HMN FINANCIAL INC - Quarter Report: 2003 September (Form 10-Q)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

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

(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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ( ) No (X)

Indicate the number of shares outstanding of each of the issuer's common stock, as of the latest practicable date.

PART I - FINANCIAL STATEMENTS

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(unaudited)

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(unaudited)

See accompanying notes to consolidated financial statements.

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

September 30, 2003 and 2002

HMN Financial, Inc. (HMN) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking and loan production 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 Holding, Inc. (HFH) which is the holding company for 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 acts as an intermediary for the Bank in transacting like-kind property exchanges for Bank customers. The Bank has a 51% owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), which was a mortgage banking and mortgage brokerage business located in Brooklyn Park, Minnesota. HFMS's brokerage and production activity stopped during the third quarter of 2002 and the company will be dissolved in the fourth quarter of 2003. The Bank has an 80% owned subsidiary, Federal Title Services, LLC. (FTS), which performs mortgage title services for Bank customers.

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

In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of Indebtedness of Others (FIN 45). FIN 45 requires disclosures be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires the recognition of a liability by a guarantor at the inception of certain guarantees that it has issued and that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. Refer to Note 11 for the related FIN 45 disclosure.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123. This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The amendments to SFAS No. 123 are effective for fiscal years ending after December 15, 2002 and for condensed interim financial statements issued after December 15, 2002. HMN has not adopted the voluntary change to the fair value based method of accounting for stock-based employee compensation as of September 30, 2003. Refer to Note 12 for required disclosures relating to stock-based compensation.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 addresses consolidation by business enterprises of variable interest entities (VIEs) that have certain characteristics. It requires a business enterprise that has a controlling interest in a VIE (as defined by FIN 46) to include the assets, liabilities, and results of the activities of the VIE in the consolidated financial statements of the business enterprise. The provisions of FIN No. 46 are applicable to variable interests in VIEs created after January 31, 2003. Variable interests in VIEs created before February 1, 2003, were originally subject to the provisions of FIN No. 46 no later than July 1, 2003, however, the effective date has been delayed under certain conditions to December 31, 2003. The impact of adopting FIN No. 46 on HMN's financial condition and results of operation will not be material.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective prospectively for contracts entered into or modified after June 30, 2003, except for those provisions of the Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, which should continue to be applied in accordance with their respective effective dates. The impact of adopting SFAS No. 149 on HMN's financial condition and results of operation was not material.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, however, the effective date has been delayed under certain conditions. The impact of adopting SFAS No. 150 on HMN's financial condition and results of operation was not material.

HMN has commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter, which is referred to as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, HMN generally enters into commitments to sell the loans into the secondary market. The commitments to originate and sell loans are derivatives that are recorded at market value. As a result of marking these derivatives to market for the period ended September 30, 2003, HMN recorded a decrease in other assets of $585,446, a decrease in other liabilities of $572,601 and losses on sales of loans of $12,845.

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market. The loans held for sale that are not hedged are recorded at the lower of cost or market. As a result of marking these loans HMN recorded a decrease to loans held for sale of $54,491, a decrease in other liabilities of $249,351, and gains on sales of loans of $194,860.

There was no hedging valuation in the third quarter of 2003. The gross unrealized holding losses on securities for the third quarter of 2003 was $926,000, the income tax benefit would have been $327,000 and therefore, the net loss was $599,000. The gross reclassification adjustment for the third quarter of 2003 was $417,000, the income tax expense would have been $147,000 and therefore, the net gain was $270,000. The gross unrealized holding gains on securities for the third quarter of 2002 was $1,837,000, the income tax expense would have been $641,000 and therefore, the net gain was $1,196,000. The gross reclassification adjustment in the third quarter of 2002 was $377,000, the income tax expense would have been $133,000 and therefore, the net gain was $244,000.

There was no hedging valuation in the nine-month period ended September 30, 2003. The gross unrealized holding losses on securities for the nine month period ended September 30, 2003 was $742,000, the income tax benefit would have been $263,000 and therefore, the net loss was $479,000. The gross reclassification adjustment in the nine month period ended September 30, 2003 was $1,233,000, the income tax expense would have been $435,000 and therefore, the net reclassification adjustment was $798,000. The gross unrealized losses in hedging valuation for the nine month period ended September 30, 2002 was $45,000, the income tax benefit would have been $9,000 and therefore, the net loss was $36,000. The gross minority interest in hedging valuation for the nine month period ended September 30, 2002 was $22,000. The gross unrealized holding gains on securities for the nine month period ended September 30, 2002 was $1,022,000, the income tax expense would have been $342,000 and therefore, the net gain was $680,000. The gross reclassification adjustment in the nine month period ended September 30, 2002 was $422,000, the income tax expense would have been $149,000 and therefore, the net reclassification adjustment was $273,000.

During the third quarter of 2003 HMN's proportionate gains from common stock investments in financial institutions was $16,653 and it recognized $6,500 of losses on low income housing partnerships. During 2003 HMN anticipates receiving low income housing credits totaling $84,000 of which $21,000 will be credited to current income tax benefits. During the third quarter of 2002 HMN's proportionate loss from a mortgage servicing partnership was $504,777, its proportionate share of losses from common stock investments in financial institutions was $19,665 and it recognized $6,500 of losses on low income housing partnerships. During 2002 HMN received low income housing credits totaling $84,000, of which $21,000 were credited to current income tax benefits.

During the nine month period ended September 30, 2003, HMN's proportionate loss from a mortgage servicing partnership was $349,577, its proportionate share of gains from the common stock investments in financial institutions was $55,916 and it recognized $19,500 of losses on the low income housing partnerships. During 2003 HMN anticipates receiving low income housing credits totaling $84,000, of which $63,000 will be credited to current income tax benefits. During the nine month period ended September 30, 2002, HMN's proportionate loss from a mortgage servicing partnership was $173,919, its proportionate share of gains from the common stock investments in financial institutions was $3,907 and it recognized $33,956 of losses on the low income housing partnerships. During 2002 HMN received low income housing credits totaling $84,000, of which $63,000 were credited to current income tax benefits. HMN's investment in a limited partnership that invested in mortgage servicing rights was dissolved in the second quarter of 2003 and the investment was written down to zero.

A summary of mortgage servicing activity is as follows:

Mortgage servicing costs, which include professional services for valuing mortgage servicing rights, were $216,917 at September 30, 2003, and $20,014 and $29,344 for the nine and twelve months ended in September and December of 2002, respectively.

All of the loans being serviced were single family loans serviced for FNMA under the mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at September 30, 2003.

The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2003 is presented in the table below. Amortization expense for intangible assets was $645,841 for the quarter ended September 30, 2003 and $1,583,156 for the nine months ended September 30, 2003.

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

Projections of amortization are based on existing asset balances and the existing interest rate environment as of September 30, 2003. HMN's actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

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

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HMN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of September 30, 2003, that the Bank meets all capital adequacy requirements to which it is subject.

Management believes that based upon the Bank's capital calculations at September 30, 2003 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On September 30, 2003 the Bank's tangible assets and adjusted total assets were $800 million and its risk-weighted assets were $634 million. The following table presents the Bank's capital amounts and ratios at September 30, 2003 for actual capital, required capital and excess capital including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations.