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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 fiscal year ended December 31, 2002
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:
Title of Class Name of Exchange on Which Registered
-------------- ------------------------------------
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 |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2) Yes [ ] No [X]
The aggregate market value of the voting and non-voting common equity
held by non-affiliates, based on the price at which the common equity was last
sold as of June 30, 2002 was $36,409,425.
The registrant had 4,534,402 shares of common stock outstanding as of
March 25, 2003.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Notice of 2003 Annual Stockholders' 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 FISCAL YEAR ENDED DECEMBER 31, 2002
INDEX
PART I PAGE
----
Item 1. Business .............................................................................................. 3
Item 2. Properties ............................................................................................ 16
Item 3. Legal Proceedings ..................................................................................... 16
Item 4. Submission of Matters to a Vote of Security Holders ................................................... 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ................................. 17
Item 6. Selected Financial Data ............................................................................... 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................. 19
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 and Related Stockholder Matters ........ 39
Item 13. Certain Relationships and Related Transactions ........................................................ 39
Item 14. Controls and Procedures ............................................................................... 39
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ....................................... 40
Signatures ...................................................................................................... 41
Certifications .................................................................................................. 42
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. Our 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., which we refer to as Hanover, was
incorporated in Maryland on June 10, 1997. Hanover is a specialty finance
company organized as a real estate investment trust, or REIT, pursuant to the
Internal Revenue Code of 1986, as amended, which we refer to as the "Code."
Hanover has two primary subsidiaries: Hanover Capital Partners Ltd., which we
refer to as HCP, and HanoverTrade, Inc., which we refer to as HT. When we use
the terms "we", "us", "our" or "the Company," we are referring to Hanover
together with its consolidated and unconsolidated subsidiaries including HCP and
HT.
We are engaged in three principal businesses, which are conducted through our
three primary operating units: Hanover, HCP and HT. Hanover's principal business
strategy is to invest in subordinate mortgage-backed securities, which we refer
to as MBS, and mortgage loans for its own account, and, since 2001, for third
parties. HCP's principal business strategy is to generate consulting and other
fee income by providing consulting and due diligence services, focusing on loan
sale advisory, loan file due diligence reviews, staffing solutions and mortgage
assignment and collateral rectification services. HT's principal business
strategy is to generate fee income by operating an Internet exchange for trading
mortgage loans, mortgage servicing rights and related assets, and providing
state-of-the-art technologies supported by experienced valuation, operations and
trading professionals. As discussed below, on July 1, 2002, Hanover acquired
100% of the ownership interests in HCP and HT. We believe that our new
consolidated financial reporting should also include segment information for
each of Hanover, HCP and HT on a stand-alone basis. Note 16 to the
consolidated financial statements attached to this Annual Report on Form 10-K
includes financial information for each of our segments on a stand-alone basis.
Our principal business objective is to generate net interest income on our
portfolio of mortgage securities and mortgage loans and to generate fee income
through HCP, HT and third party asset-management contracts.
Our principal executive offices are located at 379 Thornall Street, Edison, New
Jersey 08837.
CONSOLIDATION OF HANOVER, HCP AND HT
Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved by a
special committee of disinterested members of our Board of Directors, Hanover
acquired 100% of the outstanding common stock of each of HT, HCP and Hanover
Capital Partners 2, Inc., which we refer to as HCP-2, a previously inactive
subsidiary. Hanover had previously owned 100% of the non-voting preferred
stock, but none of the voting common stock, of each of HT, HCP and HCP-2. This
ownership structure was established in order to satisfy tax laws governing
Hanover's status as a REIT. Changes in the tax laws made it possible for
Hanover to acquire voting control of HT, HCP and HCP-2 and operate under new
rules permitting REITs to wholly own subsidiaries such as HT, HCP and HCP-2.
Therefore, as of July 1, 2002, Hanover owns 100% of the outstanding capital
stock of each of HT, HCP and HCP-2, and for periods ending after June 30, 2002,
Hanover's financial statements will be consolidated with the financial
statements of HT, HCP and HCP-2.
3
Hanover acquired the common shares of HT, HCP and HCP-2 from four of its
directors who are also executive officers for $474,000, the price set by an
independent appraiser.
HANOVER
General
Hanover's primary businesses are (1) to acquire and hold prime whole
single-family mortgage loans which serve as collateral for collateralized
mortgage obligations, which we refer to as CMOs, as well as subordinated
single-family mortgage securities and other mortgage-related assets and (2) to
generate fee income from its operating subsidiaries. "Subordinated" MBS bear
all of the credit losses on the related pool of mortgage loans. In other words,
any declines in the value of the pool of loans will erode the value of our
subordinate interests before any losses accrue to the value of more senior
interests in the pool. As a result, these securities bear much greater risk than
the more senior tranches and 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.
We also act as an outside management company for real estate investment
vehicles. In this capacity, we provide asset-management services, including due
diligence and administrative responsibilities. Currently, we manage the
investments of HDMF-I LLC, an entity that invests in sub- and non-performing
single-family mortgage loans. Our primary objectives in forming HDMF-I were to
earn a profit participation while also earning fee income from the related asset
management contract. As of December 31, 2002, HDMF-I had received capital
commitments of $18,500,000, including $5,820,000 committed by us. We are
currently negotiating with institutional investors to increase the total capital
commitments to HDMF-I, and we also intend to target other opportunities for us
to manage assets for third parties under a similar structure; however, there can
be no assurances that we will be successful in raising additional funds to
manage.
We believe that our sales and due diligence organization and mortgage industry
expertise give us advantages over other mortgage market participants. Prior to
acquiring any subordinate MBS, we use our own resources and information provided
by HCP to analyze the credit risk characteristics of these mortgage loan pools
and, we believe, to price these securities more accurately than others in the
market.
4
In the past, we invested directly in mortgage loans on our own behalf. We issued
MBS secured by these loans, and retained the subordinate securities from these
transactions. Although we may securitize additional pools of mortgage loans on
our own in the future, our current strategy is to acquire and hold prime whole
single-family mortgage loans which serve as collateral for CMOs, as well as
subordinated single-family mortgage securities and other mortgage-related
assets.
Trends and Recent Developments
Purchase and Sale of Subordinate MBS. As mentioned above, prior to 1999 we
invested primarily in prime mortgage whole loans, which we subsequently
securitized. When we securitized these mortgage whole loans, we retained a
subordinate interest in the loans, which are referred to as subordinate MBS.
Other issuers also create subordinate MBS that 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 us. As a result of the
change in relative pricing, we found that we could purchase subordinate MBS
created by other entities at very attractive yields. Our costs to acquire
subordinate MBS created by other issuers is substantially lower than the cost of
creating our own subordinate MBS. As a result of the continued evolution of the
markets in which we operate, we shifted our strategy in 1999 from a focus on
securitizing seasoned mortgage whole loans to acquiring interests in third-party
securitizations.
During 2002, we purchased thirty-seven subordinate MBS with an aggregate
principal balance of $23,255,000 at a net purchase price of $12,909,000 and we
sold twenty-four subordinate MBS with an aggregate principal balance of
$16,322,000 at a net sales price of $13,777,000. The sale of subordinate MBS
during 2002 was primarily in response to market conditions and, to a lesser
extent, asset performance. However, given that we generally intend to hold our
assets for the long-term, we do not anticipate that the sale of subordinate MBS
will be a recurring source of income for us.
During 2002, we purchased MBS issued by agencies of the Federal Government,
which we refer to as agency-issued MBS, with an aggregate principal balance of
$29,994,000 at a net purchase price of $33,243,000. During 2002, we sold
agency-issued MBS with an aggregate principal balance of $53,376,000 at a net
sales price of $58,867,000. In the third quarter of 2002, we terminated our
agency-issued MBS trading activity.
Current Portfolio Composition
At December 31, 2002, we had invested $112,969,000, or 72.5% of our total
assets, in single-family mortgage loans classified as held for sale and
collateral for CMOs, and $14,098,000, or 9.0%, of our 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 our audited consolidated financial statements included in
this Annual Report on Form 10-K.
In 2002, we experienced $347,000 of mortgage loan losses on our mortgage loan
portfolio (held for sale and collateral for CMOs), and $48,000 of losses on our
MBS portfolio (available for sale, held to maturity and trading). We experienced
$149,000 of mortgage loan losses during 2001 on our mortgage loan portfolio and
$90,000 of losses on our MBS portfolio. We recorded a provision for anticipated
credit losses of $393,000 and $709,000 in 2002 and 2001, respectively.
Generally, we intend to hold the mortgage loans and created mortgage securities
on a long-term basis, so that we will earn returns over the lives of the
mortgage loans and mortgage securities rather than from sales of the
investments. However, we may sell mortgage securities from time to time
depending on market conditions.
5
Securitization Activity
In June 2000, we 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 our 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.
Subordinate MBS Purchases
In analyzing subordinate MBS for purchase, we focus primarily on subordinated
interests, which we refer to as tranches, in pools of prime whole single-family
mortgage loans that do not fit into large conduits sponsored by government
agencies such as the Federal National Mortgage Association ("FNMA" or "Fannie
Mae"), the Federal Home Loan Mortgage Corporation ("FHLMC"), or the Government
National Mortgage Association ("GNMA" or "Ginnie Mae"). Typically, loans fail to
qualify for these programs because the principal balance of the mortgages
exceeds the maximum amount permissible in a government agency guaranteed MBS.
The subordinate interests that we purchase are generally structured so that they
will absorb the credit losses resulting from a specified pool of mortgages.
Because these tranches could potentially absorb credit losses, the securities we
purchase are generally either not rated or are rated below investment grade
(generally "BB" or "B"), although the pools are usually collateralized by "A"
quality mortgages originated by several of the largest non-government mortgage
conduits in the market. 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. A majority of
our subordinate MBS acquired to date have paid interest at fixed rates.
We purchase subordinate MBS primarily from "Wall Street" dealer firms, although
we are also attempting to develop direct relationships with the larger issuers
of subordinate MBS. For the foreseeable future, we believe that there will be an
adequate supply of subordinate MBS available in the market.
As of December 31, 2002, we had purchased since inception approximately
$104,001,000 (principal balance) of subordinate MBS from third parties at an
aggregate purchase price of $53,649,000. As of the same date, we had sold
approximately $79,134,000 (principal balance) of such securities. At December
31, 2002, we owned $23,026,000 (principal balance) of subordinate MBS purchased
from third parties, representing a subordinate interest in $5,756,230,000 of
single-family mortgage loan pools. The aggregate carrying value of these MBS at
December 31, 2002 was $12,966,000.
We are not dependent on any one source for subordinate MBS investments because
there are a number of regular issuers of such securities. Note 5 to our audited
consolidated financial statements included in this Annual Report on Form 10-K
describes the concentration of our portfolio by issuer. Management believes that
the loss of any single financial institution from which we purchase subordinate
MBS would not have any detrimental effect on us. However, we cannot assure you
that increased competition will not have a negative effect on the pricing of
such investments.
HCP has a due diligence and consulting staff, located in Edison, New Jersey,
consisting of approximately 19 full-time employees at December 31, 2002 and
access to a part-time pool of employees in excess of 500. The due diligence
staff contributes to the process of selecting and acquiring subordinate MBS by
providing expertise in the analysis of many characteristics of the underlying
single-family mortgage loans. Before we 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, reviewing other relevant material
that may be available, analyzing the underlying collateral (including reviewing
our single-family mortgage loan database which contains, among other things,
listings of property values and loan loss experience in local markets for
6
similar assets) and, in certain instances, obtaining property-specific opinions
of value from third parties. Our 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. We also review 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, we estimate a prepayment speed based
primarily upon the gross coupon rates and seasoning of the subject pool. We also
determine a "base case" default scenario and several alternative scenarios based
on the Public Securities Association's standard default assumption, which we
refer to as SDA. The default scenarios reflect our 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, we model the
pools' cash flow stream and calculate a proposed purchase price 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. We then
examine the yield of the security under various alternative SDAs and prepayment
assumptions and, if necessary, adjust the proposed purchase price so that we
will receive an acceptable yield under a variety of possible scenarios.
HANOVER CAPITAL PARTNERS LTD.
Through HCP, we provide due diligence and consulting services 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 assets we acquire, and owns a licensed
mortgage banker, Hanover Capital Mortgage Corporation, which we refer to as HCMC
and a licensed broker-dealer, Hanover Capital Securities, Inc., which we refer
to as HCS. Neither of these companies currently conducts any material ongoing
business.
In January 2000, HCP hired all of the former management of Document Management
Network, Inc., to continue as the Assignment Division of HCP. The Assignment
Division provides mortgage assignment services for many of the 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.
During 2002, HCP's assignment and due diligence fees accounted for 27% of our
total consolidated revenues. For the year ended December 31, 2002, three of
HCP's customers accounted for 49% in the aggregate of its total revenue.
7
HANOVERTRADE, INC.
Through HT, we conduct loan brokering and trading, and loan sale advisory
services. HT operates an Internet exchange for trading mortgage loans, mortgage
servicing rights and related assets, and performs loan sale advisory services
for third parties. HT was incorporated on May 28, 1999. In the third quarter of
2000, the loan brokering and trading activities of HCP were combined with the HT
activities. HT officially launched its web site on October 29, 2000.
In January 2001, HT hired all of the former employees and acquired all of the
assets of Pamex Capital Partners, LLC. Prior to its acquisition, Pamex was a
traditional broker of pools of mortgage loans and consumer loans. With the
acquisition of Pamex, subsequent reassignments and new hires, at December 31,
2002, HT had 11 full-time salespeople. These salespeople attempt to maintain
regular contact with all of the major buyers and sellers of mortgage and
consumer prime whole loans.
HT facilitates the sale of pools of mortgage loans, consumer loans and
commercial mortgage loans to institutional purchasers. HT arranges for such
sales through its web site as well as through more traditional channels,
including telephone contact and e-mail. To assist in the sales process of these
pools, HT may prepare marketing materials and marketing analyses for sellers of
pools.
During 2002, HT's loan brokering, trading and advisory services, taken together,
accounted for 17% of our total consolidated revenues. In that year, two of HT's
customers individually accounted for 66% and 24% of HT's total accounts
receivable, and one customer accounted for 49% of HT's total revenues. HT's
contract with the Federal Deposit Insurance Corporation, which was the customer
contributing 49% of HT's total revenues, ended in April 2002. Although the FDIC
from time to time retains HT to perform additional advisory services related to
that original contract, we cannot assure you that HT will be able to obtain
additional engagements that will maintain the level of revenues generated by the
FDIC contract.
8
FINANCING
General
Until we can arrange for long-term financing, we initially finance purchases of
mortgage-related assets with equity and short-term borrowings through reverse
repurchase agreements. Generally, upon repayment of each borrowing in the form
of a reverse repurchase agreement, the mortgage asset used to secure the
financing will immediately be pledged to secure a new reverse repurchase
agreement or some form of long-term financing. At December 31, 2002, we had one
established committed reverse repurchase agreement line of credit with available
capacity to borrow $10 million. In addition, we had four uncommitted reverse
repurchase agreement lines of credit.
Reverse Repurchase Agreements
A reverse repurchase agreement, although structured as a sale and repurchase
obligation, is a financing transaction in which we pledge our 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,
liquidity and price volatility of the collateral pledged. At the maturity of the
reverse repurchase agreement, we repay the loan and reclaim our collateral.
Under reverse repurchase agreements, we generally retain 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 we default
on a payment obligation under such agreements, the lending party may liquidate
the collateral.
Some of our reverse repurchase agreements may qualify for special treatment
under the United States Bankruptcy Code in the event we become bankrupt or
insolvent, 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 our claim against the lender for damages may be
treated 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, our
ability to exercise our rights to recover our 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 our claim against the bankrupt lender may be treated as an
unsecured claim. Should this occur, our claims would be subject to significant
delay and, if and when paid, could be in an amount substantially less than the
damages we actually suffered.
To reduce our exposure to the credit risk of reverse repurchase agreements, we
enter into such arrangements with several different parties. We monitor our
exposure to the financial condition of our reverse repurchase lenders on a
regular basis, including the percentage of our mortgage securities that are the
subject of reverse repurchase agreements with a single lender. Notwithstanding
these measures, we cannot assure you that we will be able to avoid such third
party risks.
Our reverse repurchase borrowings bear short-term (one year or less) fixed
interest rates indexed to LIBOR plus a spread of 40 to 200 basis points
depending on the credit of the related mortgage assets. In the event the market
value of existing collateral declines, which could occur in dramatically rising
interest-rate markets, we could be required to pledge additional collateral to
the loan, or to sell assets to reduce the borrowings.
9
CAPITAL ALLOCATION GUIDELINES (CAG)
We have adopted capital allocation guidelines, which we refer to as CAG, to
strike a balance in our ratio of debt to equity. Modifications to the CAG
require the approval of a majority of our Board of Directors. The CAG are
intended to keep our 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 our various hedging and other risk
containment programs discussed below.
Lenders generally require us to deduct a minimum fixed percentage from the
mortgage asset to determine the value of the asset for lending purposes. 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-issued 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-issued 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, including delinquencies, aging and liens.
Implementation of the CAG -- Mark to Market Accounting
Each quarter, for financial management and accounting purposes, we undertake a
valuation activity known as "mark to market." This process consists of (i)
valuing our investments acquired in the secondary market, and (ii) valuing our
non-security investments, such as retained interests in securitizations. To
value our investments acquired in the secondary market, we obtain benchmark
market quotes from traders who make markets in securities similar in nature to
our investments. We then adjust for the difference in pricing between securities
and whole loan pools. We calculate the market values of our retained interests
in securitizations using market assumptions for losses, prepayments and discount
rates.
We subtract the face amount of the financing used for the securities and
retained interests from the current market value of the mortgage assets to
obtain the current market value of our equity positions. We then compare this
value to the required capital as determined by our CAG. If our actual equity
falls below the capital required by our guidelines, we must prepare a plan to
bring the actual capital above the level required.
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 our ability 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 our 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 maintain the maximum acceptable leverage (and
earnings) while protecting our capital base. We can give you no assurance that
the CAG will successfully protect our capital.
10
RISK MANAGEMENT
We believe that our portfolio income is subject to three primary risks: credit
risk, interest rate risk and prepayment risk. Although we believe we have
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 us from the effects of credit risk, interest rate
changes, prepayments and defaults by counterparties. Further, certain of the
Federal income tax requirements that we must satisfy to qualify as a REIT may
limit our ability to fully hedge our risks.
Credit Risk Management
We attempt to reduce credit risk by (i) reviewing each MBS or mortgage loan
prior to purchase to ensure that it meets our guidelines; (ii) employing early
intervention, aggressive collection and loss mitigation techniques; (iii)
maintaining appropriate capital and reserve levels; and (iv) obtaining
representations and warranties, to the extent possible, from originators.
Although we do not set specific geographic diversification requirements, we
monitor the geographic dispersion of the mortgage loans and make decisions on a
portfolio-by-portfolio basis about adding to specific concentrations. By
diversifying our portfolio across geographic regions, we mitigate the negative
effects on our portfolio of adverse economic conditions in particular regions.
In the past, we invested directly in mortgage loans on our own behalf. We
generally purchased prime single-family mortgage loans 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. Depending on market conditions, we might decide to
undertake this business activity again in the future.
Interest Rate Risk Management
We generally attempt to hedge interest rate risks associated with all our
investments, other than assets held as collateral for CMOs. Our primary method
of addressing interest rate risk on our mortgage loans is by securitizing
mortgage loans with CMOs or through real estate mortgage investment conduits, or
"REMICs", both of which are designed to provide long-term financing while
maintaining a consistent spread in a variety of interest-rate environments. As a
result, we believe that our primary interest rate risk relates to fixed-rate MBS
and mortgage loans that we finance with reverse repurchase agreements.
A variety of hedging instruments may be used, depending on the asset or
liability to be hedged and the relative price of the various hedging
instruments. Possible hedging instruments include forward sales of mortgage
securities, interest rate futures or options, interest rate swaps, and caps and
floor agreements. Mortgage loans held as collateral for CMOs are generally
financed in a manner intended to maintain a consistent spread in a variety of
interest rate environments and therefore are not hedged.
In particular, we may purchase interest rate caps, interest rate swaps and
similar instruments to attempt to mitigate the risk of the cost of our variable
rate liabilities increasing at a faster rate than the earnings on our mortgage
assets during a period of rising interest rates. Subject to compliance with
Federal income tax laws limiting the operations of a REIT, we generally hedge as
much of the interest rate risk as management determines is reasonable, given the
cost of such hedging transactions and other factors.
As discussed above, we may use a variety of instruments in our hedging program.
Two examples of strategies we currently use 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
11
contract term if prevailing interest rates exceed the rate specified in the
contract. We enter into interest rate hedge mechanisms (interest rate caps) to
manage our interest rate exposure on certain reverse repurchase financing. "TBA"
securities (which stands for "to be announced") are commitments to deliver
mortgage securities which have not yet been created. When we sell a TBA security
short, we ordinarily cover the short sale within a month by agreeing to buy a
similar TBA security. We 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 our mortgage securities.
We may also use, but as yet have 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. We
will limit our purchases of mortgage derivative securities to investments that
meet REIT requirements. To a lesser extent, we may also enter into, but again
have not entered into, interest rate swap agreements, financial futures
contracts and options on financial futures contracts, and forward contracts.
However, we will not invest in these instruments unless we can do so without
falling under the registration requirements of the Commodity Exchange Act or
otherwise violating the provisions of that Act. The REIT rules may restrict our
ability to purchase certain instruments and employ other strategies. In all our
hedging transactions, we deal only with counterparties that we believe are sound
credit risks.
- - Costs and Limitations
We believe that we have 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 us from interest rate risks. Moreover, as noted above,
certain REIT rules may limit our ability to fully hedge our interest rate risks.
We monitor carefully, and may have to limit, hedging strategies to assure that
we do 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, we may be
prevented from effectively hedging interest rate risks without significantly
reducing our return on equity.
Prepayment Risk Management
Our senior management monitors prepayment risk through periodic reviews of the
impact of a variety of prepayment scenarios on our revenues, net earnings,
dividends, cash flow and net balance sheet market value.
REGULATION
Although HCMC does not currently originate mortgage loans, HCMC continues to
service one loan. 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 is a registered broker/dealer with the Securities and Exchange Commission.
During 2002, Pamex Securities, LLC, a wholly-owned subsidiary of HanoverTrade,
Inc, withdrew from the Securities and Exchange Commission as a registered
broker/dealer.
12
COMPETITION
We compete with a variety of institutional investors for the acquisition of
mortgage-related assets that we deem attractive. These investors include other
REITs, investment banking firms, savings and loan associations, insurance
companies, mutual funds, pension funds, banks and other financial institutions
that invest in mortgage-related assets and other investment assets. Many of
these investors have greater financial resources and access to lower costs of
capital than we do. While there is generally a broad supply of liquid mortgage
securities for companies like us to purchase, we cannot assure you that we will
always be successful in acquiring mortgage-related assets that we deem most
suitable for us, because of the number of other investors competing for the
purchase of these securities.
EMPLOYEES
We had 57 employees at December 31, 2002 with 9, 19 and 29 employees devoting
their time to Hanover, HCP and HT, respectively. 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. HCP periodically hires additional individuals on a
temporary basis for due diligence and consulting engagements from a pool of
approximately 500 individuals. To date, we believe we have been successful in
our efforts to recruit qualified employees, but there is no assurance that we
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. HT owns one registered trademark which expires in 2007, has one
trademark pending and is in the process of registering one trademark with the
United States Patent and Trademark Office. HT 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
We have elected to be treated as a Real Estate Investment Trust, or 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
13
and the amount of Hanover's after-tax cash available for distribution to its
shareholders would be reduced. Hanover believes it has satisfied the
requirements for qualification as a REIT since commencement of its operations in
September 1997. Hanover intends at all times to continue to comply with the
requirements for qualification as a REIT under the Code, as described below.
REITs currently enjoy a competitive advantage over regular C corporations in
that their distributed earnings are taxed only once, whereas a regular C
corporation's distributed earnings are generally taxed twice. The President has
submitted a legislative proposal to Congress involving a dividend exclusion for
distributions of earnings that have been subjected to corporate level tax. If
enacted, the proposal might eliminate, or at least reduce, REITs' current
competitive advantage.
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
Hanover's capital stock may be owned directly or indirectly by five or fewer
individuals, taking into account complex attribution of ownership rules. 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, shares (or transferable
certificates of beneficial interest) in another REIT, government securities,
cash and cash items (the foregoing, "Qualified REIT Assets"). 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 are not Qualified REIT Assets. Third, except as noted below, investments
in securities that are not Qualified REIT Assets are further limited as
follows: (i) not more than 20% of the value of Hanover's total assets can be
represented by securities of one of more Taxable REIT Subsidiaries (as defined
below), (ii) the value of any one issuer's securities may not exceed 5% by
value of Hanover's total assets, (iii) Hanover may not own securities
possessing more than 10% of the total voting power of any one issuer's
outstanding voting securities, and (iv) Hanover may not own securities having a
value of more than 10% of the total value of any one issuer's outstanding
securities. Clauses (ii), (iii) and (iv) of the third asset test do not apply
to securities of a Taxable REIT Subsidiary. A "Taxable REIT Subsidiary" is any
corporation in which a REIT owns stock, directly or indirectly, if the REIT and
such corporation jointly elect to treat such corporation as a Taxable REIT
Subsidiary. The amount of debt and rental payments from a Taxable REIT
Subsidiary to a REIT are limited to ensure that a Taxable REIT Subsidiary is
subject to an appropriate level of corporate tax.
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 certain real estate sources including interest on
obligations secured by mortgages on real property or interests in real property.
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 assets that can be expected to produce income that qualifies
under the 75% Income Test. Hanover's policy 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.
If it fails to distribute to its shareholders with respect to each calendar year
at least the sum of (i) 85% of its REIT ordinary income of the year, (ii) 95% of
its REIT capital gain net income for the year, and (iii) any undistributed
taxable income from prior years, Hanover will be subject to a 4% excise tax on
the excess of the required distribution over the amounts actually distributed.
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. The REIT is
subject to a New Jersey gross receipts tax (Alternative Minimum Assessment).
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. Dividends declared during the last quarter of
a calendar year and actually paid during January of the immediately following
calender year are generally treated as if received by the shareholders on
December 31 of the calendar year during which they were declared. Hanover's
distributions will not be eligible for the dividends received deduction for
corporations. Shareholders may not deduct any of Hanover's net operating losses
or capital losses. If Hanover designates one or more dividends, or parts
thereof, as a capital gain dividend in a written notice to the shareholders, the
shareholders shall treat as long-term capital gain the lesser of (i) the
aggregate amount so designated for the taxable year or (ii) Hanover's net
capital gain for the taxable year. Each shareholder will include in his
long-term capital gains for the taxable year such amount of Hanover's
undistributed as well as distributed net capital gain, if any, for the taxable
year as is designated by Hanover in a written notice. Hanover will be subject to
a corporate level tax on such undistributed gain and the shareholder will be
deemed to have paid as an income tax for the taxable year his distributive share
of the tax paid by Hanover on the undistributed gain.
Any loss on the sale or exchange of shares of Hanover's common stock 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 (or undistributed capital
gain included) with respect to the common stock held by such shareholder.
If Hanover makes distributions to its shareholders in excess of its current and
accumulated earnings and profits, those distributions will be considered first a
tax-free return of capital, reducing the tax basis of a shareholder's shares
until the tax basis is zero. Such distributions in excess of the tax basis will
be taxable as gain realized from the sale of Hanover's shares. Hanover will
withhold 30% of dividend distributions to shareholders that Hanover knows to be
foreign persons unless the shareholder provides Hanover with a properly
completed IRS form claiming a reduced withholding rate under an applicable
income tax treaty.
Under the Code, if a portion of Hanover's assets were treated as a taxable
mortgage pool or if Hanover were to hold REMIC residual interests, a portion of
Hanover's dividends would be treated as unrelated business taxable income
("UBTI") for pension plans and other tax exempt entities. Hanover believes that
it has not engaged in activities that would cause any portion of Hanover's
income to be taxable as UBTI for pension plans and similar tax-exempt
shareholders. Hanover believes that its shares of stock will be
15
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.
ITEM 2. PROPERTIES
Our operations are conducted in several leased office facilities throughout the
United States. A summary of the office leases is shown below:
OFFICE CURRENT
SPACE ANNUAL EXPIRATION
LOCATION SEGMENT (SQ. FT.) RENTAL DATE OFFICE USE
- ----------------------- ------------------- ---------- -------- -------------- --------------------------
Edison, New Jersey HanoverTrade, Inc. 5,200 $137,800 April 2005 Executive, Administration,
and Hanover Capital Accounting, Marketing,
Mortgage Holdings, Investment Operations,
Inc. Mortgage Loan Servicing
Edison, New Jersey Hanover Capital 9,724 160,932 April 2005 Administration,
Partners Ltd. Due Diligence Operations,
Assignment Operations
New York, New York Hanover Capital 1,000 39,444 September 2007 Executive, Administration,
Mortgage Holdings, Investment Operations
Inc.
Ft. Lauderdale, Florida HanoverTrade, Inc. 875 24,579 April 2003 Marketing
Jacksonville, Florida HanoverTrade, Inc. 470 18,000 November 2003 Technology Support
Chicago, Illinois HanoverTrade, Inc. 1,151 24,123 January 2004 Marketing
Alpharetta, Georgia HanoverTrade, Inc. 160 14,700 January 2004 Marketing
St. Paul, Minnesota Hanover Capital 168 11,340 Month to Month Marketing
Partners Ltd.
---------- ------------
Total 18,748 $430,918
========== ============
We believe that these facilities are adequate for our foreseeable office space
needs and that lease renewals and/or alternate space at comparable rental rates
are available, if necessary.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are involved in litigation incidental to the conduct of
our business. We are not currently a party to any lawsuit or proceeding which,
in the opinion of management, is likely to have a material adverse effect on our
business, financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Our common stock is traded on the American Stock Exchange under the
trading symbol HCM. As of March 1, 2003, 4,534,402 shares of our common
stock were issued and outstanding, held by 50 holders of record
and approximately 2,300 beneficial owners.
The following table sets forth, for the periods indicated, the high, low
and closing sales price of our common stock as reported on the
American Stock Exchange in 2001 and 2002.
COMMON STOCK
------------
High Low Close
---- --- -----
Quarter Ended March 31, 2001 7.11 5.13 6.50
Quarter Ended June 30, 2001 7.85 6.30 7.00
Quarter Ended September 30, 2001 7.50 6.51 6.55
Quarter Ended December 31, 2001 8.15 6.55 8.00
Quarter Ended March 31, 2002 8.65 7.25 8.65
Quarter Ended June 30, 2002 10.10 8.15 8.18
Quarter Ended September 30, 2002 8.60 7.15 7.30
Quarter Ended December 31, 2002 7.75 6.09 7.04
The following table sets forth, for the periods indicated, dividends
declared on our common stock for each quarter for the two most recent
fiscal years:
PER-SHARE
DIVIDENDS
DECLARED
--------
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
Quarter Ended March 31, 2002 $0.25
Quarter Ended June 30, 2002 $0.25
Quarter Ended September 30, 2002 $0.25
Quarter Ended December 31, 2002 $0.25
We intend to pay quarterly dividends and other distributions to our
shareholders of all or substantially all of our taxable income in each
year to qualify for the tax benefits accorded to a REIT under the Code.
To the extent that we record capital gain income in future years, this
income does not need to be distributed as dividends to shareholders to
the extent of unutilized capital losses recorded (more than $8,678,000
as of December 31, 2002). These capital losses expire at the end of the
year 2003. All distributions will be made at the discretion of our Board
of Directors and will depend on our earnings, financial condition,
maintenance of REIT status and such other factors as the Board of
Directors deems relevant.
(b) Item 201(d)
See Part III, Item 12 hereof.
(c) On July 1, 2002, we cancelled outstanding options that had been
issued under our 1997 Executive and Non-Employee Stock Option Plan in
connection with our initial public offering. The cancelled options had
an exercise price of $15.75 per share, were exercisable for an aggregate
of 80,160 shares of our common stock, and were subject to vest based on
our achievement of certain performance targets based on increases in
the market value of our common stock over our initial offering price.
None of the targets were met within the available vesting period, so
none of the original options ever vested. To replace these cancelled
options we granted new options, exercisable for an aggregate of 80,160
shares of our common stock at an exercise price of $15.75 per share, to
the following executive officers: John A. Burchett, Joyce S. Mizerak,
George J. Ostendorf and Irma N. Tavares. These option grants were exempt
from registration pursuant to Section 4(2) of the Securities Act of
1933. The replacement options are subject to performance-based vesting
similar to the cancelled options, but the vesting period has been
extended until 2007 and the performance targets were adjusted to relate
to increases in the market price of our common stock as compared to the
market price on July 1, 2002.
17
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited consolidated
financial statements for the years ended December 31, 2002, 2001, 2000, 1999 and
1998. The selected financial data should be read in conjunction with the more
detailed information contained in our 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):
STATEMENT OF OPERATIONS HIGHLIGHTS Years Ended December 31,
-------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
Net interest income $ 6,092 $ 6,269 $ 6,663 $ 4,408 $ 6,623
Loan loss provision (393) (709) (875) (446) (356)
Gain (loss) on sale and mark to market of
mortgage assets 3,462 4,533 1,250 (4,146) (5,704)
Loan brokering/trading, due diligence fees and other 6,594 (28) -- (1,685) --
Provision for loss on unconsolidated subsidiary -- -- -- (4,793) --
----------- ----------- ----------- ----------- -----------
Total revenue (loss) 15,755 10,065 7,038 (6,662) 563
Expenses 11,473 3,696 3,136 4,191 4,064
----------- ----------- ----------- ----------- -----------
Operating income (loss) 4,282 6,369 3,902 (10,853) (3,501)
----------- ----------- ----------- ----------- -----------
Equity in income (loss) of unconsolidated subsidiaries
Hanover Capital Partners Ltd. 112 43 455 (443) (1,039)
HanoverTrade, Inc. 655 (3,263) (1,495) (31) --
HDMF-I LLC 157 (35) -- -- --
Hanover Capital Partners 2, Inc. (19) -- -- (1,300) (394)
----------- ----------- ----------- ----------- -----------
905 (3,255) (1,040) (1,774) (1,433)
----------- ----------- ----------- ----------- -----------
Income (loss) before income tax provision (benefit) 5,187 3,114 2,862 (12,627) (4,934)
and cumulative effect of adoption of SFAS 133
Income tax provision 49 -- -- -- --
----------- ----------- ----------- ----------- -----------
Income (loss) before cumulative effect of 5,138 3,114 2,862 (12,627) (4,934)
adoption of SFAS 133
Cumulative effect of adoption of SFAS 133 -- 46 -- -- --
----------- ----------- ----------- ----------- -----------
Net income (loss) $ 5,138 $ 3,160 $ 2,862 $ (12,627) $ (4,934)
=========== =========== =========== =========== ===========
Basic earnings (loss) per share $ 1.16 $ 0.74 $ 0.56 $ (2.12) $ (0.77)
=========== =========== =========== =========== ===========
Diluted earnings (loss) per share $ 1.15 $ 0.73 $ 0.56 $ (2.12) $ (0.77)
=========== =========== =========== =========== ===========
Dividends declared per share $ 1.00 $ 0.80 $ 0.66 $ 0.50 $ 0.70
=========== =========== =========== =========== ===========
BALANCE SHEET HIGHLIGHTS December 31,
-------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
Mortgage loans $ 103,164 $ 154,273 $ 212,247 $ 270,084 $ 407,994
Mortgage securities 23,903 51,183 35,723 62,686 78,478
Cash and cash equivalents 10,605 8,946 9,958 18,022 11,837
Other assets 18,199 15,105 14,681 14,842 17,861
----------- ----------- ----------- ----------- -----------
Total assets $ 155,871 $ 229,507 $ 272,609 $ 365,634 $ 516,170
=========== =========== =========== =========== ===========
Reverse repurchase agreements $ 6,283 $ 33,338 $ 14,760 $ 55,722 $ 370,090
CMO borrowing 102,589 151,096 210,374 254,963 77,305
Other liabilities 3,935 3,532 3,451 4,443 2,995
----------- ----------- ----------- ----------- -----------
Total liabilities 112,807 187,966 228,585 315,128 450,390
Stockholders' equity 43,064 41,541 44,024 50,506 65,780
----------- ----------- ----------- ----------- -----------
Total liabilities and stockholders' equity $ 155,871 $ 229,507 $ 272,609 $ 365,634 $ 516,170
=========== =========== =========== =========== ===========
Number of common shares outstanding 4,474,222 4,275,676 4,322,944 5,826,899 6,321,899
=========== =========== =========== =========== ===========
Book value per common share $ 9.62 $ 9.72 $ 10.18 $ 8.67 $ 10.41
=========== =========== =========== =========== ===========
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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," should be read in conjunction with the
financial statements, related notes, and other detailed information included
elsewhere in this Annual Report on Form 10-K. This report contains certain
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These forward-looking statements represent our current expectations,
intentions or beliefs regarding future events or trends, including, without
limitation, statements containing the words "believes," "anticipates,"
"expects," "intends," "assumes," "will," or other similar expressions; and also
including, without limitation, the following: our business strategy; market
trends and risks; statements regarding our continuing ability to target, price
and acquire MBS or mortgage loans; our ability to manage and hedge the risks
associated with our investments; assumptions regarding interest rates and their
effect on our hedging strategies; assumptions regarding prepayment and default
rates on the mortgage loans securing our MBS and their effect on our hedging
strategies; our decision to invest in higher-risk subordinated tranches; the
liquidity of our portfolios and our ability to invest currently liquid assets;
the expected future performance of Hanover Capital Partners and HanoverTrade
and their need for additional capital; continuing availability of the master
reverse repurchase agreement financing or other financing; the sufficiency of
our working capital, cash flows and financing to support our future operating
and capital requirements; results of operations and overall financial
performance; the expected dividend distribution rate; our ability to enter into
additional asset management contracts with third parties; the adequacy of our
leased offfice space; our ability to locate additional funds for HDMF-I; our
expectations regarding the effects of accounting rules and changes thereto;
changes in government regulations affecting our business; and the expected tax
treatment of our operations. Such forward-looking statements relate to future
events and our future financial performance and involve known and unknown risks,
uncertainties and other important factors, many of which are beyond our control,
which could cause actual results, performance or achievements to differ
materially from those expressed or implied by such forward-looking statements.
In light of the risks and uncertainties inherent in all such projected
operational matters, the inclusion of forward-looking statements in this report
should not be regarded as a representation by us or any other person that our
objectives or plans will be achieved or that any of our operating expectations
will be realized. Our revenues and results of operations are difficult to
forecast and could differ materially from those projected in the forward-looking
statements contained in this report as a result of certain risks and
uncertainties including, but not limited to: changes in interest rates and the
yield curve; management of growth; changes in prepayment rates or default rates
on our mortgage assets; our ability to borrow at favorable rates and terms;
changes in business conditions and the general economy; our dependence on
effective information-systems technology; potential declines in our ability to
locate and acquire desirable mortgage assets; changes in the real estate market
both locally and nationally; the effectiveness of our hedging and other efforts
to mitigate the risks of our investments; the effect of default, bankruptcy and
severe weather or natural disasters on the ability of borrowers to repay
mortgages included in our asset pools; enforceability and collectibility of
non-standard single-family mortgage loans; our ability to retain key employees;
our ability to maintain our qualification for exemption from registration as an
investment company; our ability to obtain and maintain all licenses necessary to
our business; competition from other financial institutions, including other
mortgage real estate investment trusts, or REITs; and the possible changes in
tax and other laws applicable to REITs or our inability to maintain compliance
with such rules and to continue to qualify as a REIT. 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. These
factors should not be considered exhaustive; we undertake no obligation to
release publicly the results of any future revisions we may make
19
to forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
OVERVIEW
We are a specialty finance company organized in June 1997 as a REIT. At December
31, 2002, we had two principal consolidated subsidiaries, Hanover Capital
Partners Ltd., which we refer to as HCP, and HanoverTrade, Inc., which we refer
to as HT. When we use the terms "we", "us", "our" or "the Company," we are
referring to our company and its consolidated and unconsolidated subsidiaries
taken as a whole. To provide more meaningful disclosure, we occasionally wish to
report information regarding only our REIT entity without reference to any of
its subsidiaries. In those instances, we refer to the REIT entity as "Hanover."
Hanover's principal business strategy is to invest in mortgage-backed
securities, which we refer to as MBS, and, to a lesser extent, mortgage loans
and to earn net interest income on these investments. HCP's principal business
strategy is to generate consulting and other fee income by performing loan sale
advisory services, loan file due diligence reviews, staffing solutions and
mortgage assignment and collateral rectification services. HT's principal
business strategy is to generate fee income by operating an Internet exchange
for trading mortgage loans, mortgage servicing rights and related assets, and
providing state-of-the art technologies supported by experienced valuation,
operations and trading professionals. In addition to trading assets, HT provides
a full range of asset valuation, analysis and marketing services for:
performing, sub-performing and non-performing assets; whole loans and
participations; Community Reinvestment Act loans; and mortgage servicing rights.
In addition, Hanover has an equity interest in HDMF-I LLC, a limited liability
company formed to purchase, service, manage or otherwise liquidate pools of
primarily sub- and non-performing one-to-four family residential mortgage loans.
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.
Hanover's taxable affiliates, 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.
CRITICAL ACCOUNTING POLICIES
The significant accounting policies used in preparation of our financial
statements are more fully described in Note 2 to our consolidated financial
statements. 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 - Our 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. Because our assets
are generally not traded on a
20
national securities exchange or national automated quotation system and prices
are therefore not readily ascertainable, complex cash flow modeling is performed
in determining their fair value. Several of the assumptions used by management
are confirmed by independent third parties on at least a quarterly basis. In
using cash-flow analysis to determine fair value, 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. As a result,
a high degree of judgment is required in estimating the assumptions used in the
cash flow analysis. Should the estimates used by management be inaccurate, our
net interest income could be materially affected.
LOAN LOSS ALLOWANCE - We maintain a loan loss allowance for our subordinate MBS
and collateral for collateralized mortgage obligations, or CMOs. We monitor the
delinquencies and defaults on the underlying mortgages and, if an impairment of
the related mortgage security is deemed to be other than temporary, reduce the
carrying value of the related mortgage security to fair value. Our loan loss
provision is based on our assessment of numerous factors affecting our 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 our estimates be inaccurate, our loan loss provision could be
materially affected which could result in unexpected gains or losses from future
sales of such assets.
EQUITY INVESTMENTS - Hanover records its investment in HDMF-I LLC, which we
refer to as HDMF-I, on the equity method. Accordingly, Hanover records its
proportionate share of the earnings or losses of HDMF-I. This presentation,
while required under accounting principles generally accepted in the United
States of America, does not present the assets and liabilities of HDMF-I on our
balance sheet. In addition, the residual equity that Hanover does not own
remains "off balance sheet."
REVENUE RECOGNITION - HCP recognizes revenue from due diligence contracts in
progress as they are earned. 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.
HT recognizes revenues from loan sale advisory and trading 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. HT's billing of
fees relating to a transaction occurs concurrently with the closing and funding.
We utilize 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. We have reviewed the guidance in SAB 101 and
believe we are in compliance with SAB 101. However, if management's estimates
are incorrect, or if we are not applying SAB 101 as intended, the results of
operations could be materially affected.
INCOME TAXES - Hanover has elected to be taxed as a REIT and intends to comply
with the REIT provisions of the Internal Revenue Code of 1986, as amended, which
we refer to as the Code. Accordingly, Hanover will not be subject to Federal or
state income tax on net income that is currently distributed to stockholders 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
21
domestic corporation and the amount of Hanover's after-tax cash available for
distribution to its stockholders 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.
22
RESULTS OF OPERATIONS
In our description of financial results presented below, we use the term
"Hanover" to refer to Hanover Capital Mortgage Holdings, Inc. as a separate
entity. Hanover has two primary operating subsidiaries: Hanover Capital Partners
Ltd., which we refer to as "HCP", and HanoverTrade, Inc., which we refer to as
"HT". When we use the terms "we", "us", or "our", we are referring to Hanover
together with its consolidated and unconsolidated subsidiaries. The term "CMO"
refers to collateralized mortgage obligations, in which financing is obtained in
exchange for a pledge of mortgages, or pools of mortgages, as collateral. We use
the term "MBS" to refer to mortgage-backed securities.
On July 1, 2002, Hanover acquired 100% of the outstanding capital stock of each
of HT, HCP, and Hanover Capital Partners 2, Inc., which we refer to as HCP-2.
Hanover had previously owned 100% of the non-voting preferred stock, but none of
the voting common stock, of each of these entities. Prior to July 1, 2002, the
financial results for these three entities appeared in our financial statements
as a single line-item under "equity in income or loss of unconsolidated
subsidiaries." Due to the stock purchase, for periods ending after June 30,
2002, Hanover's financial statements will be consolidated with the financial
statements of those entities. This means that the financial results for these
three entities, whether positive or negative, will appear throughout our
financial statements as applicable, rather than in a single line-item. To assist
you in evaluating the effect of the stock purchase on our financial results, our
discussion below sometimes includes information regarding both "previously
reported" and "pro forma" financial results. "Previously reported" financial
results provide the actual results for the periods presented, which means that
they do not give effect to the stock purchase for any periods prior to July 1,
2002. "Pro forma" financial results provide financial information for the
periods shown as if the stock purchase of HT, HCP and HCP-2 had been completed
as of January 1, 2001 for statement of income purposes. "Pro forma" financial
information is presented for illustrative purposes only. Pro forma information
is not necessarily indicative of the financial position or results of operations
that would have been reported had the acquisition occurred on January 1, 2001,
and these presentations do not necessarily indicate the future financial
position or results of operations.
The following table presents the consolidated results of operations as
previously reported for 2002, 2001 and 2000 and pro forma results for 2002 and
2001 (dollars in thousands):
As Previously Reported - Pro Forma - Years
Years Ended December 31, Ended December 31,
------------------------------- --------------------
2002 2001 2000 2002 2001
-------- -------- ------- -------- --------
(unaudited)
Net interest income $ 6,092 $ 6,269 $ 6,663 $ 6,375 $ 5,871
Loan loss provision (393) (709) (875) (393) (709)
Gain on sale of mortgage assets 2,095 3,782 819 2,095 3,782
Gain on mark to market of mortgage assets,
net of associated hedge 1,367 751 431 1,237 695
Loan brokering, trading and advisory services 2,686 -- -- 6,831 3,521
Due diligence fees 2,891 -- -- 4,971 5,083
Assignment fees 1,387 -- -- 2,220 757
Other income (loss) (370) (28) -- (399) 58
-------- -------- ------- -------- --------
Total revenue 15,755 10,065 7,038 22,937 19,058
Expenses 11,473 3,696 3,136 17,805 15,987
-------- -------- ------- -------- --------
Operating income 4,282 6,369 3,902 5,132 3,071
Equity in income (loss) of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. 112 43 455 -- --
HanoverTrade, Inc. 655 (3,263) (1,495) -- --
HDMF-I LLC 157 (35) -- 157 (35)
Hanover Capital Partners 2, Inc. (19) -- -- -- --
-------- -------- ------- -------- --------
Income before income tax provision and cumulative
effect of adoption of SFAS 133 5,187 3,114 2,862 5,289 3,036
Income tax provision 49 -- -- 127 64
-------- -------- ------- -------- --------
Income before cumulative effect of adoption of SFAS 133 5,138 3,114 2,862 5,162 2,972
Cumulative effect of adoption of SFAS 133 -- 46 -- -- 46
-------- -------- ------- -------- --------
Net income $ 5,138 $ 3,160 $ 2,862 $ 5,162 $ 3,018
======== ======== ======= ======== ========
Basic earnings per share $ 1.16 $ 0.74 $ 0.56 $ 1.17 $ 0.71
======== ======== ======= ======== ========
Dividends declared per share $ 1.00 $ 0.80 $ 0.66 $ 1.00 $ 0.80
======== ======== ======= ======== ========
23
Net Income, Basic Earnings Per Share and Total Revenue
We recorded net income of $5,138,000 or $1.16 per share based on 4,417,221
weighted average shares of common stock outstanding for 2002 compared to net
income of $3,160,000 or $0.74 per share based on 4,256,874 weighted average
common shares outstanding for 2001, and 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 revenue for 2002 was $15,755,000, compared to $10,065,000 previously
reported for 2001 and $7,038,000 for 2000. On a pro forma basis, total revenue
for the 2002 period was $22,937,000, while total revenue for the 2001 period was
$19,058,000.
Net Interest Income and Loan Loss Reserve
The following table reflects the average balances for each major category of our
interest earning assets as well as our interest bearing liabilities with the
corresponding effective yields and rates of interest as follows (dollars in
thousands):
INTEREST EARNING ASSETS AND RELATED LIABILITIES
Years Ended December 31,
------------------------------------------------------------------------
2002 2001 2000
---------------------- --------------------- ---------------------
Average Effective Average Effective Average Effective
Balance Rate (1) Balance Rate (1) Balance Rate (1)
-------- -------- -------- --------- -------- ---------
Interest earning assets:
Mortgage loans $ 1,206 16.75% $ 231 8.10% $ 300 87.79%
CMO collateral 136,512 7.09% 193,840 7.41% 247,850 7.46%
Agency-issued MBS 7,186 6.70% 15,401 7.98% 41,072 7.28%
Private placement notes 14,257 15.13% 14,676 17.11% 20,266 16.84%
-------- ----- -------- ----- -------- -----
159,161 7.87% 224,148 8.08% 309,488 8.13%
-------- -------- --------
Interest bearing liabilities:
CMO borrowings 124,971 5.57% 181,669 6.72% 233,843 7.49%
Reverse repurchase borrowings on:
CMO collateral 1,786 2.97% 2,536 7.16% 3,515 7.45%
Agency-issued MBS 6,410 3.32% 9,732 6.40% 29,020 5.71%
Private placement notes 6,127 3.42% 6,085 6.86% 7,544 7.81%
-------- ----- -------- ----- -------- -----
139,294 5.34% 200,022 6.71% 273,922 7.31%
-------- -------- --------
Net interest earning assets $ 19,867 $ 24,126 $ 35,566
======== ======== ========
Net interest spread 2.53% 1.37% 0.82%
===== ===== =====
Yield on net interest earning assets (2) 25.58% 19.45% 14.43%
===== ===== =====
(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.
24
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,
------------------------------------------------------------------------------------
2002 2001 2000
------------------------- -------------------------- --------------------------
Net Loan Net Loan Net Loan
Interest Loss Interest Loss Interest Loss
Income Provision Income Provision Income Provision
----------- ------------ ------------ ------------ ------------ ------------
Mortgage loans $ 202 $ -- $ 19 $ -- $ 264 $ --
CMO collateral 2,826 (161) 2,219 (246) 963 (249)
Agency-issued MBS 268 -- 606 -- 1,330 --
Private placement MBS 2,179 (232) 2,556 (463) 3,450 (626)
Other 868 -- 869 -- 656 --
Eliminations (251) -- -- -- -- --
----------- ------------ ------------ ------------ ------------ ------------
Total net interest income $6,092 $(393) $6,269 $(709) $6,663 $ (875)
=========== ============ ============ ============ ============ ============
Years Ended December 31, 2002 and 2001
- --------------------------------------
Net interest income decreased to $6,092,000, or $1.38 per share, for 2002 from
$6,269,000, or $1.47 per share, as previously reported in 2001. The decrease in
net interest income of $177,000 was primarily due to:
-- the repayment of our mortgage loans held as collateral for CMOs offset
by decreased borrowing costs on our corresponding CMO liabilities and
reverse repurchase agreements;
-- the termination of Agency-issued MBS activity; and
-- the decrease in the average coupon rate of our purchased subordinate MBS
portfolio, decrease in the interest earned from interest-only notes
retained from our 1998-B securitization, and interest income earned from
trading activity conducted by one of our subsidiaries in 2002; no such
trading activity occurred in 2001.
The effective yield on our average CMO collateral decreased slightly to 7.09%
in 2002 from 7.41% in 2001, while the effective rate of interest on our average
CMO borrowings decreased to 5.57% in 2002 from 6.72% in 2001. Our effective
borrowings rate decreased faster than the decrease in the yield on average
assets. In addition, we recognized increased interest income from our
interest-only notes retained from our 1999-B securitization. These
interest-only notes earned interest at a rate of 4.00% in 2002 compared to 1.86%
in 2001.
Net interest income from Agency-issued MBS decreased in 2002 because we
terminated our investment in such MBS in July of 2002.
Private placement MBS net interest income was negatively impacted by a decrease
in the effective interest rate earned on our purchased subordinate MBS
portfolio to 12.53% in 2002 from 16.77% in 2001. The decrease in net interest
income recognized from interest-only notes retained from our 1998-B
securitization resulted from a decrease in the average notional amount on which
interest income is earned to $119.7 million in 2002 from $196.1 million in 2001.
During December 2002 and January 2003, we exercised call provisions in our
1998-A and 1998-B securitizations and sold the underlying mortgage loans in
February and March 2003. As a result of the two sales, we have approximately
$6,000,000 available for reinvestment. We cannot assure you that we will be
able to reinvest the proceeds in a profitable manner.
On a pro forma basis, net interest income increased to $6,375,000 for 2002
from $5,871,000 for 2001. The $504,000 increase is due to a full year of net
interest income on a pro forma basis in 2002 attributable to trading activity,
partially offset by reduced Agency-issued MBS activity.
Our provision for loan losses decreased to $393,000 in 2002 from $709,000 in
2001. The $316,000 decrease was primarily the result of sales of first-loss
subordinate MBS and a reduction in the average balance of collateral for CMOs.
First-loss subordinate MBS are generally structured to absorb the credit losses
resulting from a specified pool of mortgages. As a result, we provide for the
estimated losses associated with first-loss subordinate MBS, which increases our
overall loan loss allowance. If our loss estimates differ materially from actual
results, we could incur additional losses resulting in decreased net income in
future periods. No adjustments were required on a pro forma basis because the
provision for loan losses relates only to Hanover during these periods.
Years Ended December 31, 2001 and 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 was primarily a result
of:
-- an increase in amortization expense for whole loans as a result of
increases in assumed prepayment speeds; and
-- 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.
Our 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 from CMOs. Provision for losses
on Hanover sponsored securitizations decreased to $246,000 in 2001 from
$319,000 in 2000. Provision for loan losses on subordinate MBS purchased from
third parties decreased to $463,000 in 2001 from $555,000 in 2000. The average
balance of subordinate MBS purchased from third parties in 2001 was $12,664,000
compared to $11,973,000 in 2000.
The following tables provide details of net interest income and loan loss
provision by interest earning asset:
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,
-------------------------------------
2002 2001 2000
--------- --------- ---------
Average asset balance $ 136,512 $ 193,840 $ 247,850
Average CMO borrowing balance 124,971 181,669 233,843
Average reverse repurchase agreement borrowing balance 1,786 2,536 3,515
--------- --------- ---------
Net interest earning assets 9,755 9,635 10,492
Average leverage ratio 92.85% 95.03% 95.77%
Effective interest income rate 7.21% 7.54% 7.56%
Effective interest expense rate 5.57% 6.72% 7.49%
Effective interest expense rate - Repurchase agreements 2.97% 7.16% 7.45%
--------- --------- ---------
Net interest spread 1.67% 0.81% 0.07%
Interest income $ 9,841 $ 14,612 $ 18,745
Interest expense 6,962 12,211 17,521
Interest expense - Repurchase agreements 53 182 261
--------- --------- ---------
Net interest income before loan loss provision 2,826 2,219 963
Loan loss provision (161) (246) (249)
--------- --------- ---------
Net interest income after loan loss provision $ 2,665 $ 1,973 $ 714
========= ========= =========
Yield on net interest earning assets after loan loss provision 27.31% 20.48% 6.80%
========= ========= =========
During 2000, we 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 security
carries a fixed interest rate of 6.50%. The Hanover 2000-A security was
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. Our total investment in Hanover 98-B
private placement MBS at December 31, 2002 includes a $10,937,000 investment in
six investment-grade notes ("AA", "A" and "BBB"), six interest-only notes, six
below-investment-grade notes and three principal-only notes. However, we
classify the investment-grade and below-investment-grade notes as CMO collateral
and the interest-only and principal-only notes as private placement MBS.
For Hanover 2000-A, we record 100% of the interest income, net of servicing and
other fees, generated by the mortgage loans underlying this transaction. In
accordance with accounting principles generally accepted in the United States
of America, Hanover 2000-A is recorded as a financing transaction. The primary
source of financing for these mortgage loans is the CMO borrowing. This
financing represents the liability for certain investment-grade mortgage notes
issued by us. The interest expense on this financing represents the coupon
interest amount to be paid to the note holders.
Our net equity in these transactions was leveraged through reverse repurchase
agreement financing. In a reverse repurchase financing, we sell a pool of
assets but agree to repurchase them at a set time in the future. At December
31, 2002, we had $1,698,000 of reverse repurchase agreement financing against
our net equity in these transactions.
Interest expense includes the interest on CMO borrowings, interest on the
related reverse repurchase agreements and amortization of certain deferred
financing costs and interest rate caps.
25
Agency-issued MBS
Net interest income generated from investments in Agency-issued MBS is as
follows (dollars in thousands):
Years Ended December 31,
--------------------------------------
2002 2001 2000
---------- ---------- ----------
Average asset balance $ 7,186 $ 15,401 $ 41,072
Average reverse repurchase agreement borrowing balance 6,410 9,732 29,020
---------- ---------- ----------
Net interest earning assets 776 5,669 12,052
Average leverage ratio 89.20% 63.19% 70.66%
Effective interest income rate 6.70% 7.98% 7.28%
Effective interest expense rate 3.32% 6.40% 5.71%
---------- ---------- ----------
Net interest spread 3.38% 1.58% 1.57%
Interest income $ 481 $ 1,229 $ 2,989
Interest expense 213 623 1,659
---------- ---------- ----------
Net interest income before loan loss provision 268 606 1,330
Loan loss provision -- -- --
---------- ---------- ----------
Net interest income after loan loss provision $ 268 $ 606 $ 1,330
========== ========== ==========
Yield on net interest earning assets after loan loss provision 34.56% 10.70% 11.04%
========== ========== ==========
During 2002, we purchased $30.0 million of Agency-issued securities and sold
$53.4 million. During 2001, we purchased $125.8 million of Agency-issued
securities and sold $98.3 million. In November 2000, we purchased $1.9 million
of GNMA securities. In December 2000, we sold thirty-one FNMA Certificates,
totaling $36.9 million of principal.
Interest expense includes the interest on the related reverse repurchase
agreements and amortization of deferred financing costs and interest rate caps.
26
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,
----------------------------------
2002 2001 2000
-------- -------- --------
Average asset balance $ 14,257 $ 14,676 $ 20,266
Average reverse repurchase agreement borrowing balance 6,128 6,085 7,544
-------- -------- --------
Net interest earning assets 8,129 8,591 12,722
Average leverage ratio 42.98% 41.46% 37.23%
Effective interest income rate 16.76% 20.26% 19.93%
Effective interest expense rate 3.42% 6.86% 7.81%
-------- -------- --------
Net interest spread 13.34% 13.40% 12.12%
Interest income $ 2,389 $ 2,974 $ 4,039
Interest expense 210 418 589
-------- -------- --------
Net interest income before loan loss provision 2,179 2,556 3,450
Loan loss provision (232) (463) (626)
-------- -------- --------
Net interest income after loan loss provision $ 1,947 $ 2,093 $ 2,824
======== ======== ========
Yield on net interest earning assets after loan loss provision 23.95% 24.37% 22.19%
======== ======== ========
The Private Placement MBS category includes:
- interest-only and principal-only notes that we issued in our second
securitization, Hanover 1998-B, and
- starting in June 1999, subordinate MBS that we purchased in the open
market.
The 1998-B interest-only notes are 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.
Generally, mortgages with higher interest rates will be repaid more rapidly
than mortgages with lower interest rates.
Our investment in private placement MBS at December 31, 2002 includes an
investment of $0.6 million carrying value in 1998-B interest-only notes, an
investment of $0.6 million carrying value in 1998-B principal-only notes and an
investment of $13.0 million carrying value in below-investment-grade subordinate
MBS classified as held to maturity, available for sale or trading.
During 2002, we purchased $23.3 million of below-investment-grade MBS from third
parties and sold $16.3 million of below-investment-grade MBS to third parties.
During 2001, we 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.
27
Other Interest Income
Interest income from non-mortgage assets is as follows (dollars in thousands):
Years Ended December 31,
------------------------
2002 2001 2000
----- ---- ----
Overnight investing $ 116 $257 $124
Related party notes 752 612 532
Eliminations (251) -- --
----- ---- ----
$ 617 $869 $656
===== ==== ====
Gain on Sale and Mark to Market of Mortgage Assets
Our 2002 results include a gain on sale of mortgage assets of $2,095,000
compared to $3,782,000 for 2001 and $819 for 2000. No adjustments were required
on a pro forma basis because gain on sale of mortgage assets relates only to
Hanover during these periods. We cannot assure you that we will be able to
recognize gain on sale in the future. As a REIT, we do not actively trade our
mortgage assets.
Our purchased subordinate MBS portfolio is primarily comprised of
non-investment-grade securities. These securities are generally purchased at a
substantial discount to their principal balance to reflect their inherent
credit risk. To the extent that actual losses on the mortgage asset are less
than the discount, the discount provides a yield enhancement. We seek to reduce
credit risk by actively monitoring our portfolio for delinquency trends and due
to such monitoring we may, from time to time, decide to sell a security in
order to mitigate potential losses.
When we classified mortgage assets as trading securities during 2002, 2001 and
2000, we recognized mark to market gains or losses through our Consolidated
Statement of Income. Mortgage assets classified as available for sale are marked
to market through other comprehensive income. We recognized mark to market gains
on our purchased subordinate MBS portfolio of $1,780,000 in 2002 as compared to
$792,000 in 2001 and $49,000 in 2000. Market gains on our purchased subordinate
portfolio are primarily subject to assumptions on the underlying mortgage loan
portfolio including, but not limited to, prepayment speed assumptions, future
loss assumptions and changes in the benchmark interest rate.
Other Revenue
Revenues from loan brokering, trading and advisory services increased to
$2,686,000 in 2002, from $0 for 2001 and 2000. Revenues from due diligence
increased to $2,891,000 in 2002 from $0 for 2001 and 2000. Revenues from
assignment fees increased to $1,387,000 in 2002 from $0 for 2001 and 2000. In
each case, this is because in periods prior to the consolidation of Hanover,
HCP, HT and HCP-2, we did not separately record revenues attributable to HT,
HCP, or HCP-2, and all of the revenues listed in this paragraph are derived
from the activities of HT and HCP.
On a pro forma basis, revenues from loan brokering, trading and advisory
services increased to $6,831,000 in 2002, from $3,521,000 for 2001. This is
primarily attributable to revenue derived from a contract with the FDIC during
2002 and revenue generated by third quarter 2002 whole-loan sales. We cannot
assure you that comparable contracts will be available in the future. On a pro
forma basis, revenues from due diligence decreased to $4,971,000 in 2002 from
$5,083,000 in 2001. Although total due diligence revenues decreased, our revenue
from our largest clients increased and our number of clients increased. On a pro
forma basis, revenues from assignment fees increased to $2,220,000 in 2002 from
$757,000 for 2001, primarily because of 2 large assignment contracts. These
contracts account for 74% of the total assignment fees recognized in 2002. We
cannot assure you that we will be able to generate assignment fees comparable to
those recorded for 2002.
28
Operating Expenses
Years Ended December 31, 2002 and 2001
- --------------------------------------
Operating expenses in 2002 were $11,473,000 compared to $3,696,000 as previously
reported for 2001. Pro forma operating expenses were $17,805,000 in 2002
compared to $15,987,000 for the same period last year on a pro forma basis. The
biggest component of the increase, on a pro forma basis, was an increase in
personnel expenses. Personnel expenses for 2002, on a pro forma basis, increased
to $8,907,000 compared to, on a pro forma basis, $7,231,000 for the same period
last year. The increase in personnel expenses was primarily due to (i) a bonus
accrual established for a pool of employees during 2002 that was established
pursuant to existing contractual agreements; no such bonus accrual was
established in 2001, and (ii) an increase in commission expense, primarily
relating to the increase in loan brokering, trading and advisory services of
$459,000 in 2002 as compared to the prior year. The increase in personnel
expense was partially offset by a decrease in legal and professional fees to
$1,206,000 on a pro forma basis in 2002, from $1,704,000 on a pro forma basis
for the same period last year. Legal and professional fees decreased in 2002
primarily due to non-recurring charges in 2001.
Years Ended December 31, 2001 and 2000
- --------------------------------------
Operating expenses in 2001 were $3,696,000 compared to $3,136,000 in 2000, an
increase of $560,000. Personnel expenses decreased to $680,000 in 2001 from
$1,020,000 in 2000. Hanover billed personnel-related expenses totaling $345,000
to HT and $425,000 to HCP in 2001 compared to $369,000 and $136,000 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 consideration 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.
Equity in Income (Loss) of Unconsolidated Subsidiaries
Years Ended December 31, 2002 and 2001
- --------------------------------------
HDMF-I is a limited liability company whose objective is to purchase, service
and manage pools of primarily sub- and non-performing one-to-four family
residential whole loans. In November 2001, we made our initial investment in
HDMF-I of $115,000 to fund our proportionate share of professional,
organizational and other fees of HDMF-I. In the first quarter of 2002, we
invested an aggregate of $3,891,000 in HDMF-I to fund our proportionate share of
a loan pool with a purchase price of $12,230,000. In the second half of 2002, we
invested an additional $1,968,000 in HDMF-I to fund the purchase price of an
additional loan pool and received $1,458,000 in distributions from HDMF-I. For
2002 we recognized equity in income of $157,000 and for the comparable period in
2001, we recognized equity in losses of $35,000. At December 31, 2002, we had a
total capital contribution commitment of $5,820,000.
Years Ended December 31, 2001 and 2000
- --------------------------------------
As discussed above, Hanover acquired all of the outstanding capital stock of HCP
and HT on July 1, 2002. As a result, we did not record equity in income (loss)
of HCP and HT for the full year of 2002.
Hanover's equity in income of HCP 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, primarily due to the termination of subordinate MBS
activity in 2000. The portfolio of subordinate MBS contributed $954,000 of
revenue including gains on sale of $441,000 in 2000. This portfolio was
transferred from HCP to Hanover in July of 2000. Due diligence fees decreased
$1,213,000 or 17% to $5,803,000 in 2001 from $7,016,000 in 2000 primarily due to
contracts awarded in 2000 for which no comparable revenue was earned in 2001.
Assignment fees increased $126,000 or 20% to $757,000 in 2001 from $631,000 in
2000 primarily due to the assumption of assignment contracts and employees of a
former competitor. Loan brokering and asset management fees contributed $30,000
in 2000, this activity was transferred to HT in July of 2000.
29
Hanover recognized equity in losses of HT of $3,263,000 in 2001 compared to
$1,495,000 in 2000. HT recorded revenue of $3,599,000 and $141,000 in 2001 and
2000. HT operating expenses for 2001 and 2000 totaled $6,962,000 and $1,683,000.
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. As HT commenced operations in 1999, much of 2000 and 2001
was spent developing HT's proprietary Internet exchange for trading mortgage
loans, mortgage servicing rights and related assets. HT recorded minimal
revenues in 2000.
30
The table below highlights our historical quarterly trends and components of
return on average equity for 2000, 2001 and 2002.
Loan
Gain on Brokering/
Sale and Trading, Due
Mark to Diligence Equity in
Net Market of Fees and Income
Interest Mortgage Other Income Operating (Loss) of Income Tax Annualized
For the Income/ Assets/ (Loss)/ Expenses/ Subsidiaries/ Provision Return on
Quarters Ended Equity Equity Equity Equity Equity (Benefit)/Equity Equity
- ------------------- -------- --------- ------------ --------- ------------- ---------------- -----------
March 31, 2000 10.91% 1.57% -- 7.74% 0.71% -- 5.45%
June 30, 2000 10.99% 2.62% -- 7.95% 0.43% -- 6.09%
September 30, 2000 13.40% -- 1.16% 4.31% (4.01%) -- 6.24%
December 31, 2000 12.43% 6.61% -- 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% -- 7.46% (8.37%) -- 6.65%
September 30, 2001 13.97% 11.05% -- 10.85% (7.24%) -- 6.93%
December 31, 2001 14.66% 15.04% (0.27%) 10.25% (9.01%) -- 10.18%
March 31, 2002 15.13% 8.29% (1.63%) 9.91% 0.54% -- 12.43%
June 30, 2002 11.94% 5.50% (2.30%) 8.76% 6.27% -- 12.65%
September 30, 2002 12.96% 15.54% 26.42% 42.53% 1.18% (0.06%) 13.63%
December 31, 2002 12.45% 2.45% 37.65% 43.77% 0.26% 0.52% 8.52%
Notes: Average equity excludes unrealized loss on investments available for
sale.
Prior to July 1, 2002, the financial results for HCP, HT and HCP-2
are included in equity in income/(loss) of unconsolidated subsidiaries.
For periods ending after June 30, 2002, these entities' results are
consolidated with Hanover's and their results will appear throughout our
financial statements as applicable, rather than in a single line-item.
TAXABLE INCOME
Our taxable income for the year ended December 31, 2002 is estimated at
$565,000. Taxable income differs from GAAP net income for the year ended
December 31, 2002 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, 2002 (dollars in
thousands):
GAAP net income $ 5,138
GAAP gain on sale (2,028)
Tax gain on sale 1,950
Utilization of capital loss carryforward (1,950)
Income of subsidiaries not included in taxable income (362)
Gain on mark to market of mortgage securities, net of
associated hedge (1,066)
Loan loss provision, net of realized losses (1)
Tax amortization of net premiums on mortgages, CMO
collateral and mortgage securities and interest
accrual in excess of GAAP amortization and interest
accrual (256)
Deduction for tax for exercise of non-qualified stock
options (888)
Other 28
-------
Estimated taxable income $ 565
=======
As a REIT, we are required to pay dividends amounting to 85% of each year's
taxable ordinary income and 95% of the portion of each year's capital gain net
income that is not taxed at the REIT level, by the end of
31
each calendar year and to have declared dividends amounting to 90% of our REIT
taxable income for each year by the time we file our 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, 2002, a portion of dividends paid to shareholders was
deemed to be a return of capital for income tax purposes.
LIQUIDITY
We expect to meet our future short-term and long-term liquidity requirements
generally from our existing working capital, cash flow provided by operations,
reverse repurchase agreements and other possible sources of longer-term
financing, including CMOs and REMICs. We consider our ability to generate cash
to be adequate to meet operating requirements both in the short-term and the
long-term. However, we have exposure to market-driven liquidity events due to
the short-term reverse repurchase financing we have in place against our MBS. If
a significant decline in the market value of our portfolio should occur, our
available liquidity from existing sources and ability to access additional
sources of credit could be reduced. As a result of such a reduction in
liquidity, we may be forced to sell certain investments or incur debt 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. At December 31,
2002, we had one committed reverse repurchase line of credit with $10 million
available and four uncommitted lines of credit. We may seek to establish
additional committed and uncommitted lines of credit in the future. We cannot
assure you that we will be successful in obtaining such additional financing on
favorable terms, if at all.
Net cash provided by operating activities for the year ended December 31, 2002
was $24,994,000 compared to net income of $5,138,000 for the year. Sales of
trading securities provided $65,497,000, partially offset by the purchase of
trading securities of $41,287,000.
Net cash provided by investing activities amounted to $55,782,000 during the
year ended December 31, 2002. The majority of cash proceeds from investing
activities was generated from (i) principal payments received on collateral for
CMOs of $48,837,000, (ii) proceeds from sale of mortgage assets of $10,197,000
and (iii) principal payments received on mortgage securities of $4,446,000.
These proceeds were partially offset by capital contributions to HDMF-I of
$5,859,000 and purchase of mortgage securities of $4,866,000.
Cash flows from financing activities used $79,117,000 during the year ended
December 31, 2002. We made repayments on CMO borrowings of $48,526,000 and on
reverse repurchase agreements of $27,055,000. We also paid dividends of
$4,218,000 and purchased an additional 15,666 shares of our common stock for
$132,000 during the year. These payments were partially offset by proceeds from
the exercise of stock options resulting in the issuance of 185,610 shares of
common stock for $814,000.
CAPITAL RESOURCES
We regularly invest our capital in MBS through Hanover, our primary investment
vehicle. We have also invested a limited amount of Hanover's capital in HT. From
the inception of HT in May 1999 until December 31, 2002, Hanover advanced
$7,396,000 in the form of loans, and $173,000 in the form of short-term
advances, to HT. On July 1, 2002, Hanover acquired 100% of the outstanding
common stock of each of HT, HCP and HCP-2; for periods ending after June 30,
2002, Hanover's financial statements will be consolidated with the financial
statements of those entities. Although we have no immediate plans for a change
in the ownership of HT, we continue to pursue third-party investments to address
HT's future capitalized software budget and operating needs. If outside
financing is not located, we will continue to be responsible for HT's capital
and operating requirements, although we do not expect those needs to be
substantial in 2003.
32
RISK FACTORS
The following is a summary of the risk factors that we currently believe are
important and that could cause our results to differ from expectations. This is
not an exhaustive list; other factors not listed below could be material to our
results. If any of the risks discussed below actually occur, our business,
operating results, prospects or financial condition could be harmed.
REIT Requirements
Hanover has elected to be taxed as a REIT under the Code. We believe that we
were in full compliance with the REIT tax rules as of December 31, 2002 and
intend to remain in compliance with all REIT tax rules. If we fail to qualify as
a REIT in any taxable year and certain relief provisions of the Code do not
apply, we will be subject to Federal income tax as a regular, domestic
corporation, and our stockholders will be subject to tax in the same manner as
stockholders of a regular corporation. Distributions to our stockholders in any
year in which we fail to qualify as a REIT would not be deductible by us in
computing our taxable income. As a result, we could be subject to income tax
liability, thereby significantly reducing or eliminating the amount of cash
available for distribution to our stockholders. Further, we could also be
disqualified from re-electing REIT status for the four taxable years following
the year during which we became disqualified. At the same time, complying with
REIT requirements may limit our ability to hedge our risks, or enter into
otherwise attractive investments.
Investments in Certain Mortgage Assets
We take 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.
Credit Risk
In conducting our business, we retain credit risk primarily through (i) the
purchase of subordinate mortgage securities, (ii) the retention of subordinate
securities from our own securitization transactions, (iii) the direct investment
in mortgage loans on our own behalf and (iv) investment in HDMF-I. Through these
investing activities, we generally bear the credit losses on the related pools
of mortgage loans up to their carrying value. During the time we hold mortgage
assets for investment, we are 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 us or on any mortgage loan collateralizing below-investment-grade
MBS held by us, we 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.
As of December 31, 2002, we retain the aggregate credit risk on $5.9 billion of
mortgage loans relating to:
Principal Carrying
Balance Value Financing
--------- -------- ---------
Subordinate MBS $ 23,707 $14,098 $4,585
Collateral for CMOs 115,128 9,967 1,698
Mortgage Loans 547 413 --
-------- ------- ------
Total $139,382 $24,478 $6,283
======== ======= ======
The above carrying value of collateral for CMOs is our net invested equity in
retained mortgage-backed bonds.
In addition, HDMF-I retains the aggregate credit risk on $9,264,000 of mortgage
loans of which our portion is $4,638,000 of invested capital at risk.
If we were to invest in commercial mortgage loans, we 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
33
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, 2002, we did
not have any commercial mortgage loan investments. However, we may elect to make
such investments in the future.
Geographic Concentration
Although we do not set specific geographic diversification requirements for our
portfolio, we do monitor the geographic dispersion of our assets. Concentration
in any one geographic area will increase our exposure to the economic and
natural hazard risks associated with that area.
Negative Effects of Fluctuating Interest Rates
Changes in interest rates may impact our earnings in various ways. Approximately
one third of our mortgage loans held as collateral for CMOs are adjustable rate
mortgages ("ARMs") and approximately 5% of our MBS are collateralized by ARM
loans. Therefore, rising short-term interest rates may negatively affect our
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
us or underlying our MBS are subject to such limitations, while adjustments in
the interest rate on our borrowings are not correspondingly limited. As a
result, in periods of rising interest rates, our net interest income could
decline.
The rate of prepayment on our mortgage assets may increase if interest rates
decline or if the difference between long-term and short-term interest rates
diminishes. Increased prepayments would cause us to amortize any premiums paid
on the acquisition of our mortgage assets faster than currently anticipated,
resulting in a reduced yield on our mortgage assets. 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 assets, our earnings
may be adversely affected.
Insufficient Demand for Mortgage Loans and our Loan Products
The availability of mortgage loans that meet our 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 we
cannot obtain sufficient mortgage loans or mortgage securities that meet our
criteria, our business will be adversely affected.
Investment in Subsidiary
As of December 31, 2002, Hanover advanced $7,396,000 to HT in the form of loans.
We anticipate that HT will not need substantial capital investments to fund
operating activities in 2003. In addition, we are currently attempting
to raise outside capital to address HT's capitalized software budget and
operating needs. HT has a limited operating history and has not been profitable
to date.
34
Investment Company Act
At all times, we intend to conduct our business so as not to become regulated as
an investment company under the Investment Company Act of 1940, as amended. If
we were to become regulated as an investment company, our 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, we must maintain at least 55% of our
assets directly in Qualifying Interests. As of December 31, 2002, we believe
that we are in compliance with this requirement.
State and Local Taxes
Our shareholders may be subject to state or local taxation in various
jurisdictions, including those in which we transact business or where the
shareholders reside. The state and local tax treatment of our 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 our shares.
Available Credit
Our ability to meet our performance goals depends on our access to borrowed
funds in sufficient amounts and on favorable terms. If we are not able to renew
or replace maturing borrowings, we might have to sell some or all of our assets,
possibly under adverse market conditions, terminate hedge positions, and/or
pledge additional collateral to our existing lenders.
35
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We use certain derivative financial instruments as hedges of anticipated
transactions relating to our mortgage securities.
From time to time, we enter into forward sales of mortgage securities issued by
federal agencies to manage our exposure to market pricing changes in connection
with the purchase, holding, securitization and sale of our fixed-rate mortgage
loan portfolio and other mortgage securities. We generally close out the hedge
position to coincide with the related sale or securitization transaction. As
such hedges are considered freestanding derivatives for accounting purposes, we
recognize changes in the fair value of such hedges in earnings in the period of
change.
At December 31, 2002, we had one forward commitment to sell $4.5 million (par
value) and one forward commitment to buy $4.5 million of agency-issued mortgage
securities that had not yet settled. These forward commitments were entered into
to partially hedge the expected sale of approximately $3.4 million principal
balance of subordinate MBS classified as trading. At December 31, 2002, the fair
value of our forward sale of agency-issued MBS was ($46,000). If interest rates
decreased 300 basis points, our maximum projected loss exposure would be an
additional ($47,000); conversely, if interest rates increased 300 basis points,
our maximum projected gain would be $509,000.
The primary risk associated with short-selling agency-issued 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-issued 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-issued
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-issued 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-issued securities.
We also enter into interest rate caps to manage our interest rate exposure on
certain reverse repurchase financing and floating rate CMOs. For interest rate
caps designated as freestanding derivatives for accounting purposes, changes in
fair value are recognized in earnings in the period of change.
During the first quarter of 2002, we terminated hedge accounting for one of our
cash flow hedges. At the termination date, the loss previously reported in other
comprehensive income of $164,000 was reclassified through earnings. We then
designated this interest rate cap as a freestanding derivative.
At December 31, 2002, we had the following interest rate caps in effect (dollars
in thousands):
NOTIONAL
AMOUNT INDEX STRIKE % MATURITY DATE ACCOUNTING DESIGNATION
- ------------- ----------------- ---------- -------------- -------------------------
$ 11,000 3 Month LIBOR 7.695% October 2003 Freestanding Derivative
20,000 1 Month LIBOR 7.75% August 2004 Freestanding Derivative
- -------------
$ 31,000
=============
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. At December 31, 2002, the fair value of our interest rate
caps was $1,000; also the maximum potential loss exposure due to unfavorable
market movements.
36
INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repurchase Financing
At December 31, 2002, we owned $413,000 of mortgage loans held for sale. In
general, we expect that future loan purchases will be conducted by HDMF-I, and
we do not currently plan to purchase additional loans for our own account. If we
resume our strategy of purchasing mortgage loans for our own account, we would
finance these assets during the initial period (the time period during which
management analyzes the loans in detail and corrects deficiencies where possible
before securitizing the loans) with reverse repurchase agreement financing or
with equity. In this scenario, we would be exposed to the mismatch between the
cost of funds on our reverse repurchase agreement financing and the yield on the
mortgage loans. Our reverse repurchase agreement financing at December 31, 2002
was indexed to LIBOR plus a spread of 40 to 200 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.
We also have floating-rate reverse repurchase financing for certain fixed-rate
MBS. At December 31, 2002, we had a total of $4,585,000 of floating-rate reverse
repurchase financing compared to $7,008,000 of fixed-rate MBS investments. We
have 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, we 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, we generally
attempt to hedge these changes through the short sale of mortgage securities,
described above. At December 31, 2002, we did not have any significant mortgage
loans held for sale. We hedge the mortgage securities held for trading with the
short sale of mortgage securities described above.
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. We assign an anticipated prepayment speed to each
mortgage pool and MBS at the time of purchase and record 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, we 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.
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 $71,732,000 of fixed-rate mortgage loans and $31,019,000 of
adjustable-rate mortgage loans and $9,805,000 of mortgage securities at December
31, 2002. The primary financing for this asset category is the CMO debt of
$102,589,000 and reverse repurchase agreements of $1,698,000. The reverse
repurchase agreement financing, which is indexed to LIBOR, is subject to
interest rate volatility as the reverse repurchase agreement matures and is
extended. The financing provided by the CMOs for the 1998-A, 1999-A and 2000-A
securitizations lock in long-term fixed financing and thereby eliminates most
interest rate risk. The financing for the 1999-B securitization is indexed to
LIBOR. Accordingly, we have hedged this interest rate risk through the purchase
of interest
37
rate caps. We 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 $20 million at December 31, 2002.
Mortgage Securities
At December 31, 2002, we owned certain fixed-rate and adjustable-rate private
placement mortgage securities and certain interest-only and principal-only
private placement mortgage securities with an aggregate carrying value of
$14,098,000. 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
Our financial statements and 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 our definitive proxy statement for the 2003
Annual Meeting of Stockholders to be filed with the Securities and Exchange
Commission within 120 days after the end of our fiscal year.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated herein by reference to our definitive proxy statement for the 2003
Annual Meeting of Stockholders to be filed with the Securities and Exchange
Commission within 120 days after the end of our fiscal year.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
(a) Security Ownership of Certain Beneficial Owners and Management
Incorporated herein by reference to our definitive proxy statement for the
2003 Annual Meeting of Stockholders to be filed with the Securities and
Exchange Commission within 120 days after the end of our fiscal year.
(b) Securities Authorized for Issuance under Equity Compensation Plans
The following table sets forth information regarding outstanding options
and shares reserved for future issuance under our equity compensation
plans as of December 31, 2002. None of the plans have outstanding warrants
or rights other than options.
EQUITY COMPENSATION PLAN INFORMATION
Number of Number of Securities
Securities to be Remaining Available for
Issued upon Weighted Average Future Issuance Under
Exercise of Exercise Price Equity Compensation Plans
Outstanding of Outstanding (excluding securities
Plan Category Stock Options Stock Options reflected in column (a))
--------------------------------------- ---------------- ----------------- -------------------------
(a) (b) (c)
Equity compensation plans approved
by security holders(1) 250,824 $15.283 74,509
Equity compensation plans not
approved by security holders 258,035 $ 4.216 44,167
(1) A Bonus Incentive Compensation Plan has been established for eligible
participants of the Company. Although the annual bonus is payable one-half
in cash and one-half in shares of our common stock, no shares have been
reserved for future issuance.
Under our 1999 Equity Incentive Plan, the Compensation Committee can grant
non-qualified stock options or restricted stock to executive officers,
employees, directors, agents, advisors and consultants of Hanover and its
subsidiaries. Subject to anti-dilution provisions for stock splits, stock
dividends and similar events, the Plan authorizes the grant of options to
purchase, and awards of, an aggregate of up to 550,710 shares of our common
stock. The Compensation Committee has the authority to amend the Plan and to set
the terms of all awards granted under the Plan, including the number of shares
of common stock awarded, the exercise price and vesting provisions. The Plan
provides for option grants upon initial election and subsequent re-election to
the Board of Directors for each non-employee director, exercisable into 2,000
shares of our common stock which vest in full on the grant date. If an option
granted under the Plan expires or terminates, or an award is forfeited, the
shares subject to any unexercised portion of such option or award will again
become available for the issuance of additional options of awards under the
Plan. No eligible participant can be granted options exercisable into, or awards
of, more than 50,000 shares of our common stock in any year. In the event of a
change of control in which we are not the surviving entity, the Compensation
Committee can accelerate the vesting of all outstanding awards. The Plan will
expire in 2009, but awards granted prior to the expiration of the Plan may be
exercisable beyond that date.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference to our definitive proxy statement for the 2003
Annual Meeting of Stockholders to be filed with the Securities and Exchange
Commission within 120 days after the end of our fiscal year.
ITEM 14. CONTROLS AND PROCEDURES
(a) Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Rule 13a-14 under the
Securities Exchange Act of 1934, as amended. Based upon that evaluation,
our Chief Executive Officer and Chief Financial Officer concluded that
our disclosure controls and procedures are effective in timely alerting
them to material information required to be included in our periodic SEC
filings. However, we cannot assure you that our controls and procedures
can prevent or detect all errors and fraud. In addition, since any system
of controls is based in part upon assumptions regarding future events, we
cannot assure you that the design of our controls will be successful in
achieving its stated goals under all potential future conditions.
(b) There have been no significant changes in our internal controls or in
other factors that could significantly affect our internal controls
subsequent to the date of the evaluation referred to in subsection (a)
above.
39
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
See Part II, Item 8 hereof.
(2) Financial Statement Schedules
All schedules omitted are inapplicable or the information required
is shown in the Financial Statements or notes thereto.
(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
We did not file any current reports on Form 8-K during the last quarter of
2002.
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 March 28, 2003.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By /s/ J. Holly Loux
-------------------------------------
J. Holly Loux
Chief Financial Officer
(Principal Financial and
Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of Registrant and the
capacities indicated on March 28, 2003.
SIGNATURE TITLE
/s/ John A. Burchett Chairman of the Board of Directors,
- -------------------------------------------- President 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/ J. Holly Loux Chief Financial Officer
- -------------------------------------------- (Principal Financial and
J. Holly Loux Accounting Officer)
41
CERTIFICATIONS
I, John A. Burchett, certify that:
1. I have reviewed this Annual Report on Form 10-K of Hanover Capital Mortgage
Holdings, Inc.;
2. Based on my knowledge, this Annual Report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this Annual
Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Annual Report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Registrant as of, and for, the periods presented in this Annual Report;
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the Registrant and have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this Annual
Report is being prepared;
(b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this Annual Report (the "Evaluation Date"); and
(c) presented in this Annual Report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Registrant's auditors and the audit committee of
Registrant's Board of Directors (or persons performing the equivalent
functions):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officer and I have indicated in this Annual
Report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ John A. Burchett
---------------------------------------
John A. Burchett
President and Chief Executive Officer
42
CERTIFICATIONS (CONTINUED)
I, J. Holly Loux, certify that:
1. I have reviewed this Annual Report on Form 10-K of Hanover Capital Mortgage
Holdings, Inc.;
2. Based on my knowledge, this Annual Report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this Annual
Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Annual Report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Registrant as of, and for, the periods presented in this Annual Report;
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the Registrant and have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this Annual
Report is being prepared;
(b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this Annual Report (the "Evaluation Date"); and
(c) presented in this Annual Report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Registrant's auditors and the audit committee of
Registrant's Board of Directors (or persons performing the equivalent
functions):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officer and I have indicated in this Annual
Report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ J. Holly Loux
-----------------------
J. Holly Loux
Chief Financial Officer
43
EXHIBIT INDEX
EXHIBIT DESCRIPTION
- ------- -----------
2.1*(8) Stock Purchase Agreement dated as of July 1, 2002 by and between Registrant, John A. Burchett,
Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
3.1(9) Amended Articles of Incorporation of Registrant, as amended
3.2(1) Bylaws of Registrant
4.1(1) Specimen Common Stock Certificate of Registrant
10.3*(1) Registration Rights Agreement
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*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant
and John A. Burchett
10.8.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and John A. Burchett
10.9*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant
and Irma N. Tavares
10.9.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and Irma N. Tavares
10.10*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant
and Joyce S. Mizerak
10.10.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and Joyce S. Mizerak
10.11*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant
and George J. Ostendorf
10.11.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and George J. Ostendorf
10.11.2*(6) Employment Agreement by and between Registrant and Thomas P. Kaplan
44
10.11.3* Stock Purchase Agreement as of December 13, 2002 between Thomas P. Kaplan and Hanover Capital
Mortgage Holdings, Inc.
10.13(1) Office Lease Agreement, dated as of March 1, 1994, by and between Metroplex Associates and Hanover
Capital Mortgage Corporation, as amended by the First Modification and Extension of Lease Amendment
dated as of February 28, 1997.
10.13.1 Second Modification and Extension of Lease Agreement dated April 22, 2002
10.13.2 Third Modification of Lease Agreement dated May 8, 2002
10.13.3 Fourth Modification of Lease Agreement dated November 2002
10.14(3) Office Lease Agreement, dated as of February 1, 1999, between LaSalle-Adams, L.L.C. and Hanover
Capital Partners Ltd.
10.15 Office Lease Agreement, dated as of September 3, 1997, between Metro Four Associates Limited
Partnership and Pamex Capital Partners, L.L.C., as amended by the First Amendment to Lease dated
May 2000
10.25*(1) Contribution Agreement by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J.
Ostendorf and Irma N. Tavares
10.25.1*(8) Amendment No. 1 to Contribution Agreement entered into as of July 1, 2002 by and between
Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
10.26*(1) Participation Agreement by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J.
Ostendorf and Irma N. Tavares
10.27*(1) Loan Agreement
10.29(2) Management Agreement, dated as of January 1, 1998, by and between Registrant and Hanover Capital
Partners Ltd.
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., Registrant and Hanover Capital Partners Ltd. dated March 27, 2000
10.31.1(7) Amendment Number Three dated as of April 11, 2001 to the Amended and Restated Master Loan and Security Agreement dated
as of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products,
Inc.
10.31.2 Amendment Number Five dated as of March 28, 2002 to the Amended and Restated Master Loan and Security Agreement dated
as of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products,
Inc.
10.31.3 Amendment Number Six dated as of March 27, 2003 to the Amended and Restated Master Loan and Security Agreement dated as
of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products,
Inc.
10.33(5) Stockholder Protection Rights Agreement
10.33.1(8) Amendment to Stockholder Protection Rights Agreement effective as of September 26, 2001, by and
among Registrant, State Street Bank and Trust Company and EquiServe Trust Company, N.A.
10.33.2(8) Second Amendment to Stockholder Protection Rights Agreement dated as of June 10, 2002 by and
between Registrant and EquiServe Trust Company, N.A.
10.34(6) Asset Purchase Agreement, dated as of January 19, 2001 by and among HanoverTrade.com, Inc.,
Registrant, Pamex Capital Partners, L.L.C. and the members of Pamex Capital Partners, L.L.C.
10.35 Amended and Restated Limited Liability Agreement as of November 21, 2002 by and among BTD 2001 HDMF-1
Corp., Hanover Capital Mortgage Holdings, Inc. and Provident Financial Group, Inc.
21 Subsidiaries of Hanover Capital Mortgage Holdings, Inc.
23.1 Independent Auditors' Consent
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
45
(1) Incorporated herein by reference to Registrant's Registration Statement on
Form S-11, Registration No. 333-29261, as amended, which became effective
under the Securities Act of 1933, as amended, on September 15, 1997.
(2) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 1997, as filed with the Securities and Exchange
Commission on March 31, 1998.
(3) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 1999, as filed with the Securities and Exchange
Commission on March 30, 2000.
(4) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended March 31, 2000, as filed with the Securities and Exchange Commission
on May 15, 2000.
(5) Incorporated herein by reference to Registrant's report on Form 8-K filed
with the Securities and Exchange Commission on April 24, 2000.
(6) Incorporated herein by reference to Registrant's form 10-K for the year
ended December 31, 2000, as filed with the Securities and Exchanges
Commission on April 2, 2001.
(7) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended June 30, 2001, as filed with the Securities and Exchange Commission
on August 14, 2001.
(8) Incorporated herein by reference to Registrant's Form 8-K filed with the
Securities and Exchange Commission on July 16, 2002.
(9) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended June 30, 2002, as filed with the Securities and Exchange Commission
on August 14, 2002.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to Item 601 of Regulation S-K.
46
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, 2002 and 2001 and for the Years Ended
December 31, 2002, 2001 and 2000:
Balance Sheets ............................................................................... F-3
Statements of Income ......................................................................... 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-36
Consolidated Financial Statements as of December 31, 2002 and 2001 and for the Years Ended
December 31, 2002, 2001 and 2000:
Balance Sheets ............................................................................... F-37
Statements of Income ......................................................................... F-38
Statements of Stockholder's Equity ........................................................... F-39
Statements of Cash Flows ..................................................................... F-40
Notes to Consolidated Financial Statements ................................................... F-41
HANOVERTRADE, INC. AND SUBSIDIARY
Independent Auditors' Report ......................................................................... F-46
Consolidated Financial Statements as of December 31, 2002 and 2001 and for the Years Ended
December 31, 2002, 2001 and 2000:
Balance Sheets ............................................................................... F-47
Statements of Operations ..................................................................... F-48
Statements of Stockholder's Equity ........................................................... F-49
Statements of Cash Flows ..................................................................... F-50
Notes to Consolidated Financial Statements ................................................... F-51
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, 2002
and 2001, and the related consolidated statements of income, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 2002. 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, 2002 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 20, 2003
F-2
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
DECEMBER 31,
-------------------------
ASSETS 2002 2001
--------- ---------
Mortgage loans:
Held for sale $ 413 $ 2,391
Collateral for CMOs 102,751 151,882
Mortgage securities pledged as collateral
for reverse repurchase agreements:
Available for sale 4,082 4,404
Held to maturity 559 768
Trading 2,669 33,182
Mortgage securities pledged as collateral for CMOs 9,805 9,840
Mortgage securities, not pledged:
Available for sale 6,186 1,162
Trading 602 1,827
Cash and cash equivalents 10,605 8,946
Accounts receivable 2,450 777
Accrued interest receivable 960 1,960
Equity investments:
Hanover Capital Partners Ltd. -- 1,808
HanoverTrade, Inc. -- (4,789)
HDMF-I LLC 4,638 80
Notes receivable from related parties 2,563 12,538
Other assets 7,588 2,731
--------- ---------
TOTAL ASSETS $ 155,871 $ 229,507
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 6,283 $ 33,338
CMO borrowing 102,589 151,096
Dividends payable 1,119 855
Accounts payable, accrued expenses and other liabilities 2,816 2,677
--------- ---------
TOTAL LIABILITIES 112,807 187,966
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01, 10 million shares authorized,
-0- shares issued and outstanding
Common stock, par value $.01, 90 million shares authorized,
4,474,222 and 4,275,676 shares issued and outstanding at
December 31, 2002 and 2001, respectively 45 43
Additional paid-in capital 67,990 67,082
Retained earnings (deficit) (25,322) (25,978)
Accumulated other comprehensive income 351 394
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 43,064 41,541
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 155,871 $ 229,507
========= =========
See notes to consolidated financial statements
F-3
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
YEARS ENDED DECEMBER 31,
---------------------------------------
2002 2001 2000
-------- -------- --------
REVENUES:
Interest income $ 13,530 $ 19,702 $ 26,692
Interest expense 7,438 13,433 20,029
-------- -------- --------
Net interest income 6,092 6,269 6,663
Loan loss provision 393 709 875
-------- -------- --------
Net interest income after loan loss provision 5,699 5,560 5,788
Gain on sale of mortgage assets 2,095 3,782 819
Gain on mark to market of mortgage assets,
net of associated hedge 1,367 751 431
Loan brokering, trading and advisory services 2,686 -- --
Due diligence fees 2,891 -- --
Assignment fees 1,387 -- --
Other income (loss) (370) (28) --
-------- -------- --------
Total revenue 15,755 10,065 7,038
-------- -------- --------
EXPENSES:
Personnel 5,479 680 1,020
Subcontractor 1,812 -- --
General and administrative 1,089 1,132 924
Legal and professional 1,070 1,247 555
Depreciation and amortization 655 24 21
Other 409 410 409
Occupancy 349 151 160
Travel and entertainment 317 48 45
Technology 293 4 2
-------- -------- --------
Total expenses 11,473 3,696 3,136
-------- -------- --------
Operating income 4,282 6,369 3,902
Equity in income (loss) of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. 112 43 455
HanoverTrade, Inc. 655 (3,263) (1,495)
HDMF-I LLC 157 (35) --
Hanover Capital Partners 2, Inc. (19) -- --
-------- -------- --------
Income before income tax provision and cumulative
effect of adoption of SFAS 133 5,187 3,114 2,862
Income tax provision 49 -- --
-------- -------- --------
Income before cumulative effect of adoption of SFAS 133 5,138 3,114 2,862
Cumulative effect of adoption of SFAS 133 -- 46 --
-------- -------- --------
NET INCOME $ 5,138 $ 3,160 $ 2,862
======== ======== ========
BASIC EARNINGS PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.73 $ 0.56
Cumulative effect of adoption of SFAS 133 -- 0.01 --
-------- -------- --------
After cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.74 $ 0.56
======== ======== ========
DILUTED EARNINGS PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.72 $ 0.56
Cumulative effect of adoption of SFAS 133 -- 0.01 --
-------- -------- --------
After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.73 $ 0.56
======== ======== ========
See notes to consolidated financial statements
F-4
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(in thousands, except share data)
ACCUMULATED
ADDITIONAL RETAINED OTHER
COMMON STOCK PAID-IN COMPREHENSIVE EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL INCOME (DEFICIT) INCOME TOTAL
--------- ------ ---------- ------------- -------- ------------- --------
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
Repurchase of common stock (50,641) (1) (373) (374)
Capital contributed to related party 63,577 1 469 470
Exercise of options 185,610 2 812 814
Comprehensive income:
Net income $5,138 5,138 5,138
Other comprehensive income:
Change in net unrealized gain (loss) on
securities available for sale (207) (207) (207)
Change in net unrealized gain (loss) on
interest rate caps designated as hedges 164 164 164
------
Comprehensive income $5,095
======
Dividends declared (4,482) (4,482)
--------- ----- -------- -------- ------- --------
BALANCE, DECEMBER 31, 2002 4,474,222 $ 45 $ 67,990 $(25,322) $ 351 $ 43,064
========= ===== ======== ======== ======= ========
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,
-------------------------------------------
2002 2001 2000
-------- --------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 5,138 $ 3,160 $ 2,862
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 655 24 21
Amortization of net premium and deferred costs 133 363 203
Loan loss provision 393 709 875
Gain on sale of mortgage assets (2,095) (3,782) (873)
Gain on mark to market of mortgage assets (1,367) (1,058) (816)
Gain on mark to market of mortgage assets for SFAS 133 -- (50) --
Gain on disposition of real estate owned (107) -- --
Purchase of trading securities (41,287) (142,540) (7,634)
Sale of trading securities 65,497 113,945 2,709
Distributions from unconsolidated subsidiaries in excess of
equity (income) loss 552 3,255 1,041
(Increase) decrease in accounts receivable (494) 134 (761)
Decrease in accrued interest receivable 1,072 506 460
(Increase) decrease in notes receivable from related parties (1,342) (4,651) 300
Decrease (increase) in other assets 104 250 (1,344)
(Decrease) increase in accounts payable, accrued expenses
and other liabilities (1,858) 91 (949)
-------- --------- --------
Net cash provided by (used in) operating activities 24,994 (29,644) (3,906)
-------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage loans (51) (2,172) --
Purchase of mortgage securities (4,866) (4,431) (2,934)
Purchase of mortgage securities from affiliate -- -- (13,845)
Principal payments received on mortgage securities 4,446 5,067 8,001
Principal payments received on collateral for CMOs 48,837 59,701 57,254
Principal payments received on mortgage loans held for sale 209 11 21
Proceeds from sale of mortgage assets 10,197 16,076 43,054
Proceeds from disposition of real estate owned 253 -- --
Sales of mortgage securities to affiliates 945 -- --
Increase in cash due to acquisition of subsidiaries' residual interests 1,671 -- --
Capital contributions to HDMF-I LLC (5,859) (115) --
-------- --------- --------
Net cash provided by investing activities 55,782 74,137 91,551
-------- --------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (repayment of) borrowings from reverse repurchase agreements (27,055) 18,578 (40,962)
Net repayment of CMOs (48,526) (59,207) (45,685)
Increase in CMO discount -- -- 1,069
Payment of dividends (4,218) (3,411) (2,822)
Repurchase of common stock (132) (1,736) (7,309)
Exercise of stock options 814 271 --
-------- --------- --------
Net cash used in financing activities (79,117) (45,505) (95,709)
-------- --------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,659 (1,012) (8,064)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 8,946 9,958 18,022
-------- --------- --------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 10,605 $ 8,946 $ 9,958
======== ========= ========
See notes to consolidated financial statements
F-6
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
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 subsidiaries:
Hanover Capital Partners Ltd. ("HCP") and HanoverTrade, Inc. ("HT"). When we
refer to the "Company," we mean Hanover together with its consolidated and
unconsolidated subsidiaries.
Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved by a
special committee of disinterested members of its Board of Directors, Hanover
acquired 100% of the outstanding common stock of each of HT, HCP and Hanover
Capital Partners 2, Inc. ("HCP-2"), a previously inactive subsidiary. Hanover
had previously owned 100% of the non-voting preferred stock, but none of the
voting common stock, of each of HT, HCP and HCP-2. This ownership structure was
established in order to satisfy tax laws governing Hanover's status as a REIT.
Changes in the tax laws made it possible for Hanover to acquire voting control
of HT, HCP and HCP-2 and operate under new rules permitting REITs to wholly own
subsidiaries such as HT, HCP and HCP-2. Therefore, as of July 1, 2002, Hanover
owns 100% of the outstanding capital stock of each of HT, HCP and HCP-2, and for
periods ending after June 30, 2002, Hanover's financial statements will be
consolidated with the financial statements of HT, HCP and HCP-2.
Hanover acquired the common shares of HT, HCP and HCP-2 from four of its
directors who are also executive officers. An independent appraiser determined
that the value of the common shares of HT and HCP was $474,000 in the aggregate.
The parties agreed that the common shares of HCP-2 would be transferred to
Hanover as part of this transaction for no additional consideration. Each of the
four selling executives agreed that the purchase price would be used to
partially repay certain indebtedness owing to Hanover from them. Each of these
four executives also received a bonus in an amount sufficient to cover the tax
liability they incurred in connection with this transaction.
The Company is engaged in three principal businesses, which are conducted
through its three primary operating units: Hanover, HCP and HT. 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 providing consulting and due diligence services, focusing on
loan sale advisory, loan file due diligence reviews, staffing solutions and
mortgage assignment and collateral rectification services. The principal
business activity of HT is to generate fee income by operating an Internet
exchange for trading mortgage loans, mortgage servicing rights and related
assets, and providing state-of-the-art technologies supported by experienced
valuation, operations and trading professionals. Hanover also maintains an
equity investment in HDMF-I LLC ("HDMF-I"). 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.
The Company's principal business objective is to generate net interest income on
its portfolio of mortgage securities and mortgage loans and to generate fee
income through HCP, HT and third party asset-management contracts.
F-7
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.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand,
overnight investments deposited with banks and money market mutual funds
primarily invested in government securities with weighted maturities less than
60 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 mortgage 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 seeks to limit its exposure to credit losses on its portfolio of
mortgage loans by performing an in-depth due diligence review on every loan
purchased. The due diligence review encompasses the borrower's credit, the
enforceability of the documents, and the value of the mortgaged 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
F-8
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.
Mortgage securities transactions are recorded on settlement date for mortgage
securities 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 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 the 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 investment in HDMF-I on the equity
method. Accordingly, Hanover records its proportionate share of the earnings or
losses of HDMF-I. For all periods prior to July 1, 2002, Hanover recorded 97% of
the earnings or losses of HCP and HT and 99% of the earnings or losses of HCP-2
based on the equity method. Effective July 1, 2002, Hanover's financial
statements are consolidated with the financial statements of HT, HCP and HCP-2.
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 mortgage securities issued by U.S.
government agencies) to manage its exposure to changes in interest rates in
connection with the purchase, holding, securitization and sale of its mortgage
securities and mortgage loan portfolio. The Company generally closes out the
hedge position to coincide with a long-term securitization
F-9
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 collateralized mortgage
obligation, or 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.
REVENUE RECOGNITION - Revenues from loan brokering, trading and advisory
services 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.
Revenues from due diligence contracts in progress and assignment preparation
services are recognized for the services provided as they are earned and billed.
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 on that portion of its income that is distributed
to stockholders, as long as certain asset, income and stock ownership tests
are met.
HCP and HT file separate consolidated Federal income tax returns. HCP and HT use
the asset and liability method in accounting for income taxes. Deferred income
taxes are provided for the effect of temporary differences between the tax basis
and financial statement carrying amounts of assets and liabilities.
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.
F-10
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 of prior years' amounts have been
made to conform to the current year presentation.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS - On January 1, 2002, the Company
adopted Statement of Financial Accounting Standards 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. The adoption of SFAS
144 did not have an impact on the Company's consolidated financial position or
results of operations.
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44,
Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB
Statement No. 13, Accounting for Leases, to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. The provisions of SFAS 145 related to
the rescission of FASB Statement No. 4 are generally effective for fiscal years
beginning after May 15, 2002. The adoption of SFAS 145 did not have a material
effect on the Company's consolidated financial statements.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued
Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan. SFAS 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The adoption of SFAS 146 will not have a
material effect on our consolidated financial statements.
On November 25, 2002, the FASB issued FASB Interpretation No. ("FIN") 45
("FIN 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others, an interpretation of
FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34."
FIN 45 clarifies the requirements of FASB Statement No. 5, "Accounting for
Contingencies," relating to the guarantor's accounting for, and disclosure of,
the issuance of certain types of guarantees. The disclosure requirements of FIN
45 are effective for financial statements of interim or annual periods that end
after December 15, 2002. The disclosure provisions have been implemented and no
disclosures were required at year-end 2002. The provisions for initial
recognition and measurement are effective on a prospective basis for guarantees
that are issued or modified after December 31, 2002, irrespective of the
guarantor's year-end. FIN 45 requires that upon issuance of a guarantee, the
entity must recognize a liability for the fair value of the obligation it
assumes under that guarantee. The Company's adoption of FIN 45 in 2003 has not
and is not expected to have a material effect on the Company's consolidated
financial statements.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest
Entities - an interpretation of ARB No. 51," which addresses consolidation of
variable interest entities. FIN 46 expands the criteria for consideration in
determining whether a variable interest entity should be consolidated by a
business entity, and requires existing unconsolidated variable interest
entities (which include, but are not limited to, Special Purpose Entities, or
SPEs) to be consolidated by their primary beneficiaries if the entities do not
effectively disperse risks among parties involved. This interpretation applies
immediately to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after
that date. It applies in the first fiscal year or interim period beginning
after June 15, 2003, to variable interest entities in which an enterprise holds
a variable interest that it acquired before February 1, 2003. The adoption of
FIN 46 is not expected to have a material effect on the Company's consolidated
financial statements.
F-11
3. MORTGAGE LOANS
MORTGAGE LOANS HELD FOR SALE
(dollars in thousands)
DECEMBER 31, 2002 DECEMBER 31, 2001
------------------------------------- --------------------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
-------- -------- --------- --------- -------- ---------
Principal amount of mortgage loans $ 48 $ 499 $ 547 $ 560 $ 2,627 $ 3,187
Net premium (discount) and deferred costs (3) (111) (114) (159) (637) (796)
Loan loss allowance -- (20) (20) -- -- --
-------- -------- --------- --------- -------- ---------
Carrying value of mortgage loans $ 45 $ 368 $ 413 $ 401 $ 1,990 $ 2,391
======== ======== ========= ========= ======== =========
MORTGAGE LOANS SECURITIZED IN COLLATERALIZED MORTGAGE OBLIGATIONS
(dollars in thousands)
DECEMBER 31, 2002 DECEMBER 31, 2001
------------------------------------- --------------------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
-------- -------- --------- --------- -------- ---------
Principal amount of mortgage loans $ 71,127 $ 31,365 $ 102,492 $ 105,849 $ 45,535 $ 151,384
Net premium (discount) and deferred costs 982 (152) 830 1,442 (167) 1,275
Loan loss allowance (377) (194) (571) (553) (224) (777)
-------- -------- --------- --------- -------- ---------
Carrying value of mortgage loans $ 71,732 $ 31,019 $ 102,751 $ 106,738 $ 45,144 $ 151,882
======== ======== ========= ========= ======== =========
Hanover's securitizations were issued with various call provisions, generally
allowing for the termination of the securitization at the earlier of a certain
date or when the outstanding collateral balance is less than a pre-established
percentage of the original collateral balance. During December 2002, Hanover
exercised the call provisions of its 1998-A securitization. As of December 31,
2002, Group 3 of Hanover's 1998-B securitization was callable. As discussed in
Note 19 to the Consolidated Financial Statements, the mortgage loans underlying
the CMOs were sold during the first quarter of 2003.
F-12
4. MORTGAGE SECURITIES
FIXED-RATE AGENCY MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2001
------------------------------------------------
AVAILABLE HELD TO
FOR SALE MATURITY TRADING TOTAL
--------- -------- ------- -------
Principal balance of mortgage securities $1,378 $ -- $25,251 $26,629
Net premium(discount) and deferred costs 70 -- 2,258 2,328
------ ------ ------- -------
Total amortized cost of mortgage 1,448 -- 27,509 28,957
securities
Net unrealized gain (loss) 62 -- 45 107
------ ------ ------- -------
Carrying value of mortgage securities $1,510 $ -- $27,554 $29,064
====== ====== ======= =======
At December 31, 2002, there were no fixed-rate agency mortgage-backed
securities.
FIXED-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2002
----------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ 17,472 $ -- $ 3,433 $ 12,636 $ 33,541
Net premium (discount)
and deferred costs (9,164) -- (510) (2,466) (12,140)
-------- -------- ------- -------- --------
Total amortized cost of
mortgage securities 8,308 -- 2,923 10,170 21,401
Loan loss allowance (182) -- -- (365) (547)
Net unrealized gain (loss) 434 -- 348 -- 782
-------- -------- ------- -------- --------
Carrying value of
mortgage securities $ 8,560 $ -- $ 3,271 $ 9,805 $ 21,636
======== ======== ======= ======== ========
DECEMBER 31, 2001
------------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ 6,561 $ -- $ 6,433 $ 12,926 $ 25,920
Net premium (discount)
and deferred costs (3,440) -- (2,452) (2,742) (8,634)
------- ------ ------- -------- --------
Total amortized cost of
mortgage securities 3,121 -- 3,981 10,184 17,286
Loan loss allowance (221) -- -- (344) (565)
Net unrealized gain (loss) 623 -- 792 -- 1,415
------- ------ ------- -------- --------
Carrying value of
mortgage securities $ 3,523 $ -- $ 4,773 $ 9,840 $ 18,136
======= ====== ======= ======== ========
ADJUSTABLE-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2002
---------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ 2,121 $ -- $ -- $ -- $ 2,121
Net premium (discount)
and deferred costs (963) -- -- -- (963)
-------- -------- -------- -------- --------
Total amortized cost of
mortgage securities 1,158 -- -- -- 1,158
Loan loss allowance (25) -- -- -- (25)
Net unrealized gain (loss) 2 -- -- -- 2
-------- -------- -------- -------- --------
Carrying value of
mortgage securities $ 1,135 $ -- $ -- $ -- $ 1,135
======== ======== ======= ======== ========
DECEMBER 31, 2001
-------------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
---------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ -- $ -- $ 3,692 $ -- $ 3,692
Net premium (discount)
and deferred costs -- -- (997) -- (997)
------- ------ ------- -------- --------
Total amortized cost of
mortgage securities -- -- 2,695 -- 2,695
Loan loss allowance -- -- -- -- --
Net unrealized gain (loss) -- -- (13) -- (13)
------- ------ ------- -------- --------
Carrying value of
mortgage securities $ -- $ -- $ 2,682 $ -- $ 2,682
======= ====== ======= ======== ========
DERIVATIVE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2002
-----------------------------------------------
INTEREST- PRINCIPAL-
ONLY STRIPS ONLY STRIPS
AVAILABLE HELD TO
FOR SALE MATURITY TRADING TOTAL
----------- ----------- ------ ------
Principal balance of mortgage securities $ -- $ 681 $ -- $ 681
Net premium (discount) and deferred costs 339 (122) -- 217
-------- ------- ------ ------
Total amortized cost of mortgage securities 339 559 -- 898
Loan loss allowance -- -- -- --
Net unrealized gain (loss) 234 -- -- 234
-------- ------- ------ ------
Carrying value of mortgage securities $ 573 $ 559 $ -- $1,132
======== ======= ====== ======
DECEMBER 31, 2001
-------------------------------------------------
INTEREST- PRINCIPAL-
ONLY STRIPS ONLY STRIPS
AVAILABLE HELD TO
FOR SALE 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
======= ===== ====== =======
F-13
The carrying values of the Company's mortgage securities by average life as of
December 31, 2002 are as follows (dollars in thousands):
AVAILABLE HELD TO COLLATERAL
AVERAGE LIFE FOR SALE MATURITY TRADING FOR CMOS
-------------------- --------- -------- ------- ----------
Less than five years $ 1,325 $ 352 $ -- $9,785
Five to ten years 7,799 207 3,271 20
More than ten years 1,144 -- -- --
------- ------ ------ ------
$10,268 $ 559 $3,271 $9,805
======= ====== ====== ======
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 2002, 2001 and 2000 were as follows (dollars in
thousands):
YEAR ENDED DECEMBER 31, 2002
--------------------------------------------
GROSS GROSS
REALIZED REALIZED
PROCEEDS GAIN LOSS
-------- -------- --------
Sale of subordinate MBS $ 7,288 $1,771 $ (3)
Sale of Agency pass-through MBS 1,307 55 --
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)
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, 2002, 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 12
Texas 12
--
Total 39%
==
The Company did not have any material concentrations of credit risk in its held
for sale category at December 31, 2002.
F-14
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.
CONCENTRATION OF CREDIT RISK BY ISSUER
(dollars in thousands)
DECEMBER 31, 2002
---------------------------------------------------------------------------------
AVAILABLE HELD COLLATERAL
FOR TO FOR
ISSUER SALE MATURITY TRADING CMOS TOTAL
---------------------- --------- -------- ---------- ----------- ---------
Hanover Capital 1998-B $ 573 $ 559 $ -- $ 9,805 $ 10,937
Issuer 1 4,060 -- 372 -- 4,432
Issuer 2 903 -- 1,371 -- 2,274
Issuer 3 2,150 -- -- -- 2,150
Issuer 4 626 -- 1,298 -- 1,924
Issuer 5 669 -- -- -- 669
Issuer 6 507 -- -- -- 507
Issuer 7 507 -- -- -- 507
Issuer 8 273 -- 230 -- 503
--------- -------- ---------- --------- ---------
Total $ 10,268 $ 559 $ 3,271 $ 9,805 $ 23,903
========= ======== ========== ========= =========
CASH AND OVERNIGHT INVESTMENTS - The Company has cash and cash equivalents in
major financial institutions which are insured by the Federal Deposit Insurance
Corporation ("FDIC") up to $100,000 per institution for each legal entity. At
December 31, 2002, the Company had amounts on deposit with the financial
institutions in excess of FDIC limits. At December 31, 2002, the Company had
overnight investments of $10,026,000 primarily in money market mutual funds
invested in government securities. The Company limits its risk by placing its
cash and cash equivalents in high quality financial institutions, Federal Agency
notes or mutual funds of government securities.
6. LOAN LOSS ALLOWANCE
The following table summarizes the activity in the loan loss allowance (dollars
in thousands):
YEARS ENDED DECEMBER 31,
---------------------------------------------
2002 2001 2000
------- ------- -------
Balance, beginning of period $ 1,342 $ 1,724 $ 799
Loan loss provision 393 709 875
Transfers from related company -- -- 729
Sales (197) (852) (593)
Charge-offs (395) (241) (92)
Recoveries -- 2 6
------- ------- -------
Balance, end of period $ 1,143 $ 1,342 $ 1,724
======= ======= =======
7. EQUITY INVESTMENTS
As of and for the six months ended June 30, 2002 and for the years ended
December 31, 2001 and 2000, Hanover owned 100% of the non-voting preferred stock
of HCP, HT and HCP-2. These ownership interests entitled Hanover to receive 97%
of the earnings or losses of HCP and HT and 99% of the earnings or losses of
HCP-2. As discussed in Note 1 to the Consolidated Financial Statements,
effective July 1, 2002, Hanover acquired 100% of the common stock of HCP, HT and
HCP-2; therefore, for the periods ending after June 30, 2002, the financial
statements of HCP, HT and HCP-2 will be consolidated with the financial
statements of Hanover.
F-15
The table below reflects the activity recorded in Hanover's equity investments
(dollars in thousands):
YEARS ENDED DECEMBER 31,
--------------------------------------------------------------------------------------------------------
2002 2001
-------------------------------------------------------- ------------------------------------------
HCP HT HCP-2 HDMF-I TOTAL HCP HT HDMF-I TOTAL
------- ------- ---- ------- ------- ------ ------- ------ -------
Beginning balance $ 1,808 $(4,789) $ -- $ 80 $(2,901) $1,765 $(1,526) $ -- $ 239
Capital contribution -- 470 -- 5,859 6,329 -- -- 115 115
Applicable % of net
income (loss) 112 655 (19) 157 905 43 (3,263) (35) (3,255)
Applicable % of
comprehensive
loss -- -- -- -- -- -- -- -- --
Distributions -- -- -- (1,458) (1,458) -- -- -- --
Impact of acquisition
of subsidiaries'
common stock (1,920) 3,664 19 -- 1,763 -- -- -- --
------- ------- ---- ------- ------- ------ ------- ----- -------
Ending balance $ -- $ -- $ -- $ 4,638 $ 4,638 $1,808 $(4,789) $ 80 $(2,901)
======= ======= ==== ======= ======= ====== ======= ===== =======
YEARS ENDED DECEMBER 31,
---------------------------------
2000
---------------------------------
HCP HT TOTAL
------- ------- -------
Beginning balance $ 1,466 $ (30) $ 1,436
Capital contribution -- -- --
Applicable % of net
income (loss) 455 (1,496) (1,041)
Applicable % of
comprehensive
loss (156) -- (156)
Distributions -- -- --
Impact of acquisition
of subsidiaries'
common stock -- -- --
------- ------- -------
Ending balance $ 1,765 $(1,526) $ 239
======= ======= =======
8. NOTES RECEIVABLE AND DUE FROM RELATED PARTIES
As of December 31, 2002, Hanover had $2,563,000 of loans outstanding to four
executive officers ("Principals"), $870,000 of loans outstanding to HCP and
$7,396,000 of loans outstanding to HT. The loans to HCP and HT are eliminated in
the consolidated financial statements as of December 31, 2002. Subsequent to
June 30, 2002, the interest income and related expense on the loans to HCP and
HT are eliminated in the consolidated financial statements.
NOTES RECEIVABLE
(dollars in thousands)
DECEMBER 31, INTEREST
2002 RATE MATURITY DATE
------------ -------- -------------
Principals $ 483 6.02% September 2007
1,267 5.70 September 2007
813 5.51 March 2003
HCP 870 3.25 March 2004
HT 7,396 3.25 March 2004
Eliminations (8,266)
-------
$ 2,563
=======
The loans to Principals are partially secured solely by 116,667 shares of
Hanover's common stock owned by the Principals, collectively. The loans to HCP
and HT are unsecured.
Additional amounts due from related parties at December 31, 2002 are as follows
(dollars in thousands):
ACCRUED
INTEREST OTHER
RECEIVABLE RECEIVABLES TOTAL
---------- ----------- -----
HCP $ 5 $ 15 $ 20
HT 58 173 231
HDMF-I -- 101 101
Other 5 -- 5
Eliminations (63) (188) (251)
------- ------- -------
$ 5 $ 101 $ 106
======= ======= =======
F-16
9. REVERSE REPURCHASE AGREEMENTS
At December 31, 2002, the Company had outstanding borrowings on retained CMO
securities of $1,698,000 with a weighted average borrowing rate of 2.97% and a
weighted average remaining maturity of one month. Retained CMO securities
represent the Company's net investment in the CMOs issued by the Company. The
reverse repurchase financing agreements at December 31, 2002 are collateralized
by securities with a cost basis of $9,922,000.
At December 31, 2002, the Company had outstanding reverse repurchase agreement
financing for mortgage securities (other than retained CMO securities) of
$4,585,000 with a weighted average borrowing rate of 3.37% 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, 2002 was collateralized
by securities with a cost basis of $7,310,000.
At December 31, 2002, the Company had available capacity to borrow $10 million
under a committed reverse repurchase line of credit. This committed line matures
on March 27, 2003.
Information pertaining to reverse repurchase agreement financing as of and for
the years ended December 31, 2002 and 2001 is summarized as follows (dollars in
thousands):
REVERSE REPURCHASE AGREEMENT FINANCING
YEARS ENDED DECEMBER 31,
-------------------------------------------------------
2002 2001
------------------------ --------------------------
RETAINED OTHER RETAINED OTHER
CMO MORTGAGE CMO MORTGAGE
SECURITIES SECURITIES SECURITIES SECURITIES
---------- ---------- ---------- ----------
REVERSE REPURCHASE AGREEMENTS
Balance of borrowing at end of period $1,698 $ 4,585 $ 1,910 $31,428
Average borrowing balance during the period $1,786 $12,538 $ 2,536 $15,817
Average interest rate during the period 2.97% 3.37% 7.16% 6.58%
Maximum month-end borrowing balance
during the period $1,889 $28,899 $ 3,626 $33,496
COLLATERAL UNDERLYING THE AGREEMENTS
Balance at end of period - carrying value $9,922 $ 7,310 $10,626 $38,354
Additional information pertaining to individual reverse repurchase agreement
lenders at December 31, 2002 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 $ 1,698 $ 9,922 March 27, 2003
Lender A Mortgage Securities 578 1,133 January 8, 2003 (a)
Lender B Mortgage Securities 2,354 3,689 January 6, 2003 (a)
Lender C Mortgage Securities 1,028 1,390 January 10, 2003 (a)
Lender D Mortgage Securities 625 1,098 January 16, 2003 (a)
-------- --------
Total $ 6,283 $ 17,232
======== ========
(a) These borrowings are pursuant to uncommitted lines of credit which are
typically renewed monthly.
F-17
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,
2002 is summarized as follows (dollars in thousands):
SECURITIZATIONS
--------------------------------------------------------------------
2000-A 1999-B 1999-A 1998-A TOTAL
------- ------- ------- ------- --------
Balance of borrowing at end of period $10,737 $32,208 $43,000 $16,644 $102,589
Average borrowing balance during
the period 10,821 39,858 51,612 22,681 124,972
Average interest rate during the period 10.12% 3.00% 6.07% 6.77% 5.57%
Interest rate at end of period 9.88% 3.09% 6.61% 6.98% 5.91%
Maximum month-end borrowing
balance during the period 10,887 48,115 59,537 27,864 146,403
CMO collateral
Balance at end of period - carrying value $ 9,557 $35,667 $48,504 $18,580 $112,308
During December 2002, Hanover exercised the call provisions of its 1998-A
securitization. As of December 31, 2002, Group 3 of Hanover's 1998-B
securitization was callable. As discussed in Note 19 to the Consolidated
Financial Statements, the mortgage loans underlying the CMOs were sold during
the first quarter of 2003.
Aggregate annual principal repayments of mortgage-backed bonds based upon the
expected amortization of the underlying mortgage loan collateral at December 31,
2002 were as follows (dollars in thousands):
YEAR AMOUNT
--------- ---------
2003 $ 27,284
2004 20,037
2005 14,872
2006 11,014
2007 8,135
Thereafter 21,150
---------
$ 102,492
=========
F-18
SECURITIZED SALE - At December 31, 2002, the Company had a remaining investment
of $10,937,000 in securities retained from Hanover 1998-B; these securities had
a fair value of $12,098,000. 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 DISCOUNT PREPAYMENT AVERAGE
SECURITY RATING SPREAD RATE SPEED LIFE
----------- ------ ------- ------------ ---------- ---------
Subordinate AA/AAA 265 bp 4.30-4.10% 25-35% CPR 0-1 years
Subordinate A/AA+ 365 5.03-6.30 25-35 0-4
Subordinate BBB/A+ 615 8.80-9.11 25-35 4
Subordinate BB/BB+ 1115 13.80-14.11 25-35 4
Subordinate B/B 1515 17.80-18.11 25-35 4
Subordinate Unrated -- 80.03-93.18 25-35 3-4
Interest-only AAA/AAA -- 0.00 50-60 0-1
Principal-only AAA/AAA -- 5.00 0 4-14
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 80% - 93%. This default rate assumption results
in projected cumulative losses of $116,000, or 0.04% 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 $ 177,000
+200 bp 347,000
Interest-Only +500 bp $ 2,000
+1000 bp 4,000
Principal-Only +25 bp $ 7,000
+50 bp 15,000
SENSITIVITY TO PREPAYMENT SPEED
TYPE OF PAYMENT DECLINE IN
SECURITY SPEED VALUE
-------------- ---------- ----------
Subordinate 25-35% CPR $ --
15-25 139,000
5-15 291,000
Interest-Only 50-60 $ --
60-70 24,000
70-80 37,000
Principal-Only 0 $ --
F-19
SENSITIVITY TO LOSS ASSUMPTION
ANNUAL
TYPE OF DEFAULT CUMULATIVE DECLINE IN
SECURITY RATE LOSSES VALUE
-------------- --------- ---------- ----------
Subordinate 0.30% 0.04% $ --
0.90% 0.11% 24,000
3.00% 0.35% 239,000
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, 2002 (dollars in thousands):
MANAGED ASSETS
PRINCIPAL
BALANCE
-----------
Mortgage loans held for sale $ 547
Mortgage loans collateralizing on-balance sheet CMOs 102,492
Mortgage loans collateralizing off-balance sheet securitization
executed by the Company 68,540
-----------
Total mortgage loans purchased and managed by the Company $ 171,579
===========
DELINQUENCY
RATES
-----------
30-59 days delinquent 8.49%
60-89 days delinquent 1.68%
90 or more days delinquent 3.47%
Loans in foreclosure 1.03%
Real estate owned 0.43%
The Company realized credit losses of $347,000 on the foregoing assets during
the year ended December 31, 2002.
F-20
11. EMPLOYEE BENEFIT PLANS
401(K) PLAN - The Company participates in the HCP 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, 2002,
2001 and 2000, expense related to the 401(k) Plan was $66,487, $21,444 and
$21,987, respectively. The expense related to the 401(k) Plan for the year ended
December 31, 2002 includes $51,273 for HCP and HT for the six months ended
December 31, 2002.
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, restricted
stock, performance shares, stock appreciation rights and other equity-based
compensation. The 1997 Stock Option Plan authorized the grant of options to
purchase, and limited stock awards of, an aggregate of up to 325,333 shares of
Hanover's common stock.
Of the stock options granted by the Compensation Committee pursuant to the 1997
Stock Option Plan, stock options granted to the Principals to purchase an
aggregate of 162,664 shares of Hanover's common stock at Hanover's initial
offering price vested ratably over a 48-month period from the date of the grant
and, at December 31, 2002, are fully vested. Stock options granted to the
non-employee directors to purchase an aggregate of 8,000 shares of Hanover's
common stock are exercisable when issued. The remaining stock options granted by
the Compensation Committee pursuant to the 1997 Stock Option Plan were
contingent and would have vested, subject to other vesting requirements imposed
by the Compensation Committee, in full or in part on any September 30 beginning
with September 30, 1998 and ending with September 30, 2002 (each, an "Earn-out
Measuring Date"). No vesting occurred on any Earn-out Measuring Dates. To
maintain a tie between executive compensation and Hanover's corporate
performance, effective July 1, 2002, Hanover revised the vesting targets and
Earn-out Measuring Dates related to stock options granted to the Principals to
purchase an aggregate of 80,160 shares of Hanover's common stock. Hanover
cancelled the original options issued to the Principals and reissued new stock
options with the same exercise price of $15.75 but vesting in full or in part
on any July 1 beginning with July 1, 2003 and ending with July 1, 2007. The new
vesting targets are based on the July 1, 2002 stock price rather than Hanover's
initial offering price. All other stock options granted pursuant to the 1997
Stock Option Plan have expired.
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-21
Transactions during the years ended December 31, 2002, 2001 and 2000 relating to
the Hanover 1997 and 1999 Stock Option Plans are as follows:
# OF OPTIONS FOR SHARES WEIGHTED
-------------------------- AVERAGE
1997 1999 EXERCISE EXERCISE
PLAN PLAN PRICE PRICE
---------- --------- -------- --------
Outstanding at December 31, 1999 295,324 $15.350
=======
270,250 $ 4.625
=======
Stock Option Activity - 2000
Granted - May 18, 2000 282,210 $3.875
Cancelled (6,250) 15.750
Cancelled (2,000) 15.940
Cancelled (13,750) 3.875
Cancelled (17,500) 4.625
------- -------
Outstanding at December 31, 2000 287,074 $15.340
=======
521,210 $ 4.240
=======
Stock Option Activity - 2001
Granted - May 24, 2001 4,000 $7.750
Cancelled (7,750) 15.750
Cancelled (3,333) 4.625
Cancelled (5,000) 3.875
Exercised (36,332) 4.625
Exercised (26,566) 3.875
------- -------
Outstanding at December 31, 2001 279,324 $15.330
======= =======
453,979 $ 4.260
=======
Stock Option Activity - 2002
Granted - May 17, 2002 2,000 9.800
Reissued - July 1, 2002 80,160 15.750
Cancelled (86,160) 15.750
Cancelled (6,084) 4.625
Cancelled (6,250) 3.875
Expired (22,500) 15.750
Exercised (126,167) 4.625
Exercised (59,443) 3.875
------- -------
Outstanding at December 31, 2002 250,824 $15.283
======= =======
258,035 $ 4.216
======== =======
At December 31, 2002, 2001 and 2000, 350,878, 383,754 and 253,136 options,
respectively, were exercisable, with exercise prices ranging from $3.875 to
$18.130.
The per share weighted average fair value of stock options granted for the years
ended December 31, 2002 and 2001 was $0.10 and $1.43, respectively, at the date
of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2002 2001
---- ----
Expected life (years) 10 10
Risk-free interest rate 4.79% 5.49%
Volatility 26.38% 32.1%
Expected dividend yield 11.91% 10.3%
F-22
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 2002, 2001 and 2000. 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,
---------------------------------------
2002 2001 2000
-------- --------- --------
Net earnings:
As reported $ 5,138 $ 3,160 $ 2,862
Pro forma $ 5,130 $ 3,154 $ 2,814
Earnings per share - basic:
As reported $ 1.16 $ 0.74 $ 0.56
Pro forma $ 1.16 $ 0.74 $ 0.55
Earnings per share - diluted:
As reported $ 1.15 $ 0.73 $ 0.56
Pro forma $ 1.14 $ 0.73 $ 0.55
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. As of December 31, 2002, a bonus accrual of $198,000 was recorded. No
such accrual was recorded in 2001 and 2000.
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, 2003 with subsequent
renewal.
The 2002, 2001 and 2000 Consolidated Statements of Income include management and
administrative expenses of $345,000 (for the period January 1 through June 30,
2002), $716,000 and $634,000, respectively, relating to billings from HCP. In
addition, the 2000 Consolidated Statement of Income includes commission expense
of $4,000. The 2002 (for the period January 1 through June 30, 2002), 2001 and
2000 Consolidated Statements of Income also reflect a reduction in personnel
expenses for a portion of salaries allocated (and billed) to HCP.
During 2002, 2001 and 2000, Hanover recorded the following interest income
generated from loans to related parties (dollars in thousands):
YEARS ENDED DECEMBER 31,
----------------------------
2002 2001 2000
----- ---- ----
Principals $ 171 $184 $185
HCP 40 58 265
HT 265 368 81
HCP-2 277 2 --
Eliminations (251) -- --
----- ---- ----
$ 502 $612 $531
===== ==== ====
F-23
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 had designated two of its interest rate caps as
"cash flow hedges" and one as a "freestanding derivative". During the first
quarter of 2002, the Company terminated hedge accounting for one of its cash
flow hedges. At the termination date, the loss previously reported in other
comprehensive income of $164,000 was reclassified through earnings. The other
cash flow hedge matured in August 2002. Accordingly, at December 31, 2002, the
Company had two interest rate caps designated as freestanding derivatives. 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 partially offset increases in interest expense that could result
from increases in interest rates. Currently, both interest rate caps are indexed
to LIBOR. The Company considers its interest rate caps designated as
freestanding derivatives additional protection against the net interest margin
although they have not been specifically designated hedging instruments for
accounting purposes. The Company did not recognize any gains or losses for the
year ended December 31, 2002 as a result of hedge ineffectiveness for the
interest rate caps previously designated as cash flow hedges. The Company
recognized $161,000 of losses for the year ended December 31, 2002 in the
accompanying Consolidated Statement of Income for changes in the fair value of
interest rate caps designated as freestanding derivatives. All of these interest
rate caps relate to the payment of variable interest on existing financial
instruments. At December 31, 2002, the fair value of the Company's interest rate
caps was $1,000.
FORWARD SALES OF AGENCY SECURITIES (FREESTANDING DERIVATIVES)
For the year ended December 31, 2002, the Company entered into forward sales of
government agency guaranteed securities, known as "Agency" securities, and
futures contracts to manage the exposure to changes in the value of securities
classified as "trading securities." The Company considers these forward sales
and futures contracts 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 or futures contracts. Generally, changes in the value of the
trading securities are caused by changes in interest rates, changes in the
market for MBS, and changes in the credit quality of the asset. Changes in
interest rates and changes in the market for MBS will also affect the value of
the forward sales of Agency securities. Changes in interest rates also affect
the value of the futures contracts. (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 the trading securities, the forward sales and the futures contracts.
Using this information, the Company determines the amount of forward sales or
futures contracts 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 or
futures contracts. 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 on mark to market of mortgage assets, net of associated hedge in the
accompanying Consolidated Statement of Income. The mark to market on the
freestanding derivatives is reported as a component of other income (loss) in
the accompanying Consolidated Statement of Income. The Company realized net
losses on forward sales of $556,000 and on futures contracts of $753,000 for the
year ended December 31, 2002. At December 31 2002, the fair value of the
Company's one forward sale of Agency MBS was ($47,000).
F-24
14. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE
COMMON STOCK
In August 2000, the Board of Directors of Hanover authorized a 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 2000, Hanover
repurchased 498,975 shares under the 2000 share repurchase program at an average
price of $5.74 for a total cost of $2,863,000. Therefore, Hanover has remaining
authority to purchase up to 501,025 shares for not more than $137,000 under the
2000 share repurchase program.
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
repurchased 57,000 shares under the August 2001 share repurchase authorization
at an average price of $7.03 per share for a total cost of $401,000. Therefore,
Hanover has remaining authority to purchase up to 3,000 shares under the August
2001 share repurchase authorization.
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 December 31, 2002, 15,666 shares have been repurchased for
approximately $132,000. Therefore, Hanover has remaining authority to purchase
up to 2,500 shares under the 2002 share repurchase authorization.
On January 19, 2001, Hanover's affiliate, HT, 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 common stock. The earn-out is
based on performance targets. The performance targets for the first two years
were met during 2002 and 2001 and $500,000 was accrued by HT each year. On
February 24, 2003, Hanover made a capital contribution to HT of $75,000 in cash
and 60,180 shares of HCHI common stock with a then fair market value of
$457,970. On February 19, 2002, Hanover made a capital contribution of 63,577
shares of Hanover common stock with a then fair market value of $470,470. The
2002 diluted earnings per share including the 60,180 shares would be $1.13. The
2001 diluted earnings per share after cumulative effect of adoption of SFAS 133,
including the 63,577 shares, would be $0.72.
The following table summarizes the activity in common stock and additional
paid-in capital for 2002, 2001and 2000 (dollars in thousands except share data):
COMMON STOCK ADDITIONAL
---------------------- PAID-IN
SHARES AMOUNT CAPITAL
---------- ------ ----------
Balance, December 31, 1999 5,826,899 $ 58 $ 75,840
Repurchases on open market pursuant to 1998 share repurchase program (4,980) -- (16)
Repurchases on open market pursuant to 1999 share repurchase program (1,000,000) (10) (4,420)
Repurchases on open market pursuant to 2000 share repurchase program (498,975) (5) (2,858)
---------- ------ --------
Balance, December 31, 2000 4,322,944 43 68,546
Repurchases on open market pursuant to April 2001 share repurchase authorization (189,900) (2) (1,333)
Repurchases on open market pursuant to August 2001 share repurchase authorization (57,000) -- (400)
Options exercised by employees under 1999 Stock Option Plan 62,898 1 270
Cashless exercise of 1 warrant pursuant to Warrant Agreement with third party 136,734 1 (1)
---------- ------ --------
Balance, December 31, 2001 4,275,676 43 67,082
Repurchases from employees pursuant to February 2002 share repurchase authorization (15,666) -- (132)
Settlement of note receivable from of officer through common stock repurchase (34,975) (1) (241)
Capital contributed to HT related to first earn-out on Pamex acquisition 63,577 1 469
Options exercised by employees under 1999 Stock Option Plan 185,610 2 812
---------- ------ --------
Balance, December 31, 2002 4,474,222 $ 45 $ 67,990
========== ====== ========
F-25
STOCKHOLDER PROTECTION RIGHTS AGREEMENT
In 2000, the Board of Directors approved and adopted the Stockholder Protection
Rights Agreement and approved amendments to such agreement in September 2001 and
June 2002 (combined, the "Rights Agreement, as amended"). The Rights Agreement,
as amended, provides for the distribution of preferred purchase rights
("Rights") to common stockholders. One Right is attached to each outstanding
share of common stock and will attach to all subsequently issued shares. Each
Right entitles the holder to purchase one one-hundredth of a share (a "Unit") of
Participating Preferred Stock at an exercise price of $17.00 per Unit, subject
to adjustment. The Rights separate from the common stock ten days (or a later
date approved by the Board of Directors) following the earlier of (a) a public
announcement by a person or group of affiliated or associated persons
("Acquiring Person") that such person has acquired beneficial ownership of 10%
or more of Hanover's outstanding common shares (more than 20% of the outstanding
common stock in the case of John A. Burchett or more than 17% in the case of
Wallace Weitz) or (b) the commencement of a tender or exchange offer, the
consummation of which would result in an Acquiring Person becoming the
beneficial owner of 10% or more of Hanover's outstanding common shares (more
than 20% of the outstanding common stock in the case of John A. Burchett or more
than 17% in the case of Wallace Weitz).
If, any Acquiring Person holds 10% or more of Hanover's outstanding shares (more
than 20% of the outstanding common stock in the case of John A. Burchett or more
than 17% in the case of Wallace Weitz) or Hanover is party to a business
combination or other specifically defined transaction, each Right (other than
those held by the Acquiring Person) will entitle the holder to receive, upon
exercise, shares of common stock of the surviving company with a market value
equal to two times the exercise price of the Right. The Rights expire in 2010,
and are redeemable at the option of a majority of Hanover's Directors at $0.01
per Right at any time until the tenth day following an announcement of the
acquisition of 10% or more of Hanover's common stock.
EARNINGS PER SHARE (dollars in thousands, except per share data)
YEARS ENDED DECEMBER 31,
--------------------------------------------
2002 2001 2000
---------- ---------- ----------
EARNINGS PER SHARE BASIC:
Income before cumulative effect of adoption of SFAS 133 $ 5,138 $ 3,114 $ 2,862
Cumulative effect of adoption of SFAS 133 -- 46 --
---------- ---------- ----------
Net income (numerator) $ 5,138 $ 3,160 $ 2,862
========== ========== ==========
Average common shares outstanding (denominator) 4,417,221 4,256,874 5,102,563
========== ========== ==========
Per share:
Before cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.73 $ 0.56
Cumulative effect of adoption of SFAS 133 -- 0.01 --
---------- ---------- ----------
After cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.74 $ 0.56
========== ========== ==========
EARNINGS PER SHARE DILUTED:
Income before cumulative effect of adoption of SFAS 133 $ 5,138 $ 3,114 $ 2,862
Cumulative effect of adoption of SFAS 133 -- 46 --
---------- ---------- ----------
Net income (numerator) $ 5,138 $ 3,160 $ 2,862
========== ========== ==========
Average common shares outstanding 4,417,221 4,256,874 5,102,563
---------- ---------- ----------
Add: Incremental shares from assumed conversion of warrants -- -- 24,170
Incremental shares from assumed conversion of stock options 63,523 53,758 407
---------- ---------- ----------
Dilutive potential common shares 63,523 53,758 24,577
---------- ---------- ----------
Diluted weighted average shares outstanding (denominator) 4,480,744 4,310,632 5,127,140
========== ========== ==========
Per share:
Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.72 $ 0.56
Cumulative effect of adoption of SFAS 133 -- 0.01 --
---------- ---------- ----------
After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.73 $ 0.56
========== ========== ==========
F-26
15. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(dollars in thousands, except share data)
YEARS ENDED DECEMBER 31,
-------------------------------------
2002 2001 2000
-------- -------- -------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Income taxes $ 11 $ -- $ --
======== ======== =======
Interest $ 8,092 $ 14,135 $20,666
======== ======== =======
SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES
Dividends declared in December but not paid until the following year $ 1,119 $ 855 $ 865
======== ======== =======
Payment of note receivable from related party with Hanover common stock $ 242 $ -- $ --
======== ======== =======
Transfer of mortgage loans to real estate owned $ 369 $ -- $ --
======== ======== =======
Acquisition of common stock of subsidiaries from related parties in
exchange for reduction of notes receivable from related parties $ 474 $ -- $ --
======== ======== =======
Capital contribution of 63,577 shares of common stock to HT $ 470 $ -- $ --
======== ======== =======
Cashless exercise of 1 warrant in exchange for 136,734 shares of common stock $ -- $ 1 $ --
======== ======== =======
INCREASE IN CASH DUE TO ACQUISITION OF SUBSIDIARIES'
RESIDUAL INTERESTS
Total negative equity of subsidiaries prior to acquisition $ (1,816) $ -- $ --
Less net liabilities of subsidiaries prior to acquisition, excluding cash (3,487) -- --
-------- -------- -------
Net increase in cash due to acquisition of subsidiaries' residual interests $ 1,671 $ -- $ --
======== ======== =======
16. SEGMENT REPORTING
As discussed in Note 1 to the Consolidated Financial Statements, the Company is
engaged in three principal businesses which are conducted through its three
primary operating units, each a reportable segment: Hanover, HCP and HT. The
principal business strategy of Hanover is to invest in 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
providing consulting and due diligence services, focusing on loan sale advisory,
loan file due diligence reviews, staffing solutions and mortgage assignment and
collateral rectification services. HCP also services multifamily mortgage loans
and owns a registered broker/dealer; these two activities are not material and
are combined with HCP for purposes of segment reporting. The principal business
activity of HT is to generate fee income by operating an Internet exchange for
trading mortgage loans, mortgage servicing rights and related assets, and
providing state-of-the-art technologies supported by experienced valuation,
operations and trading professionals. HT also owns a broker/dealer whose
activities are not material and are combined with HT for segment reporting
purposes.
As discussed in Note 7 to the Consolidated Financial Statements, prior to June
30, 2002, HCP and HT were unconsolidated subsidiaries. Therefore, segment
information is only being provided for 2002 as follows (dollars in thousands):
Hanover
Capital Hanover
Mortgage Capital Hanover
Holdings, Partners Trade, Elimina-
Inc. Ltd. Inc. Other tions Consolidated
--------- -------- ------- ----- -------- ------------
Net interest income $ 5,973 $ 12 $ 6 $ 352 $ (251) $ 6,092
Other revenues (loss) 2,316 4,348 3,164 (160) (5) 9,663
Net income (loss) 5,138 482 (913) 44 387 5,138
Total assets 154,381 3,706 4,346 24 (6,586) 155,871
Capital expenditures and investments 6,391 35 710 -- -- 7,136
Depreciation and amortization 3 27 625 -- -- 655
F-27
17. COMMITMENTS AND CONTINGENCIES
Hanover entered into employment agreements with the Principals and Mr. Kaplan.
Such agreements provided for initial five-year terms, and provided for initial
aggregate annual base salaries of $1,200,000 (subject to cost of living
increases). Mr. Kaplan's agreement will terminate on December 31, 2006. However,
pursuant to the amendments upon the expiration of the initial term, the term of
each contract for the Principals would be automatically extended on its
anniversary for a one-year period, unless either party gives notice to the
contrary. Effective July 1, 2002, Hanover entered into an Amended and Restated
Employment Agreement with each of the Principals. These employment agreements
are substantially identical to the previous employment agreement with each of
these officers, except that (i) the base salary was set at the officer's current
salary as of July 1, 2002; and (ii) each agreement has a five-year term,
automatically renewing for successive one-year terms thereafter until Hanover or
the officer terminates the agreement. During 2002, 2001 and 2000, a portion of
the aggregate base salaries was allocated to Hanover's principal taxable
subsidiaries, HCP and HT, 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, pursuant to a Contribution
Agreement, 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 financial returns to stockholders are met based on its
initial offering price over certain performance periods, the last of which would
have ended on September 30, 2002. None of the targets were met within the first
four periods, so no Earn-Out Shares have been issued and none of the loans have
been forgiven. In accordance with Hanover's policy of tying executive
compensation to its corporate performance, effective July 1, 2002, Hanover has
entered into Amendment No. 1 to the Contribution Agreement. As a result, the
shares could be issued, and the loans could be forgiven, in performance periods
between 2002 and 2007 if Hanover meets new performance targets based on its July
1, 2002 market price rather than its initial offering price.
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, 2002, the Company had forward commitments to sell $4.5 million
(par value) and one forward commitment to buy $4.5 million of Agency mortgage
securities that had not yet settled. These forward commitments were entered into
to partially hedge the expected sale of approximately $3.4 million principal
balance of subordinate MBS classified as trading. At December 31, 2002, the fair
value of the Company's one forward sale of Agency MBS was ($47,000).
F-28
The Company has noncancelable operating lease agreements for office space.
Future minimum rental payments for such leases are as follows (dollars in
thousands):
YEAR AMOUNT
---------- -------
2003 $ 402
2004 343
2005 143
2006 46
2007 35
Thereafter --
-------
$ 969
=======
Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to
$239,000, $110,000 and $107,000, respectively. The rent expense for the year
ended December 31, 2002 includes $182,000 for HCP and HT for the six months
ended December 31, 2002.
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, 2002 and 2001 are as follows (dollars in thousands):
DECEMBER 31, 2002 DECEMBER 31, 2001
-------------------------- -----------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
--------- --------- -------- --------
Assets:
Mortgage loans:
Held for sale $ 413 $ 413 $ 2,391 $ 2,391
Collateral for CMOs 102,751 103,251 151,882 151,295
Mortgage securities pledged as collateral
for reverse repurchase agreements:
Available for sale 4,082 4,082 4,404 4,404
Held to maturity 559 481 768 709
Trading 2,669 2,669 33,182 33,182
Mortgage securities pledged as collateral for CMOs 9,805 11,044 9,840 9,576
Mortgage securities not pledged:
Available for sale 6,186 6,186 1,162 1,162
Trading 602 602 1,827 1,827
Interest rate caps 1 1 49 49
Forward commitments to sell mortgage securities (47) (47) 28 28
Cash and cash equivalents 10,605 10,605 8,946 8,946
Accrued interest receivable 960 960 1,960 1,960
Notes receivable from related parties 2,563 2,563 12,538 12,538
--------- --------- -------- --------
Total $ 141,149 $ 142,810 $228,977 $228,067
========= ========= ======== ========
Liabilities:
Reverse repurchase agreements $ 6,283 $ 6,283 $ 33,338 $ 33,338
CMO borrowing 102,589 104,595 151,096 149,865
Accounts payable, accrued expenses and other liabilities 2,816 2,816 2,677 2,677
--------- --------- -------- --------
Total $ 111,688 $ 113,694 $187,111 $185,880
========= ========= ======== ========
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.
F-29
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 from
related parties, reverse repurchase agreements and accounts payable, accrued
expenses and 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.
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.
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.
19. SUBSEQUENT EVENTS
On January 14, 2003, a $0.25 cash dividend, previously declared by the Board of
Directors, was paid to stockholders of record as of December 31, 2002. On
February 20, 2003, an extra one-time $0.15 cash dividend was declared by the
Board of Directors to be paid on March 20, 2003 to stockholders of record as of
March 6, 2003.
During December 2002, Hanover exercised the call provisions of its 1998-A
securitization. In February 2003, Hanover sold the underlying mortgage loans and
realized aggregate net proceeds of approximately $1,000,000 which will be
available for re-investment. As of December 31, 2002, Group 3 of Hanover's
1998-B securitization was callable. During January 2003, Hanover exercised the
call provisions of its 1998-B securitization and in March 2003, sold the
underlying mortgage loans and realized aggregate net proceeds of approximately
$5,000,000.
On February 21, 2003, the maturity date of the notes payable from HCP and HT
were extended from March 31, 2003 to March 31, 2004.
In February 2003, the Company made a capital contribution to HT of $75,000
of cash and 60,180 shares of Hanover common stock with a then fair market value
of $457,970. The capital contribution was utilized by HT to fund the second
earn-out issued in connection with HT's purchase in January 2001 of all of the
assets of Pamex.
On February 25, 2003, Hanover issued options to purchase 30,000 shares of its
common stock with an exercise price of $7.69 in satisfaction of the terms of the
purchase agreement between HT and Pamex. The stock options expire on February
24, 2008.
In March 2003, the Company renewed its $10 million committed reverse
repurchase line of credit; this committed line matures on April 27, 2003.
F-30
20. QUARTERLY FINANCIAL DATA - UNAUDITED
(dollars in thousands, except per share data)
THREE MONTHS ENDED
--------------------------------------------------------
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
2002 2002 2002 2002
------------ ------------- --------- ---------
Net interest income $ 1,520 $ 1,539 $ 1,381 $ 1,652
========= ========= ========= =========
Net income $ 928 $ 1,506 $ 1,392 $ 1,312
========= ========= ========= =========
Basic earnings per share (1) $ 0.21 $ 0.34 $ 0.32 $ 0.31
========= ========= ========= =========
Diluted earnings per share (1) $ 0.20 $ 0.33 $ 0.31 $ 0.30
========= ========= ========= =========
Dividends declared $ 0.25 $ 0.25 $ 0.25 $ 0.25
========= ========= ========= =========
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 $ 1,066 $ 725 $ 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
========= ========= ========= =========
(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.
21. PRO FORMA DISCLOSURE
The following unaudited pro forma consolidated statements of income have been
prepared to give effect to Hanover's acquisition on July 1, 2002 of 100% of the
outstanding common stock of each of HCP, HT and HCP-2 (collectively, the "Newly
Consolidated Subsidiaries"), as previously reported on Form 8-K filed on July
16, 2002. This acquisition had been accounted for using the purchase method of
accounting. These pro forma consolidated statements of income were prepared as
if the acquisition had been completed as of January 1, 2001.
The unaudited pro forma consolidated statements of income are presented for
illustrative purposes only and are not necessarily indicative of the results of
operations that would have actually been reported had the acquisition occurred
on January 1, 2001, nor are these presentations necessarily indicative of the
future results of operations.
These unaudited pro forma consolidated statements of income are based upon the
historical consolidated financial statements of Hanover and the Newly
Consolidated Subsidiaries included in Hanover's Annual Report on Form 10-K for
the year ended December 31, 2001 and the Quarterly Report on Form 10-Q for the
six months ended June 30, 2002.
F-31
Information presented for the years ended December 31, 2002 and 2001 is
presented on a consolidated pro forma basis.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
YEARS ENDED DECEMBER 31,
-------------------------
2002 2001
------- --------
REVENUES: (Pro Forma) (Pro Forma)
Interest income $13,813 $ 19,304
Interest expense 7,438 13,433
------- --------
Net interest income 6,375 5,871
Loan loss provision 393 709
------- --------
Net interest income after loan loss provision 5,982 5,162
Gain on sale of mortgage assets 2,095 3,782
Gain on mark to market of mortgage assets,
net of associated hedge 1,237 695
Loan brokering, trading and advisory services 6,831 3,521
Due diligence fees 4,971 5,083
Assignment fees 2,220 757
Other income (loss) (399) 58
------- --------
Total revenue 22,937 19,058
------- --------
EXPENSES:
Personnel 8,907 7,231
Subcontractor 2,964 2,373
Depreciation and amortization 1,280 1,184
Legal and professional 1,206 1,704
General and administrative 1,181 1,152
Technology 782 683
Occupancy 536 651
Travel and entertainment 512 548
Other 437 461
------- --------
Total expenses 17,805 15,987
------- --------
Operating income 5,132 3,071
Equity in income of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. -- --
HanoverTrade, Inc. -- --
HDMF-I LLC 157 (35)
Hanover Capital Partners 2, Inc. -- --
------- --------
Income before income tax provision (benefit) and
cumulative effect of adoption of SFAS 133 5,289 3,036
Income tax provision (benefit) 127 64
------- --------
Income before cumulative effect of adoption of SFAS 133 5,162 2,972
Cumulative effect of adoption of SFAS 133 -- 46
------- --------
NET INCOME $ 5,162 $ 3,018
======= ========
BASIC EARNINGS PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 1.17 $ 0.70
Cumulative effect of adoption of SFAS 133 -- .01
------- --------
After cumulative effect of adoption of SFAS 133 $ 1.17 $ 0.71
======= ========
DILUTED EARNINGS PER SHARE:
Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.69
Cumulative effect of adoption of SFAS 133 -- .01
------- --------
After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.70
======= ========
See notes to pro forma consolidated statements of income
F-32
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
PRO FORMA CONSOLIDATED STATEMENT OF INCOME
YEAR ENDED DECEMBER 31, 2002
(UNAUDITED)
(in thousands, except per share data)
SIX MONTHS
ENDED
HANOVER JUNE 30, 2002
CAPITAL -------------
MORTGAGE NEWLY
HOLDINGS, INC. CONSOLIDATED ADJUSTMENTS/ PRO FORMA
AS REPORTED SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------- ------------ ------------
REVENUES:
Interest income $ 13,530 $ 639 $(356)(a,d) $ 13,813
Interest expense 7,438 -- -- 7,438
----------- ------- ----- ----------
Net interest income 6,092 639 (356) 6,375
Loan loss provision 393 -- -- 393
----------- ------- ----- ----------
Net interest income after loan loss provision 5,699 639 (356) 5,982
Gain on sale of mortgage assets 2,095 -- -- 2,095
Gain (loss) on mark to market of mortgage assets 1,367 (130) -- 1,237
Loan brokering, trading and advisory services 2,686 4,145 -- 6,831
Due diligence fees 2,891 2,087 (7)(b) 4,971
Assignment fees 1,387 833 -- 2,220
Other income (loss) (370) 7 (36)(b) (399)
----------- ------- ----- ----------
Total revenue 15,755 7,581 (399) 22,937
----------- ------- ----- ----------
EXPENSES:
Personnel 5,479 3,083 345(b,d) 8,907
Subcontractor 1,812 1,152 -- 2,964
Depreciation and amortization 655 625 -- 1,280
Legal and professional 1,070 136 -- 1,206
General and administrative 1,089 505 (413)(b) 1,181
Technology 293 489 -- 782
Occupancy 349 187 -- 536
Travel and entertainment 317 195 -- 512
Other 409 359 (331)(a) 437
----------- ------- ----- ----------
Total expenses 11,473 6,731 (399) 17,805
----------- ------- ----- ----------
Operating income 4,282 850 -- 5,132
Equity in income of unconsolidated subsidiaries 905 -- (748)(c) 157
----------- ------- ----- ----------
Income before income tax provision (benefit) 5,187 850 (748) 5,289
Income tax provision (benefit) 49 78 -- 127
----------- ------- ----- ----------
NET INCOME $ 5,138 $ 772 $(748) $ 5,162
=========== ======= ===== ==========
BASIC EARNINGS PER SHARE:
Average common shares outstanding 4,417,221 4,417,221
=========== ==========
Basic earnings per share $ 1.16 $ 1.17
=========== ==========
DILUTED EARNINGS PER SHARE:
Diluted weighted average shares outstanding 4,480,744 4,480,744
=========== ==========
Diluted earnings per share $ 1.15 $ 1.15
=========== ==========
See notes to pro forma consolidated statements of income
F-33
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
PRO FORMA CONSOLIDATED STATEMENT OF INCOME
YEAR ENDED DECEMBER 31, 2001
(UNAUDITED)
(in thousands, except per share data)
HANOVER CAPITAL
MORTGAGE NEWLY
HOLDINGS, INC. CONSOLIDATED ADJUSTMENTS/ PRO FORMA
AS REPORTED SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------------- ------------ ------------ ------------
REVENUES:
Interest income $ 19,702 $ 55 $ (453)(a,d) $ 19,304
Interest expense 13,433 -- -- 13,433
----------- -------- ------- -----------
Net interest income 6,269 55 (453) 5,871
Loan loss provision 709 -- -- 709
----------- -------- ------- -----------
Net interest income after loan loss provision 5,560 55 (453) 5,162
Gain on sale of mortgage assets 3,782 -- -- 3,782
Gain on mark to market of mortgage assets, net of
associated hedge 751 (56) -- 695
Loan brokering, trading and advisory services -- 3,521 -- 3,521
Due diligence fees -- 5,803 (720)(b) 5,083
Assignment fees -- 757 -- 757
Other income(loss) (28) 86 -- 58
----------- -------- ------- -----------
Total revenue 10,065 10,166 (1,173) 19,058
----------- -------- ------- -----------
EXPENSES:
Personnel 680 6,555 (4)(b) 7,231
Subcontractor -- 2,373 -- 2,373
Depreciation and amortization 24 1,160 -- 1,184
Legal and professional 1,247 457 -- 1,704
General and administrative 1,132 736 (716)(b) 1,152
Technology 4 679 -- 683
Occupancy 151 500 -- 651
Other 413 479 (428)(a) 464
Travel and entertainment 45 500 -- 545
----------- -------- ------- -----------
Total expenses 3,696 13,439 (1,148) 15,987
----------- -------- ------- -----------
Operating income(loss) 6,369 (3,273) (25) 3,071
Equity in(loss) of unconsolidated subsidiaries (3,255) -- 3,220(d) (35)
----------- -------- ------- -----------
Income(loss) before income tax provision and cumulative
effect of adoption of SFAS 133 3,114 (3,273) 3,195 3,036
Income tax provision -- 64 -- 64
----------- -------- ------- -----------
Income(loss) before cumulative effect of adoption of SFAS 133 3,114 (3,337) 3,195 2,972
Cumulative effect of adoption of SFAS 133 46 -- -- 46
----------- -------- ------- -----------
NET INCOME(LOSS) $ 3,160 $ (3,337) $ 3,195 $ 3,018
=========== ======== ======= ===========
BASIC EARNINGS PER SHARE:
Average common shares outstanding 4,256,874 4,256,874
=========== ===========
Basic earnings per share:
Before cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.70
Cumulative effect of adoption of SFAS 133 0.01 0.01
----------- -----------
After cumulative effect of adoption of SFAS 133 $ 0.74 $ 0.71
=========== ===========
DILUTED EARNINGS PER SHARE:
Diluted weighted average shares outstanding 4,310,632 4,310,632
=========== ===========
Diluted earnings per share:
Before cumulative effect of adoption of SFAS 133 $ 0.72 $ 0.69
Cumulative effect of adoption of SFAS 133 0.01 0.01
----------- -----------
After cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.70
=========== ===========
See notes to pro forma consolidated statements of income
F-34
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(dollars in thousands)
(a) To eliminate intercompany interest income and expense summarized as
follows:
SIX MONTHS YEAR
ENDED ENDED
JUNE 30, DECEMBER 31,
2002 2001
---------- ------------
Interest on note to Hanover Capital Partners Ltd. $ 23 $ 58
Interest on note to HanoverTrade, Inc. 146 368
Interest on note to Hanover Capital Partners 2, Inc. 162 2
------- -------
$ 331 $ 428
======= =======
(b) Hanover engaged Hanover Capital Partners Ltd. pursuant to a Management
Agreement to render, among other things, due diligence, asset management
and administrative services. In addition, Hanover Capital Partners Ltd.
performed management and administrative services for HanoverTrade, Inc. To
eliminate these intercompany management fees recorded as follows:
SIX MONTHS YEAR
ENDED ENDED
JUNE 30, DECEMBER 31,
2002 2001
---------- ------------
Management fee income recorded to:
Due diligence fees $ 7 $ 720
Other revenues 36 --
Reduction of personnel expense 374 --
------- -------
$ 417 $ 720
======= =======
Management fee expensed to:
General, management and administrative $ 413 $ 716
Personnel expense 4 4
------- -------
$ 417 $ 720
======= =======
(c) With the consolidation of the results of Hanover Capital Partners Ltd.,
HanoverTrade, Inc. and Hanover Capital Partners 2, Inc., the equity in
income (loss) of these subsidiaries summarized below would be reversed:
SIX MONTHS YEAR
ENDED ENDED
JUNE 30, DECEMBER 31,
2002 2001
---------- ------------
Hanover Capital Partners Ltd. $ 112 $ 43
HanoverTrade, Inc. 655 (3,263)
Hanover Capital Partners 2, Inc. (19) --
------- -------
$ 748 $(3,220)
======= =======
(d) To exclude the interest income on the portion of the notes receivable
reduced in exchange for the purchase of the common stock of the newly
consolidated subsidiaries; interest for the year ended December 31, 2002
was forgiven and the offset is to personnel expense while for the year
ended December 31, 2001, the offset is to the balance sheet.
YEARS ENDED DECEMBER 31,
------------------------
2002 2001
------- -------
Interest income $ 25 $ 25
======= =======
Personnel expense $ (25) $ --
======= =======
******
F-35
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, 2002 and 2001,
and the related consolidated statements of income, stockholder's equity, and
cash flows for each of the three years in the period ended December 31, 2002.
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, 2002 and 2001, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2002, in conformity with accounting principles generally accepted in the
United States of America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 20, 2003
F-36
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
------------------------------
ASSETS 2002 2001
----------- -----------
CURRENT ASSETS:
Cash and cash equivalents $ 368,715 $ 847,676
Accounts receivable 1,415,159 996,777
Receivables from related parties 363,687 473,637
Accrued revenue on contracts in progress 895,303 1,035,870
Prepaid expenses and other current assets 110,852 39,580
----------- -----------
Total current assets 3,153,716 3,393,540
PROPERTY AND EQUIPMENT - Net 91,931 100,584
DEFERRED TAX ASSET - Net 239,678 294,041
MORTGAGE LOANS HELD FOR SALE 207,151 --
OTHER ASSETS 13,340 13,340
----------- -----------
TOTAL ASSETS $ 3,705,816 $ 3,801,505
=========== ===========
LIABILITIES AND STOCKHOLDER'S EQUITY
CURRENT LIABILITIES:
Accrued appraisal and subcontractor costs $ 34,612 $ 16,139
Accounts payable and accrued expenses 259,280 456,859
Due to related parties 14,841 411,232
Deferred revenue 10,000 --
Income tax payable 38,160 --
----------- -----------
Total current liabilities 356,893 884,230
NOTE PAYABLE TO RELATED PARTY 870,298 1,035,859
----------- -----------
TOTAL LIABILITIES 1,227,191 1,920,089
----------- -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDER'S EQUITY:
Preferred stock: $.01 par value, 100,000 shares authorized,
97,000 shares outstanding at December 31, 2002 and 2001 970 970
Common stock: Class A: $.01 par value, 5,000 shares authorized,
3,000 shares outstanding at December 31, 2002 and 2001 30 30
Additional paid-in capital 2,839,947 2,839,947
Retained earnings (deficit) (362,322) (959,531)
----------- -----------
TOTAL STOCKHOLDER'S EQUITY 2,478,625 1,881,416
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $ 3,705,816 $ 3,801,505
=========== ===========
See notes to consolidated financial statements
F-37
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31,
--------------------------------------------
2002 2001 2000
---------- ---------- ----------
REVENUES:
Due diligence fees $4,977,620 $5,802,720 $7,016,435
Assignment fees 2,220,083 756,683 631,093
Interest income on mortgage assets, net of interest expense
and loan loss provision of $1,137,499 in 2000 872 -- 513,391
Gain on sale of mortgage securities -- -- 440,639
Other income 184,733 22,957 112,100
---------- ---------- ----------
Total revenues 7,383,308 6,582,360 8,713,658
---------- ---------- ----------
EXPENSES:
Subcontractor 2,950,378 2,373,226 3,081,029
Personnel 2,688,339 2,956,008 3,152,852
General and administrative 330,423 311,083 309,926
Occupancy 260,414 243,888 453,372
Travel and subsistence 197,853 224,296 215,959
Professional 161,899 242,173 257,495
Depreciation and amortization 57,965 57,970 52,908
Interest 40,347 65,555 90,054
---------- ---------- ----------
Total expenses 6,687,618 6,474,199 7,613,595
---------- ---------- ----------
INCOME BEFORE INCOME TAX PROVISION 695,690 108,161 1,100,063
INCOME TAX PROVISION 98,481 64,149 631,722
---------- ---------- ----------
NET INCOME $ 597,209 $ 44,012 $ 468,341
========== ========== ==========
BASIC EARNINGS PER SHARE (NOTE 2) $ 199.07 $ 14.67 $ 156.11
========== ========== ==========
See notes to consolidated financial statements
F-38
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
PREFERRED STOCK COMMON STOCK ADDITIONAL
--------------------- ------------------ PAID-IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
------ ------ ------ ------ -----------
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
Comprehensive income:
Net income
Comprehensive income
------ ------ ----- ----- -----------
BALANCE, DECEMBER 31, 2002 97,000 $ 970 3,000 $ 30 $ 2,839,947
====== ====== ===== ===== ===========
ACCUMULATED
COMPREHENSIVE RETAINED OTHER
INCOME EARNINGS COMPREHENSIVE
(LOSS) (DEFICIT) GAIN TOTAL
------------- ----------- -------------- -----------
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
Comprehensive income:
Net income $ 597,209 597,209 597,209
-----------
Comprehensive income $ 597,209
=========== ----------- --------- -----------
BALANCE, DECEMBER 31, 2002 $ (362,322) $ -- $ 2,478,625
=========== ========= ===========
See notes to consolidated financial statements
F-39
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
------------------------------------------------
2002 2001 2000
--------- ----------- ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 597,209 $ 44,012 $ 468,341
Adjustments to reconcile net income to net cash (used in) provided by
operating activities:
Amortization of net premium -- -- (374,961)
Loan loss provision -- -- 478,330
Depreciation and amortization 57,965 53,875 42,798
Deferred tax provision 54,363 46,690 612,682
Gain on sale of mortgage-backed securities -- -- (440,639)
Gain on disposal of property and equipment -- -- (2,700)
Sale of trading securities -- -- 15,755
Changes in assets - (increase) decrease:
Accounts receivable (418,382) 1,305,434 (1,633,218)
Receivables from/payables to related parties (286,441) 469,710 (345,146)
Accrued interest receivable -- -- 181,471
Accrued revenue on contracts in progress 140,567 311,696 (585,643)
Prepaid expenses and other current assets (71,272) (13,024) 143,645
Other assets -- 3,690 161,903
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs 18,473 (20,640) 23,197
Accounts payable and accrued expenses (197,579) (1,085,149) 1,033,033
Deferred revenue 10,000 (5,276) 5,276
Income tax payable 38,160 (20,828) 20,828
--------- ----------- ------------
Net cash (used in) provided by operating activities (56,937) 1,090,190 (195,048)
--------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (49,312) (67,742) (72,914)
Sale of property and equipment -- -- 2,700
Purchase of mortgage loans from affiliate (208,274) -- --
Purchase of mortgage securities -- -- (8,450,259)
Proceeds from sale of mortgage securities to third parties -- -- 8,667,260
Proceeds from sale of mortgage securities to affiliate -- -- 13,844,223
Principal payments received on mortgage assets 1,123 -- 216,649
--------- ----------- ------------
Net cash (used in) provided by investing activities (256,463) (67,742) 14,207,659
--------- ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net repayment of note payable to related party (165,561) (668,483) (3,191,704)
Net repayment of reverse repurchase agreements -- -- (10,842,000)
--------- ----------- ------------
Net cash used in financing activities (165,561) (668,483) (14,033,704)
--------- ----------- ------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (478,961) 353,965 (21,093)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 847,676 493,711 514,804
--------- ----------- ------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 368,715 $ 847,676 $ 493,711
========= =========== ============
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 5,956 $ 60,518 $ 3,435
========= =========== ============
Interest $ 85,682 $ 43,936 $ 830,930
========= =========== ============
See notes to consolidated financial statements
F-40
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
1. BUSINESS DESCRIPTION
Hanover Capital Partners Ltd. ("HCP") and its subsidiaries operate as a
specialty finance company which is principally engaged in providing consulting
and due diligence services, focusing on loan sale advisory, loan file due
diligence reviews, staffing solutions and mortgage assignment and collateral
rectification services. Beginning in 2002, HCP began providing asset management
services to an affiliate, HDMF-I LLC ("HDMF-I"). A wholly-owned subsidiary of
HCP, Hanover Capital Mortgage Corporation ("HCMC"), is a servicer 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.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand,
overnight investments deposited with banks and money market mutual funds
primarily invested in government securities with weighted maturities less than
60 days.
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.
MORTGAGE LOANS HELD FOR SALE - All mortgage loans designated as held for sale
are reported in the aggregate at the lower of cost or market, with unrealized
losses reported as a charge to earnings in the current period.
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.
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
F-41
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 and cash
equivalents, 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. The fair value of
mortgage loans held for sale is included in Note 4 to the Consolidated Financial
Statements.
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 - On January 1, 2002, the Company
adopted Statement of Financial Accounting Standards 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. The adoption of SFAS
144 did not have an impact on the Company's consolidated financial position or
results of operations.
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44,
Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB
Statement No. 13, Accounting for Leases, to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. The provisions of SFAS 145 related to
the rescission of FASB Statement No. 4 are generally effective for fiscal years
beginning after May 15, 2002. The adoption of SFAS 145 did not have a material
effect on the Company's consolidated financial statements.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued
Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan.
F-42
SFAS 146 is to be applied prospectively to exit or disposal activities initiated
after December 31, 2002. The adoption of SFAS 146 will not have a material
effect on the Company's consolidated financial statements.
3. PROPERTY AND EQUIPMENT
DECEMBER 31,
--------------------------
2002 2001
--------- ---------
Office machinery and computer equipment $ 411,649 $ 367,430
Furniture and fixtures 12,197 7,104
--------- ---------
423,846 374,534
Less accumulated depreciation (331,915) (273,950)
--------- ---------
Property and equipment - net $ 91,931 $ 100,584
========= =========
Depreciation expense for the years ended December 31, 2002, 2001 and 2000 was
$57,965, $53,875 and $42,798, respectively.
4. MORTGAGE LOANS HELD FOR SALE
During the year ended December 31, 2002, the Company purchased $208,274 of
mortgage loans from Hanover Capital Mortgage Holdings, Inc. ("HCHI"). At
December 31, 2002, the balance of mortgage loans held for sale was $207,151,
comprised of $183,767 of adjustable-rate loans and $23,384 of fixed-rate loans.
The fair value of mortgage loans held for sale at December 31, 2002 was $207,151
based upon projected prices which could be obtained through investors
considering interest rates, loan type and credit quality.
5. CONCENTRATION RISK
As of and for the year ended December 31, 2002, the Company's accounts
receivable and revenues included customers that individually accounted for more
than 10% as follows:
ACCOUNTS RECEIVABLE AS OF REVENUES FOR THE YEAR ENDED
DECEMBER 31, 2002 DECEMBER 31, 2002
---------------------------- ---------------------------------
Major Customer # 1 22% Major Customer # 1 22%
Major Customer # 2 12% Major Customer # 2 16%
Major Customer # 3 12% Major Customer # 3 11%
Major Customer # 4 11%
6. 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, 2002 and 2001, HCMC was
servicing 1 and 3 loans, respectively, with unpaid principal balances of
$1,099,595 and $4,918,187, respectively including loans subserviced for others
of $3,774,586 at December 31, 2001. Escrow balances maintained by HCMC were
$65,282 and $152,226 at December 31, 2002 and 2001, respectively. The
aforementioned servicing portfolio and related escrow accounts are not included
in the accompanying Consolidated Balance Sheets as of December 31, 2002, and
2001.
F-43
7. RELATED PARTY TRANSACTIONS
DECEMBER 31,
-----------------------
2002 2001
-------- --------
Due from HanoverTrade, Inc. (1) $268,703 $465,987
Due from Hanover Mortgage Capital Corporation -- 6,662
Due from HDMF-I LLC (2) 94,984 988
-------- --------
Receivables from related parties $363,687 $473,637
======== ========
(1) Amounts due reflect certain costs that the Company paid on behalf of
HanoverTrade, Inc. The expenses billed include personnel, occupancy,
travel and entertainment and general and administrative.
(2) Amount due at December 31, 2002 reflects asset management and due
diligence services provided to HDMF-I.
Due to related parties of $14,841 and $411,232 at December 31, 2002 and
2001, respectively, are due to HCHI and primarily represent 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. The Company
provides among other services, due diligence, asset management and
administrative services to HCHI pursuant to a Management Agreement that
continues until December 31, 2003 with automatic annual renewal.
At December 31, 2002 and 2001, the Company had a principal balance outstanding
on a note payable to HCHI in the amount of $870,298 and $1,035,859,
respectively. The note bears interest at the prime rate minus 1% and interest is
calculated on the daily principal balance outstanding. At December 31, 2002 and
2001, the interest rate in effect was 3.25% and 3.75%, respectively. Included in
the 2002 and 2001 Consolidated Statements of Income is interest expense in the
amount of $39,454 and $65,555, 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, 2004.
8. INCOME TAXES
The components of deferred income taxes as of December 31, 2002 and 2001 are as
follows:
DECEMBER 31,
--------------------------
2002 2001
--------- ---------
Deferred tax assets
Temporary differences $ 40,240 $ 64,585
Federal net operating loss carryforward 140,045 318,254
State/Local net operating loss carryforward 66,211 106,085
AMT Credit 16,830 16,830
--------- ---------
Total deferred tax assets 263,326 505,754
Valuation allowance (23,648) (211,713)
--------- ---------
Net deferred tax assets $ 239,678 $ 294,041
========= =========
The items resulting in significant temporary differences for the years ended
December 31, 2002 and 2001 that generate deferred tax assets relate primarily to
the recognition of expense for financial reporting purposes. The net change of
$188,065 in the valuation allowance is due to a change in management's judgment
about the realizability of the related deferred tax asset in future years.
The components of the income tax provision for the years ended December 31,
2002, 2001 and 2000 consist of the following:
YEARS ENDED DECEMBER 31,
------------------------------------
2002 2001 2000
------- ------- --------
Current - Federal, state and local $44,118 $17,459 $ 19,040
Deferred - Federal, state and local 54,363 46,690 612,682
------- ------- --------
Total $98,481 $64,149 $631,722
======= ======= ========
F-44
The income tax provision differs from amounts computed at statutory rates, as
follows:
YEARS ENDED DECEMBER 31,
----------------------------------------
2002 2001 2000
--------- ------- ---------
Federal income tax provision at statutory rate $ 236,535 $32,448 $ 374,021
State and local income tax provision 41,324 10,816 72,052
Meals and entertainment 2,313 1,812 4,065
Officer's life insurance 1,870 3,551 268
Tax settlement 2,662 15,522 --
Penalties 162 -- 1,702
Realized loss on hedge transaction -- -- (14,089)
Sale of assets -- -- (18,010)
(Reversal of) provision for valuation allowance (188,065) -- 211,713
Other 1,680 -- --
--------- ------- ---------
Total $ 98,481 $64,149 $ 631,722
========= ======= =========
The Company has a Federal tax net operating loss carryforward of approximately
$0.4 million which begins to expire in the year 2012.
9. STOCKHOLDER'S EQUITY
Prior to July 1, 2002, HCHI owned 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 was owned by the
principals, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N.
Tavares. Pursuant to a Stock Purchase Agreement effective July 1, 2002, HCHI
acquired 100% of the outstanding common stock of the Company. Therefore, as of
July 1, 2002, HCHI owns 100% of the outstanding capital stock, both preferred
and common, of the Company.
10. 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
---- ---------
2003 $ 160,932
2004 160,932
2005 53,644
---------
$ 375,508
=========
Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to
$144,610, $128,345 and $144,731, respectively.
11. SUBSEQUENT EVENTS
On February 21, 2003, the maturity date of the note payable to HCHI was extended
from March 31, 2003 to March 31, 2004.
******
F-45
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
HanoverTrade, Inc. and Subsidiary
Edison, New Jersey
We have audited the accompanying consolidated balance sheets of HanoverTrade,
Inc. and Subsidiary (the "Company") as of December 31, 2002 and 2001, and the
related consolidated statements of operations, stockholder's equity, and cash
flows for each of the three years in the period ended December 31, 2002. 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, Inc. and Subsidiary
at December 31, 2002 and 2001, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2002, in
conformity with accounting principles generally accepted in the United States of
America.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 20, 2003
F-46
HANOVERTRADE, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
------------------------------
ASSETS 2002 2001
----------- -----------
CURRENT ASSETS:
Cash and cash equivalents $ 160,219 $ 196,451
Accounts receivable 298,258 590,234
Current portion of long-term note receivable 75,000 --
Prepaid expenses and other current assets 50,899 31,105
----------- -----------
Total current assets 584,376 817,790
PROPERTY AND EQUIPMENT - Net 157,426 176,728
CAPITALIZED SOFTWARE - Net 1,794,694 2,170,323
GOODWILL - Net 1,514,736 1,044,266
DEFERRED TAX ASSET - Net -- --
LONG-TERM NOTE RECEIVABLE - Net of current portion 225,000 --
OTHER ASSETS 68,971 68,971
----------- -----------
TOTAL ASSETS $ 4,345,203 $ 4,278,078
=========== ===========
LIABILITIES AND STOCKHOLDER'S EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 538,970 $ 407,372
Accrued interest due to related party 58,453 103,738
Payable under asset purchase agreement 500,000 500,000
Due to related parties 442,495 544,639
Deferred revenue 91,869 --
Other current liabilities 6,998 5,110
----------- -----------
Total current liabilities 1,638,785 1,560,859
NOTE PAYABLE TO RELATED PARTY 7,395,896 7,654,396
----------- -----------
TOTAL LIABILITIES 9,034,681 9,215,255
----------- -----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDER'S EQUITY:
Series A preferred stock: $.01 par value, 100,000 shares authorized,
97,000 shares outstanding at December 31, 2002 and 2001 970 970
Common stock: $.01 par value, 105,000 shares authorized, 3,000
shares outstanding at December 31, 2002 and 2001 30 30
Additional paid-in capital 485,021 --
Retained earnings (deficit) (5,175,499) (4,938,177)
----------- -----------
TOTAL STOCKHOLDER'S EQUITY (DEFICIT) (4,689,478) (4,937,177)
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $ 4,345,203 $ 4,278,078
=========== ===========
See notes to consolidated financial statements
F-47
HANOVERTRADE, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31,
-------------------------------------------------
2002 2001 2000
----------- ----------- -----------
REVENUES:
Loan brokering, trading and
advisory services $ 6,836,352 $ 3,521,338 $ 140,781
Consulting 693,210 -- --
Other 59,085 77,334 --
----------- ----------- -----------
Total revenues 7,588,647 3,598,672 140,781
----------- ----------- -----------
EXPENSES:
Personnel 4,199,193 3,616,575 789,646
Depreciation and amortization 1,219,174 1,102,073 150,935
General and administrative 675,214 410,036 93,471
Technology 659,409 663,955 230,520
Occupancy 413,995 325,960 130,278
Interest 266,657 366,243 81,479
Travel and entertainment 254,024 262,695 174,821
Professional 130,305 214,669 32,143
----------- ----------- -----------
Total expenses 7,817,971 6,962,206 1,683,293
----------- ----------- -----------
LOSS BEFORE INCOME TAX PROVISION (229,324) (3,363,534) (1,542,512)
INCOME TAX PROVISION 7,998 -- --
----------- ----------- -----------
NET LOSS $ (237,322) $(3,363,534) $(1,542,512)
=========== =========== ===========
BASIC LOSS PER SHARE (NOTE 2) $ (79.11) $ (1,121.18) $ (514.17)
=========== =========== ===========
See notes to consolidated financial statements
F-48
HANOVERTRADE, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
SERIES A
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------------- --------------------- PAID-IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
------ ----------- ------ ------- ----------
BALANCE, DECEMBER 31, 1999 97,000 $ 970 3,000 $ 30 $ --
Comprehensive loss:
Net loss
Comprehensive loss
------ ----------- ----- ------- --------
BALANCE, DECEMBER 31, 2000 97,000 970 3,000 30 --
Comprehensive loss:
Net loss
Comprehensive loss
------ ----------- ----- ------- --------
BALANCE, DECEMBER 31, 2001 97,000 970 3,000 30 --
Capital contribution 485,021
Comprehensive loss:
Net loss
Comprehensive loss
------ ----------- ----- ------- --------
BALANCE, DECEMBER 31, 2002 97,000 $ 970 3,000 $ 30 $485,021
====== =========== ===== ======= ========
ACCUMULATED
RETAINED OTHER
COMPREHENSIVE EARNINGS COMPREHENSIVE
LOSS (DEFICIT) GAIN TOTAL
------------- ----------- ------------- -----------
BALANCE, DECEMBER 31, 1999 $ (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 (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 (4,938,177) -- (4,937,177)
Capital contribution 485,021
Comprehensive loss:
Net loss $ (237,322) (237,322) (237,322)
-----------
Comprehensive loss $ (237,322)
=========== ----------- ----------- -----------
BALANCE, DECEMBER 31, 2002 $(5,175,499) $ -- $(4,689,478)
=========== =========== ===========
See notes to consolidated financial statements
F-49
HANOVERTRADE, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
-------------------------------------------------
2002 2001 2000
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (237,322) $(3,363,534) $(1,542,512)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization 1,219,174 1,102,073 150,935
Changes in assets - (increase) decrease:
Accounts receivable 291,976 (580,234) (9,974)
Note receivable (300,000) -- --
Prepaid expenses and other assets (19,794) (85,201) --
Changes in liabilities - increase (decrease):
Accounts payable and accrued expenses 131,598 (601,031) 1,008,403
Accrued interest due to related party (45,285) 67,874 35,864
Due to related parties (102,144) 154,501 254,512
Deferred revenue 91,869 -- --
Other current liabilities 1,888 5,110 --
----------- ----------- -----------
Net cash provided by (used in) operating activities 1,031,960 (3,300,442) (102,772)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (86,193) (28,620) (21,695)
Capitalized software costs (738,050) (424,287) (2,747,647)
Acquisition, net of cash acquired -- (833,411) --
----------- ----------- -----------
Net cash used in investing activities (824,243) (1,286,318) (2,769,342)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (repayment of) proceeds from note payable to related party (258,500) 4,750,638 2,903,758
Capital contributions 14,551 -- --
----------- ----------- -----------
Net cash (used in) provided by financing activities (243,949) 4,750,638 2,903,758
----------- ----------- -----------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (36,232) 163,878 31,644
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 196,451 32,573 929
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 160,219 $ 196,451 $ 32,573
=========== =========== ===========
See notes to consolidated financial statements
F-50
HANOVERTRADE, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
1. BUSINESS DESCRIPTION
HanoverTrade, Inc. and Subsidiary is principally engaged in operating an
Internet exchange for trading mortgage loans, mortgage servicing rights and
related assets, and providing state-of-the-art technologies supported by
experienced valuation, operations and trading professionals. In addition to
trading assets, HanoverTrade, Inc. and Subsidiary provides a full range of asset
valuation, analysis, and marketing services for performing, sub-performing and
non-performing assets, whole loans and participations, Community Reinvestment
Act loans, and mortgage servicing rights. During 2002, Pamex Securities, LLC, a
wholly-owned subsidiary of HanoverTrade, Inc., withdrew from the National
Association of Securities Dealers as a registered broker/dealer.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the
accounts of HanoverTrade, 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.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand,
overnight investments deposited with banks and money market mutual funds
primarily invested in government securities with weighted maturities less than
60 days.
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. Leasehold
improvements are amortized over the terms of the respective leases or their
estimated useful lives, whichever is shorter.
CAPITALIZED SOFTWARE - Capitalized software includes external application
development stage costs and external enhancement costs incurred to develop and
modify the Company's Internet exchange for trading loan pools and also includes
software production costs incurred to develop a mortgage loan servicing
valuation and analysis tool, a real-time Internet data analysis system and an
Internet exchange for trading assets. Capitalized software costs for the
Company's Internet exchange 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. Capitalized software costs for the
Company's mortgage loan servicing valuation and analysis tool, real-time
Internet data analysis system and Internet exchange for trading assets are
stated at the lower of unamortized cost or net realizable value. Amortization is
computed based on current and future revenue for each product with an annual
minimum equal to the straight-line amortization over the remaining estimated
economic life of the product.
F-51
GOODWILL - Goodwill represents the excess of the purchase price over the net
carrying value of assets acquired (which approximates fair value) at acquisition
date. The Company evaluates goodwill for impairment on an annual basis and if
an event occurs or circumstances change that would more likely than not reduce
the fair value of a reporting unit below its carrying amount.
DEFERRED REVENUE - 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 loan brokering, trading and advisory
services 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.
Revenues from consulting services are recognized as they are earned and billed.
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 and cash
equivalents, accounts receivable, note 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 ADOPTED ACCOUNTING PRONOUNCEMENTS - On January 1, 2002, the Company
adopted Statement of Financial Accounting Standards 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. The adoption of
SFAS 144 did not have an impact on the Company's consolidated financial position
or results of operations.
F-52
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44,
Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB
Statement No. 13, Accounting for Leases, to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. The provisions of SFAS 145 related to
the rescission of FASB Statement No. 4 are generally effective for fiscal years
beginning after May 15, 2002. The adoption of SFAS 145 did not have a material
effect on the Company's consolidated financial statements.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued
Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan. SFAS 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The adoption of SFAS 146 will not have a
material effect on the Company's consolidated financial statements.
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. ("HCHI"). The
acquisition was accounted for using the purchase method of accounting. As of
December 31, 2002, the first earn-out of $500,000 in common stock of HCHI has
been paid and a second earn-out of $500,000 has been accrued. The second
earn-out was subsequently paid on February 24, 2003. In addition, the Company
was required, under terms of the purchase agreement, to adopt an employee stock
option plan pursuant to which it was to issue options to purchase 5% of the
number of shares of common stock outstanding as of January 19, 2001. However, on
February 25, 2003, HCHI granted options to purchase 30,000 shares of its common
stock under its 1999 Equity Incentive Plan in satisfaction of the Company's
obligation. The stock options were issued with an exercise price of $7.69, were
fully vested on the date of grant and expire on February 24, 2008, excluding the
grantee's death or termination of employment. Included in the assets purchased
was Pamex Securities, LLC, 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.
F-53
4. PROPERTY AND EQUIPMENT
DECEMBER 31,
--------------------------
2002 2001
--------- ---------
Office machinery and equipment $272,244 $206,344
Furniture and fixtures 54,914 53,136
Leasehold improvements 18,985 470
--------- ---------
346,143 259,950
Less accumulated depreciation and amortization (188,717) (83,222)
--------- ---------
Property and equipment-net $157,426 $176,728
========= =========
Depreciation and amortization expense for the years ended December 31, 2002,
2001 and 2000 was $105,495, $81,208 and $2,014, respectively.
5. CAPITALIZED SOFTWARE
DECEMBER 31,
------------------------------
2002 2001
----------- -----------
Capitalized software costs $ 4,013,524 $ 3,275,474
Less accumulated amortization (2,218,830) (1,105,151)
----------- ------------
Capitalized software - net $ 1,794,694 $ 2,170,323
=========== ============
Amortization expense for the years ended December 31, 2002, 2001 and 2000 was
$1,113,679, $956,230 and $148,921, respectively. The estimated aggregate
amortization expense, as of December 31, 2002, for the years ending December 31,
2003, 2004, 2005 and 2006 is $1,183,941, $381,143, $224,501 and $5,109,
respectively.
6. GOODWILL
Balance as of December 31, 2001 $1,044,266
Adjustment (29,530)
Addition 500,000
-----------
Balance as of December 31, 2002 $1,514,736
===========
On February 19, 2002, the Company received a capital contribution from HCHI of
63,577 shares of HCHI common stock with a then fair market value of $470,470.
The Company utilized the capital contribution to fund the first 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, was reflected as an adjustment to goodwill. As of
December 31, 2002, a second earn-out of $500,000 has been accrued.
No impairment losses were recognized for the year ended December 31, 2002.
F-54
7. NOTE RECEIVABLE
On November 15, 2002, the Company entered into a credit and security agreement
with VerticalCrossings.com, Inc. ("Vcross"). Vcross specializes in trading U.S.
Treasury and Agency securities and structured products. Pursuant to this
agreement, the Company loaned Vcross $300,000 at an interest rate of 12%.
Interest is payable monthly and principal is payable in four equal quarterly
payments beginning on December 1, 2003. The loan is collateralized by all of
Vcross' assets. As additional consideration for the loan, the Company received
an exclusive perpetual license to use Vcross' proprietary software technology to
conduct on-line auctions of mortgage loans. The Company also received warrants
to purchase up to 33,469 shares of Vcross common stock. From previous
transactions with Vcross, the Company has warrants to purchase up to an
additional 15,646 shares of Vcross common stock. These warrants are not actively
traded and at December 31, 2002, the Company has valued them at zero in the
accompanying Consolidated Balance Sheet.
8. CONCENTRATION RISK
As of and for the year ended December 31, 2002, two of the Company's customers
individually accounted for 66% and 24% of accounts receivable and one customer
accounted for 49% of total revenues. No other customer individually accounted
for more than 10% of accounts receivable or total revenues.
9. RELATED PARTY TRANSACTIONS
DECEMBER 31,
--------------------------
2002 2001
--------- ---------
Due to Hanover Capital Partners Ltd. $ 270,987 $ 466,287
Due to Hanover Capital Mortgage Holdings, Inc. 172,871 78,400
Other (1,363) (48)
--------- ---------
Due to related parties $ 442,495 $ 544,639
========= =========
For the years ended December 31, 2002, 2001 and 2000, Hanover Capital Partners
Ltd. ("HCP") and HCHI billed certain expenses to the Company. The expenses
billed include personnel, travel and entertainment, general and administrative,
occupancy, technology and professional. These expenses were billed to reflect
certain costs paid on behalf of the Company. The Company expects similar
billings from HCP and HCHI in future periods.
HCP billed the following expenses to the Company for the years ended December
31, 2002, 2001 and 2000:
YEARS ENDED DECEMBER 31,
------------------------------------------
2002 2001 2000
---------- ---------- --------
Personnel $2,652,028 $2,504,855 $441,214
Travel and entertainment 140,427 150,157 57,320
General and administrative 28,764 23,215 47,299
Occupancy 7,123 20,086 25,466
Technology 4,705 10,415 3,600
Professional -- 1,961 --
---------- ---------- --------
$2,833,047 $2,710,689 $574,899
========== ========== ========
The above expenses were partially offset by revenues billed by the Company to
HCP of $110,962 for the year ended December 31, 2000.
F-55
HCHI billed the following expenses to the Company for the years ended December
31, 2002, 2001 and 2000:
YEARS ENDED DECEMBER 31,
--------------------------------------
2002 2001 2000
-------- -------- --------
Personnel $561,419 $353,993 $369,047
Occupancy -- 19,957 102,840
General and administrative 4,750 2,051 16,118
-------- -------- --------
$566,169 $376,001 $488,005
======== ======== ========
At December 31, 2002 and 2001, the Company had a principal balance on a note
payable to HCHI in the amount of $7,395,896 and $7,654,396, 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, 2002 and 2001, the interest rate
in effect was 3.25% and 3.75%, respectively. The entire unpaid principal balance
on the note is due in full on the extended maturity date, March 31, 2004.
10. INCOME TAXES
DECEMBER 31,
------------------------------
2002 2001
----------- -----------
Deferred tax assets - Federal $ 1,763,975 $ 1,660,082
Deferred tax assets - State 268,063 284,207
----------- -----------
2,032,038 1,944,289
Valuation allowance (2,032,038) (1,944,289)
----------- -----------
Deferred tax asset - net $ -- $ --
=========== ===========
The items resulting in significant temporary differences for the years ended
December 31, 2002 and 2001 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 components of the income tax provision for the years ended December 31,
2002, 2001 and 2000 consist of the following:
YEARS ENDED DECEMBER 31,
-----------------------------------------------
2002 2001 2000
----------- ----------- ---------
Current - Federal, state and local $ 7,998 $ -- $ --
Deferred - Federal, state and local (87,749) (1,323,465) (608,395)
----------- ----------- ---------
(79,751) (1,323,465) (608,395)
Valuation allowance 87,749 1,323,465 608,395
----------- ----------- ---------
Total $ 7,998 $ -- $ --
=========== =========== =========
F-56
The income tax provision differs from amounts computed at statutory rates, as
follows:
YEARS ENDED DECEMBER 31,
-----------------------------------------------
2002 2001 2000
----------- ----------- ---------
Federal income tax benefit at statutory rate $ (77,970) $(1,143,602) $(524,454)
State and local income tax benefit (12,324) (191,274) (97,050)
Meals and entertainment 7,145 8,609 11,228
Officers' life insurance 3,391 2,802 1,881
Tax amortization in excess of book amortization (38,837) -- --
Effect of rate changes on prior year deferred tax assets 32,331 -- --
State alternative minimum tax 7,998 -- --
Other (1,485) -- --
----------- ----------- ---------
(79,751) (1,323,465) (608,395)
Valuation allowance 87,749 1,323,465 608,395
----------- ----------- ---------
Income tax provision $ 7,998 $ -- $ --
=========== =========== =========
The Company has a Federal tax net operating loss carryforward of approximately
$5,162,000 that begins to expire in 2019.
11. STOCKHOLDER'S EQUITY
Prior to July 1, 2002, HCHI owned 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 was owned by the
principals, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N.
Tavares. Pursuant to a Stock Purchase Agreement effective July 1, 2002, HCHI
acquired 100% of the outstanding common stock of the Company. Therefore, as of
July 1, 2002, HCHI owns 100% of the outstanding capital stock, both preferred
and common, of the Company.
On February 19, 2002, the Company received a capital contribution from HCHI of
63,577 shares of HCHI common stock with a then fair market value of $470,470.
The Company utilized the capital contribution to fund the first 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, was reflected as an adjustment to goodwill. In
addition, on February 19, 2002, the Company received a capital contribution from
the principals of $14,551 to maintain the principals' 3% economic interest in
the Company.
12. 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
------ ---------
2003 $ 201,316
2004 141,039
2005 45,933
---------
$ 388,288
=========
Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to
$199,101, $190,379 and $69,533, respectively.
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13. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
---------------------------------------
2002 2001 2000
--------- --------- -------
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 1,000 $ -- $ --
========= ========= =======
Interest to related party $ 311,942 $ 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 NON-CASH INVESTING ACTIVITIES:
First and second earn-outs accrued in connection with the
acquisition of all of the assets of Pamex resulting in
increases in goodwill and payable under asset purchase
agreement $ 500,000 $ 500,000 $ --
========= ========= =======
Capital contribution received of 63,577 shares of HCHI common
stock utilized to fund the first earn-out in connection
with the acquisition of all of the assets of Pamex $ 470,470 $ -- $ --
========= ========= =======
14. SUBSEQUENT EVENTS
On February 21, 2003, the maturity date of the note payable to HCHI was extended
from March 31, 2003 to March 31, 2004.
On February 24, 2003, the Company received a capital contribution from HCHI of
$75,000 of cash and 60,180 shares of HCHI common stock with a then fair market
value of $457,970. The capital contribution was utilized by the Company to fund
the second earn-out issued in connection with its purchase of all of the assets
of Pamex. The difference between the amount accrued at December 31, 2002 and the
capital contribution on February 24, 2003, or $32,970, will be reflected as an
adjustment to goodwill.
******
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