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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended March 31, 2003
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)
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 whether the registrant is an accelerated filer
(as defined in Exchange Act Rule 12b-2).
Yes [ ] No [X]
The registrant had 4,503,126 shares of common stock outstanding as of
May 14, 2003.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2003
INDEX
Page No.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements 3
Consolidated Balance Sheets as of
March 31, 2003 (unaudited) and December 31, 2002 3
Consolidated Statements of Income (unaudited) for the
Three Months Ended March 31, 2003 and 2002 4
Consolidated Statement of Stockholders' Equity (unaudited)
for the Three Months Ended March 31, 2003 5
Consolidated Statements of Cash Flows (unaudited) for the
Three Months Ended March 31, 2003 and 2002 6
Notes to Consolidated Financial Statements (unaudited) 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk 28
Item 4. Controls and Procedures 30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 31
Item 2. Changes in Securities and Use of Proceeds 31
Item 3. Defaults Upon Senior Securities 31
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 5. Other Information 31
Item 6. Exhibits and Reports on Form 8-K 31
Signatures 31
Certifications 32
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
MARCH 31, DECEMBER 31,
2003 2002
------------ ------------
ASSETS (unaudited)
Mortgage loans:
Held for sale $ 410 $ 413
Collateral for CMOs 76,903 102,751
Mortgage securities pledged as collateral
for reverse repurchase agreements:
Available for sale 26,834 4,082
Held to maturity - 559
Trading - 2,669
Mortgage securities pledged as collateral for CMOs - 9,805
Mortgage securities, not pledged:
Available for sale 3,130 6,186
Trading - 602
Cash and cash equivalents 18,704 10,605
Accounts receivable 1,404 1,706
Accrued interest receivable 806 960
Equity investment in HDMF-I LLC 2,664 4,638
Notes receivable from related parties 1,750 2,563
Other assets 9,351 8,332
------------ ------------
TOTAL ASSETS $ 141,956 $ 155,871
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 23,012 $ 6,283
CMO borrowing 70,174 102,589
Dividends payable - 1,119
Accounts payable, accrued expenses and other liabilities 2,757 2,816
------------ ------------
TOTAL LIABILITIES 95,943 112,807
------------ ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $0.01, 10 million shares authorized,
-0- shares issued and outstanding
Common stock, par value $0.01, 90 million shares authorized,
4,532,402 and 4,474,222 shares issued and outstanding at
March 31, 2003 and December 31, 2002, respectively 45 45
Additional paid-in capital 68,433 67,990
Retained earnings (deficit) (23,454) (25,322)
Accumulated other comprehensive income 989 351
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 46,013 43,064
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 141,956 $ 155,871
============ ============
See notes to consolidated financial statements
3
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
THREE MONTHS ENDED
MARCH 31,
----------------------
2003 2002
-------- --------
REVENUES:
Interest income $ 2,395 $ 3,845
Interest expense 1,285 2,193
-------- ---------
Net interest income 1,110 1,652
Loan loss provision 271 54
-------- --------
Net interest income after loan loss provision 839 1,598
Gain on sale of mortgage assets 3,283 600
Gain on mark to market of mortgage assets - 275
Due diligence fees 1,319 -
Assignment fees 573 -
Technology 885 -
Loan brokering, trading and advisory services 396 -
Other income (loss) 46 (172)
-------- --------
Total revenue 7,341 2,301
-------- --------
EXPENSES:
Personnel 2,177 500
Subcontractor 942 -
Legal and professional 396 190
General and administrative 392 231
Depreciation and amortization 388 -
Other 160 106
Travel and entertainment 150 9
Occupancy 122 10
-------- --------
Total expenses 4,727 1,046
-------- --------
Operating income 2,614 1,255
Equity in income (loss) of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. - 26
HanoverTrade, Inc. - 27
HDMF-I LLC (43) (21)
Hanover Capital Partners 2, Inc. - 25
-------- --------
Income before income tax provision 2,571 1,312
Income tax provision 23 -
-------- --------
NET INCOME $ 2,548 $ 1,312
======== ========
BASIC EARNINGS PER SHARE $ 0.57 $ 0.31
======== ========
DILUTED EARNINGS PER SHARE $ 0.56 $ 0.30
======== ========
See notes to consolidated financial statements
4
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Three Months Ended March 31, 2003
(in thousands, except share data)
(unaudited)
ACCUMULATED
COMMON STOCK ADDITIONAL RETAINED OTHER
------------------- PAID-IN COMPREHENSIVE EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL INCOME (DEFICIT) INCOME TOTAL
--------- ------ ---------- ------------- --------- ------------- --------
Balance, December 31, 2002 4,474,222 $ 45 $ 67,990 $ (25,322) $ 351 $ 43,064
Capital contributed to related
party 60,180 - 458 458
Repurchase of common stock (2,000) - (15) (15)
Comprehensive income:
Net income $ 2,548 2,548 2,548
Other comprehensive income:
Change in net unrealized
gain (loss) on securities
available for sale 629 629 629
Change in net unrealized
gain (loss) on interest rate
caps designated as hedges 9 9 9
-------------
Comprehensive income $ 3,186
=============
Dividends declared (680) (680)
--------- ------ ---------- --------- ------------- --------
Balance, March 31, 2003 4,532,402 $ 45 $ 68,433 $ (23,454) $ 989 $ 46,013
========= ====== ========== ========= ============= ========
See notes to consolidated financial statements
5
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
THREE MONTHS ENDED MARCH 31,
-----------------------------
2003 2002
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,548 $ 1,312
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization 388 -
Amortization of net premium and deferred costs (107) 104
Loan loss provision 271 54
Gain on sale of mortgage assets (3,283) (600)
Gain on mark to market of mortgage assets - (275)
Loss on disposition of real estate owned 9 -
Purchase of trading securities - (34,243)
Sale of trading securities 3,267 50,154
Distributions from unconsolidated subsidiaries in excess of
equity (income) loss 1,974 (57)
Decrease in accounts receivable 302 -
Decrease in accrued interest receivable 154 694
Decrease (increase) in notes receivable from related parties 588 (2,996)
Increase in other assets (1,571) (1,716)
Increase (decrease) in accounts payable, accrued expenses and
other liabilities 441 (384)
-------- --------
Net cash provided by operating activities 4,981 12,047
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage securities (20,033) -
Principal payments received on mortgage assets 272 2,276
Principal payments received on collateral for CMOs 8,080 14,921
Principal payments received on mortgage loans held for sale 3 141
Proceeds from sale of mortgage assets 33,430 1,162
Proceeds from disposition of real estate owned 65 -
Sales of mortgage securities to affiliates - 946
Acquisitions (75) -
Capital contribution to HDMF-I LLC - (3,891)
-------- --------
Net cash provided by investing activities 21,742 15,555
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from (repayment of) reverse repurchase agreements 16,729 (15,899)
Net repayment of CMOs (33,539) (14,792)
Payment of dividends (1,799) (855)
Repurchase of common stock (15) (122)
-------- --------
Net cash (used in) financing activities (18,624) (31,668)
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 8,099 (4,066)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 10,605 8,946
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 18,704 $ 4,880
======== ========
See notes to consolidated financial statements
6
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. ORGANIZATION AND BASIS OF PRESENTATION
The interim consolidated financial statements of Hanover Capital Mortgage
Holdings, Inc. ("Hanover") and subsidiaries include the accounts of Hanover and
its wholly-owned and equity-owned subsidiaries. These interim consolidated
financial statements should be read in conjunction with Hanover's Annual Report
on Form 10-K for the year ended December 31, 2002. The interim consolidated
financial statements reflect all normal and recurring adjustments which are, in
the opinion of management, considered necessary for a fair presentation of the
financial condition and results of operations for the periods presented. There
were no adjustments of a non-recurring nature recorded during the three months
ended March 31, 2003. The interim results of operations presented are not
necessarily indicative of the results for the full year. When necessary,
reclassifications have been made to conform to current period presentation.
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.
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 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. HanoverTrade also 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. 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.
7
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.
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 did not have a material effect on our consolidated financial
statements.
In December 2002, the FASB issued Statement of Financial Accounting Standards
No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an
amendment of FASB Statement No. 123 ("SFAS 148"). SFAS 148 amends FASB Statement
No. 123, Accounting for Stock-Based Compensation ("SFAS 123"). SFAS 148 provides
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, SFAS
148 amends the disclosure requirements of SFAS 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reporting results. The transition provisions of SFAS 148 are effective
for financial statements for fiscal years ending after December 15, 2002. The
amendment of SFAS 123 requiring interim reporting is effective for interim
periods beginning after December 15, 2002. The adoption of SFAS 148 did not have
a material effect on our consolidated financial statements.
On November 25, 2002, the FASB issued FASB Interpretation No. ("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"). 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 did not
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.
8
2. MORTGAGE LOANS
MORTGAGE LOANS HELD FOR SALE
(dollars in thousands)
MARCH 31, 2003 DECEMBER 31, 2002
----------------------------- ----------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
----- ---------- ----- ----- ---------- -----
Principal amount of mortgage loans $ 48 $ 496 $ 544 $ 48 $ 499 $ 547
Net premium (discount) and deferred costs (3) (111) (114) (3) (111) (114)
Loan loss allowance - - - - - -
Net unrealized gain (loss) - (20) (20) - (20) (20)
----- ---------- ----- ----- ---------- -----
Carrying value of mortgage loans $ 45 $ 365 $ 410 $ 45 $ 368 $ 413
===== ========== ===== ===== ========== =====
MORTGAGE LOANS SECURITIZED IN COLLATERALIZED MORTGAGE OBLIGATIONS
(dollars in thousands)
MARCH 31, 2003 DECEMBER 31, 2002
------------------------------------ --------------------------------------
FIXED ADJUSTABLE FIXED ADJUSTABLE
RATE RATE TOTAL RATE RATE TOTAL
--------- ---------- -------- --------- ---------- ----------
Principal amount of mortgage loans $ 47,371 $ 29,560 $ 76,931 $ 71,127 $ 31,365 $ 102,492
Net premium (discount) and deferred costs 520 (153) 367 982 (152) 830
Loan loss allowance (192) (203) (395) (377) (194) (571)
--------- ---------- -------- --------- ---------- ----------
Carrying value of mortgage loans $ 47,699 $ 29,204 $ 76,903 $ 71,732 $ 31,019 $ 102,751
========= ========== ======== ========= ========== ==========
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 certain
percentage of the original collateral balance. 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 $1,365,000 and a gain of $123,000. 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
$5,930,000 and a gain of $3,052,000.
9
3. MORTGAGE SECURITIES
FIXED-RATE AGENCY MORTGAGE-BACKED SECURITIES
(dollars in thousands)
MARCH 31, 2003
--------------------------------------------------------
AVAILABLE HELD TO
FOR SALE MATURITY TRADING TOTAL
--------- -------- ------- --------
Principal balance of mortgage securities $ 12,190 $ - $ - $ 12,190
Net premium (discount) and deferred costs 149 - - 149
--------- -------- ------- --------
Total amortized cost of mortgage securities 12,339 - - 12,339
Net unrealized gain (loss) 177 - - 177
--------- -------- ------- --------
Carrying value of mortgage securities $ 12,516 $ - $ - $ 12,516
========= ======== ======= ========
At December 31, 2002, there were no fixed-rate agency mortgage-backed
securities.
FIXED-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
MARCH 31, 2003
-------------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ 27,412 $ - $ - $ - $ 27,412
Net premium (discount)
and deferred costs (14,678) - - - (14,678)
--------- -------- ------- ---------- --------
Total amortized cost of
mortgage securities 12,734 - - - 12,734
Loan loss allowance (357) - - - (357)
Net unrealized gain
(loss) 935 - - - 935
--------- -------- ------- ---------- --------
Carrying value of
mortgage securities $ 13,312 $ - $ - $ - $ 13,312
========= ======== ======= ========== ========
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
========= ======== ======= ========== ========
ADJUSTABLE-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
MARCH 31, 2003
-----------------------------------------------------------
AVAILABLE COLLATERAL
FOR HELD TO FOR
SALE MATURITY TRADING CMOS TOTAL
--------- -------- ------- ---------- --------
Principal balance of
mortgage securities $ 8,623 $ - $ - $ - $ 8,623
Net premium (discount)
and deferred costs (4,611) - - - (4,611)
--------- -------- ------- ---------- --------
Total amortized cost of
mortgage securities 4,012 - - - 4,012
Loan loss allowance (77) - - - (77)
Net unrealized gain (loss) 201 - - - 201
--------- -------- ------- ---------- --------
Carrying value of
mortgage securities $ 4,136 $ - $ - $ - $ 4,136
========= ======== ======= ========== ========
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
========= ======== ======= ========== =======
DERIVATIVE MORTGAGE-BACKED SECURITIES
(dollars in thousands)
DECEMBER 31, 2002
--------------------------------------------------------
INTEREST- PRINCIPAL-
ONLY STRIPS ONLY STRIPS INTEREST-
AVAILABLE HELD TO ONLY STRIPS
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
=========== =========== =========== =======
At March 31, 2003, there were no derivative mortgage-backed securities.
10
4. LOAN LOSS ALLOWANCE
The following table summarizes the activity in the loan loss allowance (dollars
in thousands):
THREE MONTHS ENDED
MARCH 31,
---------------------
2003 2002
-------- --------
Balance, beginning of period $ 1,143 $ 1,342
Loan loss provision 271 54
Sales (575) (157)
Charge-offs (10) (9)
-------- --------
Balance, end of period $ 829 $ 1,230
======== ========
5. NOTES RECEIVABLE AND AFFILIATED PARTY TRANSACTIONS
As of March 31, 2003, Hanover had the following loans outstanding to four
executive officers ("Principals"):
NOTES RECEIVABLE
(dollars in thousands)
MARCH 31, INTEREST
2003 RATE MATURITY DATE
- --------- -------- --------------
$ 483 6.02% September 2007
1,267 5.70 September 2007
- ---------
$ 1,750
=========
The loans to Principals are secured solely by 116,667 shares of Hanover's common
stock owned by the Principals, collectively.
Included in other assets in the Consolidated Balance Sheet is a receivable from
HDMF-I of $123,000 at March 31, 2003.
During the three months ended March 31, 2003 and 2002, Hanover recorded the
following interest income generated from loans to related parties (dollars in
thousands):
THREE MONTHS ENDED
MARCH 31,
------------------
2003 2002
------ ------
Principals $ 36 $ 45
HCP - 11
HT - 73
HCP-2 - 67
------ ------
$ 36 $ 196
====== ======
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 management and administrative expenses for the three months ended
March 31, 2002 were $154,000 relating to billings from HCP. The expense for the
three months ended March 31, 2003 was eliminated in consolidation in the
accompanying Consolidated Statement of Income.
11
6. REVERSE REPURCHASE AGREEMENTS
Information pertaining to individual reverse repurchase agreement lenders at
March 31, 2003 is summarized as follows (dollars in thousands):
DECEMBER 31, NET MARCH 31,
MAXIMUM 2002 (PAYDOWN) 2003 UNDERLYING
LENDER BORROWING BALANCE ADVANCE BALANCE COLLATERAL TYPE OF COLLATERAL
- -------------------- --------- ------------ --------- --------- ---------- -----------------------
Lender A (committed) $ 10,000 $ 1,698 $ (237) $ 1,461 $ 6,729 Retained CMO Securities
Lender A 578 1,172 1,750 2,767 Mortgage Securities
Lender B 1,028 13,970 14,998 16,571 Mortgage Securities
Lender C - 2,091 2,091 3,434 Mortgage Securities
Lender D 2,354 (429) 1,925 2,792 Mortgage Securities
Lender E 625 (181) 444 763 Mortgage Securities
Lender F - 343 343 507 Mortgage Securities
------------ --------- --------- ----------
Total $ 6,283 $ 16,729 $ 23,012 $ 33,563
============ ========= ========= ==========
With the exception of the first facility listed, all of the reverse repurchase
borrowings are pursuant to uncommitted financing arrangements which are
typically renewed monthly. The first facility listed matures on April 26, 2004.
7. DERIVATIVE INSTRUMENTS
INTEREST RATE CAPS (FREESTANDING DERIVATIVES)
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
March 31, 2003, 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 three months ended March 31, 2003 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
March 31, 2003, the fair value of the Company's interest rate caps was $1,000.
FORWARD SALES OF AGENCY SECURITIES (FREESTANDING DERIVATIVES)
From time to time, the Company enters into forward sales of government agency
guaranteed securities, known as "Agency" securities to manage the exposure to
changes in the value of securities classified as "trading securities." The
Company considers these forward sales to be freestanding derivatives. The
objective is to offset gains or losses on the trading securities with comparable
losses or gains on the forward sales. Generally, changes in the value of the
trading securities are caused by changes in interest rates, changes in the
market for 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. (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 and the forward sales. Using this information,
the Company determines the amount of forward sales that it needs so that the
expected gains or losses on trading securities will be offset by comparable
losses or gains on the forward sales. At March 31, 2003, the Company did not
have any forward sales of Agency MBS.
12
8. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE
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 up to a maximum of $3,000,000. In addition, on August 7, 2001, the
Board of Directors of Hanover authorized the repurchase of 60,000 shares of its
outstanding common stock. During the three months ended March 31, 2003, the
Company repurchased 2,000 shares of its common stock in open-market transactions
through one of its subsidiaries at $7.73 per share for a total cost of $15,000.
As of March 31, 2003, Hanover had remaining authority to purchase up to 501,025
shares for not more than $137,000 under the 2000 share repurchase program and
1,000 shares under the 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 March 31, 2003, Hanover had 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
Capital Partners LLC 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 Hanover 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.
Calculations for earnings per share are shown below (dollars in thousands,
except per share data):
THREE MONTHS ENDED
MARCH 31,
-------------------------
2003 2002
---------- ----------
EARNINGS PER SHARE BASIC:
Net income (numerator) $ 2,548 $ 1,312
========== ==========
Average common shares outstanding (denominator) 4,497,805 4,302,350
========== ==========
Earnings per share basic $ 0.57 $ 0.31
========== ==========
EARNINGS PER SHARE DILUTED:
Net income (numerator) $ 2,548 $ 1,312
========== ==========
Average common shares outstanding 4,497,805 4,302,350
Add: Incremental shares from assumed conversion of
stock options 74,452 90,996
---------- ----------
Diluted weighted average shares outstanding (denominator) 4,572,257 4,393,346
========== ==========
Earnings per share diluted $ 0.56 $ 0.30
========== ==========
9. HANOVER STOCK OPTION PLANS
On February 25, 2003, Hanover issued options, under the 1999 Equity Incentive
Plan, to purchase 30,000 shares of its common stock with an exercise price of
$7.69 per share in satisfaction of certain terms of the purchase agreement
between HT and Pamex. The stock options expire on February 24, 2008.
13
The per share weighted average fair value of stock options granted for the three
months ended March 31, 2003 was $0.40, at the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
Expected life (years) 5
Risk-free interest rate 3.82%
Volatility 27.63%
Expected dividend yield 10.94%
Hanover applies APB Opinion No. 25 in accounting for its Stock Option Plans and,
accordingly, no compensation cost has been recognized for its stock options in
the financial statements for 2003. 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 three months ended March 31, 2003 (dollars in thousands, except
per share data):
Net income:
As reported $ 2,548
Deduct: Total stock-based employee compensation
expense determined under fair value based
method, net of related tax effects (12)
---------
Pro forma $ 2,536
=========
Earnings per share - basic:
As reported $ 0.57
=========
Pro forma $ 0.56
=========
Earnings per share - diluted:
As reported $ 0.56
=========
Pro forma $ 0.55
=========
10. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands, except share data)
THREE MONTHS ENDED
MARCH 31,
-------------------
2003 2002
-------- --------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Income taxes $ 129 $ -
======== ========
Interest $ 1,419 $ 2,772
======== ========
SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES
Capital contribution of 63,577 shares of common stock to HT $ - $ 470
======== ========
Capital contribution of 60,180 shares of common stock to HT $ 458 $ -
======== ========
Payment of note receivable from related party with commitment of common stock $ 225 $ -
======== ========
14
11. 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 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 1 to the Consolidated Financial Statements, for the periods
ending after June 30, 2002, Hanover's financial statements will be consolidated
with HCP and HT. Therefore, segment information is only being provided as of and
for the three months ended March 31, 2003 as follows (dollars in thousands):
Hanover
Capital Hanover
Mortgage Capital Hanover
Holdings, Partners Trade, Elimina-
Inc. Ltd. Inc. Other tions Consolidated
-------- -------- -------- ------- -------- ------------
Net interest income $ 1,167 $ 5 $ 9 $ - $ (71) $ 1,110
Other revenues 2,628 1,943 1,660 - - 6,231
Net income (loss) 2,672 (54) (70) - - 2,548
Total assets 141,119 3,748 5,222 24 (8,157) 141,956
Capital expenditures and investments 540 12 1,095 - (533) 1,114
Depreciation and amortization 3 18 367 - - 388
12. SUBSEQUENT EVENTS
On May 8, 2003, the Board of Directors declared a $0.30 per share cash dividend
for the quarter ended March 31, 2003 to be paid on June 5, 2003 to stockholders
of record as of May 22, 2003.
13. 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, 2002.
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, 2002, 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 Quarterly Report on Form 10-Q
for the three months ended March 31, 2002.
15
Information presented for the three months ended March 31, 2002 is presented on
a consolidated pro forma basis. Information presented for the three months ended
March 31, 2003 is presented on an actual basis, which takes into account the
consolidation of Hanover, HT, HCP and HCP-2.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
THREE MONTHS ENDED
MARCH 31,
---------------------
2003 2002
-------- ----------
(Pro Forma)
REVENUES:
Interest income $ 2,395 $ 4,158
Interest expense 1,285 2,193
-------- ----------
Net interest income 1,110 1,965
Loan loss provision 271 54
-------- ----------
Net interest income after loan loss provision 839 1,911
Gain on sale of mortgage assets 3,283 600
Loss on mark to market of mortgage assets - (210)
Due diligence fees 1,319 916
Assignment fees 573 389
Technology 885 22
Loan brokering, trading and advisory services 396 1,815
Other income 46 26
-------- ----------
Total revenue 7,341 5,469
-------- ----------
EXPENSES:
Personnel 2,177 2,202
Subcontractor 942 501
Legal and professional 396 246
General and administrative 392 288
Depreciation and amortization 388 311
Other 160 359
Travel and entertainment 150 105
Occupancy 122 92
-------- ----------
Total expenses 4,727 4,104
-------- ----------
Operating income 2,614 1,365
Equity in income (loss) of unconsolidated subsidiaries:
Hanover Capital Partners Ltd. - -
HanoverTrade, Inc. - -
HDMF-I LLC (43) (21)
Hanover Capital Partners 2, Inc. - -
-------- ----------
Income before income tax provision 2,571 1,344
Income tax provision 23 36
-------- ----------
NET INCOME $ 2,548 $ 1,308
======== ==========
BASIC EARNINGS PER SHARE $ 0.57 $ 0.30
======== ==========
DILUTED EARNINGS PER SHARE $ 0.56 $ 0.30
======== ==========
See notes to pro forma consolidated statements of income
16
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
PRO FORMA CONSOLIDATED STATEMENT OF INCOME
Three Months Ended March 31, 2002
(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 $ 3,845 $ 470 $ (157)(a,d) $ 4,158
Interest expense 2,193 - - 2,193
-------------- ------------ ------------ ------------
Net interest income 1,652 470 (157) 1,965
Loan loss provision 54 - - 54
-------------- ------------ ------------ ------------
Net interest income after loan loss provision 1,598 470 (157) 1,911
Gain on sale of mortgage assets 600 - - 600
Gain (loss) on mark to market of mortgage assets 275 (485) - (210)
Due diligence fees - 916 - 916
Assignment fees - 389 - 389
Technology - 22 - 22
Loan brokering, trading and advisory services - 1,815 - 1,815
Other income (loss) (172) 216 (18)(b) 26
-------------- ------------ ------------ ------------
Total revenue 2,301 3,343 (175) 5,469
-------------- ------------ ------------ ------------
EXPENSES:
Personnel 500 1,505 197(b) 2,202
Subcontractor - 501 - 501
Legal and professional 190 56 - 246
General and administrative 231 272 (215)(b) 288
Depreciation and amortization - 311 - 311
Other 106 404 (151)(a) 359
Travel and entertainment 9 96 - 105
Occupancy 10 82 - 92
-------------- ------------ ------------ ------------
Total expenses 1,046 3,227 (169) 4,104
-------------- ------------ ------------ ------------
Operating income 1,255 116 (6) 1,365
Equity in income (loss) of unconsolidated
subsidiaries 57 - (78)(c) (21)
-------------- ------------ ------------ ------------
Income before income tax provision 1,312 116 (84) 1,344
Income tax provision - 36 - 36
-------------- ------------ ------------ ------------
NET INCOME $ 1,312 $ 80 $ (84) $ 1,308
============== ============ ============ ============
BASIC EARNINGS PER SHARE:
Average common shares outstanding 4,302,350 4,302,350
============== ============
Basic earnings per share $ 0.31 $ 0.30
============== ============
DILUTED EARNINGS PER SHARE:
Diluted weighted average shares outstanding 4,393,346 4,393,346
============== ============
Diluted earnings per share $ 0.30 $ 0.30
============== ============
See notes to pro forma consolidated statements of income
17
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended March 31, 2002
(unaudited)
(dollars in thousands)
(a) To eliminate intercompany interest income and expense summarized as
follows:
Interest on note to Hanover Capital Partners Ltd. $ 11
Interest on note to HanoverTrade, Inc. 73
Interest on note to Hanover Capital Partners 2, Inc. 67
--------
$ 151
========
(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:
Management fee income recorded to:
Other income (loss) $ 18
Reduction of personnel expense 199
--------
$ 217
========
Management fee expensed to:
General, management and administrative $ 215
Personnel expense 2
--------
$ 217
========
(c) With the consolidation of the results of Hanover Capital Partners Ltd.,
HanoverTrade, Inc. and Hanover Capital Partners 2, Inc., the equity in
income of these subsidiaries summarized below would be reversed:
Hanover Capital Partners Ltd. $ 26
HanoverTrade, Inc. 27
Hanover Capital Partners 2, Inc. 25
--------
$ 78
========
(d) To exclude the interest income of $6 on the portion of the notes receivable
reduced in exchange for the purchase of the common stock of the newly
consolidated subsidiaries; the offsetting amount would be to accrued
interest on the balance sheet
18
ITEM 2. 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 Quarterly Report on Form 10-Q. 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: statements regarding our
continuing ability to target, price and acquire MBS or mortgage loans; our
estimated loan-loss reserves; 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; 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; 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 investments; 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," in our Annual
Report on Form 10-K for the year ended December 31, 2002, 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 to forward-looking statements to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.
19
Investors should also carefully consider the critical accounting policies
identified in "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Critical Accounting Policies," in our Annual Report on
Form 10-K for the year ended December 31, 2002. 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 our
critical accounting policies for mortgage securities, loan loss allowance,
equity investments, revenue recognition and income taxes involve a high degree
of judgment and complexity in the preparation of our consolidated financial
statements.
OVERVIEW
We are a specialty finance company organized in June 1997 as a REIT. At March
31, 2003, 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.
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.
20
As of March 31, 2003, we retain the aggregate credit risk on $10.9 billion of
mortgage loans relating to (dollars in thousands):
Principal Carrying
Balance Value Financing
--------- -------- ---------
Subordinate MBS $ 36,035 $ 17,448 $ 9,557
Agency-issued MBS 12,190 12,516 11,994
Collateral for CMOs 76,931 6,729 1,461
Mortgage loans 544 410 -
--------- -------- ---------
Total $ 125,700 $ 37,103 $ 23,012
========= ======== =========
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 $6,995,000 of mortgage
loans of which our portion is $2,201,000 of invested capital at risk.
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, 2002 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, 2002,
and these presentations do not necessarily indicate the future financial
position or results of operations.
21
RESULTS OF OPERATIONS
The following table presents the consolidated results of operations as
previously reported for the three months ended March 31, 2003 and 2002 and pro
forma results for the three months ended March 31, 2002 (dollars in thousands,
except per share data):
As Previously Reported -
Three Months Ended Pro Forma -
March 31, Three Months
----------------------- Ended March 31,
2003 2002 2002
---------- ---------- ----------
Net interest income $ 1,110 $ 1,652 $ 1,965
Loan loss provision (271) (54) (54)
Gain on sale of mortgage assets 3,283 600 600
Gain on mark to market of mortgage assets - 275 (210)
Due diligence fees 1,319 - 916
Assignment fees 573 - 389
Technology 885 - 22
Loan brokering, trading and advisory services 396 - 1,815
Other income (loss) 46 (172) 26
---------- ---------- ----------
Total revenue 7,341 2,301 5,469
Expenses 4,727 1,046 4,104
---------- ---------- ----------
Operating income 2,614 1,255 1,365
Equity in income (loss) of unconsolidated
subsidiaries:
Hanover Capital Partners Ltd. - 26 -
HanoverTrade, Inc. - 27 -
HDMF-I LLC (43) (21) (21)
Hanover Capital Partners 2, Inc. - 25 -
---------- ---------- ----------
Income before income tax provision 2,571 1,312 1,344
Income tax provision 23 - 36
---------- ---------- ----------
Net income $ 2,548 $ 1,312 $ 1,308
========== ========== ==========
Basic earnings per share $ 0.57 $ 0.31 $ 0.30
========== ========== ==========
Dividends declared per share $ 0.30 $ 0.25 $ 0.25
========== ========== ==========
Net Income, Basic Earnings Per Share and Total Revenue
We recorded net income of $2,548,000 or $0.57 per share based on 4,497,805
weighted average shares of common stock outstanding for the three months ended
March 31, 2003 compared to net income of $1,312,000 or $0.31 per share based on
4,302,350 weighted average common shares outstanding for the three months ended
March 31, 2002. Total revenue for the three months ended March 31, 2003 was
$7,341,000, compared to $2,301,000 previously reported for the same period in
2002. On a pro forma basis, total revenue for the three months ended March 31,
2002 was $5,469,000.
22
Net Interest Income and Loan Loss Provision
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
THREE MONTHS ENDED MARCH 31,
----------------------------------------------
2003 2002
--------------------- ---------------------
NET LOAN NET LOAN
INTEREST LOSS INTEREST LOSS
INCOME PROVISION INCOME PROVISION
-------- --------- -------- ---------
Mortgage loans $ 16 $ - $ 117 $ -
CMO collateral 398 (23) 741 (47)
Agency-issued MBS 7 - 203 -
Private placement MBS 624 (248) 374 (7)
Other 65 - 217 -
-------- --------- -------- ---------
Total net interest income $ 1,110 $ (271) $ 1,652 $ (54)
======== ========= ======== =========
Net interest income decreased to $1,110,000, or $0.25 per share, for the three
months ended March 31, 2003 from $1,652,000, or $0.38 per share, as previously
reported for the same period in 2002. The decrease in net interest income of
$542,000 was primarily due to:
- the decrease in the average balance 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 interest earned from interest-only notes
retained from our 1998-B securitization offset by the increase in
the average balance of our purchased subordinate MBS portfolio.
During December 2002 and January 2003, we exercised call provisions in our
Hanover 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
$6,400,000 available for reinvestment. We cannot assure you that we will be able
to reinvest these proceeds in a profitable manner.
Net interest income from Agency-issued MBS decreased in the three months ended
March 31, 2003 because we terminated our investment in such MBS in July of 2002.
Private placement MBS net interest income increased due to the purchase of
subordinate MBS during the first quarter 2003. The average balance of our
subordinate MBS portfolio increased to $14,973,000 for the first quarter 2003
from $9,618,000 for the first quarter 2002. 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 due to the collapse of Hanover 1998-B in the three months ended March
31, 2003.
23
On a pro forma basis, net interest income decreased to $1,110,000 for the three
months ended March 31, 2003 from $1,965,000 for the same period in 2002. The
$855,000 decrease is primarily due to trading and Agency-issued MBS activity for
the first quarter 2002; no such activity occurred for the first quarter 2003.
Our provision for loan losses increased to $271,000 in the three months ended
March 31, 2003 from $54,000 for the same period in 2002. The $217,000 increase
was primarily the result of purchases of first-loss subordinate MBS offset by 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.
Gain on Sale and Mark to Market of Mortgage Assets
Our results for the three months ended March 31, 2003 include a gain on sale of
mortgage assets of $3,283,000 compared to $600,000 for the same period in 2002.
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.
The gain on sale for the three months ended March 31, 2003 primarily represents
the sales of mortgage loans that supported certain CMOs, which we refer to as
Hanover 1998-A and Hanover 1998-B. These sales resulted in aggregate net
proceeds of $7,295,000, cash available for reinvestment of approximately
$6,400,000 and a gain of $3,175,000.
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.
For the three months ended March 31, 2002, we recognized mark to market gains or
losses on mortgage assets classified as trading securities 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 $464,000 for the
three months ended March 31, 2002. We did not recognize mark to market gains or
losses for the three months ended March 31, 2003 as all securities were
classified as available for sale. Market gains or losses 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 due diligence increased to $1,319,000 for the three months ended
March 31, 2003 from $0 for the same period in 2002. Revenues from assignment
fees increased to $573,000 for the three months ended March 31, 2003 from $0 for
the same period in 2002. Revenues from technology increased to $885,000 for the
three months ended March 31, 2003 from $0 for the same period in 2002. Revenues
from loan brokering, trading and advisory services increased to $396,000 for the
three months ended March 31, 2003 from $0 for the same period in 2002. 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 due diligence increased to $1,319,000 for
the three months ended March 31, 2003 from $916,000 for the same period in 2002.
Total due diligence revenues increased due to both an increase in our number of
clients and an increase in revenue from our largest clients. On a pro
24
forma basis, revenues from assignment fees increased to $573,000 for the three
months ended March 31, 2003 from $389,000 for the same period in 2002, primarily
because of 1 large assignment contract. This contract accounted for 55% of the
total assignment fees recognized to date in 2003. We cannot assure you that we
will be able to generate assignment fees comparable to those recorded for the
three months ended March 31, 2003. On a pro forma basis, revenues from
technology increased to $885,000 for the three months ended March 31, 2003 from
$22,000 for the same period in 2002. Technology revenue was derived from the
licensing of our proprietary software and consulting services performed in
connection with such licenses. Minimal technology revenue was generated for the
three months ended March 31, 2002. Of the $885,000 of technology revenue
generated for the three months ended March 31, 2003, 84% was sourced from 2
clients. We cannot assure you that we will be able to generate technology
revenue comparable to those recorded for the three months ended March 31, 2003.
On a pro forma basis, revenues from loan brokering, trading and advisory
services decreased to $396,000 for the three months ended March 31, 2003 from
$1,815,000 for the same period in 2002. This decrease is primarily attributable
to revenue derived from a contract with the FDIC substantially completed during
2002. We cannot assure you that comparable contracts will be available in the
future.
Operating Expenses
Operating expenses for the three months ended March 31, 2003 were $4,727,000
compared to $1,046,000 as previously reported for the same period in 2002 and
$4,104,000 on a pro forma basis for the same period in 2002. The biggest
component of the increase, on a pro forma basis, was an increase in
subcontractor expenses. Subcontractor expenses for the three months ended March
31, 2003 increased to $942,000 compared to, on a pro forma basis, $501,000 for
the same period last year. The increase in subcontractor expenses is primarily
due to the increase in the number of due diligence projects in the first quarter
2003 as compared to the same period in 2002. In addition, the mix of due
diligence projects changed to require an increase in the use of subcontractors
for the first quarter 2003 as compared to the first quarter 2002 where in-house
personnel performed more projects.
Equity in Income (Loss) of Unconsolidated Subsidiaries
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
the three months ended March 31, 2003, we recognized equity in losses of $43,000
and for the comparable period in 2002, we recognized equity in losses of
$21,000. During the three months ended March 31, 2003, we received $1,931,000 in
additional distributions from HDMF-I. At March 31, 2003, we had a total capital
contribution commitment of $5,820,000.
TAXABLE INCOME
Our taxable loss for the quarter ended March 31, 2003 is estimated at
$681,000. Taxable loss differs from GAAP net income 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 loss (dollars in
thousands):
GAAP net income $ 2,548
GAAP gain on collapse of Hanover 1998-A and Hanover 1998-B (3,175)
GAAP gain on sale of mortgage securities (108)
Tax gain on collapse of Hanover 1998-A and Hanover 1998-B 2,965
Tax gain on sale of mortgage securities 87
Utilization of capital loss carryforward (3,052)
Deductible expenses relating to collapse of Hanover 1998-A and
Hanover 1998-B (1,867)
Taxable dividend from HCP-2 1,528
Loan loss provision, net of realized losses 261
Loss in subsidiaries not included in taxable income 124
Other 8
-------
Estimated taxable loss $ (681)
=======
We believe that estimated taxable loss provides useful information to investors
because it provides information relating to our dividends and REIT status.
25
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 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. Dividend payments for 2003 may
represent a partial return of capital dividend to shareholders.
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.
LIQUIDITY AND CAPITAL RESOURCES
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 March 31,
2003, we had one committed reverse repurchase line of credit with $10 million
available and six 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 three months ended March 31,
2003 was $4,981,000 compared to net income of $2,548,000 for the same period in
2003. Sales of trading securities provided $3,267,000, partially offset by the
gain on sale of mortgage assets of $3,283,000.
Net cash provided by investing activities amounted to $21,742,000 during the
three months ended March 31, 2003. The majority of cash proceeds from investing
activities was generated from (i) principal payments received on collateral for
CMOs of $8,080,000, (ii) proceeds from sale of mortgage assets of $33,430,000
and (iii) principal payments received on mortgage securities of $272,000. These
proceeds were partially offset by purchase of mortgage securities of
$20,033,000.
Cash flows from financing activities used $18,624,000 during the three months
ended March 31, 2003. We made repayments on CMO borrowings of $33,539,000
partially offset by borrowings on reverse repurchase agreements of $16,729,000.
We also paid dividends of $1,799,000.
We regularly invest our capital in MBS through Hanover, our primary investment
vehicle. 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 certain
percentage of the original collateral balance. During December 2002, Hanover
exercised the call provisions of its 1998-A securitization. In February 2003,
Hanover sold the underlying mortgage loans
26
and realized aggregate net proceeds of $1,365,000. 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
$5,930,000. Cash available for reinvestment from these sales is approximately
$6,400,000.
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.
27
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES 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 March 31, 2003, we had no forward commitments to sell or buy
agency-issued mortgage securities.
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.
At March 31, 2003, 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 March 31, 2003, the fair value of our interest rate caps
was $1,000; also the maximum potential loss exposure due to unfavorable market
movements.
INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repurchase Financing
At March 31, 2003, we owned $410,000 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 March 31, 2003 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.
28
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 March 31, 2003, we had a total of $19,267,000 of floating-rate reverse
repurchase financing for $22,858,000 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 March 31, 2003, 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 1999-A, 1999-B and 2000-A securitizations reflect
$47,699,000 of fixed-rate mortgage loans and $29,204,000 of adjustable-rate
mortgage loans. The primary financing for this asset category is the CMO debt of
$70,174,000 and reverse repurchase agreements of $1,461,000. 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 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 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 March 31, 2003.
Mortgage Securities
At March 31, 2003, we owned certain fixed-rate Agency-issued mortgage securities
and certain fixed-rate and adjustable-rate private placement mortgage securities
with an aggregate carrying value of $29,964,000. The coupon interest rates on
the fixed-rate mortgage securities would not be affected by changes in interest
rates.
29
ITEM 4.CONTROLS AND PROCEDURES
(a) Within the 90 days prior to the filing 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.
30
PART II. OTHER INFORMATION
Item 1. 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 2. Changes in Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
The exhibits listed on the Exhibit Index, which appears immediately
following the signature and certification pages below, are included or
incorporated by reference herein.
(b) Reports on Form 8-K
On May 12, 2003, we furnished on Form 8-K a press release relating to
our financial performance for the first quarter 2003 and other matters.
SIGNATURES
Pursuant to the requirements 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.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By: /s/ John A. Burchett
Dated: May 15, 2003 -------------------------------------
John A. Burchett
President and Chief Executive Officer
Chairman of the Board of Directors
(Principal Executive Officer)
By: /s/ J. Holly Loux
Dated: May 15, 2003 -------------------------------------
J. Holly Loux
Chief Financial Officer
(Principal Financial and
Accounting Officer)
31
CERTIFICATIONS
I, John A. Burchett, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Hanover Capital
Mortgage Holdings, Inc.;
2. Based on my knowledge, this Quarterly 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 Quarterly Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Quarterly 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
Quarterly 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 we 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
Quarterly 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 Quarterly Report (the "Evaluation Date"); and
(c) presented in this Quarterly 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 function):
(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
Quarterly 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: May 15, 2003
/s/ John A. Burchett
-------------------------------------
John A. Burchett
President and Chief Executive Officer
32
CERTIFICATIONS (CONTINUED)
I, J. Holly Loux, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Hanover Capital
Mortgage Holdings, Inc.;
2. Based on my knowledge, this Quarterly 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 Quarterly Report;
3. Based on my knowledge, the financial statements, and other financial
information included in this Quarterly 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
Quarterly 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 we 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
Quarterly 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 Quarterly Report (the "Evaluation Date"); and
(c) presented in this Quarterly 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 function):
(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
Quarterly 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: May 15, 2003
/s/ J. Holly Loux
--------------------------------
J. Holly Loux
Chief Financial Officer
33
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
10.11.3 (10) Stock Purchase Agreement as of December 13, 2002 between
Thomas P. Kaplan and Hanover Capital Mortgage Holdings, Inc.
10.11.4* Stock Purchase Agreement as of March 31, 2003 between John A.
Burchett and Hanover Capital Mortgage Holdings, Inc.
10.11.5* Stock Purchase Agreement as of March 31, 2003 between George
J. Ostendorf 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 (10) Second Modification and Extension of Lease Agreement dated
April 22, 2002
10.13.2 (10) Third Modification of Lease Agreement dated May 8, 2002
10.13.3 (10) 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 (10) 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
10.16* Office Lease Agreement, dated as of July 10, 2002, between 233
Broadway Owners, LLC and Hanover Capital Mortgage Holdings,
Inc.
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 (10) 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 (10) 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.
10.31.4* Amendment Number Seven dated as of April 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 (10) 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.
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
* Filed herewith.
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(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.
(10) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 2002, as filed with the Securities and Exchange
Commission on March 28, 2003.
3