HMN FINANCIAL INC - Quarter Report: 2002 September (Form 10-Q)

                    [ ] 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

(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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HMN FINANCIAL, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)

September 30, 2002 and 2001

HMN Financial, Inc. (HMN) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) which offers financial planning products and services and Home Federal REIT, Inc. (HFREIT) which invests in real estate loans acquired from the Bank. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC) which holds a limited number of commercial loans originated by third parties. The Bank has a 51% owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), which is a mortgage banking and mortgage brokerage business located in Brooklyn Park, Minnesota. The Bank is in the process of liquidating the assets of HFMS and mortgage production has ceased as of September 30, 2002.

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

(2) Basis of Preparation
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, 2002 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.

(3) New Accounting Standards
In October 2002, the FASB issued SFAS No. 147, Acquisitions of Certain Financial Institutions. Except for transactions between two or more mutual enterprises, this statement requires the application of the purchase method of accounting to all acquisitions of financial institutions. In addition, this statement amends FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. Consequently, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provision that SFAS No. 144 requires for other long-lived assets that are held and used. The provisions of SFAS No. 147, which relate to the application of the purchase method of accounting, are effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions related to accounting for the impairment or disposal of certain long-term customer-relationship intangible assets are effective on October 1, 2002. The impact of adopting SFAS No. 147 on HMN's financial condition and its results of operations will not be material.
 

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(4) Derivative Instruments and Hedging Activities
HMN adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in the first quarter of 2001. In July of 2001, HMN entered into an interest rate swap for $15 million. Under the 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. In July of 2002, the interest rate swap was called and the corresponding certificate of deposit was also called. As of September 30, 2002, HMN has not entered into any other interest rate swaps.

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 of 2001, certain 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 with no ineffectiveness recognized in the income statement. In the second quarter of 2002 cash flow hedge accounting was discontinued because HMN ceased delivery of loans under a mortgage backed security program. The mortgage banking operations  in the Brooklyn Park location were eliminated and some of the activity was moved to other branches within HMN.

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 intends to sell. These commitments are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, generally HMN simultaneously enters into commitments to sell the mortgage pipeline into the secondary market. The commitments to originate, purchase or sell loans are derivatives. As a result of marking the mortgage pipeline and the related commitments to sell to market for the third quarter ended September 30, 2002, HMN recorded an increase in Other Assets of $757,633, and an increase in Other Liabilities of $757,633.

The current commitments to sell Loans Held for Sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market. The Loans Held for Sale that are not hedged are recorded at the lower of cost or market. The lower of cost or market and the market value adjustments as of and for the quarter ended September 30, 2002 include loans that do not qualify for hedge accounting. As a result of marking these loans, HMN recorded a decrease to Loans Held for Sale of $1,567 and an increase in Other Liabilities of $188,487, and a net loss in gains or losses on sales of loans of $190,054. The unrealized gains on loans held for sale of $188,487 will not be recognized in income until the loans are sold in the fourth quarter of 2002.

(5) Comprehensive Income
Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for HMN is comprised of unrealized gains and losses on securities available for sale and unrealized gains and losses on hedging activity for loans held for sale and certificates of deposit with matching interest rate swaps.

There was no hedging activity for the third quarter of 2002 due to the phase down of the mortgage banking operations of HFMS. The gross unrealized holding gains on securities for the third quarter of 2002 was $1,837,000, the income tax expense would have been $641,000 and therefore, the net gain was $1,196,000. The gross reclassification adjustment for the third quarter of 2002 was $377,000, the income tax expense would have been $133,000 and therefore, the net gain was $244,000. 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. The gross unrealized holding losses on securities for the third quarter of 2001 was $906,000, the income tax benefit would have been $351,000 and therefore, the net loss was $555,000. The gross reclassification adjustment in the third quarter of

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2001 was $71,000, the income tax expense would have been $28,000 and therefore, the net reclassification adjustment was a gain of $43,000.

The gross unrealized losses in hedging valuation for the nine month period ended September 30, 2002 was $45,000, the income tax benefit would have been $9,000 and therefore, the net loss was $36,000. The gross minority interest in hedging valuation for the nine month period ended September 30, 2002 was $22,000. The gross unrealized holding gains on securities for the nine month period ended September 30, 2002 was $1,022,000, the income tax expense would have been $342,000 and therefore, the net gain was $680,000. The gross reclassification adjustment in the nine month period ended September 30, 2002 was $422,000, the income tax benefit would have been $149,000 and therefore, the net loss was $273,000. 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. The gross unrealized holding gains on securities for the nine month period ended September 30, 2001 was $2,319,000, the income tax benefit 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.

(6) Cash Dividend
On October 22, 2002 HMN's Board of Directors announced a cash dividend of $0.18 per share, payable on December 11, 2002 to stockholders of record on November 22, 2002.

(7) Investment in Mortgage Servicing Rights
A summary of mortgage servicing activity is as follows:

Mortgage servicing costs, which include professional services for valuing mortgage servicing rights, were $20,014 at September 30, 2002, and $11,802 and $15,365 for the nine and twelve months ended in September and December 2001, respectively.

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All of the loans being serviced were single family loans serviced for FNMA and FHLMC 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, 2002.

(8) Investment in Limited Partnerships
Investments in limited partnerships were as follows:

During the third quarter of 2002 HMN's proportionate loss from a mortgage servicing partnership was $504,777, its proportionate share of losses from common stock investments in financial institutions was $19,665 and it recognized $6,500 of losses on low income housing partnerships. During 2002 HMN anticipates receiving low income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits. During the third quarter of 2001 HMN's proportionate gains from a mortgage servicing partnership was $125,879, its proportionate share of losses from the common stock investments in financial institutions was $14,483 and it recognized $6,500 of losses on the low income housing partnerships. During 2001 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 2001.

During the nine month period ended September 30, 2002, HMN's proportionate losses from a mortgage servicing partnership was $173,919, its proportionate share of gains from the common stock investments in financial institutions was $3,907 and it recognized $33,956 of losses on the low income housing partnerships. During 2002 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, 2002. During the nine month period ended September 30, 2001 HMN's proportionate loss from a mortgage servicing partnership was $483,020, its proportionate share of losses from the common stock investments in financial institutions was $21,123 and it recognized $19,500 of losses on the low income housing partnerships. During 2001 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, 2001.
 

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(9) Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2002 is presented in the table below. Amortization expense for intangible assets was $758,307 for the nine months ended September 30, 2002.

The following table indicates the estimated future amortization expense for amortized intangible assets:

Projections of amortization are based on existing asset balances and the existing interest rate environment as of September 30, 2002. HMN's actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

Effective January 1, 2002, the amortization of goodwill was discontinued. The table below reconciles reported earnings for the third quarter of 2001 to "adjusted" earnings, which exclude goodwill amortization.

On July 23, 2002 the Board of Directors of the Bank resolved to freeze the accrual of benefits for existing participants and the addition of new enrollments to the Financial Institutions Retirement Fund (FIRF) as of September 1, 2002. The costs associated with operating the plan from June 30, 2002 to the freeze date of September 1, 2002 are not known at this time and are being calculated by the plan actuaries. Declines in the financial markets during 2002 and 2001 have caused many companies with defined benefit plans to make additional contributions to their plans to offset losses incurred in plan assets.

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