HMN FINANCIAL INC - Quarter Report: 2002 March (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 March 31, 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)

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.

                                                           HMN FINANCIAL, INC.

2

See accompanying notes to consolidated financial statements.

3

4

                                                                                                      (unaudited)

See accompanying notes to consolidated financial statements.

                                                                                               (unaudited)

See accompanying notes to consolidated financial statements.

5

                                                                                         (unaudited)

See accompanying notes to consolidated financial statements.

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                                                                                       March 31, 2002 and 2001

(1) HMN Financial, Inc.

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 statement of stockholders' equity and consolidated statements of cash flows in conformity with generally accepted accounting principles. However, all adjustments consisting of only normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The statement of income for the three month period ended March 31, 2002 is not necessarily indicative of the results which may be expected for the entire year.

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

In July 2001, the Financial Accounting Standards Board (FASB) issued 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 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

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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 August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets. This Statement supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, And Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business (as previously defined in that Opinion). The Statement also amends Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements, to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. HMN adopted the provisions of SFAS. No. 144 effective January 1, 2002 with no impact to its financial position or results of its operations.

HMN adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in the first quarter of 2001. In July of 2002, 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. On March 31, 2002, the interest rate swap had a market value adjustment of $324,559 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.

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, 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. On March 31, 2002, the carrying value of the derivatives were marked to market by a $16,563 increase in other assets, the deferred tax liability was $3,000, the minority interest amount was $8,116, and other comprehensive income was $5,447.

As the loans held for sale are ultimately sold, the gains currently in accumulated other comprehensive income will be reclassified in the gains and losses on sale of loans in the income statement. It is estimated that all of the loans held for sale at March 31, 2002 will be sold in the next three months.

HMN has commitments outstanding to extend credit to future borrowers or to purchase loans that had not closed prior to the end of the quarter which it refers to as its mortgage pipeline. Most of the time, as commitments to originate or purchase loans enter into the mortgage pipeline, HMN simultaneously enters into commitments to sell the mortgage pipeline into the secondary market in order to reduce the interest rate risk from when the loan is committed until it is sold. These commitments are freestanding derivatives. As a result of marking the mortgage pipeline and the related commitments to sell to market for the quarter ended March 31, 2002, HMN recorded an

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increase to other assets of $32,116 and an increase to other liabilities of $32,116. The net impact on the income statement of recording these derivatives at fair value was zero. Some commitments to originate or purchase loans did not have a corresponding commitment to sell at March 31, 2002. The commitments were marked to market which resulted in a decrease to other liabilities of $50,669 and a gain in the gains or losses on sales of loans of $50,669.

Loans held for sale include loans that do not qualify for hedge accounting. A significant portion of these loans have commitments to sell associated with them. As a result of marking these loans to the lower of cost or market and recording the commitments to sell at fair value, loans held for sale were reduced by $204,066 and other assets were increased by $204,066. The net impact on the income statement was zero. A portion of these loans did not have a commitment associated with them and the lower of cost or market adjustment resulted in an increase in loans held for sale of $97,507 and a gain in gains or losses on sales of loans of $97,507.

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 losses on hedging valuations.

The gross unrealized losses in hedging valuation for the first quarter of 2002 was $28,232, the income tax benefit would have been $6,000 and therefore, the net loss was $22,232. The gross minority interest in hedging valuations for the first quarter of 2002 was $13,384. There were no gains or losses on hedging valuation in the first quarter of 2001.

The gross unrealized holding gains for the first quarter of 2002 were $101,819, the income tax expense would have been $19,009 and therefore, the net gain was $82,810. The gross reclassification adjustment for the first quarter of 2002 was $18,925, the income tax expense would have been $6,609 and therefore, the net reclassification adjustment was $12,316. The gross unrealized holding gains for the first quarter of 2001 were $2.3 million, the income tax expense would have been $892,293 and therefore, the net gain was $1,357,734. The gross reclassification adjustment for the first quarter of 2001 was a gain of $277,704, the income tax expense would have been $106,993 and therefore, the net reclassification adjustment was a gain of $170,711.

(6) Cash Dividend

On April 23, 2002 HMN's Board of Directors announced a cash dividend of $0.18 per share, payable on June 10, 2002 to stockholders of record on May 23, 2002.

Investments in limited partnerships were as follows:

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During the first quarter of 2002 HMN's proportionate gain from a mortgage servicing partnership was $381,643, its proportionate share of gains from common stock investments in financial institutions was $18,234 and it recognized $20,956 of losses on low income housing partnerships. During 2002 HMN anticipates receiving low-income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits.

During the first quarter of 2001 HMN's proportionate loss from a mortgage servicing partnership was $257,517, its proportionate share of losses from the common stock investments in financial institutions was $21,264 and it recognized $6,500 of losses on the low income housing partnerships. During 2001 HMN received low-income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits in the first quarter.

A summary of mortgage servicing activity is as follows:

All of the loans being serviced were single family loans serviced for the Federal National Mortgage Association (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 March 31, 2002.

The gross carrying amount of intangible assets and the associated accumulated amortization at March 31, 2002 is presented in the table below. Amortization expense for intangible assets was $240,937 for the quarter ended March 31, 2002.

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

Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2002. HMN's actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

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

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

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 March 31, 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 March 31, 2002 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On March 31, 2002 the Bank's tangible assets and adjusted total assets were $703.7 million and its risk-weighted assets were $451.5 million. The following table presents the Bank's capital amounts and ratios at March 31, 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.

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(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 March 31, 2002 but is not reflected in the table above.

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 segments 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.

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