10-K 1 b45679hce10vk.txt HANOVER CAPITAL MORTGAGE HOLDINGS, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K |X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2002 OR |_| Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from _____________ to ______________ Commission file number: 001-13417 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. (Exact name of registrant as specified in its charter) MARYLAND 13-3950486 (State or other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 379 THORNALL STREET, EDISON, NEW JERSEY 08837 (Address of principal executive offices) (Zip Code) (732) 548-0101 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of Class Name of Exchange on Which Registered -------------- ------------------------------------ Common Stock $.01 Par Value per Share American Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes [ ] No [X] 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, 2002 was $36,409,425. The registrant had 4,534,402 shares of common stock outstanding as of March 25, 2003. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Notice of 2003 Annual Stockholders' Meeting and Proxy Statement, to be filed 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, 2002 INDEX

PART I PAGE ---- Item 1. Business .............................................................................................. 3 Item 2. Properties ............................................................................................ 16 Item 3. Legal Proceedings ..................................................................................... 16 Item 4. Submission of Matters to a Vote of Security Holders ................................................... 16 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ................................. 17 Item 6. Selected Financial Data ............................................................................... 18 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................. 19 Item 7a. Quantitative and Qualitative Disclosure About Market Risk ............................................. 36 Item 8. Financial Statements and Supplementary Data ........................................................... 38 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .................. 38 PART III Item 10. Directors and Executive Officers of the Registrant .................................................... 39 Item 11. Executive Compensation ................................................................................ 39 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters ........ 39 Item 13. Certain Relationships and Related Transactions ........................................................ 39 Item 14. Controls and Procedures ............................................................................... 39 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ....................................... 40 Signatures ...................................................................................................... 41 Certifications .................................................................................................. 42

PART I ITEM 1. BUSINESS This Annual Report on Form 10-K contains, in addition to historical information, forward-looking statements that involve risk and uncertainty. Our actual results could differ significantly from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences include those discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations," as well as those discussed elsewhere in this Annual Report on Form 10-K. GENERAL Hanover Capital Mortgage Holdings, Inc., which we refer to as 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, which we refer to as the "Code." Hanover has two primary subsidiaries: Hanover Capital Partners Ltd., which we refer to as HCP, and HanoverTrade, Inc., which we refer to as HT. When we use the terms "we", "us", "our" or "the Company," we are referring to Hanover together with its consolidated and unconsolidated subsidiaries including HCP and HT. We are engaged in three principal businesses, which are conducted through our three primary operating units: Hanover, HCP and HT. Hanover's principal business strategy is to invest in subordinate mortgage-backed securities, which we refer to as MBS, and mortgage loans for its own account, and, since 2001, for third parties. HCP's principal business strategy is to generate consulting and other fee income by providing consulting and due diligence services, focusing on loan sale advisory, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. HT's principal business strategy is to generate fee income by operating an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and providing state-of-the-art technologies supported by experienced valuation, operations and trading professionals. As discussed below, on July 1, 2002, Hanover acquired 100% of the ownership interests in HCP and HT. We believe that our new consolidated financial reporting should also include segment information for each of Hanover, HCP and HT on a stand-alone basis. Note 16 to the consolidated financial statements attached to this Annual Report on Form 10-K includes financial information for each of our segments on a stand-alone basis. Our principal business objective is to generate net interest income on our portfolio of mortgage securities and mortgage loans and to generate fee income through HCP, HT and third party asset-management contracts. Our principal executive offices are located at 379 Thornall Street, Edison, New Jersey 08837. CONSOLIDATION OF HANOVER, HCP AND HT Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved by a special committee of disinterested members of our Board of Directors, Hanover acquired 100% of the outstanding common stock of each of HT, HCP and Hanover Capital Partners 2, Inc., which we refer to as HCP-2, a previously inactive subsidiary. Hanover had previously owned 100% of the non-voting preferred stock, but none of the voting common stock, of each of HT, HCP and HCP-2. This ownership structure was established in order to satisfy tax laws governing Hanover's status as a REIT. Changes in the tax laws made it possible for Hanover to acquire voting control of HT, HCP and HCP-2 and operate under new rules permitting REITs to wholly own subsidiaries such as HT, HCP and HCP-2. Therefore, as of July 1, 2002, Hanover owns 100% of the outstanding capital stock of each of HT, HCP and HCP-2, and for periods ending after June 30, 2002, Hanover's financial statements will be consolidated with the financial statements of HT, HCP and HCP-2. 3 Hanover acquired the common shares of HT, HCP and HCP-2 from four of its directors who are also executive officers for $474,000, the price set by an independent appraiser. HANOVER General Hanover's primary businesses are (1) to acquire and hold prime whole single-family mortgage loans which serve as collateral for collateralized mortgage obligations, which we refer to as CMOs, as well as subordinated single-family mortgage securities and other mortgage-related assets and (2) to generate fee income from its operating subsidiaries. "Subordinated" MBS bear all of the credit losses on the related pool of mortgage loans. In other words, any declines in the value of the pool of loans will erode the value of our subordinate interests before any losses accrue to the value of more senior interests in the pool. As a result, these securities bear much greater risk than the more senior tranches and are generally rated below investment grade by the major statistical rating organizations, such as Moody's Investors Service, Standard & Poor's Ratings Group or Fitch Investor Service. We also act as an outside management company for real estate investment vehicles. In this capacity, we provide asset-management services, including due diligence and administrative responsibilities. Currently, we manage the investments of HDMF-I LLC, an entity that invests in sub- and non-performing single-family mortgage loans. Our primary objectives in forming HDMF-I were to earn a profit participation while also earning fee income from the related asset management contract. As of December 31, 2002, HDMF-I had received capital commitments of $18,500,000, including $5,820,000 committed by us. We are currently negotiating with institutional investors to increase the total capital commitments to HDMF-I, and we also intend to target other opportunities for us to manage assets for third parties under a similar structure; however, there can be no assurances that we will be successful in raising additional funds to manage. We believe that our sales and due diligence organization and mortgage industry expertise give us advantages over other mortgage market participants. Prior to acquiring any subordinate MBS, we use our own resources and information provided by HCP to analyze the credit risk characteristics of these mortgage loan pools and, we believe, to price these securities more accurately than others in the market. 4 In the past, we invested directly in mortgage loans on our own behalf. We issued MBS secured by these loans, and retained the subordinate securities from these transactions. Although we may securitize additional pools of mortgage loans on our own in the future, our current strategy is to acquire and hold prime whole single-family mortgage loans which serve as collateral for CMOs, as well as subordinated single-family mortgage securities and other mortgage-related assets. Trends and Recent Developments Purchase and Sale of Subordinate MBS. As mentioned above, prior to 1999 we invested primarily in prime mortgage whole loans, which we subsequently securitized. When we securitized these mortgage whole loans, we retained a subordinate interest in the loans, which are referred to as subordinate MBS. Other issuers also create subordinate MBS that trade in organized markets. The market for subordinate MBS changed dramatically at the end of 1998 and in early 1999, resulting in a substantial buying opportunity for us. As a result of the change in relative pricing, we found that we could purchase subordinate MBS created by other entities at very attractive yields. Our costs to acquire subordinate MBS created by other issuers is substantially lower than the cost of creating our own subordinate MBS. As a result of the continued evolution of the markets in which we operate, we shifted our strategy in 1999 from a focus on securitizing seasoned mortgage whole loans to acquiring interests in third-party securitizations. During 2002, we purchased thirty-seven subordinate MBS with an aggregate principal balance of $23,255,000 at a net purchase price of $12,909,000 and we sold twenty-four subordinate MBS with an aggregate principal balance of $16,322,000 at a net sales price of $13,777,000. The sale of subordinate MBS during 2002 was primarily in response to market conditions and, to a lesser extent, asset performance. However, given that we generally intend to hold our assets for the long-term, we do not anticipate that the sale of subordinate MBS will be a recurring source of income for us. During 2002, we purchased MBS issued by agencies of the Federal Government, which we refer to as agency-issued MBS, with an aggregate principal balance of $29,994,000 at a net purchase price of $33,243,000. During 2002, we sold agency-issued MBS with an aggregate principal balance of $53,376,000 at a net sales price of $58,867,000. In the third quarter of 2002, we terminated our agency-issued MBS trading activity. Current Portfolio Composition At December 31, 2002, we had invested $112,969,000, or 72.5% of our total assets, in single-family mortgage loans classified as held for sale and collateral for CMOs, and $14,098,000, or 9.0%, of our total assets, in single-family MBS classified as available for sale, held to maturity or trading. The composition of mortgage loans and mortgage securities is described in detail in Notes 3 and 4 to our audited consolidated financial statements included in this Annual Report on Form 10-K. In 2002, we experienced $347,000 of mortgage loan losses on our mortgage loan portfolio (held for sale and collateral for CMOs), and $48,000 of losses on our MBS portfolio (available for sale, held to maturity and trading). We experienced $149,000 of mortgage loan losses during 2001 on our mortgage loan portfolio and $90,000 of losses on our MBS portfolio. We recorded a provision for anticipated credit losses of $393,000 and $709,000 in 2002 and 2001, respectively. Generally, we intend to hold the mortgage loans and created mortgage securities on a long-term basis, so that we will earn returns over the lives of the mortgage loans and mortgage securities rather than from sales of the investments. However, we may sell mortgage securities from time to time depending on market conditions. 5 Securitization Activity In June 2000, we issued $13,222,000 of CMO borrowings at a discount of $2,013,000 for net proceeds before expenses of $11,209,000. The "Hanover 2000-A" CMO securities carry a fixed interest rate of 6.50%. The Hanover 2000-A securities were collateralized by $25,588,000 principal balance of the retained portions of our previous CMO borrowings, Hanover 98-A, Hanover 99-A and Hanover 99-B and certain retained MBS from Hanover 98-B at time of securitization. Subordinate MBS Purchases In analyzing subordinate MBS for purchase, we focus primarily on subordinated interests, which we refer to as tranches, in pools of prime whole single-family mortgage loans that do not fit into large conduits sponsored by government agencies such as the Federal National Mortgage Association ("FNMA" or "Fannie Mae"), the Federal Home Loan Mortgage Corporation ("FHLMC"), or the Government National Mortgage Association ("GNMA" or "Ginnie Mae"). Typically, loans fail to qualify for these programs because the principal balance of the mortgages exceeds the maximum amount permissible in a government agency guaranteed MBS. The subordinate interests that we purchase are generally structured so that they will absorb the credit losses resulting from a specified pool of mortgages. Because these tranches could potentially absorb credit losses, the securities we purchase are generally either not rated or are rated below investment grade (generally "BB" or "B"), although the pools are usually collateralized by "A" quality mortgages originated by several of the largest non-government mortgage conduits in the market. These tranches are generally purchased at a substantial discount to their principal balance. This discount provides a cushion against potential future losses and, to the extent that losses on the mortgage loans are less than the discount, the discount provides a yield enhancement. A majority of our subordinate MBS acquired to date have paid interest at fixed rates. We purchase subordinate MBS primarily from "Wall Street" dealer firms, although we are also attempting to develop direct relationships with the larger issuers of subordinate MBS. For the foreseeable future, we believe that there will be an adequate supply of subordinate MBS available in the market. As of December 31, 2002, we had purchased since inception approximately $104,001,000 (principal balance) of subordinate MBS from third parties at an aggregate purchase price of $53,649,000. As of the same date, we had sold approximately $79,134,000 (principal balance) of such securities. At December 31, 2002, we owned $23,026,000 (principal balance) of subordinate MBS purchased from third parties, representing a subordinate interest in $5,756,230,000 of single-family mortgage loan pools. The aggregate carrying value of these MBS at December 31, 2002 was $12,966,000. We are not dependent on any one source for subordinate MBS investments because there are a number of regular issuers of such securities. Note 5 to our audited consolidated financial statements included in this Annual Report on Form 10-K describes the concentration of our portfolio by issuer. Management believes that the loss of any single financial institution from which we purchase subordinate MBS would not have any detrimental effect on us. However, we cannot assure you that increased competition will not have a negative effect on the pricing of such investments. HCP has a due diligence and consulting staff, located in Edison, New Jersey, consisting of approximately 19 full-time employees at December 31, 2002 and access to a part-time pool of employees in excess of 500. The due diligence staff contributes to the process of selecting and acquiring subordinate MBS by providing expertise in the analysis of many characteristics of the underlying single-family mortgage loans. Before we offer to purchase a subordinate MBS, HCP employees conduct an extensive investigation and evaluation of the loans collateralizing the security. This examination typically consists of analyzing the information made available by the seller, reviewing other relevant material that may be available, analyzing the underlying collateral (including reviewing our single-family mortgage loan database which contains, among other things, listings of property values and loan loss experience in local markets for 6 similar assets) and, in certain instances, obtaining property-specific opinions of value from third parties. Our senior management determines the amount to be offered for the security using a proprietary stratification and pricing system which focuses on, among other things, rate, term, location, credit scores and types of the loans. We also review information on the local economy and real estate markets (including the amount of time and procedures legally required to foreclose on real property) where the loan collateral is located. By examining the mortgage pool loan data, we estimate a prepayment speed based primarily upon the gross coupon rates and seasoning of the subject pool. We also determine a "base case" default scenario and several alternative scenarios based on the Public Securities Association's standard default assumption, which we refer to as SDA. The default scenarios reflect our estimate of the most likely range of potential losses on the underlying mortgage loans, taking into consideration the credit analysis described above. After determination of a prepayment speed and a base case SDA, we model the pools' cash flow stream and calculate a proposed purchase price as the present value of the base case cash flow stream, discounted by the current market rate for securities with similar product type and credit characteristics. We then examine the yield of the security under various alternative SDAs and prepayment assumptions and, if necessary, adjust the proposed purchase price so that we will receive an acceptable yield under a variety of possible scenarios. HANOVER CAPITAL PARTNERS LTD. Through HCP, we provide due diligence and consulting services for commercial banks, government agencies, mortgage banks, credit unions and insurance companies. The operations consist of loan sale advisory assignments, the underwriting of credit, analysis of loan documentation and collateral, analysis of the accuracy of the accounting for mortgage loans serviced by third party servicers, and the preparation of documentation to facilitate the transfer of mortgage loans. The due diligence analyses are performed on a loan-by-loan basis. Consulting services include loan sale advisory work for governmental agencies such as the Small Business Administration and the Federal Deposit Insurance Corporation as well as private sector financial institutions. HCP also performs due diligence on mortgage assets we acquire, and owns a licensed mortgage banker, Hanover Capital Mortgage Corporation, which we refer to as HCMC and a licensed broker-dealer, Hanover Capital Securities, Inc., which we refer to as HCS. Neither of these companies currently conducts any material ongoing business. In January 2000, HCP hired all of the former management of Document Management Network, Inc., to continue as the Assignment Division of HCP. The Assignment Division provides mortgage assignment services for many of the customers serviced by HCP. Whenever an institution purchases a mortgage loan in the secondary market, the purchaser is required to submit paperwork (called an "assignment of mortgage") to the local county or city jurisdiction in which the mortgaged property is located in order to record the new institution's interest in the mortgaged property. The Assignment Division employees prepare and process this paperwork for third party institutions. During 2002, HCP's assignment and due diligence fees accounted for 27% of our total consolidated revenues. For the year ended December 31, 2002, three of HCP's customers accounted for 49% in the aggregate of its total revenue. 7 HANOVERTRADE, INC. Through HT, we conduct loan brokering and trading, and loan sale advisory services. HT operates an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and performs loan sale advisory services for third parties. HT was incorporated on May 28, 1999. In the third quarter of 2000, the loan brokering and trading activities of HCP were combined with the HT activities. HT officially launched its web site on October 29, 2000. In January 2001, HT hired all of the former employees and acquired all of the assets of Pamex Capital Partners, LLC. Prior to its acquisition, Pamex was a traditional broker of pools of mortgage loans and consumer loans. With the acquisition of Pamex, subsequent reassignments and new hires, at December 31, 2002, HT had 11 full-time salespeople. These salespeople attempt to maintain regular contact with all of the major buyers and sellers of mortgage and consumer prime whole loans. HT facilitates the sale of pools of mortgage loans, consumer loans and commercial mortgage loans to institutional purchasers. HT arranges for such sales through its web site as well as through more traditional channels, including telephone contact and e-mail. To assist in the sales process of these pools, HT may prepare marketing materials and marketing analyses for sellers of pools. During 2002, HT's loan brokering, trading and advisory services, taken together, accounted for 17% of our total consolidated revenues. In that year, two of HT's customers individually accounted for 66% and 24% of HT's total accounts receivable, and one customer accounted for 49% of HT's total revenues. HT's contract with the Federal Deposit Insurance Corporation, which was the customer contributing 49% of HT's total revenues, ended in April 2002. Although the FDIC from time to time retains HT to perform additional advisory services related to that original contract, we cannot assure you that HT will be able to obtain additional engagements that will maintain the level of revenues generated by the FDIC contract. 8 FINANCING General Until we can arrange for long-term financing, we initially finance purchases of mortgage-related assets with equity and short-term borrowings through reverse repurchase agreements. Generally, upon repayment of each borrowing in the form of a reverse repurchase agreement, the mortgage asset used to secure the financing will immediately be pledged to secure a new reverse repurchase agreement or some form of long-term financing. At December 31, 2002, we had one established committed reverse repurchase agreement line of credit with available capacity to borrow $10 million. In addition, we had four uncommitted reverse repurchase agreement lines of credit. Reverse Repurchase Agreements A reverse repurchase agreement, although structured as a sale and repurchase obligation, is a financing transaction in which we pledge our mortgage assets as collateral to secure a short-term loan. Generally, the other party to the agreement will loan an amount equal to a percentage of the market value of the pledged collateral, ranging from 50% to 97% depending on the credit quality, liquidity and price volatility of the collateral pledged. At the maturity of the reverse repurchase agreement, we repay the loan and reclaim our collateral. Under reverse repurchase agreements, we generally 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. Some of our reverse repurchase agreements may qualify for special treatment under the United States Bankruptcy Code in the event we become bankrupt or insolvent, which permits the creditor to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral without delay. In the event of the insolvency or bankruptcy of a lender during the term of a reverse repurchase agreement, the lender may be permitted, under the Bankruptcy Code, to repudiate the contract, and our claim against the lender for damages may be treated as that of an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970 or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our mortgage assets under a reverse repurchase agreement or to be compensated for damages resulting from the lender's insolvency may be limited by those laws. The effect of these various statutes is, among other things, that a bankrupt lender, or its conservator or receiver, may be permitted to repudiate or disaffirm its reverse repurchase agreements, and our claim against the bankrupt lender may be treated as an unsecured claim. Should this occur, our claims would be subject to significant delay and, if and when paid, could be in an amount substantially less than the damages we actually suffered. To reduce our exposure to the credit risk of reverse repurchase agreements, we enter into such arrangements with several different parties. We monitor our exposure to the financial condition of our reverse repurchase lenders on a regular basis, including the percentage of our mortgage securities that are the subject of reverse repurchase agreements with a single lender. Notwithstanding these measures, we cannot assure you that we will be able to avoid such third party risks. Our reverse repurchase borrowings bear short-term (one year or less) fixed interest rates indexed to LIBOR plus a spread of 40 to 200 basis points depending on the credit of the related mortgage assets. In the event the market value of existing collateral declines, which could occur in dramatically rising interest-rate markets, we could be required to pledge additional collateral to the loan, or to sell assets to reduce the borrowings. 9 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 are intended to keep our leverage balanced by (i) matching the amount of leverage to the riskiness (return and liquidity) of each investment and (ii) monitoring the credit and prepayment performance of each investment to adjust the required capital. This analysis takes into account our various hedging and other risk containment programs discussed below. Lenders generally require us to deduct a minimum fixed percentage from the mortgage asset to determine the value of the asset for lending purposes. There is some variation in haircut levels among lenders from time to time. From the lender's perspective, the haircut is a cushion to provide additional protection if the value of or cash flow from an asset pool declines. The size of the haircut depends on the liquidity and price volatility of each investment. Agency-issued securities are very liquid, with price volatility in line with the fixed income markets, which means a lender requires a smaller haircut, typically 3%. On the other extreme, securities rated below "AAA" and securities not registered with the Securities and Exchange Commission are substantially less liquid, and have more price volatility than agency-issued securities, which results in a lender requiring a larger haircut (5% to 50% depending on the rating). Particular securities that are performing below expectations would also typically require a larger haircut. The haircut for residential whole loan pools will generally range between 3% and 5% depending on the documentation and delinquency characteristics of the pool. Certain whole loan pools may have haircuts which may be negotiated with lenders in excess of 5% due to other attributes of the pool, including delinquencies, aging and liens. Implementation of the CAG -- Mark to Market Accounting Each quarter, for financial management and accounting purposes, we undertake a valuation activity known as "mark to market." This process consists of (i) valuing our investments acquired in the secondary market, and (ii) valuing our non-security investments, such as retained interests in securitizations. To value our investments acquired in the secondary market, we obtain benchmark market quotes from traders who make markets in securities similar in nature to our investments. We then adjust for the difference in pricing between securities and whole loan pools. We calculate the market values of our retained interests in securitizations using market assumptions for losses, prepayments and discount rates. We subtract the face amount of the financing used for the securities and retained interests from the current market value of the mortgage assets to obtain the current market value of our equity positions. We then compare this value to the required capital as determined by our CAG. If our actual equity falls below the capital required by our guidelines, we must prepare a plan to bring the actual capital above the level required. Periodically, management presents to the Board of Directors the results of the CAG compared to actual equity. Management may propose changing the capital required for a class of investments or for an individual investment based on its prepayment and credit performance relative to the market and our ability to predict or hedge the risk of the investments. As a result of these procedures, the leverage of the 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 help maintain the maximum acceptable leverage (and earnings) while protecting our capital base. We can give you no assurance that the CAG will successfully protect our capital. 10 RISK MANAGEMENT We believe that our portfolio income is subject to three primary risks: credit risk, interest rate risk and prepayment risk. Although we believe we have developed a cost-effective asset/liability management program to provide a level of protection against credit, interest rate and prepayment risks, no strategy can completely insulate us from the effects of credit risk, interest rate changes, prepayments and defaults by counterparties. Further, certain of the Federal income tax requirements that we must satisfy to qualify as a REIT may limit our ability to fully hedge our risks. Credit Risk Management We attempt to reduce credit risk by (i) reviewing each MBS or mortgage loan prior to purchase to ensure that it meets our guidelines; (ii) employing early intervention, aggressive collection and loss mitigation techniques; (iii) maintaining appropriate capital and reserve levels; and (iv) obtaining representations and warranties, to the extent possible, from originators. Although we do not set specific geographic diversification requirements, we monitor the geographic dispersion of the mortgage loans and make decisions on a portfolio-by-portfolio basis about adding to specific concentrations. By diversifying our portfolio across geographic regions, we mitigate the negative effects on our portfolio of adverse economic conditions in particular regions. In the past, we invested directly in mortgage loans on our own behalf. We generally purchased prime single-family mortgage loans in bulk pools of $2 million to $100 million. The credit underwriting process varied depending on the pool characteristics, including seasoning, loan-to-value ratios and payment histories. For a new pool of single-family mortgage loans, a full due diligence review was undertaken, including a review of the documentation, appraisal reports and credit underwriting. Where required, an updated property valuation was obtained. The bulk of the work was performed by employees in the due diligence operations of HCP. Depending on market conditions, we might decide to undertake this business activity again in the future. Interest Rate Risk Management We generally attempt to hedge interest rate risks associated with all our investments, other than assets held as collateral for CMOs. Our primary method of addressing interest rate risk on our mortgage loans is by securitizing mortgage loans with CMOs or through real estate mortgage investment conduits, or "REMICs", both of which are designed to provide long-term financing while maintaining a consistent spread in a variety of interest-rate environments. As a result, we believe that our primary interest rate risk relates to fixed-rate MBS and mortgage loans that we finance with reverse repurchase agreements. A variety of hedging instruments may be used, depending on the asset or liability to be hedged and the relative price of the various hedging instruments. Possible hedging instruments include forward sales of mortgage securities, interest rate futures or options, interest rate swaps, and caps and floor agreements. Mortgage loans held as collateral for CMOs are generally financed in a manner intended to maintain a consistent spread in a variety of interest rate environments and therefore are not hedged. In particular, we may purchase interest rate caps, interest rate swaps and similar instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the earnings on our mortgage assets during a period of rising interest rates. Subject to compliance with Federal income tax laws limiting the operations of a REIT, we generally hedge as much of the interest rate risk as management determines is reasonable, given the cost of such hedging transactions and other factors. As discussed above, we may use a variety of instruments in our hedging program. Two examples of strategies we currently use are interest rate caps and short sales of so-called "TBA" securities. In a typical interest rate cap agreement, the cap purchaser makes an initial lump sum cash payment to the cap seller in exchange for the seller's promise to make cash payments to the purchaser on fixed dates during the 11 contract term if prevailing interest rates exceed the rate specified in the contract. We enter into interest rate hedge mechanisms (interest rate caps) to manage our interest rate exposure on certain reverse repurchase financing. "TBA" securities (which stands for "to be announced") are commitments to deliver mortgage securities which have not yet been created. When we sell a TBA security short, we ordinarily cover the short sale within a month by agreeing to buy a similar TBA security. We then sell another TBA security and cover that sale in the following month and so on. The changes in market prices from such short sales are intended to offset changes in interest rates that could offset either the market price or the net interest margin earned on our mortgage securities. We may also use, but as yet have not used, mortgage derivative securities. Mortgage derivative securities can be used as effective hedging instruments in certain situations as the value and yields of some of these instruments tend to increase as interest rates rise and to decrease as interest rates decline. We will limit our purchases of mortgage derivative securities to investments that meet REIT requirements. To a lesser extent, we may also enter into, but again have not entered into, interest rate swap agreements, financial futures contracts and options on financial futures contracts, and forward contracts. However, we will not invest in these instruments unless we can do so without falling under the registration requirements of the Commodity Exchange Act or otherwise violating the provisions of that Act. The REIT rules may restrict our ability to purchase certain instruments and employ other strategies. In all our hedging transactions, we deal only with counterparties that we believe are sound credit risks. - Costs and Limitations We believe that we have implemented a cost-effective hedging policy to provide an adequate level of protection against interest rate risks. However, maintaining an effective hedging strategy is complex, and no hedging strategy can completely insulate us from interest rate risks. Moreover, as noted above, certain REIT rules may limit our ability to fully hedge our interest rate risks. We monitor carefully, and may have to limit, hedging strategies to assure that we do not violate REIT rules, which could result in disqualification and/or payment of penalties. In addition, hedging involves transaction and other costs, which can increase dramatically as the period covered by the hedge increases and also can increase in periods of rising and fluctuating interest rates. Therefore, we may be prevented from effectively hedging interest rate risks without significantly reducing our return on equity. Prepayment Risk Management Our senior management monitors 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. REGULATION Although HCMC does not currently originate mortgage loans, HCMC continues to service one loan. In addition, HCMC's activities are subject to the rules and regulations of HUD. Mortgage operations also may be subject to applicable state usury and collection statutes. HCS is a registered broker/dealer with the Securities and Exchange Commission. During 2002, Pamex Securities, LLC, a wholly-owned subsidiary of HanoverTrade, Inc, withdrew from the Securities and Exchange Commission as a registered broker/dealer. 12 COMPETITION We compete with a variety of institutional investors for the acquisition of mortgage-related assets that we deem attractive. These investors include other REITs, investment banking firms, 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. EMPLOYEES We had 57 employees at December 31, 2002 with 9, 19 and 29 employees devoting their time to Hanover, HCP and HT, respectively. Hanover engages the services of HCP to provide management expertise, product sourcing, due diligence support, and general and administrative services to assist Hanover in accomplishing its business objectives. HCP periodically hires additional individuals on a temporary basis for due diligence and consulting engagements from a pool of approximately 500 individuals. 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 the employees are subject to collective bargaining agreements. TRADEMARKS HCP owns two trademarks that have been registered with the United States Patent and Trademark Office, one which expires in the year 2003 and the other expires in 2004. HT owns one registered trademark which expires in 2007, has one trademark pending and is in the process of registering one trademark with the United States Patent and Trademark Office. HT also filed a patent application in 2001 in connection with its trading web site and approval of the patent is pending. FUTURE REVISIONS IN POLICIES AND STRATEGIES The Board of Directors has established Hanover's investment and operating policies, which can be revised only with the approval of the Board of Directors, including a majority of the unaffiliated directors. Except as otherwise restricted, the Board of Directors may revise the policies without the consent of stockholders if the Board of Directors determines that the change is in the best interests of stockholders. Developments in the market which affect the policies and strategies mentioned herein or which change Hanover's assessment of the market may cause the Board of Directors to revise Hanover's policies and financing strategies. FEDERAL INCOME TAX CONSIDERATIONS General We have elected to be treated as a Real Estate Investment Trust, or 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 Hanover does not qualify as a REIT in any year, it would be subject to Federal income tax as a domestic corporation 13 and the amount of Hanover's after-tax cash available for distribution to its shareholders would be reduced. Hanover believes it has satisfied the requirements for qualification as a REIT since commencement of its operations in September 1997. Hanover intends at all times to continue to comply with the requirements for qualification as a REIT under the Code, as described below. REITs currently enjoy a competitive advantage over regular C corporations in that their distributed earnings are taxed only once, whereas a regular C corporation's distributed earnings are generally taxed twice. The President has submitted a legislative proposal to Congress involving a dividend exclusion for distributions of earnings that have been subjected to corporate level tax. If enacted, the proposal might eliminate, or at least reduce, REITs' current competitive advantage. Requirements for Qualification as a REIT To qualify for income tax treatment as a REIT under the Code, Hanover must meet certain tests which are described briefly below. - Ownership of Common Stock For all taxable years after its first taxable year, Hanover's shares of capital stock must be held by a minimum of 100 persons for at least 335 days of a 12-month year (or a proportionate part of a short tax year). In addition, at any time during the second half of each taxable year, no more than 50% in value of Hanover's capital stock may be owned directly or indirectly by five or fewer individuals, taking into account complex attribution of ownership rules. Hanover is required to maintain records regarding the actual and constructive ownership of its shares, and other information, and to demand statements from persons owning above a specified level of the REIT's shares (if Hanover has 200 or fewer shareholders of record, from persons holding 0.5% or more of Hanover's outstanding shares of capital stock) regarding their ownership of shares. Hanover must keep a list of those shareholders who fail to reply to such a demand. Hanover is required to use (and does use) the calendar year as its taxable year for income tax reporting purposes. - Nature of Assets On the last day of each calendar quarter, Hanover must satisfy three tests relating to the nature of its assets. First, at least 75% of the value of Hanover's assets must consist of mortgage loans, certain interests in 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 (the foregoing, "Qualified REIT Assets"). Hanover expects that substantially all of its assets will continue to be Qualified REIT Assets. Second, not more than 25% of Hanover's assets may consist of securities that are not Qualified REIT Assets. Third, except as noted below, investments in securities that are not Qualified REIT Assets are further limited as follows: (i) not more than 20% of the value of Hanover's total assets can be represented by securities of one of more Taxable REIT Subsidiaries (as defined below), (ii) the value of any one issuer's securities may not exceed 5% by value of Hanover's total assets, (iii) Hanover may not own securities possessing more than 10% of the total voting power of any one issuer's outstanding voting securities, and (iv) Hanover may not own securities having a value of more than 10% of the total value of any one issuer's outstanding securities. Clauses (ii), (iii) and (iv) of the third asset test do not apply to securities of a Taxable REIT Subsidiary. A "Taxable REIT Subsidiary" is any corporation in which a REIT owns stock, directly or indirectly, if the REIT and such corporation jointly elect to treat such corporation as a Taxable REIT Subsidiary. The amount of debt and rental payments from a Taxable REIT Subsidiary to a REIT are limited to ensure that a Taxable REIT Subsidiary is subject to an appropriate level of corporate tax. Pursuant to its compliance guidelines, Hanover intends to monitor closely the purchase and holding of its assets in order to comply with the above asset tests. 14 - Sources of Income Hanover must meet the following two separate income-based tests each year: 1. 75% INCOME TEST. At least 75% of Hanover's 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 Hanover has made and expects to continue to make will give rise primarily to mortgage interest qualifying under the 75% income test. 2. 95% INCOME TEST. In addition to deriving 75% of its gross income from the sources listed above, at least an additional 20% of Hanover's gross income for the taxable year must be derived from those sources, or from dividends, interest or gains from the sale or disposition of stock or other securities that are not dealer property. Hanover intends to limit substantially all of the assets that it acquires to assets that can be expected to produce income that qualifies under the 75% Income Test. Hanover's policy to maintain REIT status may limit the types of assets, including hedging contracts and other securities, that Hanover otherwise might acquire. - Distributions Hanover must distribute to its shareholders on a pro rata basis each year an amount equal to at least (i) 90% of its taxable income before deduction of dividends paid and excluding net capital gains, plus (ii) 90% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code, less (iii) certain "excess noncash income." Hanover intends to make distributions to its shareholders in sufficient amounts to meet this 90% distribution requirement. If it fails to distribute to its shareholders with respect to each calendar year at least the sum of (i) 85% of its REIT ordinary income of the year, (ii) 95% of its REIT capital gain net income for the year, and (iii) any undistributed taxable income from prior years, Hanover will be subject to a 4% excise tax on the excess of the required distribution over the amounts actually distributed. State Income Taxation The REIT files corporate income tax returns in various states. These states treat the income of the 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. The REIT is subject to a New Jersey gross receipts tax (Alternative Minimum Assessment). Taxation of Hanover's Shareholders For any taxable year in which Hanover is treated as a REIT for Federal income tax purposes, amounts distributed by Hanover to its shareholders out of current or accumulated earnings and profits will be includable by the shareholders as ordinary income for Federal income tax purposes unless properly designated by Hanover as capital gain dividends. Dividends declared during the last quarter of a calendar year and actually paid during January of the immediately following calender year are generally treated as if received by the shareholders on December 31 of the calendar year during which they were declared. Hanover's distributions will not be eligible for the dividends received deduction for corporations. Shareholders may not deduct any of Hanover's net operating losses or capital losses. If Hanover designates 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) Hanover's net capital gain for the taxable year. Each shareholder will include in his long-term capital gains for the taxable year such amount of Hanover's undistributed as well as distributed net capital gain, if any, for the taxable year as is designated by Hanover in a written notice. Hanover 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 Hanover on the undistributed gain. Any loss on the sale or exchange of shares of Hanover's 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 Hanover makes distributions to its shareholders in excess of its current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a shareholder's shares until the tax basis is zero. Such distributions in excess of the tax basis will be taxable as gain realized from the sale of Hanover's shares. Hanover will withhold 30% of dividend distributions to shareholders that Hanover knows to be foreign persons unless the shareholder provides Hanover with a properly completed IRS form claiming a reduced withholding rate under an applicable income tax treaty. Under the Code, if a portion of Hanover's assets were treated as a taxable mortgage pool or if Hanover were to hold REMIC residual interests, a portion of Hanover's dividends would be treated as unrelated business taxable income ("UBTI") for pension plans and other tax exempt entities. Hanover believes that it has not engaged in activities that would cause any portion of Hanover's income to be taxable as UBTI for pension plans and similar tax-exempt shareholders. Hanover believes that its shares of stock will be 15 treated as publicly offered securities under the plan asset rules of the Employment Retirement Income Security Act ("ERISA") for Qualified Plans. The provisions of the Code are highly technical and complex and are subject to amendment and interpretation from time to time. This summary is not intended to be a detailed discussion of all applicable provisions of the Code, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. Hanover has not obtained a ruling from the Internal Revenue Service with respect to tax considerations relevant to its organization or operations. ITEM 2. PROPERTIES Our operations are conducted in several leased office facilities throughout the United States. A summary of the office leases is shown below:

OFFICE CURRENT SPACE ANNUAL EXPIRATION LOCATION SEGMENT (SQ. FT.) RENTAL DATE OFFICE USE ----------------------- ------------------- ---------- -------- -------------- -------------------------- Edison, New Jersey HanoverTrade, Inc. 5,200 $137,800 April 2005 Executive, Administration, and Hanover Capital Accounting, Marketing, Mortgage Holdings, Investment Operations, Inc. Mortgage Loan Servicing Edison, New Jersey Hanover Capital 9,724 160,932 April 2005 Administration, Partners Ltd. Due Diligence Operations, Assignment Operations New York, New York Hanover Capital 1,000 39,444 September 2007 Executive, Administration, Mortgage Holdings, Investment Operations Inc. Ft. Lauderdale, Florida HanoverTrade, Inc. 875 24,579 April 2003 Marketing Jacksonville, Florida HanoverTrade, Inc. 470 18,000 November 2003 Technology Support Chicago, Illinois HanoverTrade, Inc. 1,151 24,123 January 2004 Marketing Alpharetta, Georgia HanoverTrade, Inc. 160 14,700 January 2004 Marketing St. Paul, Minnesota Hanover Capital 168 11,340 Month to Month Marketing Partners Ltd. ---------- ------------ Total 18,748 $430,918 ========== ============

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. ITEM 3. LEGAL PROCEEDINGS From time to time, we are involved in litigation incidental to the conduct of our business. We are not currently a party to any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on our business, financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 16 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Our common stock is traded on the American Stock Exchange under the trading symbol HCM. As of March 1, 2003, 4,534,402 shares of our common stock were issued and outstanding, held by 50 holders of record and approximately 2,300 beneficial owners. The following table sets forth, for the periods indicated, the high, low and closing sales price of our common stock as reported on the American Stock Exchange in 2001 and 2002.

COMMON STOCK ------------ High Low Close ---- --- ----- Quarter Ended March 31, 2001 7.11 5.13 6.50 Quarter Ended June 30, 2001 7.85 6.30 7.00 Quarter Ended September 30, 2001 7.50 6.51 6.55 Quarter Ended December 31, 2001 8.15 6.55 8.00 Quarter Ended March 31, 2002 8.65 7.25 8.65 Quarter Ended June 30, 2002 10.10 8.15 8.18 Quarter Ended September 30, 2002 8.60 7.15 7.30 Quarter Ended December 31, 2002 7.75 6.09 7.04

The following table sets forth, for the periods indicated, dividends declared on our common stock for each quarter for the two most recent fiscal years:

PER-SHARE DIVIDENDS DECLARED -------- Quarter Ended March 31, 2001 $0.20 Quarter Ended June 30, 2001 $0.20 Quarter Ended September 30, 2001 $0.20 Quarter Ended December 31, 2001 $0.20 Quarter Ended March 31, 2002 $0.25 Quarter Ended June 30, 2002 $0.25 Quarter Ended September 30, 2002 $0.25 Quarter Ended December 31, 2002 $0.25

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. To the extent that we record capital gain income in future years, this income does not need to be distributed as dividends to shareholders to the extent of unutilized capital losses recorded (more than $8,678,000 as of December 31, 2002). These capital losses expire at the end of the year 2003. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant. (b) Item 201(d) See Part III, Item 12 hereof. (c) On July 1, 2002, we cancelled outstanding options that had been issued under our 1997 Executive and Non-Employee Stock Option Plan in connection with our initial public offering. The cancelled options had an exercise price of $15.75 per share, were exercisable for an aggregate of 80,160 shares of our common stock, and were subject to vest based on our achievement of certain performance targets based on increases in the market value of our common stock over our initial offering price. None of the targets were met within the available vesting period, so none of the original options ever vested. To replace these cancelled options we granted new options, exercisable for an aggregate of 80,160 shares of our common stock at an exercise price of $15.75 per share, to the following executive officers: John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares. These option grants were exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. The replacement options are subject to performance-based vesting similar to the cancelled options, but the vesting period has been extended until 2007 and the performance targets were adjusted to relate to increases in the market price of our common stock as compared to the market price on July 1, 2002. 17 ITEM 6. SELECTED FINANCIAL DATA The following selected financial data are derived from our audited consolidated financial statements for the years ended December 31, 2002, 2001, 2000, 1999 and 1998. 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 Form 10-K (dollars in thousands, except per share data):

STATEMENT OF OPERATIONS HIGHLIGHTS Years Ended December 31, ------------------------------------------------------------------- 2002 2001 2000 1999 1998 ----------- ----------- ----------- ----------- ----------- Net interest income $ 6,092 $ 6,269 $ 6,663 $ 4,408 $ 6,623 Loan loss provision (393) (709) (875) (446) (356) Gain (loss) on sale and mark to market of mortgage assets 3,462 4,533 1,250 (4,146) (5,704) Loan brokering/trading, due diligence fees and other 6,594 (28) -- (1,685) -- Provision for loss on unconsolidated subsidiary -- -- -- (4,793) -- ----------- ----------- ----------- ----------- ----------- Total revenue (loss) 15,755 10,065 7,038 (6,662) 563 Expenses 11,473 3,696 3,136 4,191 4,064 ----------- ----------- ----------- ----------- ----------- Operating income (loss) 4,282 6,369 3,902 (10,853) (3,501) ----------- ----------- ----------- ----------- ----------- Equity in income (loss) of unconsolidated subsidiaries Hanover Capital Partners Ltd. 112 43 455 (443) (1,039) HanoverTrade, Inc. 655 (3,263) (1,495) (31) -- HDMF-I LLC 157 (35) -- -- -- Hanover Capital Partners 2, Inc. (19) -- -- (1,300) (394) ----------- ----------- ----------- ----------- ----------- 905 (3,255) (1,040) (1,774) (1,433) ----------- ----------- ----------- ----------- ----------- Income (loss) before income tax provision (benefit) 5,187 3,114 2,862 (12,627) (4,934) and cumulative effect of adoption of SFAS 133 Income tax provision 49 -- -- -- -- ----------- ----------- ----------- ----------- ----------- Income (loss) before cumulative effect of 5,138 3,114 2,862 (12,627) (4,934) adoption of SFAS 133 Cumulative effect of adoption of SFAS 133 -- 46 -- -- -- ----------- ----------- ----------- ----------- ----------- Net income (loss) $ 5,138 $ 3,160 $ 2,862 $ (12,627) $ (4,934) =========== =========== =========== =========== =========== Basic earnings (loss) per share $ 1.16 $ 0.74 $ 0.56 $ (2.12) $ (0.77) =========== =========== =========== =========== =========== Diluted earnings (loss) per share $ 1.15 $ 0.73 $ 0.56 $ (2.12) $ (0.77) =========== =========== =========== =========== =========== Dividends declared per share $ 1.00 $ 0.80 $ 0.66 $ 0.50 $ 0.70 =========== =========== =========== =========== ===========

BALANCE SHEET HIGHLIGHTS December 31, ------------------------------------------------------------------- 2002 2001 2000 1999 1998 ----------- ----------- ----------- ----------- ----------- Mortgage loans $ 103,164 $ 154,273 $ 212,247 $ 270,084 $ 407,994 Mortgage securities 23,903 51,183 35,723 62,686 78,478 Cash and cash equivalents 10,605 8,946 9,958 18,022 11,837 Other assets 18,199 15,105 14,681 14,842 17,861 ----------- ----------- ----------- ----------- ----------- Total assets $ 155,871 $ 229,507 $ 272,609 $ 365,634 $ 516,170 =========== =========== =========== =========== =========== Reverse repurchase agreements $ 6,283 $ 33,338 $ 14,760 $ 55,722 $ 370,090 CMO borrowing 102,589 151,096 210,374 254,963 77,305 Other liabilities 3,935 3,532 3,451 4,443 2,995 ----------- ----------- ----------- ----------- ----------- Total liabilities 112,807 187,966 228,585 315,128 450,390 Stockholders' equity 43,064 41,541 44,024 50,506 65,780 ----------- ----------- ----------- ----------- ----------- Total liabilities and stockholders' equity $ 155,871 $ 229,507 $ 272,609 $ 365,634 $ 516,170 =========== =========== =========== =========== =========== Number of common shares outstanding 4,474,222 4,275,676 4,322,944 5,826,899 6,321,899 =========== =========== =========== =========== =========== Book value per common share $ 9.62 $ 9.72 $ 10.18 $ 8.67 $ 10.41 =========== =========== =========== =========== ===========

18 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS The following section, "Management's Discussion and Analysis of Financial Condition and Results of Operations," should be read in conjunction with the financial statements, related notes, and other detailed information included elsewhere in this Annual Report on Form 10-K. This report contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent our current expectations, intentions or beliefs regarding future events or trends, including, without limitation, statements containing the words "believes," "anticipates," "expects," "intends," "assumes," "will," or other similar expressions; and also including, without limitation, the following: our business strategy; market trends and risks; statements regarding our continuing ability to target, price and acquire MBS or mortgage loans; our ability to manage and hedge the risks associated with our investments; assumptions regarding interest rates and their effect on our hedging strategies; assumptions regarding prepayment and default rates on the mortgage loans securing our MBS and their effect on our hedging strategies; our decision to invest in higher-risk subordinated tranches; the liquidity of our portfolios and our ability to invest currently liquid assets; the expected future performance of Hanover Capital Partners and HanoverTrade and their need for additional capital; continuing availability of the master reverse repurchase agreement financing or other financing; the sufficiency of our working capital, cash flows and financing to support our future operating and capital requirements; results of operations and overall financial performance; the expected dividend distribution rate; our ability to enter into additional asset management contracts with third parties; the adequacy of our leased offfice space; our ability to locate additional funds for HDMF-I; our expectations regarding the effects of accounting rules and changes thereto; changes in government regulations affecting our business; and the expected tax treatment of our operations. Such forward-looking statements relate to future events and our future financial performance and involve known and unknown risks, uncertainties and other important factors, many of which are beyond our control, which could cause actual results, performance or achievements to differ materially from those expressed or implied by such forward-looking statements. In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this report should not be regarded as a representation by us or any other person that our objectives or plans will be achieved or that any of our operating expectations will be realized. Our revenues and results of operations are difficult to forecast and could differ materially from those projected in the forward-looking statements contained in this report as a result of certain risks and uncertainties including, but not limited to: changes in interest rates and the yield curve; management of growth; changes in prepayment rates or default rates on our mortgage assets; our ability to borrow at favorable rates and terms; changes in business conditions and the general economy; our dependence on effective information-systems technology; potential declines in our ability to locate and acquire desirable mortgage assets; changes in the real estate market both locally and nationally; the effectiveness of our hedging and other efforts to mitigate the risks of our investments; the effect of default, bankruptcy and severe weather or natural disasters on the ability of borrowers to repay mortgages included in our asset pools; enforceability and collectibility of non-standard single-family mortgage loans; our ability to retain key employees; our ability to maintain our qualification for exemption from registration as an investment company; our ability to obtain and maintain all licenses necessary to our business; competition from other financial institutions, including other mortgage real estate investment trusts, or REITs; and the possible changes in tax and other laws applicable to REITs or our inability to maintain compliance with such rules and to continue to qualify as a REIT. Investors should carefully consider the various factors identified in "Management's Discussion and Analysis of Financial Condition and Results of Operation - Risk Factors," and elsewhere in this Annual Report on Form 10-K that could cause actual results to differ materially from the results predicted in the forward-looking statements. These factors should not be considered exhaustive; we undertake no obligation to release publicly the results of any future revisions we may make 19 to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. OVERVIEW We are a specialty finance company organized in June 1997 as a REIT. At December 31, 2002, we had two principal consolidated subsidiaries, Hanover Capital Partners Ltd., which we refer to as HCP, and HanoverTrade, Inc., which we refer to as HT. When we use the terms "we", "us", "our" or "the Company," we are referring to our company and its consolidated and unconsolidated subsidiaries taken as a whole. To provide more meaningful disclosure, we occasionally wish to report information regarding only our REIT entity without reference to any of its subsidiaries. In those instances, we refer to the REIT entity as "Hanover." Hanover's principal business strategy is to invest in mortgage-backed securities, which we refer to as MBS, and, to a lesser extent, mortgage loans and to earn net interest income on these investments. HCP's principal business strategy is to generate consulting and other fee income by performing loan sale advisory services, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. HT's principal business strategy is to generate fee income by operating an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and providing state-of-the art technologies supported by experienced valuation, operations and trading professionals. In addition to trading assets, HT provides a full range of asset valuation, analysis and marketing services for: performing, sub-performing and non-performing assets; whole loans and participations; Community Reinvestment Act loans; and mortgage servicing rights. In addition, Hanover has an equity interest in HDMF-I LLC, a limited liability company formed to purchase, service, manage or otherwise liquidate pools of primarily sub- and non-performing one-to-four family residential mortgage loans. Hanover operates as a tax-advantaged REIT and is generally not subject to Federal and state income tax to the extent that it distributes its taxable earnings to its stockholders and maintains its qualification as a REIT. Hanover's taxable affiliates, however, are subject to Federal and state income tax. Hanover has engaged HCP to render due diligence, asset management and administrative services pursuant to a Management Agreement. CRITICAL ACCOUNTING POLICIES The significant accounting policies used in preparation of our 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 are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following involve a high degree of judgment and complexity in the preparation of our consolidated financial statements: MORTGAGE SECURITIES - Our mortgage securities are designated as either available for sale, trading or held to maturity. Mortgage securities designated as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. Mortgage securities designated as trading are reported at fair value. Gains and losses resulting from changes in fair value are recorded as income or expense and included in earnings. Mortgage securities classified as held to maturity are carried at amortized cost unless a decline in value is deemed other than temporary, in which case the carrying value is reduced. Because our assets are generally not traded on a 20 national securities exchange or national automated quotation system and prices are therefore not readily ascertainable, complex cash flow modeling is performed in determining their fair value. Several of the assumptions used by management are confirmed by independent third parties on at least a quarterly basis. In using cash-flow analysis to determine fair value, future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields, delinquency of the underlying loans and estimated probable losses based on historical experience and estimates of expected future performance. As a result, a high degree of judgment is required in estimating the assumptions used in the cash flow analysis. Should the estimates used by management be inaccurate, our net interest income could be materially affected. LOAN LOSS ALLOWANCE - We maintain a loan loss allowance for our subordinate MBS and collateral for collateralized mortgage obligations, or CMOs. We monitor the delinquencies and defaults on the underlying mortgages and, if an impairment of the related mortgage security is deemed to be other than temporary, reduce the carrying value of the related mortgage security to fair value. Our loan loss provision is based on our assessment of numerous factors affecting our portfolio of mortgage securities including, but not limited to, current and projected economic conditions, delinquency status, credit losses to date on underlying mortgages and remaining credit protection. Loan loss provision estimates are reviewed periodically and adjustments are reported in earnings when they become known. Should our estimates be inaccurate, our loan loss provision could be materially affected which could result in unexpected gains or losses from future sales of such assets. EQUITY INVESTMENTS - Hanover records its investment in HDMF-I LLC, which we refer to as HDMF-I, on the equity method. Accordingly, Hanover records its proportionate share of the earnings or losses of HDMF-I. This presentation, while required under accounting principles generally accepted in the United States of America, does not present the assets and liabilities of HDMF-I on our balance sheet. In addition, the residual equity that Hanover does not own remains "off balance sheet." REVENUE RECOGNITION - HCP recognizes revenue from due diligence contracts in progress as they are earned. To calculate what percentage of the total revenue of a contract has been earned, management must make estimates. Estimates, by their nature, are based on judgment and available information. Actual results could differ from estimates. As the majority of HCP's revenue relates to services performed, such estimates may include the amount of time spent by individuals in consideration of the aggregate amount of time required to complete the contract, the evaluation of both quantitative and qualitative criteria as agreed to and maintained in the contract and possibly regulations set forth by the government should the contract be with an agency of the Federal government. HT recognizes revenues from loan sale advisory and trading when the transactions close and fees are earned and billed. At the time of closing a transaction, the number of loans, loan principal balance and purchase price in the transaction are agreed upon, documentation is signed and the sale is funded. HT's billing of fees relating to a transaction occurs concurrently with the closing and funding. We utilize guidance set forth in the Securities and Exchange Commission's Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB 101"). SAB 101 draws on existing accounting rules with respect to the basic criteria that must be met before revenue can be recorded. SAB 101 further explains how those rules apply. We have reviewed the guidance in SAB 101 and believe we are in compliance with SAB 101. However, if management's estimates are incorrect, or if we are not applying SAB 101 as intended, the results of operations could be materially affected. INCOME TAXES - Hanover has elected to be taxed as a REIT and intends to comply with the REIT provisions of the Internal Revenue Code of 1986, as amended, which we refer to as the Code. Accordingly, Hanover will not be subject to Federal or state income tax on net income that is currently distributed to stockholders to the extent that its annual distributions to stockholders are equal to at least 90% of its taxable income and as long as certain asset, income and stock ownership tests are met. In the event that Hanover does not qualify as a REIT in any year, it would be subject to Federal income tax as a 21 domestic corporation and the amount of Hanover's after-tax cash available for distribution to its stockholders would be reduced. Hanover believes it has satisfied the requirements for qualification as a REIT since commencement of its operations in September 1997. Hanover intends at all times to continue to comply with the requirements for qualification as a REIT under the Code. 22 RESULTS OF OPERATIONS In our description of financial results presented below, we use the term "Hanover" to refer to Hanover Capital Mortgage Holdings, Inc. as a separate entity. Hanover has two primary operating subsidiaries: Hanover Capital Partners Ltd., which we refer to as "HCP", and HanoverTrade, Inc., which we refer to as "HT". When we use the terms "we", "us", or "our", we are referring to Hanover together with its consolidated and unconsolidated subsidiaries. The term "CMO" refers to collateralized mortgage obligations, in which financing is obtained in exchange for a pledge of mortgages, or pools of mortgages, as collateral. We use the term "MBS" to refer to mortgage-backed securities. On July 1, 2002, Hanover acquired 100% of the outstanding capital stock of each of HT, HCP, and Hanover Capital Partners 2, Inc., which we refer to as HCP-2. Hanover had previously owned 100% of the non-voting preferred stock, but none of the voting common stock, of each of these entities. Prior to July 1, 2002, the financial results for these three entities appeared in our financial statements as a single line-item under "equity in income or loss of unconsolidated subsidiaries." Due to the stock purchase, for periods ending after June 30, 2002, Hanover's financial statements will be consolidated with the financial statements of those entities. This means that the financial results for these three entities, whether positive or negative, will appear throughout our financial statements as applicable, rather than in a single line-item. To assist you in evaluating the effect of the stock purchase on our financial results, our discussion below sometimes includes information regarding both "previously reported" and "pro forma" financial results. "Previously reported" financial results provide the actual results for the periods presented, which means that they do not give effect to the stock purchase for any periods prior to July 1, 2002. "Pro forma" financial results provide financial information for the periods shown as if the stock purchase of HT, HCP and HCP-2 had been completed as of January 1, 2001 for statement of income purposes. "Pro forma" financial information is presented for illustrative purposes only. Pro forma information is not necessarily indicative of the financial position or results of operations that would have been reported had the acquisition occurred on January 1, 2001, and these presentations do not necessarily indicate the future financial position or results of operations. The following table presents the consolidated results of operations as previously reported for 2002, 2001 and 2000 and pro forma results for 2002 and 2001 (dollars in thousands):

As Previously Reported - Pro Forma - Years Years Ended December 31, Ended December 31, ------------------------------- -------------------- 2002 2001 2000 2002 2001 -------- -------- ------- -------- -------- (unaudited) Net interest income $ 6,092 $ 6,269 $ 6,663 $ 6,375 $ 5,871 Loan loss provision (393) (709) (875) (393) (709) Gain on sale of mortgage assets 2,095 3,782 819 2,095 3,782 Gain on mark to market of mortgage assets, net of associated hedge 1,367 751 431 1,237 695 Loan brokering, trading and advisory services 2,686 -- -- 6,831 3,521 Due diligence fees 2,891 -- -- 4,971 5,083 Assignment fees 1,387 -- -- 2,220 757 Other income (loss) (370) (28) -- (399) 58 -------- -------- ------- -------- -------- Total revenue 15,755 10,065 7,038 22,937 19,058 Expenses 11,473 3,696 3,136 17,805 15,987 -------- -------- ------- -------- -------- Operating income 4,282 6,369 3,902 5,132 3,071 Equity in income (loss) of unconsolidated subsidiaries: Hanover Capital Partners Ltd. 112 43 455 -- -- HanoverTrade, Inc. 655 (3,263) (1,495) -- -- HDMF-I LLC 157 (35) -- 157 (35) Hanover Capital Partners 2, Inc. (19) -- -- -- -- -------- -------- ------- -------- -------- Income before income tax provision and cumulative effect of adoption of SFAS 133 5,187 3,114 2,862 5,289 3,036 Income tax provision 49 -- -- 127 64 -------- -------- ------- -------- -------- Income before cumulative effect of adoption of SFAS 133 5,138 3,114 2,862 5,162 2,972 Cumulative effect of adoption of SFAS 133 -- 46 -- -- 46 -------- -------- ------- -------- -------- Net income $ 5,138 $ 3,160 $ 2,862 $ 5,162 $ 3,018 ======== ======== ======= ======== ======== Basic earnings per share $ 1.16 $ 0.74 $ 0.56 $ 1.17 $ 0.71 ======== ======== ======= ======== ======== Dividends declared per share $ 1.00 $ 0.80 $ 0.66 $ 1.00 $ 0.80 ======== ======== ======= ======== ========

23 Net Income, Basic Earnings Per Share and Total Revenue We recorded net income of $5,138,000 or $1.16 per share based on 4,417,221 weighted average shares of common stock outstanding for 2002 compared to net income of $3,160,000 or $0.74 per share based on 4,256,874 weighted average common shares outstanding for 2001, and net income of $2,862,000 or $0.56 per share based on 5,102,563 weighted shares of common stock outstanding for 2000. Total revenue for 2002 was $15,755,000, compared to $10,065,000 previously reported for 2001 and $7,038,000 for 2000. On a pro forma basis, total revenue for the 2002 period was $22,937,000, while total revenue for the 2001 period was $19,058,000. Net Interest Income and Loan Loss Reserve The following table reflects the average balances for each major category of our interest earning assets as well as our interest bearing liabilities with the corresponding effective yields and rates of interest as follows (dollars in thousands): INTEREST EARNING ASSETS AND RELATED LIABILITIES

Years Ended December 31, ------------------------------------------------------------------------ 2002 2001 2000 ---------------------- --------------------- --------------------- Average Effective Average Effective Average Effective Balance Rate (1) Balance Rate (1) Balance Rate (1) -------- -------- -------- --------- -------- --------- Interest earning assets: Mortgage loans $ 1,206 16.75% $ 231 8.10% $ 300 87.79% CMO collateral 136,512 7.09% 193,840 7.41% 247,850 7.46% Agency-issued MBS 7,186 6.70% 15,401 7.98% 41,072 7.28% Private placement notes 14,257 15.13% 14,676 17.11% 20,266 16.84% -------- ----- -------- ----- -------- ----- 159,161 7.87% 224,148 8.08% 309,488 8.13% -------- -------- -------- Interest bearing liabilities: CMO borrowings 124,971 5.57% 181,669 6.72% 233,843 7.49% Reverse repurchase borrowings on: CMO collateral 1,786 2.97% 2,536 7.16% 3,515 7.45% Agency-issued MBS 6,410 3.32% 9,732 6.40% 29,020 5.71% Private placement notes 6,127 3.42% 6,085 6.86% 7,544 7.81% -------- ----- -------- ----- -------- ----- 139,294 5.34% 200,022 6.71% 273,922 7.31% -------- -------- -------- Net interest earning assets $ 19,867 $ 24,126 $ 35,566 ======== ======== ======== Net interest spread 2.53% 1.37% 0.82% ===== ===== ===== Yield on net interest earning assets (2) 25.58% 19.45% 14.43% ===== ===== =====

(1) Loan loss provisions are included in the above calculations. (2) Yield on net interest earning assets is computed by dividing the applicable net interest income after loan loss provision by the average daily balance of net interest earning assets. 24 The following table provides details of net interest income and loan loss provision for interest earning assets as follows (dollars in thousands): NET INTEREST INCOME

Years Ended December 31, ------------------------------------------------------------------------------------ 2002 2001 2000 ------------------------- -------------------------- -------------------------- Net Loan Net Loan Net Loan Interest Loss Interest Loss Interest Loss Income Provision Income Provision Income Provision ----------- ------------ ------------ ------------ ------------ ------------ Mortgage loans $ 202 $ -- $ 19 $ -- $ 264 $ -- CMO collateral 2,826 (161) 2,219 (246) 963 (249) Agency-issued MBS 268 -- 606 -- 1,330 -- Private placement MBS 2,179 (232) 2,556 (463) 3,450 (626) Other 868 -- 869 -- 656 -- Eliminations (251) -- -- -- -- -- ----------- ------------ ------------ ------------ ------------ ------------ Total net interest income $6,092 $(393) $6,269 $(709) $6,663 $ (875) =========== ============ ============ ============ ============ ============

Years Ended December 31, 2002 and 2001 -------------------------------------- Net interest income decreased to $6,092,000, or $1.38 per share, for 2002 from $6,269,000, or $1.47 per share, as previously reported in 2001. The decrease in net interest income of $177,000 was primarily due to: -- the repayment of our mortgage loans held as collateral for CMOs offset by decreased borrowing costs on our corresponding CMO liabilities and reverse repurchase agreements; -- the termination of Agency-issued MBS activity; and -- the decrease in the average coupon rate of our purchased subordinate MBS portfolio, decrease in the interest earned from interest-only notes retained from our 1998-B securitization, and interest income earned from trading activity conducted by one of our subsidiaries in 2002; no such trading activity occurred in 2001. The effective yield on our average CMO collateral decreased slightly to 7.09% in 2002 from 7.41% in 2001, while the effective rate of interest on our average CMO borrowings decreased to 5.57% in 2002 from 6.72% in 2001. Our effective borrowings rate decreased faster than the decrease in the yield on average assets. In addition, we recognized increased interest income from our interest-only notes retained from our 1999-B securitization. These interest-only notes earned interest at a rate of 4.00% in 2002 compared to 1.86% in 2001. Net interest income from Agency-issued MBS decreased in 2002 because we terminated our investment in such MBS in July of 2002. Private placement MBS net interest income was negatively impacted by a decrease in the effective interest rate earned on our purchased subordinate MBS portfolio to 12.53% in 2002 from 16.77% in 2001. The decrease in net interest income recognized from interest-only notes retained from our 1998-B securitization resulted from a decrease in the average notional amount on which interest income is earned to $119.7 million in 2002 from $196.1 million in 2001. During December 2002 and January 2003, we exercised call provisions in our 1998-A and 1998-B securitizations and sold the underlying mortgage loans in February and March 2003. As a result of the two sales, we have approximately $6,000,000 available for reinvestment. We cannot assure you that we will be able to reinvest the proceeds in a profitable manner. On a pro forma basis, net interest income increased to $6,375,000 for 2002 from $5,871,000 for 2001. The $504,000 increase is due to a full year of net interest income on a pro forma basis in 2002 attributable to trading activity, partially offset by reduced Agency-issued MBS activity. Our provision for loan losses decreased to $393,000 in 2002 from $709,000 in 2001. The $316,000 decrease was primarily the result of sales of first-loss subordinate MBS and a reduction in the average balance of collateral for CMOs. First-loss subordinate MBS are generally structured to absorb the credit losses resulting from a specified pool of mortgages. As a result, we provide for the estimated losses associated with first-loss subordinate MBS, which increases our overall loan loss allowance. If our loss estimates differ materially from actual results, we could incur additional losses resulting in decreased net income in future periods. No adjustments were required on a pro forma basis because the provision for loan losses relates only to Hanover during these periods. Years Ended December 31, 2001 and 2000 -------------------------------------- Net interest income decreased to $6,269,000 in 2001 compared to $6,663,000 in 2000. The decrease in net interest income of $394,000 was primarily a result of: -- an increase in amortization expense for whole loans as a result of increases in assumed prepayment speeds; and -- a reduction in the principal balance of Hanover sponsored securitizations of whole loans partially offset by a corresponding reduction in the principal balance of CMO borrowings against such whole loans. Our provision for loan losses decreased to $709,000 in 2001 from $875,000 in 2000, primarily as a result of sales of first-loss subordinate MBS, and a reduction in the average balance of collateral from CMOs. Provision for losses on Hanover sponsored securitizations decreased to $246,000 in 2001 from $319,000 in 2000. Provision for loan losses on subordinate MBS purchased from third parties decreased to $463,000 in 2001 from $555,000 in 2000. The average balance of subordinate MBS purchased from third parties in 2001 was $12,664,000 compared to $11,973,000 in 2000. The following tables provide details of net interest income and loan loss provision by interest earning asset: CMO Collateral Net interest income generated from the CMO collateral (including mortgage loans and MBS pledged to CMOs) is as follows (dollars in thousands):

Years Ended December 31, ------------------------------------- 2002 2001 2000 --------- --------- --------- Average asset balance $ 136,512 $ 193,840 $ 247,850 Average CMO borrowing balance 124,971 181,669 233,843 Average reverse repurchase agreement borrowing balance 1,786 2,536 3,515 --------- --------- --------- Net interest earning assets 9,755 9,635 10,492 Average leverage ratio 92.85% 95.03% 95.77% Effective interest income rate 7.21% 7.54% 7.56% Effective interest expense rate 5.57% 6.72% 7.49% Effective interest expense rate - Repurchase agreements 2.97% 7.16% 7.45% --------- --------- --------- Net interest spread 1.67% 0.81% 0.07% Interest income $ 9,841 $ 14,612 $ 18,745 Interest expense 6,962 12,211 17,521 Interest expense - Repurchase agreements 53 182 261 --------- --------- --------- Net interest income before loan loss provision 2,826 2,219 963 Loan loss provision (161) (246) (249) --------- --------- --------- Net interest income after loan loss provision $ 2,665 $ 1,973 $ 714 ========= ========= ========= Yield on net interest earning assets after loan loss provision 27.31% 20.48% 6.80% ========= ========= =========

During 2000, we issued $13,222,000 of CMO borrowings at a discount of $2,013,000 for net proceeds before expenses of $11,209,000. The Hanover 2000-A CMO security carries a fixed interest rate of 6.50%. The Hanover 2000-A security was collateralized by $25,588,000 principal balance of the retained portions of Hanover's previous CMO borrowings, Hanover 98-A, Hanover 99-A and Hanover 99-B and certain retained MBS from Hanover 98-B. Our total investment in Hanover 98-B private placement MBS at December 31, 2002 includes a $10,937,000 investment in six investment-grade notes ("AA", "A" and "BBB"), six interest-only notes, six below-investment-grade notes and three principal-only notes. However, we classify the investment-grade and below-investment-grade notes as CMO collateral and the interest-only and principal-only notes as private placement MBS. For Hanover 2000-A, we record 100% of the interest income, net of servicing and other fees, generated by the mortgage loans underlying this transaction. In accordance with accounting principles generally accepted in the United States of America, Hanover 2000-A is recorded as a financing transaction. The primary source of financing for these mortgage loans is the CMO borrowing. This financing represents the liability for certain investment-grade mortgage notes issued by us. The interest expense on this financing represents the coupon interest amount to be paid to the note holders. Our net equity in these transactions was leveraged through reverse repurchase agreement financing. In a reverse repurchase financing, we sell a pool of assets but agree to repurchase them at a set time in the future. At December 31, 2002, we had $1,698,000 of reverse repurchase agreement financing against our net equity in these transactions. Interest expense includes the interest on CMO borrowings, interest on the related reverse repurchase agreements and amortization of certain deferred financing costs and interest rate caps. 25 Agency-issued MBS Net interest income generated from investments in Agency-issued MBS is as follows (dollars in thousands):

Years Ended December 31, -------------------------------------- 2002 2001 2000 ---------- ---------- ---------- Average asset balance $ 7,186 $ 15,401 $ 41,072 Average reverse repurchase agreement borrowing balance 6,410 9,732 29,020 ---------- ---------- ---------- Net interest earning assets 776 5,669 12,052 Average leverage ratio 89.20% 63.19% 70.66% Effective interest income rate 6.70% 7.98% 7.28% Effective interest expense rate 3.32% 6.40% 5.71% ---------- ---------- ---------- Net interest spread 3.38% 1.58% 1.57% Interest income $ 481 $ 1,229 $ 2,989 Interest expense 213 623 1,659 ---------- ---------- ---------- Net interest income before loan loss provision 268 606 1,330 Loan loss provision -- -- -- ---------- ---------- ---------- Net interest income after loan loss provision $ 268 $ 606 $ 1,330 ========== ========== ========== Yield on net interest earning assets after loan loss provision 34.56% 10.70% 11.04% ========== ========== ==========

During 2002, we purchased $30.0 million of Agency-issued securities and sold $53.4 million. During 2001, we purchased $125.8 million of Agency-issued securities and sold $98.3 million. In November 2000, we purchased $1.9 million of GNMA securities. In December 2000, we sold thirty-one FNMA Certificates, totaling $36.9 million of principal. Interest expense includes the interest on the related reverse repurchase agreements and amortization of deferred financing costs and interest rate caps. 26 Private Placement MBS Net interest income generated from private placement MBS excluding securities pledged as collateral for CMOs is as follows (dollars in thousands):

Years Ended December 31, ---------------------------------- 2002 2001 2000 -------- -------- -------- Average asset balance $ 14,257 $ 14,676 $ 20,266 Average reverse repurchase agreement borrowing balance 6,128 6,085 7,544 -------- -------- -------- Net interest earning assets 8,129 8,591 12,722 Average leverage ratio 42.98% 41.46% 37.23% Effective interest income rate 16.76% 20.26% 19.93% Effective interest expense rate 3.42% 6.86% 7.81% -------- -------- -------- Net interest spread 13.34% 13.40% 12.12% Interest income $ 2,389 $ 2,974 $ 4,039 Interest expense 210 418 589 -------- -------- -------- Net interest income before loan loss provision 2,179 2,556 3,450 Loan loss provision (232) (463) (626) -------- -------- -------- Net interest income after loan loss provision $ 1,947 $ 2,093 $ 2,824 ======== ======== ======== Yield on net interest earning assets after loan loss provision 23.95% 24.37% 22.19% ======== ======== ========

The Private Placement MBS category includes: - interest-only and principal-only notes that we issued in our second securitization, Hanover 1998-B, and - starting in June 1999, subordinate MBS that we purchased in the open market. The 1998-B interest-only notes are adversely affected more than other notes by higher than expected prepayment speeds on underlying mortgage loans with interest rates in excess of the pass through rate on the securitization. Generally, mortgages with higher interest rates will be repaid more rapidly than mortgages with lower interest rates. Our investment in private placement MBS at December 31, 2002 includes an investment of $0.6 million carrying value in 1998-B interest-only notes, an investment of $0.6 million carrying value in 1998-B principal-only notes and an investment of $13.0 million carrying value in below-investment-grade subordinate MBS classified as held to maturity, available for sale or trading. During 2002, we purchased $23.3 million of below-investment-grade MBS from third parties and sold $16.3 million of below-investment-grade MBS to third parties. During 2001, we purchased $16.4 million of below-investment-grade MBS from third parties and sold $34.6 million of below-investment-grade MBS to third parties. During 2000, Hanover purchased $6.0 million of below-investment-grade MBS from third parties, sold $5.9 million of below-investment-grade MBS to third parties, purchased $13.8 million of below-investment-grade subordinate MBS from HCP, and transferred $9.9 million of investment-grade and below-investment-grade subordinate MBS from Hanover's 1998-B CMO to Collateral for the 2000-A CMO. 27 Other Interest Income Interest income from non-mortgage assets is as follows (dollars in thousands):

Years Ended December 31, ------------------------ 2002 2001 2000 ----- ---- ---- Overnight investing $ 116 $257 $124 Related party notes 752 612 532 Eliminations (251) -- -- ----- ---- ---- $ 617 $869 $656 ===== ==== ====

Gain on Sale and Mark to Market of Mortgage Assets Our 2002 results include a gain on sale of mortgage assets of $2,095,000 compared to $3,782,000 for 2001 and $819 for 2000. No adjustments were required on a pro forma basis because gain on sale of mortgage assets relates only to Hanover during these periods. We cannot assure you that we will be able to recognize gain on sale in the future. As a REIT, we do not actively trade our mortgage assets. Our purchased subordinate MBS portfolio is primarily comprised of non-investment-grade securities. These securities are generally purchased at a substantial discount to their principal balance to reflect their inherent credit risk. To the extent that actual losses on the mortgage asset are less than the discount, the discount provides a yield enhancement. We seek to reduce credit risk by actively monitoring our portfolio for delinquency trends and due to such monitoring we may, from time to time, decide to sell a security in order to mitigate potential losses. When we classified mortgage assets as trading securities during 2002, 2001 and 2000, we recognized mark to market gains or losses through our Consolidated Statement of Income. Mortgage assets classified as available for sale are marked to market through other comprehensive income. We recognized mark to market gains on our purchased subordinate MBS portfolio of $1,780,000 in 2002 as compared to $792,000 in 2001 and $49,000 in 2000. Market gains on our purchased subordinate portfolio are primarily subject to assumptions on the underlying mortgage loan portfolio including, but not limited to, prepayment speed assumptions, future loss assumptions and changes in the benchmark interest rate. Other Revenue Revenues from loan brokering, trading and advisory services increased to $2,686,000 in 2002, from $0 for 2001 and 2000. Revenues from due diligence increased to $2,891,000 in 2002 from $0 for 2001 and 2000. Revenues from assignment fees increased to $1,387,000 in 2002 from $0 for 2001 and 2000. In each case, this is because in periods prior to the consolidation of Hanover, HCP, HT and HCP-2, we did not separately record revenues attributable to HT, HCP, or HCP-2, and all of the revenues listed in this paragraph are derived from the activities of HT and HCP. On a pro forma basis, revenues from loan brokering, trading and advisory services increased to $6,831,000 in 2002, from $3,521,000 for 2001. This is primarily attributable to revenue derived from a contract with the FDIC during 2002 and revenue generated by third quarter 2002 whole-loan sales. We cannot assure you that comparable contracts will be available in the future. On a pro forma basis, revenues from due diligence decreased to $4,971,000 in 2002 from $5,083,000 in 2001. Although total due diligence revenues decreased, our revenue from our largest clients increased and our number of clients increased. On a pro forma basis, revenues from assignment fees increased to $2,220,000 in 2002 from $757,000 for 2001, primarily because of 2 large assignment contracts. These contracts account for 74% of the total assignment fees recognized in 2002. We cannot assure you that we will be able to generate assignment fees comparable to those recorded for 2002. 28 Operating Expenses Years Ended December 31, 2002 and 2001 -------------------------------------- Operating expenses in 2002 were $11,473,000 compared to $3,696,000 as previously reported for 2001. Pro forma operating expenses were $17,805,000 in 2002 compared to $15,987,000 for the same period last year on a pro forma basis. The biggest component of the increase, on a pro forma basis, was an increase in personnel expenses. Personnel expenses for 2002, on a pro forma basis, increased to $8,907,000 compared to, on a pro forma basis, $7,231,000 for the same period last year. The increase in personnel expenses was primarily due to (i) a bonus accrual established for a pool of employees during 2002 that was established pursuant to existing contractual agreements; no such bonus accrual was established in 2001, and (ii) an increase in commission expense, primarily relating to the increase in loan brokering, trading and advisory services of $459,000 in 2002 as compared to the prior year. The increase in personnel expense was partially offset by a decrease in legal and professional fees to $1,206,000 on a pro forma basis in 2002, from $1,704,000 on a pro forma basis for the same period last year. Legal and professional fees decreased in 2002 primarily due to non-recurring charges in 2001. Years Ended December 31, 2001 and 2000 -------------------------------------- Operating expenses in 2001 were $3,696,000 compared to $3,136,000 in 2000, an increase of $560,000. Personnel expenses decreased to $680,000 in 2001 from $1,020,000 in 2000. Hanover billed personnel-related expenses totaling $345,000 to HT and $425,000 to HCP in 2001 compared to $369,000 and $136,000 in 2000. Legal and professional fees increased to $1,247,000 in 2001 from $555,000 in 2000 as a result of an increase in audit, tax and consulting fees due to an increased scope of services and, to a lesser extent, professional fees incurred as a result of our consideration of a corporate restructure. Financing fees declined to $246,000 in 2001 from $281,000 in 2000 reflecting reduced committed lines of credit and lower levels of activity. Equity in Income (Loss) of Unconsolidated Subsidiaries Years Ended December 31, 2002 and 2001 -------------------------------------- HDMF-I is a limited liability company whose objective is to purchase, service and manage pools of primarily sub- and non-performing one-to-four family residential whole loans. In November 2001, we made our initial investment in HDMF-I of $115,000 to fund our proportionate share of professional, organizational and other fees of HDMF-I. In the first quarter of 2002, we invested an aggregate of $3,891,000 in HDMF-I to fund our proportionate share of a loan pool with a purchase price of $12,230,000. In the second half of 2002, we invested an additional $1,968,000 in HDMF-I to fund the purchase price of an additional loan pool and received $1,458,000 in distributions from HDMF-I. For 2002 we recognized equity in income of $157,000 and for the comparable period in 2001, we recognized equity in losses of $35,000. At December 31, 2002, we had a total capital contribution commitment of $5,820,000. Years Ended December 31, 2001 and 2000 -------------------------------------- As discussed above, Hanover acquired all of the outstanding capital stock of HCP and HT on July 1, 2002. As a result, we did not record equity in income (loss) of HCP and HT for the full year of 2002. Hanover's equity in income of HCP declined to $43,000 in 2001 from $455,000 in 2000. Total revenue at HCP decreased $2,132,000 or 24% to $6,582,000 in 2001 from $8,714,000 in 2000, primarily due to the termination of subordinate MBS activity in 2000. The portfolio of subordinate MBS contributed $954,000 of revenue including gains on sale of $441,000 in 2000. This portfolio was transferred from HCP to Hanover in July of 2000. Due diligence fees decreased $1,213,000 or 17% to $5,803,000 in 2001 from $7,016,000 in 2000 primarily due to contracts awarded in 2000 for which no comparable revenue was earned in 2001. Assignment fees increased $126,000 or 20% to $757,000 in 2001 from $631,000 in 2000 primarily due to the assumption of assignment contracts and employees of a former competitor. Loan brokering and asset management fees contributed $30,000 in 2000, this activity was transferred to HT in July of 2000. 29 Hanover recognized equity in losses of HT of $3,263,000 in 2001 compared to $1,495,000 in 2000. HT recorded revenue of $3,599,000 and $141,000 in 2001 and 2000. HT operating expenses for 2001 and 2000 totaled $6,962,000 and $1,683,000. Personnel expenses increased to $3,617,000 in 2001 from $790,000 in 2000. Technology expense for web hosting and web graphics increased to $664,000 in 2001 from $231,000 in 2000. Premises expense increased to $326,000 in 2001 from $130,000 in 2000. Depreciation and amortization increased to $1,102,000 in 2001 from $151,000 in 2000. As HT commenced operations in 1999, much of 2000 and 2001 was spent developing HT's proprietary Internet exchange for trading mortgage loans, mortgage servicing rights and related assets. HT recorded minimal revenues in 2000. 30 The table below highlights our historical quarterly trends and components of return on average equity for 2000, 2001 and 2002.

Loan Gain on Brokering/ Sale and Trading, Due Mark to Diligence Equity in Net Market of Fees and Income Interest Mortgage Other Income Operating (Loss) of Income Tax Annualized For the Income/ Assets/ (Loss)/ Expenses/ Subsidiaries/ Provision Return on Quarters Ended Equity Equity Equity Equity Equity (Benefit)/Equity Equity ------------------- -------- --------- ------------ --------- ------------- ---------------- ----------- March 31, 2000 10.91% 1.57% -- 7.74% 0.71% -- 5.45% June 30, 2000 10.99% 2.62% -- 7.95% 0.43% -- 6.09% September 30, 2000 13.40% -- 1.16% 4.31% (4.01%) -- 6.24% December 31, 2000 12.43% 6.61% -- 6.24% (6.41%) -- 6.39% March 31, 2001 10.10% 8.51% 0.43% 6.54% (6.27%) -- 6.23% June 30, 2001 14.05% 8.43% -- 7.46% (8.37%) -- 6.65% September 30, 2001 13.97% 11.05% -- 10.85% (7.24%) -- 6.93% December 31, 2001 14.66% 15.04% (0.27%) 10.25% (9.01%) -- 10.18% March 31, 2002 15.13% 8.29% (1.63%) 9.91% 0.54% -- 12.43% June 30, 2002 11.94% 5.50% (2.30%) 8.76% 6.27% -- 12.65% September 30, 2002 12.96% 15.54% 26.42% 42.53% 1.18% (0.06%) 13.63% December 31, 2002 12.45% 2.45% 37.65% 43.77% 0.26% 0.52% 8.52%

Notes: Average equity excludes unrealized loss on investments available for sale. Prior to July 1, 2002, the financial results for HCP, HT and HCP-2 are included in equity in income/(loss) of unconsolidated subsidiaries. For periods ending after June 30, 2002, these entities' results are consolidated with Hanover's and their results will appear throughout our financial statements as applicable, rather than in a single line-item. TAXABLE INCOME Our taxable income for the year ended December 31, 2002 is estimated at $565,000. Taxable income differs from GAAP net income for the year ended December 31, 2002 due to various recurring and one-time book/tax differences. The following table details the major book/tax differences in arriving at the estimated taxable income for the year ended December 31, 2002 (dollars in thousands):

GAAP net income $ 5,138 GAAP gain on sale (2,028) Tax gain on sale 1,950 Utilization of capital loss carryforward (1,950) Income of subsidiaries not included in taxable income (362) Gain on mark to market of mortgage securities, net of associated hedge (1,066) Loan loss provision, net of realized losses (1) Tax amortization of net premiums on mortgages, CMO collateral and mortgage securities and interest accrual in excess of GAAP amortization and interest accrual (256) Deduction for tax for exercise of non-qualified stock options (888) Other 28 ------- Estimated taxable income $ 565 =======

As a REIT, we are required to pay dividends amounting to 85% of each year's taxable ordinary income and 95% of the portion of each year's capital gain net income that is not taxed at the REIT level, by the end of 31 each calendar year and to have declared dividends amounting to 90% of our REIT taxable income for each year by the time we file our Federal tax return. Therefore, a REIT generally passes through substantially all of its earnings to shareholders without paying Federal income tax at the corporate level. For the year ended December 31, 2002, a portion of dividends paid to shareholders was deemed to be a return of capital for income tax purposes. LIQUIDITY We expect to meet our future short-term and long-term liquidity requirements generally from our existing working capital, cash flow provided by operations, reverse repurchase agreements and other possible sources of longer-term financing, including CMOs and REMICs. We consider our ability to generate cash to be adequate to meet operating requirements both in the short-term and the long-term. However, we have exposure to market-driven liquidity events due to the short-term reverse repurchase financing we have in place against our MBS. If a significant decline in the market value of our portfolio should occur, our available liquidity from existing sources and ability to access additional sources of credit could be reduced. As a result of such a reduction in liquidity, we may be forced to sell certain investments or incur debt to maintain liquidity. If required, these sales could be made at prices lower than the carrying value of such assets, which could result in losses. At December 31, 2002, we had one committed reverse repurchase line of credit with $10 million available and four uncommitted lines of credit. We may seek to establish additional committed and uncommitted lines of credit in the future. We cannot assure you that we will be successful in obtaining such additional financing on favorable terms, if at all. Net cash provided by operating activities for the year ended December 31, 2002 was $24,994,000 compared to net income of $5,138,000 for the year. Sales of trading securities provided $65,497,000, partially offset by the purchase of trading securities of $41,287,000. Net cash provided by investing activities amounted to $55,782,000 during the year ended December 31, 2002. The majority of cash proceeds from investing activities was generated from (i) principal payments received on collateral for CMOs of $48,837,000, (ii) proceeds from sale of mortgage assets of $10,197,000 and (iii) principal payments received on mortgage securities of $4,446,000. These proceeds were partially offset by capital contributions to HDMF-I of $5,859,000 and purchase of mortgage securities of $4,866,000. Cash flows from financing activities used $79,117,000 during the year ended December 31, 2002. We made repayments on CMO borrowings of $48,526,000 and on reverse repurchase agreements of $27,055,000. We also paid dividends of $4,218,000 and purchased an additional 15,666 shares of our common stock for $132,000 during the year. These payments were partially offset by proceeds from the exercise of stock options resulting in the issuance of 185,610 shares of common stock for $814,000. CAPITAL RESOURCES We regularly invest our capital in MBS through Hanover, our primary investment vehicle. We have also invested a limited amount of Hanover's capital in HT. From the inception of HT in May 1999 until December 31, 2002, Hanover advanced $7,396,000 in the form of loans, and $173,000 in the form of short-term advances, to HT. On July 1, 2002, Hanover acquired 100% of the outstanding common stock of each of HT, HCP and HCP-2; for periods ending after June 30, 2002, Hanover's financial statements will be consolidated with the financial statements of those entities. Although we have no immediate plans for a change in the ownership of HT, we continue to pursue third-party investments to address HT's future capitalized software budget and operating needs. If outside financing is not located, we will continue to be responsible for HT's capital and operating requirements, although we do not expect those needs to be substantial in 2003. 32 RISK FACTORS The following is a summary of the risk factors that we currently believe are important and that could cause our results to differ from expectations. This is not an exhaustive list; other factors not listed below could be material to our results. If any of the risks discussed below actually occur, our business, operating results, prospects or financial condition could be harmed. REIT Requirements Hanover has elected to be taxed as a REIT under the Code. We believe that we were in full compliance with the REIT tax rules as of December 31, 2002 and intend to remain in compliance with all REIT tax rules. If we fail to qualify as a REIT in any taxable year and certain relief provisions of the Code do not apply, we will be subject to Federal income tax as a regular, domestic corporation, and our stockholders will be subject to tax in the same manner as stockholders of a regular corporation. Distributions to our stockholders in any year in which we fail to qualify as a REIT would not be deductible by us in computing our taxable income. As a result, we could be subject to income tax liability, thereby significantly reducing or eliminating the amount of cash available for distribution to our stockholders. Further, we could also be disqualified from re-electing REIT status for the four taxable years following the year during which we became disqualified. At the same time, complying with REIT requirements may limit our ability to hedge our risks, or enter into otherwise attractive investments. Investments in Certain Mortgage Assets We take certain risks in investing in non-standard, single-family mortgage loans and securities collateralized by such loans. If these mortgage loans are missing relevant documents, such as the original note, they may be difficult to enforce. These mortgage loans may also have inadequate property valuations. In addition, if a single-family mortgage loan has a poor payment history, it is more likely to have future delinquencies because of poor borrower payment habits or a continuing cash flow problem. Credit Risk In conducting our business, we retain credit risk primarily through (i) the purchase of subordinate mortgage securities, (ii) the retention of subordinate securities from our own securitization transactions, (iii) the direct investment in mortgage loans on our own behalf and (iv) investment in HDMF-I. Through these investing activities, we generally bear the credit losses on the related pools of mortgage loans up to their carrying value. During the time we hold mortgage assets for investment, we are subject to the risks of borrower defaults and bankruptcies and hazard losses (such as those occurring from earthquakes or floods) that are not covered by insurance. If a default occurs on any mortgage loan held by us or on any mortgage loan collateralizing below-investment-grade MBS held by us, we will bear the risk of loss of principal to the extent of any deficiency between the value of the mortgaged property, plus any payments from an insurer or guarantor, and the amount owing on the mortgage loan. As of December 31, 2002, we retain the aggregate credit risk on $5.9 billion of mortgage loans relating to:

Principal Carrying Balance Value Financing --------- -------- --------- Subordinate MBS $ 23,707 $14,098 $4,585 Collateral for CMOs 115,128 9,967 1,698 Mortgage Loans 547 413 -- -------- ------- ------ Total $139,382 $24,478 $6,283 ======== ======= ======

The above carrying value of collateral for CMOs is our net invested equity in retained mortgage-backed bonds. In addition, HDMF-I retains the aggregate credit risk on $9,264,000 of mortgage loans of which our portion is $4,638,000 of invested capital at risk. If we were to invest in commercial mortgage loans, we may be subject to certain additional risks. Commercial properties tend to be unique and more difficult to value than single-family residential properties. Commercial mortgage loans often have shorter maturities than single-family mortgage loans and often have a significant principal balance or "balloon" due on maturity. A balloon payment creates a 33 greater risk for the lender because the ability of a borrower to make a balloon payment normally depends on its ability to refinance the loan or sell the related property at a price sufficient to permit the borrower to make the payment. Commercial mortgage lending is generally viewed as exposing the lender to a relatively greater risk of loss than single-family mortgage lending because it usually involves larger mortgage loans to single borrowers or groups of related borrowers and the repayment of the loans is typically dependent upon the successful operation of the related properties. As of December 31, 2002, we did not have any commercial mortgage loan investments. However, we may elect to make such investments in the future. Geographic Concentration Although we do not set specific geographic diversification requirements for our portfolio, we do monitor the geographic dispersion of our assets. Concentration in any one geographic area will increase our exposure to the economic and natural hazard risks associated with that area. Negative Effects of Fluctuating Interest Rates Changes in interest rates may impact our earnings in various ways. Approximately one third of our mortgage loans held as collateral for CMOs are adjustable rate mortgages ("ARMs") and approximately 5% of our MBS are collateralized by ARM loans. Therefore, rising short-term interest rates may negatively affect our earnings in the short term. Increases in the interest rate on an ARM loan are generally limited to either 1% or 2% per adjustment period. ARM loans owned by us or underlying our MBS are subject to such limitations, while adjustments in the interest rate on our borrowings are not correspondingly limited. As a result, in periods of rising interest rates, our net interest income could decline. The rate of prepayment on our mortgage assets may increase if interest rates decline or if the difference between long-term and short-term interest rates diminishes. Increased prepayments would cause us to amortize any premiums paid on the acquisition of our mortgage assets faster than currently anticipated, resulting in a reduced yield on our mortgage assets. Additionally, to the extent proceeds of prepayments cannot be reinvested at a rate of interest at least equal to the rate previously earned on the prepaid mortgage assets, our earnings may be adversely affected. Insufficient Demand for Mortgage Loans and our Loan Products The availability of mortgage loans that meet our criteria depends on, among other things, the size of and level of activity in the residential, multifamily and commercial real estate lending markets. The size and level of activity in these markets, in turn, depends on the level of interest rates, regional and national economic conditions, inflation and deflation in property values and the general regulatory and tax environment as it relates to mortgage lending. If we cannot obtain sufficient mortgage loans or mortgage securities that meet our criteria, our business will be adversely affected. Investment in Subsidiary As of December 31, 2002, Hanover advanced $7,396,000 to HT in the form of loans. We anticipate that HT will not need substantial capital investments to fund operating activities in 2003. In addition, we are currently attempting to raise outside capital to address HT's capitalized software budget and operating needs. HT has a limited operating history and has not been profitable to date. 34 Investment Company Act At all times, we intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended. If we were to become regulated as an investment company, our use of leverage would be substantially reduced. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on interest in real estate" ("Qualifying Interests"). Under current interpretation of the staff of the Securities and Exchange Commission, to qualify for this exemption, we must maintain at least 55% of our assets directly in Qualifying Interests. As of December 31, 2002, we believe that we are in compliance with this requirement. State and Local Taxes Our shareholders may be subject to state or local taxation in various jurisdictions, including those in which we transact business or where the shareholders reside. The state and local tax treatment of our shareholders may not conform to Federal income tax consequences discussed above. Consequently, prospective shareholders should consult their own tax advisors regarding the effect of state and local tax laws on an investment in our shares. Available Credit Our ability to meet our performance goals depends on our access to borrowed funds in sufficient amounts and on favorable terms. If we are not able to renew or replace maturing borrowings, we might have to sell some or all of our assets, possibly under adverse market conditions, terminate hedge positions, and/or pledge additional collateral to our existing lenders. 35 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK We use certain derivative financial instruments as hedges of anticipated transactions relating to our mortgage securities. From time to time, we enter into forward sales of mortgage securities issued by federal agencies to manage our exposure to market pricing changes in connection with the purchase, holding, securitization and sale of our fixed-rate mortgage loan portfolio and other mortgage securities. We generally close out the hedge position to coincide with the related sale or securitization transaction. As such hedges are considered freestanding derivatives for accounting purposes, we recognize changes in the fair value of such hedges in earnings in the period of change. At December 31, 2002, we had one forward commitment to sell $4.5 million (par value) and one forward commitment to buy $4.5 million of agency-issued mortgage securities that had not yet settled. These forward commitments were entered into to partially hedge the expected sale of approximately $3.4 million principal balance of subordinate MBS classified as trading. At December 31, 2002, the fair value of our forward sale of agency-issued MBS was ($46,000). If interest rates decreased 300 basis points, our maximum projected loss exposure would be an additional ($47,000); conversely, if interest rates increased 300 basis points, our maximum projected gain would be $509,000. The primary risk associated with short-selling agency-issued securities relates to changes in interest rates. Generally, as market interest rates increase, the market value of the hedged asset (fixed-rate mortgage loans) will decrease. The net effect of increasing interest rates will generally be a favorable or gain settlement on the forward sale of the agency-issued security; this gain should offset a corresponding decline in the value of the hedged assets. Conversely, if interest rates decrease, the market value of the hedged asset will generally increase. The net effect of decreasing interest rates will generally be an unfavorable or loss settlement on the forward sale of the agency-issued security; this loss should be offset by a corresponding gain in value of the hedged assets. To mitigate interest rate risk, an effective matching of agency-issued securities with the hedged assets needs to be monitored closely. Senior management monitors the changes in weighted average duration and coupons of the hedged assets and will appropriately adjust the amount, duration and coupon of future forward sales of agency-issued securities. We also enter into interest rate caps to manage our interest rate exposure on certain reverse repurchase financing and floating rate CMOs. For interest rate caps designated as freestanding derivatives for accounting purposes, changes in fair value are recognized in earnings in the period of change. During the first quarter of 2002, we terminated hedge accounting for one of our cash flow hedges. At the termination date, the loss previously reported in other comprehensive income of $164,000 was reclassified through earnings. We then designated this interest rate cap as a freestanding derivative. At December 31, 2002, we had the following interest rate caps in effect (dollars in thousands):

NOTIONAL AMOUNT INDEX STRIKE % MATURITY DATE ACCOUNTING DESIGNATION ------------- ----------------- ---------- -------------- ------------------------- $ 11,000 3 Month LIBOR 7.695% October 2003 Freestanding Derivative 20,000 1 Month LIBOR 7.75% August 2004 Freestanding Derivative ------------- $ 31,000 =============

The primary risk associated with interest rate caps relates to interest rate increases. The interest rate caps provide a cost of funds hedge against interest rates that exceed the strike rate, subject to the limitation of the notional amount of financing. At December 31, 2002, the fair value of our interest rate caps was $1,000; also the maximum potential loss exposure due to unfavorable market movements. 36 INTEREST RATE SENSITIVITY Interest Rate Mismatch Risk - Reverse Repurchase Financing At December 31, 2002, we owned $413,000 of mortgage loans held for sale. In general, we expect that future loan purchases will be conducted by HDMF-I, and we do not currently plan to purchase additional loans for our own account. If we resume our strategy of purchasing mortgage loans for our own account, we would finance these assets during the initial period (the time period during which management analyzes the loans in detail and corrects deficiencies where possible before securitizing the loans) with reverse repurchase agreement financing or with equity. In this scenario, we would be exposed to the mismatch between the cost of funds on our reverse repurchase agreement financing and the yield on the mortgage loans. Our reverse repurchase agreement financing at December 31, 2002 was indexed to LIBOR plus a spread of 40 to 200 basis points. This financing generally is rolled and matures every 30 to 90 days. Accordingly, any increases in LIBOR will tend to reduce net interest income and any decreases in LIBOR will tend to increase net interest income. We also have floating-rate reverse repurchase financing for certain fixed-rate MBS. At December 31, 2002, we had a total of $4,585,000 of floating-rate reverse repurchase financing compared to $7,008,000 of fixed-rate MBS investments. We have attempted to hedge this exposure by using the interest rate caps described above. Price Risk The market value of mortgage loans and mortgage securities will fluctuate with changes in interest rates. In the case of mortgage loans held for sale and mortgage securities available for sale or held for trading, we will be required to record changes in the market value of such assets. In the case of mortgage loans held for sale and mortgage securities held for trading, we generally attempt to hedge these changes through the short sale of mortgage securities, described above. At December 31, 2002, we did not have any significant mortgage loans held for sale. We hedge the mortgage securities held for trading with the short sale of mortgage securities described above. Prepayment Risk Interest income on the mortgage loan and mortgage securities portfolio is also negatively affected by prepayments on mortgage loan pools or MBS purchased at a premium and positively impacted by prepayments on mortgage loan pools or MBS purchased at a discount. We assign an anticipated prepayment speed to each mortgage pool and MBS at the time of purchase and record the appropriate amortization of the premium or discount over the estimated life of the mortgage loan pool or MBS. To the extent the actual prepayment speeds vary significantly from the anticipated prepayment speeds for an extended period of time, we will adjust the anticipated prepayment speeds and amortization of the premium or discount accordingly. This will negatively (in the case of accelerated amortization of premiums or decelerated amortization of discounts) or positively (in the case of decelerated amortization of premiums or accelerated amortization of discounts) impact net interest income. Securitized Mortgage Loan Assets With respect to the matched funding of assets and liabilities, the CMO collateral relating to the 1998-A, 1999-A, 1999-B and 2000-A securitizations reflect $71,732,000 of fixed-rate mortgage loans and $31,019,000 of adjustable-rate mortgage loans and $9,805,000 of mortgage securities at December 31, 2002. The primary financing for this asset category is the CMO debt of $102,589,000 and reverse repurchase agreements of $1,698,000. The reverse repurchase agreement financing, which is indexed to LIBOR, is subject to interest rate volatility as the reverse repurchase agreement matures and is extended. The financing provided by the CMOs for the 1998-A, 1999-A and 2000-A securitizations lock in long-term fixed financing and thereby eliminates most interest rate risk. The financing for the 1999-B securitization is indexed to LIBOR. Accordingly, we have hedged this interest rate risk through the purchase of interest 37 rate caps. We purchased amortizing interest rate caps with notional balances of $110 million in August 1999 to hedge the 1999-B securitization. The remaining notional balance of these caps is $20 million at December 31, 2002. Mortgage Securities At December 31, 2002, we owned certain fixed-rate and adjustable-rate private placement mortgage securities and certain interest-only and principal-only private placement mortgage securities with an aggregate carrying value of $14,098,000. The coupon interest rates on the fixed-rate mortgage securities would not be affected by changes in interest rates. The interest-only notes remit monthly interest generated from the underlying mortgages after deducting all service fees and the coupon interest rate on the applicable notes. The interest rate on each of the interest-only notes is based on a notional amount (the principal balance of those mortgage loans with an interest rate in excess of the related note coupon interest rate). The notional amounts decline each month to reflect the related normal principal amortization, curtailments and prepayments for the related underlying mortgage loans. Accordingly, net interest income on the mortgage securities portfolio would be negatively affected by prepayments on mortgage loans underlying the mortgage securities and would further be negatively affected to the extent that higher rated coupon mortgage loans paid off more rapidly than lower rated coupon mortgage loans. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our financial statements and related notes, together with the Independent Auditors' Report thereon beginning on page F-1 of this Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 38 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated herein by reference to our definitive proxy statement for the 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference to our definitive proxy statement for the 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS (a) Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference to our definitive proxy statement for the 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year. (b) Securities Authorized for Issuance under Equity Compensation Plans The following table sets forth information regarding outstanding options and shares reserved for future issuance under our equity compensation plans as of December 31, 2002. None of the plans have outstanding warrants or rights other than options. EQUITY COMPENSATION PLAN INFORMATION

Number of Number of Securities Securities to be Remaining Available for Issued upon Weighted Average Future Issuance Under Exercise of Exercise Price Equity Compensation Plans Outstanding of Outstanding (excluding securities Plan Category Stock Options Stock Options reflected in column (a)) --------------------------------------- ---------------- ----------------- ------------------------- (a) (b) (c) Equity compensation plans approved by security holders(1) 250,824 $15.283 74,509 Equity compensation plans not approved by security holders 258,035 $ 4.216 44,167

(1) A Bonus Incentive Compensation Plan has been established for eligible participants of the Company. Although the annual bonus is payable one-half in cash and one-half in shares of our common stock, no shares have been reserved for future issuance. Under our 1999 Equity Incentive Plan, the Compensation Committee can grant non-qualified stock options or restricted stock to executive officers, employees, directors, agents, advisors and consultants of Hanover and its subsidiaries. Subject to anti-dilution provisions for stock splits, stock dividends and similar events, the Plan authorizes the grant of options to purchase, and awards of, an aggregate of up to 550,710 shares of our common stock. The Compensation Committee has the authority to amend the Plan and to set the terms of all awards granted under the Plan, including the number of shares of common stock awarded, the exercise price and vesting provisions. The Plan provides for option grants upon initial election and subsequent re-election to the Board of Directors for each non-employee director, exercisable into 2,000 shares of our common stock which vest in full on the grant date. If an option granted under the Plan expires or terminates, or an award is forfeited, the shares subject to any unexercised portion of such option or award will again become available for the issuance of additional options of awards under the Plan. No eligible participant can be granted options exercisable into, or awards of, more than 50,000 shares of our common stock in any year. In the event of a change of control in which we are not the surviving entity, the Compensation Committee can accelerate the vesting of all outstanding awards. The Plan will expire in 2009, but awards granted prior to the expiration of the Plan may be exercisable beyond that date. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference to our definitive proxy statement for the 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year. ITEM 14. CONTROLS AND PROCEDURES (a) Within the 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC filings. However, we cannot assure you that our controls and procedures can prevent or detect all errors and fraud. In addition, since any system of controls is based in part upon assumptions regarding future events, we cannot assure you that the design of our controls will be successful in achieving its stated goals under all potential future conditions. (b) There have been no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the date of the evaluation referred to in subsection (a) above. 39 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements See Part II, Item 8 hereof. (2) Financial Statement Schedules All schedules omitted are inapplicable or the information required is shown in the Financial Statements or notes thereto. (3) Exhibits Exhibits required to be attached by Item 601 of Regulation S-K are listed in the Exhibit Index attached hereto, which is incorporated herein by this reference. (b) Reports on Form 8-K We did not file any current reports on Form 8-K during the last quarter of 2002. 40 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 28, 2003. HANOVER CAPITAL MORTGAGE HOLDINGS, INC. By /s/ J. Holly Loux ------------------------------------- J. Holly Loux Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and the capacities indicated on March 28, 2003.

SIGNATURE TITLE /s/ John A. Burchett Chairman of the Board of Directors, -------------------------------------------- President and Chief Executive Officer John A. Burchett /s/ Irma N. Tavares Senior Managing Director and a Director -------------------------------------------- Irma N. Tavares /s/ Joyce S. Mizerak Senior Managing Director, Secretary and a Director -------------------------------------------- Joyce S. Mizerak /s/ George J. Ostendorf Senior Managing Director and a Director -------------------------------------------- George J. Ostendorf /s/ John A. Clymer Director -------------------------------------------- John A. Clymer /s/ Joseph J. Freeman Director -------------------------------------------- Joseph J. Freeman /s/ James F. Stone Director -------------------------------------------- James F. Stone /s/ Saiyid T. Naqvi Director -------------------------------------------- Saiyid T. Naqvi /s/ John N. Rees Director -------------------------------------------- John N. Rees /s/ J. Holly Loux Chief Financial Officer -------------------------------------------- (Principal Financial and J. Holly Loux Accounting Officer)

41 CERTIFICATIONS I, John A. Burchett, certify that: 1. I have reviewed this Annual Report on Form 10-K of Hanover Capital Mortgage Holdings, Inc.; 2. Based on my knowledge, this Annual Report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this Annual Report; 3. Based on my knowledge, the financial statements, and other financial information included in this Annual Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this Annual Report; 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this Annual Report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this Annual Report (the "Evaluation Date"); and (c) presented in this Annual Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's Board of Directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officer and I have indicated in this Annual Report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 /s/ John A. Burchett --------------------------------------- John A. Burchett President and Chief Executive Officer 42 CERTIFICATIONS (CONTINUED) I, J. Holly Loux, certify that: 1. I have reviewed this Annual Report on Form 10-K of Hanover Capital Mortgage Holdings, Inc.; 2. Based on my knowledge, this Annual Report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this Annual Report; 3. Based on my knowledge, the financial statements, and other financial information included in this Annual Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this Annual Report; 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this Annual Report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this Annual Report (the "Evaluation Date"); and (c) presented in this Annual Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's Board of Directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officer and I have indicated in this Annual Report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 /s/ J. Holly Loux ----------------------- J. Holly Loux Chief Financial Officer 43 EXHIBIT INDEX

EXHIBIT DESCRIPTION ------- ----------- 2.1*(8) Stock Purchase Agreement dated as of July 1, 2002 by and between Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares 3.1(9) Amended Articles of Incorporation of Registrant, as amended 3.2(1) Bylaws of Registrant 4.1(1) Specimen Common Stock Certificate of Registrant 10.3*(1) Registration Rights Agreement 10.5*(1) Agreement and Plan of Recapitalization 10.6*(1) Bonus Incentive Compensation Plan 10.7*(1) 1997 Executive and Non-Employee Director Stock Option Plan 10.7.1*(3) 1999 Equity Incentive Plan 10.8*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and John A. Burchett 10.8.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and John A. Burchett 10.9*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and Irma N. Tavares 10.9.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and Irma N. Tavares 10.10*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and Joyce S. Mizerak 10.10.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and Joyce S. Mizerak 10.11*(8) Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and George J. Ostendorf 10.11.1*(8) Stock Option Agreement effective as of July 1, 2002 between Registrant and George J. Ostendorf 10.11.2*(6) Employment Agreement by and between Registrant and Thomas P. Kaplan

44 10.11.3* Stock Purchase Agreement as of December 13, 2002 between Thomas P. Kaplan and Hanover Capital Mortgage Holdings, Inc. 10.13(1) Office Lease Agreement, dated as of March 1, 1994, by and between Metroplex Associates and Hanover Capital Mortgage Corporation, as amended by the First Modification and Extension of Lease Amendment dated as of February 28, 1997. 10.13.1 Second Modification and Extension of Lease Agreement dated April 22, 2002 10.13.2 Third Modification of Lease Agreement dated May 8, 2002 10.13.3 Fourth Modification of Lease Agreement dated November 2002 10.14(3) Office Lease Agreement, dated as of February 1, 1999, between LaSalle-Adams, L.L.C. and Hanover Capital Partners Ltd. 10.15 Office Lease Agreement, dated as of September 3, 1997, between Metro Four Associates Limited Partnership and Pamex Capital Partners, L.L.C., as amended by the First Amendment to Lease dated May 2000 10.25*(1) Contribution Agreement by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares 10.25.1*(8) Amendment No. 1 to Contribution Agreement entered into as of July 1, 2002 by and between Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares 10.26*(1) Participation Agreement by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares 10.27*(1) Loan Agreement 10.29(2) Management Agreement, dated as of January 1, 1998, by and between Registrant and Hanover Capital Partners Ltd. 10.30(3) Amendment Number One to Management Agreement, dated as of September 30, 1999 10.31(4) Amended and Restated Master Loan and Security Agreement by and between Greenwich Capital Financial Products, Inc., Registrant and Hanover Capital Partners Ltd. dated March 27, 2000 10.31.1(7) Amendment Number Three dated as of April 11, 2001 to the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products, Inc. 10.31.2 Amendment Number Five dated as of March 28, 2002 to the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products, Inc. 10.31.3 Amendment Number Six dated as of March 27, 2003 to the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000 by and among Registrant, Hanover Capital Partners, Ltd. and Greenwich Capital Financial Products, Inc. 10.33(5) Stockholder Protection Rights Agreement 10.33.1(8) Amendment to Stockholder Protection Rights Agreement effective as of September 26, 2001, by and among Registrant, State Street Bank and Trust Company and EquiServe Trust Company, N.A. 10.33.2(8) Second Amendment to Stockholder Protection Rights Agreement dated as of June 10, 2002 by and between Registrant and EquiServe Trust Company, N.A. 10.34(6) Asset Purchase Agreement, dated as of January 19, 2001 by and among HanoverTrade.com, Inc., Registrant, Pamex Capital Partners, L.L.C. and the members of Pamex Capital Partners, L.L.C. 10.35 Amended and Restated Limited Liability Agreement as of November 21, 2002 by and among BTD 2001 HDMF-1 Corp., Hanover Capital Mortgage Holdings, Inc. and Provident Financial Group, Inc. 21 Subsidiaries of Hanover Capital Mortgage Holdings, Inc. 23.1 Independent Auditors' Consent 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 45 (1) Incorporated herein by reference to Registrant's Registration Statement on Form S-11, Registration No. 333-29261, as amended, which became effective under the Securities Act of 1933, as amended, on September 15, 1997. (2) Incorporated herein by reference to Registrant's Form 10-K for the year ended December 31, 1997, as filed with the Securities and Exchange Commission on March 31, 1998. (3) Incorporated herein by reference to Registrant's Form 10-K for the year ended December 31, 1999, as filed with the Securities and Exchange Commission on March 30, 2000. (4) Incorporated herein by reference to Registrant's Form 10-Q for the quarter ended March 31, 2000, as filed with the Securities and Exchange Commission on May 15, 2000. (5) Incorporated herein by reference to Registrant's report on Form 8-K filed with the Securities and Exchange Commission on April 24, 2000. (6) Incorporated herein by reference to Registrant's form 10-K for the year ended December 31, 2000, as filed with the Securities and Exchanges Commission on April 2, 2001. (7) Incorporated herein by reference to Registrant's Form 10-Q for the quarter ended June 30, 2001, as filed with the Securities and Exchange Commission on August 14, 2001. (8) Incorporated herein by reference to Registrant's Form 8-K filed with the Securities and Exchange Commission on July 16, 2002. (9) Incorporated herein by reference to Registrant's Form 10-Q for the quarter ended June 30, 2002, as filed with the Securities and Exchange Commission on August 14, 2002. * Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. 46 TABLE OF CONTENTS TO FINANCIAL STATEMENTS

PAGE ---- HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES Independent Auditors' Report ......................................................................... F-2 Consolidated Financial Statements as of December 31, 2002 and 2001 and for the Years Ended December 31, 2002, 2001 and 2000: Balance Sheets ............................................................................... F-3 Statements of Income ......................................................................... F-4 Statements of Stockholders' Equity ........................................................... F-5 Statements of Cash Flows ..................................................................... F-6 Notes to Consolidated Financial Statements ................................................... F-7 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES Independent Auditors' Report ......................................................................... F-36 Consolidated Financial Statements as of December 31, 2002 and 2001 and for the Years Ended December 31, 2002, 2001 and 2000: Balance Sheets ............................................................................... F-37 Statements of Income ......................................................................... F-38 Statements of Stockholder's Equity ........................................................... F-39 Statements of Cash Flows ..................................................................... F-40 Notes to Consolidated Financial Statements ................................................... F-41 HANOVERTRADE, INC. AND SUBSIDIARY Independent Auditors' Report ......................................................................... F-46 Consolidated Financial Statements as of December 31, 2002 and 2001 and for the Years Ended December 31, 2002, 2001 and 2000: Balance Sheets ............................................................................... F-47 Statements of Operations ..................................................................... F-48 Statements of Stockholder's Equity ........................................................... F-49 Statements of Cash Flows ..................................................................... F-50 Notes to Consolidated Financial Statements ................................................... F-51

F-1 INDEPENDENT AUDITORS' REPORT To the Board of Directors of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries Edison, New Jersey We have audited the accompanying consolidated balance sheets of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries (the "Company") as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. DELOITTE & TOUCHE LLP Parsippany, New Jersey March 20, 2003 F-2 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data)

DECEMBER 31, ------------------------- ASSETS 2002 2001 --------- --------- Mortgage loans: Held for sale $ 413 $ 2,391 Collateral for CMOs 102,751 151,882 Mortgage securities pledged as collateral for reverse repurchase agreements: Available for sale 4,082 4,404 Held to maturity 559 768 Trading 2,669 33,182 Mortgage securities pledged as collateral for CMOs 9,805 9,840 Mortgage securities, not pledged: Available for sale 6,186 1,162 Trading 602 1,827 Cash and cash equivalents 10,605 8,946 Accounts receivable 2,450 777 Accrued interest receivable 960 1,960 Equity investments: Hanover Capital Partners Ltd. -- 1,808 HanoverTrade, Inc. -- (4,789) HDMF-I LLC 4,638 80 Notes receivable from related parties 2,563 12,538 Other assets 7,588 2,731 --------- --------- TOTAL ASSETS $ 155,871 $ 229,507 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reverse repurchase agreements $ 6,283 $ 33,338 CMO borrowing 102,589 151,096 Dividends payable 1,119 855 Accounts payable, accrued expenses and other liabilities 2,816 2,677 --------- --------- TOTAL LIABILITIES 112,807 187,966 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, par value $.01, 10 million shares authorized, -0- shares issued and outstanding Common stock, par value $.01, 90 million shares authorized, 4,474,222 and 4,275,676 shares issued and outstanding at December 31, 2002 and 2001, respectively 45 43 Additional paid-in capital 67,990 67,082 Retained earnings (deficit) (25,322) (25,978) Accumulated other comprehensive income 351 394 --------- --------- TOTAL STOCKHOLDERS' EQUITY 43,064 41,541 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 155,871 $ 229,507 ========= =========

See notes to consolidated financial statements F-3 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data)

YEARS ENDED DECEMBER 31, --------------------------------------- 2002 2001 2000 -------- -------- -------- REVENUES: Interest income $ 13,530 $ 19,702 $ 26,692 Interest expense 7,438 13,433 20,029 -------- -------- -------- Net interest income 6,092 6,269 6,663 Loan loss provision 393 709 875 -------- -------- -------- Net interest income after loan loss provision 5,699 5,560 5,788 Gain on sale of mortgage assets 2,095 3,782 819 Gain on mark to market of mortgage assets, net of associated hedge 1,367 751 431 Loan brokering, trading and advisory services 2,686 -- -- Due diligence fees 2,891 -- -- Assignment fees 1,387 -- -- Other income (loss) (370) (28) -- -------- -------- -------- Total revenue 15,755 10,065 7,038 -------- -------- -------- EXPENSES: Personnel 5,479 680 1,020 Subcontractor 1,812 -- -- General and administrative 1,089 1,132 924 Legal and professional 1,070 1,247 555 Depreciation and amortization 655 24 21 Other 409 410 409 Occupancy 349 151 160 Travel and entertainment 317 48 45 Technology 293 4 2 -------- -------- -------- Total expenses 11,473 3,696 3,136 -------- -------- -------- Operating income 4,282 6,369 3,902 Equity in income (loss) of unconsolidated subsidiaries: Hanover Capital Partners Ltd. 112 43 455 HanoverTrade, Inc. 655 (3,263) (1,495) HDMF-I LLC 157 (35) -- Hanover Capital Partners 2, Inc. (19) -- -- -------- -------- -------- Income before income tax provision and cumulative effect of adoption of SFAS 133 5,187 3,114 2,862 Income tax provision 49 -- -- -------- -------- -------- Income before cumulative effect of adoption of SFAS 133 5,138 3,114 2,862 Cumulative effect of adoption of SFAS 133 -- 46 -- -------- -------- -------- NET INCOME $ 5,138 $ 3,160 $ 2,862 ======== ======== ======== BASIC EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.73 $ 0.56 Cumulative effect of adoption of SFAS 133 -- 0.01 -- -------- -------- -------- After cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.74 $ 0.56 ======== ======== ======== DILUTED EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.72 $ 0.56 Cumulative effect of adoption of SFAS 133 -- 0.01 -- -------- -------- -------- After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.73 $ 0.56 ======== ======== ========

See notes to consolidated financial statements F-4 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (in thousands, except share data)

ACCUMULATED ADDITIONAL RETAINED OTHER COMMON STOCK PAID-IN COMPREHENSIVE EARNINGS COMPREHENSIVE SHARES AMOUNT CAPITAL INCOME (DEFICIT) INCOME TOTAL --------- ------ ---------- ------------- -------- ------------- -------- BALANCE, DECEMBER 31, 1999 5,826,899 $ 58 $ 75,840 $(25,496) $ 104 $ 50,506 Repurchase of common stock (1,503,955) (15) (7,294) (7,309) Comprehensive income: Net income $2,862 2,862 2,862 Other comprehensive income: Change in net unrealized gain (loss) on securities available for sale 1,216 1,216 1,216 Equity in other comprehensive loss of unconsolidated subsidiary (148) (148) (148) ------ Comprehensive income $3,930 ====== Dividends declared (3,103) (3,103) --------- ----- -------- -------- ------- -------- BALANCE, DECEMBER 31, 2000 4,322,944 43 68,546 (25,737) 1,172 44,024 Repurchase of common stock (246,900) (2) (1,733) (1,735) Exercise of options 62,898 1 270 271 Exercise of warrants 136,734 1 (1) -- Comprehensive income: Net income $3,160 3,160 3,160 Other comprehensive income: Change in net unrealized gain (loss) on securities available for sale (561) (561) (561) Change in net unrealized gain (loss) on interest rate caps designated as hedges 235 235 235 Unrealized cumulative effect of adoption of SFAS 133 (452) (452) (452) ------ Comprehensive income $2,382 ====== Dividends declared (3,401) (3,401) --------- ----- -------- -------- ------- -------- BALANCE, DECEMBER 31, 2001 4,275,676 43 67,082 (25,978) 394 41,541 Repurchase of common stock (50,641) (1) (373) (374) Capital contributed to related party 63,577 1 469 470 Exercise of options 185,610 2 812 814 Comprehensive income: Net income $5,138 5,138 5,138 Other comprehensive income: Change in net unrealized gain (loss) on securities available for sale (207) (207) (207) Change in net unrealized gain (loss) on interest rate caps designated as hedges 164 164 164 ------ Comprehensive income $5,095 ====== Dividends declared (4,482) (4,482) --------- ----- -------- -------- ------- -------- BALANCE, DECEMBER 31, 2002 4,474,222 $ 45 $ 67,990 $(25,322) $ 351 $ 43,064 ========= ===== ======== ======== ======= ========

See notes to consolidated financial statements F-5 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)

YEARS ENDED DECEMBER 31, ------------------------------------------- 2002 2001 2000 -------- --------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 5,138 $ 3,160 $ 2,862 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 655 24 21 Amortization of net premium and deferred costs 133 363 203 Loan loss provision 393 709 875 Gain on sale of mortgage assets (2,095) (3,782) (873) Gain on mark to market of mortgage assets (1,367) (1,058) (816) Gain on mark to market of mortgage assets for SFAS 133 -- (50) -- Gain on disposition of real estate owned (107) -- -- Purchase of trading securities (41,287) (142,540) (7,634) Sale of trading securities 65,497 113,945 2,709 Distributions from unconsolidated subsidiaries in excess of equity (income) loss 552 3,255 1,041 (Increase) decrease in accounts receivable (494) 134 (761) Decrease in accrued interest receivable 1,072 506 460 (Increase) decrease in notes receivable from related parties (1,342) (4,651) 300 Decrease (increase) in other assets 104 250 (1,344) (Decrease) increase in accounts payable, accrued expenses and other liabilities (1,858) 91 (949) -------- --------- -------- Net cash provided by (used in) operating activities 24,994 (29,644) (3,906) -------- --------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of mortgage loans (51) (2,172) -- Purchase of mortgage securities (4,866) (4,431) (2,934) Purchase of mortgage securities from affiliate -- -- (13,845) Principal payments received on mortgage securities 4,446 5,067 8,001 Principal payments received on collateral for CMOs 48,837 59,701 57,254 Principal payments received on mortgage loans held for sale 209 11 21 Proceeds from sale of mortgage assets 10,197 16,076 43,054 Proceeds from disposition of real estate owned 253 -- -- Sales of mortgage securities to affiliates 945 -- -- Increase in cash due to acquisition of subsidiaries' residual interests 1,671 -- -- Capital contributions to HDMF-I LLC (5,859) (115) -- -------- --------- -------- Net cash provided by investing activities 55,782 74,137 91,551 -------- --------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net (repayment of) borrowings from reverse repurchase agreements (27,055) 18,578 (40,962) Net repayment of CMOs (48,526) (59,207) (45,685) Increase in CMO discount -- -- 1,069 Payment of dividends (4,218) (3,411) (2,822) Repurchase of common stock (132) (1,736) (7,309) Exercise of stock options 814 271 -- -------- --------- -------- Net cash used in financing activities (79,117) (45,505) (95,709) -------- --------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,659 (1,012) (8,064) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 8,946 9,958 18,022 -------- --------- -------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 10,605 $ 8,946 $ 9,958 ======== ========= ========

See notes to consolidated financial statements F-6 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 1. ORGANIZATION AND BASIS OF PRESENTATION Hanover Capital Mortgage Holdings, Inc. ("Hanover") was incorporated in Maryland on June 10, 1997. Hanover is a real estate investment trust ("REIT"), formed to operate as a specialty finance company. Hanover has two primary subsidiaries: Hanover Capital Partners Ltd. ("HCP") and HanoverTrade, Inc. ("HT"). When we refer to the "Company," we mean Hanover together with its consolidated and unconsolidated subsidiaries. Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved by a special committee of disinterested members of its Board of Directors, Hanover acquired 100% of the outstanding common stock of each of HT, HCP and Hanover Capital Partners 2, Inc. ("HCP-2"), a previously inactive subsidiary. Hanover had previously owned 100% of the non-voting preferred stock, but none of the voting common stock, of each of HT, HCP and HCP-2. This ownership structure was established in order to satisfy tax laws governing Hanover's status as a REIT. Changes in the tax laws made it possible for Hanover to acquire voting control of HT, HCP and HCP-2 and operate under new rules permitting REITs to wholly own subsidiaries such as HT, HCP and HCP-2. Therefore, as of July 1, 2002, Hanover owns 100% of the outstanding capital stock of each of HT, HCP and HCP-2, and for periods ending after June 30, 2002, Hanover's financial statements will be consolidated with the financial statements of HT, HCP and HCP-2. Hanover acquired the common shares of HT, HCP and HCP-2 from four of its directors who are also executive officers. An independent appraiser determined that the value of the common shares of HT and HCP was $474,000 in the aggregate. The parties agreed that the common shares of HCP-2 would be transferred to Hanover as part of this transaction for no additional consideration. Each of the four selling executives agreed that the purchase price would be used to partially repay certain indebtedness owing to Hanover from them. Each of these four executives also received a bonus in an amount sufficient to cover the tax liability they incurred in connection with this transaction. The Company is engaged in three principal businesses, which are conducted through its three primary operating units: Hanover, HCP and HT. The principal business strategy of Hanover is to invest in mortgage-backed securities ("MBS") and mortgage loans for its own account, and, commencing in 2001, for third parties. The principal business strategy of HCP is to generate consulting and other fee income by providing consulting and due diligence services, focusing on loan sale advisory, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. The principal business activity of HT is to generate fee income by operating an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and providing state-of-the-art technologies supported by experienced valuation, operations and trading professionals. Hanover also maintains an equity investment in HDMF-I LLC ("HDMF-I"). HDMF-I was organized in August 2001 to purchase, service, manage and ultimately re-sell or otherwise liquidate pools of primarily sub- and non-performing one-to-four family residential mortgage loans. The Company's principal business objective is to generate net interest income on its portfolio of mortgage securities and mortgage loans and to generate fee income through HCP, HT and third party asset-management contracts. F-7 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of Hanover Capital Mortgage Holdings, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. BASIS OF PRESENTATION - The consolidated financial statements of the Company are prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America ("GAAP") and in conformity with the rules and regulations of the Securities and Exchange Commission ("SEC"). In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. USE OF ESTIMATES; RISKS AND UNCERTAINTIES - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates, by their nature, are based on judgment and available information. Actual results could differ from the estimates. The Company's estimates and assumptions primarily arise from risks and uncertainties associated with interest rate volatility, credit exposure and regulatory changes. Although management is not currently aware of any factors that would significantly change its estimates and assumptions in the near term, future changes in market trends and conditions may occur which could cause actual results to differ materially. CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand, overnight investments deposited with banks and money market mutual funds primarily invested in government securities with weighted maturities less than 60 days. MORTGAGE LOANS - The Company's policy is to classify each of its mortgage loans as held for sale as they are purchased and each asset is monitored for a period of time, generally four to nine months, prior to making a determination as to whether the asset will be classified as held to maturity. Mortgage loans that are securitized in a collateralized mortgage obligation ("CMO") are classified as collateral for CMOs as of the closing date of the CMO. All mortgage loans designated as held for sale are reported at the lower of cost or market, with unrealized losses reported as a charge to earnings in the current period. Mortgage loans designated as held to maturity and CMO collateral are reported at the lower of the original cost of the mortgage loans or the market value of the mortgage loans as of the date they were designated as CMO collateral or held to maturity. Premiums, discounts and certain deferred costs associated with the purchase of mortgage loans are amortized into interest income over the lives of the mortgage loans using the effective yield method adjusted for the effects of estimated prepayments. Mortgage loan transactions are recorded on the date the mortgage loans are purchased or sold. Purchases of new mortgage loans are recorded when all significant uncertainties regarding the characteristics of the mortgage loans are removed, generally on or shortly before settlement date. Realized gains and losses on mortgage loan transactions are determined on the specific identification basis. The accrual of interest on impaired loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due. When an interest accrual is discontinued, all associated unpaid accrued interest income is reversed. Interest income is subsequently recognized only to the extent cash payments are received. The Company seeks to limit its exposure to credit losses on its portfolio of mortgage loans by performing an in-depth due diligence review on every loan purchased. The due diligence review encompasses the borrower's credit, the enforceability of the documents, and the value of the mortgaged property. In addition, many mortgage loans are guaranteed by an agency of the federal government or private mortgage insurance. The Company monitors the delinquencies and losses on the underlying mortgages and makes a provision for F-8 known losses as well as unidentified potential losses in its mortgage loan portfolio if the impairment is deemed to be other than temporary. The provision is based on management's assessment of numerous factors affecting its portfolio of mortgage loans including, but not limited to, current and projected economic conditions, delinquency status, losses to date on mortgages and remaining credit protection. MORTGAGE SECURITIES - The Company's policy is to generally classify mortgage securities as available for sale as they are acquired. Each available for sale mortgage security is monitored for a period of time prior to making a determination whether the asset will be classified as held to maturity or trading. Management reevaluates the classification of the mortgage securities on a quarterly basis. Mortgage securities designated as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. Mortgage securities designated as trading are reported at fair value. Gains and losses resulting from changes in fair value are recorded as income or expense and included in earnings. Mortgage securities classified as held to maturity are carried at amortized cost unless a decline in value is deemed other than temporary, in which case the carrying value is reduced. The amortization of premiums or accretion of discounts and any unrealized losses deemed other than temporary are included in current period earnings. Mortgage securities transactions are recorded on settlement date for mortgage securities purchased or sold. Purchases of new issue mortgage securities are recorded when all significant uncertainties regarding the characteristics of the mortgage securities are removed, generally on settlement date. Realized gains and losses on mortgage securities transactions are determined on the specific identification basis. The Company purchases both investment-grade and below-investment-grade MBS. Below-investment-grade MBS have the potential to absorb credit losses caused by delinquencies and defaults on the underlying mortgage loans. When purchasing below-investment-grade MBS, the Company leverages HCP's due diligence operations and management's substantial mortgage credit expertise to make a thorough evaluation of the underlying mortgage loan collateral. The Company monitors the delinquencies and the defaults on the underlying mortgages of its mortgage securities and, if an impairment is deemed to be other than temporary, reduces the carrying value to fair value. The Company's loan loss provision, utilized in establishing its loan loss allowance, is based on management's assessment of numerous factors affecting its portfolio of mortgage securities including, but not limited to, current and projected economic conditions, delinquency status, credit losses to date on underlying mortgages and remaining credit protection. The adjustment of the carrying value is made by reducing the cost basis of the individual security and the amount of such write-down is recorded directly against the loan loss allowance. Provisions for credit losses do not reduce taxable income and therefore do not affect the dividends paid by the Company to stockholders in the period the provisions are taken. Actual losses realized by the Company reduce taxable income in the period the actual loss is realized and may affect the dividends paid to stockholders for that tax year. EQUITY INVESTMENTS - Hanover records its investment in HDMF-I on the equity method. Accordingly, Hanover records its proportionate share of the earnings or losses of HDMF-I. For all periods prior to July 1, 2002, Hanover recorded 97% of the earnings or losses of HCP and HT and 99% of the earnings or losses of HCP-2 based on the equity method. Effective July 1, 2002, Hanover's financial statements are consolidated with the financial statements of HT, HCP and HCP-2. REVERSE REPURCHASE AGREEMENTS - Reverse repurchase agreements are accounted for as collateralized financing transactions and recorded at their contractual amounts, plus accrued interest. FINANCIAL INSTRUMENTS - The Company, from time to time, enters into interest rate hedge mechanisms (forward sales of mortgage securities issued by U.S. government agencies) to manage its exposure to changes in interest rates in connection with the purchase, holding, securitization and sale of its mortgage securities and mortgage loan portfolio. The Company generally closes out the hedge position to coincide with a long-term securitization F-9 financing transaction or with any sale. As such hedges are considered freestanding derivatives for accounting purposes, the Company recognizes changes in the fair value of such hedges in earnings in the period of change. The Company also enters into interest rate caps to manage its interest rate exposure on certain reverse repurchase agreements and collateralized mortgage obligation, or CMO, financing. For interest rate caps designated as cash flow hedges for accounting purposes, the effective portion of the gain or loss due to changes in fair value is reported in other comprehensive income, and the ineffective portion is reported in earnings in the period of change. For interest rate caps designated as freestanding derivatives for accounting purposes, changes in fair value are recognized in earnings in the period of change. Any payment received under the interest rate cap agreements is recorded as a reduction of interest expense on the reverse repurchase agreement financing. For derivative financial instruments designated as hedge instruments for accounting purposes, the Company periodically evaluates the effectiveness of these hedges against the financial instrument being hedged. The Company considers a hedge to be effective so long as there is adequate correlation between the hedged results and the change in fair value of the hedged financial instrument. If the hedge instrument performance does not result in adequate correlation between the changes in fair value of the hedge instrument and the related hedged financial instrument, the Company will terminate the hedge for accounting purposes and mark the carrying value of the hedge instrument to market in earnings in the period of change. If a hedge instrument is sold or matures, or the criteria that were anticipated at the time the hedge instrument was entered into no longer exist, the hedge instrument is no longer designated as a hedge for accounting purposes. Under these circumstances, the accumulated change in the market value of the hedge is recognized in current period income or loss to the extent that the effects of interest rate or price changes of the hedged item have not offset the hedged results. The Company has provided fair value estimates and information about valuation methodologies. The estimated fair value amounts have been determined using available market information or appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop estimates of fair value, so the estimates are not necessarily indicative of the amounts that would be realized in a current market exchange. The effect of using different market assumptions and/or estimation methodologies may materially impact the estimated fair value amounts. REVENUE RECOGNITION - Revenues from loan brokering, trading and advisory services are recognized when the transactions close and fees are earned and billed. At the time of closing a transaction, the number of loans, loan principal balance and purchase price in the transaction are agreed upon, documentation is signed and the sale is funded. The Company's billing of fees relating to a transaction occurs concurrently with the closing and funding. Revenues from due diligence contracts in progress and assignment preparation services are recognized for the services provided as they are earned and billed. INCOME TAXES - Hanover has elected to be taxed as a REIT and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the "Code") with respect thereto. Accordingly, Hanover will not be subject to Federal or state income tax on that portion of its income that is distributed to stockholders, as long as certain asset, income and stock ownership tests are met. HCP and HT file separate consolidated Federal income tax returns. HCP and HT use the asset and liability method in accounting for income taxes. Deferred income taxes are provided for the effect of temporary differences between the tax basis and financial statement carrying amounts of assets and liabilities. EARNINGS PER SHARE - Basic earnings or loss per share excludes dilution and is computed by dividing income or loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings or loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock that then shared in earnings and losses. Shares issued during the period and shares reacquired during the period are weighted for the period they were outstanding. F-10 COMPREHENSIVE INCOME - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities and interest rate caps designated as hedges, are reported as separate components of the equity section of the Consolidated Balance Sheets, such items, along with net income, are components of comprehensive income. RECLASSIFICATION - Certain reclassifications of prior years' amounts have been made to conform to the current year presentation. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS - On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("SFAS 121"). SFAS 144 retains the requirements of SFAS 121 for recognizing and measuring the impairment loss of long-lived assets to be held and used. For long-lived assets to be disposed of by sale, SFAS 144 requires a single accounting model be used for all long-lived assets, whether previously held and used or newly acquired. The adoption of SFAS 144 did not have an impact on the Company's consolidated financial position or results of operations. In April 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of FASB Statement No. 4 are generally effective for fiscal years beginning after May 15, 2002. The adoption of SFAS 145 did not have a material effect on the Company's consolidated financial statements. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 will not have a material effect on our consolidated financial statements. On November 25, 2002, the FASB issued FASB Interpretation No. ("FIN") 45 ("FIN 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34." FIN 45 clarifies the requirements of FASB Statement No. 5, "Accounting for Contingencies," relating to the guarantor's accounting for, and disclosure of, the issuance of certain types of guarantees. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods that end after December 15, 2002. The disclosure provisions have been implemented and no disclosures were required at year-end 2002. The provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002, irrespective of the guarantor's year-end. FIN 45 requires that upon issuance of a guarantee, the entity must recognize a liability for the fair value of the obligation it assumes under that guarantee. The Company's adoption of FIN 45 in 2003 has not and is not expected to have a material effect on the Company's consolidated financial statements. In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51," which addresses consolidation of variable interest entities. FIN 46 expands the criteria for consideration in determining whether a variable interest entity should be consolidated by a business entity, and requires existing unconsolidated variable interest entities (which include, but are not limited to, Special Purpose Entities, or SPEs) to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. This interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of FIN 46 is not expected to have a material effect on the Company's consolidated financial statements. F-11 3. MORTGAGE LOANS MORTGAGE LOANS HELD FOR SALE (dollars in thousands)

DECEMBER 31, 2002 DECEMBER 31, 2001 ------------------------------------- -------------------------------------- FIXED ADJUSTABLE FIXED ADJUSTABLE RATE RATE TOTAL RATE RATE TOTAL -------- -------- --------- --------- -------- --------- Principal amount of mortgage loans $ 48 $ 499 $ 547 $ 560 $ 2,627 $ 3,187 Net premium (discount) and deferred costs (3) (111) (114) (159) (637) (796) Loan loss allowance -- (20) (20) -- -- -- -------- -------- --------- --------- -------- --------- Carrying value of mortgage loans $ 45 $ 368 $ 413 $ 401 $ 1,990 $ 2,391 ======== ======== ========= ========= ======== =========

MORTGAGE LOANS SECURITIZED IN COLLATERALIZED MORTGAGE OBLIGATIONS (dollars in thousands)

DECEMBER 31, 2002 DECEMBER 31, 2001 ------------------------------------- -------------------------------------- FIXED ADJUSTABLE FIXED ADJUSTABLE RATE RATE TOTAL RATE RATE TOTAL -------- -------- --------- --------- -------- --------- Principal amount of mortgage loans $ 71,127 $ 31,365 $ 102,492 $ 105,849 $ 45,535 $ 151,384 Net premium (discount) and deferred costs 982 (152) 830 1,442 (167) 1,275 Loan loss allowance (377) (194) (571) (553) (224) (777) -------- -------- --------- --------- -------- --------- Carrying value of mortgage loans $ 71,732 $ 31,019 $ 102,751 $ 106,738 $ 45,144 $ 151,882 ======== ======== ========= ========= ======== =========

Hanover's securitizations were issued with various call provisions, generally allowing for the termination of the securitization at the earlier of a certain date or when the outstanding collateral balance is less than a pre-established percentage of the original collateral balance. During December 2002, Hanover exercised the call provisions of its 1998-A securitization. As of December 31, 2002, Group 3 of Hanover's 1998-B securitization was callable. As discussed in Note 19 to the Consolidated Financial Statements, the mortgage loans underlying the CMOs were sold during the first quarter of 2003. F-12 4. MORTGAGE SECURITIES FIXED-RATE AGENCY MORTGAGE-BACKED SECURITIES (dollars in thousands)

DECEMBER 31, 2001 ------------------------------------------------ AVAILABLE HELD TO FOR SALE MATURITY TRADING TOTAL --------- -------- ------- ------- Principal balance of mortgage securities $1,378 $ -- $25,251 $26,629 Net premium(discount) and deferred costs 70 -- 2,258 2,328 ------ ------ ------- ------- Total amortized cost of mortgage 1,448 -- 27,509 28,957 securities Net unrealized gain (loss) 62 -- 45 107 ------ ------ ------- ------- Carrying value of mortgage securities $1,510 $ -- $27,554 $29,064 ====== ====== ======= =======

At December 31, 2002, there were no fixed-rate agency mortgage-backed securities. FIXED-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES (dollars in thousands)

DECEMBER 31, 2002 ---------------------------------------------------------- AVAILABLE COLLATERAL FOR HELD TO FOR SALE MATURITY TRADING CMOS TOTAL --------- -------- ------- ---------- -------- Principal balance of mortgage securities $ 17,472 $ -- $ 3,433 $ 12,636 $ 33,541 Net premium (discount) and deferred costs (9,164) -- (510) (2,466) (12,140) -------- -------- ------- -------- -------- Total amortized cost of mortgage securities 8,308 -- 2,923 10,170 21,401 Loan loss allowance (182) -- -- (365) (547) Net unrealized gain (loss) 434 -- 348 -- 782 -------- -------- ------- -------- -------- Carrying value of mortgage securities $ 8,560 $ -- $ 3,271 $ 9,805 $ 21,636 ======== ======== ======= ======== ========

DECEMBER 31, 2001 ------------------------------------------------------------ AVAILABLE COLLATERAL FOR HELD TO FOR SALE MATURITY TRADING CMOS TOTAL --------- -------- ------- ---------- -------- Principal balance of mortgage securities $ 6,561 $ -- $ 6,433 $ 12,926 $ 25,920 Net premium (discount) and deferred costs (3,440) -- (2,452) (2,742) (8,634) ------- ------ ------- -------- -------- Total amortized cost of mortgage securities 3,121 -- 3,981 10,184 17,286 Loan loss allowance (221) -- -- (344) (565) Net unrealized gain (loss) 623 -- 792 -- 1,415 ------- ------ ------- -------- -------- Carrying value of mortgage securities $ 3,523 $ -- $ 4,773 $ 9,840 $ 18,136 ======= ====== ======= ======== ========

ADJUSTABLE-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES (dollars in thousands)

DECEMBER 31, 2002 --------------------------------------------------------- AVAILABLE COLLATERAL FOR HELD TO FOR SALE MATURITY TRADING CMOS TOTAL --------- -------- ------- ---------- -------- Principal balance of mortgage securities $ 2,121 $ -- $ -- $ -- $ 2,121 Net premium (discount) and deferred costs (963) -- -- -- (963) -------- -------- -------- -------- -------- Total amortized cost of mortgage securities 1,158 -- -- -- 1,158 Loan loss allowance (25) -- -- -- (25) Net unrealized gain (loss) 2 -- -- -- 2 -------- -------- -------- -------- -------- Carrying value of mortgage securities $ 1,135 $ -- $ -- $ -- $ 1,135 ======== ======== ======= ======== ========

DECEMBER 31, 2001 ------------------------------------------------------------- AVAILABLE COLLATERAL FOR HELD TO FOR SALE MATURITY TRADING CMOS TOTAL ---------- -------- ------- ---------- -------- Principal balance of mortgage securities $ -- $ -- $ 3,692 $ -- $ 3,692 Net premium (discount) and deferred costs -- -- (997) -- (997) ------- ------ ------- -------- -------- Total amortized cost of mortgage securities -- -- 2,695 -- 2,695 Loan loss allowance -- -- -- -- -- Net unrealized gain (loss) -- -- (13) -- (13) ------- ------ ------- -------- -------- Carrying value of mortgage securities $ -- $ -- $ 2,682 $ -- $ 2,682 ======= ====== ======= ======== ========

DERIVATIVE MORTGAGE-BACKED SECURITIES (dollars in thousands)

DECEMBER 31, 2002 ----------------------------------------------- INTEREST- PRINCIPAL- ONLY STRIPS ONLY STRIPS AVAILABLE HELD TO FOR SALE MATURITY TRADING TOTAL ----------- ----------- ------ ------ Principal balance of mortgage securities $ -- $ 681 $ -- $ 681 Net premium (discount) and deferred costs 339 (122) -- 217 -------- ------- ------ ------ Total amortized cost of mortgage securities 339 559 -- 898 Loan loss allowance -- -- -- -- Net unrealized gain (loss) 234 -- -- 234 -------- ------- ------ ------ Carrying value of mortgage securities $ 573 $ 559 $ -- $1,132 ======== ======= ====== ======

DECEMBER 31, 2001 ------------------------------------------------- INTEREST- PRINCIPAL- ONLY STRIPS ONLY STRIPS AVAILABLE HELD TO FOR SALE MATURITY TRADING TOTAL ----------- ----------- ------- ------- Principal balance of mortgage securities $ -- $ 929 $ -- $ 929 Net premium (discount) and deferred costs 639 (161) -- 478 ------- ----- ------ ------- Total amortized cost of mortgage securities 639 768 -- 1,407 Loan loss allowance -- -- -- -- Net unrealized gain (loss) (106) -- -- (106) ------- ----- ------ ------- Carrying value of mortgage securities $ 533 $ 768 $ -- $ 1,301 ======= ===== ====== =======

F-13 The carrying values of the Company's mortgage securities by average life as of December 31, 2002 are as follows (dollars in thousands):

AVAILABLE HELD TO COLLATERAL AVERAGE LIFE FOR SALE MATURITY TRADING FOR CMOS -------------------- --------- -------- ------- ---------- Less than five years $ 1,325 $ 352 $ -- $9,785 Five to ten years 7,799 207 3,271 20 More than ten years 1,144 -- -- -- ------- ------ ------ ------ $10,268 $ 559 $3,271 $9,805 ======= ====== ====== ======

Actual maturities may differ from stated maturities because borrowers usually have the right to prepay certain obligations, oftentimes without penalties. Maturities of mortgage securities depend on the repayment characteristics and experience of the underlying mortgage loans. The proceeds and gross realized gain (loss) from sales of available for sale mortgage securities in 2002, 2001 and 2000 were as follows (dollars in thousands):

YEAR ENDED DECEMBER 31, 2002 -------------------------------------------- GROSS GROSS REALIZED REALIZED PROCEEDS GAIN LOSS -------- -------- -------- Sale of subordinate MBS $ 7,288 $1,771 $ (3) Sale of Agency pass-through MBS 1,307 55 --

YEAR ENDED DECEMBER 31, 2001 -------------------------------------------- GROSS GROSS REALIZED REALIZED PROCEEDS GAIN LOSS -------- -------- -------- Sale of subordinate MBS $16,079 $3,585 $ (2)

YEAR ENDED DECEMBER 31, 2000 -------------------------------------------- GROSS GROSS REALIZED REALIZED PROCEEDS GAIN LOSS -------- -------- -------- Sale of subordinate MBS $ 5,882 $1,248 $ -- Sale of Agency pass-through MBS 39,881 -- (429)

5. CONCENTRATION OF CREDIT RISK MORTGAGE LOANS - The Company's exposure to credit risk associated with its investment activities is measured on an individual customer basis as well as by groups of customers that share similar attributes. In the normal course of its business, the Company has concentrations of credit risk in its mortgage portfolio for the loans in certain geographic areas. At December 31, 2002, the percent of the total principal amount of loans outstanding in any one state exceeding 5% of the principal amount of mortgage loans are as follows: MORTGAGE LOANS HELD AS COLLATERAL FOR CMOS Florida 15% California 12 Texas 12 -- Total 39% == The Company did not have any material concentrations of credit risk in its held for sale category at December 31, 2002. F-14 MORTGAGE SECURITIES - The Company's exposure to credit risk associated with its investment activities is measured on an individual security basis as well as by groups of securities that share similar attributes. In certain instances, the Company has concentrations of credit risk in its mortgage securities portfolio for the securities of certain issuers. CONCENTRATION OF CREDIT RISK BY ISSUER (dollars in thousands)

DECEMBER 31, 2002 --------------------------------------------------------------------------------- AVAILABLE HELD COLLATERAL FOR TO FOR ISSUER SALE MATURITY TRADING CMOS TOTAL ---------------------- --------- -------- ---------- ----------- --------- Hanover Capital 1998-B $ 573 $ 559 $ -- $ 9,805 $ 10,937 Issuer 1 4,060 -- 372 -- 4,432 Issuer 2 903 -- 1,371 -- 2,274 Issuer 3 2,150 -- -- -- 2,150 Issuer 4 626 -- 1,298 -- 1,924 Issuer 5 669 -- -- -- 669 Issuer 6 507 -- -- -- 507 Issuer 7 507 -- -- -- 507 Issuer 8 273 -- 230 -- 503 --------- -------- ---------- --------- --------- Total $ 10,268 $ 559 $ 3,271 $ 9,805 $ 23,903 ========= ======== ========== ========= =========

CASH AND OVERNIGHT INVESTMENTS - The Company has cash and cash equivalents in major financial institutions which are insured by the Federal Deposit Insurance Corporation ("FDIC") up to $100,000 per institution for each legal entity. At December 31, 2002, the Company had amounts on deposit with the financial institutions in excess of FDIC limits. At December 31, 2002, the Company had overnight investments of $10,026,000 primarily in money market mutual funds invested in government securities. The Company limits its risk by placing its cash and cash equivalents in high quality financial institutions, Federal Agency notes or mutual funds of government securities. 6. LOAN LOSS ALLOWANCE The following table summarizes the activity in the loan loss allowance (dollars in thousands):

YEARS ENDED DECEMBER 31, --------------------------------------------- 2002 2001 2000 ------- ------- ------- Balance, beginning of period $ 1,342 $ 1,724 $ 799 Loan loss provision 393 709 875 Transfers from related company -- -- 729 Sales (197) (852) (593) Charge-offs (395) (241) (92) Recoveries -- 2 6 ------- ------- ------- Balance, end of period $ 1,143 $ 1,342 $ 1,724 ======= ======= =======

7. EQUITY INVESTMENTS As of and for the six months ended June 30, 2002 and for the years ended December 31, 2001 and 2000, Hanover owned 100% of the non-voting preferred stock of HCP, HT and HCP-2. These ownership interests entitled Hanover to receive 97% of the earnings or losses of HCP and HT and 99% of the earnings or losses of HCP-2. As discussed in Note 1 to the Consolidated Financial Statements, effective July 1, 2002, Hanover acquired 100% of the common stock of HCP, HT and HCP-2; therefore, for the periods ending after June 30, 2002, the financial statements of HCP, HT and HCP-2 will be consolidated with the financial statements of Hanover. F-15 The table below reflects the activity recorded in Hanover's equity investments (dollars in thousands):

YEARS ENDED DECEMBER 31, -------------------------------------------------------------------------------------------------------- 2002 2001 -------------------------------------------------------- ------------------------------------------ HCP HT HCP-2 HDMF-I TOTAL HCP HT HDMF-I TOTAL ------- ------- ---- ------- ------- ------ ------- ------ ------- Beginning balance $ 1,808 $(4,789) $ -- $ 80 $(2,901) $1,765 $(1,526) $ -- $ 239 Capital contribution -- 470 -- 5,859 6,329 -- -- 115 115 Applicable % of net income (loss) 112 655 (19) 157 905 43 (3,263) (35) (3,255) Applicable % of comprehensive loss -- -- -- -- -- -- -- -- -- Distributions -- -- -- (1,458) (1,458) -- -- -- -- Impact of acquisition of subsidiaries' common stock (1,920) 3,664 19 -- 1,763 -- -- -- -- ------- ------- ---- ------- ------- ------ ------- ----- ------- Ending balance $ -- $ -- $ -- $ 4,638 $ 4,638 $1,808 $(4,789) $ 80 $(2,901) ======= ======= ==== ======= ======= ====== ======= ===== =======

YEARS ENDED DECEMBER 31, --------------------------------- 2000 --------------------------------- HCP HT TOTAL ------- ------- ------- Beginning balance $ 1,466 $ (30) $ 1,436 Capital contribution -- -- -- Applicable % of net income (loss) 455 (1,496) (1,041) Applicable % of comprehensive loss (156) -- (156) Distributions -- -- -- Impact of acquisition of subsidiaries' common stock -- -- -- ------- ------- ------- Ending balance $ 1,765 $(1,526) $ 239 ======= ======= =======

8. NOTES RECEIVABLE AND DUE FROM RELATED PARTIES As of December 31, 2002, Hanover had $2,563,000 of loans outstanding to four executive officers ("Principals"), $870,000 of loans outstanding to HCP and $7,396,000 of loans outstanding to HT. The loans to HCP and HT are eliminated in the consolidated financial statements as of December 31, 2002. Subsequent to June 30, 2002, the interest income and related expense on the loans to HCP and HT are eliminated in the consolidated financial statements. NOTES RECEIVABLE (dollars in thousands)

DECEMBER 31, INTEREST 2002 RATE MATURITY DATE ------------ -------- ------------- Principals $ 483 6.02% September 2007 1,267 5.70 September 2007 813 5.51 March 2003 HCP 870 3.25 March 2004 HT 7,396 3.25 March 2004 Eliminations (8,266) ------- $ 2,563 =======

The loans to Principals are partially secured solely by 116,667 shares of Hanover's common stock owned by the Principals, collectively. The loans to HCP and HT are unsecured. Additional amounts due from related parties at December 31, 2002 are as follows (dollars in thousands):

ACCRUED INTEREST OTHER RECEIVABLE RECEIVABLES TOTAL ---------- ----------- ----- HCP $ 5 $ 15 $ 20 HT 58 173 231 HDMF-I -- 101 101 Other 5 -- 5 Eliminations (63) (188) (251) ------- ------- ------- $ 5 $ 101 $ 106 ======= ======= =======

F-16 9. REVERSE REPURCHASE AGREEMENTS At December 31, 2002, the Company had outstanding borrowings on retained CMO securities of $1,698,000 with a weighted average borrowing rate of 2.97% and a weighted average remaining maturity of one month. Retained CMO securities represent the Company's net investment in the CMOs issued by the Company. The reverse repurchase financing agreements at December 31, 2002 are collateralized by securities with a cost basis of $9,922,000. At December 31, 2002, the Company had outstanding reverse repurchase agreement financing for mortgage securities (other than retained CMO securities) of $4,585,000 with a weighted average borrowing rate of 3.37% and a remaining maturity of less than one month. These mortgage securities are mortgage securities that the Company has purchased or created in transactions other than CMOs. The repurchase agreement financing at December 31, 2002 was collateralized by securities with a cost basis of $7,310,000. At December 31, 2002, the Company had available capacity to borrow $10 million under a committed reverse repurchase line of credit. This committed line matures on March 27, 2003. Information pertaining to reverse repurchase agreement financing as of and for the years ended December 31, 2002 and 2001 is summarized as follows (dollars in thousands): REVERSE REPURCHASE AGREEMENT FINANCING

YEARS ENDED DECEMBER 31, ------------------------------------------------------- 2002 2001 ------------------------ -------------------------- RETAINED OTHER RETAINED OTHER CMO MORTGAGE CMO MORTGAGE SECURITIES SECURITIES SECURITIES SECURITIES ---------- ---------- ---------- ---------- REVERSE REPURCHASE AGREEMENTS Balance of borrowing at end of period $1,698 $ 4,585 $ 1,910 $31,428 Average borrowing balance during the period $1,786 $12,538 $ 2,536 $15,817 Average interest rate during the period 2.97% 3.37% 7.16% 6.58% Maximum month-end borrowing balance during the period $1,889 $28,899 $ 3,626 $33,496 COLLATERAL UNDERLYING THE AGREEMENTS Balance at end of period - carrying value $9,922 $ 7,310 $10,626 $38,354

Additional information pertaining to individual reverse repurchase agreement lenders at December 31, 2002 is summarized as follows (dollars in thousands):

REVERSE REPURCHASE UNDERLYING WEIGHTED AVERAGE LENDER TYPE OF COLLATERAL FINANCING COLLATERAL MATURITY DATE --------------------- ----------------------- --------- ---------- -------------------- Lender A (committed) Retained CMO Securities $ 1,698 $ 9,922 March 27, 2003 Lender A Mortgage Securities 578 1,133 January 8, 2003 (a) Lender B Mortgage Securities 2,354 3,689 January 6, 2003 (a) Lender C Mortgage Securities 1,028 1,390 January 10, 2003 (a) Lender D Mortgage Securities 625 1,098 January 16, 2003 (a) -------- -------- Total $ 6,283 $ 17,232 ======== ========

(a) These borrowings are pursuant to uncommitted lines of credit which are typically renewed monthly. F-17 10. CMO BORROWING, SECURITIZED SALE AND MANAGED MORTGAGED LOANS The Company has executed five securitization transactions since April 1998. Four of these transactions were structured as financings, and one of these transactions ("Hanover 1998-B") was structured as a sale transaction. In the financing transactions, the Company pledged mortgage loans to secure CMOs. These mortgage loans are treated as assets of the Company and the CMOs are treated as debt of the Company. In contrast, the mortgage loans financed through the issuance of Hanover 1998-B were treated as having been sold, and the corresponding debt is not treated as debt of the Company. COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS) - Borrower remittances received on the CMO collateral are used to make payments on the CMOs. The obligations of the CMO are payable solely from the underlying mortgage loans collateralizing the debt and otherwise are non-recourse to the Company. The maturity of each class of CMO is directly affected by principal prepayments on the related CMO collateral. Each class of CMO is also subject to redemption according to specific terms of the respective indenture agreements. As a result, the actual maturity of any class of CMO is likely to occur earlier than its stated maturity. Information pertaining to the CMOs as of and for the year ended December 31, 2002 is summarized as follows (dollars in thousands):

SECURITIZATIONS -------------------------------------------------------------------- 2000-A 1999-B 1999-A 1998-A TOTAL ------- ------- ------- ------- -------- Balance of borrowing at end of period $10,737 $32,208 $43,000 $16,644 $102,589 Average borrowing balance during the period 10,821 39,858 51,612 22,681 124,972 Average interest rate during the period 10.12% 3.00% 6.07% 6.77% 5.57% Interest rate at end of period 9.88% 3.09% 6.61% 6.98% 5.91% Maximum month-end borrowing balance during the period 10,887 48,115 59,537 27,864 146,403 CMO collateral Balance at end of period - carrying value $ 9,557 $35,667 $48,504 $18,580 $112,308

During December 2002, Hanover exercised the call provisions of its 1998-A securitization. As of December 31, 2002, Group 3 of Hanover's 1998-B securitization was callable. As discussed in Note 19 to the Consolidated Financial Statements, the mortgage loans underlying the CMOs were sold during the first quarter of 2003. Aggregate annual principal repayments of mortgage-backed bonds based upon the expected amortization of the underlying mortgage loan collateral at December 31, 2002 were as follows (dollars in thousands):

YEAR AMOUNT --------- --------- 2003 $ 27,284 2004 20,037 2005 14,872 2006 11,014 2007 8,135 Thereafter 21,150 --------- $ 102,492 =========

F-18 SECURITIZED SALE - At December 31, 2002, the Company had a remaining investment of $10,937,000 in securities retained from Hanover 1998-B; these securities had a fair value of $12,098,000. The Company determines the fair value of these securities by obtaining market quotes from a third party dealer firm. In providing these quotes, the dealer firm used the following assumptions for the Hanover 1998-B securities:

TYPE OF CREDIT DISCOUNT PREPAYMENT AVERAGE SECURITY RATING SPREAD RATE SPEED LIFE ----------- ------ ------- ------------ ---------- --------- Subordinate AA/AAA 265 bp 4.30-4.10% 25-35% CPR 0-1 years Subordinate A/AA+ 365 5.03-6.30 25-35 0-4 Subordinate BBB/A+ 615 8.80-9.11 25-35 4 Subordinate BB/BB+ 1115 13.80-14.11 25-35 4 Subordinate B/B 1515 17.80-18.11 25-35 4 Subordinate Unrated -- 80.03-93.18 25-35 3-4 Interest-only AAA/AAA -- 0.00 50-60 0-1 Principal-only AAA/AAA -- 5.00 0 4-14

Discount rates in the market for subordinate securities are typically quoted based on the assumption that the securities will not incur any losses, notwithstanding the fact that market makers expect that these securities will incur losses. The exposure of these securities to credit losses is reflected in the quoted discount rates. Although dealer firms do not typically quote credit loss assumptions, the Company monitors and projects the credit losses on its portfolio. The Company assumes that the mortgage loans in the Hanover 1998-B securitization will default at an annual rate of 0.30% per year, and the Company will recover 75% of the principal balance of the defaulted mortgage loans. Using these assumptions, the quoted prices for the unrated subordinate securities result in an annualized yield of 80% - 93%. This default rate assumption results in projected cumulative losses of $116,000, or 0.04% of the original principal balance of the mortgage loans in the Hanover 1998-B securitization. The following tables show the impact of a change of each of the foregoing assumptions on the fair value of the related securities (dollars in thousands): SENSITIVITY TO DISCOUNT RATE

TYPE CHANGE IN DECLINE OF DISCOUNT IN SECURITY RATE VALUE -------------- ---------- ---------- Subordinate +100 bp $ 177,000 +200 bp 347,000 Interest-Only +500 bp $ 2,000 +1000 bp 4,000 Principal-Only +25 bp $ 7,000 +50 bp 15,000

SENSITIVITY TO PREPAYMENT SPEED

TYPE OF PAYMENT DECLINE IN SECURITY SPEED VALUE -------------- ---------- ---------- Subordinate 25-35% CPR $ -- 15-25 139,000 5-15 291,000 Interest-Only 50-60 $ -- 60-70 24,000 70-80 37,000 Principal-Only 0 $ --

F-19 SENSITIVITY TO LOSS ASSUMPTION

ANNUAL TYPE OF DEFAULT CUMULATIVE DECLINE IN SECURITY RATE LOSSES VALUE -------------- --------- ---------- ---------- Subordinate 0.30% 0.04% $ -- 0.90% 0.11% 24,000 3.00% 0.35% 239,000

The foregoing sensitivity analysis is designed to assist the reader in evaluating the impact that changes in interest rates, prepayment speeds or default rates would have on the value of the securities retained in the Hanover 1998-B securitization. This analysis is based on projected cash flows. The projections were prepared based on a number of simplifying assumptions, including but not limited to the following: (i) all of the loans will prepay at the indicated speeds; (ii) all borrowers pay a full month's interest if they prepay their loans; (iii) there are no delinquencies on the underlying mortgage loans and (iv) the securities are not called. Actual results will differ from projected results. MANAGED MORTGAGE WHOLE LOANS - The following table presents certain information relating to all mortgage loans securitized by the Company or owned by the Company at December 31, 2002 (dollars in thousands): MANAGED ASSETS

PRINCIPAL BALANCE ----------- Mortgage loans held for sale $ 547 Mortgage loans collateralizing on-balance sheet CMOs 102,492 Mortgage loans collateralizing off-balance sheet securitization executed by the Company 68,540 ----------- Total mortgage loans purchased and managed by the Company $ 171,579 ===========

DELINQUENCY RATES ----------- 30-59 days delinquent 8.49% 60-89 days delinquent 1.68% 90 or more days delinquent 3.47% Loans in foreclosure 1.03% Real estate owned 0.43%

The Company realized credit losses of $347,000 on the foregoing assets during the year ended December 31, 2002. F-20 11. EMPLOYEE BENEFIT PLANS 401(K) PLAN - The Company participates in the HCP retirement plan ("401(k) Plan"). The 401(k) Plan is available to all full-time company employees with at least 3 months of service. The Company can, at its option, make a discretionary matching contribution to the 401(k) Plan. For the years ended December 31, 2002, 2001 and 2000, expense related to the 401(k) Plan was $66,487, $21,444 and $21,987, respectively. The expense related to the 401(k) Plan for the year ended December 31, 2002 includes $51,273 for HCP and HT for the six months ended December 31, 2002. HANOVER STOCK OPTION PLANS - Hanover has adopted two stock option plans: (i) the 1997 Executive and Non-Employee Director Stock Option Plan (the "1997 Stock Option Plan") and (ii) the 1999 Equity Incentive Plan (the "1999 Stock Option Plan", together with the 1997 Stock Option Plan, the "Stock Option Plans"). The purpose of the Stock Option Plans is to provide a means of performance-based compensation in order to attract and retain qualified personnel and to afford additional incentive to others to increase their efforts in providing significant services to the Company. 1997 Stock Option Plan - The 1997 Stock Option Plan provides for the grant of qualified incentive stock options, stock options not so qualified, restricted stock, performance shares, stock appreciation rights and other equity-based compensation. The 1997 Stock Option Plan authorized the grant of options to purchase, and limited stock awards of, an aggregate of up to 325,333 shares of Hanover's common stock. Of the stock options granted by the Compensation Committee pursuant to the 1997 Stock Option Plan, stock options granted to the Principals to purchase an aggregate of 162,664 shares of Hanover's common stock at Hanover's initial offering price vested ratably over a 48-month period from the date of the grant and, at December 31, 2002, are fully vested. Stock options granted to the non-employee directors to purchase an aggregate of 8,000 shares of Hanover's common stock are exercisable when issued. The remaining stock options granted by the Compensation Committee pursuant to the 1997 Stock Option Plan were contingent and would have vested, subject to other vesting requirements imposed by the Compensation Committee, in full or in part on any September 30 beginning with September 30, 1998 and ending with September 30, 2002 (each, an "Earn-out Measuring Date"). No vesting occurred on any Earn-out Measuring Dates. To maintain a tie between executive compensation and Hanover's corporate performance, effective July 1, 2002, Hanover revised the vesting targets and Earn-out Measuring Dates related to stock options granted to the Principals to purchase an aggregate of 80,160 shares of Hanover's common stock. Hanover cancelled the original options issued to the Principals and reissued new stock options with the same exercise price of $15.75 but vesting in full or in part on any July 1 beginning with July 1, 2003 and ending with July 1, 2007. The new vesting targets are based on the July 1, 2002 stock price rather than Hanover's initial offering price. All other stock options granted pursuant to the 1997 Stock Option Plan have expired. 1999 Stock Option Plan - The 1999 Stock Option Plan authorizes the grant of options of up to 550,710 shares of Hanover's common stock. F-21 Transactions during the years ended December 31, 2002, 2001 and 2000 relating to the Hanover 1997 and 1999 Stock Option Plans are as follows:

# OF OPTIONS FOR SHARES WEIGHTED -------------------------- AVERAGE 1997 1999 EXERCISE EXERCISE PLAN PLAN PRICE PRICE ---------- --------- -------- -------- Outstanding at December 31, 1999 295,324 $15.350 ======= 270,250 $ 4.625 ======= Stock Option Activity - 2000 Granted - May 18, 2000 282,210 $3.875 Cancelled (6,250) 15.750 Cancelled (2,000) 15.940 Cancelled (13,750) 3.875 Cancelled (17,500) 4.625 ------- ------- Outstanding at December 31, 2000 287,074 $15.340 ======= 521,210 $ 4.240 ======= Stock Option Activity - 2001 Granted - May 24, 2001 4,000 $7.750 Cancelled (7,750) 15.750 Cancelled (3,333) 4.625 Cancelled (5,000) 3.875 Exercised (36,332) 4.625 Exercised (26,566) 3.875 ------- ------- Outstanding at December 31, 2001 279,324 $15.330 ======= ======= 453,979 $ 4.260 ======= Stock Option Activity - 2002 Granted - May 17, 2002 2,000 9.800 Reissued - July 1, 2002 80,160 15.750 Cancelled (86,160) 15.750 Cancelled (6,084) 4.625 Cancelled (6,250) 3.875 Expired (22,500) 15.750 Exercised (126,167) 4.625 Exercised (59,443) 3.875 ------- ------- Outstanding at December 31, 2002 250,824 $15.283 ======= ======= 258,035 $ 4.216 ======== =======

At December 31, 2002, 2001 and 2000, 350,878, 383,754 and 253,136 options, respectively, were exercisable, with exercise prices ranging from $3.875 to $18.130. The per share weighted average fair value of stock options granted for the years ended December 31, 2002 and 2001 was $0.10 and $1.43, respectively, at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

2002 2001 ---- ---- Expected life (years) 10 10 Risk-free interest rate 4.79% 5.49% Volatility 26.38% 32.1% Expected dividend yield 11.91% 10.3%

F-22 Hanover applies APB Opinion No. 25 in accounting for its 1997 and 1999 Stock Option Plans and, accordingly, no compensation cost has been recognized for its stock options in the financial statements for 2002, 2001 and 2000. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under Statement of Financial Accounting Standards No. 123, Accounting For Stock-Based Compensation, the Company's net income would have been reduced to the pro forma amounts for the period indicated below (dollars in thousands, except per share data):

YEARS ENDED DECEMBER 31, --------------------------------------- 2002 2001 2000 -------- --------- -------- Net earnings: As reported $ 5,138 $ 3,160 $ 2,862 Pro forma $ 5,130 $ 3,154 $ 2,814 Earnings per share - basic: As reported $ 1.16 $ 0.74 $ 0.56 Pro forma $ 1.16 $ 0.74 $ 0.55 Earnings per share - diluted: As reported $ 1.15 $ 0.73 $ 0.56 Pro forma $ 1.14 $ 0.73 $ 0.55

BONUS INCENTIVE COMPENSATION PLAN - A bonus incentive compensation plan was established in 1997, whereby an annual bonus will be accrued for eligible participants of the Company. The annual bonus will be paid one-half in cash and (subject to ownership limits) one-half in shares of common stock in the following year. The Company must generate annual net income before bonus accruals that allows for a return of equity to stockholders in excess of the average weekly ten-year U.S. Treasury rate plus 4.0% before any bonus accrual is recorded. As of December 31, 2002, a bonus accrual of $198,000 was recorded. No such accrual was recorded in 2001 and 2000. 12. AFFILIATED PARTY TRANSACTIONS Hanover engaged HCP pursuant to a Management Agreement to render, among other things, due diligence, asset management and administrative services. The term of the Management Agreement continues until December 31, 2003 with subsequent renewal. The 2002, 2001 and 2000 Consolidated Statements of Income include management and administrative expenses of $345,000 (for the period January 1 through June 30, 2002), $716,000 and $634,000, respectively, relating to billings from HCP. In addition, the 2000 Consolidated Statement of Income includes commission expense of $4,000. The 2002 (for the period January 1 through June 30, 2002), 2001 and 2000 Consolidated Statements of Income also reflect a reduction in personnel expenses for a portion of salaries allocated (and billed) to HCP. During 2002, 2001 and 2000, Hanover recorded the following interest income generated from loans to related parties (dollars in thousands):

YEARS ENDED DECEMBER 31, ---------------------------- 2002 2001 2000 ----- ---- ---- Principals $ 171 $184 $185 HCP 40 58 265 HT 265 368 81 HCP-2 277 2 -- Eliminations (251) -- -- ----- ---- ---- $ 502 $612 $531 ===== ==== ====

F-23 13. DERIVATIVE INSTRUMENTS INTEREST RATE CAPS (CASH FLOW HEDGES & FREESTANDING DERIVATIVE) From time to time the Company buys interest rate caps when it finances fixed-rate assets with floating-rate reverse repurchase agreements and CMOs. At December 31, 2001, the Company had designated two of its interest rate caps as "cash flow hedges" and one as a "freestanding derivative". During the first quarter of 2002, the Company terminated hedge accounting for one of its cash flow hedges. At the termination date, the loss previously reported in other comprehensive income of $164,000 was reclassified through earnings. The other cash flow hedge matured in August 2002. Accordingly, at December 31, 2002, the Company had two interest rate caps designated as freestanding derivatives. The objective in entering into these instruments is to protect the net interest margin, which represents the difference between the interest earned on assets and the interest paid on debt. Payments received on the interest rate caps are expected to partially offset increases in interest expense that could result from increases in interest rates. Currently, both interest rate caps are indexed to LIBOR. The Company considers its interest rate caps designated as freestanding derivatives additional protection against the net interest margin although they have not been specifically designated hedging instruments for accounting purposes. The Company did not recognize any gains or losses for the year ended December 31, 2002 as a result of hedge ineffectiveness for the interest rate caps previously designated as cash flow hedges. The Company recognized $161,000 of losses for the year ended December 31, 2002 in the accompanying Consolidated Statement of Income for changes in the fair value of interest rate caps designated as freestanding derivatives. All of these interest rate caps relate to the payment of variable interest on existing financial instruments. At December 31, 2002, the fair value of the Company's interest rate caps was $1,000. FORWARD SALES OF AGENCY SECURITIES (FREESTANDING DERIVATIVES) For the year ended December 31, 2002, the Company entered into forward sales of government agency guaranteed securities, known as "Agency" securities, and futures contracts to manage the exposure to changes in the value of securities classified as "trading securities." The Company considers these forward sales and futures contracts to be freestanding derivatives. The objective is to offset gains or losses on the trading securities with comparable losses or gains on the forward sales or futures contracts. Generally, changes in the value of the trading securities are caused by changes in interest rates, changes in the market for MBS, and changes in the credit quality of the asset. Changes in interest rates and changes in the market for MBS will also affect the value of the forward sales of Agency securities. Changes in interest rates also affect the value of the futures contracts. (The Company does not attempt to hedge changes in the credit quality of individual assets.) The Company calculates the expected impact that changes in interest rates and the market will have on the price of the trading securities, the forward sales and the futures contracts. Using this information, the Company determines the amount of forward sales or futures contracts that it needs so that the expected gains or losses on trading securities will be offset by comparable losses or gains on the forward sales or futures contracts. The Company marks to market the gain or loss on all of the trading securities and all of the freestanding derivatives in each reporting period. The mark to market on the trading securities is reported as a component of gain on mark to market of mortgage assets, net of associated hedge in the accompanying Consolidated Statement of Income. The mark to market on the freestanding derivatives is reported as a component of other income (loss) in the accompanying Consolidated Statement of Income. The Company realized net losses on forward sales of $556,000 and on futures contracts of $753,000 for the year ended December 31, 2002. At December 31 2002, the fair value of the Company's one forward sale of Agency MBS was ($47,000). F-24 14. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE COMMON STOCK In August 2000, the Board of Directors of Hanover authorized a share repurchase program pursuant to which Hanover is authorized to repurchase up to 1,000,000 shares of its outstanding common stock from time to time in open market transactions at a total cost not to exceed $3,000,000. During 2000, Hanover repurchased 498,975 shares under the 2000 share repurchase program at an average price of $5.74 for a total cost of $2,863,000. Therefore, Hanover has remaining authority to purchase up to 501,025 shares for not more than $137,000 under the 2000 share repurchase program. On August 7, 2001, the Board of Directors of Hanover authorized the repurchase of 60,000 shares of its outstanding common stock. On August 13, 2001, Hanover repurchased 57,000 shares under the August 2001 share repurchase authorization at an average price of $7.03 per share for a total cost of $401,000. Therefore, Hanover has remaining authority to purchase up to 3,000 shares under the August 2001 share repurchase authorization. On February 20, 2002, the Board of Directors of Hanover authorized the repurchase of up to 18,166 shares outstanding as a result of exercise of stock option grants prior to the registration of the shares covered by the 1999 Stock Option Plan. As of December 31, 2002, 15,666 shares have been repurchased for approximately $132,000. Therefore, Hanover has remaining authority to purchase up to 2,500 shares under the 2002 share repurchase authorization. On January 19, 2001, Hanover's affiliate, HT, hired 18 employees of Pamex and purchased all of Pamex's assets. The purchase price consisted of $850,000 in cash paid at closing, plus an earn-out of between $1,250,000 and $1,500,000 payable over three years in shares of Hanover common stock. The earn-out is based on performance targets. The performance targets for the first two years were met during 2002 and 2001 and $500,000 was accrued by HT each year. On February 24, 2003, Hanover made a capital contribution to HT of $75,000 in cash and 60,180 shares of HCHI common stock with a then fair market value of $457,970. On February 19, 2002, Hanover made a capital contribution of 63,577 shares of Hanover common stock with a then fair market value of $470,470. The 2002 diluted earnings per share including the 60,180 shares would be $1.13. The 2001 diluted earnings per share after cumulative effect of adoption of SFAS 133, including the 63,577 shares, would be $0.72. The following table summarizes the activity in common stock and additional paid-in capital for 2002, 2001and 2000 (dollars in thousands except share data):

COMMON STOCK ADDITIONAL ---------------------- PAID-IN SHARES AMOUNT CAPITAL ---------- ------ ---------- Balance, December 31, 1999 5,826,899 $ 58 $ 75,840 Repurchases on open market pursuant to 1998 share repurchase program (4,980) -- (16) Repurchases on open market pursuant to 1999 share repurchase program (1,000,000) (10) (4,420) Repurchases on open market pursuant to 2000 share repurchase program (498,975) (5) (2,858) ---------- ------ -------- Balance, December 31, 2000 4,322,944 43 68,546 Repurchases on open market pursuant to April 2001 share repurchase authorization (189,900) (2) (1,333) Repurchases on open market pursuant to August 2001 share repurchase authorization (57,000) -- (400) Options exercised by employees under 1999 Stock Option Plan 62,898 1 270 Cashless exercise of 1 warrant pursuant to Warrant Agreement with third party 136,734 1 (1) ---------- ------ -------- Balance, December 31, 2001 4,275,676 43 67,082 Repurchases from employees pursuant to February 2002 share repurchase authorization (15,666) -- (132) Settlement of note receivable from of officer through common stock repurchase (34,975) (1) (241) Capital contributed to HT related to first earn-out on Pamex acquisition 63,577 1 469 Options exercised by employees under 1999 Stock Option Plan 185,610 2 812 ---------- ------ -------- Balance, December 31, 2002 4,474,222 $ 45 $ 67,990 ========== ====== ========

F-25 STOCKHOLDER PROTECTION RIGHTS AGREEMENT In 2000, the Board of Directors approved and adopted the Stockholder Protection Rights Agreement and approved amendments to such agreement in September 2001 and June 2002 (combined, the "Rights Agreement, as amended"). The Rights Agreement, as amended, provides for the distribution of preferred purchase rights ("Rights") to common stockholders. One Right is attached to each outstanding share of common stock and will attach to all subsequently issued shares. Each Right entitles the holder to purchase one one-hundredth of a share (a "Unit") of Participating Preferred Stock at an exercise price of $17.00 per Unit, subject to adjustment. The Rights separate from the common stock ten days (or a later date approved by the Board of Directors) following the earlier of (a) a public announcement by a person or group of affiliated or associated persons ("Acquiring Person") that such person has acquired beneficial ownership of 10% or more of Hanover's outstanding common shares (more than 20% of the outstanding common stock in the case of John A. Burchett or more than 17% in the case of Wallace Weitz) or (b) the commencement of a tender or exchange offer, the consummation of which would result in an Acquiring Person becoming the beneficial owner of 10% or more of Hanover's outstanding common shares (more than 20% of the outstanding common stock in the case of John A. Burchett or more than 17% in the case of Wallace Weitz). If, any Acquiring Person holds 10% or more of Hanover's outstanding shares (more than 20% of the outstanding common stock in the case of John A. Burchett or more than 17% in the case of Wallace Weitz) or Hanover is party to a business combination or other specifically defined transaction, each Right (other than those held by the Acquiring Person) will entitle the holder to receive, upon exercise, shares of common stock of the surviving company with a market value equal to two times the exercise price of the Right. The Rights expire in 2010, and are redeemable at the option of a majority of Hanover's Directors at $0.01 per Right at any time until the tenth day following an announcement of the acquisition of 10% or more of Hanover's common stock. EARNINGS PER SHARE (dollars in thousands, except per share data)

YEARS ENDED DECEMBER 31, -------------------------------------------- 2002 2001 2000 ---------- ---------- ---------- EARNINGS PER SHARE BASIC: Income before cumulative effect of adoption of SFAS 133 $ 5,138 $ 3,114 $ 2,862 Cumulative effect of adoption of SFAS 133 -- 46 -- ---------- ---------- ---------- Net income (numerator) $ 5,138 $ 3,160 $ 2,862 ========== ========== ========== Average common shares outstanding (denominator) 4,417,221 4,256,874 5,102,563 ========== ========== ========== Per share: Before cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.73 $ 0.56 Cumulative effect of adoption of SFAS 133 -- 0.01 -- ---------- ---------- ---------- After cumulative effect of adoption of SFAS 133 $ 1.16 $ 0.74 $ 0.56 ========== ========== ========== EARNINGS PER SHARE DILUTED: Income before cumulative effect of adoption of SFAS 133 $ 5,138 $ 3,114 $ 2,862 Cumulative effect of adoption of SFAS 133 -- 46 -- ---------- ---------- ---------- Net income (numerator) $ 5,138 $ 3,160 $ 2,862 ========== ========== ========== Average common shares outstanding 4,417,221 4,256,874 5,102,563 ---------- ---------- ---------- Add: Incremental shares from assumed conversion of warrants -- -- 24,170 Incremental shares from assumed conversion of stock options 63,523 53,758 407 ---------- ---------- ---------- Dilutive potential common shares 63,523 53,758 24,577 ---------- ---------- ---------- Diluted weighted average shares outstanding (denominator) 4,480,744 4,310,632 5,127,140 ========== ========== ========== Per share: Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.72 $ 0.56 Cumulative effect of adoption of SFAS 133 -- 0.01 -- ---------- ---------- ---------- After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.73 $ 0.56 ========== ========== ==========

F-26 15. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS (dollars in thousands, except share data)

YEARS ENDED DECEMBER 31, ------------------------------------- 2002 2001 2000 -------- -------- ------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for: Income taxes $ 11 $ -- $ -- ======== ======== ======= Interest $ 8,092 $ 14,135 $20,666 ======== ======== ======= SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES Dividends declared in December but not paid until the following year $ 1,119 $ 855 $ 865 ======== ======== ======= Payment of note receivable from related party with Hanover common stock $ 242 $ -- $ -- ======== ======== ======= Transfer of mortgage loans to real estate owned $ 369 $ -- $ -- ======== ======== ======= Acquisition of common stock of subsidiaries from related parties in exchange for reduction of notes receivable from related parties $ 474 $ -- $ -- ======== ======== ======= Capital contribution of 63,577 shares of common stock to HT $ 470 $ -- $ -- ======== ======== ======= Cashless exercise of 1 warrant in exchange for 136,734 shares of common stock $ -- $ 1 $ -- ======== ======== ======= INCREASE IN CASH DUE TO ACQUISITION OF SUBSIDIARIES' RESIDUAL INTERESTS Total negative equity of subsidiaries prior to acquisition $ (1,816) $ -- $ -- Less net liabilities of subsidiaries prior to acquisition, excluding cash (3,487) -- -- -------- -------- ------- Net increase in cash due to acquisition of subsidiaries' residual interests $ 1,671 $ -- $ -- ======== ======== =======

16. SEGMENT REPORTING As discussed in Note 1 to the Consolidated Financial Statements, the Company is engaged in three principal businesses which are conducted through its three primary operating units, each a reportable segment: Hanover, HCP and HT. The principal business strategy of Hanover is to invest in MBS and mortgage loans for its own account, and, commencing in 2001, for third parties. The principal business strategy of HCP is to generate consulting and other fee income by providing consulting and due diligence services, focusing on loan sale advisory, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. HCP also services multifamily mortgage loans and owns a registered broker/dealer; these two activities are not material and are combined with HCP for purposes of segment reporting. The principal business activity of HT is to generate fee income by operating an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and providing state-of-the-art technologies supported by experienced valuation, operations and trading professionals. HT also owns a broker/dealer whose activities are not material and are combined with HT for segment reporting purposes. As discussed in Note 7 to the Consolidated Financial Statements, prior to June 30, 2002, HCP and HT were unconsolidated subsidiaries. Therefore, segment information is only being provided for 2002 as follows (dollars in thousands):

Hanover Capital Hanover Mortgage Capital Hanover Holdings, Partners Trade, Elimina- Inc. Ltd. Inc. Other tions Consolidated --------- -------- ------- ----- -------- ------------ Net interest income $ 5,973 $ 12 $ 6 $ 352 $ (251) $ 6,092 Other revenues (loss) 2,316 4,348 3,164 (160) (5) 9,663 Net income (loss) 5,138 482 (913) 44 387 5,138 Total assets 154,381 3,706 4,346 24 (6,586) 155,871 Capital expenditures and investments 6,391 35 710 -- -- 7,136 Depreciation and amortization 3 27 625 -- -- 655

F-27 17. COMMITMENTS AND CONTINGENCIES Hanover entered into employment agreements with the Principals and Mr. Kaplan. Such agreements provided for initial five-year terms, and provided for initial aggregate annual base salaries of $1,200,000 (subject to cost of living increases). Mr. Kaplan's agreement will terminate on December 31, 2006. However, pursuant to the amendments upon the expiration of the initial term, the term of each contract for the Principals would be automatically extended on its anniversary for a one-year period, unless either party gives notice to the contrary. Effective July 1, 2002, Hanover entered into an Amended and Restated Employment Agreement with each of the Principals. These employment agreements are substantially identical to the previous employment agreement with each of these officers, except that (i) the base salary was set at the officer's current salary as of July 1, 2002; and (ii) each agreement has a five-year term, automatically renewing for successive one-year terms thereafter until Hanover or the officer terminates the agreement. During 2002, 2001 and 2000, a portion of the aggregate base salaries was allocated to Hanover's principal taxable subsidiaries, HCP and HT, based on management's actual and estimated time involved with the subsidiary's activities. As additional consideration to the Principals for their contribution of their HCP preferred stock to Hanover, Hanover has agreed, pursuant to a Contribution Agreement, to (i) issue to the Principals up to 216,667 additional shares of Hanover's common stock and (ii) forgive a maximum of $1,750,000 in loans made to the Principals if certain financial returns to stockholders are met based on its initial offering price over certain performance periods, the last of which would have ended on September 30, 2002. None of the targets were met within the first four periods, so no Earn-Out Shares have been issued and none of the loans have been forgiven. In accordance with Hanover's policy of tying executive compensation to its corporate performance, effective July 1, 2002, Hanover has entered into Amendment No. 1 to the Contribution Agreement. As a result, the shares could be issued, and the loans could be forgiven, in performance periods between 2002 and 2007 if Hanover meets new performance targets based on its July 1, 2002 market price rather than its initial offering price. In October 1998, the Company sold 15 adjustable-rate FNMA certificates and 19 fixed-rate FNMA certificates that the Company received in a swap for certain adjustable-rate and fixed-rate mortgage loans. These securities were sold with recourse. Accordingly, the Company retains credit risk with respect to the principal amount of these mortgage securities. At December 31, 2002, the Company had forward commitments to sell $4.5 million (par value) and one forward commitment to buy $4.5 million of Agency mortgage securities that had not yet settled. These forward commitments were entered into to partially hedge the expected sale of approximately $3.4 million principal balance of subordinate MBS classified as trading. At December 31, 2002, the fair value of the Company's one forward sale of Agency MBS was ($47,000). F-28 The Company has noncancelable operating lease agreements for office space. Future minimum rental payments for such leases are as follows (dollars in thousands):

YEAR AMOUNT ---------- ------- 2003 $ 402 2004 343 2005 143 2006 46 2007 35 Thereafter -- ------- $ 969 =======

Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to $239,000, $110,000 and $107,000, respectively. The rent expense for the year ended December 31, 2002 includes $182,000 for HCP and HT for the six months ended December 31, 2002. 18. FINANCIAL INSTRUMENTS The estimated fair value of the Company's assets and liabilities classified as financial instruments and off-balance sheet financial instruments at December 31, 2002 and 2001 are as follows (dollars in thousands):

DECEMBER 31, 2002 DECEMBER 31, 2001 -------------------------- ----------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE --------- --------- -------- -------- Assets: Mortgage loans: Held for sale $ 413 $ 413 $ 2,391 $ 2,391 Collateral for CMOs 102,751 103,251 151,882 151,295 Mortgage securities pledged as collateral for reverse repurchase agreements: Available for sale 4,082 4,082 4,404 4,404 Held to maturity 559 481 768 709 Trading 2,669 2,669 33,182 33,182 Mortgage securities pledged as collateral for CMOs 9,805 11,044 9,840 9,576 Mortgage securities not pledged: Available for sale 6,186 6,186 1,162 1,162 Trading 602 602 1,827 1,827 Interest rate caps 1 1 49 49 Forward commitments to sell mortgage securities (47) (47) 28 28 Cash and cash equivalents 10,605 10,605 8,946 8,946 Accrued interest receivable 960 960 1,960 1,960 Notes receivable from related parties 2,563 2,563 12,538 12,538 --------- --------- -------- -------- Total $ 141,149 $ 142,810 $228,977 $228,067 ========= ========= ======== ======== Liabilities: Reverse repurchase agreements $ 6,283 $ 6,283 $ 33,338 $ 33,338 CMO borrowing 102,589 104,595 151,096 149,865 Accounts payable, accrued expenses and other liabilities 2,816 2,816 2,677 2,677 --------- --------- -------- -------- Total $ 111,688 $ 113,694 $187,111 $185,880 ========= ========= ======== ========

The following methods and assumptions were used to estimate the fair value of the Company's financial instruments: Mortgage loans - The fair values of these financial instruments are based upon actual prices received upon recent sales of loans and securities to investors and projected prices which could be obtained through investors considering interest rates, loan type, and credit quality. F-29 Mortgage securities - The fair values of these financial instruments are based upon either or all of the following: actual prices received upon recent sales of securities to investors, projected prices which could be obtained through investors, estimates considering interest rates, loan type, quality and discounted cash flow analysis based on prepayment and interest rate assumptions used in the market place for similar securities with similar credit ratings. Cash and cash equivalents, accrued interest receivable, notes receivable from related parties, reverse repurchase agreements and accounts payable, accrued expenses and other liabilities - The fair value of these financial instruments was determined to be their carrying value due to their short-term nature. CMO borrowing - The fair values of these financial instruments are based upon either or all of the following: actual prices received upon recent sales of securities to investors, projected prices which could be obtained through investor estimates considering interest rates, loan type, quality and discounted cash flow analysis based on prepayment and interest rate assumptions used in the market place for similar securities with similar credit ratings. Interest rate caps - The fair values of these financial instruments are estimated based on dealer quotes and is the estimated amount the Company would pay to execute a new agreement with similar terms. Forward commitments to sell securities - The Company has outstanding forward commitments to sell mortgage securities into mandatory delivery contracts with investment bankers, private investors and agency-backed securities. The fair value of these financial instruments was determined through review of published market information associated with similar instruments. These commitment obligations are considered in conjunction with the Company's lower of cost or market valuation of its loans held for sale. 19. SUBSEQUENT EVENTS On January 14, 2003, a $0.25 cash dividend, previously declared by the Board of Directors, was paid to stockholders of record as of December 31, 2002. On February 20, 2003, an extra one-time $0.15 cash dividend was declared by the Board of Directors to be paid on March 20, 2003 to stockholders of record as of March 6, 2003. During December 2002, Hanover exercised the call provisions of its 1998-A securitization. In February 2003, Hanover sold the underlying mortgage loans and realized aggregate net proceeds of approximately $1,000,000 which will be available for re-investment. As of December 31, 2002, Group 3 of Hanover's 1998-B securitization was callable. During January 2003, Hanover exercised the call provisions of its 1998-B securitization and in March 2003, sold the underlying mortgage loans and realized aggregate net proceeds of approximately $5,000,000. On February 21, 2003, the maturity date of the notes payable from HCP and HT were extended from March 31, 2003 to March 31, 2004. In February 2003, the Company made a capital contribution to HT of $75,000 of cash and 60,180 shares of Hanover common stock with a then fair market value of $457,970. The capital contribution was utilized by HT to fund the second earn-out issued in connection with HT's purchase in January 2001 of all of the assets of Pamex. On February 25, 2003, Hanover issued options to purchase 30,000 shares of its common stock with an exercise price of $7.69 in satisfaction of the terms of the purchase agreement between HT and Pamex. The stock options expire on February 24, 2008. In March 2003, the Company renewed its $10 million committed reverse repurchase line of credit; this committed line matures on April 27, 2003. F-30 20. QUARTERLY FINANCIAL DATA - UNAUDITED (dollars in thousands, except per share data)

THREE MONTHS ENDED -------------------------------------------------------- DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, 2002 2002 2002 2002 ------------ ------------- --------- --------- Net interest income $ 1,520 $ 1,539 $ 1,381 $ 1,652 ========= ========= ========= ========= Net income $ 928 $ 1,506 $ 1,392 $ 1,312 ========= ========= ========= ========= Basic earnings per share (1) $ 0.21 $ 0.34 $ 0.32 $ 0.31 ========= ========= ========= ========= Diluted earnings per share (1) $ 0.20 $ 0.33 $ 0.31 $ 0.30 ========= ========= ========= ========= Dividends declared $ 0.25 $ 0.25 $ 0.25 $ 0.25 ========= ========= ========= =========

THREE MONTHS ENDED -------------------------------------------------------- DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, 2001 2001 2001 2001 ------------ ------------- --------- --------- Net interest income $ 1,658 $ 1,607 $ 1,674 $ 1,330 ========= ========= ========= ========= Net income $ 1,066 $ 725 $ 696 $ 673 ========= ========= ========= ========= Basic earnings per share (1) $ 0.25 $ 0.17 $ 0.17 $ 0.16 ========= ========= ========= ========= Diluted earnings per share (1) $ 0.25 $ 0.17 $ 0.16 $ 0.15 ========= ========= ========= ========= Dividends declared $ 0.20 $ 0.20 $ 0.20 $ 0.20 ========= ========= ========= =========

THREE MONTHS ENDED --------------------------------------------------------- DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, 2000 2000 2000 2000 ------------ ------------- --------- --------- Net interest income $ 1,673 $ 2,081 $ 1,425 $ 1,484 ========= ========= ========= ========= Net income $ 710 $ 727 $ 735 $ 690 ========= ========= ========= ========= Basic earnings per share (1) $ 0.16 $ 0.15 $ 0.14 $ 0.12 ========= ========= ========= ========= Diluted earnings per share (1) $ 0.15 $ 0.15 $ 0.14 $ 0.12 ========= ========= ========= ========= Dividends declared $ 0.20 $ 0.20 $ 0.14 $ 0.12 ========= ========= ========= =========

(1) Earnings per share are computed independently for each of the quarters presented; therefore the sum of the quarterly earnings per share does not equal the earnings per share total for the year. 21. PRO FORMA DISCLOSURE The following unaudited pro forma consolidated statements of income have been prepared to give effect to Hanover's acquisition on July 1, 2002 of 100% of the outstanding common stock of each of HCP, HT and HCP-2 (collectively, the "Newly Consolidated Subsidiaries"), as previously reported on Form 8-K filed on July 16, 2002. This acquisition had been accounted for using the purchase method of accounting. These pro forma consolidated statements of income were prepared as if the acquisition had been completed as of January 1, 2001. The unaudited pro forma consolidated statements of income are presented for illustrative purposes only and are not necessarily indicative of the results of operations that would have actually been reported had the acquisition occurred on January 1, 2001, nor are these presentations necessarily indicative of the future results of operations. These unaudited pro forma consolidated statements of income are based upon the historical consolidated financial statements of Hanover and the Newly Consolidated Subsidiaries included in Hanover's Annual Report on Form 10-K for the year ended December 31, 2001 and the Quarterly Report on Form 10-Q for the six months ended June 30, 2002. F-31 Information presented for the years ended December 31, 2002 and 2001 is presented on a consolidated pro forma basis. HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data) (unaudited)

YEARS ENDED DECEMBER 31, ------------------------- 2002 2001 ------- -------- REVENUES: (Pro Forma) (Pro Forma) Interest income $13,813 $ 19,304 Interest expense 7,438 13,433 ------- -------- Net interest income 6,375 5,871 Loan loss provision 393 709 ------- -------- Net interest income after loan loss provision 5,982 5,162 Gain on sale of mortgage assets 2,095 3,782 Gain on mark to market of mortgage assets, net of associated hedge 1,237 695 Loan brokering, trading and advisory services 6,831 3,521 Due diligence fees 4,971 5,083 Assignment fees 2,220 757 Other income (loss) (399) 58 ------- -------- Total revenue 22,937 19,058 ------- -------- EXPENSES: Personnel 8,907 7,231 Subcontractor 2,964 2,373 Depreciation and amortization 1,280 1,184 Legal and professional 1,206 1,704 General and administrative 1,181 1,152 Technology 782 683 Occupancy 536 651 Travel and entertainment 512 548 Other 437 461 ------- -------- Total expenses 17,805 15,987 ------- -------- Operating income 5,132 3,071 Equity in income of unconsolidated subsidiaries: Hanover Capital Partners Ltd. -- -- HanoverTrade, Inc. -- -- HDMF-I LLC 157 (35) Hanover Capital Partners 2, Inc. -- -- ------- -------- Income before income tax provision (benefit) and cumulative effect of adoption of SFAS 133 5,289 3,036 Income tax provision (benefit) 127 64 ------- -------- Income before cumulative effect of adoption of SFAS 133 5,162 2,972 Cumulative effect of adoption of SFAS 133 -- 46 ------- -------- NET INCOME $ 5,162 $ 3,018 ======= ======== BASIC EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 1.17 $ 0.70 Cumulative effect of adoption of SFAS 133 -- .01 ------- -------- After cumulative effect of adoption of SFAS 133 $ 1.17 $ 0.71 ======= ======== DILUTED EARNINGS PER SHARE: Before cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.69 Cumulative effect of adoption of SFAS 133 -- .01 ------- -------- After cumulative effect of adoption of SFAS 133 $ 1.15 $ 0.70 ======= ========

See notes to pro forma consolidated statements of income F-32 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 2002 (UNAUDITED) (in thousands, except per share data)

SIX MONTHS ENDED HANOVER JUNE 30, 2002 CAPITAL ------------- MORTGAGE NEWLY HOLDINGS, INC. CONSOLIDATED ADJUSTMENTS/ PRO FORMA AS REPORTED SUBSIDIARIES ELIMINATIONS CONSOLIDATED -------------- ------------- ------------ ------------ REVENUES: Interest income $ 13,530 $ 639 $(356)(a,d) $ 13,813 Interest expense 7,438 -- -- 7,438 ----------- ------- ----- ---------- Net interest income 6,092 639 (356) 6,375 Loan loss provision 393 -- -- 393 ----------- ------- ----- ---------- Net interest income after loan loss provision 5,699 639 (356) 5,982 Gain on sale of mortgage assets 2,095 -- -- 2,095 Gain (loss) on mark to market of mortgage assets 1,367 (130) -- 1,237 Loan brokering, trading and advisory services 2,686 4,145 -- 6,831 Due diligence fees 2,891 2,087 (7)(b) 4,971 Assignment fees 1,387 833 -- 2,220 Other income (loss) (370) 7 (36)(b) (399) ----------- ------- ----- ---------- Total revenue 15,755 7,581 (399) 22,937 ----------- ------- ----- ---------- EXPENSES: Personnel 5,479 3,083 345(b,d) 8,907 Subcontractor 1,812 1,152 -- 2,964 Depreciation and amortization 655 625 -- 1,280 Legal and professional 1,070 136 -- 1,206 General and administrative 1,089 505 (413)(b) 1,181 Technology 293 489 -- 782 Occupancy 349 187 -- 536 Travel and entertainment 317 195 -- 512 Other 409 359 (331)(a) 437 ----------- ------- ----- ---------- Total expenses 11,473 6,731 (399) 17,805 ----------- ------- ----- ---------- Operating income 4,282 850 -- 5,132 Equity in income of unconsolidated subsidiaries 905 -- (748)(c) 157 ----------- ------- ----- ---------- Income before income tax provision (benefit) 5,187 850 (748) 5,289 Income tax provision (benefit) 49 78 -- 127 ----------- ------- ----- ---------- NET INCOME $ 5,138 $ 772 $(748) $ 5,162 =========== ======= ===== ========== BASIC EARNINGS PER SHARE: Average common shares outstanding 4,417,221 4,417,221 =========== ========== Basic earnings per share $ 1.16 $ 1.17 =========== ========== DILUTED EARNINGS PER SHARE: Diluted weighted average shares outstanding 4,480,744 4,480,744 =========== ========== Diluted earnings per share $ 1.15 $ 1.15 =========== ==========

See notes to pro forma consolidated statements of income F-33 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES PRO FORMA CONSOLIDATED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 2001 (UNAUDITED) (in thousands, except per share data)

HANOVER CAPITAL MORTGAGE NEWLY HOLDINGS, INC. CONSOLIDATED ADJUSTMENTS/ PRO FORMA AS REPORTED SUBSIDIARIES ELIMINATIONS CONSOLIDATED --------------- ------------ ------------ ------------ REVENUES: Interest income $ 19,702 $ 55 $ (453)(a,d) $ 19,304 Interest expense 13,433 -- -- 13,433 ----------- -------- ------- ----------- Net interest income 6,269 55 (453) 5,871 Loan loss provision 709 -- -- 709 ----------- -------- ------- ----------- Net interest income after loan loss provision 5,560 55 (453) 5,162 Gain on sale of mortgage assets 3,782 -- -- 3,782 Gain on mark to market of mortgage assets, net of associated hedge 751 (56) -- 695 Loan brokering, trading and advisory services -- 3,521 -- 3,521 Due diligence fees -- 5,803 (720)(b) 5,083 Assignment fees -- 757 -- 757 Other income(loss) (28) 86 -- 58 ----------- -------- ------- ----------- Total revenue 10,065 10,166 (1,173) 19,058 ----------- -------- ------- ----------- EXPENSES: Personnel 680 6,555 (4)(b) 7,231 Subcontractor -- 2,373 -- 2,373 Depreciation and amortization 24 1,160 -- 1,184 Legal and professional 1,247 457 -- 1,704 General and administrative 1,132 736 (716)(b) 1,152 Technology 4 679 -- 683 Occupancy 151 500 -- 651 Other 413 479 (428)(a) 464 Travel and entertainment 45 500 -- 545 ----------- -------- ------- ----------- Total expenses 3,696 13,439 (1,148) 15,987 ----------- -------- ------- ----------- Operating income(loss) 6,369 (3,273) (25) 3,071 Equity in(loss) of unconsolidated subsidiaries (3,255) -- 3,220(d) (35) ----------- -------- ------- ----------- Income(loss) before income tax provision and cumulative effect of adoption of SFAS 133 3,114 (3,273) 3,195 3,036 Income tax provision -- 64 -- 64 ----------- -------- ------- ----------- Income(loss) before cumulative effect of adoption of SFAS 133 3,114 (3,337) 3,195 2,972 Cumulative effect of adoption of SFAS 133 46 -- -- 46 ----------- -------- ------- ----------- NET INCOME(LOSS) $ 3,160 $ (3,337) $ 3,195 $ 3,018 =========== ======== ======= =========== BASIC EARNINGS PER SHARE: Average common shares outstanding 4,256,874 4,256,874 =========== =========== Basic earnings per share: Before cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.70 Cumulative effect of adoption of SFAS 133 0.01 0.01 ----------- ----------- After cumulative effect of adoption of SFAS 133 $ 0.74 $ 0.71 =========== =========== DILUTED EARNINGS PER SHARE: Diluted weighted average shares outstanding 4,310,632 4,310,632 =========== =========== Diluted earnings per share: Before cumulative effect of adoption of SFAS 133 $ 0.72 $ 0.69 Cumulative effect of adoption of SFAS 133 0.01 0.01 ----------- ----------- After cumulative effect of adoption of SFAS 133 $ 0.73 $ 0.70 =========== ===========

See notes to pro forma consolidated statements of income F-34 HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO PRO FORMA CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (dollars in thousands) (a) To eliminate intercompany interest income and expense summarized as follows:

SIX MONTHS YEAR ENDED ENDED JUNE 30, DECEMBER 31, 2002 2001 ---------- ------------ Interest on note to Hanover Capital Partners Ltd. $ 23 $ 58 Interest on note to HanoverTrade, Inc. 146 368 Interest on note to Hanover Capital Partners 2, Inc. 162 2 ------- ------- $ 331 $ 428 ======= =======

(b) Hanover engaged Hanover Capital Partners Ltd. pursuant to a Management Agreement to render, among other things, due diligence, asset management and administrative services. In addition, Hanover Capital Partners Ltd. performed management and administrative services for HanoverTrade, Inc. To eliminate these intercompany management fees recorded as follows:

SIX MONTHS YEAR ENDED ENDED JUNE 30, DECEMBER 31, 2002 2001 ---------- ------------ Management fee income recorded to: Due diligence fees $ 7 $ 720 Other revenues 36 -- Reduction of personnel expense 374 -- ------- ------- $ 417 $ 720 ======= ======= Management fee expensed to: General, management and administrative $ 413 $ 716 Personnel expense 4 4 ------- ------- $ 417 $ 720 ======= =======

(c) With the consolidation of the results of Hanover Capital Partners Ltd., HanoverTrade, Inc. and Hanover Capital Partners 2, Inc., the equity in income (loss) of these subsidiaries summarized below would be reversed:

SIX MONTHS YEAR ENDED ENDED JUNE 30, DECEMBER 31, 2002 2001 ---------- ------------ Hanover Capital Partners Ltd. $ 112 $ 43 HanoverTrade, Inc. 655 (3,263) Hanover Capital Partners 2, Inc. (19) -- ------- ------- $ 748 $(3,220) ======= =======

(d) To exclude the interest income on the portion of the notes receivable reduced in exchange for the purchase of the common stock of the newly consolidated subsidiaries; interest for the year ended December 31, 2002 was forgiven and the offset is to personnel expense while for the year ended December 31, 2001, the offset is to the balance sheet.

YEARS ENDED DECEMBER 31, ------------------------ 2002 2001 ------- ------- Interest income $ 25 $ 25 ======= ======= Personnel expense $ (25) $ -- ======= =======

****** F-35 INDEPENDENT AUDITORS' REPORT To the Board of Directors of Hanover Capital Partners Ltd. and Subsidiaries Edison, New Jersey We have audited the accompanying consolidated balance sheets of Hanover Capital Partners Ltd. and Subsidiaries (the "Company") as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Hanover Capital Partners Ltd. and Subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. DELOITTE & TOUCHE LLP Parsippany, New Jersey March 20, 2003 F-36 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

DECEMBER 31, ------------------------------ ASSETS 2002 2001 ----------- ----------- CURRENT ASSETS: Cash and cash equivalents $ 368,715 $ 847,676 Accounts receivable 1,415,159 996,777 Receivables from related parties 363,687 473,637 Accrued revenue on contracts in progress 895,303 1,035,870 Prepaid expenses and other current assets 110,852 39,580 ----------- ----------- Total current assets 3,153,716 3,393,540 PROPERTY AND EQUIPMENT - Net 91,931 100,584 DEFERRED TAX ASSET - Net 239,678 294,041 MORTGAGE LOANS HELD FOR SALE 207,151 -- OTHER ASSETS 13,340 13,340 ----------- ----------- TOTAL ASSETS $ 3,705,816 $ 3,801,505 =========== =========== LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES: Accrued appraisal and subcontractor costs $ 34,612 $ 16,139 Accounts payable and accrued expenses 259,280 456,859 Due to related parties 14,841 411,232 Deferred revenue 10,000 -- Income tax payable 38,160 -- ----------- ----------- Total current liabilities 356,893 884,230 NOTE PAYABLE TO RELATED PARTY 870,298 1,035,859 ----------- ----------- TOTAL LIABILITIES 1,227,191 1,920,089 ----------- ----------- COMMITMENTS AND CONTINGENCIES STOCKHOLDER'S EQUITY: Preferred stock: $.01 par value, 100,000 shares authorized, 97,000 shares outstanding at December 31, 2002 and 2001 970 970 Common stock: Class A: $.01 par value, 5,000 shares authorized, 3,000 shares outstanding at December 31, 2002 and 2001 30 30 Additional paid-in capital 2,839,947 2,839,947 Retained earnings (deficit) (362,322) (959,531) ----------- ----------- TOTAL STOCKHOLDER'S EQUITY 2,478,625 1,881,416 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $ 3,705,816 $ 3,801,505 =========== ===========

See notes to consolidated financial statements F-37 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31, -------------------------------------------- 2002 2001 2000 ---------- ---------- ---------- REVENUES: Due diligence fees $4,977,620 $5,802,720 $7,016,435 Assignment fees 2,220,083 756,683 631,093 Interest income on mortgage assets, net of interest expense and loan loss provision of $1,137,499 in 2000 872 -- 513,391 Gain on sale of mortgage securities -- -- 440,639 Other income 184,733 22,957 112,100 ---------- ---------- ---------- Total revenues 7,383,308 6,582,360 8,713,658 ---------- ---------- ---------- EXPENSES: Subcontractor 2,950,378 2,373,226 3,081,029 Personnel 2,688,339 2,956,008 3,152,852 General and administrative 330,423 311,083 309,926 Occupancy 260,414 243,888 453,372 Travel and subsistence 197,853 224,296 215,959 Professional 161,899 242,173 257,495 Depreciation and amortization 57,965 57,970 52,908 Interest 40,347 65,555 90,054 ---------- ---------- ---------- Total expenses 6,687,618 6,474,199 7,613,595 ---------- ---------- ---------- INCOME BEFORE INCOME TAX PROVISION 695,690 108,161 1,100,063 INCOME TAX PROVISION 98,481 64,149 631,722 ---------- ---------- ---------- NET INCOME $ 597,209 $ 44,012 $ 468,341 ========== ========== ========== BASIC EARNINGS PER SHARE (NOTE 2) $ 199.07 $ 14.67 $ 156.11 ========== ========== ==========

See notes to consolidated financial statements F-38 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

PREFERRED STOCK COMMON STOCK ADDITIONAL --------------------- ------------------ PAID-IN SHARES AMOUNT SHARES AMOUNT CAPITAL ------ ------ ------ ------ ----------- BALANCE, DECEMBER 31, 1999 97,000 $ 970 3,000 $ 30 $ 2,839,947 Comprehensive income: Net income Other comprehensive income (loss): Change in net unrealized gain on securities available for sale, net of income tax effect Comprehensive income ------ ------ ----- ----- ----------- BALANCE, DECEMBER 31, 2000 97,000 970 3,000 30 2,839,947 Comprehensive income: Net income Comprehensive income ------ ------ ----- ----- ----------- BALANCE, DECEMBER 31, 2001 97,000 970 3,000 30 2,839,947 Comprehensive income: Net income Comprehensive income ------ ------ ----- ----- ----------- BALANCE, DECEMBER 31, 2002 97,000 $ 970 3,000 $ 30 $ 2,839,947 ====== ====== ===== ===== ===========

ACCUMULATED COMPREHENSIVE RETAINED OTHER INCOME EARNINGS COMPREHENSIVE (LOSS) (DEFICIT) GAIN TOTAL ------------- ----------- -------------- ----------- BALANCE, DECEMBER 31, 1999 $(1,471,884) $ 142,311 $ 1,511,374 Comprehensive income: Net income $ 468,341 468,341 468,341 Other comprehensive income (loss): Change in net unrealized gain on securities available for sale, net of income tax effect (142,311) (142,311) (142,311) ----------- Comprehensive income $ 326,030 =========== ----------- --------- ----------- BALANCE, DECEMBER 31, 2000 (1,003,543) -- 1,837,404 Comprehensive income: Net income $ 44,012 44,012 44,012 ----------- Comprehensive income $ 44,012 =========== ----------- --------- ----------- BALANCE, DECEMBER 31, 2001 (959,531) -- 1,881,416 Comprehensive income: Net income $ 597,209 597,209 597,209 ----------- Comprehensive income $ 597,209 =========== ----------- --------- ----------- BALANCE, DECEMBER 31, 2002 $ (362,322) $ -- $ 2,478,625 =========== ========= ===========

See notes to consolidated financial statements F-39 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, ------------------------------------------------ 2002 2001 2000 --------- ----------- ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 597,209 $ 44,012 $ 468,341 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of net premium -- -- (374,961) Loan loss provision -- -- 478,330 Depreciation and amortization 57,965 53,875 42,798 Deferred tax provision 54,363 46,690 612,682 Gain on sale of mortgage-backed securities -- -- (440,639) Gain on disposal of property and equipment -- -- (2,700) Sale of trading securities -- -- 15,755 Changes in assets - (increase) decrease: Accounts receivable (418,382) 1,305,434 (1,633,218) Receivables from/payables to related parties (286,441) 469,710 (345,146) Accrued interest receivable -- -- 181,471 Accrued revenue on contracts in progress 140,567 311,696 (585,643) Prepaid expenses and other current assets (71,272) (13,024) 143,645 Other assets -- 3,690 161,903 Changes in liabilities - increase (decrease): Accrued appraisal and subcontractor costs 18,473 (20,640) 23,197 Accounts payable and accrued expenses (197,579) (1,085,149) 1,033,033 Deferred revenue 10,000 (5,276) 5,276 Income tax payable 38,160 (20,828) 20,828 --------- ----------- ------------ Net cash (used in) provided by operating activities (56,937) 1,090,190 (195,048) --------- ----------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (49,312) (67,742) (72,914) Sale of property and equipment -- -- 2,700 Purchase of mortgage loans from affiliate (208,274) -- -- Purchase of mortgage securities -- -- (8,450,259) Proceeds from sale of mortgage securities to third parties -- -- 8,667,260 Proceeds from sale of mortgage securities to affiliate -- -- 13,844,223 Principal payments received on mortgage assets 1,123 -- 216,649 --------- ----------- ------------ Net cash (used in) provided by investing activities (256,463) (67,742) 14,207,659 --------- ----------- ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Net repayment of note payable to related party (165,561) (668,483) (3,191,704) Net repayment of reverse repurchase agreements -- -- (10,842,000) --------- ----------- ------------ Net cash used in financing activities (165,561) (668,483) (14,033,704) --------- ----------- ------------ NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (478,961) 353,965 (21,093) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 847,676 493,711 514,804 --------- ----------- ------------ CASH AND CASH EQUIVALENTS, END OF YEAR $ 368,715 $ 847,676 $ 493,711 ========= =========== ============ SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the year for: Income taxes $ 5,956 $ 60,518 $ 3,435 ========= =========== ============ Interest $ 85,682 $ 43,936 $ 830,930 ========= =========== ============

See notes to consolidated financial statements F-40 HANOVER CAPITAL PARTNERS LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 1. BUSINESS DESCRIPTION Hanover Capital Partners Ltd. ("HCP") and its subsidiaries operate as a specialty finance company which is principally engaged in providing consulting and due diligence services, focusing on loan sale advisory, loan file due diligence reviews, staffing solutions and mortgage assignment and collateral rectification services. Beginning in 2002, HCP began providing asset management services to an affiliate, HDMF-I LLC ("HDMF-I"). A wholly-owned subsidiary of HCP, Hanover Capital Mortgage Corporation ("HCMC"), is a servicer of multifamily mortgage loans. HCMC is approved by the U.S. Department of Housing and Urban Development (HUD) as a Title II Nonsupervised Mortgagee under the National Housing Act. Another wholly-owned subsidiary of HCP, Hanover Capital Securities, Inc. ("HCS"), is a registered broker/dealer with the Securities and Exchange Commission. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of HCP and its wholly-owned subsidiaries (the "Company"). The wholly-owned subsidiaries include HCMC and HCS. All significant intercompany accounts and transactions have been eliminated. USE OF ESTIMATES - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates, by their nature, are based on judgment and available information. Actual results could differ from the estimates. CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand, overnight investments deposited with banks and money market mutual funds primarily invested in government securities with weighted maturities less than 60 days. PROPERTY AND EQUIPMENT - Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, generally three years. MORTGAGE LOANS HELD FOR SALE - All mortgage loans designated as held for sale are reported in the aggregate at the lower of cost or market, with unrealized losses reported as a charge to earnings in the current period. DEFERRED REVENUE - Cash advances received for certain service contracts are recorded in the accompanying Consolidated Balance Sheets as deferred revenue and are recognized during the period the services are provided and the related revenue is earned. REVENUE RECOGNITION - Revenues from due diligence contracts in progress and assignment preparation services are recognized for the services provided as they are earned and billed. INCOME TAXES - The Company files a consolidated Federal income tax return. The Company has not been subject to an examination of its income tax returns by the Internal Revenue Service. The Company's tax sharing policy provides that each member of the Federal consolidated group receive an allocation of income taxes as if each member filed a separate Federal income tax return. HCP, HCMC and HCS generally file their state income tax returns on a separate company basis. Deferred income taxes F-41 are provided for the effect of temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. BASIC EARNINGS PER SHARE - Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of time they were outstanding. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - The fair value of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, due to and from related parties, and note payable to related party were determined to be their carrying value due to their short-term nature. The fair value of mortgage loans held for sale is included in Note 4 to the Consolidated Financial Statements. RECLASSIFICATION - Certain reclassifications of prior years' amounts have been made to conform to the current year presentation. COMPREHENSIVE INCOME - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the Consolidated Balance Sheets, such items, along with net income, are components of comprehensive income. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS - On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("SFAS 121"). SFAS 144 retains the requirements of SFAS 121 for recognizing and measuring the impairment loss of long-lived assets to be held and used. For long-lived assets to be disposed of by sale, SFAS 144 requires a single accounting model be used for all long-lived assets, whether previously held and used or newly acquired. The adoption of SFAS 144 did not have an impact on the Company's consolidated financial position or results of operations. In April 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of FASB Statement No. 4 are generally effective for fiscal years beginning after May 15, 2002. The adoption of SFAS 145 did not have a material effect on the Company's consolidated financial statements. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. F-42 SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 will not have a material effect on the Company's consolidated financial statements. 3. PROPERTY AND EQUIPMENT

DECEMBER 31, -------------------------- 2002 2001 --------- --------- Office machinery and computer equipment $ 411,649 $ 367,430 Furniture and fixtures 12,197 7,104 --------- --------- 423,846 374,534 Less accumulated depreciation (331,915) (273,950) --------- --------- Property and equipment - net $ 91,931 $ 100,584 ========= =========

Depreciation expense for the years ended December 31, 2002, 2001 and 2000 was $57,965, $53,875 and $42,798, respectively. 4. MORTGAGE LOANS HELD FOR SALE During the year ended December 31, 2002, the Company purchased $208,274 of mortgage loans from Hanover Capital Mortgage Holdings, Inc. ("HCHI"). At December 31, 2002, the balance of mortgage loans held for sale was $207,151, comprised of $183,767 of adjustable-rate loans and $23,384 of fixed-rate loans. The fair value of mortgage loans held for sale at December 31, 2002 was $207,151 based upon projected prices which could be obtained through investors considering interest rates, loan type and credit quality. 5. CONCENTRATION RISK As of and for the year ended December 31, 2002, the Company's accounts receivable and revenues included customers that individually accounted for more than 10% as follows:

ACCOUNTS RECEIVABLE AS OF REVENUES FOR THE YEAR ENDED DECEMBER 31, 2002 DECEMBER 31, 2002 ---------------------------- --------------------------------- Major Customer # 1 22% Major Customer # 1 22% Major Customer # 2 12% Major Customer # 2 16% Major Customer # 3 12% Major Customer # 3 11% Major Customer # 4 11%

6. MORTGAGE SERVICING The Company, through its wholly-owned subsidiary, HCMC, services multifamily mortgage loans on behalf of others. Loan servicing consists of the collection of monthly mortgage payments on behalf of investors, reporting information to those investors on a monthly basis, and maintaining custodial escrow accounts for the payment of principal and interest to investors and property taxes and insurance premiums on behalf of borrowers. As of December 31, 2002 and 2001, HCMC was servicing 1 and 3 loans, respectively, with unpaid principal balances of $1,099,595 and $4,918,187, respectively including loans subserviced for others of $3,774,586 at December 31, 2001. Escrow balances maintained by HCMC were $65,282 and $152,226 at December 31, 2002 and 2001, respectively. The aforementioned servicing portfolio and related escrow accounts are not included in the accompanying Consolidated Balance Sheets as of December 31, 2002, and 2001. F-43 7. RELATED PARTY TRANSACTIONS

DECEMBER 31, ----------------------- 2002 2001 -------- -------- Due from HanoverTrade, Inc. (1) $268,703 $465,987 Due from Hanover Mortgage Capital Corporation -- 6,662 Due from HDMF-I LLC (2) 94,984 988 -------- -------- Receivables from related parties $363,687 $473,637 ======== ========

(1) Amounts due reflect certain costs that the Company paid on behalf of HanoverTrade, Inc. The expenses billed include personnel, occupancy, travel and entertainment and general and administrative. (2) Amount due at December 31, 2002 reflects asset management and due diligence services provided to HDMF-I. Due to related parties of $14,841 and $411,232 at December 31, 2002 and 2001, respectively, are due to HCHI and primarily represent an allocation of payroll expenses and tax payments made by HCHI on behalf of HCP, partially offset by management fees charged by HCP to HCHI. The Company provides among other services, due diligence, asset management and administrative services to HCHI pursuant to a Management Agreement that continues until December 31, 2003 with automatic annual renewal. At December 31, 2002 and 2001, the Company had a principal balance outstanding on a note payable to HCHI in the amount of $870,298 and $1,035,859, respectively. The note bears interest at the prime rate minus 1% and interest is calculated on the daily principal balance outstanding. At December 31, 2002 and 2001, the interest rate in effect was 3.25% and 3.75%, respectively. Included in the 2002 and 2001 Consolidated Statements of Income is interest expense in the amount of $39,454 and $65,555, respectively, related to this note payable. The entire unpaid principal balance on the note is due in full on the extended maturity date, March 31, 2004. 8. INCOME TAXES The components of deferred income taxes as of December 31, 2002 and 2001 are as follows:

DECEMBER 31, -------------------------- 2002 2001 --------- --------- Deferred tax assets Temporary differences $ 40,240 $ 64,585 Federal net operating loss carryforward 140,045 318,254 State/Local net operating loss carryforward 66,211 106,085 AMT Credit 16,830 16,830 --------- --------- Total deferred tax assets 263,326 505,754 Valuation allowance (23,648) (211,713) --------- --------- Net deferred tax assets $ 239,678 $ 294,041 ========= =========

The items resulting in significant temporary differences for the years ended December 31, 2002 and 2001 that generate deferred tax assets relate primarily to the recognition of expense for financial reporting purposes. The net change of $188,065 in the valuation allowance is due to a change in management's judgment about the realizability of the related deferred tax asset in future years. The components of the income tax provision for the years ended December 31, 2002, 2001 and 2000 consist of the following:

YEARS ENDED DECEMBER 31, ------------------------------------ 2002 2001 2000 ------- ------- -------- Current - Federal, state and local $44,118 $17,459 $ 19,040 Deferred - Federal, state and local 54,363 46,690 612,682 ------- ------- -------- Total $98,481 $64,149 $631,722 ======= ======= ========

F-44 The income tax provision differs from amounts computed at statutory rates, as follows:

YEARS ENDED DECEMBER 31, ---------------------------------------- 2002 2001 2000 --------- ------- --------- Federal income tax provision at statutory rate $ 236,535 $32,448 $ 374,021 State and local income tax provision 41,324 10,816 72,052 Meals and entertainment 2,313 1,812 4,065 Officer's life insurance 1,870 3,551 268 Tax settlement 2,662 15,522 -- Penalties 162 -- 1,702 Realized loss on hedge transaction -- -- (14,089) Sale of assets -- -- (18,010) (Reversal of) provision for valuation allowance (188,065) -- 211,713 Other 1,680 -- -- --------- ------- --------- Total $ 98,481 $64,149 $ 631,722 ========= ======= =========

The Company has a Federal tax net operating loss carryforward of approximately $0.4 million which begins to expire in the year 2012. 9. STOCKHOLDER'S EQUITY Prior to July 1, 2002, HCHI owned all of the outstanding preferred stock of the Company, giving it a 97% economic interest. The remaining 3% economic interest represented by all of the common stock of the Company was owned by the principals, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares. Pursuant to a Stock Purchase Agreement effective July 1, 2002, HCHI acquired 100% of the outstanding common stock of the Company. Therefore, as of July 1, 2002, HCHI owns 100% of the outstanding capital stock, both preferred and common, of the Company. 10. COMMITMENTS AND CONTINGENCIES The Company has noncancelable operating lease agreements for office space. Future minimum rental payments for such leases are as follows:

YEAR AMOUNT ---- --------- 2003 $ 160,932 2004 160,932 2005 53,644 --------- $ 375,508 =========

Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to $144,610, $128,345 and $144,731, respectively. 11. SUBSEQUENT EVENTS On February 21, 2003, the maturity date of the note payable to HCHI was extended from March 31, 2003 to March 31, 2004. ****** F-45 INDEPENDENT AUDITORS' REPORT To the Board of Directors of HanoverTrade, Inc. and Subsidiary Edison, New Jersey We have audited the accompanying consolidated balance sheets of HanoverTrade, Inc. and Subsidiary (the "Company") as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of HanoverTrade, Inc. and Subsidiary at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. DELOITTE & TOUCHE LLP Parsippany, New Jersey March 20, 2003 F-46 HANOVERTRADE, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS

DECEMBER 31, ------------------------------ ASSETS 2002 2001 ----------- ----------- CURRENT ASSETS: Cash and cash equivalents $ 160,219 $ 196,451 Accounts receivable 298,258 590,234 Current portion of long-term note receivable 75,000 -- Prepaid expenses and other current assets 50,899 31,105 ----------- ----------- Total current assets 584,376 817,790 PROPERTY AND EQUIPMENT - Net 157,426 176,728 CAPITALIZED SOFTWARE - Net 1,794,694 2,170,323 GOODWILL - Net 1,514,736 1,044,266 DEFERRED TAX ASSET - Net -- -- LONG-TERM NOTE RECEIVABLE - Net of current portion 225,000 -- OTHER ASSETS 68,971 68,971 ----------- ----------- TOTAL ASSETS $ 4,345,203 $ 4,278,078 =========== =========== LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses $ 538,970 $ 407,372 Accrued interest due to related party 58,453 103,738 Payable under asset purchase agreement 500,000 500,000 Due to related parties 442,495 544,639 Deferred revenue 91,869 -- Other current liabilities 6,998 5,110 ----------- ----------- Total current liabilities 1,638,785 1,560,859 NOTE PAYABLE TO RELATED PARTY 7,395,896 7,654,396 ----------- ----------- TOTAL LIABILITIES 9,034,681 9,215,255 ----------- ----------- COMMITMENTS AND CONTINGENCIES STOCKHOLDER'S EQUITY: Series A preferred stock: $.01 par value, 100,000 shares authorized, 97,000 shares outstanding at December 31, 2002 and 2001 970 970 Common stock: $.01 par value, 105,000 shares authorized, 3,000 shares outstanding at December 31, 2002 and 2001 30 30 Additional paid-in capital 485,021 -- Retained earnings (deficit) (5,175,499) (4,938,177) ----------- ----------- TOTAL STOCKHOLDER'S EQUITY (DEFICIT) (4,689,478) (4,937,177) ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $ 4,345,203 $ 4,278,078 =========== ===========

See notes to consolidated financial statements F-47 HANOVERTRADE, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31, ------------------------------------------------- 2002 2001 2000 ----------- ----------- ----------- REVENUES: Loan brokering, trading and advisory services $ 6,836,352 $ 3,521,338 $ 140,781 Consulting 693,210 -- -- Other 59,085 77,334 -- ----------- ----------- ----------- Total revenues 7,588,647 3,598,672 140,781 ----------- ----------- ----------- EXPENSES: Personnel 4,199,193 3,616,575 789,646 Depreciation and amortization 1,219,174 1,102,073 150,935 General and administrative 675,214 410,036 93,471 Technology 659,409 663,955 230,520 Occupancy 413,995 325,960 130,278 Interest 266,657 366,243 81,479 Travel and entertainment 254,024 262,695 174,821 Professional 130,305 214,669 32,143 ----------- ----------- ----------- Total expenses 7,817,971 6,962,206 1,683,293 ----------- ----------- ----------- LOSS BEFORE INCOME TAX PROVISION (229,324) (3,363,534) (1,542,512) INCOME TAX PROVISION 7,998 -- -- ----------- ----------- ----------- NET LOSS $ (237,322) $(3,363,534) $(1,542,512) =========== =========== =========== BASIC LOSS PER SHARE (NOTE 2) $ (79.11) $ (1,121.18) $ (514.17) =========== =========== ===========

See notes to consolidated financial statements F-48 HANOVERTRADE, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

SERIES A PREFERRED STOCK COMMON STOCK ADDITIONAL ------------------------- --------------------- PAID-IN SHARES AMOUNT SHARES AMOUNT CAPITAL ------ ----------- ------ ------- ---------- BALANCE, DECEMBER 31, 1999 97,000 $ 970 3,000 $ 30 $ -- Comprehensive loss: Net loss Comprehensive loss ------ ----------- ----- ------- -------- BALANCE, DECEMBER 31, 2000 97,000 970 3,000 30 -- Comprehensive loss: Net loss Comprehensive loss ------ ----------- ----- ------- -------- BALANCE, DECEMBER 31, 2001 97,000 970 3,000 30 -- Capital contribution 485,021 Comprehensive loss: Net loss Comprehensive loss ------ ----------- ----- ------- -------- BALANCE, DECEMBER 31, 2002 97,000 $ 970 3,000 $ 30 $485,021 ====== =========== ===== ======= ========

ACCUMULATED RETAINED OTHER COMPREHENSIVE EARNINGS COMPREHENSIVE LOSS (DEFICIT) GAIN TOTAL ------------- ----------- ------------- ----------- BALANCE, DECEMBER 31, 1999 $ (32,131) $ -- $ (31,131) Comprehensive loss: Net loss $(1,542,512) (1,542,512) (1,542,512) ----------- Comprehensive loss $(1,542,512) =========== ----------- ----------- ----------- BALANCE, DECEMBER 31, 2000 (1,574,643) -- (1,573,643) Comprehensive loss: Net loss $(3,363,534) (3,363,534) (3,363,534) ----------- Comprehensive loss $(3,363,534) =========== ----------- ----------- ----------- BALANCE, DECEMBER 31, 2001 (4,938,177) -- (4,937,177) Capital contribution 485,021 Comprehensive loss: Net loss $ (237,322) (237,322) (237,322) ----------- Comprehensive loss $ (237,322) =========== ----------- ----------- ----------- BALANCE, DECEMBER 31, 2002 $(5,175,499) $ -- $(4,689,478) =========== =========== ===========

See notes to consolidated financial statements F-49 HANOVERTRADE, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, ------------------------------------------------- 2002 2001 2000 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (237,322) $(3,363,534) $(1,542,512) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 1,219,174 1,102,073 150,935 Changes in assets - (increase) decrease: Accounts receivable 291,976 (580,234) (9,974) Note receivable (300,000) -- -- Prepaid expenses and other assets (19,794) (85,201) -- Changes in liabilities - increase (decrease): Accounts payable and accrued expenses 131,598 (601,031) 1,008,403 Accrued interest due to related party (45,285) 67,874 35,864 Due to related parties (102,144) 154,501 254,512 Deferred revenue 91,869 -- -- Other current liabilities 1,888 5,110 -- ----------- ----------- ----------- Net cash provided by (used in) operating activities 1,031,960 (3,300,442) (102,772) ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (86,193) (28,620) (21,695) Capitalized software costs (738,050) (424,287) (2,747,647) Acquisition, net of cash acquired -- (833,411) -- ----------- ----------- ----------- Net cash used in investing activities (824,243) (1,286,318) (2,769,342) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Net (repayment of) proceeds from note payable to related party (258,500) 4,750,638 2,903,758 Capital contributions 14,551 -- -- ----------- ----------- ----------- Net cash (used in) provided by financing activities (243,949) 4,750,638 2,903,758 ----------- ----------- ----------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (36,232) 163,878 31,644 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 196,451 32,573 929 ----------- ----------- ----------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 160,219 $ 196,451 $ 32,573 =========== =========== ===========

See notes to consolidated financial statements F-50 HANOVERTRADE, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 1. BUSINESS DESCRIPTION HanoverTrade, Inc. and Subsidiary is principally engaged in operating an Internet exchange for trading mortgage loans, mortgage servicing rights and related assets, and providing state-of-the-art technologies supported by experienced valuation, operations and trading professionals. In addition to trading assets, HanoverTrade, Inc. and Subsidiary provides a full range of asset valuation, analysis, and marketing services for performing, sub-performing and non-performing assets, whole loans and participations, Community Reinvestment Act loans, and mortgage servicing rights. During 2002, Pamex Securities, LLC, a wholly-owned subsidiary of HanoverTrade, Inc., withdrew from the National Association of Securities Dealers as a registered broker/dealer. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of HanoverTrade, Inc. and its wholly-owned subsidiary (the "Company"). All significant intercompany accounts and transactions have been eliminated. USE OF ESTIMATES; RISKS AND UNCERTAINTIES - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates, by their nature, are based on judgment and available information. Actual results could differ from the estimates. The Company's estimates and assumptions primarily arise from risks and uncertainties associated with technology. Although management is not currently aware of any factors that would significantly change its estimates and assumptions in the near term, it is possible that the estimated useful lives of the Company's technology assets and related carrying values could be reduced in the near term due to competitive pressures. CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash on hand, overnight investments deposited with banks and money market mutual funds primarily invested in government securities with weighted maturities less than 60 days. PROPERTY AND EQUIPMENT - Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, generally three years. Leasehold improvements are amortized over the terms of the respective leases or their estimated useful lives, whichever is shorter. CAPITALIZED SOFTWARE - Capitalized software includes external application development stage costs and external enhancement costs incurred to develop and modify the Company's Internet exchange for trading loan pools and also includes software production costs incurred to develop a mortgage loan servicing valuation and analysis tool, a real-time Internet data analysis system and an Internet exchange for trading assets. Capitalized software costs for the Company's Internet exchange are stated at cost less accumulated amortization and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Amortization is computed on the straight-line method over the estimated useful lives of the assets, generally three years. The Company periodically reassesses the estimated useful lives of the assets considering the effects of obsolescence, technology, competition and other economic factors. Capitalized software costs for the Company's mortgage loan servicing valuation and analysis tool, real-time Internet data analysis system and Internet exchange for trading assets are stated at the lower of unamortized cost or net realizable value. Amortization is computed based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product. F-51 GOODWILL - Goodwill represents the excess of the purchase price over the net carrying value of assets acquired (which approximates fair value) at acquisition date. The Company evaluates goodwill for impairment on an annual basis and if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. DEFERRED REVENUE - Certain service contracts are recorded in the accompanying Consolidated Balance Sheets as deferred revenue and are recognized during the period the services are provided and the related revenue is earned. REVENUE RECOGNITION - Revenues from loan brokering, trading and advisory services are recognized when the transactions close and fees are earned and billed. At the time of closing a transaction, the number of loans, loan principal balance and purchase price in the transaction are agreed upon, documentation is signed and the sale is funded. The Company's billing of fees relating to a transaction occurs concurrently with the closing and funding. Revenues from consulting services are recognized as they are earned and billed. INCOME TAXES - The Company uses the asset and liability method in accounting for income taxes. This measures the tax effect of differences between the tax basis and financial statement carrying amounts of assets and liabilities. BASIC EARNINGS PER SHARE - Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of time they were outstanding. RELATED PARTY TRANSACTIONS - The results of operations may not necessarily be indicative of those that would have occurred on a stand-alone basis. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - The fair values of cash and cash equivalents, accounts receivable, note receivable, accounts payable and accrued expenses, due to related parties and note payable to related party were determined to be their carrying values due to their short-term nature. RECLASSIFICATION - Certain reclassifications of prior years' amounts have been made to conform to the current year presentation. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS - On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("SFAS 121"). SFAS 144 retains the requirements of SFAS 121 for recognizing and measuring the impairment loss of long-lived assets to be held and used. For long-lived assets to be disposed of by sale, SFAS 144 requires a single accounting model be used for all long-lived assets, whether previously held and used or newly acquired. The adoption of SFAS 144 did not have an impact on the Company's consolidated financial position or results of operations. F-52 In April 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of FASB Statement No. 4 are generally effective for fiscal years beginning after May 15, 2002. The adoption of SFAS 145 did not have a material effect on the Company's consolidated financial statements. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS - In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 will not have a material effect on the Company's consolidated financial statements. 3. ACQUISITION On January 19, 2001, the Company hired 18 employees of Pamex Capital Partners LLC ("Pamex") and purchased all of its assets. The Company entered into employment agreements with 6 of the 18 employees hired. The purchase price consisted of $850,000 in cash paid at closing, professional fees of $18,530 plus an earn-out of between $1,250,000 and $1,500,000, payable over three years in common stock of Hanover Capital Mortgage Holdings, Inc. ("HCHI"). The acquisition was accounted for using the purchase method of accounting. As of December 31, 2002, the first earn-out of $500,000 in common stock of HCHI has been paid and a second earn-out of $500,000 has been accrued. The second earn-out was subsequently paid on February 24, 2003. In addition, the Company was required, under terms of the purchase agreement, to adopt an employee stock option plan pursuant to which it was to issue options to purchase 5% of the number of shares of common stock outstanding as of January 19, 2001. However, on February 25, 2003, HCHI granted options to purchase 30,000 shares of its common stock under its 1999 Equity Incentive Plan in satisfaction of the Company's obligation. The stock options were issued with an exercise price of $7.69, were fully vested on the date of grant and expire on February 24, 2008, excluding the grantee's death or termination of employment. Included in the assets purchased was Pamex Securities, LLC, a securities broker dealer with minimal net assets and insignificant net income from continuing operations for the period from January 19, 2001 to December 31, 2001. F-53 4. PROPERTY AND EQUIPMENT

DECEMBER 31, -------------------------- 2002 2001 --------- --------- Office machinery and equipment $272,244 $206,344 Furniture and fixtures 54,914 53,136 Leasehold improvements 18,985 470 --------- --------- 346,143 259,950 Less accumulated depreciation and amortization (188,717) (83,222) --------- --------- Property and equipment-net $157,426 $176,728 ========= =========

Depreciation and amortization expense for the years ended December 31, 2002, 2001 and 2000 was $105,495, $81,208 and $2,014, respectively. 5. CAPITALIZED SOFTWARE

DECEMBER 31, ------------------------------ 2002 2001 ----------- ----------- Capitalized software costs $ 4,013,524 $ 3,275,474 Less accumulated amortization (2,218,830) (1,105,151) ----------- ------------ Capitalized software - net $ 1,794,694 $ 2,170,323 =========== ============

Amortization expense for the years ended December 31, 2002, 2001 and 2000 was $1,113,679, $956,230 and $148,921, respectively. The estimated aggregate amortization expense, as of December 31, 2002, for the years ending December 31, 2003, 2004, 2005 and 2006 is $1,183,941, $381,143, $224,501 and $5,109, respectively. 6. GOODWILL Balance as of December 31, 2001 $1,044,266 Adjustment (29,530) Addition 500,000 ----------- Balance as of December 31, 2002 $1,514,736 =========== On February 19, 2002, the Company received a capital contribution from HCHI of 63,577 shares of HCHI common stock with a then fair market value of $470,470. The Company utilized the capital contribution to fund the first earn-out issued in connection with its purchase of all of the assets of Pamex. The difference between the amount accrued at December 31, 2001 and the capital contribution at February 19, 2002, or $29,530, was reflected as an adjustment to goodwill. As of December 31, 2002, a second earn-out of $500,000 has been accrued. No impairment losses were recognized for the year ended December 31, 2002. F-54 7. NOTE RECEIVABLE On November 15, 2002, the Company entered into a credit and security agreement with VerticalCrossings.com, Inc. ("Vcross"). Vcross specializes in trading U.S. Treasury and Agency securities and structured products. Pursuant to this agreement, the Company loaned Vcross $300,000 at an interest rate of 12%. Interest is payable monthly and principal is payable in four equal quarterly payments beginning on December 1, 2003. The loan is collateralized by all of Vcross' assets. As additional consideration for the loan, the Company received an exclusive perpetual license to use Vcross' proprietary software technology to conduct on-line auctions of mortgage loans. The Company also received warrants to purchase up to 33,469 shares of Vcross common stock. From previous transactions with Vcross, the Company has warrants to purchase up to an additional 15,646 shares of Vcross common stock. These warrants are not actively traded and at December 31, 2002, the Company has valued them at zero in the accompanying Consolidated Balance Sheet. 8. CONCENTRATION RISK As of and for the year ended December 31, 2002, two of the Company's customers individually accounted for 66% and 24% of accounts receivable and one customer accounted for 49% of total revenues. No other customer individually accounted for more than 10% of accounts receivable or total revenues. 9. RELATED PARTY TRANSACTIONS

DECEMBER 31, -------------------------- 2002 2001 --------- --------- Due to Hanover Capital Partners Ltd. $ 270,987 $ 466,287 Due to Hanover Capital Mortgage Holdings, Inc. 172,871 78,400 Other (1,363) (48) --------- --------- Due to related parties $ 442,495 $ 544,639 ========= =========

For the years ended December 31, 2002, 2001 and 2000, Hanover Capital Partners Ltd. ("HCP") and HCHI billed certain expenses to the Company. The expenses billed include personnel, travel and entertainment, general and administrative, occupancy, technology and professional. These expenses were billed to reflect certain costs paid on behalf of the Company. The Company expects similar billings from HCP and HCHI in future periods. HCP billed the following expenses to the Company for the years ended December 31, 2002, 2001 and 2000:

YEARS ENDED DECEMBER 31, ------------------------------------------ 2002 2001 2000 ---------- ---------- -------- Personnel $2,652,028 $2,504,855 $441,214 Travel and entertainment 140,427 150,157 57,320 General and administrative 28,764 23,215 47,299 Occupancy 7,123 20,086 25,466 Technology 4,705 10,415 3,600 Professional -- 1,961 -- ---------- ---------- -------- $2,833,047 $2,710,689 $574,899 ========== ========== ========

The above expenses were partially offset by revenues billed by the Company to HCP of $110,962 for the year ended December 31, 2000. F-55 HCHI billed the following expenses to the Company for the years ended December 31, 2002, 2001 and 2000:

YEARS ENDED DECEMBER 31, -------------------------------------- 2002 2001 2000 -------- -------- -------- Personnel $561,419 $353,993 $369,047 Occupancy -- 19,957 102,840 General and administrative 4,750 2,051 16,118 -------- -------- -------- $566,169 $376,001 $488,005 ======== ======== ========

At December 31, 2002 and 2001, the Company had a principal balance on a note payable to HCHI in the amount of $7,395,896 and $7,654,396, respectively. The maximum loan amount under this note is $10 million. The note bears interest daily at the prime rate minus 1% and interest is calculated on the daily principal balance outstanding. At December 31, 2002 and 2001, the interest rate in effect was 3.25% and 3.75%, respectively. The entire unpaid principal balance on the note is due in full on the extended maturity date, March 31, 2004. 10. INCOME TAXES

DECEMBER 31, ------------------------------ 2002 2001 ----------- ----------- Deferred tax assets - Federal $ 1,763,975 $ 1,660,082 Deferred tax assets - State 268,063 284,207 ----------- ----------- 2,032,038 1,944,289 Valuation allowance (2,032,038) (1,944,289) ----------- ----------- Deferred tax asset - net $ -- $ -- =========== ===========

The items resulting in significant temporary differences for the years ended December 31, 2002 and 2001 that generate deferred tax assets relate primarily to the benefit of net operating loss carryforwards and goodwill amortization. The Company has established a valuation allowance for the full amount of the deferred income tax benefit. The components of the income tax provision for the years ended December 31, 2002, 2001 and 2000 consist of the following:

YEARS ENDED DECEMBER 31, ----------------------------------------------- 2002 2001 2000 ----------- ----------- --------- Current - Federal, state and local $ 7,998 $ -- $ -- Deferred - Federal, state and local (87,749) (1,323,465) (608,395) ----------- ----------- --------- (79,751) (1,323,465) (608,395) Valuation allowance 87,749 1,323,465 608,395 ----------- ----------- --------- Total $ 7,998 $ -- $ -- =========== =========== =========

F-56 The income tax provision differs from amounts computed at statutory rates, as follows:

YEARS ENDED DECEMBER 31, ----------------------------------------------- 2002 2001 2000 ----------- ----------- --------- Federal income tax benefit at statutory rate $ (77,970) $(1,143,602) $(524,454) State and local income tax benefit (12,324) (191,274) (97,050) Meals and entertainment 7,145 8,609 11,228 Officers' life insurance 3,391 2,802 1,881 Tax amortization in excess of book amortization (38,837) -- -- Effect of rate changes on prior year deferred tax assets 32,331 -- -- State alternative minimum tax 7,998 -- -- Other (1,485) -- -- ----------- ----------- --------- (79,751) (1,323,465) (608,395) Valuation allowance 87,749 1,323,465 608,395 ----------- ----------- --------- Income tax provision $ 7,998 $ -- $ -- =========== =========== =========

The Company has a Federal tax net operating loss carryforward of approximately $5,162,000 that begins to expire in 2019. 11. STOCKHOLDER'S EQUITY Prior to July 1, 2002, HCHI owned all of the outstanding preferred stock of the Company, giving it a 97% economic interest. The remaining 3% economic interest represented by all of the common stock of the Company was owned by the principals, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares. Pursuant to a Stock Purchase Agreement effective July 1, 2002, HCHI acquired 100% of the outstanding common stock of the Company. Therefore, as of July 1, 2002, HCHI owns 100% of the outstanding capital stock, both preferred and common, of the Company. On February 19, 2002, the Company received a capital contribution from HCHI of 63,577 shares of HCHI common stock with a then fair market value of $470,470. The Company utilized the capital contribution to fund the first earn-out issued in connection with its purchase of all of the assets of Pamex. The difference between the amount accrued at December 31, 2001 and the capital contribution at February 19, 2002, or $29,530, was reflected as an adjustment to goodwill. In addition, on February 19, 2002, the Company received a capital contribution from the principals of $14,551 to maintain the principals' 3% economic interest in the Company. 12. COMMITMENTS AND CONTINGENCIES The Company has noncancelable operating lease agreements for office space. Future minimum rental payments for such leases are as follows:

YEAR AMOUNT ------ --------- 2003 $ 201,316 2004 141,039 2005 45,933 --------- $ 388,288 =========

Rent expense for the years ended December 31, 2002, 2001 and 2000 amounted to $199,101, $190,379 and $69,533, respectively. F-57 13. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, --------------------------------------- 2002 2001 2000 --------- --------- ------- SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the year for: Income taxes $ 1,000 $ -- $ -- ========= ========= ======= Interest to related party $ 311,942 $ 298,369 $45,615 ========= ========= ======= ACQUISITION, NET OF CASH ACQUIRED: Fair value of assets acquired $ -- $ 259,629 $ -- Goodwill at acquisition -- 590,371 -- Direct costs of acquisition -- 18,530 -- Less cash acquired -- (35,119) -- --------- --------- ------- Net cash paid for acquisition $ -- $ 833,411 $ -- ========= ========= ======= SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING ACTIVITIES: First and second earn-outs accrued in connection with the acquisition of all of the assets of Pamex resulting in increases in goodwill and payable under asset purchase agreement $ 500,000 $ 500,000 $ -- ========= ========= ======= Capital contribution received of 63,577 shares of HCHI common stock utilized to fund the first earn-out in connection with the acquisition of all of the assets of Pamex $ 470,470 $ -- $ -- ========= ========= =======

14. SUBSEQUENT EVENTS On February 21, 2003, the maturity date of the note payable to HCHI was extended from March 31, 2003 to March 31, 2004. On February 24, 2003, the Company received a capital contribution from HCHI of $75,000 of cash and 60,180 shares of HCHI common stock with a then fair market value of $457,970. The capital contribution was utilized by the Company to fund the second earn-out issued in connection with its purchase of all of the assets of Pamex. The difference between the amount accrued at December 31, 2002 and the capital contribution on February 24, 2003, or $32,970, will be reflected as an adjustment to goodwill. ****** F-58