HMN FINANCIAL INC - Quarter Report: 2001 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2001

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission File Number 0-24100

HMN FINANCIAL, INC.

(Exact name of Registrant as specified in its Charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes (X) No ( )

Indicate the number of shares outstanding of each of the issuer's common stock as of the latest practicable date.

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PART I - FINANCIAL STATEMENTS

See accompanying notes to consolidated financial statements.

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See accompanying notes to consolidated financial statements.

4

(unaudited)

See accompanying notes to consolidated financial statements.

5

See accompanying notes to consolidated financial statements.

6

See accompanying notes to consolidated financial statements.

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(unaudited)

September 30, 2001 and 2000

The consolidated financial statements included herein are for HMN, SFC, MSI, through January 31, 2001, the Bank and the Bank's subsidiaries, OAI and HFMS. All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of income, consolidated statements of comprehensive income, consolidated statements of stockholders' equity and consolidated statements of cash flows in conformity with generally accepted accounting principles. However, all adjustments consisting of only normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The statement of income for the three month and nine month periods ended September 30, 2001 are not necessarily indicative of the results which may be expected for the entire year.

Certain amounts in the consolidated financial statements for prior periods have been reclassified to conform with the current period presentation.

In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. SFAS No. 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for

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impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.

HMN is required to adopt the provisions of SFAS No. 141 immediately and it will adopt SFAS No. 142 effective January 1, 2002. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of SFAS No. 142.

SFAS No. 141 will require upon adoption of SFAS No. 142, that HMN evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in SFAS No. 141 for recognition apart from goodwill. Upon adoption of SFAS No. 142, HMN will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, HMN will be required to test the intangible asset for impairment in accordance with the provisions of SFAS No. 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period.

In connection with the transitional goodwill impairment evaluation, SFAS No. 142 will require HMN to perform an assessment of whether there is an indication that goodwill [and equity-method goodwill] is impaired as of the date of adoption. To accomplish this HMN must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. HMN will then have up to six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired and HMN must perform the second step of the transitional impairment test. In the second step, HMN must compare the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of it assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS No. 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in HMN's income statement.

And finally, any unamortized negative goodwill and negative equity-method goodwill existing at the date SFAS No. 142 is adopted must be written off as the cumulative effect of a change in accounting principle.

On January 1, 2002 the adoption date, HMN expects to have unamortized goodwill in the amount of $3,800,938, unamortized identifiable intangible assets in the amount of $685,509 and no unamortized negative goodwill , all of which will be subject to the transition provisions of SFAS No. 141 and 142. Amortization expense related to goodwill was $180,024 and $135,027 for the year ended December 31, 2000 and the nine months ended September 30, 2001, respectively. Because of the extensive effort needed to comply with adopting SFAS No. 141 and 142, it is not practicable to reasonably estimate the impact of adopting these Statements on HMN's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle.

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In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets. This Statement supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, And Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business (as previously defined in that Opinion). The Statement also amends ARB No. 51, Consolidated Financial Statements, to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The Statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. Management is currently studying the impact of adopting SFAS No. 144.

HMN adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in the first quarter of 2001 when it had an outstanding interest rate swap of $10 million. A transition adjustment of $75,637 was recorded on January 1, 2001 as a debit to other assets and also as a credit to the related certificate of deposit.

The swap for $10 million was called in July 2001, and HMN simultaneously called the CD relating to that swap. In July HMN entered into another interest rate swap for $15 million. Under the new interest rate swap, HMN pays interest based upon the three month London Inter-Bank Offer Rate (LIBOR) and receives interest payments based upon a fixed rate of 6.0% on a notional value of $15 million in a fair value hedge with no ineffectiveness. The hedge is offsetting a callable certificate of deposit for $15 million that was issued by HMN. On September 30, 2001 the interest rate swap was marked to a market value of $135,266 which is included in other assets and the corresponding certificate of deposit was adjusted to the same value and is reflected in deposits in the consolidated balance sheet of HMN. The interest rate swap was deemed to be totally effective and therefore no gain or loss was recorded in the income statement.

HMN originates and purchases single family residential loans for sale into the secondary market and enters into commitments to sell or securitize those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. At the beginning of the second quarter, commitments to sell Loans Held for Sale were designated as a cash flow hedge of a forecasted transaction and were accounted for in accordance with SFAS No. 133. On September 30, 2001, the carrying value of the derivatives were marked to market by a $493,600 credit to Loans Held for Sale, a deferred tax asset was established for $193,000 and other comprehensive loss was debited for $300,600. The derivative adjustment in the balance sheet is a consolidated number that is partially owned by a minority interest. The adjustment to other comprehensive loss was $122,200 related to the minority interest and therefore the net adjustment to other comprehensive loss for HMN was $178,400.

As the Loans Held for Sale are ultimately sold, the losses currently in accumulated other comprehensive income will be reclassified in the gains and losses on sale of loans in the income statement. It is estimated that all of the Loans Held for Sale at September 30, 2001 will be sold in the next three months.

HMN has commitments outstanding to extend credit to future borrowers or to purchase loans that had not closed prior to the end of the quarter which it refers to as its mortgage pipeline. As commitments to originate or purchase loans enter into the mortgage pipeline, HMN simultaneously enters into commitments to sell the mortgage pipeline into the secondary market. As a result of marking the mortgage pipeline and the related commitments to sell to market during the third quarter of 2001, HMN recorded a debit to Loans Held for Sale of $1,192,000, a credit to Other Liabilities of $1,074,000 and an unrealized gain on derivatives of $118,000. As a result of marking the mortgage pipeline and the related commitments to sell to market during the nine month period ended September 30, 2001, HMN recorded a debit to Loans Held for Sale of $759,000, a credit to Other Liabilities of $696,000 and an unrealized gain on derivatives of $63,000.

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The gross unrealized losses in hedging valuation for the third quarter of 2001 was $362,000, the income tax benefit would have been $143,000 and therefore, the net loss was $219,000. The gross minority interest in hedging valuation for the third quarter of 2001 was $151,000, the income tax benefit would have been $60,000 and therefore, the net loss was $91,000. There was no hedging valuation in the third quarter of 2000. The gross unrealized holding loss on securities for the third quarter of 2001 was $906,000, the income tax benefit would have been $351,000 therefore, the net loss was $555,000. The gross reclassification adjustment for the third quarter of 2001 was $71,000, the income tax expense would have been $28,000 and therefore the net gain was $43,000. The gross unrealized holding gains on securities for the third quarter of 2000 was $673,000, the income tax expense would have been $253,000 and therefore, the net gain was $420,000. The gross reclassification adjustment in the third quarter of 2000 was $5,000, the income tax benefit would have been $2,000 and therefore, the net reclassification adjustment was a loss of $3,000. The gross unrealized losses in hedging valuation for the nine month period ended September 30, 2001 was $494,000, the income tax benefit would have been $193,000 and therefore, the net loss was $301,000. The gross minority interest in hedging valuation for the nine month period ended September 30, 2001 was $201,000, the income tax benefit would have been $79,000 and therefore, the net loss was $122,000. There was no hedging valuation in the nine month period ended September 30, 2000. The gross unrealized holding gains on securities for the nine month period ended September 30, 2001 was $2,319,000, the income tax expense would have been $931,000 and therefore, the net gain was $1,388,000. The gross reclassification adjustment in the nine month period ended September 30, 2001 was $261,000, the income tax benefit would have been $106,000 and therefore, the net reclassification adjustment was $155,000. The gross unrealized holding losses on securities for the nine month period ended September 30, 2000 was $435,000, the income tax benefit would have been $175,000 and therefore, the net loss was $260,000. The gross reclassification adjustment in the nine month period ended September 30, 2000 was $39,000, the income tax benefit would have been $15,000 and therefore, the net reclassification adjustment was $24,000.

On October 23, 2001 HMN's Board of Directors announced a cash dividend of $0.14 per share, payable on December 12, 2001 to stockholders of record on November 23, 2001.

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A summary of mortgage servicing activity is as follows:

All of the loans being serviced were single family loans serviced for FNMA under the mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at September 30, 2001.

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Investments in limited partnerships were as follows:

During the third quarter of 2001 HMN's proportionate revenue from a mortgage servicing partnership was $126,000, its proportionate share of losses from common stock investments in financial institutions was $14,500 and it recognized $6,500 of losses on low income housing partnerships. During 2001 HMN anticipates receiving low income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits in the third quarter. During the third quarter of 2000 HMN's proportionate revenue from a mortgage servicing partnership (which included the reduction of previously established impairment reserves of $146,500) was zero, its proportionate share of losses from the common stock investments in financial institutions was $37,400 and it recognized $6,500 of losses on the low income housing partnerships. During 2000 HMN received low income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits in the third quarter of 2000.

During the nine month period ended September 30, 2001, HMN's proportionate losses from a mortgage servicing partnership was $483,000, its proportionate share of losses from the common stock investments in financial institutions was $21,100 and it recognized $19,500 of losses on the low income housing partnerships. During 2001 HMN anticipates receiving low income housing credits totaling $84,000, of which $63,000 were credited to current income tax benefits in the nine month period ended September 30, 2001. During the nine month period ended September 30, 2000 HMN's proportionate revenue from a mortgage servicing partnership (which included the reduction of previously established impairment reserves of $264,500) was $174,700, its proportionate share of losses from the common stock investments in financial institutions was $76,600 and it recognized $19,500 of losses on the low income housing partnerships. During 2000 HMN received low income housing credits totaling $84,000, of which $63,000 were credited to current income tax benefits in the nine month period ended September 30, 2000.

The following table reconciles the weighted average shares outstanding and the income available to common shareholders used for basic and diluted EPS:

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The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HMN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of September 30, 2001, that the Bank meets all capital adequacy requirements to which it is subject.

Management believes that based upon the Bank's capital calculations at September 30, 2001 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On September 30, 2001 the Bank's tangible assets and adjusted total assets were $710 million and its risk-weighted assets were $466.3 million. The following table presents the Bank's capital amounts and ratios at September 30, 2001 for actual capital, required capital and excess capital including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations.