| HANOVER CAPITAL MORTGAGE HOLDINGS INC ITEM 1A RISK FACTORS Risks Related to Our Business Mortgage-related assets are subject to risks, including borrower defaults or bankruptcies, special hazard losses, declines in real estate values, delinquencies and fraud |
| During the time we hold mortgage related assets we will be subject to the risks on the underlying mortgage loans from borrower defaults and bankruptcies and from special hazard losses, such as those occurring from earthquakes or floods that are not covered by standard hazard insurance |
| If a default occurs on any mortgage loan we hold, or on any mortgage loan collateralizing mortgage-backed securities we own, we may bear the risk of loss of principal to the extent of any deficiency between the value of the mortgaged property plus any payments from any insurer or guarantor, and the amount owing on the mortgage loan |
| Defaults on mortgage loans historically coincide with declines in real estate values, which are difficult to anticipate and may be dependent on local economic conditions |
| Increased exposure to losses on mortgage loans can reduce the value of our investments |
| In addition, mortgage loans in default are generally not eligible collateral under our usual borrowing facilities and may have to be funded by us until liquidated |
| In addition, if borrowers are delinquent in making payments on the mortgage loans underlying our mortgage-related assets, or if the mortgage loans are unenforceable due to fraud or otherwise, we might not be able to recoup the entire investment in such assets |
| 13 _________________________________________________________________ [53]Table of Contents We may be unable to renew our borrowings at favorable rates or maintain longer-term financing, which may affect our profitability |
| Our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings or to refinance such borrowings with longer-term financings |
| If we are not able to renew or replace maturing borrowings, or obtain longer-term financing, we would have to sell some or all of our assets, possibly under adverse market conditions |
| In addition, the failure to renew or replace mature borrowings, or obtain longer-term financing, may require us to terminate hedge positions, which could result in further losses |
| Any number of these factors in combination may cause difficulties for us, including a possible liquidation of a major portion of our portfolio at disadvantageous prices with consequent losses, which, in the extreme, may render us insolvent |
| Our profitability depends on the availability and prices of mortgage assets that meet our investment criteria |
| The availability of mortgage assets that meet our criteria depends on, among other things, the size and level of activity in the real estate lending markets |
| The size and level of activity in these markets, in turn, depends on the level of interest rates, regional and national economic conditions, appreciation and decline in property values and the general regulatory and tax environment as it relates to mortgage lending |
| In addition, we expect to compete for these investments with other REITs, investment banking firms, savings banks, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-related assets, many of which have greater financial resources than we do |
| If we cannot obtain sufficient mortgage loans or mortgage securities that meet our criteria, at favorable yields, our business will be adversely affected |
| We are subject to various obligations related to our use of, and dependence on, debt |
| If we violate covenants in any debt agreements, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on attractive terms, if at all |
| Violations of certain debt covenants may result in our being unable to borrow unused amounts under a line of credit, even if repayment of some or all borrowings is not required |
| A violation under one debt agreement may also trigger defaults in other debt agreements requiring repayments or imposing further restrictions |
| This could force us to sell portions of our portfolio at a time when losses could result |
| In any event, financial covenants under our current or future debt obligations could impair our planned business strategies by limiting our ability to borrow |
| Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or they file for bankruptcy |
| Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay in the event that we file for bankruptcy |
| Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy |
| Thus, our use of repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us |
| We may engage in hedging transactions, which can limit our gains and increase exposure to losses |
| We may enter into hedging transactions to protect us from the effects of interest rate fluctuations on floating rate debt and also to protect our portfolio of mortgage assets from interest rate and prepayment rate fluctuations |
| Our hedging transactions may include entering into interest rate swap agreements or 14 _________________________________________________________________ [54]Table of Contents interest rate cap or floor agreements, purchasing or selling futures contracts, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements |
| There are no assurances that our hedging activities will have the desired impact on our results of operations or financial condition |
| Interest rate fluctuations may adversely affect our net income |
| Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control |
| Interest rate fluctuations can adversely affect our income |
| The relationship between short-term and longer-term interest rates is often referred to as the “yield curve |
| ” Variances in the yield curve may reduce our net income |
| Short-term interest rates are ordinarily lower than longer-term interest rates |
| If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve) or short-term interest rates exceed longer-term interest rates (a yield curve inversion), our borrowing costs may increase more rapidly than the interest income earned on our assets |
| Because our assets generally bear interest based on longer-term rates than our borrowings, a flattening or inversion of the yield curve would tend to decrease our net income |
| Additionally, the spread between the yields of the new investments and available borrowing rates may decline, which would likely decrease our net income |
| The loss of any of our executive officers could adversely affect our operating performance |
| Our operations and financial performance depend heavily upon the efforts of our executive and investment personnel |
| We cannot give assurances that these executive officers can be retained or replaced with equally skilled and experienced professionals |
| The loss of any one of these individuals could have an adverse effect upon our business and results of operations at least for a short time |
| We may hold title to real property, which could cause us to incur costly liabilities |
| We may be forced to foreclose on a defaulted mortgage loan in order to recoup part of our investment, which means we might hold title to the underlying property until we are able to arrange for resale and will therefore be subject to the liabilities of property owners |
| For example, we may become liable for the costs of removal or remediation of hazardous substances |
| These costs may be significant and may exceed the value of the property |
| In addition, current laws may materially limit our ability to resell foreclosed properties, and future laws, or more stringent interpretations or enforcement policies of existing requirements, may increase our exposure to liability |
| Further, foreclosed property is not financed and may require considerable amounts of capital before sold, thereby reducing our opportunities for alternate investments that could produce greater amounts of income |
| HCP’s and HT’s operations may be adversely affected by the loss of any one customer |
| A significant portion of HCP’s revenues came from contracts with three principal customers |
| Likewise a significant portion of HT’s revenues in 2005 came from two customers |
| If HCP or HT were to lose any one of these customers, their revenues would decline significantly until the customers were replaced, of which there can be no assurance |
| HT has invested a significant amount of its capital in software, and a significant write-down of its capitalized software could adversely affect our results of operations |
| HT has invested a significant amount of its capital in technology applications for performing analyses of mortgage pools and mortgage servicing |
| Should these assets become obsolete due to technological or competitive reasons, or lack of product acceptance by the market, then HT may have to abandon some of the existing software applications it has developed |
| A significant write-down of its capitalized software due to obsolescence could adversely affect our results of operations |
| 15 _________________________________________________________________ [55]Table of Contents Our business could be adversely affected if we are unable to safeguard the security and privacy of the personal financial information of borrowers to which we have access |
| In connection with our loan file due diligence reviews and other consulting and advisory services with respect to mortgage loans that we provide to third parties, HCP has access to the personal financial information of the borrowers |
| In addition, in operating an Internet exchange for trading mortgage loans, HT sometimes has access to borrowers’ personal financial information, which it may provide to potential third party investors in the mortgage loans |
| This personal financial information is highly sensitive and confidential, and if a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions |
| Although we have policies and procedures designed to safeguard confidential information, we cannot give complete assurances that these policies and safeguards are sufficient to prevent the misappropriation of confidential information or that our policies and safeguards will be deemed compliant with any existing Federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future |
| Risks Related to Our Status as a REIT and Our Investment Company Act Exemption If we do not maintain our status as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability |
| We believe that we currently qualify, and expect to continue to qualify, as a REIT under the Internal Revenue Code of 1986, as amended, which we refer to as the Code |
| However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist |
| Even a technical or inadvertent mistake could jeopardize our REIT status |
| Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT If we fail to qualify as a REIT in any tax year, then: • we would be taxed as a regular domestic corporation, which, among other things, means we would be unable to deduct distributions made to stockholders in computing taxable income and would be subject to Federal income tax on our taxable income at regular corporate rates; • our tax liability could be substantial and would reduce the amount of cash available for distribution to stockholders; and • unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the four taxable years following the year during which we lost our qualification, and our cash available for distribution to stockholders would be reduced for each of the years during which we did not qualify as a REIT If we fail to comply with rules governing our ownership interests in “taxable REIT subsidiaries,” we will lose our REIT qualification |
| On January 1, 2001, the REIT Modernization Act became effective |
| Among other things, it allows REITs, subject to certain limitations, to own, directly or indirectly, up to 100prca of the stock of a “taxable REIT subsidiary” that can engage in businesses previously prohibited to a REIT In particular, the Act permitted us to restructure our operating subsidiaries, HCP, HT and HCP2, as taxable REIT subsidiaries |
| As a result, for periods ending after June 30, 2002, through December 31, 2005, the financial statements of HCP, HT and HCP2 were consolidated with Hanover’s financial statements, and it is intended that we will continue to do so with the newly-merged entity Hanover Capital Partners 2, Ltd |
| However, the taxable REIT subsidiary provisions are complex and impose several conditions on the use of taxable REIT subsidiaries, which are generally designed to ensure that taxable REIT subsidiaries are subject to an appropriate level of corporate taxation |
| Further, no more than 20prca of the fair market value of a REIT’s assets may consist of securities of taxable REIT subsidiaries, and no more than 25prca of the fair market value of a REIT’s assets may consist of non-qualifying assets, including securities of taxable REIT subsidiaries and other taxable subsidiaries |
| In addition, the REIT Modernization Act legislation provides 16 _________________________________________________________________ [56]Table of Contents that a REIT may not own more than 10prca of the voting power or value of a taxable subsidiary that is not treated as a taxable REIT subsidiary |
| If our investments in our subsidiaries do not comply with these rules, we would fail to qualify as a REIT and we would be taxed as a regular corporation |
| Furthermore, certain transactions between us and a taxable REIT subsidiary that are not conducted on an arm’s length basis would be subject to a tax equal to 100prca of the amount of deviance from an arm’s length standard |
| Complying with REIT requirements may limit our ability to hedge effectively |
| The REIT provisions of the Code may substantially limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25prca of our gross income |
| In addition, we must limit our aggregate income from nonqualified hedging transactions, from our provision of services and from other non-qualifying sources to no more than 5prca of our annual gross income |
| As a result, we may have to limit our use of advantageous hedging techniques |
| This could result in greater risks associated with changes in interest rates than we would otherwise want to incur |
| If we violate the 25prca or 5prca limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability |
| If we fail to observe these limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for Federal income tax purposes |
| The fair market value of a hedging instrument will not be counted as a qualified asset for purposes of satisfying the requirement that, at the close of each calendar quarter, at least 75prca of the total value of our assets be represented by real estate and other qualified assets |
| REIT requirements may force us to forgo or liquidate otherwise attractive investments |
| In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75prca of the fair market value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets |
| The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10prca of the outstanding voting securities of any one issuer or more than 10prca of the total value of the outstanding securities of any one issuer |
| In addition, in general, no more than 5prca of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer and no more than 20prca of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries |
| Our efforts to comply with the rules might force us to pass up opportunities to acquire otherwise attractive investments |
| If we fail to comply with these requirements at the end of any calendar quarter, we may be able to correct such failure within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffer adverse tax consequences |
| As a result, we may be required to liquidate otherwise attractive investments |
| Complying with REIT requirements may force us to borrow or liquidate assets to make distributions to stockholders |
| As a REIT, we must distribute at least 90prca of our annual taxable income (subject to certain adjustments) to our stockholders |
| From time to time, we may generate taxable income greater than our net income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders |
| If we do not have other funds available in these situations, we could be required to borrow funds, sell a portion of our mortgage securities at disadvantageous prices or find another alternative source of funds in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement |
| These alternatives could increase our costs or reduce our equity |
| 17 _________________________________________________________________ [57]Table of Contents Regulation as an investment company could materially and adversely affect our business; efforts to avoid regulation as an investment company could limit our operations |
| We intend to conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act of 1940, as amended “Investment Company Act” |
| Investment company regulations, if they were deemed applicable to us, would prevent us from conducting our business as described in this report by, among other things, limiting our ability to use borrowings |
| The Investment Company Act exempts entities that are primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate |
| Under the SEC’s current interpretation, in order to qualify for this exemption we must maintain at least 55prca of our assets directly in qualifying real estate interests |
| However, mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not be counted towards our satisfaction of the 55prca requirement |
| Generally investments in the subordinated tranches of securitized loan pools do not constitute “qualifying real estate interests” unless certain qualifying abilities to govern the control of any foreclosures are in place |
| Our ownership of these mortgage-backed securities, therefore, may be limited to the extent that servicers of the loans in the pools grant such abilities to Hanover |
| If the SEC changes its position on the interpretations of the exemption, we could be required to sell assets under potentially adverse market conditions in order to meet the new requirements and also have to purchase lower-yielding assets to comply with the Investment Company Act |
| An emerging issue with the Financial Accounting Standards Board could have a major impact on our ability to operate as a REIT and retain our exemption under the Investment Company Act |
| The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) has deferred making a decision on a potential new issue pending a decision by the FASB to add to its agenda a project to provide guidance on the issue |
| That issue could have a major impact on Hanover |
| That issue deals with the accounting from the perspective of both the buyer and the seller of financial assets that are the subject of a repurchase agreement with the same parties |
| Example Transaction — Hanover’s primary current practice Hanover (the buyer) purchases a financial asset (mortgage loans or mortgage-backed securities) and simultaneously enters into a repurchase agreement with an investment bank or securities broker (the seller) to finance the transaction |
| The purchase and repurchase agreement may be settled net (no gross cash movements) with Hanover paying a deposit amount, as part of the collateral requirements of the repurchase agreement, equal to a percentage of the principal amount of the financial asset (in Hanover’s situations, amounts ranging from 30 to 50 percent) |
| Current Industry Practice It is believed that most buyers have accounted for transactions as described in the Hanover example transaction (and similar transactions) as a purchase and subsequent financing (as Hanover has done) and that there is currently minimal diversity in this practice |
| The Issue The issue is how to apply the criterion in paragraph 9(a) of SFAS Nodtta 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, in accounting for transactions involving the purchase of financial assets and simultaneous repurchase of the same financial assets with the seller |
| Paragraph 9(a) requires “isolation” from the transferor (seller) |
| If the isolation requirement is met, the seller meets the requirements in paragraph 9(a) of SFAS Nodtta 140 and the transaction qualifies as a sale by the seller and a purchase and financing by the buyer, as Hanover has done |
| If the isolation requirement is not met, the transaction is not a sale by the seller and paragraph 12 of SFAS Nodtta 140 would require the 18 _________________________________________________________________ [58]Table of Contents buyer to record the transaction as a financing to the extent of the cash or other assets that were transferred |
| The classification of the resulting financing transaction(s) if the isolation requirement is not met would most likely be that of a derivative instrument |
| There is a view, contrary to current industry and Hanover practice, that since the seller has continuing involvement through the repo, as in the Hanover example, the transferred assets have not been isolated from the seller and therefore, the isolation requirement is not met |
| Those with this view also believe that demonstrating isolation legally is not possible without a legal opinion and such opinions would be too vague to meet the isolation requirement |
| Impact on Hanover if the isolation requirement of paragraph 9(a) is not met The accounting classification of the resulting derivative instruments held by Hanover, a REIT, if the isolation requirement of paragraph 9(a) is not met, might impact Hanover’s REIT tax exempt status |
| A REIT must hold at least 75prca of its total assets in qualified real estate assets and derive at least 75prca of its gross income from real property (for example, rent or mortgage interest) |
| Derivative instruments are not qualified assets |
| Further, we could find that our ability to remain exempt under the provisions of the Investment Company Act of 1940 could be weakened as we will have to determine the appropriate treatment for the resulting derivative instruments |
| Risks Related to Our Corporate Organization and Structure Our charter limits ownership of our capital stock and attempts to acquire our capital stock |
| To facilitate maintenance of our REIT qualification and for other strategic reasons, our charter prohibits direct or constructive ownership by any person of more than 7dtta5prca (except in the case of John A Burchett, our Chairman, Chief Executive Officer and President, who can acquire up to 20prca) in value of the outstanding shares of our capital stock |
| Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity |
| As a result, the acquisition of less than 7dtta5prca of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 7dtta5prca of the outstanding stock, and thus be subject to our charter’s ownership limit |
| Any attempt to own or transfer shares of our capital stock in excess of the ownership limit without the consent of the Board of Directors will be void, and could result in the shares being transferred by operation of law to a charitable trust |
| Provisions of our charter which inhibit changes in control, could prevent stockholders from obtaining a premium price for our common stock |
| Provisions of our charter may delay or prevent a change in control of the company or other transactions that could provide stockholders with a premium over the then-prevailing market price of our common stock or that might otherwise be in the best interests of the stockholders |
| These include a staggered board of directors and our share ownership limit described above |
| Our Board of Directors could adopt the limitations available under Maryland law on changes in control that could prevent transactions in the best interests of stockholders |
| Certain provisions of Maryland law applicable to us prohibit “business combinations”, including certain issuances of equity securities, with any person who beneficially owns 10prca or more of the voting power of our outstanding shares, or with an affiliate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10prca or more of the voting power of our outstanding voting shares (which is referred to as a so-called “interested stockholder”), or with an affiliate of an interested stockholder |
| These prohibitions last for five years after the most recent date on which the stockholder became an interested stockholder |
| After the five-year period, a business combination with an interested stockholder must be approved by two super-majority stockholder votes unless, among other conditions, our 19 _________________________________________________________________ [59]Table of Contents common stockholders receive a minimum price for their shares and the consideration is received in cash or in the same form as previously paid by the interested stockholder for its shares of common stock |
| Our Board of Directors has opted out of these business combination provisions |
| As a result, the five-year prohibition and the super-majority vote requirements will not apply to a business combination involving the Company |
| Our Board of Directors may, however, repeal this election in most cases and cause the Company to become subject to these provisions in the future |
| We are dependent on external sources of capital, which may not be available |
| To qualify as a REIT, we must, among other things, distribute to our stockholders each year at least 90prca of our REIT taxable income (excluding any net capital gains) |
| Because of these distribution requirements, we likely will not be able to fund all future capital needs with income from operations |
| We therefore will have to rely on third-party sources of capital, including possible future equity offerings, which may or may not be available on favorable terms or at all |
| Our access to third-party sources of capital depends on a number of things, including the market’s perception of our growth potential and our current and potential future earnings |
| Moreover, additional equity offerings may result in substantial dilution of stockholders’ interests, and additional debt financing may substantially increase leverage |
| We may change our policies without stockholder approval |
| Our Board of Directors and management determine all of our policies, including our investment, financing and distribution policies |
| Although they have no current plans to do so, they may amend or revise these policies at any time without a vote of our stockholders |
| Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions |