10-Q 1 c04956e10vq.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, 2006 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 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 (X) No ( ) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer [X] Non-accelerated filer |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) 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 19, 2006 ----------------------------------- ----------------------------------- Common stock, $0.01 par value 4,412,964 ================================================================================ HMN FINANCIAL, INC. CONTENTS
PART I -- FINANCIAL INFORMATION Page Item 1: Financial Statements (unaudited) Consolidated Balance Sheets at March 31, 2006 and December 31, 2005 3 Consolidated Statements of Income for the Three Months Ended March 31, 2006 and 2005 4 Consolidated Statement of Stockholders' Equity and Comprehensive Income for the Three Month Period Ended March 31, 2006 5 Consolidated Statements of Cash Flows for the Three Months Ended 6 March 31, 2006 and 2005 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 19 Item 4: Controls and Procedures 21 PART II -- OTHER INFORMATION Item 1: Legal Proceedings 22 Item 1A: Risk Factors 22 Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 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 22 Signatures 23
2 PART I -- FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------------------------------------------- March 31, December 31, 2006 2005 --------------------------------------------------------------------------------------------------------------------- (unaudited) ASSETS Cash and cash equivalents.......................................... $ 55,132,473 47,268,795 Securities available for sale, at fair value: Mortgage-backed and related securities (amortized cost $7,254,122 and $7,428,504).................... 6,697,944 6,879,756 Other marketable securities (amortized cost $118,117,448 and $113,749,841)............... 117,384,344 112,778,813 ----------------- ------------------ 124,082,288 119,658,569 ----------------- ------------------ Loans held for sale................................................ 5,011,272 1,435,141 Loans receivable, net.............................................. 767,880,982 785,678,461 Accrued interest receivable........................................ 4,817,953 4,460,014 Real estate, net................................................... 1,174,315 1,214,621 Federal Home Loan Bank stock, at cost.............................. 8,364,600 8,364,600 Mortgage servicing rights, net..................................... 2,484,849 2,653,635 Premises and equipment, net........................................ 12,304,743 11,941,863 Investment in limited partnerships................................. 134,548 141,048 Goodwill........................................................... 3,800,938 3,800,938 Core deposit intangible, net....................................... 191,296 219,760 Prepaid expenses and other assets.................................. 2,150,332 1,854,948 Deferred tax asset................................................. 2,453,100 2,544,400 ----------------- ------------------ Total assets................................................... $ 989,983,689 991,236,793 ================= ================== LIABILITIES AND STOCKHOLDERS' EQUITY Deposits........................................................... $ 727,466,404 731,536,560 Federal Home Loan Bank advances.................................... 160,900,000 160,900,000 Accrued interest payable........................................... 1,859,576 2,085,573 Advance payments by borrowers for taxes and insurance.............. 1,070,637 1,038,575 Accrued expenses and other liabilities............................. 6,040,754 4,947,816 ----------------- ------------------ Total liabilities.............................................. 897,337,371 900,508,524 ----------------- ------------------ Commitments and contingencies Stockholders' equity: Serial preferred stock ($.01 par value): Authorized 500,000 shares; issued and outstanding none....... 0 0 Common stock ($.01 par value): Authorized 11,000,000; issued shares 9,128,662............... 91,287 91,287 Additional paid-in capital......................................... 57,564,482 58,011,099 Retained earnings, subject to certain restrictions................. 100,763,377 98,951,777 Accumulated other comprehensive loss............................... (778,382) (917,577) Unearned employee stock ownership plan shares...................... (4,302,642) (4,350,999) Unearned compensation restricted stock awards...................... 0 (182,521) Treasury stock, at cost 4,715,698 and 4,721,402 shares............. (60,691,804) (60,874,797) ----------------- ------------------ Total stockholders' equity..................................... 92,646,318 90,728,269 ----------------- ------------------ Total liabilities and stockholders' equity......................... $ 989,983,689 991,236,793 ================= ================== ---------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 3 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (unaudited)
----------------------------------------------------------------------------------------------------------------------- Three Months Ended March 31, 2006 2005 ----------------------------------------------------------------------------------------------------------------------- Interest income: Loans receivable................................................ $ 14,702,780 13,333,019 Securities available for sale: Mortgage-backed and related................................. 70,562 89,768 Other marketable............................................ 889,631 641,756 Cash equivalents................................................ 256,426 52,269 Other........................................................... 62,821 79,528 --------------- ------------ Total interest income....................................... 15,982,220 14,196,340 --------------- ------------ Interest expense: Deposits........................................................ 4,867,681 3,702,631 Federal Home Loan Bank advances ................................ 1,725,856 1,822,691 --------------- ------------ Total interest expense....................................... 6,593,537 5,525,322 --------------- ------------ Net interest income.......................................... 9,388,683 8,671,018 Provision for loan losses............................................ 515,000 636,000 --------------- ------------ Net interest income after provision for loan losses.......... 8,873,683 8,035,018 --------------- ------------ Non-interest income: Fees and service charges........................................ 714,778 602,597 Mortgage servicing fees......................................... 303,675 292,980 Gain on sales of loans.......................................... 245,977 293,316 Losses in limited partnerships.................................. (6,500) (7,710) Other........................................................... 228,404 245,548 --------------- ------------ Total non-interest income.................................... 1,486,334 1,426,731 --------------- ------------ Non-interest expense: Compensation and benefits...................................... 3,258,871 2,774,104 Occupancy....................................................... 1,100,292 995,254 Deposit insurance premiums...................................... 31,197 27,906 Advertising..................................................... 130,658 83,908 Data processing................................................. 288,715 237,488 Amortization of mortgage servicing rights, net.................. 216,540 239,033 Other........................................................... 913,138 932,692 --------------- ------------ Total non-interest expense................................... 5,939,411 5,290,385 --------------- ------------ Income before income tax expense............................. 4,420,606 4,171,364 Income tax expense.................................................... 1,680,200 1,356,300 --------------- ------------ Net income................................................... 2,740,406 2,815,064 =============== ============ Basic earnings per share............................................. $ 0.71 0.74 =============== ============ Diluted earnings per share........................................... $ 0.68 0.70 =============== ============ -----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 4 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2006 (unaudited)
------------------------------------------------------------------------------------------------------------------------------------ Unearned Employee Unearned Accumulated Stock Compensation Total Additional Other Ownership Restricted Stock- Common Paid-in Retained Comprehensive Plan Stock Treasury Holders' Stock Capital Earnings Income Shares Awards Stock Equity (Loss) ------------------------------------------------------------------------------------------- Balance, December 31, 2005 $91,287 58,011,099 98,951,777 (917,577) (4,350,999) (182,521) (60,874,797) 90,728,269 Net income 2,740,406 2,740,406 Other comprehensive income, net of tax: Net unrealized losses on securities available for sale 139,195 139,195 ----------- Total comprehensive income 2,879,601 Purchase of treasury stock (323,000) (323,000) Employee stock options exercised (119,812) 168,800 48,988 Tax benefits of exercised stock 47,648 47,648 options Unearned compensation restricted (337,193) 337,193 0 stock awards Stock option compensation 16,106 16,106 Reclassification of restricted stock (182,521) 182,521 equity Amortization of restricted stock 40,653 40,653 awards Dividends paid (928,806) (928,806) Earned employee stock ownership plan 88,502 48,357 136,859 shares ------------------------------------------------------------------------------------------- Balance, March 31, 2006 $91,287 57,564,482 100,763,377 (778,382) (4,302,642) 0 (60,691,804) 92,646,318 =========================================================================================== ------------------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 5 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
----------------------------------------------------------------------------------------------------------------- Three Months Ended March 31, ------------------------------- 2006 2005 ---------------- ------------- Cash flows from operating activities: Net income................................................................. $ 2,740,406 2,815,064 Adjustments to reconcile net income to cash provided by operating activities: Provision for loan losses................................................ 515,000 636,000 Depreciation............................................................. 468,791 431,856 Amortization of discounts, net........................................... (391,650) (143,378) Amortization of deferred loan fees....................................... (367,847) (208,343) Amortization of core deposit intangible.................................. 28,464 28,464 Amortization of mortgage servicing rights and servicing costs............ 216,540 239,033 Capitalized mortgage servicing rights.................................... (47,754) (144,872) Gain on sales of real estate............................................. (1,430) (5,640) Gain on sales of loans................................................... (245,977) (293,316) Proceeds from sales of real estate....................................... 41,430 39,141 Proceeds from sale of loans held for sale................................ 14,785,405 14,093,471 Disbursements on loans held for sale..................................... (17,268,774) (12,599,099) Amortization of restricted stock awards.................................. 40,653 18,140 Amortization of unearned ESOP shares..................................... 48,357 48,357 Earned employee stock ownership shares priced above original cost........ 88,502 94,237 Increase in accrued interest receivable.................................. (357,939) (787,954) Increase (decrease) in accrued interest payable.......................... (225,997) 629,045 Equity losses of limited partnerships.................................... 6,500 7,710 Decrease (increase) in other assets...................................... (213,215) 309,168 Increase in other liabilities............................................ 1,055,936 156,495 Other, net............................................................... 317 486 ---------------- ------------- Net cash provided by operating activities.............................. 915,718 5,364,065 ---------------- ------------- Cash flows from investing activities: Principal collected on securities available for sale....................... 172,868 475,599 Proceeds collected on maturities of securities available for sale.......... 30,500,000 8,000,000 Purchases of securities available for sale................................. (34,604,906) (4,991,400) Purchases of Federal Home Loan Bank Stock.................................. 0 (973,500) Redemption of Federal Home Loan Bank Stock................................. 0 1,568,700 Net decrease (increase) in loans receivable................................ 16,805,805 (31,416,483) Purchases of premises and equipment........................................ (831,671) (454,456) ---------------- ------------- Net cash provided (used) in investing activities........................ 12,042,096 (27,791,540) ----------------- ------------ Cash flows from financing activities: Increase (decrease) in deposits............................................ (3,939,486) 29,040,952 Purchase of treasury stock................................................. (323,000) (972,000) Stock options exercised.................................................... 48,988 24,887 Stock option compensation ................................................. 16,106 0 Dividends to stockholders.................................................. (928,806) (842,426) Proceeds from Federal Home Loan Bank advances.............................. 0 39,000,000 Repayment of Federal Home Loan Bank advances............................... 0 (39,000,000) Proceeds from Federal Reserve Bank advances................................ 1,000,000 0 Repayment of Federal Reserve Bank advances................................. (1,000,000) 0 Increase in advance payments by borrowers for taxes and insurance.......... 32,062 218,019 ---------------- ------------- Net cash provided (used) by financing activities........................ (5,094,136) 27,469,432 ---------------- ------------- Increase in cash and cash equivalents................................... 7,863,678 5,041,957 Cash and cash equivalents, beginning of period................................ 47,268,795 34,298,394 ---------------- ------------- Cash and cash equivalents, end of period...................................... $ 55,132,473 39,340,351 ================ ============= Supplemental cash flow disclosures: Cash paid for interest..................................................... $ 6,819,534 4,896,277 Cash paid for income taxes................................................. 1,676,278 237,000 Supplemental noncash flow disclosures: Transfer of loans to real estate........................................... 0 952,252 Loans transferred to loans held for sale................................... 844,304 0 -----------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 6 HMN FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) MARCH 31, 2006 AND 2005 (1) HMN FINANCIAL, INC. HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA) which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC) which acts as an intermediary for the Bank in transacting like-kind property exchanges for Bank customers. During the 2005 period for which financial information is presented in this Form 10-Q, the Bank had one other subsidiary that is no longer operating. Home Federal Holding, Inc. (HFH), a wholly owned subsidiary, was the holding company for Home Federal REIT, Inc. (HFREIT) which invested in real estate loans acquired from the Bank. HFH and HFREIT were both dissolved in 2005. The consolidated financial statements included herein are for HMN, SFC, the Bank and the Bank's consolidated entities as described above. All significant intercompany accounts and transactions have been eliminated in consolidation. (2) BASIS OF PREPARATION The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of income, consolidated statement of stockholders' equity and consolidated statements of cash flows in conformity with 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 statement of income for the three-month period ended March 31, 2006 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 As of January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) which requires companies to recognize in compensation expense the grant-date fair value of stock awards issued. The Company adopted FAS 123R using the modified prospective transition method. In accordance with the modified prospective transition method, the Company's Consolidated Financial Statements for prior periods have not been restated to reflect the impact of FAS 123R. As a result of applying FAS 123R, the Company recognized share-based compensation expense of $16,100 for the three months ended March 31, 2006 (for additional information see Note 12). In March 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 156, Accounting for Servicing of Financial Assets -- an amendment of FASB Statement No. 140. Effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006, an entity is required to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset. SFAS No. 156 requires that all separately recognized servicing assets and liabilities be initially measured at fair value and permits, but does not require, the subsequent measurement of servicing assets and liabilities at fair value. It also permits a one-time reclassification, at the time of initial adoption, of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the entity's exposure to changes in the fair value of servicing assets or liabilities that a servicer elects to subsequently measure at 7 fair value. Separate presentation of servicing assets and liabilities subsequently measured at fair value are required to be disclosed in the statement of financial position. The impact of adopting SFAS No. 156 in the first quarter of 2007 is not anticipated to have a material impact on the Company's financial condition or results of operations. (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, 2006, the Company recorded an increase in other assets of $9,403 and an increase in other liabilities of $84,650 and a loss included in the gain on sales of loans of $75,247. The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market and the related loans held for sale are recorded at the lower of cost or market. The Company recorded a decrease in loans held for sale of $72,766 and an increase in other assets of $72,766 due to the mark to market adjustment on the commitments to sell loans held for sale. (5) COMPREHENSIVE INCOME Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income and the related tax effects were as follows:
For the period ended March 31, -------------------------------------------------------------------------------------- (Dollars in thousands) 2006 2005 ----------------------------------------- ---------------------------------------- Securities available for sale: Before tax Tax effect Net of tax Before tax Tax effect Net of tax ------------ ---------- ----------- ---------- ----------- ---------- Net unrealized gains (losses) arising during the period $ 230 91 139 (759) (268) (491) ------------ ---------- ----------- ---------- ----------- ---------- Other comprehensive income $ 230 91 139 (759) (268) (491) ============ ========== =========== ========== =========== ==========
(6) SECURITIES AVAILABLE FOR SALE The following table shows the securities available for sale portfolio's gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position, at March 31, 2006. The Company has reviewed these securities and has concluded that the unrealized losses are temporary and no other-than-temporary impairment has occurred at March 31, 2006.
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 2 $ 2,821 (292) 2,821 (292) FNMA 1 364 (18) 2 3,148 (251) 3,512 (269) Other marketable debt securities: FNMA 4 19,832 (31) 3 14,897 (95) 34,729 (126) FHLMC 1 4,878 (12) 4 19,795 (195) 24,673 (207) FHLB 1 4,992 (6) 7 34,556 (443) 39,548 (449) ---------- ------------ ---------- ---------- ---------- ---------- ---------- ---------- Total temporarily impaired securities 7 $ 30,066 (67) 18 $75,217 (1,276) 105,283 (1,343) ========== ============ ========== ========== ========== ========== ========== ==========
These fixed rate investments are temporarily impaired due to changes in interest rates and the Company has the ability and intent to hold to maturity or until the temporary loss is recovered. Mortgage backed securities in the table above had an average life of less than four years and the other marketable securities had an average life of less than one year at March 31, 2006. 8 (7) INVESTMENT IN MORTGAGE SERVICING RIGHTS A summary of mortgage servicing activity is as follows:
------------------------------------------------------------------------------------------------ Three months Twelve months Three months ended ended ended March 31, 2006 December 31, 2005 March 31, 2005 ------------------------------------------------------------------------------------------------ Mortgage servicing rights: Balance, beginning of period........ $ 2,653,635 3,231,242 3,231,242 Originations........................ 47,754 442,159 144,872 Amortization........................ (216,540) (1,019,766) (239,033) ------------- ------------- ------------ Balance, end of period.............. 2,484,849 2,653,635 3,137,081 ------------- ------------- ------------ Mortgage servicing rights, net...... $ 2,484,849 2,653,635 3,137,081 ============= ============= ============ Fair value of mortgage servicing rights................................ $ 4,419,868 4,598,931 4,644,284 ============= ============= ============ ------------------------------------------------------------------------------------------------
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, 2006.
--------------------------------------------------------------------------------------------------------- Weighted Loan Weighted Average Principal Average Remaining Number Balance Interest Rate Term of Loans --------------- --------------- ------------- ---------- Original term 30 year fixed rate $ 209,943,413 5.90 % 328 1,845 Original term 15 year fixed rate 200,244,090 5.28 % 137 2,580 Adjustable rate 5,185,170 5.37 % 318 51 ---------------------------------------------------------------------------------------------------------
(8) INTANGIBLE ASSETS The gross carrying amount of intangible assets and the associated accumulated amortization at March 31, 2006 is presented in the table below. Amortization expense for intangible assets was $245,004 for the period ended March 31, 2006.
-------------------------------------------------------------------------------------------------------------------- Gross Unamortized Carrying Accumulated Valuation Intangible Amount Amortization Adjustment Assets -------------------------------------------------------------------------------------------------------------------- Amortized intangible assets: Mortgage servicing rights $ 4,361,030 (1,876,181) 0 2,484,849 Core deposit intangible 1,567,000 (1,375,704) 0 191,296 --------------- --------------- --------------- --------------- Total $ 5,928,030 (3,251,885) 0 2,676,145 =============== =============== =============== ===============
The following table indicates the estimated future amortization expense for amortized intangible assets:
------------------------------------------------------------------------------------------------------ Mortgage Core Servicing Deposit Rights Intangible Total ------------------------------------------------------------------------------------------------------ Year ended December 31, 2006 325,438 85,393 410,831 2007 375,907 105,903 481,810 2008 318,387 0 318,387 2009 269,182 0 269,182 2010 227,124 0 227,124 ------------------------------------------------------------------------------------------------------
9 Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2006. 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, 2006 2005 ------------- --------------- Weighted average number of common shares outstanding used in basic earnings per common share calculation 3,839,874 3,824,857 Net dilutive effect of: Options 168,074 173,788 Restricted stock awards 12,877 7,014 ------------- --------------- Weighted average number of shares outstanding adjusted for effect of dilutive securities 4,020,825 4,005,659 ============= =============== Income available to common shareholders $ 2,740,406 2,815,064 Basic earnings per common share $ 0.71 0.74 Diluted earnings per common share $ 0.68 0.70 ------------------------------------------------------------------------------------------
(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, 2006, 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, 2006 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, 2006 the Bank's tangible assets and adjusted total assets were $982.9 million and its risk-weighted assets were $797.9 million. The following table presents the Bank's capital amounts and ratios at March 31, 2006 for actual capital, required capital and excess capital including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations. 10
------------------------------------------------------------------------------------------------------------------------- To Be Well Capitalized Required to be Under Prompt Adequately Corrective Actions Actual Capitalized Excess Capital Provisions --------------------- ------------------ ----------------- ------------------ Percent Percent Percent Percent of of of of (dollars in thousands) Amount Assets(1) Amount Assets(1) Amount Assets(1) Amount Assets(1) ---------- --------- ------ --------- ------ --------- ------ --------- Bank stockholder's equity........... $ 88,200 Less: Net unrealized losses on certain securities available for sale.... 778 Goodwill and core deposit intangible....................... (3,992) Excess mortgage servicing rights.. (1,747) --------- Tier I or core capital 83,239 --------- Tier I capital to adjusted total assets............................ 8.47% 39,318 4.00% 43,921 4.47% 49,147 5.00% Tier I capital to risk-weighted assets............................ 10.43% 31,915 4.00% 51,324 6.43% 47,872 6.00% Plus: Allowable allowance for loan losses........................... 9,117 --------- Risk-based capital.................. $ 92,356 63,830 28,526 79,787 ========= Risk-based capital to risk-weighted assets.............................. 11.58% 8.00% 3.58% 10.00% (1) Based upon the Bank's adjusted total assets for the tangible and core capital ratios and risk-weighted assets for the risk-based capital ratio. -------------------------------------------------------------------------------------------------------------------------
The tangible capital of the Bank was in excess of the minimum 2% required at March 31, 2006 but is not reflected in the table above. (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, 2006 were approximately $16.3 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. (12) STOCK-BASED COMPENSATION The company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS 123R) on January 1, 2006 using the modified prospective transition method. Under the modified prospective transition method, awards that are granted, modified or settled beginning at the date of adoption will be measured and accounted for in accordance with FAS 123R. In addition, expense is recognized in the statement of income for unvested awards that were granted prior to the date of adoption based on the fair value of the award as determined at the grant date. The consolidated financial statements as of and for the three months ended March 31, 2006 reflect $16,100 of additional compensation expense as a result of implementing FAS 123R. In accordance with the modified prospective transition method, the Consolidated Financial Statements for prior periods have not been restated. Therefore, the results for the first quarter of 2006 are not directly comparable to the same period in 2005. Prior to the adoption of FAS 123R, the Company applied the existing accounting rules under APB Opinion No. 25, which provided that no compensation expense was charged for options granted at an exercise price equal to the market value of the underlying common stock on the date of the grant. If the fair value recognition provisions of FAS 123R had been applied to stock-based compensation for the three months ended March 31, 2005, the Company's pro forma net income and earnings per share would have been as follows: 11
------------------------------------------------------------------------------ Quarter Ended March 31, 2005 -------------- Net income: As reported........................................... $ 2,815,064 Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects.................. 41,910 -------------- Pro forma............................................ $ 2,773,154 ============== Earnings per Common share: As reported: Basic................................................ $ 0.74 Diluted.............................................. 0.70 Pro forma: Basic ............................................... 0.73 Diluted.............................................. 0.70 ------------------------------------------------------------------------------
The Company utilizes a valuation model to determine the fair value of stock options on the date of grant. The model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. No stock options were granted during the quarter ended March 31, 2006. (13) BUSINESS SEGMENTS The Bank has been identified as a reportable operating segment in accordance with the provisions of SFAS No. 131. SFC and HMN, the holding company, did not meet the quantitative thresholds for determining reportable segments and therefore are included in the "Other" category. The Company evaluates performance and allocates resources based on the segments net income and 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. 12 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 (Dollars in thousands) Federal Savings Other Eliminations Consolidated Bank Total ---------------------------------------------------------------------------------------------------------- AT OR FOR THE QUARTER ENDED MARCH 31, 2006: Interest income - external customers.... $ 15,939 43 0 15,982 Non-interest income - external customers 1,493 0 0 1,493 Losses on limited partnerships.......... (7) 0 0 (7) Intersegment non-interest income........ 34 2,808 (2,842) 0 Interest expense........................ 6,594 0 0 6,594 Amortization of mortgage servicing rights, net ........................... 217 0 0 217 Other non-interest expense.............. 5,598 157 (33) 5,722 Income tax expense (benefit)............ 1,725 (45) 0 1,680 Net income.............................. 2,810 2,739 (2,809) 2,740 Goodwill .............................. 3,801 0 0 3,801 Total assets............................ 985,107 93,269 (88,392) 989,984 Net interest margin..................... 4.10 % NM NM 4.10% Return on average assets................ 1.14 % NM NM 1.14% Return on average realized common equity 12.96 % NM NM 11.82% AT OR FOR THE QUARTER ENDED MARCH 31, 2005: Interest income - external customers.... $ 14,186 10 0 14,196 Non-interest income - external customers 1,434 0 0 1,434 Losses on limited partnerships.......... (8) 0 0 (8) Intersegment interest income............ 0 16 (16) 0 Intersegment non-interest income........ 34 2,847 (2,881) 0 Interest expense........................ 5,541 0 (16) 5,525 Amortization of mortgage servicing rights, net ........................... 239 0 0 239 Other non-interest expense.............. 4,923 162 (34) 5,051 Income tax expense (benefit)............ 1,459 (103) 0 1,356 Net income.............................. 2,848 2,814 (2,847) 2,815 Goodwill .............................. 3,801 0 0 3,801 Total assets............................ 987,117 85,056 (80,847) 991,326 Net interest margin..................... 3.78 % NM NM 3.79% Return on average assets................ 1.17 % NM NM 1.18% Return on average realized common equity 14.36 % NM NM 13.22%
NM - Not meaningful 13 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 with the Securities and Exchange Commission may contain "forward-looking" statements that deal with future results, plans or performance. When used in this Form 10-Q, the words "anticipates", "believes", "estimates", "expects", "intends" and similar expressions, as they relate to the Company and its management, are intended to identify such forward-looking statements. In addition, the Company's management may make such statements orally to the media, or to securities analysts, investors or others. Forward looking statements deal with matters that do not relate strictly to historical facts. The Company's future results may differ materially from historical performance and forward-looking statements about the Company's expected financial results or other plans are subject to a number of risks and uncertainties. These include but are not limited to possible legislative changes and adverse economic, business and competitive developments such as shrinking interest margins; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines or monetary and fiscal policies of the federal government or tax laws; changes in credit and 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 or other significant uncertainties. For additional discussion of the risks and uncertainties applicable to the Company, see the "Risk Factors" section of the Company's Annual Report on Form 10-K for the year ended December 31, 2005. GENERAL The earnings of the Company are primarily dependant on the Bank's net interest income, which is the difference between interest earned on its loans and investments, and the interest paid on interest-bearing liabilities such as deposits and Federal Home Loan Bank (FHLB) advances. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. The Company's interest rate spread has been enhanced by the increased level of commercial loans placed in portfolio and the increased amount of lower rate deposits. Net interest income and net interest rate spread 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. 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, 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 expense on mortgage servicing assets. The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Commercial real estate loan activity was down in the first quarter of 2006 when compared to the same period of 2005 due to increased rate competition on long term fixed rate loans, and we expect this trend to continue. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. The interest rates charged by the FHLB on advances to the Bank also have a significant impact on the Bank's overall cost of funds. CRITICAL ACCOUNTING POLICIES Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company's financial condition and operating results. The Company has identified the following policies as being critical because they require difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used. 14 Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company's ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company's own loss experience and external industry data and are assigned to all loans without identified credit weaknesses. The Company also performs an individual analysis of impairment on each non-performing loan that is based on the expected cash flows or the value of the assets collateralizing the loans. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans. The adequacy of the allowance for loan losses is dependent upon management's estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future. Mortgage Servicing Rights The Company recognizes as an asset the rights to service mortgage loans for others, which are referred to as mortgage servicing rights (MSRs). MSRs are capitalized at the relative fair value of the servicing rights on the date the mortgage loan is sold and are carried at the lower of the capitalized amount, net of accumulated amortization, or fair value. MSRs are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. Each quarter the Company evaluates its MSRs for impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and interest rate are the predominant risk characteristics of the underlying loans used to stratify the MSRs for purposes of measuring impairment. If temporary impairment exists, a valuation allowance is established for any excess of amortized cost over the current fair value through a charge to income. If the Company later determines that all or a portion of the temporary impairment no longer exists, a reduction of the valuation allowance is recorded as an increase to income. The valuation is based on various assumptions, including the estimated prepayment speeds and default rates of the stratified portfolio. Changes in the mix of loans, interest rates, prepayment speeds, or default rates from the estimates used in the valuation of the mortgage servicing rights may have a material effect on the amortization and valuation of MSRs. Management believes that the assumptions used and the values determined are reasonable based on current conditions. However, future economic conditions may differ substantially from those anticipated in determining the value of the MSRs and adjustments may be required in the future. The Company does not formally hedge its MSRs because they are hedged naturally by the Company's origination volume. Generally, as interest rates rise the origination volume declines and the value of MSRs increases and as interest rates decline the origination volume increases and the value of MSRs decreases. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. 15 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. NET INCOME The Company's net income for the first quarter of 2006 was $2.7 million, down $75,000, or 2.7%, from net income of $2.8 million for the first quarter of 2005. Diluted earnings per common share for the first quarter of 2006 were $0.68, down $0.02, or 2.9%, from $0.70 for the first quarter of 2005. Pretax income for the first quarter of 2006 was $4.4 million, up $249,000, or 6.0%, from pretax income of $4.2 million for the first quarter of 2005. The increase in pretax income in 2006 was offset by an increase in income taxes due to an increase in the Company's effective tax rate from 32.5% in the first quarter of 2005 to 38.0% in the first quarter of 2006. The increase in the effective tax rate was primarily due to changes in state tax laws that were enacted in the third quarter of 2005. ......... NET INTEREST INCOME Net interest income was $9.4 million for the first quarter of 2006, an increase of $718,000, or 8.3%, compared to $8.7 million for the first quarter of 2005. Interest income was $16.0 million for the first quarter of 2006, an increase of $1.8 million, or 12.6%, from $14.2 million for the first quarter of 2005. Interest income increased because of an increase in the average interest rate earned on loans and investments. Interest rates increased primarily because of the 200 basis point increase in the prime interest rate between the periods. Increases in the prime rate, which is the rate that banks charge their prime business customers, generally increase the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. The increase in interest income due to increased rates was partially offset by a $28 million decrease in the average outstanding single-family mortgage and consumer loan portfolio balances between the periods. The average yield earned on interest-earning assets was 6.98% for the first quarter of 2006, an increase of 77 basis points from the 6.21% average yield for the first quarter of 2005. Interest expense was $6.6 million for the first quarter of 2006, an increase of $1.1 million, or 19.3%, compared to $5.5 million for the first quarter of 2005. Interest expense increased because of the higher interest rates paid on deposits which were caused by the 200 basis point increase in the federal funds rate between the periods. Increases in the federal funds rate, which is the rate that banks charge other banks for short term loans, generally increase the rates banks pay for deposits. The average interest rate paid on interest-bearing liabilities was 3.07% for the first quarter of 2006, an increase of 51 basis points from the 2.56% average interest rate paid in the first quarter of 2005. Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2006 was 4.10%, an increase of 31 basis points, compared to 3.79% for the first quarter of 2005. PROVISION FOR LOAN LOSSES The provision for loan losses was $515,000 for the first quarter of 2006, a decrease of $121,000, compared to $636,000 for the first quarter of 2005. The provision for loan losses decreased primarily because of the $12 million reduction in the commercial loan portfolio in the first quarter of 2006 compared to the $40 million in growth that was experienced in the first quarter of 2005. The reduction in loan growth was the result of management's decision not to pursue long-term, low fixed-rate commercial loan business in an environment of rising short-term interest rates. The decrease in the provision related to the reduced loan growth was partially offset by an increase in the provision due to increased commercial loan risk rating downgrades in the first quarter of 2006 when compared to the same period of 2005. 16 A reconciliation of the Company's allowance for loan losses is summarized as follows:
2006 2005 ------------- --------------- Balance at January 1, $ 8,777,655 8,995,892 Provision 515,000 636,000 Charge offs (91,208) (271,737) Recoveries 47,203 33,420 ------------- --------------- Balance at March 31, $ 9,248,650 9,393,575 ============= ===============
NON-INTEREST INCOME Non-interest income was $1.5 million for the first quarter of 2006, an increase of $60,000, or 4.2%, from $1.4 million for the first quarter of 2005. Fees and service charges increased $112,000 between the periods primarily because of increased retail deposit account activity and late fees. Loan servicing fees increased $11,000 primarily because of an increase in the number of commercial loans that are being serviced for others. Gain on sale of loans decreased $47,000 between the periods due to a decrease in the number of single-family mortgage loans sold and a decrease in the profit margins realized on the loans that were sold. Competition in the single-family loan origination market has increased as the overall market has slowed and profit margins have been lowered in order to remain competitive and maintain origination volumes. Other non-interest income decreased $17,000 primarily because of lower revenues from the sale of uninsured investment products. NON-INTEREST EXPENSE Non-interest expense was $5.9 million for the first quarter of 2006, an increase of $649,000, or 12.3%, from $5.3 million for the first quarter of 2005. Compensation expense increased $485,000 primarily because of annual payroll cost increases, an increase in the number of employees and increased pension costs. Occupancy expense increased $105,000 due primarily to additional costs associated with new branch and loan origination offices opened in Rochester in the first quarter of 2006. Data processing costs increased $51,000 due to increases in the services provided by the Bank's third party processor between the periods. Advertising expense increased $47,000 between the periods primarily because of the costs associated with promoting the new branch and the introduction of new checking account offerings in the first quarter of 2006. INCOME TAX EXPENSE Income tax expense increased $324,000 between the periods due to an increase in taxable income and an effective tax rate that increased from 32.5% for the first quarter of 2005 to 38.0% for the first quarter of 2006. The increase in the effective tax rate was primarily the result of state tax law changes enacted in the third quarter of 2005. In the first quarter of 2005, the Company had a Real Estate Investment Trust (REIT) and related company that acquired and held mortgage assets and other authorized investments to generate income. The tax laws relating to these entities were changed, retroactively to January 1, 2005, in the third quarter of 2005. A tax adjustment was recorded in the third quarter of 2005 to account for the increase in tax for the first two quarters of 2005. Because of this adjustment, quarterly tax expense for the first three quarters of 2006 will not be comparable to the tax expense for same periods in 2005. 17 NON-PERFORMING ASSETS The following table summarizes the amounts and categories of non-performing assets in the Bank's portfolio at March 31, 2006 and December 31, 2005.
--------------------------------------------------------------------------------------------------- March 31, December 31, (Dollars in Thousands) 2006 2005 --------------------------------------------------------------------------------------------------- Non-Accruing Loans: One-to-four family real estate $ 529 $ 626 Commercial real estate 948 948 Consumer 274 496 Commercial business 284 259 ------------ ---------------- Total 2,035 2,329 ------------ ---------------- Other assets 177 178 Foreclosed and Repossessed Assets: One-to-four family real estate 1,274 1,315 Consumer 4 61 ------------ ---------------- Total non-performing assets $ 3,491 $ 3,883 ============ ================ Total as a percentage of total assets 0.35 % 0.39 % ============ ================ Total non-performing loans $ 2,035 $ 2,329 ============ ================ Total as a percentage of total loans receivable, net 0.26 % 0.30 % ============ ================ Allowance for loan loss to non-performing loans 454.37 % 376.88 % ============ ================ ---------------------------------------------------------------------------------------------------
Total non-performing assets were $3.5 million at March 31, 2006, a decrease of $392,000, from $3.9 million at December 31, 2005. During the first quarter of 2006, the following activity occurred related to non-performing assets: $390,000 of previously performing loans were classified as non-performing, $7,000 in non-performing loans were foreclosed or repossessed, $82,000 in loans were charged off as a loss, $110,000 in foreclosed assets were sold, and $597,000 in assets were reclassified as performing. DIVIDENDS On April 25, 2006 the Company declared a cash dividend of $0.24 per share, payable on June 7, 2006 to shareholders of record on May 19, 2006. During the first quarter of 2006, the Company declared and paid dividends as follows:
Record date Payable date Dividend per share Dividend Payout Ratio ----------- ------------ ------------------ --------------------- February 17, 2006 March 7, 2006 $0.24 27.59%
The annualized dividend payout ratio for the past four quarters, ending with the June 7, 2006 payment will be 35.04%. The declaration of dividends are subject to, among other things, the Company'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. LIQUIDITY For the quarter ended March 31, 2006, the net cash provided by operating activities was $916,000. The Company collected $30.7 million in principal repayments and maturities on securities during the quarter. It purchased $34.6 million in securities and $832,000 in premises and equipment and received $16.8 million relating to a decrease in net loans receivable. The Company had a net decrease in deposit balances of $3.9 million during the quarter, received $49,000 related to the exercise of HMN stock options, paid $929,000 in dividends to its shareholders and paid $323,000 to purchase treasury stock. The Company has certificates of deposits with outstanding balances of $227.0 million that come due over the next 18 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits which do not renew will be replaced with deposits from other customers or brokers. FHLB advances or proceeds form the sale of securities could also be used to replace unanticipated outflows of deposits. The Company has $10.0 million of FHLB advances that will mature during the next twelve months. The Company also has $110.9 million of FHLB advances that mature beyond March 31, 2007 but have call features that can be exercised by the FHLB during the next twelve months. If the call features are exercised, the Company has the option of requesting any advance otherwise available to it pursuant to the credit policy of the FHLB. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. The Company'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. The Company's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact the Company'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. The Company 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, which follows, discloses the Company's projected changes in net interest income based upon immediate interest rate changes called rate shocks. The Company utilizes a model that 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. The Company believes that over the next twelve months interest rates could fluctuate in a range of 200 basis points up or down from where the rates were at March 31, 2006. The following table discloses the projected changes in market value to the Company'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, 2006.
------------------------------------------------------------------------------------------------------------ Market Value --------------------------------------------------------------- (Dollars in thousands) Basis point change in interest rates -200 -100 0 +100 +200 ------------------------------------------------------------------------------------------------------------ Total market risk sensitive assets......... $ 996,293 990,164 981,791 970,995 958,597 Total market risk sensitive liabilities.... 870,946 856,444 844,655 834,505 825,797 Off-balance sheet financial instruments.... 246 110 0 (310) (588) Net market risk............................ $ 125,593 133,830 137,136 136,180 132,212 Percentage change from current market value (8.42) % (2.41) % 0.00 % (0.70) % (3.59) % ------------------------------------------------------------------------------------------------------------
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 10% to 76%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 11% and 31%, depending on the note rate and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 5% and 49% depending on the note rate 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 accounts were assumed to decay at an annual rate of 20% and money market accounts were assumed to decay at an annual rate of 31%. Non-interest checking accounts were assumed to decay at an annual rate of 33% and NOW accounts were assumed to decay at an annual rate of 17%. FHLB advances were projected to be called at the first call date where the projected interest rate on similar remaining term 19 advances exceeded the interest rate on the 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 a substantial sustained interest rate increase. ASSET/LIABILITY MANAGEMENT The Company's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following March 31, 2005 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.
Projected Rate Shock Change in Net in Basis Interest Percentage (Dollars in thousands) Points Income Change ------------- --------------- ------------ +200 $1,487 12.67 % +100 782 6.66 % 0 0 0.00 % -100 (1,366) (11.64)% -200 (2,919) (24.88)%
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 prepared by third parties. 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 which meets frequently to discuss changes in the interest rate risk position and projected profitability. The Committee makes adjustments to the asset liability position of the Bank which are reviewed by 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, each quarter the Board reviews 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, in certain situations, provide high enough returns to justify the increased exposure to sudden and unexpected changes in interest rates. 20 To the extent consistent with its interest rate spread objectives, the Bank attempts to manage its interest rate risk and has taken a number of steps to restructure its balance sheet in order to better match the maturities of its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans that are saleable to third parties and only places fixed rate loans that meet certain risk characteristics into its loan portfolio. The Bank does place into portfolio adjustable rate single-family loans that reprice over a one, three or five-year period. The Bank's commercial loan production has primarily been in adjustable rate loans and the fixed rate commercial loans placed in portfolio have been shorter-term loans, usually with maturities of five years or less, in order to manage the Company's interest rate risk exposure. ITEM 4: CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (Exchange Act). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Changes in internal controls. There was no change in the Company's internal controls over financial reporting during the Company's most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal controls over financial reporting. 21 HMN FINANCIAL, INC. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings. None. ITEM 1A. Risk Factors. No changes from risk factors previously disclosed in December 31, 2005 Form 10-K. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds. (a) and (b) Not applicable (c) Information Regarding Share Repurchases
(c) Total Number of Shares (a) Total Purchased as Part (d) Maximum Number Number of (b) Average of Publicly of Shares that May Yet Shares Price Paid Announced Plans Be Purchased Under the Period Purchased per Share or Programs Plans or Programs -------------------------------------- ------------ ---------------- -------------------- ----------------------- January 1 through January 31, 2006 0 $ N/A N/A 197,000 February 1 through February 28, 2006 10,000 32.30 10,000 187,000 March 1 through March 31, 2006 0 N/A N/A 187,000 --------- ------------- Total 10,000 $32.30 10,000 ========= =============
(1) On July 26, 2005, the Board of Directors extended the stock repurchase program for 197,000 shares of the Company's common stock. This program expires on February 25, 2007. 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. See Index to Exhibits on page 24 of this report. 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 4, 2006 /s/ Michael McNeil ------------------------------ Michael McNeil, President and Chief Executive Officer (Principal Executive Officer) (Duly Authorized Representative) Date: May 4, 2006 /s/ Jon Eberle ------------------------------ Jon Eberle, Chief Financial Officer (Principal Financial Officer) 23 HMN FINANCIAL, INC. INDEX TO EXHIBITS FOR FORM 10-Q
Sequential Reference Page Numbering Regulation to Prior Where Attached S-K Filing or Exhibits Are Exhibit Exhibit Located in This Number Document Attached Hereto Number Form 10-Q Report -------------------------------------------------------------------------------------------------------------------------------- 3.1 Amended and Restated Articles of Incorporation *1 N/A 3.2 Amended and Restated By-laws *2 N/A 4 Form of Common Stock Certificates *3 N/A 31.1 Rule 13a-14(a)/15d-14(a) Certification of CEO 31.1 Filed Electronically 31.2 Rule 13a-14(a)/15d14(a) Certification of CFO 31.2 Filed Electronically 32 Section 1350 Certification of CEO and CFO 32 Filed Electronically ------------------------------------------------------------------------------------------------------------------------------- *1 Incorporated by reference to the same numbered exhibit 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 Exhibit 3 to the Company's Current Report on Form 8-K dated February 22, 2005, filed on February 23, 2005 (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). -------------------------------------------------------------------------------------------------------------------------------
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