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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)

Delaware

41-1777397

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification Number)

1016 Civic Center Drive N.W., 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 May 3, 2002

Common stock, $0.01 par value

 

4,399,345

 


 

 

                                                           HMN FINANCIAL, INC.

                                                                      CONTENTS

PART I - FINANCIAL INFORMATION

   

Page

Item 1:

Financial Statements (unaudited)

 
     
 

Consolidated Balance Sheets at March 31, 2002 and December 31, 2001

3

     
 

Consolidated Statements of Income for the Three Months Ended March 31, 2002 and 2001

4

     
 

Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2002 and 2001

5

     
 

Consolidated Statement of Stockholders' Equity for the Three Month Period Ended March 31, 2002

5

     
 

Consolidated Statements of Cash Flows for the Three Months Ended

March 31, 2002 and 2001

6

     
 

Notes to Consolidated Financial Statements

7-14

     

Item 2:

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

15-22

     

Item 3:

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

17

     

PART II - OTHER INFORMATION

     

Item 1:

Legal Proceedings

23

     

Item 2:

Changes in Securities

23

     

Item 3:

Defaults Upon Senior Securities

23

     

Item 4:

Submission of Matters to a Vote of Security Holders

23

     

Item 5:

Other Information

23

     

Item 6:

Exhibits and Reports on Form 8-K

23

     

Signatures

24

 

2


 

 

                                                 HMN FINANCIAL, INC. AND SUBSIDIARIES

                                                                Consolidated Balance Sheets

                                                                              (unaudited)

   

March 31,

 

December 31,

 
   

2002

 

2001

 

Assets

         

Cash and cash equivalents

$

65,425,262

 

23,019,553

 

Securities available for sale:

         

   Mortgage-backed and related securities

         

    (amortized cost $64,704,962 and $65,878,534)

 

65,533,335

 

66,229,732

 

    Other marketable securities

         

     (amortized cost $74,017,398 and $53,439,401)

 

73,849,217

 

53,665,502

 


   

139,382,552

 

119,895,234

 
   
 
 

Loans held for sale

 

25,853,978

 

68,017,570

 

Loans receivable, net

 

448,976,189

 

471,667,772

 

Accrued interest receivable

 

3,495,845

 

3,508,828

 

Federal Home Loan Bank stock, at cost

 

12,245,000

 

12,245,000

 

Premises and equipment, net

 

11,816,652

 

10,860,756

 

Investment in limited partnerships

 

1,902,571

 

1,523,650

 

Goodwill

 

3,800,938

 

3,800,938

 

Mortgage servicing rights, net

 

2,284,068

 

1,903,636

 

Core deposit intangible

 

654,464

 

685,509

 

Prepaid expenses and other assets

 

2,943,178

 

3,985,625

 


    Total assets

$

718,780,697

 

721,114,071

 
   
 
 

Liabilities and Stockholders' Equity

         

Deposits

$

414,023,610

 

421,843,369

 

Federal Home Loan Bank advances

 

217,800,000

 

217,800,000

 

Accrued interest payable

 

923,953

 

1,017,456

 

Advance payments by borrowers for taxes and insurance

 

1,346,543

 

1,015,570

 

Accrued expenses and other liabilities

 

5,714,276

 

6,535,734

 

Deferred tax liabilities

 

878,900

 

976,900

 

Due to broker

 

5,020,313

 

0

 


    Total liabilities

 

645,707,595

 

649,189,029

 


Commitments and contingencies

         

Minority interest

 

(209,470)

 

(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

 

59,131,787

 

59,168,782

 

Retained earnings, subject to certain restrictions

 

78,397,443

 

76,956,978

 

Accumulated other comprehensive income

 

429,840

 

367,744

 

Unearned employee stock ownership plan shares

 

(5,076,390)

 

(5,124,746)

 

Unearned compensation restricted stock awards

 

(1,725)

 

(7,350)

 

Treasury stock, at cost 4,757,596 and 4,732,521 shares

 

(59,689,670)

 

(59,291,344)

 


    Total stockholders' equity

 

73,282,572

 

72,161,351

 


Total liabilities and stockholders' equity

$

718,780,697

 

721,114,071

 
   
 
 

See accompanying notes to consolidated financial statements.

 

3


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income

(unaudited)

   
   

Three Months Ended March 31,

   

             2002                             2001

Interest income:

     
    Loans receivable $ 9,749,506 11,226,494

     Securities available for sale:

       

         Mortgage-backed and related

 

458,061

 

1,248,629

         Other marketable

 

732,793

 

857,943

     Cash equivalents

 

90,579

 

43,228

     Other

 

109,662

 

165,886



         Total interest income

 

11,140,601

 

13,542,180

   
 

Interest expense:

       

     Deposits

 

3,113,547

 

5,061,602

     Federal Home Loan Bank advances

 

2,576,863

 

3,330,364



        Total interest expense

 

5,690,410

 

8,391,966



   Net interest income

 

5,450,191

 

5,150,214

Provision for loan losses

 

720,000

 

150,000



        Net interest income after provision for loan losses

 

4,730,191

 

5,000,214

   
 

Non-interest income:

       

     Fees and service charges

 

403,809

 

351,791

     Mortgage servicing fees

 

159,933

 

106,774

     Securities gains, net

 

18,925

 

277,704

     Gain on sales of loans

 

1,044,560

 

852,336

     Earnings (losses) in limited partnerships

 

378,921

 

(303,281)

     Other

 

258,066

 

130,124



        Total non-interest income

 

2,264,214

 

1,415,448

   
 

Non-interest expense:

       

     Compensation and benefits

 

1,951,484

 

1,913,011

     Occupancy

 

683,427

 

565,219

     Federal deposit insurance premiums

 

19,436

 

20,803

     Advertising

 

142,545

 

86,155

     Data processing

 

264,459

 

230,826

     Amortization of mortgage servicing rights, net of 

       

       valuation adjustments and servicing costs

 

211,202

 

140,643

     Other

 

873,106

 

842,618



        Total non-interest expense

 

4,145,659

 

3,799,275



        Income before income tax expense

 

2,848,746

 

2,616,387

Income tax expense

 

840,100

 

997,600



        Income before minority interest

 

2,008,646

 

1,618,787

Minority interest

 

40,674

 

27,879



        Net income

$

1,967,972

 

1,590,908



Basic earnings per share

$

0.53

 

0.43



Diluted earnings per share

$

0.50

 

0.40

   
 

See accompanying notes to consolidated financial statements.

4


 

 

                                                                     HMN FINANCIAL, INC. AND SUBSIDIARIES

                                                                Consolidated Statements of Comprehensive Income

                                                                    For the Three Months Ended March 31, 2002

                                                                                                      (unaudited)

 


   

Three Months Ended March 31,

   

2002

 

2001



Net income

$

       

1,967,972

         

1,590,908

Other comprehensive income, net of tax:

                       

   Unrealized losses on hedging valuation

 

(22,232)

         

0

       

      Less: minority interest in hedging valuation  

 

(13,834)

         

0

       


      Net unrealized losses on hedging valuation

     

(8,398)

         

0

   

   Unrealized gains on securities:

                       

   Unrealized holding gains arising during period

 

82,810

         

1,357,734

       

   Less: reclassification adjustment for gains

                       

     Included in net income

 

12,316

         

170,711

       


   Net unrealized gains on securities

     

70,494

         

1,187,023

   


Other comprehensive income

         

62,096

         

1,187,023



Comprehensive income

$

       

2,030,068

         

2,777,931

           
         

See accompanying notes to consolidated financial statements.

 

                                                                 HMN FINANCIAL, INC. AND SUBSIDIARIES

                                               Consolidated Statement of Stockholders' Equity

                                                           For the Three Month Period Ended March 31, 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

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

   

1,967,972 

       

1,967,972 

  Other comprehensive income

     

62,096

     

62,096 

  Treasury stock purchases

           

(658,611)

(658,611)

  Employee stock options

               

    exercised

 

(109,245)

       

260,285 

151,040 

  Tax benefits of exercised

               

    stock options

 

44,542

         

44,542

  Amortization of restricted

               

    stock awards

         

5,625

 

5,625

  Dividends paid

   

(527,507)

       

(527,507)

  Earned employee stock

               

    ownership plan shares

 

27,708

   

48,356

   

76,064


Balance, March 31, 2002

$ 91,287

59,131,787

78,397,443 

429,840

(5,076,390)

(1,725)

(59,689,670)

73,282,572



See accompanying notes to consolidated financial statements.

 

5


                                                                HMN FINANCIAL, INC. AND SUBSIDIARIES

                                                                   Consolidated Statements of Cash Flows

                                                                                         (unaudited)


   

Three Months Ended

March 31,


   

2002

 

2001


Cash flows from operating activities:

       

Net income

$

1,967,972

 

1,590,908

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

       

Provision for loan losses

 

720,000

 

150,000

Depreciation

 

312,487

 

243,694

Amortization of (discounts) premiums, net

 

79,702

 

(1,867)

Amortization of deferred loan fees

 

(260,091)

 

(92,784)

Amortization of goodwill

 

0

 

45,009

Amortization of core deposit intangible

 

31,045

 

33,039

Amortization of other purchase accounting adjustments

 

2,376

 

3,171

Amortization of mortgage servicing rights and net valuation adjustments

 

203,792

 

139,258

Capitalized mortgage servicing rights

 

(584,224)

 

(194,575)

Deferred income taxes

 

(104,400)

 

62,500

Securities gains, net

 

(18,925)

 

(277,704)

Gain on sales of loans

 

(1,044,560)

 

(852,336)

Proceeds from sale of loans held for sale

 

123,270,922

 

141,878,210

Disbursements on loans held for sale

 

(77,698,382)

 

(177,712,362)

Principal collected on loans held for sale

 

65,647

 

12,175

Amortization of restricted stock awards

 

5,625

 

1,837

Amortization of unearned ESOP shares

 

48,356

 

48,357

Earned employee stock ownership shares priced above original cost

 

27,708

 

23,585

Decrease in accrued interest receivable

 

12,983

 

598,074

Decrease in accrued interest payable

 

(93,503)

 

(278,704)

Equity (earnings) losses of limited partnerships

 

(378,921)

 

303,281

     Equity earnings of minority interest

 

40,674

 

27,879

Increase in other assets

 

(54,490)

 

(523,256)

Decrease (increase) in other liabilities

 

(595,232)

 

1,060,897

Other, net

 

(42)

 

38,167



Net cash provided by (used) operating activities

 

45,956,519

 

(33,673,547)



Cash flows from investing activities:

       

Proceeds from sales of securities available for sale

 

1,461,425

 

15,000,567

Principal collected on securities available for sale

 

6,347,804

 

2,249,266

Proceeds collected on maturity of securities available for sale

 

3,250,000

 

8,695,000

Purchases of securities available for sale

 

(25,518,515)

 

0

Net decrease (increase) in loans receivable

 

20,558,281

 

(1,359,467)

Purchases of premises and equipment

 

(1,268,383)

 

(468,143)



Net cash provided by investing activities

 

4,830,612

 

24,117,223

Cash flows from financing activities:

 
 

Decrease in deposits

 

(7,677,317)

 

(321,102)

Purchase of treasury stock

 

(658,611)

 

0

Stock options exercised

 

151,040

 

86,056

Dividends to stockholders

 

(527,507)

 

(365,040)

Proceeds from Federal Home Loan Bank advances

 

0

 

76,400,000

Repayment of Federal Home Loan Bank advances

 

0

 

(66,500,000)

   Minority interest in mortgage services

 

0

 

125,000

Increase in advance payments by borrowers for taxes and insurance

 

330,973

 

451,616



Net cash (used) provided by financing activities

 

(8,381,422)

 

9,876,530



Increase in cash and cash equivalents

 

42,405,709

 

320,206

Cash and cash equivalents, beginning of period

 

23,019,553

 

14,416,861



Cash and cash equivalents, end of period

$

64,425,262

 

14,737,067

Supplemental cash flow disclosures:

 
 

Cash paid for interest

$

5,783,913

 

8,670,670

Cash paid for income taxes

 

42,500

 

442,000

Supplemental noncash flow disclosures:

       

Loans transferred to loans held for sale

 

1,592,095

 

727,243

Transfer of loans to real estate

 

0

 

50,645


See accompanying notes to consolidated financial statements.

 

 

6


 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

                                                                            Notes to Consolidated Financial Statements

                                                                                                    (unaudited)

                                                                                       March 31, 2002 and 2001

(1) HMN Financial, Inc.

HMN Financial, Inc. (HMN) is a stock savings bank holding company which 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 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.

(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 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

7


 

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.

 

(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 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

8


 

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.

 

(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 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.

 

(7) Investment in Limited Partnerships

Investments in limited partnerships were as follows:


 

Primary partnership activity

 

 

March 31, 2002

 

 

December 31, 2001

 




Mortgage servicing rights

$

1,373,584

 

991,941

 

Common stock of financial institutions

 

284,189

 

265,955

 

Low to moderate income housing

 

244,798

 

265,754

 



 

$

1,902,571

 

1,523,650

 




 

 

9


 

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.

 

(8) Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:


 

 

 

 

Three months ended

March 31, 2002

 

Twelve months ended

December 31, 2001

   
 

Mortgage servicing rights

 

 

 

 

Balance, beginning of period

$

1,922,736

 

1,188,928

Originations

 

584,224

 

1,458,321

Amortization

 

(209,892)

 

(724,513)

   
 

Balance, March 31

 

2,297,068

 

1,922,736

   
 

Valuation reserve

 

 

 

 

Balance, beginning of period

 

(19,100)

 

0

Additions

 

0

 

(19,100)

Reductions

 

6,100

 

0

   
 

Balance, March 31

 

(13,000)

 

(19,100)

 

 


 


Mortgage servicing rights, net

$

2,284,068

 

1,903,636

   
 

Fair value of mortgage servicing rights

$

2,491,000

 

1,939,000

   
 

 

 

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.


 

 

 

 

Loan Principal Balance

Weighted Average

Interest Rate

Weighted Average Remaining Term

 

Number of Loans





Original term 30 year fixed rate

$

122,169,000

7.09

%

341

1,342

Original term 15 year fixed rate

143,690,000

6.48

%

163

2,057

Seven year balloon

122,000

7.07

%

312

2

Adjustable rate

3,722,000

6.72

%

314

27


 

10


 

(9) Intangible Assets

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.


   

Gross

         

Unamortized

   

Carrying

 

Accumulated

 

Valuation

 

Intangible

   

Amount

 

Amortization

 

Adjustment

 

Assets


Amortized intangible assets:

               

Mortgage servicing rights*

$

3,435,455

 

(1,145,287)

 

(6,100)

 

2,284,068

Core deposit intangible

 

1,567,000

 

(912,536)

 

0

 

654,464





Total

$

5,002,455

 

(2,057,823)

 

(6,100)

 

2,938,532






* 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.

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


   

Mortgage

 

Core

   
   

Servicing

 

Deposit

   
   

Rights

 

Intangible

 

Total


Nine months ended December 31, 2002

 

286,526

 

93,134

 

379,659

             

Year ended December 31,

           

2003

 

340,133

 

113,857

 

453,990

2004

 

297,672

 

113,857

 

411,529

2005

 

260,418

 

113,857

 

374,275

2006

 

227,707

 

113,857

 

341,564

2007

 

199,106

 

105,902

 

305,008


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.

 

(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 first quarter of 2001 to "adjusted" earnings, which exclude goodwill amortization.


     

Quarter Ended March 31, 2001


   

Quarter

           
   

Ended

 

Reported

Earnings

 

Goodwill

Amortization

 

Adjusted

Earnings

   

March 31, 2002

     

Income before income tax expense

$

2,848,746

 

2,616,387

 

45,009

 

2,661,396

Income tax expense

 

840,100

 

997,600

 

0

 

997,600





Income before minority interest

 

2,008,646

 

1,618,787

 

45,009

 

1,663,796

Minority interest

 

40,674

 

27,879

 

0

 

27,879





Net income

$

1,967,972

 

1,590,908

 

45,009

 

1,691,675





Earnings per common share

$

0.53

 

0.43

 

0.01

 

0.44





Diluted earnings per common share

$

0.50

 

0.40

 

0.01

 

0.41

   
 
 
 

 

11


 

(11) 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 March 31,

 

   

2002

 

2001

 


Weighted average number of common shares outstanding

         

   used in basic earnings per common share calculation

 

3,733,673

 

3,722,627

 
           

Net dilutive effect of:

         

   Options

 

194,677

 

216,704

 

   Restricted stock awards

 

135

 

735

 


Weighted average number of shares outstanding

         

   adjusted for effect of dilutive securities

 

3,928,485

 

3,940,066

 
   
 
 

Income available to common shareholders

$

1,967,972

 

1,590,908

 

Basic earnings per common share

$

0.53

 

0.43

 

Diluted earnings per common share

$

0.50

 

0.40

 
           

 

(12) 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 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.

12


 

                     

To Be Well

 
             

Required to be

     

Capitalized Under

 
             

Adequately

     

Prompt Corrective

 
   

Actual

   

   Capitalized

     

Excess Capital

   

Actions Provision

 




       

Percent of

       

Percent of

       

Percent of

       

Percent of

 

(in thousands)

 

Amount

 

Assets (1)

   

Amount

 

Assets (1)

   

Amount

 

Assets (1)

   

Amount

 

Assets (1)

 








Bank stockholder's equity

$

62,100 

                                   

Plus:

                                       

    Net unrealized loss (gain) on      certain securities available

                                       

     for sale and cash flow hedges

 

(391) 

                                   

Less:

                                       

    Goodwill and core deposit       intangible

 

4,455 

                                   

    Excess mortgage servicing       rights

 

177 

                                   

    Tier I or core capital

 

57,077 

                                   

    Tier I capital to adjusted        total assets

     

8.11%

 

$

28,148  

 

4.00%

 

$

28,929  

 

4.11%

 

$

35,185  

 

5.00%

 

    Tier I capital to        risk-weighted assets

     

12.64%

 

$

18,058  

 

4.00%

 

$

39,019  

 

8.64%

 

$

27,087  

 

6.00%

 

Plus:

                                       

    Allowable allowance for loan        losses

 

3,512 

                                   

    Risk-based capital

$

60,589 

     

$

36,116  

     

$

24,473  

     

$

45,145  

     

    Risk-based capital to

                                       

       risk-weighted assets

     

13.42%

       

8.00%

       

5.42%

       

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

(13) 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 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.

13


 

       

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

                             

    March 31, 2002:

                             

Interest income

                             

    - external customers

$

10,359

 

0

 

674

 

11,033

 

108

 

 

11,141

 

Non-interest income

                             

    - external customers

 

1,644

 

11

 

205

 

1,860

 

25

 

 

1,885

 

Earnings on limited partnerships

 

361

 

0

 

0

 

361

 

18

 

 

379

 

Intersegment interest income

 

316

 

0

 

0

 

316

 

0

 

(316)

 

0

 

Intersegment non-interest income

 

280

 

0

 

0

 

280

 

1,913

 

(2,193)

 

0

 

Interest expense

 

5,690

 

0

 

316

 

6,006

 

0

 

(316)

 

5,690

 

Amortization of mortgage servicing

                             

   rights and net valuation adjustments

 

226

 

17

 

0

 

243

 

0

 

(32) 

 

211

 

Other non-interest expense

 

3,488

 

0

 

474

 

3,962

 

139

 

(166)

 

3,935

 

Income tax expense (benefit)

 

883

 

0

 

0

 

883

 

(43)

 

 

840

 

Minority interest

 

41

 

0

 

0

 

41

 

0

 

 

41

 

Net income (loss)

 

1,912

 

(6)

 

89

 

1,995

 

1,968

 

(1,995)

 

1,968

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

0

 

0

 

3,801

 

Total assets

 

721,297

 

66

 

17,964

 

739,327

 

73,434

 

(193,980)

 

718,781

 

Net interest margin

 

3.22

%

NM

 

NM

 

NM

 

NM

 

NM

 

3.23

%

Return on average assets

 

1.09

%

(35.05)

%

0.89

%

NM

 

NM

 

NM

 

1.11

%

Return on average realized

                             

   common equity

 

12.51

%

(2,013.06)

%

49.95

%

NM

 

NM

 

NM

 

10.92

%

                               

At or for the quarter ended

                             

   March 31, 2001:

                             

Interest income

                             

   - external customers

$

12,969

 

0

 

462

 

13,431

 

111

 

 

13,542

 

Non-interest income

                             

   - external customers

 

943

 

16

 

509

 

1,468

 

250

 

 

1,718

 

Earnings (loss) on

                             

limited partnerships

 

(282)

 

0

 

0

 

(282)

 

(21)

 

 

(303)

 

Intersegment interest income

 

418

 

0

 

0

 

418

 

88

 

(506)

 

0

 

Intersegment non-interest income

 

151

 

0

 

0

 

151

 

1,401

 

(1,552)

 

0

 

Interest expense

 

8,410

 

0

 

476

 

8,886

 

12

 

(506)

 

8,392

 

Amortization of mortgage servicing

                             

   rights and net valuation adjustments

 

118

 

23

 

0

 

141

 

0

 

 

141

 

Other non-interest expense

 

3,153

 

1

 

500

 

3,654

 

128

 

(124)

 

3,658

 

Income tax expense (benefit)

 

928

 

0

 

(28)

 

900

 

98

 

 

998

 

Minority interest

 

28

 

0

 

0

 

28

 

0

 

 

28

 

Net income (loss)

 

1,412

 

(8)

 

23

 

1,427

 

1,591

 

(1,427)

 

1,591

 

Goodwill

 

3,936

 

0

 

0

 

3,936

 

0

 

0

 

3,936

 

Total assets

 

717,148

 

153

 

43,460

 

760,761

 

69,944

 

(100,215)

 

730,490

 

Net interest margin

 

2.95

%

NM

 

NM

 

NM

 

NM

 

NM

 

2.97

%

Return on average assets

 

0.80

%

(16.85)

%

0.32

%

NM

 

NM

 

NM

 

0.88

%

Return on average realized

                             

   common equity

 

10.52

%

(218.00)

%

8.24

%

NM

 

NM

 

NM

 

9.18

%

                               

N/M -Not meaningful

14


 

                                                                         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 first quarter of 2002 was $2.0 million, an increase of $377,000, or 23.7%, compared to net income of $1.6 million for the first quarter of 2001. Basic earnings per share were $0.53 for the quarter ended March 31, 2002, an increase of $0.10 per share, from $0.43 basic earnings per share for the same quarter of 2001. Diluted earnings per share were $0.50 for the first quarter of 2002, an increase of $0.10 from $0.40 diluted earnings per share for the first quarter of 2001. The average number of outstanding shares for the basic earnings per share calculation increased by 11,046 shares from 3,722,627 at March 31, 2001, to 3,733,673 at March 31, 2002. The average number of outstanding shares for the diluted earnings per share calculation declined by 11,581 shares from 3,940,066 at March 31, 2001, to 3,928,485 at March 31, 2002. The adoption of SFAS No. 142, Goodwill and Other Intangible Assets, increased diluted earnings per common shares by $0.01 for the quarter ended March 31, 2002. Refer to Note 10 of the Notes to Consolidated Financial Statements for more information.

 

Net Interest Income

Net interest income for the first quarter of 2002 was $5.5 million, an increase of $300,000, or 5.8%, compared to $5.2 million for the first quarter of 2001. Interest income for the first quarter of 2002 was $11.1 million, a decrease of $2.4 million, or 17.7%, compared to $13.5 million for the first quarter of 2001. The interest income decreased by $2.0 million because the yield earned on interest earning assets decreased from the first quarter of 2001. During the past year, the Federal Reserve reduced the Federal Funds interest rate eight times and the Wall Street Journal prime rate decreased by 3.25%. As a result, loans with rates that were indexed to prime, such as commercial loans and consumer lines of credit, earned less interest income. The yield earned on interest-earning assets decreased from 7.81% at March 31, 2001 to 6.6% at March 31, 2002. Interest income decreased by $400,000 due to a $19.0 million net decrease in average interest-earning assets from the first quarter of 2001 to the first quarter of 2002.

15


 

Interest expense was $5.7 million for the first quarter of 2002, a decrease of $2.7 million, or 32.2%, compared to $8.4 million for the same quarter of 2001. Interest expense on deposits decreased by $1.4 million due to decreased interest rates paid on certificates of deposit and by $338,000 due to a decrease in the average outstanding balance of deposits. Interest expense on Federal Home Loan Bank advances decreased by $577,000 due to decreased interest rates paid and by $177,000 due to a decrease in the average outstanding balance of advances. The average interest rate paid on the average interest-bearing liabilities was 3.64% during the first quarter of 2002, compared to 5.27% for the first quarter of 2001. Net interest earning assets decreased from $57.2 million at March 31, 2001 to $50.0 million at March 31, 2002. The decrease in net earning assets is primarily due to stock repurchases, dividend payments to shareholders, and purchases of premises and equipment Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2002 was 3.23%, an increase of 26 basis points, compared to 2.97% for the first quarter of 2001.

 

Provision for Loan Losses

*The provision for loan losses for the first quarter ended March 31, 2002 was $720,000, an increase of $570,000, compared to $150,000 for the first quarter of 2001. The provision for loan losses increased primarily due to increases in specific loan reserves of $451,000 on two non-accruing commercial loan relationships during the first quarter of 2002. 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 loan portfolio, historic level of non-performing loans, an increase 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, single family loan delinquencies as reported separately by FNMA and the Federal Home Loan Mortgage Corporation (FHLMC), local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed that an increase in the provision for loan losses was required in the first quarter of 2002 compared to the first quarter of 2001. 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

720,000 

 

150,000 

Charged off

(61,096)

 

(3,978) 

Recoveries

1,761 

 

326 



Balance at March 31,

$  4,443,777 

 

$  3,290,094 

 
 

 

 

Non-Interest Income

Non-interest income was $2.3 million for the first quarter of 2002, an increase of $849,000, or 60%, from $1.4 million for the first quarter of 2001. Non-interest income increased by $682,000 due to an increase in the earnings of limited partnership investments, $192,000 due to an increase in the gains recognized on loan sales, $128,000 increase in other income primarily from increased sales of non-deposit investment products and by $53,000 due to increased mortgage servicing fees. The increase in non-interest income was partially offset by a decline of $259,000 in revenue from security gains. Interest rates on mortgage loans increased slightly during the first quarter of 2002 which caused the value of HMN's investment in a limited partnership which owns mortgage loan servicing assets to increase in value. The value of mortgage servicing rights fluctuates with interest rates and generally increases when mortgage rates increase because of the anticipated decrease in prepayments expected to be received on the mortgage loan servicing assets.

*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 21 of this discussion

16


 

Non-Interest Expense

Non-interest expense was $4.1 million for the first quarter of 2002, an increase of $346,000, or 9.1%, from $3.8 million for the first quarter of 2001. Occupancy expense increased by $118,000, or 20.9%, due to additional operating costs associated with maintaining additional facilities including the new corporate office. Advertising expense increased by $56,000 and amortization of mortgage servicing rights, net of valuation adjustments and servicing costs increased by $71,000 because of the increase in the mortgage servicing assets.

Income Tax Expense

Income tax expense was $840,000 for the first quarter of 2002, a decrease of $158,000 compared to $998,000 for the first quarter of 2001. During the first quarter of 2002, the Bank reduced its effective income tax rate from 38.1% to 29.5% through the use of certain state tax planning initiatives. As a result of the change in the effective rate, HMN recognized a $104,400 tax benefit in the first quarter of 2002 when it recalculated its net deferred tax liability utilizing the lower effective income tax rate. The lower effective rate when coupled with the deferred tax liability reduction is the primary reason for the decrease in income tax expense between the two quarters.

Non-Performing Assets

The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at

March 31, 2002 and December 31, 2001.

 

 

March 31,

   

December 31,

 

(Dollars in Thousands)

 

2002

   

2001

 


Non-Accruing Loans

           

One-to-four family real estate

$

975

   

771

 

Commercial real estate

 

236

   

187

 

Consumer

 

389

   

311

 

Commercial business

 

1,803

   

890

 


Total

 

   3,403

   

2,159

 


Accruing loans delinquent 90 days or more

 

0

   

24

 

Other assets (impaired securities)

 

1,390

   

1390

 

Foreclosed and Repossessed Assets

           

Consumer

 

173

   

155

 

Commercial business

 

0

   

33

 


Total non-performing assets

$

4,966

 

$

3,761

 


Total as a percentage of total assets

 

0.69

%

 

0.52

%



Total non-performing loans

$

3,403

 

$

2,183

 

 
   
 

Total as a percentage of total loans receivable, net

 

0.76

%

 

0.46

%

 
   
 

 

Total non-performing assets at March 31, 2002 were $5.0 million, an increase of $1.2 million, from $3.8 million at

December 31, 2001. During the first quarter of 2002 the following activity occurred related to non-accruing loans: $2,259,000 of loans were transferred in, $35,000 were transferred out to foreclosed and repossessed assets, $935,000 were transferred out to performing loans and $45,000 were charged off. During the same period $24,000 of accruing loans delinquent 90 days or more were transferred to performing status.

Dividends

On April 23, 2002 HMN declared a cash dividend of $.18 per share, payable on June 10, 2002 to shareholders of record on May 23, 2002.

17


 

During the first quarter of 2002, HMN declared and paid dividends as follows:

Record date                Payable date         Dividend per share         Dividend Payout Ratio

February 21, 2002      March 7, 2002               $0.14                           100.00 %

The annualized dividend payout ratio for the past four quarters, ending with the June 10, 2002 payment will be 41.10%.

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 quarter ended March 31, 2002, the net cash provided by operating activities was $46.0 million. HMN collected $1.5 million from the sale of securities and $9.6 million in principal repayments or on the maturity of securities during the quarter. It purchased $25.5 million in securities and received $20.6 million relating to a decrease in net loans receivable. It purchased premises and equipment of $1.3 million. HMN had a net decrease in deposit balances of $7.7 million during the quarter. It received net proceeds of $331,000 from increased advance payments from borrowers for taxes and insurance. HMN received $151,000 related to the exercise of HMN stock options. HMN paid $528,000 in dividends to its shareholders and $659,000 to purchase treasury stock.

*HMN has certificates of deposits with outstanding balances of $153.7 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 which 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 $65.0 million of FHLB advances which mature after March 31, 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. Since HMN has the ability to request another advance to replace the advance that is being called, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period.

Market Risk

Market risk is the risk of loss from adverse changes in market prices and 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 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 March 31, 2002. HMN does not have a trading portfolio. The

*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 21 of this discussion

18


 

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 March 31, 2002.


Other than trading portfolio

Market Value

 


(Dollars in thousands)

Basis point change in interest rates

 

 

 

 

-100

 

 

0

 

 

+100

 

 

+200

 

Cash and cash equivalents

$

 

65,379

 

65,425

 

65,275

 

65,223

 

Securities available for sale:

 

 

 

 

 

 

 

 

 

 

Fixed-rate CMOs

 

 

9,674

 

9,524

 

9,211

 

8,963

 

Variable-rate CMOs

 

 

52,494

 

53,246

 

52,633

 

50,966

 

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

 

 

2,259

 

2,190

 

2,121

 

2,050

 

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

 

 

577

 

574

 

570

 

567

 

Fixed-rate available for sale other marketable securities

 

 

75,056

 

73,736

 

71,644

 

70,012

 

Variable-rate available for sale other marketable securities

 

 

114

 

113

 

108

 

108

 

Federal Home Loan Bank stock

 

 

12,231

12,245

12,211

12,201

 

Loans held for sale

 

 

26,823

 

25,810

 

24,735

 

24,287

 

Loans receivable, net:

 

 

 

 

 

 

 

 

 

 

Fixed-rate real estate loans

 

 

195,788

 

190,979

 

185,626

 

180,358

 

Variable-rate real estate loans

 

 

122,724

 

120,596

 

118,416

 

116,250

 

Fixed-rate other loans

 

 

77,375

 

76,409

 

74,993

 

73,711

 

Variable-rate other loans

 

 

80,041

 

78,926

 

76,417

 

74,657

 

Mortgage servicing rights, net

 

 

1,177

 

2,284

 

2,880

 

3,100

 

Investment in limited partnerships

 

 

1,245

 

1,895

 

2,088

 

2,233

 





Total market risk sensitive assets

 

 

722,957

 

713,952

 

698,928

 

684,686

 





NOW deposits

 

 

57,535

 

57,535

 

57,535

 

57,535

 

Passbook deposits

 

 

34,127

 

34,127

 

34,127

 

34,127

 

Money market deposits

 

 

49,142

 

49,142

 

49,142

 

49,142

 

Certificate deposits

 

 

281,351

 

278,152

 

275,027

 

271,979

 

Federal Home Loan Bank:

Fixed-rate advances

 

 

188,224

 

184,614

 

181,827

 

179,214

 

Variable-rate advances

 

 

37,531

 

37,442

 

37,417

 

37,391

 





Total market risk sensitive liabilities

 

 

647,910

 

641,012

 

635,075

 

629,388

 

Off-balance sheet financial instruments:

 

 


 


 


 


 

Commitments to extend credit

 

 

(110)

 

0

 

(334)

 

(478)

Commitments to sell or deliver loans

 

 

(996)

 

0

 

999

 

1,427

 

Interest rate swap

 

 

(325)

 

(325)

 

(324)

 

(323)

 




Net market risk

$

 

75,828

 

72,615

 

62,864

 

54,026

 





Percentage change from current market value

$

 

4.42

%

0.00

%

(13.43)

%

(25.60)

%






 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 21 of this discussion

19


 

The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 7% to 38%, depending on the coupon and period to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at annual rates of between 11% and 28%, depending on coupon and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 12% and 43% depending on the coupon 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 be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 20%. FHLB advances were projected to be called at the first call date where the projected interest rate on similar remaining term advances exceeded the interest rate on HMN's callable advance.

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

Asset/Liability Management

*HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following March 31, 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

 

23,826,000

 

6.39 %

+100

 

23,481,000

 

4.85 %

0

 

22,394,000

 

0.00 %

-100

 

19,443,000

 

(13.18) %

 

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

*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 21 of this discussion

20


 

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 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 that 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 first quarter ended March 31, 2002 was $720,000, an increase of $570,000, compared to $150,000 for the first quarter of 2001. The provision for loan losses increased primarily due to increases in specific loan reserves of $451,000 on two non-accruing commercial loan relationships during the first quarter of 2002. 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 loan portfolio, historic level of non-performing loans, an increase 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, single family loan delinquencies as reported separately by FNMA and the Federal Home Loan Mortgage Corporation (FHLMC), local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed that an increase in the provision for loan losses was required in the first quarter of 2002 compared to the first quarter of 2001. 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 $153.7 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 which 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. Competitive pricing by other institutions, the desire of a competitor to pay interest rates on deposits that are

21


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.

HMN has $65.0 million of FHLB advances which mature after March 31, 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. Since HMN has the ability to request another advance to replace the advance that is being called, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period.

Market Risk

HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or 100 basis points down from where the rates were at March 31, 2002. HMN does not have a trading portfolio. The table in the Market Risk section 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 March 31, 2002.

Certain shortcomings are inherent in the method of analysis in the table presented in the Market Risk section. 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 rate 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 March 31, 2002 to determine if its current level of interest rate risk is acceptable. HMN's actual net interest income caused by interest rate changes may differ from the amounts reflected in the table in the Asset/Liability section which projects the estimated impact on net interest income of immediate interest rate changes called rate shocks.

Certain shortcomings are inherent in the method of analysis presented in each of the tables. 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.

22


 

                                                                              HMN FINANCIAL, INC.

                                                                     PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings.

None.

ITEM 2. Changes in Securities.

Not applicable.

ITEM 3. Defaults Upon Senior Securities.

Not applicable.

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

None.

ITEM 5. Other Information.

None.

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

(a) Exhibits. See Index to Exhibits on page 25 of this report.

(b) Reports on Form 8-K. None.

23


 

                                                                                         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: May 13, 2002                                                    /s/ Michael McNeil

                                                                                   Michael McNeil,

                                                                                   President

                                                                                   (Principal Executive Officer)

 

Date: May 13, 2002                                                   /s/ Timothy P. Johnson

                                                                                  Timothy P. Johnson,

                                                                                  Chief Financial Officer

                                                                                  (Principal Financial Officer)

 

24


 

                                               HMN FINANCIAL, INC.

                                                INDEX TO EXHIBITS

                                                    FOR FORM 10-Q

 

         

Sequential

       

Reference

Page Numbering

Regulation

   

to Prior

Where Attached

S-K

   

Filing or

Exhibits Are

Exhibit

   

Exhibit

Located in This

Number

 

Document Attached Hereto

Number

Form 10-Q Report






3.1

 

Amended and Restated Articles of Incorporation

*1

N/A

3.2

 

Amended and Restated By-laws

*2

N/A

4

 

Form of Common Stock

*3

N/A

     

Including indentures

   
           

*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).

   

 

 

25