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HMN FINANCIAL INC - Quarter Report: 2002 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, 2002

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)

Delaware

41-1777397

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification Number)

1016 Civic Center Drive N.W., Rochester, MN

55901

(Address of principal executive offices)

(ZIP Code)

Registrant's telephone number, including area code:

(507) 535-1200

 

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.

Class

 

Outstanding at November 6, 2002

Common stock, $0.01 par value

 

4,449,006

 


 

HMN FINANCIAL, INC.

CONTENTS

PART I - FINANCIAL INFORMATION

 

 

Page

Item 1:

Financial Statements (unaudited)

 

 

Consolidated Balance Sheets at September 30, 2002 and December 31, 2001

3

 

 

 

 

Consolidated Statements of Income for the Three Months Ended and Nine Months Ended September 30, 2002 and 2001

4

 

 

 

 

Consolidated Statements of Comprehensive Income for the Three Months Ended and Nine Months Ended September 30, 2002 and 2001

5

 

 

 

 

Consolidated Statement of Stockholders' Equity for the Nine Month Period Ended September 30, 2002

6

 

 

 

 

Consolidated Statements of Cash Flows for the Nine Months Ended

September 30, 2002 and 2001

7

 

 

 

 

Notes to Consolidated Financial Statements

8-16

 

 

 

Item 2:

Management's Discussion and Analysis of Financial Condition and Results of Operations

17-26

 

 

 

Item 3:

Quantitative and Qualitative Disclosures about Market Risk Discussion included in Item 2 under Market Risk

22

 

 

 

Item 4:

Controls and Procedures

26

 

 

 

PART II - OTHER INFORMATION

 

 

 

Item 1:

Legal Proceedings

28

 

 

 

Item 2:

Changes in Securities

28

 

 

 

Item 3:

Defaults Upon Senior Securities

28

 

 

 

Item 4:

Submission of Matters to a Vote of Security Holders

28

 

 

 

Item 5:

Other Information

28

 

 

 

Item 6:

Exhibits and Reports on Form 8-K

28

 

 

 

Signatures

29

2

 


 

PART I - FINANCIAL STATEMENTS

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(unaudited)


 

 

 

September 30,

 

December 31,

 

 

 

2002

 

2001

 


 

Assets

 

 

 

 

 

Cash and cash equivalents

$

48,020,778

 

23,019,553

 

Securities available for sale:

 

 

 

 

 

   Mortgage-backed and related securities

 

 

 

 

 

    (amortized cost $62,334,585 and $65,878,534)

 

61,882,400

 

66,229,732

 

    Other marketable securities

 

 

 

 

 

     (amortized cost $45,181,323 and $53,439,401)

 

46,810,846

 

53,665,502

 

   
 
 

 

 

108,693,246

 

119,895,234

 

 

 


 


 

Loans held for sale

 

14,418,617

 

68,017,570

 

Loans receivable, net

 

508,035,550

 

471,667,772

 

Accrued interest receivable

 

3,170,206

 

3,508,828

 

Federal Home Loan Bank stock, at cost

 

11,880,500

 

12,245,000

 

Mortgage servicing rights, net

 

2,251,335

 

1,903,636

 

Premises and equipment, net

 

13,518,659

 

10,860,756

 

Investment in limited partnerships

 

1,318,491

 

1,523,650

 

Goodwill

 

3,800,938

 

3,800,938

 

Core deposit intangible

 

592,375

 

685,509

 

Prepaid expenses and other assets

 

3,768,574

 

3,985,625

 

   
 
 

    Total assets

$

719,469,269

 

721,114,071

 

 

 


 


 

 

 

 

 

 

 

Liabilities and Stockholders' Equity

 

 

 

 

 

Deposits

$

422,346,889

 

421,843,369

 

Federal Home Loan Bank advances

 

214,300,000

 

217,800,000

 

Accrued interest payable

 

742,024

 

1,017,456

 

Advance payments by borrowers for taxes and insurance

 

877,566

 

1,015,570

 

Accrued expenses and other liabilities

 

5,299,054

 

6,535,734

 

Deferred tax liabilities

 

1,143,300

 

976,900

 

   
 
 

    Total liabilities

 

644,708,833

 

649,189,029

 

Commitments and contingencies

 


 


 

Minority interest

 

(419,878)

 

(236,309)

 

Stockholders' equity:

 

 

 

 

 

    Serial preferred stock: ($.01 par value)

 

 

 

 

 

     authorized 500,000 shares; issued and outstanding none

 

0

 

0

 

    Common stock ($.01 par value):

 

 

 

 

 

     authorized 11,000,000; issued shares 9,128,662

 

91,287

 

91,287

 

Additional paid-in capital

 

58,934,419

 

59,168,782

 

Retained earnings, subject to certain restrictions

 

79,198,727

 

76,956,978

 

Accumulated other comprehensive income

 

760,839

 

367,744

 

Unearned employee stock ownership plan shares

 

(4,979,675)

 

(5,124,746)

 

Unearned compensation restricted stock awards

 

0

 

(7,350)

 

Treasury stock, at cost 4,701,656 and 4,732,521 shares

 

(58,825,283)

 

(59,291,344)

 

   
 
 

    Total stockholders' equity

 

75,180,314

 

72,161,351

 

   
 
 

Total liabilities and stockholders' equity

$

719,469,269

 

721,114,071

 

   
 
 

 

See accompanying notes to consolidated financial statements.

3


 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income

(unaudited)


 

 

Three Months Ended

September 30,

2002                        2001

 

Nine Months Ended

September 30,

2002                                   2001

 

 


Interest income:

 

 

 

 

 

 

     Loans receivable

$

9,502,274

 

11,057,446

 

28,271,049

 

33,605,383

     Securities available for sale:

 

 

 

 

 

 

 

         Mortgage-backed and related

 

485,086

 

893,913 

 

1,497,251

3,171,869

         Other marketable

 

515,997

 

441,500 

 

1,952,793

1,931,904

     Cash equivalents

 

38,564

 

65,571 

 

297,916

137,107

     Other

 

90,603

 

117,777 

 

265,305

 

414,505

   
 
 
 

         Total interest income

 

10,632,524

 

12,576,207 

 

32,284,314

 

39,260,768

 

 


 


 


 


Interest expense:

 

 

 

 

 

 

 

     Deposits

 

2,556,830

 

4,636,529 

 

8,304,055

 

14,607,907

     Federal Home Loan Bank advances

 

2,616,265

 

2,851,114 

 

7,788,063

 

9,199,980

   
 
 
 

        Total interest expense

 

5,173,095

 

7,487,643 

 

16,092,118

 

23,807,887

   
 
 
 

   Net interest income

 

5,459,429

 

5,088,564 

 

16,192,196

 

15,452,881

Provision for loan losses

 

771,000

 

300,000 

 

1,801,000

 

750,000

   
 
 
 

        Net interest income after provision

 

 

 

 

 

 

 

         for loan losses

 

4,688,429

 

4,788,564 

 

14,391,196

 

14,702,881

 

 


 


 


 


Non-interest income:

 

 

 

 

 

 

 

     Fees and service charges

 

418,115

 

417,116 

 

1,212,276

 

1,131,667

     Mortgage servicing fees

 

184,769

 

113,908 

 

521,931

 

328,139

     Securities gains (losses), net

 

376,838

 

71,338 

 

422,346

 

(260,958)

     Gain on sales of loans

 

432,095

 

591,881 

 

1,975,124

 

2,733,313

     Earnings (losses) in limited

 

 

 

 

 

 

 

       partnerships

 

(530,943)

 

104,896 

 

(203,968)

 

(523,643)

     Other

 

122,539

 

119,908 

 

531,519

 

449,859

   
 
 
 

        Total non-interest income

 

1,003,413

 

1,419,047 

 

4,459,228

 

3,858,377

 

 


 


 


 


Non-interest expense:

 

 

 

 

 

 

 

     Compensation and benefits

 

1,986,777

 

1,924,282 

 

6,006,821

 

5,879,340

     Occupancy

 

801,026

 

528,192 

 

2,210,714

 

1,607,983

     Federal deposit insurance premiums

 

18,173

 

19,841 

 

56,280

 

60,613

     Advertising

 

129,254

 

94,914 

 

418,336

 

295,057

     Data processing

 

272,696

 

238,728 

 

824,060

 

710,482

     Amortization of mortgage servicing

 

 

 

 

 

 

 

       rights, net of valuation adjustments

 

 

 

 

 

 

 

       and servicing costs

 

502,282

 

157,850 

 

884,588

 

493,888

     Other

 

844,581

 

812,812 

 

2,825,635

 

2,302,096

   
 
 
 

        Total noninterest expense

 

4,554,789

 

3,776,619 

 

13,226,454

 

11,349,459

   

 

 

 

 

 

 

 

        Income before income tax expense

 

1,137,053

 

2,430,992 

 

5,623,970

 

7,211,799

Income tax expense

 

312,200

 

571,285 

 

1,637,400

 

2,356,185

   
 
 
 

        Income before minority interest

 

824,853

 

1,859,707 

 

3,986,570

 

4,855,614

Minority interest

 

(67,012)

 

(163,373)

 

(141,306)

 

(30,493)

   
 
 
 

        Net income

$

891,865

 

2,023,080 

 

4,127,876

 

4,886,107

   
 
 
 

Basic earnings per share

$

0.24

 

0.53 

 

1.10

 

1.30

   
 
 
 

Diluted earnings per share

$

0.22

 

0.50 

 

          1.04

 

1.23

 

 


 


 


 


See accompanying notes to consolidated financial statements.

4


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income
(unaudited)


 

 

Three Months Ended September 30,

 

 

2002

 

2001

   
 

Net income

$

 

 

 

 

891,865

 

 

 

 

 

2,023,080

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

   Unrealized losses on hedging valuation

 

0

 

 

 

 

 

(218,985)

 

 

 

 

      Less: minority interest in hedging valuation

 

0

 

 

 

 

 

(91,484)

 

 

 

 

   
         
       

      Net unrealized losses on hedging valuation

 

 

 

0

 

 

 

 

 

(127,501)

 

 

   Unrealized gains (losses) on securities:

 

 

 

 

 

 

 

 

 

 

 

 

   Unrealized holding gains (losses) arising during period

 

1,195,786

 

 

 

 

 

(555,035)

 

 

 

 

   Less: reclassification adjustment for gains

 

 

 

 

 

 

 

 

 

 

 

 

     included in net income

 

243,738

 

 

 

 

 

43,038

 

 

 

 

   
         
       

   Net unrealized gains (losses) on securities

 

 

 

952,048

 

 

 

 

 

(598,073)

 

 

       
     
       

Other comprehensive income (loss)

 

 

 

 

 

952,048

 

 

 

 

 

(725,574)

           
         

Comprehensive income

$

 

 

 

 

1,843,913

 

 

 

 

 

1,297,506

           
         

 

 

 


 

 

Nine Months Ended September 30,

 

 

2002

 

2001

   
 

Net income

$

 

 

 

 

4,127,876

 

 

 

 

 

4,886,107 

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

   Unrealized losses on hedging valuation

 

(35,795)

 

 

 

 

 

(300,606)

 

 

 

 

      Less: minority interest in hedging valuation

 

(21,950)

 

 

 

 

 

(122,173)

 

 

 

 

   
         
       

      Net unrealized losses on hedging valuation

 

 

 

(13,845)

 

 

 

 

 

(178,433)

 

 

   Unrealized gains on securities:

 

 

 

 

 

 

 

 

 

 

 

 

   Unrealized holding gains arising during period

 

680,086

 

 

 

 

 

1,388,158

 

 

 

 

   Less: reclassification adjustment for gains (losses)

 

 

 

 

 

 

 

 

 

 

 

 

     included in net income

 

273,146

 

 

 

 

 

(154,550)

 

 

 

 

   
         
       

   Net unrealized gains on securities

 

 

 

406,940

 

 

 

 

 

1,542,708

 

 

       
         
   

Other comprehensive income

 

 

 

 

 

393,095

 

 

 

 

 

1,364,275

           
         

Comprehensive income

$

 

 

 

 

4,520,971

 

 

 

 

 

6,250,382

           
         

See accompanying notes to consolidated financial statements.

5


 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders' Equity

For the Nine Month Period Ended September 30, 2002

(unaudited)

 


 

 

 

 

 

Unearned

 

 

 

 

 

 

 

Accumulated

Employee

Unearned

 

 

 

 

 

 

Accumulated

Stock

Compensation

 

Total

 

 

Additional

 

Other

Ownership

Restricted

 

Stock-

 

Common

Paid-in

Retained

Comprehensive

Plan

Stock

Treasury

Holders'

 

Stock

Capital

Earnings

Income

Shares

Awards

Stock

Equity

 

Balance, December 31, 2001

$ 91,287

59,168,782 

76,956,978 

367,744

(5,124,746)

(7,350)

(59,291,344)

72,161,351 

  Net income

 

 

4,127,876 

 

 

 

 

4,127,876 

  Other comprehensive income

 

 

 

393,095

 

 

 

393,095 

  Treasury stock purchases

 

 

 

 

 

 

(658,611)

(658,611)

  Employee stock options

 

 

 

 

 

 

 

 

    exercised

 

(489,175)

 

 

 

 

1,124,672 

635,497 

  Tax benefits of exercised

 

 

 

 

 

 

 

 

    stock options

 

148,023 

 

 

 

 

 

148,023 

  Amortization of restricted

 

 

 

 

 

 

 

 

    stock awards

 

 

 

 

 

7,350 

 

7,350 

  Dividends paid

 

 

(1,886,127)

 

 

 

 

(1,886,127)

  Earned employee stock

 

 

 

 

 

 

 

 

    ownership plan shares

 

106,789 

 

 

145,071 

 

 

251,860 

 

Balance, September 30, 2002

$ 91,287

58,934,419 

79,198,727 

760,839

(4,979,675)

0

(58,825,283)

75,180,314 

 

See accompanying notes to consolidated financial statements.

6


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)


 

 

Nine Months Ended

September 30,

 

 

2002

 

2001

   

Cash flows from operating activities:

 

 

 

 

   Net income

$

4,127,876

 

4,886,107

   Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

       Provision for loan losses

 

1,801,000

 

750,000

       Depreciation

 

1,012,082

 

754,227

       Amortization of premiums, net

 

239,534

 

72,127

       Amortization of deferred loan fees

 

(498,149)

 

(390,794)

       Amortization of goodwill

 

0

 

135,027

       Amortization of core deposit intangible

 

93,134

 

85,802

       Amortization of other purchase accounting adjustments

 

7,495

 

9,025

       Amortization of mortgage servicing rights and net valuation adjustments

 

864,573

 

493,829

       Capitalized mortgage servicing rights

 

(1,212,272)

 

(990,324)

       Deferred income taxes

 

(104,400)

 

125,000

       Securities (gains) losses, net

 

(422,346)

 

260,958

       Gain on sales of real estate

 

(1,254)

 

(17,293)

       Gain on sales of loans

 

(1,975,124)

 

(2,733,403)

       Proceeds from sale of loans held for sale

 

202,650,820

 

568,937,142

       Disbursements on loans held for sale

 

(141,643,268)

 

(623,170,040)

       Principal collected on loans held for sale

 

106,603

 

154,425

       Amortization of restricted stock awards

 

7,350

 

2,450

       Amortization of unearned ESOP shares

 

145,071

 

145,031

       Earned employee stock ownership shares priced above original cost

 

106,789

 

76,850

       Decrease in accrued interest receivable

 

338,622

 

658,288

       Decrease in accrued interest payable

 

(275,432)

 

(475,151)

       Equity losses of limited partnerships

 

203,968

 

523,643

       Equity (losses) of minority interest

 

(141,306)

 

(30,493)

       Increase in other assets

 

(94,329)

 

(2,214,259)

       Increase (decrease) in other liabilities

 

(1,441,860)

 

2,044,898

       Other, net

 

29,614

 

(33,054)

   
 

           Net cash provided (used) by operating activities

 

63,924,791

 

(49,939,982)

   
 

Cash flows from investing activities:

 

 

 

 

   Proceeds from sales of securities available for sale

 

18,036,553

 

19,135,721

   Principal collected on securities available for sale

 

14,077,803

 

13,667,575

   Proceeds collected on maturity of securities available for sale

 

19,900,000

 

12,695,000

   Purchases of securities available for sale

 

(40,055,856)

 

0

   Proceeds from sales of loans receivable

 

0

 

12,156

   Net decrease (increase) in loans receivable

 

(42,391,910)

 

17,585,021

   Redemption of Federal Home Loan Bank stock

 

364,500

 

0

   Proceeds from sale of real estate

 

52,435

 

316,797

   Purchases of premises and equipment

 

(3,681,249)

 

(1,743,705)

   
 

       Net cash provided (used) by investing activities

 

(33,697,724)

 

61,668,565

   
 

Cash flows from financing activities:

 

 

 

 

   Increase in deposits

 

321,403

 

7,588,014

   Purchase of treasury stock

 

(658,611)

 

(74,152)

   Stock options exercised

 

635,497

 

475,586

   Dividends to stockholders

 

(1,886,127)

 

(1,347,740)

   Proceeds from Federal Home Loan Bank advances

 

0

 

259,700,000

   Repayment of Federal Home Loan Bank advances

 

(3,500,000)

 

(271,800,000)

   Minority interest in mortgage services

 

0

 

125,000

   Increase (decrease) in advance payments by borrowers for taxes and insurance

 

(138,004)

 

511,738

   
 

       Net cash used by financing activities

 

(5,225,842)

 

(4,821,554)

   
 

       Increase in cash and cash equivalents

 

25,001,225

 

6,907,029

Cash and cash equivalents, beginning of period

 

23,019,553

 

14,416,861

   
 

Cash and cash equivalents, end of period

$

48,020,778

 

21,323,890

Supplemental cash flow disclosures:

 


 


   Cash paid for interest

$

16,367,550

 

24,283,038

   Cash paid for income taxes

 

1,817,500

 

2,168,000

Supplemental noncash flow disclosures:

 

 

 

 

   Loans transferred to loans held for sale

 

4,267,484

 

1,216,509

   Transfer of loans to real estate

 

370,625

 

86,123


See accompanying notes to consolidated financial statements.

7


 

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

(unaudited)

September 30, 2002 and 2001

(1) HMN Financial, Inc.

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.
 

8



(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

9


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:


 

 

 

Nine Months ended
Sept. 30, 2002

 

Twelve Months
ended
Dec. 31, 2001

 

Nine Months
ended
Sept. 30, 2001

             

Mortgage servicing rights

 

 

 

 

 

 

Balance, beginning of period

$

1,922,736

 

1,188,928

 

1,188,928

Originations

 

1,212,272

 

1,458,321

 

990,324

Amortization

 

(665,173)

 

(724,513)

 

(493,829)

   
 
 

Balance, end of period

 

2,469,835

 

1,922,736

 

1,685,423

 

 


 


 


Valuation reserve

 

 

 

 

 

 

Balance, beginning of period

 

(19,100)

 

0

 

0

Additions

 

(210,000)

 

(19,100)

 

(1,988)

Reductions

 

10,600

 

 0

 

0

   
 
 

Balance, end of period

 

(218,500)

 

(19,100)

 

(1,988)

 

 


 


 


Mortgage servicing rights, net

$

2,251,335

 

1,903,636

 

1,683,435

   
 
 

Fair value of mortgage servicing rights

$

2,262,578

 

1,939,000

 

1,842,000

 

 


 


 


 

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.

10




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.


 

 

 

 

 

 

 

 

Loan Principal Balance

 

 

 

Weighted Average

Interest Rate

 

 

Weighted Average Remaining Term

 

 

 

 

Number of Loans

 

   
 
 
 
 

Original term 30 year fixed rate

$

138,360,000

 

6.97

%

341

 

1,451

 

Original term 15 year fixed rate

 

144,673,000

 

6.39

%

160

 

2,065

 

Seven year balloon

 

160,000

 

6.09

%

127

 

2

 

Adjustable rate  

6,597,000

 

5.67

%

334

 

48

 

 

 

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


 

Primary partnership activity

 

September 30, 2002

 

December 31, 2001

 


 
 
 

Mortgage servicing rights

$

818,022

 

991,941

 

Common stock of financial institutions

 

269,863

 

265,955

Low to moderate income housing

 

230,606

 

265,754

 

   
 
 

 

$

1,318,491

 

1,523,650

 
   
 
 

 


 

 

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.
 

11



(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.


 

 

Gross

 

 

 

 

 

Unamortized

 

 

Carrying

 

Accumulated

 

Valuation

 

Intangible

 

 

Amount

 

Amortization

 

Adjustment

 

Assets


Amortized intangible assets:

 

 

 

 

 

 

 

 

Mortgage servicing rights

$

3,633,153

 

(1,163,318)

 

(218,500)

 

2,251,335

Core deposit intangible

 

1,567,000

 

(974,625)

 

0

 

592,375

   
 
 
 

Total

$

5,200,153

 

(2,137,943)

 

(218,500)

 

2,843,710

   
 
 
 

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


 

 

Mortgage

 

Core

 

 

 

 

Servicing

 

Deposit

 

 

 

 

Rights

 

Intangible

 

Total


Three months ended December 31, 2002

$

111,041

 

31,044

 

142,085

 

 

 

 

 

 

 

Year ended December 31,

 

 

 

 

 

 

2003

 

402,167

 

113,857

 

516,024

2004

 

342,248

 

113,857

 

456,105

2005

 

290,869

 

113,857

 

404,726

2006

 

246,789

 

113,857

 

360,646

2007

 

213,279

 

105,902

 

319,181


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.

(10) "Adjusted" Earnings SFAS No. 142 Transitional Disclosure

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.


 

 

 

Quarter Ended September 30, 2001

     

 

 

Quarter

 

 

 

 

 

 

 

 

Ended

 

Reported

 

Goodwill

 

Adjusted

 

 

September 30, 2002

 

Earnings

 

Amortization

 

Earnings


Income before income tax expense

$

1,137,053

 

2,430,992

 

45,009

 

2,476,001

Income tax expense

 

312,200

 

571,285

 

0

 

571,285

   
 
 
 

Income before minority interest

 

824,853

 

1,859,707

 

45,009

 

1,904,716

Minority interest

 

(67,012)

 

(163,373)

 

0

 

(163,373)

   
 
 
 

Net income

$

891,865

 

2,023,080

 

45,009

 

2,068,089

   
 
 
 

Earnings per common share

$

0.24

 

0.53

 

0.02

 

0.55

   
 
 
 

Diluted earnings per common share

$

0.22

 

0.50

 

0.02

 

0.52

   
 
 
 
 

12


 

 


Nine Months Ended September 30, 2001

                 

 

 

Nine Months

 

 

 

 

 

 

 

 

Ended

 

Reported

 

Goodwill

 

Adjusted

 

 

September 30, 2002

 

Earnings

 

Amortization

 

Earnings

   
 
 
 

Income before income tax expense

$

5,623,970

 

7,211,799

 

135,027

 

7,346,826

Income tax expense

 

1,637,400

 

2,356,185

 

0

 

2,356,185

   
 
 
 

Income before minority interest

 

3,986,570

 

4,855,614

 

135,027

 

4,990,641

Minority interest

 

(141,306)

 

(30,493)

 

0

 

(30,493)

   
 
 
 

Net income

$

4,127,876

 

4,886,107

 

135,027

 

5,021,134

   
 
 
 

Earnings per common share

$

1.10

 

1.30

 

0.04

 

1.34

   
 
 
 

Diluted earnings per common share

$

1.04

 

1.23

 

0.03

 

1.26

   
 
 
 

 

(11) Employee Benefits

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.


(12) Earnings per Share

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


 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

2002

 

2001

 

2002

 

2001

   
 
 
 

Weighted average number of common shares outstanding

 

 

 

 

 

 

 

 

   Used in basic earnings per common share calculation

 

3,790,526

 

3,785,130

 

3,757,404

 

3,751,198

 

 

 

 

 

 

 

 

 

Net dilutive effect of:

 

 

 

 

 

 

 

 

   Options

 

232,790

 

226,322

 

224,723

 

220,716

   Restricted stock awards

 

0

 

435

 

49

 

584

   
 
 
 

Weighted average number of shares outstanding

 

 

 

 

 

 

 

 

   Adjusted for effect of dilutive securities

 

4,023,316

 

4,011,887

 

3,982,176

 

3,972,498

 

 


 


 


 


                 

Income available to common shareholders

$

891,865

 

2,023,080

 

4,127,876

 

4,886,107

Basic earnings per common share

$

0.24

 

0.53

 

1.10

 

1.30

Diluted earnings per common share

$

0.22

 

0.50

 

1.04

 

1.23


(13) Regulatory Capital
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, 2002, that the Bank meets all capital adequacy requirements to which it is subject.

13




Management believes that based upon the Bank's capital calculations at September 30, 2002 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, 2002 the Bank's tangible assets and adjusted total assets were $710 million and its risk-weighted assets were $494.2 million. The following table presents the Bank's capital amounts and ratios at September 30, 2002 for actual capital, required capital and excess capital including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations.


 

 

 

 

 

 

 

 

 

 

 

To Be Well

 

 

 

 

 

 

 

 

Required to be

 

 

 

Capitalized Under

 

 

 

 

 

 

 

 

Adequately

 

 

 

Prompt Corrective

 

 

 

Actual

 

 

   Capitalized

 

 

 

Excess Capital

 

 

Actions Provision

 

   
   
   
   
 

 

 

 

 

Percent of

 

 

 

 

Percent of

 

 

 

 

Percent of

 

 

 

 

Percent of

 

(in thousands)

 

Amount

 

Assets (1)

 

 

Amount

 

Assets (1)

 

 

Amount

 

Assets (1)

 

 

Amount

 

Assets (1)

 

   
 
   
 
   
 
   
 
 

Bank stockholder's equity

$

64,527 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Plus:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Net unrealized loss (gain) on certain

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    securities available for sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

and cash flow hedges

 

(778)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Goodwill and other intangibles

 

4,393 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Excess mortgage servicing rights

 

316 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   
                                   

    Tier I or core capital

 

59,040 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   
                                   

    Tier I capital to adjusted total assets

 

 

 

8.32%

 

$

28,399  

 

4.00%

 

$

30,641  

 

4.32%

 

$

35,499  

 

5.00%

 

    Tier I capital to risk-weighted assets

 

 

 

11.95%

 

$

19,767  

 

4.00%

 

$

39,273  

 

7.95%

 

$

29,651  

 

6.00%

 

Plus:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Allowable allowance for loan losses

 

4,109 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   
                                   

    Risk-based capital

$

63,149 

 

 

 

$

39,534  

 

 

 

$

23,615  

 

 

 

$

49,418  

 

 

 

   
                                   

    Risk-based capital to

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

       Risk-weighted assets

 

 

 

12.78%

 

 

 

 

8.00%

 

 

 

 

4.78%

 

 

 

 

10.00%

 


(1) Based upon the Bank's adjusted total assets for the purpose of the tangible and core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio.


The tangible capital of the Bank was in excess of the minimum 2% required at September 30, 2002 but is not reflected in the table above.

(14) Business Segments
HMN's subsidiary, Home Federal Savings Bank and the Bank's subsidiary, Home Federal Mortgage Services, LLC (HFMS), have been identified as reportable operating segments in accordance with the provisions of SFAS 131. HFMS was deemed to be a segment because its operations were conducted independently from the Bank. HFMS has been segmented further into Mortgage Servicing Rights and Mortgage Banking activities. The mortgage servicing segment owns servicing rights on loans which have either been sold to FNMA or securitized into mortgage-backed instruments which were issued by FNMA. HFMS receives a servicing fee that is based upon the outstanding balance of the loan being serviced and pays a subservicer a monthly fee to service the loan. HFMS's mortgage production activity ceased to operate during the third quarter of 2002. All loans that were acquired prior to that time are intended to be resold in the secondary loan market.

Security Finance Corporation and HMN, the holding company, did not meet the quantitative thresholds for determining reportable segments and therefore are included in the "Other" category.

HMN evaluates performance and allocates resources based on the segment's net income or loss, return on average assets and return on average equity. Each corporation is managed separately with its own president, who reports directly to HMN's chief operating decision maker, and the Board of Directors.

The following table sets forth certain information about the reconciliations of reported profit or loss and assets for each of HMN's reportable segments.

14


 


 

 

 

 

Home Federal

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage Services, LLC

 

 

 

 

 

 

 

 

 

       
                 

 

 

Home

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Federal

 

Mortgage

 

 

 

Total

 

 

 

 

 

 

 

 

 

Savings

 

Servicing

 

Mortgage

 

Reportable

 

 

 

 

 

Consolidated

 

(Dollars in thousands)

 

Bank

 

Rights

 

Banking

 

Segments

 

Other

 

Eliminations

 

Total

 


 

At or for the three-months ended

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    September 30, 2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    - external customers

$

10,494

 

0

 

77

 

10,571

 

62

 

 

10,633

 

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    - external customers

 

1,391

 

8

 

56

 

1,455

 

87

 

 

1,534

 

Earnings (loss) on limited partnerships

 

(511)

 

0

 

0

 

(511)

 

(20)

 

 

(531)

 

Intersegment interest income

 

57

 

0

 

0

 

57

 

24

 

(81)

 

0

 

Intersegment non-interest income

 

46

 

0

 

0

 

46

 

901

 

(947)

 

0

 

Interest expense

 

5,197

 

0

 

57

 

5,254

 

0

 

(81)

 

5,173

 

Amortization of mortgage servicing rights

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   and net valuation adjustments and

 

525

 

28

 

0

 

553

 

1

 

(51) 

 

503

 

servicing costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other non-interest expense

 

3,853

 

0

 

192

 

4,045

 

133

 

(126)

 

4,052

 

Income tax expense (benefit)

 

379

 

0

 

1

 

380

 

(68)

 

 

312

 

Minority interest

 

(67)

 

0

 

0

 

(67)

 

0

 

 

(67)

 

Net income (loss)

 

855

 

(20)

 

(117)

 

718

 

944

 

(770)

 

892

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

0

 

0

 

3,801

 

Total assets

 

715,022

 

44

 

4,997

 

720,063

 

75,384

 

(75,978)

 

719,469

 

Net interest margin

 

3.31

%

NM

 

NM

 

NM

 

NM

 

NM

 

3.29

%

Return on average assets

 

0.49

%

(141.02)

%

(7.79)

%

NM

 

NM

 

NM

 

0.51

%

Return on average realized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   common equity

 

5.35

%

(9,581.32)

%

(526.14)

%

NM

 

NM

 

NM

 

4.58

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At or for the three-months ended

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   September 30, 2001

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   - external customers

$

11,596

 

0

 

892

 

12,488

 

89

 

 

12,577

 

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   - external customers

 

979

 

6

 

106

 

1,091

 

253

 

 

1,344

 

Earnings (loss) on

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Limited partnerships

 

120

 

0

 

0

 

120

 

(15)

 

 

105

 

Intersegment interest income

 

766

 

0

 

0

 

766

 

49

 

(815)

 

0

 

Intersegment non-interest income

 

(87)

 

0

 

0

 

(87)

 

1,763

 

(1,676)

 

0

 

Interest expense

 

7,520

 

0

 

783

 

8,303

 

0

 

(815)

 

7,488

 

Amortization of mortgage servicing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   rights and net valuation adjustments

 

146

 

12

 

0

 

158

 

0

 

 

158

 

and servicing costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other non-interest expense

 

2,986

 

0

 

543

 

3,529

 

263

 

(141)

 

3,651

 

Income tax expense (benefit)

 

692

 

0

 

0

 

692

 

(121)

 

 

571

 

Minority interest

 

(163)

 

0

 

0

 

(163)

 

0

 

 

(163)

 

Net income (loss)

 

1,894

 

(6)

 

(328)

 

1,560

 

1,998

 

(1,535)

 

2,023

 

Goodwill

 

3,891

 

0

 

0

 

3,891

 

0

 

0

 

3,891

 

Total assets

 

712,716

 

114

 

65,381

 

778,211

 

72,435

 

(129,219)

 

721,427

 

Net interest margin

 

2.83

%

NM

 

NM

 

NM

 

NM

 

NM

 

2.93

%

Return on average assets

 

1.05

%

(2.06)

%

(2.11)

%

NM

 

NM

 

NM

 

1.12

%

Return on average realized common equity

 

13.17

%

(106.35)

%

(110.11)

%

NM

 

NM

 

NM

 

11.06

%


 

                    NM - Not meaningful

15


 

 

 


 

 

 

 

 

Home Federal

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage Services, LLC

 

 

 

 

 

 

 

 

 

       
                 

 

 

Home

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Federal

 

Mortgage

 

 

 

Total

 

 

 

 

 

 

 

 

 

Savings

 

Servicing

 

Mortgage

 

Reportable

 

 

 

 

 

Consolidated

 

(Dollars in thousands)

 

Bank

 

Rights

 

Banking

 

Segments

 

Other

 

Eliminations

 

Total

 


 

At or for the nine-months ended

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    September 30, 2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    - external customers

$

31,092

 

0

 

929

 

32,021

 

263

 

 

32,284

 

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    - external customers

 

4,182

 

29

 

327

 

4,538

 

125

 

 

4,663

 

Earnings (loss) on limited partnerships

 

(208)

 

0

 

0

 

(208)

 

4

 

 

(204)

 

Intersegment interest income

 

472

 

0

 

0

 

472

 

24

 

(496)

 

0

 

Intersegment non-interest income

 

307

 

0

 

0

 

307

 

4,030

 

(4,337)

 

0

 

Interest expense

 

16,116

 

0

 

472

 

16,588

 

0

 

(496)

 

16,092

 

Amortization of mortgage servicing rights

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   and net valuation adjustments and

 

974

 

52

 

0

 

1,026

 

1

 

(142) 

 

885

 

servicing costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other non-interest expense

 

11,327

 

0

 

1,049

 

12,376

 

419

 

(454)

 

12,341

 

Income tax expense (benefit)

 

1,854

 

0

 

1

 

1,855

 

(218)

 

 

1,637

 

Minority interest

 

(141)

 

0

 

0

 

(141)

 

0

 

 

(141)

 

Net income (loss)

 

4,030

 

(23)

 

(266)

 

3,741

 

4,128

 

(3,741)

 

4,128

 

Goodwill

 

3,801

 

 

 

0

 

3,801

 

0

 

0

 

3,801

 

Total assets

 

715,022

 

44

 

4,997

 

720,063

 

75,384

 

(75,978)

 

719,469

 

Net interest margin

 

3.26

%

NM

 

NM

 

NM

 

NM

 

NM

 

3.23

%

Return on average assets

 

0.77

%

(49.88)

%

(1.86)

%

NM

 

NM

 

NM

 

0.78

%

Return on average realized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   common equity

 

8.56

%

(2,651.34)

%

(98.16)

%

NM

 

NM

 

NM

 

7.33

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At or for the nine-months ended

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   September 30, 2001

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   - external customers

$

36,691

 

0

 

2,265

 

38,956

 

305

 

 

39,261

 

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   - external customers

 

2,464

 

34

 

1,289

 

3,787

 

595

 

 

4,382

 

Earnings (loss) on

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Limited partnerships

 

(503)

 

0

 

0

 

(503)

 

(21)

 

 

(524)

 

Intersegment interest income

 

2,018

 

0

 

0

 

2,018

 

222

 

(2,240)

 

0

 

Intersegment non-interest income

 

294

 

0

 

0

 

294

 

4,528

 

(4,822)

 

0

 

Interest expense

 

23,905

 

0

 

2,128

 

26,033

 

15

 

(2,240)

 

23,808

 

Amortization of mortgage servicing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   rights and net valuation adjustments

 

430

 

64

 

0

 

494

 

0

 

 

494

 

and servicing costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other non-interest expense

 

8,978

 

0

 

1,528

 

10,506

 

760

 

(411)

 

10,855

 

Income tax expense (benefit)

 

2,391

 

0

 

(28)

 

2,363

 

(7)

 

 

2,356

 

Minority interest

 

(30)

 

0

 

0

 

(30)

 

0

 

 

(30)

 

Net income (loss)

 

4,540

 

(30)

 

(74)

 

4,436

 

4,861

 

(4,411)

 

4,886

 

Goodwill

 

3,891

 

0

 

0

 

3,891

 

0

 

0

 

3,891

 

Total assets

 

712,716

 

114

 

65,381

 

778,211

 

72,435

 

(129,219)

 

721,427

 

Net interest margin

 

2.89

%

NM

 

NM

 

NM

 

NM

 

NM

 

2.97

%

Return on average assets

 

0.84

%

(21.74)

%

(0.22)

%

NM

 

NM

 

NM

 

0.90

%

Return on average realized common equity

 

10.78

%

(507.40)

%

(9.09)

%

NM

 

NM

 

NM

 

9.13

%


 

                    NM - Not meaningful

16


 

 

                                                                                HMN FINANCIAL, INC.

Item 2:                                             MANAGEMENT'S DISCUSSION AND ANALYSIS
                                            OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

HMN's net income is dependent primarily on its net interest income, which is the difference between interest earned on its loans and investments and the interest paid on interest-bearing liabilities. Net interest income is determined by (i) the difference between the yield earned on interest-earning assets and interest rates paid on interest-bearing liabilities (interest rate spread) and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities. HMN's interest rate spread is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Net interest margin is calculated by dividing net interest income by the average interest-earning assets and is normally expressed as a percentage. Net interest income and net interest margin are affected by changes in interest rates, the volume and the mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. HMN's net income is also affected by the generation of non-interest income, which primarily consists of gains from the sale of securities, gains from sale of loans, service charges, fees and other income. In addition, net income is affected by the level of operating expenses, provisions made for loan losses and impairment reserve adjustments required on mortgage servicing assets.

The operations of financial institutions, including the Bank, are significantly affected by prevailing economic conditions, competition and the monetary and fiscal policies of governmental agencies. Lending activities are influenced by the demand for and supply of housing and commercial real estate, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market rates of interest primarily on competing investments, the mix of deposit accounts, account maturities and the levels of personal income and savings in the market area of the Bank.

Net Income

HMN's net income for the third quarter of 2002 was $892,000, a decrease of $1.1 million, or 55.9%, compared to net income of $2.0 million for the third quarter of 2001. Basic earnings per share were $0.24 for the quarter ended September 30, 2002, a decrease of $0.29 per share, or 54.7%, from $0.53 basic earnings per share for the same quarter of 2001. Diluted earnings per share were $0.22 for the third quarter of 2002, a decrease of $0.28 or 56.0%, from $0.50 diluted earnings per share for the third quarter of 2001.

HMN's net income for the nine months ended September 30, 2002 was $4.1 million, a decrease of $758,000, or 15.5%, compared to net income of $4.9 million for the same nine month period of 2001. Basic earnings per share were $1.10 for the nine months ended September 30, 2002, a decrease of $0.20 per share or 15.5%, from $1.30 basic earnings per share for the same nine month period of 2001. Diluted earnings per share were $1.04 for the nine months ended September 30, 2002, a decrease of $0.19, or 15.4%, from $1.23 diluted earnings per share for the same nine month period of 2001.

Net Interest Income

Net interest income for the third quarter of 2002 was $5.5 million, an increase of $371,000, or 7.3%, compared to $5.1 million for the third quarter of 2001. Interest income for the third quarter of 2002 was $10.6 million, a decrease of $1.9 million, or 15.5%, compared to $12.5 million for the same period of 2001. Interest income decreased by $540,000 due to a decrease in interest earning assets of $30.5 million from the third quarter of 2001 to the third quarter of 2002. The decrease in average interest-earning assets is the result of HMN using cash to fund the outflow of deposits and the repayment of Federal Home Loan Bank advances. Average deposits declined between the periods as HMN lowered the interest rates it paid on deposits to take advantage of the lower interest rate environment. Interest earning assets also decreased because of increased investments in premises and equipment for four additional banking facilities, the payment of dividends on HMN common stock, and the

17


 

purchase of treasury stock. Interest income decreased by $1.4 million due to lower interest rates on assets being added to the portfolio and also due to a general decline in interest rates from the third quarter of 2001 through the third quarter of 2002. During the 12-month period ended September 30, 2002, the Federal Reserve reduced the Federal Funds interest rate three times and the Wall Street Journal prime rate decreased from 6.00% to 4.75%. As a result, loans with rates that were indexed to prime, such as commercial loans and consumer lines of credit, earned less interest income and the funds generated from fixed rate loans that prepaid during the period were reinvested in loans at lower rates. The yield earned on interest-earning assets decreased from 7.24% at September 30, 2001, to 6.41% at September 30, 2002.

Interest expense was $5.2 million for the third quarter of 2002, a decrease of $2.3 million, or 30.9%, compared to $7.5 million for the same quarter of 2001. Interest expense on deposits was $2.6 million for the third quarter of 2002, a decrease of $2.1 million, or 44.9%, from $4.6 million for the third quarter of 2001. Interest expense on deposits decreased primarily due to a decrease in the average interest rates that were paid on deposits. Interest expense decreased by $213,000 due to a $19.1 million decrease in the average outstanding deposits between the periods. The outflow of deposits were funded with excess cash made available from prepayments on mortgage loans. Interest expense on Federal Home Loan Bank (FHLB) advances and other borrowed money was $2.6 million for the third quarter of 2002, a decrease of $235,000, or 8.2%, from $2.9 million for the third quarter of 2001. Interest expense decreased due to a decrease in the cost of borrowing from the FHLB including a $187,000 decrease due to declining interest rates between the two periods. The average interest rate paid on the average interest-bearing liabilities was 3.35% during the third quarter of 2002, compared to 4.68% for the third quarter of 2001.

Net interest margin (net interest income divided by average interest earning assets) for the third quarter of 2002 was 3.29%, an increase of 36 basis points, compared to 2.93% for the third quarter of 2001.

Net interest income for the nine month period ended September 30, 2002 was $16.2 million, an increase of $739,000, or 4.8%, compared to $15.5 million for the same period of 2001. Interest income for the nine month period of 2002 was $32.3 million, a decrease of $7 million, or 17.8%, compared to $39.3 million for the same period of 2001. Interest income declined due to a reduction in interest rates and a decline in the average interest earning assets. Interest income declined by $1.4 million due to a $26.3 million net decrease in average interest-earning assets from the nine month period of 2001 to the same nine month period in 2002. The decrease in average interest-earning assets is the result of HMN using cash to fund the outflow of deposits and the repayment of Federal Home Loan Bank advances. Deposits declined between the periods as HMN lowered the interest rates it paid on deposits to take advantage of the lower interest rate environment. Interest income decreased by $5.5 million due to lower interest rates being earned on the loan and investment portfolios. The decline in rates decreased the yield earned on interest earning assets from 7.53% at September 30, 2001 to 6.44% at September 30, 2002.

Interest expense was $16.1 million for the nine months ended September 30, 2002, a decrease of $7.7 million, or 32.4%, compared to $23.8 million for the same nine month period of 2001. Interest expense on deposits was $8.3 million for the nine months ended September 30, 2002, a decrease of $6.3 million, or 43.2%, from $14.7 million for the same nine month period in 2001. Interest expense on deposits decreased by $336,000 due to a decrease in the average balance of outstanding deposits from the nine month period ended in September of 2002 to the same nine month period in 2001. Interest expense decreased by $6.0 million related to lower rates being paid on deposits. Interest expense on FHLB advances was $7.8 million for the nine month period of 2002, a decrease of $1.4 million, or 15.3%, from $9.2 million for the same period of 2001. Interest expense decreased by $331,000 due to a $8.3 million decrease in the average outstanding advances from the FHLB. The advances were paid off with excess cash made available from prepayments of single family mortgage loans. Interest expense decreased by $1.1 million due to a decrease in the cost of borrowing from the FHLB due to lowering interest rates between the two periods. The average interest rate paid on the average interest-bearing liabilities was 3.46% during the nine months ended September 30, 2002, compared to 4.96% for the same period of 2001.

18




Net interest margin (net interest income divided by average interest earning assets) for the nine months ended September 30, 2002, was 3.23%, an increase of 26 basis points, compared to 2.97% for the same period of 2001.

Provision for Loan Losses

*The provision for loan losses for the third quarter ended September 30, 2002 was $771,000, an increase of $471,000, or 157.0%, compared to $300,000 for the third quarter of 2001. The provision for loan losses increased primarily due to the $81 million in growth that was experienced in the commercial and consumer loan portfolios between the periods. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans.

*The provision for loan losses for the nine months ended September 30, 2002 was $1,801,000, an increase of $1,051,000, or 140.1% compared to $750,000 for the same nine month period ended in 2001. The provision is the result of management's evaluation of the composition of the loan portfolio, the historical level of non-performing loans, increases in loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located such as national and regional unemployment data, local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed conditions that resulted in increasing the 2002 loan loss provision compared to the provision for 2001. This increase was due primarily to the $81 million in growth that was experienced in the commercial and consumer loan portfolios between the end of the third quarter of 2001 and the end of the third quarter of 2002. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans. HMN will continue to monitor its allowance for losses and adjust it as conditions dictate. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods.

A reconciliation of HMN's allowance for loan losses is summarized as follows:


 

2002

 

2001

 
 

Balance at January 1,

$ 3,783,112

 

$  3,143,746 

Provision

1,801,000

 

750,000 

Commercial loan charge offs

(577,125)

 

(347,308)

Consumer loan charge offs

(260,895)

 

(111,788)

Single family mortgage loan charge offs

(44,408)

 

Recoveries 19,177   1,540
 
 

Balance at September 30,

$ 4,720,861

 

$  3,436,190 

 
 

Non-Interest Income

Non-interest income was $1.0 million for the third quarter of 2002, a decrease of $416,000, or 29.2%, from $1.4 million for the third quarter of 2001. Non-interest income decreased by $636,000 due to additional losses on investments in limited partnerships. The value of HMN's investment in a limited partnership that invests in mortgage servicing rights declined during the third quarter of 2002 as a result of lowering interest rates. Generally, as interest rates decline the value of fixed rate mortgage servicing rights decreases and as interest rates rise the value of the mortgage servicing rights increases due to changes in the anticipated cash flows from prepayments on the loans being serviced. This decrease was partially offset by an increase of $306,000 in the gains recognized on the sale of investments and an increase of $71,000 in mortgage servicing fees due to the increased number of loans being serviced.

* This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 25 of this discussion.

19



Non-interest income was $4.5 million for the nine months ended September 30, 2002, an increase of $601,000, or 15.6%, from $3.9 million for the same nine month period of 2001. Non-interest income increased by $683,000

due to increased gains recognized on the sale of securities. The increase in securities gains is primarily due to the $610,000 impairment loss recognized in the securities portfolio during the first nine months of 2001. Lower losses on investments in limited partnerships increased non-interest income by $320,000. The lower losses resulted because of a less severe drop in interest rates during the nine-month period of 2002 as compared to the nine-month period of 2001. Mortgage servicing fees increased by $194,000 as a result of servicing more loans. Fees and service charges increased by $81,000 and other income increased by $82,000 from the same period in 2001. These increases were partially offset by a decrease of $758,000 in gain on the sale of loans, which was caused primarily by the phase down of the mortgage banking operation in Brooklyn Park during 2002.

Non-Interest Expense

Non-interest expense was $4.6 million for the third quarter of 2002, an increase of $778,000, or 20.6%, from $3.8 million for the third quarter of 2001. Amortization of mortgage servicing rights increased by $344,000, or 218.2%, due to an increase in the number of serviced loans that prepaid during the period and a valuation reserve of $210,000 established on the existing servicing portfolio because the value of the mortgage servicing rights declined due to lowering interest rates. Occupancy expense increased by $273,000, or 51.7%, due to the costs associated with maintaining four additional facilities including the new corporate office. Data processing expense increased by $34,000, or 14.2%, due to the increased costs of various services offered to customers and the increased number of accounts. Advertising expense increased by $34,000 as a result of an increased focus on advertising.

Non-interest expense was $13.2 million for the nine months ended September 30, 2002 an increase of $1.9 million or 16.5%, from $11.3 for the same nine month period of 2001. Occupancy expense increased by $603,000, or 37.5%, as a result of maintaining four additional facilities including the new corporate headquarters. Data processing increased by $114,000 due to the increased costs of various services offered to customers and the increased number of accounts. Amortization of mortgage servicing rights increased by $391,000, or 79.1%, due to an increase in the number of serviced loans that prepaid during the period and a valuation reserve of $210,000 established on the existing servicing portfolio because the value of the mortgage servicing rights declined due to lowering interest rates. Other expenses increased by $524,000 primarily due to $245,000 of reserves established for losses on merchant and other accounts receivables and additional increases in general and administrative expenses relating to operating additional facilities in 2002.

Income Tax Expense

Income tax expense was $312,200 for the third quarter of 2002, a decrease of $259,000 compared to $571,000 for the third quarter of 2001. Income tax expense was $1.6 million for the nine months ended September 30, 2002, a decrease of $719,000 compared to $2.4 million for the same nine month period of 2001. The decreases in income taxes are primarily due to the Bank reducing its effective income tax rate through the use of certain state tax planning initiatives and a reduction in taxable income.

Non-Performing Assets

The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at
September 30, 2002 and December 31, 2001.

20


 

 


 

 

Sept.30,

 

 

Dec.31,

 

(Dollars in Thousands)

 

2002

 

 

2001

 


 

Non-Accruing Loans

 

 

 

 

 

 

     One-to-four family real estate

$

1,810

 

 

771

 

     Commercial real estate

 

167

 

 

187

 

     Consumer

 

279

 

 

311

 

     Commercial business

 

990

 

 

890

 

   
   
 

    Total

 

3,246

 

 

2,159

 

   
   
 

Accruing loans delinquent 90 days or more

 

118

 

 

24

 

Other assets

936

1,390

Foreclosed and Repossessed Assets

 

 

 

 

 

 

     One-to-four family real estate

 

309

 

 

0

 

     Consumer

 

112

 

 

155

 

     Commercial business

 

0

 

 

33

 

   
   
 

Total non-performing assets

$

4,721

 

$

3,761

 

   
   
 

Total as a percentage of total assets

 

0.66

%

 

0.52

%

   
   
 

Total non-performing loans

$

3,364

 

$

2,183

 

   
   
 

Total as a percentage of total loans receivable, net

 

0.66

%

 

0.46

%

   
   
 

Total non-performing assets at September 30, 2002 were $4,721,000, an increase of $959,000, from $3,761,000 at December 31, 2001. The increase in non-performing assets relates primarily to an increase of $1.0 million in non-accruing single-family loans primarily due to the phase down of the mortgage banking operation in Brooklyn Park.

Dividends

On October 22, 2002 HMN declared a cash dividend of $0.18 per share, payable on December 11, 2002 to shareholders of record on November 22, 2002.

During 2002, HMN has declared and paid dividends as follows:

       

Record date

Payable date

Dividend per share

Dividend Payout Ratio


February 21, 2002

March 7, 2002

$0.14

100.0%

May 23, 2002

June 10, 2002

$0.18

36.0%

August 27, 2002

September 10, 2002

$0.18

56.3%

 

 

 

 

The annualized dividend payout ratio for the past four quarters, ending with the December 11, 2002 payment will be 57.6%.

The declaration of dividends are subject to, among other things, HMN's financial condition and results of operations, the Bank's compliance with its regulatory capital requirements, including the fully phased-in capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors.

Liquidity
For the nine months ended September 30, 2002, the net cash provided by operating activities was $63.9 million. HMN collected $18.0 million from the sale of securities, $34.0 million from principal repayments and the maturity of securities and $52,000 in proceeds from the sale of real estate. It purchased premises and equipment of $3.7 million, purchased securities available for sale of $40.1 million and net loans receivable increased by $42.3 million due to loan growth primarily in the commercial and consumer loan areas. HMN had a net increase in deposit

21


balances of $321,000 for the nine month period. It paid out $3.5 million and $138,000 on advance payments from borrowers for taxes and insurance. HMN received $635,000 related to the exercise of stock options, purchased $659,000 of its own stock, and paid $1,886,000 in dividends to its shareholders.

*HMN has certificates of deposits with outstanding balances of $134.3 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits that do not renew will be replaced with deposits from other customers or brokers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits.


*HMN has $105 million of FHLB advances which mature after September 30, 2003 but have call features that can be exercised by the FHLB during the next 12 months. If the call features are exercised HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. HMN also has $60.0 million of FHLB advances which will mature during the next 12 months. Since HMN has the ability to request another advance to replace the advance that is being called or is maturing, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period.

Market Risk

Market risk is the risk of loss from adverse changes in market prices and interest rates. HMN's market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure.

HMN's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact HMN's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. HMN monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located below in the Asset/Liability Management section of this report discloses HMN's projected changes in net interest income based upon immediate interest rate changes called rate shocks.

*HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or 100 basis points down from where the interest rates were at September 30, 2002. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on September 30, 2002.

* This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 25 of this discussion.

22


 


Other than trading portfolio

Market Value

(Dollars in thousands)

Basis point change in interest rates

 

 

-100

 

 

0

 

 

+100

 

 

+200

 


Cash equivalents

$

48,021

 

47,983

 

47,945

 

47,907

 

Securities available for sale:

 

 

 

 

 

 

 

 

 

Fixed-rate CMOs

 

9,666

 

9,634

 

9,178

 

8,651

 

Variable-rate CMOs

 

49,436

 

49,539

 

49,850

 

49,147

 

Fixed-rate available for sale mortgage-backed and related securities

 

2,182

 

2,135

 

2,076

 

2,012

 

Variable-rate available for sale mortgage- backed and related securities

 

574

 

575

 

572

 

570

 

Fixed-rate available for sale other marketable securities

 

47,399

 

46,701

 

45,215

 

44,166

 

Variable-rate available for sale other marketable securities

 

111

 

110

 

105

 

105

 

Federal Home Loan Bank stock

 

11,892

 

11,878

 

11,864

 

11,851

 

Fixed-rate loans held for sale

 

15,225

 

14,381

 

14,219

 

14,003

 

Loans receivable, net:

 

 

 

 

 

 

 

 

 

Fixed-rate real estate loans

 

224,624

 

220,668

 

214,885

 

208,648

 

Variable-rate real estate loans

 

127,748

 

125,433

 

122,993

 

120,957

 

Fixed-rate other loans

 

80,815

 

79,926

 

78,183

 

76,652

 

Variable-rate other loans

 

113,240

 

111,765

 

108,388

 

106,023

 

Mortgage servicing rights, net

 

1,224

 

2,251

 

3,657

 

4,112

 

Investment in limited partnerships

 

991

 

1,319

 

1,653

 

1,775

 

   
 
 
 
 

Total market risk sensitive assets

 

733,148

 

724,298

 

710,783

 

696,579

 

   
 
 
 
 

NOW deposits

 

62,790

 

62,790

 

62,790

 

62,790

 

Passbook deposits

 

40,671

 

40,671

 

40,671

 

40,671

 

Money market deposits

 

47,741

 

47,741

 

47,741

 

47,741

 

Certificate deposits

 

277,914

 

274,130

 

270,437

 

266,831

 

Fixed-rate Federal Home Loan Bank advances

 

200,761

 

193,236

 

186,110

 

182,276

 

Variable-rate Federal Home Loan Bank advances

 

33,958

 

33,874

 

33,834

 

33,794

 

   
 
 
 
 

Total market risk sensitive liabilities

 

663,835

 

652,442

 

641,583

 

634,103

 





Off-balance sheet financial instruments:

 

 

 

 

 

 

 

 

 

Commitments to extend credit

 

1,580

 

0

 

(1,580)

 

(2,257)

 

Commitments to sell or deliver loans

(1,580)

 

0

 

1,580

 

1,499

 





Net market risk

69,313

71,856

69,200

63,234

   
 
 
 
 

Percentage change from current market value

 

(3.54)

%

0.00

%

(3.70)

%

(12.00)

%

   
 
 
 
 

 


The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 6% to 46%, depending on the note rate and the period to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at annual rates of between 11% and 27%, depending on the note rate and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 6% and 46% depending on the note rate and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the

23


instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 20%. FHLB advances were projected to be called at the first call date where the projected interest rate on similar remaining term advances exceeded the interest rate on HMN's callable advance.

*Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the "Interest Spread") will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase.

Asset/Liability Management

*HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following September 30, 2002 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated annual impact on net interest income of immediate interest rate changes called rate shocks.


Rate Shock

 

Net Interest

 

Percentage

in Basis Points

 

Income

 

Change


+200

 

24,252,000

 

10.47 %

+100

 

23,587,000

 

7.44 %

0

 

21,954,000

 

0.00 %

-100

 

19,428,000

 

-11.51 %


The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections.

*Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income.

In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee consisting of executive officers which meets at least quarterly to review the interest rate risk position and projected profitability. The committee makes recommendations for adjustments to the asset/liability position of the Bank to the Board of Directors of the Bank. This Committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, the Board reviews on a quarterly basis the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios.

In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest
* This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 25 of this discussion.

24




margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, during periods of declining or stable interest rates, provide high enough returns to justify the increased exposure to sudden and unexpected increases in interest rates.

To the extent consistent with its interest rate spread objectives, the Bank attempts to reduce its interest rate risk and has taken a number of steps to restructure its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans with contractual terms of 20 years or less. The Bank generally follows the practice of selling all of its fixed rate single family loans which conform to the secondary market guidelines. HMN has focused its portfolio lending since 1999 on the origination of commercial loan
products and consumer loans which generally have shorter weighted average terms to maturity and/or interest rates which adjust at least every three years. At times, depending on its interest rate sensitivity, the Bank may sell fixed rate single family loans with shorter contractual maturities than thirty years in order to reduce interest rate risk and record a gain on the sale of loans.

Forward-looking Information

The following paragraphs within Management's Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements and actual results may differ materially from the expectations disclosed within this Discussion and Analysis. These forward-looking statements are subject to risks and uncertainties, including those discussed below. HMN assumes no obligations to publicly release results of any revision or updates to these forward-looking statements to reflect future events or unanticipated occurrences.

Provision for Loan Losses

The provision for loan losses for the third quarter ended September 30, 2002 was $771,000, an increase of $471,000, or 157.0%, compared to $300,000 for the third quarter of 2001. The provision for loan losses increased primarily due to the $81 million in growth that was experienced in the commercial and consumer loan portfolios between the periods. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans.

The provision for loan losses for the nine months ended September 30, 2002 was $1,801,000, an increase of $1,051,000, or 140.1% compared to $750,000 for the same nine month period ended in 2001. The provision is the result of management's evaluation of the composition of the loan portfolio, the historical level of non-performing loans, increases in loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located such as national and regional unemployment data, local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed conditions that resulted in increasing the 2002 loan loss provision compared to the provision for 2001. This increase was due primarily to the $81 million in growth that was experienced in the commercial and consumer loan portfolios. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans. HMN will continue to monitor its allowance for losses and adjust it as conditions dictate. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods.

Liquidity

HMN has certificates of deposits with outstanding balances of $134.3 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits that do not renew will be replaced with deposits from other customers or brokers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits.

25


 

HMN has $105 million of FHLB advances which mature after September 30, 2003 but have call features that can be exercised by the FHLB during the next 12 months. If the call features are exercised HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. HMN also has $60.0 million of FHLB advances which will mature during the next 12 months. Since HMN has the ability to request another advance to replace the advance that is being called or is maturing, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period.

Market Risk

HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or 100 basis points down from where the interest rates were at September 30, 2002. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on September 30, 2002.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the "Interest Spread") will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase.

Asset/Liability Management

HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following September 30, 2002 to determine if its current level of interest rate risk is acceptable. The table in the asset/liability section projects the estimated annual impact on net interest income of immediate interest rate changes called rate shocks.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income.

Item 4: Controls and Procedures
Evaluation of disclosure controls and procedures. The Company's principal executive officer and its principal financial officer, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) on November 7, 2002, have concluded that, as of such date, the Company's disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities.

26


 

Changes in internal controls. There were no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's disclosure controls and procedures subsequent to the date of their evaluation, nor were there any significant deficiencies or material weaknesses in the Company's internal controls. As a result, no corrective actions were required or undertaken.

27



HMN FINANCIAL, INC.
PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings.

    None.

ITEM 2. Changes in Securities and Use of Proceeds.

    Not applicable.

ITEM 3. Defaults Upon Senior Securities.

    Not applicable.

ITEM 4. Submission of Matters to a Vote of Security Holders.

    None.

ITEM 5. Other Information.

    None.

ITEM 6. Exhibits and Reports on Form 8-K.

      1. Exhibits. See Index to Exhibits on page 30 of this report.
      2. Reports filed on Form 8-K.

None.

28


 

SIGNATURES

Pursuant to the requirement 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.

 

HMN FINANCIAL, INC.

 

Registrant

 

 

 

 

Date: November 13, 2002

/s/ Michael McNeil

 

Michael McNeil,

 

President/Chief Executive Officer

 

(Principal Executive Officer)

 

 

Date: November 13, 2002

/s/ Timothy P. Johnson

 

Timothy P. Johnson,

 

Chief Financial Officer

 

(Principal Financial Officer)

 

CERTIFICATIONS

I, Michael McNeil, President and Chief Executive Officer, certify that:

1.      I have reviewed this quarterly report on Form 10-Q of HMN Financial, Inc.

2.      Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.      Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.      The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exhange Act Rules 13a-14 and 15d-14) for the registrant and we have:

         a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

         b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

         c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.      The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):

29


 

         a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and

         b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and

6.      The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

Date: November 13, 2002                    By /s/ Michael McNeil

                                                            President/Chief Executive Officer

 

CERTIFICATIONS

I, Timothy P. Johnson, Treasurer and Chief Financial Officer, certify that:

1.      I have reviewed this quarterly report on Form 10-Q of HMN Financial, Inc.

2.      Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.      Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.      The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exhange Act Rules 13a-14 and 15d-14) for the registrant and we have:

         a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

         b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

         c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.      The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):

         a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and

30


 

         b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and

6.       The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

Date: November 13, 2002                     By /s/ Timothy P. Johnson

                                                            Treasurer and Chief Financial Officer

31


 

 

HMN FINANCIAL, INC.

INDEX TO EXHIBITS

FOR FORM 10-Q

 

 

 

 

 

 

Sequential

 

 

 

 

Reference

Page Numbering

Regulation

 

 

to Prior

Where Attached

S-K

 

 

Filing or

Exhibits Are

Exhibit

 

 

Exhibit

Located in This

Number

 

Document Attached Hereto

Number

Form 10-Q Report


3.1

 

Amended and Restated Articles of Incorporation

*1

N/A

 

 

 

 

 

 

3.2

 

Amended and Restated By-laws

*2

N/A

 

 

 

 

 

 

4

 

Form of Common Stock

*3

N/A

 

 

 

Including indentures

 

 

99.1

 

Certification Pursuant to 18 U.S.C. Section 1350 by Michael McNeil

99.1

Filed Electronically

 

 

 

 

 

99.2

 

Certification Pursuant to 18 U.S.C. Section 1350 by Timothy Johnson

99.2

Filed Electronically

 

 

 

 

 


 

 

 

 

 

 

*1

Incorporated by reference to the same numbered exhibit to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File No. 0-24100).

 

 

 

 

 

 

*2

Incorporated by reference to the same numbered exhibit to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1997 (File 0-24100).

 

 

 

 

 

 

*3

Incorporated by reference to the same numbered exhibit to the Company's Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212).


32