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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10 -K
[X] Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the year ended December 31, 1997
OR
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
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Commission file number: 001-13417
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND 13-3950486
(State or other Jurisdiction of ( I.R.S. Employer Identification No.)
Incorporation or Organization)
90 WEST STREET, SUITE 1508, NEW YORK, NY 10006
(Address of principal executive offices) (Zip Code)
(212) 732-5086
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.01 Par Value per Share - American Stock Exchange
Warrants - American Stock Exchange
Units - American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ]
The aggregate market value of units held by nonaffiliates of the registrant
as of February 20, 1998 was approximately $112,777,025 (based on closing sales
price of $19.625 per unit as reported for the American Stock Exchange).
The registrant had 6,466,677 shares of common stock outstanding as of
February 20, 1998.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement to be delivered to shareholders in
connection with the Annual Meeting of Shareholders to be held May 21, 1998 are
incorporated by reference into Part III.
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HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED DECEMBER 31, 1997
INDEX
PART I PAGE
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Item 1. Business................................................................................. 1
Item 2. Properties............................................................................... 22
Item 3. Legal Proceedings........................................................................ 23
Item 4. Submission of Matters to a Vote of Security Holders...................................... 24
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.................... 25
Item 6. Selected Financial Data.................................................................. 25
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.... 26
Item 8. Financial Statements and Supplementary Data.............................................. 33
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.... 33
PART III
Item 10. Directors and Executive Officers of the Registrant....................................... 34
Item 11. Executive Compensation................................................................... 34
Item 12. Security Ownership of Certain Beneficial Owners and Management........................... 34
Item 13. Certain Relationships and Related Transactions........................................... 34
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.......................... 35
Signatures......................................................................................... 36
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PART I
ITEM 1: BUSINESS
GENERAL
Background
In September 1997, Hanover Capital Mortgage Holdings, Inc. (the "Company")
raised net proceeds of approximately $79.1 million in its initial public
offering, pursuant to which the Company sold 5,750,000 units at $15.00 per unit.
Each unit consisted of one share of common stock, par value $.01, and one stock
purchase warrant. Each warrant entitles the holder to purchase one share of
common stock at $15.00 per share (subject to adjustment in certain events). The
warrants became exerciseable on March 19, 1998 and remain exerciseable until
September 15, 2000.
In connection with the initial public offering, the Company acquired a 97%
ownership interest (representing a 100% ownership of the non-voting preferred
stock) in Hanover Capital Partners Ltd. ("HCP") and its wholly-owned
subsidiaries, Hanover Capital Mortgage Corporation ("HCMC") and Hanover Capital
Securities, Inc. ("HCS"), in exchange for 716,667 shares of the Company's common
stock.
The Company is a specialty finance company the activities of which include
(i) acquiring primarily single-family subprime mortgage loans (as defined
below), (ii) securitizing mortgage loans and retaining interests therein, (iii)
offering due diligence services to buyers, sellers and holders of mortgage
loans, and (iv) originating, holding, selling and servicing multifamily mortgage
loans and commercial mortgage loans. The Company's principal business objective
is to generate increasing earnings and dividends for distribution to
stockholders. The Company acquires single-family mortgage loans through a
network of sales representatives targeting financial institutions throughout the
United States. The Company originates multifamily mortgage loans and commercial
mortgage loans through HCMC. The Company operates as a tax-advantaged REIT. The
Company is generally not subject to Federal income tax to the extent that it
distributes its earnings to its stockholders and maintains its qualification as
a REIT. Taxable affiliates of the Company, however, including HCP, HCMC and HCS,
are subject to Federal income tax. The Company has engaged HCP to render due
diligence, asset management and administrative services pursuant to a Management
Agreement.
The Company elected REIT status primarily for the tax advantages.
Management believes that the REIT structure is the most desirable structure for
owning mortgage assets because it eliminates corporate-level Federal income
taxation. In addition, as the Company is not a traditional lender which accepts
deposits, it is subject to substantially less regulatory oversight and incurs
lower operating expenses than banks, thrifts and many other originators of
mortgage assets. Management believes that the Company will generate attractive
earnings and dividends per share for stockholders through the combination of (i)
purchasing subprime single-family mortgage loans which generally have higher
yields than newly originated mortgage loans, (ii) using long-term financing that
allows the Company to realize net interest income over time as REIT-qualified
income, as opposed to fully taxable gain-on-sale income, and (iii) its focus on
originating multifamily mortgage loans and commercial mortgage loans, which
generally have higher yields than conforming single-family mortgage loans. As
used herein, the term "subprime single-family mortgage loan" means a single-
family mortgage loan that is either twelve months or older or
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that does not meet the originally intended credit quality due to documentation
errors or credit deterioration. Although HCP has previously rendered advisory
services in connection with securitization transactions, neither it nor HCMC has
securitized any significant amount of mortgage loans.
Business Strategy
The Company's strategy is to pursue acquisitions and originations of
mortgage loans where it believes it can receive acceptable rates of return on
invested capital and effectively utilize leverage. Key elements of this strategy
include:
o growing the Company's investment portfolio by utilizing the Company's
single-family mortgage loan acquisition network and multifamily and
commercial origination operation to create attractive investment
opportunities;
o financing the Company's investments in a manner that limits the
Company's interest rate risk while earning an attractive return on
equity; and
o owning mortgage assets in the REIT structure and thereby eliminating a
layer of taxes relative to most traditional real estate lenders.
The Company's principal executive offices are located at 90 West Street,
Suite 1508, New York, New York 10006.
INVESTMENT PORTFOLIO
General
The primary business of the Company is investing, generally on a long-term
basis, in first lien single-family mortgage loans, multifamily mortgage loans
and commercial mortgage loans and mortgage securities secured by or representing
an interest in mortgage loans (the "Investment Portfolio"). The percentage of
the Company's mortgage assets which is invested in various sectors of the
Investment Portfolio may vary significantly from time to time depending upon the
availability of mortgage loans and mortgage securities. The Company utilizes its
organization to acquire and securitize single-family mortgage loans and
originate commercial mortgage loans to earn higher returns than could generally
be earned from purchasing mortgage securities in the marketplace.
Single Family Mortgage Operations
Single-Family Mortgage Loans. The Company focuses on the purchase of pools
of whole single-family mortgage loans that do not fit into the large
government-sponsored or private conduit programs. Single-family mortgage loans
generally are acquired in pools from a wide variety of sources, including
private sellers such as banks, thrifts, finance companies, mortgage companies
and governmental agencies. The majority (65% - 70%) of the Company's acquisition
of single-family mortgage loan pools to date have been fixed rate loans, with
the balance made up of adjustable rate mortgage ("ARM") loans. At December 31,
1997, the Company had an investment in mortgage securities of $348 million. The
Company intends to liquidate these investments over the next twelve months as it
identifies and purchases additional single-family mortgage loan pools.
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The Company uses seven sales representatives from HCP, located in Illinois,
Minnesota, California, Massachusetts and New York, to source single-family
mortgage loan products. For the foreseeable future, the Company believes that
there will be an adequate supply of mortgage loan product that can be sourced by
the existing HCP sales force.
At December 31, 1997, the Company had invested $160,970,000 or 31.1% of the
Company's total assets in the following types of single-family mortgage loans in
accordance with the operating policies established by the Board of Directors.
Whole Loan Mortgage Loan Summary
Fixed Rate Mortgage Loans
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Face or principal amount $106,424,000
Carrying value 107,953,000
Weighted average net coupon 8.265%
Weighted average maturity
(in months) 242
Number of loans 1,763
Average loan size $60,365
Average loan-to-
value ratio (LTV) 67.13%
Adjustable Rate Mortgage (ARM) Loans
------------------------------------
Face or principal amount $52,365,000
Carrying value $53,017,000
Weighted average net coupon 7.925%
Weighted average maturity
(in months) 319
Number of loans 439
Average loan size $119,281
Average loan-to-
value ratio (LTV) 76.98%
At March 6, 1998, the Company had purchased since inception in excess of
$286 million of single-family mortgage loan pools and had committed to purchase
an additional $153 million of single-family mortgage loan pools.
In addition, HCP has a due diligence and underwriting staff, located in
Edison, New Jersey, consisting of approximately seven full-time employees. The
due diligence staff contributes to the single-family mortgage loan acquisition
process by providing expertise in the analysis of many characteristics of the
single-family mortgage loans. It has been Management's experience that buyers
generally discount the price of a single-family mortgage loan if there is a lack
of information. By having additional information on loan pools through its due
diligence operations, the Company is better able to assess the value of loan
pools.
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Because mortgage loan pools can be purchased from virtually any bank,
insurance company or financial institution, the Company is not dependent upon
any one source. At December 31, 1997, the Company had purchased approximately
29% of the Company's single-family mortgage loan portfolio from one source.
Management does not believe this concentration of purchases is indicative of
future trends. The Company does not service its single-family mortgage loans.
The servicing is outsourced to unrelated third parties specializing in loan
servicing.
The Company purchases ARM securities from broker-dealers and financial
institutions that regularly make markets in these securities. The Company can
also purchase mortgage-backed securities from other mortgage suppliers,
including mortgage bankers, banks, savings and loans, investment banking firms,
home builders and other firms involved in originating, packaging and selling
mortgage loans.
The mortgage loans and to a lesser extent the mortgage securities held in
the Investment Portfolio generally will be held on a long-term basis, so that
the returns will be earned over the lives of the mortgage loans and mortgage
securities rather than from sales of the investments.
Single-family mortgage loan pools are usually acquired through competitive
bids or negotiated transactions. The competition for larger single-family
mortgage loan portfolios is generally more intense, while there is less
competition for smaller single-family mortgage loan portfolios. Management
believes that the Company's funding flexibility, personnel, proprietary due
diligence software and single-family mortgage loan trading relationships provide
it with certain advantages over competitors in pricing and purchasing certain
single-family mortgage loan portfolios.
Prior to making an offer to purchase a single-family mortgage loan
portfolio, HCP employees conduct an extensive investigation and evaluation of
the loans in the portfolio. This examination typically consists of analyzing the
information made available by the portfolio seller (generally, an outline of the
portfolio with the credit and collateral files for each loan in the pool),
reviewing other relevant material that may be available, analyzing the
underlying collateral (including reviewing the Company's single-family mortgage
loan database which contains, among other things, listings of property values
and loan loss experience in local markets for similar assets), and obtaining
opinions of value from third parties (and, in some cases, conducting site
inspections). The Company's senior management determines the amount to be
offered for the portfolio using a proprietary stratification and pricing system
which focuses on, among other things, rate, term, location and types of the
loans. The Company also reviews information on the local economy and real estate
markets (including the amount of time and procedures legally required to
foreclose on real property) where the loan collateral is located.
In conducting due diligence operations, HCP often discovers non-conforming
elements of single-family mortgage loans, such as: (i) problems with documents,
including missing or lost documentation, errors on documents, nonstandard forms
of documents and inconsistent dates between documents, (ii) problems with the
real estate, including inadequate initial appraisals, deterioration in property
values or economic decline in the general geographic area, and (iii)
miscellaneous problems, including poor servicing, poor credit history of the
borrower, poor payment history by the borrower and current delinquency status.
The price paid for such loans is adjusted to compensate for these non-conforming
elements.
The Company maintains a process to improve the value of its single-family
mortgage loan portfolio, including updating data, obtaining lost note affidavits
in the event that a note has been misplaced, updating property values with new
appraisals, assembling historical records, obtaining mortgage insurance if the
value of a loan is in question, grouping similar loans in
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packages for securitization, and segmenting portfolios for different buyers.
However, Management believes any value created will be extracted by financing or
securitizing the single-family mortgage loans and then realizing the enhanced
spread on the retained pool, as opposed to recognizing a gain upon sale of the
single-family mortgage loan portfolio.
Single-Family Market Trends. The Company focuses on subprime mortgage loans
which are generally available in bulk from loan originators such as mortgage
bankers, banks and thrifts that originate primarily for sale and from mortgage
portfolio holders as they restructure their holdings.
Single-Family Acquisition Strategy. The Company believes that it can
continue to acquire single-family mortgage loans that have a relatively high
yield when compared to the applicable risk of loss. In many cases, portions of a
pool may be made eligible for inclusion in agency pools, which will raise the
credit level of the Investment Portfolio, while preserving the higher yield
obtained at the time of purchase. In addition, the Company may securitize a
single-family mortgage loan pool. In structuring a securitization, the Company
retains subordinated or other interests.
Single-Family Underwriting Guidelines. The Company has developed an
underwriting approval policy to maintain uniform control over the quality of the
single-family mortgage loans it purchases. This policy sets forth a three step
review process: (i) collateral valuation, (ii) credit review, and (iii) property
valuation. Prior to pricing a bid or final purchase of a portfolio, a senior
manager of the Company reviews the results of all three underwriting
evaluations. The collateral valuation entails a check on the collateral
documents (i.e., the note, mortgage, title policy and assignment chain). The
documents are examined for conformity among the documents and adherence to
secondary market standards. The credit review involves an analysis of the credit
of the borrower, including an examination of the origination and credit
documents, credit report and payment history. For more seasoned single-family
mortgage loans, the analysis may be more directed at payment histories and
credit scores. The property valuation involves an analysis of the loan-to-value
of the collateral, including an examination of the original appraisal in the
context of the current regional property market conditions and often a drive-by
valuation of the subject property and review of recent comparable sales.
Single-Family Servicing. Pools of single-family mortgage loans are
purchased with servicing retained or released by the seller. In the case of
pools purchased with servicing retained by the seller, the Company considers the
reputation and the servicing capabilities of the servicer. In some instances,
the Company requires a master servicer to provide the assurance of quality
required. A master servicer provides oversight of its subservicers and stands
ready, and is contractually obligated, to take over the servicing if there is a
problem with the subservicer. In the case of pools purchased with servicing
released, the Company places the servicing with a qualified servicer. In some
cases, the Company may retain the servicing and contract with a qualified
servicer to provide subservicing. In this case, the Company keeps the risk of
ownership of the servicing with respect to any change in value as a result of
prepayment of the underlying single-family mortgage loans or other factors. No
single-family mortgage loans are currently serviced by the Company.
Commercial Mortgage Loans and Multifamily Mortgage Loans
The Company's affiliate HCMC was one of the first commercial mortgage
banking operations to originate multifamily mortgage loans for sale to conduits.
From direct borrower originations and its network of third party brokers, it can
provide multifamily mortgage loans and commercial mortgage loans of sufficient
credit quality to meet the requirements for securitization, as well as sales to
third party investors and purchases by the Company for the
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Investment Portfolio. Due to low interest spreads, no multifamily mortgage loans
or commercial mortgage loans were purchased by the Company in 1997. However, in
the future, the Company may originate multifamily mortgage loans and commercial
mortgage loans, including mortgage loans secured by income-producing commercial
properties such as office, retail, warehouse and mini-storage facilities,
through HCMC and subsequently either sell the mortgage loans to investors or
hold them in the Investment Portfolio. Management of the Company believes that
the Company has certain competitive advantages in the commercial mortgage market
due to the speed, consistency and flexibility with which it can act as a
vertically integrated company (acting as originator, servicer, and owner of
commercial mortgage loans).
Commercial Production Process. The commercial process differs from the
single-family mortgage loan acquisition process because HCMC operates as a
direct originator of loans. HCMC has been engaged in this process since 1992 and
has been an active supplier to the Wall Street conduit/securitization firms,
which are Wall Street dealer firms that have set up a conduit to purchase
multifamily mortgage loans and commercial mortgage loans from national brokers
and mortgage bankers for the purpose of issuing commercial mortgage-backed
securities. HCMC has the ability to source new commercial mortgage loans
directly and through brokers, to process and underwrite the loans to the
Company's standards and to service the loans.
Commercial and Multifamily Loan Acquisition/Production Strategies. The
Company adheres to specified underwriting and due diligence requirements for the
origination of multifamily and commercial mortgage loans, such that they will
qualify for sale to third party conduits or for inclusion in securitizations.
The Company continually monitors the underwriting criteria by contacting rating
agencies and the third party conduit purchasers. In addition to the underwriting
and due diligence completed at the origination level, a separate credit
committee approves all multifamily mortgage loans and commercial mortgage loans
purchased for the Investment Portfolio. The Company intends that, with prudent
underwriting and due diligence, combined with the securitization option, it will
achieve a satisfactory reward/risk ratio; however, there are no assurances that
it will be able to do so.
HCMC originates new multifamily and commercial mortgage loans through
originators that call on brokers, real estate developers and owners. While the
Company's sales force concentrates primarily on sourcing pools of single-family
mortgage loans, it also can find leads for the multifamily and commercial
mortgage loan origination business of HCMC and the due diligence operations of
HCP.
Commercial and Multifamily Underwriting Guidelines. The Company's
underwriting guidelines for commercial and multifamily mortgage loans focus on
the origination of loans eligible for securitization. The due diligence process
focuses on four main areas: (i) a property level review, (ii) borrower credit
issues, (iii) cash flow structures, and (iv) adequacy of legal documentation.
The property level review begins with a review of the on-site inspection report
and includes an analysis of the third party reports, including the appraisal,
engineering report and environmental report. The borrower credit issues include
an analysis of the borrower's legal structure, a review of financial statements,
past credit history of principals, management's ability and experience and
prior/existing relationships. The cash flow structures include an analysis of
the loan-to-value ratio, the expense ratio, the debt service coverage, the value
per unit, the occupancy levels and the historical expense records. The legal
documentation review includes a review of any changes to the approved program
loan documents, including the note, mortgage, reserve agreements, assignments of
leases and any borrower certifications. The program loan documents will be
structured in order to meet the requirements of securitization with respect to
such matters as prepayment penalties, recourse carve-outs and the overall
soundness of the documents. In addition, the Company obtains a "Phase I"
environmental site assessment (i.e.,
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generally a record search with no invasive testing) of the property that will
secure a commercial or multifamily mortgage loan. Depending on the results of
the Phase I assessment, the Company may require a Phase II assessment. The
Company's loan servicing guidelines require that the Company obtain a Phase I
assessment (which includes invasive testing) of any mortgaged property prior to
the Company acquiring title to or assuming operation of the mortgaged property.
This requirement effectively precludes the Company from enforcing the rights
under the mortgage loan until a satisfactory Phase I environmental site
assessment is obtained or until any required remedial action is thereafter
taken, but also decreases the likelihood that the Company will become liable for
any material environmental condition at a mortgaged property.
Commercial and Multifamily Mortgage Loan Servicing. To control the credit
risk of retained interests in securitized loans, HCMC will retain the servicing
rights on any commercial mortgage loans and multifamily mortgage loans held in
the Investment Portfolio. HCMC may also retain the servicing rights on loans
originated and sold to third party conduits. HCMC, as servicer, will have the
risks associated with operating a mortgage servicing business as well as the
risk of ownership of the servicing.
At December 31, 1997, HCMC serviced approximately $121 million of
multifamily mortgage loans. The servicing of mortgage loans involves processing
and administering the mortgage loan payments for a fee. It involves collecting
mortgage payments on behalf of investors, reporting information to investors and
maintaining escrow accounts for the payment of principal and interest to
investors and property taxes and insurance premiums on behalf of borrowers.
The primary risk of operating a servicing business is failing to service
the loans in accordance with the servicing contracts, which exposes the servicer
to liability for possible losses suffered by the owner of the loans. The
operational requirements include proper handling and accounting for all payment
and escrow amounts, proper borrower and periodic credit reviews, proper value
and property reviews and proper payment of all monies due to third parties, such
as real estate taxing authorities and insurance companies.
The primary risks of ownership of servicing rights include the loss of
value through faster than anticipated loan prepayments (even though there may be
prepayment penalties) or improper servicing as outlined above.
Commercial Market Trends. The market for commercial and multifamily
mortgage loans has undergone dramatic changes in recent years with the advent of
securitizations. Financing of income-producing property has evolved from a
traditional two-party lending relationship, with the borrower obtaining funding
from a traditional lending institution, to a market in which lenders with
expertise in the creation of mortgage-backed securities offer borrowers an
alternative source of competitive financing. Securitization involves multiple
parties, each with specialized roles and responsibilities creating profitable
lending opportunities for those with experience in commercial mortgage finance
and the capital markets. Securitizations of commercial and multifamily mortgage
loans have grown rapidly during the 1990s.
The growth in securitization has been the result of two market forces.
First, during the recession of the early 1990s, traditional lenders withdrew
from the real estate credit market. Securitization filled the resulting void.
Second, Congress established the Resolution Trust Corporation ("RTC") in 1989 in
order to liquidate the commercial and single-family mortgage assets of failed
financial institutions. After unsuccessfully trying to sell the mortgages, the
RTC began securitizing commercial mortgages. The RTC's enormous securitization
program stimulated the growth of the private sector securitization market by
providing experience and knowledge to participants such as investment bankers,
rating agencies, mortgage companies,
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attorneys, accountants and loan servicers. These participants have applied the
experience and knowledge gained in the securitization of RTC assets to the
securitization of non-governmental, private-label securities. The RTC's program
also helped create an informed and active investor base for the securities
created from the securitization of commercial mortgage assets.
The Company believes that success in the commercial market depends on a
vertically integrated strategy, which includes origination of commercial and
multifamily mortgage loans, servicing, securitization and investment in the
residual security after securitization. The Company is structured to take
advantage of efficiencies in the vertically integrated strategy, which it
anticipates will result in attractive returns to equity. However, there can be
no assurance that such returns will be achieved.
ACCUMULATION PERIOD ACQUISITIONS
The Company initially allocated a majority of the net proceeds of its
initial public offering to build a portfolio of mortgage assets, primarily
composed of adjustable rate mortgage pass-through securities of high investment
quality to provide income during the time required to acquire mortgage loans.
The Company acquires mortgage loans in the secondary mortgage market as
soon as attractive opportunities are identified. Management anticipates that
the Company will earn an acceptable level of return on the initial portfolio
until the net proceeds from the initial public offering can be fully invested in
higher yielding mortgage assets. A similar portfolio acquisition strategy will
be employed whenever the Company obtains new financing or capital.
At December 31, 1997, the Company had invested $348,131,000 or 67.3% of the
Company's total assets in the following types of mortgage securities in
accordance with the operating policies established by the Board of Directors.
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) SECURITIES
Par value at purchase date $200,524,000
December 31, 1997 adjusted principal $200,524,000
Amortized cost basis $207,898,000
Market value $207,397,000
Weighted average net coupon 7.761%
Weighted average maturity
(in months) 291
FEDERAL HOME LOAN MORTGAGE BANK (FHLMC) SECURITIES
Par value at purchase date $136,237,000
December 31, 1997 adjusted principal $136,237,000
Amortized cost basis $141,075,000
Market value $140,734,000
Weighted average net coupon 7.891%
Weighted average maturity
(in months) 305
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DUE DILIGENCE OPERATIONS
The Company conducts due diligence operations through HCP for commercial
banks, government agencies, mortgage banks, credit unions and insurance
companies. The operations consist of the underwriting of credit, analysis of
loan documentation and collateral, and analysis of the accuracy of the
accounting for mortgage loan servicing by third party servicers. The due
diligence analyses are performed on a loan by loan basis. Audits of the accuracy
of the interest charged on adjustable rate mortgage loans are frequently a part
of the due diligence services provided to customers. HCP performs due diligence
on mortgage loans acquired by the Company and by unrelated third parties.
FINANCING
General
The Company's purchases of mortgage assets are initially financed primarily
with equity and short-term borrowings through reverse repurchase agreements
until long-term financing is arranged or the assets are securitized. Generally,
upon repayment of each borrowing in the form of a reverse repurchase agreement,
the mortgage asset used to collateralize the financing will immediately be
pledged to secure a new reverse repurchase agreement or long term financing. The
Company had established mortgage asset financing agreements with various
financial institutions at December 31, 1997 and is currently negotiating a
back-up line of credit agreement with several major financial institutions.
Reverse Repurchase Agreements
A reverse repurchase agreement, although structured as a sale and
repurchase obligation, is a financing transaction in which the Company pledges
its mortgage assets as collateral to secure a short-term loan. Generally, the
other party to the agreement will loan an amount equal to a percentage of the
market value of the pledged collateral, typically 80% to 98%. At the maturity of
the reverse repurchase agreement, the Company is required to repay the loan and
correspondingly receives back its collateral. Under reverse repurchase
agreements, the Company generally retains the incidents of beneficial ownership,
including the right to distributions on the collateral and the right to vote on
matters as to which certificate holders vote. If the Company defaults in a
payment obligation under such agreements, the lending party may liquidate the
collateral.
In the event of the insolvency or bankruptcy of the Company, certain
reverse repurchase agreements may qualify for special treatment under the United
States Bankruptcy Code, which permits the creditor to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral without
delay. In the event of the insolvency or bankruptcy of a lender during the term
of a reverse repurchase agreement, the lender may be permitted, under the
Bankruptcy Code, to repudiate the contract, and the Company's claim against the
lender for damages therefrom may be treated simply as that of an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970 or an insured depository institution
subject to the Federal Deposit Insurance Act, the Company's ability to exercise
its rights to recover its mortgage assets under a reverse repurchase agreement
or to be compensated for damages resulting from the lender's insolvency may be
limited by those laws. The effect of these various statutes is, among other
things, that a bankrupt lender, or its conservator or receiver, may be permitted
to repudiate or disaffirm its reverse repurchase agreements, and the Company's
claims against the bankrupt lender may be treated as an unsecured claim. Should
this occur, the Company's claims would be subject to significant delay
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and, if and when paid, could be in an amount substantially less than the damages
actually suffered by the Company.
To reduce its exposure to the credit risk of reverse repurchase agreements,
the Company enters into the arrangements with several different parties. The
Company monitors the financial condition of its reverse repurchase agreement
lenders on a regular basis, including the percentage of its mortgage loans that
are the subject of reverse repurchase agreements with a single lender.
Notwithstanding these measures, no assurance can be given that the Company will
be able to avoid such third party risks.
The reverse repurchase borrowings bear short-term fixed (one year or less)
interest rates varying from LIBOR to LIBOR plus 125 basis points depending on
the credit of the related mortgage assets. Generally, the borrowing agreements
require the Company to deposit additional collateral in the event the market
value of existing collateral declines, which, in dramatically rising
interest-rate markets, could require the Company to sell assets to reduce the
borrowings.
SECURITIZATION AND SALE PROCESS
General
When the Company acquires a sufficient volume of mortgage loans with
similar characteristics, generally $50 million to $100 million or more, the
Company plans to securitize them through the issuance of mortgage-backed
securities in the form of REMICs or CMOs. Alternatively, to a lesser extent and
to the extent consistent with the Company's qualification as a REIT, the Company
may resell loans in bulk whole loan sales. The length of time from when the
Company commits to purchase a mortgage loan to when it sells or securitizes the
loan will generally range from 30 days to one year or more, depending on certain
factors, including the length of the purchase commitment period, the amount and
type of the mortgage loan, and the securitization process. Any decision by the
Company to issue CMOs or REMICs or to sell mortgage loans in bulk will be
influenced by a variety of factors.
For accounting and tax purposes, mortgage loans financed through the
issuance of CMOs are treated as assets of the Company, and the CMOs are treated
as debt of the Company. The Company earns the net interest spread between the
interest income on the mortgage loans and the interest and other expenses
associated with the CMO financing. The net interest spread will be directly
affected by prepayments of the underlying mortgage loans and, to the extent the
CMOs have variable interest, may be affected by changes in short-term
interest-rates.
As an alternative to CMOs, the Company may issue REMICs. REMIC transactions
are generally accounted for as sales of the mortgage loans. REMIC securities
consist of one or more classes of "regular interests" and a single "residual
interest." The regular interests are tailored to the needs of investors and may
be issued in multiple classes with varying maturities, average lives and
interest-rates. These regular interests are predominantly senior securities but,
in conjunction with providing credit enhancement, may be subordinated to the
rights of other regular interests. The residual interest represents the
remainder of the cash flows from the underlying mortgage loans over the amounts
required to be distributed on the regular interests. In some cases, the regular
interests may be structured so that there is no significant residual cash flow.
In such a REMIC transaction, the Company sells its entire interest in the
mortgage loans, and all of the capital originally invested in the mortgage loans
may be redeployed. The
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Company may retain regular and residual interests on a short-term or long-term
basis. Income from REMIC issuances is not treated as REIT qualifying income.
Accordingly, REMIC issuances are not the Company's primary securitization
technique and will generally be undertaken through the taxable subsidiaries.
The Company expects that its retained interests in securitizations will be
subordinated to the securities issued to third party investors with respect to
losses of principal and interest on the underlying mortgage loans. Accordingly,
any such losses on underlying mortgage loans will be applied first to reduce the
remaining amount of the Company's retained interest, until reduced to zero. Any
retained regular interest may include "principal only" or "interest only"
securities or other interest rate or prepayment sensitive securities or
investments. Any retained securities may subject the Company to credit, interest
rate and/or prepayment risks. The Company anticipates it will retain securities
only on terms which it believes are sufficiently attractive to compensate it for
assuming the associated risks.
The Company may also retain subordinated mortgage backed securities, with
ratings ranging from AA to unrated, generally fixed-rate. The fixed-rate
securities generally evidence interests in 30-year single-family mortgage loans.
Securities backed by multifamily mortgage loans and commercial loans are
generally interests in 7 or 10 year balloon loans with 25 or 30 year
amortization schedules. In general, subordinated classes bear all losses prior
to the related senior classes. Losses in excess of losses anticipated at the
time subordinated securities are purchased would adversely affect the Company's
yield on the securities and, in extreme circumstances, could result in the
failure of the Company to recoup its initial investment.
Except in the case of breach of the representations and warranties made by
the Company when mortgage loans are securitized, the securitization of mortgage
loans will be non-recourse to the Company. As a result, the Company is able to
maintain the economic benefit of financing the mortgage assets and earning a
positive net interest spread, while limiting its potential risk of credit loss
to its investment in the subordinated or residual securities (generally
approximately 5% to 10% of the loan pool amount). A second advantage to the CMO
structure is that it is permanent financing and, therefore not subject to
margin calls during periods in which the value of the pool assets are declining
due to increases in interest rates.
The Company typically pays a monoline bond insurer a monthly fee to assume
a portion of the credit risk in a pool of mortgage loans. The monoline insurer
would generally require the issuer to retain a portion of the credit risk and
over-collateralize a particular pool of mortgage loans.
Proceeds from securitizations will be available to support new loan
originations and acquisitions. In addition to providing relatively less
expensive long-term financing, Management believes that the Company's
securitizations will reduce the Company's interest-rate risk on mortgage assets
held for long-term investment.
Credit Enhancement
REMICs or CMOs created by the Company are structured so that one or more of
the classes of the securities are rated investment grade by at least one
nationally recognized rating agency. The ratings for the Company's mortgage
assets will be based on the rating agency's view of the perceived credit risk of
the underlying mortgage loans, the structure of the mortgage assets and
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the associated level of credit enhancement. Credit enhancement is designed to
provide protection to the holders of the securities in the event of borrower
defaults and other losses including reductions in the principal or interest as
required by law or a bankruptcy court. The Company can utilize multiple forms of
credit enhancement, including special hazard insurance, monoline insurance,
reserve funds, letters of credit, surety bonds and subordination or any
combination thereof. A decline in the credit quality of the mortgage loans
backing any mortgage securities or of any third party providing credit
enhancement, or adverse developments in general economic trends affecting real
estate values or the mortgage industry, could result in ratings being
downgraded.
In determining whether to provide credit enhancement, the Company takes
into consideration the costs associated with each method. The Company generally
provides credit enhancement through the issuance of mortgage-backed securities
in senior/subordinated structures or by over-collaterization of its mortgage
assets. The need for additional collateral or other credit enhancements will
depend upon factors such as the type of collateral provided and the
interest-rates paid thereon, the geographic concentration of the mortgaged
property and other criteria established by the rating agency. The pledge of
additional collateral would reduce the capacity of the Company to raise
additional funds through short-term secured borrowings or additional CMOs and
will diminish the potential expansion of the Investment Portfolio. Accordingly,
collateral would be pledged for CMOs only in the amount required to obtain the
highest rating category of a nationally-recognized rating agency. The
subordinated mortgage securities may be sold, retained by the Company or
accumulated for sale in subsequent transactions.
Other Mortgage-Backed Securities
As an additional alternative for the financing of the Investment Portfolio,
the Company may cause to be issued other mortgage-backed securities if the
issuance of such other securities is advantageous and consistent with the
Company's qualification as a REIT. In particular, mortgage pass-through
certificates representing undivided interests in pools of mortgage loans formed
by the Company may prove to be attractive vehicles for raising funds.
The holders of mortgage pass-through certificates receive their pro rata
share of the principal payments made on a pool of mortgage loans and interest at
a pass-through interest rate that is fixed at the time of the offering. The
Company intends to retain significant portions of the undivided interests in the
mortgage loans underlying pass-through certificates. The retained interest may
also be subordinated so that, in the event of a loss, payments to certificate
holders will be made before the Company receives its payments. Unlike the
issuance of CMOs, the issuance of mortgage pass-through certificates will not
create an obligation of the Company to security holders in the event of a
borrower default. However, as in the case of CMOs, the Company may be required
to obtain credit enhancement in order to obtain a rating for the mortgage
pass-through certificates in one of the top two rating categories established of
a nationally-recognized rating agency.
Capital Allocation Guidelines (CAG)
The Company has adopted capital allocation guidelines ("CAG") in order to
strike a balance between the under-utilization of leverage and excess dependence
on leverage, which could reduce the Company's ability to meet its obligations
during adverse market conditions. Modifications to the CAG require the approval
of a majority of the Company's Board of
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Directors. The CAG are intended to keep the Company's leverage balanced by (i)
matching the amount of leverage to the riskiness (return and liquidity) of each
mortgage asset, and (ii) monitoring the credit and prepayment performance of
each mortgage asset to adjust the required capital. This analysis takes into
account the Company's various hedging and other risk containment programs
discussed below. In this way, the use of balance sheet leverage is optimized
through the implementation of the CAG controls. The lender haircut indicates the
minimum amount of equity the lender requires with a mortgage asset. There is
some variation in haircut levels among lenders from time to time. From the
lender's perspective, the haircut is a "cushion" to protect capital in case the
borrower is unable to meet a margin call. The size of the haircut depends on the
liquidity and price volatility of each mortgage asset. Agency securities are
very liquid, with price volatility in line with the fixed income markets which
means a lender requires a smaller haircut, typically 3%. On the other extreme,
"B" rated securities and securities not registered with the Securities and
Exchange Commission are substantially less liquid, and have more price
volatility than agency securities, which results in a lender requiring a larger
haircut. Particular securities that are performing below expectations would also
typically require a larger haircut. The haircut for residential whole loan pools
will generally range between 3% and 5% depending on the documentation and
delinquency characteristics of the pool. Certain whole loan pools may have
haircuts which may be negotiated with lenders in excess of 5% due to other
attributes of the pool.
Implementation of the CAG -- Mark to Market Accounting
Each quarter, for financial management purposes, the Company marks its
mortgage assets to market. This process consists of (i) valuing the Company's
mortgage assets acquired in the secondary market, and (ii) valuing the Company's
non-security investments, such as retained interests in securitizations. For the
purchased mortgage assets, the Company obtains benchmark market quotes from
traders who make markets in securities similar in nature to the mortgage assets.
The Company then adjusts for the difference in pricing between securities and
whole loan pools. Market values for the Company's retained interests in
securitizations are calculated internally using market assumptions for losses,
prepayments and discount rates.
The face amount of the financing used for the securities and retained
interests is subtracted from the current market value of the mortgage assets
(and hedges). This is the current market value of the Company's equity
positions. This value is compared to the required capital as determined by the
CAG. If the actual equity of the Company falls below the capital required by the
CAG, the Company must prepare a plan to bring the actual capital above the level
required by the CAG.
Periodically, Management presents to the Board of Directors the results of
the CAG compared to actual equity. Management may propose changing the capital
required for a class of investments or for an individual investment based on its
prepayment and credit performance relative to the market and the ability of the
Company to predict or hedge the risk of the mortgage asset.
As a result of these procedures, the leverage of the balance sheet will
change with the performance of the Company's mortgage assets. Good credit or
prepayment performance may release equity for purchase of additional mortgage
assets, leading to increased earnings. Poor credit or prepayment performance may
cause additional equity to be allocated to existing investments, forcing a
reduction in mortgage assets on the balance sheet and lower future earnings. In
either case, the constant mortgage asset performance evaluation, along with the
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corresponding leverage adjustments, helps to maintain the maximum acceptable
leverage (and earnings) while protecting the capital base of the Company.
RISK MANAGEMENT
The Company believes that its portfolio income is subject to three primary
risks: credit risk, interest rate risk and prepayment risk.
Credit Risk Management
The Company reduces credit risk through (i) the review of each mortgage
loan prior to purchase to ensure that it meets the guidelines established by the
Company, (ii) use of early intervention, aggressive collection and loss
mitigation techniques in the servicing process, (iii) use of insurance in the
securitization process, (iv) maintenance of appropriate capital and reserve
levels, and (v) obtaining representations and warranties, to the extent
possible, from originators. Although the Company does not set specific
geographic diversification requirements, the Company closely monitors the
geographic dispersion of the mortgage loans and makes decisions on a portfolio
by portfolio basis about adding to specific concentrations.
Commercial mortgage loans held by the Company generally are originated by
HCMC to underwriting standards established by the Company. These underwriting
standards reflect the experience of HCMC in its past originations as well as the
requirements of the rating agencies for commercial mortgage loans. The credit
underwriting includes a financial and credit check of the borrower, technical
reports including appraisal, engineering and environmental reports, as well as a
review of the economic status of the geographic area where the mortgaged
property is located. In addition, a separate credit sign-off is required before
commercial mortgage loans are transferred to the Investment Portfolio from HCMC.
The commercial mortgage loans in the Investment Portfolio will be monitored by
the servicing department of HCMC, which includes a periodic review of financial
statements of the mortgaged property as well as property inspections.
Single-family mortgage loans are generally purchased in bulk pools of $2
million to $100 million. 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 bulk of the work is performed by employees in the due diligence
operations of HCP.
Interest Rate Risk Management
There are two basic types of mortgage loans held by the Company: mortgage
loans held for securitization or sale and mortgage loans held in securitized
form. Mortgage loans held for securitization or sale are generally hedged. A
variety of hedging instruments may be used, depending on the asset to be hedged
and the relative price of the various hedging instruments. Hedging instruments
include forward sales of mortgage securities, and may also include interest rate
futures or options, interest rate swaps, and cap and floor agreements. Mortgage
loans held in securitized form are generally financed in a manner designed to
maintain a consistent spread in a variety of interest rate environments and
therefore do not require any hedging.
The Company may purchase interest rate caps, interest rate swaps and
similar instruments to attempt to mitigate the risk of the cost of its variable
rate liabilities increasing at a faster rate than the earnings on its mortgage
assets during a period of rising interest rates. The Company
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generally hedges as much of the interest rate risk as management determines is
reasonable, given the cost of such hedging transactions and the need to maintain
the Company's status as a REIT, among other factors. The Company may also, to
the extent consistent with its qualification as a REIT and Maryland law, utilize
financial futures contracts, options and forward contracts and other instruments
as a hedge against future interest rate changes. See "Business - Hedging."
Prepayment Risk Management
With respect to commercial and multifamily mortgage loans, the Company will
seek to minimize the effects of faster or slower than anticipated prepayment
rates by originating mortgage loans with prepayment penalties and utilizing
various financial hedging instruments. With respect to single-family mortgage
loans, the Company utilizes various financial instruments as a hedge against
prepayment risk. Prepayment risk is monitored by senior management and through
periodic review of the impact of a variety of prepayment scenarios on the
Company's revenues, net earnings, dividends, cash flow and net balance sheet
market value.
Although the Company believes it has developed a cost-effective
asset/liability management program to provide a level of protection against
interest rate and prepayment risks, no strategy can completely insulate the
Company from the effects of interest rate changes, prepayments and defaults by
counterparties. Further, certain of the Federal income tax requirements that the
Company must satisfy to qualify as a REIT limit the Company's ability to fully
hedge its interest rate and prepayment risks.
HEDGING
Investment Portfolio
The Company's primary method of addressing interest rate risk on its
mortgage assets is through its strategy of securitizing mortgage loans with
collateralized mortgage obligation ("CMO") borrowings, which are designed to
provide long term financing while maintaining a consistent spread in a variety
of interest-rate environments. The Company believes that its primary interest
rate risk relates to mortgage assets that are financed with reverse repurchase
agreements and are held for securitization.
The Company uses certain hedging strategies in connection with the
management of the Investment Portfolio. To the extent consistent with the
Company's REIT status, the Company follows a hedging program intended to protect
against interest rate changes and to enable the Company to earn net interest
income in periods of generally rising, as well as declining or static, interest
rates. Specifically, the goal of the hedging program is to offset the potential
adverse effects of changes in interest rates relative to the interest rates of
the mortgage assets held in the Investment Portfolio. As part of its hedging
program, the Company also monitors prepayment risks that arise in fluctuating
interest rate environments.
The Company may use a variety of instruments in its hedging program. One
example is an interest rate cap. In a typical interest rate cap agreement, the
cap purchaser makes an initial lump sum cash payment to the cap seller in
exchange for the seller's promise to make cash payments to the purchaser on
fixed dates during the contract term if prevailing interest rates exceed the
rate specified in the contract. The Company may also purchase mortgage
derivative securities. Mortgage derivative securities can be effective hedging
instruments in certain situations as the value and yields of some of these
instruments tend to increase as interest rates rise and to decrease as interest
rates decline, while the experience for others is the converse. The
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Company will limit its purchases of mortgage derivative securities to
investments that must meet REIT requirements. To a lesser extent, the Company
may also enter into interest rate swap agreements, financial futures contracts
and options on financial futures contracts, and forward contracts. However, the
Company will not invest in these instruments unless the Company is exempt from
the registration requirements of the Commodity Exchange Act or otherwise
complies with the provisions of that Act. The REIT rules may restrict the
Company's ability to purchase certain instruments and may restrict the Company's
ability to employ other strategies. In all its hedging transactions, the Company
deals only with counterparties that the Company believes are sound credit risks.
In connection with securitizations of mortgage loans, the Company is
subject to the risk of rising mortgage interest rates between the time it
commits to a fixed price purchase and the time it sells or securitizes the
mortgage loans. To mitigate this risk, the Company may utilize hedging
strategies, including mandatory and optional forward selling of mortgage loans
or mortgage-backed securities, interest rate caps and floors, and buying and
selling of futures and options on futures. The nature and quantity of these
hedging transactions is determined by the management of the Company based on
various factors, including market conditions and expected volume of mortgage
loan purchases.
Costs and Limitations
The Company believes that it has implemented a cost-effective hedging
policy to provide an adequate level of protection against interest-rate risks.
However, maintaining an effective hedging strategy is complex, and no hedging
strategy can completely insulate the Company from interest-rate risks. Moreover,
as noted above, certain of the REIT rules limit the Company's ability to fully
hedge its interest rate risks. The Company monitors carefully, and may have to
limit, its hedging strategies to assure that it does not violate the REIT rules,
which could result in disqualification and/or payment of penalties.
In addition, hedging involves transaction and other costs, which can
increase dramatically as the period covered by the hedge increases and also
increase in periods of rising and fluctuating interest-rates. Therefore, the
Company may be prevented from effectively hedging its interest-rate risks
without significantly reducing the Company's return on equity.
SERVICING RIGHTS
Whether servicing is purchased (along with purchased single-family mortgage
loans) or created (by the origination of multifamily mortgage loans and
commercial mortgage loans), a value is placed on the servicing as a purchased
mortgage servicing right ("PMSR") or an originated mortgage servicing right
("OMSR"), as the case may be, and recorded as an asset on the books of the
Company.
The valuation of a PMSR and an OMSR includes an analysis of the
characteristics of the size, rate, escrow amounts, type, maturity, etc. of the
loan, as well as an estimate of the mortgage loan's remaining life. To the
extent the characteristics change or the estimate of remaining life changes, the
value of the PMSR or OMSR will be adjusted. For example, if mortgage loans are
repaid more quickly than originally forecasted (increased speed), the value of
the OMSR or PMSR will be reduced.
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REGULATION
There are various state and local laws and regulations affecting the
Investment Portfolio. HCMC has mortgage-banking licenses in Arizona, Illinois,
New Jersey, Vermont and Wisconsin. In addition, the Company's activities are
subject to the rules and regulations of HUD. Mortgage operations also may be
subject to applicable state usury and collection statutes. The Company believes
that it is currently in compliance with all material rules and regulations to
which it is subject and has all required licenses.
COMPETITION
The Company participates on a national level in the mortgage market, which
is estimated at $3.8 trillion for single-family mortgage loans and $1.0 trillion
for multifamily mortgage loans and commercial loans. In purchasing mortgage
loans and issuing mortgage-backed securities, the Company competes with other
REITs, established mortgage conduit programs, investment banking firms, savings
and loan associations, banks, thrift and loan associations, finance companies,
mortgage bankers, insurance companies, other lenders and other entities
purchasing mortgage assets. In addition, there are several mortgage REITs
similar to the Company and others may be organized in the future. Continued
consolidation in the mortgage banking industry may reduce the number of sellers
of mortgage loans, which would reduce the Company's potential customer base and
result in the Company purchasing a larger percentage of mortgage loans from a
smaller number of sellers. These changes could negatively impact the Company. As
an issuer of mortgage securities, the Company will face competition for
investors from other investment opportunities.
Increasingly, mortgage lending is being conducted by mortgage lenders who
specialize in the origination and servicing of mortgage loans and then sell
these loans to other mortgage investment institutions, such as the Company. The
Company believes it has a competitive advantage because of the low cost of its
operations relative to traditional mortgage investors such as banks and savings
and loans. Like traditional financial institutions, the Company seeks to
generate income for distribution to its shareholders primarily from the
difference between the interest income on its mortgage assets and the financing
costs associated with carrying the mortgage assets.
EMPLOYEES
The Company had no employees at December 31, 1997. The Principals became
employees of the Company as of January 1, 1998. The Company engages the services
of HCP to provide management expertise, product sourcing, due diligence support,
and general and administrative services to assist the Company in accomplishing
its business objectives. At December 31, 1997, HCP employed 50 people on a
full-time basis. To date, HCP believes it has been successful in its efforts to
recruit qualified employees, but there is no assurance that it will continue to
be successful in the future. None of HCP's employees are subject to collective
bargaining agreements.
SERVICE MARKS
HCP owns two service marks that have been registered with the United States
Patent and Trademark Office, each of which expires in the year 2003.
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FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the Company's investment and
operating policies, which can be revised only with the approval of the Board of
Directors, including a majority of the unaffiliated directors. Except as
otherwise restricted, the Board of Directors may revise the policies without the
consent of stockholders if the Board of Directors determines that the change is
in the best interests of stockholders. Developments in the market which affect
the policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and financing strategies.
The Company has elected to qualify as a REIT for tax purposes (see "Federal
Income Tax Considerations"). The Company has adopted certain compliance
guidelines which include restrictions on the acquisition, holding and sale of
assets. Prior to the acquisition of any asset, the Company determines whether
the asset meets REIT requirements. Substantially all of the assets that the
Company has acquired and will acquire for investment are expected to qualify as
REIT assets. This requirement limits the Company's investment strategies.
The Company closely monitors its purchases of mortgage assets and the
sources of its income, including from its hedging strategies, to ensure at all
times that it maintains its qualifications as a REIT. The Company has developed
certain accounting systems and testing procedures to facilitate its ongoing
compliance with the REIT provisions of the Code. No changes in the Company's
investment policies and operating strategies, including credit criteria for
mortgage asset investments, may be made without the approval of the Company's
Board of Directors, including a majority of the unaffiliated directors.
The Company intends to conduct its business so as not to become regulated
as an investment company under the Investment Company Act of 1940. The
Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under current interpretation
of the staff of the Securities and Exchange Commission, in order to qualify for
this exemption, the Company must maintain at least 55% of its assets directly in
Qualifying Interests. In addition, unless certain mortgage securities represent
all the securities issued with respect to an underlying pool of mortgages, the
securities may be treated as securities separate from the underlying mortgage
pool and, thus, may not be considered Qualifying Interests for purposes of the
55% requirement. The Company closely monitors its compliance with this
requirement and intends to maintain its exempt status. As of this date, the
Company has been able to maintain its exemption through the purchase of mortgage
loan pools and certain whole pool government agency securities that qualify for
the exemption.
RELATIONSHIPS WITH AFFILIATES AND PRIOR BUSINESS
HCP has rendered asset management services in connection with the
short-term trading of seasoned (more than one year since origination)
single-family mortgage loans since 1995. In managing mortgage activities, HCP
typically targeted mortgage loan pools containing subprime single-family
mortgage loans with deficiencies that could be corrected so as to permit resales
on favorable terms. In managing sale activities, HCP generally has pursued a
strategy of selling single-family mortgage loans within eighteen months after
their acquisition. The Company, on the other hand, generally holds mortgage
loans on a long-term basis, so that returns are earned over the lives of
mortgage loans rather than from their sales.
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In the past, HCP has engaged in single-family mortgage loan acquisition,
financing, hedging and sale activities pursuant to private management
arrangements with (i) Alpine Associates, a Limited Partnership ("Alpine
Associates"), (ii) a limited liability company formed by HCP, Alpine Associates
and an affiliate of Bankers Trust New York Corp. and (iii) certain affiliates of
Bankers Trust New York Corp. The objective in each of those arrangements was to
profit from purchasing and reselling mortgage loans rather than, as in the case
of the Company, from holding, financing and securitizing mortgage loans.
Alpine Associates and HCP formed Alpine/Hanover LLC in May of 1996, as a
successor to a partnership formed by them in February of 1994, to trade in
portfolios of subprime single-family mortgage loans. In October of 1995, HCP,
Alpine/Hanover LLC and BAHT 1995-1 Corp., an affiliate of Bankers Trust New York
Corp., formed ABH-I LLC to trade in subprime single-family mortgage loans.
Pursuant to separate asset management contracts with BT Realty Resources, Inc.,
HCP has rendered management services similar to those it has rendered for ABH-I
LLC. HCP intends to wind down and terminate Alpine/Hanover LLC and ABH-I LLC at
such time as all of the ABH-I LLC assets have been sold. As of February 28,
1998, the remaining assets of ABH-I LLC had an aggregate principal amount of
approximately $300,000. HCP intends to wind down and terminate its management
arrangement with BT Realty Resources, Inc. at such time as all of the assets
under management have been sold. As of February 28, 1998, the remaining assets
under management had an aggregate principal amount of approximately $100,000.
After the closing of the initial public offering, the Company acquired and
holds the Investment Portfolio. HCP has continued to conduct the due diligence
operations and, in addition, support the Company's acquisition and investment
activities by providing due diligence services to the Company. HCMC has
continued to originate, sell and service multifamily mortgage loans and
commercial mortgage loans and, in addition, may in the future support the
Company's acquisition and investment activities by serving as a source of
multifamily mortgage loans and commercial mortgage loans. HCS facilitates the
Company's trading activities by acting as a broker/dealer.
MANAGEMENT AGREEMENT
Effective as of January 1, 1998, the Company entered into a Management
Agreement (the "Management Agreement") with HCP. Under this agreement, HCP,
subject to the direction and control of the Company's Board of Directors,
provides certain services for the Company, including, among other things: (i)
serving as the Company's consultant with respect to formulation of investment
criteria and preparation of policy guidelines by the Board of Directors; (ii)
assisting the Company in developing criteria for the purchase of mortgage assets
that are specifically tailored to the Company's investment objectives; (iii)
representing the Company in connection with the purchase and commitment to
purchase or sell mortgage assets; (iv) arranging for the issuance of mortgage
securities from a pool of mortgage loans; (v) furnishing reports and statistical
and economic research to the Company regarding the Company's activities and the
services performed for the Company by HCP; (vi) monitoring and providing to the
Board of Directors on an ongoing basis price information and other data; (vii)
investing or reinvesting any money of the Company in accordance with its
policies and procedures and the terms and conditions of the Management
Agreement; (viii) providing the executive and administrative personnel office
space and services required in rendering such services to the Company; and (ix)
administering the day-to-day operations of the Company. For these services, the
Company pays HCP for each month an amount equal to the sum of (a)
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the wages and salaries of the personnel employed by HCP and/or its affiliates
(other than independent contractors and other third parties rendering due
diligence services in connection with the acquisition of any mortgage assets)
apportioned to the Company for such month, plus (b) twenty-five percent (25%) of
(a). The Company also is required to pay HCP for each month an amount equal to
the sum of (c) the expense of HCP for any due diligence services provided by
independent contractors and other third parties in connection with the
acquisition of any mortgage assets during such month plus (d) three percent (3%)
of (c). Any amount that may become payable by HCP to the Company for any
services provided by the Company to HCP, including the services of the
Principals, is offset against amounts payable to HCP.
Subject to other contractual limitations, the Management Agreement does not
prevent HCP from acting as an investment advisor or manager for any other
person, firm or corporation. The term of the Management Agreement continues
until December 31, 1999 and thereafter is automatically renewed for successive
one-year periods unless the Unaffiliated Directors (as defined therein) resolve
to terminate the Management Agreement.
FEDERAL INCOME TAX CONSIDERATIONS
General
The Company has elected to be treated as a REIT for tax purposes. 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 the Company does not
qualify as a REIT in any year, it would be subject to federal income tax as a
domestic corporation and the amount of the Company's after-tax cash available
for distribution to its shareholders would be reduced. The Company believes it
has satisfied the requirements for qualification as a REIT since commencement of
its operations in September 1997. The Company intends at all times to continue
to comply with the requirements for qualification as a REIT under the Code, as
described below.
Requirements for Qualification as a REIT
To qualify for tax treatment as a REIT under the Code, the Company must
meet certain tests which are described briefly below.
Ownership of Common Stock
For all taxable years after its first taxable year, the Company's shares of
capital stock must be held by a minimum of 100 persons for at least 335 days of
a 12 month year (or a proportionate part of a short tax year). In addition, at
all times during the second half of each taxable year, no more than 50% in value
of the capital stock of the Company may be owned directly or indirectly by five
or fewer individuals. The Company is required to maintain records regarding the
actual and constructive ownership of its shares, and other information, and to
demand statements from persons owning above a specified level of the REITs
shares (if the Company has 200 or fewer shareholders of record, from persons
holding 0.5% or more of the Company's outstanding shares of capital stock)
regarding their ownership of shares. The Company must keep a list of those
shareholders who fail to reply to such a demand. The Company is required to use
and does use the calendar year as its taxable year for income.
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Nature of Assets
On the last day of each calendar quarter, the Company must satisfy three
tests relating to the nature of its assets. First, at least 75% of the value of
the Company's assets must consist of mortgage loans, certain interests in
mortgage loans, real estate, certain interests in real estate (the foregoing,
"Qualified REIT Assets"), government securities, cash and cash items. The
Company expects that substantially all of its assets will continue to be
Qualified REIT Assets. Second, not more than 25% of the Company's assets may
consist of securities that do not qualify under the 75% asset test. Third, of
the investments in securities not included in the 75% asset test, the value of
any one issuer's securities may not exceed 5% by value of the Company's total
assets, and the Company may not own more than 10% of any one issuer's
outstanding voting securities. Pursuant to its compliance guidelines, the
Company intends to monitor closely the purchase and holding of its assets in
order to comply with the above asset tests.
Sources of Income
The Company must meet the following three separate income-based tests each
year:
1. 75% INCOME TEST. At least 75% of the Company's gross income for the
taxable year must be derived from Qualified REIT Assets including interest on
obligations secured by mortgages on real property or interests in real property.
During the first year of operations certain temporary investment income also
qualify under the 75% income test. The investments that the Company has made and
will continue to make will give rise primarily to mortgage interest qualifying
under the 75% income test.
2. 95% INCOME TEST. In addition to deriving 75% of its gross income from
the sources listed above, at least an additional 20% of the Company's gross
income for the taxable year must be derived from those sources, or from
dividends, interest or gains from the sale or disposition of stock or other
securities that are not dealer property. The Company intends to limit
substantially all of the assets that it acquires to Qualified REIT Assets. The
policy of the Company to maintain REIT status may limit the types of assets,
including hedging contracts and other securities, that the Company otherwise
might acquire.
3. 30% INCOME LIMIT. Through the close of 1997, the Company must also
derive less than 30% of its gross income from the sale or other disposition of
(i) Qualified REIT Assets held for less than four years, other than foreclosure
property or property involuntarily or compulsorily converted through
destruction, condemnation or similar events, (ii) stock or securities held for
less than one year (including hedges) and (iii) property in a prohibited
transaction (generally, a sale of dealer property that is not foreclosure
property).
Distributions
The Company must distribute to its shareholders on a pro rata basis each
year an amount equal to at least (i) 95% of its taxable income before deduction
of dividends paid and excluding net capital gains, plus (ii) 95% 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". The Company intends to
make distributions to its shareholders in sufficient amounts to meet this 95%
distribution requirement.
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Taxation of the Company's Shareholders
For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its shareholders out of
current or accumulated earnings and profits will be includable by the
shareholders as ordinary income for federal income tax purposes unless properly
designated by the Company as capital gain dividends. Distributions of the
Company will not be eligible for the dividends received deduction for
corporations. Shareholders may not deduct any net operating losses or capital
losses of the Company. Any loss on the sale or exchange of shares of the common
stock of the Company held by a shareholder for six months or less will be
treated as a long-term capital loss to the extent of any capital gain dividends
received on the common stock held by such shareholder.
If the Company makes distributions to its shareholders in excess of its
current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a
shareholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of the Company's
shares. The Company will withhold 30% of dividend distributions to shareholders
that the Company knows to be foreign persons unless the shareholder provides the
Company with a properly completed IRS form claiming a reduced withholding rate
under an applicable income tax treaty.
Under the Code, if a portion of the Company's assets were treated as a
taxable mortgage pool or if the Company were to hold REMIC residual interests, a
portion of the Company's dividends would be treated as unrelated business
taxable income ("UBTI") for pension plans and other tax exempt entities. The
Company believes that it has not engaged in activities that would cause any
portion of the Company's income to be taxable as UBTI for pension plans and
similar tax exempt shareholders. The Company believes that its shares of stock
will be treated as publicly offered securities under the plan asset rules of the
Employment Retirement Income Security Act ("ERISA") for Qualified Plans.
The provisions of the Code are highly technical and complex and are subject
to amendment and interpretation from time to time. This summary is not intended
to be a detailed discussion of all applicable provisions of the Code, the rules
and regulations promulgated thereunder, or the administrative and judicial
interpretations thereof. The Company has not obtained a ruling from the Internal
Revenue Service with respect to tax considerations relevant to its organization
or operations.
ITEM 2: PROPERTIES
The Company's operations are conducted in several leased office facilities
throughout the United States. A summary of the office leases is shown below:
MINIMUM
-------
OFFICE ANNUAL EXPIRATION
SPACE ------ ----------
LOCATION (SQ.FT.) RENTAL DATE OFFICE USE
- -------- -------- ------ ---- ----------
New York, New York 2,300 $42,800 November 2001 Executive, Administration,
Investment Operations
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Edison, New Jersey 5,850 75,400 June 2002 Accounting, Administration, Due
Diligence Operations, Mortgage
Loan Servicing, Investment
Operations
Chicago, Illinois 3,900 58,900 June 1999 Due Diligence Operations,
Investment Operations
St., Louis, Missouri 1,007 26,800 August 1998 Mortgage Origination Operations
Rockland, Massachusetts 300 6,000 Month to Month Investment Operations
Sacramento, California 150 7,400 Month to Month Due Diligence Operations,
Investment Operations
St. Paul, Minnesota 150 5,600 July 1998 Investment Operations
------ --------
13,657 $222,900
Total: ------ --------
Management of the Company believes that these facilities are adequate for
the Company's foreseeable needs and that lease renewals and/or alternate space
at comparable rental rates is available, if necessary.
ITEM 3: LEGAL PROCEEDINGS
The Company is not engaged in any material legal proceedings. However, two
affiliates have been parties to certain proceedings described below. To the
extent that the results of these proceedings are adverse to the affiliates, the
proceedings could also adversely affect the Company.
On or about January 15, 1997, Quarters on Melody Lane Partnership
("Quarters") brought suit against HCMC in the District Court in Dallas County,
Texas (titled Quarters on Melody Lane Partnership v. Hanover Capital Mortgage
Corporation et al.) In a letter dated December 17, 1996, Quarters threatened to
sue HCMC and others unless Quarters was permitted to repay a multifamily
mortgage loan, which had been originated by HCMC, without pre-payment penalties.
The initial principal balance of the multifamily mortgage loan, which closed on
June 28, 1994, was approximately $1.76 million. A portion of the proceeds of the
loan was retained in an escrow account to fund the cost of repairs, replacements
and improvements. Quarters alleged that HCMC personnel orally represented before
the closing that funds would be disbursed from the escrow account other (and
more favorably to the obligor) than as provided in the loan documents.
Disbursements have not been made in accordance with such alleged
representations. HCMC sold the loan on the day of closing and sold the servicing
rights to the loan in December 1994. In a written response to the letter, HCMC
denied that its representatives made any misrepresentations to Quarters.
Thereafter, Quarters filed suit against HCMC and others as defendants, in
District Court in Dallas County, Texas. The complaint alleges that HCMC is
guilty of fraudulent misrepresentation, breach of contract, fraudulent
withholding of funds, breach of fiduciary duty and conversion. On July 17, 1997,
Quarters filed an amended petition, alleging actual damages in the amount of
$300,000.00 and seeking punitive damages in the amount of $1,000,000.00. On
August 29, 1997, a court-ordered mediation between all parties was held, at
which time it was believed that a settlement had been reached. In exchange for a
complete release, HCMC agreed to pay Quarters $20,000.00. However, as of this
date, a final settlement agreement has not yet been executed and other
defendants have not yet agreed to the settlement. In early January 1998,
Quarters requested certain defendants, including HCMC, to settle separately.
However, HCMC elected not to settle separately. HCMC has retained counsel and is
defending itself in such action. Management of the Company does not believe
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that this claim will have a material adverse effect on the Company's financial
condition and results of operations.
In August 1992, the IRS proposed a tax deficiency against HCP arising from
HCP's treatment of certain alleged employees as independent contractors for tax
purposes. HCP negotiated a closing agreement with the IRS and, on October 6,
1997, accepted a settlement offer of $99,240 from the IRS, which also requires
HCP to treat the individuals in question as employees on a prospective basis
beginning in 1998. The treatment of the individuals as employees requires HCP to
withhold income and employment taxes from payments made to them and to make
certain matching employment tax payments.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
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PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In September 1997, the Company raised net proceeds of approximately $79.1
million in its initial public offering (the "IPO"). In the IPO, the Company
sold 5,750,000 units at $15.00 per unit. Each unit consists of one share of
common stock, par value $.01 and one stock purchase warrant. Each warrant
entitles the holder to purchase one share of common stock at $15.00 per share
(subject to adjustment in certain events). The warrants became exerciseable on
March 19, 1998 and remain exerciseable until September 15, 2000.
On September 19, 1997 the units began trading on the American Stock
Exchange under the trading symbol HCM.U or HCM/U. Commencing March 19, 1998,
the warrants became detachable from the common stock and, commencing March 20,
1998, the common stock and warrants began trading separately on the American
Stock Exchange under the trading symbols HCM and HCM.WS, respectively. As of
February 24, 1998, the Company had 6,466,677 shares of common stock issued and
outstanding, which was held by 86 holders of record and approximately 2,900
beneficial owners.
The following table sets forth, for the periods indicated, the high, low
and closing sales price per unit as reported on the American Stock Exchange.
Unit Prices Dividends
High Low Close Declared Per Share
---- --- ----- ------------------
Third Quarter Ended September 30, 1997 17 1/4 15 17 1/8 --
Fourth Quarter Ended December 31, 1997 18 7/8 15 1/8 16 1/2 $0.16
The Company intends to pay quarterly dividends and other distributions to
its shareholders of all or substantially all of its taxable income in each year
in order to quality for the tax benefits accorded to a REIT under the Code. All
distributions will be made by the Company at the discretion of the Board of
Directors and will depend on the earnings of the Company, financial condition
of the Company, maintenance of REIT status and such other factors as the Board
of Directors deems relevant.
ITEM 6: SELECTED FINANCIAL DATA
The following selected financial data are derived from audited financial
statements of the Company for the period from inception (June 10, 1997) through
December 31, 1997. The selected financial data should be read in conjunction
with the more detailed information contained in the Financial Statements and
Notes thereto and "Management's Discussion and Analysis of Financial Conditions
and Results of Operations" included elsewhere in this Form 10-K.
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OPERATIONS STATEMENT HIGHLIGHTS
1997
----
Net interest income $1,676,000
Net income 499,000
Basic earnings per share 0.15
Diluted earnings per share 0.14
Dividends declared per share $0.16
BALANCE SHEET HIGHLIGHTS
December 31
1997
----
Adjustable-rate mortgage securities $348,131,000
Mortgage loans 160,970,000
Total assets 517,543,000
Shareholders' Equity 78,098,000
Number of common
shares outstanding 6,466,677
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is a specialty finance company the activities of which
include (i) acquiring primarily subprime single-family mortgage loans, (ii)
securitizing mortgage loans and retaining interests therein, (iii) offering due
diligence services to buyers, sellers and holders of mortgage loans and (iv)
originating, holding, selling and servicing multifamily mortgage loans and
commercial mortgage loans. The Company's principal business objective is to
generate increasing earnings and dividends for distribution to stockholders.
The Company acquires single-family mortgage loans through a network of sales
representatives targeting financial institutions throughout the United States.
The Company originates multifamily mortgage loans and commercial mortgage loans
through HCMC.
RESULTS OF OPERATIONS
The Company was organized on June 10, 1997, but did not commence
operations until September 19, 1997 (the date of the IPO closing). For the
period from June 10, 1997 to December 31, 1997, the Company's net income was
$499,000 or
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$0.15 per share based on a weighted average of 3,296,742 shares of common stock
outstanding. The Company's net income for the period September 19, 1997
to December 31, 1997 was $499,000 or $.08 per share based on a weighted average
of 6,466,677 shares of common stock outstanding.
Net interest income for 1997 totaled $1,676,000. Net interest income is
interest income earned on mortgage securities, fixed rate and adjustable rate
mortgage loans, and other temporary investments less interest expense from
borrowings related to the investments.
General and administration expenses for 1997 totaled $940,000. The majority
of general and administrative expenses relate to management and administrative
expenses, due diligence acquisition costs, commission expenses, and legal and
professional fees. Due diligence acquisition costs averaged .156 % of the
principal balance of the mortgage loans purchased in 1997.
On September 19, 1997 (the IPO date), the Company acquired 100% of the
nonvoting preferred stock of HCP, which represents a 97% ownership interest in
HCP and its wholly owned subsidiaries. While the Company will generally have no
right to control the affairs of HCP because the Company owns only the preferred
stock of HCP, management believes that the Company has the ability to exert
significant influence over HCP and therefore the investment in HCP is accounted
for on the equity method. The Company recorded a loss of $254,000 in 1997 for
its equity investment in HCP. The HCP loss was a result of a decline in
consulting (due diligence/ARMS audit) revenues and a slowdown in the mortgage
originations division during the fourth quarter of 1997.
The table below highlights the Company's brief historical trends and
components of return on average equity.
COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY (1)
Gain on Equity in
Net Interest Sale of G & A Earnings (Loss) Annualized
For the Income/ Securities/ Expense/ of Subsidiary/ Return on
Quarter Ended Equity Equity Equity Equity Equity
------------- ------ ------ ------ ------ ------
June 30, 1997 (2) 0.00% 0.00% 0.00% 0.00% 0.00%
September 30, 1997(3) 4.85% 0.00% 3.59% 0.97% 2.23%
December 31, 1997 7.71% 0.18% 4.26% (1.41%) 2.22%
(1) Average equity excludes unrealized loss on investments available for sale.
(2) The Company was organized on June 10, 1997, but did not begin operations
until September 19, 1997.
(3) Average equity is based on equity balances at September 19, 1997 (IPO date),
and equity balances at September 30, 1997, excluding unrealized loss on
investments available for sale.
For the period from inception through December 31, 1997, the Company's
taxable income was $1,077,000 or $0.167 per weighted average share outstanding.
Taxable income is higher than GAAP net income primarily because taxable income
does not include the equity in the loss of HCP ($254,000), and due diligence
costs and
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commission expenses incurred to acquire mortgage loan pools ($324,000) that are
expensed under GAAP, but capitalized and amortized for tax purposes.
As a REIT, the Company is required to declare dividends amounting to 85% of
each years taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of the Company's taxable income for each year by the
time the Company files its federal tax return. Therefore, a REIT generally
passes through substantially all of its earnings to shareholders without paying
federal income tax at the corporate level. The Company paid a fourth quarter
dividend of $0.16 per share, which was equivalent to a dividend of
approximately 96.0% of taxable income.
The following table reflects the average balances for each major category
of the Company's interest earning assets as well as the Company's interest
bearing liabilities with the corresponding effective rate of interest annualized
for the period September 30, 1997 (initial purchase of mortgage assets) through
December 31, 1997:
Average Effective
Balance Rate
------- ----
Interest Earning Assets:
Mortgage Loans (1) $ 83,776,000 7.317%
Mortgage Securities 116,375,000 6.268%
------------ -----
$200,151,000 6.707%
============ =====
Interest Bearing Liabilities
Reverse repurchase borrowings on mortgage loans $ 32,674,000 6.313%
Reverse repurchase borrowings on mortgage securities 113,803,000 5.723%
------------ -----
$146,477,000 5.855%
============ -----
Net Interest Earning Assets $ 53,674,000
Net Interest Spread ============ 0.852%
=====
Yield on Net Interest Earnings Assets (2) 9.034%
=====
(1) Loan loss reserves are excluded in above calculations.
(2) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of net interest earnings
assets.
For the year ended December 31, 1997, the Company's ratio of operating
expenses to average assets was 1.59%. The Company's 1997 operating expense did
not include any incentive bonus compensation. In order for the eligible
participants to earn incentive bonus compensation, the rate of return on
shareholders' investment must exceed the average ten-year U.S. Treasury rate
during the year plus 4.0%.
FINANCIAL CONDITION
At December 31, 1997, the Company had total assets of $517,543,000.
Mortgage loans totaled $160,970,000 or 31.1% of total assets, while mortgage
securities totaled $348,131,000 or 67.3% of total assets.
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The following table presents a schedule of mortgage loans at December
31, 1997, classified by fixed rate mortgage and adjustable rate mortgages:
Carrying Portfolio
Value Mix
----- ---
Fixed rate mortgages $107,953,000 67.1%
Adjustable rate mortgages 53,017,000 32.9%
------------ -----
$160,970,000 100.0%
============ =====
The following table presents a schedule of mortgage securities at
December 31, 1997, classified by type of issue:
Carrying Portfolio
Value Mix
----- ---
FNMA $207,397,000 59.6%
FHLMC 140,734,000 40.4%
------------ -----
$348,131,000 100.0%
============ =====
LIQUIDITY AND CAPITAL RESOURCES
The Company expects to meet its short-term and long-term liquidity
requirements generally from its existing working capital, cash flow provided by
operations, reverse repurchase agreements and other possible sources of
financings, including CMO's and REMICs, additional equity generated by the
exercise of some or all of the outstanding warrants and additional equity
offerings. The Company considers its ability to generate cash to be adequate to
meet operating requirements both in the short-term and long-term.
Net cash provided by operating activities for the period June 10, 1997
to December 31, 1997 was $49,000. The cash flows generated from operating
activities (mainly from net income ($499,000), non cash expense items such as
amortization of mortgage loans and mortgage security premiums, and the increase
of certain liability accounts) were reduced by amounts expended for the
purchase of accrued interest on mortgage loan pools and by loans ($482,000)
made to John A. Burchett, Irma N. Tavares and Joyce S. Mizerak (together with
George J. Ostendorf, the "Principals").
Net cash used in investing activities for the period from June 10, 1997 to
December 31, 1997 was $510,287,000. The majority of the cash used in investing
activities related to the purchase of FNMA securities and FHLMC securities
($349,287,000) and mortgage loan pools ($163,030,000).
Cash flows from financing activities generated $514,260,000 during the
period from June 10, 1997 to December 31, 1997. The cash flows from financing
activities represent net proceeds from reverse repurchase agreements used to
finance the purchase of mortgage securities ($341,407,000), pools of
single-family mortgage loans ($93,731,000), and the net proceeds of the IPO
($79,122,000).
Management anticipates that the Company will continue to purchase single
family mortgage loan pools and will finance the purchase of the mortgage loan
pools through existing equity,
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reverse repurchase agreements, and other sources of financing including CMO's
and REMICs. The Company may also realize additional liquidity beginning in
March 1998 when the warrants become exercisable.
The Company is obligated to make additional loans to the Principals
($1,268,000) at their request. It is anticipated that the Principals will
request additional loans in April 1998 for tax purposes. Further, in lieu of
their exercise of certain registration rights, the Principals have also
requested additional loans in the aggregate amount of $1,500,000, which was
approved by the Board of Directors. The Company has guaranteed HCP's line of
credit facility. The Company has advanced $900,000 to HCP in February 1998 for
working capital purposes and Management anticipates that the Company may advance
additional funds in 1998 to HCP.
OTHER MATTERS
REIT Requirements
The Company has elected to be taxed as a REIT under the Code. The Company
believes that it was in full compliance with the REIT tax rules as of December
31, 1997 and intends to remain in compliance with all REIT tax rules. If the
Company fails to qualify as a REIT in any taxable year and certain relief
provisions of the Code do not apply, the Company will be subject to Federal
income tax as a regular, domestic corporation, and its stockholders will be
subject to tax in the same manner as stockholders of a regular corporation.
Distributions to its stockholders in any year in which the Company fails to
qualify as a REIT would not be deductible by the Company in computing its
taxable income. As a result, the Company could be subject to income tax
liability, thereby significantly reducing or eliminating the amount of cash
available for distribution to its stockholders. Further, the Company could also
be disqualified from re-electing REIT status for the four taxable years
following the year during which it became disqualified.
Investments in Certain Mortgage Assets
The Company takes certain risks in investing in subprime single-family
mortgage loans. If these mortgage loans are missing relevant documents, such as
the original note, they may be difficult to enforce. These mortgage loans may
also have inadequate property valuations. In addition, if a single-family
mortgage loan has a poor payment history, it is more likely to have future
delinquencies because of poor borrower payment habits or a continuing cash flow
problem.
Defaults on Mortgage Assets
The Company makes long-term investments in mortgage assets. During the time
it holds mortgage assets for investment, the Company is subject to the risks of
borrower defaults and bankruptcies and hazard losses (such as those occurring
from earthquakes or floods) that are not covered by insurance. If a default
occurs on any mortgage loan held by the Company, the Company will bear the risk
of loss of principal to the extent of any deficiency between the value of the
mortgaged property, plus any payments from an insurer or guarantor, and the
amount owing on the mortgage loan.
With respect to commercial mortgage loans, the Company may be subject to
certain additional risks. Commercial properties tend to be unique and more
difficult to value than single-family residential properties. Commercial
mortgage loans often have shorter maturities
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than single-family mortgage loans and often have a significant principal balance
or "balloon" due on maturity. A balloon payment creates a greater risk for the
lender because the ability of a borrower to make a balloon payment normally
depends on its ability to refinance the loan or sell the related property at a
price sufficient to permit the borrower to make the payment. Commercial mortgage
lending is generally viewed as exposing the lender to a relatively greater risk
of loss than single-family mortgage lending because it usually involves larger
mortgage loans to single borrowers or groups of related borrowers and the
repayment of the loans is typically dependent upon the successful operation of
the related properties.
Negative Effects of Fluctuating Interest Rates
Changes in interest rates may impact the Company's earnings in various
ways. While the Company anticipates that over the long term less than 25% of
its mortgage loans will be ARMs, rising short term interest rates may
negatively affect the Company's earnings in the short term. Increases in the
interest rate on an ARM loan are generally limited to either 1% or 2% per
adjustment period. ARM loans owned by the Company are subject to such
limitations, while adjustments in interest rate on the Company's borrowings are
not correspondingly limited. As a result, in periods of rising interest rates,
the Company's net interest income could temporarily decline.
The rate of prepayment on the Company's mortgage loans may increase if
interest rates decline, or if the difference between long-term and short-term
interest rates diminishes. Increased prepayments would cause the Company to
amortize any premiums paid on the acquisition of its mortgage loans faster than
currently anticipated, resulting in a reduced yield on its mortgage loans.
Additionally, to the extent proceeds of prepayments cannot be reinvested at a
rate of interest at least equal to the rate previously earned on the prepaid
mortgage loans, the Company's earnings may be adversely affected.
Insufficient Demand for Mortgage Loans and the Company's Loan Products
The availability of mortgage loans that meet the Company's criteria depends
on, among other things, the size of and level of activity in the residential,
multifamily and commercial real estate lending markets. The size and level of
activity in these markets, in turn, depends on the level of interest rates,
regional and national economic conditions, inflation and deflation in property
values and the general regulatory and tax environment as it relates to mortgage
lending. If the Company can not obtain sufficient mortgage loans that meet its
criteria, its business will be adversely affected.
Year 2000 Compliance
The inability of computers, software and other equipment utilizing
microprocessors to recognize and properly process data fields containing a two
digit year is commonly referred to as the Year 2000 Compliance issue. As the
year 2000 approaches, such systems may be unable to accurately process certain
date-based information.
The Company has identified all significant applications that will require
modification to ensure Year 2000 Compliance. Internal resources are primarily
being used to make the required modifications and test Year 2000 Compliance.
The modification process of all significant applications is substantially
complete. The Company plans to complete the testing process of all significant
applications by December 31, 1998.
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In addition, the Company has communicated with others with whom it does
significant business to determine their Year 2000 readiness and the extent to
which the Company may be vulnerable to any third party Year 2000 issues.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have a material adverse effect on the Company.
The total cost to the Company of these Year 2000 Compliance activities has
not been and is not anticipated to be material to the Company's financial
position or results of operations in any year. These costs and the date on
which the Company plans to complete the Year 2000 modification and testing
processes are based on management's best estimates, which were derived
utilizing numerous assumptions of future events including the continued
availability of certain resources, third party modification plans and other
factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ from those plans.
Investment Company Act
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act. If
the Company were to become regulated as an investment company, the Company's use
of leverage would be substantially reduced. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on interest in real estate" ("Qualifying
Interests"). Under current interpretation of the staff of the Securities and
Exchange Commission, in order to qualify for this exemption, the Company must
maintain at least 55% of its assets directly in Qualifying Interests. As of
December 31, 1997, Management calculates that the Company is in compliance with
this requirement.
IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
The preceding section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and other sections of this Annual Report
on Form 10-K contain various "forward-looking statements" within the meaning of
Section 27A of the Securities Act 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
represent the Company's expectations or beliefs concerning future events,
including, without limitation, statements containing the words "believes,"
"anticipates," "expects" and words of similar import; and also including,
without limitation, the following: statements regarding the Company's
continuing ability to target and acquire mortgage loans; expected availability
of the master repurchase agreement; the sufficiency of the Company's working
capital, cash flows and financing to support the Company's future operating and
capital requirements; results of operations and overall financial performance;
the expected dividend distribution rate; and the expected tax treatment of the
Company's operations. Such forward-looking statements relate to future events
and the future financial performance of the Company and the industry and
involve known and unknown risks, uncertainties and other important factors
which could cause actual results, performance or achievements of the Company or
industry to differ materially from the future results, performance or
achievements expressed or implied by such forward-looking statements.
32
35
Investors should carefully consider the various factors identified in
"Management's Discussion and Analysis of Financial Condition and Results of
Operation - Other Matters," and elsewhere in this Annual Report that could cause
actual results to differ materially from the results predicted in the
forward-looking statements. Further, the Company specifically cautions
investors to consider the following important factors in conjunction with the
forward-looking statements: the possible decline in the Company's ability to
locate and acquire mortgage loans; the possible adverse effect of changing
economic conditions, including fluctuations in interest rates and changes in the
real estate market both locally and nationally; the effect of severe weather or
natural disasters; the effect of competitive pressures from other financial
institutions, including mortgage REITs; and the possible changes, if any, in
the REIT rules. Because of the foregoing factors, the actual results achieved
by the Company in the future may differ materially from the expected results
described in the forward-looking statements.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together
with the Independent Auditors' Report thereon begin on pages F-1 through F-34
of this Form 10-K.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
33
36
PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.
ITEM 11: EXECUTIVE COMPENSATION
Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.
34
37
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
See Part II, Item 8 hereof.
2. Financial Statements and Auditors' Reports
All schedules omitted are inapplicable or the information required is
shown in the Financial Statements or notes thereto. The auditors'
reports of Deloitte & Touche LLP with respect to the Financial
Statements are located at pages F-2 and F-22.
3. Exhibits
Exhibits required to be attached by Item 601 of Regulation S-K are listed
in the Exhibit Index attached hereto, which is incorporated herein by this
reference. Following is a list of management contracts and compensatory
plans and arrangements required to be filed as exhibits to this form by
Item 14(c) hereof:
Management Agreement, dated as of January 1, 1998, by and between the
Company and HCP.
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the last quarter of 1997.
(c) Exhibits
See Item 14(a)3 above.
35
38
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, on March 30, 1998.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By /s/ Ralph F. Laughlin
-------------------------------------------------
Ralph F. Laughlin
Senior Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on be half of Registrant
and the capacities indicated on March 30, 1998.
SIGNATURE TITLE
/s/ John A. Burchett Chairman of the Board of Directors
- ------------------------ and Chief Executive Officer
John A. Burchett
/s/ Irma N. Tavares Managing Director and a Director
- ------------------------
Irma N. Tavares
/s/ Joyce S. Mizerak Managing Director, Secretary and a Director
- ------------------------
Joyce S. Mizerak
/s/ George J. Ostendorf Managing Director and a Director
- ------------------------
George J. Ostendorf
/s/ John A. Clymer Director
- ------------------------
John A. Clymer
/s/ Joseph J. Freeman Director
- ------------------------
Joseph J. Freeman
/s/ Robert E. Campbell Director
- ------------------------
Robert E. Campbell
/s/ Saiyid T. Naqvi Director
- ------------------------
Saiyid T. Naqvi
/s/ Ralph F. Laughlin Senior Vice President and Chief Financial Officer
- ------------------------ (Principal Financial and Accounting Officer)
Ralph F. Laughlin
39
EXHIBIT INDEX
* 3.1 Articles of Incorporation of the Company, as amended
* 3.2 By-Laws of the Company
* 4.1 Specimen Common Stock Certificate
* 4.2 Warrant Agreement pursuant to which Warrants are to be issued
(including form of Warrant)
* 4.3 Representatives' Warrant Agreement pursuant to which the
Representatives' Warrants are to be issued.
* 4.4 Specimen Unit Certificate
*10.3 Registration Rights Agreement
*10.4 Shareholders' Agreement of HCP
*10.5 Agreement and Plan of Recapitalization
*10.6 Bonus Incentive Compensation Plan
*10.7 1997 Executive and Non-Employee Director Stock Option Plan
*10.8 Employment Agreement by and between the Company and John A. Burchett
*10.9 Employment Agreement by and between the Company and Irma N. Tavares
*10.10 Employment Agreement by and between the Company and Joyce S. Mizerak
*10.11 Employment Agreement by and between the Company and George J. Ostendorf
*10.12 Standard Form of Office Lease, dated as of May 6, 1991, by and between
Irwin Kahn and HCP, as amended by the First Amendment of Lease, dated
as of July 1, 1996
*10.13 Office Lease Agreement, dated as of March 1, 1994, by and between
Metroplex Associates and HCMC, as amended by the First Modification
and Extension of Lease Agreement, dated as of February 28, 1997
*10.14 Indenture, dated as of June 28, 1993, by and between LaSalle National
Bank, N.A., as Trustee, and HCP, as amended by the Lease Amendment
dated as of August 23, 1995
*10.15 Office building space, dated as of February 5, 1993, by and between
Bonhomme Place Associates, Inc. and HCMC, as amended by Lease
Amendment #1, dated as of December 1, 1993 and as further amended
by Second Amendment and Extention of Lease, dated as of March 1,
1996
*10.16 Office Lease and Service Agreement, dated as of August 28, 1995 by and
between Federal Deposit Insurance Receiver for Merchants Bank and
HCP
*10.17 Agreement of Lease, dated as of January 8, 1997 by and between Saint
Paul Executive Office Suites, Inc., d.b.a. LesWork Inc. and HCP
*10.18 Revolving Credit Agreement, dated as of December 10, 1996 between Fleet
National Bank and HCP
*10.19 Guaranty, dated as of December 10, 1996, by John A. Burchett to Fleet
National Bank
*10.20 Guaranty, dated as of December 10, 1996, by HCMC to Fleet National Bank
*10.21 Guaranty, dated as of December 10, 1996, by HCMF to Fleet National Bank
*10.22 Guaranty, dated as of December 10, 1996, by HCA to Fleet National Bank
*10.23 Guaranty, dated as of December 10, 1996, by HCS to Fleet National Bank
*10.24 Modification Agreement, dated as of June , 1997, among Fleet
National Bank, HCP, HCMC, HCMF, HCS, HCA and John A. Burchett
*10.25 Contribution Agreement
*10.26 Participation Agreement
*10.27 Loan Agreement
**10.28 Master Repurchase Agreement Governing Purchases and Sales of Mortgage
Loans, between Nomura Asset Capital Corporation and the Company,
dated September 29, 1997
10.29 Management Agreement, dated as of January 1, 1998, by and between the
Company and HCP
10.30 Master Loan and Security Agreement between the Company and Morgan
Stanely Mortgage Capital Inc., dated as of December 8,1997
*21 Subsidiaries of the Company
27 Financial Data Schedule
- -------------
* Incorporated herein by reference to the Company's Registration Statement
No. 333-29261, as amended, as filed with the Securities and Exchange
Commission.
** Incorporated herein by reference to the Company's Form 10-Q, as amended, for
the quarter ended September 30, 1997, as filed with the Securities and
Exchange Commission.
40
TABLE OF CONTENTS TO FINANCIAL STATEMENTS
PAGE
----
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
Independent Auditors' Report................................................... F-2
Financial Statements as of December 31, 1997 and for the Period from June 10,
1997 (inception) through December 31, 1997:
Balance Sheet............................................................... F-3
Statement of Operations..................................................... F-4
Statement of Stockholders' Equity........................................... F-5
Statement of Cash Flows..................................................... F-6
Notes to Financial Statements............................................... F-7
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
Independent Auditors' Report................................................... F-22
Consolidated Financial Statements as of December 31, 1997 and December 31, 1996
and for each of the Three Years in the Period Ended December 31, 1997:
Balance Sheet............................................................... F-23
Statements of Operations.................................................... F-24
Statements of Stockholders' Equity.......................................... F-25
Statements of Cash Flows.................................................... F-26
Notes to Consolidated Financial Statements.................................. F-27
F-1
41
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Mortgage Holdings, Inc.
New York, New York
We have audited the accompanying balance sheet of Hanover Capital Mortgage
Holdings, Inc. (the "Company") as of December 31, 1997 and the related
statements of operations, stockholders' equity and cash flows for the period
June 10, 1997 (inception) through December 31, 1997. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Hanover Capital Mortgage
Holdings, Inc. as of December 31, 1997 and the results of its operations and
its cash flows for the period June 10, 1997 (inception) through December 31,
1997, in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 20, 1998
F-2
42
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
BALANCE SHEET
(in thousands, except as noted)
DECEMBER 31,
1997
------------
ASSETS
ARM securities, available for sale $ 348,131
Mortgage loans, held for sale 160,970
Cash and cash equivalents 4,022
Accrued interest receivable 3,597
Equity investment 100
Notes receivable from related parties 482
Prepaid expenses and other assets 241
---------
TOTAL ASSETS $ 517,543
=========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 435,138
Accrued interest payable 2,250
Dividends payable 1,035
Due to related party 540
Accrued expenses and other liabilities 482
---------
Total liabilities 439,445
---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01
authorized, 10 million shares, issued
and outstanding, -0- shares --
Common stock, par value $.01
authorized, 90 million shares, issued
and outstanding, 6,466,677 shares 65
Additional paid-in-capital 79,411
Available for sale securities:
Unrealized (loss) on investments available
for sale (842)
Retained earnings (deficit) (536)
---------
Total stockholders' equity 78,098
---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 517,543
=========
See notes to financial statements
F-3
43
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
STATEMENT OF OPERATIONS
PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(in thousands, except per share data)
REVENUES:
Interest income $ 4,880
Interest expense 3,204
-----------
Net interest income 1,676
Loan loss provision 18
-----------
Net interest income after loan loss
provision 1,658
-----------
Gain on sale of securities 35
-----------
Total revenues 1,693
-----------
EXPENSES:
General and administrative expenses
Management and administrative 400
Due diligence 266
Commissions 61
Legal and professional 170
Other 43
-----------
Total expenses 940
-----------
Operating income 753
Equity in (loss) of unconsolidated subsidiary (254)
-----------
NET INCOME $ 499
===========
BASIC EARNINGS PER SHARE $ 0.15
===========
DILUTED EARNINGS PER SHARE $ 0.14
===========
See notes to financial statements
F-4
44
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(in thousands)
AVAILABLE
FOR SALE
ADDITIONAL SECURITIES RETAINED
COMMON STOCK PAID-IN UNREALIZED EARNINGS
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) TOTAL
------------------------------------------------------------------------------------
Issuance of common stock 6,466,677 $ 65 $ 79,411 $ 79,476
Unrealized (loss) on available-for-sale $(842) (842)
securities
Net income $499 499
Dividends declared (1,035) (1,035)
-----------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1997 6,466,677 $ 65 $ 79,411 $(842) $(536) $78,098
===================================================================================
See notes to financial statements
F-5
45
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
STATEMENT OF CASH FLOWS
PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 499
Adjustments to reconcile net income to net
cash provided by operating activities:
Amortization of net premium - ARM securities 314
Amortization of net premium - mortgage loans 47
Loan loss provision 18
Gain on sale of securities (35)
Equity in loss of unconsolidated subsidiary 254
Increase in accrued interest receivable (3,597)
Loans to officers/stockholders (482)
Increase in prepaid expenses and other assets (241)
Increase in accrued interest payable 2,250
Increase in due to related party 540
Increase in accrued expenses and other liabilities 482
---------
Net cash provided by operating activities 49
---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of ARM securities (349,287)
Purchase of mortgage loans (163,030)
Principal payments on mortgage loans 1,995
Proceeds from sale of securities 35
---------
Net cash (used in) investing activities (510,287)
---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 435,138
Net proceeds of initial public offering 79,122
---------
Net cash provided by investing activities 514,260
---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 4,022
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 0
---------
CASH AND CASH EQUIVALENTS, END OF PERIOD 4,022
=========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES
Operating activity - increase in dividends payable ($1,035,000) relating to the
declaration of dividends in December 1997.
Investing activity - acquisition of a 97% ownership interest in Hanover Capital
Partners Ltd ($354,000).
Financing activities - issuance of 716,667 shares of the Company's common stock
used to acquire an equity investment in HCP ($354,000), and the declaration of
$1,035,000 of dividends in December 1997 that was paid in January 1998.
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the period for:
Income taxes $ -0-
==========
Interest $ 884
==========
See notes to financial statements
F-6
46
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997
1. BUSINESS DESCRIPTION
GENERAL
Hanover Capital Mortgage Holdings, Inc. (the "Company") was incorporated in
Maryland on June 10, 1997. The Company is a self-managed real estate investment
trust ("REIT"), formed to operate as a specialty finance company. The principal
business strategy of the company is to (i) acquire primarily single-family
mortgage loans that are at least twelve months old or that were intended to be
of certain credit quality but that do not meet the originally intended market
parameters due to errors or credit deterioration, (ii) securitize the mortgage
loans and retain interests therein, (iii) originate, hold, sell and service
multifamily mortgage loans and commercial mortgage loans and (iv) acquire
multifamily mortgage loans. The Company's principal business objective is to
generate increasing earnings and dividends for distribution to its stockholders.
The Company acquires single-family mortgage loans through a network of sales
representatives targeting financial institutions throughout the United States.
The Company may also acquire multifamily mortgage loans from a taxable
subsidiary of the Company.
CAPITALIZATION
In September 1997, the Company raised net proceeds of approximately $79 million
in its initial public offering (the "IPO"). In the IPO, the Company sold
5,750,000 units (each unit consists of one share of common stock, par value
$.01 and one stock warrant) at $15.00 per unit including 750,000 units sold
pursuant to the underwriters' overallotment option, which was exercised in
full. Each warrant entitles the holder to purchase one share of common stock at
the original issue price - $15.00. The warrants became exercisable on March 19,
1998 and remain exercisable until September 15, 2000. The Company will utilize
substantially all of the net proceeds of the IPO to fund leveraged purchases of
mortgage assets.
In connection with the closing of the IPO the Company acquired a 97% ownership
interest (representing a 100% ownership of the non-voting preferred stock) in
Hanover Capital Partners Ltd. and its wholly-owned subsidiaries: Hanover Capital
Mortgage Corporation and Hanover Capital Securities, Inc., in exchange for
716,667 shares of the Company's common stock. Hanover Capital Partners Ltd. and
its wholly-owned subsidiaries offer due diligence services to buyers, sellers
and holders of mortgage loans and originate, sell and service multifamily
mortgage loans and commercial loans.
F-7
47
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
RISKS AND UNCERTAINTIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amount of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. The
Company's estimates and assumptions primarily arise from risks and uncertainties
associated with interest rate volatility, credit exposure and regulatory
changes. Although management is not currently aware of any factors that would
significantly change its estimates and assumptions in the near term, future
changes in market trends and conditions may occur which could cause actual
results to differ materially.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand, overnight investments deposited
with banks and government securities with maturities less than 30 days.
ADJUSTABLE RATE MORTGAGE SECURITIES
The Company's policy is to classify its adjustable rate mortgage ("ARM")
securities as available-for-sale as they are purchased and each asset is
monitored for a period of time, generally three to six months, prior to making a
determination whether the asset will be classified as held-to-maturity. At
December 31, 1997 management has made the determination that all ARM securities
are available-for-sale in order to be prepared to respond to potential future
opportunities in the market, to sell ARM securities in order to optimize the
portfolio's total return and to retain its ability to respond to economic
conditions that require the Company to sell assets in order to maintain an
appropriate level of liquidity. Management re-evaluates the classification of
the ARM securities on a quarterly basis. ARM securities classified as
held-to-maturity are carried at the fair value of the security at the time the
designation is made and any fair value adjustment to the cost basis as of the
date of the classification is amortized into interest income as a yield
adjustment. All ARM securities designated as available-for-sale are reported at
fair value, with unrealized gains and losses excluded from earnings and reported
as a separate component of stockholders' equity.
Premiums and discounts associated with the purchase of ARM securities are
amortized into interest income over the lives of the securities using the
effective yield method adjusted for the effects of estimated prepayments. ARM
securities transactions are recorded on the date the ARM securities are
purchased or sold. Purchases of new issue ARM securities are recorded when all
significant uncertainties regarding the characteristics of the securities are
removed, generally on or shortly before settlement date. Realized gains and
losses on ARM securities transactions are determined on the specific
identification basis.
F-8
48
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
The Company has limited its exposure to credit losses on its portfolio of ARM
securities by only purchasing ARM securities that have some form of credit
enhancement and that are either guaranteed by an agency of the federal
government or have an investment grade rating at the time of purchase, or the
equivalent, by at least one of two nationally recognized rating agencies,
Moody's or Standard & Poor's (the "Rating Agencies"). The Company monitors the
delinquencies and losses on the underlying mortgages of its ARM securities and,
if the credit performance of the underlying mortgage loans is not as good as
expected, makes a provision for possible credit losses as well as unidentified
potential future losses in its ARM securities portfolio. The provision is based
on management's assessment of numerous factors affecting its portfolio of ARM
securities including, but not limited to, current and projected economic
conditions, delinquency status, credit losses to date on underlying mortgages
and remaining credit protection. The provision is made by reducing the cost
basis of the individual security and the amount of such write-down is recorded
as a realized loss, thereby reducing earnings. Provisions for credit losses do
not reduce taxable income and therefore do not affect the dividends paid by the
Company to stockholders in the period the provisions are taken. Actual losses
realized by the Company reduce taxable income in the period the actual loss is
realized and would affect the dividends paid to stockholders for that tax year.
MORTGAGE LOANS
The Company's policy is to classify each of its mortgage loans as held for sale
as they are purchased and each asset is monitored for a period of time,
generally four to nine months, prior to making a determination as to whether the
asset will be classified as held-to-maturity. At December 31, 1997 management
has made the determination that all mortgage loans are held for sale in order to
be prepared to respond to potential future opportunities in the market, to sell
mortgage loans in order to optimize the portfolio's total return and to retain
its ability to respond to economic conditions that require the Company to sell
mortgage loans in order to maintain an appropriate level of liquidity.
Management re-evaluates the classification of mortgage loans on a quarterly
basis. All mortgage loans designated as held for sale are reported at the lower
of cost or market, with unrealized losses reported as a charge to earnings in
the current period.
Premiums and discounts associated with the purchase of mortgage loans are
amortized into interest income over the lives of the mortgage loans using the
effective yield method adjusted for the effects of estimated prepayments.
Mortgage loan transactions are recorded on the date the mortgage loans are
purchased or sold. Purchases of new mortgage loans are recorded when all
significant uncertainties regarding the characteristics of the mortgage loans
are removed, generally on or shortly before settlement date. Realized gains and
losses on mortgage loan transactions are determined on the specific
identification basis.
F-9
49
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
The accrual of interest on impaired loans is discounted when, in management's
opinion, the borrower may be unable to meet payments as they become due. When
interest accrual is discontinued, all unpaid accrued interest is reversed.
Interest income is subsequently recognized only to the extent cash payments are
received.
The Company has limited its exposure to credit losses on its portfolio of
mortgage loans by performing an in-depth due diligence on every loan purchased.
The due diligence encompasses the borrowers credit, the enforceability of the
documents, and the value of the mortgage property. In addition many mortgage
loans are guaranteed by an agency of the federal government or private mortgage
insurance. The Company monitors the delinquencies and losses on the underlying
mortgages and makes a provision for known losses as well as unidentified
potential losses in its mortgage loan portfolio if the impairment is deemed to
be other than temporary. The provision is based on management's assessment of
numerous factors affecting its portfolio of mortgage loans including, but not
limited to, current and projected economic conditions, delinquency status,
losses to date on mortgages and remaining credit protection.
FINANCIAL INSTRUMENTS
The Company from time to time enters into interest rate hedge mechanisms to
manage its exposure to interest rate changes in connection with the purchase,
securitization and sale of its mortgage loans. The Company closes out the hedge
position to coincide with the related mortgage loan sale and securitization
transactions and recognizes the results of the hedge transaction in determining
the amount of the related mortgage loan sale gain for loans sold or, as a basis
adjustment to mortgage loans held to maturity.
EQUITY INVESTMENT
The Company's 97% ownership investment in Hanover Capital Partners Ltd. ("HCP")
is accounted for by the equity method of accounting. The Company generally has
no right to control the affairs of HCP because the Company's investment in HCP
is based solely on a 100% ownership of HCP's non-voting preferred stock. Even
though the Company has no right to control the affairs of HCP, management
believes that the Company has the ability to exert significant influence over
HCP and therefore the investment in HCP is accounted for by the equity method of
accounting.
REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts, plus accrued interest.
F-10
50
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
INCOME TAXES
The Company has elected to be taxed as a real estate investment trust ("REIT")
and intends to comply with the provisions of the Internal Revenue Code of 1986,
as amended (the "Code") with respect thereto. Accordingly, the Company will not
be subject to Federal income tax to the extent of its distributions to
stockholders as long as certain asset, income and stock ownership tests are met.
EARNINGS PER SHARE
At December 31, 1997 the Company adopted Statement of Financial Accounting
Standards No. 128 "Earnings per Share"("SFAS 128"). Under SFAS 128 basic
earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding during the period. Diluted earnings per share reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock that then shared in earnings.
Shares issued during the period and shares reacquired during the period are
weighted for the period they were outstanding.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income
("SFAS 130"). SFAS 130 establishes standards for reporting and displaying of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general purpose financial statements. SFAS 130 requires that
all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. SFAS 130 is
effective for fiscal years beginning after December 15, 1997. Reclassification
of financial statements for earlier periods provided for comparative purposes is
required.
The FASB issued SFAS No.131 Disclosures About Segments of an Enterprise and
Related Information ("SFAS 131") in June 1997. SFAS 131 establishes standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosures about products and services, geographic areas and major customers.
SFAS 131 is effective for financial statements for periods beginning after
December 15, 1997. Management has not yet determined what effect, if any,
adoption will have on the Company's financial condition and results of
operations.
3. ADJUSTABLE RATE MORTGAGE SECURITIES
ARM securities consist of FNMA and FHLMC mortgage certificates secured by ARM
loans on single-family residential housing. The following table summarizes the
Company's ARM
F-11
51
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
securities classified as available-for-sale as of December 31, 1997, which are
carried at their fair value (dollars in thousands):
AVAILABLE-FOR-SALE PORTFOLIO MIX
------------------ -------------
Amortized cost :
FNMA certificates $ 207,898 59.6%
FHLMC certificates 141,075 40.4%
--------- -----
Total amortized cost 348,973 100.0%
=====
Gross unrealized (losses) (842)
---------
Fair value $ 348,131
=========
The scheduled maturities of ARM securities available for sale at December 31,
1997, were as follows:
AMORTIZED FAIR
COST VALUE
--------- ---------
Due in one year or less $ -0- $ -0-
Due from one to five years -0- -0-
Due from five to ten years -0- -0-
Due after ten years 348,973 348,131
--------- ---------
Total $ 348,973 $ 348,131
========= =========
As mentioned above, actual maturities may differ from scheduled maturities
because borrowers may have the right to prepay certain obligations, often times
without penalties. Maturities of mortgage securities depend on the repayment
characteristics and experience of the underlying obligations.
As of December 31, 1997, the average effective yield on the ARM securities
including the amortization of the net premiums paid for the ARM securities, was
6.268%.
4. MORTGAGE LOANS HELD FOR SALE
Investments in single-family mortgage loans held for sale consist of fixed rate
mortgages and adjustable rate mortgages. The following table summarizes the
Company's single-family mortgage loan pools as of December 31, 1997, which are
carried at the lower of cost or market (dollars in thousands):
F-12
52
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
COST MIX
---- ---
Fixed rate $ 106,397 67.1%
Adjustable rate 52,392 32.9%
--------- -----
Subtotal 158,789 100.0%
=====
Net deferred loan fees,
Premiums and discounts 2,199
Loan loss provision (18)
---------
Total $ 160,970
=========
An analysis of the change in the loan loss provision is as follows:
Balance beginning of period $ 0
Loan loss provision 18
---
Balance at December 31, 1997 $18
===
The following table summarizes certain characteristics of the Company's
single-family fixed rate and adjustable rate mortgage loan portfolios as of
December 31, 1997 (dollars in thousands):
CARRYING VALUE PRINCIPAL WEIGHTED WEIGHTED
OF MORTGAGE AMOUNT OF AVERAGE NET AVERAGE
LOANS MORTGAGE LOANS COUPON MATURITY (1)
----- -------------- ------ ------------
Fixed Rate $107,953 $106,424 8.265% 242
Adjustable Rate 53,017 52,365 7.925% 319
-------- -------- ----- --------
$160,970 $158,789 8.153% 267
======== ======== ===== ========
(1) weighted average maturity reflects the number of months remaining until
maturity
As of December 31, 1997 the average effective yield on the mortgage loan
portfolio, including the amortization of the net premiums paid for the mortgage
loans, was 7.317%.
5. CONCENTRATION OF CREDIT RISK
The Company's exposure to credit risk associated with its lending activities is
measured on an individual customer basis as well as by groups of customers that
share similar attributes. In the normal course of its business, the Company has
concentrations of credit risk in its portfolio for the mortgage loans in certain
geographic areas. At December 31, 1997, the percent of total principal amount of
mortgage loans outstanding in any one state, exceeding 5% of the principal
amount of mortgage loans held for sale, are as follows:
F-13
53
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
STATE PERCENT
----- -------
Florida 25%
South Carolina 13%
California 10%
Ohio 9%
Texas 6%
The Company's management believes exposure to credit risk associated with agency
ARM securities is minimal due to the guarantees provided by FNMA and FHLMC.
During 1997 the Company purchased approximately 61.9% of its total outstanding
principal amount of mortgage loans from three financial institutions (the
largest of which represented approximately 29.1% of the total outstanding
principal amount of mortgage loans). Management attributes the high
concentration of purchases from these three financial institutions to the
initial ramp up phase of mortgage loan acquisitions and does not foresee that
this is a trend that will continue into the future.
ARM securities were purchased from six securities firms in 1997. The largest
concentration of ARM purchases from one firm represented approximately 22.8% of
the total principal amount of ARM securities outstanding at December 31, 1997.
The company has cash and cash equivalents in a financial institution which is
insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 per
institution. As of December 31, 1997, the Company had amounts on deposit with
the financial institution in excess of FDIC limits. The Company limits its risk
by placing its cash and cash equivalents in a high quality financial
institution.
6. REVERSE REPURCHASE AGREEMENTS
In September 1997, the Company entered into a master repurchase agreement with a
lender in an amount up to $200 million ($100 million committed and $100 million
uncommitted) for a period of one year. Any borrowings under this facility will
be secured by mortgage loans, or other securities, and will bear interest at the
six-month LIBOR, plus a spread ranging from 0.70% to 1.25%.
In December 1997 the Company entered into a second master repurchase agreement
with another lender in an amount up to $125 million ($100 million committed and
$25 million uncommitted) for a period of one year. Any borrowings under this
facility will be secured by mortgage loans, or other securities and will bear
interest at the six-month LIBOR, plus a spread of 60 basis points.
At December 31, 1997 the Company had outstanding borrowings of $93,731,000 under
the above mentioned reverse repurchase agreements with a weighted average
borrowing rate of 6.313% and a weighted average remaining maturity of
approximately one month. The reverse
F-14
54
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
repurchase agreements at December 31, 1997 were collateralized by mortgage loans
with a cost basis of $160,970,000 (which approximates market value).
In November 1997 the Company entered into six separate reverse repurchase
agreements to finance all of its ARM securities purchases. Each of the reverse
repurchase agreements are secured by the market value of the Company's ARM
securities ($348,131,000) at December 31, 1997 and bear interest at LIBOR.
As of December 31, 1997, the Company had outstanding ARMS securities reverse
repurchase agreements of $341,407,000 with a weighted average borrowing rate of
5.723 % and a weighted average remaining maturity of less than one month.
Information concerning the reverse repurchase agreements and the pledged
collateral at December 31, 1997 is summarized as follows: (dollars in
thousands):
Collateral (dollars in thousands)
---------------------------------
ARM Mortgage
Reverse Repurchase Agreements Securities Loans
- ----------------------------- ---------- -----
Average balance during the period (1) $113,803 $ 32,674
Average interest rate during period (1) 5.723% 6.313%
Maximum month-end balance during
the period $341,407 $ 93,731
Collateral Underlying the Agreements
- ------------------------------------
Carrying balance $348,131 $160,970
Estimated fair value $348,131 $160,970
(1) above table reflects the period beginning September 30, 1997 (the date
of the first mortgage asset purchase) through December 31, 1997.
7. EMPLOYEE BENEFIT PLANS
401(k) PLAN
The Company participates in the HCP non-contributory retirement plan ("401(k)
Plan"). The 401(k) plan is available to all full-time company employees with at
least six months of service. The 401(k) Plan is designed to be tax deferred in
accordance with provisions of Section 401(k) of the Internal Revenue Code. The
401(k) Plan provides that each participant may contribute 15.0% of his or her
salary subject to the maximum allowable each fiscal year ($9,500 in 1997). Under
the 401(k) Plan, an employee may elect to enroll on January 1, or July 1,
provided that the employee has met the six month employment service requirement.
F-15
55
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
1997 STOCK OPTION PLAN
The Company's 1997 Executive and Non-Employee Director Stock Option Plan (the
"1997 Stock Option Plan") provides for the grant of qualified incentive stock
options ("ISOs") which meet the requirements of Section 422 of the Internal
Revenue Code, stock options not so qualified ("NQSOs"), deferred stock,
restricted stock, performance shares, stock appreciation rights and limited
stock awards ("Awards") and dividend equivalent rights ("DERs").
Subject to anti-dilution provisions of stock splits, stock dividends and similar
events, the 1997 Stock Option Plan authorizes the grant of options to purchase,
and Awards of, an aggregate of up to 325,333 shares of the common stock. If an
option granted under the 1997 Stock Option Plan expires or terminates, or an
Award is forfeited, the shares subject to any unexercised portion of such option
or Award will again become available for the issuance of further options or
Awards under the 1997 Stock Option Plan.
Unless previously terminated by the Board of Directors, the 1997 Stock Option
Plan will terminate ten years from the date of approval (or five years in the
case of ISO's granted to an employee who is deemed to own in excess of 10% of
combined voting power of the Company's outstanding equity stock) and no options
or Awards may be granted under the 1997 Stock Option Plan thereafter, but
existing options or Awards remain in effect until the options are exercised or
the options or the Awards are terminated by their terms. The aggregate fair
market value (determined as of the time of grant) of the shares of the common
stock with respect to which ISOs are exercisable for the first time by an
employee during any calendar year may not exceed $100,000.
All stock options granted by the Compensation Committee pursuant to the 1997
Stock Option Plan will be contingent and may vest, subject to other vesting
requirements imposed by the Compensation Committee in full or in part on any
September 30 beginning with September 30, 1998 and ending with September 30,
2002 (each, an "Earn-Out Measuring Date"). Subject to any other applicable
vesting restrictions, any outstanding stock options will vest in full as of any
Earn-Out Measuring Date through which the return on a unit (a unit is composed
of one common stock certificate and one warrant certificate) is at least equal
to the initial public offering price of the unit. In addition, subject to any
other applicable vesting restrictions, one-third of any outstanding stock
options will vest as of any Earn-Out Measuring Date through which the return on
a unit is at least equal to a 20% annualized return on the initial public
offering price of the unit. The return on a unit is determined by adding (i) the
appreciation in the value of the unit since the closing of the initial public
offering and (ii) the amount of distributions made by the Company on the share
of common stock included in the unit since the closing of the initial public
offering. The appreciation in the value of a unit as of any Earn-Out Measuring
Date is the average difference, during the 30 day period that ends on the
Earn-Out Measuring Date, between the market price of the share of common stock
included in the unit and the initial public offering price of the unit
multiplied by two to take into account the value of the stock warrant included
in the unit. In determining whether such stock options have vested, appropriate
adjustments will be made for stock splits, recapitalizations, stock dividends
and transactions having similar effects.
F-16
56
\ HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
A summary of the status of the Company's 1997 Stock Options Plan as of December
31, 1997 and changes during the period from September 19, 1997 through December
31, 1997 is presented below:
STOCK OPTION SHARES EXERCISE PRICE
- ------------ ------ --------------
Granted - September 19, 1997 162,664 $15.00
Granted - September 28, 1997 160,660 15.75
Cancelled (3,000) 15.75
-------- ------
Outstanding at December 31, 1997 320,324 $15.37
======== ======
No shares were exercisable at December 31, 1997.
The per share weighted average fair value of stock options granted during the
period ended December 31, 1997 was $0.27 at the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
1997
----
Expected life (years) 5
Risk-free interest rate 5.77%
Volatility 12.0%
Expected dividend yield 10.0%
The Company applies APB opinion No. 25 in accounting for its 1997 Stock Option
Plan and, accordingly, no compensation cost has been recognized for its stock
options in the financial statements. Had the Company determined compensation
cost based on the fair value at the grant date for its stock options under
Statements of Financial Accounting Standards No. 123, Accounting For Stock-Based
Compensation, the Company's net income would have been reduced to the pro forma
amounts indicated below (in thousands, except per share data):
YEAR ENDED
DECEMBER 31, 1997
-----------------
Net earnings:
As reported $ 499
Pro forma 417
Earnings per share - basic:
As reported $0.15
Pro forma 0.13
Earnings per share - diluted
As reported $0.14
Pro forma 0.11
BONUS INCENTIVE COMPENSATION PLAN
A bonus incentive compensation plan was established in 1997, whereby an annual
bonus will be accrued for eligible participants of the Company. The annual bonus
will be paid one-half in cash
F-17
57
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
and (subject to ownership limits) one-half in shares of common stock in the
following year. The Company must generate annual net income before bonus
accruals that allow for a return of equity to stockholders in excess of the
average weekly ten-year U.S. Treasury rate plus 4.0% before any bonus accrual is
recorded. No such accrual was recorded in 1997.
8. AFFILIATED PARTY TRANSACTIONS
The Company has engaged HCP pursuant to a Management Agreement to render, among
other things, due diligence, asset management and administrative services. The
1997 statement of operations of the Company includes management and
administrative expenses of $400,000, due diligence expenses of $266,000 and
commission expenses of $61,000 relating to billings from HCP. At December 31,
1997 the balance sheet of the Company included an amount due HCP of $540,000.
The term of the Management Agreement continues until December 31, 1999 with
subsequent renewal provisions.
The Company has agreed to lend (a maximum of) $1,750,000 collectively, to four
officer/stockholders (collectively referred to as the "Principals") to enable
the Principals to pay tax on the gains they must recognize upon contributing
their HCP preferred stock to the Company for shares of the Company's common
stock. The loans will be secured solely by 116,667 shares of the Company's
common stock owned by the Principals, collectively. The loans bear interest at
the lowest applicable federal tax rate during the month the loans are made. At
December 31, 1997 loans outstanding to three of the Principals totaled $482,000.
9. EARNINGS PER SHARE
On December 31, 1997 the Company adopted SFAS 128 for calculating earnings per
share as shown below: (dollars in thousands, except per share data)
Earnings per share - basic:
Net income (numerator) $ 499
==========
Average common shares
outstanding (denominator) 3,296,742
==========
Per share $ 0.15
==========
Earnings per share - diluted:
Net income (numerator) $ 499
==========
Average common shares outstanding 3,296,742
Add: Incremental shares from
assumed conversion of
warrants 374,943
----------
Dilutive potential common shares 374,943
----------
Adjusted weighted average shares
(denominator) 3,671,685
==========
Per share $ 0.14
==========
F-18
58
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
10. COMMITMENTS AND CONTINGENCIES
At December 31, 1997 the Company had committed to purchase approximately
$111,092,000 of fixed and ARM loans.
The Company entered into employment agreements with the Principals. Such
agreements are for five year terms which expire in 2002, and provide for
aggregate annual base salaries of $975,000. A portion of the aggregate base
salaries is allocated to the Company's taxable subsidiary based on management's
actual and estimated time involved with the subsidiary's activities.
As additional consideration to the Principals for their contribution of their
HCP preferred stock to the Company, the Company has agreed to (1) issue to the
Principals up to 216,667 additional shares of the Company's common stock and (2)
forgive a maximum of $1,750,000 in loans made to the Principals; if certain
financial returns to stockholders are met, at certain Earn-Out Measuring Dates
as described in the Company's IPO Prospectus dated September 15, 1997.
The Company has guaranteed the line-of-credit of its majority owned subsidiary,
Hanover Capital Partners Ltd. The maximum line-of-credit obligation and the
actual line-of-credit obligation at December 31, 1997 was $1,700,000 and
$1,405,000, respectively.
11. FINANCIAL INSTRUMENTS
In accordance with SFAS No. 107, Disclosure about Derivative Financial
Instruments, and SFAS No. 119, Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments, the Company has provided fair value
estimates and information about valuation methodologies. The estimated fair
value amounts have been determined using available market information or
appropriate valuation methodologies. However, considerable judgment is required
in interpreting market data to develop estimates of fair value, so the estimates
are not necessarily indicative of the amounts that would be realized in a
current market exchange. The effect of using different market assumptions and/or
estimation methodologies may materially impact the estimated fair value amounts.
The estimated fair value of the Company's assets and liabilities classified as
financial instruments and off-balance sheet financial instruments at December
31, 1997 are as follows (dollars in thousands):
F-19
59
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
CARRYING FAIR
AMOUNT VALUE
-------- --------
Assets:
ARM securities $348,131 $348,131
Mortgage loans 160,970 160,970
Cash and cash equivalents 4,022 4,022
Accrued interest receivable 3,597 3,597
Notes receivable 482 482
-------- --------
Total $517,202 $517,202
======== ========
Liabilities:
Reverse repurchase agreements 435,138 435,138
Accrued interest payable 2,250 2,250
Other liabilities 2,057 2,057
-------- --------
Total $439,445 $439,445
======== ========
Off-Balance Sheet: Notional
--------
Commitments to purchase loans $111,092 $111,132
======== ========
Forward commitments to sell
mortgage securities $122,650 $122,378
======== ========
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Cash and cash equivalents, accrued interest receivable, notes receivable,
reverse repurchase agreements, accrued interest payable, other liabilities - The
fair value of these financial instruments was determined to be their carrying
value due to their short-term nature.
ARM securities - The fair values of these financial instruments are based upon
either or all of the following: actual prices received upon recent sales of
mortgage securities to investors, projected prices which could be obtained
through investor estimates considering interest rates, mortgage loan type,
quality and discounted cash flow analysis based on prepayment and interest rate
assumptions used in the market place for similar securities with similar credit
ratings.
Mortgage loans held for sale - The fair values of these financial instruments
are based upon actual prices received upon recent sales of mortgage loans and
securities to investors and projected prices which could be obtained through
investors considering interest rates, mortgage loan type, an credit quality.
Commitments to purchase/originate mortgages - The Company has outstanding
commitments to purchase mortgage loans at market terms at the time of
commitment. The fair value of these financial instruments was determined through
a review of published market information associated with similar instruments.
These commitment obligations are considered in conjunction with the Company's
lower of cost or market valuation of its mortgage loans held for sale.
F-20
60
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM JUNE 10, 1997 (INCEPTION) TO DECEMBER 31, 1997 - (CONTINUED)
Forward commitments to sell mortgage securities - The Company has outstanding
forward commitments to sell mortgages and/or mortgage securities into mandatory
delivery contracts with investment bankers, private mortgage investors and
agency mortgage-backed securities. The fair value of these financial instruments
was determined through review of published market information associated with
similar instruments. These commitment obligations are considered in conjunction
with the Company's lower of cost or market valuation of its mortgage loans held
for sale.
12. SUBSEQUENT EVENT
On January 12, 1998 a $0.16 cash dividend previously declared by the Board of
Directors was paid to stockholders of record as of December 31, 1997.
13. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data are as follows (dollars in thousands, except
per share data):
Period from June 10, 1997 (inception)
through December 31, 1997
(1) (1)
THREE MONTHS THREE MONTHS JUNE 10, 1997
ENDED ENDED THROUGH
DECEMBER 31, 1997 SEPTEMBER 30, 1997 JUNE 30, 1997
---------------------------------------------------------------------------
Net interest income $ 1,548 $ 128 $ 0
=================================================================
Net income 440 59 0
=================================================================
Basic earnings per share(2) 0.07 0.07 0.00
=================================================================
Diluted earnings per share(2) 0.07 0.07 0.00
=================================================================
Dividends declared 0.16 0.00 0.00
=================================================================
(1) - the Company was organized on June 10, 1997, however operations did not
begin until the IPO date - September 19, 1997
(2) - earnings per share are computed independently for each of the quarters
presented; therefore the sum of the quarterly earnings per share do not equal
the earnings per share total for the year
F-21
61
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Partners Ltd.
We have audited the accompanying consolidated balance sheets of Hanover Capital
Partners Ltd. and Subsidiaries (the "Company") as of December 31, 1997 and 1996,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 1997.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Hanover Capital Partners Ltd. and
Subsidiaries at December 31, 1997 and 1996, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1997 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 20, 1998
F-22
62
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
- --------------------------------------------------------------------------------
ASSETS 1997 1996
---- ----
CURRENT ASSETS:
Cash $ 208,315 $ 161,546
Investment in marketable securities 17,394 16,443
Accounts receivable 133,829 3,683,865
Receivables from related parties 757,384 521,539
Accrued revenue on contracts in progress 35,413 549,781
Prepaid expenses and other current assets 118,552 143,026
---------- ----------
Total current assets 1,270,887 5,076,200
PROPERTY AND EQUIPMENT - Net 213,137 316,057
MORTGAGE SERVICING RIGHTS 49,449 30,587
DEFERRED TAX ASSET 20,081 --
OTHER ASSETS 166,670 227,548
INCOME TAX RECEIVABLE 292,885 --
DUE FROM OFFICER 53,766 107,532
---------- ----------
TOTAL ASSETS $2,066,875 $5,757,924
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accrued appraisal and subcontractor costs $ 131,978 $2,807,172
Accounts payable and accrued expenses 334,591 678,390
Income taxes payable -- 89,477
Deferred revenue 104,950 194,334
Notes payable to related parties -- 133,018
Deferred income taxes -- 12,993
Other liabilities -- 122,400
---------- ----------
Total current liabilities 571,519 4,037,784
---------- ----------
LONG-TERM LIABILITIES
Note payable to bank 1,405,000 1,045,000
Minority interest 616 250
---------- ----------
Total long-term liabilities 1,405,616 1,045,250
---------- ----------
Total liabilities 1,977,135 5,083,034
---------- ----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000
shares authorized, 97,000 shares
outstanding at December 31, 1997 970 --
Common stock: Class A: $.01 par value,
5,000 and 1,000 shares authorized at
December 31, 1997 and 1996, 3,000
and 166.424 shares outstanding at
December 31, 1997 and 1996 30 2
Additional paid-in capital 56,442 57,440
Retained earnings 32,298 617,448
---------- ----------
Total stockholders' equity 89,740 674,890
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $2,066,875 $5,757,924
========== ==========
See notes to consolidated financial statements.
F-23
63
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
1997 1996 1995
---- ---- ----
REVENUES:
Due diligence fees $ 4,058,609 $ 8,323,789 $ 7,525,620
Loan brokering/asset management
fees 3,027,319 2,469,378 1,770,665
Mortgage sales and servicing 826,486 970,757 2,289,440
Other income 58,151 355,715 295,944
----------- ----------- -----------
Total revenues 7,970,565 12,119,639 11,881,669
----------- ----------- -----------
EXPENSES:
Personnel expense 5,373,331 4,227,226 3,831,426
Appraisal, inspection and other
professional fees 618,059 3,128,225 2,593,001
Subcontractor expense 1,386,979 2,919,509 2,738,903
Travel and subsistence 302,936 616,795 860,253
Occupancy expense 495,285 536,520 437,830
General and administrative expense 419,543 525,143 1,066,220
Reversal of reserve for IRS
assessment (23,160) (277,600) --
Interest expense 117,894 134,393 160,439
Depreciation and amortization 117,675 125,928 114,174
----------- ----------- -----------
Total expenses 8,808,542 11,936,139 11,802,246
----------- ----------- -----------
INCOME (LOSS) BEFORE INCOME TAX
PROVISION (BENEFIT) (837,977) 183,500 79,423
INCOME TAX (BENEFIT) PROVISION (325,959) 73,870 51,165
----------- ----------- -----------
NET INCOME (LOSS) $ (512,018) $ 109,630 $ 28,258
=========== =========== ===========
BASIC EARNINGS (LOSS) PER SHARE $ (525.79) $ 658.74 $ 169.80
=========== =========== ===========
See notes to consolidated financial statements.
F-24
64
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1997 AND 1996
- --------------------------------------------------------------------------------
Common Stock Common Stock Common Stock Additional
Preferred Stock New Class A Old Class A Class B Paid-in Retained
Shares Amount Shares Amount Shares Amount Shares Amount Capital Earnings Total
--------- ------ ------------- ------------- ------------- ------- -------- -----
BALANCE, DECEMBER 31, 1995 $165.800 $1 41,600 $1 $165,999 $500,846 $666,847
-------- -- ------ -- -------- -------- --------
Net income 109,630 109,630
Distribution of subsidiary to stockholders 6,972 6,972
Shareholders' Exchange Agreement:
Redemption of Class A shares (40.836) (108,559) (108,559)
Exchange of Class B shares for Class A shares 41.460 1 (41,600) (1) -- -- --
-------- -- ------ -- -------- -------- --------
BALANCE, DECEMBER 31, 1996 166.424 2 57,440 617,448 674,890
Net(loss) (512,018) (512,018)
Dividends (noncash) (73,132) (73,132)
Agreement and Plan of Recapitalization:
Exchange of "old" Class A shares
for "new" Class A shares and
Series A preferred Stock 97,000 $970 3,000 $30 (166.474) (2) (998) -- --
------ ---- ----- --- -------- -- -------- -------- --------
BALANCE, DECEMBER 31, 1997 97,000 $970 3,000 $30 -- -- $ 56,442 $ 32,298 $ 89,740
====== ==== ===== === ======== == ======== ======== ========
See notes to consolidated financial statements.
F-25
65
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
1997 1996 1995
---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (512,018) $ 109,630 $ 28,258
Adjustments to reconcile net income (loss)
to net cash (used in) provided by
operating activities:
Depreciation and amortization 117,675 125,928 114,174
Gain on sale of mortgage servicing rights (16,916) (52,318) (232,587)
Reversal of reserve for IRS assessment (23,160) (277,600) --
IRS payroll tax settlement (99,240) -- --
Loss on disposal of property and equipment 35,696 -- 10,261
Loss on sale of trading securities -- 1,360 753
Purchase of trading securities (951) (1,931) (29,951)
Sale of trading securities -- 26,593 100,016
Distribution of subsidiary to stockholders -- 6,972 --
Changes in assets - (increase) decrease:
Accounts receivable 3,550,036 (2,150,117) 862,364
Receivables from related parties (315,097) (308,808) 22,582
Accrued revenue on contracts in progress 514,368 (384,880) 1,011,785
Income tax receivable (292,885) -- --
Prepaid expenses and other current assets 24,474 (49,871) (39,169)
Deferred tax asset (20,081) -- --
Other assets (12,254) (22,914) (154,108)
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs (2,675,194) 2,741,014 21,931
Accounts payable and accrued expenses (343,799) 104,018 (913,692)
Income taxes payable (89,477) (90,490) 15,634
Deferred income taxes (12,993) (17,222) (114,326)
Deferred revenue (89,384) (14,946) 113,855
Minority interest 366 (26,935) (147,057)
---------- ---------- ----------
Net cash (used in) provided by
operating activities (260,834) (282,517) 670,723
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (43,060) (133,317) (43,421)
Sale of property and equipment -- 4,592 1,704
Proceeds from sale of mortgage servicing rights 34,446 94,043 423,563
Capitalization of mortgage servicing rights (43,783) (37,451) (264,141)
---------- ---------- ----------
Net cash (used in) provided
by investing activities (52,397) (72,133) 117,705
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (repayment of) note
payable to bank 360,000 (330,000) (125,000)
Redemption of Class A common stock -- (66,000) --
Repayment of subordinated debt -- -- (51,299)
---------- ---------- ----------
Net cash provided by (used in)
financing activities 360,000 (396,000) (176,299)
---------- ---------- ----------
NET INCREASE (DECREASE) WITH IN CASH AND
CASH EQUIVALENTS 46,769 (750,650) 612,129
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 161,546 912,196 300,067
---------- ---------- ----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 208,315 $ 161,546 $ 912,196
========== ========== ==========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $25,649,378 and $35,831,617 were
originated by HCMC and funded by investors
in 1997 and 1996, respectively.
Noncash dividends of $73,132, were distributed
to the Company's stockholders on
September 19, 1997.
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for:
Income taxes $ 129,359 $ 205,075 $ 176,119
========== ========== ==========
Interest $ 116,993 $ 125,748 $ 164,420
========== ========== ==========
See notes to consolidated financial statements.
F-26
66
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
1. BUSINESS DESCRIPTION
Hanover Capital Partners Ltd. ("HCP") and its subsidiaries operate as a
specialty finance company which is principally engaged in performing due
diligence services, mortgage and investment banking services and, prior to
September 1997, asset management services. A wholly-owned subsidiary of
HCP, Hanover Capital Mortgage Corporation ("HCMC"), is an originator and
servicer of multifamily mortgage loans. HCMC's operations are conducted
from multiple branches located throughout the United States. HCMC is
approved by the U.S. Department of Housing and Urban Development (HUD) as
a Title II Nonsupervised Mortgagee under the National Housing Act. Another
wholly-owned subsidiary of HCP, Hanover Capital Securities, Inc. ("HCS")
is a registered broker/dealer with the Securities and Exchange Commission.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. Principles of Consolidation - The consolidated financial statements
include the accounts of HCP and its majority and wholly-owned
subsidiaries (the "Company"). The wholly owned subsidiaries include
HCMC, HCS, Hanover Capital Advisors, Inc. (through September 1997)
and Hanover Capital Mortgage Fund, Inc. (through September 1997).
Majority owned subsidiaries include Hanover Joint Ventures, Inc.
(75% owned) and Hanover On-Line Mortgage Edge, LLC (50% owned,
through September 1997). All significant intercompany accounts and
transactions have been eliminated.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amount of assets and
liabilities at the date of the financial statements and the required
amounts of revenues and expenses during the reporting period.
b. Investments in Limited Liability Companies - Minority ownership
interests in limited liability companies are accounted for by the
equity method of accounting. HCP's investment in limited liability
companies are classified as other assets in the accompanying
consolidated balance sheets. The ownership of each limited liability
company at December 31, 1997 and 1996 is detailed below:
1997 1996
---- ----
AGR Financial, LLC - 25.0%
Alpine/Hanover, LLC 1.0% 1.0%
ABH-I, LLC 1.0% 1.0%
Alpine/Hanover II, LLC - 1.0%
c. Minority Interests - Minority interests, representing other
stockholders' interests in majority-owned companies are consolidated
in the accompanying balance sheets.
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67
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
d. Revenue Recognition - Revenues from due diligence contracts in
progress are recognized for the services provided as they are earned
and billed.
e. Loan Origination Fees and Costs - Loan origination fees and costs
are deferred until the sale of the loan. The Company sells all
originated loans to investors at the time of origination, and
accordingly, recognizes loan origination fees at that time. Direct
loan origination costs and loan origination fees are offset and
included in mortgage sales revenue.
f. Loan Servicing Fees - Loan servicing fees consist of fees paid by
investors for the collection of monthly mortgage payments,
maintenance of required escrow accounts, remittance to investors,
and ancillary income associated with those activities. The Company
recognizes loan servicing fees as payments are collected.
g. Deferred Revenue - Cash advances received for certain service
contracts are recorded in the accompanying consolidated balance
sheets as deferred revenue and are recognized during the period the
services are provided and the related revenue is earned.
h. Income Taxes - The Company records deferred taxes in accordance with
Statement of Financial Accounting Standards No. 109, Accounting for
Income Taxes ("SFAS 109"). Under SFAS 109 a current or deferred tax
liability or asset is recognized for the current or deferred tax
effects of all events recognized in the financial statements. Those
effects are measured based on provisions of current tax law to
determine the amount of taxes payable or refundable currently or in
future years. The tax effects of earning income or incurring
expenses in future years or the future enactment of a change in tax
laws or rates are not anticipated in determining deferred tax assets
or liabilities.
The Company files a consolidated Federal income tax return. The
Company has not been subject to an examination of their income tax
returns by the Internal Revenue Service.
i. Property and Equipment - Property and equipment is stated at cost
less accumulated depreciation. Depreciation is computed on the
straight-line method over the estimated useful lives of the assets,
generally three to seven years. Leasehold improvements are
depreciated over the terms of the respective leases or their
estimated useful lives, whichever is shorter.
j. Investment in Marketable Securities - Investment in marketable
securities which the Company has classified as trading securities
are reported in the accompanying consolidated balance sheets at
market value at December 31, 1997 and 1996.
k. Cash and Cash Equivalents - For cash flow purposes, the Company
considers highly liquid investments, purchased with an original
maturity of three months or less, to be cash equivalents. There were
no cash equivalents at December 31, 1997 and 1996.
l. Mortgage Servicing Rights - Effective January 1, 1997, the Company
adopted Statement of Financial Accounting Standards No. 125,
Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities ("SFAS 125"). SFAS 125 supersedes
Statement of Financial Accounting Standards No. 122, Accounting for
Mortgage Servicing Rights, an amendment of FASB Statement No. 65.
Under SFAS 125, after the transfer of a financial asset, the Company
recognizes the financial assets it controls and the liabilities it
has incurred. Furthermore, the Company no longer recognizes the
financial assets for which control has been
F-28
68
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
surrendered and liabilities have been extinguished. The adoption of
SFAS 125 did not have an effect on the financial position or results
of operations of the Company.
In December 1996, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 127, Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125
("SFAS 127"). SFAS 127 defers for one year the effective date of
certain sections of SFAS 125, including those relating to repurchase
agreement, dollar-roll, securities lending and similar transactions,
as prescribed by SFAS 125. The adoption of SFAS 127 will not have a
material effect on the Company's financial position or results of
operations.
Prior to January 1, 1997, the Company accounted for mortgage
servicing rights in accordance with SFAS 122. For purposes of
assessing impairment, the lower of carrying value or fair value of
servicing rights is determined on an individual loan basis.
Capitalized servicing rights are amortized in proportion to
projected net servicing revenue. The fair value of servicing rights
is determined using a discounted cash flow method.
m. Basic Earnings per Share - The Company computes earnings per share
in accordance with statement of Financial Accounting Standards No.
128, Earnings per Share ("SFAS 128"). Basic earnings per share is
computed by dividing income available to common stockholders by the
weighted average number of common shares outstanding during the
period. Shares issued during the period and shares reacquired during
the period are weighted for the portion of time they were
outstanding.
3. PAYROLL TAX SETTLEMENT
In 1994, the Internal Revenue Service ("IRS") began an examination of the
Company's payroll tax withholding practices with respect to independent
contractors who provided services to HCP's due diligence business.
Pursuant to the IRS Classification Settlement Program ("CSP"), HCP settled
all disputed payroll taxes relating to the IRS examination of HCP's
payroll withholding practices with respect to independent contractors. In
October 1997, management agreed to the terms of the CSP which required HCP
to pay the United States Government $99,240 in full discharge of any
federal employment tax liability and to further treat the workers as
employees (rather than independent contractors) on a prospective basis
effective April 1, 1998.
At December 31, 1995, HCP had recorded an accrual of $400,000 for payroll
withholding tax for independent contractors. HCP recorded a reversal of
reserve of $23,160 and $277,600 for the payroll tax matter in the
accompanying consolidated statements of operations for the years ended
December 31, 1997 and 1996, respectively, to adjust the previously
established reserve to the actual and expected settlement amounts.
F-29
69
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
4. CONCENTRATION RISK
For the years ended December 31, 1997, 1996 and 1995, the Company received
revenues from certain customers, which are subject to change annually,
which exceeded 10% of total revenues as follows:
1997 1996 1995
---- ---- ----
24% 46% 32%
18% 26% 16%
5. MORTGAGE SERVICING
The Company, through its wholly-owned subsidiary HCMC, services
multifamily mortgage loans on behalf of others. Loan servicing consists of
the collection of monthly mortgage payments on behalf of investors,
reporting information to those investors on a monthly basis and
maintaining custodial escrow accounts for the payment of principal and
interest to investors and property taxes and insurance premiums on behalf
of borrowers. As of December 31, 1997 and 1996, HCMC was servicing 43 and
46 loans, respectively, with unpaid principal balances of $120,736,400 and
$129,315,400, including loans subserviced for others of $40,055,200 and
$44,241,919, respectively. Escrow balances maintained by HCMC were
$3,087,400 and $4,352,400 at December 31, 1997 and 1996, respectively. The
aforementioned servicing portfolio and related escrow accounts are not
included in the accompanying consolidated balance sheets as of December
31, 1997 and 1996.
Activity in mortgage servicing rights for the years ended December 31,
1997 and 1996 was as follows:
1997 1996
-------- --------
Beginning balance $ 30,587 $ 46,904
Capitalization 43,783 37,451
Sales (17,530) (41,725)
Scheduled amortization (7,391) (12,043)
-------- --------
$ 49,449 $ 30,587
======== ========
The fair value of the Company's servicing rights at December 31, 1997 and
1996 was $79,504 and $46,606, respectively.
F-30
70
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
6. RELATED PARTY TRANSACTIONS
Receivables from related parties at December 31, 1997 and 1996 consist of
the following:
1997 1996
-------- --------
Due from Hanover Capital Mortgage Holdings, Inc. (1) $540,044 $ --
Due from ABH-I, LLC (includes $28,984 and
$431,118 of asset management fees at
December 31, 1997 and 1996, respectively) (2) 51,321 451,604
Due from Hanover Asset Services, Inc. (3) 8,070 6,420
Due from Alpine/Hanover, LLC (2) 9,273 4,361
Due from Alpine/Hanover II, LLC (3) 5,000 --
Due from Hanover Mortgage Capital Corporation (3) 5,962 --
Due from AGR Financial, LLC (4) 80,813 --
-------- --------
Due from related entities 700,483 462,385
Due from officers (5) 110,667 166,686
-------- --------
Receivables from related parties $811,150 $629,071
======== ========
(1) The Company entered into a Management Agreement in 1998 to provide,
among other things, due diligence, asset management and
administrative services to Hanover Capital Mortgage Holdings, Inc.
("HCHI") in connection with acquiring single-family mortgage loan
pools and managing and servicing HCHI's investment portfolio. The
term of the Management Agreement continues until December 31, 1999
with subsequent renewal provisions.
(2) Amounts due from entities that the Company had a minority ownership
percentage in for all of 1997 represent receivables resulting
primarily from fees generated from asset management services and
out-of-pocket expenses. The Company ceased providing asset
management services to these entities in September 1997. Asset
management fees are recognized in the period earned and amounted to
$2,446,000, $1,370,000 and $1,362,000 for the years ended December
31, 1997, 1996 and 1995, respectively.
(3) Amounts due from entities that are owned by certain of the Company's
officers/owners at December 31, 1997 represent receivables resulting
primarily from accounting fees and out-of-pocket expenses.
(4) Amounts due from AGR Financial, LLC represent unpaid billings for
services that the Company provides to AGR Financial, LLC pursuant to
an agreement dated August 1996. The services include but are not
limited to providing AGR Financial, LLC with office space, office
equipment, software operating systems, processing capabilities and
accounting services.
(5) Amounts due from officers in 1997 include $107,532 from the
Company's President which will be repaid in annual amounts of
$53,766 in August 1998 and August 1999.
F-31
71
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
Notes payable to related parties at December 31, 1996 consisted of the
following:
1996
----
Note payable to officer $ 42,559
Notes payable to ABH-I, LLC 90,459
--------
Notes payable to related parties $133,018
========
On January 1, 1996, HCP and its stockholders entered into an Exchange
Agreement (see Note 9) whereby HCP redeemed 40.836 shares of Class A
common stock from one of its stockholders in exchange for cash ($66,000)
and a term note in the amount of $42,559. The note was paid in full, with
interest at the prime rate plus 2.0% in January 1997.
Notes payable to ABH-I, LLC at December 31, 1996 consisted of three (3)
promissory notes totaling $90,459. All of the promissory notes bear
interest at the prime rate (8.25% at December 31, 1996). The promissory
notes were paid in full in 1997.
7. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 1997 and 1996 consists of the
following:
1997 1996
--------- ---------
Office machinery and equipment $ 381,189 $ 388,123
Furniture and fixtures 111,246 111,246
Leasehold improvements 68,553 68,553
--------- ---------
560,988 567,922
Less accumulated depreciation and
amortization (347,851) (251,865)
--------- ---------
Property and equipment - net $ 213,137 $ 316,057
========= =========
Depreciation expense for the years ended December 31, 1997, 1996 and 1995
was $110,284, $113,885 and $87,913, respectively.
8. INCOME TAXES
The components of deferred income taxes as of December 31, 1997 and 1996
are as follows:
1997 1996
--------- ---------
Deferred tax assets $ 44,499 $ 52,409
Deferred tax liabilities (24,418) (65,402)
--------- ---------
Net deferred tax assets (liabilities) $ 20,081 $ (12,993)
========= =========
The items resulting in significant temporary differences for the years
ended December 31, 1997 and 1996 that generate deferred tax assets relate
primarily to the recognition of deferred revenue, accounts payable and
accrued liabilities for financial reporting purposes. Temporary
differences that generate
F-32
72
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
deferred tax liabilities relate primarily to the Company's change from the
cash method to the accrual method of accounting for income tax reporting
purposes.
The components of the income tax provision (benefit) for the years ended
December 31, 1997, 1996 and 1995 consist of the following:
1997 1996 1995
--------- --------- ---------
Current - Federal, state and local $(292,885) $ 91,092 $ 165,491
Deferred - Federal, state and local (33,074) (17,222) (114,326)
--------- --------- ---------
Total $(325,959) $ 73,870 $ 51,165
========= ========= =========
The income tax provision (benefit) differs from amounts computed at
statutory rates, as follows:
1997 1996 1995
--------- --------- ---------
Federal income taxes at statutory rate $(285,167) $ 56,518 $ 27,006
State and local income taxes net
of Federal benefit (59,486) 14,836 9,417
Unconsolidated subsidiary's net income (12,793) -- 1,177
Meals and entertainment 4,052 3,719 6,291
Officer's life insurance 9,613 8,576 9,114
Other, net 3,852 3,014 (663)
--------- --------- ---------
Total $(325,959) $ 73,870 $ 51,165
========= ========= =========
9. STOCKHOLDERS' EQUITY
On September 19, 1997, the Company entered into an Agreement and Plan of
Recapitalization ("Agreement") with its four stockholders to recapitalize
the Company. The Agreement provided for the tax-free exchange of the
stockholders 166.424 Class A "old" common stock shares for 3,000 shares of
"new" Class A common stock shares, $0.01 par value (representing a 3%
economic interest in the Company and 97,000 shares of Series A preferred
stock, $0.01 par value (representing a 97% economic interest in the
Company). The preferred stock has no dividend rate or preference over the
common stock. Dividend distributions will be made in the same amount on a
per share basis of the common stock as for the preferred stock. Dividend
distributions will be made to the common stockholders and the preferred
stockholders in proportion to the number of outstanding shares. The
preferred stockholder has the right to receive $10,750,005 upon
liquidation of the Company before common stockholders receive any
liquidating distributions.
On January 1, 1996, HCP entered into an exchange agreement ("Exchange
Agreement") with its stockholders in order to restructure the ownership of
HCP so that HCP had only 166.424 Class A shares of common stock
outstanding. The terms of the Exchange Agreement required HCP to: (1)
redeem 40.836 shares of Class A common stock; (2) exchange 41.460 shares
of Class B common stock for Class A common stock; (3) effect an exchange
of 8.468 shares of Class A common stock among certain stockholders; and
(4) transfer the ownership of Hanover Mortgage Capital Corporation
(formerly a wholly-owned subsidiary of HCP) to HCP's stockholders.
F-33
73
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (CONTINUED)
- --------------------------------------------------------------------------------
On January 1, 1996, pursuant to the Exchange Agreement, HCP transferred
its total ownership interests in its wholly-owned subsidiary, Hanover
Mortgage Capital Corporation to HCP's stockholders. Hanover Mortgage
Capital Corporation had a retained earnings deficiency at the time of
transfer.
10. NOTE PAYABLE TO BANK
In December 1996, HCP entered into a $2.0 million Line of Credit Facility
Agreement ("Line") with a bank that extends through December 31, 1999. The
note payable to the bank at December 31, 1997 and 1996 consisted of a
short-term note of $1,405,000 and $1,045,000, respectively, with an annual
interest rate at the prime rate as of December 31, 1997. In October 1997,
the terms of the Line were amended to decrease the interest rate on the
Line from the prime rate plus 1.5% to the prime rate. The interest rate in
effect at December 31, 1997 and 1996 was 8.50% and 9.75%, respectively.
The maximum borrowing capacity under the terms of the Line reduce every
six (6) months, beginning at June 30, 1997, by $150,000. The line is
collateralized by all of the assets of HCHI and guaranteed by HCHI. Prior
to September 1997, the line was collateralized by all of the assets of the
Company and guaranteed by the President and all of the wholly-owned
subsidiaries of HCP.
At December 31, 1997, the Company was in violation of certain financial
debt covenants of the Line that required the Company (on a stand-alone
basis) to: (1) maintain a maximum debt to net worth ratio of 3 to 1 at
December 31, 1997 and (2) to maintain a minimum debt service coverage
ratio of 1.25 to 1.00 at December 31, 1997. To mitigate the above
violations, the Company agreed to make a voluntary paydown on the Line of
$860,000 on February 17, 1998, thereby reducing the outstanding borrowings
on the line to $505,000.
11. COMMITMENTS AND CONTINGENCIES
The Company is involved in ongoing litigation regarding a mortgage loan
and a related reserve agreement. The Company has retained the services of
outside counsel. As of the date of this report, an evaluation of the
likelihood of success or an unfavorable outcome could not be performed. As
such, no amount has been provided for in the accompanying financial
statements. The Company intends to attempt to achieve final settlement of
the matter and if for any reason, the final settlement cannot be
effectuated, the Company intends to respond vigorously and will evaluate
the progress of the litigation as information becomes available.
The Company has noncancelable operating lease agreements for office space.
Future minimum rental payments for such leases are as follows:
YEAR AMOUNT
---- ------
1998 $187,414
1999 104,882
2000 37,714
--------
Total $330,010
========
Rent expense for the years ended December 31, 1997, 1996 and 1995 amounted
to $310,814, $339,421, and $345,716 respectively.
******
F-34