HMN FINANCIAL INC - Quarter Report: 2007 June (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 June 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 classes of common stock as of the latest practicable date.

Class		Outstanding at July 23, 2007
Common stock, $0.01 par value		4,276,140

 

 

HMN FINANCIAL, INC.

CONTENTS

						Page
PART I — FINANCIAL INFORMATION
		Item 1:		Financial Statements (unaudited)
				Consolidated Balance Sheets at June 30, 2007 and December 31, 2006			3
				Consolidated Statements of Income for the Three Months Ended and Six Months Ended June 30, 2007 and 2006			4
				Consolidated Statement of Stockholders’ Equity and Comprehensive Income for the Six Month Period Ended June 30, 2007			5
				Consolidated Statements of Cash Flows for the Six Months Ended June 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 Included in Item 2 under Market Risk			20
		Item 4:		Controls and Procedures			22
PART II — OTHER INFORMATION
		Item 1:		Legal Proceedings			23
		Item 1A:		Risk Factors			23
		Item 2:		Unregistered Sales of Equity Securities and Use of Proceeds			23
		Item 3:		Defaults Upon Senior Securities			23
		Item 4:		Submission of Matters to a Vote of Security Holders			23
		Item 5:		Other Information			24
		Item 6:		Exhibits			24
		Signatures					25
Amended and Restated By-Laws
Certification
Certification
Certification

Part I – FINANCIAL INFORMATION

Item 1: Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES

		June 30,				December 31,
(dollars in thousands)		2007				2006
		(unaudited)
Assets
Cash and cash equivalents		$	35,592				43,776
Securities available for sale:
Mortgage-backed and related securities (amortized cost $15,357 and $6,671)			14,417				6,178
Other marketable securities (amortized cost $189,911 and $119,940)			189,511				119,962
			203,928				126,140
Loans held for sale			4,454				1,493
Loans receivable, net			843,221				768,232
Accrued interest receivable			7,111				5,061
Real estate, net			4,703				2,072
Federal Home Loan Bank stock, at cost			6,412				7,956
Mortgage servicing rights, net			1,597				1,958
Premises and equipment, net			10,977				11,372
Goodwill			3,801				3,801
Core deposit intangible, net			49				106
Prepaid expenses and other assets			2,148				2,943
Deferred tax asset			3,433				2,879
Total assets		$	1,127,426				977,789
Liabilities and Stockholders’ Equity
Deposits		$	925,511				725,959
Federal Home Loan Bank advances			97,500				150,900
Accrued interest payable			4,406				1,176
Customer escrows			814				721
Accrued expenses and other liabilities			4,479				5,891
Total liabilities			1,032,710				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			57,691				57,914
Retained earnings, subject to certain restrictions			107,225				103,643
Accumulated other comprehensive loss			(809	)			(284	)
Unearned employee stock ownership plan shares			(4,061	)			(4,158	)
Treasury stock, at cost 4,852,522 and 4,813,232 shares			(65,421	)			(64,064	)
Total stockholders’ equity			94,716				93,142
Total liabilities and stockholders’ equity		$	1,127,426				977,789

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

(unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
(dollars in thousands)		2007				2006				2007				2006
Interest income:
Loans receivable		$	16,629				15,081				32,374				29,784
Securities available for sale:
Mortgage-backed and related			171				69				282				140
Other marketable			2,417				1,322				4,313				2,212
Cash equivalents			279				453				722				709
Other			132				85				216				149
Total interest income			19,628				17,011				37,907				32,994
Interest expense:
Deposits			8,346				5,516				15,223				10,384
Federal Home Loan Bank advances			1,427				1,745				3,045				3,471
Total interest expense			9,773				7,261				18,268				13,855
Net interest income			9,855				9,750				19,639				19,139
Provision for loan losses			1,028				980				1,483				1,495
Net interest income after provision for loan losses			8,827				8,770				18,156				17,644
Non-interest income:
Fees and service charges			781				795				1,477				1,510
Mortgage servicing fees			265				302				536				605
Securities gains, net			0				48				0				48
Gains on sales of loans			189				303				985				549
Other			57				318				362				540
Total non-interest income			1,292				1,766				3,360				3,252
Non-interest expense:
Compensation and benefits			3,262				3,118				6,623				6,377
Occupancy			1,112				1,103				2,196				2,203
Advertising			195				107				301				238
Data processing			321				287				616				576
Amortization of mortgage servicing rights, net			189				236				371				453
Other			1,070				912				1,992				1,856
Total non-interest expense			6,149				5,763				12,099				11,703
Income before income tax expense			3,970				4,773				9,417				9,193
Income tax expense			1,520				1,829				3,699				3,509
Net income		$	2,450				2,944				5,718				5,684
Basic earnings per share		$	0.65				0.77				1.52				1.48
Diluted earnings per share		$	0.62				0.73				1.45				1.41

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

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

																		Unearned
																		Employee
														Accumulated				Stock
						Additional								Other				Ownership				Total				Stock-
		Common				Paid-in				Retained				Comprehensive				Plan				Treasury				Holders’
(dollars in thousands)		Stock				Capital				Earnings				Loss				Shares				Stock				Equity
Balance, December 31, 2006		$	91				57,914				103,643				(284	)			(4,158	)			(64,064	)			93,142
Net income											5,718																5,718
Other comprehensive income, net of tax:
Net unrealized losses on securities available for sale															(525	)											(525	)
Total comprehensive income																											5,193
Purchase of treasury stock																							(2,194	)			(2,194	)
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							(469	)															469				0
Restricted stock awards forfeited							17																(17	)			0
Stock compensation tax benefits							22																				22
Amortization of restricted stock awards							165																				165
Dividends paid											(1,886	)															(1,886	)
Earned employee stock ownership plan shares							189																97				286
Balance, June 30, 2007		$	91				57,691				107,225				(809	)			(4,061	)			(65,421	)			94,716

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
(unaudited)

		Six Months Ended
		June 30,
(dollars in thousands)		2007				2006
Cash flows from operating activities:
Net income		$	5,718				5,684
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses			1,483				1,495
Depreciation			959				952
Amortization of discounts, net			(1,510	)			(588	)
Amortization of deferred loan fees			(478	)			(781	)
Amortization of core deposit intangible			57				57
Amortization of mortgage servicing rights			371				453
Capitalized mortgage servicing rights			(10	)			(96	)
Securities gains, net			0				(48	)
Losses on sales of real estate			133				19
Gain on sales of loans			(985	)			(549	)
Proceeds from sale of real estate			1,557				347
Proceeds from sale of loans held for sale			34,883				34,976
Disbursements on loans held for sale			(26,616	)			(38,908	)
Amortization of restricted stock awards			165				91
Amortization of unearned ESOP shares			97				97
Earned employee stock ownership shares priced above original cost			189				184
Stock option compensation			22				32
(Increase) decrease in accrued interest receivable			(2,051	)			63
Increase (decrease) in accrued interest payable			3,230				(517	)
Decrease (increase) in other assets			437				(496	)
Decrease in other liabilities			(1,447	)			(331	)
Other, net			115				9
Net cash provided by operating activities			16,319				2,145
Cash flows from investing activities:
Proceeds from sales of securities available for sale			0				2,988
Principal collected on securities available for sale			967				371
Proceeds collected on maturities of securities available for sale			75,000				55,500
Purchases of securities available for sale			(153,376	)			(83,465	)
Purchase of Federal Home Loan Bank Stock			(999	)			(36	)
Redemption of Federal Home Loan Bank Stock			2,543				0
Net (increase) decrease in loans receivable			(90,743	)			25,805
Purchases of premises and equipment			(562	)			(1,045	)
Net cash (used) provided by investing activities			(167,170	)			118
Cash flows from financing activities:
Increase in deposits			199,815				16,570
Purchase of treasury stock			(2,194	)			(1,512	)
Stock options exercised			139				81
Excess tax benefits from options exercised			99				48
Dividends to stockholders			(1,886	)			(1,851	)
Proceeds from Federal Home Loan Bank advances			111,100				0
Repayment of Federal Home Loan Bank advances			(164,500	)			0
Proceeds from Federal Reserve Bank advances			2,000				1,000
Repayment of Federal Reserve Bank advances			(2,000	)			(1,000	)
Increase (decrease) in customer escrows			94				(259	)
Net cash provided by financing activities			142,667				13,077
(Decrease) increase in cash and cash equivalents			(8,184	)			15,340
Cash and cash equivalents, beginning of period			43,776				47,269
Cash and cash equivalents, end of period		$	35,592				62,609
Supplemental cash flow disclosures:
Cash paid for interest		$	15,038				14,372
Cash paid for income taxes			5,206				4,889
Supplemental noncash flow disclosures:
Transfer of loans to real estate			4,438				252
Loans transferred to loans held for sale			10,309				1,285

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(unaudited)

June 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 six-month period ended June 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.

(4) Derivative Instruments and Hedging Activities

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 June 30, 2007, the Company recorded an increase in other liabilities of $36,000 and a loss in the gain on sales of loans of $36,000.

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 $102,000 and an increase in other assets of $102,000 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 June 30,
		2007												2006
(Dollars in thousands)		Before tax				Tax effect				Net of tax				Before tax				Tax effect				Net of tax
Securities available for sale:
Net unrealized losses arising during the period		$	(1,242	)			(492	)			(750	)			(113	)			(47	)			(66	)
Less reclassification of net gains included in net income			0				0				0				48				17				31
Other comprehensive loss		$	(1,242	)			(492	)			(750	)			(161	)			(64	)			(97	)

		For the six months ended June 30,
		2007												2006
(Dollars in thousands)		Before tax				Tax effect				Net of tax				Before tax				Tax effect				Net of tax
Securities available for sale:
Net unrealized (losses) gains arising during the period		$	(869	)			(344	)			(525	)			118				45				73
Less reclassification of net gains included in net income			0				0				0				48				17				31
Other comprehensive (loss) income		$	(869	)			(344	)			(525	)			70				28				42

(6) Securities Available For Sale

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 loss position at June 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			$	4,578				(61	)			1			$	2,360				(534	)			6,938				(595	)
FNMA			2				4,409				(42	)			3				2,887				(307	)			7,296				(349	)
Other marketable securities:
FNMA Notes			9				54,588				(60	)			0				0				0				54,588				(60	)
FHLMC Notes			2				9,920				(12	)			0				0				0				9,920				(12	)
FFCB Notes			3				14,855				(49	)															14,855				(49	)
FHLB Notes			16				89,565				(285	)			0				0				0				89,565				(285	)
Total temporarily impaired Securities			33			$	177,915				(509	)			4			$	5,247				(841	)			183,162				(1,350	)

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

(7) Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

		Six Months ended				Twelve Months ended				Six Months ended
(Dollars in thousands)		June 30, 2007				December 31, 2006				June 30, 2006
Mortgage servicing rights:
Balance, beginning of period		$	1,958				2,654				2,654
Originations			10				152				95
Amortization			(371	)			(848	)			(453	)
Balance, end of period		$	1,597				1,958				2,296
Fair value of mortgage servicing rights		$	3,810				3,823				4,458

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 June 30, 2007.

						Weighted
		Loan Principal				Average				Weighted Average		Number of
(Dollars in thousands)		Balance				Interest Rate				Remaining Term		Loans
Original term 30 year fixed rate		$	192,494				5.93	%		318 months			1,713
Original term 15 year fixed rate			163,103				5.28	%		136 months			2,283
Adjustable rate			3,655				5.84	%		308 months			34

(8) Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at June 30, 2007 is presented in the table below. Amortization expense for intangible assets was $428,000 and $510,000 for the six month periods ended June 30, 2007 and 2006, respectively.

		Gross								Unamortized
		Carrying				Accumulated				Intangible
(Dollars in thousands)		Amount				Amortization				Assets
Amortized intangible assets:
Mortgage servicing rights		$	4,082				(2,485	)			1,597
Core deposit intangible			1,567				(1,518	)			49
Total		$	5,649				(4,003	)			1,646

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

		Mortgage				Core
		Servicing				Deposit
(Dollars in thousands)		Rights				Intangible				Total
Year ended December 31, 2007		$	289				49				338
2008			541				0				541
2009			397				0				397
2010			217				0				217
2011			105				0				105

Projections of amortization are based on existing asset balances and the existing interest rate environment as of June 30, 2007. The Company’s actual experiences 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 June 30,								Six Months Ended June 30,
		2007				2006				2007				2006
Weighted average number of common shares outstanding used in basic earnings per common share calculation			3,751,616				3,842,994				3,763,663				3,849,078
Net dilutive effect of:
Options			164,482				174,480				168,262				169,670
Restricted stock awards			20,766				14,303				20,157				13,593
Weighted average number of shares outstanding adjusted for effect of dilutive securities			3,936,864				4,031,777				3,952,082				4,032,341
Income available to common shareholders		$	2,449,730				2,943,370				5,717,504				5,683,776
Basic earnings per common share		$	0.65				0.77				1.52				1.48
Diluted earnings per common share		$	0.62				0.73				1.45				1.41

(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 in the regulations). Management believes, as of June 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 June 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 June 30, 2007 the Bank’s tangible assets and adjusted total assets were $1.1 billion and its risk-weighted assets were $887 million. The following table presents the Bank’s capital amounts and ratios at June 30, 2007 for actual capital, required capital and excess capital, including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations.

										Required to be																To Be Well Capitalized
										Adequately																Under Prompt Corrective
		Actual								Capitalized								Excess Capital								Actions 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		$	92,071
Plus:
Net unrealized loss on certain securities available for sale			809
Less:
Goodwill and core deposit intangibles			(3,850	)
Disallowed assets			(2,519	)
Tier I or core capital			86,511
Tier I capital to adjusted total assets							7.71	%		$	44,880				4.00	%		$	41,631				3.71	%		$	56,100				5.00	%
Tier I capital to risk-weighted assets							9.75	%		$	35,475				4.00	%		$	51,036				5.75	%		$	53,212				6.00	%
Plus:
Allowable allowance for loan losses			10,063
Risk-based capital		$	96,574							$	70,950							$	25,624							$	88,687
Risk-based capital to risk- weighted assets							10.89	%							8.00	%							2.89	%							10.00	%

In addition, the tangible capital of the Bank was in excess of the minimum 2% required by OTS regulations at June 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 June 30, 2007 were approximately $11.8 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 has filed a response, however, no court date has been set.

In addition, the Company adopted the provisions of FIN 48 on January 1, 2007. The adoption did not have a material effect on the contractual obligations table presented in the Company’s annual report on Form 10-K for the year ended December 31, 2006.

(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 $24,000 in interest expense was recorded in other operating expense during the first six months of 2007. The liability for unrecognized tax benefits includes $84,000 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 determining reportable segments and therefore are included in the “Other” category.

The Company evaluates performance and allocates resources based on the segment’s net income. 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 reconciliation of reported profit or loss and assets for each of the Company’s reportable segments.

		Home Federal
(Dollars in thousands)		Savings Bank				Other				Eliminations				Consolidated Total
At or for the six months ended June 30, 2007:
Interest income — external customers		$	37,869				38				0				37,907
Non-interest income — external customers			3,360				0				0				3,360
Intersegment interest income			0				58				(58	)			0
Intersegment non-interest income			87				5,866				(5,953	)			0
Interest expense			18,326				0				(58	)			18,268
Amortization of mortgage servicing rights, net			371				0				0				371
Other non-interest expense			11,456				359				(87	)			11,728
Income tax expense (benefit)			3,810				(111	)			0				3,699
Net income			5,869				5,715				(5,866	)			5,718
Goodwill			3,801				0				0				3,801
Total assets			1,124,354				95,369				(92,297	)			1,127,426
At or for the six months ended June 30, 2006:
Interest income — external customers		$	32,918				76				0				32,994
Non-interest income — external customers			3,252				0				0				3,252
Intersegment non-interest income			67				5,829				(5,896	)			0
Interest expense			13,855				0				0				13,855
Amortization of mortgage servicing rights, net			453				0				0				453
Other non-interest expense			10,998				319				(67	)			11,250
Income tax expense (benefit)			3,605				(96	)			0				3,509
Net income			5,832				5,681				(5,829	)			5,684
Goodwill			3,801				0				0				3,801
Total assets			1,006,973				94,271				(91,309	)			1,009,935
At or for the quarter ended June 30, 2007:
Interest income — external customers		$	19,611				17				0				19,628
Non-interest income — external customers			1,292				0				0				1,292
Intersegment interest income			0				17				(17	)			0
Intersegment non-interest income			43				2,541				(2,584	)			0
Interest expense			9,790				0				(17	)			9,773
Amortization of mortgage servicing rights, net			189				0				0				189
Other non-interest expense			5,815				189				(44	)			5,960
Income tax expense (benefit)			1,581				(61	)			0				1,520
Net income			2,542				2,448				(2,540	)			2,450
Goodwill			3,801				0				0				3,801
Total assets			1,124,354				95,369				(92,297	)			1,127,426
At or for the quarter ended June 30, 2006:
Interest income — external customers		$	16,979				32				0				17,011
Non-interest income — external customers			1,766				0				0				1,766
Intersegment non-interest income			33				3,021				(3,054	)			0
Interest expense			7,261				0				0				7,261
Amortization of mortgage servicing rights, net			236				0				0				236
Other non-interest expense			5,400				162				(34	)			5,528
Income tax expense (benefit)			1,880				(51	)			0				1,829
Net income			3,022				2,941				(3,020	)			2,943
Goodwill			3,801				0				0				3,801
Total assets			1,006,973				94,271				(91,309	)			1,009,935

Item 2:

HMN FINANCIAL, INC.
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 $2.4 million for the second quarter of 2007, down $494,000, or 16.8%, from net income of $2.9 million for the second quarter of 2006. Basic earnings per share for the second quarter of 2007 were $0.65, down $0.12, or 15.6%, from $0.77 for the second quarter of 2006. Diluted earnings per common share for the second quarter of 2007 were $0.62, down $0.11, or 15.1%, from $0.73 for the second quarter of 2006.

Net income was $5.7 million for the six month period ended June 30, 2007, an increase of $34,000, or 0.6%, from $5.7 million for the six month period ended June 30, 2006. Basic earnings per share were $1.52, up $0.04, or 2.7%, from $1.48 for the same six month period in 2006. Diluted earnings per share for the six month period in 2007 were $1.45, up $0.04, or 2.8%, from $1.41 for the same period in 2006. The increases in basic and diluted earnings per share were primarily due to a net decrease of 85,415 shares in average net shares outstanding between the periods as a result of the Company’s share repurchase program.

Net Interest Income

Net interest income was $9.9 million for the second quarter of 2007, an increase of $105,000, or 1.1%, compared to $9.8 million for the second quarter of 2006. Interest income was $19.6 million for the second quarter of 2007, an increase of $2.6 million, or 15.4%, from $17.0 million for the same period in 2006. Interest income increased primarily because average interest earning assets increased $94 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 $50 million increase in the average outstanding loans and $44 million increase in the average outstanding cash equivalents and investments between the periods. The average yield on investments increased 110 basis points between the periods primarily because maturing investments were reinvested at higher rates. The average yield earned on interest-earning assets was 7.47% for the second quarter of 2007, an increase of 36 basis points from the 7.11% average yield for the second quarter of 2006.

Interest expense was $9.8 million for the second quarter of 2007, an increase of $2.5 million, or 34.6%, compared to $7.3 million for the second quarter of 2006. Interest expense increased primarily because of the higher interest rates paid on new commercial money market accounts and retail and brokered certificates of deposits. The increased rates were the result of the 100 basis point increase in the 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 3.94% for the second quarter of 2007, an increase of 71 basis points from the 3.23% average interest rate paid in the second quarter of 2006.

Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2007 was 3.75%, a decrease of 33 basis points, compared to 4.08% for the second quarter of 2006.

Net interest income was $19.6 million for the first six months of 2007, an increase of $500,000, or 2.6%, from $19.1 million for the same period in 2006. Interest income was $37.9 million for the six month period ended June 30, 2007, an increase of $4.9 million, or 14.9%, from $33.0 million for the same six month period in 2006. Interest income increased because of an increase in the average interest rates earned on loans and investments and also because of the $78 million increase in the average interest earning assets between the periods. Interest rates increased primarily because maturing investments were reinvested at higher rates. Interest on loans increased 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 originated. The average yield earned on interest-earning assets was 7.48% for the first six months of 2007, an increase of 43 basis points from the 7.05% average yield for the first six months of 2006.

Interest expense was $18.3 million for the first six months of 2007, an increase of $4.4 million, or 31.9%, compared to $13.9 million for the first six months of 2006. Interest expense increased because of the higher interest rates paid on new commercial money market accounts opened between the periods and the higher rates paid on retail and brokered certificates of deposits. The increased rates were the result of the 100 basis point increase in the federal funds rate during the first six months of 2006 that was not fully reflected in deposit rates until the second half of 2006. The average interest rate paid on interest-bearing liabilities was 3.82% for the first six months of 2007, an increase of 67 basis points from the 3.15% average interest rate paid in the first six months of 2006.

Net interest margin (net interest income divided by average interest earning assets) for the first six months of 2007 was 3.88%, a decrease of 21 basis points, compared to 4.09% for the first six months of 2006.

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

		For the six month period ending
		June 30, 2007												June 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		$	180,616				4,595				5.13	%		$	126,153				2,352				3.76	%
Loans held for sale			2,316				71				6.21				3,380				106				6.34
Mortgage loans, net			139,721				4,309				6.22				127,315				3,724				5.90
Commercial loans, net			578,852				24,304				8.47				546,175				21,799				8.05
Consumer loans, net			84,933				3,690				8.76				99,504				4,155				8.42
Cash equivalents			27,867				722				5.23				33,389				709				4.28
Federal Home Loan Bank stock			7,541				216				5.78				8,380				149				3.58
Total interest-earning assets			1,021,846				37,907				7.48				944,296				32,994				7.05
Interest-bearing liabilities:
Noninterest checking			55,079				0				0.00				48,245				0				0.00
NOW accounts			110,918				1,723				3.13				99,184				1,208				2.46
Savings accounts			40,750				273				1.35				74,495				712				1.93
Money market accounts			223,058				4,226				3.82				124,862				1,855				3.00
Certificates			235,205				5,092				4.37				231,534				4,007				3.49
Brokered deposits			162,837				3,909				4.84				145,955				2,602				3.60
Federal Home Loan Bank advances			135,679				3,045				4.53				160,906				3,471				4.35
Other			958				0				0.00				901				0				0.00
Total interest-bearing liabilities			964,484				18,268				3.82				886,082				13,855				3.15
Net interest income						$	19,639											$	19,139
Net interest rate spread											3.66	%											3.89	%
Net earning assets		$	57,362											$	58,214
Net interest margin											3.88	%											4.09	%
Average interest-earning assets to average interest-bearing liabilities							105.95	%											106.57	%