HMN FINANCIAL INC - Quarter Report: 2003 March (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

(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.

1

2

      See accompanying notes to consolidated financial statements.

3

See accompanying notes to consolidated financial statements.

4

See accompanying notes to consolidated financial statements.

                                                See accompanying notes to consolidated financial statements.

5

                                                See accompanying notes to consolidated financial statements.

6

March 31, 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 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.

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.

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.

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.

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

Investments in limited partnerships were as follows:

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.

A summary of mortgage servicing activity is as follows:

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.

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

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

11

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 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

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.

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:

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.