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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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 June 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 NW, Rochester, Minnesota  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 August 1, 2002
Common stock, $0.01 par value 4,426,906


1
 


HMN FINANCIAL, INC.

CONTENTS

PART I - FINANCIAL INFORMATION                                                                                Page

Item 1: Financial Statements (unaudited)

Consolidated Balance Sheets at June 30, 2002 and December 31, 2001                                           3

Consolidated Statements of Income for the

Three Months Ended and Six Months Ended June 30, 2002 and 2001                                              4

Consolidated Statements of Comprehensive Income for the

Three Months Ended and Six Months Ended June 30, 2002 and 2001                                              5

Consolidated Statement of Stockholders' Equity for the Six Month Period Ended June 30, 2002        5

Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2002 and 2001              6

Notes to Consolidated Financial Statements                                                                                       7-16

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                                                                                21

PART II - OTHER INFORMATION

Item 1: Legal Proceedings                                                                                                                  27

Item 2: Changes in Securities                                                                                                              27

Item 3: Defaults Upon Senior Securities                                                                                              27

Item 4: Submission of Matters to a Vote of Security Holders                                                               27

Item 5: Other Information                                                                                                                   28

Item 6: Exhibits and Reports on Form 8-K                                                                                         28

Signatures                                                                                                                                          29

2


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(unaudited)


   

June 30,

 

December 31,

 
   

2002

 

2001

 

Assets

         

Cash and cash equivalents

$

37,845,222

 

23,019,553

 

Securities available for sale:

         

   Mortgage-backed and related securities

         

    (amortized cost $65,838,697 and $65,878,534)

 

65,565,268

 

66,229,732

 

    Other marketable securities

         

     (amortized cost $67,061,818 and $53,439,401)

 

67,052,837

 

53,665,502

 
   
 
 
   

132,618,105

 

119,895,234

 
   
 
 
           

Loans held for sale

 

12,305,092

 

68,017,570

 

Loans receivable, net

 

470,292,428

 

471,667,772

 

Accrued interest receivable

 

3,284,326

 

3,508,828

 

Federal Home Loan Bank stock, at cost

 

12,245,000

 

12,245,000

 

Mortgage servicing rights, net

 

2,382,612

 

1,903,636

 

Premises and equipment, net

 

13,105,139

 

10,860,756

 

Investment in limited partnerships

 

1,850,514

 

1,523,650

 

Goodwill

 

3,800,938

 

3,800,938

 

Core deposit intangible

 

623,420

 

685,509

 

Prepaid expenses and other assets

 

3,370,635

 

3,985,625

 
   
 
 

    Total assets

$

693,723,431

 

721,114,071

 
   
 
 
           

Liabilities and Stockholders' Equity

         

Deposits

$

399,529,841

 

421,843,369

 

Federal Home Loan Bank advances

 

214,300,000

 

217,800,000

 

Accrued interest payable

 

725,382

 

1,017,456

 

Advance payments by borrowers for taxes and insurance

 

631,834

 

1,015,570

 

Accrued expenses and other liabilities

 

4,563,467

 

6,535,734

 

Deferred tax liabilities

 

548,900

 

976,900

 
   
 
 

    Total liabilities

 

620,299,424

 

649,189,029

 

 

 
 
 
Commitments and contingencies          

Minority interest

 

(332,553)

 

(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

 

58,920,012

 

59,168,782

 

Retained earnings, subject to certain restrictions

 

78,987,595

 

76,956,978

 

Accumulated other comprehensive income (loss)

 

(191,209)

 

367,744

 

Unearned employee stock ownership plan shares

 

(5,028,032)

 

(5,124,746)

 

Unearned compensation restricted stock awards

 

0

 

(7,350)

 

Treasury stock, at cost 4,714,756 and 4,732,521 shares

 

(59,023,093)

 

(59,291,344)

 
   
 
 

    Total stockholders' equity

 

73,756,560

 

72,161,351

 
   
 
 

Total liabilities and stockholders' equity

$

693,723,431

 

721,114,071

 
   
 
 

See accompanying notes to consolidated financial statements.

3


 

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Income

(unaudited)

 

   

Three Months Ended

 

Six Months Ended

   

June 30,

 

June 30,

   
 
   

2002

 

2001

 

2002

 

2001

   
 
 
 

Interest income:

               

Loans receivable

$

9,019,269

 

11,321,443

 

18,768,775

 

22,547,937

Securities available for sale:

               

Mortgage-backed and related

 

554,104

 

1,029,327

 

1,012,165

 

2,277,956

Other marketable

 

704,003

 

632,461

 

1,436,796

 

1,490,404

Cash equivalents

 

168,773

 

28,308

 

259,352

 

71,536

Other

 

65,040

 

130,842

 

174,702

 

296,728

   
 
 
 

Total interest income

 

10,511,189

 

13,142,381

 

21,651,790

 

26,684,561

   
 
 
 

Interest expense:

               

Deposits

 

2,633,678

 

4,909,776

 

5,747,225

 

9,971,378

Federal Home Loan Bank advances

 

2,594,935

 

3,018,502

 

5,171,798

 

6,348,866

   
 
 
 

Total interest expense

 

5,228,613

 

7,928,278

 

10,919,023

 

16,320,244

   
 
 
 

Net interest income

 

5,282,576

 

5,214,103

 

10,732,767

 

10,364,317

Provision for loan losses

 

310,000

 

300,000

 

1,030,000

 

450,000

   
 
 
 

Net interest income after provision for loan losses

 

4,972,576

 

4,914,103

 

9,702,767

 

9,914,317

   
 
 
 

Non-interest income:

               

Fees and service charges

 

390,352

 

362,760

 

794,161

 

714,551

Mortgage servicing fees

 

177,229

 

107,457

 

337,162

 

214,231

Securities gains (losses), net

 

26,583

 

(610,000)

 

45,508

 

(332,296)

Gain on sales of loans

 

498,469

 

1,453,930

 

1,543,029

 

2,207,926

Earnings (losses) in limited partnerships

 

(51,946)

 

(325,258)

 

326,975

 

(628,539)

Other

 

150,914

 

199,827

 

408,980

 

329,951

   
 
 
 

Total non-interest income

 

1,191,601

 

1,188,716

 

3,455,815

 

2,505,824

   
 
 
 

Non-interest expense :

               

Compensation and benefits

 

2,068,560

 

2,042,047

 

4,020,044

 

3,955,058

Occupancy

 

726,261

 

514,572

 

1,409,688

 

1,079,791

Federal deposit insurance premiums

 

18,671

 

19,969

 

38,107

 

40,772

Advertising

 

146,537

 

113,988

 

289,082

 

200,143

Data processing

 

286,925

 

240,928

 

551,384

 

471,754

Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs

 

171,104

 

195,395

 

382,306

 

336,038

Other

 

1,107,948

 

811,500

 

1,981,054

 

1,555,778

   
 
 
 

Total noninterest expense

 

4,526,006

 

3,938,399

 

8,671,665

 

7,639,334

   
 
 
 

Income before income tax expense

 

1,638,171

 

2,164,420

 

4,486,917

 

4,780,807

Income tax expense

 

485,100

 

787,300

 

1,325,200

 

1,784,900

   
 
 
 

Income before minority interest

 

1,153,071

 

1,377,120

 

3,161,717

 

2,995,907

Minority interest

 

(114,968)

 

105,001

 

(74,294)

 

132,880

   
 
 
 

Net income

$

1,268,039

 

1,272,119

 

3,236,011

 

2,863,027

   
 
 
 

Basic earnings per share

$

0.34

 

0.34

 

0.87

 

0.77

   
 
 
 

Diluted earnings per share

$

0.32

 

0.32

 

0.82

 

0.72

   
 
 
 

See accompanying notes to consolidated financial statements.

4


 

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
For the Three and Six Months Ended June 30, 2002
(unaudited)


   

Three Months Ended June 30,

   

2002

 

2001

   
 

Net income

$

       

1,268,039

         

1,272,119

Other comprehensive income (loss), net of tax:

                       

   Unrealized losses on hedging valuation

 

(13,563)

         

(81,621)

       

      Less: minority interest in hedging valuation

 

(8,116)

         

(30,688)

       
   
         
       

      Net unrealized losses on hedging valuation

     

(5,447)

         

(50,933)

   

   Unrealized gains (losses) on securities:

                       

   Unrealized holding gains (losses) arising

during period

 

(598,418)

         

585,459

       

   Less: reclassification adjustment for gains

                       

     (losses) included in net income

 

17,184

         

(368,300)

       
   
         
       

   Net unrealized gains (losses) on securities

     

(615,602)

         

953,759

   
       
         
   

Other comprehensive income (loss)

         

(621,049)

         

902,826

           
         

Comprehensive income

$

       

646,990

         

2,174,945

           
         

     

   

Six Months Ended June 30,

   

2002

 

2001

   
 

Net income

$

       

3,236,011

         

2,863,027

Other comprehensive income (loss), net of tax:

                       

   Unrealized losses on hedging valuation

 

(35,795)

         

(81,621)

       

      Less: minority interest in hedging valuation

 

(21,950)

         

(30,688)

       
   
         
       

      Net unrealized losses on hedging valuation

     

(13,845)

         

(50,933)

   

   Unrealized gains (losses) on securities:

                       

   Unrealized holding gains (losses) arising

during period

 

(515,700)

         

1,943,193

       

   Less: reclassification adjustment for gains

                       

     (losses) included in net income

 

29,408

         

(197,589)

       
   
         
       

   Net unrealized gains (losses) on securities

     

(545,108)

         

2,140,782

   
       
         
   

Other comprehensive income (loss)

         

(558,953)

         

2,089,849

           
         

Comprehensive income

$

       

2,677,058

         

4,952,876

           
         

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statement of Stockholders' Equity
For the Six Month Period Ended June 30, 2002
(unaudited)


       

 

 

 

Unearned

     
         

Employee

Unearned

   
       

Accumulated

Stock

Compensation

 

Total

   

Additional

 

Other

Ownership

Restricted

 

Stock-

 

Common

Paid-in

Retained

Comprehensive

Plan

Stock

Treasury

Holders'

 

Stock

Capital

Earnings

Income (Loss)

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

   

3,236,011 

       

3,236,011 

  Other comprehensive loss

     

(558,953)

     

(558,953) 

  Treasury stock purchases

           

(658,611)

(658,611)

  Employee stock options

               

     exercised

 

(415,938)

       

926,862 

510,924 

  Tax benefits of exercised

               

     stock options

 

100,011

         

100,011

  Amortization of restricted

               

     stock awards

         

7,350

 

7,350

  Dividends paid

   

(1,205,394)

       

(1,205,394)

  Earned employee stock

               

    ownership plan shares

 

67,157

   

96,714

   

163,871

 

Balance, June 30, 2002

$ 91,287

58,920,012

78,987,595 

(191,209)

(5,028,032)

0

(59,023,093)

73,756,560

 

See accompanying notes to consolidated financial statements.

5


 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)


   

Six Months Ended
June 30,

   
   

2002

 

2001

   
 

Cash flows from operating activities:

       

Net income

$

3,236,011

 

2,863,027

Adjustments to reconcile net income to cash provided (used) by operating activities:

       

Provision for loan losses

 

1,030,000

 

450,000

Depreciation

 

620,765

 

496,208

Amortization of premiums, net

 

100,001

 

46,564

Amortization of deferred loan fees

 

(415,631)

 

(260,738)

Amortization of goodwill

 

0

 

90,018

Amortization of core deposit intangible

 

62,089

 

62,749

Amortization of other purchase accounting adjustments

 

5,088

 

6,220

Amortization of mortgage servicing rights and net valuation adjustments

 

371,667

 

329,604

Capitalized mortgage servicing rights

 

(850,643)

 

(620,244)

Deferred income taxes

 

(104,400)

 

132,375

Securities(gains) losses, net

 

(45,508)

 

332,296

Gains on sales of real estate

 

0

 

(16,921)

Gain on sales of loans

 

(1,543,029)

 

(2,207,926)

Proceeds from sale of loans held for sale

 

167,703,663

 

383,937,788

Disbursements on loans held for sale

 

(105,746,755)

 

(420,124,178)

Principal collected on loans held for sale

 

87,982

 

40,905

Amortization of restricted stock awards

 

7,350

 

2,450

Amortization of unearned ESOP shares

 

96,714

 

96,714

Earned employee stock ownership shares priced above original cost

 

67,157

 

47,550

Decrease in accrued interest receivable

 

224,502

 

846,018

Decrease in accrued interest payable

 

(292,074)

 

(466,264)

Equity (earnings) losses of limited partnerships

 

(326,975)

 

628,539

     Equity earnings (losses) of minority interest

 

(74,294)

 

132,880

Increase in other assets

 

(489,476)

 

(1,260,404)

Increase (decrease) in other liabilities

 

(1,461,835)

 

1,028,834

Other, net

 

7,602

 

11,152

   
 

Net cash (used) provided by operating activities

 

62,269,971

 

(33,374,784)

   
 

Cash flows from investing activities:

       

Proceeds from sales of securities available for sale

 

3,566,891

 

15,000,567

Principal collected on securities available for sale

 

10,427,472

 

5,351,723

Proceeds collected on maturity of securities available for sale

 

12,400,000

 

8,695,000

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

 

(3,169,588)

 

14,227,463

Proceeds from sale of real estate

 

0

 

311,544

Purchases of premises and equipment

 

(2,876,412)

 

(875,372)

   
 

Net cash (used) provided by investing activities

 

(19,707,493)

 

42,723,081

   
 

Cash flows from financing activities:

       

Decrease in deposits

 

(22,499,992)

 

(9,279,172)

Purchase of treasury stock

 

(658,611)

 

(74,152)

Stock options exercised

 

510,924

 

190,506

Dividends to stockholders

 

(1,205,394)

 

(815,771)

Proceeds from Federal Home Loan Bank advances

 

0

 

194,200,000

Repayment of Federal Home Loan Bank advances

 

(3,500,000)

 

(176,300,000)

   Minority interest in mortgage services

 

0

 

125,000

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

 

(383,736)

 

237,465

   
 

Net cash (used) provided by financing activities

 

(27,736,809)

 

8,283,876

   
 

Increase in cash and cash equivalents

 

14,825,669

 

17,632,173

Cash and cash equivalents, beginning of period

 

23,019,553

 

14,416,861

   
 

Cash and cash equivalents, end of period

$

37,845,222

 

32,049,034

   
 

Supplemental cash flow disclosures:

       

Cash paid for interest

$

11,211,097

 

16,786,508

Cash paid for income taxes

 

1,492,500

 

2,163,000

Supplemental noncash flow disclosures:

       

Loans transferred to loans held for sale

 

3,621,521

 

801,947

Transfer of loans to real estate

 

224,288

 

81,242


See accompanying notes to consolidated financial statements.

6


 

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

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

HMN adopted the provisions of SFAS No. 141 effective July 1, 2001 and adopted SFAS No. 142 effective January 1, 2002. Intangible assets acquired in business combinations completed before July 1, 2001 were

7


evaluated during the first quarter of 2002 to determine if the useful lives and residual values of all intangible assets acquired in purchase business combinations met the new criteria established in SFAS No. 141 for recognition apart from goodwill and to make any necessary amortization period adjustments. Core deposit intangibles acquired in December of 1997 were assigned a remaining life of six years and are being amortized on an accelerated basis.

At December 31, 2001 the Bank (a reporting unit) had goodwill of $3,800,938 and during the first quarter of 2002 it was determined that the fair value of the Bank was in excess of the book value of the Bank therefore no impairment loss was necessary for goodwill. In determining the fair value of the Bank, management compiled recent financial institutional sale prices for similar sized financial institutions located in the Midwest and throughout the United States to determine average price to earnings multiples and average multiples of book. Fair value for the Bank was then determined by applying those multiples to the Bank's financial information. On January 1, 2002, in accordance with SFAS No. 142, goodwill amortization ceased. Goodwill amortization for the year ended 2001 was $180,036 or $45,009 per quarter.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB statement No. 13, and Technical Corrections. The provisions of this Statement related to the rescission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in Opinion 30 for classification as an extraordinary item shall be reclassified. The impact of adopting SFAS No. 145 on HMN's financial condition and its results of operations will not be material.

(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. At June 30, 2002 the interest rate swap had a market value adjustment of $4,347 which is included in other liabilities. The corresponding certificate of deposit was adjusted by the same amount and is reflected in deposits in the consolidated balance sheet of HMN. The interest rate swap was deemed to be totally effective and therefore no gain or loss was recorded in the income statement. The swap was called in July 2002, and HMN simultaneously called the certificate of deposit relating to the swap.

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. The derivative recorded in the balance sheet is a consolidated number that is partially owned by a minority interest. At June 30, 2002, there were no commitments to sell or securitize these loans and therefore, cash flow hedge accounting has been discontinued.

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, HMN simultaneously enters into commitments to sell the mortgage pipeline into the secondary market. As a result of marking the mortgage pipeline and the related commitments to sell to market for the second quarter ended June 30, 2002, HMN recorded a debit to Other Assets of $18,458, and a credit in Other Liabilities of $18,458.

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

8


ended June 30, 2002 were not material.

(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.

The gross unrealized losses in hedging valuation for the second quarter of 2002 was $17,000, the income tax benefit would have been $3,000 and therefore, the net loss was $14,000. The gross minority interest in hedging valuation for the second quarter of 2002 was $8,000. The gross unrealized holding losses on securities for the second quarter of 2002 was $916,000, the income tax benefit would have been $318,000 and therefore, the net loss was $598,000. The gross reclassification adjustment for the second quarter of 2002 was $26,000, the income tax expense would have been $9,000 and therefore the net gain was $17,000. The gross unrealized hedging valuation loss for the second quarter of 2001 was $132,000, the income tax benefit would have been $50,000 and therefore, the net loss was $82,000. The gross minority interest in hedging valuation for the second quarter of 2001 was $31,000. The gross unrealized holding gains on securities for the second quarter of 2001 was $975,000, the income tax expense would have been $390,000 and therefore, the net gain was $585,000. The gross reclassification adjustment in the second quarter of 2001 was $610,000, the income tax benefit would have been $242,000 and therefore, the net reclassification adjustment was $368,000.

The gross unrealized losses in hedging valuation for the six month period ended June 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 six month period ended June 30, 2002 was $22,000. The gross unrealized holding losses on securities for the six month period ended June 30, 2002 was $814,000, the income tax benefit would have been $298,000 and therefore, the net loss was $516,000. The gross reclassification adjustment in the six month period ended June 30, 2002 was $45,000, the income tax expense would have been $16,000 and therefore, the net reclassification adjustment was $29,000. The gross unrealized losses in hedging valuation for the six month period ended June 30, 2001 was $132,000, the income tax benefit would have been $50,000 and therefore, the net loss was $82,000. The gross minority interest in hedging valuation for the six month period ended June 30, 2001 was $31,000. The gross unrealized holding gains on securities for the six month period ended June 30, 2001 was $3,225,000, the income tax expense would have been $1,282,000 and therefore, the net gain was $1,943,000. The gross reclassification adjustment in the six month period ended June 30, 2001 was $332,000, the income tax benefit would have been $134,000 and therefore, the net reclassification adjustment was $198,000.

(6) Cash Dividend

On July 23, 2002 HMN's Board of Directors announced a cash dividend of $0.18 per share, payable on September 10, 2002 to stockholders of record on August 27, 2002.

9


(7) Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:


 

 

 

 

 

Six Months ended
June 30, 2002

 

 

Twelve Months ended
Dec 31, 2001

 

 

Six Months ended
June 30, 2001

   
 
 

Mortgage servicing rights

 

 

 

 

 

 

Balance, beginning of period

$

1,922,736

 

1,188,928

 

1,188,928

Originations

 

850,643

 

1,458,321

 

620,244

Amortization

 

(385,267)

 

(724,513)

 

(329,604)

   
 
 

Balance, end of period

 

2,388,112

 

1,922,736

 

1,479,568

 

 


 


 


Valuation reserve

 

 

 

 

 

 

Balance, beginning of period

 

(19,100)

 

0

 

0

Additions

 

0

 

(19,100)

 

0

Reductions

 

13,600

 

0

 

0

   
 
 

Balance, end of period

 

(5,500)

 

(19,100)

 

0

 

 


 


 


Mortgage servicing rights, net

$

2,382,612

 

1,903,636

 

1,479,568

   
 
 

Fair value of mortgage servicing rights

$

2,536,000

 

1,939,000

 

1,632,000

 

 


 


 



Mortgage servicing costs, which include professional services for valuing mortgage servicing rights, were $1,310 at June 30, 2002, and $6,434 and $16,750 for the six and twelve months ended in June and December 2001, respectively.

All of the loans being serviced were single family loans serviced for FNMA under the mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at June 30, 2002.


 

 

 

 

Loan Principal Balance

 

Weighted Average Interest Rate

 

Weighted Average Remaining Term

 

Number of Loans

 

   
 
 
 
 

Original term 30 year fixed rate

$

132,844,000

 

7.05

%

341

 

1,426

 

Original term 15 year fixed rate

 

143,878,000

 

6.46

%

161

 

2,068

 

Seven year balloon

 

36,000

 

7.25

%

308

 

1

 

Adjustable rate

 

5,067,000

 

6.26

%

326

 

36

 


 

10


(8) Investment in Limited Partnerships

Investments in limited partnerships were as follows:


 

Primary partnership activity

 

 

June 30, 2002

 

 

December 31, 2001

 

   
 
 

Mortgage servicing rights

$

1,322,799

 

991,941

 

Common stock of financial institutions

 

289,528

 

265,955

 

Low to moderate income housing

 

238,187

 

265,754

 

   
 
 

 

$

1,850,514

 

1,523,650

 

   
 
 

 

During the second quarter of 2002 HMN's proportionate loss from a mortgage servicing partnership was $50,785, its proportionate share of gains from the common stock investments in financial institutions was $5,339 and it recognized $6,500 of losses on the 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 in the second quarter of 2002. During the second quarter of 2001 HMN's proportionate loss from a mortgage servicing partnership (which included additional impairment reserves of $67,000) was $333,400, its proportionate share of losses from common stock investments in financial institutions was $14,600 and it recognized $6,500 of losses on 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 second quarter.

During the six month period ended June 30, 2002 HMN's proportionate gain from a mortgage servicing partnership was $330,858, its proportionate share of gains from the common stock investments in financial institutions was $23,573 and it recognized $27,456 of losses on the low income housing partnerships. During 2002 HMN anticipates receiving low income housing credits totaling $84,000, of which $42,000 were credited to current income tax benefits in the six month period ended June 30, 2002. During the six month period ended June 30, 2001 HMN's proportionate loss from a mortgage servicing partnership (which included the reduction of previously established impairment reserves of $164,300) was $608,900, its proportionate share of losses from the common stock investments in financial institutions was $6,600 and it recognized $13,000 of losses on the low income housing partnerships. During 2001 HMN received low-income housing credits totaling $84,000, of which $42,000 were credited to current income tax benefits in the six month period ended June 30, 2001.

(9) Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at June 30, 2002 is presented in the table below. Amortization expense for intangible assets was $202,148 for the second quarter of 2002 and $443,085 for the six months ended June 30, 2002.


   

Gross

         

Unamortized

   

Carrying

 

Accumulated

 

Valuation

 

Intangible

   

Amount

 

Amortization

 

Adjustment

 

Assets

 

Amortized intangible assets:

               

Mortgage servicing rights*

$

3,685,403

 

(1,316,391)

 

13,600

 

2,382,612

Core deposit intangible

 

1,567,000

 

(943,580)

 

0

 

623,420

   
 
 
 

Total

$

5,252,403

 

(2,259,971)

 

13,600

 

3,006,032

   
 
 
 

* The gross carrying amount and related accumulated amortization have been estimated because the mortgage servicing software utilized by HMN does not retain the original gross carrying amount of each mortgage servicing asset.

11




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


   

Mortgage

 

Core

   
   

Servicing

 

Deposit

   
   

Rights

 

Intangible

 

Total


Six months ended December 31, 2002

 

170,674

 

31,044

 

201,718

             

Year ended December 31,

           

2003

 

373,295

 

113,857

 

487,152

2004

 

327,080

 

113,857

 

440,937

2005

 

286,473

 

113,857

 

400,330

2006

 

250,770

 

113,857

 

364,627

2007

 

225,462

 

105,902

 

331,364


Projections of amortization are based on existing asset balances and the existing interest rate environment as of June 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 second quarter of 2001 to "adjusted" earnings, which exclude goodwill amortization.


     

Quarter Ended June 30, 2001

     
   

Quarter

           
   

Ended

 

Reported

 

Goodwill

 

Adjusted

   

June 30, 2002

 

Earnings

 

Amortization

 

Earnings


Income before income tax expense

$

1,638,171

 

2,164,420

 

45,009

 

2,209,429

Income tax expense

 

485,100

 

787,300

 

0

 

787,300

   
 
 
 

Income before minority interest

 

1,153,071

 

1,377,120

 

45,009

 

1,422,129

Minority interest

 

(114,968)

 

105,001

 

0

 

105,001

   
 
 
 

Net income

$

1,268,039

 

1,272,119

 

45,009

 

1,317,128

   
 
 
 

Earnings per common share

$

0.34

 

0.34

 

0.01

 

0.35

   
 
 
 

Diluted earnings per common share

$

0.32

 

0.32

 

0.01

 

0.33

   
 
 
 

 


     

Six Months Ended June 30, 2001

     
   

Six Months

           
   

Ended

 

Reported

 

Goodwill

 

Adjusted

   

June 30, 2002

 

Earnings

 

Amortization

 

Earnings


Income before income tax expense

$

4,486,917

 

4,780,807

 

90,018

 

4,870,825

Income tax expense

 

1,325,200

 

1,784,900

 

0

 

1,784,900

   
 
 
 

Income before minority interest

 

3,161,717

 

2,995,907

 

90,018

 

3,085,925

Minority interest

 

(74,294)

 

132,880

 

0

 

132,880

   
 
 
 

Net income

$

3,236,011

 

2,863,027

 

90,018

 

2,953,045

   
 
 
 

Earnings per common share

$

0.87

 

0.77

 

0.02

 

0.79

   
 
 
 

Diluted earnings per common share

$

0.82

 

0.72

 

0.03

 

0.75

   
 
 
 

12


(11)   Employee Benefits

At June 30, 2002 substantially all full-time employees of the Bank were included in a trusteed noncontributory retirement plan sponsored by the Financial Institutions Retirement Fund (FIRF). The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank's employees is not available at June 30, 2002 because such information is not accumulated for each participating institution. As of June 30, 2002, the FIRF valuation report reflected that the Bank was obligated to make contributions for the plan year ended June 30, 2002 totaling $20,575. 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 plan 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 but are estimated to be between $25,000 to $30,000.

(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 June 30,

 

Six Months ended June 30,

   
 

 

2002

 

2001

 

2002

 

2001

   
 
 
 

Weighted average number of common shares outstanding

Used in basic earnings per common share calculation

 

3,748,052

 

3,745,151

 

3,740,500

 

3,733,951

&#

               

Net dilutive effect of:

               

Options

 

223,398

 

219,121

 

209,038

 

217,913

Restricted stock awards

 

12

 

585

 

73

 

660

   
 
 
 

Weighted average number of shares outstanding

               

Adjusted for effect of dilutive securities

 

3,971,462

 

3,964,857

 

3,949,611

 

3,952,524

   
 
 
 

Income available to common shareholders

$

1,268,039

 

1,272,119

 

3,236,011

 

2,863,027

                 

Basic earnings per common share

 

$0.34

 

0.34

 

0.87

 

0.77

                 

Diluted earnings per common share

 

$0.32

 

0.32

 

0.82

 

0.72

                 

(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 June 30, 2002, that the Bank meets all capital adequacy requirements to which it is subject.

Management believes that based upon the Bank's capital calculations at June 30, 2002 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.



                                                                                                            13


On June 30, 2002 the Bank's tangible assets and adjusted total assets were $678.3 million and its risk-weighted assets were $465.3 million. The following table presents the Bank's capital amounts and ratios at June 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.


 

 

 

Actual

 

Required to be
Adequately Capitalized

 

 

Excess Capital

 

To Be Well Capitalized Under Prompt Corrective Actions Provisions

 

   
 
 
 
 

(in thousands)

 

Amount

 

Percent of Assets(1)

 

Amount

 

Percent of Assets (1)

 

 

Amount

 

Percent of Assets(1)

 

 

Amount

 

Percent of Assets(1)

 

   
 
 
 
 
 
 
 
 

Bank stockholder's equity

$

62,629

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Plus:
Net unrealized loss on certain securities available for sale

 



186

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Goodwill and other intangibles

 

4,424

 

                         

 

Excess mortgage servicing rights

 

226

                             
   
                             

Tier I or core capital

 

58,165

                             
   
                             

Tier I capital to adjusted total assets

 

 

 

8.58%

 

$ 27,132

 

4.00%

 

$ 31,033

 

4.58%

 

$ 33,915

5.00%

 

Tier I capital to risk-weighted assets

 

 

 

12.50%

 

$ 18,610

 

4.00%

 

$ 39,555

 

8.50%

 

$ 27,915

 

6.00%

 

Plus:
Allowable allowance for loan losses

 


3,446

 

                           
   
                             

Risk-based capital

$

61,611

 

 

 

$ 37,221

 

 

 

$ 24,390

 

 

 

$ 46,526

     
   
                             

Risk-based capital to risk- weighted assets

 

 

 


13.24%

 

 

 


8.00%

 

 

 


5.24%

 

 

 


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 June 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' mortgage banking activity purchases loans from other loan originators. All loans acquired 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 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 quarter ended
 
June 30, 2002:

                             

Interest income- external customers

$

10,240

 

0

 

178

 

10,418

 

93

 

 

10,511

 

Non-interest income- external customers

 

1,147

 

10

 

66

 

1,223

 

21

 

 

1,244

 

Earnings (loss) on limited partnerships

 

(58)

 

0

 

0

 

(58)

 

6

 

 

(52)

 

Intersegment interest income

 

99

 

0

 

0

 

99

 

0

 

(99)

 

0

 

Intersegment non-interest income (expense)

 

(19)

 

0

 

0

 

(19)

 

1,216

 

(1,197)

 

0

 

Interest expense

 

5,229

 

0

 

99

 

5,328

 

0

 

(99)

 

5,229

 

Amortization of mortgage servicing rights,  
   net valuation adjustments, and servicing
   costs

 



223

 



7

 



0

 



230

 



0

 



(59)

 



171

 

Other non-interest expense

 

3,986

 

0

 

383

 

4,369

 

147

 

(162)

 

4,354

 

Income tax expense (benefit)

 

593

 

0

 

0

 

593

 

(107)

 

 

486

 

Minority interest

 

(115)

 

0

 

0

 

(115)

 

0

 

 

(115)

 

Net income (loss)

 

1,263

 

3

 

(238)

 

1,028

 

1,216

 

(976)

 

1,268

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

0

 

0

 

3,801

 

Total assets

 

709,593

 

63

 

6,622

 

716,278

 

74,174

 

(96,729)

 

693,723

 

Net interest margin

 

3.04

%

NM

 

NM

 

NM

 

NM

 

NM

 

3.17

%

Return on average assets

 

0.71

%

18.18

%

(8.44)

%

NM

 

NM

 

NM

 

0.72

%

Return on average realized common equity

 

8.00

%

756.72

%

(336.02)

%

NM

 

NM

 

NM

 

6.75

%
                               

At or for the quarter ended June 30, 2001:

                             

   Interest income- external customers

$

12,126

 

0

 

911

 

13,037

 

105

 

 

13,142

 

  Non-interest income - external customers

 

610

 

12

 

800

 

1,422

 

92

 

 

1,514

 

Earnings (loss) on limited partnerships

 

(339)

 

0

 

0

 

(339)

 

14

 

 

(325)

 

Intersegment interest income

 

834

 

0

 

0

 

834

 

85

 

(919)

 

0

 

Intersegment non-interest income

 

230

 

0

 

0

 

230

 

1,364

 

(1,594)

 

0

 

Interest expense

 

7,975

 

0

 

869

 

8,844

 

3

 

(919)

 

7,928

 

Amortization of mortgage servicing rights,
    net valuation adjustments, and servicing
    costs

 



166

 



29

 



0

 



195

 



0

 



 



195

 

Other non-interest expense

 

2,910

 

(1)

 

611

 

3,520

 

369

 

(146)

 

3,743

 

Income tax expense

 

771

 

0

 

0

 

771

 

16

 

 

787

 

Minority interest

 

105

 

0

 

0

 

105

 

0

 

 

105

 

Net income (loss)

 

1,234

 

(16)

 

231

 

1,449

 

1,272

 

(1,449)

 

1,272

 

Goodwill

 

3,891

 

0

 

0

 

3,891

 

0

 

0

 

3,891

 

Total assets

 

723,447

 

134

 

46,115

 

769,696

 

71,156

 

(109,507)

 

731,345

 

Net interest margin

 

2.92

%

NM

 

NM

 

NM

 

NM

 

NM

 

2.98

%

Return on average assets

 

0.68

%

(44.97)

%

1.72

%

NM

 

NM

 

NM

 

0.70

%

  Return on average realized common equity

 

8.62

%

(1,991.20)

%

77.20

%

NM

 

NM

 

NM

 

7.11

%

                               

N/M -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 six months ended
  June 30, 2002:

                             

 Interest income  - external customers

$

20,599

 

0

 

852

 

21,451

 

201

 

 

21,652

 

Non-interest income  - external customers

 

2,791

 

21

 

271

 

3,083

 

46

 

 

3,129

 

Earnings (loss) on limited partnerships

 

303

 

0

 

0

 

303

 

24

 

 

327

 

Intersegment interest income

 

415

 

0

 

0

 

415

 

0

 

(415)

 

0

 

Intersegment non-interest income

 

261

 

0

 

0

 

261

 

3,129

 

(3,390)

 

0

 

Interest expense

 

10,919

 

0

 

415

 

11,334

 

0

 

(415)

 

10,919

 

Amortization of mortgage servicing rights, net valuation adjustments, and servicing costs

 



449

 



24

 



0

 



473

 



0

 



(91) 

 



382

 

Other non-interest expense

 

7,474

 

0

 

857

 

8,331

 

286

 

(328)

 

8,289

 

Income tax expense (benefit)

 

1,476

 

0

 

0

 

1,476

 

(150)

 

 

1,326

 

Minority interest

 

(74)

 

0

 

0

 

(74)

 

0

 

 

(74)

 

Net income (loss)

 

3,175

 

(3)

 

(149)

 

3,023

 

3,184

 

(2,971)

 

3,236

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

0

 

0

 

3,801

 

Total assets

 

709,593

 

63

 

6,622

 

716,278

 

74,174

 

(96,729)

 

693,723

 

Net interest margin

 

3.13

%

NM

 

NM

 

NM

 

NM

 

NM

 

3.20

%

Return on average assets

 

0.90

%

(8.98)

%

(1.16)

%

NM

 

NM

 

NM

 

0.92

%

Return on average realized common equity

 

10.22

%

(435.03)

%

(59.93)

%

NM

 

NM

 

NM

 

8.79

%

                               

At or for the six months ended
  
June 30, 2001:

                             

Interest income  - external customers

$

25,095

 

0

 

1,373

 

26,468

 

216

 

 

26,684

 

Non-interest income  - external customers

 

1,519

 

28

 

1,246

 

2,793

 

342

 

 

3,135

 

Earnings (loss) on limited partnerships

 

(622)

 

0

 

0

 

(622)

 

(7)

 

 

(629)

 

Intersegment interest income

 

1,252

 

0

 

0

 

1,252

 

173

 

(1,425)

 

0

 

Intersegment non-interest income

 

381

 

0

 

0

 

381

 

2,765

 

(3,146)

 

0

 

Interest expense

 

16,385

 

0

 

1,345

 

17,730

 

15

 

(1,425)

 

16,320

 

Amortization of mortgage servicing rights,
   net valuation adjustments, and servicing
   costs

 



284

 



52

 



0

 



336

 



0

 



 



36

 

Other non-interest expense

 

6,028

 

0

 

1,048

 

7,076

 

497

 

(270)

 

7,303

 

Income tax expense (benefit)

 

1,699

 

0

 

(28)

 

1,671

 

114

 

 

1,785

 

Minority interest

 

133

 

0

 

0

 

133

 

0

 

 

133

 

Net income (loss)

 

2,646

 

(24)

 

254

 

2,876

 

2,863

 

(2,876)

 

2,863

 

Goodwill

 

3,891

 

0

 

0

 

3,891

 

0

 

0

 

3,891

 

Total assets

 

723,447

 

134

 

46,115

 

769,696

 

71,156

 

(109,507)

 

731,345

 

Net interest margin

 

2.93

%

NM

 

NM

 

NM

 

NM

 

NM

 

2.97

%

Return on average assets

 

0.74

%

(29.69)

%

1.24

%

NM

 

NM

 

NM

 

0.79

%

Return on average realized common equity

 

9.55

%

(567.43)

%

44.14

%

NM

 

NM

 

NM

 

8.13

%

                               

N/M -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 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, 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, 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 second quarter of 2002 was $1.3 million, a decrease of $4,000, or 0.3%, compared to net income of $1.3 million for the second quarter of 2001. Basic earnings per share were $0.34 for the quarter ended June 30, 2002, the same as for the second quarter of 2001. Diluted earnings per share for the second quarter of 2002 were $0.32, the same as for the second quarter of 2001.

HMN's net income for the six months ended June 30, 2002 was $3.2 million, an increase of $373,000, or 13.0%, compared to net income of $2.9 million for the six month period ended June 30, 2001. Basic earnings per share were $0.87 for the six months ended June 30, 2002, an increase of $0.10 or 13.0%, from $0.77 for the same six month period in 2001. Diluted earnings per share for the six-month period in 2002 were $0.82, an increase of $0.10 or 13.9%, from $0.72 for the same six-month period in 2001.

Net Interest Income

Net interest income for the second quarter of 2002 was $5.3 million, an increase of $68,000 or 1.3%, compared to $5.2 million for the second quarter of 2001. Interest income for the second quarter of 2002 was $10.5 million, a decrease of $2.6 million or 20.0%, compared to $13.1 for the second quarter of 2001. Interest income decreased by $533,000 due to a $29.3 million net decrease in average interest-earning assets from the second quarter of 2001 to the second 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. 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

17


for additional banking facilities and the repurchase of HMN common stock. Interest income decreased by $2.1million due to a decrease in interest rates from the second quarter of 2001 to the second quarter of 2002. The yield on interest-earning assets decreased from 7.50% at June 30, 2001 to 6.26% at June 30, 2002. During the 12-month period ending on June 30, 2002, the Federal Reserve Board reduced the Federal Funds interest rate five times and the Wall Street Journal prime rate decreased from 6.75% to 4.75%. As a result, the yield on loans with rates that were indexed to prime such as commercial loans and consumer lines of credit and the yield on new loans originated during the period were less than the yields that were earned in the loan portfolio during a comparable period in 2001.

Interest expense was $5.2 million for the second quarter of 2002, a decrease of $2.7 million or 34.1%, compared to $7.9 million for the same quarter in 2001. Interest expense on deposit accounts was $2.6 million, a decrease of $2.3 million or 46.4%, from $4.9 million for the second quarter of 2001. Interest expense on deposits decreased by $2.1 million because HMN lowered the interest rates it paid on deposits to take advantage of the lower interest rate environment and $133,000 because of a decrease in the average outstanding balance of deposits. Interest expense on Federal Home Loan Bank (FHLB) advances was $2.6 million for the second quarter of 2002, a decrease of $424,000 or 14.0%, from $3.0 million for the second quarter of 2001. Interest expense on FHLB advances decreased by $114,000 due to a decline in the average outstanding advances between the two quarters. Interest expense also declined by $310,000 due to a decline in the interest rates paid on FHLB advances between the two quarters. HMN has many advances which are tied to a London Inter-Bank Offer Rates (LIBOR) index and the interest rate on those advances adjusts monthly to changes in the index. As the Federal Reserve Board reduced short-term interest rates between the quarters, the LIBOR index also decreased.

Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2002 was 3.17%, a 19 basis point increase, compared to 2.98% for the second quarter of 2001.

Net interest income for the six-month period ended June 30, 2002 was $10.7 million, an increase of $368,000 or 3.6%, compared to $10.4 million for the same period of 2001. Interest income for the six-month period of 2002 was $21.7 million, a decrease of $5.0 million, or 18.9%, compared to $26.7 million for the same period of 2001. Interest income decreased by $894,000 due to a $24.1 million net decrease in average interest-earning assets from the six-month period of 2001 to the same period 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. 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 $4.1 million due to lower interest rates being earned on the loan and investment portfolios. The decrease in rates paid decreased the yield on interest earning assets from 7.65% at June 30, 2001 to 6.26% at June 30, 2002.

Interest expense was $10.9 million for the six months ended June 30, 2002, a decrease of $5.4 million, or 33.1%, compared to $16.3 million for the same six-month period of 2001. Interest expense on deposits was $5.8 million for the six-month period ended June 30, 2002, a decrease of $4.2 million or 42.4%, compared to $10.0 million for the same period of 2001. Interest expense on deposits decreased $4.1 million because HMN lowered the interest rates it paid on deposits to take advantage of the lower interest rate environment and $112,000 because of the decrease in the average outstanding deposit balances. Interest expense on FHLB advances was $5.2 million for the six-month period of 2002, a decrease of $1.2 million, or 18.5%, from $6.4 million for the same period of 2001. Interest expense decreased by $289,000 due to a $10.7 million decrease in the average outstanding advances from the FHLB. Interest expense decreased by $888,000 due to a decrease in the cost of borrowing from the FHLB. HMN has many advances which are tied to a London Inter-Bank Offer Rates (LIBOR) index and the interest rate on those advances adjusts monthly to changes in the index. As the Federal Reserve Board reduced short-term interest rates between the quarters the LIBOR index also decreased. The average interest rate paid on average interest-bearing liabilities was 3.51% during the six months ended June 30, 2002, compared to 5.11% for the same period of 2001.

Net interest margin (net interest income divided by average interest earning assets) for the six months ended June 30, 2002, was 3.20%, an increase of 23 basis points, compared to 2.97% for the same period of 2001.

18


Provision for Loan Losses

*The provision for loan losses for the second quarter ended June 30, 2002 was $310,000, an increase of $10,000, or 3.3%, compared to $300,000 for the second quarter of 2001. The provision for loan losses for the six months ended June 30, 2002 was $1,030,000, an increase of $580,000, or 128.9% compared to $450,000 for the same six month period ended in 2001. The provision for loan losses increased primarily due to the specific loan reserves of $451,000 established in the first quarter of 2002 on two non-accruing commercial loan relationships. The provision also increased due to the growth that was experienced in the commercial and consumer loan portfolios which generally require a larger provision due to the greater inherent credit risk of these loans. 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 growth that was experienced in the commercial and consumer loan portfolios and an increase in loans charged off. HMN will continue to monitor its allowance for losses as these 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   1,030,000     450,000
Charge-offs   (709,737)     (68,830)
Recoveries   5,445    326
   
 
Balance at June 30, $ 4,108,820 $  3,525,242
   
 

 

Non-Interest Income

Non-interest income was $1.2 million for the second quarter of 2002, an increase of $3,000 or 0.2%, from $1.2 million for the second quarter of 2001. Non-interest income increased by $637,000 due to a decrease in the losses recognized on the sale of securities. This increase was primarily due to the recognition of $610,000 of impairment losses on corporate debt securities in the second quarter of 2001. Non-interest income improved by $273,000 due to lower losses from limited partnerships. The value of HMN's investment in a limited partnership that invests in mortgage servicing rights declined less in value during the second quarter of 2002 than in the second quarter of 2001 because of the magnitude of the changes in interest rates during the periods. Generally, as interest rates rise the value of fixed rate mortgage servicing rights increases and as rates fall the value of mortgage servicing rights declines due to changes in the anticipated cash flows caused by prepayments on the loans being serviced. The increases in securities and investments in limited partnerships were totally offset by a $955,000 decrease in the gains recognized on the sale of single family residential loans primarily due to HMN's decision to phase down the mortgage banking operation in Brooklyn Park.

Non-interest income was $3.5 million for the six months ended June 30, 2002, an increase of $950,000, or 37.9%, from $2.5 million for the same six month period of 2001. Non-interest income increased by $956,000 due to increased earnings from limited partnerships. Interest rates on fixed rate single family residential loans increased slightly during the first quarter of 2002 which caused the value of HMN's investment in a limited partnership that owns mortgage loan servicing assets to increase in value. Security losses decreased by $378,000 primarily due to a $610,000 impairment loss that was recognized in the second quarter of 2001. Mortgage servicing fees increased

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

19


 

$123,000, or 57.4%, due primarily to an increase in the amount of loans being serviced. These increases were partially offset by a $665,000 decline in loan sale gains primarily due to HMN's decision to phase down the mortgage banking operation in Brooklyn Park.

Non-Interest Expense

Non-interest expense was $4.5 million for the second quarter of 2002, an increase of $588,000, or 14.9%, from $3.9 million for the second quarter of 2001. Occupancy expense increased by $212,000, or 41.1%, due to the costs associated with maintaining additional facilities including the new corporate office. Other operating expenses increased by $296,000, or 36.5%, due primarily to $231,000 of reserves established for losses on merchant and other accounts receivables.

Non-interest expense was $8.7 million for the six months ended June 30, 2002, an increase of $1.0 million or 13.5%, from $7.7 million for the same period of 2001. Occupancy costs increased by $330,000 or 30.6%, primarily due to the costs associated with maintaining additional facilities including the new corporate office. Advertising expenses increased $89,000 and other expenses increased by $425,000 or 27.3%, primarily due to $231,000 of reserves established for losses on merchant and other accounts receivables and additional increases in general and administrative expenses relating to operating additional facilities.

Income Tax Expense

Income tax expense was $485,000 for the second quarter of 2002, a decrease of $302,000 compared to $787,000 for the second quarter of 2001. Income tax expense was $1.3 million for the six months ended June 30, 2002, a decrease of $460,000 compared to $1.8 million for the same six 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, increased tax exempt earnings, 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

June 30, 2002 and December 31, 2001.


 

June 30,

   

December 31,

 

(Dollars in Thousands)

 

2002

   

2001

 

Non-Accruing Loans

           

One-to-four family real estate

$

1,307

   

771

 

Commercial real estate

 

167

   

187

 

Consumer

 

102

   

311

 

Commercial business

 

994

   

890

 
   
   
 

Total

 

   2,570

   

2,159

 
   
   
 

Accruing loans delinquent 90

           

days or more

 

0

   

24

 

Other assets

 

1,796

   

1,390

 

Foreclosed and Repossessed Assets

           

One-to-four family real estate

 

226

   

0

 

Consumer

 

204

   

155

 

Commercial business

 

0

   

33

 
   
   
 

Total non-performing assets

$

4,796

 

$

3,761

 
   
   
 

Total as a percentage of total assets

 

0.69

%

 

0.52

%

   
   
 

Total non-performing loans

$

2,570

 

$

2,183

 
   
   
 

Total as a percentage of total

           

loans receivable, net

 

0.55

%

 

0.46

%

   
   
 

20


Total non-performing assets at June 30, 2002 were $4.8 million, an increase of $1 million, from $3.8 million at December 31, 2001. During the first six months of 2002 the following activity occurred related to non-accruing loans: $3,281,000 of loans were transferred in, $86,000 were transferred out to foreclosed and repossessed assets, $2,133,000 were transferred out to performing loans and $651,000 were charged off. During the same period $24,000 of accruing loans delinquent 90 days or more were transferred to performing status.

Dividends

On July 23, 2002 HMN declared a cash dividend of $.18 per share, payable on September 10, 2002 to shareholders of record on August 27, 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%
April 23, 2002 June 10, 2002 $0.18 36.0 %

The annualized dividend payout ratio for the past four quarters, ending with the September 10, 2002 payment will be 43.84%.

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 six months ended June 30, 2002 the net cash provided by operating activities was $62.3 million. HMN collected $3.6 million from the sale of securities and $22.8 million from principal repayments and the maturity of securities. It purchased securities available for sale of $40.1 million and premises and equipment of $2.9 million. Net loans receivable increased by $3.2 million due to loan production. HMN had a net decrease in deposit balances of $22.5 million for the six-month period. It paid out $3.5 million on FHLB advances and $384,000 on advance payments from borrowers for taxes and insurance. HMN received $511,000 related to the exercise of HMN stock options. HMN purchased $659,000 of its own stock and paid $1.2 million in dividends to its shareholders.

*HMN has certificates of deposits with outstanding balances of $153.2 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 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 $85.0 million of FHLB advances which mature after 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 $35 million of FHLB advances that 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.

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

21


 

Market Risk

Market risk is the risk of loss from adverse changes in market prices and 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 rates were at June 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 June 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 and cash equivalents

 $

38,067

 

38,067

 

38,067

 

38,067

 

Securities available for sale:

 

 

 

 

 

 

 

 

 

Fixed-rate CMOs

 

11,822

 

11,741

 

11,485

 

11,141

 

Variable-rate CMOs

 

50,830

 

51,064

 

49,977

 

48,437

 

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

 

2,250

 

2,185

 

2,118

 

2,046

 

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

 

583

 

583

 

579

 

575

 

Fixed-rate available for sale other marketable securities

 

67,933

 

66,942

 

65,046

 

63,659

 

Variable-rate available for sale other marketable securities

 

112

 

111

 

106

 

106

 

Federal Home Loan Bank stock 9; 9; 9;

 

12,224

 

12,209

 

12,195

 

12,182

 

Loans held for sale 9; 9; 9;

 

12,669

 

12,242

 

11,814

 

11,632

 

Loans receivable, net:

                 

Fixed-rate real estate loans 9; 9; 9;

 

207,948

 

202,989

 

197,235

 

191,548

 

Variable-rate real estate loans

 

122,374

 

120,216

 

117,997

 

115,921

 

Fixed-rate other loans

 

74,507

 

73,653

 

72,257

 

71,014

 

Variable-rate other loans

 

96,421

 

95,109

 

92,034

 

89,911

 

Mortgage servicing rights, net 9; 9; 9;

 

1,188

 

2,383

 

3,040

 

3,302

 

Investment in limited partnerships 9; 9; 9;

 

1,349

 

1,851

 

1,997

 

2,188

 

   
 
 
 
 

Total market risk sensitive assets

 

700,277

 

691,345

 

675,947

 

661,729

 

   
 
 
 
 

NOW deposits

 

58,126

 

58,126

 

58,126

 

58,126

 

Passbook deposits

 

34,143

 

34,143

 

34,143

 

34,143

 

Money market deposits

 

42,802

 

42,802

 

42,802

 

42,802

 

Certificate deposits

 

270,166

 

266,957

 

263,823

 

260,762

 

Federal Home Loan Bank:

                 
Fixed-rate advances  

191,783

  185,155   182,069   177,350  

Variable-rate advances

 

33,941

 

33,845

 

33,808

 

33,770

 

   
 
 
 
 

Total market risk sensitive liabilities

 

630,961

 

621,028

 

614,771

 

606,953

 

 
 
 
 

Off-balance sheet financial instruments:

Commitments to extend credit 9; 9; 9;

155

 

0

 

(156)

 

(222)

Commitments to sell or deliver loans

 

363

 

0

 

(365)

 

(520)

 

Interest rate swap

 

(4)

 

(4)

 

(4)

 

(4)

 
   
 
 
 
 

Net market risk

68,794

 

70,313

 

61,693

 

55,514

 

   
 
 
 
 

Percentage change from current market value

$

(2.16)

%

0.00

%

(12.26)

%

(21.05)

%

   
 
 
 
 


The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios that 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 45%, 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 26%, 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 45% 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 instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to

23


 

be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 9%. 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 June 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 23,261   8.49 %
+100 22,766   6.18 %
0 21,440  0.00 %
-100 18,856   -12.05 %

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 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 second quarter ended June 30, 2002 was $310,000, an increase of $10,000, or 3.3%, compared to $300,000 for the second quarter of 2001. The provision for loan losses for the six months ended June 30, 2002 was $1,030,000, an increase of $580,000, or 128.9% compared to $450,000 for the same six 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 growth that was experienced in the commercial and consumer loan portfolios and an increase in loans charged off. HMN will continue to monitor its allowance for losses as these 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 $153.2 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 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 $85.0 million of FHLB advances which mature after 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 $35 million of FHLB advances which will mature during the next 12 months. Since HMN has the

25


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.

Competitive pricing by other institutions, the desire of a competitor to pay interest rates on deposits that are above the current rates paid by HMN, or the desire by customers to put more of their funds into nontraditional bank products such as stocks and bonds could be circumstances that would cause the maturing certificates to become a liquidity problem.

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 rates were at June 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 June 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 June 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.

26



 

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.

The Annual Meeting of Stockholders of the Company was held on April 23, 2002 at 10:00 a.m.

The following is a record of the votes cast in the election of directors of the Company:

Term expiring in 2005: For  Withhold
 

Timothy P. Johnson 3,938,299   63,753
Timothy R. Geisler 3,957,930   44,121
Allan R. DeBoer 3,953,152   48,900
     
Term expiring in 2004:    
Michael J. Fogarty 3,952,978  49,074

Terms for Directors continuing in office are as follows:

  Term
 
Michael McNeil  2003
Duane D. Benson  2003
Mahlon C. Schneider  2003
Susan K. Kolling  2004
Roger P. Weise  2004

There were no broker non-votes and 31,093 abstentions for each of the directors. Accordingly the individuals named above were declared to be duly elected directors of the Company for terms to expire as stated above.

27


 

The following is a record of the votes cast in respect of the proposal to ratify the appointment of KPMG LLP as the Company's auditors for the fiscal year ending December 31, 2002.

  NUMBER  PERCENTAGE OF
  OF VOTES  VOTES ACTUALLY CAST
FOR 3,976,178   99.35%
AGAINST 19,167 0.48%
ABSTAIN 6,707   0.17%
BROKER NON-VOTE 0 0.00%

Accordingly, the proposal described above was declared to be duly adopted by the stockholders of the Company.

ITEM 5. Other Information.

None.

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

(a) Exhibits. See Index to Exhibits on page 30 of this report

    1. Reports 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: August 13, 2002                                                                                /s/ Michael McNeil
                                                                                                                    Michael McNeil, President
                                                                                                                    (Principal Executive Officer)
 

Date: August 13, 2002                                                                                 /s/ Timothy P. Johnson
                                                                                                                    Timothy P. Johnson,
                                                                                                                    Chief Financial Officer
                                                                                                                    (Principal Financial Officer)

29


 

 

HMN FINANCIAL, INC.

INDEX TO EXHIBITS
FOR FORM 10-Q

 
       Sequential
    Reference  Page Numbering
    to Prior Where Attached
Regulation   Filing or  Exhibits Are
 S-K   Exhibit  Located in This
Exhibit 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 Including indentures *3   N/A
       
10.1 Employment Agreement for Michael McNeil Dated January 1, 2002 10.1 Filed Electronically
       
10.2 Employment Agreement for Timothy Johnson Dated January 1, 2002 10.2 Filed Electronically
       
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).

30