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     o

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

Large accelerated filer o          Accelerated filer þ          Non-accelerated filer o

     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, 2005, was $88,425,700.

     The registrant had 8,496,162 shares of common stock outstanding as of March 10, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s Proxy Statement for the 2006 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, 2005

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 future results, performance or achievements. 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.

PART I

The Company

Hanover Capital Mortgage Holdings, Inc. “Hanover” was incorporated in Maryland on June 10, 1997. Hanover is a specialty finance company organized as a real estate investment trust, or “REIT”, pursuant to the Internal Revenue Code of 1986, as amended “Code”.

Hanover is engaged in three principal lines of business, each reported as a business segment, which are conducted through three primary operating units: Hanover “REIT”, Hanover Capital Partners Ltd. “HCP” and HanoverTrade, Inc. “HT”.

Effective January 1, 2006, both HCP and a subsidiary of Hanover, Hanover Capital Partners 2, Inc. “HCP2” merged with and into HT with HT remaining as the surviving entity. The newly combined entity now bears the official corporate name of Hanover Capital Partners 2, Ltd. “HCP-2”; however, we have, to assist in continuing to monitor our business segments and provide our various service offerings, retained the trade names HanoverTrade, Hanover Capital Partners, and Servicing Source. Hanover Capital Securities, Inc. “HCS” is, as a result of the merger, a subsidiary of the new HCP-2 entity.

When the term “the Company” is used, the term refers to Hanover together with its consolidated subsidiaries, including HCP and HT.

As of December 31, 2005, Hanover had two non-consolidated special purpose entities formed in 2005, Hanover Statutory Trust I and Hanover Statutory Trust II, created for the exclusive purpose of issuing and selling, to third parties, Trust Preferred Securities that are secured with Hanover’s junior subordinated notes.

The Company’s principal executive offices are located at 200 Metroplex Drive, Suite 100, Edison, New Jersey 08817. The Company also maintains an office at 55 Broadway, Suite 3002, New York, NY 10006.

Business Segments

The Company’s business is conducted through three lines of business that are each reported as business segments. They are: the REIT, operated through Hanover; consulting and outsourcing services marketed to the mortgage industry, operated by HCP; and loan sale advisory services and technology solutions for the mortgage industry, operated by HT.

The results of operations of HCP and HT each include, respectively, the results of HCS, and Pedestal Securities, Inc. “Pedestal”, registered broker-dealers, organized for the purpose of facilitating infrequent sales of registered securities in the conduct of their businesses.

Hanover — The REIT

Hanover’s 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 whole single-family mortgage loans for investment, securitization and resale. Hanover also maintains a portfolio of whole-pool Fannie Mae and Freddie Mac mortgage-backed securities, “Agency MBS”, primarily to satisfy certain exemptive provisions of the Investment Company Act of 1940. Hanover attempts to increase the earnings potential in its investments by leveraging its purchases of mortgage securities with borrowings obtained primarily through the use of 30 day revolving Repurchase Agreements which are established by sales with agreements to repurchase. The borrowings under the Repurchase Agreements are generally at 50 to 97 percent of the security’s fair market value, depending on the security, and are adjusted to market value each month as the Repurchase Agreements are re-established. Other mortgage security or mortgage loan financing is accomplished through the use of committed lines of credit, usually under repurchase agreements or through the creation of collateralized mortgage obligations, “CMOs”. Hanover also, on occasion, receives income from real estate investment management services that can include asset management, due diligence, and administrative services.

As part of its REIT operations, Hanover maintains an equity investment in a joint-venture entity, HDMF-I LLC, “HDMF-I”, formed to purchase, service, manage and ultimately re-sell or otherwise liquidate pools of sub- and non-performing one-to-four family residential mortgage loans. Hanover also receives a management fee from HDMF-I.

HCP — Consulting and Outsourcing Services

HCP provides services to commercial banks, mortgage banks, government agencies, credit unions and insurance companies. The services provided include: 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 requires an analysis of a block or pool of loans on a loan-by-loan basis. This requires the use of technology developed and owned by HCP and operated by employees highly specialized and trained by HCP. HCP may also perform certain due diligence services and analysis of mortgage assets acquired by Hanover.

HCP has one customer that has accounted for approximately half of its revenues for the year ended December 31, 2005.

HCP is dependent on Hanover for working capital.

HT — Loan Sale Advisory and Technology Solutions

HT generates income by providing loan sale advisory, “LSA”, services and technology software solutions to the mortgage industry.

The LSA operation earns fees by providing brokerage, asset valuation and consulting services. The brokerage service integrates varying degrees of traditional voice brokerage conducted primarily by telephone, web-enhanced brokerage and online auction hosting. HT also performs market price valuations for a variety of loan products and offers consulting advice on loan product pricing and business strategies.

The technology solutions operation earns licensing and related servicing fees by licensing proprietary software applications to the financial industry. HT markets web-based technology solutions to meet specific needs of the mortgage industry in the secure transmission, analysis, valuation, tracking and stratification of loan portfolios. The software technology is licensed to government agencies and financial institutions that originate and/or trade financial assets. HT also uses the applications to provide servicing rights valuation services to clients who do not license the software.

HT is dependent on Hanover for working capital.

REIT Operations

In order to maximize the interest income from its investments, Hanover invests in mortgage securities or mortgage loans that will procure the highest possible earnings where such mortgage securities or mortgage loans fall within acceptable investment parameters established by Hanover’s investment management team.

The parameters established by Hanover’s investment management team vary by type of investment but emphasize securities collateralized by prime jumbo residential mortgages or mortgage loans that generally fall into this group of residential mortgages.

The potentially higher earning mortgage securities are those series of Subordinate MBS with the higher credit risk, often referred to as the non-investment grade or first loss series or tranches. These securities 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 Hanover paid less than par to acquire the security. Hanover believes that it has 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 Hanover’s investment team will be successful.

Hanover 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 Hanover’s investment parameters and some that do not. By using Hanover’s experience, knowledge, and technology to evaluate and stratify these mortgage loans, Hanover is able to identify and put into a separate pool, or pools, the loans that do not meet Hanover’s investment parameters. These loans are sold in the marketplace and the pool of mortgage loans that remain, those that meet the investment parameters, are held for investment purposes.

Depending on market conditions and the quality of mortgage loans available for purchase in the marketplace, Hanover may pool certain investment mortgages, mortgages that have met Hanover’s investment parameters, and cause them to become collateral for a CMO. The CMO is usually divided into several maturity classes, called series or tranches, that have varying degrees of claims on any cash flows or losses on the mortgage loans held as collateral. In such securitizations, Hanover’s 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.

Hanover invests in debt securities of Fannie Mae and Freddie Mac (Government Sponsored Enterprises) Agency MBS. Only Agency securities that represent an entire pool of mortgages, not just part of a pool of mortgages, are purchased. These securities are purchased when Hanover’s monitoring model suggests that

the total assets represented by qualifying real estate investments may need to be supported by additional purchases. Such assets are sold when Hanover’s other qualifying real estate investments are of sufficient amounts to maintain the exemptive limits. These Agency MBS securities are readily marketable and contain guarantees by the sponsoring agency such that credit risks are minimal.

Investment Management

We believe that our portfolio management processes are influenced by three primary investment risks associated with the types of investments Hanover makes: credit risk (including counterparty risk), interest rate risk and prepayment risk. In order to maximize Hanover’s 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, and prepayment risks, however, no strategy can completely insulate us from these risks.

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. The majority of the work is performed by HCP.

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

Interest rate risk is the risk of changing interest rates. 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, 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 our Subordinate MBS portfolio through the purchase of long-term, out-of-the-money, interest rate caps indexed to the one-month London Interbank Offered Rate Index, “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.

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. This risk is also managed in part by the purchase of one-month LIBOR caps. A rise in interest rates will generally result in an appreciation in the value of the one-month LIBOR caps. 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 one-month LIBOR caps are treated as freestanding derivatives, the changes in the value of the one-month LIBOR caps flow through our income statement while changes in the value of the asset are reflected as Other Comprehensive Income, to the extent such Subordinate MBS have been classified as available for sale securities.

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 we believe are justified compared to the mark to market consequences of not qualifying under SFAS 133 as occurs with our use of freestanding derivatives as discussed above. Under SFAS No. 133, Hanover 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.

Mortgage Loans — Hanover’s 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.

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 we believe are 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 is the risk that homeowners will pay more than their required monthly mortgage payments. 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 Hanover 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)

We have adopted capital allocation guidelines, which we refer to as “CAG”, to strike a balance in our ratio of debt to equity. Modifications to the CAG require the approval of a majority 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 purchase 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 leverage and reduce the risk to our capital base.

Repurchase Agreements — Financing

We finance purchases of mortgage-related assets with equity and short-term borrowings through agreements where we sell the mortgage-related asset with a commitment to repurchase the asset at a later date. 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 certificate holders vote. If we default on a payment obligation under such agreements, the lending party may liquidate the collateral.

To reduce our exposure to the credit risk of Repurchase Agreements, we enter 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 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 CAG discussed above.

Developments in 2005

In mid 2005 Hanover was advised that the Securities and Exchange Commission, “SEC”, may be changing its view regarding qualification for exemption under provisions of the Investment Company Act of 1940 (“1940 Act”).

The change in the SEC view is related to not only whether certain assets constitute qualifying interests in real estate for purposes of the exemption tests, but also how the REITs should measure their assets for purposes of exemption testing. Issues about qualification of assets for test purposes relate to servicing rights and the security holders or lien holders ability to foreclose on properties and whether ownership is 100% of the first loss class of securitizations of mortgage loans. Measurement issues are related to tests being performed on a consolidated or unconsolidated basis.

As a result of this apparent changing view of the SEC, Hanover has had to modify and adjust its operations to ensure continued compliance with exemption from regulation as an investment company under the 1940 Act. Hanover has had to forego the acquisition of certain mortgage assets such as Subordinate MBS until certain servicing rights and clear abilities by Hanover to control foreclosure on loans in pools collateralizing securities owned were clearly set out in the servicing documents.

Hanover has also had to reexamine how the licensed entities that acquire mortgage loans for Hanover are structured and consolidated. This reexamination has caused Hanover to incur additional expenses related to modifying servicing agreements and to hold uninvested, longer than planned, the proceeds from its March and November 2005 Trust Preferred issuance while also holding a larger than planned Agency MBS position.

During 2005 the real estate market was impacted by rising interest rates. As a result, the availability of new mortgage loan securities has diminished making it more difficult to find investment opportunities that meet Hanover’s investment parameters. To date, however, Hanover has been able to meet its investment needs.

At the beginning of 2005, the majority of our Mortgage Loans collateralized two outstanding CMOs, 1999-A and 1999-B, of which Hanover retained certain subordinated certificates. The retained subordinated certificates from 1999-A and 1999-B collateralized a securitization, 2000-A, of which Hanover retained certain of the 2000-A certificates.

In June of 2005, Hanover exercised an available call option to retire the entire 1999-A CMO borrowing. In conjunction with the retirement, Hanover purchased the loans from the CMO Trust at fair market value. These mortgage loans were evaluated with certain ones being pooled and included exclusively in a Fannie Mae securitization in December. The remaining loans were identified for sale. Hanover retained the entire Fannie Mae securitization and intends to hold the securities to maturity.

As a result of the 1999-A retirement, the 2000-A securitization is supported only by the Hanover retained certificates from Hanover’s 1999-B securitization. Hanover owns all of the remaining 2000-A certificates.

The effects of Hurricanes Katrina and Rita in the third quarter of 2005 resulted in the designation of certain counties in Alabama, Florida, Louisiana, Mississippi and Texas as disaster areas by the Federal Emergency Management Agency. As a result, there was concern about possible losses in our Subordinate MBS portfolio related to uninsured property damage or delayed borrower mortgage loan payments. In response, we evaluated our Subordinate MBS portfolio on a loan-by-loan basis to determine, to the extent possible, the risk of hurricane related losses. Our evaluation included physical property inspections, determination of homeowner’s and flood insurance status and contact with mortgage servicers and trustees. Additionally, in the third quarter of 2005 we sold 14 bonds with an aggregate principal balance of $18.4 million whose underlying collateral pools contained mortgage loans in Hurricane Katrina disaster

areas. We continue to consider the effects of the hurricanes for portfolio acquisitions and security evaluations.

Regulation

HCS is a broker/dealer registered with the SEC and is a member of the National Association of Securities Dealers, Inc. In June 2005, we acquired the remaining 75% ownership of Pedestal, which is also a broker/dealer registered with the SEC and 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 assure you 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. In our non-investment income operations, we compete with a variety of consulting and technology firms.

Employees

As of December 31, 2005, we had 64 full-time employees. We also utilize the services of subcontractors in HCP. To date, we believe we have been successful in our efforts to recruit qualified employees, but there is no assurance that we will continue to be successful in the future. None of our employees are subject to collective bargaining agreements.

Trademarks

We own five trademarks that have been registered with the United States Patent and Trademark Office which expire in May 2007, September 2013, May 2014, June 2014 and September 2014, respectively.

Federal Income Tax Considerations

We have elected to be treated as a REIT for Federal income tax purposes, pursuant to 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 recently enacted legislation that reduced the Federal tax rate on both qualified dividend income and long-term capital gains for individuals to 15% through 2008. 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:

These reduced rates could cause shares in non-REIT corporations to be a relatively more attractive investment to individual investors than shares in REITs. The legislation also could have an adverse effect on the market price of our securities.

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.

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.

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 another REIT, 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:

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.

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.

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

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;

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

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.

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 2005. 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 overstating the return of capital component of our distributions and correspondingly understating 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. By acting appropriately to remedy any inaccuracies on the Forms 1099-DIV, we expect to demonstrate such reasonable cause. 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 Hanover’s 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.

ITEM 1A.     RISK FACTORS

Risks Related to Our Business

During the time we hold mortgage related assets we will be 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.

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 mature borrowings, 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 disadvantageous prices with consequent losses, which, in the extreme, may render us insolvent.

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 and 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.

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 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 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 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.

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.

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.

A significant portion of HCP’s revenues came from contracts with three principal customers. Likewise a significant portion of HT’s revenues in 2005 came from two customers. If HCP or HT were to lose any one of these customers, their revenues would decline significantly until the customers were replaced, of which there can be no assurance.

HT has invested a significant amount of its capital in technology applications for performing analyses of mortgage pools and mortgage servicing. Should these assets become obsolete due to technological or competitive reasons, or lack of product acceptance by the market, then HT may have to abandon some of the existing software applications it has developed. A significant write-down of its capitalized software due to obsolescence could adversely affect our results of operations.

In connection with our loan file due diligence reviews and other consulting and advisory services with respect to mortgage loans that we provide to third parties, HCP has access to the personal financial information of the borrowers. In addition, in operating an Internet exchange for trading mortgage loans, HT sometimes has access to borrowers’ personal financial information, which it may provide to potential third party investors in the mortgage loans. This personal 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

We believe that we currently qualify, and expect to continue to qualify, as a REIT under the Internal Revenue Code of 1986, as amended, which we refer to as 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:

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, HCP, HT and HCP2, as taxable REIT subsidiaries. As a result, for periods ending after June 30, 2002, through December 31, 2005, the financial statements of HCP, HT and HCP2 were consolidated with Hanover’s financial statements, and it is intended that we will continue to do so with the newly-merged entity Hanover Capital Partners 2, Ltd. 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.

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.

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.

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.

We intend to conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act of 1940, as amended “Investment Company 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 Investment Company 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 Hanover.

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 Investment Company Act.

An emerging issue with the Financial Accounting Standards Board could have a major impact on our ability to operate as a REIT and retain our exemption under the Investment Company Act.

The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) has deferred making a decision on a potential new issue pending a decision by the FASB to add to its agenda a project to provide guidance on the issue. That issue could have a major impact on Hanover.

That issue deals with the accounting from the perspective of both the buyer and the seller of financial assets that are the subject of a repurchase agreement with the same parties.

Example Transaction — Hanover’s primary current practice

Hanover (the buyer) purchases a financial asset (mortgage loans or mortgage-backed securities) and simultaneously enters into a repurchase agreement with an investment bank or securities broker (the seller) to finance the transaction. The purchase and repurchase agreement may be settled net (no gross cash movements) with Hanover paying a deposit amount, as part of the collateral requirements of the repurchase agreement, equal to a percentage of the principal amount of the financial asset (in Hanover’s situations, amounts ranging from 30 to 50 percent).

Current Industry Practice

It is believed that most buyers have accounted for transactions as described in the Hanover example transaction (and similar transactions) as a purchase and subsequent financing (as Hanover has done) and that there is currently minimal diversity in this practice.

The Issue

The issue is how to apply the criterion in paragraph 9(a) of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, in accounting for transactions involving the purchase of financial assets and simultaneous repurchase of the same financial assets with the seller.

Paragraph 9(a) requires “isolation” from the transferor (seller). If the isolation requirement is met, the seller meets the requirements in paragraph 9(a) of SFAS No. 140 and the transaction qualifies as a sale by the seller and a purchase and financing by the buyer, as Hanover has done. If the isolation requirement is not met, the transaction is not a sale by the seller and paragraph 12 of SFAS No. 140 would require the

buyer to record the transaction as a financing to the extent of the cash or other assets that were transferred. The classification of the resulting financing transaction(s) if the isolation requirement is not met would most likely be that of a derivative instrument.

There is a view, contrary to current industry and Hanover practice, that since the seller has continuing involvement through the repo, as in the Hanover example, the transferred assets have not been isolated from the seller and therefore, the isolation requirement is not met. Those with this view also believe that demonstrating isolation legally is not possible without a legal opinion and such opinions would be too vague to meet the isolation requirement. This contrary view is what the EITF has been asked to consider.

Impact on Hanover if the isolation requirement of paragraph 9(a) is not met

The accounting classification of the resulting derivative instruments held by Hanover, a REIT, if the isolation requirement of paragraph 9(a) is not met, might impact Hanover’s REIT tax exempt status. A REIT must hold at least 75% of its total assets in qualified real estate assets and derive at least 75% of its gross income from real property (for example, rent or mortgage interest). Derivative instruments are not qualified assets. Further, we could find that our ability to remain exempt under the provisions of the Investment Company Act of 1940 could be weakened as we will have to determine the appropriate treatment for the resulting derivative instruments.

Risks Related to Our Corporate Organization and Structure

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 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 and our share ownership limit described above.

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.

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.

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 operations are conducted in several leased office facilities throughout 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.

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 and our legal counsel, is likely to have a material adverse effect on our business, financial condition or results of operations.

Not applicable.

PART II

Our common stock trades on the American Stock Exchange under the symbol “HCM.” As of March 13, 2006, there were 69 record holders, and approximately 7,740 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 table lists the cash dividends we declared on each share of our common stock based on our earnings for the periods indicated:

We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our 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.

Information about our equity compensation plans required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2006 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.

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, 2005, 2004 and 2003, and as of December 31, 2005 and 2004, have been derived from our audited Consolidated Financial Statements included elsewhere in this report. The financial information for the years ended December 31, 2002 and 2001 and as of December 31, 2003, 2002 and 2001, 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)

Summary

For the year ended December 31, 2005, the Company’s net income of $1.4 million was $6.7 million lower than the previous year’s net income of $8.1 million. This is primarily attributable to the lower operating income of our REIT segment. Our net income for the year ended December 31, 2004 increased slightly over the previous year by $0.1 million. The majority of our net income in the years 2005, 2004 and 2003 is attributable to the REIT. The REIT’s decline in operating income in 2005 is primarily the result of lower gains earned in 2005 than we experienced in 2004 and 2003 in our Subordinate MBS portfolio. The REIT’s gains in 2005 from our Subordinate MBS portfolio were $4.1 million compared to $10.4 million and $10.7 million in 2004 and 2003, respectively.

A review of our operations for the years ended December 31, 2005 and 2004 is set forth below by operating segment. Since our three operating segments have generated substantially all of our net income we have concentrated our discussion and analysis on these components.

Selected Components of Operating Income by Segment

(dollars in thousands)

Our operating income declined in 2005 by $5.9 million from our 2004 operating income. That decline was the result of a decline in our REIT operating income of $5.8 million from 2004, an increase of $0.8 million in operating income of HCP and a $0.9 million increase in the operating loss of HT.

The operating income for 2004 declined from 2003 operating income by $0.9 million. That decline was the result of a $0.9 million increase in REIT operating income, a $1.6 million decrease in the operating income of HCP and a $0.2 million increase in the operating loss of HT.

Significant changes in our financial position for 2005 are primarily related to our issuance of junior subordinated notes of $40 million issued in conjunction with the creation of two statutory trusts discussed further under the Liquidity and Capital Resources section of this Item.

Critical Accounting Policies

The significant accounting policies used in preparation of our Consolidated Financial Statements are more fully described in Note 2 to our Consolidated Financial Statements. Certain critical accounting policies are complex and involve significant judgment by our management, 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.

All securities held in our Subordinate MBS portfolio are classified as available for sale with changes in fair value reported as a component of accumulated other comprehensive income. We estimate fair value on a security-specific basis by using the lower of independent third-party or management’s valuations. Because the securities are not exchange-traded, prices are not readily ascertainable and involve judgment regarding future interest rates, credit spreads (which may change as a result of changed loss estimates) and other

economic factors. Therefore, the price at which a security may trade at an arms-length auction may differ from the fair value established by management or an independent third party.

All securities held in our Agency MBS portfolio are classified as either trading or held to maturity. The Agency securities classified as trading are recorded at estimated fair value using prices obtained from an independent third party. Changes in fair value are recorded as a component of gain (loss) on mark to market of mortgage assets. Agency securities classified as held to maturity are reported at amortized cost unless a decline in value is deemed other-than-temporary, in which case an unrealized loss is recognized as a component of gain (loss) on mark to market of mortgage assets.

Mortgage Loans classified as held for sale are recorded at lower of fair market value or cost. The fair value of these financial instruments is based upon projected prices which could be obtained through investors considering interest rates, loan type and credit quality.

The forward sales used to economically hedge our Agency MBS portfolio are classified as freestanding derivatives. The forward sales are carried at estimated fair value using market prices obtained from an independent third party with changes in fair value recorded as a component of gain (loss) on freestanding derivatives.

We own one-month LIBOR interest rate cap agreements as protection against rising short-term financing rates on the liabilities used to finance our Subordinate MBS and Mortgage Loan portfolios. These derivative instruments are classified as freestanding derivatives with changes in fair value recognized in income. Fair value is determined on a monthly basis from third party sources.

For our Subordinate MBS portfolio, pursuant to The Emerging Issues Task Force of the Financial Accounting Standards Board (“EITF”) Abstract Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” we use the effective yield methodology to recognize interest income. This includes taking into account such factors as purchase discounts, loss assumptions, prepayment speeds and the type of retained interests in the bonds or the bond structures. In using the effective yield methodology, we use a level yield approach where we determine each subordinate security’s future cash flow at the time of purchase and designate a portion of the purchase discount as estimated future losses. In determining the initial yield, we discount the expected cash flows for each security assuming certain loss and prepayment assumptions using that security’s specific bond structure. Assumptions regarding future losses, prepayment speeds and interest rates are reviewed and changed, if required, on a month-to-month basis. Should the net present value of a security’s cash flow decrease we incur an impairment expense in order to maintain the previous month’s yield. Should the net present value of a security’s cash flow increase we prospectively adjust the security’s yield.

Since securities in our Subordinate MBS portfolio are usually purchased at a significant discount, increases in prepayment speeds will generally result in an increase in the yield of this portfolio and decreases in prepayment speeds will result in an impairment expense. Similarly, increases in expected losses will generally result in an impairment expense and decreases in expected losses will generally increase the yield of the subordinate portfolio. All loss, prepayment speeds and interest rate assumptions are estimations and involve uncertainty.

For our Mortgage Loan portfolio, recognized revenue consists of the coupon interest received on the loans, potentially adjusted for the amortization of any purchase premiums or accretion of any discounts depending upon the classification of the mortgage loan. Changes in market value below the amortized cost of mortgage loans classified as held for sale and other than temporary impairments of mortgage loans classified as other than held for sale are recorded in income.

For our Agency MBS portfolio, we recognize revenue consisting of the coupon interest received on the securities adjusted for the amortization or accretion of any purchase premiums or discounts.

We use forward sales to economically hedge our Agency MBS portfolio. We recognize gains or losses when forward sales are closed and recognize mark to market gains or losses on open forward sales in income.

Expected credit losses for our Subordinate MBS portfolio are estimated monthly on an individual security basis and comprise a portion of each security’s discount from its par amount. In estimating expected credit losses, we take into account the current delinquency status of the underlying mortgage loans, housing prices, interest rates, prepayment histories and other factors. In general, increased loss expectations will decrease the value of expected future cash flows, thereby causing impairment charges per the effective yield methodology. Decreased loss expectations will, in general, increase the yield on our Subordinate MBS portfolio.

Credit reserves for our Mortgage Loan portfolio are charged to income as loan loss provisions based upon our estimation of expected future losses. We analyze our Mortgage Loan portfolio on a monthly basis to determine the adequacy of the loan loss reserves. No reserves are deemed necessary for our Agency MBS portfolio because either Fannie Mae or Freddie Mac guarantees these securities.

HCP contracts have different terms based on the scope, deliverables and term of the engagement that frequently require us to make judgments and estimates in recognizing revenues. We have many types of contracts, including time-and-materials contracts, fixed-fee plus certain reimbursable expenses contracts and contracts with features of both of these types. Most of HCP’s contracts are short-term contracts and are accounted for in accordance with SEC Staff Accounting Bulletin “SAB” No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 104, “Revenue Recognition”. We recognize revenues from the remainder of HCP’s contracts, which are longer-term contracts, using the percentage-of-completion method pursuant to the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” Percentage-of-completion accounting involves calculating the percentage of services provided during the reporting period compared with the total estimated services to be provided over the duration of the contract.

We recognize revenue from loan brokering and on-line auction hosting when the loan sale transactions close and fund, at which time fees are earned. At the time a transaction closes, the number of loans, loan principal balance and purchase price in the transaction are agreed upon and the sale is funded. Because our valuation and consulting assignments are typically short term, fees are generally payable and revenues are earned at the completion of the assignment.

We earn technology revenue from the following sources: (1) software licensing fees; (2) professional services fees; and (3) valuation services utilizing proprietary software. We recognize technology revenue primarily in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition”, and AICPA Statement of Position 81-1 “Accounting for Performance of Construction Type and Certain Production Type Contracts”.

Our technology transactions (both software licensing and professional services) are documented by a written agreement setting forth the type of fees, the payment schedule, and the milestones required to invoice the client. Our proprietary software is sold either:

Annual license agreements generally run from one to three years, with optional renewal periods. Valuation services are generally offered either on a recurring basis or as a one-time transaction.

Hanover — The REIT

Revenues by Portfolio Type

(dollars in thousands)

The REIT’s total revenues declined to $10.7 million for the year ended December 31, 2005 from $16.6 million for the year ended December 31, 2004. The decline of $5.9 million is primarily due to a decrease of $5.8 million in revenue on our Subordinate MBS Portfolio and a $0.3 decline in other interest income from 2004 to 2005. Revenues from the Mortgage Loan and Agency MBS portfolios were $0.2 million greater for the period ending December 31, 2005, as compared to the comparable 2004 period.

The Mortgage Loans portfolio is comprised of mortgage loans we own that are either funded via term CMO debt or a one-year committed financing facility. In June 2005, we exercised our call rights and retired our 1999-A CMO and retained the underlying mortgage loan collateral. A portion of the 1999-A

related mortgage loans are financed on a one year committed financing facility and a portion of the remainder of the portfolio is financed via a CMO borrowing: Hanover 1999-B.

Total revenues for the Mortgage Loans portfolio decreased $0.1 million to $0.7 million for the year ended December 31, 2005 from $0.8 million for the year ended December 31, 2004. The decline in revenue is the result of a reduction of $0.3 million in net interest income due to the declining principal balance of the portfolio combined with increased financing costs associated with the rise in the one-month LIBOR rate during 2005. Both the 1999-B CMO debt and the facility used to finance the mortgage loans we retained from the call and retirement of our 1999-A CMO are indexed to one-month LIBOR. The $0.3 million decline in net interest income was partially offset by a gain of $0.2 million realized resulting from the call and retirement of our 1999-A CMO and subsequent Fannie Mae MBS securitization of a portion of the retained 1999-A mortgage loans.

The Subordinate MBS portfolio consists primarily of non-investment grade securities collateralized by prime residential mortgage loans. Total revenues for the Subordinate MBS portfolio declined $5.8 million in 2005 to $9.9 million from $15.7 million in 2004. The decline is principally due to a $6.2 million decrease in gain of sales of securities from 2005 to 2004 that was partially offset by a reduction of $0.6 million in impairment expense for the comparable period. Net interest income also declined $0.2 million for the year ended December 31, 2005, as compared to the year ended December 31, 2004.

The decline in the gain on sale revenue is the result of narrowing between the average cost basis and market value of our Subordinate MBS portfolio as well as lower sales volume in 2005 compared to 2004. The narrowing is due to a combination of factors, most importantly a rise in short term interest rates and a decrease in prepayment rates. In 2005 we sold 98 securities having a total principal balance of $87.5 million compared to 149 securities with a total principal balance of $119.6 million in 2004. The reduction in impairment expense is due to sales of bonds with unfavorable credit characteristics.

The $0.2 million decline in net interest income on our Subordinate MBS portfolio is due to a marginally greater increase in interest expense than interest income. For the year ended December 31, 2005, interest income totaled $8.5 million as compared to $7.4 million for the year ended December 31, 2004. Interest expense for the year ended December 31, 2005 totaled $2.2 million as compared to $0.9 million for the year ended December 31, 2004. The overall increase in both interest income and expense from 2004 to 2005 is the result of an increase in asset size of the Subordinate MBS portfolio. The proportionally greater increase in interest expense compared to interest income is to due to a greater rise in the short term interest rates of our financings relative to the longer term asset yields on our Subordinate MBS holdings. This mismatch is primarily due to the “flattening” of the yield curve as short term interest rates increased more than long term interest rates during 2005.

The Agency MBS portfolio includes whole pool Fannie Mae or Freddie Mac issued mortgage-backed securities that are held primarily as qualifying assets for purposes of satisfying certain exemptive provisions of the Investment Company Act of 1940. With the exception of the Fannie Mae MBS securities collateralized by 1999-A CMO loans, which total $8.0 million of the $90.5 million asset value of the Agency MBS portfolio, the Agency MBS portfolio is hedged with forward sales of like-characteristic Agency MBS securities. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency MBS that are substantially economically offset by gains or losses from forward sales of like-characteristic Agency MBS securities.

For the year ended December 31, 2005, total revenue for the Agency MBS portfolio was $0.1 million as compared to a loss of $0.3 million for the year ended December 31, 2004. The $0.3 million increase is principally the consequence of not financing certain securities during portions of 2005 due to excess liquidity as the result of the trust preferred stock issuance.

Other interest income consists largely of earnings on our cash and cash equivalents and loans to subsidiaries that are eliminated in consolidation, interest expense related to our trust preferred stock issuance and other gains that are chiefly associated with the mark to market of our interest rate caps. For the year ended December 31, 2005, other interest income was $0.02 million as compared to $0.3 million

for the year ended December 31, 2004. The decline is the result of a $0.9 million reduction in net interest income that is primarily related to the issuance of trust preferred stock. This net interest decrease was partially offset by a reduction of $0.3 million in realized losses on our interest rate caps. Our interest rate caps are used to manage the interest rate risk on our financings and are classified as freestanding derivatives.

Revenues by Portfolio Type

(dollars in thousands)

The REIT’s total revenues increased to $16.6 million for the year ended December 31, 2004 from $14.5 million for the year ended December 31, 2003. This increase is primarily due to an increase of $2.7 million in revenue on our Subordinate MBS Portfolio that was offset by a $0.4 million decline in Mortgage Loan revenue. Also, revenues from our Agency MBS and Other Income portfolios, together, were $0.2 million lower.

Our Mortgage Loans portfolio for the years ended December 31, 2004 and 2003 is comprised of mortgage loans we owned that were funded via term CMO debt. In 2003, we exercised our call rights and retired 2 of our 4 outstanding CMOs, 1998-A and 1998-B, and sold underlying mortgage loan collateral.

Total revenues for the Mortgage Loans portfolio decreased $0.4 million to $0.8 million for the year ended December 31, 2004 from $1.2 million for the year ended December 31, 2003. The decline in revenue is primarily the result of a reduction of $0.4 million in net interest income due to the declining principal balance of the portfolio due to scheduled and unscheduled principal payments, in addition to the retirement of our 1998-A and 1999-B CMOs in 2003.

Our Subordinate MBS portfolio consists primarily of non-investment grade securities collateralized by prime residential mortgage loans. Total revenues for our Subordinate MBS portfolio increased by $2.7 million in 2004 to $15.7 million from $13.1 million in 2003. The increase is primarily due to a $2.6 million increase in net interest income that is attributable to the growth in the average net interest earning assets during the year ended December 31, 2004. The increase in earning assets is primarily the result of the capital raised in August 2003 in connection with the public offering of our common stock. Gains on sales of securities declined $0.4 million to $10.4 million for the year ended December 31, 2004 from $10.7 million for the comparable 2003 period. Impairment associated expenses declined $0.1 million to $1.1 million from $1.2 million for the years ended December 31, 2004 and 2003, respectively. In 2003, there was a $0.3 million shared revenue expense with an affiliate company that was not incurred in 2004.

The Agency MBS portfolio includes whole pool Fannie Mae or Freddie Mac issued mortgage-backed securities that are held primarily as qualifying assets for purposes of satisfying certain exemptive provisions of the Investment Company Act of 1940. The Agency MBS portfolio is hedged with forward sales of like-characteristic Agency MBS securities. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency MBS that are substantially offset economically by gains or losses from forward sales of like-characteristic Agency MBS securities.

For the year ended December 31, 2004, total revenue for the Agency MBS portfolio was a loss of $0.3 million as compared to a loss of $0.1 million for the year ended December 31, 2003. This decrease in revenue is primarily related to transaction costs associated with hedging the Agency MBS portfolio.

Other interest income consists largely of earnings on our cash and cash equivalents and loans to subsidiaries that are eliminated in consolidation, and other gains that are chiefly associated with the mark to market of our interest rate caps. For the year ended December 31, 2004, other interest income was unchanged at a gain of $0.3 million as compared to the year ended December 31, 2004.

HCP

Revenues increased for the year ended December 31, 2005, as compared to the same period in 2004, primarily from the due diligence reviews for HCP’s largest customer. HCP successfully focused on expanding the business relationship with this customer during 2005 through customer attention, long-term servicing discussions, and minor pricing considerations. In addition, HCP expanded its on-site loan processing operations, allowing a greater volume of activity at a lower cost. Operating income increased over the same periods due to the increase in revenue, partially offset by an unfavorable change in product mix to services that have a lower gross margin.

Revenues decreased for the year ended December 31, 2004, as compared to the same period in 2003, primarily due to a large government project that was performed in 2003 that did not continue into 2004. Operating income decreased over the same periods primarily due to the decrease in revenues and additional legal and professional expenses incurred due to the implementation of Sarbanes Oxley requirements.

The financial condition of HCP has remained relatively constant throughout 2005 and 2004.

HCP has projected modest revenue and operating income growth for 2006. This growth is expected to occur through increases in activity with several current key customers. However, reductions in mortgage acquisition activity in the marketplace may offset this potential growth.

HT

Revenue for each of the years ended December 31, 2005 and 2004 decreased from the prior periods primarily because of lower loan sale advisory services. These services decreased as the number of customer accounts decreased due to mergers and consolidations in the marketplace. In addition, there has been a continuing reduction in loan sale advisory opportunities put forth by the Federal Deposit Insurance Corporation and other agencies which historically over past years have made up a significant portion of the loan sale advisory revenue. These decreases were partially offset by increases in technology revenue, resulting from new implementations and deployments and related professional services. Operating income decreased over the same periods due to a higher cost structure associated with the technology revenue. In addition, loan sale advisory personnel costs did not decrease at the same rate as the decrease in revenue. The decrease in operating income in 2004 was partially offset by the reduction in costs associated with the departure of two executives that terminated their employment with HT in January of 2004.

The financial condition of HT has remained relatively constant throughout 2005 and 2004.

We are projecting HT revenue for 2006 to be relatively constant with the revenue levels in 2005. We anticipate the operating loss for 2006 to be significantly lower than the operating loss for 2005. This decrease is due to a reduction in headcount, a reduction in costs related to the development of additional technology, and a significant reduction in the amortization of capitalized software costs, as several components of the capitalized software have reached, or are close to, the end of their estimated useful life. These costs have historically amounted to approximately $2.0 million in annual expense.

Operating Expenses

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

The increase in operating expenses for the year ended December 31, 2005, compared to the same period in 2004, is primarily due to the following:

These increases are partially offset by a decrease in personnel costs primarily from a reduction in bonuses and an executive that terminated employment with the Company in the middle of 2005;

The increase in operating expenses for the year ended December 31, 2004, compared to the same period in 2003, is primarily due to the increase in professional fees in connection with the change of independent accountants and Sarbanes-Oxley Act of 2002 compliance related costs and the increase in technology costs in connection with the implementation of additional technology solutions. These increases are partially offset due to the completion of the amortization of the original capitalized software related to our electronic trading platform.

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. For the year ended December 31, 2005, we recognized $(0.2) million in equity in (loss) income of HDMF-I, as compared to $0.4 million in 2004. This decrease was primarily attributable to a reduction in the size of the portfolio of distressed mortgage loans. The increase in equity in income of HDMF-I to $0.4 million in 2004 from $0.0 million in 2003 was primarily attributable to sales of mortgage loans.

The table below presents our return on average equity for 2005, 2004 and 2003.

Average equity excludes notes receivable from related parties and accumulated other comprehensive (loss) income.

The percentages in the table above were derived from our audited Consolidated Financial Statements included elsewhere in this report.

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 to 17.94% for the year ended December 31, 2005 from 25.7% for the year ended December 31, 2004. The decrease in the yield on net portfolio assets is primarily the result of the decrease in leverage in 2005 as compared to the leverage in 2004.

Net investment portfolio assets increased to $50.3 million for the year ended December 31, 2005 from $37.9 million for the year ended December 31, 2004. 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.

The yield on net portfolio assets decreased to 25.70% for the year ended December 31, 2004 from 27.73% for the year ended December 31, 2003. The decrease in the yield on net portfolio assets is primarily the result of the net interest spread increasing to 4.78% for the year ended December 31, 2004 from 4.07% for the year ended December 31, 2003. This increase was due primarily to the decline in the effective borrowing rate of our investment portfolio liabilities to 3.01% for the year ended December 31, 2004 from

3.89% for the year ended December 31, 2003. This decline was due to decreases in the rate of one-month LIBOR.

Net investment portfolio assets increased to $37.9 million for the year ended December 31, 2004 from $21.7 million for the year ended December 31, 2003. This increase is primarily due to increased Subordinate MBS and Agency MBS investments.

      Mortgage Loans

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

Our Mortgage Loan portfolio net interest income declined each of the two years ended December 31, 2005. This decline in net interest income is due to the declining principal balance of our Mortgage Loan portfolio due to scheduled and unscheduled principal payments which reduced the mortgage loan balance and the rise in the interest expense related to one-month LIBOR. In 2005, the decline was furthered when we called and retired our 1999-A CMO and purchased the underlying loans, of which a significant portion were in turn securitized in Fannie Mae issues.

The decline in net interest income in 2004 from 2003 is due to the decline in principal balance of our Mortgage Loan portfolio due to scheduled and unscheduled principal payments which reduced the mortgage loan balance and the termination of our 1998-A and 1998-B CMO securitizations.

      Subordinate MBS

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

The Subordinate MBS portfolio’s net interest income decreased to $6.3 million for the year ended December 31, 2005 from $6.5 million for the year ended December 31, 2004. This decrease in revenues was attributable to the decline in the average net interest earning assets to $29.2 million for the year ended December 31, 2005 from $29.9 million for the year ended December 31, 2004.

The Subordinate MBS portfolio’s net interest spread decreased to 6.57% for the year ended December 31, 2005 from 9.57% for the year ended December 31, 2004. The reduction in the net interest spread was due to a decline in the effective interest income rate to 11.41% for the year ended December 31, 2005 from 12.72% for the year ended December 31, 2004 and an increase in the effective interest expense rate to 4.84% for the year ended December 31, 2005 from 3.15% for the year ended December 31, 2004. The decrease in the effective interest income rate was due to a combination of a shift in the Subordinate MBS portfolio to higher-rated securities coupled with an increase in adjustable rate securities relative to fixed rate securities. The increase in the effective interest expense rate is due to increases in the rate of one-month LIBOR offset partially by lower financing rates due to a shift to higher-rated securities.

The Subordinate MBS portfolio’s net interest income increased to $6.5 million for the year ended December 31, 2004 from $3.7 million for the year ended December 31, 2003. This increase in revenues was attributable to the growth in the average net interest earning assets to $29.9 million for the year ended December 31, 2004 from $13.9 million for the year ended December 31, 2003, primarily as a result of the investments made with capital raised in August 2003 in connection with the public offering of our common stock.

The Subordinate MBS portfolio’s net interest spread decreased to 9.57% for the year ended December 31, 2004 from 13.15% for the year ended December 31, 2003. The reduction in the net interest spread was primarily due to a decline in the effective interest income rate to 12.72% for the year ended December 31, 2004 from 15.82% for the year ended December 31, 2003 and an increase in the effective interest expense rate to 3.15% for the year ended December 31, 2004 from 2.67% for the year ended December 31, 2003. The decrease in the effective interest income rate was due to lower yields on purchases of Subordinate MBS during 2004. The increase in the effective interest expense rate is due to increases in the rate of one-month LIBOR.

          Agency MBS

The following table provides details of the net interest income generated on the Agency MBS portfolio (dollars in thousands):

The Agency MBS portfolio’s net interest income decreased to $2.1 million for the year ended December 31, 2005 from $2.4 million for the year ended December 31, 2004. The decrease is primarily due to the decrease in net interest spread from 3.34% during 2004 to 1.78% during 2005, partially offset by the growth of the portfolio in 2005.

The Agency MBS portfolio’s net interest spread decreased to 1.78% for the year ended December 31, 2005 from 3.34% for the year ended December 31, 2004. The decrease in the net interest spread was due to the increase in the effective interest expense rate to 3.28% for the year ended December 31, 2005 from 1.61% for the year ended December 31, 2004 that was partially offset by the increase in the effective interest income rate to 5.06% for the year ended December 31, 2005 from 4.95% for the year ended December 31, 2004. The increase in the effective interest expense rate was due to increases in the rate of one-month LIBOR.

The Agency MBS portfolio’s net interest income increased to $2.4 million for the year ended December 31, 2004 from $0.9 million for the year ended December 31, 2003. The increase is primarily due to an increase in the average balance to $72.0 million during 2004 from $24.9 million during 2003. The increase in the Agency MBS portfolio was intended to satisfy certain REIT related income and asset requirements.

The Agency MBS portfolio’s net interest spread decreased to 3.34% for the year ended December 31, 2004 from 3.54% for the year ended December 31, 2003. The decrease in the net interest spread was primarily due to an increase in the effective interest expense rate to 1.61% for the year ended December 31, 2004 from 1.16% for the year ended December 31, 2003 and that was partially offset by an increase in the effective interest income rate to 4.95% for the year ended December 31, 2004 from 4.70% for the year ended December 31, 2003. The increase in the effective interest expense rate is due to increases in the rate of one-month LIBOR. The increase in the effective interest income rate was due the purchase of higher coupon Agency MBS during 2004 as compared to 2003.

We attempt to fully economically hedge our Agency MBS portfolio to potentially offset any gains or losses in our portfolio with losses or gains from our forward sales of like-kind Agency MBS. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency sMBS. However, these earnings are substantially economically offset by gains or losses from forward sales of like coupon Agency MBS.

The table below reflects the net economic impact of our Agency MBS portfolio for the year ended December 31, 2005 (dollars in thousands):

We operate as a REIT and are required to pay dividends equal to at least 90% of our REIT taxable income. We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our 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 tax and GAAP, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant. In 2005, we declared, respectively, regular quarterly dividends of $0.30 per share, $0.30 per share, $0.25 per share, and $0.25 per share, aggregating to $1.10 per share. In each of 2003 and 2004, we declared regular quarterly dividends aggregating to $1.20 per share. In 2004, we also paid a special dividend of $0.40 per share reflecting the earnings for the year ended December 31, 2003.

Taxable income for the year ended December 31, 2005 is approximately $7.3 million. Taxable income differs from net income because of timing differences (refers to the period in which elements of net income can be included in taxable income) and permanent differences (refers to an element of net income that must be included or excluded from taxable income).

The following table reconciles net income to estimated taxable income for the year ended December 31, 2005 (dollars in thousands):