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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, 2001
OR
| | Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ____________ to ____________
Commission file number: 001-13417
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND 13-3950486
(State or other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
379 THORNALL STREET, EDISON, NEW JERSEY 08837
(Address of principal executive offices) (Zip Code)
(732) 548-0101
(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 28, 2002 was approximately $37,407,678 (based on closing
sales price of $8.65 per share of common stock as reported for the American
Stock Exchange on March 28, 2002).
The registrant had 4,324,587 shares of common stock outstanding as of
March 28, 2002.
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.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED DECEMBER 31, 2001
INDEX
PART I PAGE
----
Item 1. Business......................................................... 3
Item 2. Properties....................................................... 17
Item 3. Legal Proceedings................................................ 17
Item 4. Submission of Matters to a Vote of Security Holders.............. 17
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.......................................................... 18
Item 6. Selected Financial Data.......................................... 20
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 21
Item 7a. Quantitative and Qualitative Disclosure About Market Risk........ 36
Item 8. Financial Statements and Supplementary Data...................... 38
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure............................................. 38
PART III
Item 10. Directors and Executive Officers of the Registrant............... 39
Item 11. Executive Compensation........................................... 39
Item 12. Security Ownership of Certain Beneficial Owners and Management... 39
Item 13. Certain Relationships and Related Transactions................... 39
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 40
Signatures................................................................ 41
2
PART I
ITEM 1: BUSINESS
This Annual Report on Form 10-K contains, in addition to historical information,
forward-looking statements that involve risk 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") pursuant to
the Internal Revenue Code of 1986, as amended (the "Code"), 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 manage investments in mortgage-backed
securities ("MBS") and 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
on-line 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.
The Company's principal executive offices are located at 379 Thornall Street,
Edison, New Jersey 08837.
RESTRUCTURE
During the third quarter of 2001, we announced our intentions to simplify our
corporate organization though an alternative structure for our operating
subsidiaries, HanoverTrade.com, Inc. and Hanover Capital Partners Ltd. The
primary purpose of the new structure is to separate the investment activities
of Hanover from the operating results of these subsidiaries and to
independently fund these subsidiaries on a go-forward basis. As planned and if
the restructuring is implemented, Hanover's earnings and dividends would reflect
only the results of its investment portfolio, thus presenting a much clearer
financial picture to its shareholders and the financial markets.
The structure under consideration would include a separate management company,
owned by several members of our senior management, that would manage both the
REIT and the subsidiaries under a management contract. This should enable
Hanover to lower its cost of operations while allowing the management company
to seek additional outside asset management contracts to cover its costs.
Implementation of the restructuring has been delayed as we continue to
investigate the tax, accounting and legal ramifications of the plan and
consider other various alternatives. It is possible that the final structure
could change. In addition, we cannot assure you when or whether we will be able
to accomplish a restructuring of our corporate organization that achieves our
objectives.
MORTGAGE LOANS AND MORTGAGE SECURITIES
General
Hanover's primary business is investing in MBS which are secured by
single-family mortgage loans. Hanover generally targets so-called "subordinate"
MBS. The subordinate MBS 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 invested directly in mortgage loans on its own behalf.
Hanover has issued MBS collateralized by these loans, and has retained the
subordinate securities from these transactions. Although Hanover no longer
invests a substantial portion of its own funds in mortgage loans, Hanover formed
an investment partnership, HDMF-I LLC, ("HDMF-I"), in 2001 to invest in sub- and
non-performing mortgage loans. Although Hanover is a minority investor in this
fund, Hanover is the founding member of HDMF-I and HCP is the asset manager. The
fund provides a means for Hanover to leverage its expertise in this market
sector by allowing HCP to earn an asset management fee and by allowing Hanover
to invest in the fund.
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Hanover has committed to provide approximately $5,820,000 of investment capital
to HDMF-I for investment in sub- and non-performing mortgage loans.
The Company believes that its sales and due diligence organization and its
mortgage industry expertise give it certain advantages over other mortgage
market participants. The Company acquires subordinate MBS 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 and to price these securities efficiently. The
investment partnership uses the Company's sales organization to source
investments.
Trends and Recent Developments
Purchase and Sale of Subordinate MBS. 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 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 MBS, as compared to 1997 and
1998. Whereas the Company had previously focused primarily on acquiring seasoned
mortgage loans, commencing in 1999, the Company focused primarily on acquiring
subordinate MBS with characteristics similar to the subordinate MBS that the
Company created in its securitizations.
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 2001, the Company purchased fifteen
subordinate MBS with an aggregate principal balance of $16,429,000 at a net
purchase price of $8,565,000. During 2001, the Company sold thirty-nine
subordinate MBS with an aggregate principal balance of $34,620,000 at a net
sales price of $21,259,000. The sale of subordinate MBS during 2001 was
primarily in response to market conditions and, to a lesser extent, asset
performance. The Company's principal business strategy is to invest in MBS and
to a lesser extent mortgage loans and to earn net interest income on these
investments. The sale of subordinate MBS should not be expected to be a
recurring source of income for the Company.
During 2001, the Company purchased MBS issued by agencies of the Federal
Government ("Agency") with an aggregate principal balance of $125,846,000 at a
net purchase price of $138,406,000. During 2001, the Company sold Agency MBS
with an aggregate principal balance of $98,327,000 at a net sales price of
$109,270,000.
Portfolio Composition
At December 31, 2001, Hanover had invested $164,113,000 or 71.5% of Hanover's
total assets in single-family mortgage loans classified as held for sale and
collateral for collateralized mortgage obligations ("CMOs"), and $41,343,000 or
18.0% of its total assets in single-family MBS classified as available for sale,
held to maturity or trading. The composition of mortgage loans and mortgage
securities is described in detail in Notes 3 and 4 to the Company's audited
consolidated financial statements included in this Annual Report on Form 10-K.
4
In 2001, the Company experienced $149,000 of mortgage loan losses on its
mortgage loan portfolio (held for sale and collateral for CMOs), and $90,000 of
losses on its MBS portfolio (available for sale, held to maturity and trading).
The Company experienced $16,000 of mortgage loan losses during 2000 on its
mortgage loan portfolio and $70,000 of losses on its MBS portfolio.
The Company recorded a provision for anticipated credit losses of $709,000 and
$875,000 in 2001 and 2000, respectively.
Generally, the mortgage loans and created mortgage securities 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 were 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 MBS from Hanover 98-B at time of
securitization.
In March 1999, the Company completed the "1999-A" securitization, and thereby
transferred $138,357,000 (par value) of mortgage loans to CMO collateral. In
August 1999, the Company completed the "1999-B" securitization, and thereby
transferred $111,575,000 (par value) of mortgage loans to CMO collateral.
5
The table below summarizes the Company's securitization transactions for the
years 1999 through 2001 (dollars in thousands):
SECURITIZATION TRANSACTIONS
Collateral Principal Mortgage
Month Balance on Transaction Security
Completed Transaction Date Type Created
------------- -------------------- ------------------- -----------------
March 1999 $138,357 CMO Private Placement
August 1999 111,575 CMO Private Placement
June 2000 25,588 CMO Private Placement
Subordinate MBS 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 subordinate MBS acquired 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, 2001, the Company had purchased since inception approximately
$80,746,000 (principal balance) of subordinate MBS from third parties at an
aggregate purchase price of $40,740,000. As of the same date, the Company had
sold approximately $62,812,000 (principal balance) of such securities. At
December 31, 2001, the Company owned $16,686,000 (principal balance) of
subordinate MBS purchased from third parties, representing a subordinate
interest in $3,548,000,000 of single-family mortgage loan pools. The aggregate
carrying value of these MBS at December 31, 2001 was $10,978,000.
Because there are a number of regular issuers of subordinate MBS, the Company is
not dependent upon any one source. Note 5 to the consolidated financial
statements describes the concentration of the Company's
6
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 23
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.
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 loans. The due diligence analyses are performed on a loan-by-loan
basis. Consulting services include loan sale advisory work for governmental
agencies such as the Small Business Administration and the 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, Hanover Capital Mortgage Corporation
("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 conducts any material ongoing business.
7
In January 2000, HCP hired all of the former management of Document Management
Network, Inc. ("DMN") 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 on-line worldwide 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 2001, HTC hired all of the former employees and acquired all of the
assets of Pamex Capital Partners, LLC ("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.
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.
In August 2001, HTC was retained by the Federal Deposit Insurance Corporation
("FDIC") to serve as a financial advisor to Superior Federal Bank FSB,
Hinsdale, Illinois ("New Superior"). New Superior was chartered on July 27,
2001 after the Office of Thrift Supervision closed Superior Bank FSB, and the
FDIC was named the receiver for Superior Bank FSB and conservator for New
Superior. HTC assisted the FDIC in valuing and marketing certain assets of New
Superior that included its loan production and servicing operations, its
portfolio of residual interests in mortgage-backed securities, and a whole loan
pipeline of new production sub-prime non-performing and performing
single-family loans. As the financial advisor, HTC provided advisory assistance
related to the assets, which included validating the assets and estimating their
value; ensuring proper maintenance of the assets; developing a disposition
strategy; and implementing the selected disposition method. The assets were
segmented into the separate units for valuation and marketing purposes and sold
in a series of sales starting in December 2001 and ending in April 2002. HTC's
fee is based on the net sales proceeds paid to the FDIC and is earned upon the
sale of each of the assets. In addition, the FDIC from time to time retains HTC
to perform additional advisory services related to the conservatorship of New
Superior and HTC is paid on an hourly basis for these types of services.
ASSET MANAGEMENT FOR THIRD PARTIES
Hanover formed an investment partnership, HDMF-I, in 2001 to invest in sub- and
non-performing single-family mortgage loans. Hanover's primary objective in
forming HDMF-I is to allow HCP to earn fee income from the related asset
management contract, and to allow Hanover to earn a profit participation. As of
December 31, 2001, HDMF-I had capital commitments of $18,500,000, including
$5,820,000 committed by Hanover. Hanover is currently negotiating with
institutional investors to increase the total capital commitments to HDMF-I, and
Hanover also intends to target other opportunities for HCP to manage assets for
third parties under a similar structure; there can be no assurances that Hanover
will be successful in raising additional funds to manage.
FINANCING
General
8
The Company's purchases of mortgage related assets are initially financed
primarily with equity and short-term borrowings through reverse repurchase
agreements ("repos") until long-term financing is arranged. Generally, upon
repayment of each borrowing in the form of a reverse repo, the mortgage asset
used to collateralize the financing will immediately be pledged to secure a new
reverse repo 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, 2001.
Reverse Repurchase Agreements
A reverse 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 repo, the Company is
required to repay the loan and correspondingly receives back its collateral.
Under reverse repos, 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 securities 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 indexed to LIBOR plus a spread of 90 to 175 basis points
depending on the credit of the related mortgage assets. Generally, the borrowing
agreements require the Company to deposit additional collateral in the event the
market value of existing collateral declines, which, in dramatically rising
interest-rate markets, could require the Company to sell assets to reduce the
borrowings.
CAPITAL ALLOCATION GUIDELINES (CAG)
The Company has adopted capital allocation guidelines ("CAG") 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.).
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
9
in securitizations are calculated internally using market assumptions for
losses, prepayments and discount rates.
The face amount of the financing used for the securities and retained interests
is subtracted from the current market value of the mortgage assets. This is the
current market value of the Company's equity positions. This value is compared
to the required capital as determined by the CAG. If the actual equity of the
Company falls below the capital required by the CAG, the Company must prepare a
plan to bring the actual capital above the level required by the CAG.
Periodically, management presents to the Board of Directors the results of the
CAG compared to actual equity. Management may propose changing the capital
required for a class of investments or for an individual investment based on its
prepayment and credit performance relative to the market and the ability of the
Company to predict or hedge the risk of the 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 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 MBS 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)
maintenance of appropriate capital and reserve levels, and (iv) 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.
Hanover has in the past invested directly in mortgage loans on its own behalf.
Single-family mortgage loans were generally purchased in bulk pools of $2
million to $100 million. The credit underwriting process varied 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 was undertaken, including a review of the documentation, appraisal
reports and credit underwriting. Where required, an updated property valuation
was obtained. The bulk of the work was performed by employees in the due
diligence operations of HCP.
Interest Rate Risk Management
For accounting purposes, the Company has two basic types of mortgage loans and
four basic types of MBS. Mortgage loans are classified as (i) mortgage loans
held for sale or (ii) collateral for CMOs. MBS are classified as (i) available
for sale, (ii) held to maturity, (iii) trading or (iv) collateral for CMOs.
Fixed-rate mortgage loans and MBS held for sale, available for sale or trading
are generally hedged. A variety of hedging instruments may be used, depending on
the asset or liability to be hedged and the
10
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 Hanover's status as a
REIT, among other factors. Hanover 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 "Hedging."
Prepayment Risk Management
Prepayment risk is monitored by senior management 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.
Limitations
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
Hanover must satisfy to qualify as a REIT may limit the Company's ability to
fully hedge its interest rate and prepayment risks.
HEDGING
Mortgage Loans and Mortgage Securities
The Company's primary method of addressing interest rate risk on its mortgage
loans is through its strategy of securitizing mortgage loans with 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 repos.
The Company uses certain hedging strategies in connection with the management of
its mortgage loans and mortgage securities. To the extent consistent with
Hanover's REIT status, the Company follows a hedging program intended to protect
against interest rate changes and to enable the Company to earn net interest
income in periods of generally rising, as well as declining or static, interest
rates. Specifically, the goal of the hedging program is to offset the potential
adverse effects of changes in interest rates relative to the interest rates of
the mortgage assets held. 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
11
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 repo financing. "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 mortgage securities. 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.
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 REIT rules may limit Hanover's ability to fully hedge its
interest rate risks. Hanover monitors carefully, and may have to limit, its
hedging strategies to assure that it does not violate 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 can 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.
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, HCMC's activities are subject to the rules and
regulations of HUD. Mortgage operations also may be subject to applicable state
usury and collection statutes.
HCS and Pamex Securities, LLC are registered broker/dealers with the Securities
and Exchange Commission.
COMPETITION
In purchasing mortgage loans and MBS, Hanover competes with other REITs,
established mortgage conduit programs, investment banking firms, Federally
regulated banks and savings institutions,
12
finance companies, mortgage bankers, insurance companies, other lenders and
other entities purchasing mortgage assets. In addition, there are several
mortgage REITs similar to Hanover 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.
EMPLOYEES
Hanover had five employees at December 31, 2001. 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, 2001, HCP employed 23 people on a full-time
basis. HCP periodically hires additional individuals on a temporary basis for
due diligence and consulting engagements from a pool of approximately 500
individuals. Twenty-five employees devote substantially all their time to HTC.
HCP bills HTC for their share of personnel expenses. To date, the Company
believes it has been successful in its 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 trademarks that have been registered with the United States Patent
and Trademark Office, one which expires in the year 2003 and the other expires
in 2004. HTC owns one registered trademark which expires in 2007, and it has one
trademark pending and it is in the process of registering one trademark with the
United States Patent and Trademark Office. HTC also filed a patent application
in 2001 in connection with its trading web site and approval of the patent is
pending.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established Hanover'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 Hanover's assessment of
the market may cause the Board of Directors to revise Hanover's policies and
financing strategies.
FEDERAL INCOME TAX CONSIDERATIONS
General
Hanover has elected to be treated as a Real Estate Investment Trust (REIT) for
Federal income tax purposes, pursuant to 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
13
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 income tax treatment as a REIT under the Code, Hanover must meet
certain tests which are described briefly below.
Ownership of Common Stock
For all taxable years after its first taxable year, Hanover's shares of capital
stock must be held by a minimum of 100 persons for at least 335 days of a
12-month year (or a proportionate part of a short tax year). In addition, at any
time during the second half of each taxable year, no more than 50% in value of
the capital stock of Hanover may be owned directly or indirectly by five or
fewer individuals. Hanover is required to maintain records regarding the actual
and constructive ownership of its shares, and other information, and to demand
statements from persons owning above a specified level of the 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, other than a
wholly-owned subsidiary or another REIT.
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
the tax rules relating to the composition of a REIT's 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.
14
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.
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.
State Income Taxation
The REIT files corporate income tax returns in various states. These states
treat the income of the REIT in a similar manner as for Federal income tax
purposes. Certain state income tax laws with respect to REITs are not
necessarily the same as Federal law. Thus, differences in state income taxation
as compared to Federal income taxation may exist in the future.
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.
15
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.
16
ITEM 2: PROPERTIES
The Company's 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
----------------------- --------- --------- -------------- --------------------------
Edison, New Jersey 5,200 $ 137,800 April 2005 Executive,
Administration,
Accounting, Operations,
Marketing
Edison, New Jersey 5,834 74,384 June 2002 Accounting,
Administration,
Due Diligence Operations,
Mortgage Loan Servicing,
Investment Operations
New York, New York 1,000 54,000 Month to Month Executive, Administration,
Investment Operations
Ft. Lauderdale, Florida 875 24,579 April 2003 Marketing
Chicago, Illinois 1,151 23,547 January 2004 Marketing
St. Paul, Minnesota 150 11,340 October 2002 Marketing
Alpharetta, Georgia 160 10,200 Month to Month Marketing
------ ---------
Total: 14,370 $ 335,850
====== =========
Management believes that these facilities are adequate for the Company's
foreseeable office space needs and that lease renewals and/or alternate space at
comparable rental rates are 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.
17
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, 2002, Hanover had 4,337,920 shares
of common stock issued and outstanding, which was held by 48 holders of record
and approximately 2,300 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 2000 and 2001.
COMMON STOCK
High Low Close
----- ----- -----
Quarter Ended March 31, 2000 3.875 3.313 3.688
Quarter Ended June 30, 2000 4.500 3.625 4.500
Quarter Ended September 30, 2000 5.438 4.375 5.000
Quarter Ended December 31, 2000 5.563 4.563 5.250
Quarter Ended March 31, 2001 6.411 4.483 5.828
Quarter Ended June 30, 2001 7.324 5.649 6.448
Quarter Ended September 30, 2001 7.112 6.022 6.211
Quarter Ended December 31, 2001 8.000 6.164 8.000
UNIT PRICES
High Low Close
----- ----- -----
Quarter Ended March 31, 2000 3.875 3.125 3.375
Quarter Ended June 30, 2000 4.188 3.250 4.125
Quarter Ended September 30, 2000 4.750 4.000 (a)
WARRANTS
High Low Close
----- ----- -----
Quarter Ended March 31, 2000 0.063 0.004 0.063
Quarter Ended June 30, 2000 0.063 0.004 0.016
Quarter Ended September 30, 2000 0.016 0.016 (a)
(a) The warrants expired on September 15, 2000, and the warrants and units
stopped trading on September 14, 2000.
18
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, 2000 $0.12
Quarter Ended June 30, 2000 $0.14
Quarter Ended September 30, 2000 $0.20
Quarter Ended December 31, 2000 $0.20
Quarter Ended March 31, 2001 $0.20
Quarter Ended June 30, 2001 $0.20
Quarter Ended September 30, 2001 $0.20
Quarter Ended December 31, 2001 $0.20
Hanover intends to pay quarterly dividends and other distributions to its
shareholders of all or substantially all of its taxable income in each year 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 $10,497,000 as of December 31, 2001). These
capital losses expire at the end of the year 2003. 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.
19
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, 2001, 2000,
1999 and 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 Company's 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, 1997
STATEMENT OF OPERATIONS HIGHLIGHTS Years Ended December 31, (inception) to
-------------------------------------------------------- December 31,
2001 2000 1999 1998 1997
----------- ----------- ----------- ----------- --------------
Net interest income $ 6,269 $ 6,663 $ 4,408 $ 6,623 $ 1,676
Loan loss provision (709) (875) (446) (356) (18)
Gain (loss) on sale, mark to market and other 4,505 1,250 (5,831) (5,704) 35
Provision for loss on unconsolidated subsidiary -- -- (4,793) -- --
----------- ----------- ----------- ----------- ------------
Total revenue (loss) 10,065 7,038 (6,662) 563 1,693
Expenses 3,696 3,136 4,191 4,064 940
----------- ----------- ----------- ----------- ------------
Operating income (loss) 6,369 3,902 (10,853) (3,501) 753
----------- ----------- ----------- ----------- ------------
Equity in income (loss) of unconsolidated
subsidiaries
Hanover Capital Partners Ltd. 43 455 (443) (1,039) (254)
Hanover Capital Partners 2, Inc. -- -- (1,300) (394) --
HanoverTrade.com, Inc. (3,263) (1,495) (31) -- --
HDMF-I LLC (35) -- -- -- --
----------- ----------- ----------- ----------- ------------
(3,255) (1,040) (1,774) (1,433) (254)
----------- ----------- ----------- ----------- ------------
Income (loss) before cumulative effect of
adoption of SFAS 133 3,114 2,862 (12,627) (4,934) 499
Cumulative effect of adoption of SFAS 133 46 -- -- -- --
----------- ----------- ----------- ----------- ------------
Net income (loss) $ 3,160 $ 2,862 $ (12,627) $ (4,934) $ 499
=========== =========== =========== =========== ============
Basic earnings (loss) per share $ 0.74 $ 0.56 $ (2.12) $ (0.77) $ 0.15
=========== =========== =========== =========== ============
Diluted earnings (loss) per share $ 0.73 $ 0.56 $ (2.12) $ (0.77) $ 0.14
=========== =========== =========== =========== ============
Dividends declared per share $ 0.80 $ 0.66 $ 0.50 $ 0.70 $ 0.16
=========== =========== =========== =========== ============
BALANCE SHEET HIGHLIGHTS December 31,
------------------------------------------------------------------------
2001 2000 1999 1998 1997
----------- ----------- ----------- ----------- ------------
Mortgage loans $ 154,273 $ 212,247 $ 270,084 $ 407,994 $ 160,970
Mortgage securities 51,183 35,723 62,686 78,478 348,131
Cash and cash equivalents 8,946 9,958 18,022 11,837 4,022
Other assets 15,105 14,681 14,842 17,861 4,420
----------- ----------- ----------- ----------- ------------
Total assets $ 229,507 $ 272,609 $ 365,634 $ 516,170 $ 517,543
=========== =========== =========== =========== ============
Reverse repos 33,338 14,760 55,722 370,090 435,138
CMO Borrowings 151,096 210,374 254,963 77,305 --
Other liabilities 3,532 3,451 4,443 2,995 4,307
----------- ----------- ----------- ----------- ------------
Total liabilities 187,966 228,585 315,128 450,390 439,445
Stockholders' equity 41,541 44,024 50,506 65,780 78,098
----------- ----------- ----------- ----------- ------------
Total liabilities and stockholders' equity $ 229,507 $ 272,609 $ 365,634 $ 516,170 $ 517,543
=========== =========== =========== =========== ============
Number of common shares outstanding 4,275,676 4,322,944 5,826,899 6,321,899 6,466,677
=========== =========== =========== =========== ============
Book value per common share $ 9.72 $ 10.18 $ 8.64 $ 10.41 $ 12.08
=========== =========== =========== =========== ============
20
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 ("MBS") and to a lesser extent mortgage
loans and to earn net interest income on these investments. Hanover 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 on-line worldwide 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 taxable
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.
IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
The following section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and other sections of this Annual Report
on Form 10-K 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 repo 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 10-K 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 MBS; 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.
CRITICAL ACCOUNTING POLICIES
The significant accounting policies used in preparation of our financial
statements are more fully described in Note 2 to the consolidated financial
statements of the Company, HCP and HTC, respectively. Certain critical
accounting policies are complex and involve significant judgment by our
management, including the use of estimates and assumptions that affect the
reported amounts of assets, liabilities, revenues and expenses. As a result,
changes in these estimates and assumptions could significantly affect our
financial position or our results of operations. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities. Actual
results may differ from these estimates under different assumptions or
conditions. We believe that of our significant accounting policies, the
following involve a high degree of judgment and complexity in the preparation of
our consolidated financial statements:
MORTGAGE SECURITIES -- The Company's mortgage securities are designated as
either available for sale, trading or held to maturity. 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 amortized cost unless a decline in value is
deemed other than temporary, in which case the carrying value is reduced.
21
Complex cash flow modeling is performed in determining the fair value of the
Company's mortgage securities. Several of the assumptions used by management are
confirmed by independent third parties on at least a quarterly basis. Prices for
such securities are not readily available on a quoted market exchange. In
performing cash flow analysis, future cash flows are based on estimates of
prepayments, the impact of interest rate movements on yields, delinquency of the
underlying loans and estimated probable losses based on historical experience
and estimates of expected future performance. A high degree of judgement is
required in estimating the assumptions utilized in the cash flow analysis.
Should the estimates used by management be inaccurate, the Company's net
interest income could be materially affected.
LOAN LOSS ALLOWANCE -- Hanover maintains a loan loss allowance for its
subordinate MBS and collateral for CMOs. The Company monitors the delinquencies
and defaults on the underlying mortgages and, if an impairment of the related
mortgage security is deemed to be other than temporary, reduces the carrying
value of the related mortgage security to fair value. The Company's loan loss
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. Loan loss provision
estimates are reviewed periodically and adjustments are reported in earnings
when they become known. Should the estimates used by management be inaccurate,
the Company's loan loss provision could be materially affected.
EQUITY INVESTMENTS -- The Company records its investments in HCP, HTC, HDMF-I
and Hanover Capital Partners 2, Inc. ("HCP-2") on the equity method.
Accordingly, Hanover records 97% of the earnings or losses of HCP and HTC,
31.45946% of HDMF-I 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 and through its share of members' equity of HDMF-I. After
writing off its investment in HCP-2 in September 1999, Hanover stopped
recording earnings or losses of HCP-2.
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. This presentation, while
required under accounting principles generally accepted in the United States of
America, does not present the assets and liabilities of HCP, HTC, HDMF-I and
HCP-2 on the balance sheet of the Company. In addition, the residual equity that
the Company does not own of 3% of HCP and HTC, 68.54054% of HDMF-I and 1% of
HCP-2 remains "off balance sheet". The consolidated financial statements for the
year ended December 31, 2001 for HCP and HTC are presented in another section of
this Annual Report on Form 10-K.
The Company conducts business with each of its unconsolidated subsidiaries. The
related party transactions are disclosed in the notes to the consolidated
financial statements of the Company, HCP and HTC.
The Company has provided on-going capital to HCP primarily for working capital
requirements due to the mismatch in timing between capital outflows and inflows
for work performed by HCP. The Company has provided HTC with on-going capital
support primarily to fund the capitalized software budget, working capital
requirements and the acquisition of Pamex. While the Company continues to pursue
an alternative corporate structure for HCP and HTC, there can be no assurances
as to when or whether the Company will be able to accomplish a restructuring of
its corporate organization that achieves its objectives. Until a restructuring
can be accomplished, Hanover will continue to record 97% of the earnings or
losses of HCP and HTC.
HCP recognizes revenue from due diligence contracts in progress as they are
earned. In order to calculate what percentage of the total revenue of a contract
has been earned, management must make estimates. Estimates, by their nature, are
based on judgment and available information. Actual results could differ from
estimates. As the majority of HCP's revenue relates to services performed, such
estimates may include the amount of time spent by individuals in consideration
of the aggregate amount of time required to complete the contract, the
evaluation of both quantitative and qualitative criteria as agreed to and
maintained in the contract and possibly regulations set forth by the government
should the contract be with an agency of the Federal government. The Company
utilizes guidance set forth in the Securities and Exchange Commission's Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB
101"). SAB 101 draws on existing accounting rules with respect to the basic
criteria that must be met before revenue can be recorded. SAB 101 further
explains how those rules apply. HCP has reviewed the guidance in SAB 101 and
believes that they are in compliance with SAB 101. However, if management's
estimates are incorrect, or if they are not applying SAB 101 as intended, the
results of operations of HCP and subsequently Hanover's investment in HCP could
be materially affected.
HTC incurs internal and external application development stage costs to develop
its on-line worldwide web-based exchange for trading loan pools. Capitalized
software costs are stated at cost less accumulated amortization and are
evaluated for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. Amortization is computed on the
straight-line method over the estimated useful lives of the assets, generally
three years. HTC periodically reassesses the estimated useful lives of the
assets considering the effects of obsolescence, technology, competition, and
other economic factors. Judgment is required in the determination of the costs
appropriate for capitalization and in the determination of the appropriateness
of the period over which such costs are amortized. However, if management's
judgment is inaccurate in determining what costs are appropriate for
capitalization or what period is appropriate for amortization, the results of
operations of HTC and subsequently Hanover's investment in HTC could be
materially affected.
22
INCOME TAXES -- Hanover has elected to be taxed as a REIT and intends to comply
with the provisions of the Code. 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. 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.
RESULTS OF OPERATIONS
(dollars in thousands, except per share data)
Years Ended December 31,
--------------------------------
2001 2000 1999
-------- -------- --------
Net interest income $ 6,269 $ 6,663 $ 4,408
Loan loss provision (709) (875) (446)
Gain on sale of mortgage assets 3,782 819 146
Gain (loss) on mark to market of mortgage assets,
net of associated hedge 751 431 (6,517)
Gain on sale of servicing rights -- -- 540
Provision for loss on disposition of
unconsolidated subsidiary -- -- (4,793)
Other (28) -- --
-------- -------- --------
Total revenue (loss) 10,065 7,038 (6,662)
Expenses 3,696 3,136 4,191
-------- -------- --------
Operating income (loss) 6,369 3,902 (10,853)
Equity in income (loss) of unconsolidated subsidiaries
Hanover Capital Partners Ltd. 43 455 (443)
Hanover Capital Partners 2, Inc. -- -- (1,300)
Hanover Trade.com, Inc. (3,263) (1,495) (31)
HDMF-I LLC (35) -- --
-------- -------- --------
Income (loss) before cumulative effect of
adoption of SFAS 133 3,114 2,862 (12,627)
Cumulative effect of adoption of SFAS 133 46 -- --
-------- -------- --------
Net income (loss) $ 3,160 $ 2,862 $(12,627)
======== ======== ========
Basic earnings per share $ 0.74 $ 0.56 $ (2.12)
======== ======== ========
Dividends declared per share $ 0.80 $ 0.66 $ 0.50
======== ======== ========
23
YEARS ENDED DECEMBER 31, 2001 AND 2000
Hanover recorded net income of $3,160,000 or $0.74 per share based on 4,256,874
weighted shares of common stock outstanding for the year ended December 31, 2001
compared to net income of $2,862,000 or $0.56 per share based on 5,102,563
weighted shares of common stock outstanding for 2000. Total revenues for the
year ended December 31, 2001 were $10,065,000 compared to $7,038,000 in 2000.
Net interest income decreased to $6,269,000 in 2001 compared to $6,663,000 in
2000. The decrease in net interest income of $394,000 is primarily a result of
(i) an increase in amortization expense for whole loans as a result of increases
in assumed prepayment speeds and (ii) a reduction in the principal balance of
Hanover-sponsored securitizations of whole loans partially offset by a
corresponding reduction in the principal balance of CMO borrowings against such
whole loans.
Hanover's provision for loan losses decreased to $709,000 in 2001 from $875,000
in 2000, primarily as a result of sales of first-loss subordinate MBS and a
reduction in the average balance of collateral for CMOs. Provision for losses on
Hanover-sponsored securitizations decreased to $246,000 for the year ended
December 31, 2001 from $319,000 for the year ended December 31, 2000. Provision
for loan losses on subordinate securities purchased from third parties decreased
to $463,000 for the year ended December 31, 2001 from $555,000 for the year
ended December 31, 2000. The average balance of subordinate securities purchased
from third parties in 2001 was $12,664,000 compared to $11,973,000 in 2000.
Hanover sold thirty-nine subordinate MBS with proceeds of $21,259,000 and a gain
of $3,782,000 and various Agency MBS with proceeds of $109,270,000 and a
gain of $716,000 during 2001. Hanover sold nine subordinate MBS with proceeds of
$5,882,000 and a gain of $1,248,000 and various Agency MBS with proceeds of
$39,881,000 and a loss of $429,000 during 2000.
Hanover held subordinate MBS from Hanover 1998-B 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 2000-A 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 $279,000 and
$84,000 in 2001 and 2000, respectively.
Operating expenses for the year ended December 31, 2001 were $3,696,000 compared
to $3,136,000 in 2000, an increase of $560,000. Personnel expenses decreased to
$664,000 in 2001 from $1,017,000 in 2000. Hanover billed personnel-related
expenses totaling $345,000 to HTC and $425,000 to HCP in 2001 compared to
$369,000 and $136,000, respectively, in 2000. Legal and professional fees
increased to $1,247,000 in 2001 from $555,000 in 2000 as a result of an
increase in audit, tax and consulting fees due to an increased scope of
services and, to a lesser extent, professional fees incurred as a result of our
pursuit of a corporate restructure. Financing fees declined to $246,000 in 2001
from $281,000 in 2000 reflecting reduced committed lines of credit and lower
levels of activity.
Hanover's equity in income of HCP, its unconsolidated consulting subsidiary,
declined to $43,000 in 2001 from $455,000 in 2000. Total revenue at HCP
decreased $2,132,000 or 24% to $6,582,000 in 2001 from $8,714,000 in 2000. Due
diligence fees decreased $1,213,000 or 17% to $5,803,000 in 2001 from $7,016,000
in 2000. Assignment fees increased $126,000 or 20% to $757,000 in 2001 from
$631,000 in
24
2000, the first year of activity in this area. The portfolio of subordinate MBS
contributed $954,000 of net interest income including gains on sales of $441,000
in 2000. This portfolio was transferred from HCP to Hanover in July of 2000.
Loan brokering and asset management fees contributed $30,000 in 2000. This
activity was transferred to HTC in July of 2000.
Hanover recognized equity in losses of HTC, its worldwide web-based exchange for
loan pool trading and loan sale advisory services, of $3,263,000 for 2001
compared to $1,495,000 for 2000. 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 $3,599,000 and
$141,000 for the years ended December 31, 2001 and 2000, respectively. HTC
operating expenses for the years ended December 31, 2001 and 2000 totaled
$6,962,000 and $1,683,000, respectively. Personnel expenses increased to
$3,617,000 in 2001 from $790,000 in 2000. Technology expense for web hosting and
web graphics increased to $664,000 in 2001 from $231,000 in 2000. Premises
expense increased to $326,000 in 2001 from $130,000 in 2000. Depreciation and
amortization increased to $1,102,000 in 2001 from $151,000 in 2000.
In November 2001, Hanover invested $115,000 in HDMF-I and recognized equity in
losses of $35,000 in 2001. HDMF-I is a limited liability company with an
objective to purchase, service, manage and ultimately re-sell or otherwise
liquidate pools of primarily sub- and non-performing one-to-four family
residential mortgage loans. At December 31, 2001, the Company had an outstanding
capital contribution commitment of $5,820,000.
YEARS ENDED DECEMBER 31, 2000 AND 1999
Hanover 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
(i) provision for loss on the disposition of an unconsolidated subsidiary,
Hanover Capital Partners 2, Inc. ("HCP-2") of $4,793,000; (ii) mark-to-market
adjustments on mortgage securities acquired from the Hanover 1998-B
securitization of $3,537,000; (iii) mark-to-market adjustments on mortgage loans
securitized in the August 1999 Hanover 1999-B securitization of $2,997,000 and
(iv) 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. Interest income in 2000 was
positively impacted by $306,000 of net revenue from subordinate MBS transferred
from HCP to Hanover on July 1, 2000 and the repositioning of Hanover's
Investment Portfolio during 2000 towards more high yielding subordinate MBS
purchased from third parties. At December 31, 1999, Hanover's direct investment
in such securities totaled $3,640,000 as compared to $19,518,000 at December 31,
2000. At December 31, 1999, Hanover'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 Hanover on
July 1, 2000. Interest income in 2000 was negatively impacted by 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.
25
Hanover's provision for loan losses increased from $447,000 in 1999 to $875,000
in 2000, primarily as a result of Hanover's increased investment in subordinate
MBS. 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.
Hanover sold nine subordinate MBS with proceeds of $5,882,000 and a gain of
$1,248,000 and thirty-two Agency MBS with proceeds of $39,881,000 and a loss of
$429,000 during 2000. Hanover sold six subordinate MBS created in the Hanover
1998-B securitization for proceeds of $2,232,000 and a gain of $146,000 during
1999.
Hanover held subordinate MBS from Hanover 1998-B 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 2000-A 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.
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. Management and administrative
expenses included office overhead in 1999 but do not in 2000, resulting in a
decrease of $135,000. Occupancy expenses are paid directly in 2000 and recorded
in the other expense category causing an increase of $175,000 from the prior
year. There were no similar billings in 1999. Hanover also billed
personnel-related expenses totaling $369,000 to HTC and $136,000 to HCP during
2000. These billings reduce personnel-related expenses of Hanover 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.
Hanover's equity in income (losses) of HCP, its unconsolidated consulting
subsidiary, improved from a loss of $443,000 in 1999 to income of $455,000 in
2000. Total revenue at HCP increased $1,644,000 or 23% to $8,714,000 in 2000
from $7,070,000 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 MBS 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 Hanover 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, Hanover reflected equity in losses of HCP-2 of $1,300,000. As noted
above, Hanover 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. During 2001, Hanover determined that it would not sell
HCP-2. Hanover is considering engaging in activity unrelated to the REMIC
activity for which this subsidiary was originally organized. We cannot assure
you that we will be able to engage in activity in HCP-2.
26
HCP-2 is an unconsolidated mortgage finance subsidiary that was organized in
October 1998 to execute a REMIC financing securitization for Hanover. 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 Hanover 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, Hanover believes it will
not record future losses from HCP-2.
Hanover recognized equity in losses of HTC, its worldwide web-based exchange for
loan pool trading and loan sale advisory services, 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.
The table below highlights Hanover's historical quarterly trends and components
of return on average equity for 1999, 2000 and 2001.
Net Equity in
Interest Gain on Income
Income Sale of Other Gains Operating (Loss) of Annualized
For the (Loss)/ Assets/ (Losses)/ Expenses/ Subsidiaries/ Return on
Quarters Ended Equity Equity Equity Equity Equity Equity
- ------------------ -------- ------- ----------- --------- ------------- ----------
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% 0.71% 5.45%
June 30, 2000 10.99% 2.62% 0.00% 7.95% 0.43% 6.09%
September 30, 2000 13.40% 0.00% 1.16% 4.31% (4.01%) 6.24%
December 31, 2000 12.43% 6.61% 0.00% 6.24% (6.41%) 6.39%
March 31, 2001 10.10% 8.51% 0.43% 6.54% (6.27%) 6.23%
June 30, 2001 14.05% 8.43% 0.00% 7.46% (8.37%) 6.65%
September 30, 2001 13.97% 11.05% 0.00% 10.85% (7.24%) 6.93%
December 31, 2001 14.66% 15.04% (0.27%) 10.25% (9.01%) 10.18%
Note: Average equity excludes unrealized loss on investments available for sale.
27
The following table reflects the average balances for each major category of
Hanover's interest earning assets as well as Hanover's interest bearing
liabilities with the corresponding effective rate of interest annualized as
follows (dollars in thousands):
INTEREST EARNING ASSETS AND RELATED LIABILITIES
Years Ended December 31,
-----------------------------------------------------------------------
2001 2000 1999
-------------------- -------------------- -------------------
Average Effective Average Effective Average Effective
Balance Rate (1) Balance Rate (1) Balance Rate (1)
-------- --------- -------- --------- ------- ---------
Interest earning assets:
Mortgage loans $ 231 8.10% $ 300 87.79% $102,890 6.55%
CMO collateral 193,840 7.41% 247,850 7.46% 217,804 6.92%
Agency MBS 15,401 7.98% 41,072 7.28% 52,017 6.85%
Private placement notes 14,676 17.11% 20,266 16.84% 17,660 4.21%
-------- ----- -------- ----- -------- ----
224,148 8.08% 309,488 8.13% 390,371 6.69%
-------- -------- --------
Interest bearing liabilities:
Reverse repurchase borrowings
on mortgage loans -- -- -- -- 93,998 6.36%
CMO borrowings 181,669 6.72% 233,843 7.49% 196,175 7.01%
Reverse repurchase borrowings on:
CMO collateral 2,536 7.16% 3,515 7.45% 9,610 4.21%
Agency MBS 9,732 6.40% 29,020 5.71% 48,850 5.50%
Private placement notes 6,085 6.86% 7,544 7.81% 4,680 5.96%
-------- ----- -------- ----- -------- ----
200,022 6.71% 273,922 7.31% 353,313 6.54%
-------- -------- --------
Net interest earning assets $ 24,126 $ 35,566 $ 37,058
======== ======== ========
Net interest spread 1.37% 0.82% 0.15%
===== ===== ====
Yield on net interest earnings assets (2) 19.45% 14.43% 8.15%
===== ===== ====
(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.
The following table provides details of net interest income and loan loss
provision for interest earning assets as follows (dollars in thousands):
NET INTEREST INCOME
Years Ended December 31,
--------------------------------------------------------------------
2001 2000 1999
-------------------- -------------------- --------------------
Net Loan Net Loan Net Loan
Interest Loss Interest Loss Interest Loss
Income Provision Income Provision Income Provision
-------- --------- -------- --------- -------- ---------
Mortgage loans $ 19 $ -- $ 264 $ -- $ 829 $ (76)
CMO collateral 2,219 (246) 963 (249) 1,078 (152)
Agency MBS 606 -- 1,330 -- 876 --
Private placement MBS 2,556 (463) 3,450 (626) 682 (218)
Other 869 -- 656 -- 943 --
-------- --------- -------- --------- -------- ---------
Total net interest income $ 6,269 $ (709) $ 6,663 $ (875) $ 4,408 $ (446)
======== ========= ======== ========= ======== =========
28
CMO Collateral
Net interest income generated from the CMO collateral (including mortgage loans
and MBS pledged to CMOs) is as follows (dollars in thousands):
Years Ended December 31,
-------------------------------------
2001 2000 1999
--------- --------- ---------
Average asset balance $ 193,840 $ 247,850 $ 217,804
Average CMO borrowing balance 181,669 233,843 196,175
Average reverse repo borrowing balance 2,536 3,515 9,610
--------- --------- ---------
Net interest earning assets 9,635 10,492 12,019
Average leverage ratio 95.03% 95.77% 94.48%
Effective interest income rate 7.54% 7.56% 6.99%
Effective interest expense rate 6.72% 7.49% 7.01%
Effective interest expense rate - Repo 7.16% 7.45% 4.21%
--------- --------- ---------
Net interest spread 0.81% 0.07% 0.12%
Interest income $ 14,612 $ 18,745 $ 15,227
Interest expense 12,211 17,521 13,745
Interest expense - Repo 182 262 405
--------- --------- ---------
Net interest income before loan loss provision 2,219 963 1,078
Loan loss provision (246) (249) (152)
--------- --------- ---------
Net interest income after loan loss provision $ 1,973 $ 714 $ 926
========= ========= =========
Yield on net interest earning assets after loan
loss provision 20.48% 6.80% 7.70%
========= ========= =========
In 2000, Hanover 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
29
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 MBS from Hanover 98-B.
In 1999, Hanover 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, Hanover 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 Hanover. The interest expense on this financing represents the coupon
interest amount to be paid to those note holders.
Hanover's net equity in these transactions was leveraged through reverse repo
financing. At December 31, 2001, Hanover had $1,910,000 of reverse repo
financing against its net equity in these transactions.
Interest expense includes the interest on CMO borrowings, interest on the
related reverse repos and amortization of certain deferred financing costs and
interest rate caps.
Agency Mortgage Securities
Net interest income generated from investments in Agency mortgage securities is
as follows (dollars in thousands):
Years Ended December 31,
-------------------------------
2001 2000 1999
------- ------- -------
Average asset balance $15,401 $41,072 $52,017
Average reverse repo borrowing balance 9,732 29,020 48,850
------- ------- -------
Net interest earning assets 5,669 12,052 3,167
Average leverage ratio 63.19% 70.66% 93.91%
Effective interest income rate 7.98% 7.28% 6.85%
Effective interest expense rate 6.40% 5.71% 5.50%
------- ------- -------
Net interest spread 1.58% 1.57% 1.35%
Interest income $ 1,229 $ 2,989 $ 3,564
Interest expense 623 1,659 2,688
------- ------- -------
Net interest income before loan loss provision 606 1,330 876
Loan loss provision -- -- --
------- ------- -------
Net interest income after loan loss provision $ 606 $ 1,330 $ 876
======= ======= =======
Yield on net interest earning assets after loan
loss provision 10.70% 11.04% 27.65%
======= ======= =======
In 2001, the Company purchased $125.8 million of Agency securities and sold
$98.3 million.
In November 2000, Hanover purchased $1.9 million of GNMA securities. In December
2000, Hanover sold thirty-one FNMA Certificates, totaling $36.9 million of
principal.
Interest expense includes the interest on the related reverse repos and
amortization of deferred financing costs and interest rate caps.
30
Private Placement MBS
Net interest income generated from private placement MBS excluding securities
pledged as collateral for CMOs is as follows (dollars in thousands):
Years Ended December 31,
----------------------------------
2001 2000 1999
-------- -------- --------
Average asset balance $ 14,676 $ 20,266 $ 17,660
Average reverse repo borrowing balance 6,085 7,544 4,680
-------- -------- --------
Net interest earning assets 8,591 12,722 12,980
Average leverage ratio 41.46% 37.23% 26.50%
Effective interest income rate 20.26% 19.93% 5.44%
Effective interest expense rate 6.86% 7.81% 5.96%
-------- -------- --------
Net interest spread 13.40% 12.12% (0.52%)
Interest income $ 2,974 $ 4,039 $ 961
Interest expense 418 589 279
-------- -------- --------
Net interest income before loan loss provision 2,556 3,450 682
Loan loss provision (463) (626) (218)
-------- -------- --------
Net interest income after loan loss provision $ 2,093 $ 2,824 $ 464
======== ======== ========
Yield on net interest earning assets after loan
loss provision 24.37% 22.19% 3.58%
======== ======== ========
The Private Placement MBS category includes (i) interest-only notes, and
principal-only notes that Hanover created in its second securitization, 1998-B,
and (ii) starting in June 1999, subordinate MBS that Hanover purchased in the
open market.
Hanover's investment in 1998-B private placement MBS at December 31, 2001
includes an $11,141,000 investment in six investment-grade notes ("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.
Hanover's investment in private placement MBS at December 31, 2001 includes an
investment of $0.5 million carrying value in 1998-B interest-only notes, an
investment of $0.8 million carrying value in 1998-B principal-only notes and an
investment of $11.0 million carrying value in below-investment- grade
subordinate MBS classified as held to maturity, available for sale or trading.
During 2001, Hanover purchased $16.4 million of below-investment-grade MBS from
third parties and sold $34.6 million of below-investment-grade MBS to third
parties.
During 2000, Hanover 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 Hanover's 1998-B CMO to Collateral for the 2000-A CMO.
During 1999, Hanover purchased twelve below-investment-grade subordinate MBS
from third parties.
31
Other interest income
Interest income from non-mortgage assets is as follows (dollars in thousands):
Years Ended December 31,
------------------------
2001 2000 1999
---- ---- ----
Overnight investing $257 $124 $598
Related party notes 612 532 345
---- ---- ----
$869 $656 $943
==== ==== ====
TAXABLE INCOME
Hanover's taxable income for the year ended December 31, 2001 is estimated at
$1,779,000. Taxable income differs from GAAP net income for the year ended
December 31, 2001 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, 2001 (dollars in
thousands):
GAAP net income $ 3,160
GAAP gain on sale (4,003)
Tax gain on sale 3,541
Utilization of capital loss carryforward (3,541)
Equity in net loss of unconsolidated subsidiaries 3,255
Gain on mark-to-market of mortgage securities, net of
associated hedge (558)
Loan loss provision, net of realized losses 470
Tax amortization of net premiums on mortgages, CMO
collateral and mortgage securities and interest
accrual in excess of GAAP amortization and interest
accrual (306)
Deduction for tax for exercise of non-qualified stock
options (170)
Other (69)
-------
Estimated taxable income $ 1,779
=======
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. For the year ended December 31, 2001, a portion of
dividends paid to shareholders was deemed to be a return of capital for income
tax purposes.
LIQUIDITY
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 repos 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 has exposure to market-driven liquidity events due to the short-term
reverse repo financing it has in place against its MBS. If a significant decline
in the market value of the
32
Company's MBS 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, Hanover may be forced to
sell certain investments 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 one committed reverse repo line of credit in place at December
31, 2001 and five uncommitted lines of credit. At December 31, 2001, the Company
had available capacity to borrow $10 million under the committed line.
Management may add additional committed and uncommitted lines of credit in the
future.
Net cash used in operating activities for the year ended December 31, 2001 was
$29,644,000 compared to net income of $3,160,000 for the year. Significant
non-cash charges and expenses included $3,255,000 of equity in net loss of
unconsolidated subsidiaries and loan loss provision of $709,000, offset by gain
on sale of mortgage assets of $3,782,000 and gain on mark to market of mortgage
securities of $1,058,000. Purchase of trading securities used $142,540,000,
partially offset by sales of trading securities of $113,945,000.
Net cash provided by investing activities amounted to $74,137,000 during the
year ended December 31, 2001. The majority of cash proceeds from investing
activities was generated from (i) principal payments received on collateral for
CMOs of $59,701,000, (ii) proceeds from the sale of mortgage assets of
$16,076,000 and (iii) principal payments received on mortgage securities of
$5,067,000. These were partially offset by cash payments to purchase mortgage
securities from third parties of $4,431,000.
Cash flows from financing activities used $45,505,000 during the year ended
December 31, 2001. The Company made repayments on CMO borrowings of $59,207,000,
partially offset by net borrowings from its reverse repo lenders of $18,578,000.
Hanover also paid dividends of $3,411,000 and purchased an additional 246,900
shares of its common stock for $1,736,000 during the year.
CAPITAL RESOURCES
The Company regularly invests its capital in MBS 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, 2001, Hanover
advanced $7,654,000 in the form of loans, and $79,000 in the form of
inter-company advances, to HTC. The Company believes that HTC will not need
substantial capital investments to fund operating activities in 2002. The
Company continues to pursue an alternative structure whereby Hanover would no
longer hold an interest in HTC and would not be responsible for its capital or
operating needs. In addition, the Company is currently attempting to raise
outside capital to address HTC's capitalized software budget and operating
needs. There can be no assurance that the Company will not be required to
provide additional funding to HTC if these efforts prove unsuccessful.
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
33
tax rules as of December 31, 2001 and intends to remain in compliance with all
REIT tax rules. If Hanover fails to qualify as a REIT in any taxable year and
certain relief provisions of the Code do not apply, Hanover will be subject to
Federal income tax as a regular, domestic corporation, and its stockholders will
be subject to tax in the same manner as stockholders of a regular corporation.
Distributions to its stockholders in any year in which Hanover fails to qualify
as a REIT would not be deductible by Hanover in computing its taxable income. As
a result, Hanover could be subject to income tax liability, thereby
significantly reducing or eliminating the amount of cash available for
distribution to its stockholders. Further, Hanover could also be disqualified
from re-electing REIT status for the four taxable years following the year
during which it became disqualified.
Investments in Certain Mortgage Assets
The Company takes certain risks in investing in 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, 2001, 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.
34
The rate of prepayment on the Company's mortgage loans may increase if interest
rates decline or if the difference between long-term and short-term interest
rates diminishes. Increased prepayments would cause the Company to amortize any
premiums paid on the acquisition of its mortgage loans faster than currently
anticipated, resulting in a reduced yield on its mortgage loans. Additionally,
to the extent proceeds of prepayments cannot be reinvested at a rate of interest
at least equal to the rate previously earned on the prepaid mortgage loans, the
Company's earnings may be adversely affected.
Insufficient Demand for Mortgage Loans and the Company's Loan Products
The availability of mortgage loans that meet the Company's criteria depends on,
among other things, the size of and level of activity in the residential,
multifamily and commercial real estate lending markets. The size and level of
activity in these markets, in turn, depends on the level of interest rates,
regional and national economic conditions, inflation and deflation in property
values and the general regulatory and tax environment as it relates to mortgage
lending. If the Company cannot obtain sufficient mortgage loans or mortgage
securities that meet its criteria, its business will be adversely affected.
Investment in Subsidiary
As of December 31, 2001, Hanover advanced $7,654,000 to HTC in the form of
loans. The Company anticipates that HTC will not need substantial capital
investments to fund operating activities in 2002. In addition, the Company
continues to pursue an alternative structure whereby Hanover would no longer
hold an interest in HTC and would not be responsible for its capital needs. In
addition, the Company is currently attempting to raise outside capital to
address HTC's capitalized software budget and operating needs. HTC has a limited
operating history and has not been profitable to date.
Restructure
Our ability to implement a restructuring of our corporate organization to
separate the investment activities of Hanover from the operating results of
HanoverTrade.com, Inc. and Hanover Capital Partners Ltd. cannot be assured. We
continue to investigate the tax, accounting and legal ramifications of the plan
and consider various alternatives. It is possible that the final structure
could change. In addition, we cannot assure you when or whether we will be able
to accomplish a restructuring of our corporate organization that achieves our
objectives. Until a restructuring can be accomplished, Hanover will continue to
record 97% of the earnings or losses of HTC and HCP.
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, to qualify for this exemption, the Company must maintain at
least 55% of its assets directly in Qualifying Interests. As of December 31,
2001, the Company believes that it is in compliance with this requirement.
State and Local Taxes
Hanover's shareholders may be subject to state or local taxation in various
jurisdictions, including those in which Hanover transacts business or where the
shareholders reside. The state and local tax treatment of Hanover's 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.
35
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
During 2001, the Company used certain derivative financial instruments as hedges
of anticipated transactions relating to its mortgage securities.
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, 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. As such hedges are considered freestanding
derivatives for accounting purposes, the Company recognizes changes in the fair
value of such hedges in earnings in the period of change.
At December 31, 2001, the Company had forward commitments to sell $7.2 million
(par value) and to buy $0.7 million (par value) of Agency mortgage securities
that had not yet settled. The net forward commitments of $6.5 million were
entered into to partially hedge the expected sale of approximately $10.1 million
principal balance of subordinate MBS classified as trading.
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 repo financing and
floating rate CMOs. For interest rate caps designated as cash flow hedges for
accounting purposes, the effective portion of the gain or loss due to changes
in fair value is reported in other comprehensive income, and the ineffective
portion is reported in earnings in the period of change. For interest rate caps
designated as freestanding derivatives for accounting purposes, changes in fair
value are recognized in earnings in the period of change.
At December 31, 2001, the Company had the following interest rate caps in effect
(dollars in thousands):
Notional Accounting
Amount Index Strike % Maturity Date Designation
-------- ------------- -------- ------------- -----------------------
$ 11,000 3 Month LIBOR 7.695% October 2003 Freestanding Derivative
30,000 1 Month LIBOR 7.25% August 2002 Cash Flow Hedge
20,000 1 Month LIBOR 7.75% August 2004 Cash Flow Hedge
--------
$ 61,000
========
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.
36
INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repo Financing
At December 31, 2001, the Company owned $2,391,000 of mortgage loans held for
sale of which $2,172,000 is expected to be sold to HDMF-I. Hanover expects to
transfer these loans to HDMF-I with no resulting gain or loss to Hanover. In
general, Hanover expects that future loan purchases will be conducted by HDMF-I,
and Hanover does not currently plan to purchase additional loans for its own
account. If the Company resumes its strategy of purchasing mortgage loans for
its own account, 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 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
reverse repo financing and the yield on the mortgage loans. The Company's
reverse repo financing at December 31, 2001 was indexed to LIBOR plus a spread
of 90 to 175 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 repo financing for certain fixed-rate
MBS. At December 31, 2001, the Company had a total of $31,428,000 of
floating-rate reverse repo financing compared to $51,183,000 of fixed-rate MBS
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, 2001, 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 and losses 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 decelerated amortization of premiums or
accelerated amortization of discounts) impact net interest income.
37
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 matched funding of assets and liabilities, the CMO
collateral relating to the 1998-A, 1999-A, 1999-B and 2000-A securitizations
reflect $106,738,000 of fixed-rate mortgage loans and $45,144,000 of
adjustable-rate mortgage loans and $9,840,000 of mortgage securities at December
31, 2001. The primary financing for this asset category is the CMO debt of
$151,096,000 and, to a much lesser extent, reverse repos of $1,910,000. The
reverse repo financing, which is indexed to LIBOR, is subject to interest rate
volatility as the reverse repo 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 $50 million at December 31, 2001.
Mortgage Securities
At December 31, 2001, 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
$41,343,000. 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.
38
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.
39
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 2001.
40
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 April 1, 2002.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By /s/ J. Holly Loux
----------------------------------------
J. Holly Loux
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 April 1, 2002.
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
- --------------------------
Thomas P. Kaplan
/s/ J. Holly Loux Chief Financial Officer
- --------------------------
J. Holly Loux
41
EXHIBIT INDEX
3.1(1) Articles of Incorporation of Hanover, as amended
3.2(1) By-Laws of Hanover
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 the 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 Hanover and John A.
Burchett
10.8.1*(1) First Amendment to Employment Agreement by and between Hanover
and John A. Burchett
10.9*(1) Employment Agreement by and between Hanover and Irma N.
Tavares
10.9.1*(1) First Amendment to Employment Agreement by and between Hanover
and Irma N. Tavares
10.10*(1) Employment Agreement by and between Hanover and Joyce S.
Mizerak
10.10.1*(1) First Amendment to Employment Agreement by and between Hanover
and Joyce S. Mizerak
10.11*(1) Employment Agreement by and between Hanover and George J.
Ostendorf
42
10.11.1*(1) First Amendment to Employment Agreement by and between Hanover
and George J. Ostendorf
10.11.2* Employment Agreement by and between Hanover 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
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 Hanover 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 Hanover, as amended
by the First Amendment and Second Amendment thereto
10.32.1(4) Third Amendment to Warehousing Credit and Security Agreement
dated as of April 30, 1999 by and between Bank United and
Hanover
10.32.2(6) Fourth Amendment to Warehousing Credit and Security Agreement
dated as of May 31, 2000 by and between Bank United and
Hanover
10.33(5) Stockholder Protection Rights Agreement
10.34(7) 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 Hanover
23 Independent Auditors' Consent
43
(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.
(7) Incorporated herein by reference to the Company's form 10-K for the year
ended December 31, 2000, as filed with the Securities and Exchanges
Commission.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to Item 601 of Regulation S-K.
44
Consolidated Subsidiaries of Hanover Capital Mortgage Holdings, Inc.
Subsidiary Jurisdiction d/b/a
- ---------- ------------ -----
Hanover Capital SPC, Inc. Delaware None
Hanover Capital Repo Corp. Delaware None
Hanover QRS-1 98-B, Inc. Delaware None
Hanover QRS-2 98-B, Inc. Delaware None
Hanover SPC-A, Inc. Delaware None
Unconsolidated Subsidiaries of Hanover Capital Mortgage Holdings, Inc.
Subsidiary Jurisdiction d/b/a
- ---------- ------------ -----
Hanover Capital Partners Ltd. New York None
Hanover Capital Mortgage Corporation(1) Missouri California d/b/a
Missouri Hanover
Capital Mortgage
Corporation
Hanover Capital Securities, Inc.(1) New York None
Hanover Capital Partners 2, Inc. Delaware None
Hanover SPC-2, Inc.(2) Delaware None
HanoverTrade.com, Inc. Delaware None
Pamex Securities, LLC(3) New Jersey None
HDMF-I LLC Delaware None
(1) Subsidiary of Hanover Capital Partners Ltd.
(2) Subsidiary of Hanover Capital Partners 2, Inc.
(3) Subsidiary of HanoverTrade.com, Inc.
45
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, 2001 and 2000
and for the Years Ended December 31, 2001, 2000 and 1999:
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-33
Consolidated Financial Statements as of December 31, 2001 and 2000
and for the Years Ended December 31, 2001, 2000 and 1999:
Balance Sheets ..................................................... F-34
Statements of Operations ........................................... F-35
Statements of Stockholders' Equity ................................. F-36
Statements of Cash Flows ........................................... F-37
Notes to Consolidated Financial Statements ......................... F-38
HANOVERTRADE.COM, INC. AND SUBSIDIARY
Independent Auditors' Report ............................................. F-44
Consolidated Financial Statements as of December 31, 2001 and 2000
and for the Years Ended December 31, 2001 and 2000 and for the
Period from May 28, 1999 (inception) to December 31, 1999:
Balance Sheets ..................................................... F-45
Statements of Operations ........................................... F-46
Statements of Stockholders' Equity ................................. F-47
Statements of Cash Flows ........................................... F-48
Notes to Consolidated Financial Statements ......................... F-49
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Mortgage Holdings, Inc. and Subsidiaries
Edison, New Jersey
We have audited the accompanying consolidated balance sheets of Hanover Capital
Mortgage Holdings, Inc. and Subsidiaries (the "Company") as of December 31,
2001 and 2000, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 2001. 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 financial position of Hanover Capital Mortgage Holdings,
Inc. and Subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001, in conformity with accounting principles generally accepted
in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 22, 2002
F-2
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
DECEMBER 31,
------------------------
ASSETS 2001 2000
---------- ----------
Mortgage loans:
Held for sale $ 2,391 $ 230
Collateral for CMOs 151,882 212,017
Mortgage securities pledged as collateral
for reverse repurchase agreements:
Available for sale 4,404 11,785
Held to maturity 768 1,384
Trading 33,182 1,743
Mortgage securities pledged as collateral for CMOs 9,840 9,877
Mortgage securities, not pledged:
Available for sale 1,162 4,744
Held to maturity -- 3,133
Trading 1,827 3,057
Cash and cash equivalents 8,946 9,958
Accrued interest receivable 1,960 2,466
Equity investments:
Hanover Capital Partners Ltd. 1,808 1,765
HanoverTrade.com, Inc. (4,789) (1,526)
HDMF-I LLC 80 --
Notes receivable from related parties 12,538 7,887
Due from related parties 842 38
Other receivables 777 911
Prepaid expenses and other assets 1,889 3,140
---------- ----------
TOTAL ASSETS $ 229,507 $ 272,609
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 33,338 $ 14,760
CMO borrowing 151,096 210,374
Accrued interest payable 1,094 1,796
Dividends payable 855 865
Accrued expenses and other liabilities 1,583 790
---------- ----------
TOTAL LIABILITIES 187,966 228,585
---------- ----------
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, 4,275,676 and 4,322,944 shares issued
and outstanding at December 31, 2001 and 2000,
respectively 43 43
Additional paid-in capital 67,082 68,546
Retained earnings (deficit) (25,978) (25,737)
Accumulated other comprehensive income 394 1,172
---------- ----------
TOTAL STOCKHOLDERS' EQUITY 41,541 44,024
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 229,507 $ 272,609
========== ==========
See notes to consolidated financial statements
F-3
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
YEARS ENDED DECEMBER 31,
--------------------------------
2001 2000 1999
-------- -------- --------
REVENUES:
Interest income $ 19,702 $ 26,692 $ 27,505
Interest expense 13,433 20,029 23,097
-------- -------- --------
Net interest income 6,269 6,663 4,408
Loan loss provision 709 875 446
-------- -------- --------
Net interest income after loan loss provision 5,560 5,788 3,962
Gain on sale of mortgage assets 3,782 819 146
Gain (loss) on mark to market of mortgage assets,
net of associated hedge 751 431 (4,292)
Gain on sale of servicing rights -- -- 540
Impairment charge on mortgage securities -- -- (2,225)
Provision for (loss) on unconsolidated subsidiary -- -- (4,793)
Other (28) -- --
-------- -------- --------
Total revenue (loss) 10,065 7,038 (6,662)
-------- -------- --------
EXPENSES:
Legal and professional 1,247 555 1,201
Management and administrative 847 759 894
Personnel 664 1,017 1,235
Occupancy 275 273 98
Financing/commitment fees 246 281 404
Other 173 123 284
Insurance 164 128 75
Casualty loss 80 -- --
-------- -------- --------
Total expenses 3,696 3,136 4,191
-------- -------- --------
Operating income (loss) 6,369 3,902 (10,853)
Equity in income (loss) of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. 43 455 (443)
Hanover Capital Partners 2, Inc. -- -- (1,300)
HanoverTrade.com, Inc. (3,263) (1,495) (31)
HDMF-I LLC (35) -- --
-------- -------- --------
Income (loss) before cumulative effect of adoption of SFAS 133 3,114 2,862 (12,627)
Cumulative effect of adoption of SFAS 133 46 -- --
-------- -------- --------
NET INCOME (LOSS) $ 3,160 $ 2,862 $(12,627)
======== ======== ========
BASIC EARNINGS (LOSS) PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.56 $ (2.12)
Cumulative effect of adoption of SFAS 133 0.01 -- --
-------- -------- --------
After cumulative effect of adoption of SFAS 133 $ 0.74 $ 0.56 $ (2.12)
======== ======== ========
DILUTED EARNINGS (LOSS) PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 0.72 $ 0.56 $ (2.12)
Cumulative effect of adoption of SFAS 133 0.01 -- --
-------- -------- --------
After cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.56 $ (2.12)
======== ======== ========
See notes to consolidated financial statements
F-4
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
(in thousands, except share data)
ACCUMULATED
OTHER
COMMON STOCK ADDITIONAL COMPREHENSIVE RETAINED COMPREHENSIVE
------------------- PAID-IN INCOME EARNINGS INCOME
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) (LOSS) TOTAL
---------- ------ ---------- ------------- --------- ------------- --------
BALANCE, DECEMBER 31, 1998 6,321,899 $ 65 $ 78,069 $ (9,955) $(2,399) $ 65,780
Repurchase of common stock (495,000) (2,236) (2,236)
Treasury stock par value reclass (7) 7 --
Comprehensive (loss):
Net (loss) $(12,627) (12,627) (12,627)
Other comprehensive (loss):
Change in net unrealized gain
(loss) on securities available for
sale, net of reclassification
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
(loss) 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
Repurchase of common stock (246,900) (2) (1,733) (1,735)
Exercise of options 62,898 1 270 271
Exercise of warrants 136,734 1 (1) --
Comprehensive income:
Net income $ 3,160 3,160 3,160
Other comprehensive income:
Change in net unrealized gain (loss)
on securities available for sale (561) (561) (561)
Change in net unrealized gain (loss)
on interest rate caps designated as
hedges 235 235 235
Unrealized cumulative effect of
adoption of SFAS 133 (452) (452) (452)
--------
Comprehensive income $ 2,382
========
Dividends declared (3,401) (3,401)
---------- ---- -------- -------- ------- --------
BALANCE, DECEMBER 31, 2001 4,275,676 $ 43 $ 67,082 $(25,978) $ 394 $ 41,541
========== ==== ======== ======== ======= ========
See notes to consolidated financial statements
F-5
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
YEARS ENDED DECEMBER 31,
--------------------------------------
2001 2000 1999
---------- ---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 3,160 $ 2,862 $ (12,627)
Adjustments to reconcile net income (loss) to net cash
(used in) provided by operating activities:
Amortization of net premium and deferred costs 363 203 4,300
Loan loss provision 709 875 446
(Gain) on sale of servicing rights -- -- (540)
(Gain) on sale of mortgage assets (3,782) (873) (146)
(Gain) loss on mark to market of mortgage assets (1,058) (816) 4,292
(Gain) on market to market of mortgage assets for SFAS 133 (50) -- --
Impairment charge on mortgage securities -- -- 2,225
Provision for loss on sale of unconsolidated subsidiary -- -- 4,793
Purchase of trading securities (142,540) (7,634) --
Sale of trading securities 113,945 2,709 --
Equity in net loss of unconsolidated subsidiaries 3,255 1,041 1,774
Decrease in accrued interest receivable 506 460 1,014
(Increase) decrease in notes receivable from related parties (4,651) 300 (4,294)
(Increase) decrease in due from related parties (804) (93) 169
(Increase) decrease in other receivables 134 (761) 1,104
(Increase) decrease in prepaid expenses and other assets 1,078 (1,230) (1,305)
Increase (decrease) in accrued interest payable (702) (637) 1,039
Increase (decrease) in accrued expenses and other liabilities 793 (312) 432
---------- ---------- ----------
Net cash (used in) provided by operating activities (29,644) (3,906) 2,676
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage loans (2,172) -- (1,449)
Purchase of mortgage securities (4,431) (2,934) (3,668)
Purchase of mortgage securities from affiliate -- (13,845) --
Principal payments received on mortgage securities 5,067 8,001 12,895
Principal payments received on collateral for CMOs 59,701 57,254 61,613
Principal payments received on mortgage loans held for sale
and held to maturity 11 21 44,429
Proceeds from sale of mortgage assets 16,076 43,054 30,909
Proceeds from sale of servicing rights -- -- 786
Additions to investments (115) -- --
---------- ---------- ----------
Net cash provided by investing activities 74,137 91,551 145,515
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from (repayment of) reverse repurchase agreements 18,578 (40,962) (314,368)
Net (repayment of) borrowing from CMOs (59,207) (45,685) 177,624
Increase in CMO discount -- 1,069 --
Payment of dividends (3,411) (2,822) (3,026)
Repurchase of common stock (1,736) (7,309) (2,235)
Exercise of options 271 -- --
Equity investment in Subsidiary -- -- (1)
---------- ---------- ----------
Net cash (used in) financing activities (45,505) (95,709) (142,006)
---------- ---------- ----------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1,012) (8,064) 6,185
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 9,958 18,022 11,837
---------- ---------- ----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 8,946 $ 9,958 $ 18,022
========== ========== ==========
See notes to consolidated financial statements
F-6
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
1. ORGANIZATION AND BASIS OF PRESENTATION
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 mortgage loans for its own account, and, commencing in 2001, for third
parties. 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 on-line 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, HTC and third party asset-management contracts.
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 accounting
principles generally accepted in the United States of America ("GAAP") and in
conformity with the rules and regulations of the Securities and Exchange
Commission ("SEC"). In the opinion of management, all adjustments (consisting of
normal recurring adjustments) considered necessary for a fair presentation have
been included.
USE OF ESTIMATES; RISKS AND UNCERTAINTIES - The preparation of financial
statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Estimates, by their nature, are based on judgment and
available information. Actual results could differ from the 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.
F-7
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 an
interest accrual is discontinued, all associated 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.
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 amortized
cost unless a decline in value is deemed other than temporary, in which case
the carrying value is reduced. The amortization of premiums or accretion of
discounts and any unrealized losses deemed other than temporary are included in
current period earnings.
F-8
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 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 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, reduces
the carrying value to fair value. The Company's loan loss provision, utilized in
establishing its loan loss allowance, 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 adjustment of the carrying value is made by reducing the cost basis of the
individual security and the amount of such write-down is recorded directly
against the loan loss allowance. Provisions for credit losses do not reduce
taxable income and therefore do not affect the dividends paid by the Company to
stockholders in the period the provisions are taken. Actual losses realized by
the Company reduce taxable income in the period the actual loss is realized and
may affect the dividends paid to stockholders for that tax year.
EQUITY INVESTMENTS - Hanover records its investments in HCP, HTC, HDMF-I LLC
("HDMF-I") and Hanover Capital Partners 2, Inc. ("HCP-2") on the equity method.
Accordingly, Hanover records 97% of the earnings or losses of HCP and HTC,
31.45946% of HDMF-I 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 and through its share of members' equity of HDMF-I. 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.
F-9
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,
securitization and sale of its mortgage loan and mortgage securities
portfolio. The Company generally closes out the hedge position to coincide with
a long-term securitization financing transaction or with any sale. As such
hedges are considered freestanding derivatives for accounting purposes, the
Company recognizes changes in the fair value of such hedges in earnings in the
period of change.
The Company also enters into interest rate caps to manage its interest rate
exposure on certain reverse repurchase agreements and CMO financing. For
interest rate caps designated as cash flow hedges for accounting purposes, the
effective portion of the gain or loss due to changes in fair value is reported
in other comprehensive income, and the ineffective portion is reported in
earnings in the period of change. For interest rate caps designated as
freestanding derivatives for accounting purposes, changes in fair value are
recognized in earnings in the period of change. Any payment received under the
interest rate cap agreements is recorded as a reduction of interest expense on
the reverse repurchase agreement financing.
For derivative financial instruments designated as hedge instruments for
accounting purposes, the Company periodically evaluates the effectiveness of
these hedges against the financial instrument being hedged. The Company
considers a hedge to be effective so long as there is adequate correlation
between the hedged results and the change in fair value of the hedged financial
instrument. If the hedge instrument performance does not result in adequate
correlation between the changes in fair value of the hedge instrument and the
related hedged financial instrument, the Company will terminate the hedge for
accounting purposes and mark the carrying value of the hedge instrument to
market in earnings in the period of change. If a hedge instrument is sold or
matures, or the criteria that were anticipated at the time the hedge instrument
was entered into no longer exist, the hedge instrument is no longer designated
as a hedge for accounting purposes. 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.
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 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.
F-10
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 and interest rate caps designated as hedges, are
reported as separate components of the equity section of the Consolidated
Balance Sheets, such items, along with net income, are components of
comprehensive income.
RECLASSIFICATION - Certain reclassifications for prior years' amounts have been
made to conform to the current year presentation.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS - In September 2000, the Financial
Accounting Standards Board ("FASB") 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"). The components of SFAS 140 that relate to disclosure and
accounting for collateral were adopted by the Company for the year ended
December 31, 2000. The Company adopted the remaining provisions of SFAS 140 in
2001. 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 MBS retained in connection with one of the Company's securitization
transactions.
On January 1, 2001, the Company implemented Statement of Financial Accounting
Standards No. 133 ("SFAS 133"), as amended and interpreted, Accounting for
Derivative Instruments and Hedging Activities. SFAS 133 establishes accounting
and reporting standards for derivative instruments and hedging activities. 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, certain of the hedges that the Company had in place were designated as
Cash Flow Hedges and certain of the hedges that the Company had in place were
designated as freestanding derivatives.
On September 28, 2001, the Company elected to discontinue hedge accounting for
its fair value hedges and transferred 5 securities with a carrying value of
$3,124,000 from available for sale to trading. As a result of this transfer,
$39,000 in previously unrealized mark to market adjustments was reflected as
income. On September 28, 2001, the derivative instruments that had been
designated as fair value hedges were redesignated as freestanding derivatives.
Changes in the fair value of Fair Value Hedges were reflected in income, and an
offsetting amount reflecting changes in fair value of the related hedged assets
were also reflected in income for the period from January 1, 2001 through
September 28, 2001. The effect of this treatment was to reflect in income any
ineffective portion of such hedges.
Changes in the fair value of Cash Flow Hedges are reflected as other
comprehensive income or loss, but only to the extent that the hedging
relationship is expected to be highly effective. The ineffective portion of
changes in the fair value of cash flow hedges is reflected in income.
Changes in the fair value of freestanding derivatives are reflected in income.
The following table summarizes the impact of adopting SFAS 133 on January 1,
2001:
Comprehensive
Income Earnings
------------- --------
Gain (loss) on mark-to-market of:
Cash flow hedges designated against floating rate borrowings $(408) $ -
Freestanding derivatives, expired in first quarter - 83
Freestanding derivatives, still outstanding - (87)
Mortgage securities transferred to trading from held-to-maturity - 50
Mortgage securities transferred to available-for-sale from held-to-maturity (44) -
----- ----
Total $(452) $ 46
===== ====
F-11
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In August 2001, the FASB issued
Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets ("SFAS 144"). SFAS 144 supersedes Statement No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of
("SFAS 121"). SFAS 144 retains the requirements of SFAS 121 for recognizing and
measuring the impairment loss of long-lived assets to be held and used. For
long-lived assets to be disposed of by sale, SFAS 144 requires a single
accounting model be used for all long-lived assets, whether previously held and
used or newly acquired. Long-lived assets to be disposed of other than by sale
would be considered held and used until disposition. SFAS 144 also broadens the
presentation of discontinued operations in the income statement to include more
disposal transactions. SFAS 144 is effective for fiscal years beginning after
December 15, 2001. The Company adopted SFAS 144 effective January 1, 2002. The
adoption of SFAS 144 did not have an impact on the consolidated financial
position or results of operations of the Company.
F-12
3. MORTGAGE LOANS
MORTGAGE LOANS HELD FOR SALE
(dollars in thousands)
DECEMBER 31, 2001 DECEMBER 31, 2000
---------------------------------- --------------------------------
Fixed Adjustable Fixed Adjustable
Rate Rate Total Rate Rate Total
-------- ---------- -------- -------- ---------- --------
Principal amount of mortgage loans $ 560 $ 2,627 $ 3,187 $ 31 $ 199 $ 230
Net premium (discount) and deferred (159) (637) (796) -- -- --
costs
Loan loss discount -- -- -- -- -- --
-------- ---------- -------- -------- ---------- --------
Carrying value of mortgage loans $ 401 $ 1,990 $ 2,391 $ 31 $ 199 $ 230
======== ========== ======== ======== ========== ========
MORTGAGE LOANS SECURITIZED IN COLLATERALIZED MORTGAGE OBLIGATIONS
(dollars in thousands)
DECEMBER 31, 2001 DECEMBER 31, 2000
------------------------------------ ------------------------------------
Fixed Adjustable Fixed Adjustable
Rate Rate Total Rate Rate Total
--------- ---------- --------- --------- ---------- ---------
Principal amount of mortgage loans $ 105,849 $ 45,535 $ 151,384 $ 140,867 $ 70,059 $ 210,926
Net premium (discount)
and deferred costs 1,442 (167) 1,275 1,952 (159) 1,793
Loan loss allowance (553) (224) (777) (489) (213) (702)
--------- ---------- --------- --------- ---------- ---------
Carrying value of mortgage loans $ 106,738 $ 45,144 $ 151,882 $ 142,330 $ 69,687 $ 212,017
========= ========== ========= ========= ========== =========
4. MORTGAGE SECURITIES
FIXED-RATE AGENCY MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2001 DECEMBER 31, 2000
---------------------------------------- ------------------------------------------
Available Held to Available Held to
For Sale Maturity Trading Total For Sale Maturity Trading Total
--------- -------- ------- ------- --------- -------- ------- -------
Principal balance of mortgage securities $ 1,378 $ -- $25,251 $26,629 $ 2,047 $ -- $ 1,681 $ 3,728
Net premium and deferred costs 70 -- 2,258 2,328 105 -- 65 170
--------- -------- ------- ------- --------- -------- ------- -------
Total amortized cost of mortgage securities 1,448 -- 27,509 28,957 2,152 -- 1,746 3,898
Net unrealized gain (loss) 62 -- 45 107 (35) -- (3) (38)
--------- -------- ------- ------- --------- -------- ------- -------
Carrying value of mortgage securities $ 1,510 $ -- $27,554 $29,064 $ 2,117 $ -- $ 1,743 $ 3,860
========= ======== ======= ======= ========= ======== ======= =======
FIXED-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2001
------------------------------------------------------
Available Collateral
For Held to For
Sale Maturity Trading CMOs Total
--------- -------- -------- ---------- --------
Principal balance of
mortgage securities $ 6,561 $ -- $ 10,125 $ 12,926 $ 29,612
Net (discount) and
deferred costs (3,440) -- (3,449) (2,742) (9,631)
--------- -------- -------- ---------- --------
Total amortized cost of
mortgage securities 3,121 -- 6,676 10,184 19,981
Loan loss allowance (221) -- (344) (565)
Net unrealized gain 623 -- 779 -- 1,402
--------- -------- -------- ---------- --------
Carrying value of
mortgage securities $ 3,523 $ -- $ 7,455 $ 9,840 $ 20,818
========= ======== ======== ========== ========
DECEMBER 31, 2000
-------------------------------------------------------
Available Collateral
For Held 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)
Net unrealized gain 1,009 -- 49 -- 1,058
--------- -------- ------- ---------- --------
Carrying value of
mortgage securities $ 12,862 $ 3,600 $ 3,057 $ 9,877 $ 29,396
========= ======== ======= ========== ========
F-13
DERIVATIVE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2001
---------------------------------------------------
Interest- Principal-
Only Strip Only Strip
Available Held to
For Sales Maturity Trading Total
---------- ---------- ---------- ----------
Principal balance of mortgage securities $ -- $ 929 $ -- $ 929
Net premium (discount) and deferred costs 639 (161) -- 478
---------- ---------- ---------- ----------
Total amortized cost of mortgage securities 639 768 -- 1,407
Loan loss allowance -- -- -- --
Net unrealized gain (loss) (106) -- -- (106)
---------- ---------- ---------- ----------
Carrying value of mortgage securities $ 533 $ 768 $ -- $ 1,301
========== ========== ========== ==========
DECEMBER 31, 2000
--------------------------------------------------
Interest- Principal-
Only Strip Only Strip
Available Held to
For Sales Maturity Trading Total
---------- ---------- ---------- ----------
Principal balance of mortgage securities $ -- $ 1,111 $ -- $ 1,111
Net premium (discount) and deferred costs 1,170 (194) -- 976
---------- ---------- ---------- ----------
Total amortized cost of mortgage securities 1,170 917 -- 2,087
Loan loss allowance -- -- -- --
Net unrealized gain (loss) 380 -- -- 380
---------- ---------- ---------- ----------
Carrying value of mortgage securities $ 1,550 $ 917 $ -- $ 2,467
========== ========== ========== ==========
The carrying values of the Company's mortgage securities by average life as of
December 31, 2001 are as follows (dollars in thousands):
Available Held to Collateral
Average Life for Sale Maturity Trading For CMOs
-------------------- --------- -------- ------- ----------
One to five years $ 1,670 $ 494 $27,555 $ --
Five to ten years 3,896 274 6,218 9,840
More than ten years -- -- 1,236 --
--------- -------- ------- ----------
$ 5,566 $ 768 $35,009 $ 9,840
========= ======== ======= ==========
Actual maturities may differ from stated maturities because borrowers usually
have the right to prepay certain obligations, oftentimes without penalties.
Maturities of mortgage securities depend on the repayment characteristics and
experience of the underlying mortgage loans.
The proceeds and gross realized gain (loss) from sales of available for sale
mortgage securities in 2001, 2000 and 1999 were as follows (dollars in
thousands):
YEAR ENDED
DECEMBER 31, 2001
--------------------------------
GROSS GROSS
REALIZED REALIZED
PROCEEDS GAIN LOSS
-------- -------- ----------
Sale of subordinate MBS $ 16,079 $ 3,585 $ (2)
YEAR ENDED
DECEMBER 31, 2000
--------------------------------
GROSS GROSS
REALIZED REALIZED
PROCEEDS GAIN LOSS
-------- -------- ----------
Sale of subordinate MBS $ 5,882 $ 1,248 $ --
Sale of Agency pass-through MBS 39,881 -- (429)
YEAR ENDED
DECEMBER 31, 1999
--------------------------------
GROSS GROSS
REALIZED REALIZED
PROCEEDS GAIN LOSS
-------- -------- ----------
Hanover Capital 1998-B subordinate MBS $ 2,232 $ 146 $ --
======== ======== ==========
F-14
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, 2001, the
percent of the total principal amount of loans outstanding in any one state
exceeding 5% of the principal amount of mortgage loans are as follows:
MORTGAGE LOANS HELD AS
COLLATERAL FOR CMOS
Florida 15%
California 13%
Texas 10%
Ohio 5%
Maryland 5%
--
Total 48%
==
The Company did not have any material concentrations of credit risk in its held
for sale category at December 31, 2001.
On December 31, 2001, the Company purchased $2.2 million of mortgage loans. The
Company did not purchase any mortgage loans in 2000 or 1999. Management believes
that the loss of any single financial institution from which the Company
purchased mortgage loans would not have any material detrimental effect on the
Company.
MORTGAGE SECURITIES - The Company's exposure to credit risk associated with its
investment activities is measured on an individual security basis as well as by
groups of securities that share similar attributes. In certain instances, the
Company has concentrations of credit risk in its mortgage securities portfolio
for the securities of certain issuers. Management believes exposure to credit
risk associated with purchased Agency mortgage securities is minimal due to the
guarantees provided by the Agency.
CONCENTRATION OF CREDIT RISK BY ISSUER
(dollars in thousands)
DECEMBER 31, 2001
-----------------------------------------------------
Available Held Collateral
For To For
Issuer Sale Maturity Trading CMOs Total
----------------------- --------- -------- ------- ---------- -------
FNMA $ 1,510 $ -- $18,416 $ -- $19,926
FHLMC -- -- 9,138 -- 9,138
Hanover Capital 1998-B 533 768 -- 9,840 11,141
Issuer 1 829 -- 1,714 -- 2,543
Issuer 2 1,220 -- -- -- 1,220
Issuer 3 612 -- -- -- 612
Issuer 4 862 -- 2,036 -- 2,898
Issuer 5 -- -- 2,683 -- 2,683
Issuer 6 -- -- 859 -- 859
Issuer 7 -- -- 163 -- 163
--------- -------- ------- ---------- -------
Total $ 5,566 $ 768 $35,009 $ 9,840 $51,183
========= ======== ======= ========== =======
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
F-15
December 31, 2001, the Company had amounts on deposit with the financial
institution in excess of FDIC limits. At December 31, 2001, the Company had
overnight investments of $6,126,000 in mutual funds investing primarily in
treasury securities and overnight investments in commercial paper. The Company
limits its risk by placing its cash and cash equivalents in high quality
financial institutions, Federal Agency notes, mutual funds of treasury
securities or in the highest rated commercial paper.
6. LOAN LOSS ALLOWANCE
The following table summarizes the activity in the loan loss allowance (dollars
in thousands):
YEARS ENDED DECEMBER 31,
--------------------------------
2001 2000 1999
-------- -------- --------
Balance, beginning of period $ 1,724 $ 799 $ 372
Loan loss provision 709 875 446
Transfers from related company -- 729 39
Sales (852) (593) --
Charge-offs (241) (92) (110)
Recoveries 2 6 52
-------- -------- --------
Balance, end of period $ 1,342 $ 1,724 $ 799
======== ======== ========
7. EQUITY INVESTMENTS
Hanover owns 100% of the non-voting preferred stock of HCP and HTC, which
entitles Hanover to receive 97% of the earnings or losses of HCP and HTC and
their 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 November 2001, Hanover
invested approximately $115,000 for a 31.45946% interest in HDMF-I.
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. Hanover 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. HDMF-I was organized in August 2001 to purchase,
service, manage and ultimately re-sell or otherwise liquidate pools of primarily
sub- and non-performing one-to-four family residential mortgage loans.
HCP and its subsidiaries operate as a specialty finance company that is
principally engaged in performing due diligence, consulting and mortgage
investment banking services. A wholly-owned subsidiary of HCP, Hanover Capital
Mortgage Corporation ("HCMC"), is a servicer of multifamily mortgage loans and,
prior to June 1999, was an originator of multifamily and commercial loans.
Another wholly-owned subsidiary of HCP, Hanover Capital Securities, Inc. is a
registered broker/dealer with the SEC.
The principal business activity of HTC is to generate fee income by operating an
on-line worldwide web-based exchange for trading loan pools (primarily mortgage
loan pools) and by performing loan sale advisory services for third parties. On
January 19, 2001, HTC purchased all the assets of Pamex Capital Partners, LLC
("Pamex"), a whole loan mortgage broker, and hired 18 Pamex employees. Included
in the purchase was Pamex Securities, LLC, a licensed securities
broker/dealer registered with the SEC
F-16
and the National Association of Securities Dealers. The combined sales force
markets HTC product and continues to broker whole loans through traditional
channels.
The table below reflects the activity recorded in Hanover's equity investments
(dollars in thousands):
YEARS ENDED DECEMBER 31,
----------------------------------------------------------------------------------------------------
2001 2000 1999
--------------------------------- --------------------------- ----------------------------------
HCP HTC HDMF-I Total HCP HTC Total HCP HCP-2 HTC Total
------ ------- ----- ------- ------- ------- ------- ------- ------- ---- -------
Beginning balance $1,765 $(1,526) $ -- $ 239 $ 1,466 $ (30) $ 1,436 $ 1,761 $ 5,728 $ -- $ 7,489
Capital contribution -- -- 115 115 -- -- -- -- -- 1 1
Applicable % of net
income (loss) 43 (3,263) (35) (3,255) 455 (1,496) (1,041) (443) (1,300) (31) (1,774)
Applicable % of
comprehensive
gain (loss) -- -- -- -- (156) -- (156) 148 -- -- 148
Write-off of
investment -- -- -- -- -- -- -- -- (4,428) -- (4,428)
------ ------- ----- ------- ------- ------- ------- ------- ------- ---- -------
Ending balance $1,808 $(4,789) $ 80 $(2,901) $ 1,765 $(1,526) $ 239 $ 1,466 $ -- $(30) $ 1,436
====== ======= ===== ======= ======= ======= ======= ======= ======= ==== =======
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 John A.
Burchett, George J. Ostendorf, Irma N. Tavares and Joyce S. Mizerak
(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, 2001,
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,
2001.
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 originally were due and payable on March 31, 1999, but in March
1999 their term was extended to March 31, 2001 and were also modified to provide
for accelerated repayment by a Principal in the event of such Principal's
voluntary termination of employment. Similarly, in February 2001, their term was
extended to March 31, 2003. These loans bear interest at 5.51% at December 31,
2001.
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, 2001, the balance of these loans was $83,505.
In September 1999, in connection with hiring Thomas P. Kaplan as Chief Financial
Officer and a Managing Director, Hanover agreed to loan Mr. Kaplan an amount
sufficient to purchase up to 50,000 shares of Hanover common stock. No payment
of principal on the loan is due before maturity (September 2002) unless Mr.
Kaplan is terminated for "good cause" under his employment agreement
F-17
with Hanover, in which case the loan will become immediately due and payable.
Interest, however, is payable in arrears. Although Mr. Kaplan's loan is a
nonrecourse loan, it is secured by 50,000 shares of Hanover common stock. The
loan bears interest at 5.29% at December 31, 2001.
In March 2000, Hanover amended the terms of the notes due from the Principals to
provide that the notes would be forgiven in the event of certain changes in
control.
During 2001 and 2000, Hanover advanced funds to HCP, HTC and HCP-2 pursuant to
unsecured loan agreements. These loans bear interest at 1.00% below the prime
rate. At December 31, 2001, the loans outstanding to HCP, HTC and HPC-2 were
$1,036,000, $7,654,000 and $569,000, respectively.
Accrued interest receivable from related parties was $347,000 at December 31,
2001 and $172,000 at December 31, 2000. Additional amounts due from (to) related
parties are detailed below (dollars in thousands):
INTERCOMPANY BALANCES
DECEMBER 31,
---------------
2001 2000
------ ------
Due from HTC $ 79 $ 51
Due from (to) HCP 411 (185)
Due from HCP-2 5 --
------ ------
$ 495 $ (134)
====== ======
NOTES RECEIVABLE
DECEMBER 31,
------------------
2001 2000
-------- --------
Principals $ 3,279 $ 3,279
HCP 1,036 1,704
HTC 7,654 2,904
HCP-2 569 --
-------- --------
$ 12,538 $ 7,887
======== ========
9. REVERSE REPURCHASE AGREEMENTS
At December 31, 2001, the Company had outstanding borrowings on retained CMO
securities of $1,910,000 with a weighted average borrowing rate of 7.16% and a
weighted average remaining maturity of three months. Retained CMO securities
represent the Company's net investment in the CMOs issued by the Company. The
reverse repurchase financing agreements at December 31, 2001 are collateralized
by securities with a cost basis of $10,626,000.
At December 31, 2001, the Company had outstanding reverse repurchase agreement
financing for mortgage securities (other than retained CMO securities) of
$31,428,000 with a weighted average borrowing rate of 6.58% 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, 2001 was collateralized
by securities with a cost basis of $38,354,000.
F-18
At December 31, 2001, the Company had available capacity to borrow $10 million
under a committed reverse repurchase line of credit. This committed line matures
on March 28, 2002.
Information pertaining to reverse repurchase agreement financing as of and for
the years ended December 31, 2001 and 2000 is summarized as follows (dollars in
thousands):
REVERSE REPURCHASE AGREEMENT FINANCING
YEAR ENDED
DECEMBER 31, 2001
-----------------------
RETAINED OTHER
CMO MORTGAGE
SECURITIES SECURITIES
---------- ----------
REVERSE REPURCHASE AGREEMENTS
Balance of borrowing at end of period $ 1,910 $ 31,428
Average borrowing balance during the period $ 2,536 $ 15,817
Average interest rate during the period 7.16% 6.58%
Maximum month-end borrowing balance
during the period $ 3,626 $ 33,496
COLLATERAL UNDERLYING THE AGREEMENTS
Balance at end of period - carrying value $ 10,626 $ 38,354
YEAR ENDED
DECEMBER 31, 2000
-----------------------
RETAINED OTHER
CMO MORTGAGE
SECURITIES SECURITIES
---------- ----------
REVERSE REPURCHASE AGREEMENTS
Balance of borrowing at end of period $ 3,627 $ 11,133
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
Additional information pertaining to individual reverse repurchase agreement
lenders at December 31, 2001 is summarized as follows (dollars in thousands):
Reverse
Repurchase Underlying Weighted Average
Lender Type of Collateral Financing Collateral Maturity Date
- -------------------- ----------------------- ---------- ---------- -------------------
Lender A (committed) Retained CMO Securities $ 1,910 $ 10,626 January 8, 2002
Lender A Mortgage Securities 3,609 6,210 January 8, 2002 (a)
Lender B Mortgage Securities 25,787 29,064 January 2, 2002 (a)
Lender C Mortgage Securities 1,462 2,305 January 4, 2002 (a)
Lender D Mortgage Securities 504 612 January 4, 2002 (a)
Lender E Mortgage Securities 66 163 January 7, 2002 (a)
---------- ----------
Total $ 33,338 $ 48,980
========== ==========
(a) These borrowings are pursuant to uncommitted lines of credit which are
typically renewed monthly.
F-19
10. CMO BORROWING, SECURITIZED SALE AND MANAGED MORTGAGED LOANS
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 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.
Information pertaining to the CMOs as of and for the year ended December 31,
2001 is summarized as follows (dollars in thousands):
SECURITIZATIONS
--------------------------------------------------------
2000-A 1999-B 1999-A 1998-A TOTAL
-------- -------- -------- -------- --------
Balance of borrowing at end of period $ 10,904 $ 49,607 $ 61,755 $ 28,830 $151,096
Average borrowing balance during
the period 10,978 60,826 73,715 36,150 181,669
Average interest rate during the period 9.87% 6.14% 6.67% 6.85% 6.72%
Interest rate at end of period 9.74% 4.90% 6.55% 6.94% 6.31%
Maximum month-end borrowing
balance during the period 11,072 70,223 83,680 41,566 206,541
CMO collateral
Balance at end of period - carrying value $ 10,127 $ 53,257 $ 67,373 $ 31,252 $162,009
Aggregate annual repayments of mortgage-backed bonds based upon the expected
amortization of the underlying mortgage loan collateral at December 31, 2001
were as follows (dollars in thousands):
YEAR AMOUNT
---------- --------
2002 $ 40,593
2003 29,617
2004 22,394
2005 16,878
2006 12,851
Thereafter 41,977
--------
$164,310
========
F-20
SECURITIZED SALE - At December 31, 2001, the Company had a remaining investment
of $11,141,000 in securities retained from Hanover 1998-B. These securities had
a fair value of $10,817,000. 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:
TYPE OF CREDIT SPREAD DISCOUNT PREPAYMENT AVERAGE
SECURITY RATING RATE SPEED LIFE
-------------- ------- ------- ------------ ---------- ---------
Subordinate AA/AAA 300 bp 6.63-7.79% 200 PSA 5-9 years
Subordinate A/AA+ 400 7.63-8.79 200 PSA 5-9
Subordinate BBB/A+ 675 10.37-11.54 200 PSA 5-9
Subordinate BB/BB+ 1125 14.87-16.03 200 PSA 5-9
Subordinate B/B 1875 22.37-23.54 200 PSA 5-9
Subordinate unrated - 53.94-71.55 200 PSA 5-9
Interest-only AAA/AAA - 0.00 55-65 CPR 1
Principal-only AAA/AAA 200 4.95-6.76 6 CPR 3-9
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 54% - 72%. This default rate assumption results
in projected cumulative losses of $434,000, or 0.14% of the original principal
balance of the mortgage loans in the Hanover 1998-B securitization.
The following tables show the impact of a change of each of the foregoing
assumptions on the fair value of the related securities (dollars in thousands):
SENSITIVITY TO DISCOUNT RATE
TYPE CHANGE IN DECLINE
OF DISCOUNT IN
SECURITY RATE VALUE
-------------- -------- ----------
Subordinate +100 bp $ 537,000
+200 bp 1,033,000
Interest-Only +500 bp $ 14,000
+1000 bp 27,000
Principal-Only +25 bp $ 7,000
+50 bp 14,000
F-21
SENSITIVITY TO PREPAYMENT SPEED
TYPE OF PAYMENT DECLINE IN
SECURITY SPEED VALUE
-------------- --------- ----------
Subordinate 200 PSA $ --
150 PSA 129,000
100 PSA 279,000
Interest-Only 55-65 CPR $ --
65-75 CPR 149,000
75-85 CPR 230,000
Principal-Only 6 CPR $ --
4 CPR 23,000
2 CPR 49,000
SENSITIVITY TO LOSS ASSUMPTION
ANNUAL
TYPE OF DEFAULT CUMULATIVE DECLINE IN
SECURITY RATE LOSSES VALUE
----------- ------- ---------- ----------
Subordinate 0.30% 0.14% $ --
0.90% 0.40% 158,000
3.00% 1.23% 1,081,000
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 cash flows. 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, 2001 (dollars in thousands):
MANAGED ASSETS
Principal
Balance
--------
Mortgage loans held for sale $ 3,187
Mortgage loans collateralizing on-balance sheet CMOs 151,384
Mortgage loans collateralizing off-balance sheet
securitization executed by the Company 122,277
--------
Total mortgage loans purchased and managed by the Company $276,848
========
Delinquency
Rates
-----------
30-59 days delinquent 7.05%
60-89 days delinquent 1.80%
90 or more days delinquent 2.39%
Loans in foreclosure 1.37%
Real estate owned 0.13%
The Company realized credit losses of $149,000 on the foregoing assets during
the year ended December 31, 2001.
F-22
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 Company can, at its option,
make a discretionary matching contribution to the 401(k) Plan. For the years
ended, December 31, 2001 and 2000, expense related to the 401(k) Plan was
$21,444 and $21,987, respectively. No matching contribution was made by the
Company for the year ended December 31, 1999.
HANOVER STOCK OPTION PLANS - Hanover has adopted two stock option plans: (i) the
1997 Executive and Non-Employee Director Stock Option Plan (the "1997 Stock
Option Plan") and (ii) the 1999 Equity Incentive Plan (the "1999 Stock Option
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, stock options not so qualified, deferred
stock, restricted stock, performance shares, stock appreciation and limited
stock awards, and dividend equivalent rights. The 1997 Stock Option Plan
authorizes the grant of options to purchase, and limited stock awards of, an
aggregate of up to 325,333 shares of Hanover's common stock.
All stock options granted by the Compensation Committee pursuant to the 1997
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 has occurred on the
September 30, 2001, 2000, 1999 or 1998 Earn-out Measuring Dates.
1999 Stock Option Plan - The 1999 Stock Option Plan authorizes the grant of
options of up to 550,710 shares of Hanover's common stock.
F-23
Transactions during the years ended December 31, 2001, 2000 and 1999 relating to
the Hanover 1997 and 1999 Stock Option Plans are as follows:
# of Options for Shares
----------------------- Weighted
1997 1999 Exercise
Plan Plan Exercise Price
------- ------- ------- -------
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
=======
Stock Option Activity - 2001
Granted - May 24, 2001 4,000 $ 7.75
Cancelled (7,750) 15.75
Cancelled (3,333) 4.625
Cancelled (5,000) 3.875
Exercised (36,332) 4.625
Exercised (26,566) 3.875
------- -------
Outstanding at Dec. 31, 2001 279,324 $ 15.33
======= =======
453,979 $ 4.26
======= =======
At December 31, 2001, 2000 and 1999, 213,091, 90,250 and 2,000 options,
respectively, were exercisable, with exercise prices ranging from $3.88 to
$7.75.
The per share weighted average fair value of stock options granted for the years
ended December 31, 2001 and 2000 was $1.43 and $0.17, respectively at the date
of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2001 2000
---- ----
Expected life (years) 10 10
Risk-free interest rate 5.49% 6.54%
Volatility 32.1% 42.1%
Expected dividend yield 10.3% 12.6%
F-24
Hanover 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 2001, 2000 and 1999. Had the
Company determined compensation cost based on the fair value at the grant date
for its stock options under Statement 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):
YEARS ENDED DECEMBER 31,
------------------------------------
2001 2000 1999
---------- ---------- ----------
Net earnings (loss):
As reported $ 3,160 $ 2,862 $ (12,627)
Pro forma $ 3,154 $ 2,814 $ (12,766)
Earnings (loss) per share - basic:
As reported $ 0.74 $ 0.56 $ (2.12)
Pro forma $ 0.74 $ 0.55 $ (2.15)
Earnings (loss) per share - diluted:
As reported $ 0.73 $ 0.56 $ (2.12)
Pro forma $ 0.73 $ 0.55 $ (2.14)
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 2001, 2000 and 1999.
12. AFFILIATED PARTY TRANSACTIONS
Hanover engaged HCP pursuant to a Management Agreement to render among other
things, due diligence, asset management and administrative services. The term of
the Management Agreement continues until December 31, 2002 with subsequent
renewal.
The 2001, 2000 and 1999 Consolidated Statements of Operations include management
and administrative expenses of $716,000, $634,000 and $809,000, respectively and
commission expense of $0, $4,000 and $5,000, respectively relating to billings
from HCP. In addition, the 1999 Consolidated Statement of Operations includes
due diligence expense of $119,000. The 2001, 2000 and 1999 Consolidated
Statements of Operations also reflect a reduction in personnel expenses for a
portion of salaries allocated (and billed) to HCP.
During 2001, 2000 and 1999, Hanover recorded the following interest income
generated from loans to related parties:
YEARS ENDED DECEMBER 31,
------------------------
2001 2000 1999
---- ---- ----
Principals $184 $185 $175
HCP 58 265 168
HTC 368 81 --
HCP-2 2 -- --
---- ---- ----
$612 $531 $343
==== ==== ====
F-25
13. DERIVATIVE INSTRUMENTS
INTEREST RATE CAPS (CASH FLOW HEDGES & FREESTANDING DERIVATIVE)
From time to time the Company buys interest rate caps when it finances fixed
rate assets with floating rate reverse repurchase agreements and CMOs. At
December 31, 2001, the Company has designated two of its interest rate caps as
"cash flow hedges" and one as a "freestanding derivative". The objective in
entering into these instruments is to protect the net interest margin, which
represents the difference between the interest earned on assets and the interest
paid on debt. Payments received on the interest rate caps are expected to offset
increases in interest expense that could result from increases in interest
rates. For cash flow hedges, the Company purchases caps that are indexed to the
same floating interest rate as the hedged borrowing. Currently, all of the
interest rate caps are indexed to LIBOR, and those liabilities for which a
specific interest rate cap has been designated a cash flow hedge are also
indexed to LIBOR. The Company considers its one interest rate cap designated as
a freestanding derivative additional protection against the net interest margin
although it has not been specifically designated a hedging instrument for
accounting purposes. The Company did not recognize any gains or losses for the
year ended December 31, 2001 as a result of hedge ineffectiveness for those
interest rate caps designated as cash flow hedges. The Company recognized
$56,000 of losses for the year ended December 31, 2001 in the accompanying
consolidated statement of operations for changes in the fair value of interest
rate caps designated as freestanding derivatives. As one of the Company's cash
flow hedges matures in August 2002, the Company estimates $147,000 of losses,
that are reported in accumulated other comprehensive income as of December 31,
2001, are expected to be reclassified into income within the next twelve months.
All of these interest rate caps relate to the payment of variable interest on
existing financial instruments.
FORWARD SALES OF AGENCY SECURITIES (FAIR VALUE HEDGES & FREESTANDING
DERIVATIVES)
For the period from January 1, 2001 to September 28, 2001, the Company entered
into forward sales of government agency guaranteed securities, known as "Agency"
securities, to manage the exposure to changes in the value of some of its
mortgage securities classified as "available for sale." This type of hedge is
called a "fair value hedge." The objective in entering into these hedges was to
offset gains or losses on the hedged asset with comparable losses or gains on
the hedge. Generally, changes in the value of the Company's hedged assets were
caused by changes in interest rates, changes in the market for mortgage-backed
securities, and changes in the credit quality of the asset. Changes in interest
rates and changes in the market for mortgage-backed securities also affect the
value of the Company's forward sales of agency securities. (The Company does not
attempt to hedge changes in the credit quality of individual assets.) For the
period from January 1, 2001 to September 28, 2001, the Company calculated the
expected impact that changes in interest rates and the market would have on the
price of both the hedged asset and the hedge. Using this information, the
Company determined the amount of forward sales needed so that expected gains or
losses on assets would be offset by comparable losses or gains on the hedges. In
order to monitor the risk that results from this activity, the Company estimated
the daily gain or loss from both the hedged asset and the hedge for every
business day. At the end of each quarter, the Company performed a statistical
analysis to ensure that the daily changes in the value of the hedge were
correlated to changes in the value of the hedged asset.
On September 28, 2001, the Company elected to discontinue hedge accounting for
its fair value hedges and transferred 5 securities with a carrying value of
$3,124,000 from available for sale to trading. As a result of this transfer,
$39,000 in previously unrealized mark to market adjustments was reflected as
income. In addition, the Company realized net gains on these hedges of $28,000
for the period from September 29, 2001 to December 31, 2001. This amount is
reported as a component of other income in the accompanying consolidated
statement of operations.
For the period from September 29, 2001 to December 31, 2001, the Company
continued to enter into forward sales of Agency securities. However, for this
period, the Company entered into these forward sales to manage the exposure to
changes in the value of securities classified as "trading securities." The
Company considers these forward sales to be freestanding derivatives. The
objective is to offset gains or losses on the trading securities with comparable
losses or gains on the forward sales. Generally, changes in the value of the
trading securities are caused by changes in interest rates, changes in the
market for mortgage-backed securities, and changes in the credit quality of the
asset. Changes in interest rates and changes in the market for mortgage-backed
securities will also affect the value of the forward sales of agency securities.
(The Company does not attempt to hedge changes in the credit quality of
individual assets.) The Company calculates the expected impact that changes in
interest rates and the market will have on the price of both the trading
securities and the forward sales. Using this information, the Company determines
the amount of forward sales that it needs so that the expected gains or losses
on trading securities will be offset by comparable losses or gains on the
forward sales. The Company marks to market the gain or loss on all of the
trading securities and all of the freestanding derivatives in each reporting
period. The mark to market on the trading securities is reported as a component
of gain (loss) on mark to market of mortgage securities, net of associated hedge
in the accompanying consolidated statement of operations. The mark to market on
the freestanding derivatives is reported as a component of other income in the
accompanying consolidated statements of operations.
F-26
14. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE
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 MBS.
In July 1998, the Board of Directors of Hanover authorized a share repurchase
program pursuant to which Hanover was authorized to repurchase up to 646,880
shares of the Company's outstanding common stock. During the year ended December
31, 1998, Hanover 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 were 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. On July 11, 2001,
RFC exercised the warrants with Hanover issuing 136,734 shares of common stock.
As permitted by the terms of the warrant, RFC requested that Hanover withhold
163,265 shares of common stock to pay for the exercise price, in lieu of
collecting the exercise price in cash.
During the year ended December 31, 1999, Hanover 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 Hanover authorized a second share
repurchase program pursuant to which Hanover 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 Hanover authorized a third share
repurchase program pursuant to which Hanover 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, Hanover 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.
On April 20, 2001, the Board of Directors of Hanover authorized the repurchase
of 189,900 shares of its outstanding common stock. On April 25, 2001, Hanover
purchased 189,900 shares at an average price of $7.03 per share for a total cost
of $1,335,000.
On August 7, 2001, the Board of Directors of Hanover authorized the repurchase
of 60,000 shares of its outstanding common stock. On August 13, 2001, Hanover
purchased 57,000 shares at an average price of $7.03 per share for a total cost
of $401,000.
As of December 31, 2001, Hanover has repurchased 646,880 shares pursuant to the
1998 share repurchase program, 1,000,000 shares pursuant to the 1999 share
repurchase program, 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, and 246,900 shares
at an average price of $7.03 for a total cost of $1,736,000 pursuant to the 2001
share repurchase programs. As of December 31, 2001, Hanover had remaining
authority to purchase up to
501,025 shares for not more than $137,000 under the 2000 share repurchase
program and 3,000 shares under the 2001 share repurchase authorizations.
During 2001, 62,898 shares were issued as a result of exercise of stock option
grants under the 1999 Stock Option Plan.
On January 24, 2001, Hanover's affiliate, HTC, hired 18 employees of Pamex and
purchased all of Pamex's assets. 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. The earn-out is based on
performance targets. The performance target for the first year was met during
2001 and $500,000 was accrued by HTC. On February 19, 2002, 63,577 shares of
Hanover were issued. The 2001 diluted earnings per share after cumulative effect
of adoption of SFAS 133, including the 63,577 shares, would be $0.72.
On February 20, 2002, the Board of Directors of Hanover authorized the
repurchase of up to 18,166 shares outstanding as a result of exercise of stock
option grants prior to the registration of the shares covered by the 1999 Stock
Option Plan. As of March 28, 2002, 14,666 shares have been repurchased for
$121,495.
F-27
Calculations for earnings (loss) per share are shown below (dollars in
thousands, except per share data):
YEARS ENDED DECEMBER 31,
-------------------------------------
2001 2000 1999
---------- ---------- -----------
EARNINGS (LOSS) PER SHARE BASIC:
Income (loss) before cumulative effect of
adoption of SFAS 133 $ 3,114 $ 2,862 $ (12,627)
Cumulative effect of adoption of SFAS 133 46 -- --
---------- ---------- -----------
Net income (loss) (numerator) $ 3,160 $ 2,862 $ (12,627)
========== ========== ===========
Average common shares
outstanding (denominator) 4,256,874 5,102,563 5,942,403
========== ========== ===========
Per share:
Before cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.56 $ (2.12)
Cumulative effect of adoption of SFAS 133 0.01 -- --
---------- ---------- -----------
After cumulative effect of adoption of SFAS 133 $ 0.74 $ 0.56 $ (2.12)
========== ========== ===========
EARNINGS (LOSS) PER SHARE DILUTED:
Income (loss) before cumulative effect of
adoption of SFAS 133 $ 3,114 $ 2,862 $ (12,627)
Cumulative effect of adoption of SFAS 133 46 -- --
---------- ---------- -----------
Net income (loss) (numerator) $ 3,160 $ 2,862 $ (12,627)
========== ========== ===========
Average common shares outstanding 4,256,874 5,102,563 5,942,403
---------- ---------- -----------
Add: Incremental shares from assumed
conversion of warrants -- 24,170 27,016
Incremental shares from assumed
conversion of stock options 53,758 407 --
---------- ---------- -----------
Dilutive potential common shares 53,758 24,577 27,016
---------- ---------- -----------
Diluted weighted average shares
outstanding (denominator) 4,310,632 5,127,140 5,969,419
========== ========== ===========
Per share:
Before cumulative effect of adoption of SFAS 133 $ 0.72 $ 0.56 $ (2.12)
Cumulative effect of adoption of SFAS 133 0.01 -- --
---------- ---------- -----------
After cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.56 $ (2.12)
========== ========== ===========
F-28
15. 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 $ 1,312
of mortgage securities
Impairment charge on mortgage securities 2,225
Realized (loss) on mark to market of
mortgage loans 2,997
Provision for (loss) on disposition of
unconsolidated subsidiary (HCP-2) 4,793
Additional operating expenses relating
to the provision for (loss) on sale of
unconsolidated subsidiary (HCP-2) 153
Loss from unconsolidated subsidiary (HCP-2) 403
Catch-up premium, (discount), deferred
financing adjustments on certain
CMOs and mortgage securities 1,821
Mortgage loan net interest income adjustment 357
-------
$14,061
=======
16. SUPPLEMENTAL DISLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands except share data):
Cash paid during the year for interest:
YEARS ENDED DECEMBER 31,
-----------------------------
2001 2000 1999
-------- -------- -------
$ 14,135 $ 20,666 $22,058
======== ======== =======
Supplemental Schedule of Noncash Activities
Dividends of $855,000, $865,000 and $583,000 were declared in December 2001,
2000 and 1999, respectively but were not paid until January 2002, February 2001,
and February 2000, respectively.
Issuance of 136,734 of common stock in exchange for withholding of 163,265
shares in the exercise of a stock purchase warrant entitling the holder to
purchase up to 299,999 shares of Hanover's common stock at an exercise price of
$4.00.
17. COMMITMENTS AND CONTINGENCIES
Hanover has entered into employment agreements with the Principals and Mr.
Kaplan. Such agreements provide for initial 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 upon the expiration of the initial term,
the term of each contract is automatically extended on its anniversary for a one
year period, 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 (i) issue to the
Principals up to 216,667 additional shares of Hanover's common stock and (ii)
forgive a maximum of $1,750,000 in loans made to the Principals if certain
F-29
financial returns to stockholders are met, at certain Earn-out Measuring Dates
as described in Hanover's IPO Prospectus dated September 15, 1997.
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, 2001, the Company had forward commitments to sell $7.2 million
(par value) and to buy $0.7 million (par value) of Agency mortgage securities
that had not yet settled. These net forward commitments were entered into to
hedge the expected sale of approximately $10.1 million, principal balance, of
purchased subordinate MBS classified as trading.
18. 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, 2001 and 2000 are as follows (dollars in thousands):
DECEMBER 31, 2001 DECEMBER 31, 2000
------------------- ----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------- -------- --------- ---------
Assets:
Mortgage loans
Held for sale $ 2,391 $ 2,391 $ 230 $ 230
Collateral for CMOs 151,882 151,295 212,017 207,741
Mortgage securities pledged
as collateral for reverse
repurchase agreements:
Available for sale 4,404 4,404 11,785 11,785
Held to maturity 768 709 1,384 1,392
Trading 33,182 33,182 1,743 1,743
Mortgage securities pledged
as collateral for CMOs 9,840 9,576 9,877 9,340
Mortgage securities not pledged:
Available for sale 1,162 1,162 4,744 4,744
Held to maturity -- -- 3,133 3,033
Trading 1,827 1,827 3,057 3,057
Interest rate caps 49 49 619 206
Forward commitments to sell
mortgage securities 28 28 (103) (103)
Cash and cash equivalents 8,946 8,946 9,958 9,958
Accrued interest receivable 1,960 1,960 2,466 2,466
Notes receivable 12,538 12,538 7,887 7,887
-------- -------- --------- ---------
Total $228,977 $228,067 $ 268,797 $ 263,479
======== ======== ========= =========
F-30
Liabilities:
Reverse repurchase agreements $ 33,338 $ 33,338 $ 14,760 $ 14,760
CMO borrowing 151,096 149,865 210,374 209,331
Accrued interest payable 1,094 1,094 1,796 1,796
Other liabilities 1,583 1,583 790 790
-------- -------- --------- ---------
Total $187,111 $185,880 $ 227,720 $ 226,677
======== ======== ========= =========
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Mortgage loans - The fair values of these financial instruments are based upon
actual prices received upon recent sales of loans and securities to investors
and projected prices which could be obtained through investors considering
interest rates, loan type, and credit quality.
Mortgage securities - The fair values of these financial instruments are based
upon either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investors, estimates considering interest rates, loan type, quality and
discounted cash flow analysis based on prepayment and interest rate assumptions
used in the market place for similar securities with similar credit ratings.
Cash and cash equivalents, accrued interest receivable, notes receivable,
reverse repurchase agreements, accrued interest payable, other liabilities - The
fair value of these financial instruments was determined to be their carrying
value due to their short-term nature.
CMO Borrowing - The fair values of these financial instruments are based upon
either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investor estimates considering interest rates, loan type, quality and discounted
cash flow analysis based on prepayment and interest rate assumptions used in the
market place for similar securities with similar credit ratings.
Forward commitments to sell securities - The Company has outstanding forward
commitments to sell mortgage securities into mandatory delivery contracts with
investment bankers, private investors and agency-backed securities. The fair
value of these financial instruments was determined through review of published
market information associated with similar instruments. These commitment
obligations are considered in conjunction with the Company's lower of cost or
market valuation of its loans held for sale.
Interest rate caps - The fair values of these financial instruments are
estimated based on dealer quotes and is the estimated amount the Company would
pay to execute a new agreement with similar terms.
19. SUBSEQUENT EVENTS
On January 9, 2002, a $0.20 cash dividend, previously declared by the Board of
Directors, was paid to stockholders of record as of December 31, 2001.
On February 19, 2002, the Company made a capital contribution to HTC of 63,577
shares of Hanover common stock with a then fair market value of $470,470. The
capital contribution was utilized by HTC to fund the earn-out issued in
connection with HTC's purchase of all of the assets of Pamex.
F-31
On March 20, 2002, the maturity date of the notes payable from HCP, HCP-2 and
HTC were extended from March 31, 2002 to March 31, 2003.
On March 27, 2002, the Company renewed its $10 million committed reverse
repurchase line of credit, this committed line matures on March 27, 2003.
20. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data are as follows (dollars in thousands, except
per share data):
Three Months Ended
---------------------------------------------------
December 31, September 30, June 30, March 31,
2001 2001 2001 2001
------------ ------------- -------- ---------
Net interest income $ 1,658 $ 1,607 $ 1,674 $ 1,330
============ ============= ======== =========
Net income $ 1,065 $ 726 $ 696 $ 673
============ ============= ======== =========
Basic earnings per share (1) $ 0.25 $ 0.17 $ 0.17 $ 0.16
============ ============= ======== =========
Diluted earnings per share (1) $ 0.25 $ 0.17 $ 0.16 $ 0.15
============ ============= ======== =========
Dividends declared $ 0.20 $ 0.20 $ 0.20 $ 0.20
============ ============= ======== =========
Three Months 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 (1) $ 0.16 $ 0.15 $ 0.14 $ 0.12
============ ============= ======== =========
Diluted earnings per share (1) $ 0.15 $ 0.15 $ 0.14 $ 0.12
============ ============= ======== =========
Dividends declared $ 0.20 $ 0.20 $ 0.14 $ 0.12
============ ============= ======== =========
Three Months Ended
---------------------------------------------------
December 31, September 30, June 30, March 31,
1999 1999 1999 1999
------------ ------------- -------- ---------
Net interest income (loss) $ 1,509 $ (884) $ 1,733 $ 2,051
============ ============= ======== =========
Net income (loss) $ 573 $ (13,994) $ 58 $ 736
============ ============= ======== =========
Basic earnings (loss) per share (1) $ 0.10 $ (2.40) $ 0.01 $ 0.12
============ ============= ======== =========
Diluted earnings (loss) per share (1) $ 0.10 $ (2.38) $ 0.01 $ 0.11
============ ============= ======== =========
Dividends declared $ 0.10 $ 0.10 $ 0.10 $ 0.20
============ ============= ======== =========
(1) 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.
******
F-32
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Partners Ltd. and Subsidiaries
Edison, New Jersey
We have audited the accompanying consolidated balance sheets of Hanover Capital
Partners Ltd. and Subsidiaries (the "Company") as of December 31, 2001 and 2000,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 2001.
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 financial position of Hanover Capital Partners Ltd. and
Subsidiaries at December 31, 2001 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2001, in conformity with accounting principles generally accepted in the
United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 22, 2002
F-33
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
--------------------------
ASSETS 2001 2000
----------- -----------
CURRENT ASSETS:
Cash $ 847,676 $ 493,711
Investment in marketable securities 3,300 3,300
Accounts receivable 996,777 2,302,211
Receivables from related parties 473,637 532,115
Accrued revenue on contracts in progress 1,035,870 1,347,566
Prepaid expenses and other current assets 39,580 26,556
----------- -----------
Total current assets 3,396,840 4,705,459
PROPERTY AND EQUIPMENT - Net 100,584 86,717
DEFERRED TAX ASSET 294,041 340,731
OTHER ASSETS 10,040 13,730
----------- -----------
TOTAL ASSETS $ 3,801,505 $ 5,146,637
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accrued appraisal and subcontractor costs $ 16,139 $ 36,779
Accounts payable and accrued expenses 456,242 1,541,328
Due to related parties 411,232 --
Deferred revenue -- 5,276
Income tax payable 617 21,508
----------- -----------
Total current liabilities 884,230 1,604,891
NOTE PAYABLE TO RELATED PARTY 1,035,859 1,704,342
----------- -----------
TOTAL LIABILITIES 1,920,089 3,309,233
----------- -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000 shares authorized,
97,000 shares outstanding at December 31, 2001 and 2000 970 970
Common stock: Class A: $.01 par value, 5,000 authorized,
3,000 shares outstanding at December 31, 2001 and 2000 30 30
Additional paid-in capital 2,839,947 2,839,947
Retained earnings (deficit) (959,531) (1,003,543)
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 1,881,416 1,837,404
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 3,801,505 $ 5,146,637
=========== ===========
See notes to consolidated financial statements
F-34
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31,
---------------------------------------
2001 2000 1999
---------- ----------- -----------
REVENUES:
Due diligence fees $5,802,720 $ 7,016,435 $ 5,530,307
Assignment fees 756,683 631,093 --
Mortgage sales and servicing 9,174 27,825 229,557
Loan brokering/asset management fees -- 30,234 789,003
Interest income on mortgage-backed securities, net of
interest expense and loan loss provision of $1,137,499
and $547,636 in 2000 and 1999, respectively -- 513,391 384,642
Gain on sale of mortgage securities -- 440,639 --
Other income 13,783 54,041 136,156
---------- ----------- -----------
Total revenues 6,582,360 8,713,658 7,069,665
---------- ----------- -----------
EXPENSES:
Personnel 2,956,008 3,152,852 3,807,127
Subcontractor 2,373,226 3,081,029 2,098,441
General and administrative 311,083 309,926 388,754
Occupancy 243,888 453,372 477,937
Professional 242,173 257,495 155,609
Travel and subsistence 224,296 215,959 390,318
Interest 65,555 90,054 252,144
Depreciation and amortization 57,970 52,908 107,583
---------- ----------- -----------
Total expenses 6,474,199 7,613,595 7,677,913
---------- ----------- -----------
NET INCOME (LOSS) BEFORE INCOME TAX
PROVISION (BENEFIT) 108,161 1,100,063 (608,248)
INCOME TAX PROVISION (BENEFIT) 64,149 631,722 (152,062)
---------- ----------- -----------
NET INCOME (LOSS) $ 44,012 $ 468,341 $ (456,186)
========== =========== ===========
BASIC EARNINGS (LOSS) PER SHARE (NOTE 2) $ 14.67 $ 156.11 $ (152.06)
========== =========== ===========
See notes to consolidated financial statements
F-35
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
Common Stock
Preferred Stock New Class A Additional
--------------- --------------- Paid-In
Shares Amount Shares Amount Capital
------ ------ ------ ------ ----------
BALANCE, DECEMBER 31, 1998 97,000 $ 970 3,000 $ 30 $2,839,947
Comprehensive (loss):
Net (loss)
Other comprehensive income:
Change in net unrealized
gain on securities
available for sale, net
of income tax effect
Comprehensive (loss)
------ ------ ------ ------ ----------
BALANCE, DECEMBER 31, 1999 97,000 970 3,000 30 2,839,947
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 2,839,947
Comprehensive income:
Net income
Comprehensive income
------ ------ ------ ------ ----------
BALANCE, DECEMBER 31, 2001 97,000 $ 970 3,000 $ 30 $2,839,947
====== ====== ====== ====== ==========
Accumulated
Comprehensive Retained Other
Income Earnings Comprehensive
(Loss) (Deficit) Gain Total
------------- ----------- ------------- -----------
BALANCE, DECEMBER 31, 1998 $(1,015,698) $ -- $ 1,825,249
Comprehensive (loss):
Net (loss) $ (456,186) (456,186) (456,186)
Other comprehensive income:
Change in net unrealized
gain on securities
available for sale, net
of income tax effect 142,311 142,311 142,311
-------------
Comprehensive (loss) $ (313,875)
============= ----------- ------------- -----------
BALANCE, DECEMBER 31, 1999 (1,471,884) 142,311 1,511,374
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 (1,003,543) -- 1,837,404
Comprehensive income:
Net income $ 44,012 44,012 44,012
-------------
Comprehensive income 44,012
============= ----------- ------------- -----------
BALANCE, DECEMBER 31, 2001 $ (959,531) $ -- $ 1,881,416
=========== ============= ===========
See notes to consolidated financial statements
F-36
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
--------------------------------------------
2001 2000 1999
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 44,012 $ 468,341 $ (456,186)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Amortization of net premium -- (374,961) (204,010)
Loan loss provision -- 478,330 289,297
Depreciation and amortization 53,875 42,798 107,583
Deferred tax provision (benefit) 46,690 612,682 (152,062)
Gain on sale of mortgage-backed securities -- (440,639) --
(Gain) loss on disposal of property and equipment -- (2,700) 14,588
Sale (purchase) of trading securities -- 15,755 (1,063)
Changes in assets - (increase) decrease:
Accounts receivable 1,305,434 (1,633,218) (151,748)
Receivables from/payables to related parties 469,710 (345,146) 26,810
Accrued interest receivable -- 181,471 (181,471)
Accrued revenue on contracts in progress 311,696 (585,643) (514,823)
Income tax receivable -- -- 219,563
Prepaid expenses and other current assets (13,024) 143,645 22,379
Other assets 3,690 161,903 (47,062)
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs (20,640) 23,197 (7,148)
Accounts payable and accrued expenses (1,085,086) 1,032,353 42,278
Income tax payable (20,891) 21,508 --
Deferred revenue (5,276) 5,276 (89,625)
------------ ------------ ------------
Net cash provided by (used in) operating activities 1,090,190 (195,048) (1,082,700)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (67,742) (72,914) (38,598)
Sale of property and equipment -- 2,700 1,285
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 (67,742) 14,207,659 (14,063,202)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (repayment of) proceeds from note payable to related party
(668,483) (3,191,704) 4,183,222
Net (repayment of) borrowings from reverse repurchase agreements
-- (10,842,000) 10,842,000
------------ ------------ ------------
Net cash (used in) provided by financing activities (668,483) (14,033,704) 15,025,222
------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH 353,965 (21,093) (120,680)
CASH, BEGINNING OF YEAR 493,711 514,804 635,484
------------ ------------ ------------
CASH, END OF YEAR $ 847,676 $ 493,711 $ 514,804
============ ============ ============
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $7,165,000 were originated by HCMC
and funded by investors in 1999
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 60,518 $ 3,435 $ 5,350
============ ============ ============
Interest $ 43,936 $ 830,930 $ 323,851
============ ============ ============
See notes to consolidated financial statements
F-37
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
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.
USE OF ESTIMATES - The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Estimates, by their nature,
are based on judgment and available information. Actual results could differ
from the estimates.
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, 2001
and 2000.
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.
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.
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.
F-38
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.
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.
ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - The fair value of cash, accounts
receivable, accounts payable and accrued expenses, due to and from related
parties, and note payable to related party were determined to be their carrying
value due to their short-term nature.
RECLASSIFICATION - Certain reclassifications of prior years' amounts have been
made to conform to the current year presentation.
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 ADOPTED 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.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In August 2001, the Financial
Accounting Standards Board issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes
Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of ("SFAS 121"). SFAS 144 retains the
requirements of SFAS 121 for recognizing and measuring the impairment loss of
long-lived assets to be held and used. For long-lived assets to be disposed of
by sale, SFAS 144 requires a single accounting model be used for all long-lived
assets, whether previously held and used or newly acquired. Long-lived assets to
be disposed of other than by sale would be considered held and used until
disposition. SFAS 144 also broadens the presentation of discontinued operations
in the income statement to include more disposal transactions. SFAS 144 is
effective for fiscal years beginning after December 15, 2001. The Company
adopted SFAS 144 effective January 1, 2002. The adoption of SFAS 144 did not
have an impact on the consolidated financial position or results of operations
of the Company.
F-39
3. PROPERTY AND EQUIPMENT
DECEMBER 31,
------------------------
2001 2000
---------- ----------
Office machinery and computer equipment $ 367,430 $ 302,047
Furniture and fixtures 7,104 4,745
---------- ----------
374,534 306,792
Less accumulated depreciation (273,950) (220,075)
---------- ----------
Property and equipment - net $ 100,584 $ 86,717
========== ==========
Depreciation expense for the years ended December 31, 2001, 2000 and 1999 was
$53,875, $42,798 and $107,583, respectively.
4. CONCENTRATION RISK
For the year ended December 31, 2001 the Company received revenues from certain
customers which exceeded 10% of total revenues as follows:
2001
----
Major Customer # 1 17%
Major Customer # 2 13%
Major Customer # 3 10%
Major Customer # 4 10%
5. MORTGAGE SERVICING
The Company, through its wholly-owned subsidiary, HCMC, services multifamily
mortgage loans on behalf of others. Loan servicing consists of the collection of
monthly mortgage payments on behalf of investors, reporting information to those
investors on a monthly basis, and 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, 2001 and 2000, HCMC was
servicing 3 and 5 loans, respectively, with unpaid principal balances of
$4,918,187 and $10,227,119 including loans subserviced for others of $3,774,586
and $7,584,236, respectively. Escrow balances maintained by HCMC were $152,226
and $170,830 at December 31, 2001 and 2000, respectively. The aforementioned
servicing portfolio and related escrow accounts are not included in the
accompanying Consolidated Balance Sheets as of December 31, 2001, and 2000.
F-40
6. RELATED PARTY TRANSACTIONS
DECEMBER 31,
-------------------
2001 2000
-------- --------
Due from Hanover Capital Mortgage Holdings, Inc. (1) $ -- $185,381
Due from Hanover Mortgage Capital Corporation (2) 6,662 6,661
Due from HanoverTrade.com, Inc. (3) 465,987 339,444
Due from HDMF-I LLC 988 --
-------- --------
Due from related entities 473,637 531,486
Due from officers (4) -- 629
-------- --------
Receivables from related parties $473,637 $532,115
======== ========
(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, 2002 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.
(4) Amounts due from officers are mostly miscellaneous travel-related
advances.
Due to related parties of $411,232 at December 31, 2001 is due to HCHI and
primarily represents an allocation of payroll expenses and tax payments made by
HCHI on behalf of HCP, partially offset by management fees charged by HCP to
HCHI as discussed in (1) above.
At December 31, 2001 and 2000, the Company had a principal balance outstanding
on a note payable to HCHI in the amount of $1,035,859 and $1,704,342,
respectively. The note bears interest at the prime rate minus 1% and interest is
calculated on the daily principal balance outstanding. At December 31, 2001, and
2000, the interest rate in effect was 3.75% and 8.50%, respectively. Included in
the 2001 and 2000 Consolidated Statements of Operations is interest expense in
the amount of $65,555 and $265,062, respectively related to this note payable.
The entire unpaid principal balance on the note is due in full on the extended
maturity date, March 31, 2003.
F-41
7. INCOME TAXES
The components of deferred income taxes as of December 31, 2001 and 2000 are as
follows:
DECEMBER 31,
-----------------------
2001 2000
---------- ----------
Deferred tax assets
Temporary differences $ 64,585 $ 112,849
Federal net operating loss carryforward 318,254 374,411
State/Local net operating loss carryforward 106,085 73,481
AMT Credit 16,830 16,830
---------- ----------
Total deferred tax assets 505,754 577,571
Deferred tax liabilities
Temporary differences -- (25,127)
Valuation allowance (211,713) (211,713)
---------- ----------
Net deferred tax assets $ 294,041 $ 340,731
========== ==========
The items resulting in significant temporary differences for the years ended
December 31, 2001 and 2000 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, 2001, 2000 and 1999 consist of the following:
YEARS ENDED DECEMBER 31,
-------------------------------
2001 2000 1999
-------- -------- ---------
Current - Federal, state and local $ 17,459 $ 19,040 $ --
Deferred - Federal, state and local 46,690 612,682 (152,062)
-------- -------- ---------
Total $ 64,149 $631,722 $(152,062)
======== ======== =========
The income tax provision (benefit) differs from amounts computed at statutory
rates, as follows:
YEARS ENDED DECEMBER 31,
--------------------------------
2001 2000 1999
-------- --------- ---------
Federal income tax provision (benefit) at $32,448 $ 374,021 $(206,804)
statutory rate
State and local income tax provision (benefit) 10,816 72,052 (40,145)
Meals and entertainment 1,812 4,065 6,486
Officer's life insurance 3,551 268 --
Tax settlement 15,522 -- --
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
-------- --------- ---------
Total $ 64,149 $ 631,722 $(152,062)
======== ========= =========
The Company has a Federal tax net operating loss carryforward of approximately
$1.1 million which begins to expire in the year 2012.
F-42
8. 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.
9. COMMITMENTS AND CONTINGENCIES
The Company has noncancelable operating lease agreements for office space which
all expire during 2002. Minimum rental payments for such leases in 2002 total
$47,687.
Rent expense for the years ended December 31, 2001, 2000 and 1999 amounted to
$116,556, $144,731 and $217,413, respectively.
HCHI guaranteed the obligations of the Company with respect to an office lease
entered into by the Company. This lease was cancelled by the landlord in October
2001 as a result of the terrorist attack in New York City on September 11, 2001.
10. SUBSEQUENT EVENTS
On March 20, 2002, the maturity date of the note payable to HCHI was extended
from March 31, 2002 to March 31, 2003.
******
F-43
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
HanoverTrade.com, Inc. and Subsidiary
Edison, New Jersey
We have audited the accompanying consolidated balance sheets of
HanoverTrade.com, Inc. and Subsidiary (the "Company") as of December 31, 2001
and 2000, and the related consolidated statements of operations, stockholders'
equity, and cash flows for the years ended December 31, 2001 and 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 consolidated financial statements present fairly, in all
material respects, the financial position of HanoverTrade.com, Inc. and
Subsidiary at December 31, 2001 and 2000, and the results of their operations
and their cash-flows for the years ended December 31, 2001, and 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 22, 2002
F-44
HANOVERTRADE.COM, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
--------------------------
ASSETS 2001 2000
----------- -----------
CURRENT ASSETS:
Cash $ 196,451 $ 32,573
Accounts receivable 590,234 10,000
Prepaid expenses and other current assets 31,105 --
----------- -----------
Total current assets 817,790 42,573
PROPERTY AND EQUIPMENT - Net 176,728 19,681
CAPITALIZED SOFTWARE - Net 2,170,323 2,702,266
GOODWILL - Net 1,044,266 --
DEFERRED TAX ASSET - Net -- --
OTHER ASSETS 68,971 --
----------- -----------
TOTAL ASSETS $ 4,278,078 $ 2,764,520
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 407,372 $ 1,008,403
Accrued interest due to related party 103,738 35,864
Payable under asset purchase agreement 500,000 --
Due to related parties 544,639 390,138
Other current liabilities 5,110 --
----------- -----------
Total current liabilities 1,560,859 1,434,405
NOTE PAYABLE TO RELATED PARTY 7,654,396 2,903,758
----------- -----------
TOTAL LIABILITIES 9,215,255 4,338,163
----------- -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Series A preferred stock: $0.01 par value, 100,000 shares authorized,
97,000 shares outstanding at December 31, 2001 and 2000 970 970
Common stock: $0.01 par value, 105,000 and 5,000 shares
authorized at December 31, 2001 and 2000, respectively,
3,000 shares outstanding at December 31, 2001 and 2000 30 30
Retained earnings (deficit) (4,938,177) (1,574,643)
----------- -----------
TOTAL STOCKHOLDERS' EQUITY (DEFICIT) (4,937,177) (1,573,643)
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 4,278,078 $ 2,764,520
=========== ===========
See notes to consolidated financial statements
F-45
HANOVERTRADE.COM, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
PERIOD FROM
MAY 28, 1999
YEARS ENDED DECEMBER 31, (INCEPTION) TO
-------------------------- DECEMBER 31,
2001 2000 1999
----------- ----------- --------------
REVENUES:
Loan brokering/trading $ 2,605,665 $ 140,781 $ --
Loan sale advisory services 993,007 -- --
----------- ----------- --------------
Total revenues 3,598,672 140,781 --
----------- ----------- --------------
EXPENSES:
Personnel 3,616,575 789,646 --
Depreciation and amortization 1,102,073 150,935 --
Technology 663,955 230,520 4,450
General and administrative 410,036 93,471 676
Interest 366,243 81,479 --
Occupancy 325,960 130,278 --
Travel and entertainment 262,695 174,821 11,892
Professional 214,669 32,143 15,113
----------- ----------- --------------
Total expenses 6,962,206 1,683,293 32,131
----------- ----------- --------------
(LOSS) BEFORE INCOME TAX (3,363,534) (1,542,512) (32,131)
INCOME TAX BENEFIT -- -- --
----------- ----------- --------------
NET (LOSS) $(3,363,534) $(1,542,512) $ (32,131)
=========== =========== ==============
BASIC (LOSS) PER SHARE (NOTE 2) $ (1,121.18) $ (514.17) $ (10.71)
=========== =========== ==============
See notes to consolidated financial statements
F-46
HANOVERTRADE.COM, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2001 AND 2000 AND PERIOD
FROM MAY 28, 1999 (INCEPTION) TO DECEMBER 31, 1999
Series A Accumulated
Preferred Stock Common Stock Retained Other
--------------- --------------- Comprehensive Earnings Comprehensive
Shares Amount Shares Amount (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)
Comprehensive (loss):
Net (loss) $ (3,363,534) (3,363,534) (3,363,534)
-------------
Comprehensive (loss) $ (3,363,534)
------ ------ ------ ------ ============= ----------- ---------- -----------
BALANCE, DECEMBER 31, 2001 97,000 $ 970 3,000 $ 30 $(4,938,177) -- $(4,937,177)
====== ====== ====== ====== =========== ========== ===========
See notes to consolidated financial statements
F-47
HANOVERTRADE.COM, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
PERIOD FROM
MAY 28, 1999
YEARS ENDED DECEMBER 31, (INCEPTION) TO
-------------------------- DECEMBER 31,
2001 2000 1999
----------- ----------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $(3,363,534) $(1,542,512) $ (32,131)
Adjustments to reconcile net (loss) to net cash (used in)
provided by operating activities:
Depreciation and amortization 1,102,073 150,935 --
Changes in assets - (increase) decrease:
Accounts receivable (580,234) (9,974) (26)
Prepaid expenses and other assets (85,201) -- --
Changes in liabilities - increase (decrease):
Accounts payable and accrued expenses (601,031) 1,008,403 --
Accrued interest due to related party 67,874 35,864 --
Due to related parties 154,501 254,512 135,626
Other current liabilities 5,110 -- --
----------- ----------- --------------
Net cash (used in) provided by operating activities (3,300,442) (102,772) 103,469
----------- ----------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (28,620) (21,695) --
Capitalized software costs (424,287) (2,747,647) (103,540)
Acquisition, net of cash acquired (833,411) -- --
----------- ----------- --------------
Net cash (used in) investing activities (1,286,318) (2,769,342) (103,540)
----------- ----------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from note payable to related party 4,750,638 2,903,758 --
Capital contributions -- -- 1,000
----------- ----------- --------------
Net cash provided by financing activities 4,750,638 2,903,758 1,000
----------- ----------- --------------
NET INCREASE IN CASH 163,878 31,644 929
CASH, BEGINNING OF YEAR 32,573 929 --
----------- ----------- --------------
CASH, END OF YEAR $ 196,451 $ 32,573 $ 929
=========== =========== ==============
See notes to consolidated financial statements
F-48
HANOVERTRADE.COM, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001 AND 2000 AND
THE PERIOD FROM MAY 28, 1999 (INCEPTION) TO DECEMBER 31, 1999
1. BUSINESS DESCRIPTION
HanoverTrade.com, Inc. and Subsidiary is principally engaged in operating a
worldwide web-based exchange for trading mortgage loans, mortgage servicing
rights and related assets, and providing a state of the art Internet trading
facility supported by experienced valuation, operations and trading
professionals. In addition to trading assets, HanoverTrade.com, Inc. and
Subsidiary provides a full range of asset valuation, analysis, due diligence and
marketing services for: performing, sub-performing and non-performing assets;
whole loans and participations; CRA loans; and mortgage servicing rights. A
wholly-owned subsidiary of HanoverTrade.com, Inc., Pamex Securities, LLC 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 HanoverTrade.com, Inc. and its wholly-owned subsidiary (the
"Company"). All significant intercompany accounts and transactions have been
eliminated.
USE OF ESTIMATES; RISKS AND UNCERTAINTIES - The preparation of financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Estimates, by their nature, are based on judgment and available information.
Actual results could differ from the estimates. The Company's estimates and
assumptions primarily arise from risks and uncertainties associated with
technology. Although management is not currently aware of any factors that would
significantly change its estimates and assumptions in the near term, it is
possible that the estimated useful lives of the Company's technology assets and
related carrying values could be reduced in the near term due to competitive
pressures.
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 years.
CAPITALIZED SOFTWARE - Capitalized software includes internal and external
application development stage costs incurred to develop the Company's on-line
worldwide web-based exchange for trading loan pools. Capitalized software costs
are stated at cost less accumulated amortization and are evaluated for
impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable. Amortization is computed on the
straight-line method over the estimated useful lives of the assets, generally
three years. The Company periodically reassesses the estimated useful lives of
the assets considering the effects of obsolescence, technology, competition, and
other economic factors.
GOODWILL - Goodwill represents the excess of the purchase price over the net
carrying value of assets acquired (which approximates fair value) at acquisition
date. Amortization is recorded over the periods estimated to be benefited, 12
years, on a straight-line basis. The Company evaluates goodwill for
F-49
impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable.
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. The Company's billing of fees relating to a transaction
occurs concurrently with the closing and funding.
INCOME TAXES - The Company uses the asset and liability method in accounting for
income taxes. This measures the tax effect of differences between the tax basis
and financial statement carrying amounts of assets and liabilities.
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.
RELATED PARTY TRANSACTIONS - The results of operations may not necessarily be
indicative of those that would have occurred on a stand-alone basis.
ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - The fair values of cash,
accounts receivable, accounts payable and accrued expenses, due to related
parties and note payable to related party were determined to be their carrying
values due to their short-term nature.
RECLASSIFICATION - Certain reclassifications of prior years' amounts have been
made to conform to the current year presentation.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2001, the Financial
Accounting Standards Board (the "FASB") issued Statement No. 142, Goodwill and
Other Intangible Assets ("SFAS 142"). SFAS 142 requires that upon adoption,
amortization of goodwill will cease and instead, the carrying value of goodwill
will be evaluated for impairment on an annual basis. Identifiable intangible
assets will continue to be amortized over their useful lives and reviewed for
impairment in accordance with SFAS No. 121 Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of. SFAS 142 is
effective for fiscal years beginning after December 15, 2001. The Company
adopted SFAS 142 effective January 1, 2002. The adoption of SFAS 142 is not
expected to have a significant impact on the consolidated financial position or
results of operations of the Company. The adoption of SFAS 142 is expected to
reduce amortization expense by approximately $92,000 for the year ending
December 31, 2002.
In August 2001, the FASB issued Statement No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes Statement No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of ("SFAS 121"). SFAS 144 retains the requirements of SFAS
121 for recognizing and measuring the impairment loss of long-lived assets to be
held and used. For long-lived assets to be disposed of by sale, SFAS 144
requires a single accounting model be used for all long-lived assets, whether
previously held and used or newly acquired. Long-lived assets to be disposed of
other than by sale would be considered held and used until disposition. SFAS 144
also broadens the presentation of discontinued operations in the income
statement to include more disposal transactions. SFAS 144 is effective for
fiscal years beginning after
F-50
December 15, 2001. The Company adopted SFAS 144 effective January 1, 2002. The
adoption of SFAS 144 did not have an impact on the consolidated financial
position or results of operations of the Company.
3. ACQUISITION
On January 19, 2001, the Company hired 18 employees of Pamex Capital Partners
LLC ("Pamex") and purchased all of its assets. The Company entered into
employment agreements with 6 of the 18 employees hired. The purchase price
consisted of $850,000 in cash paid at closing, professional fees of $18,530 plus
an earn-out of between $1,250,000 and $1,500,000, payable over three years in
common stock of Hanover Capital Mortgage Holdings, Inc. ("Hanover"). At December
31, 2001, an earn-out of $500,000 had been accrued and was subsequently paid on
February 19, 2002. Included in the assets purchased was Pamex Securities, LLC
("Psecurities"), a securities broker dealer with minimal net assets and
insignificant net income from continuing operations for the period from January
19, 2001 to December 31, 2001. Psecurities is registered with the Securities and
Exchange Commission and the National Association of Securities Dealers. In
addition, the Company is required under terms of the purchase agreement to adopt
an employee stock option plan pursuant to which it will issue options to
purchase 5% of the number of shares of common stock outstanding as of January
19, 2002.
4. PROPERTY AND EQUIPMENT
DECEMBER 31,
------------------------
2001 2000
---------- ----------
Office machinery and computer equipment $ 259,950 $ 21,695
Less accumulated depreciation (83,222) (2,014)
---------- ----------
Property and equipment - net $ 176,728 $ 19,681
========== ==========
Depreciation expense for the years ended December 31, 2001 and 2000 was $81,208
and $2,014, respectively. There was no depreciation expense for the period from
May 28, 1999 (inception) to December 31, 1999.
5. CAPITALIZED SOFTWARE
DECEMBER 31,
--------------------------
2001 2000
----------- -----------
Capitalized software costs $ 3,275,474 $ 2,851,187
Less accumulated amortization (1,105,151) (148,921)
----------- -----------
Capitalized software costs - net $ 2,170,323 $ 2,702,266
=========== ===========
Amortization expense for the years ended December 31, 2001 and 2000 was $956,230
and $148,921, respectively. There was no amortization expense for the period
from May 28, 1999 (inception) to December 31, 1999.
F-51
6. GOODWILL
DECEMBER 31,
2001
-----------
Goodwill $ 1,108,901
Less accumulated amortization (64,635)
-----------
Goodwill - net $ 1,044,266
===========
Amortization expense for the year ended December 31, 2001 was $64,635.
7. CONCENTRATION RISK
For the year ended December 31, 2001, two of the Company's customers
individually accounted for 34% and 11% of total revenues. No other customer
individually accounted for more than 10% of total revenues.
8. RELATED PARTY TRANSACTIONS
DECEMBER 31,
------------------------
2001 2000
---------- ----------
Due to Hanover Capital Partners Ltd. $ 466,287 $ 339,443
Due to Hanover Capital Mortgage Holdings, Inc. 78,400 50,695
Other (48) --
---------- ----------
Due to related parties $ 544,639 $ 390,138
========== ==========
For the years ended December 31, 2001 and 2000, and the period from May 28, 1999
(inception) to December 31, 1999, Hanover Capital Partners Ltd. ("HCP") and
Hanover billed certain expenses to HanoverTrade.com, Inc. ("HTC"). The expenses
billed include personnel, occupancy, travel and entertainment, and general and
administrative. These expenses 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 $1,693,161 and $464,000 of net expenses to HTC for the
years ended December 31, 2001 and 2000, respectively. The billings included
$1,607,094 and $441,000 of personnel, $26,465 and $26,000 of occupancy, $59,602
and $57,000 of travel and entertainment, respectively and $51,000 of general and
administrative offset by $111,000 of loan brokering/trading revenue for the year
ended December 31, 2000. For the period from May 28, 1999 (inception) to
December 31, 1999, HCP billed a total of $14,000 of expenses to HTC including
$12,000 of travel and entertainment and $2,000 of technology.
Hanover billed a total of $345,230 and $488,000 of expenses to HTC for the years
ended December 31, 2001 and 2000, respectively. The billings included $345,230
and $369,000 of personnel, respectively and $103,000 of occupancy and $16,000 of
general and administrative for the year ended December 31, 2000. For the period
from May 28, 1999 (inception) to December 31, 1999, Hanover billed a total of
$18,000 of expenses to HTC including $15,000 of professional and $3,000 of
technology.
At December 31, 2001 and 2000, HTC had a principal balance on a note payable to
Hanover in the amount of $7,654,396 and $2,903,758, respectively. 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, 2001 and 2000, the interest rate in effect was
3.75% and
F-52
8.5%, respectively. The entire unpaid principal balance on the note is due in
full on the extended maturity date, March 31, 2003.
9. INCOME TAXES
DECEMBER 31,
-------------------------
2001 2000
----------- ----------
Deferred tax assets $ 1,944,289 $ 620,824
Valuation allowance (1,944,289) (620,824)
----------- ----------
Deferred tax asset - net $ -- $ --
=========== ==========
The items resulting in significant temporary differences for the years ended
December 31, 2001 and 2000 that generate deferred tax assets relate primarily to
the benefit of net operating loss carryforwards and goodwill amortization. The
Company has established a valuation allowance for the full amount of the
deferred income tax benefit.
The income tax (benefit) differs from amounts computed at statutory rates, as
follows:
PERIOD FROM
MAY 28, 1999
YEARS ENDED DECEMBER 31, (INCEPTION) TO
------------------------- DECEMBER 31,
2001 2000 1999
----------- ---------- --------------
Federal income taxes (benefit) at statutory rate $(1,143,602) $ (524,454) $ (10,925)
State and local income taxes (benefit) (191,274) (97,050) (2,026)
Meals and entertainment 8,609 11,228 522
Officers' life insurance 2,802 1,881 --
----------- ---------- --------------
Total tax (benefit) (1,323,465) (608,395) (12,429)
Valuation Allowance 1,323,465 608,395 12,429
----------- ---------- --------------
Income tax (benefit) $ -- $ -- $ --
=========== ========== ==============
The Company has a Federal tax net operating loss carryforward of approximately
$4,860,000 that begins to expire in 2014.
10. STOCKHOLDERS' EQUITY
Hanover owns all of the outstanding preferred stock of the Company, giving it a
97% economic interest. The remaining 3% economic interest represented by all of
the common stock of the Company is owned by the principals, John A. Burchett,
Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares. 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 stockholders except
for certain situations involving merger, dissolution, sale of substantially all
the assets of the Company, and amendments to the certificate of incorporation
adversely affecting the preferred stockholder. In these situations, the
preferred stockholder shall be entitled to vote.
F-53
On February 13, 2001, the Company's Certificate of Incorporation was amended to
authorize an additional 100,000 shares of common stock.
11. 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
---- ----------
2002 $ 186,772
2003 170,112
2004 139,810
2005 45,932
----------
$ 542,626
==========
Rent expense for the years ended December 31, 2001 and 2000 amounted to $190,379
and $69,533, respectively. There was no rent expense for the period from May 28,
1999 (inception) to December 31, 1999.
12. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
PERIOD FROM
MAY 28, 1999
YEARS ENDED DECEMBER 31, (INCEPTION) TO
------------------------ DECEMBER 31,
2001 2000 1999
---------- ---------- --------------
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
Interest to related party $ 298,369 $ 45,615 $ --
========== ========== ==============
ACQUISITION, NET OF CASH ACQUIRED:
Fair value of assets acquired $ 259,629 $ -- $ --
Goodwill at acquisition 590,371 -- --
Direct costs of acquisition 18,530 -- --
Less cash acquired (35,119) -- --
---------- ---------- --------------
Net cash paid for acquisition $ 833,411 $ -- $ --
========== ========== ==============
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING ACTIVITIES:
At December 31, 2001, an earn-out of $500,000 had been accrued in connection
with the acquisition of Pamex. Accordingly, a corresponding increase in goodwill
and payable under asset purchase agreement were recorded.
13. SUBSEQUENT EVENTS
On February 19, 2002, the Company received a capital contribution from Hanover
of 63,577 shares of Hanover common stock with a then fair market value of
$470,470. The capital contribution was utilized by the Company to fund the
earn-out issued in connection with its purchase of all of the assets of Pamex.
The difference between the amount accrued at December 31, 2001 and the capital
contribution at February 19, 2002, or $29,530, will be reflected as an
adjustment to goodwill.
F-54
On March 12, 2002, the Company entered into a letter of intent with a third
party to sell its wholly-owned subsidiary, Psecurities. An officer of the
Company is related to an officer of the potential purchaser. Notwithstanding the
aforementioned relationship, the Company negotiated the terms of the letter of
intent as an arms-length transaction. There can be no guarantees that a sale of
the Company's subsidiary will occur.
On March 20, 2002, the maturity date of the note payable to Hanover was extended
from March 31, 2002 to March 31, 2003.
******
F-55