10-Q 1 q1d.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ Commission File Number 0-24100 HMN FINANCIAL, INC. --------------------- (Exact name of Registrant as specified in its Charter) Delaware 41-1777397 -------------------------------- -------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 101 North Broadway, Spring Valley, Minnesota 55975-0231 --------------------------------------------- ------------ (Address of principal executive offices) (ZIP Code) Registrant's telephone number, including area code: (507) 346-1100 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate the number of shares outstanding of each of the issuer's common stock as of the latest practicable date. Class Outstanding at May 7, 2001 Common stock, $0.01 par value 4,423,819 HMN FINANCIAL, INC. CONTENTS PART I - FINANCIAL INFORMATION Page ---- Item 1: Financial Statements (unaudited) Consolidated Balance Sheets at March 31, 2001 and December 31, 2000 3 Consolidated Statements of Income for the Three Months Ended March 31, 2001 and 2000 4 Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2001 and 2000 5 Consolidated Statement of Stockholders' Equity for the Three Month Period Ended March 31, 2001 5 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2001 and 2000 6 Notes to Consolidated Financial Statements 7-13 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations 14-21 Item 3: Quantitative and Qualitative Disclosures about Market Risk Discussion included in Item 2 under Market Risk 17 PART II - OTHER INFORMATION Item 1: Legal Proceedings 22 Item 2: Changes in Securities 22 Item 3: Defaults Upon Senior Securities 22 Item 4: Submission of Matters to a Vote of Security Holders 22 Item 5: Other Information 22 Item 6: Exhibits and Reports on Form 8-K 22 Signatures 23 PART I - FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Balance Sheets (unaudited) March 31, December 31, Assets 2001 2000 ------------- ------------- Cash and cash equivalents $ 14,737,067 14,416,861 Securities available for sale: Mortgage-backed and related securities (amortized cost $73,264,321 and $76,199,237) 73,131,964 75,379,719 Other marketable securities (amortized cost $43,641,490 and $66,392,057) 42,361,365 63,826,770 ----------- ----------- 115,493,329 139,206,489 ----------- ----------- Loans held for sale 45,231,319 7,861,029 Loans receivable, net 519,306,622 518,765,209 Accrued interest receivable 3,713,673 4,311,747 Federal Home Loan Bank stock, at cost 12,245,000 12,245,000 Mortgage servicing rights, net 1,239,195 1,188,928 Premises and equipment, net 9,684,159 9,459,710 Investment in limited partnerships 2,535,083 2,838,364 Goodwill 3,935,965 3,980,974 Core deposit intangible 761,324 794,363 Prepaid expenses and other assets 1,607,483 947,201 ----------- ----------- Total assets $730,490,219 716,015,875 =========== =========== Liabilities and Stockholders' Equity Deposits $421,455,827 421,690,548 Federal Home Loan Bank advances 231,800,000 221,900,000 Accrued interest payable 1,296,817 1,575,521 Advance payments by borrowers for taxes and insurance 1,101,964 650,348 Accrued expenses and other liabilities 4,480,358 3,355,110 Deferred tax liabilities 1,004,000 218,700 ----------- ----------- Total liabilities 661,138,966 649,390,227 ----------- ----------- Commitments and contingencies Minority interest 152,879 0 Stockholders' equity: Serial preferred stock: ($.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 91,287 91,287 Additional paid-in capital 59,420,263 59,584,176 Retained earnings, subject to certain restrictions 74,606,456 73,380,588 Accumulated other comprehensive loss (849,982) (2,037,005) Unearned employee stock ownership plan shares (5,269,710) (5,318,067) Unearned compensation restricted stock awards (7,963) (9,800) Treasury stock, at cost 4,714,843 and 4,737,521 shares (58,791,977) (59,065,531) ----------- ----------- Total stockholders' equity 69,198,374 66,625,648 ----------- ----------- Total liabilities and stockholders' equity $730,490,219 716,015,875 =========== ===========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Income (unaudited) Three Months Ended March 31, 2001 2000 ---------------------------------- Interest Income: Loans receivable $ 11,226,494 9,442,625 Securities available for sale: Mortgage-backed and related 1,248,629 1,805,672 Other marketable 857,943 1,182,516 Cash equivalents 43,228 37,455 Other 165,886 192,762 ----------- ----------- Total interest income 13,542,180 12,661,030 ----------- ----------- Interest expense: Deposits 5,061,602 4,336,621 Federal Home Loan Bank advances 3,330,364 3,368,660 ----------- ----------- Total interest expense 8,391,966 7,705,281 ----------- ----------- Net interest income 5,150,214 4,955,749 Provision for loan losses 150,000 45,000 ----------- ----------- Net interest income after provision for loan losses 5,000,214 4,910,749 ----------- ----------- Non-interest income: Fees and service charges 351,791 256,872 Mortgage servicing fees 106,774 79,243 Securities gains (losses), net 277,704 (68,761) Gain on sales of loans 852,336 182,729 Earnings (loss) in limited partnerships (303,281) 36,989 Other 130,124 125,618 ----------- ----------- Total non-interest income 1,415,448 612,690 ----------- ----------- Non-interest expense: Compensation and benefits 1,913,011 1,696,100 Occupancy 565,219 425,596 Federal deposit insurance premiums 20,803 21,451 Advertising 86,155 43,708 Data processing 230,826 185,421 Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs 140,643 69,017 Other 842,618 589,632 ----------- ----------- Total non-interest expense 3,799,275 3,030,925 ----------- ----------- Income before income tax expense 2,616,387 2,492,514 Income tax expense 997,600 962,800 ----------- ----------- Net income before minority interest $ 1,618,787 1,529,714 Minority interest 27,879 0 ----------- ----------- Net income 1,590,908 1,529,714 =========== =========== Basic earnings per share $ 0.43 0.38 =========== =========== Diluted earnings per share $ 0.40 0.37 =========== ===========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income (unaudited) Three Months Ended March 31, 2001 2000 ------------------- ----------------- Net income $ 1,590,908 1,529,714 Other comprehensive income (losses), net of tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period 1,357,734 (731,542) Less: reclassification adjustment for gains and losses included in net income 170,711 (42,269) ----------- ----------- Other comprehensive income (loss) 1,187,023 (689,273) ----------- ---------- Comprehensive income $ 2,777,931 840,441 =========== ==========
See accompanying notes to consolidated financial statements. HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statement of Stockholders' Equity For the Three Months Ended March 31, 2001 (unaudited)
Additional Accumulated Other Common Paid-in Retained Comprehensive Stock Capital Earnings Loss ----------- ------------ ------------ -------------- Balance, December 31, 2000 $ 91,287 59,584,176 73,380,588 (2,037,005) Net income 1,590,908 Other comprehensive income 1,187,023 Employee stock options exercised (187,498) Amortization of restricted stock awards Dividends paid (365,040) Earned employee stock ownership plan shares 23,585 ---------- ------------ ------------ -------------- Balance, March 31, 2001 $ 91,287 59,420,263 74,606,456 (849,982) ========== ============ ============ ============== Unearned Employee Stock Compensation Total Ownership Restricted Treasury Stockholders' Plan Shares Stock Awards Stock Equity ----------- ------------ ---------- ----------- Balance, December 31, 2000 $(5,318,067) (9,800) (59,065,531) 66,625,648 Net income 1,590,908 Other comprehensive income 1,187,023 Employee stock options exercised 273,554 86,056 Amortization of restricted stock awards 1,837 1,837 Dividends paid (365,040) Earned employee stock ownership plan shares 48,357 71,942 ----------- ----------- ----------- ---------- Balance, March 31, 2001 $(5,369,710) (7,963) (58,791,977) 69,198,374 =========== =========== =========== ==========
See accompanying notes to consolidated financial statements. HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (unaudited)
Three Months Ended March 31, 2001 2000 -------------- --------------- Cash flows from operating activities: Net income $ 1,590,908 1,529,714 Adjustments to reconcile net income to cash provided (used) by operating activities: Provision for loan losses 150,000 45,000 Depreciation 243,694 204,711 Amortization of (discounts) premiums, net (1,867) 25,070 Amortization of deferred loan fees (92,784) (96,990) Amortization of goodwill 45,009 45,006 Amortization of core deposit intangible 33,039 58,110 Amortization of other purchase accounting adjustments 3,171 (21,434) Amortization of mortgage servicing rights and net valuation adjustments 139,258 61,279 Capitalized mortgage servicing rights (194,575) (57,030) Increase in deferred income taxes 62,500 103,500 Securities (gains) losses, net (277,704) 68,761 Gain on sales of loans (852,336) (182,729) Proceeds from sales of loans held for sale 141,878,210 19,473,383 Disbursements on loans held for sale (177,712,362) (18,365,757) Principal collected on loans held for sale 12,175 8,671 Amortization of restricted stock awards 1,837 41,516 Amortization of unearned ESOP shares 48,357 48,456 Earned employee stock ownership shares priced above original cost 23,585 11,559 Decrease (increase) in accrued interest receivable 598,074 (114,616) Increase (decrease) in accrued interest payable (278,704) 693,439 Equity (earnings) losses of limited partnerships 303,281 (36,989) Equity earnings of minority interest 27,879 0 Increase in other assets (523,256) (149,606) Increase in other liabilities 1,060,897 1,021,221 Other, net 38,167 838 ----------- ----------- Net cash provided (used) by operating activities (33,673,547) 4,415,083 ----------- ----------- Cash flows from investing activities: Proceeds from sales of securities available for sale 15,000,567 6,020,320 Principal collected on securities available for sale 2,249,266 2,077,722 Proceeds collected on maturity of securities available for sale 8,695,000 1,500,000 Purchases of securities available for sale 0 (986,500) Proceeds from sales of loans receivable 0 105,464 Purchase of Federal Home Loan Bank stock 0 (320,000) Net increase in loans receivable (1,359,467) (17,145,578) Purchases of premises and equipment (468,143) (352,727) ----------- ----------- Net cash provided (used) by investing activities 24,117,223 (9,101,299) ----------- ----------- Cash flows from financing activities: Increase (decrease) in deposits (321,102) 1,098,879 Purchase of treasury stock 0 (1,603,694) Stock options exercised 86,056 46,050 Dividends to stockholders (365,040) (396,494) Proceeds from Federal Home Loan Bank advances 76,400,000 46,900,000 Repayment of Federal Home Loan Bank advances (66,500,000) (42,400,000) Minority interest 125,000 0 Increase in advance payments by borrowers for taxes and insurance 451,616 243,824 ----------- ----------- Net cash provided by financing activities 9,876,530 3,888,565 ----------- ----------- Increase (decrease) in cash and cash equivalents 320,206 (797,651) Cash and cash equivalents, beginning of period 14,416,861 9,051,380 ----------- ----------- Cash and cash equivalents, end of period$ 14,737,067 8,253,729 =========== =========== Supplemental cash flow disclosures: Cash paid for interest $ 8,670,670 7,011,842 Cash paid for income taxes 442,000 190,000 Supplemental noncash flow disclosures: Loans securitized and transferred to securities available for sale 0 8,106,230 Loans transferred to loans held for sale 727,243 245,261 Transfer of loans to real estate 50,645 49,653
See accompanying notes to consolidated financial statements. HMN FINANCIAL, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (unaudited) March 31, 2001 and 2000 (1) HMN FINANCIAL, INC. HMN Financial, Inc. (HMN) is a stock savings bank holding company which owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OAI) which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC). Prior to 2000, SFC invested in commercial loans and commercial real-estate loans located throughout the United States which were originated by third parties. During 2000 SFC sold many of its assets to the Bank and discontinued investing in commercial loans. The Bank has another subsidiary, Home Federal Mortgage Services, LLC (HFMS), which is a mortgage banking and mortgage brokerage business located in Brooklyn Park, Minnesota. Prior to 2001 the business was operated as a wholly owned subsidiary of HMN and was known as HMN Mortgage Services, Inc. (MSI). In January 2001, HMN sold 100% of the MSI stock to the Bank. The Bank formed HFMS and merged MSI into HFMS. Effective February 1, 2001 the business sold a 49% membership interest in HFMS to two individuals. The consolidated financial statements included herein are for HMN, SFC, MSI through January 31, 2001, the Bank and the Bank's subsidiaries, OAI and HFMS. All significant intercompany accounts and transactions have been eliminated in consolidation. (2) BASIS OF PREPARATION The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of income, consolidated statements of comprehensive income, consolidated statement of stockholders' equity and consolidated statements of cash flows in conformity with generally accepted accounting principles. However, all adjustments consisting of only normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The statement of income for the three month period ended March 31, 2001 is not necessarily indicative of the results which may be expected for the entire year. Certain amounts in the consolidated financial statements for prior periods have been reclassified to conform with the current period presentation. (3) NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale 7 security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. -For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. -For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. -For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. -For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Under SFAS No. 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. SFAS No. 133 precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation. Originally SFAS No. 133 was effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application should be as of the beginning of an entity's fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of SFAS No. 133. In June of 1999 the FASB issued SFAS No. 137 which deferred the required adoption of SFAS No. 133 to fiscal years starting after June 15, 2000. In June of 2000 the FASB issued SFAS No. 138 which addresses a limited number of issues causing implementation difficulties for numerous entities that must apply Statement No. 133 to their financial statements. SFAS No. 138 also amends Statement No. 133 for decisions made by the FASB relating to the Derivatives Implementation Group process. HMN adopted SFAS No. 133 in the first quarter of 2001. HMN is using an interest rate swap, whereby it pays interest based upon three month London Inter-Bank Offer Rate (LIBOR) and receives interest payments based upon a fixed rate of 7.5% on a notional value of $10 million in a fair value hedge with no ineffectiveness. The hedge is offsetting a callable certificate of deposit for $10 million which was issued by HMN. A transition adjustment of $75,637 was recorded on January 1, 2001 as a debit to other assets and also as a credit to the related certificate of deposit. On March 31, 2001 the interest rate swap was marked to a market value of $86,381 which is included in other assets and the corresponding certificate of deposit was adjusted to the 8 same value and is reflected in deposits in the consolidated balance sheet of HMN. The interest rate swap was deemed to be totally effective and therefore no gain or loss was recorded in the income statement. HMN originates and purchases single family residential loans for sale into the secondary market and enters into commitments to sell or securitize those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. The commitments to sell Loans Held for Sale were not designated as hedging instruments during the first quarter of 2001, in accordance with the requirements of SFAS No. 133, a loss of $84,861 relating to those commitments was recognized as other non-interest expense during the first quarter of 2001. HMN also had commitments outstanding to extend credit to future borrowers or to purchase loans that had not closed prior to the end of the quarter (mortgage pipeline). Simultaneously, HMN enters into commitments to sell the loans in the mortgage pipeline into the secondary market. In accordance with SFAS No. 133, on March 31, 2001, HMN recorded a debit to Loans Held for Sale of $50,872, a credit to other liabilities of $64,351, and an increase in other non-interest expense of $13,479 relating to these commitments. In September 2000, the FASB issued SFAS No. 140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES. It revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but it carries over most of Statement 125's provisions without reconsideration. The standards are based on consistent application of a financial-components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes liabilities when extinguished. SFAS No. 140 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishment of liabilities occurring after March 31, 2001. The Statement is effective for recognition and reclassification of collateral and for disclosures related to securitization transactions and collateral for fiscal years ending after December 15, 2000. The Statement is to be applied prospectively with certain exceptions. HMN adopted SFAS No. 140 for recognitions and reclassification of collateral and for disclosures related to securitization transactions and collateral on December 31, 2000. HMN will adopt SFAS No. 140 for transfers and servicing of financial assets and extinguishment of liabilities occurring after March 31, 2001. The impact of adopting SFAS No. 140 on HMN's financial condition and its results of operations will not be material. (4) COMPREHENSIVE INCOME Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for HMN is comprised entirely of unrealized gains and losses on securities available for sale. The gross unrealized holding gains for the first quarter of 2001 were $2.25 million, the income tax expense would have been $892,300 and therefore, the net gain was $1.36 million. The gross reclassification adjustment for the first quarter of 2001 was $277,700, the income tax expense would have been $107,000 and therefore, the net reclassification adjustment was $170,700. The gross unrealized holding losses for the first quarter of 2000 were $1.2 million, the income tax benefit would have been $452,500 and therefore, the net loss was $731,500. The gross reclassification adjustment for the first quarter of 2000 was a loss of $68,800, the income tax benefit would have been $26,500 and therefore, the net reclassification adjustment was a loss of $42,300. (5) CASH DIVIDEND On April 24, 2001 HMN's Board of Directors announced a cash dividend of $0.12 per share, payable on June 11, 2001 to stockholders of record on May 24, 2001. 9 (6) Investment in Mortgage Servicing Rights A summary of mortgage servicing activity is as follows: --------------------------------------------------------------------------
March 31, 2001 December 31, 2000 ------------------ ----------------- Mortgage servicing rights Balance, beginning of period $ 1,188,928 1,148,774 Originations 194,575 367,531 Amortization (139,258) (327,377) ----------- ----------- Balance, March 31 1,244,245 1,188,928 ----------- ----------- Valuation reserve Balance, beginning of period 0 (25,100) Additions (5,050) 0 Reductions 0 25,100 ----------- ----------- Balance, March 31 (5,050) 0 ----------- ----------- Mortgage servicing rights, net $ 1,239,195 1,188,928 =========== =========== Fair value of mortgage servicing rights $ 1,338,000 1,476,000 =========== =========== ---------------------------------------------------------------------------
All of the loans being serviced were single family loans serviced for the Federal National Mortgage Association (FNMA) under the mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at March 31, 2001.
---------------------------------------------------------------------------- Weighted Weighted Average Number Loan Principal Average Remaining of Balance Interest Rate Term Loans ------------ ------------- -------- ------- Original term 30 year fixed rate $ 75,523,000 7.61% 332 976 Original term 15 year fixed rate 71,890,000 6.85% 155 1,263 Seven year balloon 520,000 6.88% 328 6 Adjustable rate 4,779,000 8.26% 318 39 -----------------------------------------------------------------------------
10 (7) INVESTMENT IN LIMITED PARTNERSHIPS Investments in limited partnerships were as follows:
----------------------------------------------------------------------------- Primary partnership activity March 31, 2001 December 31, 2000 -------------------------------- --------------- ------------------ Mortgage servicing rights $ 1,982,424 2,257,941 Common stock of financial institutions 264,259 285,524 Low to moderate income housing 288,400 294,899 ----------- ----------- $ 2,535,083 2,838,364 =========== =========== -----------------------------------------------------------------------------
During the first quarter of 2001 HMN's proportionate loss from a mortgage servicing partnership was $275,517, its proportionate share of losses from common stock investments in financial institutions was $21,265 and it recognized $6,499 of losses on low income housing partnerships. During 2001 HMN anticipates receiving low-income housing credits totaling $80,000, of which $20,000 were credited to current income tax benefits. During the first quarter of 2000 HMN's proportionate revenue from a mortgage servicing partnership was $48,346, its proportionate share of losses from the common stock investments in financial institutions was $4,139 and it recognized $7,218 of losses on the low income housing partnerships. During 2000 HMN received low-income housing credits totaling $80,000, of which $20,000 were credited to current income tax benefits. (8) 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, 2001 2000 ---------------------------------- Weighted average number of common shares outstanding used in basic earnings per common share calculation 3,722,627 3,998,038 Net dilutive effect of: Options 216,704 114,964 Restricted stock awards 735 1,953 ---------- ---------- Weighted average number of shares outstanding adjusted for effect of dilutive securities 3,940,066 4,114,955 ========== ========== Income available to common shareholders $ 1,590,908 1,529,714 Basic earnings per common share $ 0.43 0.38 Diluted earnings per common share $ 0.40 0.37
(9) 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 HMN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. 11 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, 2001, 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, 2001 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, 2001 the Bank's tangible assets and adjusted total assets were $714.3 million and its risk-weighted assets were $462.7 million. The following table presents the Bank's capital amounts and ratios at March 31, 2001 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 Adequately Actual Capitalized ----------------------- ----------------------- Percent of Percent of Amount Assets Amount Assets --------- ------------ --------- ------------- Bank stockholder's equity $ 55,433 Plus: Net unrealized loss (gain) on certain securities available for sale 465 Minority interest in consolidated subsidiaries 153 Less: Goodwill and other intangibles 4,697 Excess mortgage servicing rights 198 ------ Tier I or core capital 51,156 ------ Tier I capital to adjusted total assets 7.16% $ 28,571 4.0% Tier I capital to risk- weighted assets 11.06% $ 18,508 4.0% Less: Equity investments & other assets required to be deducted 11 Plus: Allowable allowance for loan losses 3,067 ------ Risk-based capital $ 54,212 $ 37,017 ====== Risk-based capital to risk- weighted assets 11.72% 8.0% ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- To Be Well Capitalized Under Prompt Corrective Actions Excess Capital Provisions ----------------------- ----------------------- Percent of Percent of Amount Assets Amount Assets --------- -------------- --------- ------------- Bank stockholder's equity $ Plus: Net unrealized loss (gain) on certain securities available for sale Minority interest in consolidated subsidiaries Less: Goodwill and other intangibles Excess mortgage servicing rights Tier I or core capital Tier I capital to adjusted total assets $ 22,585 3.16% $ 35,714 5.0% Tier I capital to risk- weighted assets $ 32,648 7.06% $ 27,763 6.0% Less: Equity investments & other assets required to be deducted Plus: Allowable allowance for loan losses Risk-based capital $ 17,195 $ 46,271 Risk-based capital to risk- weighted assets 3.72% 10.0% Based upon the Bank's adjusted total assets for the purpose of the tangible and core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio.
---------------------------------------------------------------------------- The tangible capital of the Bank was in excess of the minimum 2% required at March 31, 2001 but is not reflected in the table above. (10) BUSINESS SEGMENTS HMN's subsidiaries, Home Federal Savings Bank and MSI (through January 31, 2001), have been identified as reportable operating segments in accordance with the provisions of SFAS 131. MSI and its successor through merger, Home Federal Mortgage Services, LLC, were deemed to be a segment because its operations were conducted independently from the Bank. MSI and HFMS, jointly called Mortgage Services, have been segmented 12 further into Mortgage Servicing Rights and Mortgage Banking activities. The mortgage servicing segment owns servicing rights on loans which have either been sold to FNMA or securitized into mortgage-backed instruments which were issued by FNMA. Mortgage Services receives a servicing fee that is based upon the outstanding balance of the loan being serviced and pays a subservicer a monthly fee to service the loan. Mortgage Services' mortgage banking activity includes an origination function and it also purchases loans from other loan originators. All loans acquired either by origination or by purchase are intended to be resold in the secondary loan market. Security Finance Corporation and HMN, the holding company, did not meet the quantitative thresholds for determining reportable segments and therefore are included in the "Other" category. HMN evaluates performance and allocates resources based on the segments net income or loss, return on average assets and return on average equity. Each corporation is managed separately with its own president, who reports directly to HMN's chief operating decision maker, and board of directors. The following table sets forth certain information about the reconciliations of reported profit or loss and assets for each of HMN's reportable segments.
Mortgage Services --------------------------------- Mortgage Total Home Federal Servicing Mortgage Reportable (Dollars in thousands) Savings Bank Rights Banking Segments --------------------------------------------------------------------------- At or for the quarter ended March 31, 2001: Interest income - external customers $ 12,969 0 462 13,431 Non-interest income - external customers 943 16 509 1,468 Earnings (loss) on limited partnerships (282) 0 0 (282) Intersegment interest income 418 0 0 418 Intersegment non-interest income 151 0 0 151 Interest expense 8,410 0 476 8,886 Amortization of mortgage servicing rights and net valuation adjustments 118 23 0 141 Other non-interest expense 3,153 1 500 3,654 Income tax expense (benefit) 928 0 (28) 900 Minority interest 28 0 0 28 Net income (loss) 1,412 (8) 23 1,427 Total assets 717,148 153 43,460 760,761 Net interest margin 2.95% NM NM NM Return on average assets 0.80% (16.85)% 0.32% NM Return on average realized common equity 10.52%(218.00)% 8.24% NM At or for the quarter ended March 31, 2000: Interest income - external customers $ 12,421 0 48 12,469 Non-interest income - external customers 452 22 100 574 Earnings (loss) on limited partnerships 41 0 0 41 Intersegment interest income 0 0 0 0 Intersegment non-interest income 86 0 0 86 Interest expense 7,705 0 33 7,738 Amortization of mortgage servicing rights and net valuation adjustments 55 6 0 61 Other non-interest expense 2,691 8 247 2,946 Income tax expense (benefit) 981 3 (53) 931 Net income (loss) 1,523 5 (79) 1,449 Total assets 691,147 216 3,650 695,013 Net interest margin 2.85% NM NM NM Return on average assets 0.89% 8.76% (10.68)% NM Return on average realized common equity 11.80% 21.35% (26.02)% NM Consolidated (Dollars in thousands) Other Eliminations Total ------------------------------------------------------------------------------ At or for the quarter ended March 31, 2001: Interest income - external customers $ 111 0 13,542 Non-interest income - external customers 250 0 1,718 Earnings (loss) on limited partnerships (21) 0 (303) Intersegment interest income 88 (506) 0 Intersegment non-interest income 1,401 (1,552) 0 Interest expense 12 (506) 8,392 Amortization of mortgage servicing rights and net valuation adjustments 0 0 141 Other non-interest expense 128 (124) 3,658 Income tax expense (benefit) 98 0 998 Minority interest 0 0 28 Net income (loss) 1,591 (1,427) 1,591 Total assets 69,944 (100,215) 730,490 Net interest margin NM NM 2.97% Return on average assets NM NM 0.88% Return on average realized common equity NM NM 9.18% At or for the quarter ended March 31, 2000: Interest income - external customers $ 192 0 12,661 Non-interest income - external customers 2 0 576 Earnings (loss) on limited partnerships (4) 0 37 Intersegment interest income 63 (63) 0 Intersegment non-interest income 1,461 (1,547) 0 Interest expense 30 (63) 7,705 Amortization of mortgage servicing rights and net valuation adjustments 0 0 61 Other non-interest expense 110 (86) 2,970 Income tax expense (benefit) 32 0 963 Net income (loss) 1,542 (1,461) 1,530 Total assets 66,150 (55,459) 705,704 Net interest margin NM NM 2.93% Return on average assets NM NM 0.87% Return on average realized common equity NM NM 9.00% NM - Not meaningful
13 HMN FINANCIAL, INC. ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL HMN's net income is dependent primarily on its net interest income, which is the difference between interest earned on its loans and investments and the interest paid on interest-bearing liabilities. Net interest income is determined by (i) the difference between the yield earned on interest-earning assets and rates paid on interest-bearing liabilities (interest rate spread) and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities. HMN's interest rate spread is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Net interest margin is calculated by dividing net interest income by the average interest-earning assets and is normally expressed as a percentage. Net interest income and net interest margin are affected by changes in interest rates, the volume and the mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. HMN's net income is also affected by the generation of non-interest income, which primarily consists of gains from the sale of securities, gains from sale of loans, service charges, fees and other income. In addition, net income is affected by the level of operating expenses, provisions made for loan losses and impairment reserve adjustments required on mortgage servicing assets. The operations of financial institutions, including the Bank, are significantly affected by prevailing economic conditions, competition and the monetary and fiscal policies of governmental agencies. Lending activities are influenced by the demand for and supply of housing, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market rates of interest primarily on competing investments, account maturities and the levels of personal income and savings in the market area of the Bank. NET INCOME HMN's net income for the first quarter of 2001 was $1.6 million, an increase of $61,000, or 4%, compared to net income of $1.5 million for the first quarter of 2000. Basic earnings per share were $0.43 for the quarter ended March 31, 2001, an increase of $0.05 per share, from $0.38 basic earnings per share for the same quarter of 2000. Diluted earnings per share were $0.40 for the first quarter of 2001, an increase of $0.03 from $0.37 diluted earnings per share for the first quarter of 2000. Earnings per share increased from the first quarter of 2000 to the first quarter of 2001 due to an increase in net income and due to HMN's treasury stock purchase program. The average number of outstanding shares for the basic earnings per share calculation declined by 275,411 shares from 3,998,038 at March 31, 2000, to 3,722,627 at March 31, 2001. The average number of outstanding shares for the diluted earnings per share calculation declined by 174,889 shares from 4,114,955 at March 31, 2000, to 3,940,066 at March 31, 2001. NET INTEREST INCOME Net interest income for the first quarter of 2001 was $5.15 million, an increase of $194,000, or 3.9%, compared to $4.96 million for the first quarter of 2000. Interest income for the first quarter of 2001 was $13.5 million, an increase of $881,000, or 7.0%, compared to $12.7 million for the first quarter of 2000. The interest income increased by $376,000 due to a $22.4 million net increase in average interest-earning assets from the first quarter of 2000 to the first quarter of 2001. The increase in average interest-earning assets is the result of HMN's emphasis on originating and/or purchasing commercial real estate loans, commercial business loans and consumer loans which generally have higher interest rates and shorter terms to maturity than fixed rate single-family residential loans. Interest income increased by $501,000 because the yield earned on interest-earning assets increased from the first quarter of 2000 to the first quarter of 2001. The yield earned on interest-earning assets increased from 7.48% at March 31, 2000, to 7.81% at March 31, 2001. 14 Interest expense was $8.4 million for the first quarter of 2001, an increase of $687,000, or 8.9%, compared to $7.7 million for the same quarter of 2000. Interest expense on deposits increased by $609,000 due to increased interest rates paid on certificates of deposit and by $116,000 due to an increase in the average outstanding balance of deposits. The average interest rate paid on the average interest-bearing liabilities was 5.27% during the first quarter of 2001, compared to 4.92% for the first quarter of 2000. Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2001 was 2.97%, an increase of 4 basis points, compared to 2.93% for the first quarter of 2000. PROVISION FOR LOAN LOSSES *The provision for loan losses for the first quarter ended March 31, 2001 was $150,000, an increase of $105,000, compared to $45,000 for the first quarter of 2000. The provision is the result of management's evaluation of the loan portfolio, a historically low level of non-performing loans, a slight increase in loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located such as national and regional unemployment data, single family loan delinquencies as reported separately by FNMA and the Federal Home Loan Mortgage Corporation (FHLMC),local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed that an increase in the provision for loan losses was required in the first quarter of 2001 compared to the first quarter of 2000. HMN will continue to monitor its allowance for losses as these conditions dictate. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods. A reconciliation of HMN's allowance for loan losses is summarized as follows: 2001 2000 ------------- ------------- Balance at January 1, $ 3,143,746 3,273,311 Provision 150,000 45,000 Charged off (3,978) 0 Recoveries 326 0 ------------ ------------- Balance at March 31, $ 3,290,094 3,318,311 ============ ============= NON-INTEREST INCOME Non-interest income was $1.4 million for the first quarter of 2001, an increase of $803,000, or 131%, from $613,000 for the first quarter of 2000. Non-interest income increased by $670,000 due to an increase in gains recognized on the sale of loans, $346,000 due to an increase in net gains recognized on the sale of securities and by $95,000 due to increased fees and service charges on deposit accounts. The increase in non-interest income was partially offset by a decline of $340,000 in revenue from limited partnership investments. The Federal Reserve substantially lowered interest rates during the first quarter of 2001, which in turn caused interest rates on single family residential loans to decline and allowed many home owners to refinance their home loans at lower interest rates. The large number of home refinances allowed HMN to sell more loans in the secondary market. The large number of home refinances also caused the value of HMN's investment in a limited partnership which owns mortgage loan servicing assets to decline in value because of anticipated increased prepayments expected to be received on mortgage loan servicing assets. NON-INTEREST EXPENSE Non-interest expense was $3.8 million for the first quarter of 2001, an increase of $768,000, or 25.4%, from $3.0 million for the first quarter of 2000. Compensation and benefits expense increased by $217,000, or 12.8%, due to annual payroll increases and additional employees added to HMN's staff. Occupancy expense increased by $140,000 due to additional operating costs related to adding another branch, additional depreciation for remodeled facilities and software improvements made during 2000. Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs increased by $72,000 due to a change in the estimated time over which * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 20 of this discussion 15 the servicing fees will be collected. Other non-interest expense increased by $253,000 partially due to increased activity in mortgage banking operations. INCOME TAX EXPENSE Income tax expense was $998,000 for the first quarter of 2001, an increase of $35,000 compared to $963,000 for the first quarter of 2000. The increase is primarily due to an increase in taxable income between the two quarters. NON-PERFORMING ASSETS The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at March 31, 2001 and December 31, 2000.
March 31, December 31, (Dollars in Thousands) 2001 2000 ------------- ------------- Non-Accruing Loans One-to-four family real estate $ 558 775 Commercial business 320 95 Consumer 302 142 ------ ------ Total 1,180 1,012 ------ ------ Accruing loans delinquent 90days or more 5 405 ------ ------ Foreclosed Assets Real estate: One-to-four family 245 195 ------ ------ Total non-performing assets $ 1,430 1,612 ====== ====== Total as a percentage of total assets 0.20% 0.23% ====== ====== Total non-performing loans $ 1,185 $ 1,417 ====== ====== Total as a percentage of total loans receivable, net 0.23% 0.27% ====== ======
Total non-performing assets at March 31, 2001 were $1.4 million, a decrease of $182,000, from $1.6 million at December 31, 2000. During the first quarter of 2001 the following activity occurred related to non-accruing loans: $596,000 of loans were transferred in, $54,000 were transferred out to foreclosed assets, $367,000 were transferred out to performing loans and $4,000 were charged off. During the same period $400,000 of accruing loans delinquent 90 days or more were transferred to performing status. DIVIDENDS On April 24, 2001 HMN declared a cash dividend of $.12 per share, payable on June 11, 2001 to shareholders of record on May 24, 2001. During the first quarter of 2001, HMN declared and paid dividends as follows: Record date Payable date Dividend per share Dividend Payout Ratio ----------------- --------------- ------------------ ---------------------- February 22, 2001 March 8, 2001 $0.12 29.27 % The annualized dividend payout ratio for the past four quarters, ending with the June 11, 2001 payment will be 27.91%. The declaration of dividends are subject to, among other things, HMN's financial condition and results of operations, the Bank's compliance with its regulatory capital requirements, including the fully phased-in capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. 16 LIQUIDITY For the quarter ended March 31, 2001, the net cash used by operating activities was $33.7 million. HMN collected $15.0 million from the sale of securities, and $10.9 million in principal repayments or on the maturity of securities during the quarter. It purchased premises and equipment of $468,000 and it funded a net increase in loans receivable of $1.4 million. HMN had a net decrease in deposit balances of $321,000 during the quarter. It received net proceeds of $9.9 million from net additional advances from the FHLB and $452,000 from increased advance payments from borrowers for taxes and insurance. HMN received $125,000 from the sale of a minority interest in HFMS and it also received $86,000 related to the exercise of HMN stock options. HMN paid $365,000 in dividends to its shareholders. *HMN has certificates of deposits with outstanding balances of $240.8 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. *HMN has $25.0 million of FHLB advances which mature after 2003 but have call features that can be exercised by the FHLB during the next 12 months. If the call features are exercised HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. Since HMN has the ability to request another advance to replace the advance that is being called, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. HMN's market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure. HMN's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact HMN's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. HMN monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located in the Asset/Liability Management section of this report discloses HMN's projected changes in net interest income based upon immediate interest rate changes called rate shocks. *HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at March 31, 2001. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on March 31, 2001. * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 20 of this discussion. 17
--------------------------------------------------------------------------- Other than trading portfolio Market Value ---------------------------------------------- (Dollars in thousands) Basis point change in interest rates -200 -100 0 +100 +200 ------------------------------------------------------------------------------ Cash and cash equivalents $ 14,754 14,744 14,737 14,724 14,714 Securities available for sale: Fixed-rate CMOs 12,022 12,031 12,008 11,659 11,254 Variable-rate CMOs 56,319 56,110 56,429 56,742 56,275 Fixed-rate available for sale mortgage-backed and related securities 2,920 2,894 2,816 2,723 2,627 Variable-rate available for sale mortgage- backed and related securities 1,901 1,890 1,879 1,867 1,846 Fixed-rate available for sale other marketable securities 43,942 43,295 42,251 37,641 35,996 Variable-rate available for sale other marketable securities 111 111 110 110 110 Federal Home Loan Bank stock 12,273 12,263 12,253 12,243 12,233 Fixed-rate loans held for sale 47,596 46,844 45,231 43,590 42,766 Loans receivable, net: Fixed-rate real estate loans 255,164 251,780 246,187 238,708 231,040 Variable-rate real estate loans 151,740 149,193 146,710 144,204 141,677 Fixed-rate other loans 54,704 54,438 53,788 52,399 51,224 Variable-rate other loans 90,349 89,130 88,385 87,644 86,956 Mortgage servicing rights, net 492 756 1,239 1,598 1,754 Investment in limited partnerships 1,327 1,413 2,535 2,932 3,081 ------- ------- ------- ------- ------- Total market risk sensitive assets 745,614 736,892 726,558 708,784 693,553 ------- ------- ------- ------- ------- NOW deposits 43,747 43,747 43,747 43,747 43,747 Passbook deposits 32,944 32,944 32,944 32,944 32,944 Money market deposits 39,348 39,348 39,348 39,348 39,348 Certificate deposits 315,571 312,499 309,500 304,258 303,717 Fixed-rate Federal Home Loan Bank advances 195,311 186,347 178,523 176,263 174,046 Variable-rate Federal Home Loan Bank advances 54,586 54,557 54,529 54,500 54,471 ------- ------- ------- ------- ------- Total market risk sensitive liabilities 681,507 669,442 658,591 651,060 648,273 ------- ------- ------- ------- ------- Off-balance sheet financial instruments: Commitments to extend credit 4,576 3,108 0 (3,233) (4,806) Commitments to sell or deliver loans (7,150) (4,982) 0 4,682 6,875 ------- ------ ------- ------- ------- Net market risk $ 66,681 66,324 67,967 56,275 43,211 ======= ====== ======= ======= ======= Percentage change from current market value (1.85)% 2.04% 0.00% (17.17)% (36.40)% ======= ====== ======= ======= ====== ----------------------------------------------------------------------------
The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 7% to 38%, depending on the coupon and period to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at annual rates of between 11% and 31%, depending on coupon and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 17% and 47% depending on the coupon and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 18 9%. FHLB advances were projected to be called at the first call date where the projected interest rate on similar remaining term advances exceeded the interest rate on HMN's callable advance. *Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the "Interest Spread") will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. ASSET/LIABILITY MANAGEMENT *HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following March 31, 2001 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated annual impact on net interest income of immediate interest rate changes called rate shocks. Table need updating!! Rate Shock Net Interest Percentage in Basis Point Income Change -------------- ----------- ----------- +200 24,378,000 5.51% +100 24,380,000 5.51% 0 23,106,000 0.00% -100 20,749,000 (10.20)% -200 18,991,000 (17.81)% The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. *Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee consisting of executive officers which meets at least quarterly to review the interest rate risk position and projected profitability. The committee makes recommendations for adjustments to the asset liability position of the Bank to the Board of Directors of the Bank. This committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, the Board reviews on a quarterly basis the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios. In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, during periods of declining or stable interest rates, provide high enough returns to justify the increased exposure to sudden and unexpected increases in interest rates. *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 20 of this discussion. 19 To the extent consistent with its interest rate spread objectives, the Bank attempts to reduce its interest rate risk and has taken a number of steps to restructure its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans with contractual terms of 20 years or less. The Bank generally follows the practice of selling all of its fixed rate single family loans that conform to the secondary market guidelines. HMN has focused its portfolio lending on the origination of commercial loan products and consumer loans which generally have shorter weighted average terms to maturity and/or interest rates which adjust at least every three years. At times, depending on its interest rate sensitivity, the Bank may sell fixed rate single family loans with shorter contractual maturities than thirty years in order to reduce interest rate risk and record a gain on the sale of loans. FORWARD-LOOKING INFORMATION The following paragraphs within Management's Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements and actual results may differ materially from the expectations disclosed within this Discussion and Analysis. These forward-looking statements are subject to risks and uncertainties, including those discussed below. HMN assumes no obligations to publicly release results of any revision or updates to these forward-looking statements to reflect future events or unanticipated occurrences. PROVISION FOR LOAN LOSSES The provision for loan losses for the first quarter ended March 31, 2001 was$150,000, an increase of $105,000, compared to $45,000 for the first quarter of 2000. The provision is the result of management's evaluation of the loan portfolio, a historically low level of non-performing loans, a slight increase in loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located such as national and regional unemployment data, single family loan delinquencies as reported separately by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC),local single family construction permits and local economic growth rates. Management's evaluation of probable losses inherent in the loan portfolio revealed that an increase in the provision for loan losses was required in the first quarter of 2001 compared to the first quarter of 2000. HMN will continue to monitor its allowance for losses as these conditions dictate. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods. LIQUIDITY HMN has certificates of deposits with outstanding balances of $240.8 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. Competitive pricing by other institutions, the desire of a competitor to pay interest rates on deposits that are above the current rates paid by HMN, or the desire by customers to put more of their funds into nontraditional bank products such as stocks and bonds could be circumstances that would cause the maturing certificates to become a liquidity problem. HMN has $25.0 million of FHLB advances which mature after 2003 but have call features that can be exercised by the FHLB during the next 12 months. If the call features are exercised HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. Since HMN has the ability to request another advance to replace the advance that is being called, management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during the next 12 month period. MARKET RISK HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model 20 also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at March 31, 2001. HMN does not have a trading portfolio. The table in the Market Risk section discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on March 31, 2001. Certain shortcomings are inherent in the method of analysis in the table presented in the Market Risk section. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest rate index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. ASSET/LIABILITY MANAGEMENT HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following March 31, 2001 to determine if its current level of interest rate risk is acceptable. HMN's actual net interest income caused by interest rate changes may differ from the amounts reflected in the table in the Asset/Liability section which projects the estimated impact on net interest income of immediate interest rate changes called rate shocks. Certain shortcomings are inherent in the method of analysis presented in each of the tables. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. 21 HMN FINANCIAL, INC. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings. None. ITEM 2. Changes in Securities. Not applicable. ITEM 3. Defaults Upon Senior Securities. Not applicable. ITEM 4. Submission of Matters to a Vote of Security Holders. None. ITEM 5. Other Information. None. ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits. See Index to Exhibits on page 24 of this report. (b) Reports on Form 8-K. None. 22 SIGNATURES Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HMN FINANCIAL, INC. Registrant Date: May 14, 2001 /s/ Michael McNeil Michael McNeil, President (Principal Executive Officer) Date: May 14, 2001 /s/ Timothy P. Johnson Timothy P. Johnson, Chief Financial Officer (Principal Financial Officer) 23 HMN FINANCIAL, INC. INDEX TO EXHIBITS FOR FORM 10-Q Reference Sequential to Prior Page Numbering Filing or Where Attached Exhibit Exhibits Are Regulation S-K Number Located in This Exhibit Number Document Attached Hereto Form 10-Q Report 3.1 Amended and Restated Certificate of Incorporation *1 N/A 3.2 Amended and Restated By-laws *2 N/A 4 Form of Common Stock *3 N/A Including indentures 11 Computation of Earnings Per Common Share 11 Filed electronically *1 Incorporated by reference to Exhibit 3a to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File No. 0-24100). *2 Incorporated by reference to Exhibit 3b to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1997 (File 0-24100). *3 Incorporated by reference to the same numbered exhibit to the Company's Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212). 24