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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number: 001-13417

Hanover Capital Mortgage Holdings, Inc.

(732) 548-0101

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

     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 þ          No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K     o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)     Yes o          No þ

     The aggregate market value of the voting and non-voting common equity held by non-affiliates, based on the price at which the common equity was last sold as of June 30, 2003 was $37,943,264.

     The registrant had 8,228,322 shares of common stock outstanding as of April 6, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s Proxy Statement for the 2004 Annual Stockholders’ Meeting, to be filed within 120 days after the end of registrant’s fiscal year, are incorporated by reference into Part III.

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

FORM 10-K ANNUAL REPORT

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

INDEX

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PART I

This Annual Report on Form 10-K contains, in addition to historical information, forward-looking statements that involve risk and uncertainty. Our actual results could differ significantly from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences include those discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as those discussed elsewhere in this Annual Report on Form 10-K.

General

Hanover Capital Mortgage Holdings, Inc., which we refer to as Hanover, was incorporated in Maryland on June 10, 1997. Hanover is a specialty finance company organized as a real estate investment trust, or REIT, pursuant to the Internal Revenue Code of 1986, as amended, which we refer to as the “Code.” Hanover has two primary subsidiaries: Hanover Capital Partners Ltd., which we refer to as HCP, and HanoverTrade, Inc., which we refer to as HT. When we use the terms “we,” “us,” “our” or “the Company,” we are referring to Hanover together with its consolidated and unconsolidated subsidiaries including HCP and HT.

We are engaged in three principal businesses, which are conducted through our three primary operating units: Hanover, HCP and HT. Hanover’s principal business strategy is to invest in subordinate mortgage-backed securities, which we refer to as MBS, and, to a lesser extent, mortgage loans and to earn net investment income on these investments. HCP’s principal business strategy is to generate non-interest income by providing consulting and advisory services for third parties, including loan sale advisory services, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. HT’s principal business activity is to generate non-interest income by providing loan sale advisory and traditional loan brokerage services, technology solutions and valuation services. HT also brokers loan pools, mortgage servicing rights and other similar assets through an Internet-based exchange. Hanover also maintains an equity investment in HDMF-I LLC, which we refer to as HDMF-I. HDMF-I was formed 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.

Our principal business objective is to generate net interest income on our portfolio of mortgage securities and mortgage loans and to generate non-interest related income through HCP, HT and third party asset-management contracts.

Our principal executive offices are located at 379 Thornall Street, Edison, New Jersey 08837.

Consolidation of Hanover, HCP and HT

Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved by a special committee of disinterested members of our Board of Directors, Hanover acquired 100% of the outstanding common stock of each of HT, HCP and Hanover Capital Partners 2, Inc., which we refer to as HCP-2, a previously inactive subsidiary. Hanover had previously owned 100% of the non-voting preferred stock, but none of the voting common stock, of each of HT, HCP and HCP-2. This ownership structure had been 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, our financial statements reflect the consolidation of the financial statements of Hanover, HCP and HCP-2.

Hanover acquired the common shares of HT, HCP and HCP-2 from four of its directors who are also executive officers for $474,000, the price set by an independent appraiser.

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Hanover

General

Hanover’s primary businesses are (1) to acquire and hold non-investment grade subordinate residential mortgage securities and other mortgage-related assets and, to a lesser extent, whole residential mortgage loans which serve as collateral for collateralized mortgage obligations, which we refer to as CMOs, and (2) to generate non-interest income from its operating subsidiaries. Subordinate MBS are allocated credit losses on the related pool of mortgage loans before senior bonds. In other words, any principal losses in the pool of loans will erode the value of our subordinate interests before any losses accrue to the value of more senior interests in the pool. As a result, these securities bear much greater risk than the more senior tranches and are generally rated below AAA by the major statistical rating organizations, such as Moody’s Investors Service, Standard & Poor’s Ratings Group or Fitch Investor Service.

In a similar manner, when we buy loans, fund them with CMO liabilities and retain subordinate bonds we end up with the credit risk on the pool of loans that are the CMO collateral. We intend in the future to attain our credit risk position by the purchase of subordinate securities and by the acquisition of loans with subsequent CMO securitizations. When we purchase subordinate securities our balance sheet reflects only the amount of our investment but when we purchase loans and subsequently securitize them, under current accounting guidance for transfers accounted for as secured borrowings, the CMO collateral and related CMO liability will be reflected in our balance sheet. Although the balance sheet presentation will be different, the net economic result of attaining our credit risk position, by the purchase of subordinate MBS or securitization, is similar in that we have a credit leveraged position in mortgage assets.

We also act as an outside management company for real estate investment vehicles. In this capacity, we provide asset-management services, including due diligence and administrative responsibilities. Currently, we manage the investments of HDMF-I LLC, an entity that primarily invests in sub- and non-performing one-to-four family residential mortgage loans. Our primary objectives in forming HDMF-I were to earn a profit participation while also earning fee income from the related asset management contract. We are currently negotiating with institutional investors to increase the total capital commitments to HDMF-I, and we also intend to target other opportunities for us to manage assets for third parties under a similar structure; however, there can be no assurances that we will be successful in raising additional funds to manage.

Trends and Recent Developments

Our primary investments are non-investment grade subordinate securities collateralized by prime quality jumbo residential mortgage loans, which we refer to as subordinate MBS. The issuers of these securities consist of banks, mortgage bankers and Wall Street conduits. The subordinate securities we purchase are structured as private placements and are traded by most large Wall Street dealers. The market for subordinate MBS experienced a dramatic increase in volume in 2002 and 2003 as lowered interest rates resulted in record mortgage origination and securitization volumes. Also during the past two years, there has been an increase in the number of subordinate MBS investors. This increased demand has caused prices for subordinate MBS to increase during the past year. For the foreseeable future, we believe that there will be an adequate supply of subordinate MBS available in the market.

One consequence of the historically lower mortgage rates that have prevailed over the past several years has been rapid prepayments on the collateral underlying our subordinate MBS portfolio. Because prepayment principal is generally allocated to bonds senior to the subordinate MBS, our subordinate MBS grow as a percentage of the collateral pool, known as credit deleverage, thereby greatly increasing its market value. We have benefited from this credit deleverage to realize gains when disposing of subordinate MBS that do not meet our credit standards. Our ability to recognize gains and the amount of these gains will depend on future prepayment and interest rates.

An additional trend in the subordinate MBS market is the increased issuance of securities backed by hybrid adjustable rate mortgage loans, known as Hybrid ARMs. Hybrid ARMs are loans that have a fixed coupon rate for a period of between 3 to 10 years after which the coupon rate typically adjusts to either LIBOR or a

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During 2003, we purchased one hundred forty subordinate MBS with an aggregate principal balance of approximately $102,909,000 at a net purchase price of approximately $51,210,000 and we sold forty-nine subordinate MBS with an aggregate principal balance of approximately $37,775,000 at a net sales price of approximately $26,799,000. The sale of subordinate MBS during 2003 was primarily in response to market conditions and, to a lesser extent, asset performance. However, given that we generally intend to hold our assets for the long-term, we do not anticipate that the sale of subordinate MBS will be a recurring source of income for us.

During 2003, we purchased MBS issued by agencies of the Federal government, which we refer to as Agency-issued MBS, with an aggregate principal balance of approximately $46,833,000 at a net purchase price of approximately $48,077,000. During 2003, we sold Agency-issued MBS with an aggregate principal balance of approximately $7,783,000 at a net sales price of approximately $7,840,000.

Current Portfolio Composition

As of December 31, 2003, we had invested:

	•	approximately $58,985,000, or 31.2% of our total assets, in single-family mortgage loans classified as held for sale and collateral for CMOs,
	•	approximately $43,682,000, or 23.1% of our total assets, in single-family subordinate MBS classified as available for sale and
	•	approximately $37,882,000, or 20.0% of our total assets, in Agency-issued MBS.

The composition of mortgage loans and mortgage securities is described in detail in Notes 3 and 4 to our audited consolidated financial statements included in this Annual Report on Form 10-K.

In 2003, we experienced approximately $32,000 of mortgage loan losses on our collateral for CMOs for which we maintain a loan loss allowance. We experienced approximately $298,000 of mortgage loan losses during 2002 on our mortgage loan portfolio. We recorded a provision for anticipated credit losses on our mortgage loan portfolio of approximately $53,000 and approximately $135,000 in 2003 and 2002, respectively.

Generally, we intend to hold the mortgage loans and CMOs on a long-term basis, so that we will earn returns over the lives of the mortgage loans and mortgage securities rather than from sales of the investments. However, we may sell mortgage securities from time to time depending on market conditions and asset or security performance.

Subordinate MBS Purchases

In analyzing subordinate MBS for purchase, we focus primarily on subordinated interests, which we refer to as tranches, in pools of prime residential mortgage loans that do not fit into large conduits sponsored by government agencies such as the Federal National Mortgage Association (“FNMA” or “Fannie Mae”), the Federal Home Loan Mortgage Corporation (“FHLMC”), or the Government National Mortgage Association (“GNMA” or “Ginnie Mae”). Typically, loans fail to qualify for these programs because the principal balance of the mortgages exceeds the maximum amount permissible in a government agency guaranteed MBS.

The subordinate interests that we purchase are generally structured so that they will absorb the credit losses resulting from a specified pool of mortgages. Because these tranches could potentially absorb credit losses, the securities we purchase are generally either not rated or are rated below investment grade (generally “BB,” “B” or non-rated). These tranches are generally purchased at a substantial discount to their principal balance. This discount reflects the potential future losses and, to the extent that actual credit losses are better than forecasted, the discount provides a yield enhancement. A majority of our subordinate MBS acquired to date have paid interest at fixed rates.

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Our senior management determines the amount to be offered for the security using a proprietary stratification and pricing system which focuses on, among other things, rate, term, location, credit scores and types of the loans. We also review information on the local economy and real estate markets (including the amount of time and procedures legally required to foreclose on real property) where the loan collateral is located.

We purchase subordinate MBS primarily from “Wall Street” dealer firms, although we are also attempting to develop direct relationships with the larger issuers of subordinate MBS. For the foreseeable future, we believe that there will be an adequate supply of subordinate MBS available in the market.

We are not dependent on any one source for subordinate MBS investments because there are a number of regular issuers of such securities. Note 5 to our audited consolidated financial statements included in this Annual Report on Form 10-K describes the concentration of our portfolio by issuer. Management believes that the loss of any single financial institution from which we purchase subordinate MBS would not have a significant detrimental effect on us. However, we cannot assure you that increased competition will not have a negative effect on the pricing of such investments.

By examining the mortgage pool loan data, we estimate a prepayment speed based primarily upon the gross coupon rates and seasoning of the subject pool. We also determine a “base case” default scenario and several alternative scenarios that reflect our estimate of the most likely range of potential losses on the underlying mortgage loans, taking into consideration the credit analysis described above.

After determination of a prepayment speed and a base case default scenario, we model the pools’ cash flow stream and calculate a proposed purchase price as the present value of the base case cash flow stream, discounted by the current market rate for securities with similar product type and credit characteristics. We then examine the yield of the security under various alternative default scenarios and prepayment assumptions and, if necessary, adjust the proposed purchase price so that we will receive an acceptable yield under a variety of possible scenarios.

We began purchasing subordinated MBS in 1999. As of December 31, 2003, we had purchased approximately $206,900,000 (principal balance) of subordinate MBS from third parties at an aggregate purchase price of approximately $104,900,000. As of the same date, we had sold approximately $116,909,000 (principal balance) of such securities. As of December 31, 2003, we owned approximately $60,464,000 and approximately $26,145,000 (principal balance) of pledged and not pledged, respectively, subordinate MBS purchased from third parties, representing a subordinate interest in approximately $28.7 billion of single-family mortgage loan pools. The aggregate carrying value of these pledged and not pledged subordinate MBS as of December 31, 2003 was approximately $29,807,000 and approximately $13,875,000, respectively.

Hanover Capital Partners Ltd. — Our Due Diligence and Consulting Operations

Through HCP, we provide due diligence and consulting services for commercial banks, government agencies, mortgage banks, credit unions and insurance companies. The operations consist of loan sale advisory assignments, the underwriting of credit, analysis of loan documentation and collateral, analysis of the operations related to mortgage loans serviced by third party servicers, and the preparation of documentation to facilitate the transfer of mortgage loans. The due diligence analyses are performed on a loan-by-loan basis. Consulting services include loan sale advisory work for governmental agencies such as the Small Business Administration and the Federal Deposit Insurance Corporation as well as private sector financial institutions. HCP also owns a licensed mortgage banker, Hanover Capital Mortgage Corporation, which we refer to as HCMC, and a licensed broker-dealer, Hanover Capital Securities, Inc., which we refer to as HCS. Neither of these companies currently conducts any material ongoing business.

For the year ended December 31, 2003, assignment and due diligence fees accounted for 32% of our total consolidated revenues. For the year ended December 31, 2003, three of HCP’s customers accounted for 57% in the aggregate of its total revenue.

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HanoverTrade, Inc. — Our Loan Brokering, Technology Solutions and Advisory Services

Through HT, we provide loan sale advisory and traditional loan brokerage services, technology solutions and valuation services. We also broker loan pools, mortgage servicing rights and other similar assets through an Internet-based exchange.

In January 2001, HT hired all of the former employees and acquired all of the assets of Pamex Capital Partners, LLC. Prior to its acquisition, Pamex was a traditional broker of pools of mortgage loans and consumer loans. With the acquisition of Pamex, subsequent reassignments and new hires, as of December 31, 2003, HT had 9 full-time salespeople. These salespeople attempt to maintain regular contact with all of the major buyers and sellers of mortgage and consumer whole loans.

HT facilitates the sale of pools of mortgage loans, consumer loans and commercial mortgage loans to institutional purchasers. HT arranges for such sales through its web site as well as through more traditional channels, including telephone contact and e-mail. To assist in the sales process of these pools, HT may prepare marketing materials and marketing analyses for sellers of pools.

For the year ended December 31, 2003, loan brokering and advisory services and technology, taken together, accounted for 20% of our total consolidated revenues. As of and for the year ended December 31, 2003, one of HT’s customers individually accounted for 62% of HT’s total accounts receivable, and one customer accounted for 30% of HT’s total revenues.

Financing

General

We finance purchases of mortgage-related assets with equity and short-term borrowings through reverse repurchase agreements. Generally, upon repayment of each borrowing in the form of a reverse repurchase agreement, the mortgage asset used to secure the financing will immediately be pledged to secure a new reverse repurchase agreement. As of December 31, 2003, we had one established committed reverse repurchase agreement line of credit with maximum capacity to borrow $10 million. In addition, we had seven uncommitted reverse repurchase agreement lines of credit from various financial institutions.

Reverse Repurchase Agreements

A reverse repurchase agreement, although structured as a sale and repurchase obligation, is a financing transaction in which we pledge our mortgage assets as collateral to secure a short-term loan. Generally, the counterparty to the agreement will loan an amount equal to a percentage of the market value of the pledged collateral, ranging from 50% to 97% depending on the credit quality, liquidity and price volatility of the collateral pledged. At the maturity of the reverse repurchase agreement, we repay the loan and reclaim our collateral. Under reverse repurchase agreements, we generally retain the incidents of beneficial ownership, including the right to distributions on the collateral and the right to vote on matters as to which certificate holders vote. If we default on a payment obligation under such agreements, the lending party may liquidate the collateral.

Our borrowings under reverse repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the reverse repurchase agreements without delay in the event that we file for bankruptcy. Furthermore, the special treatment of reverse repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy. Thus, our use of reverse repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.

To reduce our exposure to the credit risk of reverse repurchase agreements, we enter into such arrangements with several different parties. We monitor our exposure to the financial condition of our reverse repurchase lenders on a regular basis, including the percentage of our mortgage securities that are the subject of reverse

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Our reverse repurchase borrowings bear short-term (one year or less) fixed interest rates indexed to LIBOR plus a spread of 40 to 200 basis points depending on the credit of the related mortgage assets. Generally, the borrowing agreements require us to deposit additional collateral or reduce the amount of borrowings in the event the market value of existing collateral declines, which, in dramatically rising interest-rate markets, could require us to pledge additional collateral to the loan, to repay a portion of the borrowings or to sell assets to reduce the borrowings. However, through our Capital Allocation Guidelines (discussed below), we maintain cash and liquidity requirements to attempt to mitigate this risk.

Capital Allocation Guidelines (CAG)

We have adopted capital allocation guidelines, which we refer to as CAG, to strike a balance in our ratio of debt to equity. Modifications to the CAG require the approval of a majority of our Board of Directors. The CAG are intended to keep our leverage balanced by:

	•	matching the amount of leverage to the riskiness (return and liquidity) of each investment; and
	•	monitoring the credit and prepayment performance of each investment to adjust the required capital.

This analysis takes into account our various hedging and other risk-containment programs discussed below.

Lenders generally require us to deduct a minimum fixed percentage, known as a haircut, from the mortgage asset to determine the value of the asset for lending purposes pursuant to our reverse repurchase agreements. There is some variation in haircut levels among lenders from time to time. From the lender’s perspective, the haircut is a cushion to provide additional protection if the value of or cash flow from an asset pool declines. The size of the haircut depends on the liquidity and price volatility of each investment. Agency-issued securities are very liquid, with price volatility in line with the fixed income markets, which means a lender requires a smaller haircut, typically 3%. Alternatively, securities rated below “AAA” and securities not registered with the Securities and Exchange Commission are substantially less liquid, and have more price volatility than agency-issued securities, which results in a lender requiring a larger haircut (typically between 5% and 50%, depending on the rating). Particular securities that are performing below expectations would also typically require a larger haircut. The haircut for residential whole loan pools will generally range between 5% and 20% depending on the documentation and delinquency characteristics of the pool. Certain whole loan pools may have haircuts which may be negotiated with lenders in excess of 20% due to other attributes of the pool, including delinquencies, aging and liens.

Quarterly Valuation Activity

Each quarter, for financial management and accounting purposes, we undertake a valuation activity known as “mark to market.” This process consists of (1) valuing our investments acquired in the secondary market, and (2) valuing our non-security investments, such as retained interests in securitizations. To value our investments acquired in the secondary market, we obtain market quotes from traders who make markets in securities similar in nature to our investments. We calculate the market values of our retained interests in securitizations using market assumptions for losses, prepayments and discount rates and market yields for similar investments.

We subtract the face amount of the financing used for the securities and retained interests from the current market value of the mortgage assets to obtain the current market value of our equity positions. We then compare this value to the required capital as determined by our CAG. If our actual equity falls below the capital required by our guidelines, we must prepare a plan to bring the actual capital above the level required.

Periodically, management reviews and presents to our Board of Directors the results of the CAG compared to actual equity. Management may propose changing the capital required for a class of investments or for an individual investment based on its prepayment and credit performance relative to the market and our ability to predict or hedge the risk of the investments.

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As a result of these procedures, the leverage of the balance sheet will change with the performance of our investments. Good credit or prepayment performance may release equity for purchase of additional investments. Poor credit or prepayment performance may cause additional equity to be allocated to existing investments, forcing a reduction in investments on the balance sheet. In either case, the periodic performance evaluation, along with the corresponding leverage adjustments, is intended to help maintain the maximum acceptable leverage while protecting our capital base. However, our CAG may not successfully achieve these goals.

Risk Management

We believe that our portfolio income is subject to three primary risks: credit risk, interest rate risk and prepayment risk. Although we believe we have developed a cost-effective asset/liability management program to provide a level of protection against credit, interest rate and prepayment risks, no strategy can completely insulate us from the effects of credit risk, interest rate changes, prepayments and defaults by counterparties. Further, certain of the Federal income tax requirements that we must satisfy to qualify as a REIT may limit our ability to fully hedge our risks.

Credit Risk Management

We attempt to reduce credit risk by:

	•	reviewing each subordinate MBS prior to purchase to ensure that it meets our guidelines;
	•	employing early intervention, aggressive collection and loss mitigation techniques;
	•	maintaining appropriate capital and reserve levels; and
	•	obtaining representations and warranties, to the extent possible, from originators and issuers of securities.

We do not set specific geographic diversification requirements, although we do monitor the geographic dispersion of the mortgage loans that we hold or that collateralize the MBS that we own and make decisions on a portfolio-by-portfolio basis about adding to specific concentrations. Concentration in any one geographic area will increase our exposure to the economic and natural hazard risks associated with that area.

In the past, we invested directly in mortgage loans on our own behalf. We generally purchased single-family mortgage loans in bulk pools of $2 million to $100 million. The credit underwriting process varied depending on the pool characteristics, including seasoning, loan-to-value ratios and payment histories. For a new pool of single-family mortgage loans, a full due diligence review was undertaken, including a review of the documentation, appraisal reports and credit underwriting. Where required, an updated property valuation was obtained. The bulk of the work was performed by employees in the due diligence operations of HCP. Depending on market conditions, we might decide to undertake this business activity again in the future.

Prepayment Risk Management

Our senior management monitors prepayment risk through periodic reviews of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.

To the extent that we experience rapid prepayments on the collateral underlying our subordinate MBS, our subordinate MBS grows as a percentage of the collateral pool, thereby increasing its market value.

Interest Rate Risk Management

Interest rate risk management varies depending on the asset class. In general, we attempt to minimize the effect of rising rates through the use forward sales of MBS, interest rate caps and match funding.

Subordinate MBS — Our subordinate MBS portfolio consists of both fixed rate and Hybrid ARM securities. The Hybrid ARM securities have a fixed rate for a period of between 3 to 10 years and then adjust on a periodic basis to a spread above either LIBOR or a U.S. Treasury rate. Rising interest rates may both

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A rise in interest rates may also decrease the market value of the subordinate MBS and thereby cause financing firms to require additional collateral; the risk of our having to meet additional collateral requirements is known as margin risk. Margin risk is managed via our liquidity policy whereby 50% of the financed amount must be held in cash or cash equivalents and by the use of LIBOR caps. A rise in interest rates will generally result in an appreciation in the value of the LIBOR caps, although there is no assurance that the change in the value of the LIBOR caps will equal the change in the value of the subordinate MBS. Additionally, because we have elected to treat the LIBOR caps as freestanding derivatives, the changes in the value of the LIBOR cap must flow through the income statement. This may cause a mismatch in our accounting results as the change in value of the LIBOR cap will be reflected in our income statement while changes in the value of the asset may be reflected as a separate component of stockholders’ equity to the extent such subordinate MBS have been classified as available for sale securities.

CMO Collateral — Hanover has two outstanding CMOs, 1999-A and 1999-B, and a securitization 2000-A that is collateralized by certificates from 1999-A and 1999-B.

In the 1999-A CMO, the mortgage loan collateral is match funded for both maturity and coupon rate via the issuance of term CMO debt with Hanover retaining only the subordinate certificates. The 1999-A subordinate certificate balances totaled approximately $5.1 million as of December 31, 2003.

In the 1999-B CMO, the mortgage loan collateral is match funded on a maturity basis with LIBOR indexed floating rate CMO debt with Hanover retaining only the subordinate certificates. The 1999-B subordinate certificate balances totaled approximately $3.8 million as of December 31, 2003. The mortgage loan collateral for 1999-B is a mixture of both fixed rate and adjustable rate loans with the subordinate certificates receiving the difference between the net coupon on the loans and the CMO debt coupon rate, known as spread. To protect the spread Hanover owns a cap on one month LIBOR with a strike rate of 5% and maturity date of October 2006. The notional amount of the cap is $27 million until October 2004, $23.5 million until October 2005 and $20 million until October 2006. Additionally, because we have elected to treat the LIBOR caps as freestanding derivatives, the changes in the value of the LIBOR cap must flow through the income statement. This may cause a mismatch in our accounting results as the change in value in the hedges will be reflected in the income statement in the current period while changes in the asset value are only reflected in the income statement to the extent their market value declines below their cost.

The retained subordinate certificates from 1999-A and 1999-B constitute the collateral for 2000-A. The 2000-A securitization consists of two groups of certificates, one group backed by fixed rate certificates (Group 1) and the other group backed by variable rate certificates (Group 2). For each group, the 2000-A bonds match the maturity of the underlying certificates but have a floating rate coupon indexed to one month LIBOR. As of December 31, 2003, Hanover retained approximately $1.0 million of Group 1 2000-A subordinate certificate balances and approximately $5.5 million of Group 2 2000-A subordinate certificate balances.

Agency MBS — As of December 31, 2003 we owned approximately $38 million of Fannie Mae whole pool fixed rate MBS. These Agency whole pool MBS are financed by one month repurchase agreements and a liquidity reserve equal to 10% of the financed amount is maintained. To protect against potential losses due to rises in interest rates, we have entered into forward commitments to sell a similar amount of to be announced, which we refer to as TBA, Fannie Mae MBS with the same coupon interest rates as our whole pools.

Costs and Limitations — We believe that we have implemented a cost-effective hedging policy to provide an adequate level of protection against interest rate risks. However, maintaining an effective hedging strategy is

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In addition, hedging involves transaction and other costs, which can increase dramatically as the period covered by the hedge increases and also can increase in periods of rising and fluctuating interest rates. Therefore, we may be prevented from effectively hedging interest rate risks without significantly reducing our return on equity.

Regulation

HCS is a registered broker/ dealer with the Securities and Exchange Commission. During 2002, Pamex Securities, LLC, a wholly-owned subsidiary of HT, withdrew from the Securities and Exchange Commission as a registered broker/ dealer.

Competition

We compete with a variety of institutional investors for the acquisition of mortgage-related assets that we deem attractive. These investors include other REITs, investment banking firms, savings and loan associations, insurance companies, mutual funds, pension funds, banks and other financial institutions that invest in mortgage-related assets and other investment assets. Many of these investors have greater financial resources and access to lower costs of capital than we do. While there is generally a broad supply of liquid mortgage securities for companies like us to purchase, we cannot assure you that we will always be successful in acquiring mortgage-related assets that we deem most suitable for us, because of the number of other investors competing for the purchase of these securities.

Employees

As of December 31, 2003, we had 56 full-time employees. We also utilize the services of subcontractors for our due diligence and consulting operations. To date, we believe we have been successful in our efforts to recruit qualified employees, but there is no assurance that we will continue to be successful in the future. None of our employees are subject to collective bargaining agreements.

Trademarks

HCP owns two trademarks that have been registered with the United States Patent and Trademark Office, both of which are in the process of being renewed. HT owns one registered trademark which expires in 2012 and has two trademarks pending with the United States Patent and Trademark Office. HT also filed a patent application in 2001 in connection with its trading Web site for which patent approval is pending.

Future Revisions in Policies and Strategies

Our Board of Directors has established Hanover’s investment and operating policies, which can be revised only with the approval of the Board of Directors, including a majority of the unaffiliated directors. Except as otherwise restricted, the Board of Directors may revise the policies without the consent of stockholders if the Board of Directors determines that the change is in the best interests of stockholders. Developments in the market which affect the policies and strategies mentioned herein or which change Hanover’s assessment of the market may cause the Board of Directors to revise Hanover’s policies and financing strategies.

Federal Income Tax Considerations

General

We have elected to be treated as a Real Estate Investment Trust, or REIT, for Federal income tax purposes, pursuant to the Code. In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be

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At any time, the Federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations thereof may take effect retroactively and could adversely affect Hanover or its shareholders. Last year Congress enacted legislation that reduced the Federal tax rate on both qualified dividend income and long-term capital gains for individuals to 15% through 2008. Because REITs generally are not subject to corporate income tax, this reduced tax rate does not generally apply to ordinary REIT dividends, which continue to be taxed at the higher tax rates applicable to ordinary income. The 15% tax rate applies to:

	1.	long-term capital gains recognized on the disposition of REIT shares;
	2.	REIT capital gain distributions and a shareholder’s share of a REIT’s undistributed net capital gains (except, in either case, to the extent attributable to real estate depreciation, in which case such distributions will be subject to a 25% tax rate);
	3.	REIT dividends attributable to dividends received by a REIT from non-REIT corporations, such as taxable REIT subsidiaries; and
	4.	REIT dividends attributable to income that was subject to corporate income tax at the REIT level (e.g., to the extent that a REIT distributes less than 100% of its taxable income).

These reduced rates could cause shares in non-REIT corporations to be a relatively more attractive investment to individual investors than shares in REITs. The legislation also could have an adverse effect on the market price of Hanover’s securities.

To qualify for income tax treatment as a REIT under the Code, Hanover must meet certain tests which are described briefly below.

For all taxable years after its first taxable year, Hanover’s shares of capital stock must be held by a minimum of 100 persons for at least 335 days of a 12-month year (or a proportionate part of a short tax year). In addition, at any time during the second half of each taxable year, no more than 50% in value of Hanover’s capital stock may be owned directly or indirectly by five or fewer individuals, taking into account complex attribution of ownership rules. Hanover is required to maintain records regarding the actual and constructive ownership of its shares, and other information, and to demand statements from persons owning above a certain level of its shares regarding their ownership of shares. Hanover must keep a list of those shareholders who fail to reply to such a demand. Hanover is required to use (and does use) the calendar year as its taxable year for income tax reporting purposes.

Nature of Assets

On the last day of each calendar quarter, Hanover must satisfy three tests relating to the nature of its assets. First, at least 75% of the value of Hanover’s assets must consist of real estate mortgage loans, certain interests in real estate mortgage loans, real estate, certain interests in real estate, shares (or transferable certificates of beneficial interest) in another REIT, government securities, cash and cash items (the foregoing, “Qualified REIT Assets”). Hanover expects that substantially all of its assets will continue to be Qualified

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Pursuant to its compliance guidelines, Hanover intends to monitor closely the purchase and holding of its assets in order to comply with the above asset tests.

Sources of Income

Hanover must meet the following two separate income-based tests each year:

	1. 75% INCOME TEST. At least 75% of Hanover’s gross income for the taxable year must be derived from certain real estate sources including interest on obligations secured by mortgages on real property or interests in real property. Certain temporary investment income will also qualify under the 75% income test. The investments that Hanover has made and expects to continue to make will give rise primarily to mortgage interest qualifying under the 75% income test.
	2. 95% INCOME TEST. In addition to deriving 75% of its gross income from the sources listed above, at least an additional 20% of Hanover’s gross income for the taxable year must be derived from those sources, or from dividends, interest or gains from the sale or disposition of stock or other securities that are not dealer property. Hanover intends to limit substantially all of the assets that it acquires to assets that can be expected to produce income that qualifies under the 75% Income Test. Hanover’s policy to maintain REIT status may limit the types of assets, including hedging contracts and other securities, that Hanover otherwise might acquire.

Distributions

Hanover must distribute to its shareholders on a pro rata basis each year an amount equal to at least (i) 90% of its taxable income before deduction of dividends paid and excluding net capital gains, plus (ii) 90% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code, less (iii) certain “excess noncash income.” Hanover intends to make distributions to its shareholders in sufficient amounts to meet this 90% distribution requirement.

If it fails to distribute to its shareholders with respect to each calendar year at least the sum of (i) 85% of its REIT ordinary income of the year, (ii) 95% of its REIT capital gain net income for the year, and (iii) any undistributed taxable income from prior years, Hanover will be subject to a 4% excise tax on the excess of the required distribution over the amounts actually distributed.

State Income Taxation

Hanover files corporate income tax returns in various states. These states treat the income of a REIT in a similar manner as for Federal income tax purposes. Certain state income tax laws with respect to REITs are not necessarily the same as Federal law. Thus, differences in state income taxation as compared to Federal income taxation may exist in the future.

Taxation of Hanover’s Shareholders

For any taxable year in which Hanover is treated as a REIT for Federal income tax purposes, amounts distributed by Hanover to its shareholders out of current or accumulated earnings and profits will be

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Any loss on the sale or exchange of shares of Hanover’s common stock held by a shareholder for six months or less will be treated as a long-term capital loss to the extent of any capital gain dividends received (or undistributed capital gain included) with respect to the common stock held by such shareholder.

If Hanover makes distributions to its shareholders in excess of its current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a shareholder’s shares until the tax basis is zero. Such distributions in excess of the tax basis will be taxable as gain realized from the sale of Hanover’s shares. Hanover will withhold 30% of dividend distributions to shareholders that Hanover knows to be foreign persons unless the shareholder provides Hanover with a properly completed IRS form claiming a reduced withholding rate under an applicable income tax treaty.

In general, dividend income that a tax-exempt entity receives from Hanover should not constitute unrelated business or trade income, or UBTI, as defined in Section 512 of the Code. If, however, Hanover realizes excess inclusion income and allocates it to stockholders, this income cannot be offset by net operating losses. If the stockholder is a tax-exempt entity, then this income would be fully taxable as UBTI under Section 512 of the Code. If the stockholder is foreign, then it would be subject to Federal income tax withholding on this income without reduction pursuant to any otherwise applicable income tax treaty. Excess inclusion income would be generated if Hanover were to issue debt obligations with two or more maturities and the terms of the payments on these obligations bore a relationship to the payments received on the mortgage-related assets securing those debt obligations. Hanover’s borrowing arrangements are generally structured in a manner designed to avoid generating significant amounts of excess inclusion income. Hanover does, however, enter into various reverse repurchase agreements that have differing maturity dates and afford the lender the right to sell any pledged mortgage securities upon default. The IRS may determine that these borrowings give rise to excess inclusion income that should be allocated among stockholders. Furthermore, some types of tax-exempt entities, including, without limitation, voluntary employee benefit associations and entities that have borrowed funds to acquire their shares of Hanover common stock, may be required to treat a portion or all of the dividends they may receive from Hanover as UBTI. Hanover believes that its shares of stock will be treated as publicly offered securities under the plan asset rules of the Employment Retirement Income Security Act (“ERISA”) for Qualified Plans. However, in the future, Hanover may hold REMIC residual interests that would be treated as UBTI for pension plans and other tax exempt entities.

An error was made in the computation of the tax components of Hanover’s distributions to its shareholders for each of the years ended 2001, 2002 and 2003. The error related to the computation of Hanover’s tax earnings and profits for those years and had the effect of overstating the return of capital component of Hanover’s distributions and correspondingly understating the dividend component. In order to address the error in these calculations, for 2003, Hanover has prepared corrected Forms 1099-DIV and has distributed those corrected Forms 1099-DIV to its shareholders. With respect to tax years 2001 and 2002, Hanover is in the process of preparing corrected Forms 1099-DIV and will provide those to its 2001 and 2002 shareholders once they are completed. As a result of this error, the IRS may assess penalties against us for delivering

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The provisions of the Code are highly technical and complex and are subject to amendment and interpretation from time to time. This summary is not intended to be a detailed discussion of all applicable provisions of the Code, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. Hanover has not obtained a ruling from the Internal Revenue Service with respect to tax considerations relevant to its organization or operations.

Our operations are conducted in several leased office facilities throughout the United States. A summary of the office leases is shown below (dollars in thousands):

We believe that these facilities are adequate for our foreseeable office space needs and that lease renewals and/or alternate space at comparable rental rates are available, if necessary. During the normal course of our business, additional facilities may be required to accommodate growth.

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 and our legal counsel, is likely to have a material adverse effect on our business, financial condition or results of operations.

Not applicable.

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PART II

Our common stock trades on the American Stock Exchange under the symbol “HCM.” As of April 6, 2004, there were 71 record holders, and approximately 7,703 beneficial owners, of our common stock.

The following tables set forth, for the periods indicated, the high and low sales prices for our common stock as reported by the American Stock Exchange:

The following table lists the cash dividends we declared on each share of our common stock based on our earnings for the periods indicated:

(1)	In respect of 2003 earnings, and declared, paid and taxable in the first quarter of 2004.
(2)	In respect of 2002 earnings, and declared, paid and taxable in the first quarter of 2003.

We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our taxable income in each year to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant.

Information about our equity compensation plans required by this Item is set forth in our definitive Proxy Statement for the 2004 Annual Meeting of Stockholders and is incorporated by reference herein.

On July 1, 2002, we cancelled outstanding options that had been issued under our 1997 Executive and Non-Employee Stock Option Plan in connection with our initial public offering. The cancelled options had an exercise price of $15.75 per share, were exercisable for an aggregate of 80,160 shares of our common stock, and were subject to vest based on our achievement of certain performance targets based on increases in the market value of our common stock over our initial offering price. None of the targets were met within the available vesting period, so none of the original options ever vested. To replace these cancelled options we granted new options, exercisable for an aggregate of 80,160 shares of our common stock at an exercise price

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The following selected financial data are derived from our audited consolidated financial statements for the year ended December 31, 2003, 2002, 2001, 2000 and 1999. The selected financial data should be read in conjunction with the more detailed information contained in our Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K (dollars in thousands, except per share data):

Statement Of Operations Highlights

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Balance Sheet Highlights

(1)	As restated, See Note 21 to consolidated financial statements included in Item 8.

Important Factors Related to Forward-Looking Statements and Associated Risks

The following section, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” should be read in conjunction with the financial statements, related notes, and other detailed information included elsewhere in this Annual Report on Form 10-K. This report contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent our current expectations, intentions or beliefs regarding future events or trends, including, without limitation, statements containing the words “believes,” “anticipates,” “expects,” “intends,” “assumes,” “will,” or other similar expressions; and also including, without limitation, the following: our business strategy; market trends and risks; statements regarding our continuing ability to target, price and acquire MBS or mortgage loans; our ability to manage and hedge the risks associated with our investments; assumptions regarding interest rates and their effect on our hedging strategies; assumptions regarding prepayment and default rates on the mortgage loans securing our MBS and their effect on our hedging strategies; our decision to invest in higher-risk subordinated tranches; the liquidity of our portfolios and our ability to invest currently liquid assets; the expected future performance of Hanover Capital Partners and HanoverTrade and their need for additional capital; continuing availability of reverse repurchase agreement financing or other financing; the sufficiency of our working capital, cash flows and financing to support our future operating and capital requirements; results of operations and overall financial performance; the expected dividend distribution rate; our ability to enter into additional asset management contracts with third parties; the adequacy of our leased office space; our ability to locate additional funds for HDMF-I; our expectations regarding the effects of accounting rules and changes thereto; changes in government regulations affecting our business; and the expected tax treatment of our operations. Such forward-looking statements relate to future events and our future financial performance and involve known and unknown risks, uncertainties and other important factors, many of which are beyond our control, which could cause actual results, performance or achievements to differ materially from those expressed or implied by such forward-looking statements.

In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this report should not be regarded as a representation by us or any other person

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Overview

We are a specialty finance company organized in June 1997 as a REIT. As of December 31, 2003, we had two principal consolidated subsidiaries, HCP and HT.

Hanover’s principal business strategy is to invest in subordinate 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 non-interest 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 non-interest income by providing loan sale advisory and traditional loan brokerage services, technology solutions and valuation services. HT also brokers loan pools, mortgage servicing rights and other similar assets through an Internet-based exchange. 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.

Subordinate MBS

Our primary source of net revenue generation is our subordinate MBS portfolio. The performance of our portfolio is impacted by both by the level and movement in interest rates, and by the credit performance of the loans backing the securities.

Interest Rate Influence on the Portfolio

Our portfolio benefited from the relatively low level of interest rates in 2003 in two ways. First, lower interest rates were a primary cause of generally higher prepayment rates on the mortgage loans underlying MBS. Prepayments of the loans that back the subordinate MBS result in a de-leveraging of the credit position of the subordinate bonds. This is due to the fact that in general, prepayments in the early life of a security go to pay down the most senior bonds in the structure. As long as the credit level of the remaining loans remains

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To the extent that interest rates in general increase in 2004 the amount of any potential gains will decrease as a result of the increased rates, which would normally lead to slower prepayments and thus less de-levering of the subordinate bonds.

The second impact of lower rates is the increased interest margin earned on our portfolio of subordinate bonds when leveraged with short-term borrowings. To the extent that short-term rates increase in 2004 and the interest rate on the subordinate bonds remain constant, the net interest margin would decrease in 2004. The amount of the decrease in net interest margin will be mitigated to some extent, and capped as to amount, due to the hedging position held in the form of interest rate caps. These caps limit the increase in cost due to short-term interest rate increases by paying us when rates exceed the strike rate on the interest rate cap.

A third impact of lower rates and higher pre-payments is the availability of new subordinate bonds for purchase in the market. In 2003, due to a record high level of residential mortgage activity, there was an ample supply of new subordinate bonds in the market. While increasing rates and the resulting slower pre-payments will slow the production on new subordinate bonds, we feel there will be enough supply to meet our needs in the market.

Credit Performance

The subordinate bonds also benefited from low levels of credit loss in 2003. This was due both to the low level of delinquencies and losses in the general residential mortgage market as well as from our active credit management of our portfolio. To the extent that credit losses on the subordinate bonds increase in 2004, the performance of the bonds will decrease. The mortgages that back the subordinate MBS are of prime quality based on several attributes of the mortgages such as the credit score of the borrower, the loan to value ratio of the loans, the lien position of the loans, the purpose of the mortgage and the size of the loans. The generally strong housing market that showed continued increases in housing prices, combined with the credit quality of the loans underlying the subordinate MBS, led to the low rate of credit losses on our portfolio. To the extent that the housing markets have a lower rate of increase or a decrease in housing prices, it would be expected that in general there will be a higher level of credit losses on mortgage loans. This will be offset somewhat in the subordinate MBS portfolio due to both our active credit management and due to the prime quality of the loans underlying the subordinate MBS.

Mortgages Held As Collateral for CMOs

Mortgages held as collateral for CMOs declined significantly in 2003 in size as a result of high pre-payments on the loans and as a result of calling two of the securities: 1998-A and 1998-B. The calling of the two securities also generated a significant gain as the mortgages obtained from calling the securities were sold at a profit. These loans generated a profit due to the fact that the loans obtained had higher interest rates than the market at the time of sale thus generating a premium price for these loans in the sale. This price exceeded the value of the loans as carried on our books.

In 2004, the three remaining securities we created, 1999-A, 1999-B, and 2000-A may be eligible to be called depending upon the prepayment rates on the loans underlying these securities. Any gains generated from a call and subsequent sale of the loans will depend on the quality of the loans as well as the interest rates on the loans and prevailing market interest rates at the time of the sale.

The Company is also currently looking to create more assets of this type in 2004. To the extent that new issues of CMOs can be accomplished with returns and risks acceptable to the Company they will be done in 2004.

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Agency MBS

We hold Agency MBS primarily to meet regulatory requirements to maintain a certain amount of whole pool mortgage loans on our balance sheet. Agency MBS are an alternative to holding either whole loans (not securitized) or Mortgages held as Collateral for CMOs. The policy for holding Agency MBS for these requirements is to hedge the risk of ownership as much as possible. In general we will sell forward (or short) an equal amount of Agency MBS to protect our asset position against price movements. In 2003 we held Agency MBS to meet these requirements.

In 2004, we expect to issue one or more CMO securitizations that will meet the requirements now filled by the Agency MBS. The size of the Agency MBS portfolio held during 2004 will depend both on our overall size and our ability to issue CMOs.

Subsidiary Operating Results

We have two wholly owned operating subsidiaries, HCP and HT. These subsidiaries provide two functions for the Company. They provide operational support, technology, market contacts, and information to the Company, which are important to the successful investing activities of the Company. In addition these subsidiaries provide non-interest income to the Company from third party customers. In 2003 these subsidiaries contributed a significant amount in revenue to the Company. To the extent that the Company raises significant new equity capital (see below), the relative impact of the financial results of the subsidiaries will be reduced, while the company will still have the benefits that accrue to its investment operations.

Financing and Capital Activities

Financing

We used outside financing to support our balance sheet assets in 2003 as described below:

Subordinate MBS

We used reverse repurchase agreements (“Repos”) to leverage our subordinate MBS portfolio. This leverage is used to enhance the yield on the portfolio. We maintained a high level of liquidity against these borrowings in 2003 as required by our policies. We also purchase interest rate caps to partially protect against increases in our borrowing costs as rates increase. We expect to continue to follow these same policies in 2004.

CMO Borrowing

In 2003 the borrowing under the CMO securitizations was generally matched in term and tenor to the related asset on the balance sheet. Due to this matching we did not have a need to hold a liquidity reserve against these borrowings or to hedge these borrowings against changes in interest rates. To the extent that we issue CMOs in 2004, we will follow the same policies.

Agency MBS

We borrowed using Repos to support our Agency MBS position in 2003. A smaller percentage of the borrowings was held as liquidity with respect to this position as a result of the structure of the position and the hedge on the position. If rates were to change significantly or financing became hard to achieve, we have the ability to close out both sides of the transaction with little or no earnings impact. To the extent we hold Agency MBS in 2004, we will follow the same policies.

Capital Activities

We executed a secondary stock offering in 2003, raising a net of approximately $31,500,000. These new funds were primarily used to purchase subordinate MBS.

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Administration

The Company, as part of its continued growth, added two key senior positions in 2003. A new function of Human Resources was created and staffed with the Head of that Department. This function had previously been spread over several employees in the Company. The Company also added a Senior Vice President to staff a new Operations Department. The functions in this new department had also previously been spread over several employees. In 2004 the Company plans to add a Planning, Budgeting and Reporting Department. These functions are currently accomplished by the Accounting Department.

Critical Accounting Policies

The significant accounting policies used in preparation of our financial statements are more fully described in Note 2 to our consolidated financial statements. Certain critical accounting policies are complex and involve significant judgment by our management, including the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. As a result, changes in these estimates and assumptions could significantly affect our financial position or our results of operations. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We believe that of our significant accounting policies, the following involve a high degree of judgment and complexity in the preparation of our consolidated financial statements:

Mortgage Securities — Our mortgage securities are designated as either available for sale, trading or held to maturity. Mortgage securities designated as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity. Mortgage securities designated as trading are reported at estimated fair value. Gains and losses resulting from changes in fair value are recorded as income or expense and included in earnings. Mortgage securities classified as held to maturity are carried at amortized cost unless a decline in value is deemed other-than-temporary, in which case the carrying value is reduced. Because our assets are generally not traded on a national securities exchange or national automated quotation system and prices are therefore not readily ascertainable, complex cash flow modeling is performed in determining their estimated fair value. Several of the assumptions used by management are confirmed by independent third parties on at least a quarterly basis. In using cash-flow analysis to determine fair value, future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields, delinquency of the underlying loans and estimated probable losses based on historical experience and estimates of expected future performance. As a result, a high degree of judgment is required in estimating the assumptions used in the cash flow analysis. Assumptions are reviewed in light of market expectations adjusted for our experience. Such assumptions directly impact the fair values of our securities and their effective yields. To the extent that management’s assumptions do not reflect market expectations, the value of our portfolio may be adversely impacted.

Revenue Recognition — We recognize revenue from due diligence contracts in progress and long-term technology consulting contracts as they are earned. To calculate what percentage of the total revenue of a contract has been earned, management must make estimates. As the majority of these revenues relate to services performed, such estimates may include the amount of time spent by individuals in consideration of the aggregate amount of time required to complete the contract, the evaluation of both quantitative and qualitative criteria as agreed to and maintained in the contract and possibly regulations set forth by the government should the contract be with an agency of the Federal government.

HT recognizes revenues from loan brokering and advisory services when the transactions close and fund, at which time fees are earned. At the time of closing a transaction, the number of loans, loan principal balance and purchase price in the transaction are agreed upon, documentation is signed and the sale is funded.

Results of Operations

In our description of financial results presented below, we use the term “CMO” to refer to collateralized mortgage obligations, in which financing is obtained in exchange for a pledge of mortgages, or pools of mortgages, as collateral. We use the term “MBS” to refer to mortgage-backed securities.

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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 equity method investees.” Due to the stock purchase, for periods ending after June 30, 2002, Hanover’s financial statements are 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 reported 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” unaudited financial results provide financial information for the periods shown as if the stock purchase of HT, HCP and HCP-2 had been completed as of January 1, 2001 for statement of income purposes. All future references to pro forma information relates to unaudited financial results that are presented for illustrative purposes only. Pro forma unaudited financial information is not necessarily indicative of the financial position or results of operations that would have been reported had the acquisition occurred on January 1, 2001, and these presentations do not necessarily indicate the future financial position or results of operations.

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The following table presents the consolidated results of operations as previously reported for 2002 and 2001 and pro forma unaudited results for 2002 and 2001 (dollars in thousands):

Net Income, Diluted Earnings Per Share and Total Revenue

We recorded net income of approximately $8,040,000 or $1.35 per share based on 5,943,962 weighted average shares of common stock outstanding for 2003 compared to net income of $5,138,000 or $1.15 per share based on 4,480,744 weighted average common shares outstanding for 2002, and net income of $3,160,000 or $0.73 per share based on 4,310,632 weighted shares of common stock outstanding for 2001. Total revenue for 2003 was $30,917,000, compared to $15,755,000 previously reported for 2002 and $10,065,000 for 2001. On a pro forma basis, total revenue for the 2002 period was $22,937,000, while total revenue for the 2001 period was $19,058,000.

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Net Interest Income

The following table reflects the average balances for each major category of our interest earning assets as well as our interest bearing liabilities with the corresponding effective yields and rates of interest as follows (dollars in thousands):

Interest Earning Assets and Related Liabilities

(1)	Loan loss provisions are included in such calculations.
(2)	Yield on net interest earning assets is computed by dividing the applicable net interest income after loan loss provision by the average daily balance of net interest earning assets.

Mortgage loans held for sale have been a small component of our portfolio over the past three years. To the extent that a CMO securitization is in process this category could have a temporary increase in future periods. The CMO collateral has shown a rapid decline over the past periods as a result of high pre-payments and the calling of two of our securities. In the future, this asset will increase to the extent new CMOs are formed while the existing balances would be expected to decline due to pre-payments and future calls of existing securities. The Agency-issued MBS portfolio declined in 2002 from 2001 as a result of a change in strategy in trading these assets. The portfolio grew in 2003 over 2002 as the result of the need for whole pool assets on the balance sheet. Agency-issued MBS will increase or decrease in the future as a result of the need for whole pool assets.

The interest bearing liabilities, in general, increase or decrease as a result of changes in the related assets. This trend is expected to continue in the future.

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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