HMN FINANCIAL INC - Quarter Report: 2008 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, 2008

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller Reporting Company 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 22, 2008
Common stock, $0.01 par value		4,167,799

 

 

HMN FINANCIAL, INC.

CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at June 30, 2008 and December 31, 2007			3
Consolidated Statements of Income (Loss) for the Three Months Ended and Six Months Ended June 30, 2008 and 2007			4
Consolidated Statement of Stockholders’ Equity and Comprehensive Income (Loss) for the Six Month Period Ended June 30, 2008			5
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007			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			21
Item 4: Controls and Procedures			23
PART II — OTHER INFORMATION
Item 1: Legal Proceedings			24
Item 1A: Risk Factors			24
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds			24
Item 3: Defaults Upon Senior Securities			24
Item 4: Submission of Matters to a Vote of Security Holders			24
Item 5: Other Information			25
Item 6: Exhibits			25
Signatures			26
Certification of CEO
Certification of CFO
Section 1350 Certification of CEO and CFO

Part I – FINANCIAL INFORMATION

HMN FINANCIAL, INC. AND SUBSIDIARIES

		June 30,				December 31,
(Dollars in thousands)		2008				2007
		(unaudited)
Assets
Cash and cash equivalents		$	14,475				23,718
Securities available for sale:
Mortgage-backed and related securities (amortized cost $17,063 and $18,786)			16,659				18,468
Other marketable securities (amortized cost $105,468 and $165,430)			107,167				167,720
			123,826				186,188
Loans held for sale			3,699				3,261
Loans receivable, net			895,713				865,088
Accrued interest receivable			6,199				6,893
Real estate, net			4,272				2,214
Federal Home Loan Bank stock, at cost			7,460				6,198
Mortgage servicing rights, net			957				1,270
Premises and equipment, net			12,585				12,024
Goodwill			0				3,801
Prepaid expenses and other assets			1,981				1,680
Deferred tax asset			4,996				4,719
Total assets		$	1,076,163				1,117,054
Liabilities and Stockholders’ Equity
Deposits		$	832,316				888,118
Federal Home Loan Bank advances			137,900				112,500
Accrued interest payable			6,607				9,515
Customer escrows			965				866
Accrued expenses and other liabilities			3,323				7,927
Total liabilities			981,111				1,018,926
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			57,820				58,049
Retained earnings, subject to certain restrictions			108,572				110,943
Accumulated other comprehensive income			766				1,167
Unearned employee stock ownership plan shares			(3,867	)			(3,965	)
Treasury stock, at cost 4,960,863 and 4,953,045 shares			(68,330	)			(68,157	)
Total stockholders’ equity			95,052				98,128
Total liabilities and stockholders’ equity		$	1,076,163				1,117,054

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Income (Loss)
(unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
(Dollars in thousands, except per share data)		2008				2007				2008				2007
Interest income:
Loans receivable		$	14,419				16,629				29,939				32,374
Securities available for sale:
Mortgage-backed and related			213				171				437				282
Other marketable			1,507				2,417				3,417				4,313
Cash equivalents			61				279				118				722
Other			53				132				133				216
Total interest income			16,253				19,628				34,044				37,907
Interest expense:
Deposits			6,839				8,346				14,709				15,223
Federal Home Loan Bank advances			1,239				1,427				2,476				3,045
Total interest expense			8,078				9,773				17,185				18,268
Net interest income			8,175				9,855				16,859				19,639
Provision for loan losses			1,130				1,028				2,690				1,483
Net interest income after provision for loan losses			7,045				8,827				14,169				18,156
Non-interest income:
Fees and service charges			998				781				1,791				1,477
Loan servicing fees			240				265				482				536
Gains on sales of loans			228				189				384				985
Other			290				57				617				362
Total non-interest income			1,756				1,292				3,274				3,360
Non-interest expense:
Compensation and benefits			3,036				3,262				6,396				6,623
Occupancy			1,161				1,112				2,293				2,196
Advertising			92				195				216				301
Data processing			336				321				678				616
Amortization of mortgage servicing rights, net			154				189				314				371
Goodwill impairment charge			3,801				0				3,801				0
Other			1,220				1,070				2,354				1,992
Total non-interest expense			9,800				6,149				16,052				12,099
Income (loss) before income tax expense			(999	)			3,970				1,391				9,417
Income tax expense			1,026				1,520				1,928				3,699
Net income (loss)		$	(2,025	)			2,450				(537	)			5,718
Basic earnings (loss) per share		$	(0.56	)			0.65				(0.15	)			1.52
Diluted earnings (loss) per share		$	(0.56	)			0.62				(0.15	)			1.45

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity and Comprehensive Income (Loss)
For the Six-Month Period Ended June 30, 2008
(unaudited)

																		Unearned
																		Employee
														Accumulated				Stock								Total
						Additional								Other				Ownership								Stock-
		Common				Paid-in				Retained				Comprehensive				Plan				Treasury				Holders’
(Dollars in thousands)		Stock				Capital				Earnings				Income				Shares				Stock				Equity
Balance, December 31, 2007		$	91				58,049				110,943				1,167				(3,965	)			(68,157	)			98,128
Net loss											(537	)															(537	)
Other comprehensive income (loss), net of tax:
Net unrealized losses on securities available for sale															(401	)											(401	)
Total comprehensive loss																											(938	)
Purchase of treasury stock																							(723	)			(723	)
Unearned compensation restricted stock awards							(550	)															550				0
Stock compensation tax benefits							17																				17
Amortization of restricted stock awards							205																				205
Dividends paid											(1,834	)															(1,834	)
Earned employee stock ownership plan shares							99												98								197
Balance, June 30, 2008		$	91				57,820				108,572				766				(3,867	)			(68,330	)			95,052

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)		2008				2007
Cash flows from operating activities:
Net income (loss)		$	(537	)			5,718
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Provision for loan losses			2,690				1,483
Depreciation			872				959
Amortization of discounts, net			(477	)			(1,510	)
Amortization of deferred loan fees			(421	)			(478	)
Amortization of core deposit intangible			0				57
Amortization of mortgage servicing rights			314				371
Capitalized mortgage servicing rights			(1	)			(10	)
Loss (gain) on sales of real estate			(225	)			133
Gains on sales of loans			(384	)			(985	)
Proceeds from sale of real estate			3,916				1,557
Proceeds from sale of loans held for sale			34,513				34,883
Disbursements on loans held for sale			(32,497	)			(26,616	)
Amortization of restricted stock awards			205				165
Amortization of unearned ESOP shares			98				97
Earned employee stock ownership shares priced above original cost			99				189
Stock option compensation			17				22
Decrease (increase) in accrued interest receivable			694				(2,051	)
Increase (decrease) in accrued interest payable			(2,908	)			3,230
Goodwill impairment charge			3,801				0
Decrease (increase) in other assets			(291	)			437
Decrease in accrued expenses and other liabilities			(4,588	)			(1,447	)
Other, net			30				115
Net cash provided by operating activities			4,920				16,319
Cash flows from investing activities:
Principal received on securities available for sale			1,741				967
Proceeds from maturities of securities available for sale			60,000				75,000
Purchases of securities available for sale			0				(153,376	)
Purchase of Federal Home Loan Bank Stock			(4,539	)			(999	)
Redemption of Federal Home Loan Bank Stock			3,277				2,543
Net increase in loans receivable			(40,752	)			(90,743	)
Purchases of premises and equipment			(1,453	)			(562	)
Net cash provided (used) by investing activities			18,274				(167,170	)
Cash flows from financing activities:
Increase (decrease) in deposits			(55,380	)			199,815
Purchase of treasury stock			(723	)			(2,194	)
Stock options exercised			0				139
Excess tax benefits from options exercised			0				99
Dividends to stockholders			(1,834	)			(1,886	)
Proceeds from borrowings			234,701				113,100
Repayment of borrowings			(209,300	)			(166,500	)
Increase in customer escrows			99				94
Net cash provided (used) by financing activities			(32,437	)			142,667
Decrease in cash and cash equivalents			(9,243	)			(8,184	)
Cash and cash equivalents, beginning of period			23,718				43,776
Cash and cash equivalents, end of period		$	14,475				35,592
Supplemental cash flow disclosures:
Cash paid for interest		$	20,093				15,038
Cash paid for income taxes			4,059				5,206
Supplemental noncash flow disclosures:
Transfer of loans to real estate			5,760				4,438
Loans transferred to loans held for sale			2,097				10,309

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(unaudited)

June 30, 2008 and 2007

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.

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, 2008 is not necessarily indicative of the results which may be expected for the entire year.

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

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51. This Statement amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity and is reported as equity in the consolidated financial statements. This Statement applies to all for-profit entities that prepare consolidated financial statements, but affects only those entities that have an outstanding noncontrolling interest in subsidiaries or that deconsolidate a subsidiary. Since the Company has no noncontrolling interests in subsidiaries, the impact of adopting SFAS No. 160 on January 1, 2009 is not anticipated to have a material impact on the Company’s consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. This Statement replaces SFAS No. 141, Business Combinations and retains the fundamental requirements in SFAS No. 141 that the purchase method of accounting be used for all business combinations and for an acquirer to be identified for each business combination. This Statement establishes principles and requirements for how the acquirer recognizes and measures the assets acquired (including goodwill), the liabilities assumed, and any controlling interest in the acquiree. It also determines what information is to be disclosed to enable users of the financial statement to evaluate the nature and financial effect of the business combination. The impact of adopting SFAS No. 141 (revised 2007) on January 1, 2009 is not anticipated to have a material impact on the Company’s consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133. This Statement applies to all entities and requires enhanced disclosures about an entity’s derivative and hedging activities including how and why an entity uses derivative

instruments, how derivative instruments and related hedged items are accounted for under Statement 133, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008 and is not anticipated to have a material impact on the Company’s consolidated financial statements.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. This Statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statement of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This Statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles and is not anticipated to have any impact on the Company’s consolidated 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 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, 2008, the Company recorded a decrease in other liabilities of $17,000, an increase in other assets of $3,000 and a gain included in the gain on sales of loans of $20,000.

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 $7,000 and an increase in other assets of $7,000 due to the mark to market adjustment on the commitments to sell loans held for sale.

On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements. SFAS No. 157 establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following table summarizes the assets of the Company for which fair values are determined on a recurring

basis as of June 30, 2008.

		Carrying value at June 30, 2008
(Dollars in thousands)		Total				Level 1				Level 2				Level 3
Securities available for sale		$	123,826				13,253				110,573				0
Mortgage loan commitments			3				0				3				0
Total		$	123,829				13,253				110,576				0

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis in the second quarter of 2008 that were still held at June 30, 2008, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at June 30, 2008.

		Carrying value at June 30, 2008
																		Three months ended
																		June 30, 2008
(Dollars in thousands)		Total				Level 1				Level 2				Level 3				Total losses
Loans held for sale		$	3,699				0				3,699				0				(7	)
Mortgage servicing rights			957				0				957				0				0
Loans (1)			44,230				0				44,230				0				(2,731	)
Real estate, net (2)			4,272				0				4,272				0				(21	)
Total		$	53,158				0				53,158				0				(2,759	)

Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income (loss) is the total of net income (loss) and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income (loss) and the related tax effects were as follows:

		For the three months ended June 30,
		2008												2007
(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		$	(2,706	)			(1,105	)			(1,601	)			(1,242	)			(492	)			(750	)
Other comprehensive loss		$	(2,706	)			(1,105	)			(1,601	)			(1,242	)			(492	)			(750	)

		For the six months ended June 30,
		2008												2007
(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		$	(677	)			(276	)			(401	)			(869	)			(344	)			(525	)
Other comprehensive loss		$	(677	)			(276	)			(401	)			(869	)			(344	)			(525	)

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, 2008.

		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			0			$	0				0				1						$	2,450				(406	)		$	2,450				(406	)
FNMA			0				0				0				3							2,628				(166	)			2,628				(166	)
Other marketable securities:
Other debt			1				350				(350	)			0							0				0				350				(350	)
Total temporarily impaired securities			1			$	350				(350	)			4						$	5,078				(572	)		$	5,428				(922	)

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.

A summary of mortgage servicing activity is as follows:

		Six Months ended				Twelve Months ended				Six Months ended
(Dollars in thousands)		June 30, 2008				December 31, 2007				June 30, 2007
Mortgage servicing rights:
Balance, beginning of period		$	1,270				1,958				1,958
Originations			1				18				10
Amortization			(314	)			(706	)			(371	)
Balance, end of period		$	957				1,270				1,597
Fair value of mortgage servicing rights		$	2,915				3,261				3,810

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, 2008.

						Weighted				Weighted
		Loan Principal				Average				Average				Number of
(Dollars in thousands)		Balance				Interest Rate				Remaining Term				Loans
Original term 30 year fixed rate		$	203,211				5.87	%			288				1,897
Original term 15 year fixed rate			108,427				5.17	%			110				1,745
Adjustable rate			2,586				5.80	%			298				22

The gross carrying amount of intangible assets and the associated accumulated amortization at June 30, 2008 is presented in the table below. Amortization expense for intangible assets was $314,000 and $428,000 for the six month periods ended June 30, 2008 and 2007, respectively.

		Gross								Unamortized
		Carrying				Accumulated				Intangible
(Dollars in thousands)		Amount				Amortization				Assets
Amortized intangible assets:
Mortgage servicing rights		$	3,853				(2,896	)			957
Total		$	3,853				(2,896	)			957

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

		Mortgage
		Servicing
(Dollars in thousands)		Rights
Year ended December 31,
2008		$	244
2009			368
2010			201
2011			97
2012			38

Projections of amortization are based on existing asset balances and the existing interest rate environment as of June 30, 2008. The Company’s actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

The following table reconciles the weighted average shares outstanding and the income (loss) available to common shareholders used for basic and diluted earnings (loss) per share:

		Three Months Ended June 30,								Six Months Ended June 30,
(dollars in thousands, except per share data)		2008				2007				2008				2007
Weighted average number of common shares outstanding used in basic earnings per common share calculation			3,647				3,752				3,649				3,764
Net dilutive effect of:
Options			0				161				0				165
Restricted stock awards			0				21				0				20
Weighted average number of shares outstanding adjusted for effect of dilutive securities			3,647				3,934				3,649				3,949
Income (loss) available to common shareholders		$	(2,025	)			2,450				(537	)			5,718
Basic earnings (loss) per common share		$	(0.56	)			0.65				(0.15	)			1.52
Diluted earnings (loss) per common share		$	(0.56	)			0.62				(0.15	)			1.45

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, 2008, 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, 2008 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, 2008, the Bank’s tangible assets and adjusted total assets were $1.1 billion and its risk-weighted assets were $867 million. The following table presents the Bank’s capital amounts and ratios at June 30, 2008 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		$	92,569
Less:
Net unrealized gains on certain securities available for sale			(971	)
Tier I or core capital			91,598
Tier I capital to adjusted total assets							8.52	%		$	42,982				4.00	%		$	48,616				4.52	%		$	53,728				5.00	%
Tier I capital to risk-weighted assets							10.56	%		$	34,686				4.00	%		$	56,912				6.56	%		$	52,029				6.00	%
Plus:
Allowable allowance for loan losses			8,674
Risk-based capital		$	100,272							$	69,372							$	30,900							$	86,715
Risk-based capital to risk-weighted assets							11.56	%							8.00	%							3.56	%							10.00	%

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, 2008 were approximately $7.0 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 a hearing has been scheduled for the fourth quarter of 2008.

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, 2008:
Interest income — external customers		$	34,030				14				0				34,044
Non-interest income — external customers			3,273				0				0				3,273
Earnings (loss) on limited partnerships			1				0				0				1
Intersegment interest income			0				51				(51	)			0
Intersegment non-interest income			87				(367	)			280				0
Interest expense			17,236				0				(51	)			17,185
Amortization of mortgage servicing rights, net			314				0				0				314
Other non-interest expense			15,468				357				(87	)			15,738
Goodwill impairment charge			3,801				0				0				3,801
Income tax expense (benefit)			2,047				(119	)			0				1,928
Net loss			(364	)			(540	)			367				(537	)
Total assets			1,075,128				95,950				(94,915	)			1,076,163
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 quarter ended June 30, 2008:
Interest income — external customers		$	16,243				10				0				16,253
Non-interest income — external customers			1,760				0				0				1,760
Earnings (loss) on limited partnerships			(4	)			0				0				(4	)
Intersegment interest income			0				8				(8	)			0
Intersegment non-interest income			43				(1,928	)			1,885				0
Interest expense			8,086				0				(8	)			8,078
Amortization of mortgage servicing rights, net			154				0				0				154
Other non-interest expense			9,509				180				(43	)			9,646
Goodwill impairment charge			3,801				0				0				3,801
Income tax expense (benefit)			1,090				(64	)			0				1,026
Net loss			(1,927	)			(2,026	)			1,928				(2,025	)
Total assets			1,075,128				95,950				(94,915	)			1,076,163
At or for the quarter ended June 30, 2007:
Interest income — external customers		$	19,611				17				0				19,628
Non-interest income — external customers			1,296				0				0				1,296
Earnings (loss) on limited partnerships			(4	)			0				0				(4	)
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

Item 2:

HMN FINANCIAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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”, “estimate”, “project” 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; reduced collateral values; 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 or tax laws; changes in credit or 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, 2007.

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 real estate 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 and risk rating downgrades as a result of a decrease in the demand for housing and building lots.

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 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.

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 components of its overall methodology 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 generally assigned to all loans that are on performing status. 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 probable 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.

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.

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 loss for the second quarter of 2008 was $2.0 million, down $4.5 million, or 182.7%, from net income of $2.5 million for the second quarter of 2007. Basic loss per common share for the second quarter of 2008 was ($0.56), down $1.21, or 186.2%, from basic earnings per share of $0.65 for the second quarter of 2007. Diluted loss per common share for the second quarter of 2008 was ($0.56), down $1.18, or 190.3%, from diluted earnings per share of $0.62 for the second quarter of 2007. The decrease is primarily the result of a $3.8 million non-cash goodwill impairment charge that was recorded during the quarter. Net income was also adversely affected by a $1.7 million decrease in net interest income in the second quarter of 2008 when compared to the same period of 2007. The goodwill impairment charge, which was required by generally accepted accounting principles as a result of the Company’s stock trading at a discount to book value, has no impact on the Company’s liquidity, cash flows or regulatory capital.

Net loss was $537,000 for the six month period ended June 30, 2008, a decrease of $6.3 million, or 109.4 %, from $5.7 million in net income for the six month period ended June 30, 2007. Basic loss per common share for the six month period of 2008 was ($0.15), down $1.67, or 109.9%, from basic earnings per share of $1.52 for the same period of 2007. Diluted loss per share for the six month period in 2008 was ($0.15), down $1.60, or 110.3%, from $1.45 of diluted earnings per share for the same period in 2007. The decrease in net income for the six month period is primarily the result of a $3.8 million non-cash goodwill impairment charge that was recorded in the second quarter of 2008. Net income was also adversely affected by a $2.8 million decrease in net interest income in the first six months of 2008 when compared to the same period of 2007.

Net interest income was $8.2 million for the second quarter of 2008, a decrease of $1.7 million, or 17.0%, compared to $9.9 million for the second quarter of 2007. Interest income was $16.3 million for the second quarter of 2008, a decrease of $3.3 million, or 17.2%, from $19.6 million for the same period in 2007. Interest income decreased primarily because of a decrease in the average yields earned on loans and investments. Interest yields decreased primarily because of the 325 basis point decrease in the prime interest rate between the periods. Decreases in the prime rate, which is the rate that banks charge their prime business customers, generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. Adjustable rate loans accounted for 65% of the Company’s total loan portfolio at June 30, 2008. The average yield earned on interest-earning assets was 6.26% for the second quarter of 2008, a decrease of 121 basis points from the 7.47% average yield for the second quarter of 2007.

Interest expense was $8.1 million for the second quarter of 2008, a decrease of $1.7 million, or 17.3%, compared to $9.8 million for the second quarter of 2007. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 325 basis point decrease in the federal funds rate that occurred between the periods. Decreases in the federal funds rate, which is the rate that banks charge other banks for short term loans, generally have a lagging effect and

decrease the rates banks pay for deposits. The lagging effect of deposit rate changes is because many of the Bank’s deposits are in the form of certificates of deposit which do not re-price immediately when the federal funds rate changes. The decrease in deposit rates was also impacted by escrowed money market account balances that were replaced with higher cost brokered deposits. The average interest rate paid on interest-bearing liabilities was 3.33% for the second quarter of 2008, a decrease of 61 basis points from the 3.94% average interest rate paid in the second quarter of 2007.

Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2008 was 3.15%, a decrease of 60 basis points, compared to 3.75% for the second quarter of 2007.

Net interest income was $16.9 million for the first six months of 2008, a decrease of $2.7 million, or 14.2 %, from $19.6 million for the same period in 2007. Interest income was $34.0 million for the six month period ended June 30, 2008, a decrease of $3.9 million, or 10.2%, from $37.9 million for the same six month period in 2007. Interest income decreased primarily because of the 325 basis point decrease in the prime interest rate between the periods. The average yield earned on interest-earning assets was 6.49% for the first six months of 2008, a decrease of 99 basis points from the 7.48% average yield for the first six months of 2007.

Interest expense was $17.2 million for the first six months of 2008, a decrease of $1.1 million, or 5.9%, compared to $18.3 million for the first six months of 2007. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 325 basis point decrease in the federal funds rate that occurred between the periods. The average interest rate paid on interest-bearing liabilities was 3.52 % for the first six months of 2008, a decrease of 30 basis points from the 3.82% average interest rate paid in the first six months of 2007.

Net interest margin (net interest income divided by average interest earning assets) for the first six months of 2008 was 3.21%, a decrease of 67 basis points, compared to 3.88% for the first six months of 2007.

A summary of the Company’s net interest margin for the six month period ended June 30, 2008 and June 30, 2007 is as follows:

		For the six month period ending
		June 30, 2008												June 30, 2007
		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		$	153,123				3,853				5.06	%		$	180,616				4,595				5.13	%
Loans held for sale			2,484				73				5.88				2,316				71				6.21
Mortgage loans, net			161,743				5,019				6.22				139,721				4,309				6.22
Commercial loans, net			632,565				21,875				6.95				578,852				24,304				8.47
Consumer loans, net			83,324				2,973				7.17				84,933				3,690				8.76
Cash equivalents			15,172				118				1.57				27,867				722				5.23
Federal Home Loan Bank stock			6,462				133				4.14				7,541				216				5.78
Total interest-earning assets			1,054,873				34,044				6.49				1,021,846				37,907				7.48
Interest-bearing liabilities:
Noninterest checking			53,603				0				0.00				55,079				0				0.00
NOW accounts			124,305				988				1.59				110,918				1,723				3.13
Savings accounts			41,287				239				1.16				40,750				273				1.35
Money market accounts			142,134				1,800				2.54				223,058				4,226				3.82
Certificates			245,068				5,177				4.25				235,205				5,092				4.37
Brokered deposits			269,270				6,505				4.86				162,837				3,909				4.84
Federal Home Loan Bank advances			106,364				2,476				4.68				135,679				3,045				4.53
Other			1,103				0				0.00				959				0				0.00
Total interest-bearing liabilities			983,134				17,185				3.52				964,485				18,268				3.82
Net interest income						$	16,859											$	19,639
Net interest rate spread											2.98	%											3.66	%
Net earning assets		$	71,739											$	57,361
Net interest margin											3.21	%											3.88	%
Average interest-earning assets to average interest-bearing liabilities							107.30	%											105.95	%