HMN FINANCIAL INC - Quarter Report: 2009 March (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 March 31, 2009

OR

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

     Yes o       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):

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 April 21, 2009
Common stock, $0.01 par value		4,162,896

 

 

HMN FINANCIAL, INC.
CONTENTS

				Page
PART I — FINANCIAL INFORMATION
Item 1:		Financial Statements (unaudited)
		Consolidated Balance Sheets at March 31, 2009 and December 31, 2008			3
		Consolidated Statements of Income for the Three Months Ended March 31, 2009 and 2008			4
		Consolidated Statement of Stockholders’ Equity and Comprehensive Income (Loss) for the Three Month Period Ended March 31, 2009			5
		Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2009 and 2008			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 (Discussion 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			23
Item 6:		Exhibits			23
Signatures					24
EX-31.1
EX-31.2
EX-32

PART I — FINANCIAL INFORMATION

Item 1 : Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Balance Sheets

		March 31,				December 31,
(Dollars in thousands)		2009				2008
		(unaudited)
Assets
Cash and cash equivalents		$	12,541				15,729
Securities available for sale:
Mortgage-backed and related securities (amortized cost $71,138 and $76,166)			72,702				77,327
Other marketable securities (amortized cost $85,503 and $95,445)			87,167				97,818
			159,869				175,145
Loans held for sale			3,880				2,548
Loans receivable, net			877,309				900,889
Accrued interest receivable			4,758				5,568
Real estate, net			19,753				10,558
Federal Home Loan Bank stock, at cost			7,286				7,286
Mortgage servicing rights, net			765				728
Premises and equipment, net			13,759				13,972
Prepaid expenses and other assets			4,627				4,408
Deferred tax asset, net			8,812				8,649
Total assets		$	1,113,359				1,145,480
Liabilities and Stockholders’ Equity
Deposits		$	798,369				880,505
Federal Home Loan Bank advances and Federal Reserve borrowings			192,500				142,500
Accrued interest payable			4,643				6,307
Customer escrows			1,949				639
Accrued expenses and other liabilities			6,517				3,316
Total liabilities			1,003,978				1,033,267
Commitments and contingencies Stockholders’ equity:
Serial preferred stock ($.01 par value):
Authorized 500,000 shares; issued shares 26,000			23,448				23,384
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662			91				91
Additional paid-in capital			60,816				60,687
Retained earnings, subject to certain restrictions			95,264				98,067
Accumulated other comprehensive income, net of tax			1,947				2,091
Unearned employee stock ownership plan shares			(3,722	)			(3,771	)
Treasury stock, at cost 4,965,766 and 4,961,032 shares			(68,463	)			(68,336	)
Total stockholders’ equity			109,381				112,213
Total liabilities and stockholders’ equity		$	1,113,359				1,145,480

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Income (Loss)
(unaudited)

		Three Months Ended
		March 31,
(Dollars in thousands, except per share data)		2009				2008
Interest income:
Loans receivable		$	13,628				15,520
Securities available for sale:
Mortgage-backed and related			802				224
Other marketable			946				1,910
Cash equivalents			0				57
Other			(23	)			80
Total interest income			15,353				17,791
Interest expense:
Deposits			4,975				7,870
Federal Home Loan Bank advances and Federal Reserve borrowings			1,596				1,237
Total interest expense			6,571				9,107
Net interest income			8,782				8,684
Provision for loan losses			6,569				1,560
Net interest income after provision for loan losses			2,213				7,124
Non-interest income:
Fees and service charges			941				793
Loan servicing fees			252				242
Gain on sales of loans			423				156
Other			(972	)			327
Total non-interest income			644				1,518
Non-interest expense:
Compensation and benefits			3,849				3,360
Occupancy			1,092				1,132
Advertising			135				124
Data processing			193				342
Amortization of mortgage servicing rights, net			155				160
Other			1,815				1,134
Total non-interest expense			7,239				6,252
Income (loss) before income tax expense (benefit)			(4,382	)			2,390
Income tax expense (benefit)			(1,760	)			902
Net income (loss)			(2,622	)			1,488
Preferred stock dividends and discount			(429	)			0
Net income (loss) available to common shareholders			(3,051	)			1,488
Basic earnings (loss) per common share		$	(0.83	)			0.41
Diluted earnings (loss) per common share		$	(0.83	)			0.39

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statement of Stockholders’ Equity and Comprehensive Income (Loss)
For the Three Month Period Ended March 31, 2009
(unaudited)

																						Unearned
																						Employee
																		Accumulated				Stock								Total
										Additional								Other				Ownership								Stock-
		Preferred				Common				Paid-in				Retained				Comprehensive				Plan				Treasury				Holders’
(Dollars in thousands)		Stock				Stock				Capital				Earnings				Income				Shares				Stock				Equity
Balance, December 31, 2008		$	23,384				91				60,687				98,067				2,091				(3,771	)			(68,336	)			112,213
Net loss															(2,622	)															(2,622	)
Other comprehensive loss, net of tax:
Net unrealized losses on securities available for sale																			(144	)											(144	)
Total comprehensive loss																															(2,766	)
Preferred stock discount amortization			64								(64	)																			0
Restricted stock awards forfeited											127																(127	)			0
Restricted stock awards dividend forfeited															7																7
Stock compensation tax benefits											7																				7
Amortization of restricted stock awards											76																				76
Preferred stock dividends paid															(188	)															(188	)
Earned employee stock ownership plan shares											(17	)											49								32
Balance, March 31, 2009		$	23,448				91				60,816				95,264				1,947				(3,722	)			(68,463	)			109,381

See accompanying notes to consolidated financial statements.

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

		Three Months Ended
		March 31,
(Dollars in thousands)		2009				2008
Cash flows from operating activities:
Net (loss) income		$	(2,622	)			1,488
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Provision for loan losses			6,569				1,560
Provision for real estate losses			1,024				0
Depreciation			488				448
Amortization of (discounts) premiums, net			122				(542	)
Amortization of deferred loan fees			(247	)			(203	)
Amortization of mortgage servicing rights, net			155				160
Capitalized mortgage servicing rights			(193	)			0
Gain on sales of real estate			79				(156	)
Gain on sales of loans			(423	)			(156	)
Proceeds from sale of loans held for sale			25,088				16,295
Disbursements on loans held for sale			(25,987	)			(15,853	)
Amortization of restricted stock awards			76				98
Amortization of unearned ESOP shares			49				49
Earned employee stock ownership shares priced above (below) original cost			(17	)			57
Stock option compensation			7				8
Decrease in accrued interest receivable			810				467
Decrease in accrued interest payable			(1,664	)			(423	)
Decrease (increase) in other assets			(140	)			49
Increase (decrease) in other liabilities			3,113				(3,680	)
Other, net			40				19
Net cash provided by operating activities			6,327				(315	)
Cash flows from investing activities:
Principal collected on securities available for sale			5,035				852
Proceeds collected on maturities of securities available for sale			10,000				30,000
Purchases of Federal Home Loan Bank Stock			0				(1,374	)
Redemption of Federal Home Loan Bank Stock			0				1,992
Proceeds from sales of real estate			122				1,381
Net decrease (increase) in loans receivable			6,838				(17,311	)
Purchases of premises and equipment			(310	)			(836	)
Net cash provided by investing activities			21,685				14,704
Cash flows from financing activities:
Increase (decrease) in deposits			(82,322	)			5,370
Purchase of treasury stock			0				(723	)
Dividends to stockholders			(188	)			(917	)
Proceeds from borrowings			592,000				51,800
Repayment of borrowings			(542,000	)			(66,800	)
Increase in customer escrows			1,310				699
Net cash used by financing activities			(31,200	)			(10,571	)
Increase (decrease) in cash and cash equivalents			(3,188	)			3,818
Cash and cash equivalents, beginning of period			15,729				23,718
Cash and cash equivalents, end of period		$	12,541				27,536
Supplemental cash flow disclosures:
Cash paid for interest		$	8,235				9,530
Cash paid for income taxes			33				2,465
Supplemental noncash flow disclosures:
Transfer of loans to real estate			10,420				3,205
Loans transferred to loans held for sale			0				81

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)

March 31, 2009 and 2008

(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 completing certain real estate transactions.

The consolidated financial statements included herein are for HMN, SFC, the Bank and 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 (loss), consolidated statement of stockholders’ equity and comprehensive income (loss) 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 (loss) for the three-month period ended March 31, 2009 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 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 statements 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.

In April 2009, the FASB issued Staff Position No. 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (FSP FAS No. 157-4). This FSP provides additional guidance for estimating fair value in accordance with FASB Statement No. 157, Fair Value Measurements, when the volume and level of activity for the asset or liability have significantly decreased. It also includes guidance on identifying circumstances that indicate a transaction is not orderly. It emphasizes that even if there has been a significant decrease in the volume and level of activity for the asset or liability and regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received in the sale of an asset, or paid to transfer a liability, in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. This FSP is to be applied prospectively and is effective for interim and annual reporting periods ending after June 15, 2009. The impact of adopting FSP FAS No. 157-4 in the second quarter of 2009 is not anticipated to have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued Staff Position FAS No. 115-2 and FAS 124-2, Recognition and Presentation of

Other-Than-Temporary Impairments (FSP FAS No. 115-2 and FAS 124-2). This FSP amends the other-than-temporary impairment guidance in U.S. GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. This FSP is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The impact of adopting FSP FAS No. 115-2 and FAS 124-2 in the second quarter of 2009 is not anticipated to have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued Staff Position FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (FSP FAS No. 107-1 and APB 28-1). The FSP amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB Opinion No. 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. This FSP is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if a company also elects to early adopt FSP FAS 115-2 and FAS 124-2. The impact of adopting FSP FAS No. 107-1 and APB 28-1 in the second quarter of 2009 is not anticipated to have a material impact on the Company’s consolidated 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 March 31, 2009, the Company recorded an increase in other assets of $78,000, an increase in other liabilities of $56,000 and a gain included in the gain on sales of loans of $22,000.

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 an increase in other liabilities of $33,000 and a loss included in the gain on sales of loans of $33,000 due to the mark to market adjustment on the commitments to sell loans held for sale.

(5) Fair Value Measurements

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 March 31, 2009.

		Carrying value at March 31, 2009
(Dollars in thousands)		Total				Level 1				Level 2				Level 3
Securities available for sale		$	159,869				12,285				147,584				0
Mortgage loan commitments			8				0				8				0
Total		$	159,877				12,285				147,592				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 first quarter of 2009 that were still held at March 31, 2009, 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 March 31, 2009.

																		Three months ended
		Carrying value at March 31, 2009																March 31, 2009
(Dollars in thousands)		Total				Level 1				Level 2				Level 3				Total Gains (Losses)
Loans held for sale		$	3,880				0				3,880				0				(42	)
Mortgage servicing rights			765				0				765				0				0
Loans (1)			58,559				0				58,559				0				407
Real estate, net (2)			19,753				0				19,753				0				(1,024	)
Total		$	82,957				0				82,957				0				(659	)

																		Three months ended
		Carrying value at March 31, 2008																March 31, 2008
(Dollars in thousands)		Total				Level 1				Level 2				Level 3				Total Gains (Losses)
Loans held for sale		$	3,090				0				3,090				0				0
Mortgage servicing rights			1,110				0				1,110				0				0
Loans (1)			23,995				0				23,995				0				(1,316	)
Real estate, net (2)			4,184				0				4,184				0				0
Total		$	32,379				0				32,379				0				(1,316	)

(6) Comprehensive Income (Loss)

Other comprehensive income (loss) 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 (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 period ended March 31,
		2009												2008
(Dollars in thousands)		Before tax				Tax effect				Net of tax				Before tax				Tax effect				Net of tax
Securities available for sale:
Net unrealized gains (losses) arising during the period		$	(306	)			(162	)			(144	)			2,029				829				1,200
Other comprehensive income (loss)		$	(306	)			(162	)			(144	)			2,029				829				1,200

(7) 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 unrealized loss position, at March 31, 2009.

		March 31, 2009
		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			$	2,782				(63	)		$	2,782				(63	)
FNMA			1				9				0				1				2,128				(5	)			2,137				(5	)
Other marketable securities:
Corporate preferred stock			1				350				(350	)			0				0				0				350				(350	)
Total temporarily impaired securities			2			$	359				(350	)			2			$	4,910				(68	)		$	5,269				(418	)

		March 31, 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			$	2,453				(406	)		$	2,453				(406	)
FNMA			0				0				0				3				2,759				(147	)			2,759				(147	)
Total temporarily impaired securities			0			$	0				(0	)			4			$	5,212				(553	)		$	5,212				(553	)

These fixed rate investments are temporarily impaired due to changes in interest rates and the Company has the intent and ability to hold to maturity or until the temporary loss is recovered. Mortgage backed securities in the table above had an average remaining life of less than eight years and the other marketable security had an average remaining life of less than twenty-five years at March 31, 2009.

(8) Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

		Three months ended				Twelve months ended				Three months ended
(Dollars in thousands)		March 31, 2009				December 31, 2008				March 31, 2008
Mortgage servicing rights:
Balance, beginning of period		$	728				1,270				1,270
Originations			193				28				0
Amortization			(156	)			(570	)			(160	)
Balance, end of period			765				728				1,110
Fair value of mortgage servicing rights		$	2,004				2,339				2,875

All of the loans being serviced were single family loans under the FNMA mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at March 31, 2009.

						Weighted				Weighted
		Loan				Average				Average
		Principal				Interest				Remaining				Number
(Dollars in thousands)		Balance				Rate				Term				of Loans
Original term 30 year fixed rate		$	193,033				5.79	%			286				1,810
Original term 15 year fixed rate			95,780				5.14	%			107				1,606
Adjustable rate			1,288				5.05	%			290				14

The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at March 31,

2009 is presented in the following table. Amortization expense for mortgage servicing rights was $155,000 and $160,000 for the three months ended March 31, 2009 and 2008, respectively.

		Gross								Unamortized
		Carrying				Accumulated				Intangible
(Dollars in thousands)		Amount				Amortization				Assets
Amortized intangible assets:
Mortgage servicing rights		$	4,043				(3,278	)			765
Total		$	4,043				(3,278	)			765

The following table indicates the estimated future amortization expense for the next five years for mortgage servicing rights:

		Mortgage
		Servicing
(Dollars in thousands)		Rights
Year ending December 31,
2009		$	286
2010			204
2011			115
2012			65
2013			40

Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2009. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

(9) Earnings per Share

The following table reconciles the weighted average shares outstanding and the income available to common shareholders used for basic and diluted EPS:

		Three months ended March 31,
		2009				2008
Weighted average number of common shares outstanding used in basic earnings per common share calculation			3,675,984				3,650,396
Net dilutive effect of:
Options			0				96,927
Restricted stock awards			0				27,873
Weighted average number of shares outstanding adjusted for effect of dilutive securities			3,675,984				3,775,196
Income (loss) available to common shareholders		$	(3,050,752	)			1,488,000
Basic earnings (loss) per common share		$	(0.83	)			0.41
Diluted earnings (loss) per common share		$	(0.83	)			0.39

At March 31, 2009 there were 16,114 common share equivalents outstanding that are not included in the calculation of diluted earnings per share as they are antidilutive.

(10) Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of March 31, 2009, that the Bank meets all capital adequacy requirements to which it is subject.

Management believes that based upon the Bank’s capital calculations at March 31, 2009 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On March 31, 2009, the Bank’s tangible assets and adjusted total assets were $1.11 billion and its risk-weighted assets were $890.8 million. The following table presents the Bank’s capital amounts and ratios at March 31, 2009 for actual capital, required capital and excess capital including ratios required to qualify as a well capitalized institution under the Prompt Corrective Actions regulations.

										Required to be																To Be Well Capitalized
										Adequately																Under Prompt Corrective
		Actual								Capitalized								Excess Capital								Action Provisions
						Percent of								Percent of								Percent of								Percent of
(Dollars in thousands)		Amount				Assets(1)				Amount				Assets (1)				Amount				Assets(1)				Amount				Assets(1)
Bank stockholder’s equity		$	104,972
Less:
Net unrealized gains on certain securities available for sale			(2,156	)
Tier I or core capital			102,816
Tier I capital to adjusted total assets							9.27	%		$	44,351				4.00	%		$	58,465				5.27	%		$	55,439				5.00	%
Tier I capital to risk-weighted assets							11.54	%		$	35,631				4.00	%		$	67,185				7.56	%		$	53,446				6.00	%
Plus:
Allowable allowance for loan losses			10,054
Risk-based capital		$	112,870							$	71,261							$	41,609							$	89,077
Risk-based capital to risk- weighted assets							12.67	%							8.00	%							4.67	%							10.00	%

(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 issued and available at March 31, 2009 were approximately $5.3 million, expire over the next two years, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

In February 2007, the Minnesota Department of Revenue (MDR) assessed a deficiency of $2.2 million against the Company’s 2002 through 2004 Minnesota state tax payments. The deficiency relates to the tax treatment of the inter-company dividends paid to the Bank by a former subsidiary of the Company. The Company is challenging the proposed adjustments and the case was heard in the Minnesota state tax court in the fourth quarter of 2008 and a ruling is expected in the second quarter of 2009. If the assessment challenge is not successful, the Company could potentially record a net increase in income tax and related expenses of up to $1.5 million after considering federal income tax deductions and previously recorded contingency accruals.

(12) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of SFAS No. 131. SFC and HMN 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, return on average assets and equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

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

		Home Federal												Consolidated
(Dollars in thousands)		Savings Bank				Other				Eliminations				Total
At or for the quarter ended March 31, 2009:
Interest income — external customers		$	15,353				0				0				15,353
Non-interest income — external customers			648				1				0				649
Earnings (loss) on limited partnerships			(5	)			0				0				(5	)
Intersegment interest income			0				4				(4	)			0
Intersegment non-interest income			44				(2,457	)			2,413				0
Interest expense			6,575				0				(4	)			6,571
Amortization of mortgage servicing rights, net			155				0				0				155
Other non-interest expense			6,929				199				(44	)			7,084
Income tax (benefit)			(1,732	)			(28	)			0				(1,760	)
Net loss			(2,456	)			(2,623	)			2,457				(2,622	)
Total assets			1,112,271				109,981				(108,893	)			1,113,359
At or for the quarter ended March 31, 2008:
Interest income — external customers		$	17,787				4				0				17,791
Non-interest income — external customers			1,513				0				0				1,513
Earnings on limited partnerships			5				0				0				5
Intersegment interest income			0				43				(43	)			0
Intersegment non-interest income			44				1,561				(1,605	)			0
Interest expense			9,150				0				(43	)			9,107
Amortization of mortgage servicing rights, net			160				0				0				160
Other non-interest expense			5,959				177				(44	)			6,092
Income tax expense (benefit)			957				(55	)			0				902
Net income			1,563				1,486				(1,561	)			1,488
Goodwill			3,801				0				0				3,801
Total assets			1,100,736				100,316				(96,283	)			1,104,769

HMN FINANCIAL, INC.

Item 2:		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Information

This quarterly report and other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intent,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to those relating to the adequacy of available liquidity to the Bank, the future outlook for the Company and the Company’s compliance with regulatory standards. A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate securing loans to borrowers, possible legislative and regulatory 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; international economic developments, changes in credit or other risks posed by the Company’s loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program; the Company’s use of the proceeds from the sale of securities to the U.S. Treasury Department or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filing on Form 10-K and Form 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. 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, 2008 and Part II, Item 1A of this quarterly report on Form 10-Q.

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, Federal Home Loan Bank (FHLB) advances, and Federal Reserve borrowings. 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 of mortgage servicing assets. Over the past several years, the Company has increased the emphasis on commercial and commercial real estate loans, which has increased the credit risk inherent in the loan portfolio. While HMN did not originate or hold subprime mortgages in its loan portfolio, purchase investments backed by subprime mortgages, or incur any write downs directly related to subprime mortgages, subprime credit issues indirectly impacted the Company by making it more difficult for some borrowers with marginal credit to qualify for a mortgage because most of the non-traditional mortgage products were eliminated by the banks and mortgage companies that were previously offering them. This decrease in available credit reduced the demand for single family homes as there were fewer qualified buyers in the marketplace. The decrease in demand for housing and building lots affected our level of charge offs and the risk ratings on some of our residential development loans. Consequently, the provision for loan losses has increased due to commercial real estate loan charge offs and risk rating downgrades due primarily to decreased demand for housing and building and a general decline in the economic conditions in our markets.

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 business credit, 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 and Federal Reserve Bank (FRB) 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, value of underlying collateral, 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 of the loans, 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.

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.

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (FIN 48) on 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 (Loss)

The net loss for the first quarter of 2009 was $2.6 million, down $4.1 million, or 276.2%, from net income of $1.5 million for the first quarter of 2008. Net loss available to common shareholders was $3.1 million for the first quarter of 2009, down $4.6 million, or 305.0%, from net income available to common shareholders of $1.5 million for the first quarter of 2008. Net loss available to common shareholders was reduced by $429,000 of preferred stock dividends and discounts in the first quarter of 2009, with no comparable amount in the first quarter of 2008. Diluted loss per common share for the first quarter of 2009 was $0.83, down $1.22 from diluted earnings per common share of $0.39 for the first quarter of 2008. The decrease in net income was due primarily to a $5.0 million increase in the loan loss provision between the periods as a result of the increased charge offs on non-performing loans.

Net Interest Income

Net interest income was $8.8 million for the first quarter of 2009, an increase of $0.1 million, or 1.1%, compared to $8.7 million for the first quarter of 2008. Interest income was $15.4 million for the first quarter of 2009, a decrease of $2.4 million, or 13.7%, from $17.8 million for the first quarter of 2008. Interest income decreased primarily because of a decrease in the average interest rate earned on loans and investments. Interest rates decreased primarily because of the 200 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. The decrease in interest income due to decreased interest rates was partially offset by the $16.0 million increase in the average interest earning assets between the periods. Interest income was also adversely affected by the increase in non-performing assets between the periods. The average yield earned on interest-earning assets was 5.76% for the first quarter of 2009, a decrease of 96 basis points from the 6.72% average yield for the first quarter of 2008.

Interest expense was $6.6 million for the first quarter of 2009, a decrease of $2.5 million, or 27.8%, compared to $9.1 million for the first quarter of 2008. 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 200 basis point decrease in the federal funds rate that occurred between the periods as well as the 200 basis point decrease that occurred in the first quarter of 2008. 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 primarily due to the Bank’s deposits that are in the form of certificates of deposits which do not re-price immediately when the federal funds rate changes. The average interest rate paid on interest-bearing liabilities was 2.63% for the first quarter of 2009, a decrease of 107 basis points from the 3.70% average interest rate paid in the first quarter of 2008.

Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2009 was 3.30%, an increase of 2 basis points, compared to 3.28% for the first quarter of 2008.

A summary of the Company’ net interest margin for the three month period ended March 31, 2009 and March 31,

2008 is as follows:

		For the three month period ended
		March 31, 2009												March 31, 2008
		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		$	165,387				1,748				4.29	%		$	169,570				2,134				5.06	%
Loans held for sale			3,305				41				5.03				2,197				32				5.86
Mortgage loans, net			160,762				2,358				5.95				157,778				2,442				6.22
Commercial loans, net			648,210				9,958				6.23				630,868				11,490				7.33
Consumer loans, net			85,407				1,271				6.04				83,641				1,556				7.48
Cash equivalents			10,468				1				0.04				14,175				57				1.62
Federal Home Loan Bank stock			7,286				(23	)			(1.28	)			6,587				80				4.88
Total interest-earning assets			1,080,825				15,354				5.76				1,064,816				17,791				6.72
Interest-bearing liabilities and noninterest bearing deposits:
NOW accounts			112,143				40				0.14				121,675				607				2.01
Savings accounts			29,236				9				0.12				40,716				134				1.32
Money market accounts			95,983				356				1.50				160,489				1,120				2.81
Certificates			260,170				2,101				3.28				246,943				2,734				4.45
Brokered deposits			255,210				2,469				3.92				262,193				3,276				5.03
Federal Home Loan Bank advances			192,967				1,596				3.35				105,330				1,237				4.72
Total interest-bearing liabilities			945,709												937,346
Noninterest checking			65,537												52,633
Other noninterest bearing escrow deposits			1,306												1,272
Total interest-bearing liabilities and noninterest bearing deposits		$	1,012,552				6,571				2.63			$	991,251				9,108				3.70
Net interest income						$	8,783											$	8,683
Net interest rate spread											3.13	%											3.02	%
Net interest margin											3.30	%											3.28	%

Provision for Loan Losses

The provision for loan losses was $6.6 million for the first quarter of 2009, an increase of $5.0 million, or 321.1%, compared to $1.6 million for the first quarter of 2008. The provision for loan losses increased primarily because of an increase in the charge offs of commercial real estate loans in the first quarter of 2009 when compared to the same period of 2008. The increase was due primarily to decreases in the estimated value of the real estate supporting classified commercial real estate loans.

A rollforward of the Company’s allowance for loan losses for the quarters ended March 31, 2009 and 2008 is summarized as follows:

(Dollars in thousands)		2009				2008
Balance at January 1,		$	21,257			$	12,438
Provision			6,569				1,560
Charge offs:
One-to-four family			0				(60	)
Consumer			(694	)			(22	)
Commercial business			(184	)			(24	)
Commercial real estate			(9,461	)			0
Recoveries			7				21
Balance at March 31,		$	17,494			$	13,913

Non-Interest Income

Non-interest income was $0.6 million for the first quarter of 2009, a decrease of $0.9 million, or 57.6%, from $1.5 million for the first quarter of 2008. Other non-interest income decreased $1.3 million primarily because of a $1.1 million increase in the valuation reserves required on other real estate owned due to decreases in the estimated value of the real estate. Gain on sales of loans increased $267,000 between the periods due to an increase in the gains recognized on the sale of single family loans because of increased loan originations. Fees and service charges increased $148,000 between the periods primarily because of increased retail deposit account activity and fees. Loan servicing fees increased $10,000 primarily because of an increase in the number of commercial loans that are being serviced for others.

Non-Interest Expense

Non-interest expense was $7.2 million for the first quarter of 2009, an increase of $1.0 million, or 15.8%, from $6.2 million for the first quarter of 2008. Other non-interest expense increased $681,000 primarily because of a $366,000 increase in legal and other fees related to foreclosed assets and an ongoing state tax assessment challenge and because of a $222,000 increase in FDIC insurance expense. Compensation expense increased $489,000 primarily because of the accrual of contractual costs related to the departure of a former executive officer. Data processing costs decreased $149,000 primarily because of reduced fees paid to third party vendors as a result of the core system conversion that occurred in the fourth quarter of 2008. Occupancy expense decreased $40,000 due primarily to decreased depreciation expense on furniture and equipment.

Income Tax Expense

Income tax expense decreased $2.7 million between the periods due to a decrease in taxable income and an effective tax rate that increased from 37.7% for the first quarter of 2008 to 40.2% for the first quarter of 2009. The increase in the effective tax rate was primarily due to the impact of tax exempt income.

Non-Performing Assets

The following table summarizes the amounts and categories of non-performing assets in the Bank’s portfolio and loan delinquency information as March 31, 2009 and December 31, 2008.

		March 31,				December 31,
(Dollars in thousands)		2009				2008
Non-Accruing Loans:
One-to-four family real estate		$	3,812			$	7,251
Commercial real estate			29,829				46,953
Consumer			5,052				5,298
Commercial business			11,410				4,671
Total			50,103				64,173
Other assets			25				25
Foreclosed and Repossessed Assets:
One-to-four family real estate			344				258
Commercial real estate			19,409				10,300
Total non-performing assets		$	69,881			$	74,756
Total as a percentage of total assets			6.28	%			6.53	%
Total non-performing loans		$	50,103			$	64,173
Total as a percentage of total loans receivable, net			5.71	%			7.12	%
Allowance for loan loss to non-performing loans			34.92	%			33.12	%
Delinquency Data:
Delinquencies (1)
30+ days		$	7,893			$	11,488
90+ days			515				0
Delinquencies as a percentage of loan and lease portfolio (1)
30+ days			0.89	%			1.26	%
90+ days			0.06	%			0.00	%