UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-K

 

 

Commission file number: 001-13417

 

Hanover Capital Mortgage Holdings, Inc.

(Exact name of registrant as specified in its charter)

 

 

(732) 548-0101

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

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 þ     No o

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Ruler 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o     No þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates, based on the price at which the common equity was last sold as of June 30, 2007, was $34,324,000.

 

The registrant had 8,658,562 shares of common stock outstanding as of March 25, 2008.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days after the end of registrant’s fiscal year, are incorporated by reference into Part III.

 

 

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

 

FORM 10-K ANNUAL REPORT

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007

 

INDEX

 

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

 

Certain statements in this report, including, without limitation, matters discussed under Item 7, “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 Annual Report on Form 10-K. We are including this cautionary statement to make applicable and take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical fact are forward-looking statements. Certain of these forward-looking statements can be identified by the use of words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “estimates,” “assumes,” “may,” “should,” “will,” or other similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors, which could cause actual results, performance or achievements to differ materially from expectations. These forward-looking statements are based on our current beliefs, intentions and expectations. These statements are not guarantees or indicative of future performance. Important assumptions and other important factors that could cause actual results to differ materially from those forward-looking statements include, but are not limited to, those factors, risks and uncertainties described in Item 1A of this Annual Report on Form 10-K. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and involve inherent risks and uncertainties. The forward-looking statements contained in this report are made only as of the date hereof. We undertake no obligation to update or revise information contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

 

The Company

 

Hanover Capital Mortgage Holdings, Inc. (“We “ or the “Company”) is a specialty finance company whose principal business is to generate net interest income on its portfolio of prime mortgage loans and mortgage securities backed by prime mortgage loans on a leveraged basis. We avoid investments in sub-prime and Alt-A loans or securities collateralized by sub-prime or Alt-A loans. We leverage our purchases of mortgage securities with borrowings obtained primarily through the use of sales with agreements to repurchase the securities (“Repurchase Agreements”). Historically, the Repurchase Agreements were on a 30-day revolving basis and, for the majority of the Company’s investments, are currently under a single Repurchase Agreement for a one-year fixed term basis that expires in August 2008. We conduct our operations as a real estate investment trust, or REIT, for federal income tax purposes. We have one primary subsidiary, Hanover Capital Partners 2, Ltd. (“HCP-2”).

 

Our consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. Due to unprecedented turmoil in the mortgage and capital markets during 2007 and into 2008, we incurred a significant loss of liquidity over a short period of time. We experienced a net loss of approximately $80 million for the year ended December 31, 2007 and our current operations are not cashflow positive. In addition, upon the termination of our primary financing facility on August 9, 2008, we will have the option to repay the outstanding principal of approximately $85 million through cash or in-kind securities or surrender the portfolio to the lender without recourse. While we have sufficient cash to continue operations up to and beyond August 9, 2008, we do not have sufficient funds to repay the outstanding principal of this financing. Additional sources of capital are required for us to generate positive cashflow and continue operations beyond 2008. These events have raised substantial doubt about our ability to continue as a going concern.

 

We have taken the following actions to progress through these unprecedented market conditions:

 

 

 

Prior to 2007, mortgage industry service and technology related income was earned through two separate divisions in HCP-2, Hanover Capital Partners (“HCP”) and HanoverTrade (“HT”). Effective January 12, 2007, the assets of HCP’s due diligence business, representing substantially all of the assets of HCP, were sold to Terwin Acquisition I, LLC (now known as Edison Mortgage Decisioning Solutions, LLC) (the “Buyer”), which also assumed certain liabilities related thereto. As a result, the net assets and liabilities and results of operations of HCP have been presented as discontinued operations in the accompanying financial information and financial statements in this Form 10-K.

 

The Company’s principal executive office is located at 200 Metroplex Drive, Suite 100, Edison, NJ 08817. The Company also maintains an office at 55 Broadway, Suite 3002, New York, NY 10006. The Company is a Maryland corporation organized in 1997.

 

As further discussed under “Developments in 2007” in this section, we had several significant events and transactions during the year ended December 31, 2007.

 

REIT Operations

 

General

 

Our principal business is to generate net interest income by investing in subordinate mortgage-backed securities (“Subordinate MBS”) collateralized by pools of prime single-family mortgage loans, and purchasing prime whole single-family mortgage loans for investment, securitization and resale. Our primary strategy is to purchase the junior tranches of prime residential mortgage securitizations, which are exposed to the first credit losses of the underlying loan pool (“non-investment grade” or “first loss” tranches), and generally represent under 1% of the total principal balance of all loans in the pool. The collateral underlying the securitizations in which we invest is comprised of prime, jumbo single-family mortgage loans that are usually conforming, except for loan size.

 

The Subordinate MBS trade in the marketplace at substantial discounts to par value and, therefore, the earnings potential of these securities is much greater. By way of example, if a $1,000 series security were purchased at a 50% discount to par, or $500, the security’s stated interest rate would apply to the entire $1,000 until losses, if any, erode the principal amount. As a result, these securities provide a much higher effective return because we paid less than par to acquire the security. We believe that we have the experience, knowledge, and technical ability to actively evaluate and monitor the risks associated with these investments

and, therefore, can minimize the losses that might otherwise be incurred by a passive or less knowledgeable investor, although there is no assurance that we will be successful.

 

The following table provides an illustration of a typical securitization structure, with hypothetical amounts and identification of our primary investment focus:

 

 

We attempt to increase the earnings potential in our investments by leveraging our purchases of mortgage securities with borrowings obtained primarily through Repurchase Agreements. Historically, the borrowings under these Repurchase Agreements were on a 30-day revolving basis and were generally at 50 to 97 percent of the security’s fair market value, depending on the security, and were adjusted to market value each month as the Repurchase Agreements were re-established. On August 10, 2007, we entered into a new Master Repurchase Agreement with a single lender and repaid substantially all of our then outstanding Repurchase Agreements. This new Master Repurchase Agreement has a term of one year, is not adjusted to market value, and has a higher effective interest rate than our previous borrowings. Currently, there is limited availability of repurchase financing for our type of investments.

 

Although we have never utilized a securitization such as Collateralized Debt Obligations (“CDO’s”), we may use CDO’s or other similar securitizations as a source of funding for investments in Subordinate MBS if the capital markets improve. In such a securitization, investments in Subordinate MBS are sold to an independent securitization entity that creates securities backed by those assets, the CDO’s, and sells these newly-created securities to both domestic and international investors. Most of the securities created and sold will receive the highest credit rating of AAA, so the interest paid out is relatively low. We would expect to typically generate a profit from these securitization entities, consisting of the yield on the securitized assets less the interest payments made to the holders of the CDO securities sold. Currently, the CDO market is inactive.

 

We may purchase mortgage loans that are offered for sale in pools of loans. Often these pools of loans contain a mixture of loans that meet our investment parameters and some that do not. By using our experience, knowledge, and technology to evaluate and stratify these mortgage loans, we identify and put into a separate pool, or pools, the loans that do not meet our investment parameters. These loans are sold in the marketplace and the remaining mortgage loans, those that meet our investment parameters, are held for investment purposes.

 

Depending on market conditions and the quality of mortgage loans available for purchase in the marketplace, we may pool certain investment mortgages, mortgages that have met our investment parameters, and cause them to become collateral for a Collateralized Mortgage Obligation (“CMO”). The CMO is usually divided into several maturity classes, called series or tranches that are sold to investors and that have varying degrees of claims on any cash flows or losses on the mortgage loans held as collateral. In such securitizations, our intent is to hold or retain for investment purposes the highest risk series or tranches. The highest risk series

often are charged with losses before the other series and receive cash flows after the other series with higher priority on cash flows are paid. The investment cost in these higher risk securities are substantially discounted from the par value and, consistent with the previous example, are a potentially higher interest earning security.

 

We invest in whole-pool Fannie Mae and Freddie Mac mortgage-backed securities (“Agency MBS”). Only Agency MBS that represent an entire pool of mortgages, not just part of a pool of mortgages, are purchased. These securities are purchased when our monitoring model of limits for exemption under the Investment Company Act of 1940 (the “40 Act”) suggests that the total assets represented by qualifying real estate investments may need to be supported by additional purchases of Agency MBS. Such assets are sold when our other qualifying real estate investments are of sufficient amounts to maintain the exemptive limits. These Agency MBS are readily marketable and contain guarantees by the sponsoring agency such that credit risks are minimal.

 

We do not take deposits or raise money in any way that would subject us to consumer lending or banking regulations and we do not deal directly with consumers.

 

On August 15, 2007, we sold our entire portfolio of Agency MBS. This portfolio was held primarily to meet certain exemptive provisions of the 40 Act. The sales were necessary in order to generate some liquidity and close existing borrowing positions with lenders. On August 29, 2007, the Company separately financed the acquisition of approximately $30 million of Agency MBS with a 30-day revolving Repurchase Agreement. As a result, the Company maintained compliance with the 40 Act during the year ended December 31, 2007.

 

Revolving Repurchase Agreements — Financing

 

We finance purchases of mortgage-related assets with equity and short-term borrowings through Repurchase Agreements. Generally, upon repayment of each borrowing, the mortgage asset used to secure the borrowing will immediately be pledged to secure a new Repurchase Agreement.

 

A Repurchase Agreement, although structured as a sale and repurchase obligation, is a financing transaction in which we pledge our mortgage-related assets as collateral to secure a short-term loan. Generally, the counterparty to the agreement will lend an amount equal to a percentage of the market value of the pledged collateral, ranging from 50% to 97% depending on the credit quality, liquidity and price volatility of the collateral pledged. At the maturity of the Repurchase Agreement, we repay the loan and reclaim our collateral or enter into a new Repurchase Agreement. Under Repurchase Agreements, we retain the incidents of beneficial ownership, including the right to distributions on the collateral and the right to vote on matters as to which holders of the collateral would ordinarily vote. If we default on a payment obligation under such agreements, the lending party may liquidate the collateral.

 

To reduce our exposure to the liquidity and credit risk of Repurchase Agreements, we historically entered into these arrangements with several different counterparties. We monitor our exposure to the financial condition of the counterparty on a regular basis, including the percentage of our mortgage securities that are the subject of Repurchase Agreements with a single lender.

 

Our Repurchase Agreement borrowings bear short-term (one year or less) fixed interest rates indexed to the one-month London Interbank Offered Rate Index (“LIBOR”), plus a margin ranging from 0 to 200 basis points depending on the overall quality of the mortgage-related assets. Generally, the Repurchase Agreements require us to deposit additional collateral or reduce the amount of borrowings in the event the market value of existing collateral declines, which, in dramatically rising interest-rate markets, could require us to repay a significant portion of the borrowings, pledge additional collateral to the loan, or sell assets to reduce the borrowings. We attempt to minimize the impact of these severities by the use of the capital allocation guidelines discussed below.

 

See “Capital Allocation Guidelines (CAG) — Liquidity Policy” and “Developments in 2007” in this section for additional information.

 

Currently, there is limited availability of repurchase financing for our type of investments.

Fixed Term Repurchase Agreements — Financing

 

On August 10, 2007, we entered into a Master Repurchase Agreement and related Annex I thereto (as amended on October 3, 2007 and November 13, 2007) with RCG PB, Ltd, an affiliate of Ramius Capital Group, LLC (“Ramius”), in connection with a repurchase transaction with respect to our Subordinate MBS (the “Repurchase Transaction”). The purchase price of the securities in the Repurchase Transaction was $80,932,928. The fixed term of the Repurchase Transaction is one (1) year and contains no margin or call features. The Repurchase Transaction replaced substantially all of the our then outstanding Repurchase Agreements, both committed and non-committed, which previously financed our Subordinate MBS.

 

Pursuant to the Repurchase Transaction, we are required to pay interest monthly at the annual rate of approximately 12%. Other consideration includes all principal payments received on the underlying mortgage securities during the term of the Repurchase Transaction, a premium payment at the termination of the Repurchase Transaction and the issuance of 600,000 shares of our common stock (equal to approximately 7.4% of our outstanding equity).

 

Investment Management

 

We believe that our portfolio management processes are influenced by four primary investment risks associated with the types of investments we make: credit risk (including counterparty risk), interest rate risk, prepayment risk and liquidity risk. In order to maximize our net interest income, we believe we have developed an effective asset/liability management program to provide a level of protection against the costs of credit, interest rate, prepayment and liquidity risks, however, no strategy can completely insulate us from these risks.

 

Credit Risk Management

 

We define credit risk as the risk that a borrower or issuer of a mortgage loan may not make the scheduled principal and interest payments required under the loan or a sponsor or servicer of the loan or mortgage security will not perform. We attempt to reduce our exposure to credit risk on our mortgage assets by:

 

 

We do not set specific geographic diversification requirements, although we do monitor the geographic dispersion of the mortgage assets to make decisions about adding to or reducing specific concentrations. Concentration in any one geographic area will increase our exposure to the economic and natural hazard risks associated with that area.

 

When we purchase mortgage loans, the credit underwriting process varies depending on the pool characteristics, including loan seasoning or age, loan-to-value ratios, payment histories and counterparty representations and warranties. For a new pool of single-family mortgage loans, a due diligence review is undertaken, including a review of the documentation, appraisal reports and credit underwriting. Where required, an updated property valuation is obtained.

 

We attempt to reduce counterparty risk by periodically evaluating the credit worthiness of sellers, servicers, and sponsors of prime Subordinate MBS and mortgage loans.

 

Interest Rate Risk Management

 

Interest rate risk is the risk of changing interest rates in the market place. Rising interest rates may both decrease the market value of the portfolio and increase the cost of Repurchase Agreement financing. Management of these risks varies depending on the asset class. In general, we attempt to minimize the effect

of rising interest rates through asset re-allocation between fixed and variable rate securities, the use of interest rate caps and forward sales of Agency MBS.

 

Subordinate MBS — Our Subordinate MBS portfolio consists of both fixed-rate and adjustable-rate securities. We manage effects of rising interest rates on the financing of our Subordinate MBS portfolio through the purchase of long-term, out-of-the-money, interest rate caps indexed to one-month LIBOR. Increases in one-month LIBOR will decrease our net interest spread until one-month LIBOR reaches the cap strike rate. Once one-month LIBOR is at or above the cap rate, the cap will pay us, on a monthly basis, the difference between the current one-month LIBOR rate and the cap strike rate.

 

Although there is an offsetting correlation to the change in the value of the one-month LIBOR caps to the change in the value of the Subordinate MBS as interest rates increase, it is not 100 percent effective. Additionally, because our interest rate caps are treated as freestanding derivatives, the changes in the value of the interest rate caps flow through our income statement while changes in the value of the asset may be reflected as Other Comprehensive Income, to the extent such Subordinate MBS have been classified as available for sale securities and any declines in value are not considered other-than temporary.

 

Although we do not currently do so, we may use designated hedges such that the derivatives used will qualify for “hedge accounting” under the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 133. To receive such treatment requires extensive management and documentation, but the costs associated with such processes may be justified compared to the mark to market consequences of not qualifying under SFAS 133 as occurs with our use of freestanding derivatives (e.g. interest rate caps) as discussed above. Under SFAS No. 133, we would use qualifying hedges to meet strategic economic objectives, while maintaining adequate liquidity and flexibility, by managing interest rate risk mitigation strategies that should result in a lesser amount of earnings volatility under GAAP as occurs when using freestanding derivatives.

 

A rise in interest rates may also decrease the market value of the Subordinate MBS and thereby cause financing firms to require additional collateral. The unforeseen or under anticipated need to meet additional collateral requirements is known as “margin risk”. We manage margin risk with our liquidity policy, whereby a percentage of the financed amount is held in cash or cash equivalents or other readily marketable assets. See “Capital Allocation Guidelines (CAG) — Liquidity Policy” and “Developments in 2007” in this section for additional information.

 

Mortgage Loans — Our mortgage loan investments consist of both fixed-rate and adjustable-rate mortgage loans. Rising interest rates may both decrease the market value of the mortgage loans and increase the cost of Repurchase Agreement financing.

 

A rise in interest rates may cause a decrease in the market value of the mortgage loans and thereby may cause financing firms to require additional collateral. We manage the unforeseen or under anticipated need to meet additional collateral requirements with our liquidity policy, whereby a percentage of the financed amount is held in cash or cash equivalents or other readily marketable assets. See “Capital Allocation Guidelines (CAG) — Liquidity Policy” and “Developments in 2007” in this section for additional information.

 

A pool or pools of mortgage loans may reach a size where hedging our borrowing rates that finance our mortgage loan purchases may be prudent in order to avoid the increased interest expense associated with rising interest rates. In such circumstances, although we do not currently do so, we may use designated hedges such that the derivatives used will qualify for “hedge accounting” under SFAS 133. To receive such treatment requires extensive detail management and documentation but the costs associated with such processes may be justified compared to the mark to market consequences of not qualifying under SFAS 133 as occurs with our Subordinate MBS and the use of freestanding derivatives as discussed above.

 

Agency MBS — Our Agency MBS portfolio consists solely of fixed-rate securities. We enter into forward commitments to sell a similar amount of Agency MBS with the same coupon rates on a to be announced basis, “TBA”. This is an economic hedging strategy and therefore cannot insulate us completely from interest rate risks.

In addition, economic hedging involves transaction and other costs which can increase, sometimes dramatically, as the period covered by the economic hedge increases. As a result, these hedging activities may significantly reduce our net interest income on Agency MBS.

 

Prepayment Risk Management

 

Prepayment risk is the risk that homeowners will pay more than their required monthly mortgage payments including payoff of mortgages. As prepayments occur, the amount of principal retained in the security declines faster than what may have been expected, thereby shortening the average life of the security by returning principal prematurely to the holder, potentially at a time when interest rates are low, as prepayment is usually associated with declining interest rates. Prepayments could cause losses if we paid a premium for the security. We monitor prepayment risk through periodic reviews of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.

 

Capital Allocation Guidelines (CAG) — Liquidity Policy

 

We have capital allocation guidelines (“CAG”) to strike a balance in our ratio of debt to equity. Modifications to the CAG require the approval of a majority of the members of our Board of Directors. The CAG establishes a liquidity requirement and leverage criteria for each class of investment which is intended to keep our leverage balanced by:

 

 

Each quarter, we subtract the face amount of the financing used for the securities from the current market value of the mortgage assets to obtain our current equity positions. We then compare this value to the required capital as determined by our CAG. Management is required to maintain the guidelines established in the CAG and adjust the portfolio accordingly.

 

With approval of the Board of Directors, management may change the CAG criteria for a class of investments or for an individual investment based on its prepayment and credit performance relative to the market and our ability to predict or economically hedge the risk of the investments.

 

As a result of these procedures, the leverage of our balance sheet will change with the performance of our investments. Good credit or prepayment performance may release equity for purchases of additional investments. Poor credit or prepayment performance may cause additional equity to be allocated to existing investments, forcing a reduction in investments on the balance sheet. In either case, the periodic performance evaluation, along with the corresponding leverage adjustments, is intended to maintain an appropriate level of leverage and reduce the risk to our capital base.

 

As further discussed under “Developments in 2007” in this section, the estimated market values of our Subordinate MBS severely declined during 2007. Our CAG did not fully anticipate such a severe disruption in the market. We did not have sufficient cash or capital in our Subordinate MBS portfolio given the severity and quickness of the declines in the value of the portfolio. As a result, we entered into the Repurchase Transaction in August 2007 to mitigate the impact of these events.

 

Non-Core Business and Elimination of Segment Report

 

In line with our strategy to focus on our portfolio operations, we reduced the technology and loan sale advisory (“LSA”) operations that were conducted through HT in 2006, and completed the sale of our due diligence operations in 2007.

 

HT currently earns revenues from two existing customer contracts through its technology operations. Previously, HT marketed its web-based proprietary software applications to meet specific needs of the mortgage industry in the secure transmission, analysis, valuation, tracking and stratification of loan portfolios. It earned licensing and related servicing fees from its proprietary software applications to government agencies and financial institutions involved in trading and/or originating residential mortgage loans. Through its

Servicing Source division, which was sold in December 2006, HT also licensed and used applications to provide financial management of mortgage servicing rights including mark to market valuation, impairment testing, and credit and prepayment analysis to clients. HT no longer actively markets its technology to new clients.

 

The LSA operation provided brokerage, asset valuation and consulting services. The brokerage service integrated varying degrees of traditional voice brokerage conducted primarily by telephone, web-enhanced brokerage and online auction hosting. The LSA operation also performed market price valuations for a variety of loan portfolios and offered consulting advice on marketing strategies for those portfolios. The LSA operation was suspended in May 2006.

 

HCP, which was sold effective January 12, 2007, provided services to commercial banks, mortgage banks, government agencies, credit unions and insurance companies. The services provided included: loan due diligence (credit and compliance) on a full range of mortgage products, quality control reviews of newly originated mortgage loans, operational reviews of loan origination and servicing operations, mortgage assignment services, loan collateral reviews, loan document rectification, and temporary staffing services. The delivery of the HCP consulting and outsourcing services usually required an analysis of a block or pool of loans on a loan-by-loan basis. This required the use of technology developed and owned by HCP and operated by employees highly specialized and trained by HCP.

 

For the year ended December 31, 2006 and prior periods, the Company reported results of operations for three segments: REIT operations, HCP and HT. As a result of the sale of HCP and the significant decrease in the operations of HT in 2006 and the beginning of 2007, the Company now has only one segment.

 

Developments in 2007

 

Decline in Subordinate MBS Portfolio Valuation

 

As a result of the increase in the credit spreads and decreases in liquidity and the overall uncertainties in the mortgage industry during 2007, the estimated market values for our Subordinate MBS have severely decreased.

 

Although we do not invest in subprime or Alt-A mortgages or mortgage-backed securities collateralized by subprime or Alt-A mortgages, we have been negatively impacted by the general decline in the market value of all residential mortgage assets due to the significant losses in the subprime sector of the residential mortgage industry that began to occur in the first half of 2007 and have progressively worsened. The losses seem to be due to underwriting deficiencies, increases in interest rates on adjustable rate mortgages, and declining housing prices. These losses and the corresponding fervor of information reported through the media have caused the credit spreads (yield for credit risk) to increase for the industry as a whole and have caused overall investor demand for mortgage-backed securities to decrease.

 

The lower estimated fair values of our portfolio and the recent turmoil in the mortgage markets related to quality issues of loans in the subprime mortgage and mortgage securities markets negatively impacted the amounts at which we were able to borrow to finance our portfolio of securities collateralized by prime mortgages. This spill-over effect caused a reduction in the amount we were able to borrow to finance our portfolio. As lenders used the declining market prices to value the securities financed, we were required to reduce with cash the amounts we borrowed. In some cases, lenders called for deposits of cash (“margin calls”) after an evaluation of recent fair value changes and before the maturity date of our Repurchase Agreement with them, which was usually 30 days from the origination or last roll.

 

Through August 9, 2007, our lenders regularly required us to repay a portion of amounts borrowed under our Repurchase Agreements. Although no lender terminated its Repurchase Agreement with us during the period prior to August 9, 2007, these repayments were a significant drain on our available cash. The increasing frequency and amount of required repayments in the period immediately prior to August 9, 2007 posed a threat to our ability to maintain our portfolio of Subordinate MBS. In response to these deteriorating market conditions, on August 10, 2007, we entered into a one-year fixed-rate financing facility for the full amount of the then outstanding Repurchase Agreement balances of approximately $81 million and we repaid substantially

all of our then outstanding Repurchase Agreements (see “Liquidity and Capital Resources” in Item 7 in this Form 10-K).

 

For the year ended December 31, 2007, we incurred approximately $1,970,000 of actual passed through losses on the underlying mortgage loans in our Subordinate MBS portfolio. Although we have seen increases in the level of losses for the year ended December 31, 2007, compared to our historical experience, these losses are within the corresponding reserve. Our Subordinate MBS are purchased at a discount to par value, and a portion of this discount is an implied reserve for losses on the underlying mortgage loans. To the extent the timing and amount of actual losses approximate or are less than the implied losses in the purchase discount, there will not be a reduction in estimated cash flows or yield, and the long-term economic value of the bonds will not be impaired.

 

As described above, the decline in the estimated fair value of our portfolio has been significantly impacted by industry factors not directly attributable to the prime mortgage-backed securities in which we invest. Although we believe that the markets will eventually stabilize and return to ratios we have traditionally experienced, the turmoil in the industry appears to be much greater than the normal cyclical swings. We are unable to predict when a recovery will occur and the level of the recovery. In addition, we may not have sufficient funds to retire or refinance the outstanding principal under the Repurchase Transaction upon termination of that financing on August 9, 2008 and may be required to sell securities to settle the outstanding principal, which could be before a full recovery of the market has occurred. As a result, we determined the decline in the fair value of our Subordinate MBS portfolio was other than temporary and recorded impairment expense of $73.6 million for the year-ended December 31, 2007. This amount represents the difference between the adjusted cost basis and the estimated fair value at the date of the adjustments, determined on a security by security basis.

 

Financing Agreement

 

On August 10, 2007, we entered into a one-year Master Repurchase Agreement and related Annex I thereto (as amended on October 3, 2007 and November 13, 2007) with Ramius, in connection with a repurchase transaction with respect to our portfolio of Subordinate MBS. At the termination of the agreement on August 9, 2008, we are required to repay the outstanding principal through cash or in-kind securities.

 

Reduction in Agency MBS Portfolio

 

On August 15, 2007, we sold our entire portfolio of Agency MBS. This portfolio was held primarily to meet certain exemptive provisions of the 40 Act. The sales were necessary in order to generate some liquidity and close existing borrowing positions with lenders. On August 29, 2007, we separately financed the acquisition of approximately $30 million of Agency MBS with a 30-day revolving Repurchase Agreement.

 

Decline in Other Subordinate Security Valuation

 

Although we have no plans or intentions to sell our other subordinate security, there is uncertainty regarding our ability to continue operations beyond 2008 and, therefore, there is uncertainty regarding our ability to hold this security until either the maturity of the security or the recovery of the estimated fair value occurs. As a result, as of December 31, 2007, we re-assessed the classification of this security and determined the classification should be changed from held-to-maturity to available-for-sale. The estimated fair value of this security has declined during the year ended December 31, 2007. The decline in the estimated fair value of this security is primarily due to increases in credit spreads and not from increases in the underlying credit performance of the security. We are unable to predict when a recovery of the estimated fair value will occur. As a result, as of December 31, 2007, we considered the gross unrealized loss for our other subordinate security to be an other-than-temporary impairment. We recorded the difference between the adjusted cost basis and the estimated fair value of the security as of December 31, 2007 as impairment expense for the year then ended.

Sale of HCP

 

On January 16, 2007, we completed the sale of our due diligence business to Buyer. The transaction became effective on the Effective Date of January 12, 2007. The sale was affected through the sale of certain assets and assumption of certain liabilities of HCP-2. We are no longer in the business of providing due diligence services to the financial services industry and governmental agencies.

 

We will continue to utilize the name Hanover Capital Partners 2, Ltd., and plan to continue to perform certain financial and technology functions and other services through this entity.

 

Sale of Pedestal

 

In October 2007, we sold our wholly owned subsidiary Pedestal Capital Markets, Inc. (“Pedestal”), a registered broker/dealer, to Bonds.com Holdings, Inc., for approximately $92,000. We recognized a loss of approximately $41,000 on this sale. Pedestal was one of two wholly owned broker/dealers.

 

Regulation

 

Hanover Capital Securities, Inc. (“HCS”) is a broker/dealer registered with the Securities and Exchange Commission (“SEC”) and is a member of the National Association of Securities Dealers, Inc.

 

Competition

 

We compete with a variety of institutional investors for the acquisition of mortgage-related assets. These investors include other REITs, investment banking firms, savings banks, savings and loan associations, insurance companies, mutual funds, pension funds, banks and other financial institutions that invest in mortgage-related assets and other investment assets. Many of these investors have greater financial resources and access to lower costs of capital than we do. While there is generally a broad supply of liquid mortgage securities for companies like us to purchase, we cannot provide assurances that we will always be successful in acquiring mortgage-related assets that we deem most suitable for us, because of the number of other investors competing for the purchase of these securities.

 

Employees

 

As of December 31, 2007, we had 17 full-time employees. To date, we believe we have been successful in our efforts to recruit and retain qualified employees, but there is no assurance that we will continue to be successful in the future. None of our employees is subject to collective bargaining agreements.

 

Trademarks

 

We own four trademarks that have been registered with the United States Patent and Trademark Office which expire in September 2013, May 2014, June 2014 and September 2014, respectively.

 

Federal Income Tax Considerations

 

General

 

We have elected to be treated as a REIT for Federal income tax purposes, pursuant to the Internal Revenue Code of 1986, as amended (the “Code”). In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be taxed as corporations are, with certain limited exceptions, not taxed at the corporate level on their taxable income that is currently distributed to their shareholders. This treatment eliminates most of the “double taxation” (at the corporate level and then again at the shareholder level when the income is distributed) that typically results from the use of corporate investment vehicles. In the event that we do not qualify as a REIT in any year, we would be subject to Federal income tax as a domestic corporation and the amount of our after-tax cash available for distribution to our shareholders would be reduced. We believe we have satisfied the requirements for qualification as a REIT since commencement of our operations

in September 1997. We intend at all times to continue to comply with the requirements for qualification as a REIT under the Code, as described below. At any time, the Federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations thereof may take effect retroactively and could adversely affect us or our shareholders. Congress enacted legislation that went into effect on January 1, 2003 and reduced the Federal tax rate on both qualified dividend income and long-term capital gains for individuals to 15% through 2010. Because REITs generally are not subject to corporate income tax, this reduced tax rate does not generally apply to ordinary REIT dividends, which continue to be taxed at the higher tax rates applicable to ordinary income. The 15% tax rate applies to:

 

1. long-term capital gains recognized on the disposition of REIT shares;

 

2. REIT capital gain distributions and a shareholder’s share of a REIT’s undistributed net capital gains (except, in either case, to the extent attributable to real estate depreciation, in which case such distributions will be subject to a 25% tax rate);

 

3. REIT dividends attributable to dividends received by a REIT from non-REIT corporations, such as taxable REIT subsidiaries; and

 

4. REIT dividends attributable to income that was subject to corporate income tax at the REIT level (i.e., to the extent that a REIT distributes less than 100% of its taxable income).

 

Requirements for Qualification as a REIT

 

To qualify for income tax treatment as a REIT under the Code, we must meet certain tests which are described briefly below. We believe that we satisfy all of the requirements to remain qualified as a REIT.

 

Ownership of Common Stock

 

For all taxable years after our first taxable year, our shares of capital stock must be held by a minimum of 100 persons for at least 335 days of a 12-month year (or a proportionate part of a short tax year). In addition, at any time during the second half of each taxable year, no more than 50% in value of our capital stock may be owned directly or indirectly by five or fewer individuals, taking into account complex attribution of ownership rules. We are required to maintain records regarding the actual and constructive ownership of our shares, and other information, and to demand statements from persons owning above a certain level of our shares regarding their ownership of shares. We must keep a list of those shareholders who fail to reply to such a demand. We are required to use (and do use) the calendar year as our taxable year for income tax reporting purposes.

 

Nature of Assets

 

On the last day of each calendar quarter, we must satisfy three tests relating to the nature of our assets. First, at least 75% of the value of our assets must consist of real estate mortgage loans, certain interests in real estate mortgage loans, real estate, certain interests in real estate, shares (or transferable certificates of beneficial interest) in other REITs, government securities, cash and cash items (“Qualified REIT Assets”). We expect that substantially all of our assets will continue to be Qualified REIT Assets. Second, not more than 25% of our assets may consist of securities that are not Qualified REIT Assets. Third, except as noted below, investments in securities that are not Qualified REIT Assets are further limited as follows:

 

(i) not more than 20% of the value of our total assets can be represented by securities of one or more Taxable REIT Subsidiaries (as defined below),

 

(ii) the value of any one issuer’s securities may not exceed 5% by value of our total assets,

 

(iii) we may not own securities possessing more than 10% of the total voting power of any one issuer’s outstanding voting securities, and

 

(iv) we may not own securities having a value of more than 10% of the total value of any one issuer’s outstanding securities.

Clauses (ii), (iii) and (iv) of the third asset test do not apply to securities of a Taxable REIT Subsidiary. A “Taxable REIT Subsidiary” is any corporation in which a REIT owns stock, directly or indirectly, if the REIT and such corporation jointly elect to treat such corporation as a Taxable REIT Subsidiary. The amount of debt and rental payments from a Taxable REIT Subsidiary to a REIT are limited to ensure that a Taxable REIT Subsidiary is subject to an appropriate level of corporate tax.

 

In 2003, Congress enacted legislation under which, in certain circumstances, we may be able to avoid being disqualified as a REIT as a result of a failure to satisfy one or more of the foregoing asset tests provided that we satisfy certain conditions including, in some cases, the payment of an amount equal to the greater of $50,000 or an amount bearing a certain relationship to the particular violation. Notwithstanding the legislation, pursuant to our compliance guidelines, we intend to monitor closely the purchase and holding of our assets in order to comply with the foregoing asset tests.

 

Sources of Income

 

We must meet the following two separate income-based tests each year:

 

75% income test

 

At least 75% of our gross income for the taxable year must be derived from certain real estate sources including interest on obligations secured by mortgages on real property or interests in real property. Certain temporary investment income will also qualify under the 75% income test. The investments that we have made and expect to continue to make will give rise primarily to mortgage interest qualifying under the 75% income test.

 

95% income test

 

In addition to deriving 75% of our gross income from the sources listed above, at least an additional 20% of our gross income for the taxable year must be derived from those sources, or from dividends, interest or gains from the sale or disposition of stock or other securities that are not dealer property. We intend to limit substantially all of the assets that we acquire to assets that can be expected to produce income that qualifies under the 75% Income Test. Our policy to maintain REIT status may limit the types of assets, including hedging contracts and other securities, that we otherwise might acquire.

 

Distributions

 

We must distribute to our shareholders on a pro rata basis each year an amount equal to at least;

 

(i) 90% of our taxable income before deduction of dividends paid and excluding net capital gains, plus

 

(ii) 90% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code, less

 

(iii) certain “excess noncash income.”

 

We intend to make distributions to our shareholders in sufficient amounts to meet this 90% distribution requirement.

 

If we fail to distribute to our shareholders with respect to each calendar year at least the sum of;

 

(i) 85% of our REIT ordinary income of the year,

 

(ii) 95% of our REIT capital gain net income for the year, and

 

(iii) any undistributed taxable income from prior years,

 

we will be subject to a 4% excise tax on the excess of the required distribution over the amounts actually distributed.

State Income Taxation

 

We file corporate income tax returns in various states. These states treat the income of a REIT in a similar manner as for Federal income tax purposes. Certain state income tax laws with respect to REITs are not necessarily the same as Federal law. Thus, differences in state income taxation as compared to Federal income taxation may exist in the future.

 

Taxation of the Company’s Shareholders

 

For any taxable year in which we are treated as a REIT for Federal income tax purposes, amounts distributed by us to our shareholders out of current or accumulated earnings and profits will be includable by the shareholders as ordinary income for Federal income tax purposes unless properly designated by us as capital gain dividends. Dividends declared during the last quarter of a calendar year and actually paid during January of the immediately following calendar year are generally treated as if received by the shareholders on December 31 of the calendar year during which they were declared. Our dividend distributions will not generally be qualified dividend income eligible for the 15% maximum rate applicable to such income received by individuals during the period 2003 through 2008. Our distributions will not be eligible for the dividends received deduction for corporations. Shareholders may not deduct any of our net operating losses or capital losses. If we designate one or more dividends, or parts thereof, as a capital gain dividend in a written notice to the shareholders, the shareholders shall treat as long-term capital gain the lesser of (i) the aggregate amount so designated for the taxable year or (ii) our net capital gain for the taxable year. Each shareholder will include in his long-term capital gains for the taxable year such amount of our undistributed as well as distributed net capital gain, if any, for the taxable year as is designated by us in a written notice. We will be subject to a corporate level tax on such undistributed gain and the shareholder will be deemed to have paid as an income tax for the taxable year his distributive share of the tax paid by us on the undistributed gain.

 

Any loss on the sale or exchange of shares of our common stock held by a shareholder for six months or less will be treated as a long-term capital loss to the extent of any capital gain dividends received (or undistributed capital gain included) with respect to the common stock held by such shareholder.

 

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

 

In general, dividend income that a tax-exempt entity receives from us should not constitute unrelated business taxable income, or “UBTI”, as defined in Section 512 of the Code. If, however, we realize certain excess inclusion income and allocate it to stockholders, a stockholder cannot offset such income by net operating losses and, if the stockholder is a tax-exempt entity, then such income would be fully taxable as UBTI under Section 512 of the Code. If the stockholder is foreign, then it would be subject to Federal income tax withholding on such excess inclusion income without reduction pursuant to any otherwise applicable income tax treaty. Excess inclusion income would be generated if we were to issue debt obligations with two or more maturities and the terms of the payments on these obligations bore a relationship to the payments received on the mortgage related assets securing those debt obligations. Our borrowing arrangements are generally structured in a manner designed to avoid generating significant amounts of excess inclusion income. We do, however, enter into various Repurchase Agreements that have differing maturity dates and afford the lender the right to sell any pledged mortgage securities upon default. The IRS may determine that these borrowings give rise to excess inclusion income that should be allocated among stockholders. Furthermore, some types of tax-exempt entities, including, without limitation, voluntary employee benefit associations and entities that have borrowed funds to acquire their shares of our common stock, may be required to treat a portion or all of the dividends they may receive from us as UBTI. We believe that our shares of stock will be treated as publicly offered securities under the plan asset rules of the Employment Retirement Income Security Act

(“ERISA”) for Qualified Plans. However, in the future, we may hold REMIC residual interests that would give rise to UBTI for pension plans and other tax exempt entities.

 

Errors have been made in the reporting of tax components of distributions to our shareholders for each year in the five year period ended 2006. The errors relate to the change in estimates used in computation of our tax earnings and profits for those years and had the effect of misstating the return of capital component of our distributions and correspondingly the dividend income component. In order to address the incorrect reporting of these distributions, corrected Forms 1099-DIV have been or will be sent to our shareholders as considered appropriate. The IRS can assess penalties against us for delivering inaccurate Forms 1099-DIV, ranging from $50 to $100 for each incorrect Form 1099-DIV sent to shareholders. However, the IRS can also waive any penalty upon a showing by us that the error was due to reasonable cause and not willful neglect. The imposition by the IRS of penalties to which the inaccurate Forms 1099-DIV may be subject could adversely affect the results of operations.

 

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

 

Available Information

 

The Company makes available on its website, www.hanovercapitalholdings.com, at no cost, electronic filings with the SEC including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, other documents and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after they are electronically filed. In addition, through the same link, the Company makes available certain of its Corporate Governance documents including the Audit Committee Charter, Compensation Committee Charter, Nominating Committee Charter, Code of Conduct and Business Ethics, and the Code of Ethics for Principal Executive and Senior Financial Officers. Information on our website is not incorporated by reference into this report.

 

 

Risks Related to Our Business

 

Mortgage-related assets are subject to risks, including borrower defaults or bankruptcies, special hazard losses, declines in real estate values, delinquencies and fraud.

 

During the time we hold mortgage related assets we are subject to the risks on the underlying mortgage loans from borrower defaults and bankruptcies and from special hazard losses, such as those occurring from earthquakes or floods that are not covered by standard hazard insurance. If a default occurs on any mortgage loan we hold, or on any mortgage loan collateralizing mortgage-backed securities we own, we may bear the risk of loss of principal to the extent of any deficiency between the value of the mortgaged property plus any payments from any insurer or guarantor, and the amount owing on the mortgage loan. Defaults on mortgage loans historically coincide with declines in real estate values, which are difficult to anticipate and may be dependent on local economic conditions. Increased exposure to losses on mortgage loans can reduce the value of our investments. In addition, mortgage loans in default are generally not eligible collateral under our usual borrowing facilities and may have to be funded by us until liquidated.

 

In addition, if borrowers are delinquent in making payments on the mortgage loans underlying our mortgage-related assets, or if the mortgage loans are unenforceable due to fraud or otherwise, we might not be able to recoup the entire investment in such assets.

 

Nationwide declines in housing prices have already occurred during 2007 and appear to be continuing into 2008. In addition, delinquencies on the mortgage loans that collateralize our Subordinate MBS have increased during 2007 and appear to be increasing in 2008. These negative trends could further reduce the value of our securities and our interest income and cashflow from these securities.

Deteriorating debt and secondary mortgage market conditions have had and may continue to have a material adverse impact on our earnings and financial condition.

 

Beginning in the second quarter of 2007 the mortgage industry and the residential housing market was adversely affected as home prices declined and delinquencies increased, particularly in the sub-prime mortgage industry. The difficulty that arose as a result of this has spread across various mortgage sectors, including the market in which we operate. We have significant financing needs that we meet through the capital markets, including the debt and secondary mortgage markets. These markets are currently experiencing unprecedented disruptions, which have had and continue to have an adverse impact on the Company’s earnings and financial condition, particularly in the short term.

 

Current conditions in the debt markets include reduced liquidity and increased credit risk premiums for certain market participants. These conditions, which increase the cost and reduce the availability of debt, may continue or worsen in the future. In August 2007, we entered into a Master Repurchase Agreement with Ramius, through which we obtained adequate committed facilities which has assisted us in mitigating the impact of the debt market disruptions. However, the Master Repurchase Agreement expires on August 9, 2008, and there can be no assurances that we will be able to renew this facility, or obtain replacement financing if we cannot renew this facility. If overall market conditions continue to deteriorate and result in further substantial declines in the value of the assets which we use to collateralize our secured borrowing arrangements, sufficient capital may not be available to support the continued ownership of our investments, requiring certain assets to be sold at a loss.

 

The secondary mortgage markets are also currently experiencing unprecedented disruptions resulting from reduced investor demand for mortgage loans and mortgage-backed securities and increased investor yield requirements for those loans and securities. These conditions may continue or worsen in the future and have had, and continue to have, an adverse impact on our earnings and financial condition.

 

Our current financial condition and negative cashflows from operations have raised substantial doubt about our ability to continue as a going concern

 

Due to unprecedented turmoil in the mortgage and capital markets during 2007 and into 2008, we incurred a significant loss of liquidity over a short period of time. We experienced a net loss of approximately $80 million for the year ended December 31, 2007 and our current operations are not cashflow positive. In addition, upon the termination of our primary financing facility on August 9, 2008, we will have the option to repay the outstanding principal of approximately $85 million through cash or in-kind securities or surrender the portfolio to the lender without recourse. While we have sufficient cash to continue operations up to and beyond August 9, 2008, we do not have sufficient funds to repay the outstanding principal of this financing. Additional sources of capital are required for us to generate positive cashflow and continue operations beyond 2008. These events have raised substantial doubt about our ability to continue as a going concern.

 

We are currently seeking additional capital and are utilizing an investment advisor for this purpose. Although no formal agreements have been reached, we are in discussion with several potential investors. While companies with similar investment strategies to ours have recently raised significant capital in the public and private markets, there can be no assurance that we will be able to do so or, if we can, what the terms of any such financing would be.

 

We may be unable to renew our borrowings at favorable rates or maintain longer-term financing, which may affect our profitability.

 

Our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings or to refinance such borrowings with longer-term financings. If we are not able to renew or replace maturing borrowings, or obtain longer-term financing, we would have to sell some or all of our assets, possibly under adverse market conditions. In addition, the failure to renew or replace borrowings that mature, or obtain longer-term financing, may require us to terminate hedge positions, which could result in further losses. Any number of these factors in combination may cause difficulties for us,

including a possible liquidation of a major portion of our portfolio at possibly disadvantageous prices with consequent losses, which could render us insolvent.

 

In particular, on August 10, 2007, we entered into a Master Repurchase Agreement with Ramius with respect to our portfolio of subordinate mortgage-backed securities. The initial purchase price of the securities in the repurchase transaction was $80,932,928. The Master Repurchase Agreement expires on August 9, 2008, at which time we are required to repay the outstanding principal through cash or in-kind securities or surrender the portfolio to the lender without recourse. If we are unable to either extend the Master Repurchase Agreement or replace it, there could be a significant impact on our ability to operate our business.

 

Our profitability depends on the availability and prices of mortgage assets that meet our investment criteria.

 

The availability of mortgage assets that meet our criteria depends on, among other things, the size and level of activity in the real estate lending markets. The size and level of activity in these markets, in turn, depends on the level of interest rates, regional and national economic conditions, appreciation or decline in property values and the general regulatory and tax environment as it relates to mortgage lending. In addition, we expect to compete for these investments with other REITs, investment banking firms, savings banks, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-related assets, many of which have greater financial resources than we do. If we cannot obtain sufficient mortgage loans or mortgage securities that meet our criteria, at favorable yields, our business will be adversely affected.

 

We are subject to various obligations related to our use of, and dependence on, debt.

 

If we violate covenants in any debt agreements, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on attractive terms, if at all. Violations of certain debt covenants may result in our being unable to borrow unused amounts under a line of credit, even if repayment of some or all borrowings is not required.

 

A violation under one debt agreement may also trigger defaults in other debt agreements requiring repayments or imposing further restrictions. This could force us to sell portions of our portfolio at a time when losses could result. In any event, financial covenants under our current or future debt obligations could impair our planned business strategies by limiting our ability to borrow.

 

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or they file for bankruptcy.

 

Our borrowings under repurchase agreements may qualify for special treatment under the Bankruptcy Code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the Repurchase Agreements without delay in the event that we file for bankruptcy. Furthermore, the special treatment of repurchase agreements under the Bankruptcy Code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy. Thus, our use of repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.

 

We may engage in hedging transactions, which can limit our gains and increase exposure to losses.

 

We may enter into hedging transactions to protect us from the effects of interest rate fluctuations on floating rate debt and also to protect our portfolio of mortgage assets from interest rate and prepayment rate fluctuations. Our hedging transactions may include entering into interest rate swap agreements or interest rate cap or floor agreements, purchasing or selling futures contracts, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements. There are no assurances that our hedging activities will have the desired impact on our results of operations or financial condition.

Interest rate fluctuations may adversely affect our net income.

 

Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations can adversely affect our income.

 

The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Variances in the yield curve may reduce our net income. Short-term interest rates are ordinarily lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve) or short-term interest rates exceed longer-term interest rates (a yield curve inversion), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because our assets generally bear interest based on longer-term rates than our borrowings, a flattening or inversion of the yield curve would tend to decrease our net income. Additionally, the spread between the yields of the new investments and available borrowing rates may decline, which would likely decrease our net income.

 

The loss of any of our executive officers could adversely affect our operating performance.

 

Our operations and financial performance depend heavily upon the efforts of our executive and investment personnel. We cannot give assurances that these executive officers can be retained or replaced with equally skilled and experienced professionals. The loss of any one of these individuals could have an adverse effect upon our business and results of operations at least for a short time.

 

Further reductions in our workforce could adversely affect our operating performance and/or our ability to generate and issue timely financial information.

 

Primarily as a result of the January 2007 sale of assets of our primary operating subsidiary, and due to attrition, our workforce has been reduced to approximately 17 employees. A further loss of employees within a relatively short time period, together with our inability to replace these employees with comparably skilled employees within a reasonable timeframe, could adversely affect our operations and/or we could experience delays in generating and issuing financial information.

 

We may hold title to real property, which could cause us to incur costly liabilities.

 

We may be forced to foreclose on a defaulted mortgage loan in order to recoup part of our investment, which means we might hold title to the underlying property until we are able to arrange for resale and will therefore be subject to the liabilities of property owners. For example, we may become liable for the costs of removal or remediation of hazardous substances. These costs may be significant and may exceed the value of the property. In addition, current laws may materially limit our ability to resell foreclosed properties, and future laws, or more stringent interpretations or enforcement policies of existing requirements, may increase our exposure to liability. Further, foreclosed property is not financed and may require considerable amounts of capital before sold, thereby reducing our opportunities for alternate investments that could produce greater amounts of income.

 

Our business could be adversely affected if we are unable to safeguard the security and privacy of the personal financial information of borrowers to which we have access.

 

In connection with our loan file reviews and other activities with respect to mortgage loans in our portfolio, we have access to the personal non-public financial information of the borrowers. In addition, in operating an Internet exchange for trading mortgage loans, HT sometimes has access to borrowers’ personal non-public financial information, which it may provide to potential third party investors in the mortgage loans. This personal non-public financial information is highly sensitive and confidential, and if a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Although we have policies and procedures designed to safeguard confidential information, we cannot give complete assurances that these policies and safeguards are sufficient to prevent the misappropriation of confidential information or that our policies and safeguards will be deemed compliant with any existing

Federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

 

Risks Related to Our Status as a REIT and Our Investment Company Act Exemption

 

If we do not maintain our status as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.

 

We believe that we currently qualify, and expect to continue to qualify, as a REIT under the Code. However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then:

 

 

If we fail to comply with rules governing our ownership interests in “taxable REIT subsidiaries,” we will lose our REIT qualification.

 

On January 1, 2001, the REIT Modernization Act became effective. Among other things, it allows REITs, subject to certain limitations, to own, directly or indirectly, up to 100% of the stock of a “taxable REIT subsidiary” that can engage in businesses previously prohibited to a REIT. In particular, the Act permitted us to restructure our operating subsidiaries as taxable REIT subsidiaries. As a result, for periods ending after June 30, 2002, through December 31, 2007, the financial statements of certain subsidiaries were consolidated with Hanover Capital Mortgage Holding Inc.’s financial statements, and it is intended that we will continue to do so. However, the taxable REIT subsidiary provisions are complex and impose several conditions on the use of taxable REIT subsidiaries, which are generally designed to ensure that taxable REIT subsidiaries are subject to an appropriate level of corporate taxation. Further, no more than 20% of the fair market value of a REIT’s assets may consist of securities of taxable REIT subsidiaries, and no more than 25% of the fair market value of a REIT’s assets may consist of non-qualifying assets, including securities of taxable REIT subsidiaries and other taxable subsidiaries. In addition, the REIT Modernization Act legislation provides that a REIT may not own more than 10% of the voting power or value of a taxable subsidiary that is not treated as a taxable REIT subsidiary. If our investments in our subsidiaries do not comply with these rules, we would fail to qualify as a REIT and we would be taxed as a regular corporation. Furthermore, certain transactions between us and a taxable REIT subsidiary that are not conducted on an arm’s length basis would be subject to a tax equal to 100% of the amount of deviance from an arm’s length standard.

 

Complying with REIT requirements may limit our ability to hedge effectively.

 

The REIT provisions of the Code may substantially limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. In addition, we must limit our aggregate income from nonqualified hedging transactions, from our provision of services and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with

changes in interest rates than we would otherwise want to incur. If we violate the 25% or 5% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. If we fail to observe these limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for Federal income tax purposes. The fair market value of a hedging instrument will not be counted as a qualified asset for purposes of satisfying the requirement that, at the close of each calendar quarter, at least 75% of the total value of our assets be represented by real estate and other qualified assets.

 

REIT requirements may force us to forgo or liquidate otherwise attractive investments.

 

In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75% of the fair market value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer and no more than 20% of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries. Our efforts to comply with the rules might force us to pass up opportunities to acquire otherwise attractive investments. If we fail to comply with these requirements at the end of any calendar quarter, we may be able to correct such failure within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffer adverse tax consequences. As a result, we may be required to liquidate otherwise attractive investments.

 

Complying with REIT requirements may force us to borrow or liquidate assets to make distributions to stockholders.

 

As a REIT, we must distribute at least 90% of our annual taxable income (subject to certain adjustments) to our stockholders. From time to time, we may generate taxable income greater than our net income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders. If we do not have other funds available in these situations, we could be required to borrow funds, sell a portion of our mortgage securities at disadvantageous prices or find another alternative source of funds in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement. These alternatives could increase our costs or reduce our equity.

 

Regulation as an investment company could materially and adversely affect our business; efforts to avoid regulation as an investment company could limit our operations.

 

We intend to conduct our business in a manner that allows us to avoid being regulated as an investment company under the 40 Act. Investment company regulations, if they were deemed applicable to us, would prevent us from conducting our business as described in this report by, among other things, limiting our ability to use borrowings.

 

The 40 Act exempts entities that are primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. Under the SEC’s current interpretation, in order to qualify for this exemption we must maintain at least 55% of our assets directly in qualifying real estate interests. However, mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not be counted towards our satisfaction of the 55% requirement. Generally investments in the subordinated tranches of securitized loan pools do not constitute “qualifying real estate interests” unless certain qualifying abilities to govern the control of any foreclosures are in place. Our ownership of these mortgage-backed securities, therefore, may be limited to the extent that servicers of the loans in the pools grant such abilities to us.

If the SEC changes its position on the interpretations of the exemption, we could be required to sell assets under potentially adverse market conditions in order to meet the new requirements and also have to purchase lower-yielding assets to comply with the 40 Act.

 

We may be unable to maintain a sufficient amount of Agency MBS to remain exempt under the Investment Company Act of 1940, which could materially and adversely affect our financial condition and results of operations.

 

As of August 15, 2007, we sold all of our Agency MBS which was held primarily to meet compliance requirements of the 40 Act. The sales were necessary in order to generate liquidity and close existing borrowing positions with lenders. On August 29, 2007, we financed the acquisition of approximately $30 million of Agency MBS with 30-day revolving Repurchase Agreements.

 

The Repurchase Agreement relating to the Agency MBS, which we purchased on August 29, 2007, is for a 30-day revolving period, can be terminated by the lender on any renewal date, and is subject to partial repayments based upon market values and changes in the borrowing percentages. If this Repurchase Agreement is terminated, we may not be able to obtain financing for Agency MBS with any other lender. In addition, we may not have enough funds that would allow us to own a sufficient amount of Agency MBS or mortgage loans to maintain compliance with the 40 Act. If we are unable to maintain compliance with the 40 Act, we could, among other things, change the manner in which we conduct our operations, or register as an investment company under the 40 Act, either of which could have a material adverse affect on our operations, our governance costs and the market price for our common stock.

 

If certain tax positions we intend to take regarding the Repurchase Transaction with Ramius are challenged by the Internal Revenue Service, it could result in adverse tax consequences to us and could affect our status as a REIT.

 

Under the Repurchase Transaction, we have agreed with Ramius that we intend to treat the Repurchase Transaction as a sale of securities for U.S. federal income tax purposes. We and Ramius agreed to file all tax returns consistent with such intent and not to take any contrary position unless required by applicable law. Under the Repurchase Transaction we have the right, on August 9, 2008, to repurchase the securities under the Repurchase Transaction for approximately $85 million assuming all other conditions have been satisfied (the “Repurchase Right”). In addition, we have the right to receive Monthly Additional Repurchase Price Payments equal to the excess of all interest payments received on the securities under the Repurchase Transaction in excess of $810,000 (the “Monthly Payments Right”).

 

If the Repurchase Transaction is treated as a sale of securities for federal income tax purposes, we will not be treated as owning the securities for the purposes of determining whether we have complied with the requirement under Section 856(c)(4) of the Internal Revenue Code that at least 75 percent of the value of our total assets are represented by real estate assets, cash, cash equivalents and Government securities at the end of each calendar quarter (“75% Requirement”). However, the Repurchase Right and the Monthly Payments Right would be considered assets for purposes of determining whether we satisfy the 75% Requirement.

 

If the Repurchase Transaction is treated as a sale of securities for federal income tax purposes, we will not be treated as receiving the income from the securities for the purposes of determining whether we have complied with the requirement under Section 856(c)(2) of the Internal Revenue Code that at least 95% of our gross income, on an annual basis, is derived from dividends, interest, rents from real property, gain from the sale of stock, securities and real property, and certain other types of income (“95% Requirement”). However, we will be treated as receiving the payments under the Monthly Payments Right.

 

We intend to treat the Repurchase Right and the Monthly Payments Right as a qualifying real estate asset for purposes of the 75% Requirement. We intend to treat the Monthly Payments Right as additional sales proceeds under the Repurchase Transaction with a portion of the amounts to be received treated as imputed interest. We intend to treat only the portion of the payments treated as imputed interest as gross income for purposes of the 95% Requirement.

We estimated the fair value of both the Repurchase Right and the Monthly Payments Right and believe we have satisfied the 75% Requirement for the quarters ended December 31, 2007 and September 30, 2007 regardless of our treatment of these assets as qualifying real estate assets. Counsel has advised that it is unclear whether our position on these matters would be upheld if challenged by the IRS. If the IRS were to successfully challenge these positions and were to successfully challenge the fair value we assigned to these assets, then we may not have satisfied the 75% Requirement and/or the 95% Requirement for any quarter during which we relied on these positions and values.

 

We have not sought a ruling from the Internal Revenue Service with respect to the characterization of the Repurchase Transaction as a sale of securities for federal income tax purposes, the qualification of the Repurchase Right or the Monthly Payments Right as qualifying assets for purposes of the 75% Requirement, nor the qualification of the payments under the Monthly Payments Right as either additional sales proceeds or qualifying income under the 95% Requirement.

 

If we fail to satisfy either the 75% Requirement or the 95% Requirement, then we will not qualify as a REIT for our taxable year ended December 31, 2007 unless we are eligible for relief under one or more provisions of the Internal Revenue Code and pay a penalty tax. If we did not qualify as a REIT for 2007, there would be significant adverse consequences to us and our shareholders, including:

 

 

In addition, if we are not a REIT for 2007 and subsequent years, we will not be required to make distributions to our shareholders, and all distributions to shareholders for 2007 and subsequent years will be subject to tax as regular corporate dividends to the extent of current and accumulated earnings and profits.

 

Risks Related to Our Corporate Organization and Structure

 

Our charter limits ownership of our capital stock and attempts to acquire our capital stock.

 

To facilitate maintenance of our REIT qualification and for other strategic reasons, our charter prohibits direct or constructive ownership by any person of more than 7.5% (except in the case of John A. Burchett, our Chairman, Chief Executive Officer and President, who can acquire up to 20%) in value of the outstanding shares of our capital stock. Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 7.5% of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 7.5% of the outstanding stock, and thus be subject to our charter’s ownership limit. Any attempt to own or transfer shares of our capital stock in excess of the ownership limit without the consent of the Board of Directors will be void, and could result in the shares being transferred by operation of law to a charitable trust.

 

Provisions of our charter which inhibit changes in control, could prevent stockholders from obtaining a premium price for our common stock.

 

Provisions of our charter may delay or prevent a change in control of the company or other transactions that could provide stockholders with a premium over the then-prevailing market price of our common stock or that might otherwise be in the best interests of the stockholders. These include a staggered board of directors, our share ownership limit described above and our stockholders’ rights plan.

Our Board of Directors could adopt the limitations available under Maryland law on changes in control that could prevent transactions in the best interests of stockholders.

 

Certain provisions of Maryland law applicable to us prohibit “business combinations”, including certain issuances of equity securities, with any person who beneficially owns 10% or more of the voting power of our outstanding shares, or with an affiliate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of our outstanding voting shares (which is referred to as a so-called “interested stockholder”), or with an affiliate of an interested stockholder. These prohibitions last for five years after the most recent date on which the stockholder became an interested stockholder. After the five-year period, a business combination with an interested stockholder must be approved by two super-majority stockholder votes unless, among other conditions, our common stockholders receive a minimum price for their shares and the consideration is received in cash or in the same form as previously paid by the interested stockholder for its shares of common stock. Our Board of Directors has opted out of these business combination provisions. As a result, the five-year prohibition and the super-majority vote requirements will not apply to a business combination involving the Company. Our Board of Directors may, however, repeal this election in most cases and cause the Company to become subject to these provisions in the future.

 

We are dependent on external sources of capital, which may not be available.

 

To qualify as a REIT, we must, among other things, distribute to our stockholders each year at least 90% of our REIT taxable income (excluding any net capital gains). Because of these distribution requirements, we likely will not be able to fund all future capital needs with income from operations. We therefore will have to rely on third-party sources of capital, including possible future equity offerings, which may or may not be available on favorable terms or at all. Our access to third-party sources of capital depends on a number of things, including the market’s perception of our growth potential and our current and potential future earnings. Moreover, additional equity offerings may result in substantial dilution of stockholders’ interests, and additional debt financing may substantially increase leverage.

 

We may change our policies without stockholder approval.

 

Our Board of Directors and management determine all of our policies, including our investment, financing and distribution policies. Although they have no current plans to do so, they may amend or revise these policies at any time without a vote of our stockholders. Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions.

 

Our business could be adversely affected if we have deficiencies in our disclosure controls and procedures or internal control over financial reporting.

 

The design and effectiveness of our disclosure controls and procedures and internal control over financial reporting may not prevent all errors, misstatements or misrepresentations. While management continues to review the effectiveness of our disclosure controls and procedures and internal control over financial reporting, there can be no assurance that our disclosure controls and procedures or internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, particularly material weaknesses, in internal control over financial reporting which may occur in the future could result in misstatements of our results of operations, restatements of our financial statements, a decline in our stock price, or otherwise materially and adversely affect our business, reputation, results of operation, financial condition, or liquidity.

 

 

None.

 

Our operations are conducted in two leased office facilities in the United States. A summary of the office leases is shown below:

 

 

We believe that these facilities are adequate for our foreseeable office space needs and that lease renewals and/or alternate space at comparable rental rates are available, if necessary. During the normal course of our business, additional facilities may be required to accommodate growth.

 

 

The Company, its Chief Executive Officer, and its former Chief Financial Officer, J. Holly Loux, entered into a Confidential Settlement and Release Agreement (the “Settlement Agreement”), dated April 24, 2007 and effective May 3, 2007, resolving to the satisfaction of all parties, the previously pending litigation in the action entitled Loux v. Hanover Capital Mortgage Holdings, Inc., Civil Action No. 06-0122 (KSM). The details of this employment-related dispute were previously disclosed in a Form 8-K filing by the Company on June 28, 2006. All parties to the Settlement Agreement have agreed to keep the terms of the Settlement Agreement confidential, subject to some limited exceptions therein. The Company has recognized approximately $500,000 in expenses related to this settlement, taking into account any available insurance, in the quarter ended March 31, 2007.

 

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 our business, financial condition, or results of operation.

 

 

Not applicable.

 

 

Our common stock trades on the American Stock Exchange under the symbol “HCM.” As of March 25, 2008, there were 151 record holders, and approximately 4,950 beneficial owners, of our common stock.

 

The following table sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported by the American Stock Exchange:

 

 

The following graph compares the cumulative 5-year total return provided shareholders on Hanover Capital Mortgage Holdings, Inc.’s common stock relative to the cumulative total returns of the S & P 500 index, and a customized peer group of six companies that includes: Capstead Mortgage Corp., Dynex Capital Inc, Impac Mortgage Holdings Inc., Indymac Bancorp Inc., Redwood Trust Inc. and Thornburg Mortgage Inc. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock, in the peer group, and the index on 12/31/2002 and its relative performance is tracked through 12/31/2007.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among Hanover Capital Mortgage Holdings, Inc., The S & P 500 Index

And A Peer Group

 

 

 

 

Copyright^© 2008, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. www.researchdatagroup.com/S&P.htm

 

The following table lists the cash dividends we declared on each share of our common stock for the periods indicated:

 

 

We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our REIT taxable income in each year to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, both GAAP and tax, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant.

 

The following tables set forth our selected financial data as of December 31, for each of the years indicated. The selected financial data for the years ended December 31, 2007, 2006 and 2005, and as of December 31, 2007 and 2006, have been derived from our audited Consolidated Financial Statements included elsewhere in this report. The financial information for the years ended December 31, 2004 and 2003 and as of December 31, 2005, 2004 and 2003, have been derived from our audited Consolidated Financial Statements not included in this report. The historical selected consolidated financial data may not be indicative of our future performance. The selected financial data should be read in conjunction with the more detailed information contained in our Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.

 

Statement of Operations Highlights

  (dollars in thousands, except per share data)

 

 

 

 

Balance Sheet Highlights

  (dollars in thousands, except share and per share data)

 

 

 

Executive Overview

 

Our consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. Due to unprecedented turmoil in the mortgage and capital markets during 2007 and into 2008, we incurred a significant loss of liquidity over a short period of time. We experienced a net loss of approximately $80 million for the year ended December 31, 2007 and our current operations are not cashflow positive. In addition, upon the termination of our primary financing facility on August 9, 2008, we will have the option to repay the outstanding principal of approximately $85 million through cash or in-kind securities or surrender the portfolio to the lender without recourse. While we have sufficient cash to continue operations up to and beyond August 9, 2008, we do not have sufficient funds to repay the outstanding principal of this financing. Additional sources of capital are required for us to generate positive cashflow and continue operations beyond 2008. These events have raised substantial doubt about our ability to continue as a going concern.

 

We have taken the following actions to progress through these unprecedented market conditions:

 

 

 

For the year ended December 31, 2007, our net loss of $(80.0) million was $77.1 million larger than the previous year’s net loss of $(2.9) million. This increase in our net loss is primarily due to impairment expense of $73.6 million for other than temporary declines in fair value of our Subordinate MBS portfolio, a $3.8 million reduction in net interest income on our Subordinate MBS, impairment expense of $1.3 million for other than temporary declines in fair value of our other subordinate security and a $0.5 million legal settlement, partially offset by a gain on sale of $1.3 million of our HCP business. The gain on the sale of our HCP business is included in income from discontinued operations.

 

Significant changes in our financial position for 2007 are primarily related to the significant impairments recorded on our Subordinate MBS portfolio and the significant reduction in the size of our Agency MBS portfolio.

 

For the year ended December 31, 2006, our net loss of $(2.9) million was $4.3 million lower than the previous year’s net income of $1.4 million. This decrease is primarily attributable to a goodwill impairment charge for HT of $2.5 million and lower operating income of our portfolio operations. The decline in operating income in 2006 is primarily the result of lower gains earned in 2006 than we experienced in 2005 in our Subordinate MBS portfolio and impairments on real estate owned by HDMF-I. The gains in 2006 were $0.8 million compared to $4.1 million in 2005. We had impairments of real estate owned of $1.2 million during 2006.

 

Significant changes in our financial position for 2006 are primarily related to further investments from the proceeds of our issuance of junior subordinated notes of $40 million issued in conjunction with the creation of two statutory trusts.

 

Critical Accounting Estimates

 

The significant accounting policies used in the preparation of our Consolidated Financial Statements are described in Note 2 to our Consolidated Financial Statements included in this report. Certain critical accounting policies are complex and involve significant judgment, including the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. As a result, changes in these estimates and assumptions could significantly affect our financial position or our results of operations. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

 

Valuation of Mortgage Securities

 

Our Subordinate MBS securities are not readily marketable with quoted market prices. To obtain the best estimate of fair value requires a current knowledge of the Subordinate MBS attributes, characteristics related

to the underlying mortgages collateralizing the securities and the market of these securities. We maintain extensive data related to the collateral of our Subordinate MBS and as a result are able to apply this data and all other relevant market data to our estimates of fair value. We believe the estimates used reasonably reflect the values we may have been able to receive, as of December 31, 2007, should we have chosen to sell them. Many factors must be considered in order to estimate market values, including, but not limited to, estimated cash flows, interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors. Accordingly, our estimates are inherently subjective in nature and involve uncertainty and judgment to interpret relevant market and other data. Amounts realized in actual sales may differ from the fair values presented.

 

During the third and fourth quarters of 2007, due to unprecedented disruptions in the secondary mortgage markets, virtually all trading of Subordinate MBS for all market participants ceased. The fair value estimation process has been difficult due to the lack of market data and the uncertainties in the markets regarding the extent and severity of possible future losses, availability of financing, housing prices, economic activity and Federal Reserve activities.

 

We used a combination of market inputs to arrive at an estimate of fair value for the securities in our Subordinate MBS portfolio as of December 31, 2007. Inputs included estimates from a third party pricing service, results from internal proprietary pricing models and various inputs from dealer firms including security specific prices and market yields. The estimate of fair value required considerable judgment and estimates.

 

As previously reported, during the third quarter of 2007, we changed our estimation process from exclusively using our enhanced internal pricing model to using selective judgments from among various inputs including input from a pricing service offered by a third party pricing firm, dealer prices and dealer inputs. The third-party pricing service represents that they receive reliable credit spreads and prepayment speeds from various investment firms and broker / dealers and information as to trade prices that had occurred.

 

During the fourth quarter of 2007, we again used multiple inputs that include estimates from the third party pricing service, results from internal proprietary pricing models, and various inputs from several dealer firms including security specific prices and market yield spreads which were converted to a price. The resulting estimated prices were also correlated to the net present values of cash flows used in the Company’s proprietary pricing model updated for market inputs for estimated prepayment speeds and default and severity rates. The resulting values for estimated fair value as of December 31, 2007, were derived from a combination of all the inputs.

 

We believe these changes and modifications to our process, required by unprecedented disruptions in the market place, are changes in estimates under SFAS No. 154 and have been applied prospectively.

 

Amortization of Purchase Discounts on Mortgage Securities

 

Purchase discounts on mortgage securities are recognized in earnings as adjustments to interest income (accretable yield) using the effective yield method over the estimated lives of the related securities as prescribed under the Emerging Issues Task Force of the Financial Accounting Standards Board 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20). Estimates and judgments related to future levels of mortgage prepayments, mortgage default assumption rates and timing and amount of credit losses are critical to this determination. Mortgage prepayment expectations, default rate assumptions, and timing and amount of credit losses can vary considerably from period to period based on current and projected changes in interest rates and other factors such as portfolio composition. We estimate mortgage prepayments, defaults and credit losses based on past experiences with specific investments within the portfolio and current market expectations for changes in the interest rate environment. Our estimates could vary widely from the actual income ultimately experienced and, such variances could be material.

Valuation of Other Subordinate Security

 

Our other subordinate security is not readily marketable with quoted market prices. It is an asset-backed security collateralized by loans secured by manufactured housing and related real estate. We are unaware of any similar securities and the potential market for this security is limited. We estimate the fair value of this security through a discounted cashflow model using an interest rate that we believe is representative of rates required by potential investors based upon the credit rating of the security. We believe the estimates used reasonably reflect the values we may have been able to receive, as of December 31, 2007, should we have chosen to sell them. However, our estimates are inherently subjective in nature and involve uncertainty and judgment to interpret relevant market and other data. Amounts realized in actual sales may differ from the value presented.

 

Goodwill Analysis for HT

 

During the second quarter of 2006, we performed an assessment of the goodwill balance assigned to HT for potential impairment. We determined HT had a fair value in excess of its book value as of June 30, 2006 and, therefore, the goodwill was not impaired. The fair value determination was performed using an income approach based upon the discounted cashflow method. The projected cashflows were estimated by tax-effecting forecasted revenue and expenses for several future periods. These projections include estimated revenue from our existing customers and additional revenue from new customers.

 

Subsequent to our valuation performed as of June 30, 2006, we received notices from three customers terminating the services they receive from us. As part of the valuation analysis, we anticipated all of these customers to continue to receive services from us for several years into the future and one of these customers represented a significant portion of the projected revenue.

 

As a result of these terminations, we decided to re-perform the assessment of the goodwill balance for potential impairment using updated forecasted revenues and expenses. The assessment indicated that the HT reporting unit had a fair value below its book value. In accordance with the second step of the assessment, we determined the fair value of the identifiable assets of the HT reporting unit and calculated the goodwill balance as the excess of the fair value of the entire reporting unit over the fair value of the identifiable assets of the reporting unit. The goodwill was fully impaired resulting in an impairment expense of $2.5 million for the year ended December 31, 2006.

 

Impact of New Accounting Pronouncement

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115”. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. We are currently evaluating the potential impact of this pronouncement. As the majority of our assets and liabilities, except for liability to subsidiary trusts, are either already recorded at fair value or the carrying value approximates fair value, any potential impact is limited to a few specific assets and liabilities. We have not yet determined whether we will make a fair value election for the following assets and liabilities, but the potential impact is as follows:

 

 

Financial Condition

 

The most significant changes in our balance sheet as of December 31, 2007, compared to December 31, 2006, are reflected in the net decrease of our investment portfolio and changes in related accounts including the decrease in our cash balances. The tables below present the primary assets of our investment portfolio, net of related financing, as of December 31, 2007 and December 31, 2006 (dollars in thousands):

 

 

 

As of December 31, 2007 we are in violation of certain covenants of our facility for up to $200 million of financing of mortgage loans, which prohibits us from obtaining advances under the financing facility. In March 2008, we entered into a Termination Agreement with the lending institution, without the declaration of any defaults under the facility. Pursuant to the terms of the Termination Agreement, the parties mutually agreed to voluntarily terminate the facility at no further costs to us other than certain minor document preparation costs. There are no borrowings under the facility at termination.

 

Our Subordinate MBS portfolio has decreased in principal balance by $5.0 million and our carrying value has decreased by $71.9 million. The principal balance decreased due to principal payments on the securities and losses allocated to the securities from defaults on the underlying mortgage loans. The carrying value decreased primarily due to increases in credit spreads that reduced the fair value of these securities during the year ended

December 31, 2007. Our net equity in this portfolio decreased by $61.9 million primarily due to the decrease in the carrying values.

 

The Agency MBS classified as trading are held primarily to meet certain compliance needs related to exemption under the 40 Act. On August 15, 2007, we sold our entire portfolio of Agency MBS in order to generate some liquidity and close existing borrowing positions with lenders. On August 29, 2007, we financed the acquisition of approximately $30 million of Agency MBS, with a 30-day revolving Repurchase Agreement. As a result, we maintained compliance with the 40 Act during the year ended December 31, 2007.

 

Our book value per common share as of December 31, 2007 was $(2.96) compared to $6.99 as of December 31, 2006. The decrease in book value is primarily attributable to our net loss of $78.6 million and our other comprehensive loss of $2.4 million for the year ended December 31, 2007, our dividend for the first quarter of 2007 of $1.2 million and the issuance of 600,000 shares of common stock in August 2007 in connection with the Repurchase Transaction.

Results of Operations

 

Comparison of 2007 to 2006

 

Revenues by Portfolio Type
(dollars in thousands)

 

 

Net interest income from our Mortgage Loan portfolio decreased for the year ended December 31, 2007 compared to the same period of 2006 primarily due to a decrease in the level of collateral for CMOs and related financing in 2006 and the sale of mortgage loans classified as held for sale during April of 2006.

For our Subordinate MBS portfolio, the mark to market loss increased by $73.5 million for the year ended December 31, 2007 compared to the same period of 2006. The increase in market loss, we determined, is due to other than temporary declines in fair value primarily throughout the latter half of 2007. Similar declines in fair value were not experienced during 2006. For this same portfolio and related periods, net interest income decreased for the year ended December 31, 2007, compared to the same period of 2006 due to an increase in the interest expense associated with the new fixed-term financing facility we established in August 2007. This decrease is partially offset by an increase in interest income from the increase in the size of this portfolio for 2007 compared to 2006. During the beginning of 2006, we were still investing the proceeds from our $20 million trust preferred securities offering in November 2005 and were not fully invested until the end of March 2006. We had gains on sales of securities of $0.2 million for the year ended December 31, 2007, compared to gains on sales of $0.8 million for the same period of 2006. We sold 18 securities during the first two quarters of 2007 as part of a minor portfolio reorganization and in anticipation of potential credit issues.

 

Generally, our Agency MBS classified as trading are financed via Repurchase Agreements and are hedged through forward sales of similar securities. The net revenue generated from this portfolio is heavily dependent upon changes in the short-term and long-term interest rates and the spread between these two rates. The net change in the performance of this portfolio is due primarily to the timing of differences arising from the changes in the interest rates and minor differences between the principal amount of the securities and the notional amount of the hedging activity. On August 15, 2007, we sold our entire portfolio of Agency MBS in order to generate some liquidity and close existing borrowing positions with lenders. Although we purchased approximately $30 million of Agency MBS on August 29, 2007, the size of our Agency MBS portfolio during the latter part of 2007 was significantly smaller than during 2006 and the beginning of 2007. In addition, the net revenue has been positively impacted by the interest income generated from Agency MBS classified as held to maturity, which were not hedged through forward sales and were not financed for the majority of 2007 and 2006.

 

Other interest income includes interest earned from the other subordinate security and cash and cash equivalents. Other interest expense is interest incurred on the subordinated debt issued to our subsidiary trusts, HST-I and HST-II.

 

Other mark to market for the year ended December 31, 2007 is primarily due to other-than-temporary declines in the estimated fair value of our other subordinate security due to increases in credit spreads. Similar declines did not occur during the year ended December 31, 2006. Other mark to market also represents a write-down of REO that was acquired in 2005 and is included in other assets. The local economy for a portion of these properties had a significant downturn, which depressed the value of these properties. At December 31, 2007, we have one remaining property to be sold with a total carrying value of approximately $8,000.

 

Other freestanding derivatives represents the mark to market of our interest rate caps used to hedge the financing costs of our portfolio. The expense from the change in the market value of these derivatives decreased for the year ended December 31, 2007 compared to the same period in 2006. These reductions in market value are due to the passage of time and one-month LIBOR remaining substantially at or below the strike rate of the interest rate caps.

 

Loan sale advisory and technology revenue has decreased due to the suspension of the loan sale advisory activities in May 2006, the termination of technology services by several of our clients in 2006 and early 2007, and the cessation of our marketing activities for our technology solutions in 2006.

Comparison of 2006 to 2005

 

Revenues by Portfolio Type
(dollars in thousands)

 

 

Net interest income from our Mortgage Loan portfolio decreased for the year ended December 31, 2006 compared to the same period of 2005 primarily due to a decrease in the level of collateral for CMOs and related financing in 2006 and the sale of mortgage loans classified as held for sale during April of 2006.

For our Subordinate MBS portfolio, interest income increased for the year ended December 31, 2006 compared to the same period of 2005 due to the significant increase in the size of this portfolio and, to a lesser extent, increases in the interest rate for adjustable rate securities. For this same portfolio and related periods, interest expense increased as we increased financings to correspond with the increase in the portfolio and because the one-month LIBOR rate, the basis for all of the financings, has increased consistently through 2005 and 2006. We had gains on sales of securities of $0.8 million for the year ended December 31, 2006 compared to $4.1 million for the same period of 2005. This decrease in gains is the result of our long-term strategy shift that began in the middle of 2005, to focus on net interest income rather than gains on sale of securities. We sold 15 and 19 securities during the second and third quarter of 2006, respectively, as part of a minor portfolio reorganization and anticipation of potential credit issues.

 

Generally, our Agency MBS classified as trading are financed via Repurchase Agreements and are hedged through forward sales of similar securities. The net revenue generated from this portfolio is heavily dependent upon changes in the short-term and long-term interest rates and the spread between these two rates. The net change in the performance of this portfolio is due to the timing of differences arising from the changes in the interest rates and minor differences between the principal amount of the securities and the notional amount of the hedging activity. In addition, the 2006 net revenue is positively impacted by the interest income generated from Agency MBS classified as held to maturity, which were not hedged through forward sales and were not financed for the majority of 2006, as these securities were not acquired until the fourth quarter of 2005. Other interest income includes interest earned from the other subordinate security and cash and cash equivalents. Other interest expense is primarily interest incurred on the subordinated debt issued to our subsidiary trusts, HST-I and HST-II. This debt was issued in March and November of 2005, respectively, and therefore, a lesser amount of interest expense was incurred for the year ended December 31, 2005.

 

Other mark to market for the year ended December 31, 2006 represents a write-down of REO carried in HMDF and included in other assets. The local economy for a portion of these properties had a significant downturn, which depressed the value of these properties. We utilized local real estate brokers with incentive commissions to sell these properties. However, a large number of other properties were listed for sale in the same geographic area, which hampered our ability to sell these properties.

 

Other freestanding derivatives represents the mark to market of our interest rate caps used to hedge the financing costs of our portfolio. The expense from the change in the market value of these derivatives increased for the year ended December 31, 2006 compared to the same period in 2005. These reductions in market value are due to the passage of time and one-month LIBOR remaining substantially at or below the strike rate of the interest rate caps.

 

The technology and loan sale advisory revenue decreased for the year ended December 31, 2006 compared to the same period in 2005, primarily due to a suspension in the loan sale advisory activities in May 2006. These activities decreased due to the reduction in loan sale advisory opportunities in the whole loan secondary market resulting from the flattening of the yield curve and reduction in mortgage originations.

Operating Expenses

 

The following table details operating expenses for the Company on a consolidated basis (dollars in thousands):

 

 

Operating expenses for the year ended December 31, 2007 decreased by $3.2 million from the same period in 2006. The major changes within operating expenses were in personnel, legal and professional, general and administrative, technology, financing and goodwill impairment.

 

 

Operating expenses for the year ended December 31, 2006 decreased by $1.1 million from the same period in 2005. The major changes within operating expenses were in personnel, depreciation and amortization, technology, financing and goodwill impairment.

 

 

 

Equity in Income (Loss) of Unconsolidated Affiliates

 

HST-I & HST-II are unconsolidated subsidiary trusts established in connection with the issuance of preferred and capital securities in 2005. The equity in earnings of these subsidiaries represents 100% of the net earnings of these subsidiaries.

 

HDMF-I is a limited liability company whose objective is to purchase, service and manage pools of primarily sub-and non-performing one-to-four family residential whole loans. In June 2005, through a series of transactions, the Company increased its ownership in HDMF-I. The Company’s consolidated financial statements include the results of operation of HDMF-I from the date of acquisition.

 

Discontinued Operations

 

Income (loss) from discontinued operations includes the results of operations of the HCP business that was sold in January 2007. The income from discontinued operations for the year ended December 31, 2007 includes a gain on sale of $1.3 million.

 

Income (loss) decreased by $2.2 million for the year ended December 31, 2006 from the same period in 2005 primarily due to decreases in revenue from HCP’s largest customer and a negative shift in product mix. Unfavorable market conditions have resulted in reduced mortgage loan acquisitions for HCP’s largest customer, thereby resulting in reduced due diligence services performed by HCP. In addition, operating costs increased as HCP increased its headcount and occupancy structure during the latter half of 2005 to ensure available resources for anticipated revenue growth during 2006 and thereafter that failed to occur.

Additional Analysis of REIT Investment Portfolio

 

Investment Portfolio Assets and Related Liabilities

 

The following table reflects the average balances for each major category of our investment portfolio as well as associated liabilities with the corresponding effective yields and rates of interest (dollars in thousands):

 

 

 

 

The yield on net portfolio assets decreased for the year ended December 31, 2007 from the same periods in 2006. This decrease in yield is the result of an increase in the one-month LIBOR, which is the basis for substantially all of our financing prior to August 10, 2007 and the higher borrowing costs associated with the Repurchase Transaction after August 10, 2007.

 

Average net investment portfolio assets decreased for the year ended December 31, 2007 from the same period in 2006 due to the significant reductions in estimated market value of our Subordinate MBS portfolio recorded during the year ended December 31, 2007 and the significant reduction in the size of our Agency portfolio in August of 2007. These decreases are partially offset by an increase in the size of the Subordinate MBS portfolio during the first half of 2006 that carried into 2007, as we were investing the proceeds from our $20 million trust preferred securities offering in November 2005.

The yield on net portfolio assets increased to 19.08% for the year ended December 31, 2006 from 17.94% for the year ended December 31, 2005. This increase in yield is the result of additional investment in our Subordinate MBS portfolio, which is the highest yielding asset. This increase is partially offset by an increase in the one-month LIBOR, which is the basis for substantially all of our financing.

 

Average net investment portfolio assets increased to $68.1 million for the year ended December 31, 2006 from $50.3 million for the year ended December 31, 2005. This increase is primarily due to the deployment of proceeds raised in 2005 in connection with the issuance of trust preferred securities, which was primarily invested in Subordinate MBS and Agency MBS. These proceeds were invested throughout 2005 and the first quarter of 2006. These proceeds were fully invested by March 31, 2006.

 

Mortgage Loans

 

The following table provides details of the net interest income generated on our Mortgage Loan portfolio (dollars in thousands):