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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.

FORM 10-Q

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

            SECURITIES EXCHANGE ACT OF 1934

            For the quarterly period ended March 31, 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

HMN FINANCIAL, INC.

(Exact name of Registrant as specified in its Charter)

Delaware

41-1777397


 

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification Number)

     

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

55901


 

(Address of principal executive offices)

(ZIP Code)


 

Registrant's telephone number, including area code:

(507) 535-1200

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes (X)     No (  )

Indicate 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.

Class

 

Outstanding at May 6, 2003


 

Common stock, $0.01 par value

 

4,372,245

 

1


 

 

HMN FINANCIAL, INC.

CONTENTS

PART I - FINANCIAL INFORMATION

   

Page

Item 1:

Financial Statements (unaudited)

 
     
 

Consolidated Balance Sheets at March 31, 2003 and December 31, 2002

3

     
 

Consolidated Statements of Income for the Three Months Ended March 31, 2003 and 2002

4

     
 

Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2003 and 2002

5

     
 

Consolidated Statement of Stockholders' Equity for the Three Month Period Ended March 31, 2003

5

     
 

Consolidated Statements of Cash Flows for the Three Months Ended

March 31, 2003 and 2002

6

     
 

Notes to Consolidated Financial Statements

7-15

     

Item 2:

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

16-24

     

Item 3:

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

24

     

Item 4:

Controls and Procedures

24

     

PART II - OTHER INFORMATION

     

Item 1:

Legal Proceedings

25

     

Item 2:

Changes in Securities

25

     

Item 3:

Defaults Upon Senior Securities

25

     

Item 4:

Submission of Matters to a Vote of Security Holders

25

     

Item 5:

Other Information

25

     

Item 6:

Exhibits and Reports on Form 8-K

25

     

Signatures

26

2


 

 

PART I - FINANCIAL INFORMATION

Item 1 : Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(unaudited)


   

March 31,

 

December 31,

 
   

2003

 

2002

 

Assets

         

Cash and cash equivalents

$

32,794,704

 

27,729,007

 

Securities available for sale:

         

   Mortgage-backed and related securities

         

    (amortized cost $15,159,424 and $51,677,294)

 

15,049,327

 

51,895,832

 

    Other marketable securities

         

     (amortized cost $82,766,788 and $67,282,379) ...

 

83,982,472

 

69,501,417

 
   
 
 
   

99,031,799

 

121,397,249

 
   
 
 
           

Loans held for sale

 

12,999,058

 

15,126,509

 

Loans receivable, net

 

577,542,290

 

533,905,652

 

Accrued interest receivable

 

3,312,724

 

3,050,636

 

Real estate, net

 

605,551

 

426,691

 

Federal Home Loan Bank stock, at cost

 

11,880,500

 

11,880,500

 

Mortgage servicing rights, net

 

2,837,584

 

2,691,031

 

Premises and equipment, net

 

12,735,369

 

12,875,816

 

Investment in limited partnerships

 

507,349

 

862,666

 

Goodwill

 

3,800,938

 

3,800,938

 

Core deposit intangible

 

534,858

 

561,331

 

Prepaid expenses and other assets

 

2,815,822

 

3,214,792

 
   
 
 

    Total assets

$

761,398,546

 

737,522,818

 
   
 
 
           

Liabilities and Stockholders' Equity

         

Deposits

$

448,082,656

 

432,951,462

 

Federal Home Loan Bank advances

 

219,300,000

 

218,300,000

 

Accrued interest payable

 

670,343

 

849,427

 

Advance payments by borrowers for taxes and insurance

 

975,846

 

707,213

 

Accrued expenses and other liabilities

 

6,901,806

 

7,614,406

 

Deferred tax liabilities

 

985,800

 

1,456,600

 

Due to broker/trustee

 

10,000,000

 

0

 
   
 
 

    Total liabilities

 

686,916,451

 

661,879,108

 
   
 
 

Commitments and contingencies

         

Minority interest

 

(412,279)

 

(420,846)

 

Stockholders' equity:

         

    Serial preferred stock ($.01 par value):

         

     Authorized 500,000 shares; issued and outstanding none

 

0

 

0

 

    Common stock ($.01 par value):

         

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

 

91,287

 

91,287

 

Additional paid-in capital

 

58,792,387

 

58,885,279

 

Retained earnings, subject to certain restrictions

 

80,380,184

 

79,660,481

 

Accumulated other comprehensive income

 

714,387

 

1,575,577

 

Unearned employee stock ownership plan shares

 

(4,883,028)

 

(4,931,385)

 

Treasury stock, at cost 4,785,456 and 4,722,856 shares

 

(60,200,843)

 

(59,216,683)

 
   
 
 

    Total stockholders' equity

 

74,894,374

 

76,064,556

 
   
 
 

Total liabilities and stockholders' equity

$

761,398,546

 

737,522,818

 
   
 
 

 

      See accompanying notes to consolidated financial statements.

3


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income

(unaudited)


   

Three Months Ended

March 31,

   

2003

  2002

Interest income:

     

     Loans receivable

$

9,639,924

 

9,749,506

     Securities available for sale:

       

         Mortgage-backed and related

 

142,213

 

458,061

         Other marketable

 

561,219

 

732,793

     Cash equivalents

 

28,917

 

90,579

     Other

 

98,651

 

109,662

   
 

         Total interest income

 

10,470,924

 

11,140,601

   
 
         

Interest expense:

       

     Deposits

 

2,471,263

 

3,113,547

     Federal Home Loan Bank advances

 

2,478,672

 

2,576,863

   
 

        Total interest expense

 

4,949,935

 

5,690,410

   
 

   Net interest income

 

5,520,989

 

5,450,191

Provision for loan losses

 

865,000

 

720,000

   
 

        Net interest income after provision for loan losses

 

4,655,989

 

4,730,191

   
 
         

Non-interest income:

       

     Fees and service charges

 

432,140

 

403,809

     Mortgage servicing fees

 

216,576

 

159,933

    Securities gains, net...........................................................

 

591,035

 

18,925

     Gain on sales of loans

 

1,465,232

 

1,044,560

     Earnings (losses) in limited partnerships

 

(354,842)

 

378,921

     Other

 

221,100

 

258,066

   
 

        Total non-interest income

 

2,571,241

 

2,264,214

   
 
         

Non-interest expense:

       

     Compensation and benefits #9;

 

2,279,502

 

1,951,484

     Occupancy

 

823,799

 

673,436

     Federal deposit insurance premiums

 

18,936

 

19,436

     Advertising

 

84,864

 

142,545

     Data processing

 

271,108

 

264,459

     Amortization of mortgage servicing rights, net of valuation

       

       adjustments and servicing costs

 

790,530

 

211,202

     Other

 

944,551

 

883,097

   
 

        Total non-interest expense

 

5,213,290

 

4,145,659

   
 

        Income before income tax expense

 

2,013,940

 

2,848,746

Income tax expense

 

624,400

 

840,100

   
 

        Income before minority interest

 

1,389,540

 

2,008,646

Minority interest

 

0

 

40,674

   
 

        Net income

$

1,389,540

 

1,967,972

   
 

Basic earnings per share

$

0.37

 

0.53

   
 

Diluted earnings per share

$

0.36

 

0.50

   
 

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, 2003
(unaudited)


   

Three Months Ended March 31,

   

2003

 

2002

   
 

Net income

$

       

1,389,540

         

1,967,972

Other comprehensive income, net of tax:

                       

   Unrealized losses on hedging valuation

 

0

         

(22,232)

       

      Less: minority interest in hedging valuation

 

0

         

(13,834)

       
   
         
       

      Net unrealized losses on hedging valuation

     

0

         

(8,398)

   

   Unrealized gains on securities:

                       

   Unrealized holding gains (losses) arising during period

 

(479,055)

         

82,810

       

   Less: reclassification adjustment for gains

                       

     included in net income

 

382,135

         

12,316

       
   
         
       

   Net unrealized gains (losses) on securities

     

(861,190)

         

70,494

   
       
         
   

Other comprehensive income (loss)

         

(861,190)

         

62,096

           
         

Comprehensive income

$

       

528,350

         

2,030,068

           
         

 

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, 200
3

(unaudited)


       

 

Unearned

   
         

Employee

   
       

Accumulated

Stock

 

Total

   

Additional

 

Other

Ownership

 

Stock-

 

Common

Paid-in

Retained

Comprehensive

Plan

Treasury

Holders'

 

Stock

Capital

Earnings

Income (Loss)

Shares

Stock

Equity

 

Balance, December 31, 2002

$ 91,287

58,885,279

79,660,481 

1,575,577

(4,931,385)

(59,216,683)

76,064,556 

  Net income

   

1,389,540 

     

1,389,540 

  Other comprehensive income

     

(861,190)

   

(861,190) 

  Treasury stock purchases

         

(1,384,560)

(1,384,560)

  Employee stock options

             

    exercised

 

(179,360)

     

400,400 

221,040 

  Tax benefits of exercised

             

    stock options

 

54,134

       

54,134

  Dividends paid

   

(669,837)

     

(669,837)

  Earned employee stock

             

    ownership plan shares

 

32,334

   

48,357

 

80,691

 

Balance, March 31, 2003

$ 91,287

58,792,387

80,380,184 

714,387

(4,883,028)

(60,200,843)

74,894,374

 

                                                See accompanying notes to consolidated financial statements.

5


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

(unaudited)


   

Three Months Ended

March 31,

   
   

2003

 

2002

   

Cash flows from operating activities:

       

Net income

$

1,389,540

 

1,967,972

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

       

Provision for loan losses

 

865,000

 

720,000

Depreciation

 

425,466

 

312,487

Amortization of premiums, net

 

216,634

 

79,702

Amortization of deferred loan fees

 

(113,404)

 

(260,091)

Amortization of core deposit intangible

 

26,473

 

31,045

Amortization of other purchase accounting adjustments

 

(723)

 

2,376

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

 

790,530

 

203,792

Capitalized mortgage servicing rights

 

(720,166)

 

(584,224)

Deferred income taxes

 

(470,800)

 

(104,400)

Securities gains, net

 

(591,035)

 

(18,925)

Gain on sales of real estate

 

(117,139)

 

0

Gain on sales of loans

 

(1,465,232)

 

(1,044,560)

Proceeds from sale of loans held for sale

 

79,445,538

 

123,270,922

Disbursements on loans held for sale

 

(73,912,448)

 

(77,698,382)

Principal collected on loans held for sale

 

7,376

 

65,647

Amortization of restricted stock awards

 

0

 

5,625

Amortization of unearned ESOP shares

 

48,357

 

48,356

Earned employee stock ownership shares priced above original cost

 

32,334

 

27,708

Decrease (increase) in accrued interest receivable

 

(262,088)

 

12,983

Decrease in accrued interest payable

 

(179,084)

 

(93,503)

Equity (earnings) losses of limited partnerships

 

354,842

 

(378,921)

     Equity earnings of minority interest

 

0

 

40,674

Decrease (increase) in other assets

 

291,304

 

(54,490)

Decrease in other liabilities

 

(2,795)

 

(595,232)

Other, net

 

29,838

 

(42)

   
 
Net cash provided by operating activities

6,088,318

 

45,956,519

   
 

Cash flows from investing activities:

       

Proceeds from sales of securities available for sale

 

37,780,477

 

1,461,425

Principal collected on securities available for sale

 

14,300,411

 

6,347,804

Proceeds collected on maturity of securities available for sale

 

0

 

3,250,000

Purchases of securities available for sale

 

(20,652,253)

 

(25,518,515)

Net decrease (increase) in loans receivable

 

(46,849,551)

 

20,558,281

Proceeds from sale of premises

 

221,313

 

0

Purchases of premises and equipment

 

(389,488)

 

(1,268,383)

   
 

Net cash (used in) provided by investing activities

 

(15,589,091)

 

4,830,612



Cash flows from financing activities:

       

Increase (decrease) in deposits

 

15,131,194

 

(7,677,317)

Purchase of treasury stock

 

(1,384,560)

 

(658,611)

Stock options exercised

 

221,040

 

151,040

Dividends to stockholders

 

(669,837)

 

(527,507)

Proceeds from Federal Home Loan Bank advances

 

10,000,000

 

0

Repayment of Federal Home Loan Bank advances

 

(9,000,000)

 

0

Increase in advance payments by borrowers for taxes and insurance

 

268,633

 

330,973

   
 

Net cash provided by (used in) financing activities

 

14,566,470

 

(8,381,422)

   
 

Increase in cash and cash equivalents

 

5,065,697

 

42,405,709

Cash and cash equivalents, beginning of period

 

27,729,007

 

23,019,553

   
 

Cash and cash equivalents, end of period

$

32,794,704

 

65,425,262

   
 

Supplemental cash flow disclosures:

       

Cash paid for interest

$

5,129,019

 

5,783,913

Cash paid for income taxes

 

0

 

42,500

Supplemental noncash flow disclosures:

       

Loans transferred to loans held for sale

 

2,154,299

 

1,592,095

Transfer of loans to real estate

 

320,919

 

0

Transfer of real estate to loans

 

16,533

 

0


                                                See accompanying notes to consolidated financial statements.

6


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

March 31, 2003 and 2002

(1)    HMN Financial, Inc.

HMN Financial, Inc. (HMN) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) which offers financial planning products and services and Home Federal 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 Bank assumed responsibility for certain components of HFMS. The remaining assets of HFMS, consisting primarily of single family mortgage loans, are in the process of being liquidated.

The consolidated financial statements included herein are for HMN, SFC, the Bank and the Bank's consolidated entities, OIA, HFH, 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, 2003 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 June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 amends FASB Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, and applies to all entities. The Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs and was effective for financial statements issued for fiscal years beginning after June 15, 2002. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of long-lived asset, except for certain obligations of lessees. The impact of adopting SFAS No. 143 on January 1, 2003 was not material.

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

7


on HMN's financial condition and its results of operations was not material.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition of Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). One of the principal differences between SFAS No. 146 and EITF Issue No. 94-3 pertains to the criteria for recognizing a liability for exit or disposal costs. Under EITF Issue No. 94-3, a liability for such costs was recognized as of the date of an entity's commitment to an exit plan. Pursuant to SFAS No. 146, a liability is recorded as of the date an obligation is incurred. SFAS No. 146 requires that an exit or disposal liability be initially measured at fair value. Provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The impact of adopting SFAS No. 146 on HMN's financial condition and its results of operations was not material.

In October 2002, the FASB issued SFAS No. 147, Acquisitions of Certain Financial Institutions. Except for transactions between two or more mutual enterprises, this Statement removes financial institutions from the scope of SFAS No.72 and requires those transactions be accounted for in accordance with SFAS No. 141 and SFAS No. 142. In addition, this Statement amends FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. Consequently, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provision that SFAS No. 144 requires for other long-lived assets that are held and used. The provisions of SFAS No. 147, which relate to the application of the purchase method of accounting, are effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions related to accounting for the impairment or disposal of certain long-term customer-relationship intangible assets are effective on October 1, 2002. The impact of adopting SFAS No. 147 on HMN's financial condition and its results of operations was not material.

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 12 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 March 31, 2003. Refer to Note 13 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 that have certain characteristics. It requires a business enterprise that has a controlling interest in a variable interest entity (as defined by FIN 46) to include the assets, liabilities, and results of the activities of the variable interest entity in the consolidated financial statements of the business enterprise. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. For variable

8


interest acquired before February 1, 2003, it applies in the first fiscal year or interim period beginning after June 15, 2003. The impact of adopting FIN 46 will not be material as HMN does not presently have any variable interest entities.

(4) Derivative Instruments and Hedging Activities

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. These commitments are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, generally HMN simultaneously enters into commitments to sell the mortgage pipeline into the secondary market. The commitments to originate, purchase, or sell loans are derivatives. As a result of marking the mortgage pipeline and the related commitments to sell to market for the period ended March 31, 2003, HMN recorded an increase in other assets of $669,800, an increase in other liabilities of $532,705 and a gain on sales of loans of $137,095.

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market. The loans held for sale that are not hedged are recorded at the lower of cost or market. The lower of cost or market and the market value adjustments as of and for the quarter ending March 31, 2003 include loans that do not qualify for hedge accounting. As a result of marking these loans, HMN recorded a lower of cost or market adjustment of $16,498 to loans held for sale, a decrease in other liabilities of $47,776, and a net gain on sales of loans of $64,274.

(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.

There was no hedging valuation in the first quarter of 2003. 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 $13,834.

The gross unrealized holding losses on securities for the first quarter of 2003 was $740,955, the income tax benefit would have been $261,900 and therefore, the net loss was $479,055. The gross reclassification adjustment for the first quarter of 2003 was $591,035, the income tax expense would have been $208,900 and therefore, the net gain was $382,135. The gross unrealized holding gains on securities for the first quarter of 2002 was $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 gain was $12,316.

(6) Cash Dividend

On April 22, 2003 HMN's Board of Directors announced a cash dividend of $0.18 per share, payable on June 9, 2003 to stockholders of record on May 22, 2003.

9


(7) Investments in Limited Partnerships

Investments in limited partnerships were as follows:


 

Primary partnership activity

 

March 31, 2003

 

December 31, 2002

 


 
 
 

Mortgage servicing rights

$

0

 

349,577

 

Common stock of financial institutions

 

290,633

 

289,398

 

Low to moderate income housing

 

216,716

 

223,691

 

   
 
 

 

$

507,349

 

862,666

 

   
 
 

 

During the first quarter of 2003 HMN's proportionate loss from a mortgage servicing partnership was $349,577, its proportionate share of gains from common stock investments in financial institutions was $1,235 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 were credited to current income tax benefits in the first quarter. 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 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, 2003

 

 

Twelve months ended

December 31, 2002

 

Three months ended

March 31, 2002

   
 
 

Mortgage servicing rights

 

 

 

 

 

 

Balance, beginning of period

$

2,701,031

 

1,922,736

 

1,922,736

Originations

 

720,166

 

1,956,845

 

584,224

Sales

 

0

 

(41,532)

 

0

Amortization

 

(413,613)

 

(1,137,018)

 

(209,892)

   
 
 

Balance, end of period

 

3,007,584

 

2,701,031

 

2,297,068

   
 
 

Valuation reserve

 

 

 

 

Balance, beginning of period

 

(10,000)

 

(19,100)

 

(19,100)

Additions

 

(160,000)

 

(213,000)

 

0

Reductions

 

0

 

222,100

 

6,100

   
 
 

Balance, end of period

 

(170,000)

 

(10,000)

 

(13,000)

   
 
 

 

 

 

 

 

 

Mortgage servicing rights, net

$

2,837,584

 

2,691,031

 

2,284,068

   
 
 

Fair value of mortgage servicing rights

$

2,840,609

 

2,691,031

 

2,491,000

   
 
 

10


Mortgage servicing costs, which include professional services related to valuing mortgage servicing rights, were $216,917 at March 31, 2003, and $7,410 and $29,344 for the three and twelve months ended March 31, 2002 and December 31, 2002, respectively.

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, 2003.


 

 

Loan Principal Balance

Weighted Average Interest Rate

Weighted Average Remaining Term

Number of Loans





Original term 30 year fixed rate

$

150,269,000

6.51

%

346

1,468

Original term 15 year fixed rate

199,760,000

5.92

%

164

2,562

Seven year balloon

123,000

5.75

%

70

1

Adjustable rate

10,141,000

5.05

%

353

81


 

 

(9) Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at March 31, 2003 is presented in the table below. Amortization expense for intangible assets was $440,086 for the quarter ended March 31, 2003.


   

Gross

         

Unamortized

   

Carrying

 

Accumulated

 

Valuation

 

Intangible

   

Amount

 

Amortization

 

Adjustment

 

Assets


Amortized intangible assets:

               

Mortgage servicing rights

$

4,699,395

 

(1,691,811)

 

(170,000)

 

2,837,584

Core deposit intangible

 

1,567,000

 

(1,032,142)

 

0

 

534,858

   
 
 
 

Total

$

6,266,395

 

(2,723,953)

 

(170,000)

 

3,372,442

   
 
 
 

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, 2003

$

424,428

 

87,385

 

511,813

             

Year ended December 31,

           

2004

 

478,756

 

113,857

 

592,613

2005

 

395,073

 

113,857

 

508,930

2006

 

325,805

 

113,857

 

439,662

2007

 

268,404

 

105,902

 

374,306

2008

 

237,284

 

0

 

237,284


Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2003. HMN's actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

11


(10) 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,

 
   

2003

 

2002

 
   
 
 

Weighted average number of common shares outstanding

         

   Used in basic earnings per common share calculation

 

3,747,609

 

3,733,673

 
           

Net dilutive effect of:

         

   Options

 

158,538

 

194,677

 

   Restricted stock awards

 

0

 

135

 
   
 
 

Weighted average number of shares outstanding

         

   Adjusted for effect of dilutive securities

 

3,906,147

 

3,928,485

 
   
 
 

Income available to common shareholders

$

1,389,540

 

1,967,972

 
           

Basic earnings per common share

$

0.37

 

0.53

 

Diluted earnings per common share

$

0.36

 

0.50

 

 
           

(11) 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, 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 March 31, 2003 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, 2003 the Bank's tangible assets and adjusted total assets were $751.2 million and its risk-weighted assets were $566.8 million. The following table presents the Bank's capital amounts and ratios at March 31, 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.

12



 

 

 

 

 

 

Actual

 

Required to be

Adequately

Capitalized

 

 

Excess Capital

 

To Be Well Capitalized Under Prompt Corrective Actions Provisions

 

   
 
 
 
 

(in thousands)

 

Amount

 

Percent of Assets(1)

 

Amount

 

Percent of Assets (1)

 

Amount

 

Percent of Assets(1)

 

Amount

 

Percent of Assets(1)

 

   
 
 
 
 
 
 
 
 

Bank stockholder's equity

$

66,925

 

                           

Plus:

Net unrealized gain on certain

securities available for sale

 

(667)

                             

Less:

 

 

                             

Goodwill and core deposit intangible

 

4,336

                             

Excess mortgage servicing rights

 

269

                             
   
                             

Tier I or core capital

 

61,653

                             
   
                             

Tier I capital to adjusted total assets

 

 

 

8.21%

 

$ 30,050

 

4.00%

 

$ 31,603

 

4.21%

$ 37,562

5.00%

 

Tier I capital to risk-weighted assets

     

10.88%

$ 22,671

 

4.00%

$ 38,982

 

6.88%

$ 34,007

 

6.00%

 

Plus:

Allowable allowance for loan losses

 

4,742

                             
   
                             

Risk-based capital

$

66,395

 

 

 

$ 45,343

 

 

 

$ 21,052

 

 

 

$ 56,679

 

 

 

   
                             

Risk-based capital to risk-weighted assets

 

 

 

11.71%

     

8.00%

     

3.71%

 

 

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, 2003 but is not reflected in the table above.

(12) Commitments and Contingencies

The Bank entered into two guaranty agreements with third parties in order for Home Federal Mortgage Services, LLC (HFMS) to secure loan purchase agreements. Under the agreements, the Bank guarantees to satisfy and discharge all obligations of HFMS arising from transactions entered into between HFMS and the third parties if HFMS fails to fulfill their obligations. The agreements are in effect until the obligations of HFMS are fully satisfied and the Bank's guaranty is limited to a combined maximum of $3 million. No liability has been recorded in the consolidated financial statements of HMN for these guarantees and HMN is not aware of any outstanding obligations of HFMS to either of the third parties with whom a guarantee exists. There is the possibility that the Bank would be required to purchase loans that were previously sold to the third parties by HFMS if the loans did not meet the requirements in the loan purchase agreements. If this were to occur, the proceeds from the subsequent sale of these loans would enable the Bank to recover a portion of the amounts paid under the guaranty.

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding at March 31, 2003 expire over the next two years and totaled approximately $2.3 million at March 31, 2003. The letters of credit were collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

 

(13) Stock-Based Compensation

Effective January 1, 1996, HMN adopted SFAS No. 123, Accounting for Stock-Based Compensation. It elected to continue using the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25 and related interpretations which measure compensation cost using the intrinsic value method. Had compensation cost

13


 

for HMN's stock-based plan been determined in accordance with the fair value method recommended by SFAS No. 123, HMN's net income and earnings per share would have been adjusted to the pro forma amounts indicated below:


 

 

 

 

 

 

Quarter Ended March 31, 2003

 

 

Quarter Ended March 31, 2002

 

   
 
 

Net income:

 

 

 

 

As reported 9;

$

1,389,540

 

1,967,972

 

Deduct: Total stock-based employee

 

Compensation expense determined

 

 

 

 

 

under fair value based method for all

 

 

 

awards, net of related tax effects

 

10,128

 

10,524

 

   
 
 

Pro forma 9;

 

1,379,412

 

1,957,448

 

Earnings per common share:

 

 

 

 

 

As reported:

 

 

 

 

Basic 9;

$

0.37

 

0.53

 

Diluted 9;

 

0.36

 

0.50

 

Pro forma:

 

 

Basic

 

0.37

 

0.52

 

Diluted

 

0.35

 

0.50

 


 

(14) Business Segments

HMN's wholly owned subsidiary, Home Federal Savings Bank has been identified as reportable operating segment in accordance with the provisions of SFAS 131.

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.

14


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


 

 

(Dollars in thousands)

 

Home Federal Savings Bank

 

 

Other

 

 

Eliminations

 

 

Consolidated Total

 

At or for the quarter ended March 31, 2003:

 

 

 

 

 

 

 

 

 

 

 

 

Interest income - external customers

$

10,421

 

50

 

0

 

10,471

 

Non-interest income - external customers

 

2,926

 

0

 

0

 

2,926

 

Earnings (losses) on limited partnerships

 

(356)

 

1

 

0

 

(355)

 

Intersegment interest income

 

27

 

13

 

(40)

 

0

 

Intersegment non-interest income

 

269

 

1,385

 

(1,654)

 

0

 

Intersegment loan loss provision

 

200

 

0

 

(200)

 

0

 

Interest expense

 

4,990

 

0

 

(40)

 

4,950

 

Amortization of mortgage servicing rights

and net valuation adjustments

 

863

 

3

 

(75)

 

791

 

Other non-interest expense

 

4,368

 

133

 

(78)

 

4,423

 

Income tax expense (benefit)

 

700

(76)

 

0

 

624

 

Minority interest

 

0

 

0

 

0

 

0

 

Net income (loss)

 

1,303

 

1,388

 

(1,301)

 

1,390

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

Total assets   767,355   75,135   (81,091)   761,399  

Net interest margin

 

3.18

%

NM

 

NM

 

3.20

%

Return on average assets (annualized)

 

0.76

%

NM

 

NM

 

0.76

%

Return on average realized common

equity (annualized)

 

 

8.27

%

 

NM

 

 

NM

 

 

7.21

%

At or for the quarter ended March 31, 2002:

                 

Interest income - external customers

$

11,033

 

108

 

0

 

11,141

 

Non-interest income - external customers

 

1,860

 

25

 

0

 

1,885

 

Earnings on limited partnerships

 

361

 

18

 

0

 

379

 

Intersegment interest income

 

316

 

0

 

(316)

 

0

 

Intersegment non-interest income

 

280

 

1,913

 

(2,193)

 

0

 

Interest expense

 

6,006

 

0

 

(316)

 

5,690

 

Amortization of mortgage servicing rights

and net valuation adjustments

 

243

 

0

 

(32)

 

211

 

Other non-interest expense

 

3,962

 

139

 

(166)

 

3,935

 

Income tax expense (benefit)

 

883

 

(43)

 

0

 

840

 

Minority interest

 

41

 

0

 

0

 

41

 

Net income (loss)

 

1,995

 

1,968

 

(1,995)

 

1,968

 

Goodwill

 

3,801

 

0

 

0

 

3,801

 

Total assets   739,327   73,434   (93,980)   718,781  

Net interest margin

 

3.22

%

NM

 

NM

 

3.23

%

Return on average assets (annualized)

 

1.03

%

NM

 

NM

 

1.11

%

Return on average realized common

equity (annualized)

 

12.51

%

NM

 

NM

 

10.92

%

                   

NM - Not meaningful

15


 

HMN FINANCIAL, INC.
Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Information

This quarterly report and other reports filed with the Securities and Exchange Commission may contain "forward-looking" statements that deal with future results, plans or performance. In addition, HMN's management may make such statements orally to the media, or to securities analysts, investors or others. Forward looking statements deal with matters that do not relate strictly to historical facts. HMN's future results may differ materially from historical performance and forward-looking statements about HMN's expected financial results or other plans are subject to a number of risks and uncertainties. These include but are not limited to possible legislative changes and adverse economic, business and competitive developments such as shrinking interest margins; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government; changes in credit and other risks posed by HMN's loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation or other significant uncertainties.

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 or losses from the sale of securities, gains from the sale of loans, service charges, fees, earnings or losses on limited partnership investments, and other income. In addition, net income is affected by the level of operating expenses, provisions made for loan losses and amortization and valuation 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 single family and commercial properties, 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. The interest rates charged by the FHLB on advances to the Bank also have a significant impact on the Bank's overall cost of funds.

Critical Accounting Policies

Critical accounting policies are those policies that management believes are the most important to the portrayal of the company's financial condition and operating results that require difficult, subjective, or complex judgment. These judgments are often the result of the need to make estimates about the effect of matters that are inherently uncertain and therefore actual results could differ significantly from the estimates used. Management considers the following items to be the critical accounting policies of HMN.

16


 

                    Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio by management. In this analysis, management considers factors including, but not limited to, specific occurrences that include loan impairment, changes in the size of the portfolios, general economic conditions, loan portfolio composition, and historical experience. The allowance for loan losses is established for known problem loans, as well as for loans which are not currently known to require specific allowances. Loans are charged off to the extent they are deemed to be uncollectible. The adequacy of the allowance for loan losses is dependent upon management's estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Although management believes that the allowance for loan losses is maintained at an amount considered adequate to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future adjustments to the provision for loan losses may be necessary if conditions differ substantially from those in the assumptions used to determine the allowance for loan losses.

                    Mortgage Servicing Rights

Mortgage servicing rights are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. HMN periodically evaluates its capitalized mortgage servicing rights for impairment. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. The valuation of the mortgage servicing rights is based on the estimated prepayment speeds and default rates of the stratified portfolio. Changes in the mix of loans, interest rates, prepayment speeds, or default rates from the estimates used in the valuation of the mortgage servicing rights may have a material effect on the amortization and valuation of mortgage servicing rights. Although management believes that the assumptions used and the values determined are reasonable, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the value of the servicing rights. Refer to the "Mortgage servicing rights, net" line item in the market risk table on page 22 for an indication of how the value of mortgage servicing rights may change in relation to changes in interest rates.

                    Investment in Limited Partnerships

HMN has investments in limited partnerships which invest in mortgage servicing assets, the common stock of other financial institutions, and low to moderate income housing projects which generate tax credits for HMN. HMN generally accounts for the earnings or losses from the limited partnerships on the equity method. The valuation of the limited partnership that invested in mortgage servicing rights is determined using similar estimates and assumptions as outlined in the mortgage servicing rights paragraph above. Refer to the "Investments in limited partnerships" line item in the market risk table on page 22 for an indication of how the value of investments in limited partnerships may change in relation to changes in interest rates.

                    Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.

17


Net Income

HMN's net income for the first quarter of 2003 was $1.4 million, a decrease of $578,000, or 29.4%, compared to net income of $2.0 million for the first quarter of 2002. Basic earnings per share were $0.37 for the quarter ended March 31, 2003, a decrease of $0.16 per share, from $0.53 basic earnings per share for the same quarter of 2002. Diluted earnings per share were $0.36 for the first quarter of 2003, a decrease of $0.14 from $0.50 diluted earnings per share for the first quarter of 2002.

Net Interest Income

Net interest income was $5.5 million for the first quarter of 2003, an increase of $71,000, or 1.3%, compared to $5.5 million for the first quarter of 2002. Interest income was $10.5 million for the first quarter of 2003, a decrease of $670,000, or 6.0%, from $11.1 million for the first quarter of 2002. Interest income decreased by $933,000 because the yield earned on interest earning assets decreased from the first quarter of 2002 to the first quarter of 2003. During the fourth quarter of 2002, the Federal Reserve reduced the Federal Funds interest rate and the Wall Street Journal prime rate decreased by 0.50%. As a result, loans with rates that were indexed to prime, such as commercial loans and consumer lines of credit, earned less interest income. Interest income increased by $263,000 due to a $15.8 million net increase in the average interest-earning assets from the first quarter of 2002 to the first quarter of 2003. The increase in average interest-earning assets was primarily the result of the growth in commercial and multi-family loans. The yield earned on interest-earning assets decreased from 6.60% at March 31, 2002 to 6.07% at March 31, 2003.

Interest expense was $4.9 million for the first quarter of 2003, a decrease of $740,000, or 13.0%, compared to $5.7 million for the first quarter of 2002. Interest expense on deposits decreased by $820,000 due to decreased interest rates paid on certificates and other deposit products. Interest expense increased by $177,000 due to an increase in the average outstanding balance of deposits. Interest expense on Federal Home Loan Bank advances decreased by $80,000 due to decreased interest rates paid and by $18,000 due to a decrease in the average outstanding balance of advances. The average interest rate paid on average interest-bearing liabilities was 3.08% during the first quarter of 2003, compared to 3.64% for the first quarter of 2002.

Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2003 was 3.20%, a decrease of 3 basis points, compared to 3.23% for the first quarter of 2002.

Provision for Loan Losses

The provision for loan losses was $865,000 for the first quarter of 2003, an increase of $145,000, from $720,000 for the first quarter of 2002. The provision for loan losses increased primarily due to the $45 million in growth that was experienced during the first quarter of 2003 in the commercial and multi-family loan portfolios which generally require a larger provision due to the greater inherent credit risk of these loans. The provision also increased because of downgrades in the risk ratings of two nonresidential commercial loans during the first quarter of 2003. The provision for loan losses and the related allowance is considered a critical accounting policy of HMN. It is determined based on management's evaluation of the loan portfolio, historic level of non-performing loans, loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located such as national and regional unemployment data, local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed conditions that resulted in increasing the 2003 loan loss provision compared to the provision for 2002. HMN will continue to monitor its allowance for losses and adjust it as conditions dictate. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods.

18


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

    2003   2002
   
 
Balance at January 1, $ 4,824,217   3,783,112
Provision   865,000   720,000
Charged off   (39,103)   (61,096)
Recoveries   8,199   1,761
   
 
Balance at March 31,   5,658,313   4,443,777
   
 
         

Non-Interest Income

Non-interest income was $2.6 million for the first quarter of 2003, an increase of $307,000, or 13.6%, from $2.3 million for the first quarter of 2002. Non-interest income increased by $572,000 due to increased gains on securities, $421,000 due to increased gains on the sale of loans and $57,000 because of increased mortgage servicing fees. The increase in non-interest income was partially offset by a $734,000 decrease in the earnings in limited partnerships. Interest rates on mortgage loans decreased during the first quarter of 2003 which caused the value of HMN's investment in a limited partnership which owns mortgage loan servicing assets to decrease in value. The value of servicing rights generally decreases when mortgage rates decrease because of the anticipated increase in prepayments expected to be received on the mortgage servicing assets. HMN has been informed by the general partner that no liquidation distributions will be made to the limited partners when the servicing assets are sold because of the decreased value of the servicing. Therefore, the investment balance of this limited partnership was reduced to zero at March 31, 2003.

Non-Interest Expense

Non-interest expense was $5.2 million for the first quarter of 2003, an increase of $1.1 million, or 25.8%, from $4.1 million for the first quarter of 2002. Occupancy expense increased by $150,000, or 22.3%, due primarily to the costs associated with maintaining three additional facilities, amortization expense on mortgage servicing rights increased by $579,000 because of increased prepayments on the mortgage loans being serviced and because of a decrease in the value of the servicing rights caused by the decrease in interest rates. Compensation expense increased by $328,000 due to costs associated with a separation agreement with a former executive officer and because of annual payroll and health insurance cost increases. Income tax expense decreased by $216,000 primarily because of reduced taxable income.

19


Non-Performing Assets

The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at March 31, 2003 and December 31, 2002.


 

March 31,

   

December 31,

 

(Dollars in Thousands)

 

2003

   

2002

 

Non-Accruing Loans

           

One-to-four family real estate

$

1,127

   

695

 

Commercial real estate

 

2,543

   

1,719

 

Consumer

 

504

   

495

 

Commercial business

 

538

   

427

 
             

Total

 

4,712

   

3,336

 

Accruing loans delinquent 90 days or more

 

0

   

171

 

Other assets

866

866

Foreclosed and Repossessed Assets

           

One-to-four family real estate

 

492

   

300

 

Commercial real estate

 

80

   

127

 

Consumer

 

19

   

107

 
   
   
 

Total non-performing assets

$

6,169

 

$

4,907

 
   
   
 

Total as a percentage of total assets

 

0.81

%

 

0.67

%

   
   
 

Total non-performing loans

$

4,712

 

$

3,507

 
   
   
 

Total as a percentage of total loans receivable, net

 

0.82

%

 

0.66

%

   
   
 

Allowance for loan loss to non-performing loans

 

120.08

%

 

134.60

%

   
   
 

Total non-performing assets at March 31, 2003 were $6.2 million, an increase of $1.3 million, from $4.9 million at December 31, 2002. The increase in non-performing assets relates primarily to one commercial real estate loan and four single-family loans that became non-accruing during the first quarter of 2003. During the first quarter of 2003, the following activity occurred related to non-accruing loans: $1,968,000 of loans were transferred in, $8,000 were transferred out to foreclosed and repossessed assets, $584,000 were transferred out to performing loans. During the same period $171,000 of accruing loans delinquent 90 days or more were transferred to performing status.

Dividends

On April 22, 2003 HMN declared a cash dividend of $0.18 per share, payable on June 9, 2003 to shareholders of record on May 22, 2003.

During the first quarter of 2003, HMN declared and paid dividends as follows:

Record date                 Payable date         Dividend per share     Dividend Payout Ratio

February 21, 2003     March 7, 2003             $0.18                         64.29 %

The annualized dividend payout ratio for the past four quarters, ending with the June 9, 2003 payment will be 61.02%.

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, 2003, the net cash provided by operating activities was $6.1 million. HMN collected $37.8 million from the sale of securities and $14.3 million in principal repayments on

20


securities during the quarter. It purchased $20.7 million in securities and paid out $46.8 million relating to an increase in net loans receivable. It purchased premises and equipment of $389,000 million and received $221,000 in proceeds from the sale of fixed assets. HMN had a net increase in deposit balances of $15.1 million during the quarter. It received net proceeds of $269,000 from increased advance payments from borrowers for taxes and insurance. HMN received $221,000 related to the exercise of HMN stock options. HMN paid $670,000 in dividends to its shareholders and $1.4 million to purchase treasury stock.

HMN has certificates of deposits with outstanding balances of $125.2 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits 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 $115.9 million of FHLB advances that 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 that 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, 2003. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on March 31, 2003.

21


 


Other than trading portfolio

Market Value

 

 

(Dollars in thousands)

Basis point change in interest rates

 

 

-100

 

 

0

 

 

+100

 

 

+200

 

Cash and cash equivalents

$

32,801

 

32,795

 

32,751

 

32,725

 

Securities available for sale:

Fixed-rate CMOs

 

3,938

 

3,932

 

3,927

 

3,877

 

Variable-rate CMOs

 

10,117

 

10,116

 

10,128

 

9,940

 

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

 

888

 

881

 

867

 

847

 

Variable-rate available for sale mortgage-

backed and related securities

 

 

120

 

 

120

 

 

119

 

 

118

 

Fixed-rate available for sale other

marketable securities

 

85,492

 

83,876

 

82,142

 

80,519

 

Variable-rate available for sale other marketable securities

 

112

 

107

 

105

 

105

 

Federal Home Loan Bank stock

 

12,479

 

11,881

 

11,348

 

10,836

 

Loans held for sale

 

13,568

 

12,999

 

12,666

 

12,473

 

Loans receivable, net:

 

 

 

 

 

 

 

 

 

Fixed-rate real estate loans

 

196,666

 

194,271

 

190,598

 

186,118

 

Variable-rate real estate loans

 

187,844

 

184,078

 

179,963

 

176,405

 

Fixed-rate other loans

 

98,979

 

97,752

 

95,867

 

94,162

 

Variable-rate other loans

 

126,040

 

123,985

 

120,610

 

119,447

 

Mortgage servicing rights, net

 

1,631

 

2,838

 

4,350

 

4,988

 

Investment in limited partnerships

 

524

 

507

 

495

 

482

 

   
 
 
 
 

Total market risk sensitive assets

 

771,199

 

760,138

 

745,936

 

733,042

 





NOW deposits

 

71,195

 

71,195

 

71,195

 

71,195

 

Passbook deposits

 

40,678

 

40,678

 

40,678

 

40,678

 

Money market deposits

 

64,392

 

64,392

 

64,392

 

64,392

 

Certificate deposits

 

280,334

 

276,749

 

273,246

 

269,445

 

Federal Home Loan Bank:

                           Fixed-rate advances

195,221

 

188,514

 

182,130

 

182,122

Variable-rate advances

30,025

 

29,971

 

29,943

 

29,915

   
 
 
 
 

Total market risk sensitive liabilities

681,845

 

671,499

 

661,584

 

657,747





Off-balance sheet financial instruments:

Commitments to extend credit

2,354

 

0

 

(1,015)

 

(1,737)

Commitments to sell or deliver loans

(1,883)

 

0

 

818

 

1,397





Net market risk

$

88,883

 

88,639

 

84,549

 

75,635





Percentage change from current market value

$

0.28

%

0.00

%

(4.61)

%

(14.67)

%

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 9% to 49%, depending on the coupon and period to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at annual rates of between 12% and 33%, depending on coupon and the period to maturity. Growing Equity Mortgage ("GEM") loans were assumed to prepay at annual rates of between 8% and 54% 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

22


 

money market accounts were assumed to decay at an annual rate of 10%. 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, 2003 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 in Basis Points   Net Interest Income   Percentage Change  

 
 
 
+200 $ 23,694,000   9.77%  
+100   22,624,000   4.81%  
0   21,585,000   0.00%  
-100   19,655,000   (8.94)%  

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

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

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

In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest 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

23


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.

 

Item 4: Controls and Procedures

Evaluation of disclosure controls and procedures. The Company's principal executive officer and its principal financial officer, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) on May 7, 2003, have concluded that, as of such date, the Company's disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities.

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

24


 

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.

The information under this Item is being provided as required by Item 11 of Form 8-K. Participants in the Bank's 401(k) Plan were subject to a "blackout period," as defined in Regulation BTR (Blackout Trading Restriction) as a result of the transition of the plan administrator. The blackout period commenced on March 25, 2003 and ended on April 14, 2003.

During the blackout period, the ability of all participants in the affected plans to purchase, sell, or otherwise acquire or transfer an interest in plan assets, to make changes in investment options and to initiate distributions or loans was suspended. The ability of the HMN Directors and Officers to purchase, sell, or otherwise transfer (with the exception of transfers involving bona fide gifts) any equity securities of the HMN (or derivative securities of those equity securities) was also suspended. All of HMN's equity securities, namely, HMN's Common Stock, were subject to the blackout period. The person designated by HMN to respond to inquiries about the blackout period was Jeanne Parker (507) 535-1260.

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

(a) Exhibits. See Index to Exhibits on page 27 of this report.

                    (b) Reports on Form 8-K.

                    None.

25


 

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 12, 2003                                         /s/ Michael McNeil
                                                                        Michael McNeil,
                                                                        President
                                                                        Principal Executive Officer)

 

Date: May 12, 2003                                          /s/ Jon Eberle
                                                                        Jon Eberle,
                                                                        Interim Chief Financial Officer
                                                                        (Principal Financial Officer)

 

CERTIFICATIONS

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

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

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

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

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

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

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

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

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the

26


 

 registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):

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

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

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

 

Date: May 12, 2003                                                     By   /s/ Michael McNeil
                                                                                    President/Chief Executive Officer

 

CERTIFICATIONS

I, Jon Eberle, Interim Chief Financial Officer and Controller, certify that:

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

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

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

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

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

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

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

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

27


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

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

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

 

Date: May 12, 2003                                                 By    /s/ Jon Eberle
                                                                                Interim Chief Financial Officer and Controller

28


 

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 including indentures

*3

N/A

     

 

 

 

99.1

 

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

99.1

Filed Electronically

         

99.2

 

Certification Pursuant to 18 U.S.C. Section 1350 by Jon Eberle

99.2

Filed Electronically

         
         
           

*1

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

           

*2

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

           

*3

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


29