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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-K

Commission file number: 001-13417

Hanover Capital Mortgage Holdings, Inc.

(Exact name of registrant as specified in its charter)

(732) 548-0101

(Registrant’s telephone number, including area code)

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

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

None

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes 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 þ          No o

     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, 2004, was $96,765,067.

     The registrant had 8,381,583 shares of common stock outstanding as of March 25, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s Proxy Statement for the 2005 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days after the end of registrant’s fiscal year, are incorporated by reference into Part III.

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HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

FORM 10-K ANNUAL REPORT

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

INDEX

PART I

This Annual Report on Form 10-K contains, in addition to historical information, forward-looking statements that involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements to differ materially from future results, performance or achievements. 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 operating subsidiaries: Hanover Capital Partners Ltd., which we refer to as “HCP”, and HanoverTrade, Inc., which we refer to as “HT”. When we use the terms “we”, “us”, “our” or “the Company”, we are referring to Hanover together with its consolidated 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 is to generate interest income by investing in subordinate mortgage-backed securities, which we refer to as “Subordinate MBS”, and loans that collateralize mortgage-backed securities, which we refer to as “Mortgage Loans”. We also maintain a portfolio of whole pool Fannie Mae and Freddie Mac mortgage-backed securities, which we refer to as “Agency MBS”, to satisfy certain Investment Company Act of 1940 requirements. HCP’s principal business strategy is to generate non-interest income by providing consulting and outsourcing services, which we refer to as “COS”, for third parties in the mortgage industry, including 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 services, which we refer to as “LSA”, and technology solutions for third parties in the mortgage industry. We also maintain 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 executive offices are located at 379 Thornall Street, Edison, New Jersey 08837.

Consolidation of Hanover’s Subsidiaries

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 HCP, HT 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 HCP, HT 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 HCP, HT and HCP-2 and operate under new rules permitting REITs to wholly own subsidiaries such as HCP, HT and HCP-2. Therefore, as of July 1, 2002, Hanover owns 100% of the outstanding common stock of each of HCP, HT and HCP-2, and for periods ending after June 30, 2002, our financial statements reflect the consolidation of the financial statements of Hanover, HCP, HT and HCP-2.

Accordingly, throughout this Annual Report on Form 10-K, we may refer to pro forma results of operations for 2002. Pro forma unaudited results of operations provide financial information for 2002 as if the stock purchase of HCP, HT and HCP-2 had been completed as of January 1, 2002.

Hanover

General

Our primary business objectives are (1) to generate interest income from investments in Subordinate MBS and Mortgage Loans and (2) to generate non-interest income from our operating subsidiaries, HCP and HT. We also maintain a portfolio of Agency MBS to satisfy certain Investment Company Act of 1940 requirements. Subordinate MBS are allocated credit losses on the related pool of mortgage loans before the more senior bonds of the same pool. 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 securities 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 Mortgage Loans, fund them with collateralized mortgage obligations, which we refer to as “CMOs”, 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 MBS and by the acquisition of Mortgage Loans with subsequent CMO securitizations. When we purchase Subordinate MBS our balance sheet reflects only the amount of our investment but when we purchase Mortgage 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 either Subordinate MBS or Mortgage Loans with subsequent securitization, is similar in that we have a credit leveraged position in mortgage assets.

During 2004, we purchased Subordinate MBS with an aggregate principal balance of $122.4 million at a net purchase price of $77.3 million, and we sold Subordinate MBS with an aggregate principal balance of $119.6 million at a net sales price of $75.7 million. The sale of Subordinate MBS during 2004 was primarily in response to market conditions and, to a lesser extent, asset performance. However, because 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 2004, we purchased Agency MBS with an aggregate principal balance of $79.9 million at a net purchase price of $80.1 million.

We also act as an outside management company for real estate investment funds. In this capacity, we provide asset-management services, including due diligence and administrative responsibilities. Currently, we manage the investments of HDMF-I, 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 in discussions with institutional investors to increase the total capital commitments to HDMF-I. 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.

Current Portfolio Composition

As of December 31, 2004, we had invested, in aggregate carrying value:

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.

Subordinate MBS Purchases

In analyzing Subordinate MBS for purchase, we focus primarily on the lower-rated credit sensitive securities collateralized by pools of prime residential mortgage loans that do not fit into large conduits sponsored by government agencies such as Fannie Mae, Freddie Mac, or the Government National Mortgage Association, commonly referred to as “Ginnie Mae”. Typically, the loans in our Subordinate MBS fail to qualify for these programs because the original principal balance of the mortgage loans exceeds the maximum amount permissible for government agency guaranteed mortgage-backed securities.

The Subordinate MBS that we purchase are generally structured so that they will absorb the credit losses resulting from a specified pool of mortgage loans. As these securities could potentially absorb credit losses, the securities we purchase are generally either not rated or rated below investment grade (generally “BB”, “B” or Non-rated). These securities 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 less than forecasted, the discount provides a yield enhancement.

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 provides 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.

After determination of a prepayment speed and a base case default scenario, we model the pool’s 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.

As of December 31, 2004, we owned $87.5 million in principal balance of Subordinate MBS representing a subordinate interest in an aggregate of approximately $13.7 billion one-to-four family residential mortgage loan pools. The aggregate carrying value of these Subordinate MBS as of December 31, 2004 was $54.3 million.

Hanover Capital Partners Ltd. — Our Consulting and Outsourcing Services

Through our COS operations we provide services to commercial banks, mortgage banks, government agencies, credit unions and insurance companies. Our services provided include:

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.

HanoverTrade, Inc. — Our Loan Sale Advisory (LSA) and Technology Solutions

HT generates income by providing LSA services and technology software solutions to the mortgage industry.

Our LSA operations earn fees by providing brokerage, asset valuation and consulting services. Our brokerage service integrates varying degrees of traditional voice brokerage conducted primarily by telephone, web-enhanced brokerage and online auction hosting. We also perform market price valuations for a variety of loan products and offer consulting advice on loan product pricing and business strategies.

We earn licensing and related servicing fees by licensing our proprietary software applications to the financial industry. We market web-based technology solutions to meet specific needs of the mortgage industry in the secure transmission, analysis, valuation, tracking and stratification of loan portfolios. The software technology is licensed to government agencies and financial institutions that originate and/or trade financial assets. We also use the applications to provide servicing rights valuations to clients who do not license our software.

Financing — Repurchase Agreements

We finance purchases of mortgage-related assets with equity and short-term borrowings through agreements where we have sold the mortgage-related asset with a commitment to repurchase the asset at a later date. We call these agreements “Repurchase Agreements”. Generally, upon repayment of each borrowing, the mortgage asset used to secure the borrowing will immediately be pledged to secure a new Repurchase Agreement. As of December 31, 2004, we had one established committed Repurchase Agreement line of credit with a maximum capacity to borrow of $20 million. In addition, we had nine uncommitted Repurchase Agreement lines of credit from various financial institutions.

A Repurchase Agreement, although structured as a sale and repurchase obligation, is a financing transaction in which we pledge our mortgage-related 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 Repurchase Agreement, we repay the loan and reclaim our collateral or enter into a new Repurchase Agreement. Under 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 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 Repurchase Agreements without delay in the event that we file for bankruptcy. Furthermore, the special treatment of 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 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 Repurchase Agreements, we enter into such arrangements with several different counterparties. We monitor our exposure to the financial condition of our Repurchase Agreement lenders on a regular basis, including the percentage of our mortgage securities that are the subject of Repurchase Agreements with a single lender. Notwithstanding these measures, we cannot assure you that we will be able to avoid such third party risks.

Our Repurchase Agreement borrowings bear short-term (one year or less) fixed interest rates indexed to the London Interbank Offered Rate Index, often referred to as “LIBOR”, plus a margin of up to 200 basis points depending on the credit of the mortgage-related assets. Generally, the Repurchase 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 liquidity guidelines (discussed below), we maintain a cash and liquidity position 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:

This analysis takes into account our various economic 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-related asset to determine the value of the mortgage-related asset for lending purposes pursuant to our 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 our cash flow from an asset pool declines. The size of the haircut depends on the liquidity and price volatility of each investment. Agency MBS 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 MBS, 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 one-to-four family residential mortgage loans will generally range between 5% and 20% depending on the documentation and delinquency characteristics of the pool. Certain mortgage loans 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 security investments and (2) valuing our non-security investments, such as retained interests in securitizations. We value our Subordinate MBS investments at the lower of (a) market quotes obtained from traders who make markets in securities similar in nature to our investments or (b) internal valuations. We obtain the value of our Mortgage Loans and related CMO financing and Agency MBS by using third party valuations.

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 and have the plan approved by the Board of Directors.

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 economically hedge the risk of the investments.

As a result of these procedures, the leverage of our 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 (including counterparty 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 and prepayments. 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 on our mortgage assets by:

We do not set specific geographic diversification requirements, although we do monitor the geographic dispersion of the Mortgage Loans and Subordinate MBS to make decisions about adding to or reducing specific concentrations. Concentration in any one geographic area will increase our exposure to the economic and natural hazard risks associated with that area.

When we purchase Mortgage Loans, the credit underwriting process varies depending on the pool characteristics, including seasoning, loan-to-value ratios and payment histories. For a new pool of single-family mortgage loans, a full due diligence review is undertaken, including a review of the documentation, appraisal reports and credit underwriting. Where required, an updated property valuation is obtained. The majority of the work is performed by employees in our COS operations.

In addition to mortgage credit risk, we are also subject to counterparty risk. We attempt to reduce counterparty risk by periodically evaluating the credit worthiness of Subordinate MBS and Repurchase Agreement counterparties.

Prepayment Risk Management

We monitor 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.

Interest Rate Risk Management

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

Subordinate MBS — Our Subordinate MBS portfolio consists of both fixed-rate and adjustable-rate securities. Rising interest rates may both decrease the market value of the Subordinate MBS and increase the cost of Repurchase Agreement financing. In response to increasing short-term interest rates, we have adjusted the asset allocation in our portfolio so that as of December 31, 2004, approximately 51% of our Subordinate

MBS portfolio has interest rates that reset on a monthly basis to one-month LIBOR plus an interest rate margin. We also manage the risk of rising interest rates through the purchase of long-term, out-of-the-money, one-month LIBOR interest rate caps. Increases in one-month LIBOR will decrease our net interest spread until one-month LIBOR reaches the cap strike rate. Once one-month LIBOR is at or above the cap rate, the cap will pay us, on a monthly basis, the difference between the current one-month LIBOR rate and the cap strike rate. We currently own a $20 million cap on one-month LIBOR with a 6% strike rate and a maturity date of November 2008 that we economically associate with our Subordinate MBS portfolio. The amount of the one-month LIBOR cap is determined via analysis of current and projected financing amounts.

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 a percentage of the financed amount must be held in cash or cash equivalents, and by the use of one-month LIBOR caps. A rise in interest rates will generally result in an appreciation in the value of the one-month LIBOR caps, although there is no assurance that the change in the value of the one-month LIBOR caps will equal the change in the value of the Subordinate MBS. Additionally, because we have elected to treat the one-month LIBOR caps as freestanding derivatives, the changes in the value of the one-month LIBOR caps must flow through our income statement. This may cause a mismatch in our accounting results as the change in value of the one-month LIBOR caps 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.

Mortgage Loans — Our Mortgage Loans collateralize two outstanding CMOs, which we refer to as 1999-A and 1999-B, and a securitization which we refer to as 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. As of December 31, 2004, the 1999-A subordinate certificate balances totaled $4.6 million.

In the 1999-B CMO, the Mortgage Loan collateral is match funded on a maturity basis with one-month LIBOR indexed floating rate CMO debt with Hanover retaining only the subordinate certificates. As of December 31, 2004, the 1999-B subordinate certificate balances totaled $3.4 million. 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 we own a cap on one-month LIBOR with a strike rate of 5% and maturity date of October 2006 which we economically associate with our Mortgage Loan portfolio. The notional amount of the cap is $23.5 million until October 2005 and $20 million until October 2006. As we have elected to treat the one-month LIBOR cap as a freestanding derivative, the change in the value of the one-month LIBOR cap must flow through our income statement. This may cause a mismatch in our accounting results as the change in value of the one-month LIBOR cap will be reflected in our income statement while changes in the value of the asset may be reflected in our income statement to the extent its market value declines below its cost.

The retained subordinate certificates from our 1999-A and 1999-B CMOs constitute the collateral for our 2000-A CMO. The 2000-A securitization consists of two groups of certificates, one group collateralized by fixed-rate certificates and the other group collateralized by variable-rate certificates. 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, 2004, Hanover retained $0.9 million of fixed-rate 2000-A subordinate certificate balances and $5.1 million of variable-rate 2000-A subordinate certificate balances.

Agency MBS — As of December 31, 2004, we owned $110.3 million in carrying value of Fannie Mae and Freddie Mac whole pool fixed-rate MBS of which $99.1 million are financed by one-month Repurchase Agreements. To protect against potential losses due to a rise 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 and Freddie Mac mortgage-backed securities with the same coupon rates as our Agency MBS.

Costs and Limitations — We believe that we have implemented a cost-effective economic hedging policy to provide an adequate level of protection against interest rate risks. However, maintaining an effective economic hedging strategy is complex, and no economic hedging strategy can insulate us completely from interest rate risks. Moreover, certain REIT rules may limit our ability to fully economically hedge our interest rate risks. We monitor carefully, and may have to limit, economic hedging strategies to assure that we do not violate REIT rules, which could result in disqualification and/or payment of penalties.

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

Regulation

HCS is a broker/dealer registered with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc.

Competition

We compete with a variety of institutional investors for the acquisition of mortgage-related assets. 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. In our non-investment income operations, we compete with a variety of consulting and technology firms.

Employees

As of December 31, 2004, we had 58 full-time employees. We also utilize the services of subcontractors for our COS 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

We own five trademarks that have been registered with the United States Patent and Trademark Office which expire in May 2007, September 2013, May 2014, June 2014 and September 2014, respectively.

Federal Income Tax Considerations

General

We have elected to be treated as a REIT for Federal income tax purposes, pursuant to the Code. In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be taxed as corporations are, with certain limited exceptions, not taxed at the corporate level on their taxable income that is currently distributed to their shareholders. This treatment eliminates most of the “double taxation” (at the corporate level and then again at the shareholder level when the income is distributed) that typically results from the use of corporate investment vehicles. In the event that we do not qualify as a REIT in any year, we would be subject to Federal income tax as a domestic corporation and the amount of our after-tax cash available for distribution to our shareholders would be reduced. We believe we have satisfied the requirements for qualification as a REIT since commencement of our operations in September 1997. We intend at all times to continue to comply with the requirements for qualification as a REIT under the Code, as described below.

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 us or our shareholders. Congress recently 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:

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 our securities.

Requirements for Qualification as a REIT

To qualify for income tax treatment as a REIT under the Code, we must meet certain tests which are described briefly below. We believe that we satisfy all of the requirements to remain qualified as a REIT. However, last year, Congress enacted legislation under which we may be able to avoid being disqualified as a REIT as a result of a failure to satisfy certain of the tests described below provided that we satisfy certain conditions and pay $50,000 to the IRS. We will monitor the legislation enacted last year so that we are positioned to take advantage of the legislation if it were ever found that we had failed a REIT test.

Ownership of Common Stock

For all taxable years after our first taxable year, our 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 our capital stock may be owned directly or indirectly by five or fewer individuals, taking into account complex attribution of ownership rules. We are required to maintain records regarding the actual and constructive ownership of our shares, and other information, and to demand statements from persons owning above a certain level of our shares regarding their ownership of shares. We must keep a list of those shareholders who fail to reply to such a demand. We are required to use (and do use) the calendar year as our taxable year for income tax reporting purposes.

Nature of Assets

On the last day of each calendar quarter, we must satisfy three tests relating to the nature of our assets. First, at least 75% of the value of our 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”). We expect that substantially all of our assets will continue to be Qualified REIT Assets. Second, not more than 25% of our assets may consist of securities that are not Qualified REIT Assets. Third, except as noted below, investments in securities that are not Qualified REIT Assets are further limited as follows: (i) not more than 20% of the value of our total assets can be represented by securities of one or more Taxable REIT Subsidiaries (as defined below), (ii) the value of any one issuer’s securities may not exceed 5% by value of our total assets, (iii) we may not own securities possessing more than 10% of the

total voting power of any one issuer’s outstanding voting securities, and (iv) we may not own securities having a value of more than 10% of the total value of any one issuer’s outstanding securities. Clauses (ii), (iii) and (iv) of the third asset test do not apply to securities of a Taxable REIT Subsidiary. A “Taxable REIT Subsidiary” is any corporation in which a REIT owns stock, directly or indirectly, if the REIT and such corporation jointly elect to treat such corporation as a Taxable REIT Subsidiary. The amount of debt and rental payments from a Taxable REIT Subsidiary to a REIT are limited to ensure that a Taxable REIT Subsidiary is subject to an appropriate level of corporate tax.

Last year, Congress enacted legislation under which, in certain circumstances, we may be able to avoid being disqualified as a REIT as a result of a failure to satisfy one or more of the foregoing asset tests provided that we satisfy certain conditions including, in some cases, the payment of an amount equal to the greater of $50,000 or an amount bearing a certain relationship to the particular violation. Notwithstanding the legislation enacted last year, pursuant to our compliance guidelines, we intend to monitor closely the purchase and holding of our assets in order to comply with the foregoing asset tests.

Sources of Income

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

Distributions

We must distribute to our shareholders on a pro rata basis each year an amount equal to at least (i) 90% of our 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.” We intend to make distributions to our shareholders in sufficient amounts to meet this 90% distribution requirement.

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

State Income Taxation

We file 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 we are treated as a REIT for Federal income tax purposes, amounts distributed by us to our shareholders out of current or accumulated earnings and profits will be includable by the shareholders as ordinary income for Federal income tax purposes unless properly designated by us as capital

gain dividends. Dividends declared during the last quarter of a calendar year and actually paid during January of the immediately following calender year are generally treated as if received by the shareholders on December 31 of the calendar year during which they were declared. Our dividend distributions will not generally be qualified dividend income eligible for the 15% maximum rate applicable to such income received by individuals during the period 2003 through 2008. Our distributions will not be eligible for the dividends received deduction for corporations. Shareholders may not deduct any of our net operating losses or capital losses. If we designate one or more dividends, or parts thereof, as a capital gain dividend in a written notice to the shareholders, the shareholders shall treat as long-term capital gain the lesser of (i) the aggregate amount so designated for the taxable year or (ii) our net capital gain for the taxable year. Each shareholder will include in his long-term capital gains for the taxable year such amount of our undistributed as well as distributed net capital gain, if any, for the taxable year as is designated by us in a written notice. We will be subject to a corporate level tax on such undistributed gain and the shareholder will be deemed to have paid as an income tax for the taxable year his distributive share of the tax paid by us on the undistributed gain.

Any loss on the sale or exchange of shares of our 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 we make distributions to our shareholders in excess of our 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 our shares. We will withhold 30% of dividend distributions to shareholders that we know to be foreign persons unless the shareholder provides us 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 us should not constitute unrelated business taxable income, or “UBTI”, as defined in Section 512 of the Code. If, however, we realize certain excess inclusion income and allocate it to stockholders, a stockholder cannot offset such income by net operating losses and, if the stockholder is a tax-exempt entity, then such 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 such excess inclusion income without reduction pursuant to any otherwise applicable income tax treaty. Excess inclusion income would be generated if we 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. Our borrowing arrangements are generally structured in a manner designed to avoid generating significant amounts of excess inclusion income. We do, however, enter into various 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 our common stock, may be required to treat a portion or all of the dividends they may receive from us as UBTI. We believe that our 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, we may hold REMIC residual interests that would give rise to UBTI for pension plans and other tax exempt entities.

An error was made in the computation of the tax components of our distributions to our shareholders for each of the years ended 2001, 2002 and 2003. The error related to the computation of our tax earnings and profits for those years and had the effect of overstating the return of capital component of our distributions and correspondingly understating the dividend component. In order to address the error in these calculations, we have prepared corrected Forms 1099-DIV and have distributed those corrected Forms 1099-DIV to our shareholders. As a result of this error, the IRS may assess penalties against us for delivering inaccurate Forms 1099-DIV, ranging from $50 to $100 for each incorrect Form 1099-DIV sent to shareholders. However, the IRS may waive any penalty upon a showing by us that the error was due to reasonable cause and not willful neglect. By acting within a reasonable period of time to remedy any inaccuracies on the

Forms 1099-DIV, we expect to demonstrate such reasonable cause. The imposition by the IRS of penalties to which the inaccurate Forms 1099-DIV may be subject could adversely affect the results of operations.

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. We have not obtained a ruling from the IRS with respect to tax considerations relevant to its organization or operations.

Available Information

We maintain an Internet website at www.hanovercapitalholdings.com. We make available, free of charge, on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Information on our website is not incorporated by reference into this report.

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.

PART II

Our common stock trades on the American Stock Exchange under the symbol “HCM.” As of March 1, 2005, there were 64 record holders, and approximately 8,895 beneficial owners, of our common stock.

The following table sets forth, for the periods indicated, the high and low sales prices per share of 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:

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 2005 Annual Meeting of Stockholders and is incorporated herein by reference.

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 vesting based on our achievement of certain performance targets based on increases in the market value of our common stock over our initial offering price. None of the targets were met within the available vesting period, so none of the original options ever vested. To replace these cancelled options we granted new options, exercisable for an aggregate of 80,160 shares of our common stock at an exercise price of $15.75 per share, to the following executive officers: John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares. These option grants were exempt from registration pursuant to Section 4(2)

of the Securities Act of 1933. The replacement options are subject to performance-based vesting similar to the cancelled options, but the vesting period has been extended until 2007 and the performance targets were adjusted to relate to increases in the market price of our common stock as compared to the market price on July 1, 2002.

The following tables set forth our selected financial data as of December 31 of, and for, each of the years indicated. The selected financial data for the years ended December 31, 2004, 2003 and 2002, and as of December 31, 2004 and 2003, have been derived from our audited Consolidated Financial Statements included elsewhere in this report. The financial information for the years ended December 31, 2001 and 2000 and as of December 31, 2002, 2001 and 2000, have been derived from our audited Consolidated Financial Statements not included in this report. The historical selected consolidated financial data may not be indicative of our future performance. 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 Annual Report on Form 10-K.

     (dollars in thousands, except per share data)

     (dollars in thousands, except share and per share data)

Management’s Discussion and Analysis of Financial Condition and Results of Operations gives effect to the restatement discussed in Note 21 to the Consolidated Financial Statements included in Item 8.

Certain statements in this report, including, without limitation, matters discussed under this Item 7, “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. We are including this cautionary statement to make applicable and take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical fact are forward-looking statements. Certain of these forward-looking statements can be identified by the use of words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “estimates,” “assumes,” “may,” “should,” “will,” or other similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors, which could cause actual results, performance or achievements to differ materially from future results, performance or achievements. These forward-looking statements are based on our current beliefs, intentions and expectations. These statements are not guarantees or indicative of future performance. Important assumptions and other important factors that could cause actual results to differ materially from those forward-looking statements include, but are not limited to, those factors, risks and uncertainties described in Item 7A of this Annual Report on Form 10-K. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and involve inherent risks and uncertainties. The forward-looking statements contained in this report are made only as of the date hereof. We undertake no obligation to update or revise information contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Overview

We are a specialty finance company qualified as a Real Estate Investment Trust, which we refer to as a “REIT”. Accordingly, we generally distribute substantially all of our earnings to stockholders without paying Federal or state income tax at the corporate level on the distributed earnings. We seek to generate consistent income from our investments and business activities and provide steady dividends to our shareholders by investing primarily in the domestic residential mortgage market. We have three principal operating segments that conduct business in the domestic residential mortgage market:

During 2004, we reported net income of $8.1 million, or $0.97 diluted earnings per share, as compared to $8.0 million, or $1.35 diluted earnings per share, in 2003. Our earnings were driven largely by the income generated by our mortgage investment portfolio. The size of this portfolio increased to $205.7 million as of December 31, 2004 from $140.5 million as of December 31, 2003.

Our net income increased by $0.1 million in 2004 as compared to 2003. Total revenues decreased $0.1 million in 2004 as compared to 2003, and expenses increased by $0.8 million over the same period. Accordingly, operating income decreased by $0.9 million for 2004 from 2003. The increase in net income of $0.1 million for 2004 compared to 2003 was attributable to a combination of an increase in equity in income of HDMF-I LLC, which we refer to as “HDMF-I”, and a reduction in the tax provision partially offset by an increase in expenses.

In 2004, we paid four quarterly dividends of $0.30 per share for a total of $1.20 per share of regular dividends and a special divided of $0.40 per share in March 2004 based on our 2003 earnings.

Investment Portfolio

Our principal business is to invest in Subordinate MBS and Mortgage Loans. We also maintain a portfolio of whole pool Agency MBS to satisfy certain Investment Company Act of 1940 requirements.

The table below describes the principal assets of our investment portfolio as of December 31, 2004 (dollars in thousands):

Our Subordinate MBS portfolio is comprised of non-investment grade securities that represent retained interests that are subordinate to other classes of the same series of mortgage-backed securities in the right to receive payments from the underlying mortgage loans. These securities are backed by prime quality, domestic residential mortgage loans issued and serviced by large mortgage originators. Our Subordinate MBS portfolio is comprised of both adjustable- and fixed-rate securities. These securities are financed under agreements where we have sold securities with a commitment to repurchase the security at a later date, commonly referred to as “Repurchase Agreements”. Our Repurchase Agreements are both committed and uncommitted and re-price monthly based on the one-month London Interbank Offered Rate Index, or “LIBOR” index. LIBOR is an average of the interest rates that major international banks charge each other to borrow U.S. dollars in the London money market.

The investment objective for our Subordinate MBS portfolio is to generate interest income and, when appropriate, gain on sale through credit risk management combined with leverage, which incurs some interest rate risk. Credit risk management is accomplished by pre-purchase and ongoing collateral analysis coupled with a pro-active disposition strategy. As of December 31, 2004, our Subordinate MBS portfolio has financing of $34.6 million and net equity of $19.8 million for a debt to equity ratio of 1.75 over 1.00.

The investment objective for our Mortgage Loan portfolio is also to generate interest income through credit risk and interest rate risk management. As of December 31, 2004, our Mortgage Loan portfolio consists of mortgage loans that collateralize two debt securitizations. Both securitizations are financing transactions where we sold senior bonds and retained certain subordinate bonds. The Mortgage Loans are classified as assets in our Consolidated Balance Sheets and generate interest income. The sold senior bonds are classified as liabilities in our Consolidated Balance Sheets and generate interest expense. The difference between this interest income and expense is the net interest income we earn on our Mortgage Loan portfolio.

The primary objective of our Agency MBS portfolio is to satisfy Investment Company Act of 1940 requirements. Our Agency MBS portfolio is comprised of whole pool fixed-rate Fannie Mae and Freddie Mac guaranteed mortgage-backed securities that we economically hedge via forward sales of like coupon Agency MBS. We finance our Agency MBS portfolio with Repurchase Agreements, which re-price monthly based on the one-month LIBOR index. To the extent that we increase our Mortgage Loan portfolio, we would

anticipate our Agency MBS portfolio to decline as the Mortgage Loan portfolio fulfills the Investment Company Act of 1940 requirements currently met by the Agency MBS portfolio.

The results of our operations are influenced by interest rates and credit performance of assets. Credit performance of assets is influenced by unemployment levels, housing prices, inflation and casualty risks as further discussed in this “— Executive Summary — Business Environment”. Changes in interest rates primarily affect net interest income as the interest rates on our assets may not reset with the same frequency as the interest rates on our liabilities. Our net interest spread increased to 4.78% in 2004 as compared to 4.07% in 2003. The increase in the net interest spread in 2004 as compared to 2003 is primarily due to the decrease in interest costs associated with our liabilities to 3.01% in 2004 from 3.89% in 2003. This decrease was primarily caused by the reduction in the amount of CMO borrowing from 2003 to 2004.

Opportunities for HDMF-I to acquire loans at attractive prices and yields could arise should the number of defaulted Mortgage Loans increase and home prices decline.

Consulting and Outsourcing Services (COS)

Through our COS operations we provide services to commercial banks, mortgage banks, government agencies, credit unions and insurance companies. Our services provided include:

Our COS revenue is driven by our ability to generate opportunities from new clients and from continuing to provide existing clients with needed services. Our business objective is to work closely with a specifically targeted group of clients so that we may tailor our services to meet their specific outsourcing and consulting needs. To that end, we have created an on-site fulfillment center in order to provide our clients with regularly scheduled pre-and post-closing loan services. Those clients that have utilized our fulfillment center have provided us with longer-term revenue streams. The market for COS services is affected by industry trends such as the volume of loan originations and the pace of consolidation in the mortgage industry.

Loan Sale Advisory (LSA) and Technology Solutions

Our LSA operations earn fees by providing brokerage, asset valuation and consulting services. Our brokerage service integrates varying degrees of traditional voice brokerage conducted primarily by telephone, web-enhanced brokerage and on-line auction hosting. We also perform market price valuations for a variety of loan products and offer consulting advice on loan product pricing and business strategies.

We earn licensing and related servicing fees by licensing our proprietary software applications to the financial industry. We market web-based technology solutions to meet specific needs of the mortgage industry in the secure transmission, analysis, valuation, tracking and stratification of loan portfolios. The software technology is licensed to government agencies and financial institutions that originate and/or trade financial assets. We also use the applications to provide servicing rights valuations to clients who do not license our software.

The market for LSA and technology solutions is affected by industry trends such as the volume of loan originations and the pace of consolidation in the mortgage industry.

Business Environment

Our primary investments are Mortgage Loans and Subordinate MBS collateralized by prime quality jumbo residential mortgage loans. The issuers of Subordinate MBS consist of banks, mortgage bankers and Wall Street conduits. The Subordinate MBS we purchase are structured as private placements and are traded by large Wall Street dealers. The market for Subordinate MBS experienced a dramatic increase in volume in 2002, 2003 and 2004 as lowered interest rates resulted in record mortgage origination and securitization volumes. Also, during the past three years, there has been an increase in the number of Subordinate MBS investors. This increased demand has caused prices for Subordinate MBS to increase. 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. As prepayment of principal is generally allocated to bonds senior to the Subordinate MBS, prepayments cause our Subordinate MBS to grow as a percentage of the collateral pool. The result of this non-pro rata paydown of the principal is known as “credit deleverage”. One effect of the growth of the Subordinate MBS relative to the remainder of the total pool is that the implicit credit rating of the Subordinate MBS improves. 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 adjustable rate mortgage loans, which we refer to as “ARMs”. ARMs are loans that have rates that adjust to a market index such as LIBOR. This trend has caused the percentage of ARMs in our portfolio to continue to grow in size.

Since we generally invest in securities that are the first to absorb credit losses, our income can be affected both by the change in fair value of our securities and by credit losses on the securities. Both changes in fair value and credit losses are caused by increased delinquency and foreclosure rates and reductions in housing values. In general, delinquency rates are correlated with local area employment rates and loss severities are associated with regional housing price trends. With few exceptions, during 2004 most areas of the country experienced employment gains and increased housing prices that favorably impacted our results. We experienced an aggregate of $19,535 of credit losses in 2004 compared to an aggregate of $31,976 in 2003 in our Mortgage Loan portfolio.

The future direction of unemployment, home prices and interest rates is uncertain and is expected to have a material affect on the performance of our investment portfolio. Each of these macroeconomic factors tends to be cyclical. Due to the emergence of the United States economy from recession in 2001, unemployment is relatively low, which has led to relatively low delinquencies and defaults on mortgage loans. A decline of economic growth or a return to recession could result in increased delinquencies and defaults. In addition, home prices have increased over the past five years at a rate above the long-term trend. Declining home prices could lead to increased loss severity on defaulted mortgage loans. Moreover, short-term interest rates declined to recent low levels in 2004 and began to increase thereafter. Further increases in short-term interest rates will increase our cost of funds and reduce the net interest income on our portfolio.

Our exposure to adverse macroeconomic trends is mitigated by our active credit risk management and our strategy of targeting (a) high credit score borrowers, who are less likely to default in an economic downturn, and (b) loans with low loan-to-value ratios, which are less likely to suffer losses due to declining home prices. In addition, our shift to adjustable-rate Subordinate MBS and our purchase of interest rate caps reduce the risk of declining net interest income caused by rising interest rates.

The significant accounting policies used in preparation of our Consolidated 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.

Fair Value

All securities held in our Subordinate MBS portfolio are classified as available for sale with changes in fair value reported as a component of accumulated other comprehensive income. We estimate fair value on a security-specific basis by using the lower of third-party or management’s valuations. Because the securities are not exchange-traded, prices are not readily ascertainable and involve judgment regarding future interest rates, credit spreads (which may change as a result of changed loss estimates) and other economic factors. Therefore, the price at which a security may trade at an arms-length auction may differ from the fair value established by management or an individual third party.

We own two one-month LIBOR interest rate cap agreements as protection against rising short-term financing rates on the liabilities used to finance our Subordinate MBS and Mortgage Loan portfolios. These derivative instruments are classified as freestanding derivatives with changes in fair value recognized through the Consolidated Statements of Income. Fair value is determined on a monthly basis from third party sources.

Revenue Recognition & Associated Expenses

     Investment Portfolio

For our Subordinate MBS portfolio, pursuant to The Emerging Issues Task Force of the Financial Accounting Standards Board (“EITF”) Abstract Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” we use the effective yield methodology to recognize interest income. This includes taking into account such factors as purchase discounts, loss assumptions, prepayment speeds and the type of retained interests in the bonds or the bond structures. In using the effective yield methodology, we use a level yield approach where we determine each subordinate security’s future cash flow at the time of purchase and designate a portion of the purchase discount as estimated future losses. In determining the initial yield, we discount the expected cash flows for each security assuming certain loss and prepayment assumptions using that security’s specific bond structure. Assumptions regarding future losses, prepayment speeds and interest rates are reviewed, and changed, if required, on a month-to-month basis. Should the net present value of a security’s cash flow decrease we incur an impairment expense in order to maintain the previous month’s yield. Should the net present value of a security’s cash flow increase we prospectively adjust the security’s yield.

In general, increases in prepayment speeds will result in an increase in the yield of our Subordinate MBS portfolio and decreases in prepayment speeds will result in an impairment expense. Similarly, increases in expected losses will generally result in an impairment expense and decreases in expected losses will generally increase the yield of the subordinate portfolio. All loss, prepayment speeds and interest rate assumptions are estimations and involve uncertainty. Associated expenses for our Subordinate MBS portfolio consist of the interest expense on Repurchase Agreements.

For our Mortgage Loan portfolio, recognized revenue consists of the coupon interest received on the loans adjusted for the amortization of any purchase premiums or accretion of any discounts. Associated expenses are the interest expense on bonds sold that are collateralized by the mortgage loans, amortization expenses related to issuance and deferred hedging costs, interest expense on Repurchase Agreements and loan losses and loan loss reserves for certain bonds.

For our Agency MBS portfolio, we recognize revenue consisting of the coupon interest received on the securities adjusted for the amortization or accretion of any purchase premiums or discounts. Associated expenses consist of the interest expense on Repurchase Agreements. Additionally, since our Agency MBS

portfolio is classified as trading, we recognize mark to market gains/losses on the securities through the Consolidated Statements of Income.

We use forward sales to economically hedge our Agency MBS portfolio. We recognize gains or losses when forward sales are closed and mark to market gains or losses on open forward sales through the Consolidated Statements of Income.

     Due Diligence and Assignment Fees

Our COS contracts have different terms based on the scope, deliverables and term of the engagement that frequently require us to make judgments and estimates in recognizing revenues. We have many types of contracts, including time-and-materials contracts, fixed-fee plus certain reimbursable expenses contracts and contracts with features of both of these types. Most of our COS contracts are short-term contracts and are accounted for in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 104, “Revenue Recognition”. We recognize revenues from the remainder of our COS contracts, which are longer-term contracts, using the percentage-of-completion method pursuant to the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” Percentage-of-completion accounting involves calculating the percentage of services provided during the reporting period compared with the total estimated services to be provided over the duration of the contract.

     Loan Brokering and Advisory Services and Technology

We recognize revenue from loan brokering and on-line auction hosting when the loan sale transactions close and fund, at which time fees are earned. At the time a transaction closes, the number of loans, loan principal balance and purchase price in the transaction are agreed upon and the sale is funded. Because our valuation and consulting assignments are typically short term, fees are generally payable and revenues are earned at the completion of the assignment.

We derive technology revenue from the following sources: (1) software licensing fees; (2) professional services fees; and (3) valuation services utilizing proprietary software. We recognize technology revenue primarily in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition”, and AICPA Statement of Position 81-1 “Accounting for Performance of Construction Type and Certain Production Type Contracts”.

Our technology transactions (both software licensing and professional services) are documented by a written agreement setting forth the type of fees, the payment schedule, and the milestones required to invoice the client. Our proprietary software is sold either:

Annual license agreements generally run from one to three years, with optional renewal periods. Valuation services are generally offered either on a recurring basis or as a one-time transaction.

Credit Reserves

Expected credit losses for our Subordinate MBS portfolio are estimated monthly on an individual security basis and comprise a portion of each security’s discount from its par amount. In estimating expected credit losses, we take into account the current delinquency status of the underlying mortgage loans, housing prices, interest rates, prepayment histories and other factors. In general, increased loss expectations will decrease the

value of expected future cash flows, thereby causing impairment charges per the effective yield methodology. Decreased loss expectations will, in general, increase the yield on our Subordinate MBS portfolio.

Credit reserves for our Mortgage Loan portfolio are charged to income as loan loss provisions based upon our estimation of expected future losses. We analyze our Mortgage Loan portfolio on a monthly basis to determine the adequacy of the loan loss reserves. No reserves are allocated for our Agency MBS portfolio because either Fannie Mae or Freddie Mac guarantees these securities.

Consolidated Results of Operations

The following table presents consolidated results of operations for 2004, previously reported consolidated results of operations for 2003, previously reported results of operations for 2002 and pro forma unaudited results for 2002 (dollars in thousands, except per share data):

In 2004, we recorded net income of approximately $8.1 million, or $0.97 per share, based on 8,344,741 diluted weighted-average shares of common stock outstanding, compared to net income of $8.0 million, or $1.35 per share, based on 5,943,962 diluted weighted-average shares of common stock outstanding for 2003.

Total consolidated revenues for 2004 decreased $0.1 million to $32.2 million, from $32.3 million for 2003. Total expenses increased $0.8 million to $24.6 million in 2004 from $23.8 million in 2003. This increase primarily related to an increase in legal and professional expenses resulting from the change in our independent auditor and the costs of compliance with the Sarbanes-Oxley Act of 2002.

In each of 2004 and 2003, noncash payments of $1.4 million and $1.5 million, respectively, were made under the terms of an agreement between Hanover and four of its principal executive officers entered into in conjunction with our initial public offering in 1997.

Equity in income of HDMF-I increased to $0.4 million in 2004 from $0.0 million in 2003. This increase is primarily attributable to sales of mortgage loans held by HDMF-I.

In 2003, we recorded net income of approximately $8.0 million, or $1.35 per share, based on 5,943,962 diluted weighted-average shares of common stock outstanding, compared to net income of $5.1 million, or $1.15 per share, based on 4,480,744 diluted weighted-average shares of common stock outstanding for 2002. Total revenues for 2003 were $32.3 million, compared to $16.3 million previously reported for 2002, and $23.9 million on a pro forma basis for 2002.

Return on Equity

The table below presents our return on average equity for 2004, 2003 and 2002.

Notes:

Average equity excludes notes receivable from related parties and accumulated other comprehensive (loss) income.

Prior to July 1, 2002, the financial results for HCP, HT and HCP-2 are included in equity in income/(loss) of equity method investees. For periods ending after June 30, 2002, these entities’ results are consolidated with Hanover’s and their results will appear throughout our financial statements as applicable, rather than in a single line-item.

The percentages in the table above were derived from our audited Consolidated Financial Statements included elsewhere in this report.

Full year return on equity declined in 2004 to 10.89% from 13.19% in 2003. This was primarily due to lower non-investment return on equity in 2004. Full year return on equity increased to 13.19% in 2003 over the 11.81% return in 2002 primarily due to increased returns from gain on sale and mark to market gain in 2003.

Historical Trends of Selected Financial Statement Components

     Investment Portfolio Assets and Related Liabilities

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

The yield on net interest earning assets decreased to 25.70% for the year ended December 31, 2004 from 27.73% for the year ended December 31, 2003. The decrease in the yield on net interest earning assets was primarily the result of the decrease in leverage in 2004 as compared to the leverage in 2003.

Net investment portfolio assets increased to $37.9 million for the year ended December 31, 2004 from $21.8 million for the year ended December 31, 2003. This increase is primarily due to the deployment of capital raised in August 2003 in connection with the public offering of our common stock, which was primarily invested in Subordinate MBS and Agency MBS.

The yield on net interest earning assets increased to 27.73% for the year ended December 31, 2003 from 27.09% for the year ended December 31, 2002. The increase in the yield on net interest earning assets was primarily the result of the net interest spread increasing to 4.07% for the year ended December 31, 2003 from 2.72% for the year ended December 31, 2002. This increase was due primarily to the decline in the effective

rate of our investment portfolio liabilities to 3.89% for the year ended December 31, 2003 from 5.34% for the year ended December 31, 2002. This decline was due to decreases in the rate of one-month LIBOR. The decline in the effective rate on liabilities was partially offset by a decrease in the effective rate on assets to 7.96% for the year ended December 31, 2003 from 8.06% for the year ended December 31, 2002. This decline was due to lower yield on investment purchased during 2003.

Net investment portfolio assets increased to $21.8 million for the year ended December 31, 2003 from $19.9 million for the year ended December 31, 2002. This increase is primarily due to increased Subordinate MBS investments.

     Net Interest Income and Total Gains (Losses) For Interest Earning Assets

      Investment Portfolio: Net Interest Income

The following table provides details of net interest income for interest earning assets (dollars in thousands):

The investment portfolio’s net interest income increased to $9.9 million for the year ended December 31, 2004 from $6.4 million for the year ended December 31, 2003. The increase in net interest income is primarily the result of the deployment of capital raised in August 2003, which was primarily invested in Subordinate MBS and Agency MBS. Net interest income also increased substantially in the Agency MBS portfolio, as the average balance of Agency MBS increased to $72.0 million during 2004 from $24.9 million during 2003. The increase in the Agency MBS portfolio was intended to satisfy certain REIT related income and asset requirements. Net interest income in the Mortgage Loan portfolio declined $0.6 million during 2004 as a result of scheduled and unscheduled principal payments which reduced the mortgage loan balance.

The investment portfolio’s net interest income increased to $6.4 million for the year ended December 31, 2003 from $6.1 million for the year ended December 31, 2002. The increase in net interest income is primarily due to the increase in the average balance of our Subordinate MBS portfolio and to a lesser extent of our Agency MBS portfolio. Net interest income in the Mortgage Loan portfolio declined during 2003 as a result of scheduled and unscheduled principal payments which reduced the mortgage loan balance and the termination of the 1998-A and 1998-B CMO securitizations. Net interest income from other assets declined as cash was used to fund increases in the Subordinate and Agency MBS portfolios.

      Total Gains (Losses)

The following table provides details of total gains (losses) as follows (dollars in thousands):

Gain on sale of mortgage assets increased $0.9 million in 2004 as compared to 2003 due to an increased number of sales. Similarly, gain on sale of mortgage assets increased $7.7 million in 2003 as compared to 2002 as a result of an increased number of sales and the termination of the 1998-A and 1998-B CMO securitizations.

Loss on freestanding derivatives decreased $4.2 million in 2004 as compared to 2003 primarily as a result of increased expenses associated with economically hedging the Agency MBS portfolio. This increased loss was economically offset by increased net income on the Agency MBS portfolio. Loss on freestanding derivatives increased $0.5 million in 2003 as compared to 2002 as a result of reduced economic hedging expense.

          Mortgage Loans

The following table provides details of the net interest income generated on the Mortgage Loan portfolio (dollars in thousands):

Our Mortgage Loan portfolio net interest income declined to $0.8 million for the year ended December 31, 2004 from $1.4 million for the year ended December 31, 2003. This decline in net interest income is due to the declining principal balance of our Mortgage Loan portfolio due to scheduled and unscheduled principal payments which reduced the mortgage loan balance and, to a lesser extent, due to the rise in the interest expense related to one-month LIBOR indexed securities sold in our 1999-B securitization.

Our Mortgage Loan portfolio net interest income declined to $1.4 million for the year ended December 31, 2003 from $2.8 million for the year ended December 31, 2002. This decline in net interest income is due to the declining principal balance of our Mortgage Loan portfolio due to scheduled and unscheduled principal payments which reduced the mortgage loan balance and the termination of our 1998-A and 1998-B CMO securitizations.

          Subordinate MBS

The following table provides details of the net interest income generated on the Subordinate MBS portfolio (dollars in thousands):

The Subordinate MBS portfolio’s net interest income increased to $6.5 million for the year ended December 31, 2004 from $3.7 million for the year ended December 31, 2003. This increase in revenues was attributable to the growth in the average net interest earning assets to $29.9 million for the year ended December 31, 2004 from $13.9 million for the year ended December 31, 2003, primarily as a result of the capital raised in August 2003 in connection with the public offering of our common stock.

The Subordinate MBS portfolio’s net interest spread decreased to 9.57% for the year ended December 31, 2004 from 13.15% for the year ended December 31, 2003. The reduction in the net interest spread was due to a decline in the effective interest income rate to 12.72% for the year ended December 31, 2004 from 15.82% for the year ended December 31, 2003 and an increase in the effective interest expense rate to 3.15% for the year ended December 31, 2004 from 2.67% for the year ended December 31, 2003. The decrease in the effective interest income rate was due to a combination of a shift in the Subordinate MBS portfolio to higher-rated securities coupled with an increase in adjustable rate securities relative to fixed rate securities. The increase in the effective interest expense rate is due to increases in the rate of one-month LIBOR offset partially by lower financing rates due to a shift to higher-rated securities. Additionally, because the maximum amount of financing was not always utilized during 2004, our net interest spread was lower than what would have resulted had the portfolio been consistently fully leveraged.

The Subordinate MBS portfolio’s net interest income increased to $3.7 million for the year ended December 31, 2003 from $2.2 million for the year ended December 31, 2002. This increase in revenues was attributable to the growth in the average net interest earning assets to $13.9 million for the year ended December 31, 2003 from $8.1 million for the year ended December 31, 2002, primarily as a result of the capital raised in August, 2003 in connection with the public offering of our common stock.

The Subordinate MBS portfolio’s net interest spread decreased to 13.15% for the year ended December 31, 2003 from 13.34% for the year ended December 31, 2002. The reduction in the net interest spread was primarily due to a decline in the effective interest income rate to 15.82% for the year ended December 31, 2003 from 16.76% for the year ended December 31, 2002 which was partially offset by a decrease in the effective interest expense rate to 2.67% for the year ended December 31, 2003 from 3.42% for the year ended December 31, 2002. The decrease in the effective interest income rate was due to lower yields on purchases of Subordinate MBS during 2003. The decrease in the effective interest expense rate is due to decreases in the rate of one-month LIBOR.

          Agency MBS

The following table provides details of the net interest income generated on the Agency MBS portfolio (dollars in thousands):

The Agency MBS portfolio’s net interest income increased to $2.4 million for the year ended December 31, 2004 from $0.9 million for the year ended December 31, 2003. The increase is primarily due to an increase in the average balance to $72.0 million during 2004 from $24.9 million during 2003. The increase in the Agency MBS portfolio satisfies requirements under the Investment Company Act of 1940.

The Agency MBS portfolio’s net interest spread decreased to 3.34% for the year ended December 31, 2004 from 3.54% for the year ended December 31, 2003. The decrease in the net interest spread was due to the increase in the effective interest expense rate to 1.61% for the year ended December 31, 2004 from 1.16% for the year ended December 31, 2003 that was partially offset by the increase in the effective interest income rate to 4.95% for the year ended December 31, 2004 from 4.70% for the year ended December 31, 2003. The increase in the effective interest expense rate was due to increases in the rate of one-month LIBOR. The increase in the effective interest income rate was due to the purchase of higher coupon Agency MBS during 2004 as compared to 2003.

The Agency MBS portfolio’s net interest income increased to $0.9 million for the year ended December 31, 2003 from $0.3 million for the year ended December 31, 2002. The increase is primarily due to an increase in the average balance to $24.9 million during 2003 from $7.2 million during 2002. The increase in the Agency MBS portfolio was intended to satisfy certain REIT related income and asset requirements.

The Agency MBS portfolio’s net interest spread increased to 3.54% for the year ended December 31, 2003 from 3.38% for the year ended December 31, 2002. The increase in the net interest spread was primarily due to a decrease in the effective interest expense rate to 1.16% for the year ended December 31, 2003 from 3.32% for the year ended December 31, 2002 and that was partially offset by a decrease in the effective interest income rate to 4.70% for the year ended December 31, 2003 from 6.70% for the year ended December 31, 2002. The decrease in the effective interest expense rate is due to decreases in the rate of one-month LIBOR. The decrease in the effective interest income rate was due the purchase of lower coupon Agency MBS during 2003 as compared to 2002.

We attempt to fully economically hedge our Agency MBS portfolio to potentially offset any gains or losses in our portfolio with losses or gains from our forward sales of like-kind Agency MBS. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency MBS. However, these earnings are substantially economically offset by gains or losses from forward sales of like coupon Agency MBS.

The table below reflects the net economic impact of our Agency MBS portfolio for the year ended December 31, 2004 (dollars in thousands):

We believe that the net economic impact of our Agency MBS portfolio provides useful information to investors because it provides information not readily apparent from our Consolidated Statements of Income.

     COS Revenues: Due diligence fees and assignment fees

For the year ended December 31, 2004, due diligence fees and assignment fees decreased from the same period in 2003. Due diligence revenues decreased to $6.4 million for 2004 from $6.9 million for 2003 and assignment fees revenue decreased to $2.5 million for 2004 from $3.1 million for 2003. Due diligence revenues increased to $6.9 million for 2003 from $5.0 million for 2002 on a pro forma basis and assignment fees revenue increased to $3.1 million for 2003 from $2.2 million for 2002 on a pro forma basis.

The decrease in due diligence revenues in 2004 is attributed mainly to a decrease in revenues generated from temporary staffing services. These revenues were lower as a result of lower demand for temporary staff by our clients due to lower mortgage origination volume. The decrease in assignment fee revenues in 2004 was related to a large government contract in 2003, which contributed a substantial portion of the 2003 assignment fee revenue. No similarly large projects were performed in 2004.

The overall increase in COS revenue to $10.0 million in 2003 from $7.2 in 2002 on a pro forma basis was due to an increase in due diligence services resulting from increased activity with our due diligence clients and a single large government assignment fee contract largely performed in 2003.

     Technology

For the years ended December 31, 2004 and 2003, revenues generated by technology services remained constant at $2.8 million.

The increase in revenue from technology services to $2.8 million in 2003 from $0.3 million in 2002 on a pro forma basis was due to the deployment of developed software applications in 2003.

For the year ended December 31, 2004, revenues generated from loan brokering and advisory services decreased to $2.7 million from $3.3 million in 2003 due primarily to a reduced number of repeat sellers and reduced government engagements.

The decrease in loan brokering and advisory services revenue to $3.3 million in 2003 from $6.8 million in 2002 on a pro forma basis was due to a single large government contract largely performed in 2002.

     Operating Expenses

The following table details our operating expenses on a consolidated basis (dollars in thousands):

Our total expenses increased to $24.6 million for 2004 from $23.8 million for 2003. The $1.4 million increase in legal and professional fees in 2004 is primarily associated with our change in independent auditors and Sarbanes-Oxley Act of 2002 compliance related costs. The $0.6 million increase in technology expenses in 2004 was primarily due to additional implementation costs associated with the deployment of our software products. The $0.6 million decrease in depreciation and amortization expenses was primarily due to the completion of the amortization of the original capitalized software related to our electronic trading platform.

Operating expenses for 2003 increased to $23.8 million from $12.0 million as previously reported for the same period in 2002 and from $18.8 million on a pro forma basis in 2002. The increase in operating expenses in 2003 as compared to 2002 on a pro forma basis was primarily due to:

Personnel expenses increased primarily as a result of $1.5 million of compensation expense recorded in 2003 relating to the forgiveness of $0.6 million of outstanding loans to the four principal officers of the Company and the issuance of 72,222 shares of our common stock for which no comparable compensation expense was recorded in 2002.

During the third quarter of 2003, we received notice that a $0.3 million note receivable would not be repaid due to the debtor’s inability to continue as a going concern. The note receivable was written off as bad debt expense. In addition, bad debt expense for customer receivables of $0.1 million was incurred in 2003 for which no such expense was incurred in 2002. Equipment rental and maintenance increased $0.1 million in 2003 compared to 2002. Royalty fees increased by $0.2 million as a result of increased sales of technology for which an underlying royalty payment was due. In addition, we purchased information services for use in our investment activity for $0.1 million in 2003 for which no such expenditure was incurred during the comparable 2002 period. Bad debt expense, equipment rental and maintenance, royalty fees and information services are included in general and administrative expenses.

Subcontractor expenses increased in 2003 over 2002 primarily as a result of an increase in the number of due diligence projects and an increase in the overall use of subcontractors. In addition, the mix of due diligence projects changed to require an increase in the use of subcontractors for 2003 as compared to the same period in 2002 where in-house personnel performed more projects.

     Equity in Income (Loss) of HDMF-I

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. Since our initial investment in November 2001, we made investments in HDMF-I of approximately $10.2 million and received distributions to date of approximately $7.7 million. As of December 31, 2004, our maximum capital commitment to HDMF-I was $5.8 million, of which $3.1 million was invested.

For the year ended December 31, 2004, we recognized $0.4 million in equity in income of HDMF-I, as compared to $0.0 million in 2003. This increase was primarily attributable to sales of mortgage loans held by HDMF-I. The decrease in equity in income of HDMF-I from $0.2 million in 2002 to $0.0 million in 2003 was primarily attributable to a decline in loan sales.

We operate as a REIT and are required to pay dividends equal to at least 90% of our REIT taxable income. The current policy of our Board of Directors is to pay annually four quarterly dividends that represent management’s estimate of our REIT income. Our REIT income is primarily generated by our investment portfolios of Subordinate MBS and Mortgage Loans. Our per share dividend rate is determined in the first quarter of each year and, in general, would be the amount expected to be paid for each of the four quarters of the year. To the extent that our net income exceeds this rate, a special dividend would be considered after the close of the taxable year. In all cases, the required 90% of REIT taxable income would be paid under our current policy. In each of 2003 and 2004, we paid regular quarterly dividends aggregating to $1.20 per share, and in 2002 we paid regular quarterly dividends aggregating to $1.00 per share. In 2004, we also paid a special dividend of $0.40 per share reflecting the earnings for the year ended December 31, 2003. In 2003, we paid a special dividend of $0.15 per share reflecting the earnings for the year ended December 31, 2002.

Our taxable income for the year ended December 31, 2004 is estimated at approximately $12,697,000. Taxable income differs from GAAP net income for the year ended December 31, 2004 due to various recurring and one-time book/tax differences. The following table details the major book/tax differences in arriving at the estimated taxable income for the year ended December 31, 2004 (dollars in thousands):

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.

As of December 31, 2004, we had assets with a carrying value of $242.1 million compared to $189.0 million as of December 31, 2003. The majority of the increase in carrying value of assets is due to a $72.4 million increase of our Agency MBS portfolio. The carrying value of our Subordinate MBS portfolio grew $10.6 million during 2004 and the carrying value of our Mortgage Loan portfolio decreased $17.6 million during the same period. Cash and cash equivalents decreased $12.0 million in 2004 from 2003.

Our primary investments in Mortgage Loans, Subordinate MBS and Agency MBS are described below.

The carrying value of our Mortgage Loan portfolio totaled $40.9 million as of December 31, 2004, a decrease of $17.6 million from the carrying value of $58.5 million as of December 31, 2003. CMO borrowings collateralized by our Mortgage Loan portfolio declined $17.0 million to $35.1 million as of December 31, 2004 from $52.1 million as of December 31, 2003.

Our Mortgage Loan portfolio securitizations contain call provisions that allow us to redeem the outstanding bonds at par, plus accrued interest and expenses, when the security balance is 20.0% or less than the original security balance. As of December 31, 2004, the current security balances for our securitizations were below the 20% call threshold. As such, we may elect to call the securitizations in 2005.

The following tables describe the credit performance of our Mortgage Loan portfolio securitizations:

Mortgage Loan Portfolio Credit Performance

(dollars in thousands)

1999-A Securitization

Total losses allocated to our retained subordinate bonds for 2004 were less than $1,000 compared to $25,355 for 2003. Loan loss allowance as of December 31, 2004 totaled $0.1 million. We review loan loss allowance on a monthly basis.

A substantial portion of the Mortgage Loans collateralizing our 1999-A securitization is insured by the Federal Housing Administration.

1999-B Securitization

Total losses allocated to our retained subordinate bonds for 2004 were $19,058 compared to $6,619 for 2003. Loan loss allowance as of December 31, 2004 totaled $0.3 million. We review loan loss allowance on a monthly basis.

The carrying value of our Subordinate MBS portfolio totaled $54.3 million as of December 31, 2004, an increase of $10.6 million from the carrying value of $43.7 million as of December 31, 2003. The par value of our Subordinate MBS portfolio was $87.5 million as of December 31, 2004 representing an increase of $0.9 million from the par value of $86.6 million as of December 31, 2003. As of December 31, 2004 and 2003, the total amount of mortgage loans collateralizing our Subordinate MBS portfolio was $13.7 billion and $28.5 billion, respectively.

The following tables describe the credit performance of our Subordinate MBS portfolio:

Subordinate MBS Portfolio Credit Performance

(dollars in thousands)

We had total losses of less than $1,000 allocated to our Subordinate MBS portfolio for each of 2004 and 2003.

The following table describes the distribution of our Subordinate MBS portfolio by rating:

Subordinate MBS Portfolio Credit Ratings

(dollars in thousands)

The $10.6 million increase in carrying value during 2004 with a corresponding $0.9 million increase in par value is due principally to the relative increase in BB-rated securities as compared to B-rated and Non-rated securities.