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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
Form 10-K
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2006
or
o
  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
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
     
200 Metroplex Drive, Suite 100, Edison, NJ
  08817
(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, $0.01 Par Value per Share   American Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates, based on the price at which the common equity was last sold as of June 30, 2006, was $36,808,000.
 
The registrant had 8,063,962 shares of common stock outstanding as of March 13, 2007.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days after the end of registrant’s fiscal year, are incorporated by reference into Part III.
 


 

 
HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
 
FORM 10-K ANNUAL REPORT
 
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
 
INDEX
 
                 
        Page
 
  Business   2
  Risk Factors   14
  Unresolved Staff Comments   20
  Properties   20
  Legal Proceedings   21
  Submission of Matters to a Vote of Security Holders   21
 
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   22
  Selected Financial Data   24
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   25
  Quantitative and Qualitative Disclosure About Market Risk   44
  Financial Statements and Supplementary Data   50
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   50
  Controls and Procedures   51
  Other Information   51
 
  Directors, Executive Officers and Corporate Governance   52
  Executive Compensation   52
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   52
  Certain Relationships and Related Transactions, and Director Independence   52
  Principal Accounting Fees and Services   52
 
PART IV
  Exhibits and Financial Statement Schedules   53
  54
 EX-10.10.2 Separation and General Release Agreement dated January 31,2007
 EX-10.11.2 Separation and General Release Agreement dated December 29, 2006
 EX-10.38.7 Asset Purchase Agreement
 EX-21 Subsidiaries of Hanover Capital Mortgage Holdings, Inc.
 EX-23.1 Consent of Independent Registered Public Accounting Firm
 EX-31.1 Section 302 Certification of C.E.O.
 EX-31.2 Section 302 Certification of C.F.O.
 EX-32.1 Section 906 Certification of C.E.O.
 EX-32.2 Section 906 Certification of C.F.O.


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Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
 
Certain statements in this report, including, without limitation, matters discussed under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” should be read in conjunction with the financial statements, related notes, and other detailed information included elsewhere in this Annual Report on Form 10-K. We are including this cautionary statement to make applicable and take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical fact are forward-looking statements. Certain of these forward- looking statements can be identified by the use of words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “estimates,” “assumes,” “may,” “should,” “will,” or other similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors, which could cause actual results, performance or achievements to differ materially from future results, performance or achievements. These forward-looking statements are based on our current beliefs, intentions and expectations. These statements are not guarantees or indicative of future performance. Important assumptions and other important factors that could cause actual results to differ materially from those forward-looking statements include, but are not limited to, those factors, risks and uncertainties described in Item 1A of this Annual Report on Form 10-K. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and involve inherent risks and uncertainties. The forward-looking statements contained in this report are made only as of the date hereof. We undertake no obligation to update or revise information contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
 
PART I
 
ITEM 1.   BUSINESS
 
The Company
 
Hanover Capital Mortgage Holdings, Inc. (“Hanover”) is a real estate investment trust (“REIT”) formed to operate as a specialty finance company. Hanover has one primary subsidiary: Hanover Capital Partners 2, Ltd. (“HCP-2”). When we refer to the “Company,” we mean Hanover together with its consolidated subsidiaries.
 
The Company’s principal business is the REIT that generates net interest income on its portfolio of prime mortgage securities and mortgage loans on a leveraged basis. Secondarily, mortgage industry service and technology related income is earned through two separate divisions in HCP-2, Hanover Capital Partners (“HCP”) and HanoverTrade (“HT”). Effective January 12, 2007, the assets of HCP’s due diligence business, representing substantially all of the assets of HCP, were sold to Terwin Acquisition I, LLC, which also assumed certain liabilities related thereto. As a result, as of December 31,2006, the net assets and liabilities and results of operations of HCP have been presented as discontinued operations in the accompanying financial information and financial statements in this Form 10-K.
 
The Company’s principal executive offices are located at 200 Metroplex Drive, Suite 100, Edison, New Jersey 08817. The Company also maintains an office at 55 Broadway, Suite 3002, New York, NY 10006.
 
Business Segments
 
Company
 
The Company’s business is conducted through two lines of business that are each reported as business segments. They are: the REIT, operated through Hanover, and technology solutions and loan sale advisory services for the mortgage industry, operated by HT. As a result of the sale of HCP described above, the Company will no longer report a separate segment for the due diligence business.
 
The results of operations of HT include the results of Hanover Capital Securities, Inc., “HCS” and Pedestal Capital Markets, Inc. “Pedestal”, registered broker-dealers, organized for the purpose of facilitating infrequent sales of registered securities in the conduct of their businesses.


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Hanover — The REIT
 
Hanover’s principal business is to generate net interest income by investing in subordinate mortgage-backed securities, “Subordinate MBS”, collateralized by pools of prime single-family mortgage loans, and purchasing prime whole single-family mortgage loans for investment, securitization and resale. Hanover does not take deposits or raise money in any way that would subject it to consumer lending or banking regulations and does not deal directly with consumers. Hanover also maintains a portfolio of whole-pool Fannie Mae and Freddie Mac mortgage-backed securities, “Agency MBS”, primarily to satisfy certain exemptive provisions of the Investment Company Act of 1940 (the “40 Act”). Hanover attempts to increase the earnings potential in its investments by leveraging its purchases of mortgage securities with borrowings obtained primarily through the use of 30 day revolving Repurchase Agreements which are established by sales with agreements to repurchase. The borrowings under the Repurchase Agreements are generally at 50 to 97 percent of the security’s fair market value, depending on the security, and are adjusted to market value each month as the Repurchase Agreements are re-established. Other mortgage security or mortgage loan financing is accomplished through the use of committed lines of credit, usually under repurchase agreements or through the creation of collateralized mortgage obligations, “CMOs”. Hanover also, on occasion, receives income from real estate investment management services that can include asset management and administrative services.
 
HCP — Consulting and Outsourcing Services
 
During the third quarter of 2006, the Company’s Board of Directors approved the sale of certain assets of our HCP due diligence business to Terwin Acquisitions I, LLC (now known as Edison Mortgage Decisioning Solutions, LLC) (“Buyer”). This sale was completed on January 16, 2007, with an effective date of January 12, 2007. The sale was effected through the sale of certain assets to the Buyer and the assumption by the Buyer of certain liabilities of HCP-2 which comprised all of our due diligence operations. As a result of the sale, we will no longer perform due diligence activities for third parties. The net assets and liabilities and the results of operations of our HCP business have been presented as discontinued operations in the accompanying consolidated financial statements and other information presented in this Form 10-K.
 
HCP provided services to commercial banks, mortgage banks, government agencies, credit unions and insurance companies. The services provided included: loan due diligence (credit and compliance) on a full range of mortgage products, quality control reviews of newly originated mortgage loans, operational reviews of loan origination and servicing operations, mortgage assignment services, loan collateral reviews, loan document rectification, and temporary staffing services.
 
The delivery of the HCP consulting and outsourcing services usually required an analysis of a block or pool of loans on a loan-by-loan basis. This required the use of technology developed and owned by HCP and operated by employees highly specialized and trained by HCP. HCP also performed certain due diligence services and analysis of mortgage assets acquired by Hanover.
 
HT — Technology Solutions and Loan Sale Advisory
 
HT generates income by providing technology software solutions and valuation services to the mortgage industry. The technology solutions operation earns licensing and related servicing fees by licensing proprietary software applications to the financial industry. HT markets web-based technology solutions to meet specific needs of the mortgage industry in the secure transmission, analysis, valuation, tracking and stratification of loan portfolios. The software technology is licensed to government agencies and financial institutions that originate and/or trade financial assets. Previously, through its Servicing Source division, HT also licensed and used applications to provide financial management of mortgage servicing rights including mark to market valuation, impairment testing, and credit and prepayment analysis to clients. On December 29, 2006, HT sold certain assets and the trade name of its Servicing Source division, including the financial management of mortgage services rights, to the Sextant Group, Inc., which also assumed certain liabilities related to these assets. The Sextant Group, Inc. will also maintain and support certain software license and servicing agreements retained by HT.


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Prior to May 31, 2006, the loan sale advisory, “LSA”, operation of HT earned fees by providing brokerage, asset valuation and consulting services. The brokerage service integrated varying degrees of traditional voice brokerage conducted primarily by telephone, web-enhanced brokerage and online auction hosting. HT also performed market price valuations for a variety of loan products and offered consulting advice on loan product pricing and business strategies. As a result of declining sales opportunities and the departure of certain personnel, we suspended the LSA operation as of May 31, 2006. The remaining personnel and their related costs, which represent substantially all of the remaining costs of the LSA operation, have been reassigned to the REIT.
 
HT is dependent on Hanover for working capital.
 
REIT Operations
 
General
 
In order to maximize the interest income from its investments, Hanover invests in mortgage securities or mortgage loans that will generate the highest possible earnings where such mortgage securities or mortgage loans fall within acceptable investment parameters established by Hanover’s investment management team.
 
The parameters established by Hanover’s investment management team vary by type of investment but emphasize securities collateralized by prime jumbo residential mortgages or mortgage loans that generally fall into this category of residential mortgages. The parameters do not allow and Hanover does not invest in sub-prime mortgage securities or mortgage loans.
 
The potentially higher earning mortgage securities are those series of Subordinate MBS with the higher credit risk, often referred to as the non-investment grade or first loss series or tranches. These securities trade in the marketplace at substantial discounts to par value and, therefore, the earnings potential of these securities is much greater. By way of example, if a $1,000 series security were purchased at a 50% discount to par, or $500, the security’s stated interest rate would apply to the entire $1,000 until losses, if any, erode the principal amount. As a result, these securities provide a much higher effective return because Hanover paid less than par to acquire the security. Hanover believes that it has the experience, knowledge, and technical ability to actively evaluate and monitor the risks associated with these investments and, therefore, can minimize the losses that might otherwise be incurred by a passive or less knowledgeable investor, although there is no assurance Hanover’s investment team will be successful.
 
Hanover may purchase mortgage loans that are offered for sale in pools of loans. Often these pools of loans contain a mixture of loans that meet Hanover’s investment parameters and some that do not. By using Hanover’s experience, knowledge, and technology to evaluate and stratify these mortgage loans, Hanover is able to identify and put into a separate pool, or pools, the loans that do not meet Hanover’s investment parameters. These loans are sold in the marketplace and the pool of mortgage loans that remain, those that meet the investment parameters, are held for investment purposes.
 
Depending on market conditions and the quality of mortgage loans available for purchase in the marketplace, Hanover may pool certain investment mortgages, mortgages that have met Hanover’s investment parameters, and cause them to become collateral for a CMO. The CMO is usually divided into several maturity classes, called series or tranches that are sold to investors and that have varying degrees of claims on any cash flows or losses on the mortgage loans held as collateral. In such securitizations, Hanover’s intent is to hold or retain for investment purposes the highest risk series or tranches. The highest risk series often are charged with losses before the other series and receive cash flows after the other series with higher priority on cash flows are paid. The investment cost in these higher risk securities are substantially discounted from the par value and, consistent with the previous example, are a potentially higher interest earning security.
 
Hanover may also use a securitization such as Collateralized Debt Obligations “CDO’s” as a source of funding for investments in Subordinate MBS. In such a securitization, investments in Subordinate MBS are sold to an independent securitization entity that creates securities backed by those assets, the CDO’s, and sells these newly-created securities to both domestic and international investors. Most of the securities created and sold will receive the highest credit rating of AAA, so the interest paid out is relatively low. Hanover would expect


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to typically generate a profit from these securitization entities, consisting of the yield on the securitized assets less the interest payments made to the holders of the CDO securities sold. Hanover will also earn management fees from the securization entity.
 
Hanover invests in debt securities of Fannie Mae and Freddie Mac (Government Sponsored Enterprises), referred to as Agency MBS. Only Agency MBS that represent an entire pool of mortgages, not just part of a pool of mortgages, are purchased. These securities are purchased when Hanover’s monitoring model of limits for exemption under the 40 Act suggests that the total assets represented by qualifying real estate investments may need to be supported by additional purchases of Agency MBS. Such assets are sold when Hanover’s other qualifying real estate investments are of sufficient amounts to maintain the exemptive limits. These Agency MBS are readily marketable and contain guarantees by the sponsoring agency such that credit risks are minimal.
 
Investment Management
 
We believe that our portfolio management processes are influenced by three primary investment risks associated with the types of investments Hanover makes: credit risk (including counterparty risk), interest rate risk and prepayment risk. In order to maximize Hanover’s net interest income, we believe we have developed an effective asset/liability management program to provide a level of protection against the costs of credit, interest rate, and prepayment risks, however, no strategy can completely insulate us from these risks.
 
Credit Risk Management
 
We define credit risk as the risk that a borrower or issuer of a mortgage loan may not make the scheduled principal and interest payments required under the loan or a sponsor or servicer of the loan or mortgage security will not perform. We attempt to reduce our exposure to credit risk on our mortgage assets by:
 
  •  establishing investment parameters which concentrate on assets that are collateralized by prime single-family mortgage loans;
 
  •  reviewing all mortgage assets prior to purchase to ensure that they meet our investment parameters;
 
  •  employing early intervention, aggressive collection and loss mitigation techniques; and
 
  •  obtaining representations and warranties, to the extent possible, from sellers with whom we do business.
 
We do not set specific geographic diversification requirements, although we do monitor the geographic dispersion of the mortgage assets to make decisions about adding to or reducing specific concentrations. Concentration in any one geographic area will increase our exposure to the economic and natural hazard risks associated with that area.
 
When we purchase mortgage loans, the credit underwriting process varies depending on the pool characteristics, including loan seasoning or age, loan-to-value ratios, payment histories and counterparty representations and warranties. For a new pool of single-family mortgage loans, a due diligence review is undertaken, including a review of the documentation, appraisal reports and credit underwriting. Where required, an updated property valuation is obtained.
 
We attempt to reduce counterparty risk by periodically evaluating the creditworthiness of sellers, servicers, and sponsors of prime Subordinate MBS and mortgage loans.
 
Interest Rate Risk Management
 
Interest rate risk is the risk of changing interest rates in the market place. Rising interest rates may both decrease the market value of the portfolio and increase the cost of Repurchase Agreement financing. Management of these risks varies depending on the asset class. In general, we attempt to minimize the effect of rising interest rates through asset re-allocation, the use of interest rate caps and forward sales of Agency MBS.


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Subordinate MBS — Our Subordinate MBS portfolio consists of both fixed-rate and adjustable-rate securities. We manage effects of rising interest rates on the financing of our Subordinate MBS portfolio through the purchase of long-term, out-of-the-money, interest rate caps indexed to the one-month London Interbank Offered Rate Index, “LIBOR”. Increases in one-month LIBOR will decrease our net interest spread until one-month LIBOR reaches the cap strike rate. Once one-month LIBOR is at or above the cap rate, the cap will pay us, on a monthly basis, the difference between the current one-month LIBOR rate and the cap strike rate.
 
Although there is an offsetting correlation to the change in the value of the one-month LIBOR caps to the change in the value of the Subordinate MBS as interest rates increase, it is not 100 percent effective. Additionally, because our interest rate caps are treated as freestanding derivatives, the changes in the value of the interest rate caps flow through our income statement while changes in the value of the asset are reflected as Other Comprehensive Income, to the extent such Subordinate MBS have been classified as available for sale securities.
 
Although we do not currently do so, we may use designated hedges such that the derivatives used will qualify for “hedge accounting” under the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 133. To receive such treatment requires extensive management and documentation but the costs associated with such processes may be justified compared to the mark to market consequences of not qualifying under SFAS 133 as occurs with our use of freestanding derivatives as discussed above. Under SFAS No. 133, Hanover would use qualifying hedges to meet strategic economic objectives, while maintaining adequate liquidity and flexibility, by managing interest rate risk mitigation strategies that should result in a lesser amount of earnings volatility under GAAP as occurs when using freestanding derivatives.
 
A rise in interest rates may also decrease the market value of the Subordinate MBS and thereby cause financing firms to require additional collateral. The unforeseen or under anticipated need to meet additional collateral requirements is known as “margin risk”. We manage margin risk with our liquidity policy, whereby a percentage of the financed amount is held in cash or cash equivalents or other readily marketable assets.
 
Mortgage Loans — Hanover’s mortgage loan investments consist of both fixed-rate and adjustable-rate mortgage loans. Rising interest rates may both decrease the market value of the mortgage loans and increase the cost of Repurchase Agreement financing.
 
A rise in interest rates may also cause a decrease in the market value of the mortgage loans and thereby may cause financing firms to require additional collateral. We manage the unforeseen or under anticipated need to meet additional collateral requirements with our liquidity policy, whereby a percentage of the financed amount is held in cash or cash equivalents or other readily marketable assets.
 
A pool or pools of mortgage loans may reach a size where hedging our borrowing rates that finance our mortgage loan purchases may be prudent in order to avoid the increased interest expense associated with rising interest rates. In such circumstances, although we do not currently do so, we may use designated hedges such that the derivatives used will qualify for “hedge accounting” under SFAS 133. To receive such treatment requires extensive management and documentation but the costs associated with such processes may be justified compared to the mark to market consequences of not qualifying under SFAS 133 as occurs with our Subordinate MBS and the use of freestanding derivatives as discussed above.
 
Agency MBS — Our Agency MBS portfolio consists solely of fixed-rate securities. We enter into forward commitments to sell a similar amount of Agency MBS with the same coupon rates on a to be announced basis, “TBA”. This is an economic hedging strategy and therefore cannot insulate us completely from interest rate risks.
 
In addition, economic hedging involves transaction and other costs which can increase, sometimes dramatically, as the period covered by the economic hedge increases. As a result, these hedging activities may significantly reduce our net interest income on Agency MBS.


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Prepayment Risk Management
 
Prepayment risk is the risk that homeowners will pay more than their required monthly mortgage payments including payoff of mortgages. As prepayments occur, the amount of principal retained in the security declines faster than what may have been expected, thereby shortening the average life of the security by returning principal prematurely to the holder, potentially at a time when interest rates are low, as prepayment is usually associated with declining interest rates. Prepayments could cause losses if Hanover paid a premium for the security. We monitor prepayment risk through periodic reviews of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.
 
Capital Allocation Guidelines (CAG) — Liquidity Policy
 
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 the members of our Board of Directors. The CAG establishes a liquidity requirement and leverage criteria for each class of investment which is intended to keep our leverage balanced by:
 
  •  matching the amount of leverage to the level of risk (return and liquidity) of each investment; and
 
  •  monitoring the credit and prepayment performance of each investment to adjust the required capital.
 
Each quarter, we subtract the face amount of the financing used for the securities from the current market value of the mortgage assets to obtain our current equity positions. We then compare this value to the required capital as determined by our CAG. Management is required to maintain the guidelines established in the CAG and adjust the portfolio accordingly.
 
With approval of the Board of Directors, management may change the CAG criteria for a class of investments or for an individual investment based on its prepayment and credit performance relative to the market and our ability to predict or economically hedge the risk of the investments.
 
As a result of these procedures, the leverage of our balance sheet will change with the performance of our investments. Good credit or prepayment performance may release equity for purchase of additional investments. Poor credit or prepayment performance may cause additional equity to be allocated to existing investments, forcing a reduction in investments on the balance sheet. In either case, the periodic performance evaluation, along with the corresponding leverage adjustments, is intended to maintain an appropriate leverage and reduce the risk to our capital base.
 
Repurchase Agreements — Financing
 
We finance purchases of mortgage-related assets with equity and short-term borrowings through agreements where we sell the mortgage-related asset with a commitment to repurchase the asset at a later date. Generally, upon repayment of each borrowing, the mortgage asset used to secure the borrowing will immediately be pledged to secure a new Repurchase Agreement.
 
A Repurchase Agreement, although structured as a sale and repurchase obligation, is a financing transaction in which we pledge our mortgage-related assets as collateral to secure a short-term loan. Generally, the counterparty to the agreement will lend an amount equal to a percentage of the market value of the pledged collateral, ranging from 50% to 97% depending on the credit quality, liquidity and price volatility of the collateral pledged. At the maturity of the Repurchase Agreement, we repay the loan and reclaim our collateral or enter into a new Repurchase Agreement. Under Repurchase Agreements, we retain the incidents of beneficial ownership, including the right to distributions on the collateral and the right to vote on matters as to which certificate holders vote. If we default on a payment obligation under such agreements, the lending party may liquidate the collateral.
 
To reduce our exposure to the credit risk of Repurchase Agreements, we enter into these arrangements with several different counterparties. We monitor our exposure to the financial condition of the counterparty on a regular basis, including the percentage of our mortgage securities that are the subject of Repurchase Agreements with a single lender.


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Our Repurchase Agreement borrowings bear short-term (one year or less) fixed interest rates indexed to LIBOR, plus a margin ranging from 0 to 200 basis points depending on the overall quality of the mortgage-related assets. Generally, the Repurchase Agreements require us to deposit additional collateral or reduce the amount of borrowings in the event the market value of existing collateral declines, which, in rising interest-rate markets, could require us to repay a portion of the borrowings, pledge additional collateral on the loan, or sell assets to reduce the borrowings. We attempt to minimize the impact of these severities by the use of the CAG discussed above.
 
Developments in 2006
 
Financing Agreement
 
On June 22, 2006, the Company and certain of its subsidiaries entered into a Master Repurchase Agreement with Deutsche Zentral-Genossenschaftsbank, Frankfurt am Main — New York Branch (“DZ”) to finance the purchase of up to $200 million of prime residential mortgage loans. The Agreement has a five year term and provides financing of whole loans at a spread to LIBOR. The Company contemplates utilizing the facility to expand its investments in prime residential mortgage loans and facilitate the expansion of its Subordinate MBS collateralized by prime residential mortgage loans.
 
Sale of HCP
 
On January 16, 2007, the Company completed the sale of its due diligence business to Buyer, an affiliate of Terwin Holdings LLC (d/b/a The Winter Group). The transaction became effective on the Effective Date of January 12, 2007. The sale was effected through the sale of certain assets and assumption of certain liabilities (“Net Equity Amount”) of HCP-2. Hanover is thus no longer in the business of providing due diligence services to the financial services industry and governmental agencies.
 
The cash expected to be realized from the transaction will be approximately $4.7 million. The Purchase Price was approximately $1.2 million, which is subject to further post-Closing adjustments pursuant to the terms of the Asset Purchase Agreement, while HCP retained all receivables and some minor assets of approximately $3.5 million. The Asset Purchase Agreement provides for a period of up to 60 days after the Closing Date to finalize the Net Equity Amount and adjust the Purchase Price, if necessary. Hanover expects to record a gain on the sale of the due diligence business in the first quarter of 2007.
 
The Company will continue to utilize the name Hanover Capital Partners 2, Ltd., and plans to continue to perform certain financial and technology functions and other services through this entity.
 
Resignation of Directors/Executives
 
In December 2006, two senior officers of the Company were separated from the Company under terms consistent with their existing employment agreements.
 
As of December 29, 2006, the Company entered into a Separation and General Release Agreement (“Ostendorf Termination Agreement”) with George J. Ostendorf pursuant to which Mr. Ostendorf tendered, and the Company accepted, his resignation as a Senior Managing Director of the Company, as a member of the Company’s Board of Directors, and as a member of the Board of Directors of each of the Company’s affiliates of which he was a director. Pursuant to the terms of the Ostendorf Termination Agreement, Mr. Ostendorf will be paid one (1) year’s salary, twelve (12) months of COBRA benefits, and certain other benefits in exchange for his agreement to certain non-competition, non-solicitation and non-disclosure conditions as well as a release in the Company’s favor.
 
As of January 31, 2007, the Company entered into a Separation and General Release Agreement (“Mizerak Termination Agreement”) with Joyce S. Mizerak pursuant to which Ms. Mizerak tendered, and the Company accepted, her resignation as President of Hanover Capital Partners 2, Ltd., as a Senior Managing Director of the Company, as a member of the Company’s Board of Directors, and as a member of the Board of Directors of each of the Company’s affiliates of which she was a director. Pursuant to the terms of the Mizerak Termination Agreement, Ms. Mizerak will be paid sixteen (16) months salary, eighteen (18) months COBRA


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benefits and certain other benefits in exchange for her agreement to certain non-disclosure conditions as well as a release in the Company’s favor.
 
Warehouse Agreement
 
On August 28, 2006, the Company and Merrill Lynch International entered into a warehouse agreement for up to $125 million warehousing facility (the “Warehouse Agreement”), for the purpose of enhancing the Company’s liquidity. The warehousing facility will enable the Company to acquire a diversified portfolio of mezzanine grade asset-backed securities, and certain other investments and assets in anticipation of the possible formation and issuance of a CDO. As of December 31, 2006, the Company had three securities outstanding under the warehousing facility.
 
Goodwill
 
As a result of three customers terminating the technology services they receive from HT during the latter part of 2006, we decided to re-perform the assessment of the goodwill balance for potential impairment using updated forecasted revenues and expenses as of December 31, 2006. The assessment indicated that the HT reporting unit had a fair value below its book value. In accordance with the second step of the assessment, we determined the fair value of the identifiable assets of the HT reporting unit and calculated the goodwill balance as the excess of the fair value of the entire reporting unit over the fair value of the identifiable assets of the reporting unit. The goodwill was fully impaired resulting in an impairment expense of $2.5 million.
 
Stock Repurchase
 
During March of 2006, our Board of Directors approved the adoption of a stock buyback plan that authorized the Company to buy back up to a maximum of 2 million shares of Company common stock. The repurchase program may be suspended or discontinued without prior notice. During the year ended December 31, 2006, we repurchased 263,100 shares of our common stock with a total purchase price of approximately $1,479,000.
 
Change in Fair Value Methodology
 
During the second quarter of 2006, Hanover changed the methodology by which it estimated fair value for its Subordinate MBS portfolio to an enhanced proprietary valuation model developed by Hanover. Hanover’s management believes the estimates used and developed by its proprietary model reasonably reflect the values the Company may be able to receive for the securities in its Subordinate MBS portfolio should the Company choose to sell them. The impact of the change in estimate, done as of June 30, 2006, was to increase the estimated fair value of Hanover’s Subordinate MBS by $7.1 million, decrease unrealized loss included in other comprehensive income (loss) by the same amount and increase book value per share by $0.86.
 
Regulation
 
HCS is a broker/dealer registered with the SEC and is a member of the National Association of Securities Dealers, Inc. Pedestal is also a broker/dealer registered with the SEC and a member of the National Association of Securities Dealers, Inc.
 
Competition
 
We compete with a variety of institutional investors for the acquisition of mortgage-related assets. These investors include other REITs, investment banking firms, savings banks, savings and loan associations, insurance companies, mutual funds, pension funds, banks and other financial institutions that invest in mortgage-related assets and other investment assets. Many of these investors have greater financial resources and access to lower costs of capital than we do. While there is generally a broad supply of liquid mortgage securities for companies like us to purchase, we cannot assure you that we will always be successful in acquiring mortgage-related assets that we deem most suitable for us, because of the number of other investors competing for the purchase of these securities. In our non-investment income operations, we compete with a variety of consulting and technology firms.


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Employees
 
As of December 31, 2006, we had 53 full-time employees. We also utilized the services of subcontractors in HCP prior to its sale. After the sale of HCP, we have 27 full-time employees. To date, we believe we have been successful in our efforts to recruit qualified employees, but there is no assurance that we will continue to be successful in the future. None of our employees are subject to collective bargaining agreements.
 
Trademarks
 
We own five trademarks that have been registered with the United States Patent and Trademark Office.
 
Federal Income Tax Considerations
 
General
 
We have elected to be treated as a REIT for Federal income tax purposes, pursuant to the Internal Revenue Code of 1986, as amended (the “Code”). In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be taxed as corporations are, with certain limited exceptions, not taxed at the corporate level on their taxable income that is currently distributed to their shareholders. This treatment eliminates most of the “double taxation” (at the corporate level and then again at the shareholder level when the income is distributed) that typically results from the use of corporate investment vehicles. In the event that we do not qualify as a REIT in any year, we would be subject to Federal income tax as a domestic corporation and the amount of our after-tax cash available for distribution to our shareholders would be reduced. We believe we have satisfied the requirements for qualification as a REIT since commencement of our operations in September 1997. We intend at all times to continue to comply with the requirements for qualification as a REIT under the Code, as described below. At any time, the Federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations thereof may take effect retroactively and could adversely affect us or our shareholders. Congress recently enacted legislation that reduced the Federal tax rate on both qualified dividend income and long-term capital gains for individuals to 15% through 2008. Because REITs generally are not subject to corporate income tax, this reduced tax rate does not generally apply to ordinary REIT dividends, which continue to be taxed at the higher tax rates applicable to ordinary income. The 15% tax rate applies to:
 
1. long-term capital gains recognized on the disposition of REIT shares;
 
2. REIT capital gain distributions and a shareholder’s share of a REIT’s undistributed net capital gains (except, in either case, to the extent attributable to real estate depreciation, in which case such distributions will be subject to a 25% tax rate);
 
3. REIT dividends attributable to dividends received by a REIT from non-REIT corporations, such as taxable REIT subsidiaries; and
 
4. REIT dividends attributable to income that was subject to corporate income tax at the REIT level (i.e., to the extent that a REIT distributes less than 100% of its taxable income).
 
These reduced rates could cause shares in non-REIT corporations to be a relatively more attractive investment to individual investors than shares in REITs. The legislation also could have an adverse effect on the market price of our securities.
 
Requirements for Qualification as a REIT
 
To qualify for income tax treatment as a REIT under the Code, we must meet certain tests which are described briefly below. We believe that we satisfy all of the requirements to remain qualified as a REIT.


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Ownership of Common Stock
 
For all taxable years after our first taxable year, our shares of capital stock must be held by a minimum of 100 persons for at least 335 days of a 12-month year (or a proportionate part of a short tax year). In addition, at any time during the second half of each taxable year, no more than 50% in value of our capital stock may be owned directly or indirectly by five or fewer individuals, taking into account complex attribution of ownership rules. We are required to maintain records regarding the actual and constructive ownership of our shares, and other information, and to demand statements from persons owning above a certain level of our shares regarding their ownership of shares. We must keep a list of those shareholders who fail to reply to such a demand. We are required to use (and do use) the calendar year as our taxable year for income tax reporting purposes.
 
Nature of Assets
 
On the last day of each calendar quarter, we must satisfy three tests relating to the nature of our assets. First, at least 75% of the value of our assets must consist of real estate mortgage loans, certain interests in real estate mortgage loans, real estate, certain interests in real estate, shares (or transferable certificates of beneficial interest) in other REITs, government securities, cash and cash items (“Qualified REIT Assets”). We expect that substantially all of our assets will continue to be Qualified REIT Assets. Second, not more than 25% of our assets may consist of securities that are not Qualified REIT Assets. Third, except as noted below, investments in securities that are not Qualified REIT Assets are further limited as follows:
 
(i) not more than 20% of the value of our total assets can be represented by securities of one or more Taxable REIT Subsidiaries (as defined below),
 
(ii) the value of any one issuer’s securities may not exceed 5% by value of our total assets,
 
(iii) we may not own securities possessing more than 10% of the total voting power of any one issuer’s outstanding voting securities, and
 
(iv) we may not own securities having a value of more than 10% of the total value of any one issuer’s outstanding securities.
 
Clauses (ii), (iii) and (iv) of the third asset test do not apply to securities of a Taxable REIT Subsidiary. A “Taxable REIT Subsidiary” is any corporation in which a REIT owns stock, directly or indirectly, if the REIT and such corporation jointly elect to treat such corporation as a Taxable REIT Subsidiary. The amount of debt and rental payments from a Taxable REIT Subsidiary to a REIT are limited to ensure that a Taxable REIT Subsidiary is subject to an appropriate level of corporate tax.
 
In 2003, Congress enacted legislation under which, in certain circumstances, we may be able to avoid being disqualified as a REIT as a result of a failure to satisfy one or more of the foregoing asset tests provided that we satisfy certain conditions including, in some cases, the payment of an amount equal to the greater of $50,000 or an amount bearing a certain relationship to the particular violation. Notwithstanding the legislation, pursuant to our compliance guidelines, we intend to monitor closely the purchase and holding of our assets in order to comply with the foregoing asset tests.
 
Sources of Income
 
We must meet the following two separate income-based tests each year:
 
75% income test
 
At least 75% of our gross income for the taxable year must be derived from certain real estate sources including interest on obligations secured by mortgages on real property or interests in real property. Certain temporary investment income will also qualify under the 75% income test. The investments that we have made and expect to continue to make will give rise primarily to mortgage interest qualifying under the 75% income test.
 
95% income test


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In addition to deriving 75% of our gross income from the sources listed above, at least an additional 20% of our gross income for the taxable year must be derived from those sources, or from dividends, interest or gains from the sale or disposition of stock or other securities that are not dealer property. We intend to limit substantially all of the assets that we acquire to assets that can be expected to produce income that qualifies under the 75% Income Test. Our policy to maintain REIT status may limit the types of assets, including hedging contracts and other securities, that we otherwise might acquire.
 
Distributions
 
We must distribute to our shareholders on a pro rata basis each year an amount equal to at least;
 
(i) 90% of our taxable income before deduction of dividends paid and excluding net capital gains, plus
 
(ii) 90% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code, less
 
(iii) certain “excess noncash income.”
 
We intend to make distributions to our shareholders in sufficient amounts to meet this 90% distribution requirement.
 
If we fail to distribute to our shareholders with respect to each calendar year at least the sum of;
 
(i) 85% of our REIT ordinary income of the year,
 
(ii) 95% of our REIT capital gain net income for the year, and
 
(iii) any undistributed taxable income from prior years,
 
we will be subject to a 4% excise tax on the excess of the required distribution over the amounts actually distributed.
 
State Income Taxation
 
We file corporate income tax returns in various states. These states treat the income of a REIT in a similar manner as for Federal income tax purposes. Certain state income tax laws with respect to REITs are not necessarily the same as Federal law. Thus, differences in state income taxation as compared to Federal income taxation may exist in the future.
 
Taxation of Hanover’s Shareholders
 
For any taxable year in which we are treated as a REIT for Federal income tax purposes, amounts distributed by us to our shareholders out of current or accumulated earnings and profits will be includable by the shareholders as ordinary income for Federal income tax purposes unless properly designated by us as capital gain dividends. Dividends declared during the last quarter of a calendar year and actually paid during January of the immediately following calendar year are generally treated as if received by the shareholders on December 31 of the calendar year during which they were declared. Our dividend distributions will not generally be qualified dividend income eligible for the 15% maximum rate applicable to such income received by individuals during the period 2003 through 2008. Our distributions will not be eligible for the dividends received deduction for corporations. Shareholders may not deduct any of our net operating losses or capital losses. If we designate one or more dividends, or parts thereof, as a capital gain dividend in a written notice to the shareholders, the shareholders shall treat as long-term capital gain the lesser of (i) the aggregate amount so designated for the taxable year or (ii) our net capital gain for the taxable year. Each shareholder will include in his long-term capital gains for the taxable year such amount of our undistributed as well as distributed net capital gain, if any, for the taxable year as is designated by us in a written notice. We will be subject to a corporate level tax on such undistributed gain and the shareholder will be deemed to have paid as an income tax for the taxable year his distributive share of the tax paid by us on the undistributed gain.


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Any loss on the sale or exchange of shares of our common stock held by a shareholder for six months or less will be treated as a long-term capital loss to the extent of any capital gain dividends received (or undistributed capital gain included) with respect to the common stock held by such shareholder.
 
If we make distributions to our shareholders in excess of our current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a shareholder’s shares until the tax basis is zero. Such distributions in excess of the tax basis will be taxable as gain realized from the sale of our shares. We will withhold 30% of dividend distributions to shareholders that we know to be foreign persons unless the shareholder provides us with a properly completed IRS form claiming a reduced withholding rate under an applicable income tax treaty.
 
In general, dividend income that a tax-exempt entity receives from us should not constitute unrelated business taxable income, or “UBTI”, as defined in Section 512 of the Code. If, however, we realize certain excess inclusion income and allocate it to stockholders, a stockholder cannot offset such income by net operating losses and, if the stockholder is a tax-exempt entity, then such income would be fully taxable as UBTI under Section 512 of the Code. If the stockholder is foreign, then it would be subject to Federal income tax withholding on such excess inclusion income without reduction pursuant to any otherwise applicable income tax treaty. Excess inclusion income would be generated if we were to issue debt obligations with two or more maturities and the terms of the payments on these obligations bore a relationship to the payments received on the mortgage related assets securing those debt obligations. Our borrowing arrangements are generally structured in a manner designed to avoid generating significant amounts of excess inclusion income. We do, however, enter into various Repurchase Agreements that have differing maturity dates and afford the lender the right to sell any pledged mortgage securities upon default. The IRS may determine that these borrowings give rise to excess inclusion income that should be allocated among stockholders. Furthermore, some types of tax-exempt entities, including, without limitation, voluntary employee benefit associations and entities that have borrowed funds to acquire their shares of our common stock, may be required to treat a portion or all of the dividends they may receive from us as UBTI. We believe that our shares of stock will be treated as publicly offered securities under the plan asset rules of the Employment Retirement Income Security Act (“ERISA”) for Qualified Plans. However, in the future, we may hold REMIC residual interests that would give rise to UBTI for pension plans and other tax exempt entities.
 
Errors have been made in the reporting of tax components of distributions to our shareholders for each year in the five year period ended 2006. The errors relate to the change in estimates used in computation of our tax earnings and profits for those years and had the effect of misstating the return of capital component of our distributions and correspondingly the dividend income component. In order to address the incorrect reporting of these distributions, corrected Forms 1099-DIV have been or will be sent to our shareholders as considered appropriate. The IRS can assess penalties against us for delivering inaccurate Forms 1099-DIV, ranging from $50 to $100 for each incorrect Form 1099-DIV sent to shareholders. However, the IRS can also waive any penalty upon a showing by us that the error was due to reasonable cause and not willful neglect. The imposition by the IRS of penalties to which the inaccurate Forms 1099-DIV may be subject could adversely affect the results of operations.
 
The provisions of the Code are highly technical and complex and are subject to amendment and interpretation from time to time. This summary is not intended to be a detailed discussion of all applicable provisions of the Code, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. We have not obtained a ruling from the IRS with respect to tax considerations relevant to Hanover’s organization or operations.
 
Available Information
 
The Company makes available on its website, www.hanovercapitalholdings.com, at no cost, electronic filings with the SEC including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, other documents and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after they are electronically filed. In addition, through the same link, the Company makes available certain of its Corporate


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Governance documents including the Audit Committee Charter, Compensation Committee Charter, Nominating Committee Charter, Code of Conduct and Business Ethics, and the Code of Ethics for Principal Executive and Senior Financial Officers. Information on our website is not incorporated by reference into this report.
 
ITEM 1A.   RISK FACTORS
 
Risks Related to Our Business
 
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.
 
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 maturing 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 possibly 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 or decline in property values and the general regulatory and tax environment as it relates to mortgage lending. In addition, we expect to compete for these investments with other REITs, investment banking firms, savings banks, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-related assets, many of which have greater financial resources than we do. If we cannot obtain sufficient mortgage loans or mortgage securities that meet our criteria, at favorable yields, our business will be adversely affected.
 
We are subject to various obligations related to our use of, and dependence on, debt.
 
If we violate covenants in any debt agreements, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on


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attractive terms, if at all. Violations of certain debt covenants may result in our being unable to borrow unused amounts under a line of credit, even if repayment of some or all borrowings is not required.
 
A violation under one debt agreement may also trigger defaults in other debt agreements requiring repayments or imposing further restrictions. This could force us to sell portions of our portfolio at a time when losses could result. In any event, financial covenants under our current or future debt obligations could impair our planned business strategies by limiting our ability to borrow.
 
Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or they file for bankruptcy.
 
Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay in the event that we file for bankruptcy. Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy. Thus, our use of repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.
 
We may engage in hedging transactions, which can limit our gains and increase exposure to losses.
 
We may enter into hedging transactions to protect us from the effects of interest rate fluctuations on floating rate debt and also to protect our portfolio of mortgage assets from interest rate and prepayment rate fluctuations. Our hedging transactions may include entering into interest rate swap agreements or interest rate cap or floor agreements, purchasing or selling futures contracts, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements. There are no assurances that our hedging activities will have the desired impact on our results of operations or financial condition.
 
Interest rate fluctuations may adversely affect our net income.
 
Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations can adversely affect our income.
 
The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Variances in the yield curve may reduce our net income. Short-term interest rates are ordinarily lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve) or short-term interest rates exceed longer-term interest rates (a yield curve inversion), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because our assets generally bear interest based on longer-term rates than our borrowings, a flattening or inversion of the yield curve would tend to decrease our net income. Additionally, the spread between the yields earned on any 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


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remediation of hazardous substances. These costs may be significant and may exceed the value of the property. In addition, current laws may materially limit our ability to resell foreclosed properties, and future laws, or more stringent interpretations or enforcement policies of existing requirements, may increase our exposure to liability. Further, foreclosed property is not financed and may require considerable amounts of capital before sold, thereby reducing our opportunities for alternate investments that could produce greater amounts of income.
 
Our business could be adversely affected if we are unable to safeguard the security and privacy of the personal financial information of borrowers to which we have access.
 
In connection with certain of our loan file reviews and other activities with respect to mortgage loans in our portfolio, we have access to the personal non-public financial information of the borrowers. In addition, in operating an Internet exchange for trading mortgage loans, HT sometimes has access to borrowers’ personal non-public financial information, which it may provide to potential third party investors in the mortgage loans. This personal non-public financial information is highly sensitive and confidential, and if a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Although we have policies and procedures designed to safeguard confidential information, we cannot give complete assurances that these policies and safeguards are sufficient to prevent the misappropriation of confidential information or that our policies and safeguards will be deemed compliant with any existing Federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.
 
Risks Related to Our Status as a REIT and Our 40 Act Exemption
 
If we do not maintain our status as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.
 
We believe that we currently qualify, and expect to continue to qualify, as a REIT under the Code. However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then:
 
  •  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 100% of the stock of a “taxable REIT subsidiary” that can engage in businesses previously prohibited to a REIT. In particular, the Act permitted us to restructure our operating subsidiaries as taxable REIT subsidiaries. As a result, for periods ending after June 30, 2002, through December 31, 2006, the financial statements of certain subsidiaries 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


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impose several conditions on the use of taxable REIT subsidiaries, which are generally designed to ensure that taxable REIT subsidiaries are subject to an appropriate level of corporate taxation. Further, no more than 20% of the fair market value of a REIT’s assets may consist of securities of taxable REIT subsidiaries, and no more than 25% of the fair market value of a REIT’s assets may consist of non-qualifying assets, including securities of taxable REIT subsidiaries and other taxable subsidiaries. In addition, the REIT Modernization Act legislation provides that a REIT may not own more than 10% of the voting power or value of a taxable subsidiary that is not treated as a taxable REIT subsidiary. If our investments in our subsidiaries do not comply with these rules, we would fail to qualify as a REIT and we would be taxed as a regular corporation. Furthermore, certain transactions between us and a taxable REIT subsidiary that are not conducted on an arm’s length basis would be subject to a tax equal to 100% of the amount of deviance from an arm’s length standard.
 
Complying with REIT requirements may limit our ability to hedge effectively.
 
The REIT provisions of the Code may substantially limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. In addition, we must limit our aggregate income from nonqualified hedging transactions, from our provision of services and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. If we violate the 25% or 5% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. If we fail to observe these limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for Federal income tax purposes. The fair market value of a hedging instrument will not be counted as a qualified asset for purposes of satisfying the requirement that, at the close of each calendar quarter, at least 75% of the total value of our assets be represented by real estate and other qualified assets.
 
REIT requirements may force us to forgo or liquidate otherwise attractive investments.
 
In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75% of the fair market value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer and no more than 20% of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries. Our efforts to comply with the rules might force us to pass up opportunities to acquire otherwise attractive investments. If we fail to comply with these requirements at the end of any calendar quarter, we may be able to correct such failure within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffer adverse tax consequences. As a result, we may be required to liquidate otherwise attractive investments.
 
Complying with REIT requirements may force us to borrow or liquidate assets to make distributions to stockholders.
 
As a REIT, we must distribute at least 90% of our annual taxable income (subject to certain adjustments) to our stockholders. From time to time, we may generate taxable income greater than our net income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders. If we do not have other funds available in these situations, we could be required to borrow funds, sell a portion of our mortgage securities at disadvantageous prices or find another alternative source of funds in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement. These alternatives could increase our costs or reduce our equity.


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Regulation as an investment company could materially and adversely affect our business; efforts to avoid regulation as an investment company could limit our operations.
 
We intend to conduct our business in a manner that allows us to avoid being regulated as an investment company under the 40 Act. Investment company regulations, if they were deemed applicable to us, would prevent us from conducting our business as described in this report by, among other things, limiting our ability to use borrowings.
 
The 40 Act exempts entities that are primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. Under the SEC’s current interpretation, in order to qualify for this exemption we must maintain at least 55% of our assets directly in qualifying real estate interests and an additional 25% of our assets in real estate related assets. However, mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not be counted towards our satisfaction of the 55% requirement. Generally investments in the subordinated tranches of securitized loan pools do not constitute “qualifying real estate interests” unless certain qualifying abilities to govern the control of any foreclosures are in place. Our ownership of these mortgage-backed securities, therefore, may be limited to the extent that servicers of the loans in the pools do not 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 40 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 40 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
Hanover believes that most buyers have accounted for these transactions as described in the Hanover example transaction (and similar transactions) as a purchase and subsequent financing (as Hanover has done) and that there is currently minimal diversity in this practice.
 
The Issue
The issue is how to apply the criterion in paragraph 9(a) of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, in accounting for transactions involving the purchase of financial assets and simultaneous repurchase of the same financial assets with the seller.
 
Paragraph 9(a) requires “isolation” from the transferor (seller). If the isolation requirement is met, the seller meets the requirements in paragraph 9(a) of SFAS No. 140 and the transaction qualifies as a sale by the seller and a purchase and financing by the buyer, as Hanover has done. If the isolation requirement is not met, the transaction is not a sale by the seller and paragraph 12 of SFAS No. 140 would require the buyer to record the transaction as a financing to the extent of the cash or other assets that were transferred. The classification of


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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 above example, the transferred assets have not been isolated from the seller and therefore, the isolation requirement is not met. Those with this view also believe that demonstrating isolation legally is not possible without a legal opinion and such opinions would be too vague to meet the isolation requirement. This contrary view is what the EITF has been asked to consider.
 
Impact on Hanover if the isolation requirement of paragraph 9(a) is not met
The accounting classification of the resulting derivative instruments held by Hanover, a REIT, if the isolation requirement of paragraph 9(a) is not met, might impact Hanover’s REIT tax exempt status. A REIT must hold at least 75% of its total assets in qualified real estate assets and derive at least 75% of its gross income from real property (for example, rent or mortgage interest). Derivative instruments are not qualified assets. Further, we could find that our ability to remain exempt under the provisions of the 40 Act 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 7.5% (except in the case of John A. Burchett, our Chairman, Chief Executive Officer and President, who can acquire up to 20%) in value of the outstanding shares of our capital stock. Our charter’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 7.5% of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 7.5% of the outstanding stock, and thus be subject to our charter’s ownership limit. Any attempt to own or transfer shares of our capital stock in excess of the ownership limit without the consent of the Board of Directors will be void, and could result in the shares being transferred by operation of law to a charitable trust.
 
Provisions of our charter which inhibit changes in control, could prevent stockholders from obtaining a premium price for our common stock.
 
Provisions of our charter may delay or prevent a change in control of the Company or other transactions that could provide stockholders with a premium over the then-prevailing market price of our common stock or that might otherwise be in the best interests of the stockholders. These include a staggered board of directors, our share ownership limit described above and our stockholders rights plan.
 
Our Board of Directors could adopt the limitations available under Maryland law on changes in control that could prevent transactions in the best interests of stockholders.
 
Certain provisions of Maryland law applicable to us prohibit “business combinations”, including certain issuances of equity securities, with any person who beneficially owns 10% or more of the voting power of our outstanding shares, or with an affiliate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of our outstanding voting shares (which is referred to as a so-called “interested stockholder”), or with an affiliate of an interested stockholder. These prohibitions last for five years after the most recent date on which the stockholder became an interested stockholder. After the five-year period, a business combination with an interested stockholder must be approved by two super-majority stockholder votes unless, among other conditions, our common stockholders receive a minimum price for their shares and the consideration is received in cash or in the same form as previously paid by the interested stockholder for its shares of common stock. Our Board of Directors has opted out of these business combination provisions. As a result, the five-year prohibition and the super-majority vote requirements will not apply to a business combination involving the Company. Although it has no current


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plans to do so, our Board of Directors may, however, repeal this election in most cases and cause the Company to become subject to these provisions in the future.
 
We are dependent on external sources of capital, which may not be available.
 
To qualify as a REIT, we must, among other things, distribute to our stockholders each year at least 90% of our REIT taxable income (excluding any net capital gains). Because of these distribution requirements, we likely will not be able to fund all future capital needs with income from operations. We therefore will have to rely on third-party sources of capital, including possible future equity offerings, which may or may not be available on favorable terms or at all. Our access to third-party sources of capital depends on a number of things, including the market’s perception of our growth potential and our current and potential future earnings. Moreover, additional equity offerings may result in substantial dilution of stockholders’ interests, and additional debt financing may substantially increase leverage.
 
We may change our policies without stockholder approval.
 
Our Board of Directors and management determine all of our policies, including our investment, financing and distribution policies. Although they have no current plans to do so, they may amend or revise these policies at any time without a vote of our stockholders. Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions.
 
Our business could be adversely affected if we have deficiencies in our disclosure controls and procedures or internal control over financial reporting.
 
The design and effectiveness of our disclosure controls and procedures and internal control over financial reporting may not prevent all errors, misstatements or misrepresentations. While management continues to review the effectiveness of our disclosure controls and procedures and internal control over financial reporting, there can be no assurance that our disclosure controls and procedures or internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, particularly material weaknesses, in internal control over financial reporting which may occur in the future could result in misstatements of our results of operations, restatements of our financial statements, a decline in our stock price, or otherwise materially and adversely affect our business, reputation, results of operation, financial condition, or liquidity.
 
ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None.
 
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
  Hanover and HT     10,128     $ 191,672     September 2010   Executive, Administration and Technology Operations
Edison, New Jersey (1)
  Hanover     21,293       402,083     October 2010   Administration, Due Diligence Operations
New York, New York
  Hanover     2,500       87,154     December 2010   Executive, Administration, Investment Operations
Chicago, Illinois
  Hanover     423       9,400     January 2009   Marketing
                             
Total
        34,344     $ 690,309          
                             


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(1) This facility and corresponding lease agreement were assigned to Terwin Acquisition I, LLC., in connection with the sale of the Company’s HCP business effective January 12, 2007.
 
We believe that these facilities are adequate for our foreseeable office space needs and that lease renewals and/or alternate space at comparable rental rates are available, if necessary. During the normal course of our business, additional facilities may be required to accommodate growth.
 
ITEM 3.   LEGAL PROCEEDINGS
 
On or about January 11, 2006, the Company received a Complaint filed on behalf of its former CFO, J. Holly Loux, claiming the Company and its current CEO, John A. Burchett, wrongfully terminated her employment. The action is titled Loux v Hanover Capital Mortgage Holdings, Inc. Civil Action No. 06-0122 (KSM), and is currently pending in the United States District Court for the District of New Jersey. By her Complaint, Ms. Loux seeks reinstatement, attorney’s fees and costs, and an undetermined amount of damages. The Company and Mr. Burchett deny her allegations and they are vigorously defending the claims made by Ms. Loux. The matter is still in the discovery stages. A settlement conference was held on March 9, 2007. The parties were unable to resolve the case at the settlement conference.
 
From time to time, we are involved in litigation incidental to the conduct of our business. Except for the Loux matter noted above, we are not currently a party to any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on our business, financial condition, or results of operation.
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Not applicable.


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PART II
 
ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Our common stock trades on the American Stock Exchange under the symbol “HCM.” As of March 13, 2007, there were 142 record holders, and approximately 6,377 beneficial owners, of our common stock.
 
The following table sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported by the American Stock Exchange:
 
                                 
    2006     2005  
    High     Low     High     Low  
 
1st Quarter
  $ 7.20     $ 4.34     $ 11.89     $ 10.40  
2nd Quarter
    6.50       5.00       11.75       9.60  
3rd Quarter
    7.09       5.25       10.68       6.88  
4th Quarter
    6.64       4.85       8.40       6.20  
 
The following graph compares the cumulative 5-year total return provided to shareholders on Hanover Capital Mortgage Holdings, Inc.’s common stock relative to the cumulative total returns of the S & P 500 index, and a customized peer group of six companies that includes: Capstead Mortgage Corp., Dynex Capital Inc, Impac Mortgage Holdings Inc, Indymac Bancorp Inc, Redwood Trust Inc and Thornburg Mortgage Inc. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock, in the peer group, and the index on 12/31/2001 and its relative performance is tracked through 12/31/2006.
 
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Hanover Capital Mortgage Holdings, Inc., The S & P 500 Index
And A Peer Group
 
GRAPGH
 
 
$100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.
 
Copyright© 2007, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights
 
                                                             
      12/01     12/02     12/03     12/04     12/05     12/06
Hanover Capital Mortgage Holdings, Inc. 
      100.00         99.71         198.32         197.21         138.07         116.00  
S & P 500
      100.00         77.90         100.24         111.15         116.61         135.03  
Peer Group
      100.00         105.11         174.20         215.92         191.16         227.27  
                                                             


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The following table lists the cash dividends we declared on each share of our common stock for the periods indicated:
 
         
    Cash Dividends
 
    Declared Per Share  
 
2006
       
Fourth Quarter ended December 31, 2006
  $ 0.15  
Third Quarter ended September 30, 2006
    0.15  
Second Quarter ended June 30, 2006
    0.20  
First Quarter ended March 31, 2006
    0.20  
2005
       
Fourth Quarter ended December 31, 2005
  $ 0.25  
Third Quarter ended September 30, 2005
    0.25  
Second Quarter ended June 30, 2005
    0.30  
First Quarter ended March 31, 2005
    0.30  
 
We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our REIT taxable income in each year to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, both GAAP and tax, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant.


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ITEM 6.   SELECTED FINANCIAL DATA
 
The following tables set forth our selected financial data as of and for the year ended December 31, for each of the years indicated. The selected financial data for the years ended December 31, 2006, 2005 and 2004, and as of December 31, 2006 and 2005, have been derived from our audited Consolidated Financial Statements included elsewhere in this report. The financial information for the years ended December 31, 2003 and 2002 and as of December 31, 2004, 2003 and 2002, have been derived from our audited Consolidated Financial Statements not included in this report. The historical selected consolidated financial data may not be indicative of our future performance. The selected financial data should be read in conjunction with the more detailed information contained in our Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.
 
Statement of Operations Highlights
  (dollars in thousands, except per share data)
 
                                         
    Years Ended December 31,  
    2006     2005 (2)     2004     2003     2002 (1)  
 
Net interest income
  $ 10,336     $ 7,986     $ 9,935     $ 6,336     $ 5,990  
Gain on sale and mark to market of mortgage assets
    (1,362 )     1,980       6,248       8,432       2,445  
Loan brokering, technology and other
    2,885       5,303       5,799       6,165       3,031  
                                         
Total revenues
    11,859       15,269       21,982       20,933       11,466  
Total expenses
    13,913       15,008       14,503       13,244       7,650  
                                         
Operating income (loss)
    (2,054 )     261       7,479       7,689       3,816  
                                         
Equity in income (loss) of equity method investees:
                                       
Hanover Capital Partners Ltd. 
                            (143 )
HanoverTrade, Inc. 
                            511  
HDMF-I LLC
          (215 )     445       1       157  
Hanover Capital Partners 2, Inc. 
                            (19 )
HST-I
    53       42                    
HST-II
    57       8                    
                                         
      110       (165 )     445       1       506  
                                         
Minority interest in loss of consolidated affiliate
    (5 )     (57 )                  
                                         
Income (loss) from continuing operations before income tax provision (benefit)
    (1,939 )     153       7,924       7,690       4,322  
Income tax provision (benefit)
    12       2       (26 )     180       58  
                                         
Income (loss) from continuing operations
    (1,951 )     151       7,950       7,510       4,264  
                                         
Discounted Operations:
                                       
Income (loss) from discontinued operations before income tax provision (benefit)
    (917 )     1,387       108       794       865  
Income tax provision (benefit) from discontinued operations
    58       172       (63 )     264       (9 )
                                         
Income (loss) from discontinued operations
    (975 )     1,215       171       530       874  
                                         
Net income (loss)
  $ (2,926 )   $ 1,366     $ 8,121     $ 8,040     $ 5,138  
                                         
Basic earnings per share:
                                       
Income (loss) from continuing operations
  $ (0.23 )   $ 0.02     $ 0.96     $ 1.29     $ 0.97  
                                         
Net income (loss)
  $ (0.35 )   $ 0.16     $ 0.98     $ 1.38     $ 1.16  
                                         
Diluted earnings per share:
                                       
Income (loss) from continuing operations
  $ (0.23 )   $ 0.02     $ 0.95     $ 1.26     $ 0.95  
                                         
Net income (loss)
  $ (0.35 )   $ 0.16     $ 0.97     $ 1.35     $ 1.15  
                                         
Dividends declared per share
  $ 0.70     $ 1.10     $ 1.60     $ 1.35     $ 1.00  
                                         


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(1) Information prior to July 1, 2002 does not include the consolidation of Hanover Capital Partners Ltd., HanoverTrade, Inc., and Hanover Capital Partners 2, Inc. with Hanover.
 
(2) Information prior to June 1, 2005 does not include the consolidation of HDMF-I with Hanover.
 
Balance Sheet Highlights
  (dollars in thousands, except per share data)
 
                                         
    December 31,  
    2006     2005     2004     2003     2002  
 
Cash and cash equivalents
  $ 13,982     $ 30,492     $ 20,601     $ 32,586     $ 10,605  
Mortgage loans
    9,736       24,135       41,101       58,985       103,164  
Mortgage securities
    265,957       197,488       164,580       81,564       23,903  
Other subordinate security
    2,757       2,703                    
Other assets
    11,837       17,369       15,856       15,856       16,449  
                                         
Total assets
  $ 304,269     $ 272,187     $ 242,138     $ 188,991     $ 154,121  
                                         
Repurchase agreements
  $ 193,247     $ 154,268     $ 130,102     $ 55,400     $ 6,283  
CMO borrowing
    7,384       11,438       35,147       52,164       102,589  
Liability to Trusts
    41,239       41,239                    
Other liabilities
    4,816       5,622       5,670       6,608       3,935  
                                         
Total liabilities
    246,686       212,567       170,919       114,172       112,807  
Minority interest
          189                    
Stockholders’ equity
    57,583       59,431       71,219       74,819       41,314  
                                         
Total liabilities and stockholders’ equity
  $ 304,269     $ 272,187     $ 242,138     $ 188,991     $ 154,121  
                                         
Number of common shares outstanding
    8,233,062       8,496,162       8,381,583       8,192,903       4,474,222  
                                         
Book value per common share
  $ 6.99     $ 7.00     $ 8.50     $ 9.13     $ 9.23  
                                         
 
ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Summary
 
For the year ended December 31, 2006, our net income (loss) of $(2.9) million was $4.3 million lower than the previous year’s net income of $1.4 million. This decrease is primarily attributable to a goodwill impairment charge for HT of $2.5 million and lower operating income of our REIT segment. The majority of our operating income in the years 2006 and 2005 is attributable to the REIT. The REIT’s decline in operating income in 2006 is primarily the result of lower gains earned in 2006 than we experienced in 2005 in our Subordinate MBS portfolio and impairments on real estate owned by HDMF-I. The REIT’s gains in 2006 were $0.8 million compared to $4.1 million in 2005. We had impairments of real estate owned of $1.2 million during 2006.
 
For the year ended December 31, 2005, our net income of $1.4 million was $6.7 million lower than the previous year’s net income of $8.1 million. This is primarily attributable to lower operating income of our REIT segment. The majority of our net income in the years 2005 and 2004 is attributable to the REIT. The REIT’s decline in operating income in 2005 is primarily the result of lower gains earned in 2005 than we experienced in 2004 in our Subordinate MBS portfolio. The REIT’s gains in 2005 from our Subordinate MBS portfolio were $4.1 million compared to $10.4 million in 2004.


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A review of our operations for the years ended December 31, 2006, 2005 and 2004 is set forth below by operating segment. Since our two operating segments have generated substantially all of our net income we have concentrated our discussion and analysis on these components.
 
Selected Components of Operating Income by Segment
(dollars in thousands)
 
                         
    Year Ended December 31,  
    2006     2005     2004  
 
Hanover — REIT
                       
Total revenues
  $ 9,733     $ 10,731     $ 16,593  
Total expenses
    8,251       8,287       7,848  
                         
Operating income (loss)
    1,482       2,444       8,745  
                         
HT
                       
Total revenues
    2,232       4,603       5,446  
Total expenses
    5,768       6,786       6,712  
                         
Operating income (loss)
    (3,536 )     (2,183 )     (1,266 )
                         
Operating income (loss), as reported
  $ (2,054 )   $ 261     $ 7,479  
                         
 
Our operating income (loss) declined in 2006 by $2.3 million from our 2005 operating income. The decline was the result of a decline in our REIT operating income of $1.0 million from 2005 and an increase in our HT operating loss of $1.4 million from 2005.
 
Our operating income declined in 2005 by $7.2 million from our 2004 operating income. That decline was the result of a decline in our REIT operating income of $6.3 million from 2004 and a $0.9 million increase in the operating loss of HT.
 
Significant changes in our financial position for 2006 are primarily related to further investments from the proceeds of our issuance of junior subordinated notes of $40 million issued in conjunction with the creation of two statutory trusts discussed further under the Liquidity and Capital Resources section of this Item.
 
Critical Accounting Estimates
 
The significant accounting policies used in preparation of our Consolidated Financial Statements are described in Note 2 to our Consolidated Financial Statements included in this report. Certain critical accounting policies are complex and involve significant judgment by our management, including the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. As a result, changes in these estimates and assumptions could significantly affect our financial position or our results of operations. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities.
 
Change in Estimate of Fair Value
 
During the second quarter of 2006, we changed the methodology by which we determine estimated fair value for our Subordinate MBS portfolio to an enhanced proprietary valuation model we developed from a model used for several years as a bench-mark for evaluating independent third-party estimates of fair value.
 
Through the first quarter of 2006, we used the lower of independent third-party valuations or our valuations as the fair value of our Subordinate MBS. Over time, as the portfolio of these securities has changed in size, complexity, and age or maturity, historical sales data suggested that the fair values developed under this methodology were, overall, too low.


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As part of our normal quarterly activities related to fair value estimates, we conducted a review of our Subordinate MBS sales for the years 2004 and 2005 and the first two quarters of 2006 and compared prices obtained in the sales to the corresponding independent third-party estimates of fair value and the estimates determined by our enhanced internal model. The review disclosed that our enhanced model was a more accurate indicator of fair value especially as the nature of the portfolio has changed through increased size and concentration into these securities and the portfolio of Subordinate MBS has aged. Although the independent third-party estimates are useful as a comparison tool, we believe they are no longer representative of fair value. Further, we do not believe independent third-parties are willing to consistently provide valuations that are more robust in nature and therefore a more representative estimate of fair value of our Subordinate MBS without considerable cost to us.
 
Our Subordinate MBS securities are not readily marketable with quoted market prices. To obtain the best estimate of fair value requires a current knowledge of the Subordinate MBS attributes, characteristics related to the underlying mortgages collateralizing the securities and the market of these securities. We maintain extensive data related to the collateral of our Subordinate MBS and as a result are able to apply this data and all other relevant market data to our estimates of fair value. We believe the estimates used reasonably reflect the values we may be able to receive should we choose to sell them. Many factors must be considered in order to estimate market values, including, but not limited to interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors. Accordingly, our estimates are inherently subjective in nature and involve uncertainty and judgment to interpret relevant market and other data. Amounts realized in actual sales may differ from the fair values presented.
 
The following schedule shows the impact of the change in estimate as of June 30, 2006 (dollars in thousands, except per share amounts):
 
                         
          Difference in Estimated
       
          Fair Value and Adjusted
       
          Cost Basis Included In
       
          Accumulated Other
       
    Estimated
    Comprehensive Income
       
    Fair Value of
    Unrealized
    Book Value
 
    Subordinate MBS     Gain (Loss)     per Share  
 
Newly adopted methodology
  $ 145,746     $ 340     $ 7.59  
Previous methodology
    138,610       (6,796 )     6.73  
                         
Impact of change
  $ 7,136     $ 7,136     $ 0.86  
                         
 
Amortization of Purchase Discounts on Mortgage Securities
 
Purchase discounts on mortgage securities are recognized in earnings as adjustments to interest income (accretable yield) using the effective yield method over the estimated lives of the related securities as prescribed under the Emerging Issues Task Force of the Financial Accounting Standards Board 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20). Estimates and judgments related to future levels of mortgage prepayments, mortgage default assumption rates and timing and amount of credit losses are critical to this determination. Mortgage prepayment expectations, default rate assumptions, and timing and amount of credit losses can vary considerably from period to period based on current and projected changes in interest rates and other factors such as portfolio composition. Management estimates mortgage prepayments, defaults and credit losses based on past experiences with specific investments within the portfolio and current market expectations for changes in the interest rate environment. Management’s estimates could vary widely from that ultimately experienced and, such variances could be material.
 
Change in Accounting Estimate for Capitalized Software Costs
 
As of January 1, 2006, we increased the remaining estimated useful life of our capitalized software costs, as the underlying software components and modules are expected to have a useful life in excess of the original estimation. The net balance as of December 31, 2005 was originally estimated to be substantially amortized


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by the end of 2007 and that net balance will now be amortized over a three year period beginning on January 1, 2006. This change in estimate resulted in reducing amortization expense and increasing the Company’s net income by approximately $294,000 and increasing diluted earnings per share by $0.04 for the year ended December 31, 2006.
 
Real Estate Owned
 
We record our Real Estate Owned, “REO”, at the lower of cost or estimated fair value, less anticipated costs to sell. The estimated fair value is determined through real estate appraisals, broker pricing and home inspections, which are updated on a periodic basis. For the year ended December 31, 2006, we have recorded approximately $1.2 million of impairment expense related to REO based upon these estimated fair values.
 
Goodwill Analysis for HT
 
During the second quarter of 2006, we performed an assessment of the goodwill balance assigned to HT for potential impairment. We determined HT had a fair value in excess of its book value as of June 30, 2006 and, therefore, the goodwill was not impaired. The fair value determination was performed using an income approach based upon the discounted cashflow method. The projected cashflows were estimated by tax-effecting forecasted revenue and expenses for several future periods. These projections include estimated revenue from our existing customers and additional revenue from new customers.
 
Subsequent to our valuation performed as of June 30, 2006, we received notices from three customers terminating the services they receive from us. As part of the valuation analysis, we anticipated all of these customers to continue to receive services from us for several years into the future and one of these customers represented a significant portion of the projected revenue.
 
As a result of these terminations, we decided to re-perform the assessment of the goodwill balance for potential impairment using updated forecasted revenues and expenses. The assessment indicated that the HT reporting unit had a fair value below its book value. In accordance with the second step of the assessment, we determined the fair value of the identifiable assets of the HT reporting unit and calculated the goodwill balance as the excess of the fair value of the entire reporting unit over the fair value of the identifiable assets of the reporting unit. The goodwill was fully impaired resulting in an impairment expense of $2.5 million.
 
Same Party Transactions
 
The accounting profession has recently raised an issue concerning the current industry practice for recording a purchase of mortgage-backed securities from a counterparty with a subsequent financing of the security through a repurchase agreement with the same counterparty “Same Party Transactions”. The majority of our financings of our Agency MBS and Subordinate MBS portfolios was transacted through Same Party Transactions and recorded following current industry practice and accepted accounting guidelines. We recorded the purchase of these securities as an asset, and recorded the subsequent financing as a liability on our consolidated balance sheet. In addition, the corresponding interest income earned on these securities and interest expense incurred on the related repurchase agreements are reported gross on our consolidated statements of income.
 
The issue surrounds a technical interpretation of the provisions of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, which states that Same Party Transactions may not qualify as a purchase by us because the mortgage-backed securities we purchased in Same Party Transactions may not be determined to be legally isolated from the counterparty in such transactions. If the isolation requirement is not met in connection with Same Party Transactions, we would be required to record the transaction on a net basis, recording only an asset equal to the amount of the security, net of the related financing. In addition, we would also record the corresponding interest income and interest expense on a net basis. As the transaction would not qualify as a purchase, the resulting asset would be considered, and classified as, a freestanding derivative, with the corresponding change in the fair value of such derivative in the income statement. The value of the derivative created by this type of transaction would reflect the value of the underlying security and the value of the underlying financing provided by the counterparty.


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While the FASB has identified this issue as a current project, a resolution, specific guidance, or a change in the accounting standards for Same Party Transactions has not been provided. As such, we have not performed a complete assessment of the impact on our financial position, results of operations or cash flows. As of December 31, 2006, the carrying value of our Agency and Subordinate MBS portfolios subject to Same Party Transactions totaled approximately $240,429,000, or 90.40%, of the carrying value of our total Agency and Subordinate MBS portfolios. The corresponding amounts borrowed under repurchase agreements were approximately $184,929,000.
 
Financial Condition
 
The most significant changes in our balance sheet as of December 31, 2006, compared to December 31, 2005, are reflected in the net increase of our investment portfolio and changes in related accounts including the decrease in our cash balances. The tables below present the primary assets of our investment portfolio, net of related financing, as of December 31, 2006 and December 31, 2005 (dollars in thousands):
 
                                 
    Principal
    Carrying
             
December 31, 2006
  Balance     Value     Financing     Net Equity  
 
Mortgage Loans:
                               
Held for sale
  $     $     $     $  
Collateral for CMOs
    10,149       9,736       8,082       1,654  
                                 
      10,149       9,736       8,082       1,654  
Subordinate MBS:
                               
Available for sale
    230,751       154,599       89,959       64,640  
Agency MBS:
                               
Trading
    106,479       105,104       102,590       2,514  
Held to maturity
    5,845       6,254             6,254  
                                 
      112,324       111,358       102,590       8,768  
                                 
Total
  $ 353,224     $ 275,693     $ 200,631     $ 75,062  
                                 
 
                                 
    Principal
    Carrying
             
December 31, 2005
  Balance     Value     Financing     Net Equity  
 
Mortgage Loans:
                               
Held for sale
  $ 10,190     $ 10,061     $ 3,474     $ 6,587  
Collateral for CMOs
    14,537       14,074       12,201       1,873  
                                 
      24,727       24,135       15,675       8,460  
Subordinate MBS:
                               
Available for sale
    174,737       106,967       69,644       37,323  
Agency MBS:
                               
Trading
    83,505       82,487       80,387       2,100  
Held to maturity
    7,460       8,034             8,034  
                                 
      90,965       90,521       80,387       10,134  
                                 
Total
  $ 290,429     $ 221,623     $ 165,706     $ 55,917  
                                 
 
During the second quarter of 2006, all of our mortgage loans that were not collateral for CMOs were either sold or the outstanding principal was paid in full. Although we have a facility for $200 million of financing for mortgage loans, the current interest rate environment has significantly reduced the potential interest income we can earn on these loans in excess of the interest expense incurred on the financing. When the interest rate environment improves, we may invest in this portfolio type. As this portfolio type meets certain compliance


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needs related to exemption under the 40 Act, investment in this portfolio type will allow us to reduce our investments in the Agency MBS Portfolio.
 
Our Subordinate MBS portfolio has increased in principal balance by $56.0 million and our equity increased by $27.3 million as we continue our strategy to increase and optimize our investment in this primary category of our investment portfolio. In addition, this balance partially increased due to the change in estimate of determining the fair value of these investments.
 
The Agency MBS classified as trading is held primarily to meet certain compliance needs related to exemption under the 40 Act and has increased due to increases in compliance needs. The Agency MBS classified as held to maturity continues to be held without financing and qualifies for our internal liquidity reserve while earning better than short term money rates.
 
Our book value per common share as of December 31, 2006 was $6.99 compared to $7.00 as of December 31, 2005. The decrease in book value for the year ended December 31, 2006 is primarily attributable to our net loss of $2.9 million and dividends declared of $5.8 million, partially offset by other comprehensive income of $8.3 million.


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Results of Operations
 
Hanover — The REIT
 
Comparison of 2006 to 2005 Total Revenues
 
Revenues by Portfolio Type
(dollars in thousands)
 
                         
    Years Ended
    2006
 
    December 31,     Favorable
 
    2006     2005     (Unfavorable)  
 
Mortgage Loans including CMO Collateral
                       
Interest income
  $ 1,048     $ 2,179     $ (1,131 )
Interest expense
    (722 )     (1,640 )     918  
                         
Net interest income
    326       539       (213 )
Gains (losses) on sale
    94       377       (283 )
Loan loss reserve
          (26 )     26  
Mark to market
    15       (201 )     216  
                         
Total
    435       689       (254 )
Subordinate MBS
                       
Interest income
    16,847       8,471       8,376  
Interest expense
    (5,365 )     (2,184 )     (3,181 )
                         
Net interest income
    11,482       6,287       5,195  
Gains (losses) on sale
    849       4,138       (3,289 )
Mark to market
    (389 )     (562 )     173  
Other
          33       (33 )
                         
Total
    11,942       9,896       2,046  
Agency MBS
                       
Interest income
    5,020       4,908       112  
Interest expense
    (4,202 )     (2,774 )     (1,428 )
                         
Net interest income
    818       2,134       (1,316 )
Gains (losses) on sale
    (109 )           (109 )
Mark to market
    1,714       (2,300 )     4,014  
Freestanding derivatives
    (2,214 )     234       (2,448 )
                         
Total
    209       68       141  
Other
                       
Interest income
    2,179       1,358       821  
Interest expense
    (3,653 )     (1,685 )     (1,968 )
                         
Net interest income
    (1,474 )     (327 )     (1,147 )
Mark to market
    (1,192 )     348       (1,540 )
Freestanding derivatives
    (130 )     (54 )     (76 )
Other
    (57 )     111       (168 )
                         
Total
    (2,853 )     78       (2,931 )
                         
Total
  $ 9,733     $ 10,731     $ (998 )
                         


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Net interest income from our Mortgage Loan portfolio decreased for the year ended December 31, 2006 compared to the same period of 2005 primarily due to a decrease in the level of collateral for CMOs and related financing in 2006 and the sale of mortgage loans classified as held for sale during April of 2006.
 
For our Subordinate MBS portfolio, interest income increased for the year ended December 31, 2006 compared to the same period of 2005 due to the significant increase in the size of this portfolio and, to a lesser extent, increases in the interest rate for adjustable rate securities. For this same portfolio and related periods, interest expense increased as we increased financings to correspond with the increase in the portfolio and because the one-month LIBOR rate, the basis for all of the financings, has increased consistently through 2005 and 2006. We had gains on sales of securities of $0.8 million for the year ended December 31, 2006 compared to $4.1 million for the same period of 2005. This decrease in gains is the result of our long-term strategy shift that began in the middle of 2005, to focus on net interest income rather than gains on sale of securities. We sold 15 and 19 securities during the second and third quarter of 2006, respectively, as part of a minor portfolio reorganization and anticipation of potential credit issues. These sales do not modify our intent to reduce our reliance on gains.
 
Generally, our Agency MBS classified as trading are financed via repurchase agreements and are hedged through forward sales of similar securities. The net revenue generated from this portfolio is heavily dependent upon changes in the short-term and long-term interest rates and the spread between these two rates. The net change in the performance of this portfolio is due to the timing of differences arising from the changes in the interest rates and minor differences between the principal amount of the securities and the notional amount of the hedging activity. In addition, the 2006 net revenue is positively impacted by the interest income generated from Agency MBS classified as held to maturity, which were not hedged through forward sales and were not financed for the majority of 2006, as these securities were not acquired until the fourth quarter of 2005.
 
Other interest income is primarily interest earned on the note receivable from HCP-2 which increased for the year ended December 31, 2006 compared to the same period of 2005 as the prime rate, the basis for the note, has increased throughout 2005 and 2006 and the outstanding amount of the note increased during 2005 into 2006. Although this note and related interest income and expense are eliminated in consolidation, the interest income is a component of the REIT’s taxable income distributable to shareholders. Other interest expense is primarily interest incurred on the subordinated debt issued to our subsidiary trusts, HST-I and HST-II. This debt was issued in March and November of 2005, respectively, and therefore, a lesser amount of interest expense was incurred for the year ended December 31, 2005.
 
Other mark to market for the year ended December 31, 2006 represents a write-down of REO carried in HDMF-I and included in other assets. The local economy for a portion of these properties has had a significant downturn, which has depressed the value of these properties. We are actively trying to sell these properties through local real estate brokers with incentive commissions. However, a large number of other properties are listed for sale in the same geographic area, which has hampered our ability to sell these properties. At December 31, 2006, we have nineteen remaining properties to be sold with a total carrying value of approximately $788,000.
 
Other freestanding derivatives represents the mark to market of our interest rate caps used to hedge the financing costs of our portfolio. The expense from the change in the market value of these derivatives increased for the year ended December 31, 2006 compared to the same period in 2005. These reductions in market value are due to the passage of time and one-month LIBOR remaining substantially at or below the strike rate of the interest rate caps.


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Comparison of 2005 to 2004 Total Revenues
 
Revenues by Portfolio Type
(dollars in thousands)
 
                         
    Years Ended
    2005
 
    December 31,     Favorable
 
    2005     2004     (Unfavorable)  
 
Mortgage Loans including CMO Collateral
                       
Interest income
  $ 2,179     $ 3,093     $ (914 )
Interest expense
    (1,640 )     (2,260 )     620  
                         
Net interest income
    539       833       (294 )
Gains (losses) on sale
    377       38       339  
Loan loss reserve
    (26 )     (36 )     10  
Mark to market
    (201 )     18       (219 )
Other
          46       (46 )
                         
Total
    689       899       (210 )
Subordinate MBS
                       
Interest income
    8,471       7,386       1,085  
Interest expense
    (2,184 )     (887 )     (1,297 )
                         
Net interest income
    6,287       6,499       (212 )
Gains (losses) on sale
    4,138       10,362       (6,224 )
Mark to market
    (562 )     (1,125 )     563  
Other
    33             33  
                         
Total
    9,896       15,736       (5,840 )
Agency MBS
                       
Interest income
    4,908       3,569       1,339  
Interest expense
    (2,774 )     (1,124 )     (1,650 )
                         
Net interest income
    2,134       2,445       (311 )
Mark to market
    (2,300 )     1,344       (3,644 )
Freestanding derivatives
    234       (4,047 )     4,281  
                         
Total
    68       (258 )     326  
Other
                       
Interest income
    1,358       542       816  
Interest expense
    (1,685 )           (1,685 )
                         
Net interest income
    (327 )     542       (869 )
Mark to market
    348             348  
Freestanding derivatives
    (54 )     (342 )     288  
Other
    111       16       95  
                         
Total
    78       216       (138 )
                         
Total
  $ 10,731     $ 16,593     $ (5,862 )
                         
 
The REIT’s total revenues declined to $10.7 million for the year ended December 31, 2005 from $16.6 million for the year ended December 31, 2004. The decline of $5.9 million is primarily due to a decrease of $5.8 million in revenue on our Subordinate MBS.


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The Mortgage Loans portfolio is comprised of mortgage loans we own that are either funded via term CMO debt or a one-year committed financing facility. In June 2005, we exercised our call rights and retired our 1999-A CMO and retained the underlying mortgage loan collateral. A portion of the 1999-A related mortgage loans are financed on a one year committed financing facility and a portion of the remainder of the portfolio is financed via a CMO borrowing: Hanover 1999-B.
 
Total revenues for the Mortgage Loans portfolio decreased $0.2 million to $0.7 million for the year ended December 31, 2005 from $0.9 million for the year ended December 31, 2004. The decline in revenue is the result of a reduction of $0.3 million in net interest income due to the declining principal balance of the portfolio combined with increased financing costs associated with the rise in the one-month LIBOR rate during 2005. Both the 1999-B CMO debt and the facility used to finance the mortgage loans we retained from the call and retirement of our 1999-A CMO are indexed to one-month LIBOR. The $0.3 million decline in net interest income was partially offset by a gain of $0.2 million realized resulting from the call and retirement of our 1999-A CMO and subsequent Fannie Mae MBS securitization of a portion of the retained 1999-A mortgage loans.
 
The Subordinate MBS portfolio consists primarily of non-investment grade securities collateralized by prime residential mortgage loans. Total revenues for the Subordinate MBS portfolio declined $5.8 million in 2005 to $9.9 million from $15.7 million in 2004. The decline is principally due to a $6.2 million decrease in gain of sales of securities from 2005 to 2004 that was partially offset by a reduction of $0.6 million in impairment expense for the comparable period. Net interest income also declined $0.2 million for the year ended December 31, 2005, as compared to the year ended December 31, 2004.
 
The decline in the gain on sale revenue is the result of narrowing between the average cost basis and market value of our Subordinate MBS portfolio as well as lower sales volume in 2005 compared to 2004. The narrowing is due to a combination of factors, most importantly a rise in short term interest rates and a decrease in prepayment rates. In 2005 we sold 98 securities having a total principal balance of $87.5 million compared to 149 securities with a total principal balance of $119.6 million in 2004. The reduction in impairment expense is due to sales of bonds with unfavorable credit characteristics.
 
The $0.2 million decline in net interest income on our Subordinate MBS portfolio is due to a marginally greater increase in interest expense than interest income. For the year ended December 31, 2005, interest income totaled $8.5 million as compared to $7.4 million for the year ended December 31, 2004. Interest expense for the year ended December 31, 2005 totaled $2.2 million as compared to $0.9 million for the year ended December 31, 2004. The overall increase in both interest income and expense from 2004 to 2005 is the result of an increase in asset size of the Subordinate MBS portfolio. The proportionally greater increase in interest expense compared to interest income is to due to a greater rise in the short term interest rates of our financings relative to the longer term asset yields on our Subordinate MBS holdings. This mismatch is primarily due to the “flattening” of the yield curve as short term interest rates increased more than long term interest rates during 2005.
 
The Agency MBS portfolio includes whole pool Fannie Mae or Freddie Mac issued mortgage-backed securities that are held primarily as qualifying assets for purposes of satisfying certain exemptive provisions of the 40 Act. With the exception of the Fannie Mae MBS securities collateralized by 1999-A CMO loans, which total $8.0 million of the $90.5 million asset value of the Agency MBS portfolio, the Agency MBS portfolio is hedged with forward sales of like-characteristic Agency MBS securities. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency MBS that are substantially economically offset by gains or losses from forward sales of like-characteristic Agency MBS securities.
 
For the year ended December 31, 2005, total revenue for the Agency MBS portfolio was $0.1 million as compared to a loss of $0.3 million for the year ended December 31, 2004. The increase is principally the consequence of not financing certain securities during portions of 2005 due to excess liquidity as the result of the trust preferred stock issuance.


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Other interest income consists largely of earnings on our cash and cash equivalents and loans to subsidiaries that are eliminated in consolidation, interest expense related to our trust preferred stock issuance and the mark to market of our interest rate caps. For the year ended December 31, 2005, other interest income was $0.1 million as compared to $0.2 million for the year ended December 31, 2004. The decline is the result of a $0.9 million reduction in net interest income that is primarily related to the issuance of trust preferred stock. This net interest decrease was partially offset by a reduction of $0.3 million in realized losses on our interest rate caps. Our interest rate caps are used to manage the interest rate risk on our financings and are classified as freestanding derivatives.
 
HT
 
For the year ended December 31, 2006, HT’s operating loss increased by $1.4 million from the same period in 2005. This increase is due to a goodwill impairment charge of $2.5 million and a decline in the LSA operation, partially offset by improvement in the technology operation.
 
As a result of three customers terminating the services they receive from HT during the latter part of 2006, we decided to perform an assessment of the goodwill balance for potential impairment using updated forecasted revenues and expenses as of December 31, 2006. The assessment indicated that the HT reporting unit had a fair value below its book value. In accordance with the second step of the assessment, we determined the fair value of the identifiable assets of the HT reporting unit and calculated the goodwill balance as the excess of the fair value of the entire reporting unit over the fair value of the identifiable assets of the reporting unit. The goodwill was fully impaired resulting in an impairment expense of $2.5 million.
 
Revenue for the LSA operation for the year ended December 31, 2006 was significantly lower than the comparable periods of 2005 due to the reduction in loan sale advisory opportunities in the whole loan secondary market resulting from the flattening of the yield curve and the reduction in mortgage originations. This decrease in revenue was partially offset by reduced headcount and a restructuring of the salary and commission structure for certain sales personnel. As a result of the declining sales opportunities and the departure of certain personnel, we suspended the LSA operation as of May 31, 2006. The remaining personnel and their related costs, which represents substantially all of the remaining costs of the LSA operation, have been reassigned to the REIT.
 
On December 29, 2006, HT sold certain assets and trade name of its Servicing Source division, including the financial management of mortgage services rights, to the Sextant Group, Inc., which also assumed certain liabilities related to these assets. The Sextant Group, Inc. will also maintain and support certain software license and servicing agreements retained by HT.
 
Although the technology revenue decreased by $0.2 million for the year ended December 31, 2006 compared to the same period in 2005, personnel costs, technology, and amortization costs decreased by a greater amount for the same comparable periods. The personnel costs decreased due to reductions in headcount that occurred during the fourth quarter of 2005 and the first quarter of 2006. Technology costs decreased due to customization costs incurred in connection with the implementation of a technology solution for a new customer in June 2005 and other various smaller projects for existing customers in 2005 that did not occur in 2006. The amortization costs decreased as several components of the capitalized software have reached the end of their estimated useful life and the estimated useful life for other components has been extended.
 
Revenue for the year ended December 31, 2005 decreased from the prior period primarily because of lower loan sale advisory services. These services decreased as the number of customer accounts decreased due to mergers and consolidations in the marketplace. In addition, there has been a continuing reduction in loan sale advisory opportunities put forth by the Federal Deposit Insurance Corporation and other agencies which historically over past years have made up a significant portion of the loan sale advisory revenue. These decreases were partially offset by increases in technology revenue, resulting from new implementations and deployments and related professional services. Operating income decreased over the same periods due to a higher cost structure associated with the technology revenue. In addition, loan sale advisory personnel costs did not decrease at the same rate as the decrease in revenue.


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Operating Expenses
 
The following table details operating expenses for the Company on a consolidated basis (dollars in thousands):
 
                                                 
    Years Ended December 31,     Years Ended December 31,  
                Increase/
                Increase/
 
    2006     2005     (Decrease)     2005     2004     (Decrease)  
 
Personnel
  $ 4,239     $ 6,428     $ (2,189 )   $ 6,428     $ 7,355     $ (927 )
Legal and professional
    2,777       2,810       (33 )     2,810       2,904       (94 )
General and administrative
    1,183       1,259       (76 )     1,259       1,211       48  
Depreciation and amortization
    708       1,220       (512 )     1,220       912       308  
Occupancy
    315       347       (32 )     347       283       64  
Technology
    1,109       1,575       (466 )     1,575       820       755  
Goodwill impairment
    2,478             2,478                    
Other
    1,104       1,369       (265 )     1,369       1,018       351  
                                                 
Total expenses
  $ 13,913     $ 15,008     $ (1,095 )   $ 15,008     $ 14,503     $ 505  
                                                 
 
Operating expenses for the year ended December 31, 2006 decreased by $1.1 million from the same period in 2005. The major changes within operating expenses were in personnel, depreciation and amortization, technology and goodwill impairment.
 
  •  Personnel costs decreased $2.2 million due to compensation expense recorded in June 2005 for two of the Company’s executive officers pursuant to a 1997 contribution agreement that was not incurred during 2006 and the reduction in headcount in the HT operation during the fourth quarter of 2005 and the first quarter of 2006.
 
  •  The decrease in depreciation and amortization is due to a reduction in the amortization of capitalized software costs, as several components of the capitalized software have reached the end of their estimated useful life and the estimated useful life for other components has been extended.
 
  •  Technology costs decreased due to customization costs incurred in connection with the implementation of a technology solution for a new customer in June 2005 and other various smaller projects for existing customers and minor modifications to the software technology in 2005 that did not occur in 2006.
 
  •  The goodwill impairment expense incurred for the year ended 2006 represents complete impairment of the goodwill balance associated with the HT business. There were no impairments recorded during the prior periods.
 
The increase in operating expenses for the year ended December 31, 2005, compared to the same period in 2004, is primarily due to the following:
 
  •  an increase in technology costs in connection with the implementation of additional technology solutions;
 
  •  an increase in insurance premiums arising from additional and more effective coverage and overall increases in the marketplace;
 
  •  an increase in amortization expense arising from additional capitalized software amortization and the amortization of deferred financing costs of HST-I and HST-II;
 
  •  inclusion of the financing costs of the line of credit of HDMF-I in the consolidated results of operations for the last six months of 2005.
 
These increases are partially offset by a decrease in personnel costs primarily from a reduction in bonuses and an executive that terminated employment with the Company in the middle of 2005.


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Equity in Income (Loss) of Unconsolidated Affiliates
 
HDMF-I is a limited liability company whose objective is to purchase, service and manage pools of primarily sub-and non-performing one-to-four family residential whole loans. In June 2005, through a series of transactions, the Company increased its ownership in HDMF-I. The Company’s consolidated financial statements include the results of operation of HDMF-I from the date of acquisition.
 
For the year ended December 31, 2005, we recognized $(0.2) million in equity in (loss) income of HDMF-I, as compared to $0.4 million in 2004. This decrease was primarily attributable to a reduction in the size of the portfolio of distressed mortgage loans.
 
Discontinued Operations
 
Income (loss) from discontinued operations includes the results of operations of the HCP business that was sold in January of 2007.
 
Income (loss) decreased by $2.2 million for the year ended December 31, 2006 from the same period in 2005 primarily due to decreases in revenue from HCP’s largest customer and a negative shift in product mix. Unfavorable market conditions have resulted in reduced mortgage loan acquisitions for HCP’s largest customer, thereby resulting in reduced due diligence services performed by HCP. In addition, operating costs increased as HCP increased its headcount and occupancy structure during the latter half of 2005 to ensure available resources for anticipated revenue growth during 2006 and thereafter that failed to occur.
 
Income (loss) increased by $1.0 million for the year ended December 31, 2005 from the same period in 2004 primarily due to increased revenue from due diligence reviews for HCP’s largest customer. HCP successfully focused on expanding the business relationship with this customer during 2005 through customer attention, long-term servicing discussions, and minor pricing considerations. In addition, HCP expanded its on-site loan processing operations, allowing a greater volume of activity at a lower cost.


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Additional Analysis of REIT Investment Portfolio
 
Investment Portfolio Assets and Related Liabilities
 
The following table reflects the average balances for each major category of our investment portfolio as well as associated liabilities with the corresponding effective yields and rates of interest (dollars in thousands):
 
                                                 
    Years Ended December 31,  
    2006     2005     2004  
    Average
    Effective
    Average
    Effective
    Average
    Effective
 
    Balance     Rate     Balance     Rate     Balance     Rate  
 
Investment portfolio assets:
                                               
Mortgage Loans
                                               
Held for sale
  $ 2,866       7.85 %   $ 11,301       5.53 %   $ 259       7.74 %
Collateral for CMO (1)
    12,286       6.70 %     26,104       5.86 %     49,567       6.14 %
Agency MBS
    89,516       5.61 %     97,103       5.06 %     71,984       4.95 %
Subordinate MBS
    136,443       12.35 %     74,256       11.41 %     58,072       12.72 %
Other subordinate security
    2,728       13.34 %     542       15.51 %           0.00 %
                                                 
      243,839       9.55 %     209,306       7.44 %     179,882       7.79 %
                                                 
Investment portfolio liabilities:
                                               
CMO borrowing (1)
    9,515       6.50 %     21,691       5.59 %     42,808       5.18 %
Repurchase Agreements on:
                                               
Mortgage Loans held for sale
    795       6.67 %     6,569       5.72 %           0.00 %
Collateral for CMO
    736       6.93 %     1,037       5.00 %     1,340       3.21 %
Agency MBS
    80,678       5.21 %     84,613       3.28 %     69,669       1.61 %
Subordinate MBS
    84,048       6.38 %     45,089       4.84 %     28,136       3.15 %
                                                 
      175,772       5.85 %     158,999       4.11 %     141,953       3.01 %
                                                 
Net investment portfolio assets
  $ 68,067             $ 50,307             $ 37,929          
                                                 
Net interest spread
            3.70 %             3.33 %             4.78 %
                                                 
Yield on net portfolio assets (2) (3)
            19.08 %             17.94 %             25.70 %
                                                 
Ratio of portfolio liabilities to net investment
            258 %             316 %             374 %
                                                 
 
 
(1) Loan loss provisions are included in such calculations.
 
(2) Yield on net portfolio assets is computed by dividing the applicable net interest income (after loan loss provision, with respect to CMOs only) by the average daily balance of net portfolio assets.
 
(3) The yields on net portfolio assets do not include the hedging cost on the Agency MBS portfolio.
 
The yield on net portfolio assets increased to 19.08% for the year ended December 31, 2006 from 17.94% for the year ended December 31, 2005. This increase in yield is the result of additional investment in our Subordinate MBS portfolio, which is the highest yielding asset. This increase is partially offset by an increase in the one-month LIBOR, which is the basis for substantially all of our financing.
 
The yield on net portfolio assets decreased to 17.94% for the year ended December 31, 2005 from 25.7% for the year ended December 31, 2004. The decrease in the yield on net portfolio assets is primarily the result of the decrease in leverage in 2005 as compared to the leverage in 2004.
 
Average net investment portfolio assets increased to $68.1 million for the year ended December 31, 2006 from $50.3 million for the year ended December 31, 2005 and $37.9 million for the year ended December 31, 2004. This increase is primarily due to the deployment of proceeds raised in 2005 in connection with the issuance of


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trust preferred securities, which was primarily invested in Subordinate MBS and Agency MBS. These proceeds were invested throughout 2005 and the first quarter of 2006. These proceeds were fully vested by March 31, 2006.
 
Mortgage Loans
 
The following table provides details of the net interest income generated on our Mortgage Loan portfolio (dollars in thousands):
 
                         
    Years Ended December 31,  
    2006     2005     2004  
 
Average asset balance
  $ 15,152     $ 37,405     $ 49,567  
Average CMO borrowing balance
    9,515       21,691       42,808  
Average balance — Repurchase Agreements
    1,531       7,606       1,340  
                         
Net investment
    4,106       8,108       5,419  
Average leverage ratio
    72.90 %     78.32 %     89.07 %
Effective interest income rate
    6.92 %     5.83 %     6.21 %
Effective interest expense rate — CMO borrowing
    6.50 %     5.59 %     5.18 %
Effective interest expense rate — Repurchase Agreements
    6.79 %     5.62 %     3.21 %
                         
Net interest spread
    0.38 %     0.23 %     1.09 %
Interest income
  $ 1,048     $ 2,179     $ 3,079  
Interest expense — CMO borrowing
    618       1,212       2,218  
Interest expense — Repurchase Agreements
    104       428       43  
                         
Net interest income
  $ 326     $ 539     $ 818  
                         
Yield
    7.94 %     6.65 %     15.10 %
                         
 
Our Mortgage Loan portfolio net interest income declined each of the two years ended December 31, 2006. This decline in net interest income is due to the declining principal balance of our Mortgage Loan portfolio due to scheduled and unscheduled principal payments which reduced the mortgage loan balance and the rise in the interest expense related to one-month LIBOR. In 2005, the decline increased when we called and retired our 1999-A CMO and purchased the underlying loans, of which a significant portion were in turn securitized in Fannie Mae issues. In April of 2006, we sold all remaining mortgage loans that we purchased from the call and retirement of our 1999-A CMO.


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Subordinate MBS
 
The following table provides details of the net interest income generated on our Subordinate MBS portfolio (dollars in thousands):
 
                         
    Years Ended December 31,  
    2006     2005     2004  
 
Average asset balance
  $ 136,443     $ 74,256     $ 58,072  
Average balance — Repurchase Agreements
    84,048       45,089       28,136  
                         
Net investment
    52,395       29,167       29,936  
Average leverage ratio
    61.60 %     60.72 %     48.45 %
Effective interest income rate
    12.35 %     11.41 %     12.72 %
Effective interest expense rate — Repurchase Agreements
    6.38 %     4.84 %     3.15 %
                         
Net interest spread
    5.97 %     6.57 %     9.57 %
Interest income
  $ 16,847     $ 8,471     $ 7,386  
Interest expense — Repurchase Agreements
    5,365       2,184       887  
                         
Net interest income
  $ 11,482     $ 6,287     $ 6,499  
                         
Yield
    21.91 %     21.56 %     21.71 %
                         
 
The Subordinate MBS portfolio’s net interest income increased to $11.5 million for the year ended December 31, 2006 from $6.3 million for the year ended December 31, 2005 due to the significant increase in investment in this portfolio during the latter part of 2005 and 2006.
 
The Subordinate MBS portfolio’s net interest spread decreased to 5.97% for the year ended December 31, 2006 from 6.57% for the year ended December 31, 2005 due to an increase in the effective interest expense rate, partially offset by an increase in the effective interest income rate. The increase in the effective interest expense rate is due to increases in one-month LIBOR throughout 2005 and 2006. The increase in the interest income rate is due to purchase of securities in the latter part of 2005 and 2006 with effective interest rates higher than our existing securities, as overall interest rates have increased.
 
The Subordinate MBS portfolio’s net interest income decreased to $6.3 million for the year ended December 31, 2005 from $6.5 million for the year ended December 31, 2004. This decrease in revenues was attributable to the decline in the average net interest earning assets to $29.2 million for the year ended December 31, 2005 from $29.9 million for the year ended December 31, 2004.
 
The Subordinate MBS portfolio’s net interest spread decreased to 6.57% for the year ended December 31, 2005 from 9.57% for the year ended December 31, 2004. The reduction in the net interest spread was due to a decline in the effective interest income rate to 11.41% for the year ended December 31, 2005 from 12.72% for the year ended December 31, 2004 and an increase in the effective interest expense rate to 4.84% for the year ended December 31, 2005 from 3.15% for the year ended December 31, 2004. The decrease in the effective interest income rate was due to a combination of a shift in the Subordinate MBS portfolio to higher-rated securities coupled with an increase in adjustable rate securities relative to fixed rate securities. The increase in the effective interest expense rate is due to increases in the rate of one-month LIBOR offset partially by lower financing rates due to a shift to higher-rated securities.


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Agency MBS
 
The following table provides details of the net interest income generated on the Agency MBS portfolio (dollars in thousands):
 
                         
    Years Ended December 31,  
    2006     2005     2004  
 
Average asset balance
  $ 89,516     $ 97,103     $ 71,984  
Average balance — Repurchase Agreements
    80,678       84,613       69,669  
                         
Net investment
    8,838       12,490       2,315  
Average leverage ratio
    90.13 %     87.14 %     96.78 %
Effective interest income rate
    5.61 %     5.06 %     4.95 %
Effective interest expense rate — Repurchase Agreements
    5.21 %     3.28 %     1.61 %
                         
Net interest spread
    0.40 %     1.78 %     3.34 %
Interest income
  $ 5,020     $ 4,908     $ 3,569  
Interest expense — Repurchase Agreements
    4,202       2,774       1,124  
                         
Net interest income
  $ 818     $ 2,134     $ 2,445  
                         
Yield
    9.26 %     17.09 %     105.62 %
                         
 
The Agency MBS portfolio’s net interest income decreased to $0.8 million for the year ended December 31, 2006 from $2.1 million for the year ended December 31, 2005. In addition, the Agency MBS portfolio’s net interest spread decreased to 0.40% for the year ended December 31, 2006 from 1.78% for the year ended December 31, 2005. Both of these decreases were due to an increase in interest expense arising from increases in one-month LIBOR throughout 2005 and 2006. These decreases are partially offset by the purchase of several securities during 2006 with effective interest income rates higher than our existing securities, as overall interest rates have increased.
 
The Agency MBS portfolio’s net interest income decreased to $2.1 million for the year ended December 31, 2005 from $2.4 million for the year ended December 31, 2004. The decrease is primarily due to the decrease in net interest spread from 3.34% during 2004 to 1.78% during 2005, partially offset by the growth of the portfolio in 2005. The decrease in the net interest spread was due to the increase in the effective interest expense rate to 3.28% for the year ended December 31, 2005 from 1.61% for the year ended December 31, 2004 that was partially offset by the increase in the effective interest income rate to 5.06% for the year ended December 31, 2005 from 4.95% for the year ended December 31, 2004. The increase in the effective interest expense rate was due to increases in the rate of one-month LIBOR.
 
We attempt to fully economically hedge our Agency MBS portfolio to potentially offset any gains or losses in our portfolio with losses or gains from our forward sales of like-kind Agency MBS. Earnings on our Agency MBS portfolio consist of net interest income and gains or losses on mark to market of the Agency MBS. However, these earnings are substantially economically offset by gains or losses from forward sales of like coupon Agency MBS.
 
The table below reflects the net economic impact of our Agency MBS portfolio for the year ended December 31, 2006 (dollars in thousands):
 
         
Net interest income
  $ 818  
Gain on mark to market of mortgage assets
    1,714  
Gains (losses) on sale
    (109 )
Other gain (forward sales)
    (2,214 )
         
Total
  $ 209  
         


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Dividends
 
We operate as a REIT and are required to pay dividends equal to at least 90% of our REIT taxable income. We intend to pay quarterly dividends and other distributions to our shareholders of all or substantially all of our taxable income in each year to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, both tax and GAAP, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant.
 
We typically announce earnings and dividends in early May, August and November following the filing of our quarterly reports on Form 10-Q for the calender quarters. A fourth quarter dividend is usually announced in December.
 
Taxable Income
 
Taxable income (loss) for the year ended December 31, 2006 was approximately $(0.5) million. Taxable income (loss) differs from net income (loss) because of timing differences (refers to the period in which elements of net income can be included in taxable income) and permanent differences (refers to an element of net income that must be included or excluded from taxable income).
 
The following table reconciles net income (loss) to estimated taxable income (loss) for the year ended December 31, 2006 (dollars in thousands):
 
         
Net income (loss) — year ended December 31, 2006
  $ (2,926 )
Add (deduct) differences:
       
Loss on mark to market of mortgage assets
    (1,336 )
Sale of mortgage securities
    (1,072 )
Mark to market of freestanding derivatives
    (994 )
Losses in subsidiaries not consolidated for tax purposes — net
    6,209  
Other
    (380 )
         
Estimated taxable loss — year ended December 31, 2006
  $ (499 )
         
 
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 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.
 
Liquidity and Capital Resources
 
Traditional cash flow analysis may not be applicable for us as we have significant cash flow variability due to our investment activities. Our primary non-discretionary cash uses are our operating costs, pay-down of CMO debt, dividend payments and interest payments on our outstanding junior subordinated notes. We expect to meet our future short-term and longer-term liquidity requirements generally from our existing working capital, cash flow provided by operations, Repurchase Agreements and other possible sources of longer-term financing. We consider our ability to generate cash to be adequate to meet operating requirements both in the short-term and the longer-term. However, as a REIT, we are required to pay dividends equal to 90% of our taxable income and therefore must depend on raising new sources of capital for growth.
 
We have exposure to market-driven liquidity events due to our use of short-term financing. If a significant decline in the market value of our investment 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. If required, these sales could be made at prices lower than the carrying value of such assets, which could result in losses. As of December 31, 2006, we had $210 million of committed repurchase lines of credit, which were not fully utilized. In addition, as of


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December 31, 2006, we had $184.8 million outstanding under uncommitted repurchase lines of credit. We may seek to establish additional committed and uncommitted lines of credit in the future.
 
Our cash and cash equivalents as of December 31, 2006 decreased by $16.5 million from December 31, 2005. We have reduced our cash and cash equivalents balance through additional investment in our Subordinate MBS portfolio. We are satisfying a portion of our internal liquidity reserve with certain Agency MBS that are not financed.
 
In June of 2006, we entered into a master repurchase agreement with an outside lending institution for up to $200 million. We will utilize this facility primarily for the purchase of prime residential whole mortgage loans. Pursuant to the terms of the agreement, we will pay interest to the lending institution, based on one-month LIBOR plus an interest rate margin, plus various facility fees. We are required to maintain $5.0 million of cash and cash equivalents on hand at all times and a minimum level of tangible net worth, as defined. In addition, we are required to meet certain monthly net income requirements, as defined.
 
We have no current commitments for any material capital expenditures. We primarily invest our available capital in our investment portfolio. We have invested a limited amount of our capital in the development of our software products, but have no future commitments to invest further in this area.
 
Off-Balance Sheet Arrangements
 
On August 28, 2006, we entered into a warehouse agreement for up to a $125 million warehousing facility, which is established and financed by a third party. The warehousing facility will enable us to acquire a diversified portfolio of mezzanine grade asset-backed securities, and certain other investments and assets in anticipation of the possible formation and issuance of a collateralized debt obligation. As of December 31, 2006, we have sold 3 securities into the warehousing facility with total sales proceeds of $4.1 million. If we do not form and issue a collateralized debt obligation within a contractual timeframe, the warehouse agreement will expire and we will be liable for any losses incurred by the counterparty in connection with closing the warehousing facility and selling these securities. The term of the warehouse agreement as of December 31, 2006, is day-to-day or closing and issuance of the collateralized debt obligation.
 
We have forward commitments to sell mortgage-backed securities. As of December 31, 2006, we had a commitment to sell $106.4 million of TBA Securities in January 2007. The excess of the futures sales price over the market value of the securities as of December 31, 2006 is approximately $649,000, which is recorded in other assets. The forward sale commitments were settled in January 2007 with offsetting purchase commitments.
 
We have interest rate caps to manage adverse changes in floating interest rates of our debt instruments. At December 31, 2006, we had two interest rate caps indexed to one-month LIBOR with a total notional amount of $60 million.
 
As of December 31, 2006, we retained the credit risk on $3.4 million of mortgage securities that we sold with recourse in a prior year. Accordingly, we are responsible for credit losses, if any, with respect to these securities.
 
Contractual Obligations
 
The following are our contractual obligations as of December 31, 2006 (dollars in thousands):
 
                                         
          Less than
    1-3
    3-5
    More than
 
Contractual Obligations
  Total     1 Year     Years     Years     5 Years  
 
Long-term debt
  $ 48,623     $     $     $     $ 48,623  
Operating leases
    1,152       301       594       257        
                                         
Total
  $ 49,775     $ 301     $ 594     $ 257     $ 48,623  
                                         
 
Long-term debt is reflected at its stated maturity date although principal pay-downs received from the related mortgage loans held as collateral for CMOs will reduce the amount of debt outstanding.


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ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
Qualitative Disclosure about Market Risk
 
Our primary investments are our Mortgage Loan, Subordinate MBS and Agency MBS portfolios. We divide market risk into the four following areas: credit, interest rate, market value and prepayment. Within each of these risk areas, we seek to maintain a risk management process to protect the Company’s assets and maintain the dividend policy.
 
Credit Risk
 
We believe the principal risk to our investment strategy is the credit performance of the domestic, residential mortgage market. The credit exposure generally represents the amount of the mortgage loan in excess of the underlying real estate value, if any, and the carrying and maintenance costs that cannot be recouped from the homeowner for severely delinquent mortgage loans and foreclosures.
 
We employ a combination of pre-purchase due diligence, ongoing surveillance, internal and third party risk analysis models and a pro-active disposition strategy to manage credit risk. This analysis includes review of the loan to value ratio of the mortgage loans and the credit rating of the homeowner. Additionally, we continually assess exogenous economic factors including housing prices and unemployment trends, on both national and regional levels.
 
Increased credit risk manifests itself through a combination of increasing mortgage loan delinquencies and decreasing housing prices. Over the past several years, the domestic residential housing market has experienced rapid and sustained housing price gains. Should housing prices decline, we believe our investments would be subject to increased risk of credit losses. Also over the past several years, mortgage loan delinquencies have been at historically low levels and a rise in delinquency rates would increase our risk of credit losses.
 
Additionally, mortgage lenders increasingly have been originating and securitizing new loan types such as interest-only, negative amortization and payment option loans. The lack of historical data on these loan types increases the uncertainty with respect to investments in these mortgages. The increased percentage of adjustable-rate, as opposed to fixed-rate, mortgage loans may have increased the credit risk profile of the residential mortgage market.
 
Historically, we experienced nominal credit losses on our investments. However, there can be no guarantee that our favorable historical experience is predictive of future credit trends or actual results.
 
Mortgage Loan Portfolio
 
We have leveraged credit risk in our Mortgage Loan portfolio as we issued CMO debt and retained the lower-rated bond classes. As with our all of our portfolios, pre-purchase due diligence and ongoing surveillance is performed. To the extent the individual mortgage loans are in a CMO, we are not able to selectively sell these mortgage loans. A loan loss allowance has been established for our Mortgage Loan portfolio and is reviewed on at least a quarterly basis.


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The following table describes the credit performance of our Mortgage Loan portfolio securitizations:
 
Mortgage Loan Portfolio Credit Performance
(dollars in thousands)

1999-B Securitization
 
                                                                 
    December 31,  
    2006     2005  
    Principal
          # of
          Principal
          # of
       
    Balance     %     Loans     %     Balance     %     Loans     %  
 
Current
  $ 9,311       91.7 %     265       82.5 %   $ 13,174       90.6 %     386       79.1 %
30-59 days delinquent
    554       5.5 %     41       12.8 %     1,024       7.1 %     72       14.8 %
60-89 days delinquent
    71       0.7 %     5       1.6 %     115       0.8 %     13       2.7 %
90+ days delinquent
    21       0.2 %     4       1.2 %     102       0.7 %     10       2.0 %
Foreclosure
    160       1.6 %     5       1.6 %     122       0.8 %     7       1.4 %
Real Estate Owned
    32       0.3 %     1       0.3 %                        
 
Losses allocated to our retained subordinate bonds for 2006 were approximately $9,000 compared to $0 for 2005. The loan loss allowance as of December 31, 2006 totaled $0.3 million.
 
Subordinate MBS Portfolio
 
We have leveraged credit risk in our Subordinate MBS portfolio through investments in the non-investment grade classes of securities, which are collateralized by high-quality jumbo residential mortgage loans. These classes are the first to be impacted by losses on the underlying mortgage loans as their par values are written down by losses before higher-rated classes. Effectively, we are the guarantor of the higher-rated bonds, to the extent of the carrying value on the Subordinate MBS portfolio. On occasion, we will purchase subordinate bonds without owning the corresponding lower-rated class(es).
 
We generally purchase the securities in our Subordinate MBS portfolio with a significant purchase discount, which has an implicit loss component. Generally, to the extent any losses incurred are less than the implicit loss in the purchase discount, the credit losses will not have a significant impact on our operating results or the carrying value of the securities. However, any credit losses could have an impact on the overall cashflow projections for the securities and reduce the overall income potential of the securities.
 
We manage credit risk through detailed investment analysis both before purchasing subordinate securities and on an ongoing basis. Before subordinate securities are purchased we analyze the collateral using both internally developed and third party analytics, review deal structures and issuance documentation, review the servicer for acceptability and verify that the bonds are modeled on a widely used valuation system. Updated loan level collateral files are received on a monthly basis and are analyzed for favorable and unfavorable credit performance and trends. Bonds that do not meet our credit criteria may be sold via an arms-length competitive bidding process.
 
Expected credit losses are established by analyzing each subordinate security and are designated as a portion of the difference between the securities par value and amortized cost. Expected credit losses, including both timing and severity, are updated on a monthly basis based upon current collateral data.


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The following table shows the credit performance of the principal balance of underlying collateral of our Subordinate MBS portfolio:
 
Subordinate MBS Portfolio Credit Performance
(dollars in thousands)
 
                                                                 
    December 31,  
    2006     2005  
    Principal
          # of
          Principal
          # of
       
    Balance     %     Loans     %     Balance     %     Loans     %  
 
Current
  $ 46,111,855       99.4 %     85,783       99.4 %   $ 35,292,095       99.5 %     71,088       99.5 %
30-59 days delinquent
    189,117       0.4 %     361       0.5 %     155,176       0.5 %     322       0.5 %
60-89 days delinquent
    36,315       0.1 %     67       0.1 %     17,323             35        
90+ days delinquent
    20,779       0.1 %     44             7,424             16        
Foreclosure
    18,208             44             6,759             15        
Real Estate Owned
    3,441             6             1,025             2        
 
We had nominal losses allocated to our Subordinate MBS portfolio for the years ended December 31, 2006 and 2005.
 
The following table describes the distribution of our Subordinate MBS portfolio by rating:
 
Subordinate MBS Portfolio Credit Ratings
(dollars in thousands)
 
                                 
    December 31,  
    2006     2005  
    Principal
    Carrying
    Principal
    Carrying
 
    Balance     Value     Balance     Value  
 
BB-rated
  $ 52,335     $ 46,626     $ 38,225     $ 32,380  
B-rated
    102,666       78,953       82,906       58,407  
Non-rated
    75,750       29,020       53,606       16,180  
                                 
Total Subordinate MBS Portfolio
  $ 230,751     $ 154,599     $ 174,737     $ 106,967  
                                 
 
Agency MBS Portfolio
 
The securities held in our Agency MBS portfolio are guaranteed by Fannie Mae or Freddie Mac. As these are United States government-sponsored entities, we deem it unnecessary to take credit reserves on these securities.
 
Interest Rate Risk (Excluding the Impact on Market Price)
 
To the extent that our investments are financed with liabilities that re-price with different frequencies or benchmark indices, we are exposed to volatility in our net interest income. In general, we protect the interest rate spread on all of our investments through two interest rate caps that are indexed to one-month LIBOR with a total notional amount of $60 million.
 
Mortgage Loan Portfolio
 
Our Mortgage Loan portfolio has one outstanding CMO, 1999-B, and a securitization, 2000-A, that is collateralized by certificates from 1999-B.
 
In the 1999-B CMO, the Mortgage Loans were match funded on a maturity basis with one-month LIBOR indexed floating rate CMO debt where we retained only the subordinate certificates. The Mortgage Loans for


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1999-B are a mixture of both fixed-rate and adjustable-rate loans with the subordinate certificates receiving the difference between the net coupon on the loans and the CMO debt coupon rate, known as spread.
 
The retained subordinate certificates from our 1999-B CMO constitute the collateral for our 2000-A CMO. The 2000-A securitization consists of two groups of certificates, one group collateralized by fixed-rate certificates and the other group collateralized by variable-rate certificates. For each group, the 2000-A bonds match the maturity of the underlying certificates but have a floating rate coupon indexed to one-month LIBOR.
 
Subordinate MBS Portfolio
 
Our Subordinate MBS portfolio is funded with Repurchase Agreements that generally re-price monthly at a rate equal to one-month LIBOR plus an interest rate margin. Therefore, to the extent that a subordinate security is not also re-pricing on a monthly basis to one-month LIBOR, there is the potential for variability in our net interest income.
 
Agency MBS Portfolio
 
Our Agency MBS trading portfolio consists of fixed-rate bonds generally financed under one-month Repurchase Agreements that re-price monthly. To protect against potential losses due to a rise in interest rates, we have entered into forward commitments to sell a similar amount of to be announced Fannie Mae and Freddie Mac Agency MBS with the same coupon interest rates as our whole pools.
 
Prepayment Risk
 
Prepayments have a direct effect on the amortization of purchase discounts/premiums and the market value of mortgage assets. In general, in a mortgage portfolio, as interest rates increase, prepayments will decline and as interest rates decrease, prepayments will increase. For our investments purchased at a discount, a decrease in prepayments will delay the accretion of the discount, which reduces the effective yield and lowers the market value of the investment. For our investments purchased at a premium, a decrease in prepayments will delay the amortization of the premium, which increases the effective yield and increases the market value of the investment.
 
Market Value Risk
 
The market values of our investments are determined by a combination of interest rates, credit performance, prepayment speeds and asset specific performance attributes, such as loan to value ratios. In general, increases in interest rates and deteriorating credit performance will cause the value of the assets to decline. Changes in the market value of assets have two specific negative effects: increased financing margin requirements and, depending on an asset’s classification, a charge to income or to accumulated other comprehensive income.
 
We manage the market value risk through management of the other market risks described above and analysis of other asset specific attributes. We selectively sell assets that do not meet our risk management guidelines and/or performance requirements. We manage the risk of increased financing margin requirements by maintaining a liquidity reserve policy that is based upon an analysis of interest rate and credit spread volatility. We maintain liquidity under our liquidity policy to enable us to meet increased margin requirements if the value of our assets decline.
 
Mortgage Loan Portfolio
 
A portion of our Mortgage Loan portfolio is term financed via CMO borrowings and, therefore, changes in the market value of that portion of the mortgage loan portfolio cannot trigger margin requirements. Mortgage Loans that are securitized in a CMO are classified as collateral for CMOs. Mortgage loans that are 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 for investment and CMO collateral are reported at amortized cost, net of allowance for loan losses, if any. Therefore, only changes in market value


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that are deemed permanent impairments would be charged to income. Determination of market value is established by third party market prices or internal projections. As of December 31, 2006, one bond from the 2000-A securitization is financed via a $0.7 million Repurchase Agreement and is subject to margin requirements. A liquidity reserve is maintained per our liquidity policy.
 
Subordinate MBS Portfolio
 
Securities in our Subordinate MBS portfolio are generally classified as available for sale and, therefore, changes in the market value are reported as a component of accumulated other comprehensive income. Any losses deemed other than temporary would be charged to income. Determination of market value is established through internally generated valuations.
 
Agency MBS Portfolio
 
Securities in our Agency MBS portfolio are generally classified as either trading or held to maturity. Changes in market value on our trading securities are included in income. Our trading securities are economically hedged with forward sales of like coupon Agency MBS and, therefore, changes in the market value of these assets will be substantially offset by similar changes in the value of the forward sold securities. Agency securities classified as held to maturity are reported at amortized cost.
 
Quantitative Disclosure about Market Risk
 
Agency MBS Portfolio
 
Our Agency MBS portfolio consists of market risk sensitive instruments classified as trading and held to maturity securities. The following tables describe the Agency MBS portfolio instruments and the forward sales used to economically hedge the trading securities in this portfolio, as of December 31, 2006 (dollars in thousands):
 
Agency MBS Portfolio Assets
 
                                         
    December 31, 2006  
                            Weighted
 
    Principal
    Carrying
    Fair
          Average
 
Security Type
  Balance     Value     Value     Coupon     Maturity  
 
Freddie Mac Gold MBS 30 Year Fixed Rate
  $ 53,880     $ 53,285     $ 53,285       5.50 %     351 months  
Freddie Mac Gold MBS 30 Year Fixed Rate
    23,907       23,643       23,643       5.50 %     349 months  
Freddie Mac Gold MBS 30 Year Fixed Rate
    12,365       12,240       12,240       5.50 %     326 months  
Fannie Mae MBS 30 Year Fixed Rate
    9,754       9,430       9,430       5.00 %     310 months  
Freddie Mac Gold MBS 30 Year Fixed Rate
    6,573       6,506       6,506       5.50 %     323 months  
Fannie Mae MBS 30 Year Fixed Rate
    2,174       2,324       2,305       8.00 %     176 months  
Fannie Mae MBS 30 Year Fixed Rate
    1,542       1,622       1,624       7.50 %     200 months  
Fannie Mae MBS 30 Year Fixed Rate
    1,441       1,559       1,542       9.00 %     139 months  
Fannie Mae MBS 15 Year Fixed Rate
    688       749       755       10.00 %     110 months  
                                         
Total
  $ 112,324     $ 111,358     $ 111,330                  
                                         


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Agency MBS Portfolio Forward Sales
 
                                         
    December 31, 2006  
          Contractual
                Weighted
 
    Principal
    Forward Sale
    Market
          Average
 
Security Type
  Balance     Amount     Value     Coupon     Maturity  
 
Freddie Mac Gold MBS 30 Year Fixed Rate
  $ 96,650     $ 96,137     $ 95,578       5.5 %     TBA Security  
Fannie Mae MBS 30 Year Fixed Rate
    9,750       9,502       9,412       5.0 %     TBA Security  
                                         
Total
  $ 106,400     $ 105,639     $ 104,990                  
                                         
 
Subordinate MBS Portfolio
 
Our Subordinate MBS portfolio consists of market risk sensitive instruments entered into for purposes other than trading purposes. We believe the principal risk to our Subordinate MBS portfolio is the credit performance of the individual securities. The following tables present the principal balance and weighted-average portfolio coupon rate as of December 31, 2006 and loss sensitivities (future projected principal balance reductions and weighted-average portfolio coupon rate under different loss scenarios). The loss scenarios are month-by-month projected loss amounts that incorporate many assumptions and, as such, actual loss amounts may vary considerably.
 
The 100% Loss Scenario represents median expected losses. In projecting future cash flows, we utilized forward rates as of December 31, 2006.
 
Subordinate MBS Portfolio (dollars in thousands):
 
         
    December 31,
 
    2006  
 
Principal Balance
  $ 230,751  
Carrying Value
    154,599  
Weighted-Average Coupon Rate
    5.39 %
 
Subordinate MBS Portfolio Loss Sensitivity (dollars in thousands):
 
                                                     
Loss
                                       
Scenario
      2007     2008     2009     2010     2011     Thereafter  
 
0%
  Total Principal Reduction   $ 1,937     $ 8,338     $ 32,331     $ 33,367     $ 28,447     $ 126,331  
    Total Losses     0       0       0       0       0       0  
    Weighted-Average Coupon Rate     5.40 %     5.45 %     5.54 %     5.78 %     6.01 %     6.15 %
50%
  Total Principal Reduction     2,669       9,924       34,459       35,091       29,237       119,371  
    Total Losses     737       2,093       2,916       2,841       2,257       6,088  
    Weighted-Average Coupon Rate     5.40 %     5.45 %     5.53 %     5.78 %     6.01 %     6.14 %
100%
  Total Principal Reduction     3,042       11,877       36,635       36,517       29,553       113,127  
    Total Losses     1,475       4,185       5,833       5,681       4,514       12,071  
    Weighted-Average Coupon Rate     5.40 %     5.45 %     5.54 %     5.78 %     6.01 %     6.15 %
150%
  Total Principal Reduction     4,134       13,799       38,245       37,753       30,045       106,775  
    Total Losses     2,212       6,277       8,750       8,521       6,770       18,847  
    Weighted-Average Coupon Rate     5.40 %     5.45 %     5.54 %     5.78 %     6.01 %     6.13 %
200%
  Total Principal Reduction     4,867       15,683       39,952       39,126       30,569       100,554  
    Total Losses     2,949       8,369       11,667       11,357       9,522       25,691  
    Weighted-Average Coupon Rate     5.40 %     5.45 %     5.54 %     5.78 %     6.00 %     6.13 %


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Mortgage Loan Portfolio — CMO
 
Our Mortgage Loan portfolio consists of market risk sensitive instruments classified as held for investment. We believe the principal risk to our Mortgage Loan portfolio is the credit performance of the individual mortgage loans. The following tables present the principal balance and weighted-average portfolio coupon rates as of December 31, 2006 and loss sensitivities (future projected principal balance reductions and weighted-average portfolio coupons under different loss scenarios). The loss scenarios are month-by-month projected loss amounts that incorporate many assumptions and, as such, actual loss amounts may vary considerably. The 100% Loss Scenario represents median expected losses. In projecting future cash flows, we utilized forward rates as of December 31, 2006.
 
Mortgage Loan Portfolio: 1999-B Assets (dollars in thousands):
 
         
    December 31,
 
    2006  
 
Principal Balance
  $ 10,149  
Carrying Value
    9,736  
Fair Value
    10,025  
Weighted-Average Coupon Rate
    6.85 %
 
Mortgage Loan Portfolio: 1999-B Assets Loss Sensitivity (dollars in thousands):
 
                                                     
Loss
                                       
Scenario
      2007     2008     2009     2010     2011     Thereafter  
 
0%
  Total Principal Reduction   $ 2,816     $ 2,096     $ 1,547     $ 1,134     $ 821     $ 1,735  
    Total Losses     0       0       0       0       0       0  
    Weighted-Average Coupon Rate     7.08 %     6.98 %     6.94 %     6.96 %     6.97 %     6.89 %
50%
  Total Principal Reduction     2,818       2,101       1,550       1,136       819       1,725  
    Total Losses     2       7       6       6       2       4  
    Weighted-Average Coupon Rate     7.08 %     6.97 %     6.94 %     6.96 %     6.97 %     6.89 %
100%
  Total Principal Reduction     2,820       2,106       1,554       1,138       817       1,714  
    Total Losses     4       14       13       12       5       8  
    Weighted-Average Coupon Rate     7.08 %     6.97 %     6.94 %     6.96 %     6.97 %     6.89 %
150%
  Total Principal Reduction     2,823       2,111       1,557       1,139       816       1,703  
    Total Losses     7       20       19       17       7       12  
    Weighted-Average Coupon Rate     7.08 %     6.97 %     6.94 %     6.96 %     6.96 %     6.89 %
200%
  Total Principal Reduction     2,825       2,117       1,560       1,141       814       1,692  
    Total Losses     9       27       26       23       10       16  
    Weighted-Average Coupon Rate     7.08 %     6.97 %     6.94 %     6.96 %     6.96 %     6.89 %
 
ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Our financial statements and related notes, together with the Reports of Independent Registered Public Accounting Firms thereon, begin on page F-1 of this Report on Form 10-K.
 
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
Not applicable.


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ITEM 9A.  CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of our disclosure controls and procedures, as such term is defined under Rule 13a-15 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
 
Management’s Report on Internal Control Over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
 
Our internal control over financial reporting includes those policies and procedures that:
 
  •  pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
 
  •  provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
 
  •  provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
 
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on our assessment and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2006.
 
The Company’s independent registered public accounting firm has audited and issued their report on management’s assessment of the Company’s internal control over financial reporting. This report appears on page F-3 of this Annual Report on Form 10-K.
 
Changes in Internal Control Over Financial Reporting
 
There have been no changes in our internal control over financial reporting that occurred during the fourth quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
ITEM 9B.  OTHER INFORMATION
 
Not applicable.


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PART III
 
ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
The information required by Item 10 is incorporated herein by reference to our definitive Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.
 
We have adopted a Code of Ethics for Principal Executive and Senior Financial Officers which applies to our principal executive officer, principal financial and accounting officers and controller or persons performing similar functions. This Code of Ethics for Principal Executive and Senior Financial Officers is publicly available on our website at www.hanovercapitalholdings.com. If we make substantive amendments to this Code of Ethics for Principal Executive and Senior Financial Officers or grant any waiver, including any implicit waiver, we intend to disclose these events on our website.
 
ITEM 11.   EXECUTIVE COMPENSATION
 
The information required by Item 11 is incorporated herein by reference to our definitive Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.
 
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
The information required by Item 12 is incorporated herein by reference to our definitive Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.
 
ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
The information required by Item 13 is incorporated herein by reference to our definitive Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.
 
ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES
 
The information required by Item 14 is incorporated herein by reference to our definitive Proxy Statement for the 2007 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year.


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PART IV
 
ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
(a) (1)   Financial Statements
See Part II, Item 8 hereof.
 
  (2)   Financial Statement Schedules
See Part II, Item 8 hereof.
 
  (3)   Exhibits
Exhibits required to be filed by Item 601 of Regulation S-K are listed in the Exhibit Index
attached hereto, which is incorporated herein by reference.


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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 16, 2007.
 
Hanover Capital Mortgage Holdings, Inc.
 
  By: 
/s/  Harold F. McElraft
Harold F. McElraft
Chief Financial Officer and Treasurer
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 16, 2007.
 
         
Signature
 
Title
 
/s/  John A. Burchett

John A. Burchett
  Chairman of the Board of Directors,
President and Chief Executive Officer
(Principal Executive Officer)
     
/s/  Irma N. Tavares

Irma N. Tavares
  Chief Operating Officer, Senior Managing Director
and a Director
     
/s/  John A. Clymer

John A. Clymer
  Director
     
/s/  Joseph J. Freeman

Joseph J. Freeman
  Director
     
/s/  Douglas L. Jacobs

Douglas L. Jacobs
  Director
     
/s/  John N. Rees

John N. Rees
  Director
     
/s/  James F. Stone

James F. Stone
  Director
     
/s/  Harold F. McElraft

Harold F. McElraft
  Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)


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EXHIBIT INDEX
 
     
Exhibit
 
Description
 
2.1(7)
  Stock Purchase Agreement dated as of July 1, 2002 by and between Registrant and John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
3.1(8)
  Amended Articles of Incorporation of Registrant, as amended
3.2(1)
  Bylaws of Registrant
4.1(1)
  Specimen Common Stock Certificate of Registrant
4.2(15)
  Amended and Restated Trust Agreement, dated as of March 15, 2005, among Registrant, as depositor, JPMorgan Chase Bank, National Association, as property trustee, Chase Bank USA, National Association, as Delaware trustee, the administrative trustees named therein and the holders from time to time of individual beneficial interests in the assets of the trust
4.3(15)
  Junior Subordinated Indenture, dated as of March 15, 2005, between JPMorgan Chase Bank, National Association, and Registrant
4.4(15)
  Form of Junior Subordinated Note Due 2035, issued March 15, 2005
4.5(15)
  Form of Preferred Security of Hanover Statutory Trust I, issued March 15, 2005
4.6(19)
  Amended and Restated Declaration of Trust, dated as of November 4, 2005, among Registrant, as depositor, Wilmington Trust Company, as Institutional trustee and Delaware trustee, the administrative trustees named therein and the holders from time to time of the individual beneficial interests in the asset of the trust
4.7(19)
  Junior Subordinated Indenture, dated as of November 4, 2005, between Wilmington Trust Company and Registrant.
4.8(19)
  Form of Junior Subordinated Debt Security due 2035, issued November 4, 2005
4.9(19)
  Form of Floating Rate TRUPS® Certificate issued November 4, 2005
10.3(1)
  Registration Rights Agreement dated as of September 19, 1997 by and between Registrant and John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
10.5(1)
  Agreement and Plan of Recapitalization dated as of September 8, 1997 by and between Hanover Capital Partners Ltd. and John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
10.6(1)
  Bonus Incentive Compensation Plan dated as of September 9, 1997
10.7(1)
  1997 Executive and Non-Employee Director Stock Option Plan
10.7.1(3)
  1999 Equity Incentive Plan
10.8(7)
  Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and John A. Burchett
10.8.1(7)
  Stock Option Agreement effective as of July 1, 2002 between Registrant and John A. Burchett
10.9(7)
  Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and Irma N. Tavares
10.9.1(7)
  Stock Option Agreement effective as of July 1, 2002 between Registrant and Irma N. Tavares
10.10(7)
  Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and Joyce S. Mizerak
10.10.1(7)
  Stock Option Agreement effective as of July 1, 2002 between Registrant and Joyce S. Mizerak
10.10.2(25)
  Separation and General Release Agreement dated January 31, 2007 between Joyce S. Mizerak and Registrant.
10.11(7)
  Amended and Restated Employment Agreement effective as of July 1, 2002, by and between Registrant and George J. Ostendorf
10.11.1(7)
  Stock Option Agreement effective as of July 1, 2002 between Registrant and George J. Ostendorf


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Exhibit
 
Description
 
10.11.2.(25)
  Separation and General Release Agreement dated December 29, 2006 between George J. Ostendorf and Registrant.
10.11.2(6)
  Employment Agreement dated as of January 1, 2000 by and between Registrant and Thomas P. Kaplan
10.11.3(9)
  Stock Purchase Agreement as of December 13, 2002 between Thomas P. Kaplan and Registrant
10.11.4(10)
  Stock Purchase Agreement as of March 31, 2003 between John A. Burchett and Registrant
10.11.5(10)
  Stock Purchase Agreement as of March 31, 2003 between George J. Ostendorf and Registrant
10.12(16)
  Employment Agreement dated as of April 14, 2005 by and between Registrant and Harold F. McElraft
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(9)
  Second Modification and Extension of Lease Agreement dated April 22, 2002 by and between Metroplex Associates and Hanover Capital Mortgage Corporation
10.13.2(9)
  Third Modification of Lease Agreement dated May 8, 2002 by and between Metroplex Associates and Hanover Capital Mortgage Corporation
10.13.3(9)
  Fourth Modification of Lease Agreement dated November 2002 by and between Metroplex Associates and Hanover Capital Mortgage Corporation
10.13.4(12)
  Fifth Modification of Lease Agreement dated October 9, 2003 by and between Metroplex Associates and Hanover Capital Partners Ltd.
10.13.5(18)
  Sixth Modification of Lease Agreement dated August 3, 2005 by and between Metroplex Associates and HanoverTrade Inc.
10.13.6(19)
  Seventh Modification of Lease Agreement dated December 16. 2005 by and between Metroplex Associates and Hanover Capital Partners 2, Ltd.
10.14(3)
  Office Lease Agreement, dated as of February 1, 1999, between LaSalle-Adams, L.L.C. and Hanover Capital Partners Ltd.
10.14.1(12)
  First Amendment to Lease dated January 5, 2004 between LaSalle-Adams L.L.C. and Hanover Capital Partners Ltd.
10.15(9)
  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
10.15.1(12)
  Sublease Agreement dated as of April 2004 between EasyLink Services, Inc. and HanoverTrade, Inc.
10.15.2(15)
  Second Amendment to Lease, dated as of May 14, 2004, between Metro Four Associates Limited Partnership, as Landlord, and HanoverTrade, Inc. as Tenant
10.16(10)
  Office Lease Agreement, dated as of July 10, 2002, between 233 Broadway Owners, LLC and Registrant
10.17(18)
  Office Lease Agreement dated August 3, 2005 by and between Metroplex Associates and HanoverTrade Inc.
10.25(1)
  Contribution Agreement dated September 19, 1997 by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
10.25.1(7)
  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
10.25.2(13)
  Amendment No. 2 to Contribution Agreement entered into as of May 20, 2004 by and between Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
10.26(1)
  Participation Agreement dated as of August 21, 1997 by and among Registrant, John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares


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Exhibit
 
Description
 
10.27(1)
  Loan Agreement dated as of September 19, 1997 between Registrant and each of John A. Burchett, Joyce S. Mizerak, George J. Ostendorf and Irma N. Tavares
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
10.31.3(9)
  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.
10.31.4(10)
  Amendment Number Seven dated as of April 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.
10.31.5(12)
  Amendment Number Eight dated as of April 26, 2004 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.
10.31.6(18)
  Amendment Number Nine dated as of April 18, 2005 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.
10.31.7(18)
  Amendment Number Ten dated as of May 5, 2005 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.
10.31.8(18)
  Amendment Number Eleven dated as of May 16, 2005 to be Amended and Restated Master Loans and Security Agreement dated as of March 27, 2000 by and among Registrant Hanover Capital Partners, Ltd. and Greenwich Financial Products, Inc.
10.31.9(19)
  Amendment Number Twelve Dated as of January 31, 2006 of the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000, by and among Registrant, Hanover Capital Partners 2, Ltd. and Greenwich Financial Products, Inc.
10.31.10(20)
  Amendment Number Thirteen Dated as of March 31, 2006, of the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000, by and among Registrant and Greenwich Financial Products, Inc.
10.31.11(21)
  Amendment Number Fourteen dated as of May 18, 2006, of the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000, by and among the Registrant and Greenwich Financial Products, Inc.
10.31.12(21)
  Amendment Number Fifteen dated as of June 14, 2006, of the Amended and Restated Master Loan and Security Agreement dated as of March 27, 2000, by and among the Registrant and Greenwich Financial Products, Inc.
10.33(5)
  Stockholder Protection Rights Agreement dated as of April 11, 2000 by and between Registrant and State Street Bank & Trust Company, as Rights Agent
10.33.1(7)
  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(7)
  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.


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Table of Contents

     
Exhibit
 
Description
 
10.35(9)
  Amended and Restated Limited Liability Agreement as of November 21, 2002 by and among BTD 2001 HDMF-1 Corp., Registrant and Provident Financial Group, Inc.
10.36.1(14)
  Indemnity Agreement by and between Registrant and John A. Burchett, dated as of July 1, 2004
10.36.2(14)
  Indemnity Agreement by and between Registrant and John A. Clymer, dated as of July 1, 2004
10.36.3(14)
  Indemnity Agreement by and between Registrant and Joseph J. Freeman, dated as of July 1, 2004
10.36.4(14)
  Indemnity Agreement by and between Registrant and Roberta M. Graffeo, dated as of July 1, 2004
10.36.6(14)
  Indemnity Agreement by and between Registrant and Douglas L. Jacobs, dated as of July 1, 2004
10.36.7(14)
  Indemnity Agreement by and between Registrant and Harold F. McElraft, dated as of July 1, 2004
10.36.8(14)
  Indemnity Agreement by and between Registrant and Richard J. Martinelli, dated as of July 1, 2004
10.36.9(14)
  Indemnity Agreement by and between Registrant and Joyce S. Mizerak, dated as of July 1, 2004
10.36.10(14)
  Indemnity Agreement by and between Registrant and Saiyid T. Naqvi, dated as of July 1, 2004
10.36.11(14)
  Indemnity Agreement by and between Registrant and George J. Ostendorf, dated as of July 1, 2004
10.36.12(14)
  Indemnity Agreement by and between Registrant and John N. Rees, dated as of July 1, 2004
10.36.13(14)
  Indemnity Agreement by and between Registrant and David K. Steel, dated as of July 1, 2004
10.36.14(14)
  Indemnity Agreement by and between Registrant and James F. Stone, dated as of July 1, 2004
10.36.15(14)
  Indemnity Agreement by and between Registrant and James C. Strickler, dated as of July 1, 2004
10.36.16(14)
  Indemnity Agreement by and between Registrant and Irma N. Tavares, dated as of July 1, 2004
10.36.17(16)
  Indemnity Agreement by and between Registrant and Harold F. McElraft, dated as of April 14, 2005
10.36.18(19)
  Indemnity Agreement by and between Registrant and Suzette Berrios, dated as of November 28, 2005
10.37(15)
  Purchase Agreement, dated February 24, 2005, among Registrant, Hanover Statutory Trust I and Taberna Preferred Funding I, Ltd.
10.38(17)
  Master Repurchase Agreement between Sovereign Bank, as Buyer, and Registrant and Hanover Capital Partners Ltd, as Seller, dated as of June 28, 2005
10.38.2(19)
  Assignment, Assumption and Recognition Agreement dated January 20, 2006 among the Registrant, Hanover Capital Partners 2, Ltd. and Sovereign Bank
10.38.3(19)
  Assignment, Assumption and Recognition Agreement dated January 20, 2006 among the Registrant, Hanover Capital Partners 2, Ltd., Sovereign Bank and Deutsche Bank National Trust Company
10.38.4(20)
  ISDA Master Agreement dated April 3, 2006, by and among Registrant and SMBC Derivative Products Limited
10.38.5(22)
  Master Repurchase Agreement dated June 22, 2006, by and among Registrant and Deutsche Zentral-Genossenschaftsbank, Frankfurt am Main AG
10.38.6(23)
  Warehouse Agreement between Merrill Lynch International and Hanover Capital Mortgage Holdings, Inc., dated as of August 28, 2006.
10.38.7 (25)
  Asset Purchase Agreement by and between Registrant and Terwin Acquisition I, LLC, dated as of January 12, 2007


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Exhibit
 
Description
 
16.1(11)
  Letter from Deloitte & Touche LLP, dated February 23, 2004
21(25)
  Subsidiaries of Hanover Capital Mortgage Holdings, Inc.
23.1(25)
  Consent of Independent Registered Public Accounting Firm (Grant Thornton LLP)
31.1(25)
  Certification by John A. Burchett pursuant to Securities Exchange Act Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2(25)
  Certification by Harold F. McElraft pursuant to Securities Exchange Act Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1(26)
  Certification by John A. Burchett pursuant to 18 U.S.C. Section 1350), as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2(26)
  Certification by Harold F. McElraft pursuant to 18 U.S.C. Section 1350), as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
(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 Exchange Commission on April 2, 2001.
 
(7) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on July 16, 2002.
 
(8) 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.
 
(9) Incorporated herein by reference to Registrant’s Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission on March 28, 2003.
 
(10) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended March 31, 2003, as filed with the Securities and Exchange Commission on May 15, 2003.
 
(11) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on February 23, 2004.
 
(12) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended March 31, 2004, as filed with the Securities and Exchange Commission on May 24, 2004.
 
(13) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on August 12, 2004.
 
(14) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended September 30, 2004, as filed with the Securities and Exchange Commission on November 9, 2004.
 
(15) Incorporated herein by reference to Registrant’s Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission on March 31, 2005.
 
(16) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended March 31, 2005, as filed with the Securities and Exchange Commission on March 16, 2005.


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(17) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on August 4, 2005.
 
(18) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended June 30, 2005, as filed with the Securities and Exchange Commission on August 9, 2005.
 
(19) Incorporated herein by reference to Registrant’s Form 10K for the year ended December 31, 2005, as filed with the Securities and Exchange Commission on March 16, 2006.
 
(20) Incorporated herein by reference to Registrant’s Form 10K for the year ended December 31, 2005, as filed with the Securities and Exchange Commission on May 10, 2006.
 
(21) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on June 20, 2006.
 
(22) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on June 28, 2006.
 
(23) Incorporated herein by reference to Registrant’s Form 8-K filed with the Securities and Exchange Commission on September 1, 2006.
 
(24) Incorporated herein by reference to Registrant’s Form 10-Q for the quarter ended September 30, 2006, as filed with the Securities and Exchange Commission on November 9, 2006.
 
(25) Filed herewith.
 
(26) Furnished herewith.


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Table of Contents

TABLE OF CONTENTS TO FINANCIAL STATEMENTS
 
         
    Page
 
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
   
  F-2
  F-3
Consolidated Financial Statements as of December 31, 2006 and 2005 and for the Years Ended December 31, 2006, 2005 and 2004:
   
  F-4
  F-5
  F-6
  F-7
  F-8
  F-9


F-1


Table of Contents

 
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
Board of Directors and Stockholders
Hanover Capital Mortgage Holdings, Inc. and Subsidiaries
 
We have audited the accompanying consolidated balance sheets of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, other comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. 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 the standards of the Public Company Accounting Oversight Board (United States). 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hanover Capital Mortgage Holdings, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2007 expressed an unqualified opinion on management’s assessment.
 
/s/  GRANT THORNTON LLP
 
New York, New York
March 13, 2007


F-2


Table of Contents

 
HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
Board of Directors and Stockholders
Hanover Capital Mortgage Holdings, Inc. and Subsidiaries
 
We have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting, that Hanover Capital Mortgage Holdings, Inc. and Subsidiaries (the “Company”) maintained effective Internal Control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO criteria”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of operations, other comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years ended December 31, 2006 and our report dated March 13, 2007 expressed an unqualified opinion on those financial statements.
 
/s/  GRANT THORNTON LLP
 
New York, New York
March 13, 2007


F-3


Table of Contents

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
 
                 
    December 31,  
    2006     2005  
 
ASSETS
Cash and cash equivalents
  $ 13,982     $ 30,492  
Accrued interest receivable
    1,652       1,367  
Mortgage loans
               
Held for sale
          10,061  
Collateral for CMOs
    9,736       14,074  
                 
      9,736       24,135  
                 
Mortgage securities ($254,482 and $188,398 pledged under Repurchase Agreements as of December 31, 2006 and 2005, respectively)
Trading
    105,104       82,487  
Available for sale
    154,599       106,967  
Held to maturity
    6,254       8,034  
                 
      265,957       197,488  
Other subordinate security, held to maturity
    2,757       2,703  
Equity investments in unconsolidated affiliates
    1,399       1,289  
Other assets
    6,237       10,705  
Other assets of discontinued operations
    2,549       4,008  
                 
    $ 304,269     $ 272,187  
                 
 
LIABILITIES
Repurchase agreements
  $ 193,247     $ 154,268  
Collateralized mortgage obligations (CMOs)
    7,384       11,438  
Dividends payable
    1,236       2,124  
Accounts payable, accrued expenses and other liabilities
    2,757       2,651  
Liability to subsidiary trusts issuing preferred and capital securities
    41,239       41,239  
Other liabilities of discontinued operations
    823       847  
                 
      246,686       212,567  
                 
Contingencies
           
Minority interest in equity of consolidated affiliate
          189  
 
STOCKHOLDERS’ EQUITY
Preferred stock, $0.01 par value, 10 million shares authorized, no shares
issued and outstanding
           
Common stock, $0.01 par value, 90 million shares authorized, 8,233,062 and 8,496,162 shares issued and outstanding as of December 31, 2006
and 2005, respectively
    82       85  
Additional paid-in capital
    102,598       104,231  
Cumulative earnings
    8,699       11,625  
Cumulative distributions to shareholders
    (56,173 )     (50,362 )
Deferred stock-based compensation
          (205 )
Accumulated other comprehensive income (loss)
    2,377       (5,943 )
                 
      57,583       59,431  
                 
    $ 304,269     $ 272,187  
                 
 
See notes to consolidated financial statements


F-4


Table of Contents

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
 
                         
    Years Ended December 31,  
    2006     2005     2004  
 
REVENUES
                       
Interest income
  $ 24,278     $ 16,296     $ 14,242  
Interest expense
    13,942       8,284       4,271  
                         
Net interest income before loan loss provision
    10,336       8,012       9,971  
Loan loss provision
          26       36  
                         
Net interest income
    10,336       7,986       9,935  
Gain on sale of mortgage assets
    834       4,515       10,400  
Gain (loss) on mark to market of mortgage assets
    148       (2,715 )     237  
(Loss) gain on freestanding derivatives
    (2,344 )     180       (4,389 )
Technology
    2,857       3,054       2,794  
Loan brokering and advisory services
    105       1,647       2,700  
Other income (loss)
    (77 )     602       305  
                         
Total revenues
    11,859       15,269       21,982  
                         
EXPENSES
                       
Personnel
    4,239       6,428       7,355  
Legal and professional
    2,777       2,810       2,904  
General and administrative
    1,183       1,259       1,211  
Depreciation and amortization
    708       1,220       912  
Occupancy
    315       347       283  
Technology
    1,109       1,575       820  
Goodwill impairment
    2,478              
Other
    1,104       1,369       1,018  
                         
Total expenses
    13,913       15,008       14,503  
                         
Operating income (loss)
    (2,054 )     261       7,479  
Equity in income (loss) of unconsolidated affiliates
    110       (165 )     445  
Minority interest in loss of consolidated affiliate
    (5 )     (57 )      
                         
Income (loss) from continuing operations before income tax provision (benefit)
    (1,939 )     153       7,924  
Income tax provision (benefit)
    12       2       (26 )
                         
Income (loss) from continuing operations
    (1,951 )     151       7,950  
                         
DISCONTINUED OPERATIONS
                       
Income (loss) from discontinued operations before income tax provision (benefit)
    (917 )     1,387       108  
Income tax provision (benefit) from discontinued operations
    58       172       (63 )
                         
Income (loss) from discontinued operations
    (975 )     1,215       171  
                         
NET INCOME (LOSS)
  $ (2,926 )   $ 1,366     $ 8,121  
                         
Net income (loss) per common share — Basic
                       
Income (loss) from continuing operations
  $ (0.23 )   $ 0.02     $ 0.96  
Income (loss) from discontinued operations
    (0.12 )     0.14       0.02  
                         
Net income (loss) per common share — Basic
  $ (0.35 )   $ 0.16     $ 0.98  
                         
Net income (loss) per common share — Diluted
                       
Income (loss) from continuing operations
  $ (0.23 )   $ 0.02     $ 0.95  
Income (loss) from discontinued operations
    (0.12 )     0.14       0.02  
                         
Net income (loss) per common share — Diluted
  $ (0.35 )   $ 0.16     $ 0.97  
                         
Weighed average shares outstanding — Basic
    8,358,433       8,443,744       8,288,405  
Weighed average shares outstanding — Diluted
    8,358,433       8,460,903       8,344,741  
 
See notes to consolidated financial statements


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HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME (LOSS)
(in thousands)
 
                         
    Years Ended December 31,  
    2006     2005     2004  
 
Net income (loss)
  $ (2,926 )   $ 1,366     $ 8,121  
Other comprehensive income (loss), net of tax effect of $0:
                       
Net unrealized gain (loss) on mortgage securities classified as available-for-sale
    6,994       (5,556 )     (736 )
Reclassification adjustment for net gain (loss) included in net income
    1,326       242       (116 )
                         
Other comprehensive income (loss)
    8,320       (5,314 )     (852 )
                         
Comprehensive income (loss)
  $ 5,394     $ (3,948 )   $ 7,269  
                         
 
See notes to consolidated financial statements


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Table of Contents

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
 
                                                                         
                      Notes
                               
                      Receivable
          Cumulative
          Accumulated
       
                Additional
    from
          Distributions
    Deferred
    Other
       
    Common Stock     Paid-In
    Related
    Cumulative
    To
    Stock-Based
    Comprehensive
       
    Shares     Amount     Capital     Parties     Earnings     Shareholders     Compensation     Income (Loss)     Total  
 
BALANCE, JANUARY 1, 2004
    8,192,903     $ 82     $ 101,279     $ (1,167 )   $ 2,138     $ (27,736 )   $     $ 223     $ 74,819  
Common stock paid for acquisition
    35,419             494                                     494  
Forgiveness of notes receivable from four executive officers (Principals)
                      584                               584  
Common stock earned by Principals
    72,222       1       848                                     849  
Exercise of stock options
    75,646       1       424                                     425  
Stock issued under Executive Compensation Plan
    5,393             81                                     81  
Net income
                            8,121                         8,121  
Other comprehensive income (loss)
                                              (852 )     (852 )
Dividends declared
                                  (13,302 )                 (13,302 )
                                                                         
BALANCE, DECEMBER 31, 2004
    8,381,583       84       103,126       (583 )     10,259       (41,038 )           (629 )     71,219  
Forgiveness of notes receivable from four executive officers (Principals)
                      583                               583  
Common stock earned by Principals
    72,222       1       761                                     762  
Common stock grants to key employees
    22,000             236                         (236 )            
Amortization of deferred stock grant to key employees
                                        31             31  
Exercise of stock options
    18,000             83                                     83  
Stock issued under Executive Compensation Plan
    2,357             25                                     25