ITEM 1: BUSINESS
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") is a real estate investment trust (also referred to as a "REIT") which is focused on the single-family mortgage market. Hanover invests in single-family mortgage loan pools and subordinate mortgage-backed securities and provides consulting and due diligence services through its unconsolidated subsidiary, Hanover Capital Partners Ltd. ("HCP"). Additionally, Hanover is developing an internet-based mortgage whole loan trading exchange through its unconsolidated subsidiary, HanoverTrade.com, Inc. ("HTC"). Hanover is a Maryland corporation formed on June 10, 1997. Hanover owns a 97% ownership interest (representing a 100% ownership of non-voting preferred stock) in each of HCP and HTC.
The principal business strategy of Hanover and its wholly-owned subsidiaries (together referred to as the "Company") is to (i) acquire primarily single-family mortgage loans that are at least twelve months old or that were intended to be of certain credit quality but that do not meet the originally intended market parameters due to errors or credit deterioration, (ii) securitize the mortgage loans and retain subordinated interests therein and (iii) acquire subordinated mortgage backed securities ("MBS") similar in nature to the retained interests generated from internal securitizations. The Company acquires single-family mortgage loans through a network of sales representatives targeting financial institutions throughout the United States.
The principal business strategy of the Company's primary unconsolidated subsidiary, HCP, is to generate consulting and other fee income by (i) performing loan file due diligence reviews for third parties, (ii) performing loan sale advisory services, (iii) brokering and trading portfolios of loans, and (iv) providing mortgage loan assignment services for third parties. Until June 30, 1999, HCP was also engaged in the business of originating multifamily and commercial loans. This business was discontinued in the quarter ended June 30, 1999 and substantially all charges associated with its discontinuance were recognized in the quarter.
The principal business strategy of HanoverTrade.com, Inc. ("HTC") is to leverage HCP's market position as a broker of whole-loan mortgage portfolios to develop a real-time, internet-based trading exchange through which major participants in the secondary mortgage market will be able to trade bulk pools of mortgage loans among themselves.
The Company's third unconsolidated subsidiary, Hanover Capital Partners 2, Inc. ("HCP-2") was formed in October 1998 in connection with a securitization transaction. The Company wrote off its investment in HCP-2 in September, 1999 and does not expect any material future revenue or expenses associated with HCP-2.
The Company's principal business objective is to generate net interest income on its portfolio of mortgage loans and mortgage securities, and to generate fee income through HCP and HTC.
The Company's principal executive offices are located at 90 West Street, Suite 2210, 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-backed 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-related 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 believes that its sales and due diligence organization and its mortgage industry expertise gives it certain advantages over other mortgage market participants. The Company uses its sales force to source mortgage loan pools, and uses its due diligence organization to analyze the credit risk characteristics of those pools. In addition, the Company acquires subordinate mortgage backed securities that bear the credit risk of specific mortgage loan pools. The Company uses its due diligence organization and industry expertise to analyze the credit risk characteristics of these mortgage loan pools in order to price these securities efficiently.
Trends and Recent Developments
Purchase of Subordinate MBS. As a result of the continued evolution of the mortgage loan and MBS markets in which the Company operates, market conditions in 1999 dictated a shift in the Company's strategy of acquiring mortgage loans and mortgage-backed securities, as compared to 1997 and 1998. Whereas the Company had previously focused primarily on acquiring seasoned mortgage loans, in 1999 the Company focused primarily on acquiring subordinate MBS with characteristics similar to the subordinate MBS that the Company created in its first four securitizations.
Prior to 1999, the Company had primarily invested its funds in mortgage whole loans, which were subsequently securitized. When the mortgage whole loans were securitized, the Company retained a subordinate interest in the loans. These subordinate interests are referred to as subordinate MBS. Other issuers also create subordinate MBS, and these subordinate MBS trade in organized markets. Historically, the Company invested only in subordinate MBS that were created by the Company.
The market for subordinate MBS changed dramatically at the end of 1998 and in early 1999, resulting in a substantial buying opportunity for the Company. As a result of the market disruption, the Company found that it could purchase subordinate MBS created by third party securitizers at very attractive yields. In some cases these yields were higher than the yields the Company could obtain by its previous practice of purchasing whole loans, securitizing them and retaining the resulting subordinate MBS. Additionally, the Company's costs to acquire
subordinate MBS created by other issuers is substantially lower than the cost of creating its own subordinate MBS.
As a result of these changes in the market, the Company attempted to take advantage of the new market dynamic by curtailing its purchase of mortgage whole loans and purchasing existing subordinate MBS instead. In 1999, the Company purchased 12 subordinate MBS with an aggregate principal balance of $6,155,000, at a net purchase price of $3,668,000. In addition, the Company's affiliate, HCP, purchased 17 subordinate MBS with an aggregate principal balance of $33,518,000, at a net purchase price of $14,123,000. The Company receives 97% of the income attributable to the subordinate MBS purchased by its affiliate.
Third Quarter Charges. The Company also recognized $14,061,000 of charges and expenses in the third quarter of 1999, the majority of which was the result of a securitization transaction that the Company executed during substantial market turmoil in October 1998. These charges are detailed in Note 17 to the financial statements. The Company believes that these charges primarily resulted from the unusual market conditions of October 1998.
Portfolio Composition
At December 31, 1999, the Company had invested $270,084,000 or 73.9% of the Company's total assets in single-family mortgage loans classified as held for sale, held to maturity and collateral for collateralized mortgage obligations ("CMOs"), and $62,686,000 or 17.2% of its total assets in single-family mortgage-backed securities classified as available for sale, held to maturity or held for trading. The composition of the investment portfolio is described in detail in Notes 3 and 4 to the Company's audited financial statements. The revenues, operating profit and loss from the Company's investing activity is reflected on the Company's consolidated statement of operations.
In 1999, the Company experienced $58,000 of mortgage loan losses on its mortgage loan portfolio (held for sale, held to maturity and collateral for CMOs), and the Company did not experience any mortgage loan credit losses on its mortgage-backed securities portfolio (available for sale, held to maturity and trading). The Company experienced no mortgage loan losses during 1998. Notwithstanding the low level of losses actually incurred, the Company recorded a provision of $446,000 and $356,000 in 1999 and 1998.
In December 1997, the Company purchased 15 government agency adjustable rate mortgage ("Agency 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. As of December 31, 1999, the Company has not invested in any agency ARM securities.
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.
Securitization Activity
In March 1999, the Company completed its third securitization transaction, the "1999-A" securitization, and thereby transferred $138,357,000 (par value) of mortgage loans to CMO collateral. In August 1999, the Company completed its fourth securitization transaction, the "1999-B" securitization, and thereby transferred $111,575,000 (par value) of mortgage loans to CMO collateral.
In April 1998, the Company completed its first securitization, the "1998-A" securitization, and thereby transferred $103 million (par value) of mortgage loans to CMO collateral. 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. In October 1998, the Company completed a $318 million (par value) securitization accomplished as a real estate mortgage investment conduit ("REMIC") structure 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 securitization transactions (dollars in thousands):
SECURITIZATION TRANSACTIONS
Subordinate Mortgage Backed Securities Purchases
In analyzing subordinate MBS for purchase, the Company focuses primarily on subordinated interests ("tranches") in pools of whole single-family mortgage loans that do not fit into the large government-sponsored (FHA, FHLMC or GNMA) conduits, typically because the principal balance of the mortgages exceeds the maximum amount permissible in a government-agency guaranteed MBS. The Company generally purchases subordinate MBS collateralized by "A" quality mortgages originated by several of the largest non-government mortgage conduits in the market. All of the Company's acquisitions of subordinate MBS to date have been fixed rate.
The subordinate tranches that the Company purchases are generally structured so that they will absorb the credit losses resulting from a specified pool of mortgages. Since these tranches could potentially absorb credit losses, the tranches of securities the Company purchases are generally either not rated or are rated below investment grade (generally "BB" or "B"). These tranches are generally purchased at a substantial discount to their principal balance. This discount provides a cushion against potential future losses, and, to the extent that losses on the mortgage loans are less than the discount, the discount provides a yield enhancement.
The Company primarily purchases subordinate MBS from "Wall Street" dealer firms, although the Company also is attempting to develop direct relationships with the larger issuers of subordinate MBS. For the foreseeable future, the Company believes that there will be an adequate supply of subordinate MBS available in the market.
At December 31, 1999, the Company (together with its affiliate, HCP) had purchased since inception in excess of $39,673,000 (principal balance) of subordinate MBS from third parties, representing subordinate interests in approximately $6,887,000,000 (principal balance) of single-family mortgage loan pools. The aggregate purchase price of these MBS was $17,781,000.
One of the Company's unconsolidated subsidiaries, HCP, has a due diligence and consulting staff, located in Edison, New Jersey, consisting of approximately thirty-four full-time employees and access to a part-time pool of employees in excess of 600. The due diligence staff contributes to the subordinate MBS acquisition process by providing expertise in the analysis of many characteristics of the underlying single-family mortgage loans.
Because there are a number of regular issuers of subordinate MBS, the Company is not dependent upon any one source. Note 5 to the financial statements describes the concentration of the Company's portfolio by issuer. Management believes that the loss of any single financial institution from which the Company purchases subordinate MBS would not have any detrimental effect on the Company.
Prior to making an offer to purchase a subordinate MBS, HCP employees conduct an extensive investigation and evaluation of the loans collateralizing the security. This examination typically consists of analyzing the information made available by the 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 in certain instances obtaining opinions of value from third parties. The Company's senior management determines the amount to be offered for the security using a proprietary stratification and pricing system which focuses on, among other things, rate, term, location, credit scores and types of the loans. 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.
By examining the mortgage pool loan data, a prepayment speed is selected based primarily upon the gross coupons and seasoning of the subject pool. The Company also determines a "base case" default scenario and several alternative scenarios based on the Public Securities Association's standard default assumption ("SDA"). The default scenarios reflect the
Company's estimate of the most likely range of potential losses on the underlying mortgage loans, taking into consideration the credit analysis described above.
After determination of a prepayment speed and a base case SDA assumption, the pools' cash flow stream is modeled. The proposed purchase price is calculated as the present value of the base case cash flow stream, discounted by the current market rate for securities with similar product type and credit characteristics. The Company then examines the yield of the security under various alternative SDA and prepayment assumptions, and if necessary, adjusts the proposed purchase price so that it will receive an acceptable yield under a variety of possible scenarios.
Single Family Mortgage Operations
Single-Family Mortgage Loans. In 1999, the Company did not purchase any mortgage whole loans. However, the Company continues to monitor the relative value available in the mortgage whole loan market vis-a-vis the subordinate MBS market. To the extent that the Company is able to purchase and securitize mortgage whole loans at attractive prices, the Company would attempt to do so, creating attractive yields on the resulting subordinate MBS.
In analyzing potential whole loan pools for purchase, the Company focuses on 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 five 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 December 31, 1999, the Company had purchased since inception in excess of $1 billion of single-family mortgage loan pools. Also, at December 31, 1999 the Company did not have any commitments outstanding to purchase single-family mortgage 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 1999, the Company did not purchase any mortgage loan pools. 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.
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 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 pool's 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.
HCP's 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.
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 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 discontinued its commercial and multifamily mortgage origination business in the second quarter of 1999. HCP's wholly-owned subsidiary, Hanover Capital Mortgage Corporation ("HCMC"), has retained the relevant licenses necessary to originate these mortgages, and may at some point decide to re-enter this market. 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.
Commercial and Multifamily Mortgage Loan Servicing. The Company continues to service a very limited number of multifamily and commercial mortgages. HCMC, as servicer, will have the risks associated with operating a mortgage servicing business as well as the risk of ownership of the servicing.
HCMC serviced approximately $13 million and $46 million of multifamily mortgage loans at December 31, 1999 and December 31, 1998. 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.
INVESTMENT PORTFOLIO ACQUISITIONS
The Company's core business strategy is to acquire or create subordinate mortgage backed securities collateralized primarily by single-family mortgage loans. The Company either acquires the mortgage backed securities outright, or it acquires mortgage loans, securitizes the mortgage loans and retain the subordinate mortgage backed securities created thereby. The process for identifying possible mortgage backed securities or mortgage loan 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 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 subordinate mortgage backed securities and instead 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 ARM mortgage securities, never the core business of the Company, suffered from historically high prepayments, causing accelerated premium amortization and depressed market pricing.
HANOVER CAPITAL PARTNERS LTD.
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.
HCP owns a licensed mortgage banker, HCMC, and a licensed broker-dealer, Hanover Capital Securities, Inc. ("HCS"). Although HCP maintains these companies' licenses in good standing, neither of these companies currently conduct any material ongoing business. As noted above, HCMC originated multifamily mortgage loans until June 1999, when this activity was discontinued, and continues to service a small number of multifamily loans.
In January 2000, HCP hired all of the former management of Document Management Network, Inc. ("DMN"), and is continuing DMN's business as the Document Management Network division of HCP. DMN provides mortgage assignment services for many of the same customers serviced by HCP. Whenever an institution purchases a mortgage loan in the secondary market, the purchaser is required to submit paperwork (called an "assignment of mortgage") to the local county or city jurisdiction in which the mortgaged property is located in order to record the new institution's interest in the mortgaged property. DMN employees prepare and process this paperwork for third party institutions.
FINANCING
General
The Company's purchases of mortgage related assets are initially financed primarily with equity and short-term borrowings through reverse repurchase agreements until long-term financing is arranged or the assets are securitized. Generally, upon repayment of each borrowing in the form of a reverse repurchase agreement, the mortgage asset used to collateralize the financing will immediately be pledged to secure a new reverse repurchase agreement or some form of long term financing. The Company had established committed and uncommitted mortgage asset financing agreements from various financial institutions at December 31, 1999.
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 its exposure to the financial condition of its reverse repurchase agreement lenders on a regular basis, including the percentage of its mortgage loans that are the subject of reverse repurchase agreements with a single lender. Notwithstanding these measures, no assurance can be given that the Company will be able to avoid such third party risks.
The reverse repurchase borrowings bear short-term fixed (one year or less) interest rates varying from LIBOR to LIBOR plus 238 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 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 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 reinvested. The Company may retain regular and residual interests on a short-term or long-term basis. Gain on sale income from the issuance of REMICs may not qualify as acceptable REIT income for tax purposes. 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 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.
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-collateralization 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 ability of the Company to expand its 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.
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.
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 mortgage-backed security or 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.
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 and three basic types of MBS. Mortgage loans are classified as (i) mortgage loans held for sale, (ii) mortgage loans held to maturity, or (iii) collateral for CMOs. MBS are classified as (i) available for sale, (ii) held to maturity, or (iii) held for trading. Fixed rate mortgage loans and MBS held for sale, available for sale or held for trading are generally hedged. A variety of hedging instruments may be used, depending on the asset or liability to be hedged and the 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
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 loans 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 MBS and mortgage loans that are financed with reverse repurchase agreements and are held for securitization.
The Company uses certain hedging strategies in connection with the management of the Investment Portfolio. To the extent consistent with the Company's REIT status, the Company follows a hedging program intended to protect against interest rate changes and to enable the Company to earn net interest income in periods of generally rising, as well as declining or static, interest rates. Specifically, the goal of the hedging program is to offset the potential adverse effects of changes in interest rates relative to the interest rates of the mortgage assets held in the Investment Portfolio. As part of its hedging program, the Company also monitors prepayment risks that arise in fluctuating interest rate environments.
The Company may use a variety of instruments in its hedging program. One example 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.
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.
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
Although HCMC does not currently originate mortgage loans, HCMC continues to service a small number of loans and has retained its mortgage-banking licenses in several states. 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.
HCP's wholly owned subsidiary, Hanover Capital Securities, Inc., 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 $4.4 trillion for single-family mortgage loans and $1.0 trillion for multifamily mortgage loans and commercial loans. In purchasing mortgage loans and MBS and issuing mortgage-backed securities, the Company competes with other REITs, established mortgage conduit programs, investment banking firms, savings and loan associations, banks, thrift and loan associations, finance companies, mortgage bankers, insurance companies, other lenders and other entities purchasing mortgage assets. In addition, there are several mortgage REITs similar to the Company and others may be organized in the future. Continued consolidation in the mortgage banking industry may reduce the number of sellers of mortgage loans, which would reduce the Company's potential customer base and result in the Company purchasing a larger percentage of mortgage loans from a smaller number of sellers. These changes could negatively impact the Company. As an issuer of mortgage securities, the Company will face competition for investors from other investment opportunities.
Increasingly, mortgage lending is being conducted by mortgage lenders who specialize in the origination and servicing of mortgage loans and then sell these loans to other mortgage investment institutions, such as the Company. The Company believes it has a competitive advantage because of the low cost of its operations relative to traditional mortgage investors such as banks and savings and loans. Like traditional financial institutions, the Company seeks to generate income for distribution to its shareholders primarily from the difference between the interest income on its mortgage assets and the financing costs associated with carrying the mortgage assets.
EMPLOYEES
The Company had five employees (the "Principals") at December 31, 1999. 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, 1999, HCP employed 34 people on a full-time basis and 24 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 600 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.
TRADEMARKS
HCP owns two registered trademarks 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.
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 or 1999 sales transactions would be classified as prohibited transactions.
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 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. 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 each month pays HCP 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 is also required to pay HCP each month an amount equal to the sum of: (c) the expenses of HCP for any services provided to the Company; plus (d) three percent (3%) of (c). Effective July 1, 1999, the Management Agreement was amended to define HCP's monthly expenses related to services provided to the Company to include: rent; telephone; utilities; office furniture; equipment; machinery; and other office expenses of HCP required for the Company's day-to-day operations, including bookkeeping, clerical and back-office services provided by HCP. 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, 2000 and 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, pursuant to the Internal Revenue Code of 1986, as amended (sometimes referred to as the "Code"). In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be taxed as corporations are, with certain limited exceptions, not taxed at the corporate level on their taxable income that is currently distributed to their shareholders. This treatment eliminates most of the "double taxation" (at the corporate level and then again at the shareholder level when the income is
distributed) that typically results from the use of corporate investment vehicles. In the event that 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 any time 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 tax reporting purposes.
Nature of Assets
On the last day of each calendar quarter, Hanover must satisfy three tests relating to the nature of its assets. First, at least 75% of the value of Hanover's assets must consist of 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.
On December 17, 1999, as part of a larger bill, the President signed into law the REIT Modernization Act ("RMA"). Effective January 1, 2001, the RMA will amend the tax rules relating to the composition of REIT's assets. Under current law, a REIT is precluded from owning more than 10% of the outstanding voting securities of any one issuer, other than a wholly owned subsidiary or another REIT. Beginning in 2001, a REIT will remain subject to the current restriction and be precluded from owning more than 10% of the value of all classes of securities of any one issuer.
There is an exception to this prohibition. A REIT will be allowed to own up to 100% of the securities of a taxable REIT subsidiary ("TRS"). However, no more than 20% of the value of a
REIT's total assets may be represented by securities of one or more TRSs. The amount of debt and rental payments from a TRS to a REIT will be limited to ensure that a TRS is subject to an appropriate level of corporate tax. The new 10% asset test will not apply to certain arrangements (including third party subsidiaries) in place on July 12, 1999, provided that the subsidiary does not engage in a "substantial" new line of business, its existing business does not increase, and a REIT does not acquire any new securities in the subsidiary. Under the RMA, a third party subsidiary will be able to convert tax free into a TRS.
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.
Pursuant to the REIT Modernization Act ("RMA"), effective January 1, 2001, the distribution of taxable income requirement a REIT will be reduced from 95% to 90%.
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 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.
ITEM 2:
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:
(a) HCP entered into an amendment to the existing office lease in December 1998 to relocate from its former office space (2,328 sq. ft.) to larger office space (7,863 sq. ft.) in the same office building. Hanover took occupancy of the new office space in November 1999.
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:
ITEM 3: LEGAL PROCEEDINGS
The Company is not engaged in any material legal proceeding.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
PART II
ITEM 5:
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 entitled the holder to purchase one share of common stock at the original issue price - $15.00. The strike price of the warrant was subsequently reset to $14.56. The warrants became exercisable on March 19, 1998 and expire on September 15, 2000. As of December 31, 1999, 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 17, 2000, Hanover had 5,826,899 shares of common stock issued and outstanding, which was held by 73 holders of record and approximately 1,839 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 1998 and 1999.
The following table sets forth, for the periods indicated, Hanover's dividends declared for each quarter for the two most recent fiscal years:
(a) Common stock and warrants were first listed on the American Stock Exchange on March 20, 1998.
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 qualify 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 (more than $6,500,000 as of December 31, 1999). 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:
ITEM 6: SELECTED FINANCIAL DATA
The following selected financial data are derived from audited consolidated financial statements of Hanover for the years ended December 31, 1999, 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):
ITEM 7.
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 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 (together referred to as the "Company") is to (i) acquire primarily single-family mortgage loans that are at least twelve months old or that were intended to be of certain credit quality but that do not meet the originally intended market parameters due to errors or credit deterioration, (ii) securitize the mortgage loans and retain interests therein and (iii) acquire subordinated mortgage securities similar in nature to the retained interests generated from internal securitizations. The principal business strategy of the Company's primary unconsolidated subsidiary, Hanover Capital Partners Ltd. ("HCP"), is to generate consulting fee income by (i) performing loan file due diligence reviews for third parties, (ii) performing loan sale advisory services and (iii) brokering and trading portfolios of loans. Until recently, HCP was also engaged in the business of originating multifamily and commercial loans. This business was discontinued in the quarter ended June 30, 1999.
The Company's principal business objective is to generate net interest income on its portfolio of mortgage loans and mortgage securities, and to generate fee income through HCP. The Company acquires single-family mortgage loans through a network of sales representatives targeting financial institutions throughout the United States. Hanover operates as a tax-advantaged REIT and is generally not subject to Federal and state income tax to the extent that it distributes its earnings to its stockholders and maintains its qualification as a REIT. Taxable affiliates of Hanover, however, are subject to Federal and state income tax. Hanover has engaged HCP to render due diligence, asset management and administrative services pursuant to a Management Agreement.
The Company's generation of net income is dependent upon (i) the spread between interest earned on its investment portfolio and the cost of borrowed funds to finance the investment portfolio; and (ii) the aggregate amount of the investment portfolio on the Company's balance sheet. The Company strives to create a diversified portfolio of investments that in the aggregate generates increasing net income in a variety of interest rate and prepayment rate environments and preserves the equity base of the Company. The Company's primary strategy for its mortgage loan investment portfolio entails (1) efficient acquisition pricing of mortgage loans, (2) financing in the short term by reverse repurchase agreements or lines of credit, (3) hedging in the short term to offset potential adverse effects of changes in interest rates, (4) stratifying and segregating mortgage loans in securitizations to replace short term financing with collateralized mortgage obligations (CMO), real estate mortgage investment conduits (REMIC) or other types of long term debt financing, thereby eliminating the majority of refinancing and interest rate risk and (5) retaining certain residual interests of the securitization resulting in increased yields.
RESULTS OF OPERATIONS
(dollars in thousands, except per share data)
(a) The dividends relating to the three months ended December 31, 1999 were declared on December 21, 1999.
The Company recorded a net loss of ($12,627,000) or ($2.12) per share based on 5,942,403 weighted shares of common stock outstanding for the year ended December 31, 1999 compared to a net loss of ($4,934,000) or ($0.77) per share based on 6,418,305 weighted shares of common stock outstanding for 1998. Total revenues for the year ended December 31, 1999 were negative ($6,662,000) compared to a positive $563,000 in 1998.
The 1999 revenues were negatively impacted by charges for (1) provision for loss on the disposition of an unconsolidated subsidiary, Hanover Capital Partners 2, Inc. ("HCP-2") of $4,793,000, (2) mark to market adjustments on mortgage securities acquired from the Hanover 1998-B securitization of $3,537,000, (3) mark to market adjustments on mortgage loans securitized in the August 1999 Hanover 1999-B securitization of $2,997,000 and (4) adjustments to the investment portfolio's net interest income resulting primarily from cumulative prepayment speed adjustments affecting amortization totaling $2,178,000. The 1999 revenues before these charges were $6,844,000.
By comparison, 1998 revenues of $563,000 included a loss of $5,989,000 on the sale of adjustable rate mortgage securities in October, 1998. Revenues for 1998 before this loss were $6,552,000.
The Company's equity in losses of Hanover Capital Partners Ltd. ("HCP"), its consulting subsidiary, declined from a loss of $1,039,000 in 1998 to a loss of $443,000 in 1999. The Company believes that its increased focus on building fee income revenue in HCP is beginning to bear fruit. Third party consulting and loan brokering revenues at HCP increased from $3,500,000 in 1998 to $5,036,000 in 1999, and the Company recorded a profit of $383,000 from its equity in HCP in the fourth quarter of 1999.
During 1999, the Company reflected equity in losses of HCP-2 of $1,300,000 compared to $394,000 in 1998. As noted above, the Company took a provision of $4,793,000 in the quarter ended September 30, 1999 and recorded certain other operating expenses in connection with its decision to sell HCP-2.
HCP-2 is an unconsolidated mortgage finance subsidiary that was organized in October 1998 to execute a REMIC financing securitization for the Company. The financing structure required certain costs of the securitization (net premiums, hedging and deferred financing costs) to be capitalized in this subsidiary. Substantially all of HCP-2's net equity ($4,473,000 at September 30, 1999) consisted of these capitalized expenses. These deferred financing costs were being amortized through net interest income (expense) over the anticipated life of the respective mortgage loans and recorded by the Company in its economic ownership percentage (99%) of this net loss through September 30, 1999. As a result of the provision for the expected sale of HCP-2, the Company believes it will not record future losses from HCP-2.
Also included in the equity in loss of unconsolidated subsidiaries is a $31,000 loss from a newly organized subsidiary - HanoverTrade.com, Inc. ("HTC"). HTC was organized in June 1999 to develop an E-commerce business to broker mortgage loan pools to financial institutions and other finance companies via the internet.
Operating expenses for the year ended December 31, 1999 were $4,191,000, compared to $4,064,000 in 1998. The Company did not purchase any mortgage loans during 1999, compared to 1998 when the Company purchased in excess of $749,000,000 of mortgage loan pools. Accordingly, the Company incurred only a fraction of the due diligence and commission expenses in 1999 ($124,000) as compared to 1998 ($973,000) and experienced significantly lower financing and commitment fees ($404,000 vs $836,000). Offsetting these cost savings were substantial increases in legal and professional expenses ($1,201,000 vs $545,000) and personnel expenses ($1,230,000 vs $712,000). Legal and professional expenses increased substantially in 1999 compared to 1998 as a result of increased regulatory filings and the negotiation of credit lines to replace lines that were wound down during the liquidity crunch at the end of 1998. The increase in personnel expenses results primarily from the reallocation of certain personnel expenses from HCP to the Company to better reflect the proper allocation of the affected individuals' time, and from the addition of a new chief financial officer in 1999.
The Management Agreement by and between Hanover and HCP, whereby HCP provides Hanover due diligence, asset management and administrative services, was amended in September 1999 (retroactive to July 1, 1999). The amendment reallocated certain asset management and administrative service expenses between Hanover and HCP to more accurately reflect current top management personnel expense and certain other occupancy related charges. As a result of this amendment, the Company recorded additional personnel and occupancy expenses that were previously allocated to HCP. Hanover will continue to record similar expenses in future periods. Also included in personnel expense in the third quarter of 1999 is approximately $103,000 of additional compensation expense paid to certain employees of Hanover, relating to the provision for the forgiveness of certain of their loans in connection with the write-off of HCP-2.
The Company's third quarter 1999 and 1998 operating expenses did not include any incentive bonus compensation pursuant to the Company's incentive bonus plan. 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%.
The table below highlights the Company's historical trends and components of return on average equity.
COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY (1)
(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 for this period is based on the equity balance at September 19, 1997 (IPO date) and the 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):
(1) Loan loss provisions are excluded in the above calculations.
(2) 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 (EXPENSE)
Net interest income for the year ended December 31, 1999 was $4,408,000 compared to net interest income of $6,623,000 for 1998. The following table reflects net interest income (expense) generated for each period (dollars in thousands):
NET INTEREST INCOME (EXPENSE) IN 1999
NET INTEREST INCOME (EXPENSE) IN 1998
Mortgage Loans Held for Sale and Held to Maturity
Net interest income generated from investments in mortgage loans (classified as held for sale and held to maturity) during the years ended December 31, 1999 and 1998, respectively, is detailed below (dollars in thousands):
In 1999, the Company securitized substantially all of its remaining inventory of mortgage loans. These loans were transferred from the held for sale category to the CMO collateral category. Accordingly, the Company's net interest income from mortgage loans held for sale and held to maturity declined to $829,000 in 1999 compared to $6,110,000 in 1998. The Company did not purchase any mortgage loans in 1999. In 1998 the Company purchased in excess of $850,000,000 of mortgage loans.
Mortgage Loans - CMO Collateral
Net interest income generated from the Mortgage Loans - CMO collateral during 1999 and 1998 is detailed below (dollars in thousands):
In 1999, the Company securitized $249,932,000 (par value) of mortgage loans in two securitizations. The securitizations were accomplished in a grantor/owner trust format (CMO) through a wholly-owned subsidiary, Hanover SPC-A, Inc. The transactions were accounted for as financings for both GAAP and tax accounting purposes. In 1998, the company securitized $102,977,000 in a REMIC CMO format. This transaction was accounted for as a financing for GAAP and a sale for tax.
In a GAAP financing, the Company continues to record 100% of the interest income, net of servicing and other fees, generated by the mortgage loans. The primary source of financing for these mortgage loans was the CMO borrowing. These financings represent the liability for
certain investment grade mortgage notes issued by the Company. The interest expense on this financing represents the coupon interest amount to be paid to those note holders.
The Company's net equity in these transactions was leveraged through reverse repurchase financing. At December 31, 1999 the Company had $3,366,000 of reverse repurchase financing against its net equity in these transactions.
Interest expense includes the interest on CMO borrowings, interest on the related reverse repurchase agreements and amortization of certain deferred financing costs and interest rate caps.
FNMA Mortgage Securities
Net interest income in 1999 and 1998 generated from investments in FNMA mortgage securities is detailed below (dollars in thousands):
In August 1998, the Company exchanged $17.4 million of adjustable rate mortgage loans for a like amount of mortgage securities in the form of five FNMA certificates. All of these mortgage certificates were subsequently sold with recourse in October 1998. In December 1998, the Company exchanged $55.2 million of fixed rate mortgage loans (without recourse) for a like amount of mortgage securities in the form of 31 FNMA certificates. In March 1998, the Company purchased $4,122,000 of FNMA passthrough certificates from a Wall Street dealer firm.
Interest expense includes the interest on the related reverse repurchase agreements and amortization of deferred financing costs and interest rate caps.
Private Placement MBS
Net interest income (expense) generated from private placement mortgage-backed securities is detailed below (dollars in thousands):
The Private Placement MBS category includes (1) subordinate MBS, interest only notes, and principal only notes that the Company created in its second securitization, 1998-B, and (2) starting in June 1999, subordinate MBS that the company purchased in the open market.
In October 1998, the Company completed its second private placement REMIC securitization transaction, the 1998-B securitization. Hanover contributed certain mortgage loan collateral to its newly organized unconsolidated subsidiary, HCP-2. This had the effect of removing the mortgage loan collateral from Hanover's balance sheet for GAAP and tax accounting purposes.
HCP-2 accounted for the transaction as a financing for GAAP and as a sale for tax accounting purposes.
The Company's investment in 1998-B private placement MBS at December 31, 1999 includes a $13,567,000 investment in six investment grade ("AA", "A" and "BBB"), six interest only notes, six below investment grade notes and three principal only notes. The Company's investment in 1998-B private placement MBS at December 31, 1998 includes a $18,883,000 investment in the same securities plus three additional investment grade subordinate MBS and three additional below investment grade subordinate MBS.
The 1998-B interest only notes 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.
In the second quarter of 1999, the Company purchased twelve below investment grade subordinate MBS from third parties. At December 31, 1999, these securities had an aggregate book of value of $3,640,000.
Other interest income
Interest income generated during 1999 and 1998 from non-mortgage assets is detailed below (dollars in thousands):
Interest income on cash deposited as additional cash collateral (cash margin) pursuant to reverse repurchase financing agreements with certain lenders in 1998 earned interest at the respective borrowing rate charged by the lender. There was no such activity in 1999.
Interest income recorded on overnight investing was generated for the most part from investing excess cash in Federal Home Loan Bank discount notes and, to a much lesser extent, investments in the highest rated commercial paper and savings accounts. Interest rates on overnight investments ranged from 3.65% to 5.13%.
The Company had maintained a significantly higher liquidity balance in the first three quarters of 1999 as compared to 1998. (Cash and cash equivalent balances at December 31, 1999 and 1998 were $18,022,000 and $11,837,000, respectively.) Accordingly, interest income generated from overnight investing was considerably higher than in 1998. In the fourth quarter of 1999, excess cash was applied to reduce borrowings against FNMA collateral.
Notes receivable due from HCP earn interest at the prime rate less one percent. The balance due from HCP at December 31, 1999 and 1998 was $4,896,000 and $713,000, respectively. Notes receivable due from Principals earn interest at the lowest applicable Federal rate in effect at the time of the loan. The balance due from Principals at December 31, 1999 and 1998 was $3,050,000 and $3,180,000, respectively.
In September 1999 Hanover advanced $3,041,000 to HCP to fund the purchase of certain third party private placement notes by HCP. This advance is included in the notes receivable due from HCP at December 31, 1999.
TAXABLE INCOME
Hanover's taxable income for year ended December 31, 1999 is estimated at $2,367,000. Taxable income differs from GAAP net (loss) for the year ended December 31, 1999 due to various recurring and one time book/tax differences. The following table details the major book/tax differences in arriving at the estimated taxable income for the year ended December 31, 1999 (dollars in thousands):
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.
LIQUIDITY
With the completion of the 1999-B securitization and the concomitant reduction of mortgage loans held for sale to close to zero, the Company believes it has substantially reduced its exposure to liquidity events. The Company expects to meet its future short-term and long-term liquidity requirements generally from its existing working capital, cash flow provided by operations, reverse repurchase agreements and other possible sources of financing, including CMOs and REMICs. The Company considers its ability to generate cash to be adequate to meet operating requirements both short-term and long-term.
The Company's remaining exposure to market-driven liquidity events is limited to the short-term reverse repurchase financing it has in place against its mortgage-backed securities. If a significant decline in the market value of the Company's mortgage-backed securities 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.
The Company had two committed reverse repurchase agreement lines of credit in place at December 31, 1999 and four uncommitted lines of credit. Management may add additional committed and uncommitted lines of credit in the future.
Net cash provided by operating activities for the year ended December 31, 1999 was $2,676,000 compared to a net loss of ($12,627,000) for the year ended December 31, 1999. Significant non-cash charges and expenses included $6,517,000 of non cash losses from mark-to-market of certain securities and mortgage loans; $4,793,000 provision for loss on sale of HCP-2 subsidiary; and $4,300,000 in amortization of premium and deferred costs. The most significant use of cash not reflected in net income were loans to related parties of $4,294,000, consisting primarily of loans to HCP which were used to fund purchases by HCP of subordinate MBS.
Net cash provided by investing activities amounted to $145,515,000 during the year ended December 31, 1999. The majority of cash proceeds from investing activities was generated from (1) principal payments received on collateral for CMOs of $61,613,000, mortgage loans available for sale of $44,429,000 and mortgage securities of $12,895,000; and (2) proceeds from sale of mortgage loans of $28,789,000, offset by the purchase of twelve below investment grade mortgage securities for $3,668,000 in the second quarter. (In addition, HCP purchased seventeen below investment grade mortgage securities in the third quarter. The cash used for this purchase ($3,041,000) was provided by the Company in the form of a note receivable from HCP, which is reflected in the increase in loans to related parties described in the preceding paragraph.)
Cash flows from financing activities used $142,006,000 during the year ended December 31, 1999. During the year ended December 31, 1999, the Company made net repayments to its
reverse repurchase lenders of $314,368,000 and had net borrowings on CMOs (net of principal repayments) of $177,624,000. The Company also paid dividends of $3,026,000 and purchased an additional 495,000 shares of its common stock for $2,235,000 during this period.
CAPITAL RESOURCES
The Company had no significant capital expenditure during 1999 and management does not anticipate the need for any material capital expenditures in the near 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 Company did not experience any material Y2K issues. Nevertheless, there still remain some future dates that could potentially cause computer systems problems.
The following information is provided relating to the Company's preparation for Y2K issues in the year ended December 31, 1999:
1. Y2K-Readiness- The Company reviewed the status of all of its information technology ("IT") systems and determined that all of its computer hardware is Y2K compliant. In addition, the Company received satisfactory certification from virtually all of its third party vendors and/or verified to its satisfaction that their IT systems were Y2K compliant as of December 31, 1999.
The Company did not incur any significant costs associated with Y2K non-compliance by the third party vendors. The Company does not own any non-IT systems (i.e. elevator
systems, building air management systems, security and fire control systems). The Company received written and/or verbal confirmation that the non-IT systems located in the Company's principal leased facilities are all Y2K compliant.
2. Y2K-Costs - The Company did not incur any material costs related to its Y2K issues and believes its total Y2K costs to date have been less than $25,000. It does not anticipate any material costs will be incurred on as yet unidentified Y2K issues.
3. Y2K-Risks- The Company's most reasonably likely worst case scenario related to the Y2K issue would have occurred if any of the companies which service its mortgage asset 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. To the Company's knowledge, neither of these scenarios occurred.
4. Y2K-Contingency Plans- The Company developed contingency plans to handle the most reasonably likely worst case Y2K scenario. The Y2K contingency plans identified individuals within the Company to contact in the event of a Y2K problem, as well as the availability of back-up systems.
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, 1999 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 and securities collateralized by such 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 and securities. 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 or on any mortgage loan collateralizing below investment grade in BS held by the Company, the Company will bear the risk of loss of principal to the extent of any deficiency between the value of the mortgaged property, plus any payments from an insurer or guarantor, and the amount owing on the mortgage loan.
If the Company were to invest in 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. As of December 31, 1999, the Company did not have any commercial mortgage loan investments. However, the Company may elect to make such investments.
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 adjustable rate mortgages ("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 or mortgage securities 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 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, 1999, Management calculates that the Company is in compliance with this requirement.
Clinton Administration Proposal
The Clinton's administration for the fiscal year 2001 budget proposal was announced on February 1, 2000. The proposed budget would amend the tax rules relating to the distribution of a REIT's income. Under current law, a REIT is required to distribute at least 85% of its ordinary income and 95% of its capital gains during a taxable year in order to avoid a 4% excise tax on the undistributed amount. Under the Clinton Administration proposal, a REIT would be required to distribute 98% of both ordinary income and capital gain net income to avoid the excise tax. If this proposal was enacted, it would be effective for calendar years beginning after December 31, 2000.
As in previous Clinton Administration proposals, the administration proposes a "closely held REIT" ownership test, under which no "person" (i.e., a corporation, partnership or trust, including a pension or profit sharing trust) could own stock of a REIT possessing 50% or more the total combined voting power of all classes of voting stock or 50% or more of the total value of shares of all classes of stock. This 2001 proposal contains an exception for REITs owning more than 50% of another REIT. Further, there is a newly proposed "limited look-through rule" for partnerships that own REITs. There is no exception for publicly traded REITs. This proposal, if enacted, would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action (an entity that has elected REIT status prior to this date will avoid these restrictions so long as it has sufficient business assets or activities as of such date). It is presently uncertain whether these REIT proposals, or any other proposals regarding REITs, will be enacted.
State and Local Taxes
Hanover and its shareholders may be subject to state or local taxation in various jurisdictions, including those in which it or they transact business or reside. The state and local tax treatment of Hanover and its shareholders may not conform to federal income tax consequence discussed above. Consequently, prospective shareholders should consult their own tax advisors regarding the effect of state and local tax laws on an investment in Hanover shares.
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 Quarterly Report contain various "forward-looking statements" within the meaning of Section 27A of the Securities Exchange Act of 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 Report that could cause actual results to differ materially from the results predicted in the forward-looking statements. Further, the Company specifically cautions investors to consider the following important factors in conjunction with the forward-looking statements: the possible decline in the Company's ability to locate and acquire mortgage loans; the possible adverse effect of changing economic conditions, including fluctuations in interest rates and changes in the real estate market both locally and nationally; the effect of severe weather or natural disasters; the effect of competitive pressures from other financial institutions, including other mortgage REIT's; 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:
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
During 1999 the Company used 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 and certain mortgage securities. The Company generally closes out the hedge position to coincide with the related sale or securitization transactions and recognizes the results of the hedge transaction in determining the amount of the related gain or loss for loans or securities sold, or as a basis adjustment to loans held to maturity.
At December 31, 1999 the Company had forward commitments to sell $6 million (par value) of Agency mortgage securities that had not yet settled. This forward sale was entered into to hedge the expected sale of approximately $6 million of AA and A rated subordinate mortgage-backed securities held in a trading account.
The Company generally hedges its "held for sale" 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 or gains of the individual hedging transactions can vary greatly depending upon market conditions. Net hedging gains on the fixed rate mortgage pools were $86,000 during 1999.
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 should offset a corresponding decline in the value of the hedged assets. Conversely, if interest rates decrease, the market value of the hedged asset will generally increase. The net effect of decreasing interest rates will generally be an unfavorable or loss settlement on the forward sale of the Agency security; this loss should be offset by a corresponding gain in value of the hedged assets. To mitigate interest rate risk an effective matching of Agency securities with the hedged assets needs to be monitored closely. 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.
The Company also enters into interest rate hedge mechanisms (interest rate caps) to manage its interest rate exposure on certain reverse repurchase agreement financing and floating rate CMOs. 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, 1999 the Company had the following interest rate caps in effect (dollars in thousands):
In addition, the Company's affiliate, HCP, had the following interest rate caps in effect at December 31, 1999:
The primary risk associated with interest rate caps relates to interest rate increases. The interest rate caps provide a cost of funds hedge against interest rates that exceed the strike rate, subject to the limitation of the notional amount of financing.
INTEREST RATE SENSITIVITY
Interest Rate Mismatch Risk - Reverse Repo Financing
At December 31, 1999, the Company owned a de minimus amount of mortgage loans held for sale. If the Company resumes its strategy of purchasing mortgage loans, it would finance these assets during the initial period (the time period during which management analyzes the loans in detail and corrects deficiencies where possible before securitizing the loans) with reverse repurchase agreement ("repo") financing or with equity alone in certain instances. In this scenario, the Company would be exposed to the mismatch between the cost of funds on its repo financing and the yield on the mortgage loans. The Company's repo financing agreements at December 31, 1999 were indexed to LIBOR plus a spread of 125 to 238 basis points. This financing generally is rolled and matures every 30 to 90 days. Accordingly, any increases in LIBOR will tend to reduce net interest income and any decreases in LIBOR will tend to increase net interest income.
The Company also has floating rate reverse repurchase financing for certain fixed-rate mortgage backed securities. At December 31, 1999, the Company had a total of $52,356,000 of floating rate reverse repo financing compared to $62,686,000 of fixed rate mortgage-backed securities investments, and the Company's affiliate, HCP, had $10,842,000 of such financing against $14,180,000 of fixed-rate securities. The Company has attempted to hedge this exposure by using the interest rate caps described above.
Price Risk
The market value of mortgage loans and mortgage securities will fluctuate with changes in interest rates. In the case of mortgage loans held for sale and mortgage securities available for sale or held for trading, the Company will be required to record changes in the market value of such assets. In the case of mortgage loans held for sale and mortgage securities held in trading, the Company generally attempts to hedge these changes through the short sale of mortgage securities, described above. At December 31, 1999, the Company did not have any significant
mortgage loans held for sale. The mortgage securities held in trading were hedged with the short sale of mortgage securities described above.
In the case of mortgage loans held for sale, hedging gains and losses and other related hedging costs are deferred and are recorded as an adjustment of the hedged assets or liabilities. The hedging gains ("Hedging Gains") and losses ("Hedging Costs") along with the other related hedging costs are amortized over the estimated life of the asset or liability. This hedging of mortgage assets should, if properly executed, adjust the carrying value of the fixed mortgage loan pools to reflect current market pricing. The costs of the individual hedging transactions can vary greatly depending upon the market conditions. Net Hedging Gains on fixed mortgage pools were $86,000 through the first three quarters of 1999.
Prepayment Risk
Interest income on the mortgage loan and mortgage securities portfolio is also negatively affected by prepayments on mortgage loan pools or MBS purchased at a premium and positively impacted by prepayments on mortgage loan pools or MBS purchased at a discount. The Company assigns an anticipated prepayment speed to each mortgage pool and MBS at the time of purchase and records the appropriate amortization of the premium or discount over the estimated life of the mortgage loan pool or MBS. To the extent the actual prepayment speeds vary significantly from the anticipated prepayment speeds for an extended period of time, the Company will adjust the anticipated prepayment speeds and amortization of the premium or discount accordingly. This will negatively (in the case of accelerated amortization of premiums or decelerated amortization of discounts) or positively (in the case of decelerated amortization of premiums or accelerated amortization of discounts) impact net interest income.
Delinquency and Default Risk
Increases in delinquency rates and defaults by borrowers on their mortgages can also negatively impact the Company's net interest income. The Company monitors delinquencies and defaults in its mortgage loan portfolio in three categories: government, conventional and uninsured. It adjusts its loan loss provision policy and non-interest accrual policy in accordance with changes in the delinquency and default trends.
Securitized Mortgage Loan Assets
With respect to the match funding of assets and liabilities, the CMO collateral relating to the 1998-A, 1999-A and 1999-B securitizations reflect $176,751,000 of fixed rate mortgage loans and $93,082,000 of adjustable rate mortgage loans at December 31, 1999. The primary financing for this asset category is the CMOs ($254,963,000) and to a much lesser extent repo agreements ($3,366,000). The repo financing, which is indexed to LIBOR, is subject to interest rate volatility as the repo agreement matures and is extended. The financing provided by the CMOs for the 1998-A and 1999-A securitizations lock in long-term fixed financing and thereby eliminates most interest rate risk. The financing for the 1999-B securitization is indexed to LIBOR. Accordingly, the Company has hedged this interest rate risk through the purchase of interest rate caps. The Company purchased amortizing interest rate caps with notional balances of $110 million in August 1999 to hedge the 1999-B securitization.
Mortgage Securities
At December 31, 1999 the Company owned certain fixed rate Agency and private placement mortgage securities and certain interest only and principal only private placement mortgage securities ($62,686,000). The coupon interest rates on the fixed rate mortgage securities would not be affected by changes in interest rates. The interest only notes remit monthly 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. Accordingly, net interest income on the mortgage securities portfolio would be negatively affected by prepayments on mortgage loans underlying the mortgage securities and would further be negatively affected to the extent that higher rated coupon mortgage loans paid off more rapidly than lower rated coupon mortgage loans.
ITEM 8:
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 of this Form 10-K.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10:
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:
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:
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:
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.
PART IV
ITEM 14:
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 begin on page of this Form 10-K.
(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
Hanover filed no reports on Form 8-K during 1999.
(c) Exhibits
See Item 14(a) 3 above.
TABLE OF CONTENTS TO FINANCIAL STATEMENTS
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, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 1999 and 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 in the United States of America. 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, 1999 and 1998, and the consolidated results of their operations and their cash flows for the years ended December 31, 1999 and 1998 and for the period from June 10, 1997 (inception) through December 31, 1997 in conformity with generally accepted accounting principles in the United States of America.
DELOITTE & TOUCHE LLP Parsippany, New Jersey March 17, 2000
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except as noted)
See notes to consolidated financial statements
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
See notes to consolidated financial statements
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999 AND 1998 AND PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997 (in thousands except share data)
See notes to consolidated financial statements
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See notes to consolidated financial statements
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999 AND 1998 AND PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
1. ORGANIZATION AND BASIS OF PRESENTATION
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to operate as a specialty finance company. The principal business strategy of Hanover and its wholly-owned subsidiaries, (together referred to as the "Company") is to (i) acquire primarily single-family mortgage loans that are at least twelve months old or that were intended to be of certain credit quality but that do not meet the originally intended market parameters due to errors or credit deterioration, (ii) securitize the mortgage loans and retain interests therein and (iii) acquire subordinated mortgage securities similar in nature to the retained interests generated from internal securitizations. The principal business strategy of the Company's primary unconsolidated subsidiary, Hanover Capital Partners Ltd. ("HCP"), is to generate consulting and other fee income by (i) performing loan file due diligence reviews for third parties, (ii) performing loan sale advisory services and (iii) brokering and trading portfolios of loans. Until recently, HCP was also engaged in the business of originating multifamily and commercial loans. This business was discontinued in the quarter ended June 30, 1999 and substantially all charges associated with its discontinuance were recognized in the quarter. The Company's principal business objective is to generate net interest income on its portfolio of mortgage loans and mortgage securities, and to generate fee income through HCP. The Company acquires single-family mortgage loans through a network of sales representatives targeting financial institutions throughout the United States.
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 consisting 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, as adjusted on January 1, 1999, entitles the holder to purchase 1.0302 shares of common stock at the adjusted price of $14.56 per share of common stock. The warrants became exercisable on March 19, 1998 and expire on September 15, 2000. The Company utilized substantially all of the net proceeds of the IPO to fund leveraged purchases of mortgage loans and mortgage backed securities ("MBS"). As of December 31, 1999, there were 6,217,877 warrants outstanding, including 172,500 warrants issued pursuant to the underwriters over-allotment option.
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. All significant intercompany accounts and transactions have been eliminated.
BASIS OF PRESENTATION
The consolidated financial statements of the Company are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles ("GAAP") and in conformity with the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.
USE OF ESTIMATES; 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. Actual results could differ from those estimates. 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. Mortgage loans that are securitized in a collateralized mortgage obligation ("CMO") are classified as collateral for CMOs as of the closing date of the CMO. 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 and CMO collateral are reported at the lower of the original cost of the mortgaged loans or the market value of the mortgage loans as of the date they were designated as CMO collateral or held to maturity.
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 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 income 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 generally classify mortgage securities as available for sale as they are acquired. Each available for sale mortgage security is monitored for a period of time prior to making a determination whether the asset will be classified as held to maturity or trading. Management reevaluates the classification of the mortgage securities on a quarterly basis.
Mortgage securities designated as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity.
Mortgage securities designated as trading are reported at fair value. Gains and losses resulting from changes in fair value are recorded as income or expense and included in earnings.
Mortgage securities classified as held to maturity are carried at 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 adjustment of the mortgage security as of the date of the classification and is amortized into interest income as a yield adjustment.
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 consolidated statement of operations. The new cost basis shall not be changed for further increases in market value; however, further increases in market value will be reflected separately in the equity section of the Company's balance sheet. In the quarter ended September 30, 1999, the Company determined that six interest only notes were impaired. See Note 13, "Certain Charges and Expenses in the Quarter Ended September 30, 1999".
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 purchased or sold. Purchases of new issue mortgage securities are recorded when all significant uncertainties regarding the characteristics of the mortgage 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 purchases both investment grade and below investment grade mortgage backed securities. Below investment grade MBS have the potential to absorb credit losses caused by delinquencies and defaults on the underlying mortgage loans. When purchasing below investment grade MBS, the Company leverages HCP's due diligence operations and management's substantial mortgage credit
expertise to make a thorough evaluation of the underlying mortgage loan collateral. The Company monitors the delinquencies and defaults on the underlying mortgages of its mortgage securities and, if an impairment is deemed to be other than temporary, makes a provision for known losses as well as unidentified potential losses. 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 may affect the dividends paid to stockholders for that tax year.
EQUITY INVESTMENTS
Hanover records its investment in Hanover Capital Partners Ltd. ("HCP"), Hanover Capital Partners 2, Inc. ("HCP-2"), and HanoverTrade.com, Inc. ("HTC") on the equity method. Accordingly, Hanover records 97% of the earnings or losses of HCP and HTC, and, until September 30, 1999, 99% of the earnings or losses of HCP-2 through its ownership of all of the non-voting preferred stock of HCP, HTC and HCP-2, respectively. After writing off its investment in HCP-2 in September, 1999, Hanover stopped recording earnings or losses of HCP-2. Hanover believes that HCP-2 has no value.
Hanover generally has no right to control the affairs of HCP, HCP-2 or HTC because Hanover's investment in those companies is based solely on ownership of non-voting preferred stock. Even though Hanover has no right to control the affairs of these companies, management believes that Hanover has the ability to exert significant influence over these companies and therefore these investments are accounted for on the equity method.
REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing transactions and recorded at their contractual amounts, plus accrued interest.
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 mortgage loan and mortgage securities portfolio. The Company generally closes out the hedge position to coincide with the related sale or securitization transactions. Gains and losses on mortgage loan 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. Gains or losses on hedge positions associated with mortgage securities held in a trading account are recognized as income or loss in each period.
The Company also enters into interest rate caps to manage its interest rate exposure on certain reverse repurchase agreement and CMO 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 are 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 results 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.
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.
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 or state income tax to the extent that its annual distributions to stockholders are equal to at least 95% of its taxable income and as long as certain asset, income and stock ownership tests are met. Effective January 1, 2001, the distribution requirement will be reduced from 95% to 90%.
During 1998, Hanover distributed dividends in excess of its accumulated and current taxable income. Consequently, the distributions in excess of accumulated and current taxable income were treated as a return of capital to the stockholders.
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.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income.
RECLASSIFICATION
The 1998 financial statements have been reclassified to conform to the 1999 financial statement presentation.
RECENTLY ISSUED 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. 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. SFAS 137, issued in June 1999, delayed the effective date of SFAS 133 to make it effective for quarters in fiscal years beginning after June 15, 2000.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENT
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. The Company adopted SFAS 134 effective January, 1, 1999. The adoption of SFAS 134 had no affect on the Company's consolidated financial statements.
3. MORTGAGE LOANS
At December 31, 1999 management had made the determination that $251,000 of mortgage loans were held for sale. No mortgage loans were designated as held to maturity and $269,833,000 of mortgage loans were held as collateralized mortgage obligation ("CMO") collateral.
HELD FOR SALE
The following table summarizes certain characteristics of the Company's single-family mortgage loan pools, held for sale portfolio which are carried at the lower of cost or market (dollars in thousands):
The Company had one adjustable rate mortgage loan at December 31, 1999 with a one year constant maturity treasury ("CMT") reference rate index with a 12 month repricing period and a net life cap of 13.50%.
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%.
(a) The adjustable rate mortgage loans include $ -0- and $31,857,000 of hybrid mortgage loans at December 31, 1999 and December 31, 1998 respectively, which allow the coupon interest rate to change at one specified time during the life of the loan.
(b) Weighted average maturity reflects the number of months until maturity.
HELD TO MATURITY
The Company did not have any mortgage loans held to maturity at December 31, 1999. The following table summarizes certain characteristics of the Company's single-family mortgage loans, held to maturity which are carried at cost at December 31, 1998 (dollars in thousands):
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%.
The average effective yield, which includes the amortization of net premium, discounts and certain deferred costs for the periods shown below on the combined held for sale and held to maturity mortgage loan portfolio were as follows:
COLLATERAL FOR CMOS
In April 1998, the Company issued its first CMO securitization transaction, Hanover Capital SPC, Inc. Series 1998-A ("1998-A"). $102,977,000 (par value) of single family fixed rate residential mortgage loans were assigned as collateral for the 1998-A securitization. In March 1999, the Company completed its second CMO securitization transaction, Hanover Grantor Trust 1999-A ("1999-A"). $138,357,000 (par value) of single family fixed and adjustable rate residential loans were assigned as collateral for the 1999-A securitization. In August 1999, the Company completed its third CMO securitization transaction, Hanover Capital Trust 1999-B ("1999-B"). $111,575,000 (par value) of single family fixed and adjustable rate residential loans were assigned as collateral for the 1999-B securitization. The Company has limited exposure to credit risk retained on loans it has securitized through the issuance of CMOs.
The following table summarizes the Company's single-family fixed and adjustable rate mortgage loan pools held as CMO collateral (dollars in thousands):
The adjustable rate mortgage loans assigned as CMO collateral at December 31, 1999 had 18 reference rate indexes with a weighted average 4 month repricing period and a weighted average net life cap of 13.82%.
The average effective yield, which includes the amortization of net premiums, discounts and certain deferred costs, for the periods shown below on the CMO collateral were as follows:
4. MORTGAGE SECURITIES
At December 31, 1999, the Company had $45,479,000 of fixed rate FNMA mortgage-backed securities, all classified as available for sale, and $17,207,000 of fixed rate private-placement mortgage-backed securities, classified as available for sale, held to maturity, and trading, as shown in the table below.
The Company also has substantially all of the economic benefit and risks associated with $14,180,000 of fixed rate private-placement subordinate mortgage backed securities held by its affiliate, HCP. Although HCP's balance sheet is not consolidated in the Company's consolidated balance sheet, the Company receives 97% of HCP's income and has guaranteed HCP's debts associated with these securities. See Note 7 "Equity Investments."
(a) Represents 31 fixed rate FNMA pass-through certificates that the Company received in exchange for a like amount of fixed rate mortgage loans in December 1998, and one FNMA pass-through certificate purchased from a "Wall Street" dealer firm. 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.
(b) At December 31, 1999, represents six interest only notes purchased from an affiliate, Hanover Capital Partners 2, Inc. ("HCP-2"), in a private placement in October 1998 in connection with the 1998-B securitization. At December 31, 1998, represented nine investment grade ("AA", "A" and "BBB") subordinate mortgage-backed securities ("MBS") and six interest only notes purchased from HCP-2 in such private placement. At September 30, 1999 management reclassified four investment grade subordinate MBS ("AA and "A") to the trading category and two investment grade subordinate MBS ("BBB") to the held to maturity category. These MBS were transferred at their fair market value which was lower than their cost basis by $1,312,000. This decrease in market value was recorded as a one-time charge in the consolidated statements of operations. See Note 17, "Certain Charges and Expenses in the Quarter Ended September 30, 1999".
The interest rates on the investment grade subordinate MBS are fixed and range from 6.25% to 6.75%. These bonds 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. The interest only notes are divided into two major categories: at December 31, 1999, the first group had an effective weighted average interest rate of 1.055% on a notional balance of $177,641,000; and the second group had an effective weighted average interest rate of 0.25% on a notional balance of $98,071,000. At December 31, 1998, 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 $143,366,000.
(c) At December 31, 1999, represents twelve below investment grade subordinate MBS purchased from third parties in the second quarter of 1999; and two investment grade ("BBB") subordinate MBS, six below investment grade subordinate MBS and three investment grade ("AAA") principal only notes purchased from HCP-2 in October 1998 in connection with the 1998-B securitization. At December 31, 1998, represents six below investment grade subordinate MBS and three and three investment grade ("AAA") principal only notes, all purchased from HCP-2 in October 1998 in connection with the 1998-B securitization.
The coupon interest rates on the below investment grade subordinate MBS purchased from third parties are fixed and range from 6.25% to 6.68%. These notes generate normal principal and interest remittances to the Company on a monthly basis. These notes represented a $6,094,000 (principal balance) subordinated interest in $1,063,413,000 of mortgage loans at December 31, 1999. These notes were carried at $3,640,000 at December 31, 1999.
The coupon interest rates on the 1998-B subordinate MBS are fixed and range from 6.50% to 6.75%. These notes generate normal principal and interest remittances to the Company on a monthly basis. The 1998-B subordinate MBS represented a $6,360,000 (principal balance) subordinated interest in $208,447,000 of mortgage loans at December 31, 1999 and a $3,546,000 subordinated interest in $297,682,000 of mortgage loans at December 31, 1998. These notes were carried at $4,597,000 at December 31, 1999 and at $3,106,000 at December 31, 1998.
The 1998-B principal only notes do not pay interest. These notes generate principal remittances, and are carried at a discount to face value. The difference between the carrying value and the face amount is accreted into income on the constant yield method. These notes had a principal balance of $1,281,000 and $1,676,000 at December 31, 1999 and 1998, and were carried at $1,052,000 and at $1,370,000 at December 31, 1999 and 1998.
(d) Represents four investment grade subordinate MBS ("AA" and "A") purchased from HCP-2, in October 1998 in connection with the 1998-B securitization. The coupon interest rates on the investment grade notes are fixed and range from 6.50% to 6.75%. These notes generate normal principal and interest remittances to the Company on a monthly basis. These notes are carried at fair value.
(e) At December 31, 1999, represents seventeen below investment grade subordinate MBS purchased from third parties in the third quarter of 1999. The coupon interest rates on these 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. These notes represented a $33,401,000 (principal balance) subordinated interest in $5,171,979,000 of mortgage loans at December 31, 1999. These notes were carried at $14,180,000 at December 31, 1999 on the balance sheet of HCP. Although HCP's balance sheet is not consolidated in the Company's consolidated balance sheet, the Company receives 97% of HCP's income and has guaranteed HCP's debts associated with these securities. See Note 7 "Equity Investments."
The carrying value at December 31, 1999 of the Company's mortgage securities by contractual maturity dates are presented below (dollars in thousands):
As mentioned above, actual maturities may differ from stated 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 mortgage loans.
The average effective yield, which includes amortization of net premiums, (discounts) and deferred costs, for the periods shown below on the combined available for sale, held to maturity and trading mortgage securities portfolio (excluding securities owned by HCP) were as follows:
The proceeds, gross realized gains and losses from sales of available for sale mortgage securities in 1999 and 1998 were as follows (dollars in thousands):
(a) relates to the sale in March 1999 of six subordinate MBS acquired in connection with the 1998-B securitization in October 1998.
(b) relates to the sale in October 1998 of eight FNMA certificates and seven FHLMC certificates purchased in December 1997
(c) relates to the sale in October 1998 of five FNMA certificates acquired from a swap of mortgage loans in August 1998
(d) relates to the sale in October 1998 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, 1999 and 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:
The Company did not have any material concentrations of credit risk in its held for sale and held to maturity categories at December 31, 1999.
The Company did not purchase any mortgage loans in 1999. 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. 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 security basis as well as by groups of securities that share similar attributes. In certain instances, the Company has concentrations of credit risk in its mortgage securities portfolio for the securities of certain issuers. Management believes exposure to credit risk associated with purchased Agency mortgage securities is minimal due to the guarantees provided by FNMA.
CONCENTRATION OF CREDIT RISK BY ISSUER DECEMBER 31, 1999
CONCENTRATION OF CREDIT RISK BY ISSUER DECEMBER 31, 1998
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, 1999, the Company had amounts on deposit with the financial institution in excess of FDIC limits. At December 31, 1999, the Company had overnight investments of $18,000,000 in Federal Home Loan Bank 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 ALLOWANCE
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 allowance for the following periods (dollars in thousands):
7. EQUITY INVESTMENTS
Hanover owns 100% of the non-voting preferred stock of Hanover Capital Partners Ltd. ("HCP"), which entitles Hanover to receive 97% of the earnings or losses of HCP and its wholly owned subsidiaries. Hanover also owns 100% of the non-voting preferred stock of Hanover Capital Partners 2, Inc. ("HCP-2"), which entitles Hanover to receive 99% of the earnings or losses of HCP-2 and its wholly owned subsidiary. In June 1999, the Company acquired 100% of the non-voting preferred stock of HanoverTrade.com, Inc. ("HTC") which entitles Hanover to receive 97% of the earnings or losses of HTC.
Hanover currently conducts substantially all of its taxable consulting operations (i.e. due diligence consulting, loan sale advisory, and loan brokering and trading) through HCP. HCP-2 was organized in October 1998 to facilitate the securitization of $318 million of fixed and adjustable rate residential mortgage loans in connection with the issuance of the 1998-B security. HCP-2 does not conduct any ongoing business. The Company wrote off its remaining investment in HCP-2 in September, 1999. HTC was organized in June 1999 to develop an E-commerce business to broker mortgage loan pools to financial institutions via the internet.
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 a servicer of multifamily mortgage loans and, prior to June 1999, was an originator of multifamily and commercial loans. HCMC's origination operations were discontinued in June 1999. Another wholly-owned subsidiary of HCP, Hanover Capital Securities, Inc. is a registered broker/dealer with the Securities and Exchange Commission.
HCP-2 was organized in October, 1998 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, 1998-B.
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. The Board of Directors has approved the sale or disposition of the Company's preferred stock investment in HCP-2 and has recorded a one-time charge to the consolidated statement of operations for a loss on the sale of HCP-2 of $4,428,000. See Note 17, "Certain Charges and Expenses in the Three Months Ended September 30, 1999".
Until September 30, Hanover recorded 99% of the earnings or losses of HCP-2 through its ownership of all the non-voting preferred stock of HCP-2. After September 30, Hanover has not recorded earning or losses of HCP-2
The table below reflects the activity recorded in Hanover's equity investments for the following periods (dollars in thousands):
(a) represents a return of capital
8. NOTES RECEIVABLE FROM RELATED PARTIES
In connection with 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 the Company 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, 1999 Hanover had loaned the Principals the full $1,750,000. These loans bear interest at 6.02% (on $482,600 of loans) and 5.70% (on $1,267,400 of loans) at December 31, 1999.
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. These additional loans are due and payable on March 31, 2001 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 1999). A portion of these loans ($69,148) was repaid in February 1999, and another portion ($61,837) was forgiven on January 28, 2000. The Company reserved for this forgiveness on September 30, 1999. At December 31, 1999, the balance of these loans, net of the reserved amount, was $95,708.
During 1999 Hanover advanced funds to HCP pursuant to an unsecured loan agreement. These loans to HCP bear interest at 1.00% below the prime rate. At December 31, 1999 the loans outstanding to HCP totaled $4,896,046.
Amounts due from related parties and due to related parties are detailed below (dollars in thousands):
(a) The Principals are John A. Burchett, George J. Ostendorf, Irma N. Tavares and Joyce S. Mizerak, the four most senior officers/stockholders of Hanover.
(b) In March 1999, Hanover agreed to amend certain notes receivable (aggregating $1,203,880) from the Principals that had a scheduled maturity date of March 31, 1999, by extending the maturity date for two additional years. The notes were also modified to provide for accelerated repayment by a Principal in the event of such Principals' voluntary termination of employment.
(c) Pursuant to the note agreements, the Company loaned the Principals $143,000 to purchase common stock in HCP-2 in order to complete the 1998-B securitization transaction. The Principals subsequently made payments on the loans totaling $69,000. In September 1999, the Company reserved for an expected forgiveness of $62,000 of these loans. This amount was subsequently forgiven on January 28, 2000. Summarized below is the change in Principals loans during 1999:
(d) In September 1999 the Company advanced $3,041,000 to HCP to fund the purchase of certain subordinated mortgage securities pursuant to an unsecured loan agreement.
9. REVERSE REPURCHASE AGREEMENTS
At December 31, 1999 the Company had a total of $250 million of committed and uncommitted mortgage asset reverse repurchase agreement financing available pursuant to master reverse repurchase agreements with two lenders. All borrowings pursuant to the master reverse 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 125 basis points to LIBOR plus 238 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 Association (PSA) agreements and through existing reverse repurchase agreements, bear interest rates that vary from LIBOR to LIBOR plus 288 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, 1999 the Company had no outstanding borrowings on mortgage loans under the above mentioned reverse repurchase agreements.
At December 31, 1999, the Company had outstanding borrowings on retained CMO securities of $3,366,000 with a weighted average borrowing rate of 8.16% and a weighted average remaining maturity of three months. Retained CMO securities represent the Company's net investment in the CMOs issued by the Company. The reverse repurchase financing agreements at December 31, 1999 were collateralized by securities with a cost basis of $7,201,152.
At December 31, 1999, the Company had outstanding reverse repurchase agreement financing for mortgage securities (other than retained CMO securities) of $52,356,000 with a weighted average borrowing rate of 6.05% and a remaining maturity of less than one month. These mortgage securities are mortgage securities that the Company has purchased or created in transactions other than CMOs. The repurchase agreement financing at December 31, 1999 was collateralized by securities with a cost basis of $60,465,000.
The table below details the scheduled maturities of the Company's committed and uncommitted master reverse repurchase agreements at December 31, 1999:
Information pertaining to reverse repurchase agreement financing as of and for the years ended December 31, 1999 and 1998 is summarized as follows (dollars in thousands):
REVERSE REPO FINANCING YEAR ENDED DECEMBER 31, 1999
YEAR ENDED DECEMBER 31, 1998
Additional information pertaining to individual reverse repurchase agreement lenders at December 31, 1999 is summarized as follows (dollars in thousands):
(a) The Company expects that the lender will renew this facility for an additional year.
(b) The maturity date of this facility was extended to April 30, 1999 and the Company expects that the lender will renew this facility for an additional year.
(c) These borrowings are pursuant to uncommitted lines of credit which are typically renewed monthly.
10. CMO BORROWING
The Company issued its first CMO (also referred to as mortgage-backed bonds borrowing) secured by fixed rate mortgage loans in April 1998, and issued subsequent CMO borrowings secured by fixed rate and adjustable rate mortgage loans in March 1999 and August 1999. For GAAP purposes, the 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. Borrower remittances received on the CMO collateral are used to make payments on the CMOs. The obligations of the CMO are payable solely from the underlying mortgage loans collateralizing the debt and otherwise are non-recourse to the Company. The maturity of each class of CMO is directly affected by principal prepayments on the related CMO collateral. Each class of CMO is also subject to redemption according to specific terms of the respective indenture agreements. As a result, the actual maturity of any class of CMO is likely to occur earlier than its stated maturity.
Information pertaining to the CMOs as of and for the year ended December 31, 1999 is summarized as follows (dollars in thousands):
Information pertaining to the CMOs as of and for the year ended December 31, 1998 is summarized as follows (dollars in thousands):
Aggregate annual repayments of mortgage backed bonds based upon contractual amortization of the underlying mortgage loan collateral at December 31, 1999 were as follows (dollars in thousands):
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 were made from time to time in open market transactions. During the year ended December 31, 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. During the year ended December 31, 1999, the Company repurchased a total of 495,000 shares at an average price of $4.51 per share for a total cost of $2,236,000. Through December 31, 1999 the Company had repurchased a total of 641,900 shares at an average price of $5.58 per share for a total of $3,580,000. In October, 1999, the Board of Directors of the Company authorized a second share repurchase program pursuant to which the Company was authorized to repurchase up to 1,000,000 shares of its outstanding common stock from time to time in open market transactions. Through December 31, 1999, the Company had not repurchased any shares pursuant to the second program.
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 1999 and $10,000 in 1998). 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.
COMPANY STOCK OPTION PLANS
The Company has adopted two stock option plans: (1) the 1997 Executive and Non-Employee Director 1997 Stock Option Plan (the "1997 Stock Option Plan"); and (2) the 1999 Equity Incentive Plan (the "1999 Equity Incentive Plan", together with the 1997 Stock Option Plan, "the Stock Option Plans"). The purpose of the Stock Option Plans is to provide a means of performance-based compensation in order to attract and retain qualified personnel and to afford additional incentive to others to increase their efforts in providing significant services to the Company.
1997 Stock Option Plan
The 1997 Stock Option Plan provides for the grant of qualified incentive stock options ("ISOs") which meet the requirements of Section 422 of the Internal Revenue Code, stock options not so qualified ("NQSOs"), deferred stock, restricted stock, performance shares, stock appreciation and limited stock awards ("Awards"), and dividend equivalent rights ("DERs"). The 1997 Stock Option Plan authorizes the grant of options to purchase, and Awards of, an aggregate of up to 325,333 shares of the Company's Common Stock. If an option granted under the 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 issuance under the 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 ISOs granted to an employee who owns 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 with respect to
which ISOs are exercisable for the first time by an employee during any calendar year may not exceed $100,000.
All stock options granted by the Compensation Committee pursuant to the Stock Option Plan are 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) and the second Earn-Out Measuring Date (September 30, 1999) because the Company did not meet or exceed the vesting requirements. Vesting occurs when 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 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 shares 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 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.
1999 Stock Option Plan
The Company adopted the 1999 Equity Incentive Plan (the "1999 Stock Option Plan"), which provides for the grant of stock options which are not intended to be "qualified incentive stock options" pursuant to Section 422 of the Internal Revenue Code. The 1999 Stock Option Plan authorizes the grant of options of up to 550,710 shares of the Company's Common Stock. If an option granted under the 1999 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 1999 Equity Incentive Plan. The maximum number of Common Stock that any eligible participant may receive under the 1999 Stock Option Plan for any year may not exceed 50,000.
Unless terminated earlier by the Board of Directors, the 1999 Stock Option Plan will terminate ten years from its approval date. When the 1999 Stock Option Plan ends, no options or Awards may be granted under the 1999 Stock Option Plan, but existing options or Awards remain in effect until they are exercised or terminated. Each option must terminate no more than ten years from the date it is granted. Options may be granted on terms providing for exercise either in whole or in part at any time or times during their restrictive terms, or only in specified percentages at stated time periods or intervals during the term of the option. One third of the option vests one year after the grant of the option, another third of the option vests two years after the grant, and after three years the option may be exercised in full.
A summary of the status of the Company's 1997 and 1999 Stock Option Plans as of December 31, 1999 and changes during the periods from September 19, 1997 to December 31, 1997 and for the years ended December 31, 1998 and 1999 is presented below:
No shares were exercisable at December 31, 1999, 1998 and 1997.
The per share weighted average fair value of stock options granted during the period ended December 31, 1999 and 1998 was $0.49 and $0.95, respectively at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
The Company applies APB opinion No. 25 in accounting for its 1997 and 1999 Stock Option Plan and, accordingly, no compensation cost has been recognized for its stock options in the financial statements for 1999, 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):
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 1999 and 1998.
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 1999 consolidated statement of operations of the Company includes management and administrative expenses of $809,000, due diligence expenses of $119,000 and commission expenses of $5,000 relating to billings from HCP. 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 1999 and 1998 consolidated statement of operations also reflects a reduction in personnel expenses for a portion of salaries allocated (and billed) to HCP.
During 1999 and 1998 the Company recorded $175,000 and $129,000 of interest income generated from loans to the Principals and $168,000 and $126,000 of interest income from loans to HCP. The term of the Management Agreement continues until December 31, 2000 with subsequent renewal.
14. EARNINGS PER SHARE
Calculations for earnings (loss) per share are shown below (dollars in thousands, except per share data):
15. STOCK WARRANTS AND STOCK OPTIONS
In November 1998 Hanover entered into a short term financing agreement (that has since terminated) with Residential Funding Corporation ("RFC"). In connection with that financing arrangement, Hanover in April 1999 executed a Warrant Agreement to issue to RFC warrants to purchase 299,999 shares of Hanover's common stock. The warrants are 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. The warrants expire after five years, in April 2004.
16. GAIN ON SALE OF SERVICING RIGHTS
On March 31, 1999 Hanover entered into an agreement to sell the servicing rights on $148 million of single-family mortgage loans. The total income from the sale of mortgage servicing rights was $566,000. The gain on sale of mortgage servicing rights was $540,000 and the balance of the income ($26,000) relating to mortgage loans classified as held for sale, was deferred and was amortized into
interest income in 1999 over the lives of the mortgage loans using the effective yield method until the mortgage loans were securitized in August 1999.
17. CERTAIN CHARGES AND EXPENSES IN THE THREE MONTHS ENDED SEPTEMBER 30, 1999
For the three-month period ended September 30, 1999 the Company recorded certain charges and expenses totaling $14,061,000. These charges and expenses are summarized as detailed below (dollars in thousands):
(a) The realized (loss) on mark to market of mortgage securities resulted from the September 30, 1999 mark to market adjustment recorded on six 1998-B notes transferred from the available for sale category to the held to maturity and the trading categories.
(b) The impairment charge on mortgage securities resulted from the mark down of six 1998-B interest only notes to market value.
(c) The realized (loss) from mark to market resulted from a mark to market adjustment of $2,997,000 at the time of transfer of mortgage loans from the held for sale category to the collateral for CMOs category (in connection with the 1999-B securitization transaction).
(d) The financing structure for the 1998-B securitization resulted in the organization of HCP-2 in October 1998. HCP-2 was capitalized with a non-cash contribution from Hanover in the form of mortgage pools net of related reverse repurchase agreement financing in exchange for 100% of the non-voting preferred stock of HCP-2 (99% economic interest in HCP-2) and cash contributions from the Principals (which were loaned to the Principals from Hanover) in exchange for all of the common stock of HCP-2 (1% economic interest in HCP-2). The financing structure required certain costs of the securitization (net premium, hedging and deferred financing costs) to be capitalized in the subsidiary, HCP-2. Substantially all of Hanover's investment in HCP-2 consists of these capitalized costs. The capitalized costs are amortized on HCP-2's books over the anticipated life of the
respective mortgage loans and passed through to Hanover each period as Hanover's equity ownership (99%) in HCP-2. HCP-2 will continue to generate losses as these capitalized costs are amortized.
In September 1999, the Company decided to sell HCP-2. A provision for a loss on the disposition of this investment has been reflected as follows:
The Company reserved for the expected forgiveness of $62,000 of loans that Hanover advanced to the Principals in October 1998 that the Principals used to invest in HCP-2. These loans were forgiven on January 28, 2000. In addition, the Company reserved for additional compensation ($41,000) to the Principals equal to the anticipated income tax consequences attributable to the forgiveness of the notes. The total compensation costs related to the provision for forgiveness of Principals' notes ($103,000) and an estimate of costs relating to the disposition of HCP-2 (legal and other) of $50,000 are reflected as additional operating expenses in the consolidated statement of operations for 1999.
Also reflected in the above is the $403,000 loss for the three month period ended September 30, 1999 from an unconsolidated subsidiary (HCP-2). Because the Company has no basis in its investment in HCP-2 at September 30, 1999 the Company does not expect to record any future losses from HCP-2.
(e) At September 30, 1999 management reviewed the actual prepayment speeds as compared to the projected prepayment speeds on all of its investment portfolios. The review resulted in a cumulative adjustment of premiums, (discount), deferred costs and deferred financing amortization of $1,821,000 on certain of the Company's investment portfolio. The following cumulative income adjustments were recorded in the three month period ended September 30, 1999:
(f) An adjustment to mortgage loan net interest income of $357,000 was reflected in the three month period ended September 30, 1999 in connection with the 1999-B securitization. This adjustment reduced the Company's outstanding accrued interest receivable on loans included in the securitization to the amount specified in the securitization documentation.
18. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS (in thousands except share data):
Supplemental Schedule of Noncash Activities
Dividends of $583,000 and $695,000 were declared in December 1999 and December 1998 but not paid until February 2000 and January 1999, 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.
19. 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 was 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 one year reverse repurchase financing agreement for HCP. The amount of reverse repurchase financing outstanding at December 31, 1999 was $10,842,000.
Hanover has guaranteed the obligations of HCP with respect to an amendment to an office lease entered into by HCP. The office lease (effective November 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 agreed to issue and deliver to the lender warrants to purchase 299,999 shares of Hanover's common stock. The warrants are exercisable at $4.00 per share. 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 March 1999, Hanover entered into a one-year reverse repurchase financing agreement. Pursuant to the terms of the agreement, Hanover agreed to pay at least $500,000 in underwriting fees to the lender during the term of the agreement. As of December 31, 1999, Hanover had not paid any such fees to the lender. The Company expects that this commitment will be applied towards a securitization transaction that is scheduled for April 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.
At December 31, 1999 the Company had forward commitments to sell $6 million (par value) of Agency mortgage securities that had not yet settled. This forward sale was entered into to hedge the expected sale of approximately $6 million of AA and A rated subordinate mortgage-backed securities held in a trading account.
20. FINANCIAL INSTRUMENTS
The estimated fair value of the Company's assets and liabilities classified as financial instruments and off-balance sheet financial instruments at December 31, 1999 and 1998 are as follows (dollars in thousands):
The following methods and assumptions were used to estimate the fair value of the Company's financial instruments:
Mortgage loans - 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 - 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.
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.
CMO Borrowing - 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.
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.
21. SUBSEQUENT EVENTS
On February 1, 2000 a $0.10 cash dividend previously declared by the Board of Directors was paid to stockholders of record as of December 31, 1999.
On January 28, 2000 the Company forgave $62,000 of loans to Principals.
On January 27, February 18 and February 25, 2000, the Company's affiliate, HCP, purchased $819,000, $1,000,000 and $3,851,000 (principal balance) of subordinate mortgage backed securities at purchase prices of $458,000, $538,000 and $2,112,000. HCP funded these purchases with a loan of $1,297,000 from the Company and with loans of $1,838,000 from the dealers who sold such securities. Hanover guaranteed the dealer loans.
22. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data are as follows (dollars in thousands, except per share data):
(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.
******
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of Hanover Capital Partners Ltd. New York, New York
We have audited the accompanying consolidated balance sheets of Hanover Capital Partners Ltd. and Subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. 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 in the United States of America. 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, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles in the United States of America.
DELOITTE & TOUCHE LLP Parsippany, New Jersey March 17, 2000
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
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, asset management services, and mortgage and investment banking services for third parties and for its affiliate, Hanover Capital Mortgage Holdings, Inc. A wholly-owned subsidiary of HCP, Hanover Capital Mortgage Corporation ("HCMC"), is a servicer of multifamily mortgage loans and until June 30, 1999 was an originator of multifamily mortgage loans. 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
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.
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, 1999 and 1998 is detailed below:
REVENUE RECOGNITION
Revenues from due diligence contracts in progress are recognized for the services provided as they are earned and billed.
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.
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.
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.
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 income 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.
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.
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, 1999 and 1998.
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.
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.
MORTGAGE SECURITIES
The Company's policy is to generally classify mortgage securities as available for sale as they are acquired. Each available for sale mortgage security is monitored for a period of time prior to making a determination whether the asset will be classified as held to maturity or trading. Management reevaluates the classification of the mortgage securities on a quarterly basis.
Mortgage securities designated as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity.
Mortgage securities designated as trading are reported at fair value. Gains and losses resulting from changes in fair value are recorded as income or expense and included in earnings.
Mortgage securities classified as held to maturity are carried at 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 adjustment of the mortgage security as of the date of the classification and is amortized into interest income as a yield adjustment.
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 consolidated statement of operations. The new cost basis shall not be changed for further increases in market value; however, further increases in market value will be reflected separately in the equity section of the Company's consolidated 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 purchased or sold. Purchases of new issue mortgage securities are recorded when all significant uncertainties regarding the characteristics of the mortgage 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 purchases both investment grade and below investment grade mortgage backed securities ("MBS"). Below investment grade MBS have the potential to absorb credit losses caused by delinquencies and defaults on the underlying mortgage loans. When purchasing below investment grade MBS, the Company leverages off of its due diligence operations and management's substantial mortgage credit expertise to make a thorough evaluation of the underlying mortgage loan collateral. The Company monitors the delinquencies and defaults on the underlying mortgages of its mortgage securities and, if an impairment is deemed to be other than temporary, makes a provision for known losses as well as unidentified potential losses. 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.
REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing transactions and recorded at their contractual amounts, plus accrued interest.
FINANCIAL INSTRUMENTS
The Company from time to time enters into interest rate hedge mechanisms including short sales and interest rate caps to manage its exposure to market pricing changes and/or changes in costs of match funded liabilities in connection with the purchase, holding, permanent financing or sale of its mortgage securities portfolio. The Company generally closes out the hedge position to coincide with the related sale or permanent financing transactions. Gains and losses on hedge positions are either (i) deferred as an adjustment to the carrying value of the related securities until the security has been sold or permanently financed, after which the gains or losses will be amortized into income over the remaining life of the security or financing using a method that approximates the effective yield method, or (ii) deferred until such time as the related securities are sold. Gains or losses on hedge positions associated with mortgage securities held in a trading account are recognized as income or loss in each period.
The Company also enters into interest rate caps to manage its interest rate exposure on certain reverse repurchase agreement and CMO 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 are 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 utilizes hedge deferral accounting procedures in accounting for its hedging program so long as there is adequate correlation between the hedged
results 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.
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.
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.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income.
RECENTLY ISSUED 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. 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. SFAS 137, issued in June 1999, delayed the effective date of SFAS 133 to make it effective for quarters in fiscal years beginning after June 15, 2000.
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
REVENUES FROM CERTAIN CUSTOMERS
For the years ended December 31, 1999, 1998 and 1997, the Company received revenues from certain customers, which are subject to change annually, which exceeded 10% of total revenues as follows:
MORTGAGE SECURITIES
The Company's exposure to credit risk associated with its investment activities is measured on an individual security basis as well as by groups of securities that share similar attributes. In certain instances, the Company has concentrations of credit risk in its mortgage securities portfolio for the securities of certain issuers. The following table sets forth the concentrations of the Company's credit risk by issuer at December 31, 1999. The Company did not own any mortgage securities at December 31, 1998.
CONCENTRATION OF CREDIT RISK BY ISSUER DECEMBER 31, 1999
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, 1999 and 1998, HCMC was servicing 6 and 13 loans, respectively, with unpaid principal balances of $13,388,037 and $46,329,000 including loans subserviced for others of $10,690,537 and $27,533,700 respectively. Escrow balances maintained by HCMC were $212,528 and $1,316,400 at December 31, 1999 and 1998, respectively. The aforementioned servicing portfolio and related escrow accounts are not included in the accompanying consolidated balance sheets as of December 31, 1999 and 1998.
Activity in mortgage servicing rights for the years ended December 31, 1998 was as follows:
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, 1999 and 1998 consist of the following:
(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, 2000 with automatic annual renewal.
(2) Amounts due from entities that the Company had a minority ownership interest 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 for the year ended December 31, 1997.
(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, payroll services and accounting services.
(5) Amounts due from officers at December 31, 1998 include $53,766 from the Company's President, which was 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.
(7) Amounts due reflect certain costs that the Company paid for HanoverTrade.com. These expenses incurred relate to start-up costs of HanoverTrade.com.
8. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 1999 and 1998 consists of the following:
Depreciation expense for the years ended December 31, 1999, 1998 and 1997 was $107,583, $105,519, and $110,284, respectively.
9. MORTGAGE SECURITIES
At December 31, 1999, the Company had $14,180,184 of fixed rate private-placement mortgage-backed securities, classified as available for sale, as shown on the table below. The Company did not have any such securities at December 31, 1998.
(a) At December 31, 1999, represents seventeen below investment grade subordinate MBS purchased from third parties in the third quarter of 1999. The coupon interest rates on these 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. These notes represented a $33,400,795 (principal balance) subordinated interest in $5,171,979,000 of mortgage loans at December 31, 1999. These notes were carried at $14,180,184 at December 31, 1999.
The carrying value at December 31, 1999 of the Company's mortgage securities by contractual maturity dates are presented below:
As mentioned above, actual maturities may differ from stated 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 mortgage loans.
The average effective yield, which includes amortization of net premiums, (discounts) and deferred costs, for the periods shown below on the combined available for sale, held to maturity and trading mortgage securities portfolio were as follows:
10. LOAN LOSS ALLOWANCE
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 securities portfolio, including the evaluation of impaired loans. The following table summarizes the activity in the loan loss allowance for the year ended December 31, 1999. There was no loan loss reserve prior to January 1, 1999 as the Company did not invest in mortgage securities prior to January 1, 1999.
11. REVERSE REPURCHASE AGREEMENTS
At December 31, 1999 the Company had a total of $10,842,000 of uncommitted borrowings pursuant to a master reverse repurchase agreement with one lender. All borrowings pursuant to the master reverse repurchase agreement are secured by mortgage securities.
The reverse repurchase agreements bear interest rates that vary from LIBOR plus 90 to LIBOR plus 130 basis points. The lender will typically finance an amount equal to 60% to 80% of the market value of the mortgage securities, depending on the nature of the collateral.
The weighted average borrowing rate under the agreement was 7.111% at December 31, 1999. The weighted average maturity was eight months. The reverse repurchase financing agreements at December 31, 1999 were collateralized by securities with a cost basis of $14,180,184.
Information pertaining to reverse repurchase agreement financing as of and for the year ended December 31, 1999 is summarized as follows:
REVERSE REPO FINANCING YEAR ENDED DECEMBER 31, 1999 ----------------------------
12. INCOME TAXES
The components of deferred income taxes as of December 31, 1999 and 1998 are as follows:
The items resulting in significant temporary differences for the years ended December 31, 1999 and 1998 that generate deferred tax assets and liabilities relate primarily to the recognition of revenue and accrued liabilities for financial reporting purposes.
The components of the income tax (benefit) for the years ended December 31, 1999, 1998 and 1997 consist of the following:
The income tax (benefit) differs from amounts computed at statutory rates, as follows:
The Company has a Federal taxable net operating loss carryforward of approximately $1.9 million which begins to expire in the year 2012.
13. 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.
14. NOTE PAYABLE TO BANK
HCP had a $2.0 million Line of Credit Facility Agreement ("Line") with a bank that expired December 31, 1999 and was not renewed. There was no outstanding balance at December 31, 1999 and 1998.
15. NOTE PAYABLE TO RELATED PARTY
At December 31, 1999 the Company had a principal balance outstanding on a note payable to Hanover Capital Mortgage Holdings, Inc. in the amount of $4,896,046. The note bears interest at the prime rate minus 1% and interest is calculated on the daily principal balance outstanding. At December 31, 1999 the interest rate in effect was 7.5%. Included in the 1999 consolidated statement of operations is interest expense in the amount of $167,955 related to this note payable.
16. COMMITMENTS AND CONTINGENCIES
The Company has noncancelable operating lease agreements for office space. Future minimum rental payments for such leases are as follows:
Rent expense for the years ended December 31, 1999, 1998 and 1997 amounted to $217,413, $250,684, and $310,814 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 (beginning November 4, 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.
17. FINANCIAL INSTRUMENTS
The estimated fair value of the Company's assets and liabilities classified as financial instruments and off-balance sheet financial instruments at December 31, 1999 and 1998 are as follows:
The following methods and assumptions were used to estimate the fair value of the Company's financial instruments:
Mortgage securities - 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.
Cash and cash equivalents, accrued interest receivable, reverse repurchase agreements - The fair value of these financial instruments was determined to be their carrying value due to their short-term nature.
Marketable securities - The fair values of these financial instruments are based on quotes obtained from third parties.
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 EVENTS
On January 1, 2000, the Company hired the five most senior employees of Document Management Network, Inc. ("DMN") and purchased all of DMN's assets for a nominal sum. These employees have become the DMN division of the Company. DMN prepares documentation (primarily assignments of mortgage loans ) for third parties on a contract basis.
On January 27, February 18 and February 25, 2000, the Company purchased $819,000, $1,000,000 and $3,851,000 (principal balance) of subordinate mortgage backed securities at purchase prices of $458,000, $538,000 and $2,112,000. The Company funded these purchases with a loan of $1,270,000 from the Company's affiliate, Hanover Capital Mortgage Holdings, Inc. and with loans of $1,838,000 from the dealers who sold such securities.
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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 sheets of Hanover Capital Partners 2, Inc. and Subsidiary (the "Company") as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' equity and cash flows for the year ended December 31, 1999, and 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 audits in accordance with generally accepted auditing standards in the United States of America. 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 financial position of Hanover Capital Partners 2, Inc. and Subsidiary as of December 31, 1999 and 1998, and the results of their consolidated operations and their consolidated cash flows for the year ended December 31, 1999, and for the period from October 7, 1998 (inception) through December 31, 1998 in conformity with generally accepted accounting principles in the United States of America.
DELOITTE & TOUCHE LLP Parsippany, New Jersey March 17, 2000
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (in thousands, except as noted)
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands, except share data)
See notes to consolidated financial statements.
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands, except share data)
See notes to consolidated financial statements
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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.
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 amounts 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 CMOs.
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. Shares issued during the period and shares reacquired during the period are weighted for the period they were outstanding.
3. MORTGAGE LOANS
COLLATERAL FOR CMOs
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 CMOs (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 CMOs are reported at cost. Premiums, discounts and all deferred costs associated with the mortgage loans held as collateral for CMOs 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 CMOs), which are carried at cost (dollars in thousands):
The following table summarizes certain characteristics of the Company's single-family fixed rate mortgage loans held as collateral for CMOs at December 31, 1999 and 1998 (dollars in thousands):
(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 1999 and 1998 on the collateral for the mortgage backed bond portfolio was 6.930% and 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, 1999 and 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:
5. AFFILIATED PARTY TRANSACTIONS
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).
At December 31, 1999 and 1998 the Company reflected amounts due to Hanover Capital Mortgage Holdings, Inc. of $364,600 and $304,800 and Hanover Capital Partners Ltd. of $0 and $5,200 for the payment of operating expenses and securitization costs.
6. COLLATERALIZED MORTGAGE OBLIGATIONS
The Company, through a wholly owned subsidiary, Hanover SPC-2, Inc. has issued non-recourse debt in the form of CMOs. Borrower remittances received on the collateral for CMOs are used to make payments on the CMOs. The obligations under the CMOs are payable solely from the collateral for CMOs and are otherwise non-recourse to the Company. The maturity of the CMOs is directly affected by the rate of principal prepayments on the related collateral. The CMOs 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 CMOs is likely to occur earlier than its stated maturity.
Information pertaining to CMOs financing for 1999 and 1998 is summarized as follows (dollars in thousands):
Aggregate annual repayments of CMOs based upon contractual amortization of the underlying mortgage loan collateral at December 31, 1999 were as follows (dollars in thousands):
7. INCOME TAXES
The Company and its wholly owned subsidiary file a consolidated Federal income tax return. They each file separate state 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 $1,542,000 in 1999 and 1998 which is fully reserved by a valuation allowance. This deferred tax asset is substantially the result of a capital loss carryforward in the amount of $3,800,000 which expires in the year 2013 for Federal income tax purposes.
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, 1999 and 1998 is as follows (dollars in thousands):
The Company had no off-balance sheet financial instruments at December 31, 1999.
The following methods and assumptions were used to estimate the fair value of the Company's financial instruments:
Collateral for CMOs - The fair values of these 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.
CMO Borrowing - 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.
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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, 2000.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By /s/ Thomas P. Kaplan ------------------------ Thomas P. Kaplan Managing Director 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 the capacities indicated on March 30, 2000.
EXHIBIT INDEX
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* 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-K for the year ended December 31, 1997, as filed with the Securities and Exchange Commission.