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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, 1998
OR
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ____________ to _____________
Commission file number: 001-13417
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND 13-3950486
(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
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
--- ---
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 common stock held by nonaffiliates of the
registrant as of March 10, 1999 was approximately $24,352,294 (based on closing
sales price of $4.5625 per share of common stock as reported for the American
Stock Exchange).
The registrant had 6,126,899 shares of common stock outstanding as of March
10, 1999.
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, 1999 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, 1998
INDEX
PART I PAGE
----
Item 1. Business....................................................................................... 3
Item 2. Properties..................................................................................... 31
Item 3. Legal Proceedings.............................................................................. 31
Item 4. Submission of Matters to a Vote of Security Holders............................................ 32
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.......................... 33
Item 6. Selected Financial Data........................................................................ 34
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......... 36
Item 7a. Quantitative and Qualitative Disclosure About Market Risk...................................... 56
Item 8. Financial Statements and Supplementary Data.................................................... 57
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.......... 57
PART III
Item 10. Directors and Executive Officers of the Registrant............................................. 58
Item 11. Executive Compensation......................................................................... 58
Item 12. Security Ownership of Certain Beneficial Owners and Management................................. 58
Item 13. Certain Relationships and Related Transactions................................................. 58
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K................................ 59
Signatures............................................................................................... 60
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PART I
ITEM 1: BUSINESS
GENERAL
Background
In September 1997, Hanover Capital Mortgage Holdings, Inc. ("Hanover")
raised net proceeds of approximately $79 million in its initial public offering
(the "IPO"). In the IPO, Hanover 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' over-allotment 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 expire on September 15, 2000. As of December
31, 1998 there were 5,917,878 warrants outstanding including 172,500 warrants
issued pursuant to the underwriters over-allotment option. Hanover utilized
substantially all of the net proceeds of the IPO to fund leveraged purchases of
mortgage assets.
In connection with the closing of the IPO, Hanover, acquired a 97%
ownership interest (representing a 100% ownership of 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 Hanover's common stock. HCP 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.
Hanover was incorporated in Maryland on June 10, 1997. Hanover acquired
three bankruptcy remote limited purpose finance subsidiaries in 1998 in order to
complete two significant mortgage loan securitizations. In March 1998, Hanover
acquired 100% of the common stock of Hanover Capital SPC, Inc., together with
its wholly owned subsidiary Hanover Capital Repo Corp. and in October 1998
acquired 100% of the common stock of Hanover QRS-1 98-B, Inc. and Hanover QRS-2
98-B Inc. Hanover is a real estate investment trust ("REIT"), formed to operate
as a specialty finance company.
The principal business strategy of Hanover Capital Mortgage Holdings, Inc.
and its wholly owned subsidiaries, Hanover Capital SPC, Inc., Hanover QRS-1
98-B, Inc. and Hanover QRS-2 98-B, Inc. (together referred to as the "Company")
and its unconsolidated subsidiaries 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 loans and (iv) acquire multifamily
loans. Hanover's principal business objective is to generate increasing earnings
and dividends for distribution to its stockholders. Hanover acquires
single-family mortgage loans through a network of sales representatives
targeting financial institutions throughout the United States. HCMC originates
multifamily mortgage loans and commercial mortgage loans for government
sponsored and private mortgage conduits. Hanover may also acquire multifamily
mortgage loans from HCMC, but to date has not done so. Hanover operates as a
tax-advantaged REIT and 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 Hanover, however, including HCP,
HCMC and HCS, Hanover Capital Partners 2, Inc. and Hanover SPC-2, Inc. are
subject to Federal income tax. Hanover has engaged HCP to render due diligence,
asset management and administrative services pursuant to a Management Agreement.
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Hanover Capital SPC, Inc., a wholly-owned subsidiary of Hanover, was
incorporated in Delaware on March 24, 1998 for the sole purpose of issuing
mortgage notes through a private placement real estate mortgage investment
conduit ("REMIC") offering.
Hanover QRS-1 98-B, Inc., a wholly owned subsidiary of Hanover, was
incorporated in Delaware on October 16, 1998 for the sole purpose of owning
certain investment grade mortgage securities acquired from Hanover Capital
Partners 2, Inc. ("HCP-2"), an unconsolidated subsidiary of Hanover.
Hanover QRS-2 98-B, Inc., a wholly owned subsidiary of Hanover, was
incorporated in Delaware on October 19, 1998 for the sole purpose of owning
certain investment grade and subordinated mortgage securities acquired from
HCP-2.
On October 28, 1998 Hanover contributed $324.2 million of fixed rate
mortgage loans (with a par value of $318 million) subject to $310.0 million of
reverse repurchase agreement financing to HCP-2 in exchange for a 99% economic
ownership of HCP-2 (representing a 100% ownership of the non-voting preferred
stock in HCP-2).
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COMPANY ORGANIZATION CHART
|-------------------------|
|HANOVER CAPITAL MORTGAGE |
| HOLDINGS, INC. |
|-------------------------|
|
|
|
-----------------------------------|
|100% |
| |
|------------------|---------------------| |
--------|-------| |-----|----------| |------|--------| |
|(1) | |(1) | |(1) | |
|HANOVER CAPITAL| | HANOVER | | HANOVER | |
| SPC, INC. | |QRS-1 98-B, INC.| |QRS-2 98-B, INC| |
|-------|-------| |----------------| |---------------| |
| |
| 100% |
|-------|-------| |------------------|---------------|
|(5) | | 97% | 99%
|HANOVER CAPITAL| |---------------| |------|---------|
| REPO CORP. | |(2) | |(2) |
|---------------| |HANOVER CAPITAL| |HANOVER CAPITAL |
|PARTNERS LTD. | |PARTNERS 2, INC.|
-------|--------| |------|---------|
|------------------|----------| |
| 100% | 100% | 100%
|--------|------| |--------|-------| |------|---------|
|(3) | |(3) | |(4) |
|HANOVER CAPITAL| |HANOVER CAPITAL | | HANOVER SPC-2, |
| MORTGAGE | |SECURITIES, INC.| | INC. |
| CORPORATION | | | | |
|---------------| |----------------| |----------------|
(1)-Wholly-owned subsidiaries of Hanover
(2)-Majority owned unconsolidated taxable subsidiaries of Hanover
(3)-Wholly-owned subsidiaries of HCP
(4)-Wholly-owned subsidiary of HCP-2
(5)-Wholly-owned subsidiary of Hanover Capital SPC, Inc.
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Hanover 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 Hanover 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 Hanover 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 Hanover 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 through HCMC, 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 that does not meet the originally
intended credit quality due to documentation errors or credit deterioration.
Core Business Strategy
The Company's core business strategy is to pursue acquisitions 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 to
create attractive investment opportunities;
o securitizing 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 and mortgage securities
secured by or representing an interest in mortgage loans. While the Company has
not done so to date, it may in the future also invest in multifamily mortgage
loans and commercial mortgage loans (single-family mortgage loans, mortgage
securities, multifamily mortgage loans and commercial mortgage loans
collectively referred to as 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 with a view to earning higher returns than
could generally be earned from purchasing mortgage securities in the
marketplace.
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At December 31, 1998, the Company had invested $407,994,000 or 79.0% of the
Company's total assets in the following types of single-family mortgage loans
classified as held for sale, held to maturity and collateral for mortgage backed
bonds in accordance with the operating policies established by the Board of
Directors:
Mortgage Loan Summary
---------------------
Fixed Rate Mortgage Loans
-------------------------
Face or principal amount $240,942,000
Carrying value $246,780,000
Weighted average net coupon 8.339%
Weighted average maturity (1) 220
Number of loans 8,309
Average loan size $28,988
Average loan to value ratio (2) 71.0%
Adjustable Rate Mortgage (ARM) Loans
------------------------------------
Face or principal amount $160,046,000
Carrying value $161,214,000
Weighted average net coupon 7.542%
Weighted average maturity (1) 264
Number of loans 1,498
Average loan size $106,839
Average loan to value ratio (2) 70.0%
(1) weighted average maturity reflects the number of months to maturity and
does not assume any prepayment speeds
(2) average loan to value ratio reflects the ratio of outstanding loan
balances to the most recent appraisal on file for each applicable loan
The adjustable rate mortgage loans at December 31, 1998 had various index
reference rates with a weighted average 13 month repricing period and a weighted
average net life cap of 13.23%.
The weighted average effective yield for the combined fixed and adjustable
rate mortgage portfolios for 1998 was 7.339%.
The Company's exposure to credit risk associated with its portfolio
acquisition 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, 1998, the percent of
total principal amount of all mortgage loans outstanding in any one state which
exceeded 10% of the principal amount of the Company's total mortgage loan
portfolio was as follows:
STATE PERCENT
----- -------
Florida.................... 16%
California................. 16%
The Company experienced no mortgage loan losses during 1998.
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In April 1998, the Company completed its first REMIC securitization and
thereby transferred $103 million (par value) of mortgage loans to collateral for
mortgage backed bonds. In August 1998, the Company converted approximately $17
million (par value) of adjustable rate mortgage loans into FNMA mortgage
securities, and in October and December the Company converted $56 million and
$55 million (par value) of fixed rate mortgage loans into FNMA mortgage
securities. Lastly, in October 1998, the Company completed a $318 million (par
value) REMIC securitization accomplished through a taxable subsidiary of the
Company, HCP-2. Simultaneously, the Company acquired from HCP-2 in exchange for
all of the preferred stock of HCP-2, through two newly created REIT qualified
subsidiaries, all of the investment grade securities, (except for the "AAA"
rated securities), the unrated securities, the interest-only securities and the
principal only securities from the security transaction. The table below
summarizes the Company's 1998 securitization transactions (dollars in
thousands):
1998 SECURITIZATION TRANSACTIONS
--------------------------------
Mortgage Principal Mortgage
Month Balance on Transaction Security
Completed Transaction Date Type Created
--------- ------------------ ----------- -----------------
April $102,977 REMIC Private Placement
August 17,404 Swap FNMA
October 317,764 REMIC Private Placement
October 55,650 Swap FNMA
December 55,208 Swap FNMA
In December 1997, the Company purchased 15 ARM securities from various
"Wall Street" dealers and in March of 1998 purchased a fixed rate FNMA
certificate from another dealer firm. The ARM securities were purchased at a
price of 103.72% of par value or $349,186,000 and the FNMA fixed rate mortgage
security was purchased at a price of 105.125% of par or $4,333,000. In October
1998, due to (1) market dislocation, (2) desire to increase liquidity and
decrease leverage and (3) rapid prepayments experienced on the Agency ARM
securities, the Company sold all of its Agency ARM securities at a loss of
$5,989,000.
During 1998 the Company completed three separate swap transactions with
FNMA. In August 1998, the Company exchanged $17.4 million (par value) of
adjustable rate mortgage loans in exchange for a like amount of mortgage
securities in the form of five FNMA certificates. All of the mortgage
certificates were subsequently sold with recourse in October 1998. In October
and December 1998, the Company exchanged $55.6 million and $55.2 million
respectively of fixed rate mortgage loans for a like amount of mortgage
securities in the form of 19 and 31 FNMA certificates, respectively. The $55.6
million of mortgage securities represented by the 19 FNMA certificates were sold
with recourse in October, several days after the loans were securitized. At
December 31, 1998 the Company owned the fixed rate FNMA mortgage security
(purchased in March 1998) and the 31 fixed rate FNMA mortgage securities that
were acquired in December 1998.
In October 1998, the Company completed its second private placement REMIC
securitization transaction through its newly organized unconsolidated
subsidiary, HCP-2. Hanover contributed $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing to HCP-2 in exchange for a 99% economic ownership
of HCP-2 (representing a 100% ownership of the non-voting preferred stock in
HCP-2). HCP-2 issued a REMIC mortgage security and sold all of the REMIC
securities except the "AAA" rated notes to two newly created wholly-owned
subsidiaries of the Company (Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B,
Inc.). The Company's investment at December 31, 1998 includes nine investment
grade ("AA", "A" and "BBB") notes and six interest only notes.
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At December 31, 1998 the Company had invested $78,478,000 or 15.2% of the
Company's total assets in the following types of mortgage securities,
collateralized by single-family mortgage loans, in accordance with the operating
policies established by the Board of Directors:
Agency Mortgage Securities (1)
------------------------------------
December 31, 1998 adjusted principal $58,462,000
Amortized cost basis $59,641,000
Market value $59,595,000
Weighted average net coupon 7.55%
Weighted average maturity (4) 250
Private Placement Mortgage Securities (2)
------------------------------------------
December 31, 1998 adjusted principal $18,096,000
Amortized cost basis $21,236,000
Market value $18,883,000
Weighted average net coupon (3) 23.43%
Weighted average maturity (4) 264
(1) all fixed rate mortgage securities
(2) includes subordinated fixed rate mortgage securities (AA through
unrated tranches) plus interest-only tranches and principal-only
tranches
(3) includes interest income generated from six interest only notes;
see also table on page 48 for effective yield on these mortgage
securities
(4) weighted average maturity reflects the number of months to
maturity and does not assume any prepayment speeds.
The weighted average effective yield for the combined mortgage securities
portfolio for 1998 was 5.170%.
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 (FHA, FHLMC or GNMA) 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 (77%) of the
Company's acquisitions of single-family mortgage loan pools to date have been
fixed rate loans, with the balance made up of adjustable rate mortgage ("ARM")
loans.
The Company uses seven sales representatives from HCP, located in Illinois,
Minnesota, 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 March 10, 1999, the Company had purchased since inception in excess of
$1 billion of single-family mortgage loan pools. Also, at March 10, 1999 the
Company did not have any commitments outstanding to purchase single-family
mortgage pools.
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One of the Company's unconsolidated subsidiaries, HCP, has a due diligence
and consulting staff, located in Edison, New Jersey, consisting of approximately
ten full-time employees and access to a part-time pool of employees in excess of
500. 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 accumulating additional information
on loan pools through its due diligence operations, the Company believes it is
better able to assess the value of loan pools.
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. During 1998, the Company purchased approximately 22% of the
Company's single-family mortgage loan portfolio from one source (Residential
Funding Corporation). Management believes that the loss of any single financial
institution from which the Company purchases mortgage loans would not have any
detrimental effect on the Company. The Company does not service its
single-family mortgage loans. The servicing is outsourced to unrelated third
parties specializing in single-family loan servicing.
The acquisition of single-family mortgage loans and subsequent
securitization of such mortgage loans is the core business strategy of the
Company. The purchase of Agency ARM's securities is not a part of the Company's
core business strategy and is not expected to be pursued in the near term.
Because the Company has access to HCP's due diligence operations, the Company
may in the future consider purchasing non-investment grade mortgage securities
of other issuers after a thorough evaluation of the underlying mortgage loan
collateral. The Company may in the future purchase non-investment grade mortgage
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, created mortgage securities and, to a lesser extent,
the purchased 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.
The Company purchases mortgages in bulk, after its bid has been accepted,
subject to the Company's due diligence work. 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
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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,
credit scores and types of the loans. The proprietary stratification and pricing
system identifies pool characteristics and segments loans by product type (i.e.,
fixed or adjustable rate, interest rate change frequency, ARM index, etc.). The
segments are then further divided by credit quality using a logic program, which
uses credit bureau scores and other criteria to grade loans within numerous
categories. These categories include subdivisions such as loans eligible for
sale/securitization to Fannie Mae or Freddie Mac (the "Agencies"), and further
subdivisions of loans that only meet some Agency requirements, loans without
mortgage insurance, loans with certain LTV and delinquency characteristics, etc.
Upon completion of the product segmentation and loan grading phase, the
resulting pools are individually priced and totaled to determine an overall
portfolio value. The effective pricing would require information on gross
weighted average coupon, servicing fee, original term, weighted average
maturity, remittance data, settlement data and ARM data (i.e. index, margin,
rate and payment reset frequency, etc.).
By examining the mortgage pool loan data, a prepayment speed is selected
based primarily upon the gross coupons and seasoning of the subject pool. After
determination of a prepayment speed, the pools' cash flow stream is modeled. The
present value of the cash flow stream is determined by discounting the cash flow
by the current market rate for loans with similar product type and credit
characteristics.
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 packages for
securitization, and segmenting portfolios for different buyers. However,
Management believes, in most cases, 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 on
sale of the single-family mortgage loan portfolio.
SINGLE-FAMILY MARKET TRENDS. The Company focuses on purchasing its 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
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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 generally retains subordinated or
other interests (including, for example, interest only tranches and principal
only tranches). The investment grade tranches typically are not retained.
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 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. If
the Company contracts out to a servicer the servicing of a mortgage loan pool,
the servicer's responsibilities would include collection of the borrower's
remittances, proper application of the borrower's remittances to principal,
interest and escrow, remitting collections to the master servicer and remitting
advances to the master servicer on delinquent loans (for principal and interest
only). The master servicer would then remit funds and loan level documentation
to the Company, or if the loan is securitized - to the trustee. The trustee
would then distribute the funds to the certificate holders. Neither the Company
nor any of its affiliates are involved in any single-family servicing
operations.
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,
which are financial firms (generally Wall Street firms) that purchase loans on
real estate with the specific intention to convert the underlying mortgages to
securities in the form of bonds. The origination transaction is usually
"table-funded" whereby HCMC does not provide the funds for the mortgage loan
origination but rather the funds are provided by the conduit. From direct
borrower originations and its network of third party brokers, HCMC 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 1998. However, the
Company originates 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
while HCMC subsequently has sold the mortgage loans to investors, the Company
may in the future hold them in its 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 with the specific intent 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. HCMC
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.
HCMC 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 HCMC origination level, a separate credit
committee will approve all multifamily mortgage loans and commercial mortgage
loans purchased by the Company for its Investment Portfolio. To date no
multifamily mortgage loans or commercial mortgage loans have been purchased by
the Company. The Company believes that, with prudent underwriting and due
diligence, combined with the securitization option, it will achieve a
satisfactory reward/risk ratio in purchasing such loans 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 HCP's
sales representatives concentrate primarily on sourcing pools of single-family
mortgage loans for the Company, they also can find leads for the multifamily and
commercial mortgage loan origination business of HCMC.
COMMERCIAL AND MULTIFAMILY UNDERWRITING GUIDELINES. HCMC's underwriting
guidelines for commercial and multifamily mortgage loans focus on the
origination of loans eligible for securitization. The due diligence process
generally 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,
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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., 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. Upon securitization of
a pool of loans, the credit risk retained by the Company is generally limited to
the Company's net investment in the retained mortgage securities. 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, 1998, HCMC serviced approximately $46 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 1990's.
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
retained interests in the security after
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securitization. The Company is structured to take advantage of efficiencies in
such a 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.
INVESTMENT PORTFOLIO ACQUISITIONS
The Company's core business strategy is to acquire primarily single-family
mortgage loans, securitize the mortgage loans and retain interests therein. The
process for identifying possible mortgage pools in the secondary market for
acquisition, bidding, due diligence and closing is time consuming. Once a bid is
accepted, the process to conclude a successful purchase generally takes 30-60
days depending upon the complexity of each mortgage loan pool purchase.
During the accumulation period (ramp up period subsequent to Hanover's
initial public offering (IPO) in September 1997 to full investment of the
proceeds of the IPO) the Company could not invest exclusively in mortgage loans
and chose to invest a portion of its leveraged capital in Agency ARM securities.
At December 31, 1997 the Company had invested $348,131,000 or 67.3% of the
Company's total assets in Agency ARM securities, and $160,970,000 or 31.1% of
the Company's total assets in mortgage loans.
In October 1998, the Company sold off all of its Agency ARM securities at a
loss of $5,989,000. The sale of these mortgage securities was part of an action
plan taken by Management to reduce leverage and increase liquidity in response
to the severe unanticipated dislocation in the financial markets at that time.
These mortgage securities, never the core business of the Company, suffered from
historically high prepayments, causing accelerated premium amortization and
depressed market pricing.
The core business strategy of purchasing single-family mortgage loans was
initiated in late September 1997 and continued successfully in 1998 with the
purchase of $851.1 million in par value of mortgage loans and the successful
completion of five securitization transactions in 1998.
DUE DILIGENCE AND CONSULTING OPERATIONS
The Company conducts due diligence and consulting 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 loans serviced 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. Consulting services include
loan sale advisory work and brokering of mortgage loans for third parties. HCP
also performs due diligence on mortgage loans acquired by the Company. The
Company plans to devote increased attention to enhancing HCP's due diligence and
consulting operations in 1999.
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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 as 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 some form of long term
financing. The Company had established committed and uncommitted mortgage asset
financing agreements from various financial institutions at December 31, 1998
and is currently negotiating additional line of credit agreements with several
other major financial institutions.
Reverse Repurchase Agreements
A reverse repurchase agreement ("repo"), 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 97%. 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 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 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.
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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.
There exists a risk during the initial holding of the mortgage loan assets,
when the mortgage loan assets are financed with repo agreements, that adverse
developments in the mortgage market could cause the repo lenders to reduce the
mark to market on the mortgage loans collateralizing the repo agreements. A
reduction in the repo lender's market value calculations could result in margin
calls that could be in excess of the Company's liquid assets. In this situation,
the Company might be forced to sell other portfolio assets to meet the repo
lender's margin call. There also exists a risk during the initial holding period
of the mortgage loan assets that there might be no demand or very limited demand
for the creation of new mortgage securitizations. If this situation were to
exist for an extended time period, the Company might be forced to maintain repo
financing on its mortgage assets for a longer than intended period, which might
cause repo financing availability to become more scarce and might cause repo
financing terms to become more onerous for the Company.
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 normally securitizes the mortgage loans through the issuance of
mortgage-backed securities. Such securitization generally will be in the form of
collateralized mortgage obligations ("CMOs") but may also be in the form of
REMICs. 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.
The Company may from time to time issue REMICs. REMIC transactions are
generally accounted for as sales of the mortgage loans for tax purposes and can
be accounted for as sales or financing for accounting purposes depending upon
various criteria. 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
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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 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 Hanover'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 is declining
due to increases in interest rates.
The Company may also pay 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.
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Credit Enhancement
CMOs or REMICs 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 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 by
a nationally-recognized rating agency.
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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 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, securities rated below "AAA" and securities not
registered with the Securities and Exchange Commission are substantially less
liquid, and have more price volatility than Agency securities, which results in
a lender requiring a larger haircut (5% to 40% depending on the rating).
Particular securities that are performing below expectations would also
typically require a larger haircut. The haircut for residential whole loan pools
will generally range between 3% and 5% depending on the documentation and
delinquency characteristics of the pool. Certain whole loan pools may have
haircuts which may be negotiated with lenders in excess of 5% due to other
attributes of the pool (delinquencies, aging, liens etc.).
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.
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.
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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
corresponding leverage adjustments, should help 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
single-family or commercial 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 that the Company may acquire from HCMC are
subject 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 can be transferred to the Company's 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
For accounting purposes, the Company has three basic types of mortgage
loans: (i) mortgage loans held for sale, (ii) mortgage loans held to maturity
and (iii) mortgage loans held in securitized form. Fixed rate mortgage loans
held for sale are generally hedged. A variety of hedging instruments may be
used, depending on the asset or liability to be hedged and the
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relative price of the various hedging instruments. Possible hedging instruments
include forward sales of mortgage securities, and may also include interest rate
futures or options, interest rate swaps, and caps 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 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 acquiring originated mortgage loans from HCMC with prepayment penalties
and utilizing various financial hedging instruments. 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 or REMIC financing, 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.
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The Company may use a variety of instruments in its hedging program. One
example currently used 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 use, but as yet
has not used, mortgage derivative securities. Mortgage derivative securities can
be used as effective hedging instruments in certain situations as the value and
yields of some of these instruments tend to increase as interest rates rise and
to decrease as interest rates decline, while the experience for others is the
converse. The Company will limit its purchases of mortgage derivative securities
to investments that meet REIT requirements. To a lesser extent, the Company may
also enter into, but again has not entered 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 currently utilizes interest
rate caps and forward sales of Agency mortgage securities and may utilize other
hedging strategies, including mandatory and optional forward selling of mortgage
loans or mortgage-backed securities, interest rate 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.
As of December 31, 1998, the Company had entered into the following hedging
mechanisms: forward sales of Agency mortgage securities and interest rate caps.
The forward sales of Agency mortgage securities are used to provide hedge
protection against potential changes in the market value of certain of the
Company's fixed rate mortgage loan portfolio, due to potential changes in
current market interest rates. The Company only hedges its fixed rate mortgage
loan pools by selling short similar coupon and duration matched Agency
securities, usually for 30 to 60 day periods. This hedging of mortgage assets
should, if properly executed, adjust the carrying value of the hedged fixed
mortgage loan pools to reflect current market pricing. The costs of the
individual hedging transactions can vary greatly depending upon market
conditions. Net hedging costs of fixed rate mortgage pools were $541,000,
$1,287,000, $2,632,000 and $1,091,000 in the first, second, third and fourth
quarters of 1998, respectively. Management is satisfied that the Company's
hedging program has been utilized effectively as no charges relating to the
impairment of mortgage loans were booked in 1998.
The Company also enters into interest rate hedge mechanisms (interest rate
caps) to manage its interest rate exposure on certain reverse repurchase
agreement financing. The cost of the interest rate caps is amortized over the
life of the interest rate cap and is reflected as a portion of interest expense
in the consolidated statement of operations.
The FASB issued SFAS 133 Accounting for Derivative Instruments and Hedging
Activities ("SFAS 133") in June 1998. SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments imbedded in other contracts and for hedging activities. SFAS is
effective for fiscal quarters beginning after June 15, 1993. Management's
preliminary evaluation of SFAS 133 indicates the implementation of SFAS 133 will
not result in any material changes to the Company's consolidated statement of
operations.
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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 by the Company (along with purchased
single-family mortgage loans or purchased multifamily mortgage loans and
commercial mortgage loans) or created by HCMC (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 respective entity.
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.
REGULATION
HCMC has mortgage-banking licenses in Arizona, Illinois, New Jersey, 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.
HCS is a registered broker/dealer with the Securities and Exchange
Commission.
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
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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 four employees (the "Principals") at December 31, 1998. 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, 1998, HCP
employed 50 people on a full-time basis and 40 people on a part-time basis. HCP
periodically hires additional employees on a temporary basis to perform due
diligence and consulting service work on specific engagements. HCP maintains a
database of approximately 500 individuals that can be employed for due diligence
and consulting engagements. To date, the Company and its subsidiaries believe
they have been successful in their efforts to recruit qualified employees, but
there is no assurance that it will continue to be successful in the future. None
of the 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.
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.
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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.
A REIT is subject to a 100% tax on the net income from prohibited
transactions. The only "prohibited transaction" is the sale or disposition of
property, that is not foreclosure property, held primarily for sale to customers
in the ordinary course of a trade or business. Management believes that none of
the 1998 sales transactions would be classified as prohibited transactions.
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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 had 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.
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.
After the closing of the initial public offering in September 1997, the
Company acquired an Investment Portfolio, the composition of which has changed
over time. HCP has continued to conduct the due diligence and consulting
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, Hanover entered into a Management
Agreement (the "Management Agreement") with HCP. Under this agreement, HCP,
subject to the direction and control of Hanover's Board of Directors, provides
certain services for Hanover, including, among other things: (i) serving as
Hanover's consultant with respect to formulation of investment criteria and
preparation of policy guidelines by the Board of Directors; (ii) assisting
Hanover in developing criteria for the purchase of mortgage assets that are
specifically tailored to Hanover's investment objectives; (iii) representing
Hanover 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 Hanover regarding Hanover's activities and the services performed
for Hanover 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 Hanover 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 Hanover; and (ix) administering the day-to-day
operations of Hanover. For these services, Hanover pays HCP for each month an
amount equal to the sum of (a) 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 Hanover for such month, plus (b) twenty-five
percent (25%) of (a). Hanover also is required to pay HCP for each month an
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amount equal to the sum of (c) the expenses 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
Hanover for any services provided by Hanover 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 resolve to terminate the
Management Agreement.
FEDERAL INCOME TAX CONSIDERATIONS
General
Hanover 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 Hanover 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 Hanover's after-tax cash available for
distribution to its shareholders would be reduced. Hanover believes it has
satisfied the requirements for qualification as a REIT since commencement of its
operations in September 1997. Hanover intends at all times to continue to comply
with the requirements for qualification as a REIT under the Code, as described
below.
Requirements for Qualification as a REIT
To qualify for tax treatment as a REIT under the Code, Hanover must meet
certain tests which are described briefly below.
Ownership of Common Stock
For all taxable years after its first taxable year, Hanover's shares of
capital stock must be held by a minimum of 100 persons for at least 335 days of
a 12 month year (or a proportionate part of a short tax year). In addition, at
all times during the second half of each taxable year, no more than 50% in value
of the capital stock of Hanover may be owned directly or indirectly by five or
fewer individuals. Hanover is required to maintain records regarding the actual
and constructive ownership of its shares, and other information, and to demand
statements from persons owning above a specified level of the REITs shares (if
Hanover has 200 or fewer shareholders of record, from persons holding 0.5% or
more of Hanover's outstanding shares of capital stock) regarding their ownership
of shares. Hanover must keep a list of those shareholders who fail to reply to
such a demand. Hanover is required to use and does use the calendar year as its
taxable year for income.
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Nature of Assets
On the last day of each calendar quarter, Hanover must satisfy three tests
relating to the nature of its assets. First, at least 75% of the value of
Hanover's assets must consist of mortgage loans, certain interests in mortgage
loans, real estate, certain interests in real estate (the foregoing, "Qualified
REIT Assets"), government securities, cash and cash items. Hanover expects that
substantially all of its assets will continue to be Qualified REIT Assets.
Second, not more than 25% of Hanover's assets may consist of securities that 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 Hanover's total assets, and Hanover may not own more
than 10% of any one issuer's outstanding voting securities. Pursuant to its
compliance guidelines, Hanover intends to monitor closely the purchase and
holding of its assets in order to comply with the above asset tests.
Sources of Income
Hanover must meet the following two separate income-based tests each year:
1. 75% INCOME TEST. At least 75% of Hanover's gross income for the taxable
year must be derived from 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 will
also qualify under the 75% income test. The investments that Hanover 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 Hanover's gross income
for the taxable year must be derived from those sources, or from dividends,
interest or gains from the sale or disposition of stock or other securities that
are not dealer property. Hanover intends to limit substantially all of the
assets that it acquires to Qualified REIT Assets. The policy of Hanover to
maintain REIT status may limit the types of assets, including hedging contracts
and other securities, that Hanover otherwise might acquire.
Distributions
Hanover must distribute to its shareholders on a pro rata basis each year
an amount equal to at least (i) 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". Hanover intends to make
distributions to its shareholders in sufficient amounts to meet this 95%
distribution requirement.
Taxation of Hanover's Shareholders
For any taxable year in which Hanover is treated as a REIT for Federal
income tax purposes, amounts distributed by Hanover to its shareholders out of
current or accumulated earnings and profits will be includable by the
shareholders as ordinary income for Federal income tax purposes unless properly
designated by Hanover as capital gain dividends. Distributions of Hanover will
not be eligible for the dividends received deduction for corporations.
Shareholders may not
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deduct any net operating losses or capital losses of Hanover. Any loss on the
sale or exchange of shares of the common stock of Hanover 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 Hanover makes distributions to its shareholders in excess of its current
and accumulated earnings and profits, those distributions will be considered
first a tax-free return of capital, reducing the tax basis of a shareholder's
shares until the tax basis is zero. Such distributions in excess of the tax
basis will be taxable as gain realized from the sale of Hanover's shares.
Hanover will withhold 30% of dividend distributions to shareholders that Hanover
knows to be foreign persons unless the shareholder provides Hanover with a
properly completed IRS form claiming a reduced withholding rate under an
applicable income tax treaty.
Under the Code, if a portion of Hanover's assets were treated as a taxable
mortgage pool or if Hanover were to hold REMIC residual interests, a portion of
Hanover's dividends would be treated as unrelated business taxable income
("UBTI") for pension plans and other tax exempt entities. Hanover believes that
it has not engaged in activities that would cause any portion of Hanover's
income to be taxable as UBTI for pension plans and similar tax exempt
shareholders. Hanover believes that its shares of stock will be treated as
publicly offered securities under the plan asset rules of the Employment
Retirement Income Security Act ("ERISA") for Qualified Plans.
The provisions of the Code are highly technical and complex and are subject
to amendment and interpretation from time to time. This summary is not intended
to be a detailed discussion of all applicable provisions of the Code, the rules
and regulations promulgated thereunder, or the administrative and judicial
interpretations thereof. Hanover has not obtained a ruling from the Internal
Revenue Service with respect to tax considerations relevant to its organization
or operations.
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ITEM 2: PROPERTIES
The Company's and its unconsolidated subsidiaries operations are conducted
in several leased office facilities throughout the United States. A summary of
the office leases is shown below:
OFFICE MINIMUM
SPACE ANNUAL EXPIRATION
LOCATION (SQ. FT.) RENTAL DATE OFFICE USE
-------- --------- -------- ---------- ----------
New York, New York (a) 7,863 $158,800 July 2009 Executive, Administration,
Accounting, Investment
Operations
Edison, New Jersey 5,834 75,900 June 2002 Accounting, Administration, Due
Diligence Operations, Mortgage
Loan Servicing, Investment
Operations
Edison, New Jersey 1,182 25,000 August 2002 Due Diligence Operations
Chicago, Illinois (b) 1,151 49,500 February 2004 Due Diligence Operations,
Investment Operations
St. Louis, Missouri 1,007 22,200 August 2001 Mortgage Origination Operations
Rockland, Massachusetts 300 6,000 Month to Month Investment Operations
St. Paul, Minnesota 150 6,000 August 1999 Investment Operations
------ --------
Total: 17,487 $343,400
====== ========
(a) HCP entered into an amendment to the existing office lease in December 1998
to relocate from its existing office space (2,328 sq. ft.) to larger office
space (7,863 sq. ft.) in the same office building; the new office space is
expected to be ready for occupancy once the construction of the space is
completed (May 1999); the above minimum annual rent reflects 4 months of
base rental costs for the existing office space and 8 months of base rental
costs for the new office space.
(b) HCP entered into a new lease for office space (1,151 sq. ft.) effective
February 1999; HCP is still obligated on its existing office lease (3,905
sq. ft.) through June 1999; the above minimum annual rent reflects 6 months
of base rental costs for the existing office space and 10 months of base
rental costs for the new office space.
Management of the Company believes that these facilities are adequate for
the Company's and its unconsolidated subsidiaries foreseeable office space 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 proceeding. However, an
affiliate of the Company, HCMC, was a party to the legal proceeding described
below.
In November 1998, HCMC made a payment of $20,000 to Quarters on Melody Lane
Partnership ("Quarters") in full and final settlement of a lawsuit brought
against HCMC by Quarters in 1997, 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 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 prepayment penalties. The initial principal
balance of the multifamily mortgage loan, which closed in June 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)
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than as provided in the loan documents. Disbursements were not 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. While HCMC
denied that its representatives made any misrepresentations to Quarters,
Quarters filed suit against HCMC and others as defendants, in District Court in
Dallas County, Texas. The complaint alleged 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 and seeking punitive damages in the
amount of $1,000,000.
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, Hanover raised net proceeds of approximately $79 million
in its initial public offering (the "IPO"). In the IPO, Hanover sold 5,750,000
units (each unit consists of one share of common stock, par value $.01 and one
stock warrant) including 750,000 units sold pursuant to the underwriters'
over-allotment 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 expire on
September 15, 2000. As of December 31, 1998, there were 5,917,878 warrants
outstanding, including 172,500 warrants issued pursuant to the underwriters'
over-allotment option. Hanover utilized substantially all of the net proceeds of
the IPO to fund leveraged purchases of mortgage assets.
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 March 10,
1999, Hanover had 6,126,899 shares of common stock issued and outstanding, which
was held by 84 holders of record and approximately 2,000 beneficial owners.
The following tables set forth, for the periods indicated, the high, low
and closing sales price of Hanover's securities as reported on the American
Stock Exchange in 1997 and 1998.
UNIT PRICES
-----------
High Low Close
-------- ------- ------
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
First Quarter Ended March 31, 1998 21 7/8 16 1/4 19 1/16
Second Quarter Ended June 30, 1998 20 13/16 10 5/8 10 5/8
Third Quarter Ended September 30, 1998 11 3/4 7 1/4 7 1/4
Fourth Quarter Ended December 31, 1998 7 1/4 3 1/2 4 3/16
COMMON STOCK
------------
High Low Close
------ ------ ------
First Quarter Ended March 31, 1998 (a) 16 1/2 16 1/8 16 1/4
Second Quarter Ended June 30, 1998 17 3/8 9 1/2 9 1/2
Third Quarter Ended September 30, 1998 10 3/8 6 7/8 6 7/8
Fourth Quarter Ended December 31, 1998 6 7/8 3 1/2 4
WARRANTS
--------
High Low Close
----- ------ ------
First Quarter Ended March 31, 1998 (a) 3 7/8 3 1/8 3 1/8
Second Quarter Ended June 30, 1998 3 3/4 1 1/8 1 1/8
Third Quarter Ended September 30, 1998 1 3/8 3/16 3/16
Fourth Quarter Ended December 31, 1998 3/8 5/16 1/8
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The following table sets forth, for the periods indicated, Hanover's
dividends declared for each quarter:
DIVIDENDS
DECLARED
---------
Quarter Ended June 30, 1997 (b) --
Quarter Ended September 30, 1997 (b) --
Quarter Ended December 31, 1997 $0.16
Quarter Ended March 31, 1998 $0.21
Quarter Ended June 30, 1998 $0.21
Quarter Ended September 30, 1998 $0.17
Quarter Ended December 31, 1998 $0.11
(a) common stock and warrants were first listed on the American Stock
Exchange on March 20, 1998
(b) Hanover was incorporated in June 1997; operations did not begin until
September 1997
Hanover 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. To the
extent that Hanover records capital gain income in future years, this income
does not need to be distributed as dividends to shareholders to the extent of
unutilized capital losses recorded in 1998 (approximately $6,700,000). All
distributions will be made by Hanover at the discretion of the Board of
Directors and will depend on the earnings of Hanover, financial condition of
Hanover, 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 consolidated
financial statements of Hanover for the year ended December 31, 1998 and for the
period from June 10, 1997 (inception) to December 31, 1997. The selected
financial data should be read in conjunction with the more detailed information
contained in the Consolidated Financial Statements and Notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Form 10-K (dollars in thousands, except
per share data):
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Period from
STATEMENT OF OPERATIONS HIGHLIGHTS Year Ended June 10 (inception)
December 31, 1998 to December 31, 1997
----------------- --------------------
Net interest income $ 6,623 $ 1,676
Loan loss provision (356) (18)
Gain (loss) on sale of assets (5,704) 35
----------- -----------
Total revenues 563 1,693
Expenses 4,064 940
----------- -----------
Operating income (loss) (3,501) 753
Equity in (loss) of unconsolidated subsidiaries (1,433) (254)
----------- -----------
Net income (loss) $ (4,934) $ 499
=========== ===========
Basic earnings (loss) per share $ (0.77) $ 0.15
=========== ============
Diluted earnings (loss) per share $ (0.77) $ 0.14
=========== ============
Dividends declared per share $ 0.70 $ 0.16
=========== ============
BALANCE SHEET HIGHLIGHTS December 31, December 31,
1998 1997
------------ ------------
Mortgage loans $ 407,994 $ 160,970
Mortgage securities 78,478 348,131
Cash and cash equivalents 11,837 4,022
Other assets 17,861 4,420
----------- -----------
Total assets $ 516,170 $ 517,543
=========== ===========
Reverse repurchase agreements $ 370,090 $ 435,138
Mortgage backed bonds 77,305 --
Other liabilities 2,995 4,307
----------- -----------
Total liabilities 450,390 439,445
----------- -----------
Stockholders' equity 65,780 78,098
----------- -----------
Total liabilities and stockholders' equity $ 516,170 $ 517,543
=========== ===========
Number of common shares outstanding 6,321,899 6,466,677
=========== ===========
35
36
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in
Maryland on June 10, 1997. Hanover acquired three bankruptcy remote limited
purpose finance subsidiaries in 1998 in order to complete two significant
mortgage loan securitization transactions. In March 1998, Hanover acquired 100%
of the common stock of Hanover Capital SPC, Inc. and in October 1998 acquired
100% of the common stock of Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B,
Inc. Hanover is a real estate investment trust ("REIT"), formed to operate as a
specialty finance company. The principal business strategy of Hanover and its
wholly owned subsidiaries, Hanover Capital SPC, Inc., Hanover QRS-1 98-B, Inc.
and Hanover QRS-2 98-B, Inc. (together referred to as the "Company") and its
unconsolidated subsidiaries 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 loans and (iv) acquire multifamily 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 an unconsolidated subsidiary of the
Company.
Hanover Capital SPC, Inc., a wholly-owned subsidiary of Hanover, was
incorporated in Delaware on March 24, 1998 for the sole purpose of issuing
mortgage notes through a private placement (REMIC) offering. Hanover Capital
SPC, Inc. transferred all of it retained securities to its wholly owned
subsidiary, Hanover Capital Repo Corp. Hanover Capital Repo Corp. was
incorporated in Delaware on March 26, 1998.
Hanover QRS-1 98-B, Inc., a wholly owned subsidiary of Hanover, was
incorporated in Delaware on October 16, 1998 for the sole purpose of owning
certain investment grade mortgage securities acquired from Hanover Capital
Partners 2, Inc. ("HCP-2"), an unconsolidated subsidiary of Hanover.
Hanover QRS-2 98-B, Inc., a wholly owned subsidiary of Hanover, was
incorporated in Delaware on October 19, 1998 for the sole purpose of owning
certain investment grade and subordinated mortgage securities acquired from
HCP-2.
RESULTS OF OPERATIONS
GENERAL
Hanover was organized on June 10, 1997, but did not commence operations
until September 19, 1997 (the date of the IPO closing). The Company had a net
loss in 1998 of $4,934,000 or a loss of $0.77 per share based on a weighted
average of 6,418,305 shares of common stock outstanding. In the previous year,
for the period from June 10, 1997, (inception) to December
36
37
31, 1997 the Company's net income was $499,000 or $0.15 per share based on a
weighted average of 3,296,742 shares of common stock outstanding.
The core business of the Company, acquiring single-family mortgage loans
and subsequently securitizing mortgage loans and retaining interests therein,
generated net interest income of $6,880,000 in 1998 as compared to $1,051,000 in
1997, (the initial start-up year reflected only three full months of
operations).
The Company's investment in purchased mortgage securities reflected
negative net interest income of $1,335,000 in 1998. Most of the mortgage
securities were held for a period of slightly more than nine months in 1998 as
compared to a one month holding period in 1997, which generated net interest
income of $202,000. The majority of the purchased mortgage securities were
adjustable rate Agency mortgage securities collateralized by adjustable rate
mortgages that experienced extremely high prepayment speeds during 1998.
Net interest income generated from notes receivable to affiliates and
investments of excess cash and cash collateral on deposit with repo lenders
aggregated $1,070,000 in 1998 (for a full 12 month period) compared to $423,000
in 1997 (a period of slightly more than 3 months).
The most significant contributor to the 1998 net loss was the loss on the
sale of purchased mortgage securities. In October 1998, the Company sold all of
its purchased adjustable rate Agency mortgage securities at a loss of
$5,989,000. In October 1998, the Company also sold (i) certain adjustable rate
FNMA mortgage securities (that the Company received in a swap for certain
adjustable rate mortgage loans) at a loss of $161,000 and (ii) certain fixed
rate FNMA mortgage securities (that the Company received in a swap for certain
fixed rate mortgage loans) at a gain of $495,000. Lastly, the Company also sold
a pool of mortgage loans in April 1998 at a loss of $49,000.
Operating expenses in 1998 totaled $4,064,000 (a full year) compared to
$940,000 for the period September 19 to December 31, 1997. Expenses directly
related to acquisitions of mortgage loans (management and administration, due
diligence and commissions) totaled $1,706,000 in 1998 as compared to $523,000 in
1997. The Company reflected significant increases in certain operating expenses
in 1998, particularly with respect to legal and professional and
financing/commitment fees, as the Company began securitizing mortgage loans in
different formats beginning in the second quarter of 1998.
Another significant contributor to the Company's net loss in 1998 was the
loss recorded from the Company's investment in HCP (for a full year of
operations) of $1,039,000 and HCP-2 (for a period in excess of two months) of
$394,000. The net loss generated from the Company's investment in HCP in 1997
(for a period of approximately 3 1/2 months) was $254,000.
The table below highlights the Company's brief historical trends and
components of return on average equity.
37
38
COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY (1)
Gain (loss) on Equity in
Net Interest Sale of Operating Earnings (Loss) Annualized
For the Income(Loss)/ Assets/ Expenses/ of Subsidiaries/ 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%
March 31, 1998 10.78% 0.00% 4.37% (0.03%) 6.38%
June 30, 1998 3.47% (0.25%) 5.00% (1.50%) (3.28%)
September 30, 1998 8.23% 0.00% 4.89% (1.52%) 1.82%
December 31, 1998 11.12% (32.76%) 7.55% (4.89%) (34.08%)
(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 balance at September 19, 1997 (IPO date)
and equity balance at September 30, 1997, excluding unrealized loss on
investments available for sale.
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 periods shown below (dollars in thousands):
Quarter Ended Quarter Ended Quarter Ended Quarter Ended
March 31, 1998 June 30, 1998 September 30 1998 December 31, 1998
-------------------------------------------------------------------------------------
Average Effective Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate Balance Rate
------- --------- ------- --------- ------- --------- ------- ---------
Interest Earning Assets
Mortgage loans (1) $216,275 7.410% $370,811 7.371% $566,456 7.489% $465,445 7.392%
Collateral for mortgage
backed bonds (1) 92,272 7.158% 91,980 7.071% 86,477 6.230%
Mortgage securities (2) 334,722 6.116% 281,933 3.992% 243,299 4.528% 72,938 7.520%
-------- ------ -------- ------ -------- ------ -------- ------
$550,997 6.624% $745,016 6.066% $901,735 6.648% $624,860 7.246%
======== ====== ======== ====== ======== ====== ======== ======
Interest Bearing
Liabilities
Reverse repurchase
borrowings on
mortgage loans $166,881 6.318% $332,424 6.452% $523,403 6.377% $447,915 6.422%
Mortgage backed bonds 88,069 6.901% 87,524 6.916% 80,522 6.926%
Reverse repurchase
borrowings on
collateral for mortgage
backed bonds 1,076 7.031% 203 6.145% 1,760 6.616%
Reverse repurchase
borrowings on
mortgage securities 324,305 5.597% 272,176 5.616% 241,388 5.701% 58,332 5.636%
-------- ------ -------- ------ -------- ------ -------- ------
$491,186 5.842% $693,745 6.241% $852,518 6.364% $588,529 6.535%
======== ====== ======== ====== ======== ====== ======== ======
Net Interest Earning
Assets $ 59,811 $ 51,271 $ 49,217 $ 36,331
======== ======== ======== ========
Net Interest Spread 0.782% (0.175%) 0.284% 0.711%
====== ======= ====== ======
Yield on Interest Earning
Assets (3) 13.046% 3.700% 11.562% 18.769%
======= ====== ======= =======
38
39
PERIOD FROM SEPTEMBER 30 TO
DECEMBER 31, 1997
---------------------------
Average Effective
Balance Rate
------- ---------
Interest Earning Assets:
Mortgage loans (1) $ 83,776 7.317%
Mortgage securities (2) 116,375 6.268%
--------- ------
$ 200,151 6.707%
========= ======
Interest Bearing Liabilities
Reverse repurchase borrowings on mortgage loans $ 32,674 6.313%
Reverse repurchase borrowings on mortgage securities 113,803 5.723%
--------- ------
$ 146,477 5.855%
========= ======
Net Interest Earning Assets $ 53,674
=========
0.852%
======
Net Interest Spread
Yield on Net Interest Earnings Assets (3) 9.034%
======
(1) Includes mortgage loans held for sale and mortgage loans held to maturity.
Loan loss provisions are excluded in the above calculations.
(2) Loan loss provisions are excluded in the above calculations.
(3) Yield on Net Interest Earning Assets is computed by dividing the applicable
net interest income by the average daily balance of Net Interest Earning
Assets.
NET INTEREST INCOME
The combined 1998 net interest income generated from the Company's core
business is reflected in the table below (dollars in thousands):
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
1998 1998 1998 1998 Total
-------------------------------------------------------------------
Mortgage loans $1,371 $1,412 $2,076 $1,251 $6,110
Collateral for
mortgage backed bonds 113 109 (77) 145
FNMA mortgage securities -- -- 41 65 106
Private placement mortgage -- -- -- 519 519
securities
-------------------------------------------------------------------
$1,371 $1,525 $2,226 $1,758 $6,880
===================================================================
The following table reflects the average balances for each major category
of the Company's core business interest earning assets as well as the Company's
interest bearing liabilities with the corresponding effective rate of interest
annualized for the periods shown below (dollars in thousands):
39
40
Quarter Ended Quarter Ended Quarter Ended Quarter Ended
March 31, 1998 June 30, 1998 September 30 1998 December 31, 1998
-------------------------------------------------------------------------------------------
Average Effective Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate Balance Rate
------- --------- ------- --------- ------- --------- ------- ---------
Interest Earning Assets
Mortgage loans $216,275 7.410% $370,811 7.371% $566,455 7.489% $465,445 7.392%
Collateral for mortgage
backed bonds 92,272 7.158% 91,980 7.071% 86,477 6.230%
Mortgage securities 11,665 7.429% 38,340 10.187%
-----------------------------------------------------------------------------------------
$216,275 7.410% $463,083 7.329% $670,100 7.429% $590,262 7.403%
=========================================================================================
Interest Bearing
Liabilities
Reverse repurchase
borrowings on
mortgage loans $166,882 6.318% $332,424 6.452% $523,403 6.377% $447,915 6.422%
Mortgage backed bonds 88,069 6.901% 87,524 6.916% 80,522 6.926%
Reverse repurchase
borrowings on collateral for
mortgage backed bonds 1,076 7.031% 203 6.145% 1,760 6.616%
Reverse repurchase
borrowings on
mortgage securities 11,351 5.952% 26,947 5.824%
-----------------------------------------------------------------------------------------
$166,882 6.318% $421,569 6.604% $622,481 6.567% $557,144 6.581%
=========================================================================================
Net Interest Earning
Assets $49,393 $41,514 $ 47,619 $33,118
======= ======= ======== =======
Net Interest Spread 1.092% 0.725% 0.862% 0.822%
====== ====== ====== ======
Yield on Interest Earning
Assets 11.099% 14.689% 18.698% 21.233%
======= ======= ======= =======
Yield on Interest Earning
Assets [after adjustment to
include net interest income 11.099% 14.689% 18.698% 14.978%
and capital (net interest ======= ======= ======= =======
earning assets) of HCP-2]
CORE BUSINESS - MORTGAGE LOANS
Net interest income generated from investments in mortgage loans
(classified as held for sale and held to maturity) during 1998 is detailed
below (dollars in thousands):
40
41
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
Mortgage Loans 1998 1998 1998 1998
- -------------- ---------------------------------------------------------
Average asset balance $216,275 $370,811 $566,455 $465,445
Average repo balance 166,882 332,424 523,403 447,915
-------- -------- -------- --------
Net interest earning assets $ 49,393 $ 38,387 $ 43,052 $ 17,530
======== ======== ======== ========
Average leverage ratio 77.162% 89.648% 92.400% 96.234%
======== ======== ======== ========
Effective interest income rate 7.410% 7.371% 7.489% 7.392%
Effective interest expense rate 6.318% 6.452% 6.377% 6.422%
-------- -------- -------- --------
Net interest spread 1.092% 0.919% 1.112% 0.970%
======== ======== ======== ========
Interest income $ 4,006 $ 6,833 $ 10,606 $ 8,602
Interest expense 2,635 5,421 8,530 7,351
-------- -------- -------- --------
Net interest income $ 1,371 $ 1,412 $ 2,076 $ 1,251
======== ======== ======== ========
Yield on net interest earning assets
11.099% 14.712% 19.285% 28.543%
======== ======== ======== ========
The Company's core business of acquiring single-family seasoned mortgage
loans and holding the loans prior to making a determination as to whether the
mortgage loans will be securitized generated net interest income of $6,110,000
in 1998.
The average mortgage loan balance increased on a quarter to quarter basis
through September, as the Company purchased mortgage loan product at an average
rate of approximately $250 million per quarter during this time. Only $91
million of mortgage loans were purchased in the fourth quarter of 1998. In April
1998, the Company completed its first REMIC securitization and thereby
transferred $103 million (par value) of mortgage loans to collateral for
mortgage backed bonds. In August 1998, the Company converted approximately $17
million (par value) of adjustable rate mortgage loans into FNMA mortgage
securities, and in October and December 1998, the Company converted $56 million
and $55 million (par value) of fixed rate mortgage loans into FNMA mortgage
securities. Lastly, in October 1998, the Company completed a $318 million (par
value) REMIC securitization accomplished through a taxable subsidiary of the
Company, HCP-2. This transaction required the Company to contribute mortgage
loans net of the respective reverse repurchase financing to HCP-2 in exchange
for all of the preferred stock of HCP-2. Simultaneously, the Company acquired
from HCP-2, through two newly created REIT qualified subsidiaries, all of the
investment grade securities (except for the "AAA" rated securities), the unrated
securities, the interest only securities and the principal only securities from
the security transaction.
The purchase of mortgage loans was accomplished through reverse repurchase
agreement financing and equity. In the early part of 1998 the Company used
equity to the extent possible to fund the purchase of mortgage loans. The
average leverage ratio increased significantly in the last half of 1998 as the
Company implemented a plan to increase liquidity, which effectively reduced the
amount of capital employed.
41
42
The effective interest income rate (after adjusting for the amortization of
premium, discounts and certain deferred costs) on the mortgage loan portfolio
remained fairly consistent during the year. Prepayments on various mortgage
pools fluctuated during the year but overall the prepayment speed remained at
slightly higher than expected levels (20%-25%). The financing costs on the
mortgage pools varied from a low of 6.318% in the first quarter of 1998 to
6.452% in the second quarter of 1998. Interest rates are almost exclusively
indexed to LIBOR. The decreases in interest rates in 1998 resulted in larger net
interest spreads to the benefit of the Company, particularly in the third
quarter of 1998. The Company's interest expense rates rose slightly in the
fourth quarter as compared to the third quarter due to a short term financing
agreement entered into in November. The interest rate charged on this financing
agreement was 8.006% in the fourth quarter of 1998.
CORE BUSINESS - COLLATERAL FOR MORTGAGE BACKED BONDS
Net interest income generated from collateral for mortgage backed bonds
during 1998 is detailed below (dollars in thousands):
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
Collateral for mortgage backed bonds 1998 1998 1998 1998
- ------------------------------------ --------- -------- ------------- ------------
Average asset balance 0 $ 92,272 $ 91,980 $ 86,477
Average mortgage backed bonds
balance 0 88,069 87,524 80,522
Average repo balance 0 1,076 203 1,760
--- -------- -------- --------
Net interest earning assets 0 $ 3,127 $ 4,253 $ 4,195
=== ======== ======== ========
Average leverage ratio N/A 95.445% 95.155% 93.113%
=== ======== ======== ========
Effective interest income rate N/A 7.158% 7.071% 6.230%
Effective interest expense rate N/A 6.903% 6.915% 6.919%
--- -------- -------- --------
Net interest spread N/A 0.255% 0.156% (0.689)%
=== ======== ======== ========
Interest income 0 $ 1,651 $ 1,625 $ 1,346
Interest expense 0 1,538 1,516 1,423
--- -------- -------- --------
Net interest income 0 $ 113 $ 109 $ (77)
=== ======== ======== ========
Yield on net interest earning assets N/A 14.413% 10.291% (7.346)%
=== ======== ======== ========
In April 1998 the Company securitized (through a wholly owned subsidiary of
the Company - Hanover Capital SPC, Inc.) $102,977,000 (par value) of mortgage
loans. This securitization was accomplished in a REMIC format which was
accounted for as a financing for GAAP purposes and as a sale for tax purposes.
In a financing, the Company continues to record 100% of the interest
income, net of servicing fees, generated by the mortgage loans. The primary
source of financing for these mortgage loans is the mortgage backed bonds. This
financing represents the liability for the investment grade mortgage bonds not
retained by the Company - $77,305,000 at December 31, 1998. The interest expense
on this financing represents the coupon interest amount to be paid to the
investment grade bond holders. The Company's net equity in the secured
transaction represents the non-investment grade, interest only and
principal only bonds. The Company's net equity investment in collateral for
mortgage backed bonds can also be leveraged through reverse repurchase
financing. At December 31, 1998 the Company had $1,911,000 of
42
43
reverse repurchase financing on a portion of the collateral for mortgage backed
bonds ($2,542,000). The coupon interest rates on the bonds, except for the
interest only and principal only bonds, have fixed coupon interest rates of
6.75% and 7.00%. The interest only bonds generate monthly interest from the
excess interest generated on the underlying mortgages after deducting all
service fees and the coupon interest rate on the applicable bonds. The interest
rate on each of the interest only bonds is based on a notional amount (the
principal balance of those mortgage loans with an interest rate in excess of the
related bonds coupon interest rate). The notional amounts decline each month to
reflect the related normal principal amortization, curtailments and prepayments
for the related underlying mortgage loans. Accordingly, the effective interest
rate will decline as prepayments on the underlying mortgages with interest rates
in excess of the coupon rates accelerate. The mortgage loans collateralizing the
mortgage backed bonds experienced prepayment speeds over the last six months of
1998 of approximately 26%. These prepayment speeds were higher than anticipated.
Accordingly, in the fourth quarter of 1998 the Company booked an additional
premium amortization adjustment (decreasing interest income) of $145,000.
Interest expense includes the interest on the mortgage backed bonds,
interest on the related reverse repurchase agreements and amortization of
certain deferred financing costs.
CORE-BUSINESS - FNMA MORTGAGE SECURITIES (SWAPPED FOR THE COMPANY'S MORTGAGE
LOANS)
Net interest income generated from investments in FNMA mortgage securities
that were converted from the Company's mortgage loans during 1998, is detailed
below (dollars in thousands):
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
FNMA mortgage securities (swapped) 1998 1998 1998 1998
- ------------------------- ------------------------------------------------------
Average asset balance 0 0 $11,665 $24,894
Average repo balance 0 0 11,351 24,163
--- --- ------- -------
Net interest earning assets 0 0 $ 314 $ 731
=== === ======= =======
Average leverage ratio N/A N/A 97.311% 97.067%
=== === ======= =======
Effective interest income rate N/A N/A 7.429% 5.778%
Effective interest expense rate N/A N/A 5.952% 5.693%
--- --- ------- -------
Net interest spread N/A N/A 1.477% 0.085%
=== === ======= =======
Interest income 0 0 $ 213 $ 416
Interest expense 0 0 172 351
--- --- ------- -------
Net interest income 0 0 $ 41 $ 65
=== === ======= =======
Yield on net interest earning assets N/A N/A 52.001% 35.457%
=== === ======= =======
During 1998 the Company completed three separate swap transactions with
FNMA. In August 1998, the Company exchanged $17.4 million (par value) of
adjustable rate mortgage loans in exchange for a like amount of mortgage
securities in the form of five FNMA certificates. All of the mortgage
certificates were subsequently sold with recourse in October 1998. In October
and December 1998, the Company exchanged $55.6 million and $55.2 million,
respectively of fixed rate mortgage loans for a like amount of mortgage
securities in the form of 19 and 31 FNMA certificates, respectively. The $55.6
million of mortgage securities
43
44
represented by the 19 FNMA certificates was sold with recourse in October,
several days after the loans were securitized.
CORE BUSINESS - PRIVATE PLACEMENT MORTGAGE SECURITIES (PURCHASED FROM A RELATED
PARTY)
Net interest income generated from private placement securities purchased
from an affiliate, HCP-2, in October 1998 is detailed below (dollars in
thousands):
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
Private placement mortgage securities 1998 1998 1998 1998 (1)
- ------------------------------------- ---------------------------------------------------
Average asset balance 0 0 0 $13,446
Average - repo balance 0 0 0 2,784
--- --- --- -------
Net interest earning assets 0 0 0 $10,662
=== === === =======
Average leverage ratio N/A N/A N/A 20.707%
=== === === =======
Effective interest income rate N/A N/A N/A 16.662%
Effective interest expense rate N/A N/A N/A 5.729%
--- --- --- -------
Net interest spread N/A N/A N/A 10.933%
=== === === =======
Interest income 0 0 0 $ 560
Interest expense 0 0 0 41
--- --- --- -------
Net interest income 0 0 0 $ 519
=== === === =======
Yield on net interest earning assets N/A N/A N/A 19.484%
=== === === =======
(1) This table does not reflect the Company's combined overall effective yield
and the Company's total investment in private placement mortgage securities
because the table does not reflect net interest income of and equity
employed by the Company's unconsolidated subsidiary, HCP-2. See the table
on page 48 that reflects the Company's combined overall yield and total net
interest earning assets employed.
In October 1998 the Company completed its second private placement REMIC
securitization transaction through its newly organized unconsolidated
subsidiary, HCP-2. The Company contributed $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing to HCP-2 in exchange for a 99% economic ownership
of HCP-2 (representing a 100% ownership of the non-voting preferred stock of
HCP-2). HCP-2 issued a REMIC mortgage security and sold all of the REMIC
securities except the "AAA" rated notes to two newly created wholly-owned
subsidiaries of the Company (Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B,
Inc.). The Company's investment at December 31, 1998 includes nine investment
grade ("AA", "A" and "BBB") notes and six interest only notes. The interest
rates on the investment grade notes are fixed and range from 6.25% to 6.75%.
These notes generate normal principal and interest remittances to the Company on
a monthly basis. The interest only notes generate monthly interest remittances
to the Company (subject to the availability of funds) from the excess interest
generated from the underlying mortgages after deducting all service fees and the
coupon interest rate on the applicable notes. The interest rate on each of the
interest only notes is based on a notional amount (the principal balance of
those mortgage loans with an interest rate in excess of the related note coupon
interest rate). The notional amounts decline each month to reflect the related
normal principal amortization, curtailments and prepayments for the related
underlying mortgage loans. At December 31, 1998 the interest only notes were
divided into two major categories; the
44
45
first group had an effective weighted average interest rate of 1.166% on a
notional balance of $259,861,000 and the second group had an effective weighted
average interest rate of 0.255% on a notional balance of $143,666,000.
The interest only notes serve to significantly increase the overall yield
of the mortgage securities portfolio (16.662% for the fourth quarter of 1998).
The interest only notes, however, will be adversely affected more than other
notes by higher than expected prepayment speeds on underlying mortgage loans
with interest rates in excess of the net coupon rate. In all likelihood
mortgages with higher interest rates will be repaid more rapidly than mortgages
with lower interest rates. Accordingly, the effective yield generated by this
portfolio is expected to decrease over time. The underlying mortgage loans were
prepaying at an annualized speed of approximately 29% in 1998, slightly higher
than expected.
NON-CORE BUSINESS - PURCHASED AGENCY MORTGAGE SECURITIES
Net interest income (loss) generated from purchased Agency mortgage
securities in 1998 is detailed below:
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
Purchased FNMA & FHLMC mortgage securities 1998 1998 1998 1998
- ---------------------------------------------------------------------------------------------------------------------
Average asset balance $334,722 $281,933 $231,634 $34,598
Average repo balance 324,305 272,176 230,037 31,385
-------- -------- -------- -------
Net interest earning assets $ 10,417 $ 9,757 $ 1,597 $ 3,213
======== ======== ======== =======
Average leverage ratio 96.888% 96.539% 99.310% 90.712%
======== ======== ======== =======
Effective interest income rate 6.116% 3.992% 4.385% 4.564%
Effective interest expense rate 5.597% 5.616% 5.689% 5.584%
-------- -------- -------- -------
Net interest spread 0.519% (1.624)% (1.304)% (1.020)%
======== ======== ======== =======
Interest income $ 5,118 $ 2,814 $ 2,541 $ 394
Interest expense 4,538 3,864 3,344 448
-------- -------- -------- -------
Net interest income (loss) $ 580 $ (1,050) $ (803) $ (54)
======== ======== ======== =======
Yield on net interest earning assets 22.273% (43.054)% (201.112)% (6.608)%
======== ======== ======== =======
In December 1997, the Company purchased 15 ARM securities from various
"Wall Street" dealers and in March of 1998, purchased a fixed rate FNMA
certificate from another dealer firm. The ARM securities were purchased at a
price of 103.72% of par value or $349,286,000 and the FNMA fixed rate mortgage
security was purchased at a price of 105.125% of par value or $4,333,000. These
mortgage securities were financed with separate PSA reverse repurchase agreement
financing with lender haircuts generally in the 3% range. Certain lenders
require cash deposits to satisfy margin calls, while other lenders require a
paydown of the reverse repurchase agreement financing to satisfy margin calls.
In the third quarter of 1998 the net interest earning assets employed decreased
dramatically from $9,757,000 in the second quarter to $1,597,000 in the third
quarter. This decrease was attributable to (i) an increase in the negative mark
to market (unrealized loss), (ii) a reduction in net premiums (due to rapid
prepayments), and (iii) a significant increase in cash on deposit with certain
lenders relating to margin calls. In October
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1998 the Company sold all of the Agency ARM securities, leaving only the fixed
rate FNMA mortgage security at year end.
The effective interest income rate was negatively affected by the rapid
prepayments of the Agency ARM securities throughout 1998 (40-50% prepayment
speeds), particularly in the second quarter, as the Company booked additional
premium amortization to match the rapid prepayment speeds.
OTHER INTEREST INCOME
1998 interest income generated from non-mortgage assets is detailed below
(dollars in thousands):
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
1998 1998 1998 1998
--------- -------- ------------- ------------
Cash margin $109 $157 $173 --
Overnight investing 81 82 3 209
Related party notes 17 61 94 84
---- ---- ---- ----
$207 $300 $270 $293
==== ==== ==== ====
Interest income on cash deposited as additional cash collateral pursuant to
reverse repurchase financing agreements with certain lenders earned interest at
the respective borrowing rate charged by the lender generally 5.60%.
Interest income recorded on overnight investing was generated for the most
part from investing excess cash in Federal Home Loan Bank discount notes with
interest rates ranging from 4.2% to 4.5%. Overnight investing also includes, to
a much lesser extent, investments in the highest rated commercial paper and
savings accounts.
Notes receivable due from HCP earn interest at 1.00% below prime. During
the year, notes receivable due from HCP ranged from $-0- to $7,312,000. The
balance at December 31, 1998 was $713,000. Notes receivable due from Principals
earn interest at the lowest applicable federal rate in effect at the time of the
loan. The weighted average interest rate on notes due from Principals at
December 31, 1998 was 5.58% on an outstanding balance of $3,181,000.
EXPENSES
l998 personnel costs reflect the salaries, payroll taxes, and employee
benefit costs ($712,000) relating to the Principals, net of $360,000 allocated
to an unconsolidated subsidiary, HCP, for management's actual and estimated time
involved with the subsidiary. The personnel costs relating to the Principals for
1997 ($204,000) was reflected in the form of billings from HCP and was
classified as management and administrative expense because no payroll function
was established for the Company until January 1998.
The expenses (management and administrative, due diligence and commissions)
directly related to acquisitions of mortgage loans totaled $1,706,000 in 1998.
The similar figure for 1997 (period from September 30 to December 31, 1997) was
$523,000 after deducting Principals' personnel costs of $204,000. Due diligence
costs on mortgage loans acquired, as a percentage of
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par value of the mortgage loan acquired, decreased from 0.156% in 1997 to 0.075%
in 1998. Commissions expense also decreased as a percentage of par value of
mortgage loans acquired, from 0.042% in 1997 to 0.033% in 1998.
Legal and professional expenses including general legal, accounting, tax,
investor relations and other professional fees ($545,000) reflected increases in
1998 compared to the prorata period in 1997 ($138,000). These increases were
generally anticipated as the Company began implementing its strategic business
plan of securitizing mortgage loans.
Financing/commitment fees reflected the single most significant increase
from 1997 to 1998 ($804,000). During the short period of operation in 1997 the
Company had two reverse repurchase agreement lines of credit in place. A portion
of the commitment fees on these two lines of credit ($100,000 each), was
expensed in 1998. The Company increased the number of lenders providing reverse
repurchase agreement financing from two to five in 1997. One of these lines of
credit was for a short term period at a time (in the fourth quarter) when credit
sources were particularly scarce. The commitment fee expense relating to this
lender was $500,000 in 1998.
For the year ended December 31, 1998 and for the short period ended
December 31, 1997, the Company's ratio of operating expenses to average assets
was 1.59% and 0.53%, respectively. The Company's 1998 and 1997 operating
expenses 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%.
EQUITY IN (LOSS) OF UNCONSOLIDATED SUBSIDIARIES
On September 19, 1997 (the IPO date), Hanover acquired 100% of the
non-voting preferred stock of HCP, which represents a 97% ownership interest in
HCP and its wholly owned subsidiaries. Hanover's investment in HCP is accounted
for on the equity method. Hanover recorded a loss of $1,039,000 in 1998 and
$254,000 in 1997 from its equity investment in HCP. The HCP loss in 1997
reflected a significant decline in its due diligence revenue. Its loss in 1998
was a result of a decline in HCP's consulting and brokerage revenues and the
second consecutive year of subpar mortgage origination production from HCMC. The
1998 operations of HCMC were negatively affected by the credit market changes in
the third and fourth quarter of 1998 that essentially shut down the mortgage
conduit origination market.
In October 1998, the Company completed its second private placement REMIC
securitization transaction through its newly organized unconsolidated
subsidiary, HCP-2. Hanover contributed $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing to HCP-2 in exchange for a 99% economic ownership
of HCP-2 (representing a 100% ownership of the non-voting preferred stock in
HCP-2). HCP-2 issued a REMIC security and sold all of the REMIC security except
the "AAA" rated notes to two newly created wholly-owned subsidiaries of Hanover
(Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B, Inc.). Hanover's investment in
HCP-2 is accounted for on the equity method. Hanover recorded a loss of $394,000
in 1998 from its equity investment in HCP-2.
The loss generated by HCP-2 is a result of the unique securitization
transaction entered into in October 1998. The REMIC security transaction
effectively records all of the underlying
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mortgage loans as assets and the same amount of mortgage backed bonds as a
liability. Accordingly, the gross interest income generated from the underlying
mortgages will match exactly the interest expense relating to the mortgage
backed bonds. The net loss generated by HCP-2 relates to (1) the amortization of
net premiums and deferred hedge costs, reflected as a reduction of interest
income, (2) the amortization of deferred financing fees and (3) a loan loss
provision. Hanover reflected 99% of this net loss in 1998 - $394,000. It is
expected that HCP-2 will continue to reflect decreasing losses in the future.
Management believes that the net interest income calculated relating to
this securitization transaction should be adjusted to reflect the operating
activity recorded from the equity in loss of HCP-2 to more fully comprehend the
yield on the net interest earning assets. Accordingly, the table below reflects
the adjusted net interest income generated from the $318 million securitization
transaction:
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
March 31, June 30, September 30, December 31,
Private placement mortgage securities 1998 1998 1998 1998
- ------------------------------------------------- --------- -------- ------------- ------------
Average asset balance (as adjusted) 0 0 0 $ 17,917
Average repo balance 0 0 0 2,784
--- --- --- --------
Net interest earning assets (as adjusted) 0 0 0 $ 15,133
=== === === ========
Average leverage ratio (as adjusted) N/A N/A N/A 15.540%
=== === === ========
Effective interest income rate (as adjusted) N/A N/A N/A 4.686%
Effective interest expense rate N/A N/A N/A 5.729%
--- --- --- --------
Net interest spread (as adjusted) N/A N/A N/A (1.043)%
=== === === ========
Interest income (as adjusted) 0 0 0 $ 210
Interest expense 0 0 0 41
--- --- --- --------
Net interest income (as adjusted) 0 0 0 $ 169
=== === === ========
Yield on net interest earning assets (as adjusted) N/A N/A N/A 4.471%
=== === === ========
Hanover's 1998 taxable income is estimated at $1,517,000. Taxable income
exceeds GAAP net loss for the following book/tax differences relating to the
accounting for (1) equity in the loss of subsidiaries, (2) due diligence costs
and commission expenses incurred to acquire mortgage loan pools, (3) REMIC
securitization/sale transactions, (4) original issue discount adjustments, (5)
amortization of premium/discounts, (6) recognition of capital losses and (7)
other smaller items.
As a REIT, Hanover is required to declare dividends amounting to 85% of
each year's taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of Hanover's taxable income for each year by the time
Hanover 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. Hanover paid dividends of $0.70 per share for 1998,
which exceeded 100.0% of taxable income.
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LIQUIDITY
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, sale of certain mortgage securities,
and other possible sources of financing, including CMOs and REMICs, additional
equity generated by the exercise of some or all of the Company's outstanding
stock warrants and additional equity offerings. The Company considers its
ability to generate cash to be adequate to meet operating requirements both
short-term and long-term. However, if a significant decline in the market value
of the Company's investment portfolio should occur, the Company's available
liquidity from existing sources and ability to access additional sources of
credit may be reduced. As a result of such a reduction in liquidity, the Company
may be forced to sell certain investments in order to maintain liquidity. If
required, these sales could be made at prices lower than the carrying value of
such assets, which could result in losses.
In October 1998, the volatility of the mortgage market caused certain repo
lenders to widen their lending haircuts, increase borrowing rates and/or
discontinue or reduce their lending activities. Further, the turmoil in the
mortgage markets resulted in repo lenders taking a more conservative approach to
valuing the underlying mortgage collateral, often resulting in higher margin
calls. In an effort to increase liquidity and to reduce overall leverage the
Company sold all of its adjustable rate Agency mortgage securities ($189
million) in October. The sale of the adjustable rate Agency mortgage securities
resulted in a loss of $5,989,000. To further increase liquidity, the Company
also sold certain other FNMA mortgage securities ($73 million) at a net gain of
$334,000. If the Company were unable to meet the lenders's margin calls in the
future or if lenders were reluctant to extend additional repo financing the
Company would be forced to use its existing liquidity to satisfy margin calls.
Further, the Company might be forced to sell certain investments in order to
meet margin calls. The recent volatility in the mortgage markets has caused repo
financing to become marginally more expensive and has reduced the number of
lenders willing to extend repo lending to finance mortgage loan pool
acquisitions.
The Company had four reverse repurchase agreement lines of credit in place
at December 31, 1998. One of these lines of credit was renewed in December 1998
and another line of credit maturing in March 1998 is currently being
renegotiated. A commitment for a new $50 million line of credit was agreed to in
February 1999. Management is seeking to add several additional lines of credit
by June of 1999. The Company sold certain of its private placement mortgage
securities in early 1999. The mortgage securities that were sold were acquired
pursuant to the $318 million securitization completed in October 1998. Typically
investment grade mortgage securities would not be retained by the Company at the
time of the securitization, however, due to market conditions that existed at
the time of the securitization these mortgage securities were retained. The
improvement in the mortgage market allowed the Company the option of selling
these mortgage securities.
In November 1998 Hanover entered into a short term (three month) financing
arrangement with Residential Funding Corporation ("RFC") for approximately $95
million. In connection with such financing arrangement, Hanover agreed to issue
and deliver to RFC warrants to purchase approximately 300,000 shares of
Hanover's common stock exercisable at a price per share equal to the closing
price of Hanover's common stock on the American Stock Exchange on the date of
the November agreement, which was $4.00 per share. In addition Hanover and RFC
agreed to the following: (i) Hanover agreed to compensate RFC as an underwriter
on certain
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future mortgage loan securitization deals, (ii) Hanover agreed to have the
appropriate Hanover entity (HCMC) offer RFC the right to purchase any commercial
loans originated or purchased by such entity through November 2000 on the same
terms and conditions as it would offer such commercial loans to a third party,
(iii) Hanover agreed to offer RFC the opportunity to act as master servicer on
any loan securitization effected by it through November 2000 on the same terms
and conditions as it would offer such to a third party and (iv) RFC agreed to
offer the appropriate Hanover entity (HCP) the opportunity to undertake due
diligence services for RFC on the same terms and conditions as it would offer
such to a third party through November 2000.
Net cash provided by operations in 1998 was $3,898,000. Actual cash
proceeds generated from operations adjusted for non cash items was $9,154,000
offset by net cash used for operating assets and liabilities ($1,845,000) and
net loans to Principals ($2,698,000) and to HCP ($713,000).
Net cash used in investing activities amounted to $315,792,000 in 1998. The
majority of the mortgage assets purchased were mortgage loans. The average
purchase price of mortgage loans in 1998 was 101.26%. Offsetting the cash outlay
for mortgage asset purchases were receipts of principal proceeds on the mortgage
loans and mortgage securities of $296,806,000 and proceeds from the sale of
mortgage assets of $276,582,000.
Cash flows from financing activities generated $319,709,000 in 1998. The
majority of the cash flows from financing activities resulted from net
borrowings on reverse repurchase agreements ($243,218,000), net borrowings on
the mortgage backed bonds ($77,305,000), increased by dividends received from
HCP-2 ($8,054,000), reduced by dividends paid ($4,826,000), an additional
capital contribution to HCP ($2,700,000) and repurchases of the Company's common
stock ($1,345,000).
Capital Resources
The Company had no capital expenditure in 1998 and management does not
anticipate the need for any material capital expenditures for the future.
YEAR 2000 (Y2K) DISCLOSURE
The Y2K issue is the result of computer systems that use two digits rather
than four to define the applicable year, which may prevent such systems from
accurately processing dates ending in the year 2000 and thereafter. This could
result in system failures or in miscalculations causing disruption of
operations, including, but not limited to, an inability to process transactions,
to send and receive electronic data, or to engage in routine activities and
operations.
The following information is provided relating to the Company's Y2K issues:
1. Y2K-READINESS- The Company has reviewed the status of all of its
information technology ("IT") systems and has determined that all of its
computer hardware is Y2K compliant. In addition, the Company has received
satisfactory certification from certain of its third party vendors and/or
verified to its satisfaction that their IT systems are Y2K compliant or
have indicated that they will be Y2K compliant prior to December 31, 1999.
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The Company has prepared a detailed questionnaire for the remainder of the
Company's significant other third party relationships:
Certain Third Party Vendors Services Provided
--------------------------- -----------------
Securities dealer firms Financing, facilitate purchase and sale of
mortgage assets, etc.
Information processing firms Accounting, word processing, database
software systems
Mortgage loan servicers Mortgage loan servicing
Communications firms Telephone, modems, fax, financial software,
internet, postage
Facilities firms Office space, storage, security
General Legal and accounting, office supplies, etc.
The Company has sent letters requiring verification of compliance with Year
2000 matters and has followed up such letters with telephone calls as
appropriate. An evaluation of these questionnaires as well as other Y2K
readiness matters has been ongoing for several months. This process is
scheduled to be completed by March 31, 1999. The Company will then
determine the most cost-effective method to remedy any third party
non-compliance. The Company does not own any non-IT systems (i.e. elevator
systems, building air management systems, security and fire control
systems).
2. Y2K-COSTS - The Company has not incurred any material costs to date related
to its Y2K issues and believes its total Y2K costs to date have been less
than $25,000. At this time it does not anticipate any material costs will
be incurred on as yet unidentified Y2K issues. The costs of these projects
and the dates on which the Company plans to complete modifications and
replacements are based on management's best estimates, the estimates of
third-party specialists, if any, who may assist the Company, the
modification plans of third parties and other factors. However, these
estimates of future Y2K related costs may change when the assessment of
third-party issues is complete and actual results could differ materially
from the above indication.
3. Y2K-RISKS- Currently the Company's most reasonably likely worst case
scenario relating to the Y2K issue would occur if any of the companies
which service its mortgage portfolios had Y2K problems that prohibited such
companies from either (1) collecting and remitting funds or (2) providing
the related loan data to the Company on a timely basis. A scenario of this
type could, if existing for any significant length of time, create
liquidity problems for the Company and could result in decreased net income
through decreased net interest income and increased operating expenses. If
the Company does not receive borrower remittances from its servicers on a
timely basis it may have to (1) use existing capital, (2) sell other
mortgage assets or (3) try to secure additional financing sources to
satisfy lenders' margin calls. Although the likelihood of such an
occurrence seems remote, a total cessation of borrower remittances to the
Company could potentially lead to monetary defaults by the Company on its
repo lending obligations. Additionally, the Company
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estimates that expenses would increase as a result of legal and other
actions taken to attempt to collect the funds due the Company. The
third-party questionnaire described in Item 1 above is intended to assess
these risks and the alternatives available to reduce or eliminate them.
While the Company believes the probability of the above occurrences to be
low, there can be no assurance at this time that the Company will not be
materially adversely affected by possible Y2K problems.
4. Y2K-CONTINGENCY PLANS- The development of contingency plans to handle the
most reasonably likely worst case Y2K scenario is dependent upon the
completion of the assessment of the third-party questionnaires described
above. The Company anticipates it will have such a contingency plan in
place by June 30, 1999. When completed, it is intended that the Company's
documented Y2K contingency plan will include identified "individuals"
within the Company to contact in the event of a Y2K problem, as well as the
availability of back-up systems. Due to the nature of the preliminary open
issues at this time, which involve only third-party issues, the Company
does not currently anticipate the need for any third-party consultants for
remediation efforts.
OTHER MATTERS
REIT Requirements
Hanover has elected to be taxed as a REIT under the Code. Hanover believes
that it was in full compliance with the REIT tax rules as of December 31, 1998
and intends to remain in compliance with all REIT tax rules. If Hanover fails to
qualify as a REIT in any taxable year and certain relief provisions of the Code
do not apply, Hanover 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 Hanover fails to qualify as a REIT would not
be deductible by Hanover in computing its taxable income. As a result, Hanover
could be subject to income tax liability, thereby significantly reducing or
eliminating the amount of cash available for distribution to its stockholders.
Further, Hanover 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
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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 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 the 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.
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
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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, 1998, Management
calculates that the Company is in compliance with this requirement.
Proposed Legislation
The Clinton Administration's budget has modified some of the
Administration's prior tax proposals directed at REITs. The current proposals,
if enacted, would change the tax treatment of (i) a REIT's ownership of taxable
subsidiary stock, (ii) closely-held REITs, and (iii) built-in gains on the
conversion of a C corporation to a REIT or the merger of a C corporation into a
REIT. While prior attempts by the Administration to make similar changes in the
taxation of REITs were unsuccessful, and it is uncertain whether the changes
outlined in the current proposals or some variation of them, ultimately will be
enacted.
If adopted, these proposals could have an adverse effect on REITs in
general and on Hanover. More specifically, the Administration's proposals would
prohibit a REIT from owning, by vote or value, more than 10 percent of the
capital stock of any corporation. (Current law only prohibits ownership of more
than 10% of a company's voting stock.) The proposal is generally intended to
prevent REITs from conducting, through a taxable subsidiary, any business that
would be prohibited to the REIT itself.
The proposal, however, contains exceptions for two new types of taxable
subsidiaries: a qualified business subsidiary ("QBS") and a qualified
independent contractor subsidiary ("QIK"). A QBS would be permitted to earn
income by providing non-tenant related services such as third party management
services. A QIK, in addition to being permitted to earn income that could be
earned by a QBS, would also be permitted to earn income providing non-customary
and other presently prohibited services to a REIT's tenants.
Under the proposal, all taxable subsidiaries owned by a REIT could not
exceed 15% of a REIT's total assets and of that total no more than 5% could
represent the value of QIKs. Such subsidiaries would be denied the ability to
deduct interest on debt funded by a REIT. The proposal also calls for a new 100%
excise tax to ensure (i) arm's length pricing for services provided to a REIT's
tenants (to ensure that tenants are not paying a REIT higher rent in exchange
for a discount on services that would be taxable income to the service
subsidiary) and (ii) arm's length allocations for shared expenses between a REIT
and its taxable subsidiary. Additional limitations as well as unspecified
limitations on intercompany rentals between a REIT and its taxable subsidiary
will be proposed. These proposals would generally be effective on the date of
the enactment although a transition period would be provided to permit any
restructuring of taxable subsidiaries necessary to obtain a QBS or a QIK
qualification.
Currently a REIT must have at least 100 shareholders and not more than 50%
of the value of its stock can be owned by five or fewer individuals during the
last half of the REIT's taxable year. The proposal would add a new ownership
requirement that would prohibit ownership of more than 50% of a REIT's stock by
vote or value by any person other than another REIT. This
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proposal would generally apply on a prospective basis for entities electing REIT
status on or after the first date of committee action.
It is possible that if the proposal is adopted Hanover may be able to
qualify its taxable subsidiaries as QBS entities and maintain its current method
of conducting its business. However, until more details are available regarding
the proposed statutory language, it is not clear whether QBS qualification would
be obtainable. Additionally, obtaining QBS qualification may result in current
taxation to the non-REIT shareholders of Hanover's taxable subsidiaries.
Finally, certain restructurings of the credit lines of Hanover's taxable
subsidiaries and their inter-company transactions with Hanover may be required
to avoid the proposed excise taxes. Such restructuring may ultimately increase
the taxes paid by Hanover's taxable subsidiaries and thereby affect the value of
these subsidiaries to Hanover.
Currently regular or C corporations are subject to two levels of tax (first
to the corporation on income earned and second to the shareholders when
dividends are distributed). In the same manner, a dual tax situation applies on
the liquidation of a C corporation or its conversion to a partnership since the
corporation is taxed on its built-in gains and the shareholders are taxed on
their built-in gain on the stock. Current tax law provides an exception to the
double tax regime on the conversion of a C corporation to an S corporation (the
"S corporation rule"). The S corporation rule avoids corporate level tax and
instead the S corporation is taxed on such built-in gain for an asset that is
sold within 10 years of the conversion. IRS permits C corporations that convert
to REITs to avoid the immediate tax on built-in gains by electing to be subject
to rules similar to the S corporation rule.
The Administration's proposal would repeal the S corporation rule for C
corporations that have a value of $5 million or more at the time of conversion
and subject such conversions to immediate tax on the built-in gains. Accordingly
the conversion of a C corporation that has a value of at least $5 million would
result in the immediate recognition of the C corporation's built-in gain. This
proposal would generally apply for taxable years beginning after December 31,
1999.
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 reverse repurchase agreement financing; 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.
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
55
56
weather or natural disasters; the effect of competitive pressures from other
financial institutions, including other 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 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company uses certain derivative financial instruments (for purposes
other than trading) as hedges of anticipated transactions relating to its
Investment Portfolio.
The Company from time to time enters into interest rate hedge mechanisms
(forward sales of Agency mortgage securities) to manage its exposure to market
pricing changes in connection with the purchase, holding of, securitization and
sale of its fixed rate mortgage loan portfolio. The Company generally closes out
the hedge position to coincide with the related loan sale or securitization
transactions and recognizes the results of the hedge transaction in determining
the amount of the related loan sale gain or loss for loans sold, or as a basis
adjustment to loans held to maturity.
At December 31, 1998 the Company had the following forward sales of Agency
mortgage securities that had not yet settled (in thousands):
Notional
Fair Value of Amount of Positive
Derivative Derivative Change in
Financial Financial Market Settlement
Mortgage Security Instrument Instrument Value Date
- ----------------- ---------- ---------- ------ ------------
FNMA/30YR/7.0% $19,442 $19,468 $26 Jan 11, 1999
FNMA/30YR/6.5% 11,073 11,089 16 Jan 11, 1999
FNMA/15YR/7.0% 14,506 14,506 0 Jan 11, 1999
FNMA/15YR/6.5% 6,388 6,394 6 Jan 11, 1999
------- ------- ---
$51,409 $51,457 $48
======= ======= ===
The Company only hedges its fixed rate mortgage loan pools by selling short
similar coupon and duration matched Agency securities, usually for 30 to 60 day
periods. This hedging of mortgage assets should, if properly executed, adjust
the carrying value of the hedged fixed mortgage loan pools to reflect current
market pricing. The costs of the individual hedging transactions can vary
greatly depending upon market conditions. Net hedging costs of fixed rate
mortgage pools were $541,000, $1,287,000, $2,632,000 and $1,091,000 in the
first, second, third and fourth quarters of 1998, respectively. Management is
satisfied that the Company's hedging program has been utilized effectively as no
charges relating to impairment of mortgage loans were booked in 1998.
The primary risk associated with selling short Agency securities relates to
changes in interest rates. Generally, as market interest rates increase, the
market value of the hedged asset (fixed rate mortgage loans) will decrease. The
net effect of increasing interest rates will generally be a favorable or gain
settlement on the forward sale of the Agency security; this gain will result in
a negative basis adjustment to the hedged assets. Conversely, if interest rates
decrease, the market value of the hedged asset will increase. The net effect of
decreasing interest rates will generally be an unfavorable or loss settlement on
the forward sale of the Agency security; this loss should be offset by a
positive basis adjustment to the hedged assets. To mitigate interest rate risk
an effective matching of Agency securities with the hedged assets needs to be
monitored closely.
56
57
Senior Management continually monitors the changes in weighted average duration
and coupons of the hedged assets and will appropriately adjust the amount,
duration and coupon of future forward sales of Agency securities.
Mortgage loans that are identified for inclusion in the future
securitizations are generally no longer hedged. The Company anticipates that it
will have a lower volume of forward sales of Agency security hedging activity in
the future as the Company plans to securitize mortgage loans on a more frequent
basis than in 1998.
The Company also enters into interest rate hedge mechanisms (interest rate
caps) to manage its interest rate exposure on certain reverse repurchase
agreement financing. The cost of the interest rate caps is amortized over the
life of the interest rate cap and is reflected as a portion of interest expense
in the consolidated statement of operations.
At December 31, 1998 the Company had the following interest rate caps in
effect (dollars in thousands):
Notional Amount Index Strike % Maturity Date
- --------------- ------------- -------- --------------
$35,978 3 Month LIBOR 5.75% March 31, 2001
34,610 3 Month LIBOR 5.75% April 30, 2001
-------
$70,588
=======
The primary risk associated with interest rate caps relates to interest
rate increases. The interest rate caps provide a cost of funds hedge against
interest rates that exceed 5.75%, subject to the limitation of the notional
amount of financing.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together
with the Independent Auditors' Report thereon beginning on page F-1 and
continuing through page F-56 of this Form 10-K.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
57
58
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.
58
59
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, F-34 and F-46.
(3) Exhibits
Exhibits required to be attached by Item 601 of Regulation S-K are
listed in the Exhibit Index attached hereto, which is incorporated
herein by this reference.
(b) Reports on Form 8-K
The company filed no reports on Form 8-K during 1998.
(c) Exhibits
See Item 14(a) 3 above.
59
60
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, 1999.
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 behalf of Registrant
and in the capacities indicated on March 30, 1999.
SIGNATURE TITLE
/s/ John A. Burchett Chairman of the Board of Directors
- ---------------------------------
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/ John N. Rees Director
- ---------------------------------
John N. Rees
/s/ Ralph F. Laughlin Senior Vice President and Chief Financial
- --------------------------------- Officer (Principal Financial and Accounting Officer)
Ralph F. Laughlin
60
61
TABLE OF CONTENTS TO FINANCIAL STATEMENTS
PAGE
----
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
Independent Auditors' Report......................................................... F-2
Consolidated Financial Statements as of December 31, 1998 and December 31, 1997
and for the Year Ended December 31, 1998 and for the Period from June 10, 1997
(inception) through December 31, 1997:
Balance Sheets............................................................. F-3
Statements of Operations................................................... F-4
Statements of Stockholders' Equity......................................... F-5
Statements of Cash Flows................................................... F-6
Notes to Consolidated Financial Statements................................. F-7
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
Independent Auditors' Report......................................................... F-34
Consolidated Financial Statements as of December 31, 1998 and December 31, 1997
and for each of the Three Years in the Period Ended December 31, 1998:
Balance Sheets............................................................. F-35
Statements of Operations................................................... F-36
Statements of Stockholders' Equity......................................... F-37
Statements of Cash Flows................................................... F-38
Notes to Consolidated Financial Statements................................. F-39
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
Independent Auditors' Report......................................................... F-46
Consolidated Financial Statements as of December 31, 1998 and for the Period
from October 7, 1998 (inception) through December 31, 1998:
Balance Sheet.............................................................. F-47
Statement of Operations.................................................... F-48
Statement of Stockholders' Equity.......................................... F-49
Statement of Cash Flows.................................................... F-50
Notes to Consolidated Financial Statements................................. F-51
62
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Mortgage Holdings, Inc. and Subsidiaries
New York, New York
We have audited the accompanying consolidated balance sheets of Hanover Capital
Mortgage Holdings, Inc. and Subsidiaries (the "Company") as of December 31, 1998
and 1997, and the related consolidated statements of operations, stockholders'
equity and cash flows for the year ended December 31, 1998 and for the period
from 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 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, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Hanover
Capital Mortgage Holdings, Inc. and Subsidiaries as of December 31, 1998 and
1997, and the consolidated results of their operations and their cash flows for
the year ended December 31, 1998 and for the period from June 10, 1997
(inception) through December 31, 1997 in conformity with generally accepted
accounting principles.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 19, 1999
F-2
63
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
ASSETS DECEMBER 31, DECEMBER 31,
1998 1997
---- ----
Mortgage loans:
Held for sale $256,833 $160,970
Held to maturity 69,495 --
Collateral for mortgage backed bonds 81,666 --
Mortgage securities:
Available for sale 74,000 348,131
Held to maturity 4,478 --
Cash and cash equivalents 11,837 4,022
Accrued interest receivable 3,940 3,597
Equity investments 7,489 100
Notes receivable from related parties 3,893 482
Due from related parties 313 --
Other receivables 1,621 --
Prepaid expenses and other assets 605 241
-------- --------
TOTAL ASSETS $516,170 $517,543
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $370,090 $435,138
Mortgage backed bonds 77,305 --
Accrued interest payable 1,394 2,250
Dividends payable 695 1,035
Due to related party -- 540
Accrued expenses and other liabilities 906 482
-------- --------
Total liabilities 450,390 439,445
======== ========
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; 6,321,899 and
6,466,677 shares outstanding at December 31, 65 65
1998 and 1997, respectively
Additional paid-in-capital 78,069 79,411
Retained (deficit) (9,955) (536)
Accumulated other comprehensive (loss) (2,399) (842)
-------- --------
Total stockholders' equity 65,780 78,098
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $516,170 $517,543
======== ========
See notes to consolidated financial statements
F-3
64
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
PERIOD FROM JUNE 10
YEAR ENDED (INCEPTION)
DECEMBER 31, TO DECEMBER 31,
1998 1997
---- ----
REVENUES:
Interest income $47,799 $4,880
Interest expense 41,176 3,204
------- ------
Net interest income 6,623 1,676
Loan loss provision 356 18
------- ------
Net interest income after loan loss
provision 6,267 1,658
Gain (loss) on sale of assets (5,704) 35
------- ------
Total revenues 563 1,693
------- ------
EXPENSES:
Personnel 712 --
Management and administrative 733 400
Due diligence 687 266
Commissions 286 61
Legal and professional 545 138
Financing/ commitment fees 836 32
Other 265 43
------- ------
Total expenses 4,064 940
------- ------
Operating income (loss) (3,501) 753
Equity in (loss) of unconsolidated subsidiaries (1,433) (254)
------- ------
NET INCOME (LOSS) $(4,934) $ 499
======= ======
BASIC EARNINGS (LOSS) PER SHARE $ (0.77) $ 0.15
======= ======
DILUTED EARNINGS (LOSS) PER SHARE $ (0.77) $ 0.14
======= ======
See notes to consolidated financial statements
F-4
65
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 1998 AND
PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(in thousands, except share data)
ACCUMULATED
COMMON STOCK ADDITIONAL RETAINED OTHER
------------ PAID-IN COMPREHENSIVE EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) (LOSS) TOTAL
------ ------ ------- ------------- -------- ------------- -----
Issuance of
common 6,466,677 $65 $79,411 $79,476
stock
Comprehensive income
(loss):
Net income $ 499 $ 499 499
Other comprehensive
income (loss)
Unrealized (loss) (842) $ (842) (842)
-------
Comprehensive
(loss) $ (343)
=======
Dividends declared _________ ___ _______ (1,035) _______ (1,035)
------- -------
BALANCE,
DECEMBER 31, 1997 6,466,677 65 79,411 (536) (842) 78,098
Adjustment of
Initial public
offering expenses 11 11
Exercise of
Warrants 2,122 32 32
Costs associated
with registration
of warrants (40) (40)
Repurchase of
common stock (146,900) (1,345) (1,345)
Comprehensive income
(loss):
Net (loss) (4,934) (4,934) (4,934)
Other comprehensive
(loss)
Unrealized (loss) (1,557) (1,557) (1,557)
-------
Comprehensive
(loss) $(6,491)
Dividends declared _________ ___ _______ ======= (4,485) _______ (4,485)
------- -------
BALANCE,
DECEMBER 31,
1998 6,321,899 $65 $78,069 ($9,955) ($2,399) $65,780
========= === ======= ======= ======= =======
See notes to consolidated financial statements
F-5
66
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
PERIOD FROM
JUNE 10
YEAR ENDED (INCEPTION) TO
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(4,934) $ 499
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Amortization of net premium and deferred costs 6,594 361
Loan loss provision 356 18
Gain on sale of securities -- (35)
Net loss on sale of mortgage assets 5,705 --
Equity in loss of unconsolidated subsidiaries 1,433 254
(Increase) in accrued interest receivable (343) (3,597)
(Increase) in loans to related parties (3,411) (482)
(Increase) in other receivables (1,621) --
(Increase) in prepaid expenses and other assets (364) (241)
Increase in accrued interest payable 842 2,250
Increase (decrease) in due to related party (782) 540
Increase in accrued expenses and other liabilities 423 482
------- ------
Net cash provided by operating activities 3,898 49
------- ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage loans (863,324) (349,287)
Purchase of Agency mortgage securities (4,333) (163,030)
Purchase of private placement mortgage securities (21,523) --
Principal payments received on mortgage securities 150,543 --
Principal payments received on mortgage loans 123,098 1,995
Proceeds from sale of mortgage assets 276,582 --
Proceeds from sale of securities -- 35
Principal payments received on collateral for
mortgage backed bonds 23,165 --
-------- --------
Net cash (used in) investing activities (315,792) (510,287)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 243,218 435,138
Borrowings from mortgage backed bonds 100,675 --
Payments on mortgage backed bonds (23,370) --
Net proceeds of initial public offering 11 79,122
Exercise of stock warrants - net (8) --
Equity investment in HCP (2,700) --
Dividends received - unconsolidated subsidiary 8,054 --
Payment of dividends (4,826) --
Repurchase of common stock (1,345) --
------- -------
Net cash provided by financing activities 319,709 514,260
------- -------
NET INCREASE IN CASH AND CASH EQUIVALENTS 7,815 4,022
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 4,022 0
------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $11,837 $ 4,022
======= =======
See notes to consolidated financial statements
F-6
67
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 1998 AND PERIOD FROM JUNE 10 (INCEPTION)
TO DECEMBER 31, 1997
1. BUSINESS DESCRIPTION
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland
on June 10, 1997. Hanover acquired three bankruptcy remote limited purpose
finance subsidiaries in 1998 in order to complete two significant mortgage loan
securitizations in 1998. In March 1998, Hanover acquired 100% of the common
stock of Hanover Capital SPC, Inc. and in October 1998, it acquired 100% of the
common stock of Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B, Inc. Hanover is
a real estate investment trust ("REIT"), formed to operate as a specialty
finance company. The principal business strategy of Hanover and its wholly owned
subsidiaries, Hanover Capital SPC, Inc., Hanover QRS-1 98-B, Inc. and Hanover
QRS-2 98-B, Inc. (together referred to as the "Company") and its unconsolidated
subsidiaries 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 loans and (iv) acquire multifamily 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 an unconsolidated taxable subsidiary of the
Company.
Hanover Capital SPC, Inc. ("HCSPC"), a wholly-owned subsidiary of Hanover, was
incorporated in Delaware on March 24, 1998 for the sole purpose of issuing
mortgage notes through a private placement (REMIC) offering. HCSPC transferred
all of its retained securities to its wholly owned subsidiary, Hanover Capital
Repo Corp. Hanover Capital Repo Corp. was incorporated in Delaware on March 26,
1998.
Hanover QRS-1 98-B, Inc., a wholly-owned subsidiary of Hanover, was incorporated
in Delaware on October 16, 1998 for the sole purpose of owning certain
investment grade mortgage securities acquired from Hanover Capital Partners 2,
Inc. ("HCP-2"), an unconsolidated subsidiary of Hanover.
Hanover QRS-2 98-B, Inc., a wholly-owned subsidiary of the Company, was
incorporated in Delaware on October 19, 1998 for the sole purpose of owning
certain investment grade and subordinated mortgage securities acquired from
HCP-2.
CAPITALIZATION
In September 1997, Hanover raised net proceeds of approximately $79 million in
its initial public offering (the "IPO"). In the IPO, Hanover 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' over-allotment option, which was exercised in full. Each warrant
entitles the holder to purchase one share of common stock at the original
F-7
68
issue price - $15.00. The warrants became exercisable on March 19, 1998 and
expire on September 15, 2000. As of December 31, 1998 there were 5,917,878
warrants outstanding, including 172,500 warrants issued pursuant to the
underwriters' over-allotment option. Hanover utilized substantially all of the
net proceeds of the IPO to fund leveraged purchases of mortgage assets.
In connection with the closing of the IPO, Hanover 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 Hanover'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.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Hanover Capital
Mortgage Holdings, Inc. and its wholly-owned subsidiaries, Hanover Capital SPC,
Inc. and Subsidiary, Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B, Inc. All
significant intercompany accounts and transactions have been eliminated.
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.
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, 1998 management
had made the determination that $256,833,000 of mortgage loans were 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
F-8
69
order to maintain an appropriate level of liquidity. Management also determined
during 1998 that certain mortgage loans ($69,495,000 at December 31, 1998) would
be held to maturity. 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. Mortgage loans designated as held to
maturity are reported at cost.
Premiums, discounts and certain deferred costs associated with the purchase of
mortgage loans are amortized into interest income over the lives of the mortgage
loans using the effective yield method adjusted for the effects of estimated
prepayments. Mortgage loan transactions are recorded on the date the mortgage
loans are purchased or sold. Purchases of new mortgage loans are recorded on the
date the mortgage loans are purchased or sold. Purchases of new mortgage loans
are recorded when all significant uncertainties regarding the characteristics of
the mortgage loans are removed, generally on or shortly before settlement date.
Realized gains and losses on mortgage loan transactions are determined on the
specific identification basis.
The accrual of interest on impaired loans is discontinued when, in management's
opinion, the borrower may be unable to meet payments as they become due. When
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 borrower's 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.
MORTGAGE SECURITIES
The Company's policy is to classify its mortgage securities as available for
sale as they are acquired 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, 1998 management has made
the determination that $74,000,000 of mortgage securities are available for sale
in order to be prepared to respond to potential future opportunities in the
market, to sell mortgage 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 mortgage securities
on a quarterly basis. At December 31, 1998 mortgage securities classified as
held to maturity were $4,478,000. Mortgage securities classified as held to
maturity are carried at the fair value of the security at the time the
designation is made. Any fair value adjustment is reflected as a separate
component of stockholders' equity and as a cost basis adjustment of the mortgage
security as of the date of the classification and is amortized into interest
income as a yield adjustment. All mortgage securities designated as available
for sale are reported at fair
F-9
70
value, with unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity.
The Company makes periodic evaluations of all mortgage securities to determine
whether an other-than-temporary impairment is considered to have occurred. If a
decline in the fair value is judged to be other than temporary, the cost basis
of the mortgage security will be marked to fair value resulting in a current
period loss in the statement of operations. The new cost basis shall not be
changed for future increases in market value; however, future increases in
market value will be reflected separately in the equity section of the Company's
balance sheet.
Premiums, discounts and certain deferred costs associated with the acquisition
of mortgage securities are amortized into interest income over the lives of the
securities using the effective yield method adjusted for the effects of
estimated prepayments. Mortgage securities transactions are recorded on the date
the mortgage securities are acquired or sold. Purchases of new issue mortgage
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 mortgage securities transactions
are determined on the specific identification basis.
The Company has limited its exposure to credit losses on its portfolio of
purchased mortgage securities by only purchasing mortgage securities from third
parties 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"). Because the Company has access to HCP's due diligence operations,
the Company may in the future consider purchasing non investment grade mortgage
securities of other issuers after a thorough evaluation of the underlying
mortgage loan collateral. The Company monitors the delinquencies and losses on
the underlying mortgages of its mortgage securities and, if the credit
performance of the underlying loans is not as good as expected, makes a
provision for possible credit losses as well as unidentified potential future
losses in its mortgage securities portfolio. The provision is based on
management's assessment of numerous factors affecting its portfolio of mortgage
securities including, but not limited to, current and projected economic
conditions, delinquency status, credit losses to date on underlying mortgages
and remaining credit protection. The 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.
FINANCIAL INSTRUMENTS
The Company from time to time enters into interest rate hedge mechanisms
(forward sales of Agency mortgage securities) to manage its exposure to market
pricing changes in connection with the purchase, holding of, securitization and
sale of its fixed rate mortgage loan portfolio. The Company generally closes out
the hedge position to coincide with the related loan sale or securitization
transactions. Gains and losses on such hedge positions are either (i) deferred
as an adjustment to the carrying value of the related loans until the loan has
been funded and securitized, after which the gains or losses will be amortized
into income over the remaining life of the loan using a method that approximates
the effective yield method, or (ii) deferred until such time as the related
loans are sold.
The Company also enters into interest rate caps to manage its interest rate
exposure on certain reverse repurchase agreement financing. The cost of the
interest rate caps is amortized over the life of the interest rate cap and is
reflected as a portion of interest expense in the consolidated statement of
operations. Any payments received under the interest rate cap agreements would
be recorded as a reduction of interest expense on the reverse repurchase
agreement financing.
For derivative financial instruments designated as hedge instruments, the
Company periodically evaluates the effectiveness of these hedges against the
financial instrument being hedged under various interest rate scenarios. The
Company utilized hedge deferral accounting procedures in accounting for its
hedging program so long as there is adequate correlation between the hedged
result and the change in value of the hedged financial instrument. If the hedge
instrument performance does not result in adequate correlation between the
changes in value of the hedge instrument and the related hedged financial
instrument, the Company will terminate hedge deferral accounting and mark the
carrying value of the hedge instrument to market. If a hedge instrument is sold
or matures, or the criteria that was anticipated at the time the hedge
instrument was entered into no longer exists, the hedge instrument is no longer
accounted for as a hedge. Under these circumstances, the accumulated change in
the market value of the hedge is recognized in current period income or loss to
the extent that the effects of interest rate or price changes of the hedged item
have not offset the hedged results.
F-10
71
EQUITY INVESTMENT
Hanover's 97% economic ownership investment in Hanover Capital Partners Ltd.
("HCP") is accounted for by the equity method of accounting. Hanover generally
has no right to control the affairs of HCP because Hanover's investment in HCP
is based solely on a 100% ownership of HCP's non-voting preferred stock. Even
though Hanover has no right to control the affairs of HCP, management believes
that Hanover has the ability to exert significant influence over HCP and
therefore the investment in HCP is accounted for by the equity method of
accounting.
Hanover's 99% economic ownership investment in HCP-2 is also accounted for by
the equity method of accounting. Hanover generally has no right to control the
affairs of HCP-2, however management believes that Hanover has the ability to
exert significant influence over HCP-2 and therefore the investment in HCP-2 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.
INCOME TAXES
Hanover 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, Hanover 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
Basic earnings or loss per share excludes dilution and is computed by dividing
income or loss available to common stockholders by the weighted average number
of common shares outstanding during the period. Diluted earnings or loss per
share reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock
that then shared in earnings and losses. Shares issued during the period and
shares reacquired during the period are weighted for the period they were
outstanding.
RECENT ACCOUNTING PRONOUNCEMENTS
The FASB issued SFAS 133 Accounting for Derivative Instruments and Hedging
Activities ("SFAS 133") in June 1998. SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. SFAS 133 is effective for fiscal
quarters beginning after June 15, 1999. Management's preliminary evaluation of
SFAS 133 indicates the implementation of SFAS 133 will not result in any
material changes to the Company's consolidated statement of operations.
F-11
72
The FASB issued SFAS No. 134 Accounting For Mortgage-Backed Securities Retained
after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking
Enterprise ("SFAS 134") in October 1998. SFAS 134 amends FAS 65 Accounting for
Certain Mortgage Banking Activities, and FAS 115 Accounting for Certain
Investments in Debt and Equity Securities to require that after the
securitization of mortgage loans held for sale, an entity engaged in mortgage
banking activities classify the resulting mortgage-backed securities or other
retained interests based on its ability and intent to sell or hold those
investments. SFAS 134 is effective for fiscal quarters beginning after December
15, 1998. Management does not expect the adoption of SFAS 134 to have any
significant effect on the Company.
3. MORTGAGE LOANS
Investments in single-family mortgage loans consist of fixed rate mortgages and
adjustable rate mortgages. The following tables summarize the Company's
single-family mortgage loan pools as of December 31, 1998 and 1997 (dollars in
thousands):
Held for sale
- -------------
The following table summarizes the Company's single-family mortgage loan pools,
held for sale at December 31, 1998 and 1997 which are carried at the lower of
cost or market (dollars in thousands):
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -----------------
Mortgage Loans Cost Mix Cost Mix
---- --- ---- ---
Fixed rate $ 93,615 36.93% $106,397 67.01%
Adjustable rate 159,901 63.07% 52,392 32.99%
-------- ------- -------- -------
Subtotal 253,516 100.00% 158,789 100.00%
======= =======
Net premiums, discounts
and deferred costs 3,567 2,199
Loan loss provision (250) (18)
-------- --------
Carrying value $256,833 $160,970
======== ========
The following table summarizes certain characteristics of the Company's
single-family fixed rate and adjustable rate mortgage loans, held for sale
portfolio at December 31, 1998 and 1997 (dollars in thousands):
DECEMBER 31, 1998
-----------------------------------------------------------------------------
Carrying Value Principal Weighted Weighted
of Mortgage Amount of Average Net Average
Loans Mortgage Loans Coupon Maturity (1)
----- -------------- ------ ------------
Fixed rate $ 95,763 $ 93,615 8.545% 187
Adjustable rate 161,070 159,901 7.542% 264
-------- -------- ------ ---
$256,833 $253,516 7.912% 235
======== ======== ====== ===
F-12
73
The adjustable rate mortgage loans at December 31, 1998 had various reference
rate indexes with a weighted average 13 month repricing period and a weighted
average net life cap of 13.23%.
DECEMBER 31, 1997
------------------------------------------------------------------------------
Carrying Value Principal Weighted Weighted
of Mortgage Amount of Average Net Average
Loans Mortgage Loans Coupon Maturity (1)
----- -------------- ------ ------------
Fixed rate $107,953 $106,397 8.265% 242
Adjustable rate 53,017 52,392 7.925% 319
-------- -------- ------- ---
$160,970 $158,789 8.153% 267
======== ======== ======= ===
Virtually all of the adjustable rate mortgage loans had a 1 year CMT based
reference rate with a weighted average 12 month repricing period and a weighted
average net life cap of 12.56%.
(1) weighted average maturity reflects the number of months until maturity
Held to maturity
- ----------------
The following table summarizes the Company's single-family mortgage loans, held
to maturity at December 31, 1998 which are carried at cost (dollars in
thousands):
DECEMBER 31, 1998
-----------------
Mortgage Loans Cost Mix
---- ---
Fixed rate $67,515 99.79%
Adjustable rate 144 .21%
------- -------
Subtotal 67,659 100.00%
=======
Net premiums, and
deferred costs 1,878
Loan loss provision (42)
-------
Carrying value $69,495
=======
The following table summarizes certain characteristics of the Company's
single-family fixed rate and adjustable rate mortgage loans, held to maturity
portfolio at December 31, 1998 (dollars in thousands):
DECEMBER 31, 1998
-----------------
Carrying Value Principal Weighted Weighted
of Mortgage Amount of Average Net Average
Loans Mortgage Loans Coupon Maturity (1)
----- -------------- ------ ------------
Fixed rate $69,350 $67,515 8.707% 253
Adjustable rate 145 144 7.625% 302
------- ------- ------ ---
$69,495 $67,659 8.705% 253
======= ======= ====== ===
F-13
74
The adjustable rate mortgage loans had a 1 year CMT based reference rate with a
12 month repricing period and a net life cap of 10.25%.
(1) weighted average maturity reflects the number of months remaining until
maturity
The average effective yields, which include the amortization of net premium,
discounts and certain deferred costs for periods shown in 1998 and 1997 on the
combined held for sale and held to maturity mortgage loan portfolios were as
follows:
1998 1997
---- ----
Quarter Ended March 31 7.410% N/A
Quarter Ended June 30 7.371% N/A
Quarter Ended September 30 7.489% N/A
Quarter Ended December 31 7.392% 7.317%
------ ------
7.424% 7.317%
====== ======
Collateral for mortgage backed bonds
- ------------------------------------
In April 1998, the Company issued its first REMIC (real estate mortgage
investment conduit) security. $102,977,000 of single family fixed rate
residential loans (par value) were assigned as collateral for the Company's
mortgage backed bond (REMIC) securitization. The Company has limited exposure to
credit risk retained on loans it has securitized through the issuance of
collateralized bonds. All mortgage loans held as collateral for mortgage backed
bonds are reported at cost. Premiums, discounts and all deferred costs
associated with the mortgage loans held as collateral for mortgage backed bonds
are amortized into interest income over the lives of the mortgage loans using
the effective yield method adjusted for the effects of prepayments.
The following table summarizes the Company's single-family fixed rate mortgage
loan pools, classified as held to maturity (and held as collateral for mortgage
backed bonds), which are carried at cost at December 31, 1998 (dollars in
thousands):
DECEMBER 31, 1998
-----------------
Mortgage Loans Cost
----
Fixed rate $79,812
Net premiums and
deferred costs 1,934
Loan loss provision (80)
-------
Carrying value $81,666
=======
The following table summarizes certain characteristics of the Company's
single-family fixed rate mortgage loans held as collateral for mortgage backed
bonds at December 31, 1998 (dollars in thousands):
F-14
75
DECEMBER 31, 1998
-----------------
Carrying Value Principal Amount
of Collateral for of Collateral Weighted Weighted
Mortgage Backed for Mortgage Average Average
Bonds Backed Bonds Net Coupon Maturity (1)
----- ------------ ---------- ------------
$81,666 $79,812 7.787% 231
======= ======= ====== ===
(1) weighted average maturity reflects the number of months remaining until
maturity
The average effective yields, which include amortization of net premiums,
discounts and deferred costs for 1998 on the collateral for the mortgage backed
bond portfolio were as follows:
1998
----
Quarter Ended March 31 N/A
Quarter Ended June 30 7.158%
Quarter Ended September 30 7.071%
Quarter Ended December 31 6.230%
-----
6.832%
=====
4. MORTGAGE SECURITIES
Available for sale
At December 31, 1998 the Company had $74,000,000 of fixed rate mortgage
securities classified as available for sale. These mortgage securities are
secured by fixed rate mortgage loans on single-family residential housing. The
following table summarizes the Company's mortgage securities classified as
available for sale as of December 31, 1998 and 1997, which are carried at their
fair value (dollars in thousands):
DECEMBER 31, 1998
-----------------
Mix
---
Amortized cost:
FNMA certificates (a) $ 3,425 4.48%
FNMA certificates (b) 56,216 73.58%
Private placement notes (c) 16,758 21.94%
------- ------
Total amortized cost 76,399 100.00%
=======
Gross unrealized (loss) (2,399)
-------
Fair Value $74,000
=======
F-15
76
DECEMBER 31, 1997
-----------------
Mix
---
Amortized cost:
FNMA certificates (d) $207,898 59.58%
FHLMC certificates (e) 141,075 40.42%
-------- -------
Total amortized cost 348,973 100.00%
=======
Gross unrealized (loss) (842)
--------
Fair Value $348,131
========
(a) Represents one FNMA certificate with a fixed coupon interest rate of 9.0%
purchased from a "Wall Street" dealer firm. This certificate generates
normal principal and interest remittances to the Company on a monthly
basis.
(b) Represents 31 fixed rate FNMA certificates that the Company received
(swapped) for a like amount of fixed rate mortgage loans in December 1998.
The coupon interest rates range from 6.00% to 10.50%. These certificates
generate normal principal and interest remittances to the Company on a
monthly basis.
(c) Represents nine investment grade ("AA", "A" and "BBB") notes and six
interest only notes purchased from an affiliate, Hanover Capital Partners
2, Inc. ("HCP-2") in a private placement offering in October 1998.
Investment grade ratings were obtained from Standard and Poors and Fitch.
The interest rates on the investment grade notes are fixed and range from
6.25% to 6.75%. These notes generate normal principal and interest
remittances to the Company on a monthly basis. The interest only notes
generate monthly interest remittances to the Company (subject to the
availability of funds) from the excess interest generated from the
underlying mortgages after deducting all service fees and the coupon
interest rate on the applicable notes. The interest rate on each of the
interest only notes is based on a notional amount (the principal balance of
those mortgage loans with an interest rate in excess of the related note
coupon interest rate). The notional amounts decline each month to reflect
the related normal principal amortization, curtailments and prepayments for
the related underlying mortgage loans. At December 31, 1998 the interest
only notes were divided into two major categories; the first group had an
effective weighted average interest rate of 1.166% on a notional balance of
$259,861,000 and the second group had an effective weighted average
interest rate of 0.25% on a notional balance of $143,666,000.
(d) Represents eight adjustable rate FNMA certificates purchased from "Wall
Street" dealers in December 1997. At December 31, 1997 the coupon interest
rates ranged from 7.292% to 8.081%. These certificates generate normal
principal and interest remittances to the Company on a monthly basis. These
mortgage securities had a 1 year CMT based reference rate with a weighted
average 12 month repricing period and a weighted average net life cap of
11.25%.
(e) Represents seven adjustable rate FHLMC certificates purchased from "Wall
Street" dealers in December 1997. At December 31, 1997 the coupon interest
rates ranged from 7.538% to 8.041%. These certificates generate normal
principal and interest remittances to the Company on a monthly basis. These
mortgage securities had a 1 year CMT based reference rate with a weighted
average 12 month repricing period and a weighted average net life cap of
10.53%.
F-16
77
Held to maturity
- ----------------
At December 31, 1998 the Company had $4,478,000 of fixed rate mortgage
securities classified as held to maturity. These mortgage securities are secured
by fixed rate mortgage loans on single-family residential housing. The following
table summarizes the Company's fixed rate mortgage securities classified as held
to maturity as of December 31, 1998, carried at cost (dollars in thousands):
Amortized cost:
Private placement notes (a) $4,478
======
(a) Represents nine below investment grade notes purchased from an affiliate,
HCP-2, in October 1998. The coupon interest rates on the notes are fixed
and range from 6.25% to 6.75%. These notes generate normal principal and
interest remittances to the Company on a monthly basis.
The amortized cost at December 31, 1998 of the Company's available for sale and
held to maturity mortgage securities by contractual maturity dates are presented
below (dollars in thousands):
DECEMBER 31, 1998
Available for Sale Held to Maturity
------------------ ----------------
Amortized Cost Amortized Cost
-------------- --------------
Due in one year or less $ 1,314 $ 92
Due from one to five years 6,476 457
Due from five to ten years 12,048 836
Due after ten years 56,561 3,093
------- -----
Total $76,399 $4,478
======= ======
As mentioned above, actual maturities may differ from scheduled maturities
because borrowers usually 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.
The average effective yields which include amortization of net premiums and
deferred costs for periods shown in 1998 and 1997 on the combined available for
sale and held to maturity mortgage securities portfolios were as follows:
1998 1997
---- ----
Quarter Ended March 31 6.116% N/A
Quarter Ended June 30 3.992 N/A
Quarter Ended September 30 4.528 N/A
Quarter Ended December 31 7.520 6.268%
------ ------
5.170% 6.268%
====== ======
The proceeds, gross realized gains and losses from sales of available for sale
mortgage securities in October 1998 were as follows (dollars in thousands):
F-17
78
GROSS REALIZED
PROCEEDS GAIN (LOSS)
-------- --------------
Adjustable rate FNMA and FHLMC
certificates (a) $189,057 $(5,989)
Adjustable rate FNMA certificates (b) 17,172 (161)
Fixed rate FNMA certificates (c) 56,740 495
-------- -------
$262,969 $(5,655)
======== =======
(a) - relates to the sale of eight FNMA certificates and seven FHLMC
certificates purchased in December 1997
(b) - relates to the sale of five FNMA certificates acquired from a swap of
mortgage loans in August 1998
(c) - relates to the sale of nineteen FNMA certificates acquired from a swap
of mortgage loans in October 1998
5. CONCENTRATION OF CREDIT RISK
Mortgage Loans
- --------------
The Company's exposure to credit risk associated with its investment activities
is measured on an individual customer basis as well as by groups of customers
that share similar attributes. In the normal course of its business, the Company
has concentrations of credit risk in its mortgage portfolio for the loans in
certain geographic areas. At December 31, 1998 and 1997, the percent of total
principal amount of loans outstanding in any one state, exceeding 5% of the
principal amount of mortgage loans are as follows:
AT DECEMBER 31, 1998 AT DECEMBER 31, 1997
-------------------- --------------------
Mortgage Loans Mortgage Loans
--------------
Held for Sale Held to Maturity Held for Sale
------------- ---------------- -------------
California 13% 17% 10%
Texas 7 13 6
Florida 10 8 25
Missouri -- 6 --
Illinois 5 -- --
South Carolina -- -- 13
Ohio -- -- 9
-- -- --
35% 44% 63%
== == ==
AT DECEMBER 31, 1998
--------------------
Collateral for Mortgage
Backed Bonds
------------
Florida 26%
Ohio 12
California 11
Hawaii 6
--
55%
==
During 1998 the Company purchased approximately 75.2% of its total principal
amount of mortgage loans from six financial institutions, the largest of which
represented approximately 21.7% of the total principal amount of mortgage loans
purchased in 1998. During the period from September 30, 1997 to December 31,
1997 the Company purchased approximately 61.9%
F-18
79
of its total 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 purchased in 1997. Management
believes that the loss of any single financial institution from which the
Company purchased mortgage loans would not have any material detrimental effect
on the Company.
Mortgage Securities
- -------------------
The Company's exposure to credit risk associated with its investment activities
is measured on an individual customer basis as well as by groups of customers
that share similar attributes. In certain instances, the Company has
concentrations of credit risk in its mortgage securities portfolio for the
mortgage loans collateralizing the mortgage securities in certain geographic
areas. Management believes exposure to credit risk associated with purchased
Agency mortgage securities is minimal due to the guarantees provided by FNMA. At
December 31, 1998 the percent of total principal amount of mortgage loans
collateralizing mortgage securities in any one state, exceeding 5% of the
principal amount of mortgage securities are shown below:
DECEMBER 31, 1998
-----------------
Mortgage Securities Mortgage Securities
Received in Swap Purchased from
for Mortgage Loans an Affiliate
------------------ ------------
Illinois -- 25%
Florida 23% 11
Michigan 13 --
California -- 12
South Carolina 12 --
North Carolina 10 --
Ohio 8 6
Arizona -- 7
Kentucky -- 6
Texas 6 --
Oklahoma 5 --
-- --
77% 67%
== ==
The Company has cash and cash equivalents in a major financial institution which
is insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000.
At December 31, 1998, the Company had amounts on deposit with the financial
institution in excess of FDIC limits. At December 31, 1998 the Company had
overnight investments of $11,209,000 in Federal Home loan discount notes. The
Company limits its risk by placing its cash and cash equivalents in a high
quality financial institution, Federal Agency notes or in the highest rated
commercial paper.
6. LOAN LOSS PROVISION
The provision for loan loss charged to expense is based upon actual credit loss
experience and management's estimate and evaluation of potential losses in the
existing mortgage loan and mortgage securities portfolio, including the
evaluation of impaired loans. The following table summarizes the activity in the
loan loss provision for the following periods (dollars in thousands):
F-19
80
YEAR ENDED PERIOD FROM JUNE 10
DECEMBER 31, (INCEPTION) TO
1998 DECEMBER 31, 1997
---- -----------------
Balance beginning of period $ 18 $ - 0 -
Loan loss provision 356 18
Transfers/sales (2) --
Charge-offs -- --
Recoveries -- --
-- --
$372 $ 18
==== ===
7. EQUITY INVESTMENTS
Hanover recorded its investment in HCP on the equity method. Accordingly,
Hanover records 97% of the earnings or losses of HCP through its ownership of
all of the non-voting preferred stock of HCP. HCP and its subsidiaries operate
as a specialty finance company which is principally engaged in performing due
diligence, consulting and mortgage investment banking services. A wholly-owned
subsidiary of HCP, Hanover Capital Mortgage Corporation, is an originator and
servicer of multifamily mortgage loans. Another wholly-owned subsidiary of HCP,
Hanover Capital Securities, Inc. is a registered broker/dealer with the
Securities and Exchange Commission.
In October 1998, the Company completed its second private placement REMIC
securitization transaction through its newly organized unconsolidated
subsidiary, HCP-2. Hanover contributed $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310 million of reverse
repurchase agreement financing to HCP-2 in exchange for a 99% economic ownership
of HCP-2 (representing a 100% ownership of the non-voting preferred stock in
HCP-2). HCP-2 issued a REMIC mortgage security and sold all of the REMIC
mortgage securities except the AAA notes to two newly created wholly-owned
subsidiaries of Hanover (Hanover QRS-1 98-B, Inc. and Hanover QRS-2 98-B, Inc.).
Hanover recorded its investment in HCP-2 on the equity method. Accordingly,
Hanover records 99% of the earnings or losses of HCP-2 through its ownership of
all the non-voting preferred stock of HCP-2.
HCP-2 was organized to acquire single-family residential mortgage loans from
Hanover pursuant to its formation transaction and to finance the purchase of
these mortgage loans through a REMIC securitization. The table below reflects
the activity recorded in Hanover's equity investments for the following periods
(dollars in thousands):
F-20
81
PERIOD FROM
YEAR ENDED JUNE 10 (INCEPTION)
DECEMBER 31, TO DECEMBER 31,
1998 1997
--------------------- -------------------
HCP HCP-2 Total HCP HCP-2 Total
--- ----- ----- --- ----- -----
Beginning balance $ 100 -- $ 100
Applicable % of net (loss) (1,039) $ (394) (1,433) $(254) -- $(254)
Additional capital
contribution 2,700 2,700 -- -- --
Formation transaction 14,176 14,176 354 -- 354
Dividends received (a) (8,054) (8,054) -- -- --
------ ------ ------ ----- --- -----
Ending balance $1,761 $5,728 $7,489 $ 100 $-- $ 100
====== ====== ====== ===== === =====
(a) represents a return of capital
8. NOTES RECEIVABLE FROM RELATED PARTIES
In connection with the Hanover's original formation transactions in September
1997, Hanover 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 personal income taxes on the gains they must recognize
upon contributing their HCP preferred stock to Hanover for shares of Hanover's
common stock. The loans are secured solely by 116,667 shares of Hanover'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, 1998 Hanover had loaned the Principals the full $1,750,000. The
loans bear interest at 6.02% (on $482,600 of loans) and 5.70% (on $1,267,400 of
loans).
In March 1998, Hanover agreed to lend up to an additional $1,500,000 in
unsecured loans to the Principals, in lieu of incurring the costs and expenses
Hanover was required to pay associated with the registration of 100,000 shares
of Hanover's common stock owned by the Principals. Pursuant to such agreement,
Hanover loaned the Principals an additional $1,203,880 in April 1998. The
additional loans are due and payable on March 31, 1999 and bear interest at
5.51%.
In November 1998, Hanover agreed to lend an additional $226,693 in unsecured
loans to the Principals. These loans are due and payable in November 2002 and
bear interest at 4.47% (the lowest applicable Federal tax rate in November
1998). A portion of these loans ($44,223) was repaid in February 1999.
During 1998 Hanover advanced funds to HCP pursuant to an unsecured loan
agreement. The loans to HCP bear interest at 1.00% below the prime rate. At
December 31, 1998 the loans outstanding to HCP totaled $712,824.
9. REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts. At December 31, 1998 the
Company had a total of $520
F-21
82
million of committed and uncommitted mortgage asset reverse repurchase agreement
financing available pursuant to master reverse repurchase agreements with four
lenders. All borrowings pursuant to the master repurchase agreements are secured
by mortgage loans or other securities.
The reverse repurchase agreements collateralized by mortgage loans are short
term borrowings with interest rates that vary from LIBOR plus 60 basis points to
LIBOR plus 100 basis points. The lender will typically finance an amount equal
to 80% to 97% of the market value of the pledged collateral (mortgage loans)
depending on certain characteristics of the collateral (delinquencies,
liens, aging, etc.). The reverse repurchase agreement financing rates for
mortgage securities, accomplished through individual Public Securities
Associates (PSA) agreements, bear interest rates that vary from LIBOR to LIBOR
plus 50 basis points. The lender will typically finance an amount equal to 60%
to 97% of the market value of the mortgage securities, depending on the nature
of the collateral.
At December 31, 1998 the Company had outstanding borrowings on mortgage loans of
$306,239,000 under the above mentioned reverse repurchase agreements with a
weighted average borrowing rate of 6.802% and a weighted average remaining
maturity of less than one month. The reverse repurchase financing agreements at
December 31, 1998 were collateralized by mortgage loans with a cost basis of
$320,759,000.
The Company also uses the above repurchase agreement financing to finance a
portion of the collateral for mortgage backed bonds. At December 31, 1998, the
Company had outstanding borrowings of $1,911,000 with a weighted average
borrowing rate of 6.318% and a weighted average remaining maturity of less than
three months. The reverse repurchase financing agreements at December 31, 1998
were collateralized by mortgage assets with a cost basis of $2,542,000.
At December 31, 1998, the Company had outstanding mortgage securities reverse
repurchase agreement financing of $61,940,000 with a weighted average borrowing
rate of 5.336% and a remaining maturity of less than one month. The repurchase
agreement financing at December 31, 1998 was collateralized by mortgage
securities with a cost basis of $64,938,000.
The table below details the scheduled maturities of the Company's committed and
uncommitted master reverse repurchase agreements at December 31, 1998:
Committed Uncommitted Maturity Date
--------- ----------- -------------
-- $70 million (a)
$100 million -- February 1999
100 million 100 million March 1999
150 million -- June 1999
(a) the lender did not extend the term of the master reverse repurchase
agreement at the maturity date (September 1998) but has agreed to continue
to provide uncommitted financing to the Company for an unspecified
short-term period.
Information pertaining to reverse repurchase agreements for 1998 and 1997 is
summarized as follows (dollars in thousands):
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83
1998
----------------------------------------------------------
Collateral
Mortgage for Mortgage Mortgage
Reverse Repurchase Agreements Loans (a) Backed Bonds Securities
----------------------------- --------- ------------ ----------
Balance at year-end $306,239 $1,911 $ 61,940
Average balance during the period $367,656 $ 760 $224,050
Average interest rate during the period 6.511% 6.853% 5.695%
Maximum month-end balance during the
period $659,319 $2,331 $249,450
Collateral Underlying the Agreements
------------------------------------
Balance at year-end - carrying value $320,759 $2,542 $ 64,938
1997
-----------------------------------
Mortgage ARM
Reverse Repurchase Agreements Loans (a) Securities
----------------------------- --------- ----------
Balance at period-end $ 93,731 $341,407
Average balance during the period (b) $ 93,674 $341,407
Average interest rate during period (b) 6.313% 5.723%
Maximum month-end balance during the
period $ 93,731 $341,407
Collateral Underlying the Agreements
------------------------------------
Balance at period-end - carrying balance $160,970 $348,131
(a) collateral includes mortgages held for sale and mortgages held to maturity.
(b) reflects the period beginning September 30, 1997 (the date of the first
mortgage asset purchase) through December 31, 1997.
Additional information pertaining to individual reverse repurchase agreement
lenders at December 31, 1998 is summarized as follows (dollars in thousands):
Weighted
Reverse Average
Repurchase Accrued Total Underlying Maturity
Lender Type of Collateral Financing Interest Financing Collateral Date
- ----- ------------------ ---------- -------- --------- ---------- ----
Morgan Stanley Mortgage Capital Mortgage loans $118,195 $ 466 $118,641 $130,520 Feb 4, 1999
Lender A Mortgage loans 91,190 0 91,190 93,696 Feb 9, 1999
Lender B Mortgage loans 70,135 49 70,184 67,902 Feb 15, 1999
Lender C Mortgage loans 26,719 358 27,077 28,641 Feb 7, 1999
Lender C Mortgage loans 1,911 449 2,360 2,542 Mar 2, 1999
Morgan Stanley Mortgage Capital Mortgage securities $ 58,707 $ 88 58,795 61,559 Jan 25, 1999
Lender D Mortgage securities 3,233 4 3,237 3,379 Jan 22, 1999
-------- ------- -------- --------
$370,090 $ 1,394 $371,484 $388,239
======== ======= ======== ========
10. MORTGAGE BACKED BONDS
The Company, through a wholly owned subsidiary, Hanover Capital SPC, Inc. has
issued non-recourse debt in the form of mortgage backed bonds. Borrower
remittances received on the collateral for mortgage backed bonds are used to
make payments on the mortgage backed bonds. The obligations under the mortgage
backed bonds are payable solely from the collateral for mortgage backed bonds
and are otherwise non-recourse to the Company. The maturity of the bonds is
directly affected by the rate of principal prepayments on the related
collateral. The bonds are subject to redemption according to specific terms of
the respective indentures, generally when the remaining balance of the bonds
equals 20% or less of the original principal balance of the bonds. As a result,
the actual maturity of any class of mortgage backed bonds is likely to occur
earlier than its stated maturity.
Information pertaining to mortgage backed bonds financing for 1998 is summarized
as follows (dollars in thousands):
F-23
84
Mortgage
Backed Bonds
------------
Balance at year-end $77,305
Average balance during the period $63,764
Average interest rate during period 6.914%
Interest rate at year-end 6.940%
Maximum month-end balance during the
period $98,391
Collateral for Mortgage Backed Bonds
-------------------------------------
Balance at year end - carrying value $81,666
Aggregate annual repayments of mortgage backed bonds based upon contractual
amortization of the underlying mortgage loan collateral at December 31, 1998
were as follows (dollars in thousands):
YEAR AMOUNT
---- ------
1999 $ 1,729
2000 1,875
2001 2,035
2002 2,207
2003 2,394
Thereafter 67,065
-------
Total $77,305
=======
11. COMMON STOCK REPURCHASES
In July 1998, the Board of Directors of the Company authorized a share
repurchase program pursuant to which the Company was authorized to repurchase up
to 646,880 shares of the Company's outstanding common stock. The repurchases
will be made from time to time in open market transactions. During the period
from August through October 1998, the Company repurchased a total of 146,900
shares of its common stock at an average price of $9.16 per share for a total
cost of $1,345,000.
12. 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 ($10,000 in 1998 and
$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.
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
F-24
85
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").
The 1997 Stock Option Plan authorizes the grant of options to purchase an
aggregate of up to 325,333 shares of the Company's 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
the 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 ISO's 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"). No vesting occurred on the first
Earn-Out Measuring Date (September 30, 1998) as the Company did not meet or
exceed the vesting requirements. 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.
A summary of the status of the Company's 1997 Stock Option Plan as of December
31, 1998 and changes during the period from September 19, 1997 to December 31,
1997 and for the year ended December 31, 1998, is presented below:
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86
# of Weighted
Options for Average
Stock Option Activity - 1997 Shares Exercise Price 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
------- ======
Stock Option Activity - 1998
- ----------------------------
Granted - January 14, 1998 2,000 $15.94
Granted - March 9, 1998 2,000 18.13
Cancelled (1,750) 15.75
-------
Outstanding at December 31, 1998 322,574 $15.39
======= ======
No shares were exercisable at December 31, 1998 and 1997.
The per share weighted average fair value of stock options granted during the
period ended December 31, 1998 and 1997 was $0.95 and $0.27, respectively at the
date of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
1998 1997
---- ----
Expected life (years) 9 5
Risk-free interest rate 5.10% 5.77%
Volatility 60.0% 12.0%
Expected dividend yield 10.0% 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 for 1998 and 1997. 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 for the period indicated below (dollars in
thousands, except per share data):
F-26
87
YEAR PERIOD FROM JUNE 10
ENDED (INCEPTION) TO
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -----------------
Net earnings (loss):
As reported $(4,934) $ 499
Pro forma $(4,938) 417
Earnings (loss) per share - basic:
As reported $ (0.77) $0.15
Pro forma $ (0.77) 0.13
Earnings (loss) per share - diluted :
As reported $ (0.77) $0.14
Pro forma $ (0.77) 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 and (subject to ownership limits) one-half in
shares of common stock in the following year. The Company must generate annual
net income before bonus accruals that allows for a return of equity to
stockholders in excess of the average weekly ten-year U.S. Treasury rate plus
4.0% before any bonus accrual is recorded. No such accrual was recorded in 1998
and 1997.
13. AFFILIATED PARTY TRANSACTIONS
The Company engaged HCP pursuant to a Management Agreement to render among other
things, due diligence, asset management and administrative services. The 1998
consolidated statement of operations of the Company includes management and
administrative expenses of $733,000, due diligence expenses of $687,000 and
commission expenses of $286,000 relating to billings from HCP. The 1998
consolidated statement of operations also reflects a reduction in personnel
expenses for a portion of salaries allocated (and billed) to HCP. During 1998
the Company recorded $129,300 of interest income generated from loans to the
Principals and $126,200 of interest income from loans to HCP. 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, 1998 the consolidated balance
sheet of the Company included an amount due from HCP-2 of $304,800 and an amount
due from HCP of $8,200. The term of the Management Agreement continues until
December 31, 1999 with subsequent renewal provisions.
14. EARNINGS PER SHARE
In 1997 the Company adopted SFAS 128 for calculating earnings per share for the
periods shown below: (dollars in thousands, except per share data)
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88
PERIOD FROM JUNE 10
YEAR ENDED (INCEPTION) TO
DECEMBER 31, DECEMBER 31,
1998 1997
---- ----
Earnings (loss) per share - basic:
Net income (loss) (numerator) $ (4,934) $ 499
========= =========
Average common shares
outstanding (denominator) 6,418,305 3,296,742
========= =========
Per share $ (0.77) $ 0.15
========= =========
Earnings (loss) per share-diluted:
Net income (loss) (numerator) $ (4,934) $ 499
========= =========
Average common shares outstanding 6,418,305 3,296,742
Add: Incremental shares from
assumed conversion of
warrants -- 374,943
--------- ---------
Dilutive potential common shares -- 374,943
--------- ---------
Adjusted weighted average shares
(denominator) 6,418,305 3,671,685
========= =========
Per share $ (0.77) $ 0.14
========= =========
15. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands except share data):
PERIOD FROM JUNE 10
YEAR ENDED (INCEPTION) TO
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -----------------
Supplemental Cash Flow Information:
- -----------------------------------
Cash paid during the period for:
Income taxes $ 1 --
======= ====
Interest $39,876 $844
======= ====
Supplemental Schedule of Noncash Activities
- -------------------------------------------
Dividends of $695 and $1,035 were declared in December 1998 and December 1997
but not paid until January 1999 and January 1998, respectively.
Acquisition of a 99% economic ownership in Hanover Capital Partners 2, Inc. in
October 1998 from the contribution of $324,210 (book value) of mortgage loans
net of $309,963 of reverse repurchase agreement financing less funds to be
returned to Hanover of $71.
Acquisition of a 97% economic ownership in Hanover Capital Partners Ltd. in
September 1997 from the issuance of 716,667 shares of Hanover's common stock.
F-28
89
16. COMMITMENTS AND CONTINGENCIES
Hanover entered into employment agreements with the Principals in 1997. Such
agreements are for five year terms which expire in 2002, and provide for initial
aggregate annual base salaries of $975,000 (subject to cost of living
increases). A portion of the aggregate base salaries ($360,000) is allocated to
one of Hanover's taxable subsidiaries, HCP, based on management's actual and
estimated time involved with the subsidiary's activities.
As additional consideration to the Principals for their contribution of their
HCP preferred stock to Hanover, Hanover has agreed to (1) issue to the
Principals up to 216,667 additional shares of Hanover'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 Hanover's IPO Prospectus dated September 15, 1997.
Hanover has guaranteed a bank line-of-credit for HCP. The maximum line-of-credit
obligation and the actual line-of-credit obligation at December 31, 1998 were
$1,400,000 and $-0-, respectively.
Hanover has guaranteed the obligations of HCP with respect to an amendment to an
office lease entered into by HCP. The office lease (anticipated to be effective
on or about May 1, 1999) is for a period of 10 years and 3 months and obligates
HCP for $2,162,300 of base rental expense plus escalation, electric and other
billings over the lease term.
Pursuant to a short-term (3 month) reverse repurchase financing agreement
entered into in November 1998, Hanover has agreed to issue and deliver to the
lender warrants to purchase approximately 300,000 shares of Hanover's common
stock. The warrants will be exercisable at a price per share equal to the
closing price of Hanover's common stock on the American Stock Exchange on the
date of the November agreement, which was $4.00. In addition, Hanover agreed to
(1) retain and compensate the lender as an underwriter on certain future
mortgage loan securitization deals, (2) have HCMC offer the lender the right to
purchase any originated commercial loans through November 2000 on the same terms
and conditions as it would offer such to a third party and (3) offer the lender
the opportunity to act as master servicer on any mortgage loan securitization
effected by the Company through November 2000 on the same terms and conditions
as it would offer such to a third party. The lender in turn will offer HCP the
opportunity to undertake due diligence services for portfolio transactions or
for securitization transactions in which the lender is not undertaking or is
otherwise contracting with third parties for such due diligence services on the
same terms and conditions as it would offer such to a third party through
November 2000.
In October 1998, the Company sold 15 adjustable rate FNMA certificates and 19
fixed rate FNMA certificates that the Company received in a swap for certain
adjustable rate and fixed rate mortgage loans. These securities were sold with
recourse. Accordingly, the Company retains credit risk with respect to the
principal amount of these mortgage securities.
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90
17. 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, 1998 and 1997 are as follows (dollars in thousands):
DECEMBER 31, 1998
-----------------
Carrying Fair
Amount Value
------ -----
Assets:
Mortgage loans $407,994 $407,694
Mortgage securities 78,478 78,473
Cash and cash equivalents 11,837 11,837
Accrued interest receivable 3,940 3,940
Notes receivable 3,893 3,893
-------- --------
Total $506,142 $505,837
======== ========
Liabilities:
Reverse repurchase agreements $370,090 $370,090
Mortgage backed bonds 77,305 77,831
Accrued interest payable 1,394 1,394
Other liabilities 1,601 1,601
-------- --------
Total $450,390 $450,916
======== ========
Carring Notional Fair
Value Amount Value
-------- -------- -----
Off-Balance Sheet:
Forward commitments to sell
mortgage securities $ -- $ 51,457 $ 51,409
======== ======== ========
Interest rate caps $ 394 $ 69,939 $ 200
======== ======== ========
F-30
91
DECEMBER 31, 1997
-----------------
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
======== ========
Notional Fair
Off-Balance Sheet: Amount Value
-------- -----
Commitments to purchase loans $111,092 $111,132
======== ========
Forward commitments to sell
securities $122,650 $122,378
======== ========
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Mortgage loans held for sale - The fair values of these financial instruments
are based upon actual prices received upon recent sales of loans and securities
to investors and projected prices which could be obtained through investors
considering interest rates, loan type, and credit quality.
Mortgage loans held to maturity - The fair values of these financial instruments
are based upon actual prices received upon recent sales of loans and securities
to investors and projected prices which could be obtained through investors
considering interest rates, loan type, and credit quality.
Collateral for mortgage backed bonds - The fair values of these financial
instruments are based upon actual prices received upon recent sales of loans and
securities to investors and projected prices which could be obtained through
investors considering interest rates, loan type, and credit quality.
Mortgage securities available for sale - The fair values of these financial
instruments are based upon either or all of the following: actual prices
received upon recent sales of securities to investors, projected prices which
could be obtained through investors, estimates considering interest rates, loan
type, quality and discounted cash flow analysis based on prepayment and interest
rate assumptions used in the market place for similar securities with similar
credit ratings.
F-31
92
Mortgage securities held to maturity - The fair values of these financial
instruments are based upon either or all of the following: actual prices
received upon recent sales of securities to investors, projected prices which
could be obtained through investor estimates considering interest rates, loan
type, quality and discounted cash flow analysis based on prepayment and interest
rate assumptions used in the market place for similar securities with similar
credit ratings.
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.
Mortgage backed bonds - The fair values of these financial instruments are based
upon either or all of the following: actual prices received upon recent sales of
securities to investors, projected prices which could be obtained through
investor estimates considering interest rates, loan type, quality and discounted
cash flow analysis based on prepayment and interest rate assumptions used in the
market place for similar securities with similar credit ratings.
Commitments to purchase mortgages - The Company had outstanding commitments to
purchase 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 loans held for sale.
Forward commitments to sell securities - The Company has outstanding forward
commitments to sell mortgage securities into mandatory delivery contracts with
investment bankers, private investors and agency-backed securities. The fair
value of these financial instruments was determined through review of published
market information associated with similar instruments. These commitment
obligations are considered in conjunction with the Company's lower of cost or
market valuation of its loans held for sale.
Interest rate caps - The fair values of these financial instruments are
estimated based on dealer quotes and is the estimated amount the Company would
pay to execute a new agreement with similar terms.
18. SUBSEQUENT EVENT
On January 25, 1999 an $0.11 cash dividend previously declared by the Board of
Directors was paid to stockholders of record as of December 31, 1998.
In February and March 1999, Hanover purchased an additional 195,000 shares of
its common stock at a cost of $983,000 pursuant to the stock repurchase program
initiated in July 1998.
In March 1999, Hanover agreed to amend the notes receivable from Principals
($1,203,880) that had a scheduled maturity date of March 31, 1999, by extending
the maturity date for two additional years at the lowest applicable Federal
rate. The notes were also modified to provide for accelerated repayment by a
Principal in the event of such Principal's voluntary termination of employment.
In March 1999, the Company completed a $132,254,000 private placement
securitization of fixed rate and adjustable rate single-family residential
mortgage loans.
F-32
93
19. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data are as follows (dollars in thousands, except
per share data):
Three Months Three Months Three Months Three Months
Ended Ended Ended Ended
December 31, 1998 September 30, 1998 June 30, 1998 March 31, 1998
------------------------------------------------------------------------------------------
Net interest income $ 1,998 $1,692 $ 774 $2,154
==========================================================================================
Net income (loss) $(5,884) $ 346 $ (644) $1,248
==========================================================================================
Basic earnings (loss)
per share (2) $ (0.93) $ 0.05 $(0.10) $ 0.19
==========================================================================================
Diluted earnings (loss)
per share (2) $ (0.93) $ 0.05 $(0.10) $ 0.17
==========================================================================================
Dividends declared $ 0.11 $ 0.17 $ 0.21 $ 0.21
==========================================================================================
(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-33
94
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, 1998 and
1997, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. 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 consolidated financial position of Hanover Capital
Partners Ltd. and Subsidiaries at December 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998 in conformity with generally
accepted accounting principles.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 19, 1999
F-34
95
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
- --------------------------------------------------------------------------------
ASSETS 1998 1997
---- ----
CURRENT ASSETS:
Cash $ 635,484 $ 208,315
Investment in marketable securities 17,992 17,394
Accounts receivable 517,245 133,829
Receivables from related parties 213,779 757,384
Accrued revenue on contracts in progress 247,100 35,413
Prepaid expenses and other current assets 192,580 118,552
---------- ----------
Total current assets 1,824,180 1,270,887
PROPERTY AND EQUIPMENT -- Net 141,459 213,137
MORTGAGE SERVICING RIGHTS -- 49,449
DEFERRED TAX ASSET 801,351 20,081
OTHER ASSETS 128,572 166,670
INCOME TAX RECEIVABLE 219,563 292,885
DUE FROM OFFICER -- 53,766
---------- ----------
TOTAL ASSETS $3,115,125 $2,066,875
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accrued appraisal and subcontractor costs $ 20,730 $ 131,978
Accounts payable and accrued expenses 466,697 334,591
Deferred revenue 89,625 104,950
Note payable to related party 712,824 --
---------- ----------
Total current liabilities 1,289,876 571,519
---------- ----------
LONG-TERM LIABILITIES
Note payable to bank -- 1,405,000
Minority interest -- 616
---------- ----------
Total long-term liabilities -- 1,405,616
---------- ----------
Total liabilities 1,289,876 1,977,135
---------- ----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock; $.01 par value, 100,000 shares
authorized, 97,000 shares outstanding at
December 31, 1998 and 1997 970 970
Common Stock:
Class A: $.01 par value, 5,000 shares authorized,
3,000 shares outstanding at December 31, 1998
and 1997 30 30
Additional paid-in capital 2,839,947 56,442
Retained earnings (deficit) (1,015,698) 32,298
---------- ----------
Total stockholders' equity 1,825,249 89,740
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $3,115,125 $2,066,875
========== ==========
See note to consolidated financial statements.
F-35
96
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------
1998 1997 1996
----------- ---------- -----------
REVENUES:
Due diligence fees $ 5,001,047 $4,058,609 $ 8,323,789
Mortgage sales and servicing 701,574 826,486 970,757
Loan brokering/asset management fees 654,748 3,027,319 2,469,378
Other income (loss) (12,609) 58,151 355,715
----------- ---------- -----------
Total revenues 6,344,760 7,970,565 12,119,639
----------- ---------- -----------
EXPENSES:
Personnel expense 4,364,725 5,373,331 4,227,226
Subcontractor expense 1,537,294 1,386,979 2,919,509
Occupancy expense 578,512 495,285 536,520
Travel and subsistence 555,382 302,936 616,795
General and administrative expense 532,006 419,543 525,143
Appraisal, inspection and other professional fees 223,262 618,059 3,128,225
Interest expense 155,128 117,894 134,393
Depreciation and amortization 107,971 117,675 125,928
Reversal of reserve for IRS assessment -- (23,160) (277,600)
----------- ---------- -----------
Total expenses 8,054,280 8,808,542 11,936,139
----------- ---------- -----------
INCOME (LOSS) BEFORE INCOME TAX PROVISION
(BENEFIT) (1,709,520) (837,977) 183,500
INCOME TAX PROVISION (BENEFIT) (661,524) (325,959) 73,870
----------- ---------- -----------
NET INCOME (LOSS) $(1,047,996) $ (512,018) $ 109,630
=========== ========== ===========
BASIC EARNINGS (LOSS) PER SHARE $ (349.33) $ (525.79) $ 658.74
=========== ========== ===========
See notes to consolidated financial statements.
F-36
97
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------
COMMON STOCK COMMON STOCK COMMON STOCK ADDITIONAL RETAINED
PREFERRED STOCK NEW CLASS A OLD CLASS A CLASS B PAID-IN EARNINGS
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) 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 (166.424) (2) (998) -- --
------ ---- ----- --- -------- --- ---------- ----------- -----------
BALANCE, DECEMBER 31, 1997 97,000 970 3,000 30 56,442 32,298 89,740
Capital contributions 2,783,505 -- 2,783,505
Net (loss) (1,047,996) (1,047,996)
------ ---- ----- --- ---------- ----------- -----------
BALANCE DECEMBER 31, 1998 97,000 $970 3,000 $30 $2,839,947 $(1,015,698) $ 1,825,249
====== ==== ===== === ========== =========== ===========
See notes to consolidated financial statements
F-37
98
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------
1998 1997 1996
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(1,047,996) $ (512,018) $ 109,630
Adjustments to reconcile net income (loss) to
net cash (used in) operating activities:
Depreciation and amortization 107,971 117,675 125,928
Gain on sale of mortgage servicing rights (371,977) (16,916) (52,318)
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 --
Loss on disposal of securities 100,750 -- --
Loss on sale of trading securities -- -- 1,360
Purchase of trading securities (598) (951) (1,931)
Sale of trading securities -- -- 26,593
Distribution of subsidiary to stockholders -- -- 6,972
Changes in assets - (increase) decrease:
Accounts receivable (383,416) 3,550,036 (2,150,117)
Receivables from related parties 597,371 (315,097) (308,808)
Accrued revenue on contracts in progress (211,687) 514,368 (384,880)
Income tax receivable 73,322 (292,885) --
Prepaid expenses and other current assets (74,028) 24,474 (49,871)
Deferred tax asset (781,270) (20,081) --
Other assets 37,348 (12,254) (22,914)
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs (111,248) (2,675,194) 2,741,014
Accounts payable and accrued expenses 132,106 (343,799) 104,018
Income taxes payable -- (89,477) (90,490)
Deferred income taxes -- (12,993) (17,222)
Deferred revenue (15,325) (89,384) (14,946)
Minority interest (616) 366 (26,935)
----------- ----------- -----------
Net cash (used in) operating activities (1,949,293) (260,834) (282,517)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (33,841) (43,060) (133,317)
Sale of property and equipment -- -- 4,592
Proceeds from sale of mortgage servicing rights 418,974 34,446 94,043
Purchase of securities (100,000) -- --
Capitalization of mortgage servicing rights -- (43,783) (37,451)
----------- ----------- -----------
Net cash provided by (used in ) investing activities 285,133 (52,397) (72,133)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (repayment of) note payable to bank (1,405,000) 360,000 (330,000)
Net proceeds from note payable to related party 712,824 -- --
Redemption of Class A common stock -- -- (66,000)
Capital contributions 2,783,505 -- --
----------- ----------- -----------
Net cash provided by (used in) financing activities 2,091,329 360,000 (396,000)
----------- ----------- -----------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 427,169 46,769 (750,650)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 208,315 161,546 912,196
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 635,484 $ 208,315 $ 161,546
=========== =========== ===========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $13,930,000, $25,649,378 and $35,831,617 were originated by
HCMC and funded by investors in 1998, 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 $ 5,671 $ 129,359 $ 205,075
=========== =========== ===========
Interest $ 689,779 $ 116,993 $ 125,748
=========== =========== ===========
See notes to consolidated financial statements.
F-38
99
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------
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 wholly-owned subsidiaries (the
"Company"). The wholly-owned subsidiaries include HCMC and HCS. 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 amounts 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 investments 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, 1998 and 1997 is detailed below:
1998 1997
---- ----
Alpine/Hanover, LLC 1.0% 1.0%
ABH-I, LLC 1.0% 1.0%
c. Revenue Recognition - Revenues from due diligence contracts in
progress are recognized for the services provided as they are earned
and billed.
d. 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 and servicing.
F-39
100
e. 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.
f. 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.
g. Income Taxes - The Company files a consolidated Federal income tax
return. The Company has not been subject to an examination of its
income tax returns by the Internal Revenue Service. The Company's
tax sharing policy provides that each member of the Federal
consolidated group receive an allocation of income taxes as if each
filed a separate Federal income tax return.
HCP, HCMC and HCS generally file their state tax returns on a
separate Company basis.
Deferred income taxes are provided for the effect of temporary
timing differences between the tax basis of an asset or liability
and its reported amount in the consolidated financial statements.
h. 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.
i. 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, 1998 and 1997.
j. 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.
k. 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"). 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 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.
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.
l. Basic Earnings per Share - Basic earnings per share is computed by
dividing income available to common stockholders by the weighted
average number of common shares outstanding during the period.
Shares issued during the period and shares reacquired during the
period are weighted for the portion of time they were outstanding.
F-40
101
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.
4. CONCENTRATION RISK
For the years ended December 31, 1998, 1997 and 1996, the Company received
revenues from certain customers, which are subject to change annually,
which exceeded 10% of total revenues as follows:
1998 1997 1996
---- ---- ----
Major Customer #1 28% 24% 46%
Major Customer #2 13% 18% 26%
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, 1998 and 1997, HCMC was servicing 13 and
43 loans, respectively, with unpaid principal balances of $46,329,000 and
$120,736,400 including loans subserviced for others of $27,533,700 and
$40,055,200 respectively. Escrow balances maintained by HCMC were
$1,316,400 and $3,087,400 at December 31, 1998 and 1997, respectively. The
aforementioned servicing portfolio and related escrow accounts are not
included in the accompanying consolidated balance sheets as of December
31, 1998 and 1997.
F-41
102
Activity in mortgage servicing rights for the years ended December 31,
1998 and 1997 was as follows:
1998 1997
-------- --------
Beginning balance $ 49,449 $ 30,587
Capitalization - 43,783
Sales (46,997) (17,530)
Scheduled amortization (2,452) (7,391)
-------- --------
$ - $ 49,449
======== ========
The fair value of the Company's capitalized servicing rights at December
31, 1997 was $79,504.
6. MORTGAGE OPERATIONS
In September 1998, the Company purchased a portfolio of single family
mortgage loans with a principal balance of $101,586,036. This balance was
comprised of fixed rate loans ($22,752,341) and adjustable rate loans
($78,833,695). The mortgage loan portfolio was purchased at 101.395% of
par value. The Company sold this portfolio of loans at book value to
Hanover Capital Mortgage Holdings, Inc. During the period in which the
Company owned the loan portfolio, net interest income of $121,585 was
recognized and is reported as a component of other income (loss) in the
1998 consolidated statement of operations.
7. RELATED PARTY TRANSACTIONS
Receivables from related parties at December 31, 1998 and 1997 consist of
the following:
1998 1997
-------- --------
Due from Hanover Capital Mortgage Holdings, Inc. (1) $ 82,782 $540,044
Due from ABH-I, LLC (includes $9,005 and $28,984 of asset
management fees at December 31, 1998 and 1997,
respectively) (2) 16,015 51,321
Due from Hanover Asset Services, Inc. (3) -- 8,070
Due from Alpine/Hanover, LLC (2) -- 9,273
Due from Alpine/Hanover II, LLC (3) -- 5,000
Due from Hanover Mortgage Capital Corporation (3) 9,342 5,962
Due from AGR Financial, LLC (4) 44,192 80,813
Due from Hanover Investment Fund (3) 2,250 --
Due from Hanover Capital Partners 2, Inc. (6) 5,150 --
-------- --------
Due from related entities 159,731 700,483
Due from officers (5) 54,048 110,667
-------- --------
Receivables from related parties $213,779 $811,150
======== ========
(1) The Company entered into a Management Agreement in 1998 to provide,
among other services, 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.
F-42
103
(2) Amounts due from entities that the Company had a minority ownership
percentage in 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 and $1,370,000 for the
years ended December 31, 1997 and 1996, respectively.
(3) Amounts due from entities that are owned by certain of the Company's
officers/owners 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 software operating
systems, processing capabilities and accounting services.
(5) Amounts due from officers at December 31, 1998 include $53,766
from the Company's President which is scheduled to be repaid in
August 1999.
(6) Amounts due reflect certain costs that the Company paid for Hanover
Capital Partners 2, Inc. in connection with a security transaction
completed by Hanover Capital Partners 2, Inc. in October 1998.
8. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 1998 and 1997 consists of the
following:
1998 1997
--------- ---------
Office machinery and equipment $ 415,032 $ 381,189
Furniture and fixtures 111,246 111,246
Leasehold improvements 68,553 68,553
--------- ---------
594,831 560,988
Less accumulated depreciation (453,372) (347,851)
--------- ---------
Property and equipment - net $ 141,459 $ 213,137
========= =========
Depreciation expense for the years ended December 31, 1998, 1997 and 1996
was $105,519, $110,284, and $113,885, respectively.
9. INCOME TAXES
The components of deferred income taxes as of December 31, 1998 and 1997
are as follows:
1998 1997
--------- --------
Deferred tax assets $ 813,003 $ 44,499
Deferred tax liabilities (11,652) (24,418)
--------- --------
Net deferred tax assets $ 801,351 $ 20,081
========= ========
F-43
104
The items resulting in significant temporary differences for the years
ended December 31, 1998 and 1997 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 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, 1998, 1997 and 1996 consist of the following:
1998 1997 1996
--------- --------- --------
Current - Federal, state and local $ -- $(292,885) $ 91,092
Deferred - Federal, state and local (661,524) (33,074) (17,222)
--------- --------- --------
Total $(661,524) $(325,959) $ 73,870
========= ========= ========
The income tax provision (benefit) differs from amounts computed at
statutory rates, as follows:
1998 1997 1996
--------- --------- --------
Federal income taxes (benefit) at
statutory rate $(595,554) $(285,167) $ 56,518
State and local income taxes (benefit)
net of Federal benefit (76,256) (59,486) 14,836
Unconsolidated subsidiary's net income
(loss) -- 1,177 (12,793)
Meals and entertainment 6,002 4,052 3,719
Officer's life insurance 4,273 9,613 8,576
Other, net 11 3,852 3,014
--------- --------- --------
Total $(661,524) $(325,959) $ 73,870
========= ========= ========
The Company has a Federal net operating loss carryforward of approximately
$1.4 million which begins to expire in the year 2012.
10. 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.
11. 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
F-44
105
consisted of a short-term note of $1,405,000 with an annual interest rate
at the prime rate as of December 31, 1997. The interest rate in effect at
December 31, 1997 was 8.50%. 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 was 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. The Line was subsequently paid down in full in
July 1998.
12. NOTE PAYABLE TO RELATED PARTY
At December 31, 1998 the Company had a principal balance outstanding on a
note payable to Hanover Capital Mortgage Holdings, Inc. in the amount of
$712,824. The note bears interest at the prime rate minus 1% and interest
is calculated on the daily principal balance outstanding. At December 31,
1998 the interest rate in effect was 7.0%. Included in the 1998
consolidated statement of operations is interest expense in the amount of
$126,158 related to this note payable.
13. COMMITMENTS AND CONTINGENCIES
The Company has noncancelable operating lease agreements for office space.
Future minimum rental payments for such leases are as follows:
YEAR AMOUNT
---------- ----------
1999 $ 276,322
2000 358,531
2001 351,721
2002 299,586
2003 262,220
Thereafter 1,211,137
----------
Total $2,759,517
==========
Rent expense for the years ended December 31, 1998, 1997 and 1996 amounted
to $250,684, $310,814 and $339,421, respectively.
HCHI has guaranteed the obligations of the Company with respect to an
amendment to an office lease entered into by the Company. The office lease
(anticipated to be effective on or about May 1, 1999) is for a period of
10 years and 3 months and obligates the Company for $2,162,300 of base
rental expense plus escalation, electric and other billings over the lease
term.
******
F-45
106
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Hanover Capital Partners 2, Inc.
New York, New York
We have audited the accompanying consolidated balance sheet of Hanover Capital
Partners 2, Inc. and Subsidiary (the "Company") as of December 31, 1998 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the period from October 7, 1998 (inception) through December 31, 1998.
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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Hanover Capital
Partners 2, Inc. and Subsidiary as of December 31, 1998, and the results of
their consolidated operations and their consolidated cash flows for the period
from October 7, 1998 (inception) through December 31, 1998 in conformity with
generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Parsippany, New Jersey
March 19, 1999
F-46
107
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEET
(in thousands, except as noted)
ASSETS DECEMBER 31,
1998
------------
Mortgage loans:
Collateral for mortgage backed bonds $300,599
Cash and cash equivalents 143
Accrued interest receivable 1,868
Deferred financing costs 3,191
--------
TOTAL ASSETS $305,801
========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Mortgage backed bonds $297,682
Accrued interest payable 1,868
Due to related parties 310
Accrued expenses and other liabilities 154
--------
Total liabilities 300,014
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01
authorized, 9,900 shares, issued
and outstanding, 9,900 shares --
Common stock, par value $.01
authorized, 100 shares, issued and
outstanding, 100 shares --
Additional paid-in-capital 14,319
Retained (deficit) (8,532)
--------
Total stockholders' equity 5,787
--------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $305,801
========
See notes to consolidated financial statements.
F-47
108
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF OPERATIONS PERIOD FROM OCTOBER 7 (INCEPTION) TO
DECEMBER 31, 1998 (in thousands, except per share data)
REVENUES:
Interest income $ 5,611
Interest expense 5,965
----------
Net interest expense (354)
Loan loss provision 38
----------
Net interest expense after loan loss
provision (392)
----------
EXPENSES:
Operating 5
----------
NET (LOSS) $ (397)
==========
BASIC (LOSS) PER SHARE $(3,974.00)
==========
See notes to consolidated financial statements.
F-48
109
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
STATEMENT OF STOCKHOLDERS' EQUITY
PERIOD FROM OCTOBER 7 (INCEPTION) TO DECEMBER 31, 1998
(in thousands, except share data)
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------ ------------------ PAID-IN- RETAINED
SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) TOTAL
---------------------------------------------------------------------------------
Issuance of
common stock -- -- 100 -- $ 143 $ 143
Issuance of
preferred stock 9,900 -- -- -- 14,176 $ 14,176
Net (loss) (397) (397)
Dividends declared (8,135) (8,135)
---------------------------------------------------------------------------------
BALANCE,
DECEMBER 31, 1998 9,900 -- 100 -- $14,319 $(8,532) $ 5,787
=================================================================================
See notes to consolidated financial statements.
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HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS PERIOD FROM OCTOBER 7 (INCEPTION) TO
DECEMBER 31, 1998 (in thousands, except share data)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $ (397)
Adjustments to reconcile net (loss) to
net cash provided by operating activities:
Amortization of net premium and deferred costs 353
Loan loss provision 38
(Increase) in accrued interest receivable (1,868)
Increase in accrued interest payable 1,868
Increase in due to related parties 241
Increase in accrued expenses and other liabilities 73
---------
Net cash provided by operating activities 308
---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments received on collateral for
mortgage backed bonds 20,082
Transfer of premium and deferred hedge 3,320
---------
Net cash provided by investing activities 23,402
---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from mortgage backed bonds 317,764
Payoff of reverse repurchase agreements (309,963)
Payments on mortgage backed bonds (20,082)
Deferred financing costs (3,375)
Capital contributions 143
Payment of dividends (8,054)
---------
Net cash (used in) financing activities (23,567)
---------
NET INCREASE IN CASH AND CASH EQUIVALENTS $ 143
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD $ --
---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 143
=========
SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES
9,900 shares of preferred stock were issued in exchange for
$324,210 (book value) of mortgage loans net of $309,963 of
reverse repurchase financing in October 1998.
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the year for interest $ 3,913
=========
See notes to consolidated financial statements
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HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
PERIOD FROM OCTOBER 7 (INCEPTION) TO DECEMBER 31, 1998
1. BUSINESS DESCRIPTION
GENERAL
Hanover Capital Partners 2, Inc. (the "Company") was incorporated in Delaware on
October 7, 1998. The Company was formed to acquire single-family residential
mortgage loans from Hanover Capital Mortgage Holdings, Inc. pursuant to its
formation transaction and to finance the purchase of these mortgage loans
through a REMIC securitization.
Hanover SPC-2, Inc., a wholly owned subsidiary of the Company, was incorporated
in Delaware on October 9, 1998 for the sole purpose of selling certain
investment grade and subordinated securities to Hanover Capital Mortgage
Holdings, Inc., through its wholly-owned subsidiaries, Hanover QRS-1 98-B, Inc.
and Hanover QRS-2 98-B, Inc.
CAPITALIZATION
At the time of incorporation, the Company was authorized to issue 9,900 shares
of preferred stock at $.01 per share and 100 shares of common stock at $.01 per
share.
In October 1998, the Company received $324.2 million of fixed rate mortgage
loans (with a par value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing from Hanover Capital Mortgage Holdings, Inc. in
exchange for the issuance of 9,900 shares of non-voting preferred stock
(representing a 99% economic ownership of the Company). In October 1998, the
Company also received cash proceeds of $143,189 for the issuance of 100 shares
of common stock (representing a 1% economic ownership of the Company).
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Hanover Capital
Partners 2, Inc. and its wholly-owned subsidiary, Hanover SPC-2, Inc. All
significant inter-company accounts and transactions have been eliminated.
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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 may include cash on hand, overnight investments
deposited with banks and government securities with maturities of less than 30
days.
REVENUE RECOGNITION
Mortgage loan interest income is recognized on the accrual method based on the
net coupon after deducting service fees.
DEFERRED FINANCING COSTS
Deferred financing costs incurred ($3,375,000) in connection with the
securitization were capitalized and are being amortized as part of interest
expense over the life of the mortgage backed bonds.
EARNINGS PER SHARE
Basic earnings or losses per share excludes dilution and is computed by dividing
income or loss available to common stockholders by the weighted average number
of common shares outstanding during the period. Diluted earnings or loss per
share reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock
that then shared in earnings and losses. Shares issued during the period and
shares reacquired during the period are weighted for the period they were
outstanding.
3. MORTGAGE LOANS
Collateral for mortgage backed bonds
In October 1998 the Company issued its first real estate mortgage investment
conduit ("REMIC") security. $317,764,000 of par value single family fixed rate
residential mortgage loans were assigned as collateral for the Company's
mortgage backed bond (REMIC) security. The Company has limited exposure to
credit risk retained on loans it has securitized through the issuance of
collateralized bonds. All mortgage loans held as collateral for mortgage backed
bonds are reported at cost. Premiums, discounts and all deferred costs
associated with the mortgage loans held as collateral for mortgage backed bonds
are amortized into interest income over the lives of the mortgage loans using
the effective yield method adjusted for the effects of prepayments.
The following table summarizes the Company's single-family fixed rate mortgage
loan pools classified as held to maturity (and held as collateral for mortgage
backed bonds), which are carried at cost at December 31, 1998 (dollars in
thousands):
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Fixed rate $297,682
Net premiums, and
deferred costs 2,955
Loan loss provision (38)
--------
Carrying value $300,599
========
The following table summarizes certain characteristics of the Company's
single-family fixed rate mortgage loans held as collateral for mortgage backed
bonds at December 31, 1998 (dollars in thousands):
Carrying Value Principal Amount
of Collateral for of Collateral for Weighted Weighted
Mortgage Backed Mortgage Backed Average Average
Bonds Bonds Net Coupon Maturity (1)
----- ----- ---------- ------------
$300,599 $297,682 7.549% 307
======== ======== ===== ===
(1) weighted average maturity reflects the number of months remaining until
maturity.
The average effective yield after amortization of net premiums, discounts and
deferred costs for 1998 on the collateral for the mortgage backed bond portfolio
was 7.004%.
4. CONCENTRATION OF CREDIT RISK
The Company's exposure to credit risk associated with its investment activities
is measured on an individual customer basis as well as by groups of customers
that share similar attributes. In the normal course of its business, the Company
has concentrations of credit risk in its mortgage portfolio for loans in certain
geographic areas. At December 31, 1998, the percent of total principal amount of
loans outstanding in any one state, exceeding 5% of the principal amount of
mortgage loans are as follows:
State
-----
Illinois 18%
California 10
Florida 10
Ohio 8
Indiana 7
Texas 6
Arizona 6
Kentucky 6
---
71%
===
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5. AFFILIATED PARTY TRANSACTIONS
In October 1998, the Company received $324.2 million of fixed assets mortgage
loans (with a per value of $318 million) subject to $310.0 million of reverse
repurchase agreement financing from Hanover Capital Mortgage Holdings, Inc. in
exchange for the issuance of 9,800 shares of non-voting preferred stock
(representing a 99% economic ownership of the Company).
At December 31, 1998 the Company reflected amounts due to Hanover Capital
Mortgage Holdings, Inc. of $304,800 and Hanover Capital Partners, Ltd. of $5,200
for the payment of operating expenses and securitization costs.
6. MORTGAGE BACKED BONDS
The Company, through a wholly owned subsidiary, Hanover SPC-2, Inc. has issued
non- recourse debt in the form of mortgage backed bonds. Borrower remittances
received on the collateral for mortgage backed bonds are used to make payments
on the mortgage backed bonds. The obligations under the mortgage backed bonds
are payable solely from the collateral for mortgage backed bonds and are
otherwise non-recourse to the Company. The maturity of the bonds is directly
affected by the rate of principal prepayments on the related collateral. The
bonds are subject to redemption according to specific terms of the respective
indentures, generally when the remaining balance of the bonds equals 20% or less
of the original principal balance of the bonds. As a result, the actual maturity
of any class of mortgage backed bonds is likely to occur earlier than its stated
maturity.
Information pertaining to mortgage backed bonds financing for 1998 is summarized
as follows (dollars in thousands):
Mortgage
Backed Bonds
------------
Balance at period-end $297,682
Average balance during the period $307,843
Average interest rate during the period 7.512%
Interest rate at period end 7.543%
Maximum month-end balance during the
period $317,764
Collateral for Mortgage Backed Bonds
- --------------------------------------
Balance at period end - carrying value $300,599
Aggregate annual repayments of mortgage backed bonds based upon contractual
amortization of the underlying mortgage loan collateral at December 31, 1998
were as follows (dollars in thousands):
YEAR AMOUNT
---- ------
1999 $ 3,738
2000 4,045
2001 4,378
2002 4,738
2003 5,127
Thereafter 275,656
--------
Total $297,682
========
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7. INCOME TAXES
The Company and its wholly owned subsidiary file a consolidated Federal income
tax return. They each file separate income tax returns. Deferred income taxes
are provided for the effects of temporary differences between the basis of an
asset or liability and its reported amount in the financial statements. The
significant differences between the statutory income tax rate result primarily
from state income taxes and the recording of a valuation allowance for the
entire tax benefit including the deferred tax asset. The significant
differences giving rise to deferred tax assets and liabilities result primarily
from the treatment of the REMIC transaction as a sale for income tax purposes.
The Company had a net deferred tax asset of approximately $2,725,000 which is
fully reserved by a valuation allowance. This deferred tax asset is
substantially the result of a net operating loss carryforward in the amount of
$3,800,000 which expires in the year 2013 for Federal income tax purposes and
a capital loss carryforward of $3,063,000.
8. 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 at December 31, 1998 is as follows (dollars in thousands):
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116
Carrying Fair
Amount Value
-------- -----
Assets:
Mortgage loans
Collateral for mortgage backed bonds $300,599 $297,367
Cash and cash equivalents 143 143
Accrued interest receivable 1,868 1,868
-------- --------
Total $302,610 $299,378
======== ========
Liabilities:
Mortgage backed bonds $297,682 $297,367
Accrued interest payable 1,868 1,868
Other liabilities 464 464
-------- --------
Total $300,014 $299,699
======== ========
The Company had no off-balance sheet financial instruments at December 31, 1998.
The following methods and assumptions were used to estimate the fair value of
the Company's financial instruments:
Collateral for mortgage backed bonds - The fair values of mortgage loans are
based upon actual prices received upon recent sales of loans and securities to
investors and projected prices which could be obtained through investors
considering interest rates, loan type, and credit quality.
Cash and cash equivalents, accrued interest receivable, accrued interest
payable, other liabilities - The fair value of these instruments was determined
to be their carrying value due to their short-term nature.
Mortgage backed bonds -- The fair value of these financial instruments are
based upon either or all of the following: actual prices received upon record
sales of securities to investors, projected prices which could be obtained
through investor estimates considering interest rates, loan type, quality and
discount cash flow analysis based upon prepayment and interest rate
assumptions used in the market place for similar securities with similar credit
ratings.
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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 Amendment, 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 Agreement, 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 Extension of Lease,
dated as of March 1, 1996
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118
*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 Stanley Mortgage Capital Inc., dated as of December 8,
1997
***10.31 Master Loan and Security Agreement by and between Greenwich
Capital Financial Products, Inc. and Hanover Capital Mortgage
Holdings, Inc., dated March 30, 1998
10.32 Amended and Restated Master Loan and Security Agreement
between the Company, HCP and Morgan Stanley Mortgage Capital
Inc., dated January 8, 1999.
10.33 Purchase Price and Terms Letter agreement between Residential
Funding Corporation and the Company, dated November 10, 1998.
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119
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.
*** Incorporated herein by reference to the Company's Form 10-Q, for the
quarter ended March 31, 1998, as filed with Securities and Exchange
Commission.
**** Incorporated herein by reference to the Company's Form 10-K for the
year ended December 31, 1997, as filed with the Securities and Exchange
Commission.
63