HANOVER CAPITAL MORTGAGE HOLDINGS INC, 10-K/A, 1999-05-07

HANOVER CAPITAL MORTGAGE HOLDINGS INC
10-K/A, 1999-05-07
MORTGAGE BANKERS & LOAN CORRESPONDENTS

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10 -K/A
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[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the year ended December 31, 1997

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to
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Commission file number: 001-13417

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
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(Exact name of registrant as specified in its Charter)

MARYLAND 13-3950486
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)

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90 WEST STREET, SUITE 1508, NEW YORK, NY 10006 (212) 732-5086
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(Address of principal executive offices) (Zip Code) (Registrant's telephone number,
including area code)
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Securities registered pursuant to Section 12(b) of the Act:
COMMON STOCK, $.01 PAR VALUE PER SHARE -- AMERICAN STOCK EXCHANGE
WARRANTS -- AMERICAN STOCK EXCHANGE
UNITS -- AMERICAN STOCK EXCHANGE

Securities registered pursuant to Section 12(g) of the Act: NONE

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

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

The aggregate market value of units held by nonaffiliates of the registrant as
of February 20, 1998 was approximately $112,777,025 (based on closing sales
price of $19.625 per unit as reported for the American Stock Exchange).

The registrant had 6,466,677 shares of common stock outstanding as of February
20, 1998.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the definitive Proxy Statement to be delivered to shareholders in
connection with the Annual Meeting of Shareholders to be held May 21, 1998 are
incorporated by reference into Part III.

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HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

FORM 10-K ANNUAL REPORT

FOR THE YEAR ENDED DECEMBER 31, 1997

INDEX
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Page
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PART I
Item 1. Business.................................................................................1
Item 2: Properties..............................................................................22
Item 3: Legal Proceedings.......................................................................22
Item 4: Submission of Matters to a Vote of Security Holders.....................................23

PART II
Item 5: Market for Registrant's Common Equity and Related Stockholder Matters...................24
Item 6: Selected Financial Data.................................................................24
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations...........................................................................25
Item 8: Financial Statements and Supplementary Data.............................................31
Item 9: Changes In and Disagreements With Accountants on Accounting and
Financial Disclosure....................................................................31

PART III
Item 10: Directors and Executive Officers of the Registrant......................................32
Item 11: Executive Compensation..................................................................32
Item 12: Security Ownership of Certain Beneficial Owners and Management..........................32
Item 13: Certain Relationships and Related Transactions..........................................32

PART IV
Item 14: Exhibits, Financial Statements and Reports on Form 8-K..................................33
Signatures ........................................................................................34
</TABLE>

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PART I

ITEM 1. BUSINESS

GENERAL

BACKGROUND

In September 1997, Hanover Capital Mortgage Holdings, Inc. (the "Company")
raised net proceeds of approximately $79.1 million in its initial public
offering, pursuant to which the Company sold 5,750,000 units at $15.00 per unit.
Each unit consisted of one share of common stock, par value $.01, and one stock
purchase warrant. Each warrant entitles the holder to purchase one share of
common stock at $15.00 per share (subject to adjustment in certain events). The
warrants became exercisable on March 19, 1998 and remain exercisable until
September 15, 2000.

In connection with the initial public offering, the Company acquired a 97%
ownership interest (representing a 100% ownership of the non-voting preferred
stock) in Hanover Capital Partners Ltd. ("HCP") and its wholly-owned
subsidiaries, Hanover Capital Mortgage Corporation ("HCMC") and Hanover Capital
Securities, Inc. ("HCS"), in exchange for 716,667 shares of the Company's common
stock.

The Company is a specialty finance company the activities of which include
(i) acquiring primarily single-family subprime mortgage loans (as defined
below), (ii) securitizing mortgage loans and retaining interests therein, (iii)
offering due diligence services to buyers, sellers and holders of mortgage
loans, and (iv) originating, holding, selling and servicing multifamily mortgage
loans and commercial mortgage loans. The Company's principal business objective
is to generate increasing earnings and dividends for distribution to
stockholders. The Company acquires single-family mortgage loans through a
network of sales representatives targeting financial institutions throughout the
United States. The Company originates multifamily mortgage loans and commercial
mortgage loans through HCMC. The Company operates as a tax-advantaged REIT. The
Company is generally not subject to Federal income tax to the extent that it
distributes its earnings to its stockholders and maintains its qualification as
a REIT. Taxable affiliates of the Company, however, including HCP, HCMC and HCS,
are subject to Federal income tax. The Company has engaged HCP to render due
diligence, asset management and administrative services pursuant to a Management
Agreement.

The Company elected REIT status primarily for the tax advantages.
Management believes that the REIT structure is the most desirable structure for
owning mortgage assets because it eliminates corporate-level Federal income
taxation. In addition, as the Company is not a traditional lender which accepts
deposits, it is subject to substantially less regulatory oversight and incurs
lower operating expenses than banks, thrifts and many other originators of
mortgage assets. Management believes that the Company will generate attractive
earnings and dividends per share for stockholders through the combination of (i)
purchasing subprime single-family mortgage loans which generally have higher
yields than newly originated mortgage loans, (ii) using long-term financing that
allows the Company to realize net interest income over time as REIT-qualified
income, as opposed to fully taxable gain-on-sale income, and (iii) its focus on
originating multifamily mortgage loans and commercial mortgage loans, which
generally have higher yields than conforming single-family mortgage loans. As
used herein, the term "subprime single-family mortgage loan" means a single-
family mortgage loan that is either twelve months or older or that does not meet
the originally intended credit quality due to documentation errors or credit
deterioration. Although HCP has previously rendered advisory services in
connection with securitization transactions, neither it nor HCMC has securitized
any significant amount of mortgage loans.

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BUSINESS STRATEGY

The Company's strategy is to pursue acquisitions and originations of
mortgage loans where it believes it can receive acceptable rates of return on
invested capital and effectively utilize leverage. Key elements of this strategy
include:

o growing the Company's investment portfolio by utilizing the Company's
single-family mortgage loan acquisition network and multifamily and
commercial origination operation to create attractive investment
opportunities;

o financing the Company's investments in a manner that limits the
Company's interest rate risk while earning an attractive return on
equity; and

o owning mortgage assets in the REIT structure and thereby eliminating a
layer of taxes relative to most traditional real estate lenders.

The Company's principal executive offices are located at 90 West Street,
Suite 1508, New York, New York 10006.

INVESTMENT PORTFOLIO

GENERAL

The primary business of the Company is investing, generally on a long-term
basis, in first lien single-family mortgage loans, multifamily mortgage loans
and commercial mortgage loans and mortgage securities secured by or representing
an interest in mortgage loans (the "Investment Portfolio"). The percentage of
the Company's mortgage assets which is invested in various sectors of the
Investment Portfolio may vary significantly from time to time depending upon the
availability of mortgage loans and mortgage securities. The Company utilizes its
organization to acquire and securitize single-family mortgage loans and
originate commercial mortgage loans to earn higher returns than could generally
be earned from purchasing mortgage securities in the marketplace.

SINGLE FAMILY MORTGAGE OPERATIONS

SINGLE-FAMILY MORTGAGE LOANS. The Company focuses on the purchase of pools
of whole single-family mortgage loans that do not fit into the large
government-sponsored or private conduit programs. Single-family mortgage loans
generally are acquired in pools from a wide variety of sources, including
private sellers such as banks, thrifts, finance companies, mortgage companies
and governmental agencies. The majority (65% - 70%) of the Company's acquisition
of single-family mortgage loan pools to date have been fixed rate loans, with
the balance made up of adjustable rate mortgage ("ARM") loans. At December 31,
1997, the Company had an investment in mortgage securities of $348 million. The
Company intends to liquidate these investments over the next twelve months as it
identifies and purchases additional single-family mortgage loan pools.

The Company uses seven sales representatives from HCP, located in Illinois,
Minnesota, California, Massachusetts and New York, to source single-family
mortgage loan products. For the foreseeable future, the Company believes that
there will be an adequate supply of mortgage loan product that can be sourced by
the existing HCP sales force.

At December 31, 1997, the Company had invested $160,970,000 or 31.1% of the
Company's total assets in the following types of single-family mortgage loans in
accordance with the operating policies established by the Board of Directors.

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WHOLE LOAN MORTGAGE LOAN SUMMARY FIXED RATE MORTGAGE LOANS
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Face or principal amount.............................. $106,424,000
Carrying value........................................ 107,953,000
Weighted average net coupon........................... 8.265%
Weighted average maturity(1) (in months).............. 242
Number of loans....................................... 1,763
Average loan size..................................... $ 60,365
Average loan-to-value ratio (LTV)..................... 67.13%
</TABLE>

ADJUSTABLE RATE MORTGAGE (ARM) LOANS
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Face or principal amount.............................. $52,365,000
Carrying value........................................ $53,017,000
Weighted average net coupon........................... 7.925%
Weighted average maturity (in months)................. 319
Number of loans....................................... 439
Average loan size..................................... $ 119,281
Average loan-to-value ratio (LTV)..................... 76.98%
</TABLE>

On a combined basis, the weighted average yield for fixed and adjustable
rate loans was 7.317%.

Virtually all of the adjustable rate mortgage loans had a 1 year CMT based
reference rate, with a 12 month repricing period and a net life weighted average
cap of 12.56%.

The Company had no losses on mortgage loans at December 31, 1997.

At March 6, 1998, the Company had purchased since inception in excess of
$286 million of single-family mortgage loan pools and had committed to purchase
an additional $122 million of fixed rate single-family mortgage loan pools and
$31 million of adjustable rate single family mortgage loan pools. The Company
reflects mortgage acquisitions as "committed" only after its bid to purchase
these assets has been accepted, subject to the Company's due diligence work.

HCP has a due diligence and underwriting staff, located in Edison, New
Jersey, consisting of approximately seven full-time employees. The due diligence
staff contributes to the single-family mortgage loan acquisition process by
providing expertise in the analysis of many characteristics of the single-family
mortgage loans. It has been Management's experience that buyers generally
discount the price of a single-family mortgage loan if there is a lack of
information. By having additional information on loan pools through its due
diligence operations, the Company is better able to assess the value of loan
pools.

Because mortgage loan pools can be purchased from virtually any bank,
insurance company or financial institution, the Company is not dependent upon
any one source. At December 31, 1997, the Company had purchased approximately
29% of the Company's single-family mortgage loan portfolio from a leading
mortgage banker. Management does not believe this concentration of purchases is
indicative of future trends. In addition, the Company makes bids to numerous
sources for mortgage loans and management believes that the loss of any single
source would not materially affect the

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Note: (1) No assumed prepayment speeds were used in the determination of the
weighted average maturity.

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Company. The Company does not service its single-family mortgage loans. The
servicing is outsourced to unrelated third parties specializing in loan
servicing.

STATE PERCENT
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Florida............. 25%

South Carolina...... 13%

California.......... 10%

Ohio................ 9%

Texas............... 6%

The Company purchases ARM securities from broker-dealers and financial
institutions that regularly make markets in these securities. The Company can
also purchase mortgage-backed securities from other mortgage suppliers,
including mortgage bankers, banks, savings and loans, investment banking firms,
home builders and other firms involved in originating, packaging and selling
mortgage loans.

The mortgage loans and to a lesser extent the mortgage securities held in
the Investment Portfolio generally will be held on a long-term basis, so that
the returns will be earned over the lives of the mortgage loans and mortgage
securities rather than from sales of the investments.

Single-family mortgage loan pools are usually acquired through competitive
bids or negotiated transactions. The competition for larger single-family
mortgage loan portfolios is generally more intense, while there is less
competition for smaller single-family mortgage loan portfolios. Management
believes that the Company's funding flexibility, personnel, proprietary due
diligence software and single-family mortgage loan trading relationships provide
it with certain advantages over competitors in pricing and purchasing certain
single-family mortgage loan portfolios.

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 and types of the loans. Pool
characteristics are identified and loans are segmented 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 FICO scores and other criteria to

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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 certain 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 date and ARM data (i.e., index, margin,
rate and payment reset frequency, etc.).

By examining the pool loan data, a prepayment speed is selected based
primarily upon the gross coupons and seasoning of the subject pool. After
determination of a prepayment speed, the pools' cash flow stream is modeled. The
present value of the cash flow stream is determined by discounting the cash flow
by the current market rate for loans with similar product type and credit
characteristics.

The Company also reviews information on the local economy and real estate
markets (including the amount of time and procedures legally required to
foreclose on real property) where the loan collateral is located.

In conducting due diligence operations, HCP often discovers non-conforming
elements of single-family mortgage loans, such as: (i) problems with documents,
including missing or lost documentation, errors on documents, nonstandard forms
of documents and inconsistent dates between documents, (ii) problems with the
real estate, including inadequate initial appraisals, deterioration in property
values or economic decline in the general geographic area, and (iii)
miscellaneous problems, including poor servicing, poor credit history of the
borrower, poor payment history by the borrower and current delinquency status.
The price paid for such loans is adjusted to compensate for these non-conforming
elements.

The Company maintains a process to improve the value of its single-family
mortgage loan portfolio, including updating data, obtaining lost note affidavits
in the event that a note has been misplaced, updating property values with new
appraisals, assembling historical records, obtaining mortgage insurance if the
value of a loan is in question, grouping similar loans in packages for
securitization, and segmenting portfolios for different buyers. However,
Management believes any value created will be extracted by financing or
securitizing the single-family mortgage loans and then realizing the enhanced
spread on the retained pool, as opposed to recognizing a gain upon sale of the
single-family mortgage loan portfolio.

SINGLE-FAMILY MARKET TRENDS. The Company focuses on subprime mortgage loans
which are generally available in bulk from loan originators such as mortgage
bankers, banks and thrifts that originate primarily for sale and from mortgage
portfolio holders as they restructure their holdings.

SINGLE-FAMILY ACQUISITION STRATEGY. The Company believes that it can
continue to acquire single-family mortgage loans that have a relatively high
yield when compared to the applicable risk of loss. In many cases, portions of a
pool may be made eligible for inclusion in agency pools, which will raise the
credit level of the Investment Portfolio, while preserving the higher yield
obtained at the time of purchase. In addition, the Company may securitize a
single-family mortgage loan pool. In structuring a securitization, the Company
retains subordinated or other interests, which would generally include interest
only tranches and principal only tranches. Certain other interests, such as
investment grade tranches, typically would not be retained. At December 31,
1997, the Company held no retained interests.

SINGLE-FAMILY UNDERWRITING GUIDELINES. The Company has developed an
underwriting approval policy to maintain uniform control over the quality of the
single-family mortgage loans it purchases. This

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policy sets forth a three step review process: (i) collateral valuation, (ii)
credit review, and (iii) property valuation. Prior to pricing a bid or final
purchase of a portfolio, a senior manager of the Company reviews the results of
all three underwriting evaluations. The collateral valuation entails a check on
the collateral documents (i.e., the note, mortgage, title policy and assignment
chain). The documents are examined for conformity among the documents and
adherence to secondary market standards. The credit review involves an analysis
of the credit of the borrower, including an examination of the origination and
credit documents, credit report and payment history. For more seasoned
single-family mortgage loans, the analysis may be more directed at payment
histories and credit scores. The property valuation involves an analysis of the
loan-to-value of the collateral, including an examination of the original
appraisal in the context of the current regional property market conditions and
often a drive-by valuation of the subject property and review of recent
comparable sales.

SINGLE-FAMILY SERVICING. Pools of single-family mortgage loans are
purchased with servicing retained or released by the seller. In the case of
pools purchased with servicing retained by the seller, the Company considers the
reputation and the servicing capabilities of the servicer. In some instances,
the Company requires a master servicer to provide the assurance of quality
required. A master servicer provides oversight of its subservicers and stands
ready, and is contractually obligated, to take over the servicing if there is a
problem with the subservicer. In the case of pools purchased with servicing
released, the Company places the servicing with a qualified servicer. In some
cases, the Company may retain the servicing and contract with a qualified
servicer to provide subservicing. 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, it would then distribute the funds to the certificate holders.
In this case, the Company keeps the risk of ownership of the servicing with
respect to any change in value as a result of prepayment of the underlying
single-family mortgage loans or other factors. No single-family mortgage loans
are currently serviced by the Company.

COMMERCIAL MORTGAGE LOANS AND MULTIFAMILY MORTGAGE LOANS

The Company's affiliate HCMC was one of the first commercial mortgage
banking operations to originate multifamily mortgage loans for sale to conduits,
which are financial firms (generally Wall Street firms) that purchase loans on
real estate with the specific intention to convert the underlying mortgages to
securities in the form of bonds. The origination transaction is usually
"table-funded" whereby the Company does not provide the funds for the mortgage
loan origination but rather the funds are provided by the conduit. From direct
borrower originations and its network of third party brokers, it can provide
multifamily mortgage loans and commercial mortgage loans of sufficient credit
quality to meet the requirements for securitization, as well as sales to third
party investors and purchases by the Company for the Investment Portfolio.

Due to low interest spreads, no multifamily mortgage loans or commercial
mortgage loans were purchased by the Company in 1997. However, in the future,
the Company may originate multifamily mortgage loans and commercial mortgage
loans, including mortgage loans secured by income-producing commercial
properties such as office, retail, warehouse and mini-storage facilities,
through HCMC and subsequently either sell the mortgage loans to investors or
hold them in the Investment Portfolio. Management of the Company believes that
the Company has certain competitive advantages in the commercial mortgage market
due to the speed, consistency and flexibility with which it can act as a
vertically integrated company (acting as originator, servicer, and owner of
commercial mortgage loans).

COMMERCIAL PRODUCTION PROCESS. The commercial process differs from the
single-family mortgage loan acquisition process because HCMC operates as a
direct originator of loans. HCMC has been engaged in this process since 1992 and
has been an active supplier to the Wall Street

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conduit/securitization firms, which are Wall Street dealer firms that have set
up a conduit to purchase multifamily mortgage loans and commercial mortgage
loans from national brokers and mortgage bankers for the purpose of issuing
commercial mortgage-backed securities. HCMC has the ability to source new
commercial mortgage loans directly and through brokers, to process and
underwrite the loans to the Company's standards and to service the loans.

COMMERCIAL AND MULTIFAMILY LOAN ACQUISITION/PRODUCTION STRATEGIES. The
Company adheres to specified underwriting and due diligence requirements for the
origination of multifamily and commercial mortgage loans, such that they will
qualify for sale to third party conduits or for inclusion in securitizations.
The Company continually monitors the underwriting criteria by contacting rating
agencies and the third party conduit purchasers. In addition to the underwriting
and due diligence completed at the origination level, a separate credit
committee approves all multifamily mortgage loans and commercial mortgage loans
purchased for the Investment Portfolio. The Company intends that, with prudent
underwriting and due diligence, combined with the securitization option, it will
achieve a satisfactory reward/risk ratio; however, there are no assurances that
it will be able to do so.

HCMC originates new multifamily and commercial mortgage loans through
originators that call on brokers, real estate developers and owners. While the
Company's sales force concentrates primarily on sourcing pools of single-family
mortgage loans, it also can find leads for the multifamily and commercial
mortgage loan origination business of HCMC and the due diligence operations of
HCP.

COMMERCIAL AND MULTIFAMILY UNDERWRITING GUIDELINES. The Company's
underwriting guidelines for commercial and multifamily mortgage loans focus on
the origination of loans eligible for securitization. The due diligence process
focuses on four main areas: (i) a property level review, (ii) borrower credit
issues, (iii) cash flow structures, and (iv) adequacy of legal documentation.
The property level review begins with a review of the on-site inspection report
and includes an analysis of the third party reports, including the appraisal,
engineering report and environmental report. The borrower credit issues include
an analysis of the borrower's legal structure, a review of financial statements,
past credit history of principals, management's ability and experience and
prior/existing relationships. The cash flow structures include an analysis of
the loan-to-value ratio, the expense ratio, the debt service coverage, the value
per unit, the occupancy levels and the historical expense records. The legal
documentation review includes a review of any changes to the approved program
loan documents, including the note, mortgage, reserve agreements, assignments of
leases and any borrower certifications. The program loan documents will be
structured in order to meet the requirements of securitization with respect to
such matters as prepayment penalties, recourse carve-outs and the overall
soundness of the documents. In addition, the Company obtains a "Phase I"
environmental site assessment (i.e., generally a record search with no invasive
testing) of the property that will secure a commercial or multifamily mortgage
loan. Depending on the results of the Phase I assessment, the Company may
require a Phase II assessment. The Company's loan servicing guidelines require
that the Company obtain a Phase I assessment (which includes invasive testing)
of any mortgaged property prior to the Company acquiring title to or assuming
operation of the mortgaged property. This requirement effectively precludes the
Company from enforcing the rights under the mortgage loan until a satisfactory
Phase I environmental site assessment is obtained or until any required remedial
action is thereafter taken, but also decreases the likelihood that the Company
will become liable for any material environmental condition at a mortgaged
property.

COMMERCIAL AND MULTIFAMILY MORTGAGE LOAN SERVICING. To control the credit
risk of retained interests in securitized loans, HCMC will retain the servicing
rights on any commercial mortgage loans and multifamily mortgage loans held in
the Investment Portfolio. HCMC may also retain the servicing rights on loans
originated and sold to third party conduits. HCMC, as servicer, will have the
risks associated with operating a mortgage servicing business as well as the
risk of ownership of the servicing.

At December 31, 1997, HCMC serviced approximately $121 million of
multifamily mortgage loans. The servicing of mortgage loans involves processing
and administering the mortgage loan payments for a fee. It involves collecting
mortgage payments on behalf of investors, reporting

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information to investors and maintaining escrow accounts for the payment of
principal and interest to investors and property taxes and insurance premiums on
behalf of borrowers.

The primary risk of operating a servicing business is failing to service
the loans in accordance with the servicing contracts, which exposes the servicer
to liability for possible losses suffered by the owner of the loans. The
operational requirements include proper handling and accounting for all payment
and escrow amounts, proper borrower and periodic credit reviews, proper value
and property reviews and proper payment of all monies due to third parties, such
as real estate taxing authorities and insurance companies.

The primary risks of ownership of servicing rights include the loss of
value through faster than anticipated loan prepayments (even though there may be
prepayment penalties) or improper servicing as outlined above.

COMMERCIAL MARKET TRENDS. The market for commercial and multifamily
mortgage loans has undergone dramatic changes in recent years with the advent of
securitizations. Financing of income-producing property has evolved from a
traditional two-party lending relationship, with the borrower obtaining funding
from a traditional lending institution, to a market in which lenders with
expertise in the creation of mortgage-backed securities offer borrowers an
alternative source of competitive financing. Securitization involves multiple
parties, each with specialized roles and responsibilities creating profitable
lending opportunities for those with experience in commercial mortgage finance
and the capital markets. Securitizations of commercial and multifamily mortgage
loans have grown rapidly during the 1990s.

The growth in securitization has been the result of two market forces.
First, during the recession of the early 1990s, traditional lenders withdrew
from the real estate credit market. Securitization filled the resulting void.
Second, Congress established the Resolution Trust Corporation ("RTC") in 1989 in
order to liquidate the commercial and single-family mortgage assets of failed
financial institutions. After unsuccessfully trying to sell the mortgages, the
RTC began securitizing commercial mortgages. The RTC's enormous securitization
program stimulated the growth of the private sector securitization market by
providing experience and knowledge to participants such as investment bankers,
rating agencies, mortgage companies, attorneys, accountants and loan servicers.
These participants have applied the experience and knowledge gained in the
securitization of RTC assets to the securitization of non-governmental,
private-label securities. The RTC's program also helped create an informed and
active investor base for the securities created from the securitization of
commercial mortgage assets.

The Company believes that success in the commercial market depends on a
vertically integrated strategy, which includes origination of commercial and
multifamily mortgage loans, servicing, securitization and investment in the
residual security after securitization. The Company is structured to take
advantage of efficiencies in the vertically integrated strategy, which it
anticipates will result in attractive returns to equity. However, there can be
no assurance that such returns will be achieved.

ACCUMULATION PERIOD ACQUISITIONS

The Company initially allocated a majority of the net proceeds of its
initial public offering to build a portfolio of mortgage assets, primarily
composed of adjustable rate mortgage pass-through securities of high investment
quality to provide income during the time required to acquire mortgage loans.
The Company acquires mortgage loans in the secondary mortgage market as soon as
attractive opportunities are identified. Management anticipates that the Company
will earn an acceptable level of return on the initial portfolio until the net
proceeds from the initial public offering can be fully invested in higher
yielding mortgage assets. A similar portfolio acquisition strategy will be
employed whenever the Company obtains new financing or capital.

At December 31, 1997, the Company had invested $348,131,000 or 67.3% of the
Company's total assets in the following types of adjustable rate mortgage
securities in accordance with the operating

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policies established by the Board of Directors. The Company did not own any
fixed rate mortgage securities at December 31, 1997.

FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) SECURITIES

Par value at purchase date $200,524,000
December 31, 1997 adjusted principal $200,524,000
Amortized cost basis $207,898,000
Market value $207,397,000
Weighted average net coupon 7.761%
Weighted average maturity (in months) 291
CMT based reference rate 1 year
Repricing period 12 months
Weighted average net life cap 11.25%

Seven of the eight FNMA securities had a net interest cap of 2.0%. The
remaining security had no net interest rate cap.

FEDERAL HOME LOAN MORTGAGE BANK (FHLMC) SECURITIES

Par value at purchase date $136,237,000
December 31, 1997 adjusted principal $136,237,000
Amortized cost basis $141,075,000
Market value $140,734,000
Weighted average net coupon 7.891%
Weighted average maturity (in months) 305
CMT based reference rate 1 year
Repricing period 12 months
Weighted average net life cap 10.53%

The FHLMC securities had a 1.71% weighted average net interest cap. The
weighted average maturity of the FNMA and FHLMC securities reflects the weighted
average number of months remaining on the scheduled maturity of the mortgage
securities. The weighted average maturity does not reflect any prepayment speed
assumptions.

All of these FNMA and FHLMC securities were pass-through certificates
whereby the Company receives monthly principal and interest payments.

DUE DILIGENCE OPERATIONS

The Company conducts due diligence operations through HCP for commercial
banks, government agencies, mortgage banks, credit unions and insurance
companies. The operations consist of the underwriting of credit, analysis of
loan documentation and collateral, and analysis of the accuracy of the
accounting for mortgage loan servicing by third party servicers. The due
diligence analyses are performed on a loan by loan basis. Audits of the accuracy
of the interest charged on adjustable rate mortgage loans are frequently a part
of the due diligence services provided to customers. HCP performs due diligence
on mortgage loans acquired by the Company and by unrelated third parties.

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FINANCING

GENERAL

The Company's purchases of mortgage assets are initially financed primarily
with equity and short-term borrowings through reverse repurchase agreements
until long-term financing is arranged or the assets are securitized. Generally,
upon repayment of each borrowing in the form of a reverse repurchase agreement,
the mortgage asset used to collateralize the financing will immediately be
pledged to secure a new reverse repurchase agreement or long term financing. The
Company had established mortgage asset financing agreements with various
financial institutions at December 31, 1997 and is currently negotiating a
back-up line of credit agreement with several major financial institutions.

REVERSE REPURCHASE AGREEMENTS

A reverse repurchase agreement ("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 98%. At the maturity of
the reverse repurchase agreement, the Company is required to repay the loan and
correspondingly receives back its collateral. Under reverse repurchase
agreements, the Company generally retains the incidents of beneficial ownership,
including the right to distributions on the collateral and the right to vote on
matters as to which certificate holders vote. If the Company defaults in a
payment obligation under such agreements, the lending party may liquidate the
collateral.

In the event of the insolvency or bankruptcy of the Company, certain
reverse repurchase agreements may qualify for special treatment under the United
States Bankruptcy Code, which permits the creditor to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral without
delay. In the event of the insolvency or bankruptcy of a lender during the term
of a reverse repurchase agreement, the lender may be permitted, under the
Bankruptcy Code, to repudiate the contract, and the Company's claim against the
lender for damages therefrom may be treated simply as that of an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970 or an insured depository institution
subject to the Federal Deposit Insurance Act, the Company's ability to exercise
its rights to recover its mortgage assets under a reverse repurchase agreement
or to be compensated for damages resulting from the lender's insolvency may be
limited by those laws. The effect of these various statutes is, among other
things, that a bankrupt lender, or its conservator or receiver, may be permitted
to repudiate or disaffirm its reverse repurchase agreements, and the Company's
claims against the bankrupt lender may be treated as an unsecured claim. Should
this occur, the Company's claims would be subject to significant delay and, if
and when paid, could be in an amount substantially less than the damages
actually suffered by the Company.

To reduce its exposure to the credit risk of reverse repurchase agreements,
the Company enters into the arrangements with several different parties. The
Company monitors the financial condition of its reverse repurchase agreement
lenders on a regular basis, including the percentage of its mortgage loans that
are the subject of reverse repurchase agreements with a single lender.
Notwithstanding these measures, no assurance can be given that the Company will
be able to avoid such third party risks.

The reverse repurchase borrowings bear short-term fixed (one year or less)
interest rates varying from LIBOR to LIBOR plus 125 basis points depending on
the credit of the related mortgage assets. Generally, the borrowing agreements
require the Company to deposit additional collateral in the event the market
value of existing collateral declines, which, in dramatically rising
interest-rate markets, could require the Company to sell assets to reduce the
borrowings.

There exists a risk during the initial holding period of the mortgage loan
assets, when the mortgage loan assets are financed with repo agreements, that
adverse developments in the mortgage

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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 plans to securitize them through the issuance of mortgage-backed
securities in the form of REMICs or CMOs. Alternatively, to a lesser extent and
to the extent consistent with the Company's qualification as a REIT, the Company
may resell loans in bulk whole loan sales. The length of time from when the
Company commits to purchase a mortgage loan to when it sells or securitizes the
loan will generally range from 30 days to one year or more, depending on certain
factors, including the length of the purchase commitment period, the amount and
type of the mortgage loan, and the securitization process. Any decision by the
Company to issue CMOs or REMICs or to sell mortgage loans in bulk will be
influenced by a variety of factors.

For accounting and tax purposes, mortgage loans financed through the
issuance of CMOs are treated as assets of the Company, and the CMOs are treated
as debt of the Company. The Company earns the net interest spread between the
interest income on the mortgage loans and the interest and other expenses
associated with the CMO financing. The net interest spread will be directly
affected by prepayments of the underlying mortgage loans and, to the extent the
CMOs have variable interest, may be affected by changes in short-term
interest-rates.

As an alternative to CMOs, the Company may issue REMICs. REMIC transactions
are generally accounted for as sales of the mortgage loans. REMIC securities
consist of one or more classes of "regular interests" and a single "residual
interest." The regular interests are tailored to the needs of investors and may
be issued in multiple classes with varying maturities, average lives and
interest-rates. These regular interests are predominantly senior securities but,
in conjunction with providing credit enhancement, may be subordinated to the
rights of other regular interests. The residual interest represents the
remainder of the cash flows from the underlying mortgage loans over the amounts
required to be distributed on the regular interests. In some cases, the regular
interests may be structured so that there is no significant residual cash flow.
In such a REMIC transaction, the Company sells its entire interest in the
mortgage loans, and all of the capital originally invested in the mortgage loans
may be redeployed. The Company may retain regular and residual interests on a
short-term or long-term basis. Income from REMIC issuances is not treated as
REIT qualifying income. Accordingly, REMIC issuances are not the Company's
primary securitization technique and will generally be undertaken through the
taxable subsidiaries.

The Company expects that its retained interests in securitizations will be
subordinated to the securities issued to third party investors with respect to
losses of principal and interest on the underlying mortgage loans. Accordingly,
any such losses on underlying mortgage loans will be applied first to reduce the
remaining amount of the Company's retained interest, until reduced to zero. Any
retained regular interest may include "principal only" or "interest only"
securities or other interest rate or prepayment sensitive securities or
investments. Any retained securities may subject the Company to credit, interest
rate and/or prepayment risks. The Company anticipates it will retain securities
only on terms which it believes are sufficiently attractive to compensate it for
assuming the associated risks.

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The Company may also retain subordinated mortgage backed securities, with
ratings ranging from AA to unrated, generally fixed-rate. The fixed-rate
securities generally evidence interests in 30-year single-family mortgage loans.
Securities backed by multifamily mortgage loans and commercial loans are
generally interests in 7 or 10 year balloon loans with 25 or 30 year
amortization schedules. In general, subordinated classes bear all losses prior
to the related senior classes. Losses in excess of losses anticipated at the
time subordinated securities are purchased would adversely affect the Company's
yield on the securities and, in extreme circumstances, could result in the
failure of the Company to recoup its initial investment.

Except in the case of breach of the representations and warranties made by
the Company when mortgage loans are securitized, the securitization of mortgage
loans will be non-recourse to the Company. As a result, the Company is able to
maintain the economic benefit of financing the mortgage assets and earning a
positive net interest spread, while limiting its potential risk of credit loss
to its investment in the subordinated or residual securities (generally
approximately 5% to 10% of the loan pool amount). A second advantage to the CMO
structure is that it is permanent financing and, therefore not subject to margin
calls during periods in which the value of the pool assets are declining due to
increases in interest rates.

The Company typically pays a monoline bond insurer a monthly fee to assume
a portion of the credit risk in a pool of mortgage loans. The monoline insurer
would generally require the issuer to retain a portion of the credit risk and
over-collateralize a particular pool of mortgage loans.

Proceeds from securitizations will be available to support new loan
originations and acquisitions. In addition to providing relatively less
expensive long-term financing, Management believes that the Company's
securitizations will reduce the Company's interest-rate risk on mortgage assets
held for long-term investment.

CREDIT ENHANCEMENT

REMICs or CMOs created by the Company are structured so that one or more of
the classes of the securities are rated investment grade by at least one
nationally recognized rating agency. The ratings for the Company's mortgage
assets will be based on the rating agency's view of the perceived credit risk of
the underlying mortgage loans, the structure of the mortgage assets and the
associated level of credit enhancement. Credit enhancement is designed to
provide protection to the holders of the securities in the event of borrower
defaults and other losses including reductions in the principal or interest as
required by law or a bankruptcy court. The Company can utilize multiple forms of
credit enhancement, including special hazard insurance, monoline insurance,
reserve funds, letters of credit, surety bonds and subordination or any
combination thereof. A decline in the credit quality of the mortgage loans
backing any mortgage securities or of any third party providing credit
enhancement, or adverse developments in general economic trends affecting real
estate values or the mortgage industry, could result in ratings being
downgraded.

In determining whether to provide credit enhancement, the Company takes
into consideration the costs associated with each method. The Company generally
provides credit enhancement through the issuance of mortgage-backed securities
in senior/subordinated structures or by over-collaterization of its mortgage
assets. The need for additional collateral or other credit enhancements will
depend upon factors such as the type of collateral provided and the
interest-rates paid thereon, the geographic concentration of the mortgaged
property and other criteria established by the rating agency. The pledge of
additional collateral would reduce the capacity of the Company to raise
additional funds through short-term secured borrowings or additional CMOs and
will diminish the potential expansion of the Investment Portfolio. Accordingly,
collateral would be pledged for CMOs only in the amount required to obtain the
highest rating category of a nationally-recognized rating agency. The
subordinated mortgage securities may be sold, retained by the Company or
accumulated for sale in subsequent transactions.

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OTHER MORTGAGE-BACKED SECURITIES

As an additional alternative for the financing of the Investment Portfolio,
the Company may cause to be issued other mortgage-backed securities if the
issuance of such other securities is advantageous and consistent with the
Company's qualification as a REIT. In particular, mortgage pass-through
certificates representing undivided interests in pools of mortgage loans formed
by the Company may prove to be attractive vehicles for raising funds.

The holders of mortgage pass-through certificates receive their pro rata
share of the principal payments made on a pool of mortgage loans and interest at
a pass-through interest rate that is fixed at the time of the offering. The
Company intends to retain significant portions of the undivided interests in the
mortgage loans underlying pass-through certificates. The retained interest may
also be subordinated so that, in the event of a loss, payments to certificate
holders will be made before the Company receives its payments. Unlike the
issuance of CMOs, the issuance of mortgage pass-through certificates will not
create an obligation of the Company to security holders in the event of a
borrower default. However, as in the case of CMOs, the Company may be required
to obtain credit enhancement in order to obtain a rating for the mortgage
pass-through certificates in one of the top two rating categories established of
a nationally-recognized rating agency.

CAPITAL ALLOCATION GUIDELINES (CAG)

The Company has adopted capital allocation guidelines ("CAG") in order to
strike a balance between the under-utilization of leverage and excess dependence
on leverage, which could reduce the Company's ability to meet its obligations
during adverse market conditions. Modifications to the CAG require the approval
of a majority of the Company's Board of Directors. The CAG are intended to keep
the Company's leverage balanced by (i) matching the amount of leverage to the
riskiness (return and liquidity) of each mortgage asset, and (ii) monitoring the
credit and prepayment performance of each mortgage asset to adjust the required
capital. This analysis takes into account the Company's various hedging and
other risk containment programs discussed below. In this way, the use of balance
sheet leverage is optimized through the implementation of the CAG controls. The
lender haircut indicates the minimum amount of equity the lender requires with a
mortgage asset. There is some variation in haircut levels among lenders from
time to time. From the lender's perspective, the haircut is a "cushion" to
protect capital in case the borrower is unable to meet a margin call. The size
of the haircut depends on the liquidity and price volatility of each mortgage
asset. Agency securities are very liquid, with price volatility in line with the
fixed income markets which means a lender requires a smaller haircut, typically
3%. On the other extreme, "B" rated securities and securities not registered
with the Securities and Exchange Commission are substantially less liquid, and
have more price volatility than agency securities, which results in a lender
requiring a larger haircut. Particular securities that are performing below
expectations would also typically require a larger haircut. The haircut for
residential whole loan pools will generally range between 3% and 5% depending on
the documentation and delinquency characteristics of the pool. Certain whole
loan pools may have haircuts which may be negotiated with lenders in excess of
5% due to other attributes of the pool.

IMPLEMENTATION OF THE CAG -- MARK-TO-MARKET ACCOUNTING

Each quarter, for financial management purposes, the Company marks its
mortgage assets to market. This process consists of (i) valuing the Company's
mortgage assets acquired in the secondary market, and (ii) valuing the Company's
non-security investments, such as retained interests in securitizations. For the
purchased mortgage assets, the Company obtains benchmark market quotes from
traders who make markets in securities similar in nature to the mortgage assets.
The Company then adjusts for the difference in pricing between securities and
whole loan pools. Market values for the Company's retained interests in
securitizations are calculated internally using market assumptions for losses,
prepayments and discount rates.

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The face amount of the financing used for the securities and retained
interests is subtracted from the current market value of the mortgage assets
(and hedges). This is the current market value of the Company's equity
positions. This value is compared to the required capital as determined by the
CAG. If the actual equity of the Company falls below the capital required by the
CAG, the Company must prepare a plan to bring the actual capital above the level
required by the CAG.

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

As a result of these procedures, the leverage of the balance sheet will
change with the performance of the Company's mortgage assets. Good credit or
prepayment performance may release equity for purchase of additional mortgage
assets, leading to increased earnings. Poor credit or prepayment performance may
cause additional equity to be allocated to existing investments, forcing a
reduction in mortgage assets on the balance sheet and lower future earnings. In
either case, the constant mortgage asset performance evaluation, along with the
corresponding leverage adjustments, helps to maintain the maximum acceptable
leverage (and earnings) while protecting the capital base of the Company.

RISK MANAGEMENT

The Company believes that its portfolio income is subject to three primary
risks: credit risk, interest rate risk and prepayment risk.

CREDIT RISK MANAGEMENT

The Company reduces credit risk through (i) the review of each mortgage
loan prior to purchase to ensure that it meets the guidelines established by the
Company, (ii) use of early intervention, aggressive collection and loss
mitigation techniques in the servicing process, (iii) use of insurance in the
securitization process, (iv) maintenance of appropriate capital and reserve
levels, and (v) obtaining representations and warranties, to the extent
possible, from originators. Although the Company does not set specific
geographic diversification requirements, the Company closely monitors the
geographic dispersion of the mortgage loans and makes decisions on a portfolio
by portfolio basis about adding to specific concentrations.

Commercial mortgage loans held by the Company generally are originated by
HCMC to underwriting standards established by the Company. These underwriting
standards reflect the experience of HCMC in its past originations as well as the
requirements of the rating agencies for commercial mortgage loans. The credit
underwriting includes a financial and credit check of the borrower, technical
reports including appraisal, engineering and environmental reports, as well as a
review of the economic status of the geographic area where the mortgaged
property is located. In addition, a separate credit sign-off is required before
commercial mortgage loans are transferred to the Investment Portfolio from HCMC.
The commercial mortgage loans in the Investment Portfolio will be monitored by
the servicing department of HCMC, which includes a periodic review of financial
statements of the mortgaged property as well as property inspections.

Single-family mortgage loans are generally purchased in bulk pools of $2
million to $100 million. The credit underwriting process varies depending on the
pool characteristics, including seasoning, loan-to-value ratios and payment
histories. For a new pool of single-family mortgage loans, a full due diligence
review is undertaken, including a review of the documentation, appraisal reports
and credit underwriting. Where required, an updated property valuation is
obtained. The bulk of the work is performed by employees in the due diligence
operations of HCP.

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INTEREST RATE RISK MANAGEMENT

There are two basic types of mortgage loans held by the Company: mortgage
loans held for securitization or sale and mortgage loans held in securitized
form. Mortgage loans held for securitization or sale are generally hedged. A
variety of hedging instruments may be used, depending on the asset to be hedged
and the relative price of the various hedging instruments. Hedging instruments
include forward sales of mortgage securities, and may also include interest rate
futures or options, interest rate swaps, and cap and floor agreements. Mortgage
loans held in securitized form are generally financed in a manner designed to
maintain a consistent spread in a variety of interest rate environments and
therefore do not require any hedging.

The Company may purchase interest rate caps, interest rate swaps and
similar instruments to attempt to mitigate the risk of the cost of its variable
rate liabilities increasing at a faster rate than the earnings on its mortgage
assets during a period of rising interest rates. The Company generally hedges as
much of the interest rate risk as management determines is reasonable, given the
cost of such hedging transactions and the need to maintain the Company's status
as a REIT, among other factors. The Company may also, to the extent consistent
with its qualification as a REIT and Maryland law, utilize financial futures
contracts, options and forward contracts and other instruments as a hedge
against future interest rate changes. See "Business Hedging."

PREPAYMENT RISK MANAGEMENT

With respect to commercial and multifamily mortgage loans, the Company will
seek to minimize the effects of faster or slower than anticipated prepayment
rates by originating mortgage loans with prepayment penalties and utilizing
various financial hedging instruments. With respect to single-family mortgage
loans, the Company may utilize various financial instruments as a hedge against
prepayment risk. Prepayment risk is monitored by senior management and through
periodic review of the impact of a variety of prepayment scenarios on the
Company's revenues, net earnings, dividends, cash flow and net balance sheet
market value.

Although the Company believes it has developed a cost-effective
asset/liability management program to provide a level of protection against
interest rate and prepayment risks, no strategy can completely insulate the
Company from the effects of interest rate changes, prepayments and defaults by
counterparties. Further, certain of the Federal income tax requirements that the
Company must satisfy to qualify as a REIT limit the Company's ability to fully
hedge its interest rate and prepayment risks.

HEDGING

INVESTMENT PORTFOLIO

The Company's primary method of addressing interest rate risk on its
mortgage assets is through its strategy of securitizing mortgage loans with
collateralized mortgage obligation ("CMO") borrowings, which are designed to
provide long term financing while maintaining a consistent spread in a variety
of interest-rate environments. The Company believes that its primary interest
rate risk relates to mortgage assets that are financed with reverse repurchase
agreements and are held for securitization.

The Company uses certain hedging strategies in connection with the
management of the Investment Portfolio. To the extent consistent with the
Company's REIT status, the Company follows a hedging program intended to protect
against interest rate changes and to enable the Company to earn net interest
income in periods of generally rising, as well as declining or static, interest
rates. Specifically, the goal of the hedging program is to offset the potential
adverse effects of changes in interest rates relative to the interest rates of
the mortgage assets held in the Investment Portfolio. As part of its hedging
program, the Company also monitors prepayment risks that arise in fluctuating
interest rate environments.

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The Company may use a variety of instruments in its hedging program. One
example is an interest rate cap. In a typical interest rate cap agreement, the
cap purchaser makes an initial lump sum cash payment to the cap seller in
exchange for the seller's promise to make cash payments to the purchaser on
fixed dates during the contract term if prevailing interest rates exceed the
rate specified in the contract. The Company may also purchase mortgage
derivative securities. Mortgage derivative securities can be effective hedging
instruments in certain situations as the value and yields of some of these
instruments tend to increase as interest rates rise and to decrease as interest
rates decline, while the experience for others is the converse. The Company will
limit its purchases of mortgage derivative securities to investments that must
meet REIT requirements. To a lesser extent, the Company may also enter into
interest rate swap agreements, financial futures contracts and options on
financial futures contracts, and forward contracts. However, the Company will
not invest in these instruments unless the Company is exempt from the
registration requirements of the Commodity Exchange Act or otherwise complies
with the provisions of that Act. The REIT rules may restrict the Company's
ability to purchase certain instruments and may restrict the Company's ability
to employ other strategies. In all its hedging transactions, the Company deals
only with counterparties that the Company believes are sound credit risks.

In connection with securitizations of mortgage loans, the Company is
subject to the risk of rising mortgage interest rates between the time it
commits to a fixed price purchase and the time it sells or securitizes the
mortgage loans. To mitigate this risk, the Company may utilize hedging
strategies, including mandatory and optional forward selling of mortgage loans
or mortgage-backed securities, interest rate caps and floors, and buying and
selling of futures and options on futures. The nature and quantity of these
hedging transactions is determined by the management of the Company based on
various factors, including market conditions and expected volume of mortgage
loan purchases.

As of December 31, 1997, the only hedging transactions that the Company has
entered into are forward sales of Agency mortgage securities. These forward
sales are used to provide hedge protection against potential changes in the
market value of the hedged assets, which include the Company's fixed rate
mortgage loan portfolio, due to potential changes in current market interest
rates.

COSTS AND LIMITATIONS

The Company believes that it has implemented a cost-effective hedging
policy to provide an adequate level of protection against interest-rate risks.
However, maintaining an effective hedging strategy is complex, and no hedging
strategy can completely insulate the Company from interest-rate risks. Moreover,
as noted above, certain of the REIT rules limit the Company's ability to fully
hedge its interest rate risks. The Company monitors carefully, and may have to
limit, its hedging strategies to assure that it does not violate the REIT rules,
which could result in disqualification and/or payment of penalties.

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

SERVICING RIGHTS

Whether servicing is purchased (along with purchased single-family mortgage
loans) or created (by the origination of multifamily mortgage loans and
commercial mortgage loans), a value is placed on the servicing as a purchased
mortgage servicing right ("PMSR") or an originated mortgage servicing right
("OMSR"), as the case may be, and recorded as an asset on the books of the
Company.

The valuation of a PMSR and an OMSR includes an analysis of the
characteristics of the size, rate, escrow amounts, type, maturity, etc. of the
loan, as well as an estimate of the mortgage loan's

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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

There are various state and local laws and regulations affecting the
Investment Portfolio. HCMC has mortgage-banking licenses in Arizona, Illinois,
New Jersey, Vermont and Wisconsin. In addition, the Company's activities are
subject to the rules and regulations of HUD. Mortgage operations also may be
subject to applicable state usury and collection statutes. The Company believes
that it is currently in compliance with all material rules and regulations to
which it is subject and has all required licenses.

COMPETITION

The Company participates on a national level in the mortgage market, which
is estimated at $3.8 trillion for single-family mortgage loans and $1.0 trillion
for multifamily mortgage loans and commercial loans. In purchasing mortgage
loans and issuing mortgage-backed securities, the Company competes with other
REITs, established mortgage conduit programs, investment banking firms, savings
and loan associations, banks, thrift and loan associations, finance companies,
mortgage bankers, insurance companies, other lenders and other entities
purchasing mortgage assets. In addition, there are several mortgage REITs
similar to the Company and others may be organized in the future. Continued
consolidation in the mortgage banking industry may reduce the number of sellers
of mortgage loans, which would reduce the Company's potential customer base and
result in the Company purchasing a larger percentage of mortgage loans from a
smaller number of sellers. These changes could negatively impact the Company. As
an issuer of mortgage securities, the Company will face competition for
investors from other investment opportunities.

Increasingly, mortgage lending is being conducted by mortgage lenders who
specialize in the origination and servicing of mortgage loans and then sell
these loans to other mortgage investment institutions, such as the Company. The
Company believes it has a competitive advantage because of the low cost of its
operations relative to traditional mortgage investors such as banks and savings
and loans. Like traditional financial institutions, the Company seeks to
generate income for distribution to its shareholders primarily from the
difference between the interest income on its mortgage assets and the financing
costs associated with carrying the mortgage assets.

EMPLOYEES

The Company had no employees at December 31, 1997. The Principals became
employees of the Company as of January 1, 1998. The Company engages the services
of HCP to provide management expertise, product sourcing, due diligence support,
and general and administrative services to assist the Company in accomplishing
its business objectives. At December 31, 1997, HCP employed 50 people on a
full-time basis. To date, HCP believes it has been successful in its efforts to
recruit qualified employees, but there is no assurance that it will continue to
be successful in the future. None of HCP's employees are subject to collective
bargaining agreements.

SERVICE MARKS

HCP owns two service marks that have been registered with the United States
Patent and Trademark Office, each of which expires in the year 2003.

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

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directors. Except as otherwise restricted, the Board of Directors may revise the
policies without the consent of stockholders if the Board of Directors
determines that the change is in the best interests of stockholders.
Developments in the market which affect the policies and strategies mentioned
herein or which change the Company's assessment of the market may cause the
Board of Directors to revise the Company's policies and financing strategies.

The Company has elected to qualify as a REIT for tax purposes (see "Federal
Income Tax Considerations"). The Company has adopted certain compliance
guidelines which include restrictions on the acquisition, holding and sale of
assets. Prior to the acquisition of any asset, the Company determines whether
the asset meets REIT requirements. Substantially all of the assets that the
Company has acquired and will acquire for investment are expected to qualify as
REIT assets. This requirement limits the Company's investment strategies.

The Company closely monitors its purchases of mortgage assets and the
sources of its income, including from its hedging strategies, to ensure at all
times that it maintains its qualifications as a REIT. The Company has developed
certain accounting systems and testing procedures to facilitate its ongoing
compliance with the REIT provisions of the Code. No changes in the Company's
investment policies and operating strategies, including credit criteria for
mortgage asset investments, may be made without the approval of the Company's
Board of Directors, including a majority of the unaffiliated directors.

The Company intends to conduct its business so as not to become regulated
as an investment company under the Investment Company Act of 1940. The
Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under current interpretation
of the staff of the Securities and Exchange Commission, in order to qualify for
this exemption, the Company must maintain at least 55% of its assets directly in
Qualifying Interests. In addition, unless certain mortgage securities represent
all the securities issued with respect to an underlying pool of mortgages, the
securities may be treated as securities separate from the underlying mortgage
pool and, thus, may not be considered Qualifying Interests for purposes of the
55% requirement. The Company closely monitors its compliance with this
requirement and intends to maintain its exempt status. As of this date, the
Company has been able to maintain its exemption through the purchase of mortgage
loan pools and certain whole pool government agency securities that qualify for
the exemption.

RELATIONSHIPS WITH AFFILIATES AND PRIOR BUSINESS

HCP has rendered asset management services in connection with the
short-term trading of seasoned (more than one year since origination)
single-family mortgage loans since 1995. In managing mortgage activities, HCP
typically targeted mortgage loan pools containing subprime single-family
mortgage loans with deficiencies that could be corrected so as to permit resales
on favorable terms. In managing sale activities, HCP generally has pursued a
strategy of selling single-family mortgage loans within eighteen months after
their acquisition. The Company, on the other hand, generally holds mortgage
loans on a long-term basis, so that returns are earned over the lives of
mortgage loans rather than from their sales.

In the past, HCP has engaged in single-family mortgage loan acquisition,
financing, hedging and sale activities pursuant to private management
arrangements with (i) Alpine Associates, a Limited Partnership ("Alpine
Associates"), (ii) a limited liability company formed by HCP, Alpine Associates
and an affiliate of Bankers Trust New York Corp. and (iii) certain affiliates of
Bankers Trust New York Corp. The objective in each of those arrangements was to
profit from purchasing and reselling mortgage loans rather than, as in the case
of the Company, from holding, financing and securitizing mortgage loans.

Alpine Associates and HCP formed Alpine/Hanover LLC in May of 1996, as a
successor to a partnership formed by them in February of 1994, to trade in
portfolios of subprime single-family

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<PAGE> 21

mortgage loans. In October of 1995, HCP, Alpine/Hanover LLC and BAHT 1995-1
Corp., an affiliate of Bankers Trust New York Corp., formed ABH-I LLC to trade
in subprime single-family mortgage loans. Pursuant to separate asset management
contracts with BT Realty Resources, Inc., HCP has rendered management services
similar to those it has rendered for ABH-I LLC. HCP intends to wind down and
terminate Alpine/Hanover LLC and ABH-I LLC at such time as all of the ABH-I LLC
assets have been sold. As of February 28, 1998, the remaining assets of ABH-I
LLC had an aggregate principal amount of approximately $300,000. HCP intends to
wind down and terminate its management arrangement with BT Realty Resources,
Inc. at such time as all of the assets under management have been sold. As of
February 28, 1998, the remaining assets under management had an aggregate
principal amount of approximately $100,000.

After the closing of the initial public offering, the Company acquired and
holds the Investment Portfolio. HCP has continued to conduct the due diligence
operations and, in addition, support the Company's acquisition and investment
activities by providing due diligence services to the Company. HCMC has
continued to originate, sell and service multifamily mortgage loans and
commercial mortgage loans and, in addition, may in the future support the
Company's acquisition and investment activities by serving as a source of
multifamily mortgage loans and commercial mortgage loans. HCS facilitates the
Company's trading activities by acting as a broker/dealer.

MANAGEMENT AGREEMENT

Effective as of January 1, 1998, the Company entered into a Management
Agreement (the "Management Agreement") with HCP. Under this agreement, HCP,
subject to the direction and control of the Company's Board of Directors,
provides certain services for the Company, including, among other things: (i)
serving as the Company's consultant with respect to formulation of investment
criteria and preparation of policy guidelines by the Board of Directors; (ii)
assisting the Company in developing criteria for the purchase of mortgage assets
that are specifically tailored to the Company's investment objectives; (iii)
representing the Company in connection with the purchase and commitment to
purchase or sell mortgage assets; (iv) arranging for the issuance of mortgage
securities from a pool of mortgage loans; (v) furnishing reports and statistical
and economic research to the Company regarding the Company's activities and the
services performed for the Company by HCP; (vi) monitoring and providing to the
Board of Directors on an ongoing basis price information and other data; (vii)
investing or reinvesting any money of the Company in accordance with its
policies and procedures and the terms and conditions of the Management
Agreement; (viii) providing the executive and administrative personnel office
space and services required in rendering such services to the Company; and (ix)
administering the day-to-day operations of the Company. For these services, the
Company pays HCP for each month an amount equal to the sum of (a) the wages and
salaries of the personnel employed by HCP and/or its affiliates (other than
independent contractors and other third parties rendering due diligence services
in connection with the acquisition of any mortgage assets) apportioned to the
Company for such month, plus (b) twenty-five percent (25%) of (a). The Company
also is required to pay HCP for each month an amount equal to the sum of (c) the
expense of HCP for any due diligence services provided by independent
contractors and other third parties in connection with the acquisition of any
mortgage assets during such month plus (d) three percent (3%) of (c). Any amount
that may become payable by HCP to the Company for any services provided by the
Company to HCP, including the services of the Principals, is offset against
amounts payable to HCP.

Subject to other contractual limitations, the Management Agreement does not
prevent HCP from acting as an investment advisor or manager for any other
person, firm or corporation. The term of the Management Agreement continues
until December 31, 1999 and thereafter is automatically renewed for successive
one-year periods unless the Unaffiliated Directors (as defined therein) resolve
to terminate the Management Agreement.

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<PAGE> 22

FEDERAL INCOME TAX CONSIDERATIONS

GENERAL

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

REQUIREMENTS FOR QUALIFICATION AS A REIT

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

OWNERSHIP OF COMMON STOCK

For all taxable years after its first taxable year, the Company's shares of
capital stock must be held by a minimum of 100 persons for at least 335 days of
a 12 month year (or a proportionate part of a short tax year). In addition, at
all times during the second half of each taxable year, no more than 50% in value
of the capital stock of the Company may be owned directly or indirectly by five
or fewer individuals. The Company is required to maintain records regarding the
actual and constructive ownership of its shares, and other information, and to
demand statements from persons owning above a specified level of the REITs
shares (if the Company has 200 or fewer shareholders of record, from persons
holding 0.5% or more of the Company's outstanding shares of capital stock)
regarding their ownership of shares. The Company must keep a list of those
shareholders who fail to reply to such a demand. The Company is required to use
and does use the calendar year as its taxable year for income.

NATURE OF ASSETS

On the last day of each calendar quarter, the Company must satisfy three
tests relating to the nature of its assets. First, at least 75% of the value of
the Company's assets must consist of mortgage loans, certain interests in
mortgage loans, real estate, certain interests in real estate (the foregoing,
"Qualified REIT Assets"), government securities, cash and cash items. The
Company expects that substantially all of its assets will continue to be
Qualified REIT Assets. Second, not more than 25% of the Company's assets may
consist of securities that do not qualify under the 75% asset test. Third, of
the investments in securities not included in the 75% asset test, the value of
any one issuer's securities may not exceed 5% by value of the Company's total
assets, and the Company may not own more than 10% of any one issuer's
outstanding voting securities. Pursuant to its compliance guidelines, the
Company intends to monitor closely the purchase and holding of its assets in
order to comply with the above asset tests.

SOURCES OF INCOME

The Company must meet the following three separate income-based tests each
year:

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<PAGE> 23

1. 75% INCOME TEST. At least 75% of the Company's gross income for
the taxable year must be derived from Qualified REIT Assets including interest
on obligations secured by mortgages on real property or interests in real
property. During the first year of operations certain temporary investment
income also qualify under the 75% income test. The investments that the Company
has made and will continue to make will give rise primarily to mortgage interest
qualifying under the 75% income test.

2. 95% INCOME TEST. In addition to deriving 75% of its gross income
from the sources listed above, at least an additional 20% of the Company's gross
income for the taxable year must be derived from those sources, or from
dividends, interest or gains from the sale or disposition of stock or other
securities that are not dealer property. The Company intends to limit
substantially all of the assets that it acquires to Qualified REIT Assets. The
policy of the Company to maintain REIT status may limit the types of assets,
including hedging contracts and other securities, that the Company otherwise
might acquire.

3. 30% INCOME LIMIT. Through the close of 1997, the Company must also
derive less than 30% of its gross income from the sale or other disposition of
(i) Qualified REIT Assets held for less than four years, other than foreclosure
property or property involuntarily or compulsorily converted through
destruction, condemnation or similar events, (ii) stock or securities held for
less than one year (including hedges) and (iii) property in a prohibited
transaction (generally, a sale of dealer property that is not foreclosure
property).

DISTRIBUTIONS

The Company must distribute to its shareholders on a pro rata basis each
year an amount equal to at least (i) 95% of its taxable income before deduction
of dividends paid and excluding net capital gains, plus (ii) 95% of the excess
of the net income from foreclosure property over the tax imposed on such income
by the Code, less (iii) certain "excess noncash income". The Company intends to
make distributions to its shareholders in sufficient amounts to meet this 95%
distribution requirement.

TAXATION OF THE COMPANY'S SHAREHOLDERS

For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its shareholders out of
current or accumulated earnings and profits will be includable by the
shareholders as ordinary income for federal income tax purposes unless properly
designated by the Company as capital gain dividends. Distributions of the
Company will not be eligible for the dividends received deduction for
corporations. Shareholders may not deduct any net operating losses or capital
losses of the Company. Any loss on the sale or exchange of shares of the common
stock of the Company held by a shareholder for six months or less will be
treated as a long-term capital loss to the extent of any capital gain dividends
received on the common stock held by such shareholder.

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

Under the Code, if a portion of the Company's assets were treated as a
taxable mortgage pool or if the Company were to hold REMIC residual interests, a
portion of the Company's

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<PAGE> 24

dividends would be treated as unrelated business taxable income ("UBTI") for
pension plans and other tax exempt entities. The Company believes that it has
not engaged in activities that would cause any portion of the Company's income
to be taxable as UBTI for pension plans and similar tax exempt shareholders. The
Company believes that its shares of stock will be treated as publicly offered
securities under the plan asset rules of the Employment Retirement Income
Security Act ("ERISA") for Qualified Plans.

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

ITEM 2: PROPERTIES

The Company's operations are conducted in several leased office facilities
throughout the United States. A summary of the office leases is shown below:
<TABLE>
<CAPTION>
OFFICE SPACE MINIMUM ANNUAL EXPIRATION
LOCATION (SQ.FT.) RENTAL DATE OFFICE USE
- ------------------------- ------------ -------------- -------------- -------------------------------------
<S> <C> <C> <C> <C>
New York, New York....... 2,300 $ 42,800 November 2001 Executive, Administration, Investment
Operations
Edison, New Jersey....... 5,850 75,400 June 2002 Accounting, Administration, Due
Diligence Operations, Mortgage Loan
Servicing, Investment Operations
Chicago, Illinois........ 3,900 58,900 June 1999 Due Diligence Operations, Investment
Operations
St., Louis, Missouri..... 1,007 26,800 August 1998 Mortgage Origination Operations
Rockland, Massachusetts.. 300 6,000 Month to Month Investment Operations
Sacramento, California... 150 7,400 Month to Month Due Diligence Operations, Investment
Operations
St. Paul, Minnesota...... 150 5,600 July 1998 Investment Operations
------ --------
Total:.............. 13,657 $222,900
====== ========
</TABLE>

Management of the Company believes that these facilities are adequate for
the Company's foreseeable needs and that lease renewals and/or alternate space
at comparable rental rates is available, if necessary.

ITEM 3: LEGAL PROCEEDINGS

The Company is not engaged in any material legal proceedings. However, two
affiliates have been parties to certain proceedings described below. To the
extent that the results of these proceedings are adverse to the affiliates, the
proceedings could also adversely affect the Company.

On or about January 15, 1997, Quarters on Melody Lane Partnership
("Quarters") brought suit against HCMC in the District Court in Dallas County,
Texas (titled Quarters on Melody Lane Partnership v. Hanover Capital Mortgage
Corporation et al.) In a letter dated December 17, 1996, Quarters threatened to
sue HCMC and others unless Quarters was permitted to repay a multifamily
mortgage loan, which had been originated by HCMC, without pre-payment penalties.
The initial principal balance of the multifamily mortgage loan, which closed on
June 28, 1994, was approximately $1.76 million. A portion of the proceeds of the
loan was retained in an escrow account to fund the cost of repairs, replacements
and improvements. Quarters alleged that HCMC personnel orally represented before
the closing that funds would be disbursed from the escrow account other (and
more favorably to the obligor) than as provided in the loan documents.
Disbursements have not been made in accordance with such alleged
representations. HCMC sold the loan on the day of closing and sold the servicing
rights to the loan in December 1994. In a written response to the letter, HCMC
denied that its representatives made any

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<PAGE> 25

misrepresentations to Quarters. Thereafter, Quarters filed suit against HCMC and
others as defendants, in District Court in Dallas County, Texas. The complaint
alleges that HCMC is guilty of fraudulent misrepresentation, breach of contract,
fraudulent withholding of funds, breach of fiduciary duty and conversion. On
July 17, 1997, Quarters filed an amended petition, alleging actual damages in
the amount of $300,000.00 and seeking punitive damages in the amount of
$1,000,000.00. On August 29, 1997, a court-ordered mediation between all parties
was held, at which time it was believed that a settlement had been reached. In
exchange for a complete release, HCMC agreed to pay Quarters $20,000.00.
However, as of this date, a final settlement agreement has not yet been executed
and other defendants have not yet agreed to the settlement. In early January
1998, Quarters requested certain defendants, including HCMC, to settle
separately. However, HCMC elected not to settle separately. HCMC has retained
counsel and is defending itself in such action. Management of the Company does
not believe that this claim will have a material adverse effect on the Company's
financial condition and results of operations.

In August 1992, the IRS proposed a tax deficiency against HCP arising from
HCP's treatment of certain alleged employees as independent contractors for tax
purposes. HCP negotiated a closing agreement with the IRS and, on October 6,
1997, accepted a settlement offer of $99,240 from the IRS, which also requires
HCP to treat the individuals in question as employees on a prospective basis
beginning in 1998. The treatment of the individuals as employees requires HCP to
withhold income and employment taxes from payments made to them and to make
certain matching employment tax payments.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

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<PAGE> 26

PART II

ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

In September 1997, the Company raised net proceeds of approximately $79.1
million in its initial public offering (the "IPO"). In the IPO, the Company sold
5,750,000 units at $15.00 per unit. Each unit consists of one share of common
stock, par value $.01 and one stock purchase warrant. Each warrant entitles the
holder to purchase one share of common stock at $15.00 per share (subject to
adjustment in certain events). The warrants became exercisable on March 19,
1998 and remain exercisable until September 15, 2000.

On September 19, 1997 the units began trading on the American Stock
Exchange under the trading symbol HCM.U or HCM/U. Commencing March 19, 1998, the
warrants became detachable from the common stock and, commencing March 20, 1998,
the common stock and warrants began trading separately on the American Stock
Exchange under the trading symbols HCM and HCM.WS, respectively. As of February
24, 1998, the Company had 6,466,677 shares of common stock issued and
outstanding, which was held by 86 holders of record and approximately 2,900
beneficial owners.

The following table sets forth, for the periods indicated, the high, low
and closing sales price per unit as reported on the American Stock Exchange.
<TABLE>
<CAPTION>
UNIT PRICES
-------------------------- DIVIDENDS DECLARED
HIGH LOW CLOSE PER SHARE
---- --- ----- ------------------
<S> <C> <C> <C> <C>
Third Quarter Ended September 30, 1997............ 17 1/4 15 17 1/8 --
Fourth Quarter Ended December 31, 1997............ 18 7/8 15 1/8 16 1/2 $0.16
</TABLE>

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

ITEM 6: SELECTED FINANCIAL DATA

The following selected financial data are derived from audited financial
statements of the Company for the period from inception (June 10, 1997) through
December 31, 1997. The selected financial data should be read in conjunction
with the more detailed information contained in the Financial Statements and
Notes thereto and "Management's Discussion and Analysis of Financial Conditions
and Results of Operations" included elsewhere in this Form 10-K.

OPERATIONS STATEMENT HIGHLIGHTS

1997
----------
Net interest income $1,676,000
Net income 499,000
Basic earnings per share 0.15
Diluted earnings per share 0.14
Dividends declared per share 0.16

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<PAGE> 27

BALANCE SHEET HIGHLIGHTS

December 31,1997
----------------
Adjustable-rate mortgage securities $348,131,000
Mortgage loans 160,970,000
Total assets 517,543,000
Shareholders' Equity 78,098,000
Number of common shares outstanding 6,466,677

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

The Company is a specialty finance company the activities of which include
(i) acquiring primarily subprime single-family mortgage loans, (ii) securitizing
mortgage loans and retaining interests therein, (iii) offering due diligence
services to buyers, sellers and holders of mortgage loans and (iv) originating,
holding, selling and servicing multifamily mortgage loans and commercial
mortgage loans. The Company's principal business objective is to generate
increasing earnings and dividends for distribution to stockholders. The Company
acquires single-family mortgage loans through a network of sales representatives
targeting financial institutions throughout the United States. The Company
originates multifamily mortgage loans and commercial mortgage loans through
HCMC.

RESULTS OF OPERATIONS

The Company was organized on June 10, 1997, but did not commence operations
until September 19, 1997 (the date of the IPO closing). For the period from June
10, 1997 to December 31, 1997, the Company's net income was $499,000 or $0.15
per share based on a weighted average of 3,296,742 shares of common stock
outstanding. The Company's net income for the period September 19, 1997 to
December 31, 1997 was $499,000 or $.08 per share based on a weighted average of
6,466,677 shares of common stock outstanding.

Net interest income for 1997 totaled $1,676,000. Net interest income is
interest income earned on mortgage securities, fixed rate and adjustable rate
mortgage loans, and other temporary investments less interest expense from
borrowings related to the investments.

General and administration expenses for 1997 totaled $940,000. The majority
of general and administrative expenses relate to management and administrative
expenses, due diligence acquisition costs, commission expenses, and legal and
professional fees. Due diligence acquisition costs averaged .156 % of the
principal balance of the mortgage loans purchased in 1997.

On September 19, 1997 (the IPO date), the Company acquired 100% of the
nonvoting preferred stock of HCP, which represents a 97% ownership interest in
HCP and its wholly owned subsidiaries. While the Company will generally have no
right to control the affairs of HCP because the Company owns only the preferred
stock of HCP, management believes that the Company has the ability to exert
significant influence over HCP and therefore the investment in HCP is accounted
for on the equity method. The Company recorded a loss of $254,000 in 1997 for
its equity investment in HCP. The HCP loss was a result of a decline in
consulting (due diligence/ARMS audit) revenues and a slowdown in the mortgage
originations division during the fourth quarter of 1997.

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<PAGE> 28

The table below highlights the Company's brief historical trends and
components of return on average equity.

COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY(1)

<TABLE>
<CAPTION>
EQUITY IN
GAIN ON SALE OF EARNINGS (LOSS) ANNUALIZED
NET INTEREST SECURITIES/ G & A EXPENSE/ OF SUBSIDIARY/ RETURN ON
FOR THE QUARTER ENDED INCOME/EQUITY EQUITY EQUITY EQUITY EQUITY
- ----------------------------- ------------- --------------- -------------- --------------- -----------
<S> <C> <C> <C> <C> <C>
June 30, 1997 (2)............ 0.00% 0.00% 0.00% 0.00% 0.00%
September 30, 1997(3)........ 4.85% 0.00% 3.59% 0.97% 2.23%
December 31, 1997............ 7.71% 0.18% 4.26% (1.41%) 2.22%
</TABLE>

- -----------------------
(1) Average equity excludes unrealized loss on investments available for sale.

(2) The Company was organized on June 10, 1997, but did not begin operations
until September 19, 1997.

(3) Average equity is based on equity balances at September 19, 1997 (IPO
date), and equity balances at September 30, 1997, excluding unrealized loss
on investments available for sale.

For the period from inception through December 31, 1997, the Company's
taxable income was $1,077,000 or $0.167 per weighted average share outstanding.
Taxable income is higher than GAAP net income primarily because taxable income
does not include the equity in the loss of HCP ($254,000), and due diligence
costs and commission expenses incurred to acquire mortgage loan pools ($324,000)
that are expensed under GAAP, but capitalized and amortized for tax purposes.

As a REIT, the Company is required to declare dividends amounting to 85% of
each years taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of the Company's taxable income for each year by the
time the Company files its federal tax return. Therefore, a REIT generally
passes through substantially all of its earnings to shareholders without paying
federal income tax at the corporate level. The Company paid a fourth quarter
dividend of $0.16 per share, which was equivalent to a dividend of approximately
96.0% of taxable income.

The following table reflects the average balances for each major category
of the Company's interest earning assets as well as the Company's interest
bearing liabilities with the corresponding effective rate of interest annualized
for the period September 30, 1997 (initial purchase of mortgage assets) through
December 31, 1997:
<TABLE>
<CAPTION>
AVERAGE BALANCE EFFECTIVE RATE
--------------- --------------
<S> <C> <C>
Interest Earning Assets:
Mortgage Loans(1)............................................ $ 83,776,000 7.317%
Mortgage Securities.......................................... 116,375,000 6.268%
------------ ------
$200,151,000 6.707%
============ ======
Interest Bearing Liabilities:
Reverse repurchase borrowings on mortgage loans.............. $ 32,674,000 6.313%
Reverse repurchase borrowings on mortgage securities......... 113,803,000 5.723%
------------ ------
$146,477,000 5.855%
============ ======

Net Interest Earning Assets...................................... $ 53,674,000
============
Net Interest Spread.............................................. 0.852%
======

Yield on Net Interest Earnings Assets(2)......................... 9.034%
======
</TABLE>

- --------------------------

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<PAGE> 29

(1) Loan loss reserves are excluded in above calculations.

(2) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of net interest earnings
assets.

For the year ended December 31, 1997, the Company's ratio of operating
expenses to average assets was 1.59%. The Company's 1997 operating expense did
not include any incentive bonus compensation. In order for the eligible
participants to earn incentive bonus compensation, the rate of return on
shareholders' investment must exceed the average ten-year U.S. Treasury rate
during the year plus 4.0%.

FINANCIAL CONDITION

At December 31, 1997, the Company had total assets of $517,543,000.
Mortgage loans totaled $160,970,000 or 31.1% of total assets, while mortgage
securities totaled $348,131,000 or 67.3% of total assets.

The following table presents a schedule of mortgage loans at December 31,
1997, classified by fixed rate mortgage and adjustable rate mortgages:
<TABLE>
<CAPTION>
CARRYING VALUE PORTFOLIO MIX
-------------- -------------
<S> <C> <C>
Fixed rate mortgages....................... $107,953,000 67.1%
Adjustable rate mortgages.................. 53,017,000 32.9%
------------ -----
$160,970,000 100.0%
============ =====
</TABLE>

The following table presents a schedule of mortgage securities at
December 31, 1997, classified by type of issue:
<TABLE>
<CAPTION>
CARRYING VALUE PORTFOLIO MIX
-------------- -------------
<S> <C> <C>
FNMA....................................... $207,397,000 59.6%
FHLMC...................................... 140,734,000 40.4%
------------ -----
$348,131,000 100.0%
============ =====
</TABLE>

LIQUIDITY AND CAPITAL RESOURCES

The Company expects to meet its short-term and long-term liquidity
requirements generally from its existing working capital, cash flow provided by
operations, reverse repurchase agreements and other possible sources of
financings, including CMO's and REMICs, additional equity generated by the
exercise of some or all of the outstanding warrants and additional equity
offerings. The Company considers its ability to generate cash to be adequate to
meet operating requirements both in the short-term and long-term.

Net cash provided by operating activities for the period June 10, 1997 to
December 31, 1997 was $49,000. The cash flows generated from operating
activities (mainly from net income ($499,000), non cash expense items such as
amortization of mortgage loans and mortgage security premiums, and the increase
of certain liability accounts) were reduced by amounts expended for the purchase
of accrued interest on mortgage loan pools and by loans ($482,000) made to John
A. Burchett, Irma N. Tavares and Joyce S. Mizerak (together with George J.
Ostendorf, the "Principals").

-27-

<PAGE> 30

Net cash used in investing activities for the period from June 10, 1997 to
December 31, 1997 was $510,287,000. The majority of the cash used in investing
activities related to the purchase of FNMA securities and FHLMC securities
($349,287,000) and mortgage loan pools ($163,030,000).

Cash flows from financing activities generated $514,260,000 during the
period from June 10, 1997 to December 31, 1997. The cash flows from financing
activities represent net proceeds from reverse repurchase agreements used to
finance the purchase of mortgage securities ($341,407,000), pools of
single-family mortgage loans ($93,731,000), and the net proceeds of the IPO
($79,122,000).

Management anticipates that the Company will continue to purchase single
family mortgage loan pools and will finance the purchase of the mortgage loan
pools through existing equity, reverse repurchase agreements, and other sources
of financing including CMO's and REMICs. The Company may also realize additional
liquidity beginning in March 1998 when the warrants become exercisable.

The Company is obligated to make additional loans to the Principals
($1,268,000) at their request. It is anticipated that the Principals will
request additional loans in April 1998 for tax purposes. Further, in lieu of
their exercise of certain registration rights, the Principals have also
requested additional loans in the aggregate amount of $1,500,000, which was
approved by the Board of Directors. The Company has guaranteed HCP's line of
credit facility. The Company has advanced $900,000 to HCP in February 1998 for
working capital purposes and Management anticipates that the Company may advance
additional funds in 1998 to HCP.

OTHER MATTERS

REIT REQUIREMENTS

The Company has elected to be taxed as a REIT under the Code. The Company
believes that it was in full compliance with the REIT tax rules as of December
31, 1997 and intends to remain in compliance with all REIT tax rules. If the
Company fails to qualify as a REIT in any taxable year and certain relief
provisions of the Code do not apply, the Company will be subject to Federal
income tax as a regular, domestic corporation, and its stockholders will be
subject to tax in the same manner as stockholders of a regular corporation.
Distributions to its stockholders in any year in which the Company fails to
qualify as a REIT would not be deductible by the Company in computing its
taxable income. As a result, the Company could be subject to income tax
liability, thereby significantly reducing or eliminating the amount of cash
available for distribution to its stockholders. Further, the Company could also
be disqualified from re-electing REIT status for the four taxable years
following the year during which it became disqualified.

INVESTMENTS IN CERTAIN MORTGAGE ASSETS

The Company takes certain risks in investing in subprime single-family
mortgage loans. If these mortgage loans are missing relevant documents, such as
the original note, they may be difficult to enforce. These mortgage loans may
also have inadequate property valuations. In addition, if a single-family
mortgage loan has a poor payment history, it is more likely to have future
delinquencies because of poor borrower payment habits or a continuing cash flow
problem.

DEFAULTS ON MORTGAGE ASSETS

The Company makes long-term investments in mortgage assets. During the time
it holds mortgage assets for investment, the Company is subject to the risks of
borrower defaults and bankruptcies and hazard losses (such as those occurring
from earthquakes or floods) that are not covered by insurance. If a default
occurs on any mortgage loan held by the Company, the Company will bear the risk
of loss of principal to the extent of any deficiency between the value of the
mortgaged property, plus any payments from an insurer or guarantor, and the
amount owing on the mortgage loan.

-28-

<PAGE> 31

With respect to commercial mortgage loans, the Company may be subject to
certain additional risks. Commercial properties tend to be unique and more
difficult to value than single-family residential properties. Commercial
mortgage loans often have shorter maturities than single-family mortgage loans
and often have a significant principal balance or "balloon" due on maturity. A
balloon payment creates a greater risk for the lender because the ability of a
borrower to make a balloon payment normally depends on its ability to refinance
the loan or sell the related property at a price sufficient to permit the
borrower to make the payment. Commercial mortgage lending is generally viewed as
exposing the lender to a relatively greater risk of loss than single-family
mortgage lending because it usually involves larger mortgage loans to single
borrowers or groups of related borrowers and the repayment of the loans is
typically dependent upon the successful operation of the related properties.

NEGATIVE EFFECTS OF FLUCTUATING INTEREST RATES

Changes in interest rates may impact the Company's earnings in various
ways. While the Company anticipates that over the long term less than 25% of its
mortgage loans will be ARMs, rising short term interest rates may negatively
affect the Company's earnings in the short term. Increases in the interest rate
on an ARM loan are generally limited to either 1% or 2% per adjustment period.
ARM loans owned by the Company are subject to such limitations, while
adjustments in interest rate on the Company's borrowings are not correspondingly
limited. As a result, in periods of rising interest rates, the Company's net
interest income could temporarily decline.

The rate of prepayment on the Company's mortgage loans may increase if
interest rates decline, or if the difference between long-term and short-term
interest rates diminishes. Increased prepayments would cause the Company to
amortize any premiums paid on the acquisition of its mortgage loans faster than
currently anticipated, resulting in a reduced yield on its mortgage loans.
Additionally, to the extent proceeds of prepayments cannot be reinvested at a
rate of interest at least equal to the rate previously earned on the prepaid
mortgage loans, the Company's earnings may be adversely affected.

INSUFFICIENT DEMAND FOR MORTGAGE LOANS AND THE COMPANY'S LOAN PRODUCTS

The availability of mortgage loans that meet the Company's criteria depends
on, among other things, the size of and level of activity in the residential,
multifamily and commercial real estate lending markets. The size and level of
activity in these markets, in turn, depends on the level of interest rates,
regional and national economic conditions, inflation and deflation in property
values and the general regulatory and tax environment as it relates to mortgage
lending. If the Company can not obtain sufficient mortgage loans that meet its
criteria, its business will be adversely affected.

YEAR 2000 COMPLIANCE

The inability of computers, software and other equipment utilizing
microprocessors to recognize and properly process data fields containing a two
digit year is commonly referred to as the Year 2000 Compliance issue. As the
year 2000 approaches, such systems may be unable to accurately process certain
date-based information.

The Company has identified all significant applications that will require
modification to ensure Year 2000 Compliance. Internal resources are primarily
being used to make the required modifications and test Year 2000 Compliance. The
modification process of all significant applications is substantially complete.
The Company plans to complete the testing process of all significant
applications by December 31, 1998.

In addition, the Company has communicated with others with whom it does
significant business to determine their Year 2000 readiness and the extent to
which the Company may be vulnerable to any third party Year 2000 issues.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another

-29-

<PAGE> 32

company, or a conversion that is incompatible with the Company's systems, would
not have a material adverse effect on the Company.

The total cost to the Company of these Year 2000 Compliance activities has
not been and is not anticipated to be material to the Company's financial
position or results of operations in any year. These costs and the date on which
the Company plans to complete the Year 2000 modification and testing processes
are based on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no guarantee that these estimates will be achieved and actual results could
differ from those plans.

INVESTMENT COMPANY ACT

The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act. If
the Company were to become regulated as an investment company, the Company's use
of leverage would be substantially reduced. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on interest in real estate" ("Qualifying
Interests"). Under current interpretation of the staff of the Securities and
Exchange Commission, in order to qualify for this exemption, the Company must
maintain at least 55% of its assets directly in Qualifying Interests. As of
December 31, 1997, Management calculates that the Company is in compliance with
this requirement.

IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS

The preceding section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and other sections of this Annual Report
on Form 10-K contain various "forward-looking statements" within the meaning of
Section 27A of the Securities Act 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
represent the Company's expectations or beliefs concerning future events,
including, without limitation, statements containing the words "believes,"
"anticipates," "expects" and words of similar import; and also including,
without limitation, the following: statements regarding the Company's continuing
ability to target and acquire mortgage loans; expected availability of the
master repurchase agreement; the sufficiency of the Company's working capital,
cash flows and financing to support the Company's future operating and capital
requirements; results of operations and overall financial performance; the
expected dividend distribution rate; and the expected tax treatment of the
Company's operations. Such forward-looking statements relate to future events
and the future financial performance of the Company and the industry and involve
known and unknown risks, uncertainties and other important factors which could
cause actual results, performance or achievements of the Company or industry to
differ materially from the future results, performance or achievements expressed
or implied by such forward-looking statements.

Investors should carefully consider the various factors identified in
"Management's Discussion and Analysis of Financial Condition and Results of
Operation - Other Matters," and elsewhere in this Annual Report that could cause
actual results to differ materially from the results predicted in the
forward-looking statements. Further, the Company specifically cautions investors
to consider the following important factors in conjunction with the
forward-looking statements: the possible decline in the Company's ability to
locate and acquire mortgage loans; the possible adverse effect of changing
economic conditions, including fluctuations in interest rates and changes in the
real estate market both locally and nationally; the effect of severe weather or
natural disasters; the effect of competitive pressures from other financial
institutions, including mortgage REITs; and the possible changes, if any, in the
REIT rules. Because of the foregoing factors, the actual results achieved by the
Company in the future may differ materially from the expected results described
in the forward-looking statements.

-30-

<PAGE> 33

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements of the Company and the related notes, together
with the Independent Auditors' Report thereon begin on pages F-1 through F-3 of
this Form 10-K.

ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

-31-

<PAGE> 34

PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.

ITEM 11: EXECUTIVE COMPENSATION

Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Incorporated herein by reference to the Company's definitive proxy
statement to be filed with the Securities and Exchange Commission.

-32-

<PAGE> 35

PART IV

ITEM 14: EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K

(a) 1. FINANCIAL STATEMENTS

See Part II, Item 8 hereof.

2. FINANCIAL STATEMENTS AND AUDITORS' REPORTS

All schedules omitted are inapplicable or the information
required is shown in the Financial Statements or notes thereto. The auditors'
reports of Deloitte & Touche LLP with respect to the Financial Statements are
located at pages F-2 and F-20.

3. EXHIBITS

Exhibits required to be attached by Item 601 of Regulation S-K
are listed in the Exhibit Index attached hereto, which is incorporated herein by
this reference. Following is a list of management contracts and compensatory
plans and arrangements required to be filed as exhibits to this form by Item
14(c) hereof:

Management Agreement, dated as of January 1, 1998, by and
between the Company and HCP.

(b) REPORTS ON FORM 8-K

The Company filed no reports on Form 8-K during the last quarter
of 1997.

See Item 14(a)3 above.

-33-

<PAGE> 36

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 April 30, 1999.

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

By /s/ RALPH F. LAUGHLIN
-----------------------------------------------------
Ralph F. Laughlin
SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of Registrant
and the capacities indicated on April 30, 1999.
<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<S> <C>
/s/ JOHN A. BURCHETT Chairman of the Board of Directors
.................... and Chief Executive Officer
John A. Burchett

/s/ IRMA N. TAVARES Managing Director and a Director
...................
Irma N. Tavares

/s/ JOYCE S. MIZERAK Managing Director, Secretary and a Director
...................
Joyce S. Mizerak

/s/ GEORGE J. OSTENDORF Managing Director and a Director
.......................
George J. Ostendorf

/s/ JOHN A. CLYMER Director
..................
John A. Clymer

/s/ JOSEPH J. FREEMAN Director
.....................
Joseph J. Freeman

/s/ ROBERT E. CAMPBELL Director
......................
Robert E. Campbell

/s/ SAIYID T. NAQVI Director
...................
Saiyid T. Naqvi

/s/ RALPH F. LAUGHLIN Senior Vice President and Chief Financial
..................... Officer (Principal Financial and Accounting
Ralph F. Laughlin Officer)
</TABLE>

-34-

<PAGE> 37

EXHIBIT INDEX
-------------

<TABLE>
<CAPTION>
NO. DESCRIPTION
- -- -----------
<S> <C>
* 3.1 Articles of Incorporation of the Company, as amended

* 3.2 By-Laws of the Company

* 4.1 Specimen Common Stock Certificate

* 4.2 Warrant Agreement pursuant to which Warrants are to be issued (including form of Warrant)

* 4.3 Representatives' Warrant Agreement pursuant to which the Representatives' Warrants are to
be issued.

* 4.4 Specimen Unit Certificate

* 10.3 Registration Rights Agreement

* 10.4 Shareholders' Agreement of HCP

* 10.5 Agreement and Plan of Recapitalization

* 10.6 Bonus Incentive Compensation Plan

* 10.7 1997 Executive and Non-Employee Director Stock Option Plan

* 10.8 Employment Agreement by and between the Company and John A. Burchett

* 10.9 Employment Agreement by and between the Company and Irma N. Tavares

* 10.10 Employment Agreement by and between the Company and Joyce S. Mizerak

* 10.11 Employment Agreement by and between the Company and George J. Ostendorf

* 10.12 Standard Form of Office Lease, dated as of May 6, 1991, by
and between Irwin Kahn and HCP, as amended by the First
Amendment of Lease, dated as of July 1, 1996

* 10.13 Office Lease Agreement, dated as of March 1, 1994, by and
between Metroplex Associates and HCMC, as amended by the First
Modification and Extension of Lease Agreement, dated as of
February 28, 1997

* 10.14 Indenture, dated as of June 28, 1993, by and between
LaSalle National Bank, N.A., as Trustee, and HCP, as amended by
the Lease Amendment dated as of August 23, 1995

* 10.15 Office building space, dated as of February 5, 1993, by
and between Bonhomme Place Associates, Inc. and HCMC, as amended
by Lease Amendment #1, dated as of December 1, 1993 and as
further amended by Second Amendment and Extension of Lease,
dated as of March 1, 1996

* 10.16 Office Lease and Service Agreement, dated as of August 28, 1995 by and between Federal
Deposit Insurance Receiver for Merchants Bank and HCP

* 10.17 Agreement of Lease, dated as of January 8, 1997 by and between Saint Paul Executive Office
Suites, Inc., d.b.a. LesWork Inc. and HCP

* 10.18 Revolving Credit Agreement, dated as of December 10, 1996 between Fleet National Bank and
HCP

* 10.19 Guaranty, dated as of December 10, 1996, by John A. Burchett to Fleet National Bank

* 10.20 Guaranty, dated as of December 10, 1996, by HCMC to Fleet National Bank
</TABLE>

-35-

<PAGE> 38

<TABLE>
<CAPTION>
<S> <C>
* 10.21 Guaranty, dated as of December 10, 1996, by HCMF to Fleet National Bank

* 10.22 Guaranty, dated as of December 10, 1996, by HCA to Fleet National Bank

* 10.23 Guaranty, dated as of December 10, 1996, by HCS to Fleet National Bank

* 10.24 Modification Agreement, dated as of June , 1997, among Fleet National Bank, HCP, HCMC,
HCMF, HCS, HCA and John A. Burchett

* 10.25 Contribution Agreement

* 10.26 Participation Agreement

* 10.27 Loan Agreement

**10.28 Master Repurchase Agreement Governing Purchases and Sales of Mortgage Loans, between Nomura
Asset Capital Corporation and the Company, dated September 29, 1997

***10.29 Management Agreement, dated as of January 1, 1998, by and between the Company and HCP

***10.30 Master Loan and Security Agreement between the Company and Morgan Stanley Mortgage Capital
Inc., dated as of December 8,1997

***21 Subsidiaries of the Company

***27 Financial Data Schedule
</TABLE>
- ------------------------

* Incorporated herein by reference to the Company's Registration Statement
No. 333-29261, as amended, as filed with the Securities and Exchange
Commission.

** Incorporated herein by reference to the Company's Form 10-Q, as amended,
for the quarter ended September 30, 1997, as filed with the Securities and
Exchange Commission.

*** Previously filed.

-36-

<PAGE> 39

TABLE OF CONTENTS TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
<S> <C>
Independent Auditors' Report.............................................................. F-2
Financial Statements as of December 31, 1997 and for the Period from June 10, 1997
(inception) through December 31, 1997:
Balance Sheet......................................................................... F-3
Statement of Operations............................................................... F-4
Statement of Stockholders' Equity..................................................... F-5
Statement of Cash Flows............................................................... F-6
Notes to Financial Statements......................................................... F-7

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES

Independent Auditors' Report.............................................................. F-20
Consolidated Financial Statements as of December 31, 1997 and December 31, 1996 and
for each of the Three Years in the Period Ended December 31, 1997:
Balance Sheets........................................................................ F-21
Statements of Operations.............................................................. F-22
Statements of Stockholders' Equity.................................................... F-23
Statements of Cash Flows.............................................................. F-24
Notes to Consolidated Financial Statements............................................ F-25
</TABLE>

F-1

<PAGE> 40

INDEPENDENT AUDITORS' REPORT

To the Board of Directors of
Hanover Capital Mortgage Holdings, Inc.
New York, New York

We have audited the accompanying balance sheet of Hanover Capital Mortgage
Holdings, Inc. (the "Company") as of December 31, 1997 and the related
statements of operations, stockholders' equity and cash flows for the period
June 10, 1997 (inception) through December 31, 1997. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Hanover Capital Mortgage
Holdings, Inc. as of December 31, 1997 and the results of its operations and its
cash flows for the period June 10, 1997 (inception) through December 31, 1997,
in conformity with generally accepted accounting principles.

DELOITTE & TOUCHE LLP

Parsippany, New Jersey
March 20, 1998

F-2

<PAGE> 41

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

BALANCE SHEET
(IN THOUSANDS, EXCEPT AS NOTED)
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------
<S> <C>
ASSETS
ARM securities, available for sale...................... $348,131
Mortgage loans, held for sale........................... 160,970
Cash and cash equivalents............................... 4,022
Accrued interest receivable............................. 3,597
Equity investment....................................... 100
Notes receivable from related parties................... 482
Prepaid expenses and other assets....................... 241
--------
TOTAL ASSETS............................................ $517,543
========

LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements........................... $435,138
Accrued interest payable................................ 2,250
Dividends payable....................................... 1,035
Due to related party.................................... 540
Accrued expenses and other liabilities.................. 482
--------
Total liabilities............................... 439,445
--------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01 authorized, 10
million shares, issued and outstanding, -0-
shares.............................................. --
Common stock, par value $.01 authorized, 90
million shares, issued and outstanding,
6,466,677 shares.................................... 65
Additional paid-in-capital.............................. 79,411
Available for sale securities:
Unrealized (loss) on investments available
for sale........................................ (842)
Retained earnings (deficit)............................. (536)
--------
Total stockholders' equity...................... 78,098
--------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY................................ $517,543
========
</TABLE>

See notes to financial statements.

F-3

<PAGE> 42

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

STATEMENT OF OPERATIONS

PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
REVENUES:
<S> <C>
Interest income........................................................ $4,880
Interest expense....................................................... 3,204
------
Net interest income............................................... 1,676
Loan loss provision ................................................... 18
------
Net interest income after loan loss provision..................... 1,658
------
Gain on sale of securities............................................. 35
------
Total revenues................................................ 1,693
------
EXPENSES:

General and administrative expenses:
Management and administrative .................................... 400
Due diligence..................................................... 266
Commissions....................................................... 61
Legal and professional............................................ 170
Other............................................................. 43
------
Total expenses................................................ 940
------
Operating income.............................................. 753

Equity in (loss) of unconsolidated subsidiary............................... (254)
------
NET INCOME.................................................................. $ 499
======
BASIC EARNINGS PER SHARE.................................................... $ 0.15
======

DILUTED EARNINGS PER SHARE.................................................. $ 0.14
======
</TABLE>

See notes to financial statements.

F-4

<PAGE> 43

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

STATEMENT OF STOCKHOLDERS' EQUITY

PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(IN THOUSANDS)

<TABLE>
<CAPTION>
COMMON STOCK AVAILABLE FOR SALE RETAINED
-------------------- ADDITIONAL SECURITIES EARNINGS
SHARES AMOUNT PAID-IN CAPITAL UNREALIZED (LOSS) (DEFICIT) TOTAL
------ ------ --------------- ----------------- --------- -----
<S> <C> <C> <C> <C> <C> <C>
Issuance of common stock........ 6,466,677 $65 $79,411 $79,476

Unrealized (loss) on available-
for-sale securities........ $(842) (842)

Net Income $ 499 499
Dividends declared.............. (1,035) (1,035)
---------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1997...... 6,466,677 $65 $79,411 $(842) $ (536) $78,098
=======================================================================================
</TABLE>

See notes to financial statements

F-5

<PAGE> 44

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

STATEMENT OF CASH FLOWS

PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(IN THOUSANDS)
<TABLE>
<CAPTION>
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income............................................................................. $ 499
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of net premium - ARM securities....................................... 314
Amortization of net premium - mortgage loans....................................... 47
Loan loss provision................................................................ 18
Gain on sale of securities......................................................... (35)
Equity in loss of unconsolidated subsidiary........................................ 254
Increase in accrued interest receivable............................................ (3,597)
Loans to officers/stockholders..................................................... (482)
Increase in prepaid expenses and other assets...................................... (241)
Increase in accrued interest payable............................................... 2,250
Increase in due to related party................................................... 540
Increase in accrued expenses and other liabilities................................. 482
--------
Net cash provided by operating activities..................................... 49
--------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of ARM securities............................................................. (349,287)
Purchase of mortgage loans............................................................. (163,030)
Principal payments on mortgage loans................................................... 1,995
Proceeds from sale of securities....................................................... 35
--------
Net cash (used in) investing activities....................................... (510,287)
--------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements...................................... 435,138
Net proceeds of initial public offering................................................ 79,122
--------
Net cash provided by investing activities..................................... 514,260
--------
NET INCREASE IN CASH AND CASH EQUIVALENTS................................................... 4,022

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD.............................................. 0
--------
CASH AND CASH EQUIVALENTS, END OF PERIOD.................................................... $ 4,022
========
</TABLE>

SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES

OPERATING ACTIVITY -- increase in dividends payable ($1,035,000)
relating to the declaration of dividends in
December 1997.
INVESTING ACTIVITY -- acquisition of a 97% ownership interest in
Hanover Capital Partners Ltd. ($354,000).
FINANCING ACTIVITIES -- issuance of 716,667 shares of the Company's
common stock used to acquire an equity
investment in HCP ($354,000), and the
declaration of $1,035,000 of dividends in
December 1997 that was paid in January 1998.

SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid during the period for:

Income taxes....................... $ 0
====
Interest........................... $884
====

See notes to financial statements.

F-6

<PAGE> 45

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

NOTES TO FINANCIAL STATEMENTS

PERIOD FROM JUNE 10 (INCEPTION) TO DECEMBER 31, 1997
(IN THOUSANDS)

1. BUSINESS DESCRIPTION

GENERAL

Hanover Capital Mortgage Holdings, Inc. (the "Company") was
incorporated in Maryland on June 10, 1997. The Company is a self-managed real
estate investment trust ("REIT"), formed to operate as a specialty finance
company. The principal business strategy of the company is to (i) acquire
primarily single-family mortgage loans that are at least twelve months old or
that were intended to be of certain credit quality but that do not meet the
originally intended market parameters due to errors or credit deterioration,
(ii) securitize the mortgage loans and retain interests therein, (iii)
originate, hold, sell and service multifamily mortgage loans and commercial
mortgage loans and (iv) acquire multifamily mortgage loans. The Company's
principal business objective is to generate increasing earnings and dividends
for distribution to its stockholders. The Company acquires single-family
mortgage loans through a network of sales representatives targeting financial
institutions throughout the United States. The Company may also acquire
multifamily mortgage loans from a taxable subsidiary of the Company.

CAPITALIZATION

In September 1997, the Company raised net proceeds of approximately $79
million in its initial public offering (the "IPO"). In the IPO, the Company sold
5,750,000 units (each unit consists of one share of common stock, par value $.01
and one stock warrant) at $15.00 per unit including 750,000 units sold pursuant
to the underwriters' overallotment option, which was exercised in full. Each
warrant entitles the holder to purchase one share of common stock at the
original issue price - $15.00. The warrants became exercisable on March 19, 1998
and remain exercisable until September 15, 2000. The Company will utilize
substantially all of the net proceeds of the IPO to fund leveraged purchases of
mortgage assets.

In connection with the closing of the IPO the Company acquired a 97%
ownership interest (representing a 100% ownership of the non-voting preferred
stock) in Hanover Capital Partners Ltd. and its wholly-owned subsidiaries:
Hanover Capital Mortgage Corporation and Hanover Capital Securities, Inc., in
exchange for 716,667 shares of the Company's common stock. Hanover Capital
Partners Ltd. and its wholly-owned subsidiaries offer due diligence services to
buyers, sellers and holders of mortgage loans and originate, sell and service
multifamily mortgage loans and commercial loans.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

RISKS AND UNCERTAINTIES

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's estimates and assumptions primarily arise from
risks and uncertainties associated with interest rate volatility, credit
exposure and regulatory changes. Although management is not currently aware of
any factors that would significantly change its estimates and assumptions in the
near term, future changes in market trends and conditions may occur which could
cause actual results to differ materially.

F-7

<PAGE> 46

CASH AND CASH EQUIVALENTS

Cash and cash equivalents include cash on hand, overnight investments
deposited with banks and government securities with maturities less than 30
days.

ADJUSTABLE RATE MORTGAGE SECURITIES

The Company's policy is to classify its adjustable rate mortgage ("ARM")
securities as available-for-sale as they are purchased and each asset is
monitored for a period of time, generally three to six months, prior to making a
determination whether the asset will be classified as held-to-maturity. At
December 31, 1997 management has made the determination that all ARM securities
are available-for-sale in order to be prepared to respond to potential future
opportunities in the market, to sell ARM securities in order to optimize the
portfolio's total return and to retain its ability to respond to economic
conditions that require the Company to sell assets in order to maintain an
appropriate level of liquidity. Management re-evaluates the classification of
the ARM securities on a quarterly basis. ARM securities classified as
held-to-maturity are carried at the fair value of the security at the time the
designation is made and any fair value adjustment to the cost basis as of the
date of the classification is amortized into interest income as a yield
adjustment. All ARM securities designated as available-for-sale are reported at
fair value, with unrealized gains and losses excluded from earnings and reported
as a separate component of stockholders' equity.

Premiums and discounts associated with the purchase of ARM securities are
amortized into interest income over the lives of the securities using the
effective yield method adjusted for the effects of estimated prepayments. ARM
securities transactions are recorded on the date the ARM securities are
purchased or sold. Purchases of new issue ARM securities are recorded when all
significant uncertainties regarding the characteristics of the securities are
removed, generally on or shortly before settlement date. Realized gains and
losses on ARM securities transactions are determined on the specific
identification basis.

The Company has limited its exposure to credit losses on its portfolio of
ARM securities by only purchasing ARM securities that have some form of credit
enhancement and that are either guaranteed by an agency of the federal
government or have an investment grade rating at the time of purchase, or the
equivalent, by at least one of two nationally recognized rating agencies,
Moody's or Standard & Poor's (the "Rating Agencies"). The Company monitors the
delinquencies and losses on the underlying mortgages of its ARM securities and,
if the credit performance of the underlying mortgage loans is not as good as
expected, makes a provision for possible credit losses as well as unidentified
potential future losses in its ARM securities portfolio. The provision is based
on management's assessment of numerous factors affecting its portfolio of ARM
securities including, but not limited to, current and projected economic
conditions, delinquency status, credit losses to date on underlying mortgages
and remaining credit protection. The provision is made by reducing the cost
basis of the individual security and the amount of such write-down is recorded
as a realized loss, thereby reducing earnings. Provisions for credit losses do
not reduce taxable income and therefore do not affect the dividends paid by the
Company to stockholders in the period the provisions are taken. Actual losses
realized by the Company reduce taxable income in the period the actual loss is
realized and would affect the dividends paid to stockholders for that tax year.

The Company makes periodic evaluations of mortgage securities to determine
whether an other-than-temporary impairment is considered to have occurred. If a
decline in the fair value is judged to be other than temporary, the cost basis
of the mortgage security will be marked to fair value resulting in a current
period loss in the statement of operations. The new cost basis shall not be
changed for future increases in market value; however, future increases in
market value will be reflected separately in the equity section of the Company's
balance sheet.

F-8

<PAGE> 47

MORTGAGE LOANS

The Company's policy is to classify each of its mortgage loans as held for
sale as they are purchased and each asset is monitored for a period of time,
generally four to nine months, prior to making a determination as to whether the
asset will be classified as held-to-maturity. At December 31, 1997 management
has made the determination that all mortgage loans are held for sale in order to
be prepared to respond to potential future opportunities in the market, to sell
mortgage loans in order to optimize the portfolio's total return and to retain
its ability to respond to economic conditions that require the Company to sell
mortgage loans in order to maintain an appropriate level of liquidity.
Management re-evaluates the classification of mortgage loans on a quarterly
basis. All mortgage loans designated as held for sale are reported at the lower
of cost or market, with unrealized losses reported as a charge to earnings in
the current period.

Premiums and discounts associated with the purchase of mortgage loans are
amortized into interest income over the lives of the mortgage loans using the
effective yield method adjusted for the effects of estimated prepayments.
Mortgage loan transactions are recorded on the date the mortgage loans are
purchased or sold. Purchases of new mortgage loans are recorded when all
significant uncertainties regarding the characteristics of the mortgage loans
are removed, generally on or shortly before settlement date. Realized gains and
losses on mortgage loan transactions are determined on the specific
identification basis.

The accrual of interest on impaired loans is discontinued when, in
management's opinion, the borrower may be unable to meet payments as they become
due. When interest accrual is discontinued, all unpaid accrued interest is
reversed. Interest income is subsequently recognized only to the extent cash
payments are received.

The Company has limited its exposure to credit losses on its portfolio of
mortgage loans by performing an in-depth due diligence on every loan purchased.
The due diligence encompasses the borrowers credit, the enforceability of the
documents, and the value of the mortgage property. In addition many mortgage
loans are guaranteed by an agency of the federal government or private mortgage
insurance. The Company monitors the delinquencies and losses on the underlying
mortgages and makes a provision for known losses as well as unidentified
potential losses in its mortgage loan portfolio if the impairment is deemed to
be other than temporary. The provision is based on management's assessment of
numerous factors affecting its portfolio of mortgage loans including, but not
limited to, current and projected economic conditions, delinquency status,
losses to date on mortgages and remaining credit protection.

FINANCIAL INSTRUMENTS

The Company may from time to time enter into interest rate hedge mechanisms
to manage its exposure to changes in the market value of its fixed rate mortgage
loan portfolio due to interest rate changes in connection with the purchase,
securitization and sale of its mortgage loans. In such a case the Company would
close out the hedge position to coincide with the related mortgage loan sale and
securitization transactions and recognize the results of the hedge transaction
in determining the amount of the related mortgage loan sale gain for loans sold
or, as a basis adjustment to mortgage loans held to maturity.

EQUITY INVESTMENT

The Company's 97% ownership investment in Hanover Capital Partners Ltd.
("HCP") is accounted for by the equity method of accounting. The Company
generally has no right to control the affairs of HCP because the Company's
investment in HCP is based solely on a 100% ownership of HCP's non-voting
preferred stock. Even though the Company has no right to control the affairs of
HCP,

F-9

<PAGE> 48

management believes that the Company has the ability to exert significant
influence over HCP and therefore the investment in HCP is accounted for by the
equity method of accounting.

REVERSE REPURCHASE AGREEMENTS

Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts, plus accrued interest.

INCOME TAXES

The Company has elected to be taxed as a real estate investment trust
("REIT") and intends to comply with the provisions of the Internal Revenue Code
of 1986, as amended (the "Code") with respect thereto. Accordingly, the Company
will not be subject to Federal income tax to the extent of its distributions to
stockholders as long as certain asset, income and stock ownership tests are met.

EARNINGS PER SHARE

At December 31, 1997 the Company adopted Statement of Financial Accounting
Standards No. 128 "Earnings per Share"("SFAS 128"). Under SFAS 128 basic
earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding during the period. Diluted earnings per share reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock that then shared in earnings.
Shares issued during the period and shares reacquired during the period are
weighted for the period they were outstanding.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income
("SFAS 130"). SFAS 130 establishes standards for reporting and displaying of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general purpose financial statements. SFAS 130 requires that
all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. SFAS 130 is
effective for fiscal years beginning after December 15, 1997. Reclassification
of financial statements for earlier periods provided for comparative purposes is
required.

The FASB issued SFAS No. 131 Disclosures About Segments of an Enterprise
and Related Information ("SFAS 131") in June 1997. SFAS 131 establishes
standards for the way that public business enterprises report information about
operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to stockholders. It also establishes standards for
related disclosures about products and services, geographic areas and major
customers. SFAS 131 is effective for financial statements for periods beginning
after December 15, 1997. Management has not yet determined what effect, if any,
adoption will have on the Company's financial condition and results of
operations.

F-10

<PAGE> 49

3. ADJUSTABLE RATE MORTGAGE SECURITIES

ARM securities consist of FNMA and FHLMC mortgage certificates secured by
ARM loans on single-family residential housing. The following table summarizes
the Company's ARM securities classified as available-for-sale as of December 31,
1997, which are carried at their fair value (dollars in thousands):
<TABLE>
<CAPTION>
AVAILABLE-FOR-SALE PORTFOLIO MIX
------------------ -------------
<S> <C> <C>
Amortized cost:
FNMA certificates............. $207,898 59.6%
HLMC certificates............. 141,075 40.4%
-------- -----
Total amortized cost.................. 348,973 100.0%
Gross unrealized (losses)............. (842) =====
--------
Fair value............................ $348,131
========
</TABLE>

The scheduled maturities of ARM securities available for sale at December
31, 1997, were as follows:
<TABLE>
<CAPTION>
AMORTIZED FAIR
COST VALUE
--------- -----
<S> <C> <C>
Due in one year or less............... $ -0- $ -0-
Due from one to five years............ -0- -0-
Due from five to ten years............ -0- -0-
Due after ten years................... 348,973 348,131
-------- --------
Total........................ $348,973 $348,131
======== ========
</TABLE>
As mentioned above, actual maturities may differ from scheduled maturities
because borrowers may have the right to prepay certain obligations, often times
without penalties. Maturities of mortgage securities depend on the repayment
characteristics and experience of the underlying obligations.

As of December 31, 1997, the average effective yield on the ARM securities
including the amortization of the net premiums paid for the ARM securities, was
6.268%.

4. MORTGAGE LOANS HELD FOR SALE

Investments in single-family mortgage loans held for sale consist of fixed
rate mortgages and adjustable rate mortgages. The following table summarizes the
Company's single-family mortgage loan pools as of December 31, 1997, which are
carried at the lower of cost or market (dollars in thousands):
<TABLE>
<CAPTION>

COST MIX
---- ---
<S> <C> <C>
Fixed rate............................ $106,397 67.1%
Adjustable rate....................... 52,392 32.9%
-------- -----
Subtotal..................... 158,789 100.0%
=====
Net deferred loan fees, premiums
and discounts..................... 2,199
Loan loss provision................... 18
--------
Total........................ $160,970
========
</TABLE>

F-11

<PAGE> 50

An analysis of the change in the loan loss provision is as follows:
<TABLE>
<CAPTION>
<S> <C>
Balance beginning of period...... $ 0
Loan loss provision.............. 18
---
Balance at December 31, 1997..... $18
===
</TABLE>

The following table summarizes certain characteristics of the Company's
single-family fixed rate and adjustable rate mortgage loan portfolios as of
December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>

CARRYING VALUE PRINCIPAL WEIGHTED WEIGHTED
OF MORTGAGE AMOUNT OF AVERAGE NET AVERAGE
LOANS MORTGAGE LOANS COUPON MATURITY(1)
-------------- -------------- ----------- -----------
<S> <C> <C> <C> <C>
Fixed Rate........... $107,953 $106,424 8.265% 242
Adjustable Rate...... 53,017 52,365 7.925% 319
-------- -------- ----- ---
$160,970 $158,789 8.153% 267
======== ======== ===== ===
</TABLE>

(1) Weighted average maturity reflects the number of months remaining
until maturity.

As of December 31, 1997 the average effective yield on the mortgage loan
portfolio, including the amortization of the net premiums paid for the mortgage
loans, was 7.317%.

5. CONCENTRATION OF CREDIT RISK

The Company's exposure to credit risk associated with its lending
activities is measured on an individual customer basis as well as by groups of
customers that share similar attributes. In the normal course of its business,
the Company has concentrations of credit risk in its portfolio for the mortgage
loans in certain geographic areas. At December 31, 1997, the percent of total
principal amount of mortgage loans outstanding in any one state, exceeding 5% of
the principal amount of mortgage loans held for sale, are as follows:
<TABLE>
<CAPTION>
STATE PERCENT
----- -------
<S> <C>
Florida................. 25%
South Carolina.......... 13%
California.............. 10%
Ohio.................... 9%
Texas................... 6%
</TABLE>
The Company's management believes exposure to credit risk associated with
agency ARM securities is minimal due to the guarantees provided by FNMA and
FHLMC.

During 1997 the Company purchased approximately 61.9% of its total
outstanding principal amount of mortgage loans from three financial institutions
(the largest of which represented approximately 29.1% of the total outstanding
principal amount of mortgage loans). Management attributes the high
concentration of purchases from these three financial institutions to the
initial ramp up phase of mortgage loan acquisitions and does not foresee that
this is a trend that will continue into the future.

F-12

<PAGE> 51

ARM securities were purchased from six securities firms in 1997. The
largest concentration of ARM purchases from one firm represented approximately
22.8% of the total principal amount of ARM securities outstanding at December
31, 1997.

The Company has cash and cash equivalents in a financial institution which
is insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000
per institution. As of December 31, 1997, the Company had amounts on deposit
with the financial institution in excess of FDIC limits. The Company limits its
risk by placing its cash and cash equivalents in a high quality financial
institution.

6. REVERSE REPURCHASE AGREEMENTS

In September 1997, the Company entered into a master repurchase agreement
with a lender in an amount up to $200 million ($100 million committed and $100
million uncommitted) for a period of one year. Any borrowings under this
facility will be secured by mortgage loans, or other securities, and will bear
interest at the six-month LIBOR, plus a spread ranging from 0.70% to 1.25%.

In December 1997 the Company entered into a second master repurchase
agreement with another lender in an amount up to $125 million ($100 million
committed and $25 million uncommitted) for a period of one year. Any borrowings
under this facility will be secured by mortgage loans, or other securities and
will bear interest at the six-month LIBOR, plus a spread of 60 basis points.

At December 31, 1997 the Company had outstanding borrowings of $93,731,000
under the above mentioned reverse repurchase agreements with a weighted average
borrowing rate of 6.313% and a weighted average remaining maturity of
approximately one month. The reverse repurchase agreements at December 31, 1997
were collateralized by mortgage loans with a cost basis of $160,970,000 (which
approximates market value).

In November 1997 the Company entered into six separate reverse repurchase
agreements to finance all of its ARM securities purchases. Each of the reverse
repurchase agreements are secured by the market value of the Company's ARM
securities ($348,131,000) at December 31, 1997 and bear interest at LIBOR.

As of December 31, 1997, the Company had outstanding ARMS securities
reverse repurchase agreements of $341,407,000 with a weighted average borrowing
rate of 5.723 % and a weighted average remaining maturity of less than one
month.

Information concerning the reverse repurchase agreements and the pledged
collateral at December 31, 1997 is summarized as follows:
<TABLE>
<CAPTION>
COLLATERAL (DOLLARS IN THOUSANDS)
--------------------------------
ARM MORTGAGE
REVERSE REPURCHASE AGREEMENTS SECURITIES LOANS
----------------------------- ---------- --------
<S> <C> <C>
Average balance during the period (1)...... $113,803 $ 32,674
Average interest rate during period (1).... 5.723% 6.313%
Maximum month-end balancing during
the period............................... $341,407 $ 93,731

COLLATERAL UNDERLYING THE AGREEMENTS
------------------------------------
Carrying balance............................ $348,131 $160,970
Estimated fair value........................ $348,131 $160,970
</TABLE>

F-13

<PAGE> 52

(1) Above table reflects the period beginning September 30, 1997 (the
date of the first mortgage asset purchase) through December 31, 1997.

7. EMPLOYEE BENEFIT PLANS

401(k) PLAN

The Company participates in the HCP non-contributory retirement plan
("401(k) Plan"). The 401(k) plan is available to all full-time company employees
with at least six months of service. The 401(k) Plan is designed to be tax
deferred in accordance with provisions of Section 401(k) of the Internal Revenue
Code. The 401(k) Plan provides that each participant may contribute 15.0% of his
or her salary subject to the maximum allowable each fiscal year ($9,500 in
1997). Under the 401(k) Plan, an employee may elect to enroll on January 1, or
July 1, provided that the employee has met the six month employment service
requirement.

1997 STOCK OPTION PLAN

The Company's 1997 Executive and Non-Employee Director Stock Option Plan
(the "1997 Stock Option Plan") provides for the grant of qualified incentive
stock options ("ISOs") which meet the requirements of Section 422 of the
Internal Revenue Code, stock options not so qualified ("NQSOs"), deferred stock,
restricted stock, performance shares, stock appreciation rights and limited
stock awards ("Awards") and dividend equivalent rights ("DERs").

Subject to anti-dilution provisions of stock splits, stock dividends and
similar events, the 1997 Stock Option Plan authorizes the grant of options to
purchase, and Awards of, an aggregate of up to 325,333 shares of the common
stock. If an option granted under the 1997 Stock Option Plan expires or
terminates, or an Award is forfeited, the shares subject to any unexercised
portion of such option or Award will again become available for the issuance of
further options or Awards under the 1997 Stock Option Plan.

Unless previously terminated by the Board of Directors, the 1997 Stock
Option Plan will terminate ten years from the date of approval (or five years in
the case of ISO's granted to an employee who is deemed to own in excess of 10%
of combined voting power of the Company's outstanding equity stock) and no
options or Awards may be granted under the 1997 Stock Option Plan thereafter,
but existing options or Awards remain in effect until the options are exercised
or the options or the Awards are terminated by their terms. The aggregate fair
market value (determined as of the time of grant) of the shares of the common
stock with respect to which ISOs are exercisable for the first time by an
employee during any calendar year may not exceed $100,000.

All stock options granted by the Compensation Committee pursuant to the
1997 Stock Option Plan will be contingent and may vest, subject to other vesting
requirements imposed by the Compensation Committee in full or in part on any
September 30 beginning with September 30, 1998 and ending with September 30,
2002 (each, an "Earn-Out Measuring Date"). Subject to any other applicable
vesting restrictions, any outstanding stock options will vest in full as of any
Earn-Out Measuring Date through which the return on a unit (a unit is composed
of one common stock certificate and one warrant certificate) is at least equal
to the initial public offering price of the unit. In addition, subject to any
other applicable vesting restrictions, one-third of any outstanding stock
options will vest as of any Earn-Out Measuring Date through which the return on
a unit is at least equal to a 20% annualized return on the initial public
offering price of the unit. The return on a unit is determined by adding (i) the
appreciation in the value of the unit since the closing of the initial public
offering and (ii) the amount of distributions made by the Company on the share
of common stock included in the unit since the closing of the initial public
offering. The appreciation in the value of a unit as of any Earn-Out Measuring
Date is the average difference, during the 30 day period that ends on the
Earn-Out Measuring Date, between the market price of the share of common stock
included in the unit and the initial public offering price of the unit

F-14

<PAGE> 53

multiplied by two to take into account the value of the stock warrant included
in the unit. In determining whether such stock options have vested, appropriate
adjustments will be made for stock splits, recapitalizations, stock dividends
and transactions having similar effects.

A summary of the status of the Company's 1997 Stock Options Plan as of
December 31, 1997 and changes during the period from September 19, 1997 through
December 31, 1997 is presented below:
<TABLE>
<CAPTION>
SHARES EXERCISE PRICE
------ --------------
<S> <C> <C>
Granted - September 19, 1997........... 162,664 $15.00
Granted - September 28, 1997........... 160,660 15.75
Cancelled.............................. (3,000) 15.75
------- ------
Outstanding at December 31, 1997....... 320,324 $15.37
======= ======
</TABLE>

No shares were exercisable at December 31, 1997.

The per share weighted average fair value of stock options granted during
the period ended December 31, 1997 was $0.27 at the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
<TABLE>
<CAPTION>
1997
----
<S> <C>
Expected life (years).................. 5
Risk-free interest rate................ 5.77%
Volatility............................. 12.0%
Expected dividend yield................ 10.0%
</TABLE>
The Company applies APB opinion No. 25 in accounting for its 1997 Stock
Option Plan and, accordingly, no compensation cost has been recognized for its
stock options in the financial statements. Had the Company determined
compensation cost based on the fair value at the grant date for its stock
options under Statements of Financial Accounting Standards No. 123, Accounting
For Stock-Based Compensation, the Company's net income would have been reduced
to the pro forma amounts indicated below (in thousands, except per share data):
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1997
-----------------
<S> <C>
Net earnings:
As reported............................ $ 499
Pro forma.............................. 417

Earnings per share - basic:
As reported............................ $0.15
Pro forma.............................. 0.13

Earnings per share - diluted:
As reported............................ $0.14
Pro forma.............................. 0.11
</TABLE>

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

F-15

<PAGE> 54

must generate annual net income before bonus accruals that allow for a return of
equity to stockholders in excess of the average weekly ten-year U.S. Treasury
rate plus 4.0% before any bonus accrual is recorded. No such accrual was
recorded in 1997.

8. AFFILIATED PARTY TRANSACTIONS

The Company has engaged HCP pursuant to a Management Agreement to render,
among other things, due diligence, asset management and administrative services.
The 1997 statement of operations of the Company includes management and
administrative expenses of $400,000, due diligence expenses of $266,000 and
commission expenses of $61,000 relating to billings from HCP. At December 31,
1997 the balance sheet of the Company included an amount due HCP of $540,000.
The term of the Management Agreement continues until December 31, 1999 with
subsequent renewal provisions.

The Company has agreed to lend (a maximum of) $1,750,000 collectively,
to four officer/stockholders (collectively referred to as the "Principals") to
enable the Principals to pay tax on the gains they must recognize upon
contributing their HCP preferred stock to the Company for shares of the
Company's common stock. The loans will be secured solely by 116,667 shares of
the Company's common stock owned by the Principals, collectively. The loans bear
interest at the lowest applicable federal tax rate during the month the loans
are made. At December 31, 1997 loans outstanding to three of the Principals
totaled $482,000.

9. EARNINGS PER SHARE

On December 31, 1997 the Company adopted SFAS 128 for calculating earnings
per share as shown below: (dollars in thousands, except per share data)

<TABLE>
<CAPTION>
<S> <C>
Earnings per share - basic:
Net income (numerator)........................ $ 499
==========
Average common shares
outstanding (denominator)..................... $3,296,742
==========
Per share......................................... $ 0.15
==========
Earnings per share - diluted:
Net income (numerator)........................ $ 499
==========

Average common shares outstanding............. 3,296,742
Add: Incremental shares from
assumed conversion of warrants........... 374,943
----------
Dilutive potential common shares.............. 374,943
Adjusted weighted average shares ----------
denominator)............................... 3,671,685
==========

Per share......................................... $ 0.14
==========
</TABLE>

10. COMMITMENTS AND CONTINGENCIES

At December 31, 1997 the Company had committed to purchase approximately
$111,092,000 of fixed and ARM loans.

F-16

<PAGE> 55

The Company entered into employment agreements with the Principals. Such
agreements are for five year terms which expire in 2002, and provide for
aggregate annual base salaries of $975,000. A portion of the aggregate base
salaries is allocated to the Company's taxable subsidiary based on management's
actual and estimated time involved with the subsidiary's activities.

As additional consideration to the Principals for their contribution of
their HCP preferred stock to the Company, the Company has agreed to (1) issue to
the Principals up to 216,667 additional shares of the Company's common stock and
(2) forgive a maximum of $1,750,000 in loans made to the Principals; if certain
financial returns to stockholders are met, at certain Earn-Out Measuring Dates
as described in the Company's IPO Prospectus dated September 15, 1997.

The Company has guaranteed the line-of-credit of its majority owned
subsidiary, Hanover Capital Partners Ltd. The maximum line-of-credit obligation
and the actual line-of-credit obligation at December 31, 1997 was $1,700,000 and
$1,405,000, respectively.

11. FINANCIAL INSTRUMENTS

In accordance with SFAS No. 107, Disclosure about Derivative Financial
Instruments, and SFAS No. 119, Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments, the Company has provided fair value
estimates and information about valuation methodologies. The estimated fair
value amounts have been determined using available market information or
appropriate valuation methodologies. However, considerable judgment is required
in interpreting market data to develop estimates of fair value, so the estimates
are not necessarily indicative of the amounts that would be realized in a
current market exchange. The effect of using different market assumptions and/or
estimation methodologies may materially impact the estimated fair value amounts.

The estimated fair value of the Company's assets and liabilities classified
as financial instruments and off-balance sheet financial instruments at December
31, 1997 are as follows (dollars in thousands):
<TABLE>
<CAPTION>
CARRYING FAIR
AMOUNT VALUE
------ -----
<C> <C> <C>
Assets:
ARM Securities....................... $348,131 $348,131
Mortgage loans....................... 160,970 160,970
Cash and cash equivalents............ 4,022 4,022
Accrued interest receivable.......... 3,597 3,597
Notes receivable..................... 482 482
-------- --------
Total....................... $517,202 $517,202
======== ========

Liabilities:
Reverse repurchase agreements........ 435,138 435,138
Accrued interest payable............. 2,250 2,250
Other liabilities.................... 2,057 2,057
-------- --------
Total....................... $439,445 $439,445
======== ========

Off-Balance Sheet: NOTIONAL
--------
Commitments to purchase loans........ $111,092 $111,132
======== ========
Forward commitments to sell mortgage
securities......................... $122,650 $122,378
======== ========
</TABLE>

F-17

<PAGE> 56

The following methods and assumptions were used to estimate the fair value
of the Company's financial instruments:

CASH AND CASH EQUIVALENTS, ACCRUED INTEREST RECEIVABLE, NOTES RECEIVABLE,
REVERSE REPURCHASE AGREEMENTS, ACCRUED INTEREST PAYABLE, OTHER LIABILITIES - The
fair value of these financial instruments was determined to be their carrying
value due to their short-term nature.

ARM SECURITIES - The fair values of these financial instruments are based
upon either or all of the following: actual prices received upon recent sales of
mortgage securities to investors, projected prices which could be obtained
through investor estimates considering interest rates, mortgage loan type,
quality and discounted cash flow analysis based on prepayment and interest rate
assumptions used in the market place for similar securities with similar credit
ratings.

MORTGAGE LOANS HELD FOR SALE - The fair values of these financial
instruments are based upon actual prices received upon recent sales of mortgage
loans and securities to investors and projected prices which could be obtained
through investors considering interest rates, mortgage loan type, an credit
quality.

COMMITMENTS TO PURCHASE/ORIGINATE MORTGAGES - The Company has outstanding
commitments to purchase mortgage loans at market terms at the time of
commitment. The fair value of these financial instruments was determined through
a review of published market information associated with similar instruments.
These commitment obligations are considered in conjunction with the Company's
lower of cost or market valuation of its mortgage loans held for sale.

FORWARD COMMITMENTS TO SELL MORTGAGE SECURITIES - The Company has
outstanding forward commitments to sell mortgages and/or mortgage securities
into mandatory delivery contracts with investment bankers, private mortgage
investors and agency mortgage-backed securities. The fair value of these
financial instruments was determined through review of published market
information associated with similar instruments. These commitment obligations
are considered in conjunction with the Company's lower of cost or market
valuation of its mortgage loans held for sale.

12. SUBSEQUENT EVENT

On January 12, 1998 a $0.16 cash dividend previously declared by the Board
of Directors was paid to stockholders of record as of December 31, 1997.

13. QUARTERLY FINANCIAL DATA - UNAUDITED

Selected quarterly financial data are as follows (dollars in thousands,
except per share data):
<TABLE>
<CAPTION>

Period from June 10, 1997 (inception)
Through December 31, 1997

THREE MONTHS THREE MONTHS JUNE 10, 1997
ENDED ENDED THROUGH
DECEMBER 31, 1997 SEPTEMBER 30, 1997(1) JUNE 30, 1997(1)
----------------- --------------------- ----------------
<S> <C> <C> <C>
Net interest income.............. $1,548 $128 $ 0
========================================================
Net income....................... 440 59 0
========================================================
Basic earnings per share(2)...... 0.07 0.07 0.00
========================================================
Diluted earnings per share(2).... 0.07 0.07 0.00
========================================================
Dividends declared............... 0.16 0.00 0.00
========================================================
</TABLE>

F-18

<PAGE> 57

-----------------------------

(1) The Company was organized on June 10, 1997, however operations did not
begin until the IPO date - September 19, 1997.

(2) Earnings per share are computed independently for each of the quarters
presented; therefore the sum of the quarterly earnings per share do
not equal the earnings per share total for the year.

F-19

<PAGE> 58

INDEPENDENT AUDITORS' REPORT

To the Board of Directors of
Hanover Capital Partners Ltd.

We have audited the accompanying consolidated balance sheets of Hanover
Capital Partners Ltd. and Subsidiaries (the "Company") as of December 31, 1997
and 1996, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Hanover Capital Partners Ltd.
and Subsidiaries at December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.

DELOITTE & TOUCHE LLP

Parsippany, New Jersey
March 20, 1998

F-20

<PAGE> 59

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996

1997 1996
---- ----
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash.................................................. $ 208,315 $ 161,546
Investment in marketable securities................... 17,394 16,443
Accounts receivable................................... 133,829 3,683,865
Receivables from related parties...................... 757,384 521,539
Accrued revenue on contracts in progress.............. 35,413 549,781
Prepaid expenses and other current assets............. 118,552 143,026
---------- ----------
Total current assets......................... 1,270,887 5,076,200
PROPERTY AND EQUIPMENT - NET................................... 213,137 316,057
MORTGAGE SERVICING RIGHTS...................................... 49,449 30,587
DEFERRED TAX ASSET............................................. 20,081 --
OTHER ASSETS................................................... 166,670 227,548
INCOME TAX RECEIVABLES......................................... 292,885 --
DUE FROM OFFICER............................................... 53,766 107,532
---------- ----------
TOTAL ASSETS................................................... $2,066,875 $5,757,924
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accrued appraisal and subcontractor costs............. $ 131,978 $2,807,172
Accounts payable and accrued expenses................. 334,591 678,390
Income tax payable.................................... -- 89,477
Deferred revenue...................................... 104,950 194,334
Notes payable to related parties...................... -- 133,018
Deferred income taxes................................. -- 12,993
Other liabilities..................................... -- 122,400
---------- ----------
Total current liabilities........................ 571,519 4,037,784
---------- ----------
LONG-TERM LIABILITIES:
Note payable to bank.................................. 1,405,000 1,045,000
Minority interest..................................... 616 250
---------- ----------
Total long-term liabilities...................... 1,405,616 1,045,250
---------- ----------
Total liabilities.......................... 1,977,135 5,083,034
---------- ----------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000 shares
authorized, 97,000 shares outstanding at
December 31, 1997..................................... 970 --
Common stock: Class A: $0.01 par value,5,000 and
1,000 shares authorized at December 31, 1997
and 1996, 3,000 and 166.424 shares outstanding
at December 31, 1997 and 1996.................... 30 2
Additional paid-in capital............................ 56,442 57,440
Retained earnings..................................... 32,298 617,448
---------- ----------
Total stockholders' equity................. 89,740 674,890
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY......................................................... $2,066,875 $5,757,924
========== ==========
</TABLE>

See notes to consolidated financial statements.

F-21

<PAGE> 60

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>

1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
REVENUES:

Due diligence fees.......................... $4,058,609 $8,323,789 $7,525,620
Loan brokering/asset management fees........ 3,027,319 2,469,378 1,770,665
Mortgage sales and servicing................ 826,486 970,757 2,289,440
Other income................................ 58,151 355,715 295,944
---------- ---------- ----------
Total revenues..................... 7,970,565 12,119,639 11,881,669
---------- ---------- ----------

EXPENSES:
Personnel expense........................... 5,373,331 4,227,226 3,831,426
Appraisal, inspection and other professional
fees................................... 618,059 3,128,225 2,593,001
Subcontractor expenses...................... 1,386,979 2,919,509 2,738,903
Travel and subsistence...................... 302,936 616,795 860,253
Occupancy expenses.......................... 495,285 536,520 437,830
General and administrative expense.......... 419,543 525,143 1,066,220
Reversal of reserve of IRS assessment....... (23,160) (277,600) --
Interest expense............................ 117,894 134,393 160,439
Depreciation and amortization............... 117,675 125,928 114,174
---------- ---------- ----------
Total expenses..................... 8,808,542 11,936,139 11,802,246
---------- ---------- ----------
INCOME (LOSS) BEFORE PROVISION (BENEFIT)............. (837,977) 183,500 79,423
INCOME TAX PROVISION (BENEFIT)....................... (325,959) 73,870 51,165
---------- ---------- ----------
NET INCOME (LOSS).................................... $ (512,018) $ 109,630 $ 28,258
========== ========== ==========
BASIC EARNINGS (LOSS) PER SHARE...................... $ (525.79) $ 658.74 $ 169.80
========== ========== ==========
</TABLE>

See notes to consolidated financial statements.

F-22

<PAGE> 61

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>

COMMON STOCK
-----------------------------------------
NEW CLASS A OLD CLASS A CLASS B ADDITIONAL
PREFERRED STOCK ----------------------------------------- PAID-IN RETAINED
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL EARNINGS TOTAL
------ ------ ------ ------ ------ ------ ------ ------ ------- -------- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1995............ 165.800 $ 1 41,600 $1 $165,999 $500,846 $666,847
Net income.......................... 109,630 109,630
Distribution of subsidiary to
stockholders....................... 6,972 6,972
Shareholders' Exchange Agreement:
Redemption of Class A shares..... (40.836) (108,559) (108,559)
Exchange of Class B shares
for Class A shares.............. 41.460 1 (41,600) (1) -- -- --
------ --- ------- -- -------- ------- --------

BALANCE, DECEMBER 31, 1996............ 166.424 2 57,440 617,448 674,890
Net (loss).......................... (512,018) (512,018)
Dividends (non-cash)................ (73,132 (73,132)
Agreement and Plan of
Recapitalization:
Exchange of "old" Class A
shares for "new" Class A
shares and Series A Preferred
Stock........................... 97,000 $970 3,000 $30 (166.424) (2) (998) -- --
------ ---- ----- --- -------- --- -------- -------- --------

BALANCE, DECEMBER 31, 1997............ 97,000 $970 3,000 $30 -- $-- $ 56,442 $ 32,298 $ 89,740
====== ==== ===== === ======== === ======== ======== ========
</TABLE>

See notes to consolidated financial statements.

F-23

<PAGE> 62

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>

1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).................................. $(512,018) $ 109,630 $ 28,258
Adjustments to reconcile net income (loss) to net
cash (used in) provided by operating activities:
Depreciation and amortization..................... 117,675 125,928 114,174
Gain and sale of mortgage servicing rights...... (16,916) (52,318) (232,587)
Reversal of reserve for IRS assessment.......... (23,160) (277,600) --
IRS payroll tax settlement...................... (99,240) -- --
Loss on disposal of property and equipment...... 35,696 -- 10,261
Loss on sale of trading securities.............. -- 1,360 753
Purchase of trading securities.................. (951) (1,931) (29,951)
Sale of trading securities...................... -- 26,593 100,016
Distribution of subsidiary to stockholders...... -- 6,972 --
Changes in assets - (increase) decrease:
Accounts receivable........................ 3,550,036 (2,150,117) 862,364
Receivables from related parties........... (315,097) (308,808) 22,582
Accrued revenue on contract in progress.... 514,368 (384,880) 1,011,785
Income tax receivable...................... (292,885) -- --
Prepaid expenses and other current assets.. 24,474 (49,871) (39,169)
Deferred tax asset......................... (20,081) -- --
Other assets............................... (12,254) (22,914) (154,108)
Changes in liabilities - increase (decrease):
Accrued appraisal and subcontractor costs.. (2,675,194) 2,741,014 21,931
Accounts payable and accrued expenses...... (343,799) 104,018 (913,692)
Income taxes payable....................... (89,477) (90,490) 15,634
Deferred income taxes...................... (12,993) (17,222) (114,326)
Deferred revenue........................... (89,384) (14,946) 113,855
Minority interest.......................... 366 (26,935) (147,057)
--------- ----------- ---------
Net cash (used in) provided by
operating activities................... (260,834) (282,517) 670,723
--------- ----------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment................. (43,060) (133,317) (43,421)
Sale of property and equipment...................... -- 4,592 1,704
Proceeds from sale of mortgage servicing rights..... 34,446 94,043 423,563
Capitalization of mortgage servicing rights......... (43,783) (37,451) (264,141)
--------- ----------- ---------
Net cash (used in) provided
by investing activities................ (52,397) (72,133) 117,705
--------- ----------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (repayment of) note
payable to bank................................. 360,000 (330,000) (125,000)
Redemption of Class A common stock.................. -- (66,000) --
Repayment of subordinated debt...................... -- -- (51,299)
--------- ----------- ---------
Net cash provided by (used in)
financing activities................... 360,000 (396,000) (176,299)
--------- ----------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS..
46,769 (750,650) 612,129
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR................................ 161,546 912,196 300,067
--------- ----------- ---------
CASH AND CASH EQUIVALENTS, END
OF YEAR.......................................... $ 208,315 $ 161,546 $ 912,196
========= =========== =========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES:
Loans of $25,649,378 and $35,831,617 were originated by HCMC and funded by investors in 1997 and 1996, respectively.
Noncash dividends of $73,132, were distributed to the Company's stockholders on September 19, 1997.
</TABLE>
<TABLE>
<CAPTION>
SUPPLEMENTAL CASH FLOW INFORMATION: 1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Cash paid during the year for:
Income taxes................................... $129,359 $205,075 $176,119
======== ======== ========
Interest....................................... $116,993 $125,748 $164,420
======== ======== ========
</TABLE>

See notes to consolidated financial statements.

F-24

<PAGE> 63

HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

1. BUSINESS DESCRIPTION

Hanover Capital Partners Ltd. ("HCP") and its subsidiaries operate as a
specialty finance company which is principally engaged in performing due
diligence services, mortgage and investment banking services and, prior to
September 1997, asset management services. A wholly-owned subsidiary of HCP,
Hanover Capital Mortgage Corporation ("HCMC"), is an originator and servicer of
multifamily mortgage loans. HCMC's operations are conducted from multiple
branches located throughout the United States. HCMC is approved by the U.S.
Department of Housing and Urban Development (HUD) as a Title II Nonsupervised
Mortgagee under the National Housing Act. Another wholly-owned subsidiary of
HCP, Hanover Capital Securities, Inc. ("HCS") is a registered broker/dealer with
the Securities and Exchange Commission.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

a. PRINCIPLES OF CONSOLIDATION. The consolidated financial statements
include the accounts of HCP and its majority and wholly-owned subsidiaries (the
"Company"). The wholly owned subsidiaries include HCMC, HCS, Hanover Capital
Advisors, Inc. (through September 1997) and Hanover Capital Mortgage Fund, Inc.
(through September 1997). Majority owned subsidiaries include Hanover Joint
Ventures, Inc. (75% owned) and Hanover On-Line Mortgage Edge, LLC (50% owned,
through September 1997). All significant intercompany accounts and transactions
have been eliminated.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities at the
date of the financial statements and the required amounts of revenues and
expenses during the reporting period.

b. INVESTMENTS IN LIMITED LIABILITY COMPANIES. Minority ownership
interests in limited liability companies are accounted for by the equity method
of accounting. HCP's investment in limited liability companies are classified as
other assets in the accompanying consolidated balance sheets. The ownership of
each limited liability company at December 31, 1997 and 1996 is detailed below:
<TABLE>
<CAPTION>

1997 1996
---- ----
<S> <C> <C>
AGR Financial, LLC............. -- 25.0%
Alpine/Hanover, LLC............ 1.0% 1.0%
ABH-I, LLC..................... 1.0% 1.0%
Alpine/Hanover II, LLC......... -- 1.0%
</TABLE>

c. MINORITY INTERESTS. Minority interests, representing other
stockholders' interests in majority-owned companies are consolidated in the
accompanying balance sheets.

d. REVENUE RECOGNITION. Revenues from due diligence contracts in
progress are recognized for the services provided as they are earned and billed.

e. LOAN ORIGINATION FEES AND COSTS. Loan origination fees and costs are
deferred until the sale of the loan. The Company sells all originated loans to
investors at the time of origination, and accordingly, recognizes loan
origination fees at that time. Direct loan origination costs and loan
origination fees are offset and included in mortgage sales revenue.

F-25

<PAGE> 64

f. LOAN SERVICING FEES. Loan servicing fees consist of fees paid by
investors for the collection of monthly mortgage payments, maintenance of
required escrow accounts, remittance to investors, and ancillary income
associated with those activities. The Company recognizes loan servicing fees as
payments are collected.

g. DEFERRED REVENUE. Cash advances received for certain service contracts
are recorded in the accompanying consolidated balance sheets as deferred revenue
and are recognized during the period the services are provided and the related
revenue is earned.

h. INCOME TAXES. The Company records deferred taxes in accordance with
Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes
("SFAS 109"). Under SFAS 109 a current or deferred tax liability or asset is
recognized for the current or deferred tax effects of all events recognized in
the financial statements. Those effects are measured based on provisions of
current tax law to determine the amount of taxes payable or refundable currently
or in future years. The tax effects of earning income or incurring expenses in
future years or the future enactment of a change in tax laws or rates are not
anticipated in determining deferred tax assets or liabilities.

The Company files a consolidated Federal income tax return. The Company has
not been subject to an examination of their income tax returns by the Internal
Revenue Service.

i. PROPERTY AND EQUIPMENT. Property and equipment is stated at cost less
accumulated depreciation. Depreciation is computed on the straight-line method
over the estimated useful lives of the assets, generally three to seven years.
Leasehold improvements are depreciated over the terms of the respective leases
or their estimated useful lives, whichever is shorter.

j. INVESTMENT IN MARKETABLE SECURITIES. Investment in marketable
securities which the Company has classified as trading securities are reported
in the accompanying consolidated balance sheets at market value at December 31,
1997 and 1996.

k. CASH AND CASH EQUIVALENTS. For cash flow purposes, the Company
considers highly liquid investments, purchased with an original maturity of
three months or less, to be cash equivalents. There were no cash equivalents at
December 31, 1997 and 1996.

l. MORTGAGE SERVICING RIGHTS. Effective January 1, 1997, the Company
adopted Statement of Financial Accounting Standards No. 125, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
("SFAS 125"). SFAS 125 supersedes Statement of Financial Accounting Standards
No. 122, Accounting for Mortgage Servicing Rights, an amendment of FASB
Statement No. 65. Under SFAS 125, after the transfer of a financial asset, the
Company recognizes the financial assets it controls and the liabilities it has
incurred. Furthermore, the Company no longer recognizes the financial assets for
which control has been surrendered and liabilities have been extinguished. The
adoption of SFAS 125 did not have an effect on the financial position or results
of operations of the Company.

In December 1996, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 127, Deferral of the Effective Date of
Certain Provisions of FASB Statement No. 125 ("SFAS 127"). SFAS 127 defers for
one year the effective date of certain sections of SFAS 125, including those
relating to repurchase agreement, dollar-roll, securities lending and similar
transactions, as prescribed by SFAS 125. The adoption of SFAS 127 will not have
a material effect on the Company's financial position or results of operations.

Prior to January 1, 1997, the Company accounted for mortgage servicing
rights in accordance with SFAS 122. For purposes of assessing impairment, the
lower of carrying value or fair value of servicing rights is determined on an
individual loan basis. Capitalized servicing rights are amortized in proportion
to projected net servicing revenue. The fair value of servicing rights is
determined using a discounted cash flow method.

F-26

<PAGE> 65

m. BASIC EARNINGS PER SHARE. The Company computes earnings per share in
accordance with statement of Financial Accounting Standards No. 128, Earnings
per Share ("SFAS 128"). Basic earnings per share is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding during the period. Shares issued during the period and shares
reacquired during the period are weighted for the portion of time they were
outstanding.

3. PAYROLL TAX SETTLEMENT

In 1994, the Internal Revenue Service ("IRS") began an examination of the
Company's payroll tax withholding practices with respect to independent
contractors who provided services to HCP's due diligence business.

Pursuant to the IRS Classification Settlement Program ("CSP"), HCP settled
all disputed payroll taxes relating to the IRS examination of HCP's payroll
withholding practices with respect to independent contractors. In October 1997,
management agreed to the terms of the CSP which required HCP to pay the United
States Government $99,240 in full discharge of any federal employment tax
liability and to further treat the workers as employees (rather than independent
contractors) on a prospective basis effective April 1, 1998.

At December 31, 1995, HCP had recorded an accrual of $400,000 for payroll
withholding tax for independent contractors. HCP recorded a reversal of reserve
of $23,160 and $277,600 for the payroll tax matter in the accompanying
consolidated statements of operations for the years ended December 31, 1997 and
1996, respectively, to adjust the previously established reserve to the actual
and expected settlement amounts.

4. CONCENTRATION RISK

For the years ended December 31, 1997, 1996 and 1995, the Company received
revenues from certain customers, which are subject to change annually, which
exceeded 10% of total revenues as follows:
<TABLE>
<CAPTION>

1997 1996 1995
---- ---- ----
<S> <C> <C>
24% 46% 32%
18% 26% 16%
</TABLE>

5. MORTGAGE SERVICING

The Company, through its wholly-owned subsidiary HCMC, services multifamily
mortgage loans on behalf of others. Loan servicing consists of the collection of
monthly mortgage payments on behalf of investors, reporting information to those
investors on a monthly basis and maintaining custodial escrow accounts for the
payment of principal and interest to investors and property taxes and insurance
premiums on behalf of borrowers. As of December 31, 1997 and 1996, HCMC was
servicing 43 and 46 loans, respectively, with unpaid principal balances of
$120,736,400 and $129,315,400, including loans subserviced for others of
$40,055,200 and $44,241,919, respectively. Escrow balances maintained by HCMC
were $3,087,400 and $4,352,400 at December 31, 1997 and 1996, respectively. The
aforementioned servicing portfolio and related escrow accounts are not included
in the accompanying consolidated balance sheets as of December 31, 1997 and
1996.

Activity in mortgage servicing rights for the years ended December 31, 1997
and 1996 was as follows:

F-27

<PAGE> 66

<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Beginning balance................. $30,587 $46,904
Capitalization.................... $43,783 $37,451
Sales............................. (17,530) (41,725)
Scheduled amortization............ (7,391) (12,043)
------- -------
$49,449 $30,587
======= =======
</TABLE>

The fair value of the Company's servicing rights at December 31, 1997 and
1996 was $79,504 and $46,606, respectively.

6. RELATED PARTY TRANSACTIONS

Receivables from related parties at December 31, 1997 and 1996 consist of
the following:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Due from Hanover Capital Mortgage Holdings, Inc.(1)............ $540,044 $ --
Due from ABH-I, LLC (includes $28,984 and $431,118 of
asset management fees at December 31, 1997 and 1996,
respectively)(2)............................................ 51,321 451,604
Due from Hanover Asset Services, Inc.(3)....................... 8,070 6,420
Due from Alpine/Hanover, LLC(2)................................ 9,273 4,361
Due from Alpine/Hanover II, LLC(3)............................. 5,000 --
Due from Hanover Mortgage Capital Corporation(3)............... 5,962 --
Due from AGR Financial, LLC(4)................................. 80,813 --
-------- --------

Due from related entities...................................... 700,483 462,385
Due from officers(5)........................................... 110,667 166,686
-------- --------

Receivables from related parties............................... $811,150 $629,071
======== ========
</TABLE>
- -----------------------------
(1) The Company entered into a Management Agreement in 1998 to provide,
among other things, due diligence, asset management and administrative
services to Hanover Capital Mortgage Holdings, Inc. ("HCHI") in
connection with acquiring single-family mortgage loan pools and
managing and servicing HCHI's investment portfolio. The term of the
Management Agreement continues until December 31, 1999 with subsequent
renewal provisions.

(2) Amounts due from entities that the Company had a minority ownership
percentage in for all of 1997 represent receivables resulting primarily
from fees generated from asset management services and out-of-pocket
expenses. The Company ceased providing asset management services to
these entities in September 1997. Asset management fees are recognized
in the period earned and amounted to $2,446,000, $1,370,000 and
$1,362,000 for the years ended December 31, 1997, 1996 and 1995,
respectively.

(3) Amounts due from entities that are owned by certain of the Company's
officers/owners at December 31, 1997 represent receivables resulting
primarily from accounting fees and out-of-pocket expenses.

(4) Amounts due from AGR Financial, LLC represent unpaid billings for
services that the Company provides to AGR Financial, LLC pursuant to an
agreement dated August 1996. The services

F-28

<PAGE> 67

include but are not limited to providing AGR Financial, LLC with
office space, office equipment, software operating systems, processing
capabilities and accounting services.

(5) Amounts due from officers in 1997 include $107,532 from the Company's
President which will be repaid in annual amounts of $53,766 in August
1998 and August 1999.

Notes payable to related parties at December 31, 1996 consisted of the
following:
<TABLE>
<CAPTION>
1996
----
<S> <C>
Note payable to officer............. $ 42,559
Notes payable to ABH-I, LLC......... 90,459
--------
Notes payable to related parties.... $133,018
========
</TABLE>

On January 1, 1996, HCP and its stockholders entered into an Exchange
Agreement (see Note 9) whereby HCP redeemed 40.836 shares of Class A common
stock from one of its stockholders in exchange for cash ($66,000) and a term
note in the amount of $42,559. The note was paid in full, with interest at the
prime rate plus 2.0% in January 1997.

Notes payable to ABH-I, LLC at December 31, 1996 consisted of three (3)
promissory notes totaling $90,459. All of the promissory notes bear interest at
the prime rate (8.25% at December 31, 1996). The promissory notes were paid in
full in 1997.

7. PROPERTY AND EQUIPMENT

Property and equipment at December 31, 1997 and 1996 consists of the
following:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Office machinery and equipment.......... $381,189 $388,123
Furniture and fixtures.................. 111,246 111,246
Leashold improvements................... 68,553 68,553
-------- --------
560,988 567,922
Less accumulated depreciation and
amortization......................... (347,851) (251,865)
-------- --------
Property and equipment - net............ $213,137 $316,057
======== ========
</TABLE>
Depreciation expense for the years ended December 31, 1997, 1996 and 1995
was $110,284, $113,885 and $87,913, respectively.

8. INCOME TAXES

The components of deferred income taxes as of December 31, 1997 and 1996
are as follows:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deferred tax assets..................... $44,499 $ 52,409
Deferred tax liabilities................ (24,418) (65,402)
------- --------
Net Deferred tax assets (liabilities)... $20,081 $(12,993)
======= ========
</TABLE>

The items resulting in significant temporary differences for the years
ended December 31, 1997 and 1996 that generate deferred tax assets relate
primarily to the recognition of deferred revenue, accounts payable and accrued
liabilities for financial reporting purposes. Temporary differences that

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<PAGE> 68

generate deferred tax liabilities relate primarily to the Company's change from
the cash method to the accrual method of accounting for income tax reporting
purposes.

The components of the income tax provision (benefit) for the years ended
December 31, 1997, 1996 and 1995 consist of the following:
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Current - Federal, state and local........ $(292,885) $91,092 $165,491
Deferred - Federal, state and local....... (33,074) (17,222) (114,326)
--------- ------- --------
Total..................................... $(325,959) $73,870 $ 51,165
========= ======= ========
</TABLE>

The income tax provision (benefit) differs from amounts computed at
statutory rates, as follows:
<TABLE>
<CAPTION>

1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Federal income taxes at statutory rate.... $(285,167) $56,518 $27,006
State and local income taxes net of
Federal benefit....................... (59,486) 14,836 9,417
Unconsolidated subsidiary's net income.... 1,177 (12,793)
Meals and entertainment................... 4,052 3,719 6,291
Officer's life insurance.................. 9,613 8,576 9,114
Other, net................................ 3,852 3,014 (663)
--------- ------- -------
Total..................................... $(325,959) $73,870 $51,165
========= ======= =======
</TABLE>

9. STOCKHOLDERS' EQUITY

On September 19, 1997, the Company entered into an Agreement and Plan of
Recapitalization ("Agreement") with its four stockholders to recapitalize the
Company. The Agreement provided for the tax-free exchange of the stockholders
166.424 Class A "old" common stock shares for 3,000 shares of "new" Class A
common stock shares, $0.01 par value (representing a 3% economic interest in the
Company and 97,000 shares of Series A preferred stock, $0.01 par value
(representing a 97% economic interest in the Company). The preferred stock has
no dividend rate or preference over the common stock. Dividend distributions
will be made in the same amount on a per share basis of the common stock as for
the preferred stock. Dividend distributions will be made to the common
stockholders and the preferred stockholders in proportion to the number of
outstanding shares. The preferred stockholder has the right to receive
$10,750,005 upon liquidation of the Company before common stockholders receive
any liquidating distributions.

On January 1, 1996, HCP entered into an exchange agreement ("Exchange
Agreement") with its stockholders in order to restructure the ownership of HCP
so that HCP had only 166.424 Class A shares of common stock outstanding. The
terms of the Exchange Agreement required HCP to: (1) redeem 40.836 shares of
Class A common stock; (2) exchange 41.460 shares of Class B common stock for
Class A common stock; (3) effect an exchange of 8.468 shares of Class A common
stock among certain stockholders; and (4) transfer the ownership of Hanover
Mortgage Capital Corporation (formerly a wholly-owned subsidiary of HCP) to
HCP's stockholders.

On January 1, 1996, pursuant to the Exchange Agreement, HCP transferred its
total ownership interests in its wholly-owned subsidiary, Hanover Mortgage
Capital Corporation to HCP's stockholders. Hanover Mortgage Capital Corporation
had a retained earnings deficiency at the time of transfer.

10. NOTE PAYABLE TO BANK

In December 1996, HCP entered into a $2.0 million Line of Credit Facility
Agreement ("Line") with a bank that extends through December 31, 1999. The note
payable to the bank at December 31,

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<PAGE> 69

1997 and 1996 consisted of a short-term note of $1,405,000 and $1,045,000,
respectively, with an annual interest rate at the prime rate as of December 31,
1997. In October 1997, the terms of the Line were amended to decrease the
interest rate on the Line from the prime rate plus 1.5% to the prime rate. The
interest rate in effect at December 31, 1997 and 1996 was 8.50% and 9.75%,
respectively. The maximum borrowing capacity under the terms of the Line reduce
every six (6) months, beginning at June 30, 1997, by $150,000. The line is
collateralized by all of the assets of HCHI and guaranteed by HCHI. Prior to
September 1997, the line was collateralized by all of the assets of the Company
and guaranteed by the President and all of the wholly-owned subsidiaries of HCP.

At December 31, 1997, the Company was in violation of certain financial
debt covenants of the Line that required the Company (on a stand-alone basis)
to: (1) maintain a maximum debt to net worth ratio of 3 to 1 at December 31,
1997 and (2) to maintain a minimum debt service coverage ratio of 1.25 to 1.00
at December 31, 1997. To mitigate the above violations, the Company agreed to
make a voluntary paydown on the Line of $860,000 on February 17, 1998, thereby
reducing the outstanding borrowings on the line to $505,000.

11. COMMITMENTS AND CONTINGENCIES

The Company is involved in ongoing litigation regarding a mortgage loan and
a related reserve agreement. The Company has retained the services of outside
counsel. As of the date of this report, an evaluation of the likelihood of
success or an unfavorable outcome could not be performed. As such, no amount has
been provided for in the accompanying financial statements. The Company intends
to attempt to achieve final settlement of the matter and if for any reason, the
final settlement cannot be effectuated, the Company intends to respond
vigorously and will evaluate the progress of the litigation as information
becomes available.

The Company has noncancelable operating lease agreements for office space.
Future minimum rental payments for such leases are as follows:
<TABLE>
<CAPTION>
YEAR AMOUNT
---- ------
<S> <C>
1998.......................... $187,414
1999.......................... 104,882
2000.......................... 37,714
--------
Total......................... $330,010
========
</TABLE>

Rent expense for the years ended December 31, 1997, 1996 and 1995 amounted
to $310,814, $339,421, and $345,716 respectively.

F-31