<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10 -Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended September 30, 1999
OR
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _____________ to _______________
Commission file number: 001-13417
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND 13-3950486
(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
90 WEST STREET, SUITE 2210, NEW YORK, NY 10006
(Address of principal executive offices) (Zip Code)
(212) 732-5086
(Registrant's telephone number, including area code)
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 [ ]
The registrant had 5,826,899 shares of common stock outstanding as of
November 5, 1999.
<PAGE> 2
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
FORM 10-Q
For the Quarter Ended September 30, 1999
INDEX
PART I. FINANCIAL INFORMATION
Page No.
-------
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 1999 and December 31, 1998 3
Condensed Consolidated Statements of Operations
for the Three and Nine Months Ended September
30, 1999 and 1998 4
Condensed Consolidated Statement of
Stockholders' Equity for the Nine Months Ended
September 30, 1999 5
Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended September 30, 1999
and 1998 6
Notes to Condensed Consolidated Financial
Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 31
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 55
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 58
Item 2. Changes in Securities 58
Item 3. Defaults Upon Senior Securities 58
Item 4. Submission of Matters to a Vote of Security Holders 58
Item 5. Other Information 58
Item 6. Exhibits and Reports on Form 8-K 58
Signatures 59
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
<TABLE>
<CAPTION>
SEPTEMBER 30,
1999 DECEMBER 31,
(unaudited) 1998
------------ -----------
<S> <C> <C>
ASSETS
Mortgage loans:
Held for sale $ 251 $256,833
Held to maturity -- 69,495
Collateral for CMOs and mortgage-backed bonds 288,745 81,666
Mortgage securities:
Available for sale 49,995 74,000
Held to maturity 8,337 4,478
Trading 5,993 --
Cash and cash equivalents 18,584 11,837
Accrued interest receivable 3,257 3,940
Equity investments
Operating (Hanover Capital Partners Ltd.) 934 1,761
Mortgage finance (Hanover Capital Partners 2, Inc.) -- 5,728
Other (HanoverTrade.com, Inc.) (5) --
Notes receivable from related parties 8,378 3,893
Due from related parties 79 313
Other receivables 174 1,621
Prepaid expenses and other assets 2,409 605
-------- --------
TOTAL ASSETS $387,131 $516,170
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Reverse repurchase agreements $ 59,456 $370,090
CMO and mortgage-backed bonds borrowing 273,514 77,305
Accrued interest payable 2,132 1,394
Dividends payable -- 695
Due to related party 336 --
Accrued expenses and other liabilities 1,614 906
-------- --------
Total liabilities 337,052 450,390
-------- --------
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, 5,826,899 and
6,321,899 shares outstanding at September 30, 1999
and December 31, 1998, respectively 58 65
Additional paid-in-capital 75,840 78,069
Retained earnings (deficit) (24,903) (9,955)
Accumulated other comprehensive (loss) (916) (2,399)
-------- --------
Total stockholders' equity 50,079 65,780
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $387,131 $516,170
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
3
<PAGE> 4
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1999 1998
-------- ------- -------- -------
<S> <C> <C> <C> <C>
REVENUES:
Interest income $ 4,740 $15,256 $ 20,720 $36,186
Interest expense 5,624 13,564 17,820 31,561
-------- ------- -------- -------
Net interest income (expense) (884) 1,692 2,900 4,625
Loan loss provision 107 130 339 278
-------- ------- -------- -------
Net interest income (expense)
after loan loss provision (991) 1,562 2,561 4,347
Gain on sale of servicing rights 196 -- 540 --
Gain (loss) on sale of mortgage assets (17) -- 146 (49)
Realized (loss) on mark to market of
mortgage securities and mortgage loans (6,534) -- (6,534) --
Provision for (loss) on disposition of
unconsolidated subsidiary (4,793) -- (4,793) --
-------- ------- -------- -------
Total revenues (loss) (12,139) 1,562 (8,080) 4,298
-------- ------- -------- -------
EXPENSES:
Personnel 508 172 878 535
Management and administrative 241 193 611 522
Due diligence 12 158 119 578
Commissions -- 65 5 282
Legal and professional 375 99 927 338
Financing/commitment fees 82 179 230 311
Other 86 62 219 194
-------- ------- -------- -------
Total expenses 1,304 928 2,989 2,760
-------- ------- -------- -------
Operating income (loss) (13,443) 634 (11,069) 1,538
Equity in (loss) of unconsolidated subsidiaries:
Operating
(Hanover Capital Partners Ltd.) (142) (288) (826) (588)
Mortgage finance
(Hanover Capital Partners 2, Inc.) (403) -- (1,299) --
Other (Hanover Trade.com, Inc.) (6) -- (6) --
-------- ------- -------- -------
NET INCOME (LOSS) $(13,994) $ 346 $(13,200) $ 950
======== ======= ======== =======
BASIC EARNINGS (LOSS) PER SHARE $ (2.40) $ 0.05 $ (2.21) $ 0.15
======== ======= ======== =======
DILUTED EARNINGS (LOSS) PER SHARE $ (2.38) $ 0.05 $ (2.19) $ 0.15
======== ======= ======== =======
</TABLE>
See accompanying notes to condensed consolidated financial statements.
4
<PAGE> 5
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 1999
(in thousands, except share data)
(unaudited)
<TABLE>
<CAPTION>
ACCUMULATED
COMMON STOCK ADDITIONAL COMPREHENSIVE RETAINED OTHER
------------ PAID-IN INCOME EARNINGS COMPREHENSIVE
SHARES AMOUNT CAPITAL (LOSS) (DEFICIT) (LOSS) TOTAL
------ ------ ------- ------ --------- ------ -----
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE,
December 31, 1998 6,321,899 $ 65 $ 78,069 $ (9,955) $ (2,399) $ 65,780
Repurchase of
common stock (495,000) (7) (2,229) (2,236)
Comprehensive (loss):
Net (loss) $(13,200) (13,200) (13,200)
Other comprehensive income (loss)
Unrealized income on mortgage
securities, net of reclassification
adjustment (see disclosure) 1,483 1,483 1,483
--------
Comprehensive (loss) $(11,717)
========
Dividends declared (1,748) (1,748)
--------- ---- -------- -------- -------- --------
BALANCE,
September 30, 1999 5,826,899 $ 58 $ 75,840 $(24,903) $ (916) $ 50,079
========= ==== ======== ======== ======== ========
Disclosure of reclassification amount:
Unrealized (losses) during the period $ (1,179)
Unrealized gain during the period 11
Less: reclassification adjustment for
realized (losses) included in comprehensive
net (loss) 2,651
--------
Net unrealized income on mortgage securities $ 1,483
========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
5
<PAGE> 6
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
NINE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, 1999 SEPTEMBER 30, 1998
------------------ ------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (13,200) $ 950
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Amortization of net premium and deferred costs 3,963 5,515
Loan loss provision 339 278
(Gain) on sale of mortgage servicing rights (540) --
(Gain)/loss on sale of mortgage assets (146) 49
Realized loss on mark to market of mortgage securities
and mortgage loans 6,534 --
Provision for loss on disposition of unconsolidated
subsidiary 4,793 --
Equity in loss of unconsolidated subsidiaries 2,131 588
(Increase) decrease in accrued interest receivable 683 (4,242)
(Increase) in loans to related parties (4,485) (9,784)
(Increase) in due from related parties (131) --
(Increase) decrease in other receivables 1,447 (1,351)
(Increase) in prepaid expenses and other assets (1,512) (493)
Increase in accrued interest payable 738 2,228
Increase (decrease) in due to related party 336 (592)
Increase in accrued expenses and
other liabilities 707 5,923
--------- ---------
Net cash provided by (used in) operating activities 1,657 (931)
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net (increase) decrease in mortgage loans 64,859 (684,159)
Principal payments received on collateral for
CMOs and mortgage-backed bonds 42,875 15,096
Principal payments received on mortgage securities 10,580 133,597
Proceeds from the sale of mortgage securities and loans 8,743 20,118
Proceeds from the sale of mortgage servicing rights 806 --
Purchase of mortgage securities (3,668) (4,333)
--------- ---------
Net cash provided by (used in) investing activities 124,195 (519,681)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from CMOs and mortgage-backed bonds 196,209 85,330
Net borrowings from (repayments for) reverse repurchase
agreements (310,634) 446,077
Repurchase of common stock (2,236) (1,324)
Payment of dividends (2,443) (3,751)
Equity investment in subsidiaries (1) (2,700)
Exercise of stock warrants -- 3
--------- ---------
Net cash provided by (used in) financing activities (119,105) 523,635
-------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 6,747 3,023
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 11,837 4,022
--------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 18,584 $ 7,045
========= =========
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES
Operating activity - increase in dividends payable ($1,075) relating to the
declaration of dividends in September 1998
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the period for:
Income taxes $ 2 $ 1
========= =========
Interest $ 17,082 $ 29,043
========= =========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
6
<PAGE> 7
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF PRESENTATION
GENERAL
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland
on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to
operate as a specialty finance company. The principal business strategy of
Hanover and its wholly-owned subsidiaries, (together referred to as the
"Company") is to (i) acquire primarily single-family mortgage loans that are at
least twelve months old or that were intended to be of certain credit quality
but that do not meet the originally intended market parameters due to errors or
credit deterioration, (ii) securitize the mortgage loans and retain interests
therein and (iii) acquire subordinated mortgage securities similar in nature to
the retained interests generated from internal securitizations. The principal
business strategy of the Company's primary unconsolidated subsidiary, Hanover
Capital Partners Ltd. ("HCP"), is to generate consulting and other fee income by
(i) performing loan file due diligence reviews for third parties, (ii)
performing loan sale advisory services and (iii) brokering and trading
portfolios of loans. Until recently, HCP was also engaged in the business of
originating multifamily and commercial loans. This business was discontinued in
the quarter ended June 30, 1999 and substantially all charges associated with
its discontinuance were recognized in the quarter. The Company's principal
business objective is to generate net interest income on its portfolio of
mortgage loans and mortgage securities, and to generate fee income through HCP.
The Company acquires single-family mortgage loans through a network of sales
representatives targeting financial institutions throughout the United States.
CAPITALIZATION
In September 1997, 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 consisting of one share of common stock, par value
$.01 and one stock warrant) at $15.00 per unit including 750,000 units sold
pursuant to the underwriters' over-allotment option, which was exercised in
full. Each warrant, as adjusted on January 1, 1999, entitles the holder to
purchase 1.0302 shares of common stock at the adjusted price of $14.56 per share
of common stock. The warrants became exercisable on March 19, 1998 and expire on
September 15, 2000. The Company utilized substantially all of the net proceeds
of the IPO to fund leveraged purchases of mortgage loans. As of September 30,
1999, there were 6,217,877 warrants outstanding, including 172,500 warrants
issued pursuant to the underwriters over-allotment option.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The condensed consolidated financial statements include the accounts of Hanover
Capital Mortgage Holdings, Inc. and its wholly-owned subsidiaries. All
significant intercompany accounts and transactions have been eliminated.
7
<PAGE> 8
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared by the management of the Company in accordance with generally accepted
accounting principles ("GAAP") for interim financial information and in
conformity with the rules and regulations of the Securities and Exchange
Commission. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation
have been included. The results of operations for the nine months ended
September 30, 1999 are not necessarily indicative of the results that may be
expected for the full year. For further information, refer to the audited
financial statements and footnotes included in the Company's 1998 Form 10-K.
METHOD OF ACCOUNTING
The condensed consolidated financial statements of the Company are prepared on
the accrual basis of accounting in accordance with generally accepted accounting
principles. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
INCOME TAXES
Hanover has elected to be taxed as REIT and intends to comply with the
provisions of the Internal Revenue Code of 1986, as amended (the "Code") with
respect thereto. Accordingly, Hanover will not be subject to Federal or state
income tax to the extent that its annual distributions to stockholders are equal
to at least 95% of its taxable income and as long as certain asset, income and
stock ownership tests are met.
EARNINGS PER SHARE
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.
8
<PAGE> 9
Calculations for earnings (loss) per share are shown below (dollars in
thousands, except per share data):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
EARNINGS (LOSS) PER SHARE BASIC:
Net income (loss) [numerator] $ (13,994) $ 346 $ (13,200) $ 950
=========== =========== =========== ===========
Average common shares
outstanding [denominator] 5,826,899 6,417,947 5,984,500 6,450,749
=========== =========== =========== ===========
Per share $ (2.40) $ 0.05 $ (2.21) $ 0.15
=========== =========== =========== ===========
EARNINGS (LOSS) PER SHARE DILUTED:
Net income (loss) [numerator] $ (13,994) $ 346 $ (13,200) $ 950
=========== =========== =========== ===========
Average common shares
outstanding 5,826,899 6,417,947 5,984,500 6,450,749
=========== =========== =========== ===========
Add: Incremental shares from
assumed conversion of
warrants 50,000 0 32,294 0
----------- ----------- ----------- -----------
Dilutive potential common shares 50,000 0 32,294 0
----------- ----------- ----------- -----------
Adjusted weighted average shares
outstanding [denominator] 5,876,899 6,417,947 6,016,794 6,450,749
=========== =========== =========== ===========
Per share $ (2.38) $ 0.05 $ (2.19) $ 0.15
=========== =========== =========== ===========
</TABLE>
3. 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 September 30, 1999 management
had made the determination that $251,000 of mortgage loans were held for sale.
No mortgage loans were designated as held to maturity and $288,745,000 of
mortgage loans were held as collateralized mortgage obligation ("CMO") and
mortgage-backed bonds collateral. All mortgage loans designated as held for sale
are reported at the lower of cost or market, with unrealized losses reported as
a charge to earnings in the current period. Mortgage loans designated as held to
maturity and CMO and mortgage-backed bonds collateral are reported at cost.
Premiums, discounts and certain deferred costs associated with the purchase of
mortgage loans are amortized into interest income over the lives of the mortgage
loans using the effective yield method adjusted for the effects of estimated
prepayments. Mortgage loan transactions are recorded on the date the mortgage
loans are purchased or sold. Purchases of new mortgage loans are recorded 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.
9
<PAGE> 10
The accrual of interest on impaired loans is discontinued when, in management's
opinion, the borrower may be unable to meet payments as they become due. When
interest accrual is discontinued, all unpaid accrued interest income is
reversed. Interest income is subsequently recognized only to the extent cash
payments are received.
HELD FOR SALE
The following table summarizes certain characteristics of the Company's
single-family mortgage loan pools, held for sale portfolio which are carried at
the lower of cost or market (dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1999
------------------
Fixed Adjustable
Rate Rate (a) Total
----- ---------- -----
<S> <C> <C> <C>
Principal amount of mortgage loans $ 45 $ 206 $ 251
----- ----- -----
Carrying cost of mortgage loans $ 45 $ 206 $ 251
===== ===== =====
Mix 17.93% 82.07% 100.00%
Weighted average net coupon 7.441% 8.125% 8.002%
Weighted average maturity (b) 199 203 202
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
Fixed Adjustable
Rate Rate (a) Total
----- ---------- -----
<S> <C> <C> <C>
Principal amount of mortgage loans $ 93,615 $ 159,901 $ 253,516
Net premium and deferred costs 2,305 1,262 3,567
Loan loss provision (157) (93) (250)
--------- --------- ---------
Carrying cost of mortgage loans $ 95,763 $ 161,070 $ 256,833
========= ========= =========
Mix 37.29% 62.71% 100.00%
Weighted average net coupon 8.545% 7.542% 7.912%
Weighted average maturity (b) 187 264 235
</TABLE>
The Company had one adjustable rate mortgage loan at September 30, 1999
with a one year constant maturity treasury ("CMT") reference rate index with a
12 month repricing period and a net life cap of 13.50%.
The adjustable rate mortgage loans at December 31, 1998 had various reference
rate indexes with a weighted average 13 month repricing period and a weighted
average net life cap of 13.23%.
(a) The adjustable rate mortgage loans include $ -0- and $31,857,000 of hybrid
mortgage loans at September 30, 1999 and December 31, 1998 respectively,
which allow the coupon interest rate to change at one specified time during
the life of the loan.
(b) Weighted average maturity reflects the number of months until maturity.
10
<PAGE> 11
HELD TO MATURITY
The Company did not have any mortgage loans held to maturity at September 30,
1999. The following table summarizes certain characteristics of the Company's
single-family mortgage loans, held to maturity which are carried at cost at
December 31, 1998 (dollars in thousands):
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
Fixed Adjustable
Rate Rate Total
----- ---------- -----
<S> <C> <C> <C>
Principal balance of mortgage loans $ 67,515 $ 144 $ 67,659
Net premium (discount) 1,802 4 1,806
Deferred costs 72 -- 72
Loan loss provision (39) (3) (42)
-------- -------- --------
Carrying cost of mortgage loans $ 69,350 $ 145 $ 69,495
======== ======== ========
Mix 99.79% 0.21% 100.00%
Weighted average net coupon 8.707% 7.625% 8.705%
Weighted average maturity 253 302 253
</TABLE>
The adjustable rate mortgage loans had a 1 year CMT based reference rate with a
12 month repricing period and a net life cap of 10.25%.
The average effective yield, which includes the amortization of net premium,
discounts and certain deferred costs for the periods shown below on the total
mortgage loan portfolio were as follows:
<TABLE>
<CAPTION>
1999 1998
---- ----
<S> <C> <C>
Quarter ended March 31 7.092% 7.410%
Quarter ended June 30 7.010% 7.371%
Quarter ended September 30 2.704% 7.489%
</TABLE>
COLLATERAL FOR CMOS AND MORTGAGE-BACKED BONDS
In April 1998, the Company issued its first CMO securitization transaction,
Hanover Capital SPC, Inc. Series 1998-A ("1998-A"). $102,977,000 (par value) of
single family fixed rate residential mortgage loans were assigned as collateral
for the 1998-A securitization. In March 1999, the Company completed its second
CMO securitization transaction, Hanover Grantor Trust 1999-A ("1999-A").
$138,357,000 (par value) of single family fixed and adjustable rate residential
loans were assigned as collateral for the 1999-A securitization. In August 1999,
the Company completed its third CMO securitization transaction, Hanover Capital
Trust 1999-B ("1999-B"). $111,575,000 (par value) of single family fixed and
adjustable rate residential loans were assigned as collateral for the 1999-B
securitization. At the time of the 1999-B securitization, the Company recorded a
one-time charge in the consolidated statement of operations for the lower of
cost or market adjustment ($2,997,000) against the related mortgage loans. See
Note 13, "Certain Charges and Expenses in the Quarter Ended September 30, 1999".
The Company has limited exposure to credit risk retained on loans it has
securitized through the issuance of CMOs. All mortgage loans held as CMO and
mortgage-backed bonds collateral are reported at the lower of the original cost
of the mortgage loans or the market value of the mortgage loans as of the date
they were securitized. Premiums, discounts and all deferred costs associated
with the mortgage loans held as CMO and mortgage-backed bonds collateral are
amortized into interest income over
11
<PAGE> 12
the lives of the mortgage loans using the effective yield method adjusted for
the effects of estimated prepayments.
The following table summarizes the Company's single-family fixed and adjustable
rate mortgage loan pools held as CMO and mortgage-backed bonds collateral
(dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1999
------------------
Security
1998-A Security 1999-A Security 1999-B
-------- ------------------------ ------------------------
Fixed Fixed Adjustable Fixed Adjustable
Rate Rate Rate Rate Rate Total
----- ----- ---------- ----- ---------- -----
<S> <C> <C> <C> <C> <C> <C>
Principal balance of mortgage loans $ 60,114 $ 87,788 $ 30,494 $ 37,226 $ 71,249 $ 286,871
Net premium (discount) and deferred costs 1,334 1,567 544 (364) (697) 2,384
Loan loss provision (119) (167) (58) (57) (109) (510)
--------- --------- --------- --------- --------- ---------
Carrying cost of mortgage loans $ 61,329 $ 89,188 $ 30,980 $ 36,805 $ 70,443 $ 288,745
========= ========= ========= ========= ========= =========
Mix 21.24% 30.88% 10.73% 12.75% 24.40% 100.00%
Weighted average net coupon 7.745% 8.211% 7.145% 8.407% 6.731% 7.658%
Weighted average maturity 222 240 314 160 231 232
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
Security
1998-A
--------
Fixed
Rate
-----
<S> <C>
Principal balance of mortgage loans $79,812
Net premium and deferred costs 1,934
Loan loss provision (80)
-------
Carrying cost of mortgage loans $81,666
=======
Mix 100.00%
Weighted average net coupon 7.787%
Weighted average maturity 231
</TABLE>
The adjustable rate mortgage loans assigned as collateral for the 1999-A
securitization at September 30, 1999 had three reference rate indexes (more than
97% based on the one year CMT) with a weighted average 10 month repricing period
and a weighted average net life cap of 12.86%.
The adjustable rate mortgage loans assigned as collateral for the 1999-B
securitization at September 30, 1999 had 16 reference rate indexes (more than
51% based on the one year CMT) with a weighted average 6 month repricing period
and a weighted average net life cap of 14.22%.
12
<PAGE> 13
The average effective yield, which includes the amortization of net premiums,
discounts and certain deferred costs, for the periods shown below on the CMO and
mortgage-backed bonds collateral were as follows:
<TABLE>
<CAPTION>
SECURITY 1999-B 1999 1998
--------------- ---- ----
<S> <C> <C>
Quarter ended September 30 7.457% N/A
SECURITY 1999-A 1999 1998
--------------- ---- ----
Quarter ended March 31 7.054% N/A
Quarter ended June 30 7.302% N/A
Quarter ended September 30 6.895% N/A
SECURITY 1998-A 1999 1998
--------------- ---- ----
Quarter ended March 31 6.680% N/A
Quarter ended June 30 6.637% 7.158%
Quarter ended September 30 5.769% 7.071%
</TABLE>
4. MORTGAGE SECURITIES
The Company's policy is to generally classify mortgage securities as available
for sale as they are acquired. Each available for sale mortgage security is
monitored for a period of time prior to making a determination whether the asset
will be classified as held to maturity. Management reevaluates the
classification of the mortgage securities on a quarterly basis. Mortgage
securities designated as available for sale are reported at fair value, with
unrealized gains and losses excluded from earnings and reported as a separate
component of stockholders' equity.
Mortgage securities classified as held to maturity are carried at the fair value
of the security at the time the designation is made. Any fair value adjustment
is reflected as a separate component of stockholders' equity and as a cost
adjustment of the mortgage security as of the date of the classification and is
amortized into interest income as a yield adjustment.
The Company makes periodic evaluations of all mortgage securities to determine
whether an other than temporary impairment is considered to have occurred. If a
decline in the fair value is judged to be other than temporary, the cost basis
of the mortgage security will be marked to fair value, resulting in a current
period loss in the consolidated statement of operations. The new cost basis
shall not be changed for further increases in market value; however, further
increases in market value will be reflected separately in the equity section of
the Company's balance sheet. In the quarter ended September 30, 1999, the
Company determined that six interest only notes were impaired. See Note 13,
"Certain Charges and Expenses in the Quarter Ended September 30, 1999".
Premiums, discounts and certain deferred costs associated with the acquisition
of mortgage securities are amortized into interest income over the lives of the
securities using the effective yield method adjusted for the effects of
estimated prepayments. Mortgage securities transactions are recorded on the date
the mortgage securities are purchased or sold. Purchases of new issue mortgage
securities are recorded when all significant uncertainties regarding the
characteristics of the mortgage securities are removed, generally on or shortly
before settlement date. Realized
13
<PAGE> 14
gains and losses on mortgage securities transactions are determined on the
specific identification basis.
At September 30, 1999, the Company had $49,995,000 of fixed rate mortgage
securities classified as available for sale. These mortgage securities are
secured by fixed rate mortgage loans on single-family residential housing. The
following table summarizes certain characteristics of the Company's mortgage
securities classified as available for sale, which are carried at their fair
value (dollars in thousands):
MORTGAGE SECURITIES FOR SALE
<TABLE>
<CAPTION>
SEPTEMBER 30, 1999
------------------
1998-B
Purchased Swapped Private
FNMA FNMA Placement
Certificate (a) Certificates (b) Notes(c) Total
--------------- ---------------- --------- -----
<S> <C> <C> <C> <C>
Principal balance of mortgage securities $ 2,645 $ 45,599 $ -- $ 48,244
Net premium (discount) and deferred costs 137 778 1,752 2,667
--------- --------- --------- ---------
Total amortized cost of mortgage securities 2,782 46,377 1,752 50,911
Gross unrealized loss (35) (881) -- (916)
--------- --------- --------- ---------
Carrying cost of mortgage securities $ 2,747 $ 45,496 $ 1,752 $ 49,995
========= ========= ========= =========
Mix 5.49% 91.00% 3.51% 100.00%
Principal balance of mortgage loans $ 2,645 $ 45,599 $ 218,329 $ 266,573
Weighted average net coupon 9.000% 7.384% 0.776% 12.122%
Weighted average maturity 283 244 298 248
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
1998-B
Purchased Swapped Private
FNMA FNMA Placement
Certificate (a) Certificates (b) Notes (d) Total
--------------- ---------------- ---------- -----
<S> <C> <C> <C> <C>
Principal balance of mortgage securities $ 3,255 $ 55,207 $ 14,279 $ 72,741
Net premium (discount) and deferred costs 170 1,009 2,479 3,658
--------- --------- --------- ---------
Total amortized cost of mortgage securities 3,425 56,216 16,758 76,399
Gross unrealized loss (46) -- (2,353) (2,399)
--------- --------- --------- ---------
Carrying cost of mortgage securities $ 3,379 $ 56,216 $ 14,405 $ 74,000
========= ========= ========= =========
Mix 4.57% 75.97% 19.46% 100.00%
Principal balance of mortgage loans $ 3,255 $ 55,207 $ 297,682 $ 356,144
Weighted average net coupon 9.000% 7.462% 28.592% 11.679%
Weighted average maturity 294 248 307 298
</TABLE>
14
<PAGE> 15
(a) Represents one FNMA certificate with a fixed coupon interest rate of 9.00%
purchased from a "Wall Street" dealer firm. This certificate generates
normal principal and interest remittances to the Company on a monthly
basis.
(b) Represents 31 fixed rate FNMA certificates that the Company received in
exchange for a like amount of fixed rate mortgage loans in December 1998.
The coupon interest rates range from 6.00% to 10.50%. These certificates
generate normal principal and interest remittances to the Company on a
monthly basis.
(c) Represents six interest only notes purchased from an affiliate, Hanover
Capital Partners 2, Inc. ("HCP-2"), in a private placement in October 1998
in connection with the 1998-B securitization. The interest only notes
generate monthly interest remittances to the Company (subject to the
availability of funds) from the excess interest generated from the
underlying mortgages after deducting all service fees and the coupon
interest rate on the applicable notes. The interest rate on each of the
interest only notes is based on a notional amount (the principal balance of
those mortgage loans with an interest rate in excess of the related note
coupon interest rate). The notional amounts decline each month to reflect
the related normal principal amortization, curtailments and prepayments for
the related underlying mortgage loans. At September 30, 1999 the interest
only notes were divided into two major categories: the first group had an
effective weighted average interest rate of 1.066% on a notional balance of
$186,370,000; and the second group had an effective weighted average
interest rate of 0.25% on a notional balance of $102,780,000 for a combined
weighted average interest rate on the notional balances of 0.776%. At
September 30, 1999 management reclassified four investment grade notes ("AA
and "A") to the trading category and two investment grade notes ("BBB") to
the held to maturity category. These notes were transferred at their fair
market value which was lower than their cost basis by $1,312,000. This
decrease in market value was recorded as a one-time charge in the
consolidated statements of operations. See Note 13, "Certain Charges and
Expenses in the Quarter Ended September 30, 1999".
(d) Represents nine investment grade ("AA", "A" and "BBB") notes and six
interest only notes purchased from HCP-2 in a private placement in October
1998 in connection with the 1998-B securitization. The interest rates on
the investment grade notes are fixed and range from 6.25% to 6.75%. These
notes generate normal principal and interest remittances to the Company on
a monthly basis. The interest only notes generate monthly interest
remittances to the Company (subject to the availability of funds) from the
excess interest generated from the underlying mortgages after deducting all
service fees and the coupon interest rate on the applicable notes. The
interest rate on each of the interest only notes is based on a notional
amount (the principal balance of those mortgage loans with an interest rate
in excess of the related note coupon interest rate). The notional amounts
decline each month to reflect the related normal principal amortization,
curtailments and prepayments for the related underlying mortgage loans. At
December 31, 1998 the interest only notes were divided into two major
categories: the first group had an effective weighted average interest rate
of 1.166% on a notional balance of $259,861,000; and the second group had
an effective weighted average interest rate of 0.25% on a notional balance
of $143,666,000.
HELD TO MATURITY
At September 30, 1999, the Company had $8,337,000 of fixed rate mortgage
securities classified as held to maturity. These mortgage securities are secured
by fixed rate mortgage loans on single-family residential housing. The following
tables summarize certain characteristics of the
15
<PAGE> 16
Company's fixed rate mortgage securities classified as held to maturity, which
are carried at cost (dollars in thousands):
MORTGAGE SECURITIES HELD TO MATURITY
<TABLE>
<CAPTION>
SEPTEMBER 30, 1999
------------------
Third Party 1998-B
Private Private
Placement Placement
Notes (a) Notes (b) Total
----------- --------- -----
<S> <C> <C> <C>
Principal balance of mortgage securities $ 6,124 $ 7,723 $ 13,847
Net premium (discount) and deferred costs (2,447) (2,863) (5,310)
Loan loss provision (22) (178) (200)
----------- ----------- -----------
Carrying cost of mortgage securities $ 3,655 $ 4,682 $ 8,337
=========== =========== ===========
Mix 43.84% 56.16% 100.00%
Principal balance of mortgage loans (d) $ 1,079,255 $ 218,329 $ 1,297,584
Weighted average net coupon 6.479% 5.456% 5.908%
Weighted average maturity 316 298 307
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
1998-B
Private
Placement
Notes (c)
---------
<S> <C>
Principal balance of mortgage securities $ 3,816
Net premium and deferred costs 662
--------
Carrying cost of mortgage securities $ 4,478
========
Mix 100.00%
Principal balance of mortgage loans (d) $297,682
Weighted average net coupon 9.899%
Weighted average maturity 307
</TABLE>
(a) Represents twelve below investment grade notes purchased from third parties
in the second quarter of 1999. The coupon interest rates on the below
investment grade notes are fixed and range from 6.25% to 6.68%. These notes
generate normal principal and interest remittances to the Company on a
monthly basis.
(b) Represents two investment grade notes ("BBB"), six below investment grade
notes and three principal only (investment grade) notes purchased from
HCP-2 in October 1998 in connection with the 1998-B securitization. The
coupon interest rates on the below investment grade notes are fixed and
range from 6.50% to 6.75%. These notes generate normal principal and
interest remittances to the Company on a monthly basis.
(c) Represents nine below investment grade notes and three principal only
(investment grade) notes purchased from an affiliate, HCP-2, in October
1998 in connection with the Hanover SPC-2, Inc 1998-B ("1998-B")
securitization. The coupon interest rates on the below investment grade
notes are fixed and range from 6.25% to 6.75%. These notes generate normal
principal and interest remittances to the Company on a monthly basis.
16
<PAGE> 17
(d) The third party private placement notes represented a $6,124,000
subordinated interest in $1,079,255,000 of mortgage loans at September 30,
1999. The 1998-B private placement notes represented a $7,723,000
subordinated interest in $218,329,000 of mortgage loans at September 30,
1999 and a $3,816,000 subordinated interest in $297,682,000 of mortgage
loans at December 31, 1998.
TRADING
At September 30, 1999, the Company had $5,993,000 of fixed rate mortgage
securities classified as trading. These mortgage securities are secured by fixed
rate mortgage loans on single-family residential housing. The following tables
summarize certain characteristics of the Company's fixed rate mortgage
securities classified as trading, which are carried at market (dollars in
thousands):
MORTGAGE SECURITIES TRADING
SEPTEMBER 30, 1999
------------------
<TABLE>
<CAPTION>
1998-B
Private
Placement
Notes (a)
---------
<S> <C>
Principal balance of mortgage securities $ 7,129
Net market value (discount) (1,136)
--------
Carrying cost of mortgage securities $ 5,993
========
Principal balance of mortgage loans (b) $218,329
Weighted average net coupon 6.594%
Weighted average maturity 298
</TABLE>
(a) Represents four investment grade notes ("AA" and "A") purchased from HCP-2,
in October 1998 in connection with the 1998-B securitization. The coupon
interest rates on the investment grade notes are fixed and range from 6.50%
to 6.75%. These notes generate normal principal and interest remittances to
the Company on a monthly basis.
(b) The 1998-B private placement notes represented a $7,129,000 senior
subordinated interest in $218,329,000 of mortgage loans at September 30,
1999.
The average effective yield, which includes amortization of net premiums,
(discounts) and deferred costs, for the periods shown below on the combined
available for sale, held to maturity and trading mortgage securities portfolio
were as follows:
<TABLE>
<CAPTION>
1999 1998
---- ----
<S> <C> <C>
Quarter ended March 31 8.784% 6.116%
Quarter ended June 30 8.752% 3.992%
Quarter ended September 30 (1.335%) 4.528%
</TABLE>
17
<PAGE> 18
MORTGAGE SECURITIES HELD BY AFFILIATE
In addition to the mortgage securities detailed above, the Company also has
substantially all of the economic benefit of $14,012,000 of mortgage securities
held by its affiliate, HCP. See Note 6, "Equity Investments".
5. LOAN LOSS PROVISION
The provision for loan loss charged to expense is based upon actual credit loss
experience and management's estimate and evaluation of potential losses in the
existing mortgage loan and mortgage securities portfolio, including the
evaluation of impaired loans. The following table summarizes the activity in the
loan loss provision for the following periods (dollars in thousands):
<TABLE>
<CAPTION>
NINE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
1999 1998
------------------- -------------------
<S> <C> <C>
Balance - beginning of period $373 $ 18
Loan loss provision 339 277
Transfers/sales 39 --
Charge-offs (41) --
---- ----
Balance - end of period $710 $295
==== ====
</TABLE>
6. EQUITY INVESTMENTS
Hanover owns 100% of the non-voting preferred stock of HCP, which represents a
97% ownership interest in HCP and its wholly owned subsidiaries. Hanover also
owns 100% of the non-voting preferred stock of HCP-2, which represents a 99%
ownership interest in HCP-2 and its wholly owned subsidiary. In June 1999, the
Company acquired a 97% ownership interest in HanoverTrade.com, Inc. ("HTC")
represented by 100% of the non-voting preferred stock of HTC.
Hanover currently conducts substantially all of its taxable business operations
(i.e. due diligence consulting, loan sale advisory, and loan brokering and
trading) through HCP. HCP-2 was organized in October 1998 to facilitate the
securitization of $318 million of fixed and adjustable rate residential mortgage
loans in connection with the issuance of the 1998-B security. HCP-2 does not
conduct any ongoing business. HTC was organized in June 1999 to develop an
E-commerce business to broker mortgage loan pools to financial institutions via
the internet.
Hanover records its investment in HCP, HCP-2 and HTC on the equity method.
Accordingly, Hanover records 97% of the earnings or losses of HCP and HTC, and
99% of the earnings or losses of HCP-2 through its ownership of all of the
non-voting preferred stock of HCP, HTC and HCP-2, respectively. Summarized
financial information for HCP and HCP-2 is detailed below (dollars in
thousands):
18
<PAGE> 19
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
<TABLE>
<CAPTION>
SEPTEMBER 30,
1999 DECEMBER 31,
(unaudited) 1998
------------- ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash $ 308 $ 635
Interest receivable 182 --
Receivables from related parties 599 517
Other current assets 1,889 672
-------- --------
Total current assets 2,978 1,824
NET INVESTMENT IN MORTGAGE SECURITIES
Available for sale 14,012 --
PROPERTY AND EQUIPMENT-Net 69 141
INCOME TAX RECEIVABLE -- 220
OTHER ASSETS 1,172 930
-------- --------
TOTAL ASSETS $ 18,231 $ 3,115
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Reverse repurchase agreements $ 11,082 $ --
Accounts payable and accrued expenses 925 467
Note payable to related party 5,329 713
Other current liabilities -- 110
-------- --------
Total current liabilities 17,336 1,290
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock: $.01 par value, 100,000 shares
authorized, 97,000 shares outstanding 1 1
Common stock:
Class A: $.01 par value, 5,000 shares authorized,
3,000 shares outstanding -- --
Additional paid-in capital 2,840 2,840
Retained earnings (deficit) (1,868) (1,016)
Accumulated other comprehensive (loss) (78) --
-------- --------
Total stockholders' equity 895 1,825
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $ 18,231 $ 3,115
======== ========
</TABLE>
19
<PAGE> 20
HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
REVENUES:
Due diligence fees $ 1,917 $ 1,295 $ 3,861 $ 3,534
Mortgage sales and servicing 28 175 219 816
Loan brokering and other income 141 167 741 487
Net interest income:
Mortgage securities 100 -- 100 --
Mortgage loans -- 7 -- 7
------- ------- ------- -------
Total revenues 2,186 1,644 4,921 4,844
------- ------- ------- -------
EXPENSES:
Personnel expense 1,884 1,641 4,569 4,232
General and administrative expense 71 136 347 457
Other expenses 275 283 840 928
Interest expense 49 51 156 114
Depreciation and amortization 54 29 95 83
------- ------- ------- -------
Total expenses 2,333 2,140 6,007 5,814
------- ------- ------- -------
(LOSS) BEFORE INCOME
TAX (BENEFIT) (147) (496) (1,086) (970)
INCOME TAX (BENEFIT) -- (197) (235) (382)
------- ------- ------- -------
NET (LOSS) $ (147) $ (299) $ (851) $ (588)
======= ======= ======= =======
</TABLE>
HCP and its subsidiaries operate as a specialty finance company which is
principally engaged in performing due diligence consulting services, loan sale
advisory services and loan brokering and trading. A wholly-owned subsidiary of
HCP, Hanover Capital Mortgage Corporation ("HCMC"), operates as a servicer of
multifamily mortgage loans and prior to June 1999 was an originator of
multifamily and commercial mortgage loans. HCMC's origination operations were
discontinued in June 1999. Another wholly-owned subsidiary of HCP, Hanover
Capital Securities, Inc. ("HCS"), is a registered broker/dealer with the
Securities and Exchange Commission.
In September 1999, HCP purchased 17 below investment grade notes from an
unrelated third party. The coupon interest rates on the below investment grade
notes are fixed and range from 6.25% to 6.75%. These notes generate normal
principal and interest remittances to HCP on a monthly basis. HCP financed the
purchase of these notes through a one year reverse repurchase agreement
($11,082,000 at September 30, 1999) and a note payable from Hanover of
$3,041,000.
20
<PAGE> 21
At September 30, 1999, HCP had $14,012,000 of fixed rate mortgage securities
classified as available for sale. These mortgage securities are secured by fixed
rate mortgage loans on single-family residential housing. The following table
summarizes certain characteristics of HCP's mortgage securities classified as
available for sale, which are carried at their fair value (dollars in
thousands):
MORTGAGE SECURITIES AVAILABLE FOR SALE
<TABLE>
<CAPTION>
SEPTEMBER 30, 1999
Third Party
Private
Placement
Notes
-----------
<S> <C>
Principal balance of mortgage securities $33,506
Net (discount) (19,344)
Loan loss provision (72)
------
Total amortized cost of mortgage securities 14,090
Gross unrealized loss (78)
------
Carrying cost of mortgage securities $14,012
=======
Mix 100.00%
Principal balance of mortgage loans (a) $5,254,584
Weighted average net coupon 6.520%
Weighted average maturity 347
</TABLE>
(a) The third party private placement notes represented a $33,506,000
subordinated interest in $5,254,584,000 of mortgage loans at September 30, 1999.
21
<PAGE> 22
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except as noted)
<TABLE>
<CAPTION>
SEPTEMBER 30,
1999 DECEMBER 31,
(unaudited) 1998
------------ ----
<S> <C> <C>
ASSETS
Mortgage loans:
Collateral for CMOs and
mortgage-backed bonds $ 220,636 $ 300,599
Cash and cash equivalents -- 143
Accrued interest receivable 1,329 1,868
Deferred financing costs 2,531 3,191
Other assets 1 --
--------- ---------
TOTAL ASSETS $ 244,497 $ 305,801
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
CMO borrowing $ 218,330 $ 297,682
Accrued interest payable 1,329 1,868
Due to related parties 365 310
Accrued expenses and other
liabilities -- 154
--------- ---------
Total liabilities 220,024 300,014
--------- ---------
STOCKHOLDERS' EQUITY:
Preferred stock par value $.01
authorized, 9,900 shares; issued
and outstanding, 9,900 shares
Common stock, par value $.01
authorized, 100 shares; issued
and outstanding, 100 shares
Additional paid-in capital 14,319 14,319
Retained earnings (deficit) (9,846) (8,532)
--------- ---------
Total stockholders' equity 4,473 5,787
--------- ---------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 224,497 $ 305,801
========= =========
</TABLE>
22
<PAGE> 23
HANOVER CAPITAL PARTNERS 2, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
1999 1999
---- ----
<S> <C> <C>
REVENUES
Interest income
Interest income $ 4,128 $ 13,735
Amortization of premium
and deferred costs (191) (621)
-------- --------
Total interest income 3,937 13,114
-------- --------
Interest expense
Interest expense 4,128 13,735
Amortization of deferred
financing costs 212 687
-------- --------
Total interest expense 4,340 14,422
-------- --------
Net interest (expense) (403) (1,308)
-------- --------
EXPENSES:
Operating 5 6
-------- --------
NET (LOSS) $ (408) $ (1,314)
======== ========
</TABLE>
Hanover Capital Partners 2, Inc. was formed to acquire single-family residential
mortgage loans from Hanover pursuant to its formation transaction and to finance
the purchase of these mortgage loans through a REMIC securitization, 1998-B.
Hanover SPC-2, Inc., a wholly owned subsidiary of HCP-2, was incorporated for
the sole purpose of selling certain investment grade and subordinated notes to
certain wholly-owned subsidiaries of Hanover.
The Board of Directors has approved the sale or disposition of the Company's
preferred stock investment in HCP-2 and has recorded a one-time charge to the
consolidated statement of operations for a loss on the sale of HCP-2 of
$4,428,000. See Note 13, "Certain Charges and Expenses in the Three Months Ended
September 30, 1999".
7. REVERSE REPURCHASE AGREEMENTS
Reverse repurchase agreements are accounted for as collateralized financing
transactions and recorded at their contractual amounts. At September 30, 1999
the Company had a total of $300 million of committed and uncommitted mortgage
asset reverse repurchase agreement financing available pursuant to master
reverse repurchase agreements with two lenders. All borrowings pursuant to the
master reverse repurchase agreements are secured by mortgage loans or other
securities.
23
<PAGE> 24
The reverse repurchase agreements collateralized by mortgage loans are short
term borrowings with interest rates that vary from LIBOR plus 125 basis points
to LIBOR plus 238 basis points.
The lender will typically finance an amount equal to 80% to 97% of the market
value of the pledged collateral (mortgage loans) depending on certain
characteristics of the collateral (delinquencies, liens, aging, etc.). The
reverse repurchase agreement financing rates for mortgage securities,
accomplished through individual Public Securities Association (PSA) agreements
and through existing reverse repurchase agreements, bear interest rates that
vary from LIBOR to LIBOR plus 288 basis points. The lender will typically
finance an amount equal to 60% to 97% of the market value of the mortgage
securities, depending on the nature of the collateral.
At September 30, 1999 the Company had no outstanding borrowings on mortgage
loans under the above mentioned reverse repurchase agreements.
At September 30, 1999, the Company had outstanding borrowings on retained CMO
securities of $3,366,000 with a weighted average borrowing rate of 7.241% and a
weighted average remaining maturity of less than one month. Retained CMO
securities represent the Company's net investment in the CMOs issued by the
Company. The reverse repurchase financing agreements at September 30, 1999 were
collateralized by securities with a cost basis of $7,343,000.
At September 30, 1999, the Company had outstanding reverse repurchase agreement
financing for purchased mortgage securities of $56,090,000 with a weighted
average borrowing rate of 5.673% and a remaining maturity of less than one
month. Other mortgage securities are mortgage securities that the Company has
purchased or created in transactions other than CMOs. The repurchase agreement
financing at September 30, 1999 was collateralized by securities with a cost
basis of $59,629,000.
The table below details the scheduled maturities of the Company's committed and
uncommitted master reverse repurchase agreements at September 30, 1999:
<TABLE>
<CAPTION>
Committed Uncommitted Maturity Date
--------- ----------- -------------
<S> <C> <C>
$ 50 million -- April 2000
100 million $100 million March 2000
</TABLE>
Information pertaining to reverse repurchase agreement financing as of and for
the three months ended September 30, 1999 is summarized as follows (dollars in
thousands):
<TABLE>
<CAPTION>
Other
Mortgage Retained CMO Mortgage
Reverse Repurchase Agreements Loans Securities Securities
----------------------------- -------- ------------ ----------
<S> <C> <C> <C>
Balance of borrowing at end of period 0 $ 3,366 $ 56,090
Average borrowing balance during the period $ 37,031 $ 2,373 $ 52,470
Average interest rate during the period 6.258% 6.963% 5.276%
Maximum month-end borrowing balance
during the period $102,385 $ 3,393 $ 56,090
Collateral Underlying the Agreements
------------------------------------
Balance at end of period - carrying value 0 $ 7,343 $ 59,629
</TABLE>
24
<PAGE> 25
Information pertaining to reverse repurchase agreement financing as of and for
the year ended December 31, 1998 is summarized as follows (dollars in
thousands):
<TABLE>
<CAPTION>
Other
Mortgage Retained CMO Mortgage
Reverse Repurchase Agreements Loans Securities Securities
- ----------------------------- -------- ------------ ----------
<S> <C> <C> <C>
Balance of borrowing at end of period $306,239 $ 1,911 $ 61,940
Average borrowing balance during the period $367,656 $ 760 $224,050
Average interest rate during the period 6.511% 6.853% 5.695%
Maximum month-end borrowing balance
during the period $659,319 $ 2,331 $249,450
Collateral Underlying the Agreements
- ------------------------------------
Balance at end of period - carrying value $320,759 $ 2,542 $ 64,938
</TABLE>
At September 30, 1999 the Company was in default of its tangible net worth debt
covenant with one of its reverse repurchase lenders. The Company had $5,000,000
of outstanding reverse repurchase debt outstanding with this lender at September
30, 1999; which was subsequently paid in full in October. The Company has
notified the lender of the default and is in the process of obtaining a waiver
from the lender.
8. CMO AND MORTGAGE-BACKED BONDS BORROWING
The Company issued its CMO, also referred to as mortgage-backed bonds borrowing
secured by fixed rate mortgage loans in April 1998 and issued subsequent CMO
borrowings secured by fixed rate and adjustable rate mortgage loans in March
1999 and August 1999. For GAAP purposes, the mortgage loans financed through the
issuance of CMOs are treated as assets of the Company and the CMOs are treated
as debt of the Company. Borrower remittances received on the CMO collateral are
used to make payments on the CMOs. The obligations of the CMO are payable solely
from the underlying mortgage loans collateralizing the debt and otherwise are
non-recourse to the Company. The maturity of each class of CMO is directly
affected by principal prepayments on the related CMO collateral. Each class of
CMO is also subject to redemption according to specific terms of the respective
indenture agreements. As a result, the actual maturity of any class of CMO is
likely to occur earlier than its stated maturity.
Information pertaining to the CMOs as of and for the three months ended
September 30, 1999 is summarized as follows (dollars in thousands):
25
<PAGE> 26
<TABLE>
<CAPTION>
1999-B 1999-A 1998-A
SECURITIZATION SECURITIZATION SECURITIZATION TOTAL
-------------- -------------- -------------- -----
<S> <C> <C> <C> <C>
Balance of borrowing at end of period $103,474 $112,281 $ 57,759 $273,514
Average borrowing balance during the period $ 56,249 $116,345 $ 59,905 $232,499
Average interest rate during the period 6.196% 7.022% 6.850% 6.778%
Interest rate at end of period 6.214% 7.164% 6.970% 6.764%
Maximum month-end borrowing balance
during the period $106,554 $117,759 $ 60,764 $285,077
CMO and mortgage-backed bonds collateral
- ----------------------------------------
Balance at end of period - carrying balance $107,247 $120,169 $ 61,329 $288,745
</TABLE>
Information pertaining to the CMOs as of and for the year ended December 31,
1998 is summarized as follows (dollars in thousands):
<TABLE>
<CAPTION>
1998-A
Securitization
--------------
<S> <C>
Balance of borrowing at end of period $77,305
Average borrowing balance during the period $63,764
Average interest rate during the period 6.914%
Maximum month-end borrowing balance
during the period $98,391
CMO and mortgage-backed bonds collateral
----------------------------------------
Balance at end of period - carrying value $81,666
</TABLE>
9. AFFILIATED PARTY TRANSACTIONS
The Company engaged HCP pursuant to a Management Agreement to render among other
things, due diligence, asset management and administrative services. The
consolidated statement of operations of the Company for the three months ended
September 30, 1999 includes management and administrative expenses of $241,000,
and due diligence expenses of $12,000 relating to billings from HCP. The
consolidated statement of operations of the Company for the three months ended
September 30, 1998 included management and administrative expenses of $193,000,
due diligence expenses of $158,000 and commissions of $65,000 relating to
billings from HCP.
26
<PAGE> 27
Amounts due from related parties and due to related parties are detailed below
(dollars in thousands):
INTERCOMPANY BALANCES
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
<S> <C> <C>
Due from HTC $ 79 --
Due from HCP-2 -- $310
Due from HCP -- 3
---- ----
$ 79 $313
==== ====
Due to HCP $336 --
==== ====
</TABLE>
NOTES RECEIVABLE
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------- ------------
<S> <C> <C>
Principals (a) (b) (c) $3,049 $3,180
HCP (d) 5,329 713
------ ------
$8,378 $3,893
====== ======
</TABLE>
(a) The Principals are John A. Burchett, George J. Ostendorf, Irma N. Tavares
and Joyce S. Mizerak, the four most senior officers/stockholders of
Hanover.
(b) In March 1999, Hanover agreed to amend certain notes receivable
(aggregating $1,203,880) from the Principals that had a scheduled maturity
date of March 31, 1999, by extending the maturity date for two additional
years. The notes were also modified to provide for accelerated repayment by
a Principal in the event of such Principals' voluntary termination of
employment.
(c) Pursuant to the note agreements, the Company loaned the Principals $143,000
to purchase common stock in HCP-2 in order to complete the 1998-B
securitization transaction. The Principals subsequently made payments on
the loans totaling $69,000. The Company believes it is probable that
$62,000 of these loans will be forgiven in connection with the disposition
of HCP-2. Summarized below is the change in Principals loans during the
nine month period ended September 30, 1999:
<TABLE>
<CAPTION>
<S> <C>
Balance at January 1, 1999 $3,180
Loan repayments (69)
Provision for loan forgiveness (62)
------
Balance at September 30, 1999 $3,049
======
</TABLE>
(d) In September 1999 the Company advanced $3,041,000 to HCP to fund the
purchase of certain subordinated mortgage securities pursuant to an
unsecured loan agreement.
10. COMMON STOCK REPURCHASES
In July 1998, the Board of Directors of the Company authorized a share
repurchase program pursuant to which the Company was authorized to repurchase up
to 646,880 shares of the
27
<PAGE> 28
Company's outstanding common stock. The repurchases were made from time to time
in open market transactions. During the nine months ended September 30, 1999 the
Company repurchased 495,000 shares of its common stock at an average price of
$4.51 per share for a total cost of $2,236,000. Through September 30, 1999 the
Company had repurchased a total of 641,900 shares of its common stock at an
average price of $5.58 per share for a total cost of $3,580,000.
11. STOCK WARRANTS AND STOCK OPTIONS
In November 1998 Hanover entered into a short term financing agreement (that has
since terminated) with Residential Funding Corporation ("RFC"). In connection
with that financing arrangement, Hanover in April 1999 executed a Warrant
Agreement to issue to RFC warrants to purchase 299,999 shares of Hanover's
common stock. The warrants are exercisable at a price per share equal to the
closing price of Hanover's common stock on the American Stock Exchange on the
date of the November agreement, which was $4.00 per share. The warrants expire
after five years, in April 2004.
On July 23, 1999 Hanover's Board of Directors adopted and approved the 1999
Equity Incentive Plan (the "1999 Plan") which provides for the grant of both
non-qualified options and shares of restricted stock. The 1999 Plan is intended
to attract, retain and motivate employees, non-employee directors, and
consultants of the Company and to enable them to participate in the growth of
the Company by providing for or increasing the proprietary interests of such
persons in the Company. The terms of the 1999 Plan will allow for the granting
of a maximum of 550,710 shares of Hanover's common stock. 282,750 stock options
were granted on August 29, 1999 to employees and to members of the Board of
Directors of the Company. These stock options are not exercisable until after
the first anniversary date of the grant. Thereafter the options may become
exercisable over a three-year period.
12. GAIN ON SALE OF SERVICING RIGHTS
On March 31, 1999 Hanover entered into an agreement to sell the servicing rights
on $148 million of single-family mortgage loans. The total income from the sale
of mortgage servicing rights was $566,000. The gain on sale of mortgage
servicing rights was $540,000 and the balance of the income ($26,000) relating
to mortgage loans classified as held for sale, was deferred and was amortized
into interest income in 1999 over the lives of the mortgage loans using the
effective yield method until the mortgage loans were securitized in August 1999.
13. CERTAIN CHARGES AND EXPENSES IN THREE MONTHS ENDED SEPTEMBER 30, 1999
For the three-month period ended September 30, 1999 the Company recorded certain
charges and expenses totaling $14,061,000. These charges and expenses are
summarized as detailed below (dollars in thousands):
28
<PAGE> 29
<TABLE>
<CAPTION>
<S> <C>
Realized (loss) on mark to
market of mortgage securities $ 3,537 (a)
Realized (loss) on mark to
market of mortgage loans 2,997 (b)
Provision for (loss) on disposition of
unconsolidated subsidiary (HCP-2) 4,793 (c)
Additional operating expenses relating
to the provision for (loss) on
unconsolidated subsidiary (HCP-2) 153 (c)
Loss from unconsolidated subsidiary
(HCP-2) 403 (c)
Catch-up premium, (discount), deferred
financing adjustments on certain
CMOs and mortgage securities 1,821 (d)
Mortgage loan net interest
income adjustment 357 (e)
--------
$ 14,061
========
</TABLE>
(a) The unrealized (loss) on mark to market of mortgage securities resulted
from the September 30, 1999 mark to market adjustment ($1,312,000) recorded
on six 1998-B notes transferred from the available for sale category to the
held to maturity and the trading categories, and the mark down ($2,225,000)
of the six 1998-B interest only notes to market value.
(b) The unrealized (loss) from mark to market resulted from a mark to market
adjustment of $2,997,000 at the time of transfer of mortgage loans from the
held for sale category to the held to maturity category (the 1999-B
securitization transaction).
(c) The financing structure for the 1998-B securitization resulted in the
organization of HCP-2 in October 1998. HCP-2 was capitalized with a
non-cash contribution from Hanover in the form of mortgage pools net of
related reverse repurchase agreement financing in exchange for 100% of the
non-voting preferred stock of HCP-2 (99% economic interest in HCP-2) and
cash contributions from the Principals (which were loaned to the Principals
from Hanover) in exchange for all of the common stock of HCP-2 (1% economic
interest in HCP-2). The financing structure required certain costs of the
securitization (net premium, hedging and deferred financing costs) to be
capitalized in the subsidiary, HCP-2. Substantially all of Hanover's
investment in HCP-2 consists of these capitalized costs. The capitalized
costs are amortized on HCP-2 over the anticipated life of the respective
mortgage loans and passed through to Hanover each period as Hanover's
equity ownership (99%) in HCP-2. HCP-2 will continue to generate losses as
these capitalized costs are amortized.
The Company believes that the capitalization of HCP-2 and the non-cash
amortization of the capitalized costs were confusing and difficult for its
investors to understand. Therefore, in September 1999, the Company decided
to sell HCP-2. A provision for a loss on the disposition of this investment
has been reflected as follows:
<TABLE>
<CAPTION>
<S> <C>
100% of the balance of the
investment in HCP-2 $4,428,000
Advances to HCP-2 365,000
----------
Total provision $4,793,000
==========
</TABLE>
29
<PAGE> 30
The Company believes it is probable that it will forgive $62,000 of loans
that Hanover advanced to the Principals in October 1998 that the Principals
used to invest in HCP-2. In addition, the Company anticipates that it will
pay additional compensation ($41,000) to the Principals equal to the
anticipated income tax consequences attributable to the forgiveness of the
notes. The total compensation costs related to the provision for
forgiveness of Principals' notes ($103,000) and an estimate of costs
relating to the disposition of HCP-2 (legal and other) of $50,000
are reflected as additional operating expenses in the condensed
consolidated statement of operations for the three month period ended
September 30, 1999.
Also reflected in the above is the $403,000 loss for the three month period
ended September 30, 1999 from an unconsolidated subsidiary (HCP-2). Because
the Company has no basis in its investment in HCP-2 at September 30, 1999
the Company does not expect to record any future losses from HCP-2.
(d) At September 30, 1999 management reviewed the actual prepayment speeds as
compared to the projected prepayment speeds on all of its investment
portfolios. The review resulted in a cumulative adjustment of premiums,
(discount), deferred costs and deferred financing amortization of
$1,821,000 on certain of the Company's investment portfolio. The following
cumulative expense adjustments were recorded in the three month period
ended September 30, 1999:
<TABLE>
<CAPTION>
<S> <C> <C>
Mortgage securities - 1998-B $1,606,000
Collateral for CMO - 1998-A 138,000
Collateral for CMO - 1999-A 58,000
Mortgage securities - swapped
FNMA certificates 19,000
----------
$1,821,000
==========
</TABLE>
(e) An adjustment to mortgage loan net interest income of $357,000 was
reflected in the three month period ended September 30, 1999 in connection
with the 1999-B securitization. This adjustment reduced the Company's
outstanding accrued interest receivable on loans included in the
securitization to the amount specified in the securitization documentation.
14. COMMITMENTS AND CONTINGENCIES
Hanover has guaranteed a one year reverse repurchase financing agreement for
HCP. The amount of reverse repurchase financing outstanding at September 30,
1999 was $11,082,000.
15. SUBSEQUENT EVENTS
On October 29, 1999, the Board of Directors of Hanover declared a cash dividend
of $0.10 per share for the third quarter of 1999 payable on November 22, 1999 to
stockholders of record as of November 15, 1999.
On October 29, 1999 Board of Directors of Hanover authorized the Company to
initiate a stock repurchase program to buy back up to 1,000,000 shares of
Hanover common stock from time to time in open market transactions. Any shares
so purchased will be available for general corporate and other purposes,
including the issuance of shares in connection with the exercise of stock
warrants or stock options. Depending upon the relative opportunities offered in
the mortgage market compared to the price of Hanover shares, the Company may or
may not repurchase some or all of the authorized amount.
30
<PAGE> 31
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland
on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to
operate as a specialty finance company. The principal business strategy of
Hanover and its wholly-owned subsidiaries, (together referred to as the
"Company") is to (i) acquire primarily single-family mortgage loans that are at
least twelve months old or that were intended to be of certain credit quality
but that do not meet the originally intended market parameters due to errors or
credit deterioration, (ii) securitize the mortgage loans and retain interests
therein and (iii) acquire subordinated mortgage securities similar in nature to
the retained interests generated from internal securitizations. The principal
business strategy of the Company's primary unconsolidated subsidiary, Hanover
Capital Partners Ltd. ("HCP"), is to generate consulting fee income by (i)
performing loan file due diligence reviews for third parties, (ii) performing
loan sale advisory services and (iii) brokering and trading portfolios of loans.
Until recently, HCP was also engaged in the business of originating multifamily
and commercial loans. This business was discontinued in the quarter ended June
30, 1999 and substantially all charges associated with its discontinuance were
recognized in the quarter.
The Company's principal business objective is to generate net interest income on
its portfolio of mortgage loans and mortgage securities, and to generate fee
income through HCP. The Company acquires single-family mortgage loans through a
network of sales representatives targeting financial institutions throughout the
United States. Hanover operates as a tax-advantaged REIT and is generally not
subject to Federal and state income tax to the extent that it distributes its
earnings to its stockholders and maintains its qualification as a REIT. Taxable
affiliates of Hanover, however, are subject to Federal and state income tax.
Hanover has engaged HCP to render due diligence, asset management and
administrative services pursuant to a Management Agreement.
The Company's generation of net income is dependent upon (i) the spread between
interest earned on its investment portfolio and the cost of borrowed funds to
finance the investment portfolio; and (ii) the aggregate amount of the
investment portfolio on the Company's balance sheet. The Company strives to
create a diversified portfolio of investments that in the aggregate generates
increasing net income in a variety of interest rate and prepayment rate
environments and preserves the equity base of the Company. The Company's primary
strategy for its mortgage loan investment portfolio entails (1) efficient
acquisition pricing of mortgage loans, (2) financing in the short term by
reverse repurchase agreements or lines of credit, (3) hedging in the short term
to offset potential adverse effects of changes in interest rates, (4)
stratifying and segregating mortgage loans in securitizations to replace short
term financing with collateralized mortgage obligations (CMO), real estate
mortgage investment conduits (REMIC) or other types of long term debt financing,
thereby eliminating the majority of refinancing and interest rate risk and (5)
retaining certain residual interests of the securitization resulting in
increased yields.
31
<PAGE> 32
RESULTS OF OPERATIONS
(dollars in thousands, except per share data)
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Net interest income (expense) $ (884) $ 1,692 $ 2,900 $ 4,625
Loan loss provision (107) (130) (339) (278)
Gain on sale of servicing rights 196 -- 540 --
Gain (loss) on sale of mortgage assets (17) -- 146 (49)
Realized (loss) on mark to market
of mortgage securities and mortgage loans (6,534) -- (6,534) --
Provision for (loss) on disposition of
unconsolidated subsidiary (4,793) -- (4,793) --
-------- -------- -------- --------
Total revenues (loss) (12,139) 1,562 (8,080) 4,298
Expenses 1,304 928 2,989 2,760
-------- -------- -------- --------
Operating income (loss) (13,443) 634 (11,069) 1,538
Equity in (loss) of unconsolidated subsidiaries (551) (288) (2,131) (588)
-------- -------- -------- --------
Net income (loss) $(13,994) $ 346 $(13,200) $ 950
======== ======== ======== ========
Basic earnings (loss) per share $ (2.40) $ 0.05 $ (2.21) $ 0.15
======== ======== ======== ========
Dividends declared per share (a) $ 0.10 $ 0.17 $ 0.40 $ 0.59
======== ======== ======== ========
</TABLE>
(a) The dividends relating to the three months ended September 30, 1999 were
declared on October 29, 1999.
The Company recorded a net loss of ($13,994,000) or ($2.40) per share based on
5,826,899 weighted shares of common stock outstanding for the quarter ended
September 30, 1999 compared to net income of $346,000 or $0.05 per share based
on 6,417,947 weighted shares of common stock outstanding for the same period in
1998. Total revenues before certain adjustments for the three months ended
September 30, 1999 were $1,366,000 as compared to $1,562,000 for the three month
period ended September 30, 1998 (a decrease of 12.6%). These adjustments are
described in Note 13 to the financial statements attached hereto. Total revenues
for the three months ended September 30, 1999 including adjustments of
$13,505,000 were negative $12,139,000. The third quarter 1999 revenues were
negatively impacted by charges for (1) provision for loss on the disposition of
an unconsolidated subsidiary, Hanover Capital Partners 2, Inc. ("HCP-2") of
$4,793,000, (2) mark to market adjustments on mortgage securities acquired from
the Hanover 1998-B securitization of $3,537,000, (3) mark to market adjustments
on mortgage loans securitized in the August 1999 Hanover 1999-B securitization
of $2,997,000 and (4) adjustments to the investment portfolio's net interest
income resulting primarily from cumulative prepayment speed adjustments
affecting amortization totaling $2,178,000.
32
<PAGE> 33
Operating expenses for the third quarter of 1999 were $1,304,000, approximately
40.5% higher than in the similar period in 1998 $928,000. The overall increase
in operating expenses $376,000 resulted primarily from (1) the reallocation of
certain expenses (primarily personnel expenses and management and administrative
expenses) between Hanover and HCP of $350,000, (2) increased legal and
professional fees of $589,000 (including $50,000 of professional expenses
relating to the disposition of HCP-2), (3) additional compensation of $103,000
relating to the disposition of HCP-2, offset by (4) the combined decreases in
due diligence, commissions and financing/commitment fees of $817,000.
The equity in loss of unconsolidated subsidiaries for the third quarter of 1999
($551,000) reflects a wider negative variance compared to the similar period in
1998 ($288,000). This variance relates primarily to the Company's investment in
HCP-2, which the Company has decided to sell. As noted above, the Company took a
provision of $4,793,000 in the quarter ended September 30, 1999 and recorded
certain other operating expenses in connection with its decision to sell HCP-2.
HCP-2 is an unconsolidated mortgage finance subsidiary that was organized in
October 1998 to execute a REMIC financing securitization for the Company. The
financing structure required certain costs of the securitization (net premiums,
hedging and deferred financing costs) to be capitalized in this subsidiary.
Substantially all of HCP-2's net equity ($4,473,000 at September 30, 1999)
consists of these capitalized expenses. These deferred financing costs are being
amortized through net interest income (expense) over the anticipated life of the
respective mortgage loans and recorded by the Company in its economic ownership
percentage (99%) of this net loss through September 30, 1999. As a result of the
provision for the expected sale of HCP-2, the Company believes it will not
record future losses from HCP-2.
Also included in the equity in loss of unconsolidated subsidiaries is a $6,000
loss from a newly organized subsidiary - HanoverTrade.com, Inc. ("HTC"). HTC was
organized in June 1999 to develop an E-commerce business to broker mortgage loan
pools to financial institutions and other finance companies via the internet.
For the nine month period ended September 30, 1999, the Company reflected a net
loss of ($13,200,000) or ($2.21) per share, based on 5,984,500 weighted shares
of common stock outstanding, compared to the same period in 1998 when the
Company reflected net income of $950,000 or $0.15 per share based on 6,450,749
weighted shares of common stock outstanding.
Operating expenses for the nine months ended September 30, 1999 were $229,000
higher than in the similar period in 1998. The Company did not purchase any
mortgage loans during the first nine months of 1999 and accordingly incurred
only a fraction of the due diligence and commission expenses in 1999 ($124,000)
as compared to 1998 ($860,000) when the Company purchased in excess of
$749,000,000 of mortgage loan pools. Offsetting the cost savings in due
diligence and commission expense were substantial increases in legal and
professional expenses ($589,000) and personnel expenses ($343,000).
During the first nine months of 1998 the Company reflected a loss from its
equity investment in HCP of $(588,000). For the nine month period ended
September 30, 1999 the Company reflected a loss from its equity investment in
HCP of $(826,000). The losses generated by HCP in 1998 were considerably less
than in 1999 because (1) 1998 results included a one time revenue item of
$400,000 resulting from a special consulting assignment and an additional
$350,000 of gains in 1998 from the sale of mortgage servicing rights owned by
Hanover Capital Mortgage Corporation, a wholly owned subsidiary of HCP. This
increased loss was offset by (1) increased
33
<PAGE> 34
due diligence fee gross profit in 1999 compared to 1998 and (2) a reallocation
of certain expenses between Hanover and HCP in 1999.
During the first nine months of 1999, the Company reflected a loss from its
equity investment in HCP-2 of $1,299,000. There was no comparable loss in 1998,
since HCP-2 was formed in October 1998. As noted above, HCP-2's net loss is the
result of the amortization of approximately $4,473,000 of capitalized expenses
at September 30, 1999, which were created in the October 1998-B securitization.
As a result of the provision for the expected sale of HCP-2, the Company
believes it will not record future losses from HCP-2.
The table below highlights the Company's historical trends and components of
return on average equity.
COMPONENTS OF ANNUALIZED RETURN ON AVERAGE EQUITY (1)
<TABLE>
<CAPTION>
Gain (loss) on Other Equity in
Net Interest Sale of Gains or Operating Earnings (Loss) Annualized
For the Income/ Assets/ (Losses)/ Expenses/ of Subsidiaries/ Return on
Quarter Ended Equity Equity Equity Equity Equity Equity
------------- ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C>
June 30, 1997 (2) 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
September 30, 1997 (3) 4.85% 0.00% 0.00% 3.59% 0.97% 2.23%
December 31, 1997 7.71% 0.18% 0.00% 4.26% (1.41%) 2.22%
March 31, 1998 10.78% 0.00% 0.00% 4.37% (0.03%) 6.38%
June 30, 1998 3.47% (0.25%) 0.00% 5.00% (1.50%) (3.28%)
September 30, 1998 8.23% 0.00% 0.00% 4.89% (1.52%) 1.82%
December 31, 1998 11.12% (32.76%) 0.00% 7.55% (4.89%) (34.08%)
March 31, 1999 11.36% 2.97% 0.00% 4.85% (5.15%) 4.33%
June 30, 1999 9.89% 0.01% 0.00% 5.25% (4.30%) 0.35%
September 30, 1999 (6.57%) 1.19% (75.10%) 8.65% (3.65%) (92.78%)
</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 for this period is based on the equity balance at
September 19, 1997 (IPO date) and the equity balance at September 30, 1997,
excluding unrealized loss on investments available for sale.
The following table reflects the average balances for each major category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities with the corresponding effective rate of interest annualized for the
periods shown below (dollars in thousands):
34
<PAGE> 35
<TABLE>
<CAPTION>
INTEREST EARNING ASSETS AND RELATED LIABILITIES
QUARTER ENDED
QUARTER ENDED SEPTEMBER 30, 1999 QUARTER ENDED
SEPTEMBER 30, 1999 REVISED (4) SEPTEMBER 30, 1998
AVERAGE EFFECTIVE AVERAGE EFFECTIVE AVERAGE EFFECTIVE
BALANCE RATE (1) BALANCE RATE (1) BALANCE RATE (1)
------- -------- ------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Interest earning assets:
Mortgage loans $ 41,034 2.704% $ 41,034 6.188% $566,456 7.489%
CMO collateral 1999-B 74,219 7.457% 74,219 7.457%
CMO collateral 1999-A 124,649 6.895% 124,649 7.145%
CMO collateral 1998-A 63,798 5.769% 63,798 6.634% 91,980 7.071%
FNMA swap securities 47,197 6.659% 47,197 6.819% 11,665 7.429%
Private placement notes - 1998-B 14,972 (31.624%) 14,972 11.283%
Private placement notes - third parties 3,671 12.382% 3,671 12.382%
Purchased Agency securities 2,711 7.996% 2,771 7.996% 231,634 4.385%
-------- ------ -------- ------ -------- ------
$372,311 4.836% $372,311 7.197% $901,735 6.648%
======== ====== ======== ====== ======== ======
Interest bearing liabilities:
Reverse repurchase borrowings on
mortgage loans $ 37,031 6.258% $ 37,031 6.258% $523,403 6.377%
CMO borrowing - 1999-B 55,331 7.182% 55,331 7.182%
CMO borrowing - 1999-A 116,932 6.766% 116,932 6.833%
CMO borrowing - 1998-A 59,869 6.878% 59,869 6.878% 87,524 6.916%
Reverse repurchase borrowings on:
CMO collateral - 1999-B 13,953 6.958% 13,953 6.958%
CMO collateral - 1998-A 1,408 6.398% 1,408 6.398% 203 6.145%
FNMA swap securities 45,180 5.781% 45,180 5.781% 11,351 5.952%
Private placement notes - 1998-B 3,301 5.677% 3,301 5.677%
Private placement notes - third parties 942 6.445% 942 6.445%
Purchased Agency securities 2,708 5.354% 2,708 5.354% 230,037 5.689%
-------- ------ -------- ------ -------- ------
$336,655 6.682% $336,655 6.705% $852,518 6.364%
======== ====== ======== ====== ======== ======
Net interest earning assets $ 35,656 $ 35,656 $ 49,217
======== ======== ========
Net interest spread (1.846%) 0.492% 0.284%
======= ====== ======
Yield on net interest earning
assets (2) (3) (12.597%) 11.842% 11.562%
======= ====== ======
</TABLE>
(1) Loan loss provisions are excluded in the above calculations.
(2) Yield on net interest earning assets is computed by dividing the applicable
net interest income by the average daily balance of net interest earning
assets.
(3) This yield does not reflect the Company's combined overall effective yield
and the Company's total investment in private placement mortgage securities
because the table does not reflect net interest expense of and equity
employed by the Company's unconsolidated subsidiary, HCP-2. See the
discussion on page 48.
(4) Certain effective interest rates, the net interest spread and the yield on
net interest earning assets were revised assuming the adjustments
affecting net interest income ($2,178,000) had all been recorded prior to
July 1, 1999. Net interest income was primarily affected by cumulative
amortization of premium, (discount) and deferred costs adjustments
resulting from the change of prepayment speeds on certain of the Company's
investment portfolio.
35
<PAGE> 36
NET INTEREST INCOME (EXPENSE)
Net interest (expense) for the three months ended September 30, 1999 was
($884,000) compared to net interest income of $1,692,000 for the three months
ended September 30, 1998. The following table reflects net interest income
(expense) generated for each period (dollars in thousands):
NET INTEREST INCOME (LOSS)
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER QUARTER
ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1999 1999(1) 1998
----------------------------------------------------
<S> <C> <C> <C>
Mortgage loans $ (314) $ 43 $ 2,076
CMO collateral - 1999-B 142 142 --
CMO collateral - 1999-A 171 229 109
CMO collateral - 1998-A (132) 6 41
FNMA swap securities 125 144 --
Private placement notes - 1998-B (1,231) 375 --
Private placement notes - third party 99 99
------- ------- -------
Core business - subtotal (1,140) 1,038 2,226
------- ------- -------
Purchased Agency mortgage securities 18 18 (803)
Other 238 238 269
------- ------- -------
Total $ (884) $ 1,294 $ 1,692
======= ======= =======
</TABLE>
(1) Net interest income for the three month period ended September 30, 1999 was
revised assuming certain adjustments affecting net interest income
($2,178,000) had all been recorded prior to July 1, 1999. Net interest
income was primarily affected by cumulative amortization of premium,
(discount) and deferred cost adjustments resulting from the change of
prepayment speeds on certain of the Company's investment portfolios.
36
<PAGE> 37
CORE BUSINESS - MORTGAGE LOANS HELD FOR SALE
Net interest income generated from investments in mortgage loans (classified as
held for sale and held to maturity) during the three months ended September 30,
1999 and 1998, respectively, is detailed below (dollars in thousands):
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER QUARTER
ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1999 1999(1) 1998
------------------- --------------------- ---------------------
<S> <C> <C> <C>
Mortgage Loans
- --------------
Average asset balance $ 41,034 $ 41,034 $566,456
Average repo balance 37,031 37,031 523,403
-------- -------- --------
Net interest earning assets $ 4,003 $ 4,003 $ 43,053
======== ======== ========
Average leverage ratio 90.245% 90.245% 92.400%
======== ======== ========
Effective interest income rate 2.704% 6.188% 7.489%
Effective interest expense rate 6.258% 6.258% 6.377%
-------- -------- --------
Net interest spread (3.554%) (0.070%) 1.112%
======== ======== ========
Interest income $ 278 $ 635 $ 10,606
Interest expense 592 592 8,530
-------- -------- --------
Net interest income (expense) $ (314) $ 43 $ 2,076
======== ======== ========
Yield on net interest earning assets (31.376%) 4.297% 19.285%
======== ======== ========
</TABLE>
(1) Net interest income for the three month period ended September 30,1999 was
revised assuming certain adjustments affecting net interest income had all
been recorded prior to July 1, 1999. The adjustments affecting net interest
income ($357,000) resulted from the reduction of outstanding accrued
interest receivable in connection with the 1999-B securitization.
In the quarter ended September 1999, the Company securitized substantially all
of its remaining inventory of mortgage loans. These loans were transferred from
the held for sale category to the CMO collateral category. Accordingly, the
Company's net interest income from mortgage loans held for sale declined to
$43,000 (excluding the effect of the $357,000 adjustment described above) in the
third quarter of 1999 compared to $2,076,000 in the third quarter of 1998. The
results for the third quarter of 1999 reflect approximately one month's
activity. Net interest income on these loans for the remaining two quarters is
reflected as CMO collateral. The Company did not purchase any mortgage loans in
the third quarter of 1999. In the same period during 1998 the Company purchased
$272 million (par value) of mortgage loans.
37
<PAGE> 38
CORE BUSINESS - CMO COLLATERAL - 1999-B
Net interest income generated from the CMO collateral for the 1999-B
securitization during the third quarter of 1999 is detailed below (dollars in
thousands):
<TABLE>
<CAPTION>
QUARTER
ENDED
SEPTEMBER 30,
CMO Collateral - 1999-B 1999
- ----------------------- -------------
<S> <C>
Average asset balance $74,219
Average CMO borrowing balance 55,331
Average repo balance 13,953
-------
Net interest earning assets $ 4,935
=======
Average leverage ratio 93.351%
=======
Effective interest income rate 7.457%
Effective interest expense rate 7.168%
-------
Net interest spread 0.289%
=======
Interest income $ 1,384
Interest expense 1,242
-------
Net interest income $ 142
=======
Yield on net interest earning assets 11.510%
=======
</TABLE>
In August 1999, the Company securitized $111,575,000 (par value) of mortgage
loans. The securitization was accomplished in a grantor/owner trust format (CMO)
through a wholly-owned subsidiary, Hanover SPC-A, Inc. The transaction was
accounted for as a financing for both GAAP and tax accounting purposes.
In a financing, the Company continues to record 100% of the interest income, net
of servicing and other fees, generated by the mortgage loans. The primary source
of financing for these mortgage loans was the CMO borrowing. This financing
represents the liability for certain investment grade mortgage notes issued by
the Company of $103,474,000 at September 30, 1999. The interest expense on this
financing represents the coupon interest amount to be paid to those note
holders. The notes have adjustable coupon interest rates indexed to LIBOR plus
1.01% for the Class 1 notes and LIBOR plus 1.05% for the Class 2 notes. (6.214%
weighted average rate at September 30, 1999).
The Company's net equity in this transaction was leveraged through reverse
repurchase financing. At September 30, 1999 the Company had $2,000,000 of
reverse repurchase financing against its net equity in this transaction.
Interest expense includes the interest on mortgage backed bonds, interest on the
related reverse repurchase agreements and amortization of certain deferred
financing costs and interest rate caps.
38
<PAGE> 39
CORE BUSINESS - CMO COLLATERAL - 1999-A
Net interest income generated from the CMO collateral for the 1999-A
securitization during the third quarter of 1999 is detailed below (dollars in
thousands):
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
CMO Collateral - 1999-A 1999 1999 (1)
- ----------------------- ------------- -------------
<S> <C> <C>
Average asset balance $124,649 $124,649
Average CMO borrowing balance 116,932 116,932
-------- --------
Net interest earning assets $ 7,717 $ 7,717
======== ========
Average leverage ratio 93.809% 93.809%
======== ========
Effective interest income rate 6.895% 7.145%
Effective interest expense rate 6.766% 6.833%
-------- --------
Net interest spread 0.129% 0.312%
======== ========
Interest income $ 2,149 $ 2,226
Interest expense 1,978 1,997
-------- --------
Net interest income $ 171 $ 229
======== ========
Yield on net interest earning assets 8.864% 11.870%
======== ========
</TABLE>
(1) Net interest income for the three month period ended September 30, 1999 was
revised assuming certain adjustments affecting net interest income
($58,000) had all been recorded prior to July 1, 1999. The adjustments
affecting net interest income resulted from adjusting amortization of
premiums and deferred expenses to actual prepayments experienced to date
and projected prepayment speeds of 26%.
In March 1999, the Company securitized $138,357,000 (par value) of mortgage
loans. The securitization was accomplished in a grantor/owner trust format (CMO)
which entailed the creation of a wholly-owned subsidiary, Hanover SPC-A, Inc.
The transaction was accounted for as a financing for both GAAP and tax
accounting purposes.
In a financing, the Company continues to record 100% of the interest income, net
of servicing and other fees, generated by the mortgage loans. The sole source of
financing for these mortgage loans was the CMO borrowing. This financing
represents the liability for certain investment grade mortgage notes issued by
the Company of $112,281,000 at September 30, 1999. The interest expense on this
financing represents the coupon interest amount to be paid to those note
holders. The notes, except for the interest only and principal only notes, have
fixed coupon interest rates of 6.50% and 6.75% and an adjustable rate at 6.12%
at September 30, 1999. The interest only notes generate monthly interest from
the excess interest generated on the underlying mortgages after deducting all
service fees and the coupon interest rate on the applicable notes.
The interest rate on each of the interest only notes is based on a notional
amount (the principal
39
<PAGE> 40
balance of those mortgage loans with an interest rate in excess of the related
notes' coupon interest rate). The notional amounts decline each month to reflect
the related normal principal amortization, curtailments, and prepayments for the
related underlying mortgage loans. Accordingly, the effective interest rate will
decline as prepayments on the underlying mortgages with interest rates in excess
of the coupon rates accelerate. The mortgage loans collateralizing the mortgage
backed bonds experienced annualized prepayment speeds during the third quarter
of 1999 of approximately 27%.
Interest expense includes the interest on mortgage backed bonds and amortization
of certain deferred financing costs.
CORE BUSINESS - CMO COLLATERAL - 1998-A
Net interest income generated from the CMO Collateral for the 1998-A
securitization during the third quarter of 1999 and 1998 is detailed below
(dollars in thousands):
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER QUARTER
ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1999 1999 (1) 1998
------------- ------------- -------------
CMO Collateral - 1998-A
- -----------------------
<S> <C> <C> <C>
Average asset balance $ 63,798 $ 63,798 $ 91,980
Average CMO borrowing balance 59,869 59,869 87,524
Average repo balance 1,408 1,408 203
-------- -------- --------
Net interest earning assets $ 2,521 $ 2,521 $ 4,253
======== ======== ========
Average leverage ratio 96.048% 96.048% 95.376%
======== ======== ========
Effective interest income rate 5.769% 6.634% 7.071%
Effective interest expense rate 6.870% 6.870% 6.915%
-------- -------- --------
Net interest spread (1.101)% (0.236)% 0.156%
======== ======== ========
Interest income $ 920 $ 1,058 $ 1,625
Interest expense 1,052 1,052 1,516
-------- -------- --------
Net interest income (expense) $ (132) $ 6 $ 109
======== ======== ========
Yield on net interest earning assets (20.944%) 0.952% 10.291%
======== ======== ========
</TABLE>
(1) Net interest income for the three month period ended September 30, 1999 was
revised assuming certain adjustments affecting net interest income
($138,000) had all been recorded prior to July 1, 1999. The adjustments
affecting net interest income resulted from adjusting amortization of
premiums to actual prepayment speeds to date and projected prepayment
speeds of 33%.
In April 1998 the Company securitized $102,977,000 (par value) of mortgage
loans. This securitization was accomplished in a REMIC format, which was
accounted for as a financing for GAAP purposes and as a sale for tax accounting
purposes.
In a financing, the Company continues to record 100% of the interest income, net
of servicing fees, generated by the mortgage loans.
40
<PAGE> 41
The primary source of financing for these mortgage loans is the CMO bonds. This
financing represents the liability for the investment grade mortgage bonds
issued by the Company - $60,764,000 at September 30, 1999. The interest expense
on this financing represents the coupon interest amount to be paid to the
investment grade bond holders. The Company's net equity in the secured
transaction represents the non-investment grade, interest only and principal
only bonds. The Company's net equity investment in collateral for mortgage
backed bonds can also be leveraged through reverse repurchase financing. At
September 30, 1999, the Company had $1,366,000 of reverse repurchase financing
on a portion of the collateral for mortgage backed bonds ($3,569,000). The bonds
have fixed coupon interest rates of 6.75% and 7.00%. The mortgage loans
collateralizing the mortgage backed bonds experienced annualized prepayment
speeds during the third quarter of 1999 of approximately 23%.
Interest expense includes the interest on the mortgage backed bonds, interest on
the related reverse repurchase agreements and amortization of certain deferred
financing costs.
CORE-BUSINESS - FNMA MORTGAGE SECURITIES (SWAPPED FOR THE COMPANY'S MORTGAGE
LOANS)
Net interest income in 1999 and 1998 generated from investments in FNMA mortgage
securities that were converted from the Company's mortgage loans in 1998 is
detailed below (dollars in thousands):
<TABLE>
<CAPTION>
(1) REVISED
QUARTER QUARTER QUARTER
ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1999 1999 1998
------------- ------------- -------------
<S> <C> <C> <C>
FNMA Mortgage Securities (swapped)
- ----------------------------------
Average asset balance $47,197 $47,197 $11,665
Average repo balance 45,180 45,180 11,351
------- ------- -------
Net interest earning assets $ 2,017 $ 2,017 $ 314
======= ======= =======
Average leverage ratio 95.726% 95.726% 97.308%
======= ======= =======
Effective interest income rate 6.659% 6.819% 7.429%
Effective interest expense rate 5.781% 5.781% 5.952%
------- ------- -------
Net interest spread 0.878% 1.038% 1.477%
======= ======= =======
Interest income $ 785 $ 804 $ 213
Interest expense 660 660 172
------- ------- -------
Net interest income $ 125 $ 144 $ 41
======= ======= =======
Yield on net interest earning assets 24.789% 28.557% 52.223%
======= ======= =======
</TABLE>
(1) Net interest income for the three month period ended September 30, 1999 was
revised assuming certain adjustments affecting net interest income
($19,000) had all been recorded prior to July 1, 1999. The adjustments
affecting net interest income resulted from adjusting amortization of
premiums and deferred expenses to actual prepayment speeds to date and
projected prepayment speeds of 22%.
41
<PAGE> 42
In August 1998, the Company exchanged $17.4 million of adjustable rate mortgage
loans for a like amount of mortgage securities in the form of five FNMA
certificates. All of these mortgage certificates were subsequently sold with
recourse in October 1998.
In December 1998, the Company exchanged $55.2 million of fixed rate mortgage
loans (without recourse) for a like amount of mortgage securities in the form of
31 FNMA certificates. The mortgage loans securing the FNMA mortgage securities
experienced annualized prepayment speeds of approximately 18% during the third
quarter of 1999.
Interest expense includes the interest on the related reverse repurchase
agreements and amortization of deferred financing costs and interest rate caps.
CORE BUSINESS - PRIVATE PLACEMENT NOTES - 1998-B
Net interest income (expense) generated from private placement notes for the
1998-B securitization, purchased from an affiliate, HCP-2, in October 1998 is
detailed below (dollars in thousands):
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 (1) 1999 (1)(2)
------------- ----------------
<S> <C> <C>
Private Placement Notes - 1998-B
- --------------------------------
Average asset balance $ 14,972 $ 14,972
Average - repo balance 3,301 3,301
-------- --------
Net interest earning assets $ 11,671 $ 11,671
======== ========
Average leverage ratio 22.048% 22.048%
======== ========
Effective interest income rate (31.624%) 11.283%
Effective interest expense rate 5.677% 5.677%
-------- --------
Net interest spread (37.301%) 5.606%
======== ========
Interest income $ (1,184) $ 422
Interest expense 47 47
-------- --------
Net interest income (expense) $ (1,231) $ 375
======== ========
Yield on net interest earning assets (42.190%) 12.852%
======== ========
</TABLE>
(1) This table does not reflect the Company's combined overall effective yield
and the Company's total investment in private placement mortgage securities
because the table does not reflect net interest income of and equity
employed by the Company's unconsolidated subsidiary, HCP-2. See the
discussion on page 49.
(2) Net interest income (expense) for the three month period ended September
30, 1999 was revised assuming certain adjustments affecting net interest
income ($1,606,000) had all been recorded prior to July 1, 1999. The
adjustments affecting net interest income resulted from adjusting
amortization of premiums and deferred expenses to actual speeds to date and
projected prepayment speeds ranging from 6% to 40%.
42
<PAGE> 43
In October 1998, the Company completed its second private placement REMIC
securitization transaction, the 1998-B securitization. Hanover contributed
certain mortgage loan collateral to its newly organized unconsolidated
subsidiary, HCP-2. This had the effect of removing the mortgage loan collateral
from Hanover's balance sheet for GAAP and tax accounting purposes. HCP-2
accounted for the transaction as a financing for GAAP and as a sale for tax
accounting purposes.
In the quarter ended September 30, 1999, the Company recorded a total of
$10,492,000 of charges related to the 1998-B securitization of which $1,606,000
was reflected in net interest income. These charges were as follows:
- - The Company booked amortization expense of $1,951,000 for the three months
ended September 30, 1999 compared to $281,000 for three months ended June
30, 1999. Of the $1,951,000 of amortization expense recorded in the third
quarter of 1999, $1,606,000 was a catch up adjustment resulting from
adjusting to actual prepayment speeds to date and a revision in estimated
future prepayment speeds.
- - The Company took an impairment charge of $2,225,000 for six interest-only
notes.
- - Management made a decision to dispose of its investment in HCP-2. As a
result of this decision, the Company recorded a provision for loss on sale
of HCP-2 of $4,793,000; reserved $50,000 for expenses related to the sale;
and forgave $62,000 in loans to Principals (which resulted in $103,000 of
additional compensation to the Principals) related to the HCP-2
disposition.
- - Management made a decision to sell four of the investment grade notes.
These notes were transferred from the available for sale category to the
trading category. As a result of this decision, the Company recorded a
mark-to-market charge of $987,000.
- - Management made a decision to hold two of the investment grade ("BBB")
notes to maturity. These notes were transferred from the available for sale
category to the held to maturity category. As a result of this decision,
the Company booked a mark-to-market charge of $325,000
- - The Company recorded, on the equity method, its share of losses ($403,000)
generated by HCP-2 in the three month period ended September 30, 1999.
Management determined that prepayment speeds on the 1998-B securitization have
been substantially faster than originally projected. In accordance with SFAS
#91, the Company adjusted the balance of premium and deferred hedge expenses to
reflect the actual prepayments to date and revised projections of future
prepayment speeds. These adjustments resulted in the $1,606,000 amortization
charge.
As a result of the amortization adjustments described above, the Company
determined that its investment in six interest-only notes from the 1998-B
securitization were impaired. Therefore, these notes were written down to fair
value, resulting in the $2,225,000 charge.
At September 30, 1999, HCP-2 owned $218,330,000 (principal balance) of mortgage
loans, and has $218,330,000 principal balance of REMIC debt. HCP-2 had no other
tangible assets. The principal and interest payments due on the REMIC debt are
exactly equal to the principal and
43
<PAGE> 44
interest payments received from the mortgage loan collateral. Because of this,
the Company believes that the net economic value of HCP-2 is close to zero.
However, since the 1998-B securitization was structured as a GAAP financing,
HCP-2 reports the mortgage loan collateral at historical cost. On a historical
cost basis, HCP-2 owned $220,636,000 of mortgage loans, plus $2,531,000 of
prepaid securitization costs, and had $218,330,000 of REMIC debt at September
30, 1999. As a result of this accounting treatment, HCP-2 reported $4,473,000 of
net equity at September 30, 1999, notwithstanding the fact that the Company
believes that the net economic value of HCP-2 is close to zero.
As a result of this historical cost-based accounting, HCP-2 also recognized a
substantial amount of non-cash amortization expense each month. In the three
month period ended September 30, 1999, HCP-2 recognized $403,000 of non-cash
amortization expense.
The Company believes that both the reported equity in HCP-2 and the non-cash
amortization expense were confusing and difficult for its investors to
understand. Therefore, the Company decided in September 1999 to sell HCP-2. As a
result of the proposed sale, the Company has recorded a provision of $4,428,000
against its investment in HCP-2 and a provision of $365,000 against a receivable
due from HCP-2. After giving effect to the provision, the Company's net
investment in HCP-2 will be zero, which is what the Company believes HCP-2 is
worth.
Equity in (loss) of unconsolidated subsidiary for HCP-2 for the three months
ended September, 1999 was $403,000. Going forward, the Company does not expect
to report equity in (loss) of unconsolidated subsidiary for HCP-2, since it no
longer will have any net investment in HCP-2.
The Company's investment in 1998-B private placement securities at September 30,
1999 includes six investment grade ("AA", "A" and "BBB") notes, six interest
only notes, six below investment grade notes and three principal only notes. The
interest rates on the investment and below investment grade notes are fixed and
range from 6.50% to 6.75%. These notes generate normal principal and interest
remittances to the Company on a monthly basis. The interest only notes generate
monthly interest remittances to the Company (subject to the availability of
funds) from the excess interest generated from the underlying mortgages after
deducting all service fees and the coupon interest rate on the applicable notes.
The interest rate on each of the interest only notes is based on a notional
amount (the principal balance of those mortgage loans with an interest rate in
excess of the related note coupon interest rate). The notional amounts decline
each month to reflect the related normal principal amortization, curtailments
and prepayments for the related underlying mortgage loans. At September 30, 1999
the interest only notes were divided into two major categories; the first group
had an effective weighted average interest rate of 1.066% on a notional balance
of $186,370,000 and the second group had an effective weighted average interest
rate of 0.250% on a notional balance of $102,780,000.
The interest only notes will be adversely affected more than other notes by
higher than expected prepayment speeds on underlying mortgage loans with
interest rates in excess of the net coupon rate. In all likelihood, mortgages
with higher interest rates will be repaid more rapidly than mortgages with lower
interest rates. Accordingly, the effective yield generated by this portfolio is
expected to decrease over time.
44
<PAGE> 45
CORE BUSINESS - PRIVATE PLACEMENT NOTES - THIRD PARTIES
Net interest income generated from private placement notes purchased from third
parties is detailed below (dollars in thousands).
<TABLE>
<CAPTION>
QUARTER
ENDED
SEPTEMBER 30,
1999
-------------
<S> <C>
Private Placement Notes-Third Parties
- -------------------------------------
Average asset balance $3,671
Average repo balance 942
------
Net interest earning assets $2,729
======
Average leverage ratio 25.661%
======
Effective interest income rate 12.382%
Effective interest expense rate 6.445%
------
Net interest spread 5.937%
======
Interest income $ 114
Interest expense 15
------
Net interest income $ 99
======
Yield on net interest earning assets 14.511%
======
</TABLE>
At September 30, 1999, the Company had an investment of $3,655,000 in 12
subordinated mortgage securities issued by third parties, all of which were
acquired during the quarter ended June 30, 1999. These securities are either
unrated or are rated "BB" or "B" by a major rating agency. These securities
represent subordinated interests in $1,079,255,000 of mortgage loans. The
mortgage loans underlying these securities are generally newly originated, "A"
quality loans.
45
<PAGE> 46
NON-CORE BUSINESS - PURCHASED AGENCY MORTGAGE SECURITIES
Net interest income (loss) generated from purchased Agency mortgage securities
in 1999 and 1998 is detailed below:
<TABLE>
<CAPTION>
QUARTER QUARTER
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1998
------------- -------------
Purchased Agency Mortgage Securities
- ------------------------------------
<S> <C> <C>
Average asset balance $ 2,771 $ 231,634
Average repo balance 2,708 230,037
--------- ---------
Net interest earning assets $ 63 $ 1,597
========= =========
Average leverage ratio 97.726% 99.311%
========= =========
Effective interest income rate 7.996% 4.385%
Effective interest expense rate 5.354% 5.689%
--------- ---------
Net interest spread 2.642% (1.304)%
========= =========
Interest income $ 55 $ 2,541
Interest expense 37 3,344
--------- ---------
Net interest income (loss) $ 18 $ (803)
========= =========
Yield on net interest earning assets 114.286% (201.112)%
========= =========
</TABLE>
The Company invested a significant portion of its initial capital in December
1997, shortly after the inception of the Company, in Agency ARM securities
purchased from various "Wall Street" dealers and in March, 1998, the Company
purchased an additional fixed rate FNMA certificate from another dealer firm.
All of the ARM securities were subsequently sold in October 1998 at a loss of
$5,989,000. The Agency ARM securities experienced extremely high prepayment
speeds from March 1998 through October 1998, causing higher than anticipated
premium amortization write-offs, and accordingly were not contributing any
positive net interest income to the Company. Because of the rapid prepayment
experienced and the Company's desire to increase liquidity the ARM securities
were sold in October 1998. At September 30, 1999 the Company owned only the
fixed rate FNMA mortgage security purchased in March 1998.
46
<PAGE> 47
OTHER INTEREST INCOME
Interest income generated during the three months ended September 30, 1999 and
1998 from non-mortgage assets is detailed below (dollars in thousands):
<TABLE>
<CAPTION>
QUARTER QUARTER
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1998
---- ----
<S> <C> <C>
Overnight investing $146 $ 3
Related party notes 92 94
Cash margin 172
---- ----
$238 $269
==== ====
</TABLE>
Interest income on cash deposited as additional cash collateral (cash margin)
pursuant to reverse repurchase financing agreements with certain lenders earned
interest at the respective borrowing rate charged by the lender approximately
5.60%.
Interest income recorded on overnight investing was generated for the most part
from investing excess cash in Federal Home Loan Bank discount notes with
interest rates ranging from 4.2% to 4.5%. Overnight investing also includes, to
a much lesser extent, investments in the highest rated commercial paper and
savings accounts.
Notes receivable due from HCP earn interest at the prime rate less one percent
(7.25% at September 30, 1999). The balance due from HCP at September 30, 1999
and 1998 was $5,329,000 and $713,000, respectively. Notes receivable due from
Principals earn interest at the lowest applicable Federal rate in effect at the
time of the loan. The balance due from Principals at September 30, 1999 and 1998
was $3,049,000 and $3,180,000, respectively.
The Company had maintained a significantly higher liquidity balance in the third
quarter of 1999 as compared to the third quarter of 1998. (Cash and cash
equivalent balances at September 30, 1999 and 1998 were $18,584,000 and
$7,045,000, respectively). Accordingly, interest income generated from overnight
investing was considerably higher than in the corresponding period in 1998.
In September 1999 Hanover advanced $3,041,000 to HCP to fund the purchase of
certain third party private placement notes by HCP. This advance is included in
the notes receivable due from HCP at September 30, 1999.
EXPENSES
For the three months ended September 30, 1999 and 1998 the Company's ratio of
operating expenses to average assets was 1.32% and 0.39%, respectively. The
increase in the ratio of operating expenses to average assets results from the
reduction of the Company's total assets resulting from (1) the sale of Agency
mortgage securities in October 1998, (2) the 1998-B securitization transaction
which reduced total assets by approximately $300 million and (3) net operating
expense increases detailed below.
The Company did not purchase any mortgage loans in the third quarter of 1999 and
accordingly incurred very little expenses for due diligence and commissions
during this period. In the third quarter of 1998, the Company recorded $158,000
and $65,000 of due diligence and commission
47
<PAGE> 48
expenses, respectively, directly relating to the purchase of $219 million (par
value) of mortgage loans.
The Management Agreement by and between Hanover and HCP, whereby HCP provides
Hanover due diligence, asset management and administrative services, was amended
in September 1999 (retroactive to July 1, 1999). The amendment reallocated
certain asset management and administrative service expenses between Hanover and
HCP to more accurately reflect current top management personnel expense and
certain other occupancy related charges. In the three month period ended
September 30, 1999, the Company recorded additional personnel expenses of
$163,000 that were previously allocated to HCP. Hanover will continue to record
similar expenses in future periods. Also included in personnel expense in the
third quarter of 1999 is approximately $103,000 of additional compensation
expense to the Principals, relating to the provision for forgiveness of
Principals' notes.
The Company continued to experience significant increases in legal and
professional expenses in the third quarter of 1999 ($375,000) compared to the
third quarter of 1998 ($99,000). During the three months ended September 30,
1999 general corporate legal and tax expenses increased greatly as the Company
incurred significant expenses relating to new business opportunities, credit
line negotiations, tax planning strategies, regulatory issues and the issuance
of warrants. Also recorded in the third quarter of 1999 are legal and
professional expenses of $50,000 for the disposition of Hanover's investment in
HCP-2.
The Company's third quarter 1999 and 1998 operating expenses did not include any
incentive bonus compensation. In order for the eligible participants to earn
incentive bonus compensation, the rate of return on shareholders' investment
must exceed the average ten-year U.S. Treasury rate during the year plus 4.0%.
EQUITY IN (LOSS) OF UNCONSOLIDATED SUBSIDIARIES
Hanover owns 100% of the non-voting preferred stock of HCP, which represents a
97% ownership interest in HCP and its wholly-owned subsidiaries. The Company
conducts all of its taxable businesses (i.e., due diligence consulting, loan
sale advisory, and loan brokering) through HCP. Hanover's investment in HCP is
accounted for on the equity method. Hanover recorded a loss for the three months
ended September 30 1999 and 1998 of ($142,000) and ($288,000), respectively,
from its equity investment in HCP. HCP revenues in the third quarter of 1999
increased by $452,000 or 27.7% over third quarter 1998 revenues. HCP also
reflected net interest income in the third quarter of 1999 of $100,000 from its
investment in 17 subordinated mortgage securities. These revenue increases
coupled with a reallocation of certain (primarily personnel) expenses from HCP
to Hanover resulted in a net loss before tax benefit in the third quarter of
1999 of ($147,000) compared to a net loss before tax benefit in the third
quarter of 1998 of ($469,000). HCP recorded an after tax loss for the three
month period ended September 30, 1999 of ($147,000) versus ($299,000) in the
same period in the prior year as management elected not to book any further
deferred tax benefit in the third quarter of 1999.
In October 1998, the Company completed the 1998-B REMIC securitization
transaction through its newly organized unconsolidated subsidiary, HCP-2.
Hanover contributed certain fixed rate mortgage loans, subject to the related
reverse repurchase agreement financing, to HCP-2 in exchange for a 99% economic
ownership of HCP-2 (representing a 100% ownership of the non-voting preferred
stock in HCP-2). HCP-2 issued a REMIC security and sold all of the REMIC
security except the "AAA" rated notes to two newly created wholly-owned
subsidiaries of
48
<PAGE> 49
Hanover. Hanover's investment in HCP-2 is accounted for on the equity method.
Hanover recorded a loss in the third quarter of 1999 from its equity investment
in HCP-2 of $403,000.
The loss generated by HCP-2 is a result of the unique securitization transaction
entered into in October 1998. The REMIC security transaction effectively records
all of the underlying mortgage loans as assets and the same amount of CMO.
Accordingly, the gross interest income generated from the underlying mortgages
will match exactly the interest expense relating to the CMO. The net loss
generated by HCP-2 relates to (1) the amortization of net premiums and deferred
hedge costs, reflected as a reduction of interest income, (2) the amortization
of deferred financing costs and (3) to a much lesser extent, certain
administrative expenses. It is expected that HCP-2 will continue to reflect
decreasing losses in the future.
Management believes that the net interest income calculated relating to the
1998-B securitization transaction should be adjusted to reflect the operating
activity recorded from the equity in loss of HCP-2 to more fully comprehend the
yield on the net interest earning assets. Accordingly, the table below reflects
the adjusted net interest income generated from the $318 million securitization
transaction (dollars in thousands):
<TABLE>
<CAPTION>
REVISED
QUARTER QUARTER
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1999 (1)
------------- -------------
<S> <C> <C>
Private Placement Notes - 1998-B (as adjusted)
- ----------------------------------------------
Average asset balance (as adjusted) $ 20,009 $ 14,972
Average repo balance 3,301 3,301
-------- --------
Net interest earning assets (as adjusted) $ 16,708 $ 11,671
======== ========
Average leverage ratio (as adjusted) 16.498% 22.048%
======== ========
Effective interest income rate (as adjusted) (31.633%) 11.283%
Effective interest expense rate 5.677% 5.677%
-------- --------
Net interest spread (as adjusted) (37.310%) 5.606%
======== ========
Interest income (as adjusted) $ (1,582) $ 422
Interest expense 47 47
-------- --------
Net interest income (expense) (as adjusted) $ (1,629) $ 375
======== ========
Yield on net interest earning assets (as adjusted) (38.999%) (12.852%)
======== ========
</TABLE>
(1) Net interest income for the three month period ended September 30, 1999 was
revised assuming certain adjustments affecting net interest income had all
been recorded prior to July 1, 1999. The adjustments affecting net interest
income were (1) $1,606,000 resulting from adjusting amortization of
premiums and deferred expenses to actual prepayment speeds to date and
projected prepayment speeds ranging from 6% to 40%, and (2) $403,000 to
eliminate the loss Hanover recorded from its investment in HCP-2 in the
third quarter of 1999.
49
<PAGE> 50
TAXABLE INCOME
Hanover's taxable loss for the three months ended September 30, 1999 is
estimated at ($355,000). Taxable loss differs from GAAP net loss for the three
months ended September 30, 1999 due to various recurring and one time book/tax
differences. The following table details the major book/tax differences in
arriving at the estimated taxable loss for the three months ended September 30,
1999 (dollars in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED
SEPTEMBER 30,
1999
-------------
<S> <C>
GAAP net (loss) $(13,994)
Recurring adjustments:
Add: Equity in loss of unconsolidated
Subsidiaries 551
GAAP amortization of net premiums
on mortgages, CMO collateral and
mortgage securities in excess of tax
amortization 78
Net loan loss provision 61
Less: Difference in recognition on sales of
servicing rights and
mortgage loans (129)
Other (70)
Adjustments related to third quarter charges:
Add: Realized loss on mark to market of
mortgage securities and mortgage loans 6,534
Provision for loss on disposition of
unconsolidated subsidiary (HCP-2) 4,793
Catch up amortization of net premiums
and deferred costs on CMO collateral
and mortgage securities 1,821
--------
Estimated taxable (loss) $ (355)
========
</TABLE>
As a REIT, Hanover is required to declare dividends amounting to 85% of each
year's taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of Hanover's taxable income for each year by the time
Hanover files its Federal tax return. Therefore, a REIT generally passes through
substantially all of its earnings to shareholders without paying Federal income
tax at the corporate level.
LIQUIDITY
With the completion of the 1999-B securitization this quarter and the
concomitant reduction of mortgage loans held for sale to close to zero, the
Company believes it has substantially reduced its exposure to liquidity events.
The Company expects to meet its future short-term and long-term liquidity
requirements generally from its existing working capital, cash flow provided by
50
<PAGE> 51
operations, reverse repurchase agreements and other possible sources of
financing, including CMOs and REMICs. The Company considers its ability to
generate cash to be adequate to meet operating requirements both short-term and
long-term.
The Company's remaining exposure to market-driven liquidity events is limited to
the short-term reverse repurchase financing it has in place against its
mortgage-backed securities. If a significant decline in the market value of the
Company's mortgage-backed securities portfolio should occur, the Company's
available liquidity from existing sources and ability to access additional
sources of credit may be reduced. As a result of such a reduction in liquidity,
the Company may be forced to sell certain investments in order to maintain
liquidity. If required, these sales could be made at prices lower than the
carrying value of such assets, which could result in losses.
The Company had two reverse repurchase agreement lines of credit in place at
September 30, 1999. One of these lines of credit was renewed in March 1999 and
the other line of credit (a $50 million line of credit facility) was closed in
April 1999. Management may add additional committed and uncommitted lines of
credit in the future.
In November 1998, Hanover entered into a short term financing arrangement (that
has since terminated) with Residential Funding Corporation ("RFC"). In
connection with such financing arrangement, Hanover in April 1999 executed a
Warrant Agreement to issue to RFC warrants to purchase 299,999 shares of
Hanover's common stock. The warrants are exercisable at a price per share equal
to the closing price of Hanover's common stock on the American Stock Exchange on
the date of the November agreement, which was $4.00 per share. The warrants
expire after five years, in April 2004.
Net cash provided by operating activities for the nine months ended September
30, 1999 was $1,657,000, compared to a net loss of ($13,200,000) for the nine
months ended September 30, 1998. Significant non-cash charges and expenses
through the third quarter included $6,534,000 of unrealized losses from
mark-to-market of certain securities and mortgage loans; $4,793,000 provision
for loss on sale of HCP-2 subsidiary; and $3,963,000 in amortization of premium
and deferred costs. The most significant use of cash not reflected in net income
were loans to related parties of $4,485,000, consisting primarily of loans to
HCP.
Net cash provided by investing activities amounted to $124,195,000 during the
period from January 1, 1999 through September 30, 1999. The majority of cash
proceeds from investing activities was generated from (1) the net decrease in
mortgage loans available for sale and held to maturity of $64,859,000; (2)
principal payments received on collateral for CMOs of $42,875,000 and mortgage
securities of $10,580,000; and (3) proceeds from sale of mortgage securities and
loans of $8,743,000, offset by the purchase of twelve below investment grade
mortgage securities for $3,668,000 in the second quarter. (In addition, HCP
purchased seventeen below investment grade mortgage securities in the third
quarter. The cash used for this purchase ($3,041,000) was provided by the
Company in the form of a note receivable from HCP, which is reflected in the
increase in loans to related parties described in the preceding paragraph.)
Cash flows from financing activities used $119,105,000 during the nine months
ended September 30, 1999. During the nine months ended September 30, 1999, the
Company made net repayments to its reverse repurchase lenders of $310,634,000
and had net borrowings on CMOs and mortgage-backed bonds of $196,209,000. The
Company also paid dividends of $2,443,000 and purchased an additional 495,000
shares of its common stock for $2,236,000 during this period.
51
<PAGE> 52
CAPITAL RESOURCES
The Company had no capital expenditure during the quarter and nine months ended
September 30, 1999 and management does not anticipate the need for any material
capital expenditures in the near future.
YEAR 2000 (Y2K) DISCLOSURE
The Y2K issue is the result of computer systems that use two digits rather than
four to define the applicable year, which may prevent such systems from
accurately processing dates ending in the year 2000 and thereafter. This could
result in system failures or in miscalculations causing disruption of
operations, including, but not limited to, an inability to process transactions,
to send and receive electronic data, or to engage in routine activities and
operations.
The following information is provided relating to the Company's Y2K issues:
1. Y2K-READINESS- The Company has reviewed the status of all of its
information technology ("IT") systems and has determined that all of its
computer hardware is Y2K compliant. In addition, the Company has received
satisfactory certification from virtually all of its third party vendors
and/or verified to its satisfaction that their IT systems are Y2K compliant
or have indicated that they are on schedule to be Y2K compliant prior to
December 31, 1999.
<TABLE>
<CAPTION>
Key Third Party Vendors Services Provided
----------------------- -----------------
<S> <C>
Securities dealer firms Financing, facilitate purchase and sale of
mortgage assets, etc.
Information processing firms Accounting, word processing, database
software systems
Mortgage loan servicers Mortgage loan servicing
Communications firms Telephone, modems, fax, financial software,
internet, postage
Facilities firms Office space, storage, security
General Legal and accounting, office supplies, etc.
</TABLE>
By virtue of the responses received from third party vendors, the Company
does not anticipate any significant costs associated with Y2K
non-compliance by the third party vendors. The Company does not own any
non-IT systems (i.e. elevator systems, building air management systems,
security and fire control systems). The Company has received written and/or
verbal confirmation that the non-IT systems located in the Company's
principal leased facilities are all Y2K compliant.
2. Y2K-COSTS - The Company has not incurred any material costs related to its
Y2K issues and believes its total Y2K costs to date have been less than
$25,000. At this time it does not anticipate any material costs will be
incurred on as yet unidentified Y2K issues. The costs of these projects and
the dates on which the Company plans to complete modifications and
replacements are based on management's best estimates, the estimates of
third-party
52
<PAGE> 53
specialists, if any, who may assist the Company, the
modification plans of third parties and other factors. However, these
estimates of future Y2K related costs may change if actual results differ
materially from the above indication.
3. Y2K-RISKS- Currently the Company's most reasonably likely worst case
scenario relating to the Y2K issue would occur if any of the companies
which service its mortgage asset portfolios had Y2K problems that
prohibited such companies from either (1) collecting and remitting funds or
(2) providing the related loan data to the Company on a timely basis. A
scenario of this type could, if existing for any significant length of
time, create liquidity problems for the Company and could result in
decreased net income through decreased net interest income and increased
operating expenses. If the Company does not receive borrower remittances
from its servicers on a timely basis it may have to (1) use existing
capital, (2) sell other mortgage assets or (3) try to secure additional
financing sources to satisfy lenders' margin calls. Although the likelihood
of such an occurrence seems remote, a total cessation of borrower
remittances to the Company could potentially lead to monetary defaults by
the Company on its repo lending obligations. Additionally, the Company
estimates that expenses would increase as a result of legal and other
actions taken to attempt to collect the funds due the Company. While the
Company believes the probability of the above occurrences to be low, there
can be no assurance at this time that the Company will not be materially
adversely affected by possible Y2K problems.
4. Y2K-CONTINGENCY PLANS- The development of contingency plans to handle the
most reasonably likely worst case Y2K scenario has been completed. The Y2K
contingency plans identify individuals within the Company to contact in the
event of a Y2K problem, as well as the availability of back-up systems. The
Company does not currently anticipate the need for any third-party
consultants for remediation efforts.
OTHER MATTERS
REIT Requirements
Hanover has elected to be taxed as a REIT under the Code. Hanover believes that
it was in full compliance with the REIT tax rules as of September 30, 1999 and
intends to remain in compliance with all REIT tax rules. If Hanover fails to
qualify as a REIT in any taxable year and certain relief provisions of the Code
do not apply, Hanover will be subject to Federal income tax as a regular,
domestic corporation, and its stockholders will be subject to tax in the same
manner as stockholders of a regular corporation. Distributions to its
stockholders in any year in which Hanover fails to qualify as a REIT would not
be deductible by Hanover in computing its taxable income. As a result, Hanover
could be subject to income tax liability, thereby significantly reducing or
eliminating the amount of cash available for distribution to its stockholders.
Further, Hanover could also be disqualified from re-electing REIT status for the
four taxable years following the year during which it became disqualified.
IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
The preceding section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and other sections of this Quarterly
Report contain various "forward-looking statements" within the meaning of
Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21E
of the Securities Exchange Act of 1934, as amended. These forward-looking
statements represent the Company's expectations or beliefs concerning future
events, including, without limitation, statements containing the words
"believes," "anticipates,"
53
<PAGE> 54
"expects" and words of similar import; and also including, without limitation,
the following: statements regarding the Company's continuing ability to target
and acquire mortgage loans; expected availability of the master reverse
repurchase agreement financing; the sufficiency of the Company's working
capital, cash flows and financing to support the Company's future operating and
capital requirements; results of operations and overall financial performance;
the expected dividend distribution rate; and the expected tax treatment of the
Company's operations. Such forward-looking statements relate to future events
and the future financial performance of the Company and the industry and involve
known and unknown risks, uncertainties and other important factors which could
cause actual results, performance or achievements of the Company or industry to
differ materially from the future results, performance or achievements expressed
or implied by such forward-looking statements.
Investors should carefully consider the various factors identified in
"Management's Discussion and Analysis of Financial Condition and Results of
Operation - Other Matters," and elsewhere in this Quarterly Report that could
cause actual results to differ materially from the results predicted in the
forward-looking statements. Further, the Company specifically cautions investors
to consider the following important factors in conjunction with the
forward-looking statements: the possible decline in the Company's ability to
locate and acquire mortgage loans; the possible adverse effect of changing
economic conditions, including fluctuations in interest rates and changes in the
real estate market both locally and nationally; the effect of severe weather or
natural disasters; the effect of competitive pressures from other financial
institutions, including other mortgage REIT's; and the possible changes, if any,
in the REIT rules. Because of the foregoing factors, the actual results achieved
by the Company in the future may differ materially from the expected results
described in the forward-looking statements.
54
<PAGE> 55
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
During the third quarter of 1999 the Company used certain derivative financial
instruments (for purposes other than trading) as hedges of anticipated
transactions relating to its investment portfolio.
The Company from time to time enters into interest rate hedge mechanisms
(forward sales of Agency mortgage securities) to manage its exposure to market
pricing changes in connection with the purchase, holding of, securitization and
sale of its fixed rate mortgage loan portfolio. The Company generally closes out
the hedge position to coincide with the related loan sale or securitization
transactions and recognizes the results of the hedge transaction in determining
the amount of the related loan sale gain or loss for loans sold, or as a basis
adjustment to loans held to maturity.
At September 30, 1999 the Company did not have any forward sales of Agency
mortgage securities that had not yet settled.
The Company only hedges its fixed rate mortgage loan pools by selling short
similar coupon and duration matched Agency securities, usually for 30 to 60 day
periods. This hedging of mortgage assets should, if properly executed, adjust
the carrying value of the hedged fixed mortgage loan pools to reflect current
market pricing. The costs or gains of the individual hedging transactions can
vary greatly depending upon market conditions. Net hedging gains on the fixed
rate mortgage pools were $86,000 during the first nine months of 1999.
The primary risk associated with selling short Agency securities relates to
changes in interest rates. Generally, as market interest rates increase, the
market value of the hedged asset (fixed rate mortgage loans) will decrease. The
net effect of increasing interest rates will generally be a favorable or gain
settlement on the forward sale of the Agency security; this gain will result in
a negative basis adjustment to the hedged assets. Conversely, if interest rates
decrease, the market value of the hedged asset will increase. The net effect of
decreasing interest rates will generally be an unfavorable or loss settlement on
the forward sale of the Agency security; this loss should be offset by a
positive basis adjustment to the hedged assets. To mitigate interest rate risk
an effective matching of Agency securities with the hedged assets needs to be
monitored closely. Senior Management continually monitors the changes in
weighted average duration and coupons of the hedged assets and will
appropriately adjust the amount, duration and coupon of future forward sales of
Agency securities.
The Company also enters into interest rate hedge mechanisms (interest rate caps)
to manage its interest rate exposure on certain reverse repurchase agreement
financing. The cost of the interest rate caps is amortized over the life of the
interest rate cap and is reflected as a portion of interest expense in the
consolidated statement of operations.
At September 30, 1999 the Company had the following interest rate caps in effect
(dollars in thousands):
<TABLE>
<CAPTION>
Notional Amount Index Strike % Maturity Date
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
$ 31,394 3 Month LIBOR 5.75% March, 2001
29,366 3 Month LIBOR 5.75% April, 2001
75,000 1 Month LIBOR 7.75% August, 2002
35,000 1 Month LIBOR 7.75% August, 2004
--------
$170,760
========
</TABLE>
55
<PAGE> 56
The primary risk associated with interest rate caps relates to interest rate
increases. The interest rate caps provide a cost of funds hedge against interest
rates that exceed 5.75% and 7.75%, respectively, subject to the limitation of
the notional amount of financing.
INTEREST RATE SENSITIVITY
MORTGAGE LOAN ASSETS
The Company's mortgage loan assets are classified into two subcategories, fixed
rate loans and adjustable rate loans, and further classified as mortgages held
for sale vs. mortgages held to maturity. The financing of these assets during
the initial period (the time period during which management analyzes the loans
in detail and corrects deficiencies where possible before securitizing the
loans) is accomplished with reverse repurchase agreement ("repo") financing or
with equity alone in certain instances. The unsecuritized mortgage assets held
by the Company at September 30, 1999 were a combination of adjustable rate
mortgage ("ARM") loans (82.1%) and fixed rate mortgage loans (17.9%). The yield
on the fixed rate mortgage loans would not be affected by changes in interest
rates. The ARM loans would be affected by interest rate changes depending upon
repricing frequencies, indexes and interest caps. There were no significant
coupon interest rate adjustments on the ARM pools during the third quarter of
1999. The Company's greatest interest rate volatility risk relates to its repo
financing. The Company's repo financing agreements at September 30, 1999 were
indexed to LIBOR plus a spread of 125 to 238 basis points. This financing
generally is rolled and matures every 30 to 90 days. Accordingly, any increases
in LIBOR will tend to reduce net interest income and any decreases in LIBOR will
tend to increase net interest income.
Interest income on the mortgage portfolio is also negatively affected by
prepayments on mortgage loan pools purchased at a premium and positively
impacted by prepayments on mortgage loan pools purchased at a discount. The
Company assigns an anticipated prepayment speed to each mortgage pool at the
time of purchase and records the appropriate amortization of the premium or
discount over the estimated life of the mortgage loan pool. To the extent the
actual prepayment speeds vary significantly from the anticipated prepayment
speeds for an extended period of time, the Company will adjust the anticipated
prepayment speeds and amortization of the premium or discount accordingly. This
will negatively (in the case of accelerated amortization of premiums or
decelerated amortization of discounts) or positively (in the case of decelerated
amortization of premiums or accelerated amortization of discounts) impact net
interest income. Based on management's evaluation of the prepayment speeds
relating to the mortgage loan pools, no such adjustment was deemed necessary for
the three months ended September 30, 1999.
Increases in delinquency rates and defaults by borrowers on their mortgages can
also negatively impact the Company's net interest income. The Company monitors
delinquencies and defaults in its mortgage loan portfolio in three categories:
government, conventional and uninsured. It adjusts its loan loss provision
policy and non-interest accrual policy in accordance with changes in the
delinquency and default trends.
Hedging gains and losses and other related hedging costs are deferred and are
recorded as an adjustment of the hedged assets or liabilities. The hedging gains
("Hedging Gains") and losses ("Hedging Costs") along with the other related
hedging costs are amortized over the estimated life of the asset or liability.
The Company only hedges its fixed rate mortgage portfolio and certain repo
exposure. There was no hedging instruments in place at September 30, 1999 for
the fixed rate mortgage portfolio. The cost of hedging repo liabilities with
interest rate caps previously in place for the mortgage loan category was
transferred to the mortgage security category subsequent to the securitization
of certain mortgage loans. The Company's customary
56
<PAGE> 57
hedging of fixed rate mortgage loan pools by selling short similar duration
matched Agency securities, usually for 30 to 60 day periods, was deemed to be
unnecessary at September 30, 1999 due to the relatively low principal balance of
fixed rate mortgage loans held for sale. This hedging of mortgage assets should,
if properly executed, adjust the carrying value of the fixed mortgage loan pools
to reflect current market pricing. The costs of the individual hedging
transactions can vary greatly depending upon the market conditions. Net Hedging
Gains on fixed mortgage pools were $86,000 through the first three quarters of
1999.
SECURITIZED MORTGAGE LOAN ASSETS
With respect to the match funding of assets and liabilities, the CMO and
mortgage-backed bond collateral relating to the 1998-A, 1999-A and 1999-B
securitizations reflect $187,323,000 of fixed rate mortgage loans and
$101,422,000 of adjustable rate mortgage loans at September 30, 1999. The
primary financing for this asset category is the CMOs ($273,514,000) and to a
much lesser extent repo agreements ($3,366,000). The repo financing, which is
indexed to LIBOR, is subject to interest rate volatility as the repo agreement
matures and is extended. The financing provided by the CMOs for the 1998-A and
1999-A securitizations lock in long-term fixed financing and thereby eliminates
most interest rate risk. The financing for the 1999-B securitization is indexed
to LIBOR. Accordingly, the Company has hedged this interest rate risk through
the purchase of interest rate caps. The Company purchased amortizing interest
rate caps with notional balances of $110 million in August 1999.
MORTGAGE SECURITIES
At September 30, 1999 the Company owned certain fixed rate Agency and private
placement mortgage securities and certain interest only and principal only
private placement mortgage securities ($64,325,000). The coupon interest rates
on the fixed rate mortgage securities would not be affected by changes in
interest rates. The interest only notes remit monthly interest generated from
the underlying mortgages after deducting all service fees and the coupon
interest rate on the applicable notes. The interest rate on each of the interest
only notes is based on a notional amount (the principal balance of those
mortgage loans with an interest rate in excess of the related note coupon
interest rate). The notional amounts decline each month to reflect the related
normal principal amortization, curtailments and prepayments for the related
underlying mortgage loans. Accordingly, net interest income on the mortgage
securities portfolio would be negatively affected by prepayments on mortgage
loans underlying the mortgage securities and would further be negatively
affected to the extent that higher rated coupon mortgage loans paid off more
rapidly than lower rated coupon mortgage loans.
Certain of the mortgage securities are financed with repo agreements
($56,090,000 at September 30, 1999) indexed to LIBOR, and as such any increase
in LIBOR will tend to reduce net interest income and any decreases in LIBOR will
tend to increase net interest income.
57
<PAGE> 58
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
During the third quarter of 1999, there were no material
developments with respect to legal proceedings to which the
Company or any of its affiliates have been a party.
ITEM 2. CHANGES IN SECURITIES
Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:
(a) Exhibits filed with this Form 10-Q
Ex. 27 Financial Data Schedule
(b) Reports on Form 8-K
None
58
<PAGE> 59
SIGNATURES
Pursuant to the requirements 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.
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
By: /s/ John A. Burchett
Dated: November 12, 1999 ---------------------------------
-----------------
John A. Burchett
Chairman of the Board of Directors
Dated: November 12, 1999 By: /s/ Thomas P. Kaplan
----------------- ---------------------------------
Thomas P. Kaplan
Chief Financial Officer
59
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE HANOVER
CAPITAL MORTGAGE HOLDINGS, INC'S QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD
FROM JANUARY 1, 1999 TO SEPTEMBER 30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 18,584
<SECURITIES> 353,321
<RECEIVABLES> 3,431
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 387,131
<CURRENT-LIABILITIES> 63,538<F1>
<BONDS> 273,514
0
0
<COMMON> 58
<OTHER-SE> 50,021<F2>
<TOTAL-LIABILITY-AND-EQUITY> 387,131
<SALES> 20,720
<TOTAL-REVENUES> (8,080)
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 2,989
<LOSS-PROVISION> 339
<INTEREST-EXPENSE> 17,820
<INCOME-PRETAX> (13,200)
<INCOME-TAX> 0
<INCOME-CONTINUING> (13,200)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,200)
<EPS-BASIC> (2.21)
<EPS-DILUTED> (2.19)
<FN>
<F1>As a Real Estate Investment Trust our balance sheet is not classified.
<F2>Includes Retained Earnings and Paid In Capital.
</FN>
</TABLE>
