HMN FINANCIAL INC - Quarter Report: 2007 September (Form 10-Q)

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2007

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

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 þ      No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o      Accelerated filer þ       Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o      No þ

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

Class		Outstanding at October 19, 2007
Common stock, $0.01 par value		4,255,617

 

 

HMN FINANCIAL, INC.

CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at September 30, 2007 and December 31, 2006			3
Consolidated Statements of Income for the Three Months Ended and Nine Months Ended September 30, 2007 and 2006			4
Consolidated Statement of Stockholders’ Equity and Comprehensive Income for the Nine Month Period Ended September 30, 2007			5
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2006			6
Notes to Consolidated Financial Statements			7
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
Item 3: Quantitative and Qualitative Disclosures about Market Risk			22
Item 4: Controls and Procedures			24
PART II — OTHER INFORMATION
Item 1: Legal Proceedings			25
Item 1A: Risk Factors			25
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds			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			25
Signatures			26
Certification
Certification
Certification

PART I — FINANCIAL STATEMENTS

Item 1: Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES

		September 30,				December 31,
		2007				2006
(dollars in thousands)		(unaudited)
Assets
Cash and cash equivalents		$	51,916				43,776
Securities available for sale:
Mortgage-backed and related securities (amortized cost $19,538 and $6,671)			18,927				6,178
Other marketable securities (amortized cost $190,185 and $119,940)			191,251				119,962
			210,178				126,140
Loans held for sale			2,153				1,493
Loans receivable, net			846,201				768,232
Accrued interest receivable			7,350				5,061
Real estate, net			2,505				2,072
Federal Home Loan Bank stock, at cost			5,580				7,956
Mortgage servicing rights, net			1,431				1,958
Premises and equipment, net			12,082				11,372
Goodwill			3,801				3,801
Core deposit intangible			21				106
Prepaid expenses and other assets			1,473				2,943
Deferred tax asset			2,722				2,879
Total assets		$	1,147,413				977,789
Liabilities and Stockholders’ Equity
Deposits		$	936,419				725,959
Federal Home Loan Bank advances			97,500				150,900
Accrued interest payable			7,827				1,176
Customer escrows			1,349				721
Accrued expenses and other liabilities			7,018				5,891
Total liabilities			1,050,113				884,647
Commitments and contingencies
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				91
Additional paid-in capital			57,890				57,914
Retained earnings, subject to certain restrictions			109,079				103,643
Accumulated other comprehensive income (loss)			275				(284	)
Unearned employee stock ownership plan shares			(4,012	)			(4,158	)
Treasury stock, at cost 4,873,045 and 4,813,232 shares			(66,023	)			(64,064	)
Total stockholders’ equity			97,300				93,142
Total liabilities and stockholders’ equity		$	1,147,413				977,789

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income
(unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
(dollars in thousands, except per share amounts)		2007				2006				2007				2006
Interest income:
Loans receivable		$	17,258				14,962				49,632				44,747
Securities available for sale:
Mortgage-backed and related			212				66				495				206
Other marketable			2,498				1,512				6,810				3,724
Cash equivalents			250				546				972				1,254
Other			60				89				276				238
Total interest income			20,278				17,175				58,185				50,169
Interest expense:
Deposits			9,283				5,813				24,506				16,198
Federal Home Loan Bank advances			1,182				1,660				4,227				5,130
Total interest expense			10,465				7,473				28,733				21,328
Net interest income			9,813				9,702				29,452				28,841
Provision for loan losses			921				6,026				2,404				7,521
Net interest income after provision for loan losses			8,892				3,676				27,048				21,320
Non-interest income:
Fees and service charges			828				820				2,306				2,331
Mortgage servicing fees			254				291				789				896
Securities gains, net			0				0				0				48
Gain on sales of loans			205				481				1,189				1,030
Other			362				143				724				683
Total non-interest income			1,649				1,735				5,008				4,988
Non-interest expense:
Compensation and benefits			3,147				2,706				9,770				9,083
Occupancy			1,127				1,131				3,323				3,335
Advertising			123				108				424				346
Data processing			325				306				941				882
Amortization of mortgage servicing rights, net			169				208				540				661
Other			1,062				980				3,054				2,836
Total non-interest expense			5,953				5,439				18,052				17,143
Income (loss) before income tax expense (benefit)			4,588				(28	)			14,004				9,165
Income tax expense (benefit)			1,806				(102	)			5,505				3,408
Net income		$	2,782				74				8,499				5,757
Basic earnings per share		$	0.74				0.02				2.26				1.50
Diluted earnings per share		$	0.71				0.02				2.16				1.43

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity and Comprehensive Income
For the Nine-Month Period Ended September 30, 2007
(unaudited)

																		Unearned
																		Employee
														Accumulated				Stock
						Additional								Other				Ownership								Stock-
		Common				Paid-in				Retained				Comprehensive				Plan				Treasury				Holders’
(dollars in thousands)		Stock				Capital				Earnings				Income (Loss)				Shares				Stock				Equity
Balance, December 31, 2006		$	91				57,914				103,643				(284	)			(4,158	)			(64,064	)			93,142
Net income											8,499																8,499
Other comprehensive income, net of tax:
Net unrealized gains on securities available for sale															559												559
Total comprehensive income																											9,058
Purchase of treasury stock																							(2,778	)			(2,778	)
FIN 48 - cumulative effect adjustment											(250	)															(250	)
Employee stock options exercised							(246	)															385				139
Tax benefits of exercised stock options							99																				99
Unearned compensation restricted stock awards							(468	)															468				0
Restricted stock awards forfeited							34																(34	)			0
Stock compensation tax benefits							32																				32
Amortization of restricted stock awards							251																				251
Dividends paid											(2,813	)															(2,813	)
Earned employee stock ownership plan shares							274												146								420
Balance, September 30, 2007		$	91				57,890				109,079				275				(4,012	)			(66,023	)			97,300

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
(unaudited)

		Nine Months Ended
		September 30,
(dollars in thousands)		2007				2006
Cash flows from operating activities:
Net income		$	8,499				5,757
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses			2,404				7,521
Depreciation			1,429				1,433
Amortization of discounts, net			(2,183	)			(1,189	)
Amortization of deferred loan fees			(997	)			(1,168	)
Amortization of core deposit intangible			85				85
Amortization of mortgage servicing rights			540				661
Capitalized mortgage servicing rights			(13	)			(147	)
Securities gains, net			0				(48	)
Losses on sales of real estate			35				19
Gain on sales of loans			(1,189	)			(1,030	)
Proceeds from sales of real estate			4,903				348
Proceeds from sales of loans held for sale			51,215				59,652
Disbursements on loans held for sale			(39,470	)			(58,735	)
Amortization of restricted stock awards			251				141
Amortization of unearned ESOP shares			146				145
Earned employee stock ownership shares priced above original cost			274				285
Stock option compensation			32				48
Increase in accrued interest receivable			(2,289	)			(199	)
Increase (decrease) in accrued interest payable			6,651				(651	)
Decrease (increase) in other assets			1,034				(4,812	)
Increase (decrease) in other liabilities			1,126				(780	)
Other, net			13				90
Net cash provided by operating activities			32,496				7,426
Cash flows from investing activities:
Proceeds from sales of securities available for sale			0				2,988
Principal collected on securities available for sale			1,677				617
Proceeds collected on maturities of securities available for sale			120,000				105,500
Purchases of securities available for sale			(203,067	)			(132,998	)
Purchase of Federal Home Loan Bank stock			(999	)			0
Redemption of Federal Home Loan Bank stock			3,375				409
Net (increase) decrease in loans receivable			(96,004	)			46,998
Purchases of premises and equipment			(2,136	)			(1,189	)
Net cash (used) provided by investing activities			(177,154	)			22,325
Cash flows from financing activities:
Increase in deposits			210,923				9,733
Purchase of treasury stock			(2,778	)			(2,954	)
Stock options exercised			139				138
Excess tax benefits from options exercised			99				47
Dividends to stockholders			(2,813	)			(2,797	)
Proceeds from Federal Home Loan Bank advances			112,100				0
Repayment of Federal Home Loan Bank advances			(165,500	)			(10,000	)
Proceeds from Federal Reserve Bank advances			2,000				1,000
Repayment of Federal Reserve Bank advances			(2,000	)			(1,000	)
Increase in customer escrows			628				52
Net cash provided (used) by financing activities			152,798				(5,781	)
Increase in cash and cash equivalents			8,140				23,970
Cash and cash equivalents, beginning of period			43,776				47,269
Cash and cash equivalents, end of period		$	51,916				71,239
Supplemental cash flow disclosures:
Cash paid for interest		$	22,083				21,978
Cash paid for income taxes			5,482				6,851
Supplemental noncash flow disclosures:
Transfer of loans to real estate			5,388				252
Loans transferred to loans held for sale			11,239				2,694

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(unaudited)

September 30, 2007 and 2006

(1) HMN Financial, Inc.

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA) which offers financial planning products and services. 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 consolidated financial statements included herein are for HMN, SFC, the Bank and the Bank’s wholly owned subsidiary, OIA. 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 statement of stockholders’ equity and comprehensive income and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles. However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The consolidated statement of income for the nine-month period ended September 30, 2007 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 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires companies to recognize in their financial statements the impact of a tax position, taken or expected to be taken, if it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The Interpretation requires the use of a cumulative probability methodology to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available at the reporting date. It also requires that interest expense be accrued on the difference between the tax position recognized in accordance with the Interpretation and the amount previously taken or expected to be taken in a tax return. The provisions of FIN 48 were adopted by the Company on January 1, 2007 and as a result, the Company recognized an increase in its liability recorded for tax exposure reserves. See Note 12 Income Taxes for additional FIN 48 disclosures.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about the use of fair value to measure assets and liabilities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The impact of adopting SFAS No. 157 on January 1, 2008 is not anticipated to have a material impact on the Company’s financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115. This Statement permits entities to measure many financial instruments and other items at fair value and most of the provisions of the Statement apply only to entities that elect the fair value option. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. Early adoption is permitted as of the beginning of a fiscal year that begins prior to the effective date, provided the entity also elects to apply the provisions of FASB Statement No. 157, Fair Value Measurements. The impact of adopting SFAS No. 159 on January 1, 2008 is not anticipated to have a material impact on the Company’s financial statements.

The Company has commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter. The Company intends to sell these commitments which are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, the Company generally enters into commitments to sell the mortgage pipeline into the secondary market on a firm commitment or best efforts basis. The commitments to originate, purchase or sell loans on a firm commitment basis are derivatives. As a result of marking to market the mortgage pipeline and the related firm commitments to sell for the period ended September 30, 2007, the Company recorded an increase in other liabilities of $1,000 and a loss included in the gain on sales of loans of $1,000.

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 and the related loans held for sale are recorded at the lower of cost or market. The Company recorded a decrease in loans held for sale of $24,000 and an increase in other assets of $24,000 due to the mark to market adjustment on the commitments to sell loans held for sale.

(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 the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income and the related tax effects were as follows:

		For the three months ended September 30,
		2007												2006
(Dollars in thousands)		Before tax				Tax effect				Net of tax				Before tax				Tax effect				Net of tax
Securities available for sale:
Gross unrealized gains arising during the period		$	1,796				712				1,084				801				317				484
Reclassification of net gains included in net income			0				0				0				0				0				0
Other comprehensive income		$	1,796				712				1,084				801				317				484

		For the nine months ended September 30,
		2007												2006
		Before tax				Tax effect				Net of tax				Before tax				Tax effect				Net of tax
Securities available for sale:
Gross unrealized gains arising during the period		$	927				368				559				919				362				557
Reclassification of net gains included in net income			0				0				0				48				17				31
Other comprehensive income		$	927				368				559				871				345				526

The following table shows the gross unrealized losses and fair value for the securities available for sale portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2007.

		Less than twelve months												Twelve months or more												Total
		# of				Fair				Unrealized				# of				Fair				Unrealized				Fair				Unrealized
(Dollars in thousands)		Investments				Value				Losses				Investments				Value				Losses				Value				Losses
Mortgage backed securities:
FHLMC			1			$	13				—				1			$	2,430				(436	)		$	2,443				(436	)
FNMA			1				38				—				3				2,854				(236	)			2,892				(236	)
Other marketable securities:
FNMA			1				9,984				(9	)			—				—				—				9,984				(9	)
FHLMC			1				4,991				—				—				—				—				4,991				—
Total temporarily impaired securities			4			$	15,026				(9	)			4			$	5,284				(672	)		$	20,310				(681	)

These fixed rate investments are temporarily impaired due to changes in interest rates and the Company has the ability and intent to hold to maturity or until the temporary loss is recovered. Mortgage backed securities in the table above had an average remaining life of less than eight years and the other marketable securities had an average remaining life of less than one year at September 30, 2007.

(7) Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

		Nine Months ended				Twelve Months ended				Nine Months ended
(Dollars in thousands)		Sept. 30, 2007				Dec. 31, 2006				Sept. 30, 2006
Mortgage servicing rights
Balance, beginning of period		$	1,958				2,654				2,654
Originations			13				152				147
Amortization			(540	)			(848	)			(662	)
Balance, end of period			1,431				1,958				2,139
Fair value of mortgage servicing rights		$	3,703				3,823				4,233

All of the loans being serviced were single-family loans serviced for FNMA under the mortgage-backed security program or individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at September 30, 2007.

						Weighted				Weighted
		Loan				Average				Average
		Principal				Interest				Remaining				Number
(Dollars in thousands)		Balance				Rate				Term				of Loans
Original term 30 year fixed rate		$	188,809				5.93	%			315				1,684
Original term 15 year fixed rate			156,888				5.27	%			134				2,223
Adjustable rate			3,241				5.83	%			306				30

The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2007 is presented in the following table. Amortization expense for intangible assets was $625,000 and $746,000 for the nine months ended September 30, 2007 and 2006, respectively.

		Gross								Unamortized
		Carrying				Accumulated				Intangible
(Dollars in thousands)		Amount				Amortization				Assets
Amortized intangible assets:
Mortgage servicing rights		$	3,920				(2,489	)			1,431
Core deposit intangible			1,567				(1,546	)			21
Total		$	5,487				(4,035	)			1,452

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

		Mortgage				Core
		Servicing				Deposit
(Dollars in thousands)		Rights				Intangible				Total
Year ending December 31,
2007		$	141				21				162
2008			532				0				532
2009			392				0				392
2010			214				0				214
2011			104				0				104

Projections of amortization are based on existing asset balances and the existing interest rate environment as of September 30, 2007. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

(9) 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 September 30,								Nine months ended September 30,
		2007				2006				2007				2006
Weighted average number of common shares outstanding used in basic earnings per common share calculation			3,738,462				3,807,223				3,755,720				3,834,973
Net dilutive effect of:
Options			143,492				181,737				157,714				174,474
Restricted stock awards			17,386				12,744				19,223				13,307
Weighted average number of shares outstanding adjusted for effect of dilutive securities			3,899,340				4,001,704				3,932,657				4,022,754
Income available to common shareholders		$	2,781,881				73,512				8,499,385				5,757,288
Basic earnings per common share		$	0.74				0.02				2.26				1.50
Diluted earnings per common share		$	0.71				0.02				2.16				1.43

(10) 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 the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of September 30, 2007, that the Bank meets all capital adequacy requirements to which it is subject.

Management believes that based upon the Bank’s capital calculations at September 30, 2007 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On September 30, 2007 the Bank’s tangible assets and adjusted total assets were $1.14 billion and its risk-weighted assets were $847.7 million. The following table presents the Bank’s capital amounts and ratios at September 30, 2007 for actual capital, required capital and excess capital including ratios required to qualify as a well capitalized institution under the Prompt Corrective Actions regulations.

										Required to be																To Be Well Capitalized
										Adequately																Under Prompt Corrective
		Actual								Capitalized								Excess Capital								Action Provisions
						Percent of								Percent of								Percent of								Percent of
(Dollars in thousands)		Amount				Assets(1)				Amount				Assets(1)				Amount				Assets(1)				Amount				Assets(1)
Bank stockholder’s equity		$	92,977
Less:
Net unrealized gain on certain securities available for sale			(275	)
Goodwill and core deposit intangibles			(3,822	)
Disallowed assets			(2,518	)
Tier I or core capital			86,362
Tier I capital to adjusted total assets							7.60	%		$	45,475				4.00	%		$	40,887				3.60	%		$	56,844				5.00	%
Tier I capital to risk-weighted assets							10.19	%		$	33,907				4.00	%		$	52,455				6.19	%		$	50,861				6.00	%
Plus:
Allowable allowance for loan losses			10,596
Risk-based capital		$	96,958							$	67,815							$	29,143							$	84,769
Risk-based capital to risk- weighted assets							11.44	%							8.00	%							3.44	%							10.00	%

The tangible capital of the Bank was in excess of the minimum 2% required by OTS regulations at September 30, 2007.

(11) Commitments and Contingencies

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding at September 30, 2007 were approximately $7.3 million, expire over the next two years and are 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.

In February 2007, the Minnesota Department of Revenue (MDR) assessed a deficiency of $2.2 million against the Company’s 2002 through 2004 Minnesota state tax payments. The deficiency relates to the tax treatment of the inter-company dividends paid to the Bank by a former subsidiary of the Company. The Company filed a Notice of Appeal in the Minnesota Tax Court challenging that assessment and the MDR filed a response and has started the discovery process.

(12) Income Taxes

On January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). Implementation of FIN 48 resulted in a $250,000 cumulative effect adjustment to retained earnings as of the date of adoption. At January 1, 2007, the total amount of unrecognized tax benefits under FIN 48 was $600,000, of which $390,000 related to tax benefits that if recognized, would impact the annual effective tax rate. We recognize both interest and penalties as a component of other operating expense and $36,000 in interest expense was recorded in other operating expense during the first nine months of 2007. The liability for unrecognized tax benefits includes $96,000 of interest and no penalties. It is reasonably possible that the total unrecognized tax benefit as of January 1, 2007 could increase by $1.6 million or be reduced to zero within the next 12 month period. It is also reasonably possible that any benefit may be substantially offset by new matters arising during this same period. The Company files consolidated federal and state income tax returns. With few exceptions, we are not subject to federal income tax examinations for taxable years prior to 2003, or state examinations prior to 2002.

The adoption of FIN 48 may result in increased volatility to our annual effective tax rate because FIN 48 requires that any change in judgment or change in measurement of a tax position taken in a prior annual period be recognized as a discrete event in the period in which it occurs. There have been no material changes in judgment or changes in the measurement of a tax position from the January 1, 2007 date of adoption.

(13) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of SFAS No. 131. SFC and HMN, the holding company, did not meet the quantitative thresholds for a reportable segment and therefore are included in the “Other” category.

The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets and equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

The following table sets forth certain information about the reconciliations of reported net income and assets for each of the Company’s reportable segments.

		Home Federal												Consolidated
(Dollars in thousands)		Savings Bank				Other				Eliminations				Total
At or for the quarter ended September 30, 2007:
Interest income — external customers		$	20,276				2				0				20,278
Non-interest income — external customers			1,549				100				0				1,649
Intersegment interest income			0				27				(27	)			0
Intersegment non-interest income			44				2,821				(2,865	)			0
Interest expense			10,492				0				(27	)			10,465
Amortization of mortgage servicing rights, net			169				0				0				169
Other non-interest expense			5,634				194				(44	)			5,784
Income tax expense (benefit)			1,832				(26	)			0				1,806
Net income			2,821				2,782				(2,821	)			2,782
Goodwill			3,801				0				0				3,801
Total assets			1,142,558				97,981				(93,126	)			1,147,413
At or for the quarter ended September 30, 2006:
Interest income — external customers		$	17,165				10				0				17,175
Non-interest income — external customers			1,735				0				0				1,735
Intersegment interest income			3				0				(3	)			0
Intersegment non-interest income			34				223				(257	)			0
Interest expense			7,473				3				(3	)			7,473
Amortization of mortgage servicing rights, net			208				0				0				208
Other non-interest expense			5,008				257				(34	)			5,231
Income tax (benefit)			(3	)			(99	)			0				(102	)
Net income			225				72				(223	)			74
Goodwill			3,801				0				0				3,801
Total assets			986,694				92,742				(88,178	)			991,258
At or for the nine months ended September 30, 2007:
Interest income — external customers		$	58,145				40				0				58,185
Non-interest income — external customers			4,908				100				0				5,008
Intersegment interest income			0				85				(85	)			0
Intersegment non-interest income			131				8,687				(8,818	)			0
Interest expense			28,818				0				(85	)			28,733
Amortization of mortgage servicing rights, net			540				0				0				540
Other non-interest expense			17,090				553				(131	)			17,512
Income tax expense (benefit)			5,642				(137	)			0				5,505
Net income			8,690				8,496				(8,687	)			8,499
Goodwill			3,801				0				0				3,801
Total assets			1,142,558				97,981				(93,126	)			1,147,413
At or for the nine months ended September 30, 2006:
Interest income — external customers		$	50,083				86				0				50,169
Non-interest income — external customers			4,988				0				0				4,988
Intersegment interest income			3				0				(3	)			0
Intersegment non-interest income			101				6,052				(6,153	)			0
Interest expense			21,328				3				(3	)			21,328
Amortization of mortgage servicing rights, net			661				0				0				661
Other non-interest expense			16,007				576				(101	)			16,482
Income tax expense (benefit)			3,603				(195	)			0				3,408
Net income			6,055				5,754				(6,052	)			5,757
Goodwill			3,801				0				0				3,801
Total assets			986,694				92,742				(88,178	)			991,258

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 by the Company with the Securities and Exchange Commission may contain “forward-looking” statements that deal with future results, plans or performance. In addition, the Company’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. Words such as “anticipate”, “believe”, “expect”, “intend”, “would”, “could” and similar expressions, as they relate to us, are intended to identify such forward-looking statements. The Company’s future results may differ materially from historical performance and forward-looking statements about the Company’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 the Company’s loan and investment portfolios; changes in loan repayment and prepayment patterns; changes in loan terms and conditions; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation or other significant uncertainties. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

General

The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and Federal Home Loan Bank (FHLB) advances. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the “interest rate spread”. Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities and the level of non-performing assets. The Company’s net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization and valuation adjustments on mortgage servicing assets. The increased emphasis on commercial loans over the past several years has increased the credit risk inherent in the loan portfolio and the provision for loan losses has increased due to commercial loan charge offs.

The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies and regulations of various regulatory authorities. 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 deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. 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 the Company’s management believes are the most important to understanding the Company’s financial condition and operating results. The Company has identified the following policies as being critical because they require difficult, subjective, and/or complex

judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used.

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company’s ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company’s own loss experience and external industry data and are assigned to all loans without identified credit weaknesses. The Company also performs an individual analysis of impairment on each non-performing loan that is based on the expected cash flows or the value of the assets collateralizing the loans. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans.

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. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

Mortgage Servicing Rights

The Company recognizes as an asset the rights to service mortgage loans for others, which are referred to as mortgage servicing rights (MSRs). MSRs are capitalized at the fair value of the servicing rights on the date the mortgage loan is sold and are carried at the lower of the capitalized amount, net of accumulated amortization, or fair value. MSRs are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. Each quarter the Company evaluates its MSRs for impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and interest rate are the predominant risk characteristics of the underlying loans used to stratify the MSRs for purposes of measuring impairment. If temporary impairment exists, a valuation allowance is established for any excess of amortized cost over the current fair value through a charge to income. If the Company later determines that all or a portion of the temporary impairment no longer exists, a reduction of the valuation allowance is recorded as an increase to income. The valuation is based on various assumptions, including 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 MSRs. Management believes that the assumptions used and the values determined are reasonable based on current conditions. However, future economic conditions may differ substantially from those anticipated in determining the value of the MSRs and adjustments may be required in the future. The Company does not formally hedge its MSRs because they are hedged naturally by the Company’s origination volume. Generally, as interest rates rise

the origination volume declines and the value of MSRs increases and as interest rates decline the origination volume increases and the value of MSRs decreases.

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.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). The Company adopted FIN 48 effective January 1, 2007. FIN 48 requires the use of estimates and management’s best judgment to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available. The application of FIN 48 requires significant judgment in arriving at the amount of tax benefits to be recognized in the financial statements for a given tax position. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.

Net Income

The Company’s net income was $2.8 million for the third quarter of 2007, up $2.7 million from net income of $74,000 for the third quarter of 2006. The increase in net income was due primarily to a $5.1 million decrease in the loan loss provision between the periods as a result of decreased commercial loan charge offs. Basic earnings per share for the third quarter of 2007 were $0.74, up $0.72, from $0.02 for the same quarter of 2006. Diluted earnings per common share for the third quarter of 2007 were $0.71, up $0.69 from $0.02 for the third quarter of 2006.

Net income was $8.5 million for the nine-month period ended September 30, 2007, an increase of $2.7 million, or 47.6%, compared to $5.8 million for the nine-month period ended September 30, 2006. The increase in net income was due primarily to a $5.1 million decrease in the loan loss provision between the periods as a result of decreased commercial loan charge offs. Basic earnings per share were $2.26 for the nine-months ended September 30, 2007, an increase of $0.76, or 50.7%, from $1.50 for the same nine-month period of 2006. Diluted earnings per common share for the nine-month period in 2007 were $2.16, up $0.73, or 51.0%, from $1.43 for the same period in 2006.

Net Interest Income

Net interest income was $9.8 million for the third quarter of 2007, an increase of $111,000, or 1.1%, compared to $9.7 million for the third quarter of 2006. Interest income was $20.3 million for the third quarter of 2007, an increase of $3.1 million, or 18.1%, from $17.2 million for the same period in 2006. Interest income increased primarily because average interest earning assets increased $141 million between the periods and because the average yield earned on loans and investments increased. The increase in average interest earning assets was the result of a $101 million increase in the average outstanding loans and a $40 million increase in the average outstanding cash and investments between the periods. The increase in outstanding loans was primarily in commercial business and commercial real estate loans. The increase in cash and investments was the result of obtaining collateralized deposit relationships that required the purchase of additional investments in order to collateralize the deposits and maintain adequate liquidity. The average yield on investments increased 84 basis points between the periods primarily because maturing investments were reinvested at higher rates. The average yield earned on interest-earning assets was 7.39% for the third quarter of 2007, an increase of 20 basis points from

the 7.19% average yield for the third quarter of 2006.

Interest expense was $10.5 million for the third quarter of 2007, an increase of $3.0 million, or 40.0%, compared to $7.5 million for the third quarter of 2006. Interest expense increased primarily because of higher interest rates paid on commercial money market accounts and certificates of deposits. The increased rates were the result of the 100 basis point increase in federal funds rate that occurred throughout the first six months of 2006 that was not fully reflected in deposit rates until the second half of 2006. Increases in the federal funds rate, which is the rate that banks charge other banks for short term loans, generally has a lagging effect and increases the rates banks pay for deposits. The average interest rate paid on interest-bearing liabilities was 4.05% for the third quarter of 2007, an increase of 71 basis points from the 3.34% average rate paid in the third quarter of 2006.

Net interest margin (net interest income divided by average interest earning assets) for the third quarter of 2007 was 3.58%, a decrease of 48 basis points, compared to 4.06% for the third quarter of 2006.

Net interest income was $29.4 million for the first nine months of 2007, an increase of $611,000, or 2.1%, from $28.8 million for the same period in 2006. Interest income was $58.2 million for the nine-month period ended September 30, 2007, an increase of $8.0 million, or 16.0%, from $50.2 million for the same period in 2006. Interest income increased because of a $99 million increase in average interest earning assets and also because the average yields earned on loans and investments increased between the periods. The increase in average interest earning assets was the result of a $54 million increase in the average outstanding loans and a $45 million increase in the average outstanding cash and investments between the periods. The increase in outstanding loans was primarily in commercial business and commercial real estate loans. The increase in cash and investments was the result of obtaining collateralized deposit relationships that required the purchase of additional investments in order to collateralize the deposits and maintain adequate liquidity. Yields increased primarily because of the 100 basis point increase in the prime interest rate that occurred during the first six months of 2006. Increases in the prime rate, which is the rate that banks charge their prime business customers, generally increase the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans and investments. The yield earned on interest-earning assets was 7.45% for the first nine months of 2007, an increase of 35 basis points from the 7.10% yield for the same period in 2006.

Interest expense was $28.7 million for the nine-month period ended September 30, 2007, an increase of $7.4 million, or 34.7%, from $21.3 million for the same period in 2006. Interest expense increased primarily because of higher interest rates paid on commercial money market accounts and certificates of deposits. The increased rates were the result of the 100 basis point increase in federal funds rate that occurred throughout the first six months of 2006 that was not fully reflected in deposit rates until the second half of 2006. Increases in the federal funds rate generally has a lagging effect and increases the rates banks pay for deposits. The average interest rate paid on interest-bearing liabilities was 3.90% for the first nine-months of 2007, an increase of 68 basis points from the 3.22% paid for the same period of 2006.

Net interest margin for the first nine months of 2007 was 3.77%, a decrease of 31 basis points, compared to 4.08% for the same period of 2006.

A summary of the Company’ net interest margin for the nine month period ended September 30, 2007 and September 30, 2006 is as follows:

		For the nine month period ended
		September 30, 2007												September 30, 2006
		Average				Interest								Average				Interest
		Outstanding				Earned/				Yield/				Outstanding				Earned/				Yield/
(Dollars in thousands)		Balance				Paid				Rate				Balance				Paid				Rate
Interest-earning assets:
Securities available for sale		$	190,231				7,305				5.13	%		$	132,688				3,930				3.96	%
Loans held for sale			2,368				110				6.23				3,891				186				6.39
Mortgage loans, net			142,034				6,531				6.15				128,880				5,723				5.94
Commercial loans, net			593,080				37,530				8.46				538,096				32,697				8.12
Consumer loans, net			84,248				5,461				8.67				97,346				6,141				8.43
Cash equivalents			25,516				972				5.09				36,218				1,254				4.63
Federal Home Loan Bank stock			6,940				276				5.32				8,266				238				3.85
Total interest-earning assets			1,044,417				58,185				7.45				945,385				50,169				7.10
Interest-bearing liabilities:
Noninterest checking			55,607				0				0.00				50,188				0				0.00
NOW accounts			113,733				2,685				3.16				97,138				1,873				2.58
Savings accounts			40,654				414				1.36				67,090				942				1.88
Money market accounts			222,056				6,314				3.80				145,732				3,527				3.24
Certificates			235,787				7,815				4.43				232,604				6,238				3.59
Brokered deposits			193,332				7,278				5.03				134,861				3,618				3.59
Federal Home Loan Bank advances			122,817				4,227				4.60				157,863				5,130				4.34
Other			1,030				0				0.00				927				0				0.00
Total interest-bearing liabilities			985,016				28,733				3.90				886,403				21,328				3.22
Net interest income						$	29,452											$	28,841
Net interest rate spread											3.55	%											3.88	%
Net earning assets		$	59,401											$	58,982
Net interest margin											3.77	%											4.08	%
Average interest-earning assets to average interest-bearing liabilities							106.03	%											106.65	%

Provision for Loan Losses

The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed appropriate by management based on factors disclosed in the critical accounting policies previously discussed. The provision for loan losses was $921,000 for the third quarter of 2007, a decrease of $5.1 million, or 84.7%, from $6.0 million for the third quarter of 2006. The provision for loan losses decreased primarily because of a decrease in commercial real estate loans charged off between the periods. In the third quarter of 2006, $7.4 million in related commercial real estate development loans secured primarily by developed and undeveloped single family home lots and a golf course were charged off. In the third quarter of 2007, loan charge-offs were $129,000. The decrease in the provision related to decreased loan charge offs was partially offset by an increase of $537,000 in the provision required for risk rated commercial loans in the third quarter of 2007 compared to the same period of 2006.

The provision for loan losses was $2.4 million for the first nine-months of 2007, a decrease of $5.1 million, or 68.0%, from $7.5 million for the same nine-month period in 2006. The provision for loan losses decreased primarily because $7.4 million in related commercial real estate development loans were charged off during the third quarter of 2006. The decrease in the provision related to loan charge offs was partially offset by an increase in the provision for the $62 million increase in outstanding commercial loans during the first nine months of 2007.

The Company’s allowance for loan losses for the nine-month periods ended September 30, 2007 and 2006 is summarized as follows:

(in thousands)		2007				2006
Balance at January 1,		$	9,873			$	8,778
Provision			2,404				7,521
Charge offs:
Commercial loans			(16	)			(151	)
Commercial real estate loans			(138	)			(7,222	)
Consumer loans			(694	)			(235	)
Recoveries			123				55
Balance at September 30,		$	11,552			$	8,746

Non-Interest Income

Non-interest income was $1.6 million for the third quarter of 2007, a decrease of $86,000, or 5.0%, from $1.7 million for the same period in 2006. Gains on sales of loans decreased $276,000 due to a decrease in the single-family mortgage loans that were sold and a decrease in the profit margins realized on the loans that were sold. Competition in the single-family loan origination market has remained strong as the overall market has slowed and profit margins have been lowered in order to remain competitive and maintain origination volume. Mortgage servicing fees decreased $37,000 due primarily to a decrease in the single-family mortgage loans being serviced. Other non-interest income increased $219,000 primarily because of increased gains on the sale of real estate owned in the third quarter of 2007 when compared to the same period in 2006.

Non-interest income was $5.0 million for the first nine months of 2007, an increase of $20,000, or 0.4%, from $5.0 million for the same period in 2006. Gains on sales of loans increased $159,000 between the periods primarily because of the $559,000 increase in the gains recognized on the sale of government guaranteed commercial loans that was partially offset by a $400,000 decrease in the gains recognized on the sales of single-family loans due to a decrease in the volume of loans sold and profit margins realized on the loans that were sold. Competition in the single- family loan origination market has remained strong as the overall market has slowed and profit margins were lowered in order to remain competitive and maintain origination volume. Fees and service charges decreased $25,000 between the periods primarily because of a decrease in late charges and overdraft fees that was partially offset by an increase in debit card income. Mortgage servicing fees decreased $107,000 between the periods due primarily to a decrease in the single-family mortgage loans being serviced. Security gains decreased $48,000 due to decreased security sales. Other non-interest income increased $41,000 primarily because of increased gains on the sale of real estate owned in the first nine months of 2007 when compared to the same period of 2006.

Non-Interest Expense

Non-interest expense was $6.0 million for the third quarter of 2007, an increase of $514,000, or 9.4%, from $5.4 million for the same period of 2006. Compensation expense increased $441,000 between the periods due primarily to an increase in incentive compensation and annual payroll cost increases. Other noninterest expenses increased $82,000 primarily because of increased loan costs and legal fees relating to foreclosed assets. Data processing costs increased $19,000 primarily because of an increase in internet and other banking services provided by a third party processor between the periods. Advertising expense increased $15,000 between the periods due to increased mortgage loan advertising. Amortization of mortgage servicing rights decreased $39,000 due to a decrease in single-family mortgage loans being serviced in the third quarter of 2007 when compared to the same period in 2006.

Non-interest expense was $18.1 million for the first nine months of 2007, an increase of $909,000, or 5.3%, from $17.1 million for the same period in 2006. Compensation expense increased $687,000 between the periods due primarily to an increase in annual payroll costs and incentive compensation. Other noninterest expenses increased

$218,000 primarily because of increased legal fees and other expenses relating to foreclosed assets. Advertising expense increased $78,000 between the periods due to increased loan and deposit product advertising. Data processing costs increased $59,000 primarily because of an increase in internet and other banking services provided by a third party processor between the periods. Amortization of mortgage servicing rights decreased $121,000 due to a decrease in single-family mortgage loans being serviced when compared to the same period in 2006.

Income Tax Expense

Income tax expense was $1.8 million for the third quarter of 2007, an increase of $1.9 million from the $102,000 income tax benefit realized in the third quarter of 2006. The increase was primarily due to an increase in taxable income.

Income tax expense was $5.5 million for the first nine months of 2007, an increase of $2.1 million, or 61.5%, compared to $3.4 million for the first nine months of 2006. Income tax expense increased between the periods due to an increase in taxable income and an effective tax rate that increased from 37.2% for the first nine months of 2006 to 39.3% for the first nine months of 2007. The increase in the effective tax rate was primarily the result of decreased tax exempt income and changes in state tax allocations.

Non-Performing Assets

The following table sets forth the amounts and categories of non-performing assets in the Company’s portfolio at September 30, 2007, June 30, 2007 and December 31, 2006.

		Sept. 30,				June 30,				Dec. 31,
(Dollars in thousands)		2007				2007				2006
Non-Accruing Loans:
One-to-four family real estate		$	2,169				634				1,364
Commercial real estate			11,551				8,361				5,296
Consumer			1,222				972				1,254
Commercial business			2,798				1,641				394
Total			17,740				11,608				8,308
Other assets			34				44				44
Foreclosed and Repossessed Assets:
One-to-four family real estate			905				4,052				1,422
Commercial real estate			1,600				650				650
Consumer			0				11				0
Total non-performing assets		$	20,279			$	16,365			$	10,424
Total as a percentage of total assets			1.77	%			1.45	%			1.07	%
Total non-performing loans		$	17,740			$	11,608			$	8,308
Total as a percentage of total loans receivable, net			2.10	%			1.38	%			1.08	%
Allowance for loan loss to non-performing loans			65.12	%			92.39	%			118.84	%