accrued revenue on contracts in progress (585,643) (514,823) (211,687)
Income tax receivable -- 219,563 73,322
Prepaid expenses and other current assets 143,645 22,379 (74,028)
Deferred tax assets 612,682 -- (781,270)
Other assets 161,903 (47,062) 37,348
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs 23,197 (7,148) (111,248)
Accounts payable and accrued expenses 1,032,353 42,278 132,106
Income tax payable 21,508 -- --
Deferred income taxes -- (152,062) --
Deferred revenue 5,276 (89,625) (15,325)
Minority interest
-- -- (616)
------------ ------------ ------------
Net cash (used in) operating activities (195,048) (1,082,700) (1,949,293)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (72,914) (38,598) (33,841)
Sale of property and equipment 2,700 1,285 --
Proceeds from sale of mortgage servicing rights -- -- 418,974
Purchase of securities -- -- (100,000)
Purchase of mortgage securities (8,450,259) (14,110,858) --
Proceeds from sale of mortgage securities to third parties 8,667,260 -- --
Proceeds from sale of mortgage securities to related party 13,844,223 -- --
Principal payments received on mortgage securities 216,649 84,969 --
------------ ------------ ------------
Net cash (used in) provided by investing activities 14,207,659 (14,063,202) 285,133
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of note payable to bank -- -- (1,405,000)
Net proceeds from (repayment of) note payable to related party (3,191,704) 4,183,222 712,824
Capital contributions -- -- 2,783,505
Net borrowings from (repayment of) reverse repurchase agreements (10,842,000) 10,842,000 --
------------ ------------ ------------
Net cash provided by (used in) financing activities (14,033,704) 15,025,222 2,091,329
------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS (21,093) (120,680) 427,169
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 514,804 635,484 208,315
------------ ------------ ------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 493,711 $ 514,804 $ 635,484
============ ============ ============
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $7,165,000, and $13,930,000, were originated by HCMC
and funded by investors in 1999 and 1998, respectively
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for:
Income taxes $ 3,435 $ 5,350 $ 5,671
============ ============ ============
Interest $ 830,930 $ 323,851 $ 689,779
============ ============ ============
See notes to consolidated financial statements
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102
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
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, mortgage loan assignment
preparation 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. During the year ended December 31, 2000 HCP's investment in the
limited liability companies was liquidated. The ownership of each limited
liability company at December 31, 2000 and 1999 is detailed below:
2000 1999
---- ----
Alpine/Hanover, LLC 0.0% 1.0%
ABH-I, LLC 0.0% 1.0%
REVENUE RECOGNITION
Revenues from due diligence contracts in progress and assignment preparation
services are recognized for the services provided as they are earned and billed.
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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
member 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 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, 2000 and 1999.
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.
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MORTGAGE SERVICING RIGHTS
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.
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 is
not changed for further increases in market value; however, further increases in
market value are 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-47
105
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
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
F-48
106
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.
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
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities, is effective for all fiscal years
beginning after June 15, 2000. SFAS 133, as amended, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. Under SFAS
133, certain contracts that were not formerly considered derivatives may now
meet the definition of a derivative. The Company adopted SFAS 133 effective
January 1, 2001. The adoption of SFAS 133 did not have a significant impact on
the financial position, results of operations, or cash flows of the Company.
3. CONCENTRATION RISK
REVENUES FROM CERTAIN CUSTOMERS
For the years ended December 31, 2000, 1999 and 1998, the Company received
revenues from certain customers, which are subject to change annually, which
exceeded 10% of total revenues as follows:
F-49
107
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2000 1999 1998
---- ---- ----
Major Customer # 1 30% 22% 28%
Major Customer # 2 22% 13% 13%
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 Company did not own any mortgage securities
at December 31, 2000. The following table sets forth the concentrations of the
Company's credit risk by issuer at December 31, 1999.
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
===========
4. 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 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, 2000 and 1999, HCMC was
servicing 5 and 6 loans, respectively, with unpaid principal balances of
$10,227,119 and $13,388,037 including loans subserviced for others of $7,584,236
and $10,690,537 respectively. Escrow balances maintained by HCMC were $170,830
and $212,528 at December 31, 2000 and 1999, respectively. The aforementioned
servicing portfolio and related escrow accounts are not included in the
accompanying consolidated balance sheets as of December 31, 2000 and 1999.
5. 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
F-50
108
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.
6. RELATED PARTY TRANSACTIONS
Receivables from related parties at December 31, 2000 and 1999 consist of the
following:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Due from Hanover Capital Mortgage Holdings, Inc. (1) $185,381 $150,027
Due from ABH-I, LLC -- 9,005
Due from Hanover Mortgage Capital Corporation (2) 6,661 6,727
Due from Hanover Investment Fund (2) -- 125
Due from HanoverTrade.com (3) 339,444 14,274
-------- --------
Due from related entities 531,486 180,158
Due from officers (4) 629 6,811
-------- --------
Receivables from related parties $532,115 $186,969
======== ========
(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 are owned by certain of the Company's
officers/owners represent receivables resulting primarily from accounting
fees and out-of-pocket expenses.
(3) Amounts due reflect certain costs that the Company paid for
HanoverTrade.com ("HTC"). Beginning July 1, 2000, normal recurring
operating expenses paid on behalf of HTC were billed to HTC. The expenses
billed include personnel expense, occupancy expense, travel, entertainment
and trade show expense and general and administrative expenses. During 1999
the expenses incurred relate to start-up costs of HTC.
(4) Amounts due from officers are mostly miscellaneous travel related advances.
F-51
109
7. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 2000 and 1999 consists of the following:
DECEMBER, 31 DECEMBER, 31
2000 1999
---- ----
Office machinery and computer equipment $ 302,047 $ 229,133
Furniture and fixtures 4,745 4,745
--------- ---------
306,792 233,878
Less accumulated depreciation (220,075) (177,277)
--------- ---------
Property and equipment - net $ 86,717 $ 56,601
========= =========
Depreciation expense for the years ended December 31, 2000, 1999 and 1998 was
$42,798, $107,583, and $105,519, respectively.
8. MORTGAGE SECURITIES
On July 1, 2000 the Company sold the mortgage-backed securities at book value
net of loan loss reserve and reverse repurchase debt to Hanover Capital Mortgage
Holdings, Inc. 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.
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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110
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%
======
9. 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. There was no loan loss reserve at December 31, 2000. On July 1, 2000 the
mortgage-backed securities were sold at book value net of loan loss reserve to
Hanover Capital Mortgage Holdings, Inc. The following table summarizes the
activity in the loan loss allowance for the years ended December 31, 2000 and
1999.
YEAR ENDED YEAR ENDED
DECEMBER 31, 2000 DECEMBER 31, 1999
----------------- -----------------
Balance beginning of period $ 285,291 $ -
Loan loss provision 478,330 289,297
Transfers/sales (729,366) -
Charge-offs (34,255) (4,006)
-------- --------
Balance end of period $ - $285,291
======== ========
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111
10. REVERSE REPURCHASE AGREEMENTS
At December 31, 2000 there were no reverse repurchase agreements. The borrowings
pursuant to the reverse repurchase agreement were sold along with the
mortgage-backed securities to Hanover Capital Mortgage Holdings, Inc. on July 1,
2000. 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.
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 years ended December 31, 2000 and 1999 is summarized as follows:
REVERSE REPO FINANCING FOR
YEARS ENDED:
--------------------------
REVERSE REPURCHASE AGREEMENTS DECEMBER 31, 2000 DECEMBER 31, 1999
----------------------------- ----------------- -----------------
Balance of borrowing at end of period $ 0 $10,842,000
Accrued interest at end of period $ 0 $ 66,572
Average borrowing balance during the
period $ 6,356,000 $11,022,000
Average interest rate during the period 7.617% 6.874%
Maximum month-end borrowing balance
during the period $15,079,000 $11,082,000
COLLATERAL UNDERLYING THE AGREEMENTS
------------------------------------
Balance at end of period - carrying value $ 0 $14,180,184
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112
11. INCOME TAXES
The components of deferred income taxes as of December 31, 2000 and 1999 are as
follows:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
DEFERRED TAX ASSETS
Temporary differences $ 112,849 $ 223,643
Federal net operating loss carryforward 374,411 638,950
State/Local net operating loss carryforward 73,481 124,032
Amt credit 16,830 --
--------- ---------
Total deferred tax assets 577,571 986,625
DEFERRED TAX LIABILITIES
Temporary differences (25,127) (33,212)
Tax liability for other comprehensive income -- (97,270)
--------- ---------
Total deferred tax liabilities (25,127) (130,482)
Valuation allowance (211,713) --
--------- ---------
Net deferred tax assets $ 340,731 $ 856,143
========= =========
The items resulting in significant temporary differences for the years ended
December 31, 2000 and 1999 that generate deferred tax assets and liabilities
relate primarily to the recognition of revenue and accrued liabilities for
financial reporting purposes.
The components of the income tax provision (benefit) for the years ended
December 31, 2000, 1999 and 1998 consist of the following:
DECEMBER, 31 DECEMBER, 31 DECEMBER, 31
2000 1999 1998
---- ---- ----
Current - Federal, state and local $ 19,040 $ -- $ --
Deferred - Federal, state and local 612,682 (152,062) (661,524)
--------- --------- ---------
Total $ 631,722 $(152,062) $(661,524)
========= ========= =========
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113
The income tax (benefit) differs from amounts computed at statutory rates, as
follows:
DECEMBER, 31 DECEMBER, 31 DECEMBER, 31
2000 1999 1998
---- ---- ----
Federal income taxes (benefit) at statutory rate $ 374,021 $ (206,804) $ (595,554)
State and local income taxes (benefit) 72,052 (40,145) (76,256)
Meals and entertainment 4,065 6,486 6,002
Officer's life insurance 268 -- 4,273
Penalties 1,702 -- --
Realized loss on hedge transaction (14,089) -- --
Sale of assets (18,010) -- --
Provision for valuation allowance 211,713 -- --
Adjustment of deferred tax asset -- 88,401 --
Other, net -- -- 11
---------- ----------- ----------
Total $ 631,722 $ (152,062) $ (661,524)
========== =========== ==========
The Company has a Federal tax net operating loss carryforward of approximately
$1.1 million which begins to expire in the year 2012.
12. 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 receive
$10,750,005 upon liquidation of the Company before common stockholders receive
any liquidating distributions.
13. NOTE PAYABLE TO BANK
HCP had a $2.0 million Line of Credit Facility Agreement with a bank that
expired December 31, 1999 and was not renewed. There was no outstanding balance
at December 31, 1999.
14. NOTE PAYABLE TO RELATED PARTY
At December 31, 2000 and 1999 the Company had a principal balance outstanding on
a note payable to Hanover Capital Mortgage Holdings, Inc. in the amount of
$1,704,342 and $4,896,046 respectively. The note bears interest at the prime
rate minus 1% and interest is calculated on the daily principal balance
outstanding. At December 31, 2000, and 1999 the interest rate in effect was 8.5%
and 7.5% respectively. Included in the 2000 and 1999 consolidated statement of
operations is interest expense in the amount of $265,062 and $167,955
respectively related to this note payable. The entire unpaid principal balance
on the note is due in full on the maturity date, March 31, 2002.
F-56
114
15. 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
---- ------
2001 $ 324,901
2002 283,045
2003 241,189
2004 218,312
2005 216,233
Thereafter 774,835
----------
Total $2,058,515
==========
Rent expense for the years ended December 31, 2000, 1999 and 1998 amounted to
$144,731 and $217,413, $250,684, 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.
16. 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, 2000 and 1999 are as follows:
DECEMBER 31, 2000 DECEMBER 31, 1999
--------------------------- ---------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
Assets:
Mortgage securities, available -- -- $14,180,184 $14,180,184
for sale
Interest rate caps -- -- 135,609 245,000
Cash and cash equivalents $ 493,711 $ 493,711 515,804 514,804
Marketable Securities 3,300 3,300 19,055 19,055
Accrued interest receivable -- -- 181,471 181,471
----------- ----------- ----------- -----------
Total $ 497,011 $ 497,011 $15,032,123 $15,140,514
=========== =========== =========== ===========
Liabilities:
Reverse repurchase agreements -- -- $10,842,000 $10,842,000
Note Payable to related party $ 1,704,342 $ 1,704,342 4,896,046 4,896,046
----------- ----------- ----------- -----------
Total $ 1,704,342 $ 1,704,342 $15,738,046 $15,738,046
=========== =========== =========== ===========
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115
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, note payable to related party - 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.
******
F-58
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INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
HanoverTrade.com, Inc.
New York, New York
We have audited the accompanying balance sheets of HanoverTrade.com, Inc. (the
"Company") as of December 31, 2000 and 1999, and the related statements of
operations, stockholders' equity, and cash flows for the year ended December 31,
2000 and the period from May 28, 1999 (inception) to 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 auditing standards generally accepted
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 financial statements present fairly, in all material
respects, the financial position of HanoverTrade.com, Inc. at December 31, 2000
and 1999, and the results of its operations and cash flows for the year ended
December 31, 2000 and the period from May 28, 1999 (inception) to December 31,
1999 in conformity with accounting principles generally accepted in the United
States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 27, 2001
F-59
117
HANOVERTRADE.COM, INC.
BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
ASSETS 2000 1999
---- ----
CURRENT ASSETS:
Cash $ 32,573 $ 929
Accounts receivable 10,000 26
----------- -----------
Total Current Assets 42,573 955
PROPERTY AND EQUIPMENT - Net 19,681 --
COMPUTER SOFTWARE - Net 2,702,266 103,540
DEFERRED INCOME TAX BENEFIT -- --
----------- -----------
TOTAL ASSETS $ 2,764,520 $ 104,495
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 1,008,403 $ --
Accrued interest due to related parties 35,864 --
Due to related parties 390,138 135,626
----------- -----------
Total current liabilities 1,434,405 135,626
----------- -----------
Notes payable to related parties 2,903,758 --
----------- -----------
TOTAL LIABILITIES 4,338,163 135,626
----------- -----------
COMMITMENTS AND CONTINGENCIES -- --
STOCKHOLDERS' EQUITY:
Series A Preferred stock: $0.01 par value, 100,000 shares
Authorized, 97,000 shares outstanding at December 31,
2000 and 1999 970 970
Common Stock:
$0.01 par value, 5,000 shares authorized, 3,000 shares
outstanding at December 31, 2000 and 1999 30 30
Retained earnings (deficit) (1,574,643) (32,131)
----------- -----------
TOTAL STOCKHOLDERS' EQUITY: (1,573,643) (31,131)
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,764,520 $ 104,495
=========== ===========
See notes to financial statements.
F-60
118
HANOVERTRADE.COM, INC.
STATEMENTS OF OPERATIONS
PERIOD FROM
MAY 28, 1999
YEAR ENDED (INCEPTION) TO
DECEMBER 31, DECEMBER 31,
2000 1999
----------- -----------
REVENUES:
Loan brokering/Trading $ 140,781 $ --
----------- -----------
Total revenues 140,781 --
----------- -----------
EXPENSES:
Personnel expense 789,646 --
Technology 230,520 4,450
Occupancy expense 130,278 --
Travel and entertainment 174,821 11,892
General and administrative expense 93,471 676
Professional fees 32,143 15,113
Interest expense 81,479 --
Depreciation and amortization 150,935 --
----------- -----------
Total expenses 1,683,293 32,131
----------- -----------
(LOSS) BEFORE INCOME TAX (1,542,512) (32,131)
INCOME TAX BENEFIT -- --
----------- -----------
NET (LOSS) $(1,542,512) $ (32,131)
=========== ===========
BASIC (LOSS) PER SHARE $ (514.17) $ (10.71)
=========== ===========
See notes to financial statements
F-61
119
HANOVERTRADE.COM, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 2000 AND PERIOD FROM MAY 28, 1999 (INCEPTION)
TO DECEMBER 31, 1999
Series A Accumulated
Preferred Stock Common Stock Additional Retained Other
--------------- -------------- Paid-In Comprehensive Earnings Comprehensive
Shares Amount Shares Amount Capital (Loss) (Deficit) Gain Total
------ ------ ------ ------ ------- ------ --------- ---- -----
Capital Contribution 97,000 $ 970 3,000 $ 30 -- $ 1,000
Comprehensive (loss):
Net (loss) $ (32,131) $ (32,131) (32,131)
-----------
Comprehensive (loss) $ (32,131) -- --
------ ----- ------ ----- ------ =========== ----------- ----------- -----------
BALANCE, DECEMBER 31, 1999 97,000 970 3,000 30 -- (32,131) -- (31,131)
Comprehensive (loss):
Net (loss) $(1,542,512) (1,542,512) (1,542,512)
-----------
Comprehensive (loss) $(1,542,512)
------ ----- ------ ----- ------ =========== ----------- ----------- -----------
BALANCE, DECEMBER 31, 2000 97,000 $ 970 3,000 $ 30 -- $(1,574,643) -- $(1,573,643)
====== ===== ====== ===== =========== ===========
See notes to financial statements
F-62
120
HANOVERTRADE.COM, INC.
STATEMENTS OF CASH FLOWS
PERIOD FROM MAY 28
YEAR ENDED (INCEPTION) TO
DECEMBER 31, DECEMBER 31,
2000 1999
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $(1,542,512) $ (32,131)
Adjustments to reconcile net (loss) to net cash (used in)
provided by operating activities:
Depreciation and amortization 150,935 --
Changes in assets - (increase) decrease:
Accounts receivable (9,974) (26)
Changes in liabilities - increase (decrease):
Accounts payable and accrued expenses 1,008,403 --
Payable to related party 254,512 135,626
Accrued interest due to related party 35,864 --
----------- -----------
Net cash (used in) provided by operating activities (102,772) 103,469
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (21,695) --
Investment in web-site software (2,747,647) (103,540)
----------- -----------
Net cash (used in) investing activities (2,769,342) (103,540)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from notes payable to related party 2,903,758 --
Capital contributions -- 1,000
----------- -----------
Net cash provided by financing activities 2,903,758 1,000
----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS 31,644 929
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 929 --
----------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 32,573 $ 929
=========== ===========
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for:
Income taxes $ 680 $ --
=========== ===========
Interest to related party $ 45,615 $ --
=========== ===========
See notes to financial statements
F-63
121
HANOVERTRADE.COM, INC.
NOTES TO FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 2000 AND THE PERIOD MAY 28, 1999
(INCEPTION) TO DECEMBER 31, 1999
1. BUSINESS DESCRIPTION
HanoverTrade.com, Inc. ("HTC"), a Delaware corporation, is principally engaged
in operating an online world wide web-based exchange for trading loan pools
(primarily mortgage loan pools) and performing loan sale advisory services for
third parties.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION
Revenues from loan sale advisory and trading are recognized when the
transactions close and fees are earned and billed. At the time of closing a
transaction, the number of loans, loan principal balance and purchase price in
the transaction are agreed upon, documentation is signed and the sale is funded.
HTC billing of fees relating to a transaction occurs concurrently with the
closing and funding.
INCOME TAXES
A deferred income tax asset is recorded to reflect the effect of temporary
differences between the tax basis of an asset or liability and its reported
amount in the financial statements and to reflect the future tax benefit of net
operating losses.
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.
TECHNOLOGY EXPENSES
Professional fees for technology are included in technology expenses.
Capitalized software includes internal and external application development
stage costs incurred to develop the Company's online world wide web based
exchange for trading loan pools. Capitalized software costs are stated at cost
less accumulated amortization. Amortization is computed on the straight-line
method over the estimated useful life of the asset, generally three years.
Expenses for web page design are expensed as incurred.
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.
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
F-64
122
during the period and shares reacquired during the period are weighted for the
portion of time they were outstanding.
RELATED PARTY TRANSACTIONS
The results of operations may not necessarily be indicative of those that would
have occurred on a stand alone basis.
ESTIMATE FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of cash and cash equivalents, accounts receivable, accounts
payable and accrued expenses, due to related parties and note payable to
affiliate were determined to be their carrying value due to their short-term
nature.
3. CONCENTRATION RISK
REVENUES FROM CERTAIN CUSTOMERS
For the year ended December 31, 2000 and the Period May 28, 1999 (inception) to
December 31, 1999, the Company received revenues from certain customers, which
are subject to change annually, which exceeded 10% of total revenues as follows:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Major Customer # 1 29% -
Major Customer # 2 16% -
Major Customer # 3 14% -
Major Customer # 4 11% -
4. RELATED PARTY TRANSACTIONS
Payables due to related parties at December 31, 2000 and 1999 consist of the
following:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Due to Hanover Capital Partners Ltd $339,443 $ 14,274
Due to Hanover Capital Mortgage Holdings, Inc 50,695 121,352
-------- --------
Payables to related parties $390,138 $135,626
======== ========
For the year ended December 31, 2000 and the period from May 28, 1999
(inception) to December 31, 1999, Hanover Capital Partners Ltd. ("HCP") and
Hanover Capital Mortgage Holdings, Inc., ("Hanover") billed certain expenses to
HTC. The expenses billed included personnel expense, occupancy expense, travel
and trade show expense and general and administrative expenses and were billed
to reflect activity on behalf of HTC. HTC expects similar billings from HCP and
Hanover in future periods.
HCP billed a total of $464,000 of net expenses to HTC for the year ended
December 31, 2000. The billing included $441,000 of personnel expense, $26,000
of occupancy expense, $57,000 of travel and trade show expense, and $51,000 of
general and administrative expense offset by $111,000 of trading and brokering
revenue.
HCP billed a total of $14,000 of expenses to HTC for the period May 28, 1999
(inception) to December 31, 1999. The billings included $12,000 of travel and
tradeshow expenses and $2,000 of technology expenses.
F-65
123
Hanover billed a total of $488,000 of expenses to HTC during the year ended
December 31, 2000. The billing included $369,000 of personnel expense, $103,000
of occupancy expense, and $16,000 of general and administrative expenses.
Hanover billed a total of $18,000 of expenses to HTC for the period May 28, 1999
(inception) to December 31, 1999. The billings included $15,000 of professional
fees and $3,000 of technology expense.
At December 31, 2000 HTC had a principal balance on a note payable to Hanover in
the amount of $2,904,000. The maximum loan amount under this note is $10
million. The note bears interest daily at the prime rate minus 1% and interest
is calculated on the daily principal balance outstanding. At December 31, 2000
the interest rate in effect was 8.5%. The entire unpaid principal balance on
the note is due in full on the maturity date, March 31, 2002.
5. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 2000 consists of the following:
DECEMBER 31,
2000
----
Office machinery and computer equipment $ 21,695
Less accumulated depreciation (2,014)
--------
Property and equipment - net $ 19,681
========
Depreciation expense for the year ended December 31, 2000 was $2,014.
6. CAPITALIZED SOFTWARE COSTS
Capitalized software costs at December 31, 2000 and December 31, 1999 consists
of the following:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Capitalized Software $ 2,851,187 $ 103,540
Less accumulated amortization (148,921) --
----------- -----------
Capitalized Software Costs - net $ 2,702,266 $ 103,540
=========== ===========
Amortization expense for the year ended December 31, 2000 and the period May 28,
1999 (inception) to December 31, 1999 was $148,921 and $0 respectively.
7. INCOME TAXES
The components of deferred income taxes as of December 31, 2000 and 1999 are as
follows:
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124
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Deferred tax assets $ 620,824 $ 12,429
Valuation allowance (620,824) (12,429)
--------- ---------
Net deferred tax assets $ 0 $ 0
========= =========
The items resulting in significant temporary differences for the year ended
December 31, 2000 and the Period May 28, 1999 (inception) to December 31, 1999
that generate deferred tax assets relate primarily to the benefit of net
operating losses. The Company has established a valuation allowance for the full
amount of the benefit.
The income tax (benefit) differs from amounts computed at statutory rates, as
follows:
DECEMBER 31, DECEMBER 31,
2000 1999
---- ----
Federal income taxes (benefit) at
statutory rate $(524,454) $ (10,925)
State and local income taxes (benefit) (97,050) (2,036)
Meals and entertainment 11,228 522
Officer's life insurance 1,881 --
Adjustment of deferred tax asset -- --
Other, net -- --
--------- ---------
Total tax benefit (608,395) (12,429)
Valuation allowance 608,395 12,429
--------- ---------
Net tax benefit $ 0 $ 0
========= =========
The Company has a Federal tax net operating loss carryforward of approximately
$1,548,000 that begins to expire in 2014.
8. STOCKHOLDERS' EQUITY
On May 28, 1999 (inception) HTC was incorporated in Delaware with 5,000
authorized shares of Common Stock (par value $0.01) and 100,000 authorized
shares of Series A Preferred Stock (par value $0.01).
F-67
125
HTC issued 3000 shares to the principals, John A. Burchett, Joyce Mizerak,
George Ostendorf and Irma Tavares, giving them a 3% economic interest. HTC
issued 97,000 shares of Series A Preferred Stock to Hanover Capital Mortgage
Holdings, Inc. giving it a 97% economic interest.
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 for
the common stock as for the Preferred Stock.
All voting power is held by the Common Stock except for certain situations
involving merger, dissolution, sale of substantially all the assets of HTC, and
amendments to the certificate of incorporation adversely affecting the Preferred
Stockholders. In these situations, the Preferred stockholders shall be entitled
to vote.
9. SUBSEQUENT EVENTS
On January 24, 2001, the Company hired 18 employees of Pamex Capital Partners
L.L.C. ("Pamex") and purchased all of Pamex's assets. The Company entered into
employment agreements with 5 of the 18 employees hired. The purchase price
consisted of $850,000 in cash paid at closing plus an earn out of between
$1,250,000 and $1,500,000, payable over three years in shares of Hanover.
Included in the assets purchased was Pamex Securities, L.L.C. a securities
broker dealer registered with the Securities Exchange Commission and National
Association of Securities Dealers.
On February 13, 2001, the Certificate of Incorporation was amended to authorize
an additional 100,000 shares of Common Stock.
The note payable due Hanover on March 31, 2001 was extended to March 31, 2002.
126
On March 30, 2001, we entered into a loan agreement with VerticalCrossings.com,
Inc. (which we refer to as "Vcross"). Vcross is a world-wide web based exchange
for mortgage-backed securities, asset-backed securities, and other structured
securities. We lent Vcross $200,000 for a 120 day term at an interest rate of
12%, and we agreed to lend them an additional $100,000 upon the completion of a
project to integrate our technology. Our loan was collateralized by all of
Vcross's assets. As additional consideration for the loan, we received a
lifetime license to use Vcross' proprietary software technology to conduct
online auctions of mortgage loans. We also received warrants to purchase 3.67%
of Vcross's common stock, and we will receive warrants to purchase an additional
1.33% of Vcross's common stock when we fund the final $100,000.
******
F-68
127
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, 2001.
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, 2001.
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
Thomas P. Kaplan Accounting Officer)
54