Description

Hanover Capital Mortgage Holdings, Inc. (“HCM”)

Description:

Hanover Capital Mortgage Holdings, Inc. (XASE: HCM) is a mortgage REIT whose primary asset is its portfolio of subordinated mortgage securitizations and mortgage loans of prime, jumbo loans.  Hanover’s investments do not include any sub-prime loans or securities collateralized by sub-prime loans, but rather secured, jumbo (above Fannie Mae limits) loans from credit-worthy homeowners.  The company leverages its purchases of mortgage securities with borrowings obtained primarily through the use of agreements to repurchase the securities.  HCM’s book value per share is now $1.39.  After write-downs of $11.8 million in 2Q 07 and $30.2 million during the third quarter of 2007, HCM currently trades at $0.55 per share, which is 0.42x book.  At a minimum, HCM should trade closer to its now very conservative book value which was aggressively written-down in, we believe, an over-reaction to the sub-prime pricing issues in the market.

All of HCM’s current financing is from a Master Repurchase Agreement (MRA) with Ramius Capital, a multi-strategy hedge fund.  The initial purchase price of the securities in the Repurchase Transaction was $80.9 million. The fixed term of the MRA is one year. 

Investors have mistakenly associated HCM with the subprime mortgage debacle and the difficulty in pricing of the illiquid and small tranches it owns; however it is my belief that the management team at HCM can take advantage of the dislocation in the mortgage markets and create value by purchasing fundamentally sound mortgage-backed securities at significant discounts to their actual value.  At a minimum, the true (as approved to the artificially deflated) value of the assets should provide a cushion at HCM’s current price.

The company is actively trying to access the capital markets so it can resume purchasing mortgage-backed securities.

Recent History:

-          Sale of Hanover’s due diligence business platform to Terwin Acquisition I, LLC (now known as Edison Mortgage Decisioning Solutions, LLC) closed January 12, 2007.   

-          On August 15, 2007, the company sold its entire portfolio of whole-pool Fannie Mae and Freddie Mac mortgage-backed securities (“Agency MBS”).  The sales were necessary in order to generate some liquidity and close existing borrowing positions.

-          Company entered into a MRA on August 10, 2007 with Ramius Capital Group, LLC, which reduced capital and Company has been in discussions with potential investors for additional lines.

Prime vs. Subprime:

While the number of nationwide foreclosures continues to rise, the vast majority of problems appear to center around homeowners with sub-prime and/or adjustable rate mortgages (ARMs) and little equity in their home. However credit-worthy homeowners who have seasoned, fixed-rate mortgages on middle class and upper middle class homes are mostly managing to steer clear of default by remaining current on payments and avoiding delinquencies. Statistics show that more than 97% of fixed-rate loans are current and those that are past due thirty days or more account for just 2.6% of all loans in the U.S.  The statistics are even better for prime, jumbo, fixed-rate loans.  In addition, more seasoned loans are less prone to default, were done prior to the rapid housing appreciation of the last six years, and were underwritten during the period before bubble-like home appreciation and undue relaxation of credit standards.

In the sub-prime group, more than 14% of those ARMs that reset to higher interest rates after two to three years, are now 30 days or more behind on their payments. That amounts to a percentage that is five times higher than in the fixed-rate segment. Even so, more than 85% of the subprime borrowers have still managed to keep their payments current.

Typical securitization structure illustrating HCM’s primary focus:

HCM Collateral:

Prime Residential Mortgage Pool Principal Balance:                            $500 mil

Number of Loans                                                                                              1,000

Average Loan Size                                                                                            $500,000

Weighted Average LTV                                                                                   68%

Average Appraised Value of Homes                                                        $735,000

Average FICO score                                                                                        741

HCM Securization:

AAA                                                      Senior Bonds                                      97.00%

AA                                                         Senior                                                    2.40%

A                                                             Subordinated

BBB                                                        Bonds                                                   

BB                                                          Junior                                                    0.60%   

B                                                             Subordinated                                                     Hanover’s Primary Investment Focus

Not Rated                                            Bonds

$500 Million Principal Balance                                                                    100%

Value Scenarios:                                              

Average Appraised Value              $735,000               $735,000               $735,000               $735,000               $735,000

Estimated Market Decline              5%                          10%                        15%                        20%                        25%

Estimated Current Value                $698,250               $661,500               $624,750               $588,000               $551,250              

Average Loan Size                            $500,000               $500,000               $500,000               $500,000               $500,000

Equity Cushion                                 $198,250               $161,500               $124,750               $88,000                 $51,250

Less than 0.50% of HCM’s Subordinate MBS portfolio is 60 days delinquent.  Also, we believe this class of mortgages are from borrowers who are highly unlikely to abandon their homes even if the mortgage exceeds current market value.

Value to the Subordinate MBS Portfolio:

These $400,000 - $750,000 houses need to depreciate and realize losses of nearly 1/3 for the subordinated and equity tranches that HCM holds to be impaired.  Even if this were to happen, the borrowers who took out these mortgages are the opposite of sub-prime; they are credit-worthy, and highly unlikely to walk away from middle class and upper middle class single family homes and condominiums.  Unlike sub-prime borrowers, these borrowers generally have savings and employment opportunities to keep their largest asset, their homes, intact. 

FINANCIAL INFORMATION:

HCM took a $42.0 million ($11.8 million in 2Q07 and $30.2 million in 3Q07) impairment expense on the Subordinate MBS portfolio in the first nine months which resulted in a $4.85 per share decrease in the company’s book value.  This write-down was taken based on estimated fair value as of September 30, 2007 when the market for this type of asset was basically not trading. While management of the Company is unable to predict if and to what level these markets may improve, to the extent that they do improve a portion of the decline in book value should be reversed. 

Comps:  

                                                                                  HCM            RWT           MFA

Book Value                                                            12,061          148,792          765,839

Shares                                                                   8,664,000   28,073,000     104,641,121  

Book Value/ Share                                                 $1.39            $5.30               $7.32

Adjusted Book Value / Share                               $1.39           $28.00               $7.32

Current Price                                                           $0.58           $36.91               $8.54

Price to Book                                                           0.42x          1.32x                 1.17x

HCM is currently trading at 0.42x book after the $4.85 per share write-down. 

Catalysts:

-          Market place realizing the assets have been written down too aggressively

-          Experienced management team

-          We believe that the company will be able to access the capital markets

-          The company stated that they are seeking additional capital and is in discussions with potential investors

-          The company does not invest in sub-prime mortgages so we believe this equity was over sold.  If that is the case, when these markets revert, a portion of the resulting decline in book value will reverse.

Catalyst