10-Q 1 b40062hce10-q.txt HANOVER CAPITAL MORTGAGE HOLDINGS INC. 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 June 30, 2001 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 Identification No.) Incorporation or Organization) 90 WEST STREET, SUITE 2210, NEW YORK, NY 10006 (Address of principal executive offices) (Zip Code) (212) 225-0740 (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 4,249,344 shares of common stock, par value $.01 per share, outstanding as of August 13, 2001. 2 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. FORM 10-Q For the Quarter Ended June 30, 2001 INDEX PART I. FINANCIAL INFORMATION Page No. -------- Item 1. Financial Statements 3 Consolidated Balance Sheets as of June 30, 2001 and December 31, 2000 3 Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2001 and 2000 4 Consolidated Statement of Stockholders' Equity for the Six Months Ended June 30, 2001 5 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2001 and 2000 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities and Use of Proceeds 25 Item 3. Defaults Upon Senior Securities 25 Item 4. Submission of Matters to a Vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits and Reports on Form 8-K 25 Signatures 26 2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data)
JUNE 30 DECEMBER 31 2001 2000 ----------- ----------- (unaudited) ASSETS Mortgage loans: Held for sale $ 225 $ 230 Collateral for CMOs 184,033 212,017 Mortgage securities pledged as collateral for reverse repurchase agreements: Available for sale 8,174 11,785 Held to maturity -- 1,384 Trading 7,618 1,743 Mortgage securities pledged as collateral for CMOs 9,867 9,877 Mortgage securities, not pledged: Available for sale 5,780 4,744 Held to maturity 865 3,133 Trading -- 3,057 Cash and cash equivalents 9,979 9,958 Accrued interest receivable 2,157 2,466 Equity investments Hanover Capital Partners Ltd. 1,778 1,765 HanoverTrade.com, Inc. (3,092) (1,526) Notes receivable from related parties 10,688 7,887 Due from related parties 551 237 Other receivables 251 911 Prepaid expenses and other assets 2,460 3,140 -------- -------- TOTAL ASSETS $241,334 $272,808 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reverse repurchase agreements $ 13,282 $ 14,760 CMO borrowings 182,753 210,374 Accrued interest payable 1,532 1,796 Dividends payable -- 865 Accrued expenses and other liabilities 1,125 989 -------- -------- TOTAL LIABILITIES 198,692 228,784 -------- -------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, par value $.01, 10 million shares authorized, -0- shares issued and outstanding -- -- Common stock, par value $.01, 90 million shares authorized, 4,149,710 and 4,322,944 shares outstanding at June 30, 2001 and December 31, 2000, respectively 41 43 Additional paid-in-capital 67,290 68,546 Retained earnings (deficit) (25,199) (25,737) Accumulated other comprehensive income 510 1,172 -------- -------- TOTAL STOCKHOLDERS' EQUITY 42,642 44,024 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $241,334 $272,808 ======== ========
See notes to consolidated financial statements 3 4 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 2001 2000 2001 2000 ------ ------ -------- ------- REVENUES: Interest income $5,327 $6,466 $ 10,805 $13,140 Interest expense 3,653 5,041 7,801 10,231 ------ ------ -------- ------- Net interest income 1,674 1,425 3,004 2,909 Loan loss provision 204 99 443 202 ------ ------ -------- ------- Net interest income after loan loss provision 1,470 1,326 2,561 2,707 Gain on sale of mortgage assets 728 -- 1,853 -- Gain on mark to market of mortgage securities, net of associated hedge 144 316 18 515 Gain (loss) on mark to market of interest rate caps not designated as hedges 10 -- (70) -- ------ ------ -------- ------- Total revenue 2,352 1,642 4,362 3,222 EXPENSES: Personnel 170 341 337 697 Management and administrative 192 218 396 441 Legal and professional 191 127 276 319 Financing/commitment fees 55 115 153 178 Other 172 158 324 304 ------ ------ -------- ------- Total expenses 780 959 1,486 1,939 ------ ------ -------- ------- Operating income 1,572 683 2,876 1,283 Equity in income/(loss) of unconsolidated subsidiaries Hanover Capital Partners Ltd. 10 98 12 211 HanoverTrade.com, Inc. (886) (46) (1,565) (69) ------ ------ -------- ------- Income before cumulative effect of adoption of SFAS 133 696 735 1,323 1,425 Cumulative effect of adoption of SFAS 133 -- -- 46 -- ------ ------ -------- ------- NET INCOME $ 696 $ 735 $ 1,369 $ 1,425 ====== ====== ======== ======= BASIC EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 0.17 $ 0.14 $ 0.31 $ 0.26 Cumulative effect of adoption of SFAS 133 -- -- 0.01 -- ------ ------ -------- ------- After cumulative effect of adoption of SFAS 133 $ 0.17 $ 0.14 $ 0.32 $ 0.26 ====== ====== ======== ======= DILUTED EARNINGS PER SHARE Before cumulative effect of adoption of SFAS 133 $ 0.16 $ 0.14 $ 0.30 $ 0.26 Cumulative effect of adoption of SFAS 133 -- -- 0.01 -- ------ ------ -------- ------- After cumulative effect of adoption of SFAS 133 $ 0.16 $ 0.14 $ 0.31 $ 0.26 ====== ====== ======== =======
See notes to consolidated financial statements 4 5 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY SIX MONTHS ENDED JUNE 30, 2001 (in thousands except share data) (unaudited)
ACCUMULATED OTHER COMMON STOCK ADDITIONAL COMPRE- RETAINED COMPRE- ------------------- PAID-IN HENSIVE EARNINGS HENSIVE SHARES AMOUNT CAPITAL INCOME (LOSS) (DEFICIT) INCOME (LOSS) TOTAL --------- ------ ---------- ------------- --------- ------------- ------- Balance, December 31, 2000 4,322,944 $43 $68,546 $(25,737) $1,172 $44,024 Repurchase of common stock (189,900) (2) (1,333) (1,335) Exercise of options 16,666 77 77 Comprehensive income: Net income $1,369 1,369 1,369 Other comprehensive income (loss): Change in net unrealized gain (loss) on securities available for sale (339) (339) (339) Change in net unrealized gain (loss) on interest rate caps designated as hedges 129 129 129 Unrealized cumulative effect of adoption of SFAS 133 (452) (452) (452) ------ Comprehensive income $ 707 ====== Dividends declared (831) (831) --------- --- ------- -------- ------ ------- Balance, June 30, 2001 4,149,710 $41 $67,290 $(25,199) $ 510 $42,642 ========= === ======= ======== ====== =======
See notes to consolidated financial statements 5 6 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
SIX MONTHS ENDED JUNE 30 2001 2000 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,369 $ 1,425 Adjustments to reconcile net income to net cash (used in) operating activities: Amortization of net premium and discount 170 460 Amortization of original issue discount from CMOs (53) -- Loan loss provision 443 202 (Gain) on sale of mortgage assets (1,853) -- (Gain) on mark to market of mortgage assets for SFAS 133 (50) -- (Gain) on mark to market of mortgage assets (167) (515) Purchase of trading securities (45,061) -- Sales of trading securities 43,447 -- Equity in (income) loss of unconsolidated subsidiaries 1,553 (142) Decrease in accrued interest receivable 309 227 (Increase) in loans to related parties (2,801) (3,283) (Increase) decrease in due from related parties (314) 143 (Increase) decrease in other receivables 660 (125) (Increase) decrease in prepaid expenses and other assets 680 (1,553) Increase in CMO discount -- 1,069 Change in other comprehensive (loss) resulting from change in other assets (280) -- (Decrease) in accrued interest payable (264) (428) (Decrease) in due to related party -- (88) Increase in accrued expenses and other liabilities 136 25 -------- -------- Net cash (used in) operating activities (2,076) (2,583) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of mortgage securities available for sale (4,433) -- Principal payments received on mortgage securities 1,772 3,888 Principal payments received on collateral for CMOs 27,768 26,350 (Increase) decrease in mortgage loans 5 (101) Proceeds from sale of mortgage securities available for sale 8,984 -- -------- -------- Net cash provided by investing activities 34,096 30,137 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net (repayment of) reverse repurchase agreements (1,478) (22,318) Net borrowing from CMOs and mortgage backed bonds -- 11,209 Net repayment of CMOs (27,568) (26,103) Payment of dividends (1,695) (1,273) Repurchase of common stock (1,335) (4,047) Exercise of stock options 77 -- -------- -------- Net cash (used in) financing activities (31,999) (42,532) -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 21 (14,978) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 9,958 18,022 -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 9,979 $ 3,044 ======== ======== SUPPLEMENTAL SCHEDULE OF NON CASH ACTIVITIES Cash paid during the period for: Income taxes: $ 6 $ 4 ======== ======== Interest $ 601 $ 1,725 ======== ========
See notes to consolidated financial statements 6 7 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. ORGANIZATION AND BASIS OF PRESENTATION The interim consolidated financial statements of Hanover Capital Mortgage Holdings, Inc. ("Hanover") and subsidiaries (with its subsidiaries, the "Company") include the accounts of Hanover and its wholly-owned subsidiaries. These interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2000. The interim consolidated financial statements reflect all normal and recurring adjustments which are, in the opinion of management, considered necessary for a fair presentation of the financial condition and results of operations for the periods presented. There were no adjustments of a non-recurring nature recorded during the three and six months ended June 30, 2001. The interim results of operations presented are not necessarily indicative of the results for the full year. When necessary, reclassifications have been made to conform to current period presentation. On January 1, 2001, we implemented Statements of Financial Accounting Standards ("SFAS") 133, 137 and 138. SFAS 133, Accounting for Derivative Instruments and Hedging Activities, issued in June 1998, establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS 137, issued in June 1999, delayed the effective date of SFAS 133 to make it effective for quarters in fiscal years beginning after June 15, 2000. SFAS 138, issued in June 2000, amends certain technical provisions of SFAS 133. In connection with the implementation of these financial standards, we adopted a hedging policy on January 1, 2001. Certain of the hedges that we had in place as of December 31, 2000 were designated as Fair Value Hedges, and certain of the hedges that we had in place were designated as Cash Flow Hedges. Changes in the value of Fair Value Hedges will be reflected in income, and an offsetting amount reflecting changes in value of the related hedged assets will also be reflected in income. The effect of this treatment will be to reflect in income any ineffective portion of such hedges. Changes in the value of Cash Flow Hedges will be reflected as other comprehensive income or loss, but only to the extent that the hedging relationship is expected to be highly effective. In September 2000, the Financial Accounting Standards Board issued SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125. SFAS 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but it carries over most of SFAS 125's provisions without reconsideration. SFAS 140 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. SFAS 140 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. SFAS 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. We adopted the collateral and disclosure provisions of SFAS 140 as of and for the year ended December 31, 2000, and we adopted the remaining provisions of SFAS 140 during the quarter ended June 30, 2001. The adoption of the remaining provisions did not have an effect on our financial statements. 7 8 In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS 141, "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. The Company does not believe that the adoption of SFAS 141 will have a significant impact on its financial statements. In July 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets", which is effective January 1, 2002. SFAS 142 will require that goodwill no longer be amortized, but instead tested for impairment at least annually. SFAS 142 will also require recognized intangible assets be amortized over their respective estimated useful lives and reviewed for impairment in accordance with SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." Any recognized intangible asset determined to have an indefinite useful life will not be amortized, but instead tested for impairment in accordance with the Standard until its life is determined to no longer be indefinite. The Company is currently assessing but has not yet determined the impact of SFAS 142 on its financial position and results of operations. At June 30, 2001 Hanover's affiliate HanoverTrade.com, Inc. ("HTC") had recorded goodwill of $631,000, net of amortization on its balance sheet. HTC recognized goodwill amortization expense of $13,000 and $27,000, respectively, in its statements of operations for the three and six month periods ended June 30, 2001. 2. MORTGAGE LOANS At June 30, 2001 we had $225,000 of mortgage loans designated as "held for sale." No mortgage loans were designated as held to maturity and $184,033,000 of mortgage loans were held as collateralized mortgage obligation ("CMO") collateral. HELD FOR SALE The following table summarizes certain characteristics of our single-family mortgage loan pools held for sale which are reflected at the lower of cost or market value (dollars in thousands):
JUNE 30, 2001 DECEMBER 31, 2000 ------------------------- --------------------------- Fixed Adjustable Fixed Adjustable Rate Rate Total Rate Rate Total ----- ---------- ----- ----- ---------- ----- Principal amount of mortgage loans $ 30 $195 $225 $ 31 $199 $230 Net premium and deferred cost -- -- -- -- -- -- Loan loss allowance -- -- -- -- -- -- ---- ---- ---- ---- ---- ---- Carrying cost of mortgage loans $ 30 $195 $225 $ 31 $199 $230 ==== ==== ==== ==== ==== ====
COLLATERAL FOR CMOS The following table summarizes our single-family fixed and adjustable rate mortgage loan pools held as CMO collateral (dollars in thousands):
JUNE 30, 2001 DECEMBER 31, 2000 --------------------------------- -------------------------------- Fixed Adjustable Fixed Adjustable Rate Rate Total Rate Rate Total -------- ---------- -------- -------- ---------- -------- Principal amount of mortgage loans $124,769 $58,461 $183,230 $140,867 $70,059 $210,926 Net premium (discount) and deferred costs 1,692 (147) 1,545 1,952 (159) 1,793 Loan loss allowance (519) (223) (742) (489) (213) (702) -------- ------- -------- -------- ------- -------- Carrying cost of mortgage loans $125,942 $58,091 $184,033 $142,330 $69,687 $212,017 ======== ======= ======== ======== ======= ========
8 9 3. MORTGAGE SECURITIES The following tables summarize certain information about our mortgage-backed securities (dollars in thousands):
FIXED RATE AGENCY MORTGAGE-BACKED SECURITIES JUNE 30, 2001 DECEMBER 31, 2000 ---------------------------------------------- ------------------------------------------------ Available Held Collateral Available Held Collateral For to for for to for Sale Maturity Trading CMOs Total Sale Maturity Trading CMOs Total -------- -------- ------- ---------- ------ --------- -------- ------- ---------- ------ Principal balance of mortgage securities $1,474 $-- $7,127 $-- $8,601 $2,047 $-- $1,681 $-- $3,728 Net premium and deferred costs 75 -- 497 -- 572 105 -- 65 -- 170 ------ --- ------ --- ------ ------ --- ------ --- ------ Total amortized cost of mortgage securities 1,549 -- 7,624 -- 9,173 2,152 -- 1,746 -- 3,898 Gross unrealized loss (2) -- (6) -- (8) (35) -- (3) -- (38) ------ --- ------ --- ------ ------ --- ------ --- ------ Carrying cost of mortgage securities $1,547 $-- $7,618 $-- $9,165 $2,117 $-- $1,743 $-- $3,860 ====== === ====== === ====== ====== === ====== === ======
FIXED RATE SUBORDINATE MORTGAGE-BACKED SECURITIES JUNE 30, 2001 DECEMBER 31, 2000 ---------------------------------------------- ------------------------------------------------ Available Held Collateral Available Held Collateral For to for for to for Sale Maturity Trading CMOs Total Sale Maturity Trading CMOs Total -------- -------- ------- ---------- ------- --------- -------- -------- ---------- ------ Principal balance of mortgage securities $ 22,417 $-- $-- $13,069 $35,486 $ 25,305 $ 5,986 $ 3,921 $13,234 $48,446 Net (discount) and deferred costs (11,434) (2,878) (14,312) (12,857) (2,281) (913) (3,035) (19,086) -------- --- --- ------- ------- -------- ------- -------- ------- ------- Total amortized cost of mortgage securities 10,983 -- -- 10,191 21,174 12,448 3,705 3,008 10,199 29,360 Loan loss allowance (387) -- -- (324) (711) (595) (105) -- (322) (1,022) Gross unrealized gain 564 -- -- -- 564 1,009 -- 49 -- 1,058 -------- --- --- ------- ------- -------- ------- -------- ------- ------- Carrying cost of mortgage securities $ 11,160 $-- $-- $ 9,867 $21,027 $ 12,862 $ 3,600 $ 3,057 $ 9,877 $29,396 ======== === === ======= ======= ======== ======= ======== ======= =======
DERIVATIVE MORTGAGE-BACKED SECURITIES JUNE 30, 2001 DECEMBER 31, 2000 ----------------------------------------------- ------------------------------------------------- Interest Principal Interest Principal Only Only Only Only Strips Strips Strips Strips Available Held Collateral Available Held Collateral for to for for to for Sale Maturity Trading CMOs Total Sale Maturity Trading CMOs Total --------- -------- ------- ---------- ----- --------- --------- ------- ---------- ------ Principal balance of mortgage securities $ -- $1,043 $-- $-- $1,043 $ -- $ 1,111 $-- $-- $1,111 Net premium (discount) and deferred costs 876 (178) -- -- 698 1,170 (194) -- -- 976 ------ ------ --- --- ------ ------ ------- --- --- ------ Total amortized cost of mortgage securities 876 865 -- -- 1,741 1,170 917 -- -- 2,087 Gross unrealized gain 371 -- -- -- 371 380 -- -- -- 380 ------ ------ --- --- ------ ------ ------- --- --- ------ Carrying cost of mortgage securities $1,247 $ 865 $-- $-- $2,112 $1,550 $ 917 $-- $-- $2,467 ====== ====== === === ====== ====== ======= === === ======
9 10 4. LOAN LOSS ALLOWANCE The provision for loan loss charged to expense is based upon actual credit loss experience and management's estimate and evaluation of potential losses in the existing mortgage loan and mortgage securities portfolio, including the evaluation of impaired loans. The following table summarizes the activity in the loan loss allowance for the following periods (dollars in thousands):
SIX MONTHS ENDED JUNE 30 2001 2000 ------ ---- Balance, beginning of period $1,724 $799 Loan loss provision 443 203 Sales (607) - Charge-offs (108) (47) Recoveries -- -- ------ ---- Balance, end of period $1,452 $955 ====== ====
5. EQUITY INVESTMENTS Hanover owns 100% of the non-voting preferred stock of Hanover Capital Partners Ltd. ("HCP"), a due diligence consulting firm, and HanoverTrade.com ("HTC"), an internet-based loan trading firm. These ownership interests entitle Hanover to receive 97% of the earnings or losses of HCP and HTC. HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands) (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 2001 2000 2001 2000 ------ ------ ------ ------ REVENUES: Due diligence fees $1,227 $1,742 $2,585 $3,284 Mortgage sales and servicing 3 6 5 18 Assignment fees 201 102 367 273 Loan brokering and other income 4 28 8 35 Net interest income on mortgage securities -- 373 -- 688 ------ ------ ------ ------ Total revenues 1,435 2,251 2,965 4,298 ------ ------ ------ ------ EXPENSES: Personnel expense 1,081 1,587 2,309 3,066 General and administrative expense 90 88 150 170 Other expenses 213 252 416 421 Interest expense 17 121 27 218 Depreciation and amortization 14 14 29 26 ------ ------ ------ ------ Total expenses 1,415 2,062 2,931 3,901 ------ ------ ------ ------ INCOME BEFORE INCOME TAXES 20 189 34 397 INCOME TAX PROVISION 10 88 22 179 ------ ------ ------ ------ NET INCOME $ 10 $ 101 $ 12 $ 218 ====== ====== ====== ======
10 11 HANOVERTRADE.COM, INC. CONDENSED STATEMENTS OF OPERATIONS (in thousands) (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 2001 2000 2001 2000 ------- ---- ------- ---- REVENUES: Loan brokering and other income $ 827 $ -- $ 1,765 $ -- ------- ---- ------- ---- Total revenues 827 -- 1,765 -- ------- ---- ------- ---- EXPENSES: Personnel expense 955 -- 1,869 -- Occupancy expense 79 -- 135 -- Network and technology expense 103 24 219 34 Professional fees 63 8 105 12 Travel and trade shows 97 6 195 16 General and administrative 65 1 111 3 Interest expense 104 7 198 7 Depreciation and amortization expense 274 -- 544 -- ------- ---- ------- ---- Total expenses 1,740 46 3,376 72 ------- ---- ------- ---- (LOSS) BEFORE INCOME TAXES (913) (46) (1,611) (72) INCOME TAX PROVISION 1 -- 1 -- ------- ---- ------- ---- NET (LOSS) $ (914) $(46) $(1,612) $(72) ======= ==== ======= ====
HTC's total assets at June 30, 2001 were $3,707,000, which includes $2,304,000 of capitalized software costs, $631,000 of goodwill, and a $200,000 loan to VerticalCrossings.com, Inc. HTC's total liabilities at June 30, 2001 were $6,893,000, which includes a note payable to Hanover of $6,170,000, which matures on March 31, 2002, and intercompany payables of $344,000. The Company established a valuation allowance for the full amount of the income tax benefit resulting from net operating losses. The maturity date of the $200,000 loan to VerticalCrossing.com, Inc has been extended until September 25, 2001. 11 12 6. AFFILIATED PARTY TRANSACTIONS During the second quarter of 2001, Hanover advanced funds to HCP and HTC pursuant to unsecured loan agreements. These loans to HCP and HTC bear interest at 1.00% below the prime rate. The loans to HCP and HTC mature on March 31, 2002. In addition, Hanover has outstanding loans to John A. Burchett, Thomas P. Kaplan, Joyce S. Mizerak, George J. Ostendorf, and Irma N. Tavares ("Principals"). The loans to the Principals bear interest at the lowest applicable Federal interest rate during the month the loans were made. NOTES RECEIVABLE (in thousands)
March 31, 2001 June 30, 2001 Balance Advances Repayment Balance -------------- -------- --------- ------------- Principal Loans $3,279 $ - $ - $ 3,279 HCP Loan 789 750 (300) 1,239 HTC Loan 5,386 784 - 6,170 ------ ------ ----- ------- $9,454 $1,534 $(300) $10,688 ====== ====== ===== =======
During the second quarters of 2001 and 2000, we recorded $46,000 and $46,000, respectively, of interest income generated from loans to the Principals, $17,000 and $121,000, respectively, of interest income from loans to HCP and $110,000 and $7,000, respectively, of interest income from loans to HTC. Hanover engaged HCP pursuant to a management agreement to provide, among other things, due diligence, asset management and administrative services. The term of the management agreement continues until December 31, 2001 with provisions for automatic renewal. Our consolidated statements of operations for the quarters ended June 30, 2001 and June 30, 2000 include management and administrative expenses of $163,000 and $191,000, respectively, relating to billings from HCP. The 2001 consolidated statement of operations also reflects a reduction in personnel expenses for salaries allocated (and billed) to HCP and HTC. 7. REVERSE REPURCHASE AGREEMENTS Information pertaining to individual reverse repurchase agreement lenders at June 30, 2001 is summarized as follows (dollars in thousands):
March 31, Net June 30, Type Maximum 2001 (Paydown) 2001 Underlying Of Lender Borrowing Balance Advance Balance Collateral Collateral ------ --------- --------- -------- -------- ---------- ---------- Lender A (committed) $ 10,000 $ 3,627 $ (1,570) $ 2,057 $11,146 Retained CMO Securities Lender A 969 (969) - - Mortgage Securities Lender B 590 (590) - - Mortgage Securities Lender C - 6,643 6,643 9,165 Mortgage Securities Lender D 4,520 (1,660) 2,860 4,258 Mortgage Securities Lender E 1,034 (1,034) - - Mortgage Securities Lender F 527 (47) 480 674 Mortgage Securities Lender G 913 (350) 563 984 Mortgage Securities Lender H 3,968 (3,289) 679 711 Mortgage Securities -------- --------- ------- ------- Total $ 16,148 $ (2,866) $13,282 $26,938 ======== ========= ======= =======
With the exception of the first facility listed, all of the reverse repurchase borrowings are pursuant to uncommitted financing arrangements which are typically renewed monthly. The first facility listed matures on March 28, 2002. 12 13 8. DERIVATIVE INSTRUMENTS FAIR VALUE HEDGES From time to time we enter into forward sales of Agency mortgage securities to manage our exposure to changes in the value of some of our mortgage securities. We call this type of hedge a "fair value hedge." Our objective in entering into these hedges is to offset gains or losses on the hedged asset with comparable losses or gains on the hedge. Generally, changes in the value of our hedged assets are caused by changes in interest rates, changes in the market for mortgage-backed securities, and changes in the credit quality of the asset. Changes in interest rates and changes in the market for mortgage-backed securities will also affect the value of our forward sales of agency securities. (We do not attempt to hedge changes in the credit quality of individual assets.) We calculate the expected impact that changes in interest rates and the market will have on the price of both the hedged asset and the hedge. Using this information, we determine the amount of forward sales that we need so that our expected gains or losses on assets will be offset by comparable losses or gains on the hedges. In order to monitor the risk that results from this activity, we estimate the daily gain or loss from both the hedged asset and the hedge for every business day. At the end of each quarter, we perform a statistical analysis to ensure that the daily changes in the value of the hedge are correlated to changes in the value of the hedged asset. In the three months ended June 30, 2001, we realized net gains on these hedges of $7,000. In the same period, we recognized net mark-to-market gains of $23,000 on the hedged assets. We consider the mismatch of $30,000 to be the amount of the hedge's ineffectiveness. This amount is reported as a component of gain (loss) on mark to market of mortgage securities, net of associated hedge in the accompanying financial statements. CASH FLOW HEDGES From time to time we also buy interest rate caps when we finance fixed rate assets with floating rate reverse repurchase agreements and CMOs. We call these "cash flow hedges." Our objective in entering into these hedges is to protect our net interest margin, which represents the difference between the interest we earn on our assets and the interest we pay on the debt. Payments we receive on the interest rate caps are expected to offset increases in our interest expenses that could result from increases in interest rates. We attempt to purchase caps that are indexed to the same floating interest rate as the hedged borrowing. Currently, all of our interest rate caps are indexed to LIBOR, and the hedged liabilities are also indexed to LIBOR. We did not record any gains or losses as a result of hedge ineffectiveness for these hedges in the three months ended June 30, 2001. We do not anticipate any transactions within the next twelve months that will cause us to reclassify gains or losses on these hedges. All of these hedges relate to the payment of variable interest on existing financial instruments. We currently expect that the hedged financial instruments will remain outstanding, and therefore we do not expect to discontinue these hedges. 9. STOCKHOLDERS' EQUITY In August 2000, our Board of Directors authorized a share repurchase program pursuant to which we are authorized to repurchase up to 1,000,000 shares of our outstanding common stock from time to time in open market transactions up to a maximum of $3,000,000. As of June 30, 2001, we have remaining authority to purchase up to 501,025 shares for not more than $137,000. On April 20, 2001, our Board of Directors authorized the repurchase of 189,900 shares of our common stock. We purchased 189,900 shares on April 25, 2001 at $7.03 per share including expenses. As a result of the repurchase, our outstanding common stock was reduced from 4,322,944 shares as of March 31, 2001 to 4,133,044 shares as of April 25, 2001. This repurchase does not affect the Company's remaining authority to repurchase shares under the August 2000 Board of Directors authorization. 13 14 10. EARNINGS PER SHARE Calculations for earnings per share are shown below (dollars in thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 2001 2000 2001 2000 ---------- ---------- ---------- ---------- INCOME: Net income before cumulative effect of Adoption of SFAS 133 $ 696 $ 735 $ 1,323 $ 1,425 Cumulative effect of adoption of SFAS 133 -- -- 46 -- ---------- ---------- ---------- ---------- NET INCOME $ 696 $ 735 $ 1,369 $ 1,425 ========== ========== ========== ========== AVERAGE COMMON SHARES OUTSTANDING 4,191,735 5,404,957 4,256,977 5,570,844 BASIC EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 0.17 $ 0.14 $ 0.31 $ 0.26 Cumulative effect of adoption of SFAS 133 -- -- 0.01 -- ---------- ---------- ---------- ---------- After cumulative effect of adoption of SFAS 133 $ 0.17 $ 0.14 $ 0.32 $ 0.26 ========== ========== ========== ========== DILUTIVE POTENTIAL COMMON SHARES: Average common shares outstanding 4,191,735 5,404,957 4,256,977 5,570,844 Add: Incremental shares from assumed Conversion of Warrants 132,952 3,381 121,643 -- Incremental shares from assumed exercise of stock options 53,171 -- 39,456 -- ---------- ---------- ---------- ---------- Dilutive potential common shares 186,123 3,381 161,099 -- ---------- ---------- ---------- ---------- Adjusted weighted average shares outstanding 4,377,858 5,408,338 4,418,076 5,570,844 ========== ========== ========== ========== DILUTED EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 0.16 $ 0.14 $ 0.30 $ 0.26 Cumulative effect of adoption of SFAS 133 -- -- 0.01 -- ---------- ---------- ---------- ---------- $ 0.16 $ 0.14 $ 0.31 $ 0.26 ========== ========== ========== ==========
11. SUBSEQUENT EVENTS On July 30, 2001 a $0.20 cash dividend was declared by the Board of Directors for the quarter ended June 30, 2001 to be paid on August 21, 2001 to stockholders of record as of August 14, 2001. On June 20, 2001, the holder of a warrant notified us of its intent to exercise its right to convert its warrant into newly issued shares of our common stock in a cashless transaction. The warrant entitled the holder to purchase 299,999 shares of our common stock at an exercise price of $4.00 per share. As permitted by the cashless exercise terms of the warrant, the holder requested that we withhold 163,265 shares to pay for the exercise price in lieu of collecting the exercise price in cash. This entitled the warrant holder to receive 136,734 shares of our common stock without payment of a cash exercise price upon surrender of the warrant. We issued the holder the 136,734 shares on July 11, 2001 and cancelled the warrant. Total Stockholders Equity will increase by $546,936 as a result of this warrant exercise. On August 1, 2001, Hanover agreed to invest in a closed-end investment fund to invest in sub-performing and non-performing mortgage loans. The fund's assets will be managed by Hanover Capital Partners LTD pursuant to an asset management agreement. The fund expects to purchase, service, manage and liquidate non-performing assets in the fifty states. At the initial closing, institutional investors (including Hanover) committed a total of $18.5 million of capital to the 14 15 fund. Of the total, Hanover committed to provide $5.82 million, and institutional investors not affiliated with Hanover committed to provide the balance. On August 7, 2001, our Board of Directors authorized us to repurchase 60,000 shares of our common stock. We purchased 57,000 shares of our common stock on August 13, 2001 at $7.03 per share including expenses for a total of $400,710. As a result of the repurchase, our outstanding common stock has been reduced to 4,249,344 shares as of August 13, 2001. This repurchase does not affect Hanover's remaining authority to repurchase shares under the August 2000 Board of Directors authorization. 15 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net income decreased $39,000, or 5.3%, to $696,000 for the three months ended June 30, 2001, from $735,000 for the same period in 2000. Net income for the six months ended June 30, 2001 decreased $56,000, or 3.9%, to $1,369,000, from $1,425,000 for the same period in 2000. Net income per share increased $0.03, or 21.4%, to $0.17 per share based on 4,191,735 weighted average shares of common stock outstanding for the three months ended June 30, 2001, from $0.14 per share based on 5,404,957 weighted average common shares outstanding for the same period in 2000. Net income per share increased $0.05, or 19.2%, to $0.31 per share based on 4,256,977 weighted average shares for the six months ended June 30, 2001, from $0.26 per share based on 5,570,844 weighted average shares for the six months ended June 30, 2000. Total revenue increased $1,140,000, or 35.4%, to $4,362,000 for the first half of 2001 compared to $3,222,000 for the first half of 2000. The results for the three and six months ended June 30, 2001 included a gain on sale of mortgage assets of $728,000 and $1,853,000, respectively. There was no gain on sale in the first half of 2000. The 2001 results also include mark-to-market gains of $144,000 and $18,000 for the three and six month periods ended June 30, 2001, respectively, compared to mark-to-market gains of $316,000 and $515,000, respectively, for the comparable periods last year. In the six months ended June 30, 2001, we recorded gains from the cumulative effect of adoption of SFAS 133 of $46,000. We did not have any similar gains in 2000. Our net interest income after loan-loss provision increased $144,000 or 10.9%, to $1,470,000, or $0.35 per share, in the three months ended June 30, 2001 from $1,326,000, or $0.31 per share, for the same period in 2000. The increase resulted from an increase in the net interest spread between our assets and liabilities, as a result of (1) changes in market interest rates and (2) a shift in our asset portfolio composition from lower-yielding government agency mortgage backed securities to higher-yielding subordinate mortgage backed securities. The increase was partially offset by an increase in our provision for loan losses, which resulted from the increase in our portfolio of subordinate mortgage backed securities. We provide for reserves against possible credit losses on subordinate mortgage backed securities, but we do not provide for reserves on government agency guaranteed securities, known as "Agency" securities. For the six months ended June 30, 2001, our net interest income after loan loss provision decreased $146,000 or 5.4%, to $2,561,000, or $0.60 per share, from $2,707,000, or $0.49 per share, for the same period in 2000. The decrease resulted primarily from a reduction of our total investment portfolio and to a lesser extent from our decision to replace certain short-term financing with less volatile long-term securitization financing in the second quarter of 2000. Earnings per share for the six months ended June 30, 2001 were impacted by the decline in net income. However, this was offset by the reduction in average number of shares outstanding to 4,256,977 for the first half of 2001 from 5,570,844 for the first half of 2000. Since June 30, 2000, we have repurchased 775,910 shares of our common stock. This has reduced our total stockholder's equity to $42,642,000 at June 30, 2001 from $47,097,000 at June 30, 2000. Our loan-loss provision increased $105,000, or 106%, to $204,000 for the quarter ended June 30, 2001 from $99,000 for the quarter ended June 30, 2000, and increased $241,000, or 119%, to $443,000 for the six months ended June 30, 2001 from $202,000 for the same period last year However, our unconsolidated subsidiary, Hanover Capital Partners Ltd, or HCP, recorded $246,000 and $478,000 of loan loss provision, respectively, for the three and six months ended June 30, 2000 and none this year. HCP owned $20,676,000 of mortgage backed securities at June 30, 2000. These were transferred to the parent REIT on July 1, 2000. HCP has not owned any 16 17 mortgage backed securities during 2001. In total (combining HCP and the parent REIT), our loan loss provision declined as a result of the smaller overall investment portfolio. Our income from HCP, our consulting subsidiary, decreased $88,000 or 89.8% to $10,000 three months ended June 30, 2001 from $98,000 for the three months ended June 30, 2000. Our income from HCP decreased $199,000, or 94.3%, to $12,000 for the six months ended June 30, 2001, from $211,000 for the same period last year. However, HCP's income for the three and six months ended June 30 last year included $373,000 and $688,000, respectively, of net interest income earned on subordinate mortgage-backed securities. These securities were transferred to the parent REIT on July 1, 2000. Total revenues at HCP for the three months ended June 30,2001 declined $816,000 or 36.3% to $1,435,000 from $2,251,000 over the same period in 2000. HCP's total revenues decreased $1,333,000, or 31%, to $2,965,000 for the six months ended June 30, 2001 from $4,298,000 for the same period in 2000. Revenues from HCP's consulting and assignment businesses in the three and six months ended June 30, 2001 totaled $1,428,000 and $2,952,000 compared to revenues of $1,844,000 and $3,557,000 for the comparable periods in 2000. Most of the decline occurred in the second quarter of 2001. The second quarter of 2000 included revenues from a single large consulting assignment as well as a number of smaller assignments. Although we had many small assignments in the second quarter of 2001 we have not had a large transaction comparable to last year's. Expenses at HCP for the three months ended June 30, 2001 declined $647,000 or 31.4% to $1,415,000 compared to $2,062,000 for the same period in 2000. HCP's expenses decreased $970,000, or 24.9%, to $2,931,000 for the six months ended June 30, 2001 from $3,901,000 for the same period in 2000. HCP had fewer expenses because it had fewer assignments. A portion of the expense reduction is also attributable to the transfer of HCP's sales force in July, 2000 to its sister company HanoverTrade.com. Our loss from our investment in HanoverTrade.com, or HTC, our internet loan-trading business, increased $840,000, or 1,826%, to $886,000 for the second quarter of 2001 from $46,000 for the second quarter of 2000. This loss increased $1,496,000, or 2,168%, to $1,565,000 for the six months ended June 30, 2001 from $69,000 for the six months ended June 30, 2000. We formally launched HTC in October of 2000. HTC generated revenues of $827,000 and $1,765,000 in the first three and six months of this year, compared to operating expenses of $1,740,000 and $3,376,000. There were no revenues in the same periods last year. The largest components of operating expenses at HTC for the three and six months ended June 30, 2001 were personnel expense of $955,000 and $1,869,000, depreciation and amortization of $274,000 and $544,000 related to our investment in our proprietary web site software, and network and technology expenses of $103,000 and $219,000 related to operating our website. Operating expenses of the parent REIT decreased $179,000, or 18.7%, to $780,000 for the quarter ended June 30, 2001 from $959,000 for the quarter ended June 30, 2000. The REIT's operating expenses decreased $453,000, or 23.3%, to $1,486,000 for the six months ended June 30, 2001 from $1,939,000 for the same period last year. The biggest component of the decline was a reduction in personnel expense. Personnel expenses for the three and six month periods declined to $170,000 and $337,000 this year compared to $341,000 and $697,000 last year. The reduction in personnel expense resulted from a re-allocation of three of our most senior officers out of the REIT and into the operating subsidiaries, as a result of a shift in their responsibilities. NET INTEREST INCOME (EXPENSE) Net interest income for the three and six months ended June 30, 2001 was $1,674,000 and $3,004,000 compared to net interest income of $1,425,000 and $2,909,000 for 2000. 17 18 The following tables reflect net interest income and loan loss provision for each period (dollars in thousands):
THREE MONTHS ENDED JUNE 30 2001 2000 -------------------- -------------------- NET LOAN NET LOAN INTEREST LOSS INTEREST LOSS INCOME PROVISION INCOME PROVISION -------- --------- -------- --------- Mortgage loans $ 8 -- $ 4 -- CMO collateral 550 $ (64) 222 $(46) Agency MBS 99 -- 261 -- Subordinate MBS (excluding collateral for CMOs) 542 (140) 379 (53) Derivative MBS 236 -- 356 -- Other 239 -- 203 -- ------ ----- ------ ---- Total $1,674 $(204) $1,425 $(99) ====== ===== ====== ====
SIX MONTHS ENDED JUNE 30 2001 2000 -------------------- -------------------- NET LOAN NET LOAN INTEREST LOSS INTEREST LOSS INCOME PROVISION INCOME PROVISION -------- --------- -------- --------- Mortgage loans $ 10 -- $ 214 -- CMO collateral 774 $(134) 801 $(169) Agency MBS 230 -- 541 -- Subordinate MBS (excluding collateral for CMOs) 996 (309) 228 (33) Derivative MBS 482 -- 728 -- Other 512 -- 397 -- ------ ----- ------ ----- Total $3,004 $(443) $2,909 $(202) ====== ===== ====== =====
18 19 TAXABLE INCOME Our taxable income for the quarter ended June 30, 2001 is estimated at $834,000. Taxable income differs from GAAP net income due to various recurring and one-time book/tax differences. The following table details the significant book/tax differences in arriving at the estimated taxable income (dollars in thousands): GAAP net income $ 696 RECURRING ADJUSTMENTS: Loan loss provision 204 Realized losses on mortgage assets (19) Tax interest and amortization on mortgage assets in excess of GAAP interest and amortization (11) Gain on mark-to-market of mortgage securities, net of associated hedge (144) Gain on mark-to-market of interest rate caps not designated as hedges (10) Equity in (income) loss of unconsolidated subsidiaries Hanover Capital Partners (10) HanoverTrade.com 886 Other (30) ADJUSTMENTS RELATED TO SECOND QUARTER TRANSACTIONS: GAAP gain on sale (728) Tax gain on sale 681 Utilization of capital loss carryforward (681) ----- Estimated taxable income $ 834 ===== As a REIT, Hanover is required to pay dividends amounting to 85% of each year's taxable income by the end of each calendar year and to have declared dividends amounting to 90% of Hanover's taxable income for each year by the time Hanover files its Federal tax return. Therefore, Hanover generally passes through substantially all of its earnings to shareholders without paying Federal income tax at the corporate level. LIQUIDITY We expect to meet future short-term and long-term liquidity requirements generally from existing working capital, cash flow provided by operations, and reverse repurchase agreements. We consider our ability to generate cash to be adequate to meet operating requirements both short-term and long-term. We have short-term reverse repurchase financing in place against some of our mortgage-backed securities, known as "MBS". If a significant decline in the market value of our MBS portfolio should occur, our available liquidity from existing sources and ability to access additional sources of credit could be reduced. If this happened, we might be forced to sell investments in order to 19 20 maintain liquidity. If required, these sales might need to be made at prices lower than the carrying value of such assets, which could result in losses. We had one committed reverse repurchase agreement line of credit in place at June 30, 2001 and five uncommitted lines of credit. Our aggregate outstanding balance was $13,282,000 under all such lines of credit as of June 30, 2001. We may enter into additional committed and uncommitted lines of credit in the future. Net cash used in operating activities for the six months ended June 30, 2000 was $2,583,000. Net cash used in operating activities for the six months ended June 30, 2001 was $2,076,000 compared to net income of $1,369,000. This figure includes a net use of cash of $1,614,000 resulting from the purchase of $45,061,000 of trading securities, compared to sales of $43,447,000 of trading securities. Excluding this activity, other operations used $462,000 of cash during the six months ended June 30, 2001. The most significant use of cash during the six months ended June 30, 2001 was a net increase in loans to HanoverTrade.com of $3,266,000, partially offset by a reduction in loans to Hanover Capital Partners of $465,000, resulting in a net use of cash for loans to related parties of $2,801,000. The advances to HanoverTrade.com were used to fund HanoverTrade's ongoing operations. During the second quarter of 2001, Hanover advanced $784,000 to HTC, and $750,000 to HCP (of which HCP has since repaid $300,000). Net cash provided by investing activities amounted to $34,096,000 compared to $30,317,000 for the same period last year. The majority of cash from investing activities was generated from principal payments received on collateral for CMOs of $27,768,000, which was almost entirely offset by repayment of CMOs of $27,568,000 resulting in net principal payments to us of only $200,000 from our CMOs. We also received $1,772,000 of principal payments from mortgage securities we own. Proceeds from the sales of mortgage securities of $8,984,000 was offset by purchases of mortgage securities of $4,433,000. Net cash used in financing activities totaled $31,999,000 compared to $42,532,000 last year. Excluding the repayment of CMOs discussed above, we repaid a net $1,478,000 to our reverse repurchase lenders and used $1,695,000 to pay dividends. On April 25, 2001, we paid an aggregate of $1,335,000 to repurchase 189,900 shares of our common stock. CAPITAL RESOURCES We regularly invest our capital in mortgage backed securities through our parent REIT, which we call Hanover. Hanover has also invested in HTC, its internet-based loan trading company. From the inception of HTC in May 1999 until June 30, 2001, Hanover advanced $6,170,000 in the form of loans to HTC. We believe that HTC will continue to have significant capital needs for the remainder of 2001. We are attempting to raise outside capital to address HTC's capital budget. However, if we are unable to raise outside capital on acceptable terms, we expect to continue to advance funds from Hanover to HTC for the remainder of 2001. HTC has a limited operating history and has not been profitable to date. Although we currently expect that HTC will not need substantial capital investments after the end of 2001, there can be no assurances that HTC will generate sufficient revenues to cover its own capital costs and operating costs at that time. If future revenues are insufficient to cover such costs, HTC would require additional advances from Hanover in order to remain as a going concern. 20 21 In August of 2001 Hanover agreed to invest up to $5.82 million in exchange for a minority equity interest in a closed-end fund which is expected to invest in sub-performing and non-performing residential mortgage loans. Hanover will act as the Manager of the fund. HCP will be the Asset Manager of the fund and is entitled to a fee for such services. In addition to the potential fee income, we believe this fund offers an opportunity to earn a potential return on our capital investment. However, we cannot assure you that this fund will generate positive results for the Company. 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," should be read in conjunction with the financial statements, related notes, and other detailed information included elsewhere in this Quarterly Report on Form 10-Q. This report contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are statements other than historical information or statements of current condition. These forward-looking statements relate to our plans, objectives and expectations for future operations and growth. Other forward-looking statements in this Quarterly Report on Form 10-Q include statements regarding our ability to target and acquire mortgage loans, the anticipated availability of the master reverse repurchase agreement financing, the sufficiency of our working capital, cash flows and financing to support our future operating and capital requirements, and the necessity for and availability of additional financing; our results of operations and overall financial performance; our expected dividend distributions; our expectations regarding management fees to be earned by HCP; our expectations regarding returns on Hanover's investment in the closed-end fund; and our expected tax treatment. Such forward-looking statements relate to future events and our future financial performance and the condition of our industry and involve known and unknown risks, uncertainties and other important factors which could cause our actual results, performance or achievements to differ materially from the future results, performance or achievements expressed or implied by such forward-looking statements. In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this report should not be regarded as a representation by us or any other person that our objectives or plans will be achieved or that any of our operating expectations will be realized. Our revenues and results of operations are difficult to forecast and could differ materially from those projected in the forward-looking statements contained in this report as a result of certain risks and uncertainties including, but not limited to, our ability to integrate and manage acquired assets and personnel; management of growth; the availability and terms of additional financing; entry into new markets; our dependence on effective information-systems technology; the possible decline in our 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 default, bankruptcy and severe weather or natural disasters on the ability of borrowers to repay mortgages included in our asset pools; enforceability and collectibility of non-standard single-family mortgage loans; competition from other financial institutions, including other mortgage REITs; the performance of the new closed-end fund in which Hanover invested; proper assessment and establishment of loan-loss provisions; the continued need to fund our subsidiaries; our ability to identify and establish proper hedging mechanisms; and the possible changes in tax and other laws applicable to REITs or in our ability to maintain compliance with such rules and continue to qualify as a REIT. These factors should not be considered exhaustive; we undertake no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. 21 22 ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK During the second quarter of 2001 we used certain derivative financial instruments (for purposes other than trading) as hedges for our investment portfolio. From time to time we enter into forward sales of Agency mortgage securities to manage our exposure to changes in the value of our mortgage securities. We generally close out the hedge position when we sell the related security. At June 30, 2001 we had forward commitments to sell $4,100,000 million (par value) of Agency mortgage securities that had not yet settled. These forward sales were entered into to hedge the net interest margin between approximately $8,182,000 investment in rated subordinate mortgage-backed securities and the financing associated with these securities. The primary risk associated with selling short Agency securities relates to changes in interest rates. Generally, as market interest rates increase, the market yield of the hedged asset (fixed rate mortgage securities) will increase. The net effect of increasing interest rates will generally be a favorable or gain settlement on the forward sale of the Agency security; this gain should offset a corresponding decline in the net interest margin of the hedged assets. Conversely, if interest rates decrease, the market yield of the hedged asset will generally decrease. The net effect of decreasing interest rates will generally be an unfavorable or loss settlement on the forward sale of the Agency security; this loss should be offset by a corresponding increase in net interest margin of the hedged assets. To mitigate interest rate risk an effective matching of Agency securities with the hedged assets needs to be monitored closely. Senior management continually monitors the changes in weighted average duration and coupons of the hedged net interest margin and will appropriately adjust the amount, duration and coupon of future forward sales of Agency securities. We also enter into interest rate caps to manage our interest rate exposure on certain reverse repurchase agreement financing and floating rate CMOs. We call these cash flow hedges. The cost of these 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. Changes in the value of these interest rate caps are reflected in other comprehensive income and result in an increase or decrease in our stockholders' equity. We have one interest rate cap that we purchased as a hedge for floating rate borrowings that have since been repaid. Changes in the value of this interest rate cap are reflected in earnings. At June 30, 2001 we had the following interest rate caps in effect (dollars in thousands):
NOTIONAL AMOUNT INDEX STRIKE % MATURITY DATE --------------- ------------- -------- ------------- $11,000 3 Month LIBOR 7.695% October, 2003 50,000 1 Month LIBOR 7.25% August, 2002 25,000 1 Month LIBOR 7.75% August, 2004 ------- $86,000 =======
The primary risk associated with interest rate caps relates to interest rate increases. The interest rate caps provide a cost of funds hedge against interest rates that exceed the strike rate, subject to the limitation of the notional amount of financing. 22 23 INTEREST RATE SENSITIVITY Interest Rate Mismatch Risk - Reverse Repurchase Financing We have floating rate reverse repurchase financing for certain fixed-rate mortgage backed securities. At June 30, 2001, we had a total of $11,225,000 of floating rate reverse repurchase financing compared to a $15,792,000 investment in fixed rate mortgage-backed securities, and $2,057,000 of floating rate reverse repurchase financing against an $11,146,000 investment in retained CMO securities. We have attempted to hedge this exposure by using the rate caps and short sales of agency mortgage backed securities described above. Price Risk The market value of mortgage loans and mortgage securities will fluctuate with changes in interest rates. In the case of mortgage loans held for sale and mortgage securities available for sale or held for trading, we will be required to record changes in the market value of such assets. We generally attempt to hedge these changes through the short sale of mortgage securities, described above. Prepayment Risk Interest income on the mortgage loan and mortgage securities portfolio can also be negatively affected by prepayments on mortgage loan pools or MBS purchased at a premium and positively impacted by prepayments on mortgage loan pools or MBS purchased at a discount. We assign an anticipated prepayment speed to each mortgage pool and MBS at the time of purchase and record the appropriate amortization of the premium or discount over the estimated life of the mortgage loan pool or MBS. To the extent the actual prepayment speeds vary significantly from the anticipated prepayment speeds for an extended period of time, we will adjust the anticipated prepayment speeds and amortization of the premium or discount accordingly. This will negatively (in the case of accelerated amortization of premiums or decelerated amortization of discounts) or positively (in the case of decelerated amortization of premiums or accelerated amortization of discounts) impact net interest income. Delinquency and Default Risk Increases in delinquency rates and defaults by borrowers on their mortgages can also negatively impact our net interest income. We monitor delinquencies and defaults in our mortgage loan portfolio in three categories: government, conventional and uninsured. We adjust our loan loss provision policy and non-interest accrual policy in accordance with changes in the delinquency and default trends. Securitized Mortgage Loan Assets With respect to the match funding of assets and liabilities, the CMO collateral relating to the 1998-A, 1999-A, 1999-B and 2000-A securitizations reflect $125,942,000 investment in fixed rate mortgage loans, $58,091,000 in adjustable rate mortgage loans and $9,867,000 of mortgage securities at June 30, 2001. The primary financing for this asset category is the CMOs of $182,753,000 and to a much lesser extent repurchase agreements of $2,057,000. The repurchase financing, which is indexed to LIBOR, is subject to interest rate volatility as the repurchase agreement matures and is extended. The financing provided by the CMOs for the 1998-A, 1999-A and 2000-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, we have hedged this interest rate risk through the purchase of interest rate caps. We purchased amortizing interest rate caps with notional balances of $110 million in August 1999 to hedge the 23 24 1999-B securitization. These caps have a remaining notional balance of $75 million at June 30, 2001. Mortgage Securities At June 30, 2001 we owned fixed rate Agency and subordinate mortgage securities and interest only and principal only mortgage securities with an aggregate carrying value of $22,437,000. 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. 24 25 PART II OTHER INFORMATION Item 1. Legal Proceedings From time to time we are involved in litigation incidental to the conduct of our business. We are not currently a party to any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on the business, financial condition or results of operations. Item 2. Changes in Securities and Use of Proceeds Not Applicable Item 3. Defaults Upon Senior Securities Not Applicable Item 4. Submission of Matters to a Vote of Security Holders We held our annual meeting of stockholders on May 24, 2001. 4,322,944 shares of our common stock were outstanding and entitled to vote at the annual meeting, and 4,153,633 shares were represented at the annual meeting in person or by proxy. The following matters were voted upon at the annual meeting: (a) The following members were re-elected to our Board of Directors: Term Expiring in 2004 Votes For Votes Against Abstentions --------------------- --------- ------------- ----------- George J. Ostendorf 4,132,393 0 21,240 John N. Rees 4,128,843 0 24,790 Joseph J. Freeman 4,128,843 0 24,790 (b) The appointment of Deloitte & Touche LLP as independent auditors to audit and report on our financial statements for fiscal year 2001 was ratified by the stockholders with the following vote: Votes For Votes Against Abstentions --------- ------------- ----------- 4,141,808 8,650 3,175 There were no broker non-votes at the annual meeting. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 10.31.1 Amendment Number Three to the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000, among Hanover Capital Mortgage Holdings, Inc., Hanover Capital Partners, LTD and Greenwich Capital Financial Products, Inc. (b) Exhibit 10.35 Limited Liability Company Agreement Of HDMF-I LLC, dated as of July 11, 2001. 25 26 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. Dated: August 13, 2001 By: /s/ John A. Burchett -------------------------------------- John A. Burchett President and Chief Executive Officer Chairman of the Board of Directors Dated: August 13, 2001 By: /s/ Thomas P. Kaplan -------------------------------------- Thomas P. Kaplan Chief Financial Officer 26