10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF 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 No.)
1016 Civic Center Drive Northwest, PO Box 6057		55901
Rochester, Minnesota		(Zip Code)
(Address of Principal Executive Offices)
	(507) 535-1200
Registrant’s telephone number, including area code

Securities Registered Pursuant to Section 12(b) of the Act: Common Stock, par value $.01 per share (Title of each class)

Securities Registered Pursuant to Section 12(g) of the Act: None

Name of each exchange on which registered: NASDAQ stock exchange

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. YES o NO þ

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 requirements for the past 90 days. YES þ NO o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best or registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by checkmark 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.

Large accelerated filer o       Accelerated filer þ      Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

As of June 30, 2006, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $116.6 million based on the closing stock price of $34.80 on such date as reported on the NASADAQ National Market (now the NASADAQ Global Market).

As of February 12, 2007 the number of outstanding shares of common stock of the registrant was 4,319,395.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s annual report to stockholders for the year ended December 31, 2006, are incorporated by reference in Parts I, II and IV of this Form 10-K. Portions of the registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the registrant’s fiscal year ended December 31, 2006 are incorporated by reference in Part III of this Form 10-K.

TABLE OF CONTENTS

	Page
PART I
Item 1. Business
General		4
Market Area		4
Lending Activities		5
Origination, Purchases and Sales of Mortgage-Backed and Related Securities		12
Classified Assets and Delinquencies		14
Investment Activities		15
Sources of Funds		19
Other Information
Service Corporations of the Bank		22
Competition		23
Other Corporations Owned by HMN		23
Employees		23
Regulation and Supervision		23
Executive Officers		28
Item 1A. Risk Factors		29
Item 1B. Unresolved Staff Comments		32
Item 2. Properties		32
Item 3. Legal Proceedings		32
Item 4. Submission of Matters to a Vote of Security Holders		32
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		33
Item 6. Selected Financial Data		34
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations		34
Item 7A. Quantitative and Qualitative Disclosure About Market Risk		35
Item 8. Financial Statements and Supplementary Data		35
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		35
Item 9A. Controls and Procedures		35
Item 9B. Other Information		37
PART III
Item 10. Directors and Executive Officers of the Registrant		37
Item 11. Executive Compensation		37
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		38
Item 13. Certain Relationships and Related Transactions		38
Item 14. Principal Accountant Fees and Services		38
PART IV
Item 15. Exhibits and Financial Statement Schedules		39
Signatures		42
Index to Exhibits		43
Form of Restricted Stock Agreement
Portions of Annual Report to Security Holders
Subsidiaries of Registrant
Consent of KPMG LLP
Rule 13a-14(a)/15d-14(a) Certification of CEO
Rule 13a-14(a)/15d-14(a) Certification of CFO
Section 1350 Certifications

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Forward-Looking Statements

The information presented or incorporated by reference in this Annual Report on Form 10-K under the headings “Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Words such as “anticipate”, “believe”, “expect”, “intend”, “would”, “could” and similar expressions, as they relate to us, are intended to identify such forward-looking statements. These statements are subject to risks and uncertainties, including those discussed under “Risk Factors” on pages 29-31 of this Form 10-K, that could cause actual results to differ materially from those projected. Because actual results may differ, we caution you not to place undue reliance on these forward-looking statements.

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PART I

ITEM 1. BUSINESS

General

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 facilities 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 period for which financial information is presented in this Form 10-K, the Bank had two other subsidiaries that are 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. Federal Title Services, LLC (FTS), which was 80% owned by the Bank, performed mortgage title services for Bank customers and was dissolved in 2004.

As a community-oriented financial institution, the Company seeks to serve the financial needs of communities in its market area. The Company’s business involves attracting deposits from the general public and businesses and using such deposits to originate or purchase one-to-four family residential, commercial real estate, and multi-family mortgage loans as well as consumer, construction, and commercial business loans. The Company also invests in mortgage-backed and related securities, U.S. government agency obligations, and other permissible investments. The executive offices of the Company are located at 1016 Civic Center Drive Northwest, Rochester, Minnesota 55901. Its telephone number at that address is (507) 535-1200. The Company’s website is located at www.hmnf.com. Information contained on the Company’s website is expressly not incorporated by reference into this Form 10-K.

Market Area

The Company serves the southern Minnesota counties of Fillmore, Freeborn, Houston, Mower, Olmsted and Winona and portions of Steele, Dodge, Goodhue and Wabasha through its corporate office located in Rochester, Minnesota and its nine branch offices located in Albert Lea, Austin, LaCrescent, Rochester, Spring Valley and Winona, Minnesota. The portion of the Company’s southern Minnesota market area consisting of Rochester and the contiguous communities is composed of primarily urban and suburban communities, while the balance of the Company’s southern Minnesota market area consists primarily of rural areas and small towns. Primary industries in the Company’s southern Minnesota market area include manufacturing, agriculture, health care, wholesale and retail trade, service industries and education. Major employers include IBM, Mayo Clinic and Hormel (a food processing company). The Company’s market area is also the home of Winona State University, Rochester Community and Technical College, University of Minnesota — Rochester Center, Winona State University — Rochester Center and Austin’s Riverland Community College.

The Company serves the Iowa counties of Marshall and Tama through its branch offices located in Marshalltown and Toledo. Major industries in the area are Swift & Company (pork processors), Fisher Controls International (valve and regulator manufacturing), Lennox Industries (furnace and air conditioner manufacturing), Iowa Veterans Home (hospital care), Marshall Community School District (education), Marshall Medical & Surgical Center (hospital care) and Meskwaki Casino (gaming operations).

Based upon information obtained from the U.S. Census Bureau for 2005 (the last year for which information is available), the population of the six primary counties in the Bank’s southern Minnesota market area was estimated as follows: Fillmore – 21,368; Freeborn — 31,946; Houston - 19,941; Mower — 38,799; Olmsted — 135,189; and Winona — 49,276. The median household income for these six counties ranged from $38,291 to $56,721. With respect to Iowa, the population of Marshall County was 39,418 and the population of Tama County was 17,919. The median household income of these two counties ranged from $38,939 to $39,887.

The Company also serves a diverse high net worth customer base primarily in the seven county metropolitan area of Minneapolis and St. Paul from Eagle Crest Capital Bank, a division of the Bank, located in Edina, Minnesota.

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The Company serves a similar group of individuals and businesses in Olmsted county from its Eagle Crest Capital Bank locations in Rochester, Minnesota.

Lending Activities

General. Historically, the Company has originated 15 and 30-year, fixed rate mortgage loans secured by one-to-four family residences for its loan portfolio. More recently, the Company has focused on managing interest rate risk and increasing interest income by increasing its investment in shorter term and generally higher yielding commercial real estate, commercial business, consumer, and construction loans and reducing its investment in longer term one-to-four family real estate loans. The Company continues to originate 15 and 30 year fixed rate mortgage loans, including growing equity mortgage (GEM) loans that have a fixed rate, but payments that increase after the first year, and adjustable rate mortgage loans that are fixed for an initial period of one, three or five years and some shorter term fixed rate loans that have certain characteristics. The shorter term fixed and adjustable rate loans are placed into portfolio. The majority of the 15 and 30-year fixed rate mortgage loans are sold in the secondary mortgage market. In 2006 a larger percentage of 15 and 30 year loans were placed into portfolio in order to maintain the single family portfolio and to offset the decline in outstanding commercial loan balances. The Company also offers an array of consumer loan products that include both open lines and closed end home equity loans. The home equity line of credit has an adjustable interest rate based upon the prime rate as published in the Wall Street Journal plus a margin. Refer to Note 4 of the Notes to Consolidated Financial Statements in the Annual Report for more information on the loan portfolio (incorporated by reference in Item 8. of Part II of this Form 10-K).

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The following table shows the composition of the Company’s loan portfolio by fixed and adjustable rate loans as of December 31:

	2006					2005					2004					2003					2002
(Dollars in thousands)	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
Fixed rate Loans
Real Estate:
One-to-four family
GEM	$	13,335		1.70	%	$	14,812		1.84	%	$	16,133		2.01	%	$	13,387		1.89	%	$	17,394		3.18	%
Other		62,184		7.92			55,700		6.94			59,937		7.48			65,004		9.17			74,510		13.63
Total one-to-four family		75,519		9.62			70,512		8.78			76,070		9.49			78,391		11.06			91,904		16.81
Multi-family		6,193		0.79			5,956		0.74			6,387		0.79			6,471		0.91			6,588		1.20
GEM — multi-family		45		0.01			51		0.01			57		0.01			61		0.01			64		0.01
Commercial		100,562		12.80			89,905		11.19			51,390		6.41			52,563		7.42			37,878		6.93
Construction or development		6,640		0.84			12,919		1.61			27,557		3.44			17,215		2.43			17,234		3.15
Total fixed rate real estate loans		188,959		24.06			179,343		22.33			161,461		20.14			154,701		21.83			153,668		28.10
Consumer loans:
Savings		814		0.10			605		0.07			454		0.06			494		0.07			534		0.10
Automobile		3,093		0.39			5,462		0.68			9,496		1.18			14,754		2.08			11,062		2.02
Home equity		21,181		2.70			19,289		2.40			20,019		2.50			18,742		2.65			21,049		3.85
Mobile home		2,052		0.26			2,299		0.29			2,896		0.36			3,665		0.52			4,534		0.83
Land/Lot Loans		1,426		0.18			1,234		0.15			818		0.10			754		0.11			781		0.15
Other		2,192		0.28			2,569		0.32			3,134		0.39			3,105		0.43			3,299		0.60
Total consumer loans		30,758		3.91			31,458		3.91			36,817		4.59			41,514		5.86			41,259		7.55
Commercial business loans		65,347		8.32			49,297		6.14			69,671		8.69			51,609		7.28			42,272		7.73
Total other loans		96,105		12.23			80,755		10.05			106,488		13.28			93,123		13.14			83,531		15.28
Total fixed rate loans		285,064		36.29			260,098		32.38			267,949		33.42			247,824		34.97			237,199		43.38
Adjustable rate Loans
Real estate:
One-to-four family		58,751		7.48			56,563		7.04			62,938		7.85			65,924		9.30			59,662		10.91
Multi-family		23,624		3.01			34,745		4.33			35,478		4.43			25,008		3.53			9,113		1.67
Commercial		193,928		24.69			170,363		21.21			173,554		21.65			146,603		20.69			92,539		16.92
Construction or development		53,538		6.82			67,424		8.39			70,841		8.84			78,131		11.02			44,102		8.07
Total adjustable rate real estate loans		329,841		42.00			329,095		40.97			342,811		42.77			315,666		44.54			205,416		37.57
Consumer (home equity and other)		54,328		6.91			60,853		7.57			67,154		8.38			54,425		7.68			52,131		9.53
Land/Lot loans		4,076		0.52			8,197		1.02			10,754		1.34			9,732		1.38			2,809		0.52
Other		686		0.09			390		0.05			248		0.03			234		0.03			222		0.04
Total consumer loans		59,090		7.52			69,440		8.64			78,156		9.75			64,391		9.09			55,162		10.09
Commercial business loans		111,423		14.19			144,665		18.01			112,698		14.06			80,808		11.40			48,989		8.96
Total other loans		170,513		21.71			214,105		26.65			190,854		23.81			145,199		20.49			104,151		19.05
Total adjustable rate loans		500,354		63.71			543,200		67.62			533,665		66.58			460,865		65.03			309,567		56.62
Total loans		785,418		100.00	%		803,298		100.00	%		801,614		100.00	%		708,689		100.00	%		546,766		100.00	%
Less
Loans in process		5,252					7,008					7,561					11,298					6,826
Unamortized discounts		40					190					63					166					142
Net deferred loan fees		2,021					1,644					1,781					1,334					1,068
Allowance for losses on loans		9,873					8,778					8,996					6,940					4,824
Total loans receivable, net	$	768,232				$	785,678				$	783,213				$	688,951				$	533,906

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The following table illustrates the interest rate maturities of the Company’s loan portfolio at December 31, 2006. Loans which have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. Scheduled repayments of principal are reflected in the year in which they are scheduled to be paid. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.

	Real Estate
						Multi-family and
	One-to-four family					Commercial					Construction					Consumer					Commercial Business					Total
			Weighted					Weighted					Weighted					Weighted					Weighted					Weighted
Due During Years			Average					Average					Average					Average					Average					Average
Ending December 31,	Amount		Rate			Amount		Rate			Amount		Rate			Amount		Rate			Amount		Rate			Amount		Rate
2007 (1)	$	6,747		6.13	%	$	69,478		8.64	%	$	39,682		8.95	%	$	14,394		9.19	%	$	95,587		8.34	%	$	225,888		8.55	%
2008		6,782		6.33			65,870		8.16			612		7.25			10,575		8.55			26,591		8.16			110,430		8.08
2009		5,744		5.76			37,402		7.93			439		6.31			9,408		8.72			20,653		7.99			73,646		7.87
2010 through 2011		12,344		5.75			42,837		7.62			1,207		6.93			18,595		8.98			20,307		8.32			95,290		7.78
2012 through 2016		29,318		5.88			66,798		7.42			10,060		8.32			28,769		9.22			11,194		7.33			146,139		7.52
2017 through 2031		57,392		5.97			41,967		7.35			6,749		6.36			8,100		8.67			2,405		6.74			116,613		6.69
2032 and following		15,943		5.96			0		0.00			1,429		5.92			7		3.64			33		8.00			17,412		5.96
	$	134,270				$	324,352				$	60,178				$	89,848				$	176,770				$	785,418

(1) Includes demand loans, loans having no stated maturity, overdraft loans and education loans.

The total amount of loans due after December 31, 2007 that have predetermined interest rates is $210.5 million, while the total amount of loans due after such date that have floating or adjustable interest rates is $349 million. Construction or development loans were $36.1 million for one to four family dwellings, $4.5 million for multifamily and $19.6 million for nonresidential.

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Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the aggregate amount of loans that the Bank is permitted to make to any one borrower is generally limited to 15% of unimpaired capital and surplus (25% if the security for such loan has a “readily ascertainable” value or 30% for certain residential development loans). At December 31, 2006, based upon the 15% limitation, the Bank’s regulatory limit for loans to one borrower was approximately $13.7 million. At December 31, 2006, the dollar amount of outstanding loans to three different groups of related borrowers exceeded this amount, but some of the loans included in these loan totals were exempt from the lending limit under the direct benefit and common enterprise rules of the Financial Institutions Reform, Recovery and Enforcement Act of 1989, as a portion of these loans did not benefit the same individual borrowers. The largest of these borrowing relationships is secured by a manufacturing facility, commercial real estate and equipment and was performing in accordance with its terms at December 31, 2006. The total loans outstanding to this borrower at December 31, 2006 were $16.7 million. The amount outstanding, excluding those loans that were exempt from the loans to one borrower limits because of the direct benefit and common enterprise rules was $12.4 million.

All of the Bank’s lending is subject to its written underwriting standards and to loan origination procedures. Decisions on loan applications are made on the basis of detailed applications and property valuations determined by an independent appraiser. The loan applications are designed primarily to determine the borrower’s ability to repay. The more significant items on the application are verified through the use of credit reports, financial statements, tax returns or confirmations. The Bank also offers the Home Credit Plus Program which relies on the credit score of the loan applicant instead of income, asset and employment verification procedures. The Bank also offers other loan programs with low or alternative documentation underwriting procedures that conform to Federal National Mortgage Association (FNMA) underwriting guidelines.

The Bank’s Mortgage and Consumer Loan Committee is responsible for reviewing and approving all loans over the Federal Home Loan Mortgage Corporation/FNMA conforming loan dollar limit originated by the Bank that are not sold in the secondary loan market. This limit was $417,000 for 2006 and $359,650 for 2005. Approval of at least one member of the Mortgage and Consumer Loan Committee was obtained on all loans above this limit.

The Bank’s Commercial Loan Committee is responsible for reviewing and approving individual commercial loans or loans to borrowers with aggregate lending relationships ranging from $1.0 million to $7.5 million. The Bank’s individual commercial loan officers have the authority to approve loans that meet the guidelines established by the Bank’s commercial loan policy for loans up to $250,000, subject to specific loan officer authority limits. The Bank’s Commercial Loan Officers Committee has the authority to approve loans that meet the commercial loan policy guidelines that are less than $1.0 million. Individual loans of $7.5 million or more, and loans to borrowers with aggregate lending relationships that exceed that amount, must be approved by the Company’s Board of Directors or its Executive Commercial Loan Committee.

The Bank generally requires title insurance on its mortgage loans as well as fire and extended coverage casualty insurance in amounts at least equal to the principal amount of the loan or the value of improvements on the property. The Bank also requires flood insurance to protect the property securing its interest when the property is located in a flood plain.

One-to-Four Family Residential Real Estate Lending. At December 31, 2006 the Company’s one-to-four family real estate loans, consisting of both fixed rate and adjustable rate loans, totaled $134.3 million, an increase of $7.2 million, from $127.1 million at December 31, 2005. The increase in the one-to-four family loans in 2006 is the result of placing more loans into the portfolio in order to offset the decline that was experienced in the commercial loan portfolio. The Company’s long term strategy is to maintain the single family loan portfolio and to increase the amount of shorter term commercial real estate and commercial business loan portfolios.

The Company offers conventional fixed rate one-to-four family loans that have maximum terms of 30 years. In order to manage interest rate risk, the Company typically sells the majority of fixed rate loan originations or refinances with terms to maturity of 15 years or greater that are eligible for sale in the secondary market. The interest rates charged on the fixed rate loan products are based on the FNMA delivery rates, as well as other competitive factors. The Company also originates a limited number of fixed rate loans with terms up to 30 years

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that are insured by the Federal Housing Authority, Veterans Administration, Minnesota Housing Finance Agency or Iowa Finance Authority.

The Company also offers one-year adjustable rate mortgages (ARMs) at a margin (generally 275 to 375 basis points) over the yield on the Average Monthly One Year U.S. Treasury Constant Maturity Index for terms of up to 30 years. The ARM loans offered by the Company allow the borrower to select (subject to pricing) an initial period of one year, three years, or five years between the loan origination and the date the first interest rate change occurs. The ARMs generally have a 200 basis point annual interest rate change cap and a lifetime cap of 600 basis points over or under the initial rate. Initial interest rates offered on the ARM loans during 2006 ranged from 100 basis points below the fully indexed loan rate to 100 basis points over that rate. All borrowers are qualified for the loan at the fully indexed rate. The Company’s originated ARMs do not permit negative amortization of principal, generally do not contain prepayment penalties and are not convertible into fixed rate loans.

In underwriting one-to-four family residential real estate loans, the Company evaluates the borrower’s credit history; ability to make principal, interest and escrow payments; the value of the property that will secure the loan; and debt to income ratios. Properties securing one-to-four family residential real estate loans made by the Company are appraised by independent fee appraisers. The Company originates residential mortgage loans with loan-to-value ratios up to 100% for owner-occupied homes and up to 90% for non-owner occupied homes; however, private mortgage insurance is generally required to reduce the Company’s exposure to 80% of value or less on most loans. The Company generally seeks to underwrite its loans in accordance with secondary market standards.

The Company’s residential mortgage loans customarily include due-on-sale clauses giving it the right to declare the loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the property subject to the mortgage.

Fixed rate loans in the Company’s portfolio include both GEM loans and conventional fixed rate loans. The GEM loans require payments that increase after the first year. Under the GEM loans, the monthly payments required for the first year are established based on a 30-year amortization schedule. Depending upon the program selected, the payments may increase in the succeeding years by amounts ranging from 0% to 6.2%. Most of the GEM loans originated by the Company provide for at least four annual payment increases over the first five years of the loan. The increased payments required under GEM loans are applied to principal and have the effect of shortening the term to maturity; the GEM loans do not permit negative amortization. The Company currently offers one GEM product with a contractual maturity of approximately 15 years. The GEMs are generally priced based upon loans with similar contractual maturities. The GEMs are popular with consumers who anticipate future increases in income and who desire an amortization schedule of less than 30 years. Low mortgage interest rates over the past several years have decreased the demand for GEM loans as consumers have opted for shorter term fixed rate loans.

Commercial Real Estate and Multi-Family Lending. The Company originates permanent commercial real estate and multi-family loans secured by properties located primarily in its market area. It also purchases participations in commercial real estate and multi-family loans originated by third parties on properties outside of its market area. The commercial real estate and multi-family loan portfolio includes loans secured by motels, hotels, apartment buildings, churches, ethanol plants, manufacturing plants, office buildings, business facilities, shopping malls, nursing homes, golf courses, entertainment facilities, warehouses and other non-residential building properties primarily located in the upper Midwest part of the United States.

Permanent commercial real estate and multi-family loans are generally originated for a maximum term of 10 years and may have longer amortization periods with balloon maturity features. The interest rates may be fixed for the term of the loan or have adjustable features that are tied to the prime rate or a published index. Commercial real estate and multi-family loans are generally written in amounts up to 80% of the lesser of the appraised value of the property or the purchase price and generally have a debt service coverage ratio of at least 120%. The debt service coverage ratio is the ratio of net cash from operations to debt service payments. The Company may

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originate construction loans secured by commercial or multi-family real estate, or may purchase participation interests in third party originated construction loans secured by commercial or multi-family real estate.

Appraisals on commercial real estate and multi-family real estate properties are performed by independent appraisers prior to the time the loan is made. For transactions less than $250,000, the Company may use an internal valuation. All appraisals on commercial and multi-family real estate are reviewed and approved by a commercial loan officer, credit manager, commercial department manager, or a qualified third party. The Bank’s underwriting procedures require verification of the borrower’s credit history, income and financial statements, banking relationships and income projections for the property. All commercial real estate and multi-family loans over $1.0 million must be approved by a majority of the Commercial Loan Committee prior to closing. The commercial loan policy generally requires personal guarantees from the proposed borrowers. An initial on-site inspection is generally required for all collateral properties for loans with balances in excess of $250,000. Independent annual reviews are performed for aggregate commercial lending relationships that exceed $500,000. The reviews cover financial performance, documentation completeness and accuracy of loan risk ratings.

At December 31, 2006, the Company’s two largest commercial real estate loans totaled $11.6 million and $11.7 million. These loans are secured by a golf course housing development in southeastern Minnesota and a commercial land development in the Minneapolis/St. Paul metro area. Both loans were performing at December 31, 2006.

Multi-family and commercial real estate loans generally present a higher level of risk than loans secured by one-to-four family residences. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family and commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower’s ability to repay the loan may be impaired. At December 31, 2006, $5.3 million of loans in the commercial real estate portfolio were nonperforming, with the largest relationship being $4.2 million in related loans that were secured by a golf course development that was sold in 2006 after being partially charged off. The guaranteed portion of these notes was nonperforming at December 31, 2006. There can be no assurance that the amount of nonperforming loans will not increase in the future.

Construction Lending. The Company makes construction loans to individuals for the construction of their residences and to builders for the construction of one-to-four family residences. It also makes some loans to builders for houses built on speculation. Construction loans also include commercial real estate loans.

Almost all loans to individuals for the construction of their residences are structured as permanent loans. Such loans are made on the same terms as residential loans, except that during the construction phase, which typically lasts up to nine months, the borrower pays interest only. Generally, the borrower also pays a construction fee at the time of origination equal to the origination fee plus other costs associated with processing the loan. Residential construction loans are underwritten pursuant to the same guidelines used for originating residential loans on existing properties.

Construction loans to builders or developers of one-to-four family residences generally carry terms of one year or less and may permit the payment of interest from loan proceeds.

Construction loans to owner occupants are generally made in amounts up to 95% of the lesser of cost or appraised value, but no more than 85% of the loan proceeds can be disbursed until the building is completed. The Company generally limits the loan-to-value ratios on loans to builders to 80%. Prior to making a commitment to fund a construction loan, the Company requires a valuation of the property, financial data, and verification of the borrower’s income. The Company obtains personal guarantees for substantially all of its construction loans to builders. Personal financial statements of guarantors are also obtained as part of the loan underwriting process. Construction loans are generally located in the Company’s market area.

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Construction loans are obtained principally through continued business from builders and developers who have previously borrowed from the Bank, as well as referrals from existing customers and walk-in customers. The application process includes a submission to the Bank of accurate plans, specifications and costs of the project to be constructed. These items are used as a basis to determine the appraised value of the subject property to be built.

At December 31, 2006 construction loans totaled $60.2 million, of which one-to-four family residential totaled $36.1 million, multi-family residential totaled $4.5 million and commercial real estate totaled $19.6 million.

The nature of construction loans makes them more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project, experience of the builder, and the estimated cost (including interest) of the project. If the estimate of value proves to be inaccurate, the Company may be confronted, at or prior to the maturity of the loan, with a project having a value that is insufficient to assure full repayment and/or the possibility of having to make substantial investments to complete and sell the project. Because defaults in repayment may not occur during the construction period, it may be difficult to identify problem loans at an early stage. In these cases, the Company may be required to modify the terms of the loan.

Consumer Lending. The Company originates a variety of consumer loans, including home equity loans (open-end and closed-end), automobile, home improvement, mobile home, lot loans, loans secured by deposit accounts and other loans for household and personal purposes.

Consumer loan terms vary according to the type and value of collateral, length of contract and creditworthiness of the borrower. The Company’s consumer loans are made at fixed or adjustable interest rates, with terms up to 20 years for secured loans and up to three years for unsecured loans.

The Company’s home equity loans are written so that the total commitment amount, when combined with the balance of any other outstanding mortgage liens, may not exceed 100% of the appraised value of the property. The closed-end home equity loans are written with fixed or adjustable rates with terms up to 15 years. The open-end home equity lines are written with an adjustable rate with a 10 year draw period that requires “interest only” payments followed by a 10-year repayment period that fully amortizes the outstanding balance. The consumer may access the open-end home equity line either by making a withdrawal at the Bank or writing a check on the home equity line of credit account. Open and closed-end equity loans, which are generally secured by second mortgages on the borrower’s principal residence, represented 84.0% of the consumer loan portfolio at December 31, 2006.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount. Consumer loans may entail greater credit risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or are secured by rapidly depreciable assets, such as automobiles or mobile homes. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various Federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. At December 31, 2006, $1.3 million of the consumer loan portfolio was non-performing. There can be no assurance that the amount of nonperforming loans will not increase in the future.

Commercial Business Lending. In order to satisfy the demand for financial services to individuals and businesses in its market area, the Company maintains a portfolio of commercial business loans primarily to retail, manufacturing operations and professional firms. The Company’s commercial business loans generally have terms ranging from six months to five years and may have either fixed or variable interest rates. The Company’s commercial business loans generally include personal guarantees and are usually, but not always, secured by

11

business assets such as inventory, equipment, leasehold interests in equipment, fixtures, real estate and accounts receivable. The underwriting process for commercial business loans includes consideration of the borrower’s financial statements, tax returns, projections of future business operations and inspection of the subject collateral, if any. The Company also purchases participation interests in commercial business loans originated outside of the Company’s market area from third party originators. These loans generally have underlying collateral of inventory or equipment and repayment periods of less than ten years.

Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her income, and which are secured by real property with more easily ascertainable value, commercial business loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself. Furthermore, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. At December 31, 2006, $394,000 of loans in the commercial business loan portfolio were non-performing. There can be no assurance that the amount of nonperforming loans will not increase in the future.

Originations, Purchases and Sales of Loans and Mortgage-Backed and Related Securities

Real estate loans are generally originated by the Company’s staff of salaried and commissioned loan officers. Loan applications are taken in all branch and loan production offices.

The Company originates both fixed and adjustable rate loans, however, its ability to originate loans is dependent upon the relative customer demand for loans in its markets. Demand for adjustable rate loans is affected by the interest rate environment. The Company originated for its portfolio $13.5 million of one-to-four family adjustable rate loans during 2006, an increase of $400,000, from $13.1 million in 2005, compared to $16.8 million in 2004. The Company also originated for its portfolio $14.7 million of fixed rate one-to-four family loans during 2006, an increase of $13.1 million, from $1.6 million for 2005, compared to $5.7 million for 2004.

During the past several years, the Company has focused its portfolio loan origination efforts on commercial real estate, commercial business and consumer loans because these loans have terms to maturity and adjustable interest rate characteristics that are generally more beneficial to the Company than single family fixed rate conventional loans. In 2006, more fixed rate single family loans were placed in portfolio in order to maintain the single family loan portfolio and to offset the decline in the commercial loan portfolio. The Company originated $292.0 million of multi-family and commercial real estate, commercial business and consumer loans (which excludes commercial real estate loans in construction or development) during 2006, an increase of $5.8 million, from originations of $286.2 million for 2005, compared to $204.4 million for 2004.

In order to supplement loan demand in the Company’s market area and geographically diversify its loan portfolio, the Company purchases participations in real estate loans from selected sellers, with yields based upon current market rates. The Company reviews and underwrites all loans purchased to ensure that they meet the Company’s underwriting standards and the seller generally continues to service the loans. The Company purchased $27.5 million of loans during 2006, a decrease of $4.8 million, from $32.3 million during 2005, compared to $91.8 million during 2004. The purchased commercial real estate and commercial business loans have terms and interest rates that are similar in nature to the Company’s originated commercial and business portfolio. Refer to Note 4 of the Notes to Consolidated Financial Statements in the Annual Report for more information on purchased loans (incorporated by reference in Item 8 of Part II of this Form 10-K).

The Company has some mortgage-backed and related securities that are held, based on investment intent, in the “available for sale” portfolio. The Company did not purchase or sell any mortgage-backed securities during 2006, 2005 or 2004. See – “Investment Activities.”

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The following table shows the loan and mortgage-backed and related securities origination, purchase, acquisition, sale and repayment activities of the Company for the periods indicated.

LOANS HELD FOR INVESTMENT

	Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Originations by type:
Adjustable rate:
Real estate -
- one-to-four family	$	13,493			13,064			16,840
- multi-family		0			258			2,391
- commercial		76,797			70,742			44,046
- construction or development		159,278			45,551			84,328
Non-real estate -
- consumer		11,607			12,964			13,822
- commercial business		94,603			91,697			50,467
Total adjustable rate		355,778			234,276			211,894
Fixed rate:
Real estate -
- one-to-four family		14,671			1,587			5,738
- multi-family		0			35			1,418
- commercial		31,635			41,534			17,544
- construction or development		5,691			10,144			38,731
Non-real estate -
- consumer		23,127			27,421			28,347
- commercial business		54,261			41,535			46,414
Total fixed rate		129,385			122,256			138,192
Total loans originated		485,163			356,532			350,086
Purchases:
Real estate -
- one-to-four family		0			130			0
- commercial		8,874			16,823			4,125
- construction or development		9,700			11,900			56,798
Non-real estate -
- commercial business		8,885			3,412			30,862
Total loans purchased		27,459			32,265			91,785
Sales, Participations and repayments:
Real estate -
- commercial		21,588			23,974			2,400
- construction or development		107,649			21,646			34,800
Non-real estate -
- consumer		2,416			1,248			0
- commercial business		15,912			8,813			9,000
Total sales		147,565			55,681			46,200
Transfers to (from) loans held for sale		5,994			7,373			(2,437	)
Principal repayments		373,953			320,869			300,407
Total reductions		527,512			383,923			344,170
Decrease in other items, net		(2,990	)		(3,190	)		(4,776	)
Net (decrease) increase	$	(17,880	)		1,684			92,925

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LOANS HELD FOR SALE

	Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Originations by type:
Adjustable rate:
Real estate -
- one-to-four family	$	1,400			1,389			851
- construction or development		0			0			225
Total adjustable rate		1,400			1,389			1,076
Fixed rate:
Real estate -
- one-to-four family		57,277			77,924			83,469
- construction or development		1,340			1,093			2,896
Total fixed rate		58,617			79,017			86,365
Total loans originated		60,017			80,406			87,441
Sales and repayments:
Real estate -
- one-to-four family		65,951			89,089			88,808
Total sales		65,951			89,089			88,808
Transfers to (from) loans held for investment		(5,994	)		(7,373	)		2,437
Total reductions		59,957			81,716			91,245
Net (increase) decrease	$	60			(1,310	)		(3,804	)

MORTGAGE-BACKED AND RELATED SECURITIES

	Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Purchases:
Mortgage-backed securities:
CMOs and REMICs (1)	$	0			0			0
Total purchases		0			0			0
Sales:
Mortgage-backed securities:
CMOs and REMICs		0			0			0
Total sales		0			0			0
Principal repayments		(702	)		(2,271	)		(3,898	)
Net decrease	$	(702	)		(2,271	)		(3,898	)

⁽¹⁾ Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits

Classified Assets and Delinquencies

Classification of Assets. Federal regulations require that each savings institution classify its assets on a regular basis. In addition, in connection with examinations of savings institutions, the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC) examiners may identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Assets classified as substandard have one or more defined weaknesses and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have the weaknesses of those classified as substandard, with additional characteristics that make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset on the balance sheet of the institution is not warranted. Assets classified as substandard or doubtful require the institution to establish prudent general allowances for loan losses. If an asset, or portion thereof, is classified as loss, the institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified as loss, or charge off such amount. If an institution does not agree with an OTS or FDIC examiner’s classification of an asset, it may appeal the determination to the OTS District Director or the

14

appropriate FDIC personnel, depending on the regulator. On the basis of management’s review of its assets, at December 31, 2006, the Bank classified a total of $15.6 million of its loans and other assets as follows:

	One-to-Four		Commercial and				Commercial		Other
(Dollars in thousands)	Family		Multi-family		Consumer		Business		Assets		Total
Substandard	$	946		11,387		142		551		1,422		14,448
Doubtful		0		0		1,112		0		44		1,156
Loss		0		0		0		0		0		0
Total	$	946		11,387		1,254		551		1,466		15,604

The Bank’s classified assets consist of non-performing loans and loans and other assets of concern discussed herein. As of the date of this report, these asset classifications are materially consistent with those of the OTS and FDIC.

Delinquency Procedures. When a borrower fails to make a required payment on a loan, the Company attempts to cure the delinquency by contacting the borrower. A late notice is sent on all loans over 16 days delinquent. Additional written and verbal contacts are made with the borrower between 30 and 60 days after the due date. If the loan is contractually delinquent 90 days, the Company sends a 30-day demand letter to the borrower and after the loan is contractually delinquent 120 days, institutes appropriate action to foreclose on the property. If foreclosed, the property is sold at a sheriff’s sale and may be purchased by the Company. Delinquent consumer loans are generally handled in a similar manner. The Company’s procedures for repossession and sale of consumer collateral are subject to various requirements under state consumer protection laws.

Real estate acquired by the Company as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate in judgment for six to twelve months and thereafter as real estate owned until it is sold. When property is acquired or expected to be acquired by foreclosure or deed in lieu of foreclosure, it is recorded at the lower of cost or estimated fair value, less the estimated cost of disposition. After acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of fair value less disposition cost.

The following table sets forth the Company’s loan delinquencies by loan type, amount and percentage of type at December 31, 2006.

	Loans Delinquent For:														Total Delinquent
	60-89 Days							90 Days and Over							Loans
					Percent							Percent							Percent
					of Loan							of Loan							of Loan
(Dollars in thousands)	Number		Amount		Category			Number		Amount		Category			Number		Amount		Category
One-to-four family real estate		3	$	327		0.24	%		4	$	946		0.71	%		7	$	1,273		0.95	%
Nonresidential		3		1,413		0.48			1		162		0.05			4		1,575		0.53
Consumer		8		178		0.20			6		1,254		1.40			14		1,432		1.60
Total		14	$	1,918		0.24	%		11	$	2,362		0.30	%		25	$	4,280		0.54	%

Investment Activities

The Company and the Bank utilize the available for sale securities portfolio in virtually all aspects of asset/liability management. In making investment decisions, the Investment-Asset/Liability Committee considers, among other things, the yield and interest rate objectives, the credit risk position, and the Bank’s liquidity and projected cash flow requirements.

Securities. Federally chartered savings institutions have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements and federal funds.

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Subject to various restrictions, the holding company of a federally chartered savings institution may also invest its assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly.

The investment strategy of the Company and the Bank has been directed toward a mix of high-quality assets (primarily government agency obligations) with short and intermediate terms to maturity. At December 31, 2006, the Company did not own any investment securities of a single issuer that exceeded 10% of the Company’s stockholder’s equity other than U.S. government agency obligations.

The Bank invests a portion of its liquid assets in interest-earning overnight deposits of the Federal Home Loan Bank of Des Moines (FHLB), other banks and money market mutual funds. Other investments include high grade medium-term (up to three years) federal agency notes, and a variety of other types of mutual funds that invest in adjustable rate, mortgage-backed securities, asset-backed securities, repurchase agreements and U.S. Treasury and agency obligations. The Company invests in the same type of investment securities as the Bank and also invests in taxable and tax exempt municipal obligations and corporate equities such as preferred and common stock. Refer to Note 3 of the Notes to Consolidated Financial Statements in the Annual Report for additional information regarding the Company’s securities portfolio (incorporated by reference in Item 8 of Part II of this Form 10-K).

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The following table sets forth the composition of the Company’s securities portfolio, excluding mortgage-backed and related securities, at the dates indicated.

	2006									2005										2004
	Amort		Adjusted		Market		% of			Amort		Adjusted			Market		% of			Amort		Adjusted			Market		% of
	Cost		To		Value		Total			Cost		To			Value		Total			Cost		To			Value		Total
Securities available for sale:
U.S. Government agency obligations	$	119,240		22		119,262		74.68	%	$	110,110		(971	)		109,139		71.61	%	$	91,371		(575	)		90,796		77.42	%
Municipal obligations		0		0		0		0.00			0		0			0		0.00			65		0			65		0.06
Corporate equity (1)		700		0		700		0.44			700		0			700		0.46			700		0			700		0.60
Preferred stock of federal agencies (1)		0		0		0		0.00			2,940		0			2,940		1.93			2,961		0			2,961		2.52
Subtotal		119,940				119,962		75.12			113,750					112,779		74.00			95,097					94,522		80.60
Federal Home Loan Bank stock		7,956				7,956		4.98			8,365					8,365		5.49			9,293					9,293		7.92
Total investment securities and Federal Home Loan Bank stock		127,896				127,918		80.10			122,115					121,144		79.49			104,390					103,815		88.52
Average remaining life of investment securities excluding Federal Home Loan Bank stock	1.1 years									0.7 years										1.5 years
Other interest earning assets:
Cash equivalents		31,776				31,776		19.90			31,269					31,269		20.51			13,467					13,467		11.48
Total	$	159,672				159,694		100.00	%	$	153,384					152,413		100.00	%	$	117,857					117,282		100.00	%
Average remaining life or term to repricing of investment securities and other interest earning assets, excluding Federal Home Loan Bank stock	0.8 years									0.5 years										1.3 years

⁽¹⁾ Average life assigned to corporate equity holdings and preferred stock of federal agencies is five years.

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The composition and maturities of the investment securities portfolio, excluding Federal Home Loan Bank stock, mortgage-backed and related securities, are indicated in the following table.

	December 31, 2006
				After 1			After 5
	1 Year			through 5			through 10			Over 10			No Stated
	or Less			Years			Years			Years			Maturity			Total Securities
	Amortized			Amortized			Amortized			Amortized			Amortized			Amortized			Adjusted			Market
(Dollars in thousands)	Cost			Cost			Cost			Cost			Cost			Cost			To			Value
Securities available for sale:
U.S. government agency securities	$	64,478			54,762			0			0			0			119,240			(22	)		119,262
Corporate equity		0			0			0			0			700			700			0			700
Total stock	$	64,478			54,762			0			0			700			119,940			(22	)		119,962
Weighted average yield (1)		4.87	%		5.09	%		0.00	%		0.00	%		7.80	%		4.99	%

⁽¹⁾   Yields are computed on a tax equivalent basis.

Mortgage-Backed and Related Securities. In order to supplement loan production and achieve its asset/liability management goals, the Company invests in mortgage-backed and related securities. All of the mortgage-backed and related securities owned by the Company are issued, insured or guaranteed either directly or indirectly by a federal agency or are rated “AA” or higher. The Company had $6.2 million of mortgage-backed and related securities classified as available for sale at December 31, 2006, compared to $6.9 million at December 31, 2005 and $9.2 million at December 31, 2004.

The contractual maturities of the mortgage-backed and related securities portfolio without any prepayment assumptions at December 31, 2006 are as follows:

													Dec. 31,
													2006
	5 Years			5 to 10			10 to 20			Over 20			Balance
(Dollars in thousands)	or Less			Years			Years			Years			Outstanding
Securities available for sale:
Federal Home Loan Mortgage Corporation	$	27			139			0			0			166
Government National Mortgage Association		0			10			0			0			10
Collateralized Mortgage Obligations		139			0			3,209			2,654			6,002
Total	$	166			149			3,209			2,654			6,178
Weighted average yield		6.58	%		7.12	%		3.69	%		4.00	%		3.96	%

At December 31, 2006, the Company did not have any non-agency mortgage-backed or related securities in excess of 10% of its stockholders’ equity.

Collateralized Mortgage Obligations (CMOs) are securities derived by reallocating the cash flows from mortgage-backed securities or pools of mortgage loans in order to create multiple classes, or tranches, of securities with coupon rates and average lives that differ from the underlying collateral as a whole. The terms to maturity of any particular tranche is dependent upon the prepayment speed of the underlying collateral as well as the structure of the particular CMO. Although a significant proportion of the Company’s CMOs are in tranches which have been structured (through the use of cash flow priority and support tranches) to give somewhat more predictable cash flows, the cash flow and hence the value of CMOs is subject to change.

At December 31, 2006, the Company had $22,000 invested in CMOs that have floating interest rates that change either monthly or quarterly, compared to $34,000 at December 31, 2005 and $52,000 at December 31, 2004.

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Mortgage-backed and related securities can serve as collateral for borrowings and, through sales and repayments, as a source of liquidity. In addition, mortgage-backed and related securities available for sale can be sold to respond to changes in economic conditions.

Sources of Funds

General. The Bank’s primary sources of funds are retail and brokered deposits, payments of loan principal, interest earned on loans and securities, repayments and maturities of securities, borrowings and other funds provided from operations.

Deposits. The Bank offers a variety of deposit accounts having a wide range of interest rates and terms. The Bank’s deposits consist of passbook, negotiable order of withdrawal (NOW), money market, non-interest bearing checking and certificate accounts (including individual retirement accounts) to retail and commercial business customers. The Bank relies primarily on competitive pricing policies and customer service to attract and retain these deposits.

The variety of deposit accounts offered by the Bank has allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. As customers have become more interest rate conscious, the Bank has become more susceptible to short-term fluctuations in deposit flows. The Bank manages the pricing of its deposits in keeping with its asset/liability management, profitability and growth objectives. Based on its experience, the Bank believes that its passbook and NOW accounts are relatively stable sources of deposits. However, the ability of the Bank to attract and maintain certificate deposits and money market accounts, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.

The following table sets forth the savings flows at the Bank during the periods indicated.

	Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Opening balance	$	731,537			698,902			551,688
Deposits		4,861,548			4,202,022			3,750,395
Withdrawals		(4,889,449	)		(4,185,251	)		(3,613,887	)
Interest credited		22,323			15,864			10,706
Ending balance		725,959			731,537			698,902
Net increase (decrease)	$	(5,578	)		32,635			147,214
Percent increase (decrease)		(0.76)	%		4.67	%		26.68	%

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The following table sets forth the dollar amount of deposits in the various types of deposit programs offered by the Bank as of December 31:

	2006					2005					2004
			Percent					Percent					Percent
(Dollars in thousands)	Amount		of Total			Amount		of Total			Amount		of Total
Transaction and Savings Deposits(1):
Non-interest checking	$	68,990		9.50	%	$	58,430		7.99	%	$	42,777		6.12	%
NOW Accounts – 2.54%(2)		87,074		12.00			101,942		13.94			95,294		13.63
Passbook Accounts – 1.37%(3)		40,445		5.57			84,858		11.60			47,416		6.78
Money Market Accounts – 3.31%(4)		178,694		24.61			96,947		13.25			129,098		18.47
Total Non-Certificates	$	375,203		51.68	%	$	342,177		46.78	%	$	314,585		45.00	%
Certificates:
0.00 - 0.99%	$	532		0.08	%	$	651		0.09	%	$	883		0.13	%
1.00 - 1.99%		157		0.02			5,846		0.80			62,833		8.99
2.00 - 2.99%		25,700		3.54			118,723		16.23			160,829		23.01
3.00 - 3.99%		126,409		17.41			211,019		28.84			108,938		15.59
4.00 - 4.99%		119,376		16.45			52,319		7.15			49,449		7.08
5.00 - 5.99%		78,582		10.82			797		0.11			1,266		0.20
6.00 - 6.99%		0		0.00			5		0.00			5		0.00
7.00 - 7.99%		0		0.00			0		0.00			114		0.00
Total Certificates		350,756		48.32			389,360		53.22			384,317		55.00
Total Deposits	$	725,959		100.00	%	$	731,537		100.00	%	$	698,902		100.00	%

(1)	Reflects rates paid on transaction and savings deposits at December 31, 2006.
(2)	The rate on NOW Accounts for 2005 was 2.08% and 2004 was 1.09%.
(3)	The rate on Passbook Accounts for 2005 was 2.04% and 2004 was 0.19%.
(4)	The rate on Money Market Accounts for 2005 was 2.59% and 2004 was 1.72%.

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The following table shows rate and maturity information for the Bank’s certificates of deposit as of December 31, 2006.

	0.00-			1.00-			2.00-			3.00-			4.00-			5.00-						Percent
(Dollars in thousands)	0.99%			1.99%			2.99%			3.99%			4.99%			5.99%			Total			of Total
Certificate accounts maturing in quarter ending:
March 31, 2007	$	56			141			5,678			38,353			20,822			1,283			66,333			18.91	%
June 30, 2007		45			11			4,816			29,699			28,546			2,781			65,898			18.79
September 30, 2007		75			3			6,125			23,117			21,642			13,465			64,427			18.36
December 31, 2007		42			0			1,974			11,771			25,483			48,266			87,536			24.96
March 31, 2008		34			0			884			3,584			4,170			5,756			14,428			4.11
June 30, 2008		20			0			620			3,221			2,910			2,053			8,824			2.52
September 30, 2008		9			0			1,070			3,634			2,589			3,706			11,008			3.14
December 31, 2008		17			0			1,444			8,238			1,516			258			11,473			3.27
March 31, 2009		1			0			1,301			427			1,447			39			3,215			0.92
June 30, 2009		5			0			933			500			1,267			254			2,959			0.84
September 30, 2009		5			0			104			1,137			1,407			271			2,924			0.83
December 31, 2009		11			2			103			850			1,012			299			2,277			0.65
Thereafter		212			0			648			1,878			6,565			151			9,454			2.70
Total	$	532			157			25,700			126,409			119,376			78,582			350,756			100.00	%
Percent of total		0.15	%		0.04	%		7.34	%		36.04	%		34.03	%		22.40	%		100.00	%

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          The following table indicates the amount of the Bank’s certificates of deposit and other deposits by time remaining until maturity as of December 31, 2006.

	Maturity
			Over		Over		Over
	3 Months		3 to 6		6 to 12		12
(Dollars in thousands)	or Less		Months		Months		Months		Total
Certificates of deposit less than $100,000	$	34,000		37,138		65,340		40,509		176,987
Certificates of deposit of $100,000 or more		31,452		27,965		81,885		26,050		167,352
Public funds less than $100,000(1)		238		74		291		3		606
Public funds of $100,000 or more(1)		643		721		4,447		0		5,811
Total certificates of deposit	$	66,333		65,898		151,963		66,562		350,756
Passbook of $100,000 or more	$	13,573		0		0		0		13,573
Accounts of $100,000 or more	$	45,668		28,686		86,332		26,050		186,736

⁽¹⁾ Deposits from governmental and other public entities.

For additional information regarding the composition of the Bank’s deposits, see Note 11 of the Notes to Consolidated Financial Statements in the Annual Report (incorporated by reference in Item 8 of Part II of this Form 10-K). For additional information on certificate maturities and the impact on the Company’s liquidity see “Management’s Discussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources” of the Annual Report (incorporated by reference in Item 7 of Part II of this Form 10-K).

Borrowings. The Bank’s other available sources of funds include advances from the FHLB and other borrowings. As a member of the FHLB, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances. Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB may prescribe the acceptable uses for these advances, as well as limitations on the size of the advances and repayment provisions. Consistent with its asset/liability management strategy, the Bank has utilized FHLB advances from time to time to fund loan demand and extend the term to maturity of its liabilities. The Bank also uses short-term FHLB borrowings to offset short term cash needs due to deposit outflows or loan fundings. At December 31, 2006, the Bank had $150.9 million of FHLB advances outstanding. On such date, the Bank had a collateral pledge arrangement with the FHLB of Des Moines pursuant to which the Bank may borrow up to an additional $13.3 million for liquidity purposes. Refer to Note 12 of the Notes to Consolidated Financial Statements in the Annual Report for more information on FHLB advances (incorporated by reference in Item 8 of Part II of this Form 10-K).

The Company had a $5.0 million revolving line of credit established with a bank that was not drawn at December 31, 2006.

Service Corporations of the Bank

As a federally chartered savings bank, the Bank is permitted by OTS regulations to invest up to 2% of its assets in the stock of, or loans to, service corporation subsidiaries, and may invest an additional 1% of its assets in service corporations where these additional funds are used for inner-city or community development purposes. In addition to investments in service corporations, federal institutions are permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities in which a federal savings bank may engage directly.

OIA is a Minnesota corporation that was organized in 1983 and operated as an insurance agency until 1986 when its assets were sold. OIA remained inactive until 1993 when it began offering credit life insurance, annuity and mutual fund products to the Bank’s customers and others.

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HFH was a wholly owned Delaware corporation that was formed in 2002, and had its principal office in Grand Cayman Islands. HFH was the holding company for HFREIT which invested in real estate loans acquired from the Bank. HFH and HFREIT were both dissolved in 2005.

The Bank owned an 80% interest in FTS, a Minnesota limited liability company formed in 2003 to operate a mortgage title services business located in Minnetonka, Minnesota. FTS stopped accepting title orders in the third quarter of 2004 and was dissolved.

Competition

The Bank faces strong competition both in originating real estate, commercial and consumer loans and in attracting deposits. Competition in originating loans comes primarily from mortgage bankers, commercial banks, credit unions and other savings institutions, which have offices in the Bank’s market area and those that operate through Internet banking operations throughout the United States. The Bank competes for loans principally on the basis of the interest rates and loan fees it charges, the types of loans it originates and the quality of services it provides to borrowers.

Competition for deposits is principally from mutual funds, securities firms, commercial banks, credit unions and other savings institutions located in the same communities and those that operate through Internet banking operations throughout the United States. The ability of the Bank to attract and retain deposits depends on its ability to provide an investment opportunity that satisfies the requirements of investors as to rate of return, liquidity, risk, convenience and other factors. The Bank competes for these deposits by offering a variety of deposit accounts at competitive rates, convenient business hours and a customer oriented staff.

Other Corporations Owned by the Company

HMN has one other wholly owned subsidiary, SFC, which acts as an intermediary for the Bank in transacting like kind property exchanges for Bank customers.

Employees

At December 31, 2006 the Company had a total of 223 employees, including part-time employees. None of the employees of the Company or its subsidiaries are represented by any collective bargaining unit. Management considers its employee relations to be good.

Regulation and Supervision

The banking industry is highly regulated. As a savings and loan holding company, the Company is subject to regulation by the Office of Thrift Supervision (OTS). The Bank, a federally-chartered savings association, is subject to extensive regulation and examination by the OTS, which is the Bank’s primary federal regulator. The FDIC also has some authority to regulate the Bank. Subsidiaries of the Company and the Bank may also be subject to state regulation and/or licensing in connection with certain insurance and investment activities. The Company and the Bank are subject to numerous laws and regulations. These laws and regulations impose restrictions on activities, set minimum capital requirements, impose lending and deposit restrictions and establish other restrictions. References in this section to applicable statutes and regulations are brief and incomplete summaries only. You should consult the statutes and regulations for a full understanding of the details of their operation. Changes in statutes, regulation or regulatory policies applicable to the Bank or the Company, including interpretation or implementation thereof, could have a material effect on the Company’s business.

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Holding Company Regulation

An entity that owns a savings association is a savings and loan holding company (SLHC). If a holding company owns more than one savings association, it is a multiple SLHC; if it owns only one savings association, it is a unitary SLHC. HMN is a unitary SLHC. The Home Owners Loan Act (HOLA) historically limited multiple SLHCs and their non-association subsidiaries to financial activities and services and to activities authorized for bank holding companies, but unitary SLHCs, in the past, were not subject to restrictions on the activities that could be conducted by holding companies or their affiliates.

In November of 1999 the Gramm-Leach-Bliley Act (the GLB Act) was signed into law. The GLB Act made significant changes to laws regulating the financial services industry. Changes included: (1) a new framework in which bank holding companies can own securities firms, insurance companies and other financial companies; (2) prohibitions on new unitary SLHCs from engaging in non-financial activities or affiliating with non-financial entities; (3) new consumer protections associated with the transfer and use of non-public personal information by financial institutions; and (4) modifications to the Federal Home Loan Bank System. Unitary SLHCs, such as HMN, that were in existence or had an application filed with the OTS on or before May 4, 1999, are not subject to the new restrictions on unitary SLHCs. As a result, the GLB Act did not affect HMN’s ability to control non-financial firms or engage in non-financial activities.

Acquisitions by Savings and Loan Holding Companies. Acquisition of a savings association or a savings and loan holding company is generally subject to OTS approval and the public must have an opportunity to comment on the proposed acquisition. Without prior approval from the OTS, HMN may not acquire, directly or indirectly, control of another savings association.

Examination and Reporting. Under HOLA and OTS regulations HMN, as a SLHC, must file periodic reports with the OTS. In addition, HMN must comply with OTS record keeping requirements and is subject to holding company examination by the OTS. The OTS may take enforcement action if the activities of a SLHC constitute a serious risk to the financial safety, soundness or stability of a subsidiary savings association.

Affiliate Transactions. The Bank, as a holding company subsidiary that is a depository institution, is subject to both qualitative and quantitative limitations on transactions with HMN and HMN’s other subsidiaries. See “Transactions with Affiliates and Insiders”.

Capital Adequacy. HMN is not currently subject to regulatory capital requirements, the Bank is subject to various capital requirements. See “Capital Requirements”.

Bank Regulation

As a federally-chartered savings association, the Bank is subject to regulation and supervision by the OTS. Federal law authorizes the Bank as a federal savings association, to conduct, subject to various conditions and limitations, business activities that include: accepting deposits and paying interest on them; making and buying loans secured by residential and other real estate; making a limited amount of consumer loans; making a limited amount of commercial loans; investing in corporate obligations, government debt securities, and other securities; and offering various banking, trust, securities and insurance agency services to its customers.

OTS regulations place limits on the Bank’s lending and investment powers. Savings associations are expected to conduct lending activities in a prudent, safe and sound manner. OTS regulations set aggregate limits on certain types of loans including commercial, commercial real estate, and consumer loans. OTS regulations also establish limits on loans to a single borrower. As of December 31, 2006, the Bank’s lending limit to one borrower was approximately $13.7 million. A federal savings association generally may not invest in noninvestment-grade debt

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securities. A federal savings association may establish subsidiaries to conduct any activity the association is authorized to conduct and may establish service corporation subsidiaries for limited preapproved activities.

Qualified Thrift Lender Test. Savings associations, including the Bank, must be qualified thrift lenders (QTLs). A savings association generally satisfies the QTL requirement if at least 65% of a specified asset base consists of things such as loans to small businesses and loans to purchase or improve domestic residential real estate. Savings associations may qualify as QTLs in other ways. Savings associations that do not qualify as QTLs are subject to significant restrictions on their operations. If the Bank fails to meet QTL requirements the Bank and HMN would face certain limitations, including limits on HMN’s ability to control non-financial firms. As of December 31, 2006, the Bank met the QTL test.

OTS Assessments. HOLA authorizes the OTS to charge assessments to recover the costs of examining savings associations, holding companies, and their affiliates. The assessment is done semi-annually. The OTS bases the assessment on three factors: 1) asset size; 2) condition; and 3) complexity of the institution. The Bank’s and Holding Company’s OTS assessments for the year ended December 31, 2006, were approximately $217,000.

Transactions with Affiliates and Insiders. Banks and savings associations are subject to affiliate and insider transaction restrictions. The restrictions prohibit or limit a savings association from extending credit to, or entering into certain transactions with affiliates, principal stockholders, directors and executive officers of the savings association and its affiliates. The term “affiliate” generally includes a holding company, such as HMN, and any company under common control with the savings association. Federal law limits transactions between the Bank and any one affiliate to 10% of the Bank’s capital and surplus and with all affiliates in the aggregate to 20%. In addition, the federal law governing unitary savings and loan holding companies prohibits the Bank from making any loan to any affiliate whose activity is not permitted for a subsidiary of a bank holding company. This law also prohibits the Bank from making any equity investment in any affiliate that is not its subsidiary. The Bank is currently in compliance with these requirements.

Dividend Restrictions. Federal law limits the ability of a depository institution, such as the Bank, to pay dividends or make other capital distributions. The Bank, as a subsidiary of a savings and loan holding company, must file a notice with the OTS before payment of a dividend or approval of a proposed capital distribution by its board of directors and must obtain prior approval from the OTS if it fails to meet certain regulatory conditions. The Bank declared and distributed dividends to HMN of $8.0 million in 2006.

Deposit Insurance

The FDIC insures the deposits of the Bank through the Deposit Insurance Fund (DIF). The DIF is funded by assessments of FDIC members such as the Bank. The FDIC applies a risk-based system for setting deposit insurance assessments. Under the risk-based assessment system, an institution’s insurance assessments vary according to the level of capital the institution holds and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the DIF, federal law requires the FDIC to establish assessment rates that will maintain DIF’s ratio of reserves to insured deposits at a ratio, determined by the FDIC, of between $1.15 and $1.50 per $100. During 2006, the assessment rate for deposits ranged from zero to 0.27 basis points on covered deposits. The Bank qualified for the lowest rate and thus paid $0 in 2006. In 2007, the assessment rate for deposits will range from 5 and 43 basis points for every $100 of qualifying deposits. Many financial institution will be eligible for a one-time credit against the 2007 assessment which will offset some, or all of the assessment. The Bank anticipates that it will be eligible for the one-time credit of $663,000.

In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against insured deposits to be paid to the Financing Corporation (FICO) to service FICO debt incurred in the 1980s. The FICO assessment rate is adjusted quarterly. In 2006 the Bank paid an assessment of approximately $92,000.

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Capital Requirements

The federal bank regulatory agencies, including the OTS, have a risk-based capital framework in place. The regulators use a combination of risk-based guidelines and leverage ratios to evaluate capital adequacy.

The following table sets forth the current regulatory requirement for capital ratios for savings associations as compared with the Bank’s capital ratios at December 31, 2006:

	Core or Tier 1 Capital to			Tangible			Core or Tier 1			Total Capital to
	Adjusted			Capital to			Capital to Risk-			Risk-Weighted
	Total Assets			Assets			Weighted Assets			Assets
Regulatory Minimum		3.00	%(1)		1.50	%		4.00	%		8.00	%
The Bank’s Actual		8.34	%		8.34	%		10.19	%		11.33	%

⁽¹⁾ Savings associations are required to maintain a leverage ratio of 4.00% or more to be considered adequately capitalized.

Capital Categories and Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) created a statutory framework that increased the importance of meeting applicable capital requirements. FDICIA established five capital categories: (1) well-capitalized; (2) adequately capitalized; (3) undercapitalized; (4) significantly undercapitalized; and (5) critically undercapitalized. The activities in which a depository institution may engage and regulatory responsibilities of federal bank regulatory agencies vary depending upon whether an institution is well-capitalized, adequately capitalized or under capitalized. Under capitalized institutions are subject to various restrictions such as limitations on dividends and growth. A depository institution’s category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure and certain other factors. The federal banking agencies (including the OTS) adopted regulations that implement this statutory framework. Under these regulations, an institution is generally treated as well-capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of core capital to risk-weighted assets is 6.00% or more, its ratio of core capital to adjusted total assets (leverage ratio) is 5.00% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and a leverage ratio of not less than 4.00%. Any institution that is neither well capitalized nor adequately capitalized will be considered undercapitalized. The Bank currently is considered well capitalized.

Other Regulations and Examination Authority

The FDIC has adopted regulations to protect the deposit insurance funds and depositors, including regulations governing the deposit insurance of various forms of accounts. Federal regulation of depository institutions is intended for the protection of depositors (and the BIF and the SAIF), and not for the protection of stockholders or other creditors. In addition, federal law requires that in any liquidation or other resolution of any FDIC-insured depository institution, claims for administrative expenses of the receiver and for deposits in U.S. branches (including claims of the FDIC as subrogee of the insured institution) shall have priority over the claims of general unsecured creditors.

The OTS may sanction any OTS-regulated bank that does not operate in accordance with OTS regulations, policies and directives. The FDIC has additional authority to terminate insurance of accounts, after notice and hearing, upon a finding that the insured institution is or has engaged in any unsafe or unsound practice that has not

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been corrected, is operating in an unsafe or unsound condition, or has violated any applicable law, regulation, rule, or order of or condition imposed by the FDIC.

Federal Home Loan Bank (FHLB) System

The Bank is a member of the FHLB of Des Moines, which is one of the 12 regional Federal Home Loan Banks (FHBs). The primary purpose of the FHBs is to provide funding to their saving association members in support of the home financing credit function of the members. Each FHB serves as a reserve or central bank for its members within its assigned region. FHBs are funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. FHBs make loans or advances to members in accordance with policies and procedures established by the board of directors of the FHB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Financing Board. All advances from an FHB are required to be fully secured by sufficient collateral as determined by the FHB. Long-term advances are required to be used for residential home financing and small business and agricultural loans.

As a member, the Bank is required to purchase and maintain stock in the FHLB of Des Moines. As of December 31, 2006, the Bank had $8.0 million in FHB stock, which was in compliance with this requirement. The Bank receives dividends on its FHB stock and over the past five calendar years dividends have averaged approximately 3.04% and averaged 3.83% in 2006.

Federal Reserve Regulation

Under Federal Reserve Board regulations, the Bank is required to maintain reserves against transaction accounts (primarily interest-bearing and noninterest-bearing checking accounts). Because reserves must generally be maintained in cash or in noninterest-bearing accounts, the effect of the reserve requirements is to increase an institution’s cost of funds. These regulations generally require that the Bank maintain reserves against net transaction accounts. The reserve levels are subject to adjustment by the Federal Reserve Board. A savings association, like other depository institutions maintaining reservable accounts, may, under certain conditions, borrow from the Federal Reserve Bank discount window.

Numerous other regulations promulgated by the Federal Reserve Board or the OTS affect the business operations of the Bank. These include regulations relating to privacy, equal credit access, electronic fund transfers, collection of checks, lending and savings disclosures, and availability of funds.

Community Reinvestment Act

The Community Reinvestment Act (CRA) requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of their delineated communities, including low-to moderate-income neighborhoods within those communities, while maintaining safe and sound banking practices. The regulatory agency assigns one of four possible ratings to an institution’s CRA performance and is required to make public an institution’s rating and written evaluation. The four possible ratings of meeting community credit needs are outstanding, satisfactory, needs improvement and substantial noncompliance. Under regulations that apply to all CRA performance evaluations after July 1, 1997, many factors play a role in assessing a financial institution’s CRA performance. The institution’s regulator must consider its financial capacity and size, legal impediments, local economic conditions and demographics, including the competitive environment in which it operates. The evaluation does not rely on absolute standards, and the institutions are not required to perform specific activities or to provide specific amounts or types of credit. The Bank maintains a CRA statement for public viewing, as well as an annual CRA highlights document. These documents describe the Bank’s credit programs and services, community outreach activities, public comments and other efforts to meet community credit needs. The Bank’s last CRA exam was September 28, 2004 and the Bank received a “Satisfactory” rating.

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Bank Secrecy Act

The Bank Secrecy Act (BSA) requires financial institutions to verify the identity of customers, keep records and file reports that are determined to have a high degree of usefulness in criminal, tax and regulatory matters, and to implement counter-money laundering programs and compliance procedures. The impact on Bank operations from the BSA depends on the types of customers served by the Bank.

EXECUTIVE OFFICERS

Officers are chosen by and serve at the discretion of the Board of Directors of the Company and the Bank. There are no family relationships among any of the directors or officers of the Company and the Bank. The business experience of each executive officer of both the Company and the Bank is set forth below.

Michael McNeil, age 59. Mr. McNeil has been a director of the Company since 1999, the President of the Company since 2000 and the Chief Executive Officer of the Company since 2004. Mr. McNeil has been the President and Chief Executive Officer of the Bank since 1999 and a director of the Bank since 1998. From April 1998 through December 1998, Mr. McNeil was the Senior Vice President of Business Development of the Bank. Prior to joining the Bank, Mr. McNeil was the President and a director of Stearns Bank, N.A. in St. Cloud, Minnesota from 1991 to 1998.

Jon J. Eberle, age 41. Mr. Eberle is Chief Financial Officer, Senior Vice President and Treasurer of the Company and the Bank. Mr. Eberle has held such positions since 2003. Prior to that he served as a Vice President since 2000 and as the Controller since 1998. From 1994 to 1998, he served as the Director of Internal Audit for the Company and the Bank.

Dwain C. Jorgensen, age 58. Mr. Jorgensen has served as Senior Vice President of Operations of the Company and the Bank since 1998. From 1989 to 1998, he served as Vice President, Controller and Chief Accounting Officer of the Company and the Bank. From 1983 to 1989, Mr. Jorgensen was an Assistant Vice President and Operations Officer for the Bank.

Susan K. Kolling, age 55. Ms. Kolling has been a director of the Company since 2001. Ms. Kolling served as a Vice President of the Bank from 1992 to 1994 and has served as a Senior Vice President of the Bank since 1995. In addition, from 1997 to 2003, Ms. Kolling was an owner of Kolling Family Corp. which does business as Valley Home Improvement, a retail lumber yard. Ms. Kolling became a director of Kolling Family Corp. in 2004.

Bradley C. Krehbiel, age 48. Mr. Krehbiel is Executive Vice President of the Bank, a position he has held since 2004. Mr. Krehbiel joined the Bank as Vice President of Business Banking in 1998. Prior to his employment at the Bank, Mr. Krehbiel held several positions in the financial services industry, including six years as a private banking consultant.

Available Information

The Company’s website is www.hmnf.com. The Company makes available, free of charge, through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as soon as reasonably practicable after it electronically files these materials with, or furnishes them to, the Securities and Exchange Commission (the SEC).

Members of the public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public

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Reference Room is available by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements and other information about us and other issuers that file electronically at www.sec.gov.

ITEM 1A. RISK FACTORS

Like all financial companies, the Company’s business and results of operations are subject to a number of risks, many of which are outside of the Company’s control. In addition to the other information in this report, readers should carefully consider that the following important factors, among others, could materially impact the Company’s business and future results of operations.

Changes in interest rates could negatively impact the Company’s results of operations.

The earnings of the Company are primarily dependent on net interest income, which is the difference between interest earned on loans and investments, and interest paid on interest-bearing liabilities such as deposits and borrowings. Interest rates are highly sensitive to many factors, including government monetary and fiscal policies and domestic and international economic and political conditions. Conditions such as inflation, recession, unemployment, money supply, government borrowing and other factors beyond management’s control may also affect interest rates. If the Company’s interest-earning assets mature, reprice or prepay more quickly than interest-bearing liabilities in a given period, a decrease in market interest rates could adversely affect net interest income. Likewise, if interest-bearing liabilities mature or reprice, or, in the case of deposits, are withdrawn by the accountholder, more quickly than interest-earning assets in a given period, an increase in market interest rates could adversely affect net interest income. Given the Company’s current mix of assets and liabilities, a declining interest rate environment would negatively impact the Company’s results of operations.

Fixed rate loans increase the Company’s exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing. Adjustable rate loans decrease the risks to a lender associated with changes in interest rates but involve other risks. As interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, and the increased payment increases the potential for default. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there is likely to be an increase in prepayment activity on loans as the borrowers refinance their loans at lower interest rates. Under these circumstances, the Company’s results of operations could be negatively impacted.

Changes in interest rates also can affect the value of loans, investments and other interest-rate sensitive assets including mortgage servicing rights, and the Company’s ability to realize gains on the sale or resolution of assets. This type of income can vary significantly from quarter-to-quarter and year-to-year based on a number of different factors, including the interest rate environment. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on loans may lead to an increase in non-performing assets and increased loan loss reserve requirements that could have a material adverse effect on the Company’s results of operations.

The Company has increased its commercial real estate loan originations, increasing the risk in its loan portfolio.

In order to enhance the yield and shorten the term-to-maturity of its loan portfolio, the Company has expanded its commercial real estate lending during recent years. Commercial real estate lending has increased as a percentage of the Company’s total loan portfolio from 23.9% at December 31, 2002 to 37.5% at December 31, 2006. Much of the increase in the Company’s commercial real estate portfolio over this period has been in land development loans. Commercial real estate loans generally, and especially land development loans, present a higher level of risk than loans secured by one-to-four family residences. This greater risk is due to several factors, including the

29

concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower’s ability to repay the loan may be impaired. In 2006, the Company charged off $7.4 million in commercial loans relating to a real estate and golf course development. If the Company’s commercial real estate loan portfolio fails to perform, the Company’s results of operations and financial condition could be adversely affected.

Changes in interest rates or prepayment speeds could negatively impact the value of capitalized mortgage servicing rights.

The capitalization, amortization and impairment of mortgage servicing rights are subject to significant estimates. These estimates are based upon loan types, note rates and prepayment speed assumptions. Changes in interest rates or prepayment speeds may have a material effect on the net carrying value of mortgage servicing rights. In a declining interest rate environment, prepayment speed assumptions will increase and result in an acceleration in the amortization of the mortgage servicing rights as the assumed underlying portfolio declines and also may result in impairment as the value of the mortgage servicing rights declines.

Regional economic changes in the Company’s markets could adversely impact results from operations.

Like all banks, the Company is subject to the effects of any economic downturn, and in particular a significant decline in home values or reduced commercial development in the Company’s markets could have a negative effect on results of operations. The Company’s success depends primarily on the general economic conditions in the counties in which the Company conducts business, and in the southern Minnesota and northern Iowa area in general. Unlike larger banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the southern Minnesota counties of Fillmore, Freeborn, Houston, Mower, Olmsted and Winona and portions of Steele, Dodge, Goodhue and Wabasha counties, as well as Marshall and Tama counties in Iowa. The local economic conditions in these market areas have a significant impact on the Company’s ability to originate loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in the general economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control would affect these local economic conditions and could adversely affect the Company’s financial condition and results of operations. Additionally, because the Company has a significant amount of commercial real estate loans, decreases in tenant occupancy may also have a negative effect on the ability of many of the Company’s borrowers to make timely repayments of their loans, which would have an adverse impact on the Company’s earnings. A significant decline in home values would likely lead to increased delinquencies and defaults in both the consumer home equity loan and residential real estate loan portfolios and result in increased losses in these portfolios.

New or revised tax, accounting and other laws, regulations, rules and standards could significantly impact strategic initiatives, results of operations and financial condition.

The financial services industry is highly regulated and laws and regulations may sometimes impose significant limitations on operations. These limitations, and sources of potential liability for the violation of such laws and regulations, are described in Item 1 of Part I of this report under the heading “Business — Regulation and Supervision.” These regulations, along with the currently existing tax and accounting laws, regulations, rules and standards, control the methods by which financial institutions conduct business; implement strategic initiatives, as well as past, present, and contemplated tax planning; and govern financial disclosures. These laws, regulations, rules, and standards are constantly evolving and may change significantly over time. The nature, extent, and timing of the adoption of significant new laws, changes in existing laws, or repeal of existing laws may have a

30

material impact on the Company’s results of operations and financial condition, the effects of which are impossible to predict at this time.

In January 2007, the Company received notification that the Minnesota Department of Revenue was proposing adjustments of $2.2 million to the Company’s 2002 through 2004 Minnesota state tax liability. The proposed adjustments relate to the tax treatment of the inter-company dividends paid to the Bank by Home Federal Holding. The Company intends to challenge the proposed adjustments. A tax exposure reserve has been established based on a range of probable outcomes, however, the final liability may exceed the amount of the reserve. If the final resolution of the proposed adjustment exceeds the tax exposure reserve established by the Company, the Company’s results of operations could be adversely affected.

The extended disruption of vital infrastructure could negatively impact the Company’s results of operations and financial condition.

The Company’s operations depend upon, among other things, its technological and physical infrastructure, including its equipment and facilities. Extended disruption of its vital infrastructure by fire, power loss, natural disaster, telecommunications failure, computer hacking and viruses, terrorist activity or the domestic and foreign response to such activity, or other events outside of the Company’s control, could have a material adverse impact either on the financial services industry as a whole, or on the Company’s business, results of operations, and financial condition.

Strong competition within the Company’s market area may limit profitability.

The Company faces significant competition both in attracting deposits and in the origination of loans, as described under the heading “Business — Competition.” Mortgage bankers, commercial banks, credit unions and other savings institutions, which have offices in the Bank’s market area have historically provided most of the Company’s competition for deposits; however, the Company also competes with financial institutions that operate through Internet banking operations throughout the United States. In addition, and particularly in times of high interest rates, the Company faces additional and significant competition for funds from money market and mutual funds, securities firms, commercial banks, credit unions and other savings institutions located in the same communities and those that operate through Internet banking operations throughout the United States. Many competitors have substantially greater financial and other resources than the Company. Moreover, the Company may face increased competition in the origination of loans if competing thrift institutions convert to stock form, because such converting thrifts would likely seek to invest their new capital into loans. Finally, credit unions do not pay federal or state income taxes and are subject to fewer regulatory constraints than savings banks and as a result, they may enjoy a competitive advantage over the Company. The Bank competes for loans principally on the basis of the interest rates and loan fees it charges, the types of loans it originates and the quality of services it provides to borrowers. This advantage places significant competitive pressure on the prices of loans and deposits.

Loss of large checking and money market deposit customers could increase cost of funds and have a negative effect on results of operations.

The Company has a number of large deposit customers that maintain balances in checking and money market accounts at the Bank. The ability to attract these types of deposits has a positive effect on the Company’s net interest margin as they provide a relatively low cost of funds to the Company compared to certificates of deposits or advances. If these depositors were to withdraw these funds and the Bank were not able to replace them with similar types of deposits, the Banks cost of funds would increase and the Company’s results of operation would be negatively impacted.

This report, other reports filed by the Company with the Securities and Exchange Commission, and the Company’s proxy statement may contain “forward-looking” statements that deal with future results, plans or

31

performance. In addition, the Company’s management may make such statements orally to the media, or to securities analysts, investors or others. Forward-looking statements deal with matters that do not relate strictly to historical facts. Words such as “anticipate”, “believe”, “expect”, “intend”, “would”, “could” and similar expressions, as they relate to us, are intended to identify such forward-looking statements. The Company’s future results may differ materially from historical performance and forward-looking statements about the Company’s expected financial results or other plans are subject to a number of risks and uncertainties. These include but are not limited to possible legislative changes and adverse economic, business and competitive developments such as shrinking interest margins; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government; changes in credit and other risks posed by the Company’s loan and investment portfolios; changes in loan repayment and prepayment patterns; changes in loan terms and conditions; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation or other significant uncertainties.

Because of the limited size of the Company, losses on a few large loans or lending relationships can cause significant volatility in earnings.

Due to the Company’s limited size, individual loan values can be large relative to the Company’s earnings for a particular period. If one or a few relatively large loans become non-performing in a period and the Company is required to increase its loss reserves, or to write off principal or interest relative to such loans, the operating results of that period could be significantly adversely affected. The effect on results of operations for any given period from a change in the performance of a small number of loans may be disproportionately larger than the impact of such loans on the quality of the Company’s overall loan portfolio. In each of the third and fourth quarters of 2006, the Company incurred losses on individual loans or lending relationships that significantly impacted operating results for the relevant periods.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

The Company leases the corporate office in Rochester, Minnesota and owns the buildings and land for 9 of its 12 full service branches. The remaining three full service branches are leased, as well as the Eagle Crest Capital Bank locations. The Bank uses all properties and they are all located in Minnesota, except for two full service branches located in Iowa.

ITEM 3. LEGAL PROCEEDINGS

From time to time, the Bank and the Company are involved as plaintiff or defendant in various legal proceedings arising in the normal course of its business. While the ultimate outcome of these various legal proceedings cannot be predicted with certainty, it is the opinion of management that the resolution of these legal actions should not have a material effect on the Company’s consolidated financial condition or results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

32

PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The information on page 20 under the caption “Dividends”, page 42 in paragraphs 1, 2, 3, 5 and 6 under the caption “Note 17 Stockholders’ Equity”, and page 52 under the caption “Common Stock Information” and the inside back cover page of the Annual Report to Security Holders for the year ended December 31, 2006 is incorporated herein by reference.

Set forth below is information concerning purchases of the Company’s common stock made by or on behalf of the Company during the quarter ended December 31, 2006:

					(c) Total Number
					of Shares (or		(d) Maximum Number (or
			(b) Average		Units) Purchased		Approximate Dollar Value) of
	(a) Total Number of		Price Paid per		as Part of Publicly		Shares (or Units) that May
	Shares (or Units)		Share (or		Announced Plans		Yet Be Purchased Under the
Period	Purchased		Unit)		or Programs		Plans or Programs
October 1 through October 31, 2006		30,000	$	33.55		30,000		82,000
November 1 through November 30, 2006		0		0		0		82,000
December 1 through December 31, 2006		0		0		0		82,000
Total		30,000	$	33.55		30,000

On February 24, 2004, the Company announced a program to repurchase up to 350,000 shares of the Company’s common stock. As of December 31, 2006, there were 82,000 shares authorized for repurchase under the stock repurchase program, which was set to expire on February 25, 2007. On January 23, 2007, the Company’s Board of Directors extended the stock repurchase program to July 23, 2008 and increased the number of shares authorized for future repurchases to 300,000 shares.

STOCKHOLDER RETURN PERFORMANCE PRESENTATION

The following graph compares the total cumulative stockholders’ return on the Company’s Common Stock to the NASDAQ U.S. Stock Index (“NASDAQ Composite”), which includes all NASDAQ traded stocks of U.S. companies, the SNL Bank NASDAQ Index, and the SNL Securities Midwest Thrift Index (the “SNL Midwest Index”), which includes publicly traded financial institutions located in selected Midwestern states with assets of $500 million to $1 billion, for the period of December 31, 2001 through December 31, 2006. Those Midwestern states include Indiana, Minnesota, Missouri, Ohio and South Dakota. The graph assumes that $100 was invested on December 31, 2001 and that all dividends were reinvested. The index was changed from the customized SNL Midwest Index to the SNL Bank NASDAQ Index in 2006 as the SNL Bank NASDAQ Index is more readily available.

33

Total Return Performance

	Period Ending
Index	12/31/01		12/31/02		12/31/03		12/31/04		12/31/05		12/31/06
HMN Financial, Inc.		100.00		113.02		169.52		237.34		218.57		263.24
NASDAQ Composite		100.00		68.76		103.67		113.16		115.57		127.58
SNL Bank NASDAQ Index		100.00		102.85		132.76		152.16		147.52		165.62
SNL Midwest Index		100.00		126.11		171.38		193.64		193.66		195.18

ITEM 6. SELECTED FINANCIAL DATA

The information on page 5 under the caption “Five Year Consolidated Financial Highlights” of the Annual Report to Security Holders for the year ended December 31, 2006 is incorporated herein by reference.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information on pages 6 through 23 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, other than the section captioned “Market Risk”, of the Annual Report to Security Holders for the year ended December 31, 2006 is incorporated herein by reference.

34

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The information on pages 21 through 23 under the captions “Market Risk” and “Asset/Liability Management” of the Annual Report to Security Holders for the year ended December 31, 2006 is incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements (including the notes to the financial statements) on pages 24 through 48, other than the sections captioned “Other Financial Data” and “Common Stock Information”, of the Annual Report to Security Holders for the year ended December 31, 2006 is incorporated herein by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. An evaluation was carried out under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have 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 SEC rules and forms.

Management’s Annual Report on Internal Control over Financial Reporting. The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Internal control over financial reporting includes those policies and procedures that pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are only being made in accordance with authorizations of management and directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

Any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of a control system inherently has limitations, and the benefits of controls must be weighed against their costs. Additionally, controls can be circumvented by the individual acts of some persons by collusion of two or more people, or by management override of the control. Therefore, no assessment of a cost-effective system of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, will be detected.

Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of

35

Sponsoring Organizations of the Treadway Commission. Based on the Company’s evaluation under this framework, the Company’s management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2006.

Attestation Report of the Registered Public Accounting Firm. Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report that follows:

Report of Independent Registered Public Accounting Firm

The Board of Directors
HMN Financial, Inc.:

We have audited management’s assessment, included in the accompanying “Management’s Annual Report on Internal Control over Financial Reporting”, that HMN Financial, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). HMN Financial, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that HMN Financial, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, HMN Financial, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal

36

Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of HMN Financial Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated March 1, 2007 expressed an unqualified opinion on those consolidated financial statements.

KPMG LLP

Minneapolis, Minnesota
March 1, 2007

Changes in internal controls. No change in the Company’s internal control over financial reporting was identified in connection with the evaluation required by Rule 13a-15(d) of the Exchange Act that occurred during the period covered by this report and that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item is incorporated by reference from the information under the caption “Executive Officers” in Part I of this report and under the captions “Director Nominees,” “Directors continuing in office after Annual Meeting,” “Directors Emeritus,” “Board Meetings and Committees” (excluding any information not related to the audit committee) and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Company’s fiscal year ended December 31, 2006.

The Company has adopted a Code of Ethics that applies to its principal executive officer, principal financial and accounting officer, controller and other persons performing similar functions. The Company has posted the Code of Ethics on its website located at www.hmnf.com. The Company intends to post on its website any amendment to, or waiver from, a provision of the Code of Ethics that applies to its principal executive officer, principal financial and accounting officer, controller or other persons performing similar functions within five business days following the date of such amendment or waiver.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated by reference from the information under the caption “Executive Compensation” (excluding information under caption “Compensation Committee Report on Executive Compensation”), “Compensation Committee Interlocks and Insider Participation” and “Director Compensation”

37

in the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Company’s fiscal year ended December 31, 2006.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item is incorporated by reference from the information under the captions “Security Ownership of Management and Certain Beneficial Owners” in the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Company’s fiscal year ended December 31, 2006.

The following table provides information as of December 31, 2006 for compensation plans under which equity securities may be issued.

	(a)		(b)		(c)
	Number of Securities to be		Weighted-average		Number of securities remaining
	issued upon exercise of		exercise price of		available for future issuance under
	outstanding options,		outstanding options,		equity compensation plans (excluding
Plan Category	warrants and rights		warrants and rights		securities reflected in column (a)) (1)
Equity compensation plans approved by stockholders		356,181	$	16.55		154,127
Equity compensation plans not approved by stockholders		0		0		0
Total		356,181	$	16.55		154,127

⁽¹⁾ Includes securities available for future issuance under stockholder approved compensation plans other than upon the exercise of an option, warrant or right, as follows: 154,127 shares under the Company’s 2001 Omnibus Stock Plan.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated by reference from the information under the captions “Certain Transactions” in the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Company’s fiscal year ended December 31, 2006.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item is incorporated by reference from the information under the caption “Independent Auditor Fees” in the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Company’s fiscal year ended December 31, 2006.

38

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

1. Financial Statements

The following financial statements appearing in the Company’s Annual Report to Security Holders for the year ended December 31, 2006, are incorporated herein by reference.

	Pages in
Annual Report Section	2006 Annual Report
Consolidated Balance Sheets —
December 31, 2006 and 2005		24
Consolidated Statements of Income —
Each of the Years in the Three-Year Period Ended December 31, 2006		25
Consolidated Statements of Stockholders’ Equity and Comprehensive Income —
Each of the Years in the Three-Year Period Ended December 31, 2006		26
Consolidated Statements of Cash Flows —
Each of the Years in the Three-Year Period Ended December 31, 2006		27
Notes to Consolidated Financial Statements		28
Report of Independent Registered Public Accounting Firm		49

2. Financial Statement Schedules

All financial statement schedules have been omitted as this information is not required under the related instructions, is not applicable or has been included in the Notes to Consolidated Financial Statements.

39

3. Exhibits

Exhibit
Number	Exhibit
3.1	Amended and Restated Certificate of Incorporation (1)
3.2	Amended and Restated By-laws (2)
4	Form of Common Stock Certificate (3)
10.1†	Change in Control Agreement with Michael McNeil dated as of March 1, 2004(4)
10.2†	Employment Agreement with Michael McNeil dated as of January 1, 2002 (5)
10.3†	Form of Change in Control Agreement with executive officers (6)
10.4†	Directors Deferred Compensation Plan (7)
10.5†	Amended and Restated HMN Financial, Inc. Stock Option and Incentive Plan dated July 29, 1998 (8)
10.6†	HMN Financial, Inc. 2001 Omnibus Stock Plan (9)
10.7†	Form of Incentive Stock Option Agreement for HMN Financial, Inc. 2001 Omnibus Stock (10)
10.8†	Form of Non-Statutory Stock Option Agreement for HMN Financial, Inc. 2001 Omnibus Stock (11)
10.9†	Form of Restricted Stock Agreement for HMN Financial, Inc. 2001 Omnibus Stock*
10.10†	Description of Michael McNeil 2007 Bonus Plan (12)
13	Portions of Annual Report to Security Holders incorporated by reference*
14	Code of Business Conduct and Ethics(13)
21	Subsidiaries of Registrant*
23	Consent of KPMG LLP*
24	Powers of Attorney (included with signatures to this Annual Report on Form 10-K)*
31.1	Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer*
31.2	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer*
32	Section 1350 Certifications*

†	Management contract or compensatory arrangement
*	Filed herewith
1	Incorporated by reference to Exhibit 3(a) 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 3 to the Company’s Current Report on Form 8-K dated February 22, 2005, filed on February 23, 2005 (File No. 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).
4	Incorporated by reference to Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the period ending December 31, 2004 (File No. 0-24100).
5	Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002 (File No. 0-24100).
6	Incorporated by reference to Exhibit 10 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004 (File No. 0-24100).

40

7	Incorporated by reference to the same numbered exhibit to the Company’s Annual Report on Form 10-K for the period ended December 31, 1994 (File No. 0-24100).
8	Incorporated by reference to Exhibit 10.1(b) to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1998 (File No. 0-24100).
9	Incorporated by reference to Exhibit B to the Company’s Proxy Statement for its Annual Meeting of Stockholders held on April 24, 2001 (File no. 0-24100).
10	Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2004 (File No. 0-24100).
11	Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2004 (File No. 0-24100).
12	Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 22, 2007, filed on January 26, 2007 (File No. 0-24100).
13	Incorporated by reference to Exhibit 14 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2005 (File No. 0-24100).

41

SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 1, 2007	By:	/s/ Michael McNeil
		Michael McNeil,
		President and Chief Executive Officer

     Each of the undersigned hereby appoints Michael McNeil and Jon J. Eberle, and each of them (with full power to act alone), as attorneys and agents for the undersigned, with full power of substitution, for and in the name, place and stead of the undersigned, to sign and file with the Securities and Exchange Commission under the Securities Act of 1934, as amended, any and all amendments and exhibits to this Annual Report on Form 10-K and any and all applications, instruments, and other documents to be filed with the Securities and Exchange Commission pertaining to this Annual Report on Form 10-K or any amendments thereto, with full power and authority to do and perform any and all acts and things whatsoever requisite and necessary or desirable. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated on March 1, 2007.

Name	Title
/s/ Michael McNeil	President, Chief Executive Officer and
Michael McNeil	Director (Principal Executive Officer)
	Senior Vice President,
/s/ Jon J. Eberle	Chief Financial Officer and Treasurer
Jon J. Eberle	(Principal Financial and Accounting Officer)
/s/ Timothy R. Geisler	Chairman of the Board
Timothy R. Geisler
/s/ Allan R. DeBoer	Director
Allan R. DeBoer
/s/ Duane D. Benson	Director
Duane D. Benson
/s/ Michael J. Fogarty	Director
Michael J. Fogarty
/s/ Karen L. Himle	Director
Karen L. Himle
/s/ Susan K. Kolling	Director
Susan K. Kolling
/s/ Malcolm W. McDonald	Director
Malcolm W. McDonald
/s/ Mahlon C. Schneider	Director
Mahlon C. Schneider

42

INDEX TO EXHIBITS

Exhibit
Number	Exhibit	Filing Status
3.1	Amended and Restated Certificate of Incorporation	Incorporated by Reference
3.2	Amended and Restated By-laws	Incorporated by Reference
4	Form of Common Stock Certificate	Incorporated by Reference
10.1	Change in Control Agreement with Michael McNeil dated as of March 1, 2004	Incorporated by Reference
10.2	Employment Agreement with Michael McNeil dated as of January 1, 2002	Incorporated by Reference
10.3	Form of Change in Control Agreement with executive officers	Incorporated by Reference
10.4	Directors Deferred Compensation Plan	Incorporated by Reference
10.5	Amended and Restated HMN Financial, Inc. Stock Option and Incentive Plan dated July 29, 1998	Incorporated by Reference
10.6	HMN Financial, Inc. 2001 Omnibus Stock Plan	Incorporated by Reference
10.7	Form of Incentive Stock Option Agreement for HMN Financial, Inc. 2001 Omnibus Stock	Incorporated by Reference
10.8	Form of Non-Statutory Stock Option Agreement for HMN Financial, Inc. 2001 Omnibus Stock	Incorporated by Reference
10.9	Form of Restricted Stock Agreement for HMN Financial, Inc. 2001 Omnibus Stock	Filed Electronically
10.10	Description of Michael McNeil 2007 Bonus Plan	Incorporated by Reference
13	Portions of Annual Report to Security Holders incorporated by reference	Filed Electronically
14	Code of Business Conduct and Ethics	Incorporated by Reference
21	Subsidiaries of Registrant	Filed Electronically
23	Consent of KPMG LLP	Filed Electronically
24	Powers of Attorney	Included with Signatures
31.1	Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer	Filed Electronically
31.2	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer	Filed Electronically
32	Section 1350 Certifications	Filed Electronically

43

EX-10.9

Exhibit 10.9

HMN FINANCIAL, INC.
2001 OMNIBUS STOCK PLAN

Restricted Stock Agreement

Name of Employee:
No. of Shares Covered:	Date of Issuance:
Vesting Schedule pursuant to Section 4:
Vesting Date(s)	No. of Shares Which Become Vested as of Such Date

This is a Restricted Stock Agreement (“Agreement”) between HMN Financial, Inc., a Delaware corporation (the “Company”), and the above-named employee of the Company (the “Employee”).

Recitals

     WHEREAS, the Company maintains the HMN Financial, Inc. 2001 Omnibus Stock Plan (the “Plan”);

     WHEREAS, the Board of Directors of the Company has appointed the Compensation Committee (the “Committee”) with the authority to determine the awards to be granted under the Plan; and

     WHEREAS, the Committee or its designee has determined that the Employee is eligible to receive an award under the Plan in the form of restricted stock and has set the terms thereof;

     NOW, THEREFORE, the Company and the Employee mutually agree as follows.

Terms and Conditions*

* Unless the context indicates otherwise, terms that are not defined in this Agreement shall have the meaning set forth in the Plan as it currently exists or as it is amended in the future.

1. Issuance of Restricted Shares.

(a)

Subject to the terms and conditions of this Agreement, the Company has granted to the Employee the number of Shares specified at the beginning of this Agreement. Such Shares are subject to the restrictions provided for in this Agreement and are referred to collectively as the “Restricted Shares” and each as a “Restricted Share.” The term “Restricted Shares” also refers to all securities received by the Employee in replacement of or in connection with the Restricted Shares acquired hereby pursuant to a recapitalization, reclassification, stock dividend, stock split, stock combination or other relevant event.

(b)

Each Restricted Share will be registered, as a share subject to transfer restrictions and forfeiture, in the name of the Employee on the stock register maintained by the transfer agent of the Company (the “Transfer Agent”), and upon the written request of the Employee, will be evidenced by a duly issued stock certificate (which may represent more than one Restricted Share). The Employee will have all rights of a stockholder of the Company with respect to each Restricted Share (including the right to receive dividends and other distributions, if any). However, all restrictions provided for in this Agreement will apply to each Restricted Share and to any other securities distributed with respect to such Restricted Share. No Restricted Share may be sold, transferred, pledged, hypothecated or otherwise encumbered or disposed of until such Restricted Share has vested in the Employee in accordance with all terms and conditions of this Agreement. Each Restricted Share will remain restricted and subject to forfeiture to the Company unless and until such Restricted Share has vested in the Employee in accordance with all of the terms and conditions of this Agreement. Any stock certificate evidencing any Restricted Share may contain such legends and stock transfer instructions or limitations as may be determined or authorized by the Company in its sole discretion. The Company may, in its sole discretion, retain custody of any such certificate throughout the period during which any restrictions are in effect and require, as a condition to issuing any such certificate, that the Employee tender to the Company a stock power duly executed in blank relating to such custody.

2. Forfeiture and Transfer Restrictions.

(a) Forfeiture. If (i) the Employee’s employment with the Company, or a parent or subsidiary thereof, is terminated for any reason, whether by the Company with or without cause, voluntarily or involuntarily by the Employee or otherwise, or (ii) the Employee attempts to transfer or otherwise dispose of any of the Restricted Shares or the Restricted Shares become subject to attachment or any similar involuntary process, in violation of this Agreement, then any Restricted Shares that have not previously vested will be forfeited by the Employee to the Company, the Employee will thereafter have no right, title or interest whatsoever in such Restricted Shares. The Company unilaterally may instruct the Transfer Agent to adjust the stock register of the Company to reflect the forfeiture of any Restricted Shares. If the

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Company does not have custody of any and all certificates representing Restricted Shares so forfeited, the Employee must immediately return to the Company any and all certificates representing Restricted Shares so forfeited. Additionally, the Employee must deliver to Company a stock power duly executed in blank relating to any and all certificates representing Restricted Shares forfeited to the Company in accordance with the previous sentence or, if such stock power has previously been tendered to the Company, the Company will be authorized to deem such previously tendered stock power delivered, and the Company will be authorized to cancel any and all certificates representing Restricted Shares so forfeited and issue and deliver to the Employee a new certificate for any Shares which vested prior to forfeiture. For purposes of this Agreement, neither the transfer of the Employee between any combination of the Company and its Affiliates, nor a leave of absence granted to the Employee by the Company, shall be deemed a termination of employment.

(b)

Limitation on Transfer. Until such time as the Restricted Shares have become vested under Section 3 of this Agreement, the Employee shall not transfer the Restricted Shares and the Restricted Shares shall not be subject to pledge, hypothecation, execution, attachment or similar process. Any attempt to assign, transfer, pledge, hypothecate or otherwise dispose of any Restricted Shares contrary to the provisions hereof, and any attempt to levy any attachment or pursue any similar process with respect to them, shall be null and void.

3.	Vesting. The Restricted Shares shall cease to be subject to forfeiture under Section 2 hereof in the numbers and on the dates specified in the vesting schedule at the beginning of this Agreement; provided, however, that the Restricted Shares shall immediately cease to be subject to forfeiture under Section 2 hereof upon the occurrence of a “Fundamental Change” (as such term is defined in the Plan) with respect to the Company. Restricted Shares that have so ceased to be subject to forfeiture are sometimes referred to as “vested” or as “Vested Shares” in this Agreement.
	Death or Disability. If the Employee’s employment with the Company or an Affiliate terminates because of death or disability, the number of shares that are subject to forfeiture under this Agreement shall be prorated for the portion of the term of this award during which the Participant was employed by the Company and its Affiliates, and, with respect to such Restricted Shares, shall be Vested Shares. Any Restricted Shares which do not become vested under the preceding sentence shall terminate at the date of the Employee’s termination of employment and such Restricted Shares shall be forfeited to the Company.
4.	Stockholder Rights. As of the date of issuance specified at the beginning of this Agreement, the Employee shall have all of the rights of a stockholder of the Company with respect to the Restricted Shares, except as otherwise specifically provided in this Agreement.
5.	Tax Withholding. The parties hereto recognize that the Company or a subsidiary of the Company may be obligated to withhold federal and state taxes or other taxes upon the vesting of the Restricted Shares, or, in the event that the Employee elects under Code Section

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83(b) to report the receipt of the Restricted Shares as income in the year of receipt, upon the Employee’s receipt of the Restricted Shares. The Employee agrees that, at such time, if the Company or a subsidiary is required to withhold such taxes, the Employee will promptly pay, in cash upon demand to the Company or the subsidiary having such obligation, such amounts as shall be necessary to satisfy such obligation. The Employee further acknowledges that the Company has directed the Employee to seek independent advice regarding the applicable provisions of the Code, the income tax laws of any municipality, state or foreign country in which the Employee may reside, and the tax consequences of the Employee’s death.

6.

Restrictive Legends and Stop-Transfer Orders.

(a) Legends. Any certificate or certificates representing the Restricted Shares shall bear the following legend (as well as any legends required by applicable state and federal corporate and securities laws) noting the existence of the restrictions set forth in this Agreement:

“THE SHARES REPRESENTED BY THIS CERTIFICATE MAY BE TRANSFERRED ONLY IN ACCORDANCE WITH THE TERMS OF A RESTRICTED STOCK AGREEMENT BETWEEN THE COMPANY AND THE EMPLOYEE, A COPY OF WHICH IS ON FILE WITH THE SECRETARY OF THE COMPANY.”

(b)

Stop-Transfer Notices. The Employee agrees that, in order to ensure compliance with the restrictions referred to herein, the Company may issue appropriate “stop transfer” instructions to its transfer agent, if any, and that, if the Company transfers its own securities, it may make appropriate notations to the same effect in its own records.

(c)

Refusal to Transfer. The Company shall not be required (i) to transfer on its books any Restricted Shares that have been sold or otherwise transferred in violation of any of the provisions of this Agreement or (ii) to treat as owner of the Restricted Shares or to accord the right to vote or pay dividends to any purchaser or other transferee to whom the Restricted Shares shall have been so transferred.

7.

Interpretation of This Agreement. All decisions and interpretations made by the Committee with regard to any question arising hereunder or under the Plan shall be binding and conclusive upon the Company and the Employee. If there is any inconsistency between the provisions of this Agreement and the Plan, the provisions of the Plan shall govern.

8.

Not Part of Employment Contract; Discontinuance of Employment. This Agreement awards restricted stock to the Employee, but does not impose any obligation on the Company to make any future grants or issue any future awards to the Employee or otherwise continue the participation of the Employee under the Plan. This Agreement shall not give the Employee a right to continued employment with the Company or any

-4-

	Affiliate, and the Company or Affiliate employing the Employee may terminate his or her employment and otherwise deal with the Employee without regard to the effect it may have upon him or her under this Agreement
	By executing this Agreement, the Employee expressly acknowledges the above.
9.	Interpretation of This Agreement. All decisions and interpretations made by the Committee with regard to any question arising hereunder or under the Plan shall be binding and conclusive upon the Company and the Employee. If there is any inconsistency between the provisions of this Agreement and the Plan, the provisions of the Plan shall govern.
10.	Binding Effect. This Agreement shall be binding in all respects on the heirs, representatives, successors and assigns of the Employee.
11.	Choice of Law. This Agreement is entered into under the laws of the State of Delaware and shall be construed and interpreted thereunder (without regard to its conflict-of-law principles).
12.	Entire Agreement. This Agreement and the Plan set forth the entire agreement and understanding of the parties hereto with respect to the issuance and sale of the Restricted Shares and the administration of the Plan and supersede all prior agreements, arrangements, plans, and understandings relating to the issuance and sale of these Restricted Shares and the administration of the Plan.
13.	Amendment and Waiver. Except as provided in the Plan, this Agreement may be amended, waived, modified, or canceled only by a written instrument executed by the parties or, in the case of a waiver, by the party waiving compliance.
14.	Acknowledgment of Receipt of Copy. By execution hereof, the Employee acknowledges having received a copy of the Plan.
15.	Section 409A. Notwithstanding anything in this Agreement to the contrary, any payments hereunder that would be subject to an additional or accelerated tax under Section 409A of the Code shall be deferred until the earliest date that such payments may be made without the imposition of such tax.

-5-

     IN WITNESS WHEREOF, the Employee and the Company have executed this Agreement as of the date of issuance specified at the beginning of this Agreement.

EMPLOYEE
HMN FINANCIAL, INC.
By
	Its

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EX-13

F I V E - Y E A R  C O N S O L I D A T E D  F I N A N C I A L  H I G H L I G H T S

Selected Operations Data:

	Year Ended December 31,
(Dollars in thousands, except per share data)	2006		2005			2004			2003			2002
Total interest income	$	67,527		60,281			51,617			44,937			42,868
Total interest expense		28,841		24,511			20,993			20,289			21,295
Net interest income		38,686		35,770			30,624			24,648			21,573
Provision for loan losses		8,878		2,674			2,755			2,610			2,376
Net interest income after provision for loan losses		29,808		33,096			27,869			22,038			19,197
Fees and service charges		3,111		2,719			2,776			2,304			1,723
Loan servicing fees		1,172		1,210			1,169			998			715
Securities gains (losses), net		48		(21	)		(535	)		1,275			422
Gain on sales of loans		1,255		1,853			1,703			5,240			3,077
Other non-interest income		855		748			854			438			(62	)
Total non-interest income		6,441		6,509			5,967			10,255			5,875
Total non-interest expense		22,596		21,801			20,162			19,653			17,849
Income tax expense		5,225		6,736			4,387			4,038			2,099
Income before minority interest		8,428		11,068			9,287			8,602			5,124
Minority interest		0		0			(3	)		(3	)		(142	)
Net income	$	8,428		11,068			9,290			8,605			5,266
Per common share and common share equivalents:
Basic	$	2.20		2.89			2.40			2.26			1.40
Diluted		2.10		2.77			2.31			2.16			1.32

Selected Financial Condition Data:

	December 31,
(Dollars in thousands, except per share data)	2006			2005			2004			2003			2002
Total assets	$	977,789			991,237			960,673			866,726			737,523
Securities available for sale		126,140			119,659			103,672			104,664			121,397
Loans held for sale		1,493			1,435			2,712			6,543			15,127
Loans receivable, net		768,232			785,678			783,213			688,951			533,906
Deposits		725,959			731,537			698,902			551,688			432,951
Federal Home Loan Bank advances		150,900			160,900			170,900			203,900			218,300
Stockholders’ equity		93,142			90,728			83,771			80,931			76,065
Book value per share		21.58			20.59			18.95			17.93			17.28
Number of full service offices		15			13			13			12			13
Number of loan origination offices		2			3			2			6			2
Key Ratios(1)
Stockholders’ equity to total assets at year end		9.53	%		9.15	%		8.72	%		9.34	%		10.31	%
Average stockholders’ equity to average assets		9.70			9.05			9.17			10.15			10.66
Return on stockholders’ equity (ratio of net income to average equity)		8.85			12.42			11.03			10.85			6.94
Return on assets (ratio of net income to average assets)		0.86			1.12			1.01			1.10			0.74
Dividend payout ratio (ratio of dividends paid to net income)		42.61			38.02			36.36			39.58			57.63

⁽¹⁾ Average balances were calculated based upon amortized cost without the market value impact of SFAS No. 115.

5

M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

This Annual Report, other reports filed by the Company with the Securities and Exchange Commission, and the Company’s proxy statement may contain “forward-looking” statements that deal with future results, plans or performance. In addition, the Company’s management may make such statements orally to the media, or to securities analysts, investors or others. Forward-looking statements deal with matters that do not relate strictly to historical facts. Words such as “anticipate”, “believe”, “expect”, “intend”, “would”, “could” and similar expressions, as they relate to us, are intended to identify such forward-looking statements. The Company’s future results may differ materially from historical performance and forward-looking statements about the Company’s expected financial results or other plans are subject to a number of risks and uncertainties. These include but are not limited to possible legislative changes and adverse economic, business and competitive developments such as shrinking interest margins; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government; changes in credit and other risks posed by the Company’s loan and investment portfolios; changes in loan repayment and prepayment patterns; changes in loan terms and conditions; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation or other significant uncertainties.

OVERVIEW

HMN Financial, Inc. (HMN or the Company) is the stock savings bank holding company for Home Federal Savings Bank (the Bank) which operates community retail banking facilities and loan production offices in Minnesota and Iowa. Eagle Crest Capital Bank, a division of Home Federal Savings Bank, provides private banking services to a diverse group of high net worth customers from offices in Edina and Rochester, Minnesota. The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and Federal Home Loan Bank (FHLB) advances. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the “interest rate spread”. Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. The Company’s interest rate spread has been enhanced over the past several years by the increased level of commercial loans placed in portfolio and the increased amount of lower rate deposit products such as checking, savings and money market accounts. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company’s net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization and valuation adjustments on mortgage servicing assets. The increased emphasis on commercial loans over the past several years has increased the credit risk inherent in the loan portfolio and the provision for loan losses has increased due to commercial loan charge offs.

The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings.

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 three critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the assumptions, estimates and other factors used.

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company’s ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company’s own loss experience and external industry data and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is

6

based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary specific reserves. 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 for all non-performing loans. The Company’s policies and procedures related to the allowance for loan losses are consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses that was issued in December 2006.

     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 loans are 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. The amount of MSRs capitalized continues to decline as the Company sells the servicing rights along with the loans for the majority of its single family loans that are sold.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). The Company adopted FIN 48 effective January 1, 2007. FIN 48 requires the use of estimates to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available. The application of FIN 48 requires significant judgment in arriving at the amount of tax benefits to be recognized in the financial statements for a given tax position. It is possible that the tax benefits realized upon the ultimate resolution of a tax position taken by the Company may be significantly different from those estimated.

7

M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

Results of Operations

Net income was $8.4 million for the year ended December 31, 2006, compared to $11.1 million for the year ended December 31, 2005. Diluted earnings per common share for the year ended December 31, 2006 were $2.10, compared to $2.77 for the year ended December 31, 2005. Return on average assets was 0.86% and 1.12% and return on average equity was 8.85% and 12.42% for the years ended December 31, 2006 and 2005, respectively.

     In comparing the year ended December 31, 2006 to the year ended December 31, 2005, net interest income increased $2.9 million primarily because of an increase in interest rates and because of a change in the mix of funding sources away from brokered deposits to less expensive checking, savings and money market deposits. The increased emphasis on commercial loans over the past several years has increased the credit risk inherent in the loan portfolio and the provision for loan losses increased $6.2 million in 2006, primarily because of an increase in commercial loan charge offs. Non-interest income decreased $68,000 primarily because of a decrease in the gain recognized on the sale of single family mortgages, which was partially offset by an increase in fees and service charges on checking accounts. Non-interest expense increased $795,000 primarily because of increased compensation and benefits costs and increased occupancy costs due in part to additional branch facilities opened in the first quarter of 2006.

Net Interest Income

Net interest income was $38.7 million for the year ended December 31, 2006, an increase of $2.9 million from $35.8 million in 2005. Interest income was $67.5 million for the year ended December 31, 2006, an increase of $7.2 million from $60.3 million for the same period in 2005. Interest income increased primarily because of an increase in the average interest rates earned on loans and investments. Interest rates increased primarily because of the 100 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 and investments. The increase in interest income due to increased rates was partially offset by a $42 million decrease in the average outstanding loan portfolio balance between the periods due to an increase in commercial loan prepayments and an increase in loan participations sold in order to comply with lending limit restrictions and reduce credit risk. The average yield earned on interest-earning assets was 7.21% for the year ended December 31, 2006, an increase of 80 basis points from the 6.41% yield for the same period of 2005. Interest expense was $28.8 million for the year ended December 31, 2006, an increase of $4.3 million from $24.5 million for the same period in 2005. Interest expense increased primarily because of higher interest rates paid on deposits which were caused by the 100 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 increase in deposit rates was partially offset by a change in the mix of funding sources between the periods. The average outstanding balances of $57 million in brokered deposits and Federal Home Loan Bank advances were replaced with other less expensive deposits which lowered the Bank’s overall cost of funds. The average interest rate paid on interest-bearing liabilities was 3.28% for the year ended December 31, 2006, an increase of 52 basis points from the 2.76% paid for the same period of 2005. Net interest margin for the year ended December 31, 2006 was 4.13%, an increase of 33 basis points, compared to 3.80% for the same period of 2005. The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Non-accruing loans have been included in the table as loans carrying a zero yield.

8

	Year Ended December 31,
	2006								2005								2004
	Average		Interest			Average			Average		Interest			Average			Average		Interest			Average
	Outstanding		Earned/			Yield/			Outstanding		Earned/			Yield/			Outstanding		Earned/			Yield/
(Dollars in thousands)	Balance		Paid			Rate			Balance		Paid			Rate			Balance		Paid			Rate
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities	$	7,045		271			3.85	%	$	8,509		326			3.83	%	$	11,225		385			3.43	%
Other marketable securities		124,684		5,195			4.17			95,193		2,744			2.88			97,508		2,898			2.97
Loans held for sale		3,383		216			6.40			3,308		189			5.71			4,349		249			5.73
Loans receivable, net(1)(2)		760,990		59,965			7.88			802,637		56,189			7.00			732,638		47,714			6.51
Federal Home Loan Bank stock		8,235		325			3.95			8,960		253			2.82			9,889		207			2.10
Other, including cash equivalents		32,867		1,555			4.73			21,714		580			2.67			18,954		164			0.87
Total interest-earning assets	$	937,204		67,527			7.21		$	940,321		60,281			6.41		$	874,563		51,617			5.90
Interest-bearing liabilities:
Noninterest checking	$	51,017		0			0.00	%	$	45,263		0			0.00	%	$	38,862		0			0.00	%
NOW accounts		97,753		2,635			2.70			104,271		1,770			1.70			88,559		638			0.72
Passbooks		60,577		1,084			1.79			48,297		435			0.90			43,186		77			0.18
Money market accounts		153,889		5,119			3.33			106,819		2,273			2.13			106,943		1,519			1.42
Certificate accounts		233,074		8,652			3.71			243,853		7,093			2.91			257,911		7,254			2.81
Brokered deposits		125,055		4,553			3.64			167,181		5,660			3.39			96,900		2,909			3.00
Federal Home Loan Bank advances		156,399		6,795			4.34			170,914		7,278			4.26			196,662		8,595			4.37
Other interest-bearing liabilities		834		3			0.00			866		2			0.00			905		1			0.00
Total interest-bearing liabilities	$	878,598		28,841			3.28		$	887,464		24,511			2.76		$	829,928		20,993			2.53
Net interest income				38,686								35,770								30,624
Net interest rate spread							3.93	%							3.65	%							3.37	%
Net earning assets	$	58,606							$	52,857							$	44,635
Net interest margin							4.13	%							3.80	%							3.50	%
Average interest-earning assets to average interest-bearing liabilities				106.67	%							105.96	%							105.38	%

(1)	Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis for any of the years presented. The tax-exempt income was $1.1 million for 2006 and 2005, and $1.0 million for 2004.
(2)	Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve.

     Net interest margin increased to 4.13% in 2006 from 3.80% for 2005 because of the increase in the prime rate, which generally increases the yield on the adjustable rate commercial and consumer loans in the portfolio and on new loans and investments. The change in the mix of liabilities from higher rate brokered deposits to lower rate checking, savings and money market deposit accounts also had a positive effect on the net interest margin. Net interest margin was enhanced 10 basis points in 2006 because of an increase in the amount of prepayment penalties received on commercial loans. Commercial loan refinance activity increased in 2006 due to the competitive rate environment that existed during the year. Average net interest-earning assets were $58.6 million in 2006 compared to $52.9 million for 2005. Net interest-earning assets increased primarily because of an increase in cash from operations and an increase of $3.0 million in interest earning cash balances between the periods due to a reduction in the compensating balance requirements at the Federal Reserve Bank. Net interest-earning assets were reduced by the repurchase of HMN common stock and the payment of dividends. During 2006 and 2005 the Company paid $4.0 million and $1.0 million to purchase its common stock in the open market and paid dividends to stockholders of $3.7 million and $3.5 million, respectively.

     The table on the following page presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It quantifies the changes in interest income and interest expense related to changes in the average outstanding balances (volume) and those changes caused by fluctuating interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume).

9

M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

	Year Ended December 31,
	2006 vs. 2005								2005 vs. 2004
	Increase (Decrease)								Increase (Decrease)
	Due to								Due to
						Total									Total
						Increase									Increase
(Dollars in thousands)	Volume(1)			Rate(1)		(Decrease)			Volume(1)			Rate(1)			(Decrease)
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities	$	(56	)		1		(55	)	$	(100	)		41			(59	)
Other marketable securities		850			1,601		2,451			(69	)		(85	)		(154	)
Loans held for sale		4			23		27			(60	)		0			(60	)
Loans receivable, net		(2,832	)		6,608		3,776			5,099			3,376			8,475
Cash equivalents		298			677		975			27			389			416
Other		(21	)		92		71			(20	)		67			47
Total interest-earning assets	$	(1,757	)		9,002		7,245		$	4,877			3,788			8,665
Interest-bearing liabilities:
NOW accounts	$	(81	)		947		866		$	241			891			1,132
Passbooks		111			538		649			10			348			358
Money market accounts		1,292			1,552		2,844			93			662			755
Certificates		(313	)		1,873		1,560			(403	)		241			(162	)
Brokered deposits		(1,426	)		319		(1,107	)		2,339			412			2,751
Federal Home Loan Bank advances		(618	)		135		(483	)		(1,148	)		(169	)		(1,317	)
Other interest-bearing liabilities		0			0		0			0			2			2
Total interest-bearing liabilities	$	(1,035	)		5,364		4,329		$	1,132			2,387			3,519
Net interest income						$	38,686								$	35,770

⁽¹⁾ For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate.

     The following table sets forth the weighted average yields on the Company’s interest-earning assets, the weighted average interest rates on interest-bearing liabilities and the interest rate spread between the weighted average yields and rates as of the date indicated. Non-accruing loans have been included in the table as loans carrying a zero yield.

At December 31, 2006

Weighted average yield on:
Securities available for sale:
Mortgage-backed and related securities	3.79	%
Other marketable securities	4.96
Loans held for sale	6.45
Loans receivable, net	8.12
Federal Home Loan Bank stock	4.25
Other interest-earnings assets	5.20
Combined weighted average yield on interest-earning assets	7.12
Weighted average rate on:
NOW accounts	2.54	%
Passbooks	1.37
Money market accounts	3.31
Certificates	4.23
Federal Home Loan Bank advances	4.27
Combined weighted average rate on interest-bearing liabilities	3.41
Interest rate spread	3.71

Provision For Loan Losses

The provision for loan losses is recorded to maintain the allowance for loan losses at a level deemed appropriate by management based on the factors disclosed in the critical accounting policy previously discussed. The provision for loan losses was $8.9 million for 2006 compared to $2.7 million in 2005. The provision for loan losses increased primarily because $7.4 million in commercial loans relating to a real estate and golf course development were charged off during the year. The increase in the provision related to loan charge offs was partially offset by a $12 million decrease in outstanding commercial loans between the periods. Loans charged off during 2006 included commercial loans of $7.4 million, consumer loans of $269,000 and mortgage loans of $150,000.

10

Non-Interest Income

Non-interest income was $6.4 million for the year ended December 31, 2006, a decrease of $68,000, from $6.5 million for the same period in 2005. The following table presents the components of non-interest income:

									Percentage
	Year Ended December 31,								Increase (Decrease)
(Dollars in thousands)	2006		2005			2004			2006/2005			2005/2004
Fees and service charges		$   3,111		2,719			2,776			14.4	%		(2.1	)%
Loan servicing fees		1,172		1,210			1,169			(3.1	)		3.5
Securities gains (losses), net		48		(21	)		(535	)		328.6			96.1
Gain on sales of loans		1,255		1,853			1,703			(32.3	)		8.8
Other non-interest income		855		748			854			14.3			(12.4	)
Total non-interest income		$   6,441		6,509			5,967			(1.0	)		9.1

     Fees and service charges earned in 2006 increased $392,000 from those earned in 2005 primarily because of an increase in overdraft fees and service charges on deposit accounts.

     Loan servicing fees decreased $38,000 for the year ended December 31, 2006. Single-family loan servicing fees decreased $102,000 due to a decrease in the number of single-family loans that were serviced for others. The number of loans serviced decreased because of a decrease in single-family loans sold and because the servicing rights on most of the loans originated in 2006 were sold along with the loans. Sold loans decreased because there were fewer single-family loans originated and more of the loans that were originated were placed into the loan portfolio to replace prepaying loans. The decrease in single-family loan servicing fees was partially offset by a $64,000 increase in commercial loan servicing fees. Commercial loan servicing fees increased as a result of an increase in loans serviced for others. The commercial loan servicing portfolio increased because the Bank continues to sell off participations in, but retains the servicing responsibilities for, certain originated commercial loans in order to adhere to regulatory lending limits and manage credit risk within the portfolio.

     Security gains increased $69,000 for the year ended December 31, 2006 due to the gain on the sale of a Federal Home Loan Mortgage Corporation (FHLMC) preferred stock investment that had previously been written down because its decline in value was determined to be other than temporary. The ability to realize gains on the sale of securities is dependent upon the type of securities in the portfolio and on changes in the general interest rate environment. The FHLMC preferred stock was the only investment sold in 2006 and no investments were sold in 2005 because the rising interest rate environment limited the opportunity to sell securities at a gain.

     Gain on sales of loans decreased $598,000 in 2006. Gain on sale of single-family loans decreased $491,000 due to a decrease in the number of single-family loans sold and a decrease in the profit margins realized on the loans that were sold. Competition in the single-family loan origination market remained strong in 2006 and profit margins were lowered in order to remain competitive. Government guaranteed commercial loan sale gains decreased $107,000 in 2006 due to fewer loan sales. The Company expects mortgage interest rates to trend higher in 2007, which may result in lower loan originations and less gain on sales of single-family loans than that experienced in 2006. Commercial government guaranteed loan volume is anticipated to increase in 2007 due to the preferred lender status that the Bank obtained from the Small Business Administration (SBA) in 2006. This status allows the Company to streamline the underwriting process by making certain underwriting decisions on behalf of the SBA and should help attract more SBA loan volume which the Company intends to sell on the secondary market.

     Other non-interest income consists primarily of fees and commissions earned on the sale of financial planning and insurance products and the gains and losses from the sale of assets. For 2006, other non-interest income increased $107,000, primarily because of decreased losses on the sale of repossessed and foreclosed assets that were partially offset by decreased sales of financial planning and insurance products.

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M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

Non-Interest Expense

Non-interest expense for the year ended December 31, 2006 was $22.6 million, compared to $21.8 million for the year ended in 2005. The following table presents the components of non-interest expense:

							Percentage
	Year Ended December 31,						Increase (Decrease)
(Dollars in thousands)	2006		2005		2004		2006/2005			2005/2004
Compensation and benefits		$   11,869		11,140		10,187		6.5	%		9.4	%
Occupancy		4,435		4,081		3,630		8.7			12.4
Deposit insurance premiums		102		130		96		(21.5	)		35.4
Advertising		475		384		430		23.7			(10.7	)
Data processing		1,183		1,032		930		14.6			11.0
Amortization of mortgage servicing rights, net		848		1,020		1,061		(16.9	)		(3.9	)
Other		3,684		4,014		3,828		(8.2	)		4.9
Total non-interest expense		$   22,596		21,801		20,162		3.6			8.1

     Non-interest expense increased $795,000 in 2006 primarily because of a $729,000 increase in compensation and benefits expense due to annual salary increases and increases in employee pension costs. Occupancy expense increased $355,000 primarily because of the additional costs associated with the new branch and loan origination offices opened in Rochester in the first quarter of 2006. Data processing costs increased $151,000 primarily because of increased internet and other banking services provided by a third party processor between the periods. Other non-interest expense decreased $331,000 primarily because of a decrease in mortgage loan expenses and professional fees. Mortgage servicing rights amortization decreased $171,000 between the periods because there were fewer mortgage loans being serviced.

Income Taxes

     The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities. Income tax expense was $5.2 million in 2006 compared to $6.7 million for 2005. Income tax expense decreased between the periods primarily because of a decrease in taxable income.

     In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires companies to recognize in their financial statements the impact of a tax position, taken or expected to be taken, if it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The Interpretation requires the use of a cumulative probability methodology to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available at the reporting date. It also requires that interest expense be accrued on the difference between the tax position recognized in accordance with the Interpretation and the amount previously taken or expected to be taken in a tax return. The provisions of FIN 48 were adopted by the Company on January 1, 2007 and as a result, the Company recognized an immaterial increase in its liability recorded for tax exposure reserves for unrecognized tax benefits upon adoption. The adjustment was recorded as a reduction to the January 1, 2007 retained earnings balance and an increase in tax liability in accordance with the requirements of FIN 48.

     The Company is located in Minnesota and files a state income tax return with the Minnesota Department of Revenue (MDR). In January 2007, the Company received notification that the MDR was proposing adjustments of $2.2 million to the Company’s 2002 through 2004 Minnesota state tax liability. The proposed adjustments relate to the tax treatment of the inter-company dividends paid to the Bank by Home Federal Holding. The Company intends to challenge the proposed adjustments. A tax exposure reserve has been established during 2002 through 2006 based on a range of probable outcomes, however, the final liability will depend on the ultimate resolution of this issue. In 2005, Minnesota state tax laws were changed and the Company’s Minnesota tax filings for 2005 and forward do not have exposure relating to the treatment of the inter-company dividend payment.

COMPARISON OF 2005 WITH 2004

     Net income was $11.1 million for the year ended December 31, 2005, compared to $9.3 million for the year ended December 31, 2004. Diluted earnings per common share for the year ended December 31, 2005 were $2.77, compared to

12

$2.31 for the year ended December 31, 2004. Return on average assets was 1.12% and 1.01% and return on average equity was 12.42% and 11.03% for the years ended December 31, 2005 and 2004, respectively.

     In comparing the year ended December 31, 2005 to the year ended December 31, 2004, net interest income increased $5.2 million primarily because of an increase in interest rates and because of a higher concentration of commercial loans and increased checking and savings deposits. Non-interest income increased $542,000 primarily because of a decrease in the losses recognized on securities. Non-interest expense increased $1.6 million primarily because of increased compensation and benefits costs and increased occupancy costs due in part to additional corporate office facilities occupied in the first quarter of 2005.

     Net interest income was $35.8 million for the year ended December 31, 2005, an increase of $5.2 million from $30.6 million in 2004. Interest income was $60.3 million for the year ended December 31, 2005, an increase of $8.7 million from $51.6 million for the same period in 2004. Interest income increased because of an increase in the average outstanding balance of interest-earning assets of $66 million between the periods and an increase in interest rates. Interest rates increased primarily because of the 200 basis point increase in the prime interest rate between the periods. Increases in the prime rate generally increase the rates on adjustable rate consumer and commercial loans in the portfolio and new loans originated. The increase in average interest-earning assets was primarily the result of the $85 million increase in the average outstanding balance of commercial loans between the periods. During 2005, the Company’s commercial portfolio continued to increase and represented 66.8% of the Company’s outstanding loans at December 31, 2005, compared to 63.6% at December 31, 2004. The average yield earned on interest-earning assets was 6.41% for the year ended December 31, 2005, an increase of 51 basis points from the 5.90% yield for the same period of 2004. Interest expense was $24.5 million for the year ended December 31, 2005, an increase of $3.5 million from $21.0 million for the same period in 2004. Interest expense increased primarily because of 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 generally increase the rates banks pay for deposits. Interest expense also increased because of the $58 million increase in the average outstanding interest bearing liabilities between the periods. The average interest rate paid on interest-bearing liabilities was 2.76% for the year ended December 31, 2005, an increase of 23 basis points from the 2.53% paid for the same period of 2004.

     Net interest margin increased to 3.80% in 2005 from 3.50% for 2004 primarily because of the growth in commercial loans, which generally have a higher yield than other interest-earning assets, and the increase in the outstanding average balance of checking accounts, which generally have a lower rate than other interest-bearing liabilities. Average net interest-earning assets were $52.9 million in 2005 compared to $44.6 million for 2004. Net interest-earning assets increased because of net income and an increase of $1.5 million in interest-earning cash balances between the periods due to a reduction in the compensating balance requirements at the Federal Reserve Bank. Net interest-earning assets were reduced by the repurchase of HMN common stock and the payment of dividends. During 2005 and 2004 the Company paid $1.0 million and $3.3 million to purchase its common stock in the open market and paid dividends to stockholders of $3.5 million and $3.2 million, respectively.

     The provision for loan losses was $2.7 million for 2005 compared to $2.8 million in 2004. The provision for loan losses decreased primarily because the commercial loan portfolio growth rate decreased from 13.5% in 2004 to 3.4% in 2005. The decrease in the provision related to reduced loan growth during the period was partially offset by an increase in the provision related to loan charge offs which increased from $738,000 in 2004 to $3.1 million in 2005. Loans charged off during 2005 included commercial loans of $2.6 million, consumer loans of $228,000 and mortgage loans of $234,000. The commercial loan charge offs were the result of acquiring multiple related real estate properties during the year that were subsequently sold at a loss.

     Non-interest income was $6.5 million for the year ended December 31, 2005, an increase of $542,000, from $6.0 million for the same period in 2004. Fees and service charges earned in 2005 decreased $57,000 from those earned in 2004 due to a decrease in overdraft fees and service charges because of customer behavior changes that resulted in a lower volume of activity in 2005. Title service fees also decreased because Federal Title Services, LLC was dissolved in 2004. Loan servicing fees increased $41,000 for the year ended December 31, 2005. Commercial loan servicing fees increased $57,000 as a result of an increase in loans serviced for others. The commercial loan servicing portfolio increased because the Bank continues to sell off participations in, but retains the servicing responsibility for, certain originated commercial loans in order to adhere to regulatory lending limits and manage credit risk within the portfolio. Single-family loan servicing fees decreased $16,000 due to a decrease in the number of single-family loans that were serviced for others. The number of loans serviced decreased because of decreased single-family loan production and because the servicing rights on many of the loans originated in 2005 were sold

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M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

with the loans. Security losses decreased $514,000 for the year ended December 31, 2005 due to the $539,000 write down in the fourth quarter of 2004 of a Federal Home Loan Mortgage Corporation (FHLMC) preferred stock investment whose decline in value due to decreased interest rates was determined to be other than temporary. An additional write down of $21,000 was recorded on the same security in 2005. The ability to realize gains on the sale of securities is dependent on the type of securities in the securities portfolio and on changes in the general interest rate environment. There were no investment sales in 2005 and sales were limited in 2004 because the rising interest rate environment limited the opportunity to sell securities at a gain. Gain on sales of loans increased $150,000 in 2005. Gains on the sale of single-family loans decreased $321,000 in 2005 due to decreased loan originations. The decrease in single-family loan sale gains was offset entirely by an increase in the gains recognized on the sale of government guaranteed commercial loans sold in 2005. In an effort to diversify the Bank’s product offerings, the Bank began offering Small Business Administration (SBA) and U.S. Department of Agriculture (USDA) guaranteed loans in 2005. Other non-interest income consists primarily of fees and commissions earned on the sale of financial planning and insurance products and the gains and losses from the sale of assets. For 2005, other non-interest income decreased $105,000, primarily because of increased losses on the sale of repossessed and foreclosed assets that were partially offset by increased rental income from leasing space at an existing branch facility to a third party.

     Non-interest expense for the year ended December 31, 2005 was $21.8 million, compared to $20.2 million for the year ended December 31, 2004. Non-interest expense increased $1.6 million in 2005 primarily because of a $954,000 increase in compensation and benefits expense due to increases in payroll costs, which were primarily due to annual salary increases and increases in employee benefit costs. Occupancy expense increased $451,000 primarily because of the additional corporate office space that was occupied in the first quarter of 2005 and increased amortization expense on various software upgrades. Other operating expenses increased $186,000 primarily because of increased costs on foreclosed and repossessed assets and increased charitable contributions in 2005 when compared to 2004.

     Income tax expense was $6.7 million for the year ended December 31, 2005, compared to $4.4 million for 2004. Income tax expense increased between the periods due to an increase in taxable income and an increase in the effective tax rate from 32.1% in 2004 to 37.8% in 2005. The increase in the effective tax rate was primarily the result of additional state tax expense due to changes in state tax laws that occurred in 2005 relating to the tax treatment of dividends paid to the Bank by Home Federal Holding.

14

Financial Condition

Loans Receivable, Net

The following table sets forth the information on the Company’s loan portfolio in dollar amounts and percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated:

	December 31,
	2006					2005					2004					2003					2002
(Dollars in thousands)	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
Real Estate Loans:
One-to-four family	$	134,269		17.10	%	$	127,075		15.82	%	$	139,008		17.34	%	$	144,315		20.37	%	$	151,566		27.72	%
Multi-family		29,863		3.80			40,753		5.07			41,922		5.23			31,540		4.45			15,766		2.88
Commercial		294,490		37.49			260,268		32.40			224,945		28.06			199,124		28.10			130,417		23.85
Construction or development		60,178		7.66			80,342		10.00			98,397		12.28			95,346		13.45			61,336		11.22
Total real estate loans		518,800		66.05			508,438		63.29			504,272		62.91			470,325		66.37			359,085		65.67
Other Loans:
Consumer Loans:
Automobile		3,093		0.39			5,461		0.68			9,496		1.18			14,754		2.08			11,062		2.02
Home equity line		54,247		6.91			61,011		7.60			67,140		8.38			54,193		7.64			52,106		9.53
Home equity		21,263		2.71			19,076		2.37			20,033		2.50			18,974		2.68			21,075		3.85
Mobile home		2,052		0.26			2,299		0.29			2,896		0.36			3,665		0.52			4,534		0.83
Land/lot loans		5,501		0.70			9,487		1.18			11,572		1.44			10,486		1.48			3,590		0.66
Other		3,692		0.47			3,564		0.44			3,836		0.48			3,833		0.54			4,054		0.75
Total consumer loans		89,848		11.44			100,898		12.56			114,973		14.34			105,905		14.94			96,421		17.64
Commercial business loans		176,770		22.51			193,962		24.15			182,369		22.75			132,459		18.69			91,260		16.69
Total other loans		266,618		33.95			294,860		36.71			297,342		37.09			238,364		33.63			187,681		34.33
Total loans		785,418		100.00	%		803,298		100.00	%		801,614		100.00	%		708,689		100.00	%		546,766		100.00	%
Less:
Loans in process		5,252					7,008					7,561					11,298					6,826
Unamortized discounts		40					190					63					166					142
Net deferred loan fees		2,021					1,644					1,781					1,334					1,068
Allowance for losses		9,873					8,778					8,996					6,940					4,824
Total loans receivable, net	$	768,232				$	785,678				$	783,213				$	688,951				$	533,906

     The Company continues to manage interest rate risk and increase interest income by increasing its investment in shorter term and generally higher yielding commercial real estate loans. The Company intends to increase the size of its commercial real estate, consumer and commercial business portfolios while maintaining the one-to-four family loan portfolio.

     One-to-four family real estate loans were $134.3 million at December 31, 2006, an increase of $7.2 million, compared to $127.1 million at December 31, 2005. Loan originations decreased in 2006 but more of the loans that were originated were placed in portfolio. The increase in the amount of mortgage loans placed in portfolio was the primary reason for the growth in the one-to-four family loan portfolio during 2006.

     Commercial real estate loans were $294.5 million at December 31, 2006, an increase of $34.2 million, compared to $260.3 million at December 31, 2005. Commercial business loans were $176.8 million at December 31, 2006, a decrease of $17.2 million, compared to $194.0 million at December 31, 2005. The Company’s continued emphasis on commercial real estate and commercial business loans resulted in the origination or purchase of these loans totaling $437.6 million in 2006, compared to $306.5 million in 2005. The increase in production was offset by an increase in participations sold in order to comply with lending limit

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M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

restrictions and reduce credit risk concentrations. The commercial business loans decreased primarily because several large loans were paid off during the year due to aggressive financing rates from competing lenders.

     Home equity line loans were $54.2 million at December 31, 2006, compared to $61.0 million at December 31, 2005. The open-end home equity lines are written with an adjustable rate with a 10 year draw period which requires “interest only” payments followed by a 10 year repayment period which fully amortizes the outstanding balance. Closed-end home equity loans are written with fixed or adjustable rates with terms up to 15 years. Home equity loans were $21.3 million at December 31, 2006, compared to $19.1 million at December 31, 2005. The prime interest rate increased 100 basis points in 2006, while long term mortgage rates decreased. Since most home equity loan rates are tied to the prime interest rate, some borrowers rolled their adjustable rate home equity loans into a mortgage loan in order to lock in a long term fixed rate. The higher rates also decreased demand for second mortgages from other borrowers who were unable to combine their first and second mortgages.

Allowance for Loan Losses

     The determination of the allowance for loan losses and the related provision is a critical accounting policy of the Company that is subject to significant estimates, as previously discussed. The current level of the allowance for loan losses is a result of management’s assessment of the risks within the portfolio based on the information obtained through the credit evaluation process. The Company utilizes a risk-rating system on non-homogenous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to establish general allowances and specific reserves on the basis of these reviews.

     Management continues to actively monitor asset quality and to charge off loans against the allowance for loan losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the size of the allowance for loan losses.

     The allowance for loan losses was $9.9 million, or 1.26% of gross loans at December 31, 2006, compared to $8.8 million, or 1.09% of gross loans at December 31, 2005. The allowance for loan losses and the related ratios increased primarily because of a $6.0 million increase in nonperforming loans between the periods. The following table reflects the activity in the allowance for loan losses and selected statistics:

	December 31,
(Dollars in thousands)	2006			2005			2004			2003			2002
Balance at beginning of year		$   8,778			8,996			6,940			4,824			3,783
Provision for losses		8,878			2,674			2,755			2,610			2,376
Charge-offs:
One-to-four family		(150	)		(234	)		(331	)		(69	)		(44	)
Consumer		(269	)		(228	)		(407	)		(226	)		(310	)
Commercial business and real estate		(7,430	)		(2,615	)		0			(255	)		(1,015	)
Recoveries		66			185			39			56			34
Net charge-offs		(7,783	)		(2,892	)		(699	)		(494	)		(1,335	)
Balance at end of year		$   9,873			8,778			8,996			6,940			4,824
Year end allowance for loan losses as a percent of year end gross loan balance		1.26	%		1.09	%		1.12	%		0.98	%		0.88	%
Ratio of net loan charge-offs to average loans outstanding		0.98			0.36			0.09			0.08			0.20

16

The following table reflects the allocation of the allowance for loan losses:

	December 31,
	2006						2005						2004						2003						2002
				Percent						Percent						Percent						Percent						Percent
	Allocated			of loans			Allocated			of loans			Allocated			of loans			Allocated			of loans			Allocated			of loans
	allowance			in each			allowance			in each			allowance			in each			allowance			in each			allowance			in each
	as a %			category			as a %			category			as a %			category			as a %			category			as a %			category
	of loan			to total			of loan			to total			of loan			to total			of loan			to total			of loan			to total
	category			loans			category			loans			category			loans			category			loans			category			loans
Real estate loans:
One-to-four family		0.22	%		17.10	%		0.21	%		15.82	%		0.17	%		17.34	%		0.12	%		20.36	%		0.06	%		27.72	%
Multi-family		1.49			3.80			1.56			5.07			1.67			5.23			1.34			4.45			1.30			2.88
Commercial real estate		1.67			37.49			1.32			32.40			1.60			28.06			1.42			28.10			1.55			23.88
Construction or development		1.16			7.66			1.14			10.00			1.07			12.28			0.92			13.45			0.97			11.22
Consumer loans		1.59			11.44			0.88			12.56			0.81			14.34			0.98			14.95			0.56			17.63
Commercial business loans		1.18			22.51			1.36			24.15			1.36			22.75			1.20			18.69			1.48			16.67
Total		1.26			100.00	%		1.09			100.00	%		1.12			100.00	%		0.98			100.00	%		0.88			100.00	%

     The allocation of the allowance for loan losses increased in 2006 for one-to-four family and consumer loans due to an increase in the reserve for unclassified loans based on management’s assessment of the risk in these portfolios based on historical experience. The allocation for consumer loans also increased due to the increased specific reserves on certain home equity loans in this category. The allocated percentage for commercial real estate and construction or development loans increased in 2006 due to management’s assessment of the risk and assignment of risk ratings of certain individual loans in this category. The allocated percentage for multi-family loans decreased between the years because some of the loans that were classified at the end of 2005 paid off during 2006.

Allowance for Real Estate Losses

Real estate properties acquired or expected to be acquired through loan foreclosures are initially recorded at the lower of the related loan balance, less any specific allowance for loss, or fair value less estimated selling costs. Management periodically performs valuations and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. There was limited activity in the allowance for real estate losses and the balance was $125,000 and $100,000 at December 31, 2006 and 2005, respectively.

Non-performing Assets

Loans are reviewed at least quarterly and any loan whose collectibility is doubtful is placed on non-accrual status. Loans are placed on non-accrual status when either principal or interest is 90 days or more past due, unless, in the judgment of management, the loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectibility of the loan. Restructured loans include the Bank’s troubled debt restructurings that involved forgiving a portion of interest or principal or making loans at a rate materially less than the market rate. Foreclosed and repossessed assets include assets acquired in settlement of loans.

     Non-performing assets are comprised of non-accrual loans, restructured loans, impaired securities, delinquent accounts receivable, real estate acquired through foreclosure, and repossessed assets and totaled $10.4 million at December 31, 2006, compared to $3.9 million at December 31, 2005. The $6.5 million increase in non-performing assets at December 31, 2006 relates primarily to a $6.0 million increase in non-performing loans and a $696,000 increase in foreclosed and repossessed assets. The non-performing loan increase was primarily due to a $4.2 million increase in non-performing commercial real estate loans as a result of a golf course and real estate development loan of which the guaranteed portion of the note was non-performing at December 31, 2006. The single-family non-performing loans increased $738,000 from the prior year due to a small number of single family loans that were classified as non-performing because of the delinquency of the loan payments. These increases are partially offset by a decrease of $134,000 in non-performing other assets.

17

M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

The following table sets forth the amounts and categories of non-performing assets in the Company’s portfolio:

	December 31,
(Dollars in thousands)	2006			2005			2004			2003			2002
Non-accruing loans:
Real estate:
One-to-four family	$	1,364			626			1,864			1,177			695
Commercial real estate		5,296			948			1,114			2,162			1,719
Consumer		1,254			496			472			1,050			495
Commercial business		394			259			261			186			427
Total		8,308			2,329			3,711			4,575			3,336
Accruing loans delinquent 90 days or more:
One-to-four family		0			0			628			114			171
Other assets		44			178			201			211			866
Foreclosed and repossessed assets:
Real estate:
One-to-four family		1,422			565			141			73			300
Commercial real estate		650			750			0			0			127
Consumer		0			61			201			62			107
Total		2,072			1,376			342			135			534
Total non-performing assets	$	10,424		$	3,883		$	4,882		$	5,035		$	4,907
Total as a percentage of total assets		1.07	%		0.39	%		0.51	%		0.58	%		0.67	%
Total non-performing loans	$	8,308		$	2,329		$	4,339		$	4,689		$	3,507
Total as a percentage of total loans receivable, net		1.08	%		0.30	%		0.55	%		0.68	%		0.66	%
Allowance for loan losses to non-performing loans		118.94	%		376.88	%		207.30	%		147.99	%		134.60	%

     For the years ended December 31, 2006, 2005 and 2004, gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $1,824,267, $327,280 and $271,071, respectively. The amounts that were included in interest income on a cash basis for such loans were $845,346, $273,458 and $158,767, respectively.

     In addition to the non-performing assets set forth in the table above, as of December 31, 2006 there were no loans with known information about the possible credit problems of the borrowers or the cash flows of the secured properties that have caused management to have concerns as to the ability of the borrowers to comply with present loan repayment terms which may result in the future inclusion of such items in the non-performing asset categories. Management has considered the Bank’s non-performing and “of concern” assets in establishing its allowance for loan losses.

Liquidity and Capital Resources

The Company manages its liquidity position to ensure that the funding needs of borrowers and depositors are met timely and in the most cost effective manner. Asset liquidity is the ability to convert assets to cash through the maturity or sale of the asset. Liability liquidity is the ability of the Bank to attract retail or brokered deposits or to borrow funds from third parties such as the Federal Home Loan Bank (FHLB).

     The primary investing activities are the origination of loans and the purchase of securities. Principal and interest payments on loans and securities along with the proceeds from the sale of loans held for sale are the primary sources of cash for the Company.

Additional cash can be obtained by selling securities from the available for sale portfolio or by selling loans or mortgage servicing rights. Unpledged securities could also be pledged and used as collateral for additional borrowings with the FHLB to generate additional cash.

     The primary financing activity is the attraction of retail and brokered deposits. The Bank has the ability to borrow additional funds from the FHLB by pledging additional securities or loans. Refer to Note 12 of the Notes to Consolidated Financial Statements for more information on additional advances that could be drawn based upon existing collateral levels with the FHLB. Information on outstanding advance maturities and related early call features is also included in Note 12.

     The Company’s most liquid assets are cash and cash equivalents, which consist of short-term highly liquid investments with original maturities of less than three months that are readily convertible to known amounts of cash and interest-bearing deposits. The level of these assets is dependent on the operating, financing and investing activities during any given period.

     Cash and cash equivalents at December 31, 2006 were $43.8 million, a decrease of $3.5 million, compared to $47.3 million at December 31, 2005. Net cash provided by operating activities during 2006 was $19.7 million. The Company conducted the following major investing activities during 2006: principal payments received and maturities of securities available for sale and FHLB stock were $152.6 million, proceeds from sales of securities available for sale were $3.0 million, purchases of securities available for sale

18

and FHLB stock were $158.4 million and loans receivable decreased $4.9 million. The Company spent $1.4 million for the purchase of equipment and updating its premises. Net cash provided by investing activities during 2006 was $603,000. The Company conducted the following major financing activities during 2006: purchased treasury stock of $4.0 million, paid $3.7 million in dividends to HMN stockholders, received proceeds from advances totaling $34.5 million, repaid advances totaling $44.5 million, and deposits decreased $6.0 million. Net cash used by financing activities was $23.8 million.

     The Company has certificates of deposit with outstanding balances of $284.2 million that mature during 2007. Based upon past experience management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits that do not renew will be replaced with deposits from a combination of other customers or brokers. FHLB advances or the sale of securities could also be used to replace unanticipated outflows of deposits.

     The Company has deposits of $117.1 million in checking and money market accounts with customers that have individual balances greater than $5 million. While these funds may be withdrawn at any time, management anticipates that the majority will remain on deposit with the Bank over the next twelve months. If these deposits were to be withdrawn, they would be replaced with deposits from other customers or brokers. FHLB advances or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.

     The Company has $40 million in FHLB advances that mature in 2007 and it has $100.9 million of FHLB advances with maturities beyond 2007 that have call features that may be exercised by the FHLB during 2007. 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.

     The credit policy of the FHLB may change such that the current collateral pledged to secure the advances is no longer acceptable or the formulas for determining the excess pledged collateral may change. If this were to happen, the Bank may not have additional collateral to pledge to secure the existing advances which could cause the FHLB advances to become a liquidity problem during 2007.

     The Company anticipates that its liquidity requirements for 2007 will be similar to the cash flows it experienced in 2006.

     As of December 31, 2006, there were 82,000 shares authorized for repurchase under the existing stock repurchase program that was set to expire on February 25, 2007. On January 23, 2007, the Company’s Board of Directors extended the stock repurchase program to July 23, 2008 and authorized HMN to repurchase up to 300,000 shares of its common stock in the open market.

Contractual Obligations and Commercial Commitments

The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2006, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows:

	Payments Due by Period
			Less than 1						After 5
(Dollars in thousands)	Total		Year		1-3 Years		4-5 Years		Years
Contractual Obligations:
Total borrowings	$	150,900		40,000		20,000		20,900		70,000
Annual rental commitments under non-cancelable operating leases		3,204		772		1,412		1,020		0
	$	154,104		40,772		21,412		21,920		70,000
	Amount of Commitments — Expiring by Period
Other Commercial Commitments:
Commercial lines of credit	$	72,151		59,191		4,104		1,826		7,030
Commitments to lend		93,098		42,485		10,721		8,941		30,951
Standby letters of credit		13,263		12,383		880		0		0
	$	178,512		114,059		15,705		10,767		37,981

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M A N A G E M E N T ’ S  D I S C U S S I O N  A N D  A N A L Y S I S

Regulatory Capital Requirements

As a result of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), banking and thrift regulators are required to take prompt regulatory action against institutions which are undercapitalized. FDICIA requires banking and thrift regulators to categorize institutions as “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized”, or “critically undercapitalized”. A savings institution will be deemed to be well capitalized if it: (i) has a total risk-based capital ratio of 10% or greater, (ii) has a Tier 1 (core) risk-based capital ratio of 6% or greater, (iii) has a leverage ratio of 5% or greater, and (iv) is not subject to any order or written directive by the Office of Thrift Supervision (OTS) to meet and maintain a specific capital level for any capital measure. Management believes that, as of December 31, 2006, the Bank met all of the capital requirements to which it was subject and is well capitalized based on the regulatory definition described above. Refer to Note 18 of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to its capital requirements.

Dividends

The declaration of dividends is subject to, among other things, the Company’s financial condition and results of operations, the Bank’s compliance with its regulatory capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. Refer to Note 17 of the Notes to Consolidated Financial Statements for information on regulatory limitations on dividends from the Bank to the Company and additional information on dividends. The payment of dividends is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders. The Company does not anticipate a liquidity problem in 2007 relating to the payment of dividends.

Impact of Inflation and Changing Prices

The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

New Accounting Pronouncements

The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) on January 1, 2006. It 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 $64,423 for the year ended December 31, 2006.

     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 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 provisions of SFAS No. 156 were adopted by the Company on January 1, 2007 and did not have a material impact on the Company’s results of operations or financial position.

     In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires companies to recognize in their financial statements the impact of a tax position, taken or expected to be taken, if it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The Interpretation requires the use of a cumulative probability methodology to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available at the reporting date. It also requires that interest expense be accrued on the difference between the tax position recognized in accordance with the Interpretation and the amount previously taken or expected to be taken in a tax return. The provisions of FIN 48 were adopted by the Company on January 1, 2007 and as a result, the Company recognized an immaterial increase in its liability recorded for tax exposure reserves for unrecognized tax benefits upon adoption. The adjustment was recorded as a reduction to the January 1, 2007 retained earnings balance and an increase in tax liability in accordance with the requirements of FIN 48.

20

     In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about the use of fair value to measure assets and liabilities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The impact of adopting SFAS No. 157 on January 1, 2008 is not anticipated to have a material impact on the Company’s results of operations or financial position.

     In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R). This Statement improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. Since the Company’s only defined benefit pension plan is a multiemployer plan, the requirements of this statement do not apply and therefore SFAS No. 158 did not have any impact on the Company’s December 31, 2006 results of operations or financial position.

     In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for years ending on or after November 15, 2006. The application of SAB 108 did not have any impact on the Company’s December 31, 2006 results of operations or financial position.

Market Risks

     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 change 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 Management’s Discussion and Analysis section 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 under different interest rate changes.

     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 December 31, 2006.

	Market Value
(Dollars in thousands)
Basis point change in interest rates	–200			–100			0			+100			+200
Total market risk sensitive assets	$	993,956			986,046			975,951			963,308			949,778
Total market risk sensitive liabilities		870,067			858,342			848,570			841,062			834,877
Off-balance sheet financial instruments		(30	)		(12	)		0			72			137
Net market risk	$	123,919			127,716			127,381			122,174			114,764
Percentage change from current market value		(2.72	)%		0.26	%		0.00	%		(4.09	)%		(9.90	)%

21

M A N A G E M E N T ’ S   D I S C U S S I O N   A N D   A N A L Y S I S

     The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that 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% and 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 6% 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 and money market accounts were assumed to decay at an annual rate of 23%. Non-interest checking and NOW accounts were assumed to decay at an annual rate of 17%. Commercial NOW and MMDA accounts were assumed to decay at an annual rate of 31%. 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 the callable advance. Refer to Note 12 of the Notes to Consolidated Financial Statements for more information on call provisions of the FHLB advances.

     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 that 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 that are approaching their lifetime interest rate caps could be different from the values calculated 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 increase in interest rates.

Asset/Liability Management

The Company’s management reviews the impact that changing interest rates will have on the net interest income projected for the twelve months following December 31, 2006 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on net interest income of immediate interest rate changes called rate shocks:

(Dollars in thousands)
Rate Shock	Net Interest			Percentage
in Basis Points	Change			Change
+200	$	(1,529	)		(3.93	)%
+100	$	(640	)		(1.65	)%
0		0			0.00	%
-100	$	(130	)		(0.33	)%
-200	$	(916	)		(2.36	)%

22

     The preceding table was prepared utilizing the Model Assumptions. 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. The decrease in interest income in a rising rate environment is because some adjustable rate loans hit their interest rate ceilings and will not reprice higher. In addition, the model assumes that outstanding callable advances would be called in an up 100 basis point rate shock scenario, which would increase the Bank’s cost of funds and reduce net interest income.

     In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Company has an Asset/Liability Committee that meets frequently to discuss changes made to the interest rate risk position and projected profitability. The Committee makes adjustments to the asset-liability position of the Bank that 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 Bank’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 may, at times, depending on the relationship between long and short-term interest rates, market conditions and consumer preference, 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.

     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 generally places only those 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-year, three-year 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.

23

C O N S O L I D A T E D   B A L A N C E   S H E E T S

December 31, 2006 and 2005	2006			2005
A S S E T S
Cash and cash equivalents	$	43,775,988			47,268,795
Securities available for sale:
Mortgage-backed and related securities (amortized cost $6,671,042 and $7,428,504)		6,177,829			6,879,756
Other marketable securities (amortized cost $119,940,282 and $113,749,841)		119,962,274			112,778,813
		126,140,103			119,658,569
Loans held for sale		1,493,011			1,435,141
Loans receivable, net		768,231,579			785,678,461
Accrued interest receivable		5,060,839			4,460,014
Real estate, net		2,072,032			1,214,621
Federal Home Loan Bank stock, at cost		7,956,300			8,364,600
Mortgage servicing rights, net		1,957,699			2,653,635
Premises and equipment, net		11,372,103			11,941,863
Goodwill		3,800,938			3,800,938
Core deposit intangible, net		105,903			219,760
Prepaid expenses and other assets		2,943,037			1,995,996
Deferred tax assets, net		2,879,000			2,544,400
Total assets	$	977,788,532			991,236,793
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits	$	725,958,830			731,536,560
Federal Home Loan Bank advances		150,900,000			160,900,000
Accrued interest payable		1,176,024			2,085,573
Customer escrows		720,732			1,038,575
Accrued expenses and other liabilities		5,890,605			4,947,816
Total liabilities		884,646,191			900,508,524
Commitments and contingencies
Stockholders’ equity:
Serial preferred stock: ($.01 par value)
Authorized 500,000 shares; issued and outstanding shares none		0			0
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662		91,287			91,287
Additional paid-in capital.		57,913,743			58,011,099
Retained earnings, subject to certain restrictions		103,642,975			98,951,777
Accumulated other comprehensive loss		(284,421	)		(917,577	)
Unearned employee stock ownership plan shares		(4,157,698	)		(4,350,999	)
Unearned compensation restricted stock awards		0			(182,521	)
Treasury stock, at cost 4,813,232 and 4,721,402		(64,063,545	)		(60,874,797	)
Total stockholders’ equity		93,142,341			90,728,269
Total liabilities and stockholders’ equity	$	977,788,532			991,236,793

See accompanying notes to consolidated financial statements.

24

C O N S O L I D A T E D   S T A T E M E N T S   O F   I N C O M E

Years ended December 31, 2006, 2005 and 2004	2006		2005			2004
Interest income:
Loans receivable	$	60,180,932		56,376,920			47,962,485
Securities available for sale:
Mortgage-backed and related		271,060		325,940			385,067
Other marketable		5,194,856		2,744,202			2,897,834
Cash equivalents		1,554,937		580,500			164,061
Other		325,036		253,611			207,240
Total interest income		67,526,821		60,281,173			51,616,687
Interest expense:
Deposits		22,045,858		17,233,400			12,398,505
Federal Home Loan Bank advances		6,794,964		7,278,050			8,594,790
Total interest expense		28,840,822		24,511,450			20,993,295
Net interest income		38,685,999		35,769,723			30,623,392
Provision for loan losses.		8,878,000		2,674,000			2,755,000
Net interest income after provision for loan losses		29,807,999		33,095,723			27,868,392
Non-interest income:
Fees and service charges		3,110,863		2,719,004			2,776,553
Loan servicing fees		1,172,166		1,210,192			1,168,760
Securities gains (losses), net		48,122		(21,000	)		(535,188	)
Gain on sales of loans		1,254,707		1,852,940			1,702,979
Other		855,578		748,084			854,115
Total non-interest income		6,441,436		6,509,220			5,967,219
Non-interest expense:
Compensation and benefits		11,868,879		11,140,329			10,186,538
Occupancy		4,435,468		4,080,880			3,629,766
Deposit insurance premiums		102,145		129,683			95,465
Advertising		475,257		384,184			430,417
Data processing		1,182,538		1,031,630			930,144
Amortization of mortgage servicing rights, net		848,347		1,019,766			1,061,407
Other		3,683,750		4,014,482			3,828,086
Total noninterest expense		22,596,384		21,800,954			20,161,823
Income before income tax expense		13,653,051		17,803,989			13,673,788
Income tax expense		5,225,500		6,736,100			4,387,100
Income before minority interest		8,427,551		11,067,889			9,286,688
Minority interest		0		0			(3,109	)
Net income	$	8,427,551		11,067,889			9,289,797
Basic earnings per share	$	2.20		2.89			2.40
Diluted earnings per share	$	2.10		2.77			2.31

See accompanying notes to consolidated financial statements.

25

C O N S O L I D A T E D   S T A T E M E N T S   O F   S T O C K   H O L D E R S ’   E Q U I T Y   A N D  
C O M P R E H E N S I V E   I N C O M E

												Unearned
												Employee
									Accumulated			Stock			Unearned
			Additional						Other			Ownership			Compensation						Total
	Common		Paid-In			Retained			Comprehensive			Plan			Restricted			Treasury			Stockholders’
	Stock		Capital			Earnings			Income (Loss)			Shares			Stock Awards			Stock			Equity
Balance, December 31, 2003	$	91,287		57,863,726			85,364,657			(50,725	)		(4,738,084	)		0			(57,599,804	)		80,931,057
Net income							9,289,797															9,289,797
Other comprehensive loss, net of tax:
Net unrealized losses on securities available for sale										(553,721	)											(553,721	)
Total comprehensive income																						8,736,076
Treasury stock purchases																			(3,316,550	)		(3,316,550	)
Employee stock options exercised				(394,392	)														461,026			66,634
Tax benefits of exercised stock options				98,096																		98,096
Earned employee stock ownership plan shares				308,165									193,784									501,949
Dividends paid							(3,246,426	)														(3,246,426	)
Balance, December 31, 2004	$	91,287		57,875,595			91,408,028			(604,446	)		(4,544,300	)		0			(60,455,328	)		83,770,836
Net income							11,067,889															11,067,889
Other comprehensive loss, net of tax:
Net unrealized losses on securities available for sale										(313,131	)											(313,131	)
Total comprehensive income																						10,754,758
Treasury stock purchases																			(972,000	)		(972,000	)
Employee stock options exercised				(247,613	)														285,500			37,887
Tax benefits of exercised stock options				29,907																		29,907
Unearned compensation restricted stock awards				15,616												(326,528	)		310,912			0
Restricted stock awards forfeited				(2,204	)											46,085			(43,881	)		0
Amortization of restricted stock awards																97,922						97,922
Earned employee stock ownership plan shares				339,798									193,301									533,099
Dividends paid							(3,524,140	)														(3,524,140	)
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							8,427,551															8,427,551
Other comprehensive gain, net of tax:
Net unrealized gains on securities available for sale										633,156												633,156
Total comprehensive income																						9,060,707
Treasury stock purchases																			(3,960,350	)		(3,960,350	)
Employee stock options exercised				(268,125	)														434,409			166,284
Tax benefits of exercised stock options				55,820																		55,820
Unearned compensation restricted stock awards				(337,193	)														337,193			0
Stock compensation benefits				64,423																		64,423
Reclassification for FAS 123R adoption				(182,521	)											182,521						0
Amortization of restricted stock awards				190,711																		190,711
Earned employee stock ownership plan shares				379,529									193,301									572,830
Dividends paid							(3,736,353	)														(3,736,353	)
Balance, December 31, 2006	$	91,287		57,913,743			103,642,975			(284,421	)		(4,157,698	)		0			(64,063,545	)		93,142,341

See accompanying notes to consolidated financial statements.

26

C O N S O L I D A T E D  S T A T E M E N T S  O F  C A S H  F L O W S

Years ended December 31, 2006, 2005 and 2004	2006			2005			2004
Cash flows from operating activities:
Net income	$	8,427,551			11,067,889			9,289,797
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses		8,878,000			2,674,000			2,755,000
Depreciation		1,918,719			1,750,953			1,596,252
Amortization of discounts, net		(1,657,626	)		(849,539	)		(353,598	)
Amortization of deferred loan fees		(1,587,093	)		(1,071,078	)		(1,166,855	)
Amortization of core deposit intangible		113,857			113,857			113,857
Amortization of mortgage servicing rights, net		848,348			1,019,766			1,061,407
Capitalized mortgage servicing rights		(152,412	)		(442,159	)		(844,806	)
Deferred income tax benefit		(750,000	)		(1,259,100	)		(737,200	)
Securities (gains) losses, net		(48,122	)		21,000			535,188
Loss on sales of real estate		25,410			17,575			21,775
Proceeds from sales of real estate		357,057			605,072			825,461
Gain on sales of loans		(1,254,707	)		(1,852,940	)		(1,702,979	)
Proceeds from sales of loans held for sale		71,982,371			97,015,434			90,118,839
Disbursements on loans held for sale		(66,818,657	)		(85,200,488	)		(84,592,187	)
Amortization of restricted stock awards		190,711			97,922			0
Amortization of unearned ESOP Shares		193,301			193,301			193,784
Earned employee stock ownership shares priced above original cost		379,529			339,798			308,165
Stock option compensation		64,423			0			0
Increase in accrued interest receivable		(600,825	)		(765,881	)		(231,912	)
Increase (decrease) in accrued interest payable		(909,549	)		771,217			547,519
Equity losses of limited partnerships		28,559			27,210			26,118
Decrease (increase) in other assets		(978,910	)		776,290			(533,660	)
Increase (decrease) in other liabilities		947,591			(90,880	)		(1,918,729	)
Other, net		106,944			82,596			(22,542	)
Net cash provided by operating activities		19,704,470			25,041,815			15,288,694
Cash flows from investing activities:
Proceeds from sales of securities available for sale		2,988,122			0			15,129,325
Principal collected on securities available for sale		752,159			2,138,735			4,354,497
Proceeds collected on maturity of securities available for sale		150,500,000			21,000,000			15,000,000
Purchases of securities available for sale		(157,527,725	)		(39,463,634	)		(34,877,137	)
Redemption of interest in limited partnership		0			0			422,474
Purchase of Federal Home Loan Bank stock		(902,300	)		(2,427,300	)		(1,793,200	)
Redemption of Federal Home Loan Bank stock		1,310,600			3,355,500			2,504,800
Net decrease (increase) in loans receivable		4,852,819			(14,532,425	)		(96,761,454	)
Proceeds from sale of premises		0			0			266,972
Purchases of premises and equipment		(1,370,409	)		(1,208,518	)		(2,220,610	)
Net cash provided (used) by investing activities		603,266			(31,137,642	)		(97,974,333	)
Cash flows from financing activities:
Increase (decrease) in deposits		(6,008,101	)		33,218,736			147,580,390
Purchase of treasury stock		(3,960,350	)		(972,000	)		(3,316,550	)
Stock options exercised		166,284			37,887			66,634
Excess tax benefit from options exercised		55,820			29,907			98,096
Dividends to stockholders		(3,736,353	)		(3,524,140	)		(3,246,426	)
Proceeds from Federal Home Loan Bank advances		33,500,000			78,000,000			54,900,000
Repayment of Federal Home Loan Bank advances		(43,500,000	)		(88,000,000	)		(87,900,000	)
Proceeds from Federal Reserve Bank advances		1,000,000			0			0
Repayment of Federal Reserve Bank advances		(1,000,000	)		0			0
(Decrease) increase in customer escrows		(317,843	)		275,838			(21,694,934	)
Net cash (used) provided by financing activities		(23,800,543	)		19,066,228			86,487,210
(Decrease) increase in cash and cash equivalents		(3,492,807	)		12,970,401			3,801,571
Cash and cash equivalents, beginning of year		47,268,795			34,298,394			30,496,823
Cash and cash equivalents, end of year	$	43,775,988			47,268,795			34,298,394
Supplemental cash flow disclosures:
Cash paid for interest	$	29,750,371			23,740,233			20,445,776
Cash paid for income taxes		6,972,238			6,601,281			6,548,500
Supplemental noncash flow disclosures:
Loans transferred to loans held for sale		3,968,368			8,662,175			0
Transfer of loans to real estate		1,325,264			15,994,671			892,802
Transfer of real estate to loans		0			14,195,361			0

See accompanying notes to consolidated financial statements.

27

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  STATEMENTS

December 31, 2006, 2005 and 2004

NOTE 1 Description of the Business and Summary of Significant Accounting Policies

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 facilities in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA) which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC) which acts as an intermediary for the Bank in transacting like-kind property exchanges for Bank customers. The Bank had two other subsidiaries during the years presented that are 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. Federal Title Services, LLC (FTS), which was 80% owned by the Bank, performed mortgage title services for Bank customers and was dissolved in 2004.

     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.

Use of Estimates In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates.

     Estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the valuation of mortgage servicing rights.

     Management believes that the allowance for loan losses is adequate to cover probable losses inherent in the portfolio at the date of the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require additions to the allowance based on their judgment about information available to them at the time of their examination.

     Mortgage servicing rights are stratified by loan type and note rate and are valued quarterly by a third party using prepayment and default rate assumptions. While management believes that the assumptions used and the values determined are reasonable, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the value of the mortgage servicing rights.

Cash and Cash Equivalents The Company considers highly liquid investments with original maturities of three months or less to be cash equivalents.

Securities Securities are accounted for according to their purpose and holding period. The Company classifies its debt and equity securities in one of three categories:

     Trading Securities Securities held principally for resale in the near term are classified as trading securities and are recorded at their fair values. Unrealized gains and losses on trading securities are included in other income.

     Securities Held to Maturity Securities that the Company has the positive intent and ability to hold to maturity are reported at cost and adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities held to maturity reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established.

     Securities Available for Sale Securities available for sale consist of securities not classified as trading securities or as securities held to maturity. They include securities that management intends to use as part of its asset/liability strategy or that may be sold in response to changes in interest rate, changes in prepayment risk, or similar factors. Unrealized gains and losses, net of income taxes, are reported as a separate component of stockholders’ equity until realized. Gains and losses on the sale of securities available for sale are determined using the specific identification method and recognized on the trade date. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities available for sale reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established.

Loans Held for Sale Mortgage loans originated or purchased which are intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net fees and costs associated with acquiring and/or originating loans held for sale are deferred and included in the basis of the loan in determining the gain or loss on the sale of the loans. Gains are recognized on the settlement date. Net unrealized losses are recognized through a valuation allowance by charges to income.

Loans Receivable, Net Loans receivable, net are considered long-term investments and, accordingly, are carried at amortized cost. Loan origination fees received, net of certain loan origination costs, are deferred as an adjustment to the carrying value of the related loans, and are amortized into income using the interest method over the estimated life of the loans.

     Premiums and discounts on loans are amortized into interest income using the interest method over the period to contractual maturity, adjusted for estimated prepayments.

     The allowance for loan losses is maintained at an amount considered adequate by management to provide for probable losses inherent in the loan portfolio as of the balance sheet dates. The allowance for loan losses is based on a quarterly analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences which include loan impairment, changes in the size of the portfolios, general economic conditions, loan portfolio composition and historical experience. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties or other collateral securing delinquent loans. The allowance for loan losses is established for known problem loans, as well as for loans which are not currently known to require specific allowances. Loans are charged off to the extent they are deemed to be uncollectible. The

28

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.

     Interest income is recognized on an accrual basis except when collectibility is in doubt. When loans are placed on a non-accrual basis, generally when the loan is 90 days past due, previously accrued but unpaid interest is reversed from income. Interest is subsequently recognized as income to the extent cash is received when, in management’s judgment, principal is collectible.

     All impaired loans are valued at the present value of expected future cash flows discounted at the loan’s initial effective interest rate. The fair value of the collateral of an impaired collateral-dependent loan or an observable market price, if one exists, may be used as an alternative to discounting. If the value of the impaired loan is less than the recorded investment in the loan, impairment will be recognized through the allowance for loan losses. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all loans which are on nonaccrual, delinquent as to principal and interest for 90 days or greater and all loans that are restructured in a troubled debt restructuring involving a modification of terms. All non-accruing loans are reviewed for impairment on an individual basis.

Mortgage Servicing Rights Mortgage servicing rights are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. The Company evaluates its capitalized mortgage servicing rights for impairment each quarter. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. Any impairment is recognized through a valuation allowance.

Real Estate, Net Real estate acquired through loan foreclosures are initially recorded at the lower of the related loan balance, less any specific allowance for loss, or fair value less estimated selling costs. Valuations are reviewed quarterly by management and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs.

Premises and Equipment Land is carried at cost. Office buildings, improvements, furniture and equipment are carried at cost less accumulated depreciation.

     Depreciation is computed on a straight-line basis over estimated useful lives of 5 to 40 years for office buildings and improvements and 3 to 10 years for furniture and equipment.

Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of The Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Investment in Limited Partnerships The Company has investments in limited partnerships that invest in low to moderate income housing projects that generate tax credits for the Company. The Company accounts for the earnings or losses from the limited partnerships on the equity method.

Intangible Assets Goodwill resulting from acquisitions is not amortized but is tested for impairment annually in accordance with the requirements of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Deposit base intangibles are amortized on an accelerated basis as the deposits run off. The Company reviews the recoverability of the carrying value of these assets annually or whenever an event occurs indicating that they may be impaired.

Stock-Based Compensation On 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 as 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 the prior periods have not been restated to reflect the impact of FAS 123R. Had compensation cost for the Company’s stock based plan been determined in accordance with SFAS No. 123R in prior years, the Company’s net income and earnings per share would have been adjusted to the following pro forma amounts:

	Year ended December 31,
	2005		2004
Net income:
As reported	$	11,067,889		9,289,797
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		54,619		37,822
Pro forma	$	11,013,270		9,251,975
Earnings per common share:
As reported:
Basic	$	2.89		2.40
Diluted		2.77		2.31
Pro forma:
Basic		2.88		2.39
Diluted		2.77		2.30

Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Earnings per Share Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential

29

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that shared in the earnings of the entity.

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.

Segment Information The amount of each segment item reported is the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an enterprise’s general-purpose financial statements and allocations of revenues, expenses and gains or losses are included in determining reported segment profit or loss if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets that are included in the measure of the segment’s assets that are used by the chief operating decision maker are reported for that segment.

New Accounting Pronouncements The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) on January 1, 2006. It 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 $64,423 for the year ended December 31, 2006.

     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 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 provisions of SFAS No. 156 were adopted by the Company on January 1, 2007 and did not have a material impact on the Company’s results of operations or financial position.

     In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires companies to recognize in their financial statements the impact of a tax position, taken or expected to be taken, if it is more likely than not that the position will be sustained on audit based on the technical merits of the position. The Interpretation requires the use of a cumulative probability methodology to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available at the reporting date. It also requires that interest expense be accrued on the difference between the tax position recognized in accordance with the Interpretation and the amount previously taken or expected to be taken in a tax return. The provisions of FIN 48 were adopted by the Company on January 1, 2007 and as a result, the Company recognized an immaterial increase in its liability recorded for tax exposure reserves for unrecognized tax benefits upon adoption. The adjustment was recorded as a reduction to the January 1, 2007 retained earnings balance and an increase in tax liability in accordance with the requirements of FIN 48.

     In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about the use of fair value to measure assets and liabilities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The impact of adopting SFAS No. 157 on January 1, 2008 is not anticipated to have a material impact on the Company’s results of operations or financial position.

     In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans –an amendment of FASB Statements No. 87, 88, 106, and 132(R). This Statement improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. Since the Company’s only defined benefit pension plan is a multiemployer plan, the requirements of this statement do not apply and therefore SFAS No. 158 did not have any impact on the Company’s December 31, 2006 results of operations or financial position.

     In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides interpretive guidance on how the effects of

30

the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for years ending on or after November 15, 2006. The application of SAB 108 did not have any impact on the Company’s December 31, 2006 results of operations or financial position.

Derivative Financial Instruments The Company uses derivative financial instruments in order to manage the interest rate risk on residential loans held for sale and its commitments to extend credit for residential loans. The Company may also use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments.

Reclassifications Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with the current year presentation.

NOTE 2 Other Comprehensive Income

The components of other comprehensive income and the related tax effects were as follows:

	For the years ended December 31,
	2006						2005
(Dollars in thousands)	Before tax		Tax effect		Net of tax		Before tax			Tax effect			Net of tax
Securities available for sale:
Gross unrealized gains (losses) arising during the period .	$	1,097		433		664		(607	)		(279	)		(328	)
Less reclassification of net gains (losses) included in net income		48		17		31		(21	)		(6	)		(15	)
Net unrealized gains (losses) arising during the period		1,049		416		633		(586	)		(273	)		(313	)
Other comprehensive income(loss)	$	1,049		416		633		(586	)		(273	)		(313	)

NOTE 3 Securities Available for Sale

A summary of securities available for sale at December 31, 2006 and 2005 is as follows:

			Gross		Gross
	Amortized		unrealized		unrealized			Fair
	cost		gains		losses			value
December 31, 2006:
Mortgage-backed securities:
FHLMC	$	162,606		3,457		0			166,063
GNMA		9,876		67		0			9,943
Collateralized mortgage obligations:
FHLMC		2,932,395		0		(263,048	)		2,669,347
FNMA		3,566,165		566		(234,255	)		3,332,476
		6,671,042		4,090		(497,303	)		6,177,829
Other market able securities:
U.S. Government and agency obligations		119,240,282		118,943		(96,951	)		119,262,274
Corporate and agency preferred stock		700,000		0		0			700,000
		119,940,282		118,943		(96,951	)		119,962,274
	$	126,611,324		123,033		(594,254	)		126,140,103
December 31, 2005:
Mortgage-backed securities:
FHLMC	$	196,085		5,590		0			201,675
GNMA		14,229		276		0			14,505
Collateralized mortgage obligations:
FHLMC		3,117,121		0		(302,494	)		2,814,627
FNMA		4,101,069		2,027		(254,147	)		3,848,949
		7,428,504		7,893		(556,641	)		6,879,756
Other market able securities:
U.S. Government and agency obligations		110,109,841		0		(971,028	)		109,138,813
Corporate and agency preferred stock		3,640,000		0		0			3,640,000
		113,749,841		0		(971,028	)		112,778,813
	$	121,178,345		7,893		(1,527,669	)		119,658,569

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N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

     Proceeds from the sale of securities available for sale in 2006 were $2,988,122 resulting in gross gains of $48,122. The Company did not sell any securities available for sale during 2005 and proceeds from securities available for sale that were sold during 2004 were $15,129,325, resulting in gross gains of $8,029 and gross losses of $4,217. The Company also recognized losses of $21,000 and $539,000 on a FHLMC preferred stock investment due to an other than temporary impairment in 2005 and 2004, respectively.

     The table to the right indicates amortized cost and estimated fair value of securities available for sale at December 31, 2006 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates. Actual maturities may differ from the maturities in the following table because obligors may have the right to call or prepay obligations with or without call or prepayment penalties:

	Amortized		Fair
	cost		value
Due less than one year	$	65,350,978		65,270,623
Due after one year through five years		57,022,384		56,905,483
Due after five years through ten years		1,445,971		1,336,421
Due after ten years		2,091,991		1,927,576
No stated maturity		700,000		700,000
Total	$	126,611,324		126,140,103

     The allocation of mortgage-backed securities and collateralized mortgage obligations in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds.

     The following table shows the gross unrealized losses and fair values for the securities available for sale portfolio aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 and December 31, 2005:

	Less than twelve months							Twelve months or more							Total
December 31, 2006	# 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			2	$	2,670		(263	)	$	2,670		(263	)
FNMA				0		0			3		3,177		(234	)		3,177		(234	)
Other marketable debt securities:
FNMA		3		14,925		(3	)		0		0		0			14,925		(3	)
FHLMC		2		9,792		(2	)		0		0		0			9,792		(2	)
FFCB		1		4,878		(3	)		0		0		0			4,878		(3	)
FHLB		4		19,878		(69	)		2		9,980		(20	)		29,858		(89	)
Total temporarily impaired securities		10	$	49,473		(77	)		7	$	15,827		(517	)	$	65,300		(594	)

	Less than twelve months							Twelve months or more							Total
December 31, 2005	# 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			2	$	2,814		(303	)	$	2,814		(303	)
FNMA		1		384		(11	)		2		3,304		(243	)		3,688		(254	)
Other marketable debt securities:
FNMA		1		4,958		(6	)		3		14,836		(147	)		19,794		(153	)
FHLMC		5		24,700		(13	)		4		19,725		(257	)		44,425		(270	)
FHLB		2		9,906		(62	)		7		35,014		(486	)		44,920		(548	)
Total temporarily impaired securities		9	$	39,948		(92	)		18	$	75,693		(1,436	)	$	115,641		(1,528	)

     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 eight years and the other marketable securities had an average life of less than three years at December 31, 2006.

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NOTE 4 Loans Receivable, Net

A summary of loans receivable at December 31 is as follows:

	2006			2005
Residential real estate loans:
1-4 family conventional	$	133,960,403			126,397,513
1-4 family conventional-construction		36,112,745			38,558,199
1-4 family FHA		87,527			450,087
1-4 family VA		221,486			227,055
		170,382,161			165,632,854
5 or more family		29,862,527			40,752,809
5 or more family-construction		4,474,361			11,210,771
		204,719,049			217,596,434
Commercial real estate:
Lodging		46,952,699			47,247,644
Retail/office		63,538,480			51,062,980
Nursing home/health care		14,827,079			6,868,065
Land developments		108,748,666			101,069,732
Golf courses		19,108,878			26,905,139
Restaurant/bar/café		3,310,212			4,402,806
Ethanol plants		8,121,891			8,898,424
Warehouse		7,842,840			8,092,314
Manufacturing		15,580,836			2,998,990
Churches/community service		3,975,566			3,364,752
Other		22,073,368			29,930,294
		314,080,515			290,841,140
Other loans:
Autos		3,092,931			5,461,586
Home equity line		54,246,929			61,011,142
Home equity		21,262,535			19,075,822
Consumer-secured		658,647			979,349
Commercial business		176,769,830			193,962,012
Land/lot loans		5,501,352			9,486,634
Savings		813,823			605,383
Mobile home		2,052,496			2,298,816
Consumer-unsecured		2,219,587			1,979,533
		266,618,130			294,860,277
Total loans		785,417,694			803,297,851
Less:
Unamortized discounts		40,077			190,388
Net deferred loan fees		2,020,773			1,643,629
Allowance for losses		9,873,145			8,777,655
Loans in process		5,252,120			7,007,718
	$	768,231,579			785,678,461
Commitments to originate or purchase loans	$	42,506,639			44,927,627
Commitments to deliver loans to secondary market	$	2,284,894			4,690,823
Weighted average contractual rate of loans in portfolio		7.69	%		6.32	%

     Included in total commitments to originate or purchase loans are fixed rate loans aggregating $14.1 million and $10.4 million as of December 31, 2006 and 2005 respectively. The interest rates on all loan commitments ranged from 5.63% to 8.95% at December 31, 2006 and from 5.50% to 8.15% at December 31, 2005.

     At December 31, 2006, 2005 and 2004, the recorded investment in loans considered to be impaired was $8.3 million, $2.3 million and $3.7 million for which the related allowance for credit losses was $1.7 million, $384,374 and $523,312, respectively. The average investment in impaired loans during 2006, 2005 and 2004 was $8.0 million, $4.2 million and $3.4 million, respectively. If the loans had performed in accordance with their original terms, the Company would have recorded gross interest income of $1.8 million, $327,280 and $271,071 in 2006, 2005 and 2004, respectively. For the years ended December 31, 2006, 2005 and 2004, the Company recognized interest income of $845,346, $273,458 and $158,767, respectively. All of the interest income that was recognized for impaired loans was recognized using the cash basis method of income recognition.

     At December 31, 2006 and 2005 no loans were included in loans receivable, net, with terms that had been modified in a troubled debt restructuring and there were no loans past due more than 90 days and still accruing. There were no material commitments to lend additional funds to customers whose loans were classified as restructured or nonaccrual at December 31, 2006.

     The aggregate amounts of loans to executive officers and directors of the Company was $518,276, $595,249 and $706,869 at December 31, 2006, 2005 and 2004, respectively. During 2006 repayments on loans to executive officers and directors were $59,164, new loans to executive officers and directors totaled $47,500 and net loans removed from the executive officer listing due to change in status of the officer were $65,309. During 2005 repayments on loans to executive officers and directors were $161,620, new loans originated aggregated $768,500 and sales of executive officer and director loans totaled $698,500. All loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated parties.

     At December 31, 2006, 2005 and 2004, the Company was servicing real estate loans for others with aggregate unpaid principal balances of approximately $480.6 million, $541.6 million and $523.6 million, respectively.

     The Company originates residential, commercial real estate and other loans primarily in Minnesota and Iowa. Prior to 2003, the Company also purchased loans from a third party broker located in the southeastern United States. At December 31, 2006 and 2005, the Company had in its portfolio single-family and multi-family residential loans located in the following states:

	2006					2005
			Percent					Percent
	Amount		of Total			Amount		of Total
Alabama	$	269,169		0.1	%	$	1,114,760		0.5	%
Arizona		2,735,791		1.3			2,497,464		1.1
Georgia		2,564,331		1.3			3,071,349		1.4
Iowa		11,792,485		5.8			13,059,087		6.0
Minnesota		178,121,661		87.0			187,307,513		86.1
North Carolina		746,734		0.4			1,316,680		0.6
Wisconsin		4,317,283		2.1			4,567,778		2.1
Other states		4,171,595		2.0			4,661,803		2.2
Total	$	204,719,049		100.0	%	$	217,596,434		100.0	%

Amounts under one million dollars in both years are included in “Other states”.

33

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

At December 31, 2006 and 2005, the Company had in its portfolio commercial real estate loans located in the following states:

	2006					2005
			Percent					Percent
	Amount		of Total			Amount		of Total
Arizona	$	2,885,220		0.9	%	$	3,159,523		1.1	%
California		1,185,060		0.4			1,000,000		0.3
Idaho		5,389,064		1.7			0		0.0
Iowa		13,398,633		4.3			15,757,914		5.4
Kansas		3,519,660		1.1			8,303,539		2.9
Minnesota		280,371,174		89.3			251,087,445		86.3
Missouri		4,225,581		1.3			4,298,961		1.5
Montana		0		0.0			2,026,126		0.7
Utah		2,030,452		0.7			1,840,143		0.6
Other states		1,075,671		0.3			3,367,489		1.2
Total	$	314,080,515		100.0	%	$	290,841,140		100.0	%

Amounts under one million dollars in both years are included in “Other states”.

NOTE 5 Allowance for Loan Losses

The allowance for loan losses is summarized as follows:

Balance, December 31,2003	$	6,939,602
Provision for losses		2,755,000
Charge-offs		(737,917	)
Recoveries		39,207
Balance, December 31,2004		8,995,892
Provision for losses		2,674,000
Charge-offs		(3,076,815	)
Recoveries		184,578
Balance, December 31,2005		8,777,655
Provision for losses		8,878,000
Charge-offs		(7,848,744	)
Recoveries		66,234
Balance, December 31,2006	$	9,873,145

NOTE 6 Accrued Interest Receivable

Accrued interest receivable at December 31 is summarized as follows:

	2006		2005
Securities available for sale	$	930,889		578,068
Loans receivable		4,129,950		3,881,946
	$	5,060,839		4,460,014

NOTE 7 Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

	2006			2005
Mortgage servicing rights
Balance, beginning of year	$	2,653,635			3,231,242
Originations		152,412			442,159
Amortization		(848,348	)		(1,019,766	)
Balance, end of year		1,957,699			2,653,635
Valuation reserve		0			0
Mortgage servicing rights, net	$	1,957,699			2,653,635

     All of the loans being serviced were single family loans serviced for 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 December 31, 2006:

						Weighted
			Weighted			Average
	Loan		Average			Remaining		Number
	Principal		Interest			Term		of
	Balance		Rate			(months)		Loans
Original term 30 year fixed rate	$	201,432,065		5.93	%		324		1,779
Original term 15 year fixed rate		176,433,952		5.27			141		2,386
Adjustable rate		4,323,275		5.62			314		40

NOTE 8 Real Estate

A summary of real estate at December 31 is as follows:

	2006			2005
Real estate in judgment subject to redemption	$	943,452			43,052
Real estate acquired through foreclosure		503,580			521,569
Real estate acquired through deed in lieu of foreclosure		750,000			750,000
		2,197,032			1,314,621
Allowance for losses		(125,000	)		(100,000	)
	$	2,072,032			1,214,621

34

NOTE 9 Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2006 and 2005 are presented in the following table. Amortization expense for intangible assets was $962,204 and $1,133,623 for the years ended December 31, 2006 and 2005.

	Gross					Unamortized
	Carrying		Accumulated			Intangible
	Amount		Amortization			Assets
December 31, 2006
Amortized intangible assets:
Mortgage servicing rights	$	4,148,292		(2,190,593	)		1,957,699
Core deposit intangible		1,567,000		(1,461,097	)		105,903
Total	$	5,715,292		(3,651,690	)		2,063,602
December 31, 2005
Amortized intangible assets:
Mortgage servicing rights	$	4,410,439		(1,756,804	)		2,653,635
Core deposit intangible		1,567,000		(1,347,240	)		219,760
Total	$	5,977,439		(3,104,044	)		2,873,395

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

	Mortgage		Core
	Servicing		Deposit
	Rights		Intangible		Total
Year ended December 31,
2007	$	320,919		105,903		426,822
2008		273,948		0		273,948
2009		233,515		0		233,515
2010		198,732		0		198,732
2011		168,832		0		168,832

Projections of amortization are based on existing asset balances and the existing interest rate environment as of December 31, 2006. The Company’s actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

NOTE 10 Premises and Equipment

A summary of premises and equipment at December 31 is as follows:

	2006			2005
Land	$	1,300,819			1,309,519
Office buildings and improvements		9,794,819			9,428,917
Furniture and equipment		11,956,882			10,997,705
		23,052,520			21,736,141
Less accumulated depreciation		(11,680,417	)		(9,794,278	)
	$	11,372,103			11,941,863

35

N O T E S   T O   C O N S O L I D A T E D   F I N A N C I A L   S T A T E M E N T S

NOTE 11 Deposits

Deposits and their weighted average interest rates at December 31 are summarized as follows:

	2006								2005
	Weighted					Percent of			Weighted					Percent of
	average rate			Amount		total			average rate			Amount		total
Noninterest checking		0.00	%	$	68,990,483		9.5	%		0.00	%	$	58,429,385		8.0	%
NOW accounts		2.54			87,073,869		12.0			2.08			101,942,029		13.9
Savings accounts		1.37			40,445,255		5.6			2.04			84,858,265		11.6
Money market accounts		3.31			178,693,804		24.6			2.59			96,947,209		13.3
					375,203,411		51.7						342,176,888		46.8
Certificates:
0-0.99%					531,367		0.1						650,578		0.1
1-1.99%					157,434		0.1						5,846,533		0.8
2-2.99%					25,699,769		3.5						118,722,782		16.2
3-3.99%					126,408,633		17.4						211,018,548		28.8
4-4.99%					119,376,256		16.4						52,319,449		7.2
5-5.99%					78,581,959		10.8						796,604		0.1
6-6.99%					0		0.0						5,157		0.0
Total certificates		4.23			350,755,419		48.3			3.39			389,359,672		53.2
Total deposits		3.24		$	725,958,830		100.0	%		2.67		$	731,536,560		100.0	%

     At December 31, 2006 and 2005, the Company had $187.0 million and $265.5 million, respectively, of deposit accounts with balances of $100,000 or more. At December 31, 2006 and 2005, the Company had $115.2 million and $165.5 million of certificate accounts, respectively, that had been acquired through a broker.

     Certificates had the following maturities at December 31:

	2006					2005
			Weighted					Weighted
	Amount		average			Amount		average
Remaining term to maturity	(in thousands)		rate			(in thousands)		rate
1-6 months	$	132,231		3.92	%	$	102,326		3.06	%
7-12 months		151,962		4.56			96,919		3.25
13-36 months		57,106		4.08			172,362		3.65
Over 36 months		9,456		4.08			17,753		3.59
	$	350,755		4.23		$	389,360		3.39

     At December 31, 2006, mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $37.1 million and letters of credit from the Federal Home Loan Bank (FHLB) of $4.1 million were pledged as collateral on Bank deposits.

     Interest expense on deposits is summarized as follows for the years ended December 31:

	2006		2005		2004
NOW accounts	$	2,635,488		1,770,001		702,102
Savings accounts		1,083,709		435,164		77,293
Money market accounts		5,119,314		1,328,344		645,153
Certificates		13,207,347		13,699,891		10,973,957
	$	22,045,858		17,233,400		12,398,505

36

NOTE 12 Federal Home Loan Bank Advances

Fixed rate Federal Home Loan Bank advances consisted of the following at December 31:

	2006					2005
Year of Maturity	Amount		Rate			Amount		Rate
2007	$	40,000,000		2.91	%	$	40,000,000		2.91	%
2008		20,000,000		3.83			20,000,000		3.83
2010		10,000,000		6.48			10,000,000		6.48
2011		10,900,000		4.81			10,900,000		4.81
2013		70,000,000		4.77			80,000,000		4.75
		150,900,000		4.27			160,900,000		4.29
Lines of Credit		0					0
	$	150,900,000		4.27		$	160,900,000		4.29

     Many of the advances listed above have call provisions which allow the FHLB to request that the advance be paid back or refinanced at the rates then being offered by the FHLB. As of December 31, 2006, the Company had advances from the FHLB with the following call features:

	Callable Quarterly
Year of Maturity	in 2007
2008	$	10,000,000
2010		10,000,000
2011		10,900,000
2013		70,000,000
	$	100,900,000

     At December 31, 2006, the advances from the FHLB were collateralized by the Bank’s FHLB stock and mortgage loans with unamortized principal balances of $168.3 million. The Bank has the ability to draw additional borrowings of $13.3 million based upon the mortgage loans that are currently pledged, subject to a requirement to purchase additional FHLB stock.

NOTE 13 Other Borrowed Money

The Company had available a $5.0 million revolving line of credit that was not drawn upon at December 31, 2006 or December 31, 2005. The current outstanding line of credit expires on October 24, 2007.

NOTE 14 Income Taxes

Income tax expense (benefit) for the years ended December 31 is as follows:

	2006			2005			2004
Current:
Federal	$	4,546,800			6,251,100			4,688,700
State		1,428,700			1,744,100			435,600
Total current		5,975,500			7,995,200			5,124,300
Deferred:
Federal		(612,200	)		(843,400	)		(683,200	)
State		(137,800	)		(415,700	)		(54,000	)
Total deferred		(750,000	)		(1,259,100	)		(737,200	)
	$	5,225,500			6,736,100			4,387,100

37

N O T E S   T O   C O N S O L I D A T E D   F I N A N C I A L   S T A T E M E N T S

     The reasons for the difference between “expected” income tax expense utilizing the federal corporate tax rate of 34% and the actual income tax expense are as follows:

	2006			2005			2004
Expected federal income tax expense	$	4,642,000			6,053,400			4,651,300
Items affecting federal income tax:
Dividend received deduction		(23,000	)		(25,700	)		(16,200	)
State income taxes, net of federal income tax benefit		880,400			974,900			247,900
Reduction of tax rate due to employee stock ownership plan dividends		0			0			(170,200	)
Low income housing credits		(9,700	)		(42,000	)		(84,000	)
Tax exempt interest		(377,200	)		(378,000	)		(340,300	)
Other, net		113,000			153,500			98,600
	$	5,225,500			6,736,100			4,387,100

     The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31:

	2006		2005
Deferred tax assets:
Allowances for loan and real estate losses	$	3,905,800		3,479,700
Allowance for other assets		51,500		81,200
Discounts on assets and liabilities acquired from Marshalltown Financial Corporation		100		100
Deferred compensation costs		172,300		195,800
Impairment losses on securities available for sale		0		221,900
Net unrealized loss on market value adjustments to securities available for sale		186,800		602,200
Deferred ESOP loan asset		544,500		506,900
Restricted stock expense		77,300		0
Nonqualified stock options		12,100		0
Deferred tax assets		4,950,400		5,087,800
Valuation allowance		0		0
Total gross deferred tax assets		4,950,400		5,087,800
Deferred tax liabilities:
Premium on assets acquired from Marshalltown Financial Corporation		42,000		87,300
Deferred loan fees and costs		494,400		475,200
Premises and equipment basis difference		646,800		835,500
Originated mortgage servicing rights		775,700		1,051,400
Other		112,500		94,000
Total gross deferred tax liabilities		2,071,400		2,543,400
Net deferred tax assets	$	2,879,000		2,544,400

     Retained earnings at December 31, 2006 included approximately $8.8 million for which no provision for income taxes was made. This amount represents allocations of income to bad debt deductions for tax purposes. Reduction of amounts so allocated for purposes other than absorbing losses will create income for tax purposes, which will be subject to the then-current corporate income tax rate. The Company has, in its judgment, made reasonable assumptions relating to the realization of deferred tax assets. Based upon these assumptions, the Company has determined that no valuation allowance is required with respect to the deferred tax assets.

     The Company is located in Minnesota and files a state income tax return with the Minnesota Department of Revenue (MDR). In January 2007, the Company received notification that the MDR was proposing adjustments of $2.2 million to the company’s 2002 through 2004 Minnesota state tax liability. The proposed adjustments relate to the tax treatment of the inter-company dividends paid to the Bank by Home Federal Holding. The Company intends to challenge the proposed adjustments. A tax exposure reserve has been established during 2002 through 2006 based on a range of probable outcomes, however, the final liability will depend on the ultimate resolution of this issue. In 2005, Minnesota state tax laws were changed and the Company’s Minnesota tax filings for 2005 and forward do not have exposure relating to the treatment of the inter-company dividend payment.

38

NOTE 15 Employee Benefits

All eligible full-time employees of the Bank that were hired prior to 2002 were included in a noncontributory multiemployer retirement plan sponsored by the Financial Institutions Retirement Fund (FIRF). Effective September 1, 2002 the Bank froze the accrual of benefits for existing participants and no new enrollments were permitted into the plan. The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank’s employees was not available at December 31, 2006 because such information is not accumulated for each participating institution. As of June 30, 2006, the FIRF valuation report reflected that the Bank was obligated make a contribution totaling $217,688. The required contribution was $235,465 in 2005 and $71,807 in 2004.

     The Company has a qualified, tax-exempt savings plan with deferred feature qualifying under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). All employees who have attained 18 years of age are eligible to participate in the Plan. Participants are permitted to make contributions to the 401(k) Plan equal to the lesser of 50% of the participant’s annual salary or the maximum allowed by law, which was $15,000 for 2006. The Company matches 25% of each participant’s contributions up to a maximum of 8% of the participant’s annual salary. Participant contributions and earnings are fully and immediately vested. The Company’s contributions are vested on a three year cliff basis, are expensed when made, and were $140,787, $122,428 and $118,665, in 2006, 2005 and 2004, respectively.

     The Company has adopted an Employee Stock Ownership Plan (the ESOP) that meets the requirements of Section (e)(7) of the Internal Revenue Code and Section 407(d)(6) of the Employee Retirement Income Security Act of 1974, as amended (ERISA) and, as such the ESOP is empowered to borrow in order to finance purchases of the common stock of HMN. The ESOP borrowed $6,085,770 from the Company to purchase 912,866 shares common stock in the initial public offering of HMN. As a result a merger with Marshalltown Financial Corporation (MFC), the ESOP borrowed $1,476,000 to purchase 76,933 shares of HMN common stock to provide the employees from MFC with an ESOP benefit. The ESOP debt requires quarterly payments of principal plus interest 7.52%. The Company has committed to make quarterly contributions to the ESOP necessary to repay the loan including interest. The Company contributed $525,229 for 2006 and 2005 and $526,552 for 2004.

     As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral and allocated to active employees based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6, Employers’ Accounting for Employee Stock Ownership Plans. Accordingly, the shares pledged as collateral are reported as unearned ESOP shares in stockholders’ equity. As shares are determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations. ESOP compensation benefit expense was $822,116, $756,166 and $670,112, respectively, for 2006, 2005 and 2004.

     All employees of the Bank are eligible to participate in the ESOP after they attain age 21 and complete one year of service during which they worked at least 1,000 hours. A summary of the ESOP share allocation is as follows for the years ended:

	2006			2005			2004
Shares allocated to participants beginning of the year		286,018			270,884			275,588
Shares allocated to participants		24,317			24,317			24,380
Shares purchased with dividends from allocated shares		9,223			8,311			7,368
Shares distributed to participants		(24,927	)		(17,494	)		(36,452	)
Shares allocated to participants end of year		294,631			286,018			270,884
Unreleased shares beginning of the year		547,416			571,733			596,113
Shares released during year		(24,317	)		(24,317	)		(24,380	)
Unreleased shares end of year		523,099			547,416			571,733
Total ESOP shares end of year		817,730			833,434			842,617
Fair value of unreleased shares at December 31	$	18,052,146			16,148,772			18,861,472

     In June 1995, the Company adopted the 1995 Stock Option and Incentive Plan (1995 Plan). The provisions of the 1995 Plan expired on April 25, 2005 and options may no longer be granted from the plan. At December 31, 2006, there were 3,000 unvested and 113,774 vested options under the 1995 Plan that remained unexercised. These options vest over a 5 year period, expire 10 years from the date of grant, and have an average exercise price of $12.13.

     In March 2001, the Company adopted the HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan). The purpose of the 2001 Plan is to promote the interests of the Company and its stockholders by providing key personnel with an opportunity to acquire a proprietary interest in the Company and reward them for achieving a high level of corporate performance and thereby develop a stronger incentive to put forth maximum effort for the success and growth of the Company. The total number of shares of HMN common stock available for distribution under the 2001 Plan in either restricted stock or stock options is 400,000 and is subject to adjustment for future stock splits, stock dividends and similar changes to the capitalization of the Company. No more than 100,000 shares from the 2001 Plan may be issued as restricted stock.

39

N O T E S   T O   C O N S O L I D A T E D   F I N A N C I A L   S T A T E M E N T S

     The fair value of options granted under the 2001 Plan were $3.59, $2.62, $2.10 and $2.10 for May 2005, July 2004, March 2004 and February 2004, respectively. A summary of activities under both plans for the past three years is as follows:

												Unvested options
	Shares			Restricted						Award value/					Weighted average
	available for			shares			Options			weighted average					granted date		Vesting
	grant			outstanding			outstanding			exercise price		Number			fair value		period
1995 Stock Option and Incentive Plan
December 31, 2003		9,397						178,755		$	11.36		37,000		$	2.88
Options exercised								(43,814	)		9.47
Vested													(22,000	)		3.39
December 31, 2004		9,397						134,941			11.97		15,000			2.15
Options exercised								(10,941	)		9.56
Expired		(9,397	)								N/A
Vested													(9,000	)		2.34
December 31, 2005		0						124,000			12.18		6,000			1.85
Options exercised								(7,226	)		13.00
Vested													(3,000	)		1.85
December 31, 2006		0						116,774			12.13		3,000			1.85
2001 Omnibus Stock Plan
December 31, 2003		204,037						195,963		$	16.13		195,963		$	1.43
Granted February 13, 2004		(5,000	)					5,000			27.64		5,000			2.10	4 years
Granted March 3, 2004		(20,000	)					20,000			27.66		20,000			2.10	3 years
Granted July 27, 2004		(15,000	)					15,000			26.98		15,000			2.62	5 years
Options forfeited		17,618						(17,618	)		19.05		(17,618	)		1.60
Options vested													0
December 31, 2004		181,655						218,345			17.96		218,345			1.57
Granted January 25, 2005		(10,047	)		10,047			0			N/A		N/A			N/A	3 years
Granted May 24, 2005		(15,000	)					15,000			30.00		15,000			3.59	5 years
Forfeited		7,997			(1,418	)		(6,579	)		16.13		(6,579	)		1.43
Vested													(15,895	)		1.93
December 31, 2005		164,605			8,629			226,766			18.81		210,871			1.70
Granted January 24, 2006		(7,895	)		7,895			0			N/A						3 years
Granted January 26, 2006		(2,583	)		2,583			0			N/A						3 years
Options exercised								(6,466	)		16.13
Vested													(12,429	)		2.59
December 31, 2006		154,127			19,107			220,300			18.89		198,442			1.64
Total both plans		154,127			19,107			337,074			16.55		201,442			1.64

40

     The following table summarizes information about stock options outstanding at December 31, 2006:

											Weighted average
											years over
			Weighted average						Unrecognized		which unrecognized
Exercise	Number		remaining contractual		Number		Number		compensation		compensation will
price	outstanding		life in years		exercisable		unexercisable		expense		be recognized
$ 13.00		6,774		0.3		6,774		0	$	0
11.50		65,000		2.3		65,000		0		0
11.25		30,000		3.4		30,000		0		0
16.13		169,760		5.4		0		169,760		105,789		5.0
16.25		15,000		5.4		12,000		3,000		404		0.4
27.64		5,000		7.2		2,500		2,500		962		0.2
27.66		15,540		7.2		10,358		5,182		928		0.2
26.98		15,000		7.6		6,000		9,000		12,689		2.6
30.00		15,000		8.4		3,000		12,000		20,884		3.4
		337,074				135,632		201,442	$	141,656

     The Company will issue shares from treasury upon the exercise of outstanding options.

     Prior to January 1, 2006 the Company used the intrinsic value method as described in APB Opinion No. 25 and related interpretations to account for its stock incentive plans. Accordingly, there were no charges or credits to expense with respect to the granting or exercise of options since the options were issued at fair value on the respective grant dates. On January 1, 2006 the Company adopted FAS No. 123(R), which replaced FAS No. 123 and supercedes APB Opinion No. 25. In accordance with this standard, in 2006 the Company recognized compensation expense relating to stock options that vested during the year. The amount of the expense was determined under the fair value method. Pro forma disclosures for years prior to 2006 are included in Note 1.

     The fair value for each option grant is estimated on the date of the grant using a Black Scholes option valuation model. There were no options granted in 2006. The following table shows the assumptions that were used in determining the fair value of options granted during the indicated years:

	2005			2004
Risk-free interest rate		4.03	%		4.13	%
Expected life	9 years			9 years
Expected volatility		8.75	%		10.63	%
Expected dividends		2.9	%		3.9	%

NOTE 16 Earnings per Share

The following table reconciles the weighted average shares outstanding and net income for basic and diluted EPS:

	Year ended December 31,
	2006		2005		2004
Weighted average number of common shares outstanding used in basic earnings per common share calculation		3,822,189		3,824,555		3,868,223
Net dilutive effect of:
Options		174,883		166,207		159,442
Restricted stock awards		12,770		7,683		0
Weighted average number of shares outstanding adjusted for effect of dilutive securities		4,009,842		3,998,445		4,027,665
Net income available to common shareholders	$	8,427,551		11,067,889		9,289,797
Basic earnings per common share	$	2.20		2.89		2.40
Diluted earnings per common share	$	2.10		2.77		2.31

41

N O T E S   T O   C O N S O L I D A T E D   F I N A N C I A L   S T A T E M E N T S

NOTE 17 Stockholders’ Equity

     The Company repurchased in the open market and placed in treasury 115,000 shares of its common stock in 2006, 30,000 shares in 2005 and 123,000 shares in 2004, for $4.0 million, $1.0 million and $3.3 million, respectively.

     HMN declared and paid dividends as follows:

				Quarterly
		Dividend		Dividend
Record date	Payable date	per share		Payout Ratio
February 20, 2004	March 8, 2004	$	0.20		37.74	%
May 21, 2004	June 8, 2004	$	0.20		38.46	%
August 27, 2004	September 10, 2004	$	0.22		35.48	%
November 26, 2004	December 15, 2004	$	0.22		34.38	%
February 18, 2005	March 7, 2005	$	0.22		41.51	%
May 20, 2005	June 8, 2005	$	0.22		31.43	%
August 26, 2005	September 9, 2005	$	0.24		38.71	%
November 25, 2005	December 14, 2005	$	0.24		42.11	%
February 17, 2006	March 7, 2006	$	0.24		27.59	%
May 19, 2006	June 7, 2006	$	0.24		35.29	%
August 25, 2006	September 8, 2006	$	0.25		34.25	%
November 24, 2006	December 13, 2006	$	0.25		1,250.00	%

     On January 23, 2007 the Company declared a cash dividend of $0.25 per share payable on March 7, 2007, to stockholders of record on February 16, 2007. The annualized dividend payout ratios for 2006, 2005 and 2004 were 42.61%, 38.02% and 36.36%, respectively.

     The Company’s certificate of incorporation authorizes the issuance of up to 500,000 shares of preferred stock, but to date no shares have been issued.

     In order to grant a priority to eligible accountholders in the event of future liquidation, the Bank, at the time of conversion to a stock savings bank, established a liquidation account equal to its regulatory capital as of September 30, 1993. In the event of future liquidation of the Bank, an eligible accountholder who continues to maintain their deposit account shall be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account will be decreased as the balance of eligible accountholders are reduced subsequent to the conversion, based on an annual determination of such balance.

     The Bank may not declare or pay a cash dividend to the Company without filing a capital distribution application with the OTS if the total amount of the dividends for the year exceeds the Bank’s net income for the year plus the Bank’s retained net income for the preceding two years. Additional limitations on dividends declared or paid on, or repurchases of, the Bank’s capital stock are tied to the Bank’s level of compliance with its regulatory capital requirements.

NOTE 18 Federal Home Loan Bank Investment and Regulatory Capital Requirements

The Bank, as a member of the Federal Home Loan Bank System, is required to hold a specified number of shares of capital stock, which are carried at cost, in the Federal Home Loan Bank of Des Moines. The Bank met this requirement at December 31, 2006.

     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 December 31, 2006 and 2005, that the Bank met all capital adequacy requirements to which it was subject.

     Management believes that based upon the Bank’s capital calculations at December 31, 2006 and 2005 and other conditions consistent with the Prompt Corrective Actions provisions of the OTS regulations, the Bank would be categorized as well capitalized.

42

     At December 31, 2006 and 2005 the Bank’s capital amounts and ratios are also presented for actual capital, required capital and excess capital including amounts and ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations:

																To Be Well Capitalized
						Required to										Under Prompt
						be Adequately										Corrective Actions
	Actual					Capitalized					Excess Capital					Provisions
			Percent of					Percent of					Percent of					Percent of
(Dollars in thousands)	Amount		Assets (1)			Amount		Assets (1)			Amount		Assets (1)			Amount		Assets (1)
December 31, 2006
Tier I or core capital	$	80,586		8.34	%	$	38,650		4.00	%	$	41,936		4.34	%	$	48,312		5.00	%
Tier I risk based capital		80,586		10.19			31,630		4.00			48,956		6.19			47,445		6.00
Risk-based capital to risk-weighted assets		89,611		11.33			63,261		8.00			26,350		3.33			79,076		10.00
December 31, 2005
Tier I or core capital	$	80,401		8.18	%	$	39,330		4.00	%	$	41,071		4.18	%	$	49,163		5.00	%
Tier I risk based capital		80,401		10.02			32,102		4.00			48,299		6.02			48,153		6.00
Risk-based capital to risk-weighted assets		89,007		11.09			64,204		8.00			24,803		3.09			80,254		10.00

⁽¹⁾ Based upon the Bank’s adjusted total assets for the purpose of the Tier I or core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio.

NOTE 19 Financial Instruments with Off-Balance Sheet Risk

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of these instruments reflect the extent of involvement by the Company.

     The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contract amount of these commitments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments.

	December 31,
	Contract amount
(Dollars in thousands)	2006		2005
Financial instruments whose contract amount represents credit risk:
Commitments to originate, fund or purchase loans:
1-4 family mortgages	$	786		3,850
Commercial real estate mortgages		38,996		19,835
Non-mortgage loans		2,725		21,243
Undisbursed balance of loans closed		96,843		75,465
Unused lines of credit		129,728		97,445
Letters of credit		13,263		10,158
Total commitments to extend credit	$	282,341		227,996
Forward commitments	$	2,285		4,691

     Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the loan type and on management’s credit evaluation of the borrower. Collateral consists primarily of residential and commercial real estate and personal property.

     Forward commitments represent commitments to sell loans to a third party and are entered into in the normal course of business by the Bank.

     The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding at December 31, 2006 expire over the next 3 months and totaled $680,000 at December 31, 2006 and $1.7 million at December 31, 2005. The letters of credit were 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.

43

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

NOTE 20 Derivative Instruments and Hedging Activities

The Company originates and purchases single-family residential loans for sale into the secondary market and enters into commitments to sell those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. The Company accounts for these commitments in accordance with SFAS No. 133, Accounting for 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 year, which is referred to as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, the Company generally enters into commitments to sell the loans into the secondary market. The commitments to originate and sell loans are derivatives that are recorded at market value. As a result of marking these derivatives to market for the period ended December 31, 2006, the Company recorded a decrease in other liabilities of $4,802 and a net gain on the sale of loans of $4,802.

     As of December 31, 2006 the 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. The loans held for sale that are not hedged are recorded at the lower of cost or market. As a result of marking these loans, the Company recorded an increase in loans held for sale of $3,310 and a decrease in other assets of $3,310.

NOTE 21 Fair Value of Financial Instruments

SFAS No. 107, Disclosures about Fair Values of Financial Instruments, requires disclosure of estimated fair values of the Company’s financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value estimates are made as of December 31, 2006 and 2005 based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. The estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

     Fair value estimates are based only on existing financial instruments without attempting to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.

     The estimated fair value of the Company’s financial instruments are shown below. Following the table, there is an explanation of the methods and assumptions used to estimate the fair value of each class of financial instruments.

	December 31,
	2006								2005
	Carrying			Estimated			Contract		Carrying			Estimated			Contract
(Dollars in thousands)	amount			fair value			amount		amount			fair value			amount
Financial assets:
Cash and cash equivalents	$	43,776			43,776					47,269			47,269
Securities available for sale		126,140			126,140					119,659			119,659
Loans held for sale		1,493			1,493					1,435			1,435
Loans receivable, net		768,232			776,895					785,678			785,189
Federal Home Loan Bank stock		7,956			7,956					8,365			8,365
Accrued interest receivable		5,061			5,061					4,460			4,460
Financial liabilities:
Deposits		725,959			697,370					731,536			684,586
Federal Home Loan Bank advances		150,900			151,200					160,900			161,929
Accrued interest payable		1,176			1,176					2,086			2,086
Off-balance sheet financial instruments:
Commitments to extend credit		2			2			282,341		5			5			227,996
Commitments to sell loans		(14	)		(14	)		2,285		(19	)		(19	)		4,691

44

Cash and Cash Equivalents The carrying amount of cash and cash equivalents approximates their fair value.

Securities Available for Sale The fair values of securities were based upon quoted market prices.

Loans Held for Sale The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity.

Loans Receivable The fair values of loans receivable were estimated for groups of loans with similar characteristics. The fair value of the loan portfolio, with the exception of the adjustable rate portfolio, was calculated by discounting the scheduled cash flows through the estimated maturity using anticipated prepayment speeds and using discount rates that reflect the credit and interest rate risk inherent in each loan portfolio. The fair value of the adjustable loan portfolio was estimated by grouping the loans with similar characteristics and comparing the characteristics of each group to the prices quoted for similar types of loans in the secondary market.

Federal Home Loan Bank Stock The carrying amount of FHLB stock approximates its fair value.

Accrued Interest Receivable The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns.

Deposits Under SFAS No. 107, the fair value of deposits with no stated maturity such as checking, savings and money market accounts,
is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows using as discount rates the rates that were offered by the Company as of December 31, 2006 and 2005 for deposits with maturities similar to the remaining maturities of the existing certificates of deposit.

     The fair value estimate for deposits does not include the benefit that results from the low cost funding provided by the Company’s existing deposits and long-term customer relationships compared to the cost of obtaining different sources of funding. This benefit is commonly referred to as the core deposit intangible.

Federal Home Loan Bank Advances The fair values of advances with fixed maturities are estimated based on discounted cash flow analysis using as discount rates the interest rates charged by the FHLB at December 31, 2006 and 2005 for borrowings of similar remaining maturities.

Accrued Interest Payable The carrying amount of accrued interest payable approximates its fair value since it is short-term in nature.

Commitments to Extend Credit The fair values of commitments to extend credit for 2006 and 2005 are estimated using the fees normally charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties.

Commitments to Sell Loans The fair values of commitments to sell loans for 2006 and 2005 are estimated using the quoted market prices for loans with similar interest rates and terms to maturity.

45

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

NOTE 22 HMN Financial, Inc. Financial Information (Parent Company Only)

The following are the condensed financial statements for the parent company only as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004.

	2006			2005			2004
Condensed Balance Sheets
Assets:
Cash and cash equivalents	$	5,742,163			4,885,596
Investment in subsidiaries		86,770,255			85,298,915
Real estate, net		650,000			750,000
Prepaid expenses and other assets		450,938			231,433
Deferred tax asset		173,200			195,400
Total assets	$	93,786,556			91,361,344
Liabilities and Stockholders’ Equity:
Accrued expenses and other liabilities	$	644,215			633,075
Total liabilities		644,215			633,075
Common stock		91,287			91,287
Additional paid-in capital		57,913,743			58,011,099
Retained earnings		103,642,975			98,951,777
Net unrealized loss on securities available for sale		(284,421	)		(917,577	)
Unearned employee stock ownership plan shares		(4,157,698	)		(4,350,999	)
Unearned compensation stock awards		0			(182,521	)
Treasury stock, at cost, 4,813,232 and 4,721,402 shares		(64,063,545	)		(60,874,797	)
Total stockholders’ equity		93,142,341			90,728,269
Total liabilities and stockholders’ equity	$	93,786,556			91,361,344
Condensed Statements of Income
Interest income	$	121,125			107,574			69,936
Interest expense		(3,460	)		0			0
Equity earnings of subsidiaries		8,838,184			11,375,240			9,453,280
Equity earnings of limited partnerships		0			0			803
Other income		808			0			0
Compensation and benefits		(236,000	)		(247,300	)		(207,300	)
Occupancy		(21,300	)		(20,400	)		(14,400	)
Data processing		(4,200	)		(3,600	)		(2,600	)
Mortgage servicing		0			0			(145	)
Other		(502,706	)		(375,525	)		(409,377	)
Income before income tax benefit		8,192,451			10,835,989			8,890,197
Income tax benefit		(235,100	)		(231,900	)		(399,600	)
Net income	$	8,427,551			11,067,889			9,289,797

46

	2006			2005			2004
Condensed Statements of Cash Flows
Cash flows from operating activities:
Net income	$	8,427,551			11,067,889			9,289,797
Adjustments to reconcile net income to cash provided by operating activities:
Equity earnings of subsidiaries		(8,838,184	)		(11,375,240	)		(9,453,280	)
Provision for loan losses		100,000			0			0
Equity earnings in limited partnership		0			0			(803	)
Deferred income taxes		22,200			(33,400	)		(128,400	)
Earned employee stock ownership shares priced above original cost		379,529			339,798			308,165
Stock option compensation		64,423			0			0
Amortization of restricted stock awards		190,711			97,922			0
Decrease in unearned ESOP shares		193,301			193,301			193,784
Decrease (increase) in accrued interest receivable		0			8,462			(2,842	)
Increase in accrued expenses and other liabilities		11,140			67,129			340,696
Decrease (increase) in other assets		(219,505	)		89,354			997,526
Other, net		0			0			(2	)
Net cash provided by operating activities		331,166			455,215			1,544,641
Cash flows from investing activities:
Purchase of real estate owned from subsidiary		0			(750,000	)		0
Decrease in loans receivable, net		0			0			110,000
Redemption of investment in limited partnership		0			0			422,474
Net cash (used) provided by investing activities		0			(750,000	)		532,474
Cash flows from financing activities:
Purchase of treasury stock		(3,960,350	)		(972,000	)		(3,316,550	)
Stock options exercised		166,284			37,887			66,634
Excess tax benefit from options exercised		55,820			29,907			98,096
Dividends to stockholders		(3,736,353	)		(3,524,140	)		(3,246,426	)
Proceeds from dividends on Bank stock		8,000,000			4,000,000			4,000,000
Net cash provided (used) by financing activities		525,401			(428,346	)		(2,398,246	)
Increase (decrease) in cash and cash equivalents		856,567			(723,131	)		(321,131	)
Cash and cash equivalents, beginning of year		4,885,596			5,608,727			5,929,858
Cash and cash equivalents, end of year	$	5,742,163			4,885,596			5,608,727

47

N O T E S  T O  C O N S O L I D A T E D  F I N A N C I A L  S T A T E M E N T S

NOTE 23 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 a reportable segment and therefore are included in the “Other” category.

     The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets and return on average equity. Each corporation is managed separately with its own officers and board of directors.

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

	Home Federal									Consolidated
(Dollars in thousands)	Savings Bank			Other			Eliminations			Total
At or for the year ended December 31, 2006:
Interest income – external customers	$	67,418			109			0			67,527
Non-interest income – external customers		6,469			1			0			6,470
Losses in limited partnerships		(29	)		0			0			(29	)
Intersegment interest income		4			12			(16	)		0
Intersegment non-interest income		144			8,838			(8,982	)		0
Interest expense		28,853			4			(16	)		28,841
Amortization of mortgage servicing rights, net		848			0			0			848
Other non-interest expense		21,120			772			(144	)		21,748
Income tax expense (benefit)		5,463			(238	)		0			5,225
Net income		8,844			8,422			(8,838	)		8,428
Goodwill		3,801			0			0			3,801
Total assets		970,941			93,831			(86,983	)		977,789
At or for the year ended December 31, 2005:
Interest income – external customers	$	60,201			80			0			60,281
Non-interest income – external customers		6,536			0			0			6,536
Losses in limited partnerships		(27	)		0			0			(27	)
Intersegment interest income		0			28			(28	)		0
Intersegment non-interest income		134			11,375			(11,509	)		0
Interest expense		24,539			0			(28	)		24,511
Amortization of mortgage servicing rights, net		1,020			0			0			1,020
Other non-interest expense		20,260			655			(134	)		20,781
Income tax expense (benefit)		6,971			(235	)		0			6,736
Net income		11,380			11,063			(11,375	)		11,068
Goodwill		3,801			0			0			3,801
Total assets		985,456			91,410			(85,629	)		991,237
At or for the year ended December 31, 2004:
Interest income – external customers	$	51,568			49			0			51,617
Non-interest income – external customers		5,993			0			0			5,993
Earnings (losses) on limited partnerships		(27	)		1			0			(26	)
Intersegment interest income		0			21			(21	)		0
Intersegment non-interest income		174			9,453			(9,627	)		0
Interest expense		21,014			0			(21	)		20,993
Amortization of mortgage servicing rights, net		1,061			0			0			1,061
Other non-interest expense		18,633			642			(174	)		19,101
Income tax expense (benefit)		4,790			(403	)		0			4,387
Minority interest		(3	)		0			0			(3	)
Net income		9,458			9,285			(9,453	)		9,290
Goodwill		3,801			0			0			3,801
Total assets		954,779			84,391			(78,497	)		960,673

48

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

HMN Financial, Inc.:

We have audited the accompanying consolidated balance sheets of HMN Financial, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

     We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of HMN Financial, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

     We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of HMN Financial, Inc.’s internal control over financial reporting as of December 31, 2006, based on, criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 1, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

KPMG LLP

Minneapolis, MN
March 1, 2007

49

S E L E C T E D  Q U A R T E R L Y  F I N A N C I A L  D A T A

	December 31,			September 30,			June 30,
(Dollars in thousands, except per share data)	2006			2006			2006
Selected Operations Data (3 months ended):
Interest income	$	17,358			17,175			17,011
Interest expense		7,513			7,473			7,261
Net interest income		9,845			9,702			9,750
Provision for loan losses		1,357			6,026			980
Net interest income after provision for loan losses		8,488			3,676			8,770
Noninterest income:
Fees and service charges		780			820			796
Loan servicing fees		276			291			301
Securities gains (losses), net		0			0			48
Gain on sales of loans		225			481			303
Other noninterest income		173			143			318
Total noninterest income		1,454			1,735			1,766
Noninterest expense:
Compensation and benefits		2,786			2,706			3,118
Occupancy		1,101			1,131			1,103
Deposit insurance premiums		23			23			25
Advertising		129			108			107
Data processing		300			307			287
Amortization of mortgage servicing rights, net		187			208			237
Other noninterest expense		928			957			886
Total noninterest expense		5,454			5,440			5,763
Income (loss) before income tax expense		4,488			(29	)		4,773
Income tax expense (benefit)		1,818			(102	)		1,829
Net income		2,670			73			2,944
Basic earnings per share	$	0.71			0.02			0.77
Diluted earnings per share	$	0.67			0.02			0.73
Financial Ratios:
Return on average assets(1)		1.11	%		0.03			1.18
Return on average equity(1)		11.18			0.30			12.34
Average equity to average assets		9.70			9.64			9.60
Dividend payout ratio		1,250.00			34.25			35.29
Net interest margin(1)(2)		4.28			4.06			4.08

(Dollars in thousands)
Selected Financial Condition Data:
Total assets	$	977,789	991,258	1,009,935
Securities available for sale:
Mortgage-backed and related securities		6,178	6,221	6,267
Other marketable securities		119,962	139,787	138,953
Loans held for sale		1,493	4,217	7,129
Loans receivable, net		768,232	729,381	757,621
Deposits		725,959	741,618	748,355
Federal Home Loan Bank advances		150,900	150,900	160,900
Stockholders’ equity		93,142	92,064	93,624

(1)	Annualized
(2)	Net interest income divided by average interest-earning assets.

50

March 31,		December 31,			September 30,		June 30,		March 31,
2006		2005			2005		2005		2005
	15,983		16,074			15,238		14,773		14,196
	6,594		6,667			6,292		6,027		5,525
	9,389		9,407			8,946		8,746		8,671
	515		179			952		907		636
	8,874		9,228			7,994		7,839		8,035
	715		725			706		685		603
	304		308			305		304		293
	0		(21	)		0		0		0
	246		611			625		324		293
	221		164			85		262		237
	1,486		1,787			1,721		1,575		1,426
	3,259		2,800			2,781		2,785		2,774
	1,100		1,002			1,042		1,042		995
	31		33			35		34		28
	131		93			102		105		84
	289		270			279		245		238
	216		253			257		271		239
	913		989			1,054		1,039		932
	5,939		5,440			5,550		5,521		5,290
	4,421		5,575			4,165		3,893		4,171
	1,680		2,098			1,889		1,393		1,356
	2,741		3,477			2,276		2,500		2,815
	0.71		0.91			0.59		0.65		0.74
	0.68		0.87			0.57		0.62		0.70
	1.14		1.39			0.92		1.01		1.18
	11.82		15.03			10.02		11.41		13.22
	9.67		9.05			8.99		8.90		8.92
	27.59		42.11			38.71		31.43		41.51
	4.10		3.94			3.79		3.70		3.79
	989,984		991,237			982,304		985,662		991,326
	6,698		6,880			7,481		8,220		8,470
	117,384		112,779			91,031		91,053		90,980
	5,011		1,435			4,058		4,290		1,510
	767,881		785,678			815,164		819,940		813,244
	727,466		731,537			714,711		720,230		727,815
	160,900		160,900			170,900		170,900		170,900
	92,646		90,728			88,018		86,558		84,488

51

O T H E R  F I N A N C I A L   D A T A

	Year Ended December 31,
(Dollars in thousands)	2006		2005		2004
Maximum Balance:
Federal Home Loan Bank advances	$	162,900		193,900		214,800
Federal Home Loan Bank short-term borrowings		52,000		33,000		43,900
Average Balance:
Federal Home Loan Bank advances		155,972		170,919		196,008
Federal Home Loan Bank short-term borrowings		28,513		10,047		26,918

The following table sets forth certain information as to the Bank’s Federal Home Loan Bank (FHLB) advances.

	December 31,
	2006					2005					2004
			Weighted					Weighted					Weighted
			Average					Average					Average
(Dollars in thousands)	Amount		Rate			Amount		Rate			Amount		Rate
FHLB short-term borrowings	$	40,000		2.91	%	$	0		0.00	%	$	10,000		2.69	%
Other FHLB long-term advances		110,900		4.76			160,900		4.29			160,900		4.29
Total	$	150,900		4.27		$	160,900		4.29		$	170,900		4.20

C O M M O N  S T O C K  I N F O R M A T I O N

The common stock of HMN Financial, Inc. is listed on the Nasdaq Stock Market under the symbol: HMNF. As of December 31, 2006, the Company had 9,128,662 shares of common stock outstanding and 4,813,232 shares in treasury stock. As of December 31, 2006 there were 713 stockholders of record and 1,124 estimated beneficial stockholders. The following table represents the stock price information for HMN Financial, Inc. as furnished by Nasdaq for each quarter starting with the quarter ended December 31, 2006 and regressing back to March 30, 2001.

	Dec. 29,		Sept. 29,		June 30,		March 31,		Dec. 30,		Sept. 30,		June 30,		March 31,
	2006		2006		2006		2006		2005		2005		2005		2005
HIGH	$	35.10		36.10		35.02		34.79		32.00		32.39		32.00		33.06
LOW		32.75		33.75		33.14		28.84		28.14		30.75		28.55		29.70
CLOSE		34.51		34.76		34.80		34.79		29.50		31.92		31.48		31.00

	Dec. 31,		Sept. 30,		June 30,		March 31,		Dec. 31,		Sept. 30,		June 30,		March 31,
	2004		2004		2004		2004		2003		2003		2003		2003
HIGH	$	33.50		27.99		27.65		28.19	$	24.70		21.63		20.04		16.82
LOW		27.35		25.10		24.51		23.25		20.00		19.36		15.85		15.55
CLOSE		32.99		27.75		27.09		27.48		24.29		21.50		19.40		16.05

	Dec. 31,		Sept. 30,		June 28,		March 29,		Dec. 31,		Sept. 28,		June 29,		March 30,
	2002		2002		2002		2002		2001		2001		2001		2001
HIGH	$	18.14		19.31		20.25		16.17		15.85		17.10		17.15		15.06
LOW		15.78		16.50		15.90		15.24		13.27		14.35		13.50		13.00
CLOSE		16.82		17.46		19.06		16.05		15.49		15.10		17.10		14.75

52

EX-21

Exhibit 21

Subsidiaries of Registrant

		Date and % of Voting
		Shares, Partnership
		Interests, Voting Trust
	Year &	Certificates, Capital
Name & Address	State Inc.	Contributions	Description of Activity
Home Federal Savings Bank	1934	6/29/94	Federally Chartered Stock
1016 Civic Center Drive NW	Federal	HMN owns 100% of	Savings Bank
Rochester, MN 55901	Charter	voting shares
Osterud Insurance Agency, Inc. DBA Home Federal Investment Svcs. 1016 Civic Center Drive NW Rochester, MN 55901	1983 MN	12/1983 Bank owns 100%	Investment products and financial planning
Security Finance Corporation		12/29/95	Corporation invests in
1016 Civic Center Drive NW	1929	HMN owns 100% of	Securities, loans and real estate
Rochester, MN 55901	MN	voting shares

EX-23

Exhibit 23

Consent of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
HMN Financial, Inc.:

We consent to the incorporation by reference in the registration statement (No. 333-88228, 33-94388, 33-94386, and 33-64232) on Form S-8 of HMN Financial, Inc. of our report dated March 1, 2007, with respect to the consolidated balance sheets of HMN Financial, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, and all related financial statement schedules, management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006 and the effectiveness of internal control over financial reporting as of December 31, 2006, which reports appear in the December 31, 2006 annual report on Form 10-K of HMN Financial, Inc.

/s/ KPMG LLP

Minneapolis, MN
March 1, 2007

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Michael McNeil, certify that:

1. I have reviewed this annual report on Form 10-K of HMN Financial, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15a-15(f)) for the registrant and have:

     (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     (b) designed such internal control over financial reporting, or cause such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

     (c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     (d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

     a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 1, 2007	By:	/s/ Michael McNeil
		Michael McNeil
		President and Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Jon J. Eberle, certify that:

1. I have reviewed this annual report on Form 10-K of HMN Financial, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15a-15(f)) for the registrant and have:

     (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     (b) designed such internal control over financial reporting, or cause such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

     (c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     (d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

     a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 1, 2007	By:	/s/ Jon J. Eberle
		Jon J. Eberle
		Senior Vice President, Chief Financial Officer and Treasurer

EX-32

Exhibit 32

HMN FINANCIAL, INC.

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of HMN Financial, Inc. (the “Company”) on Form 10-K for the period ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Michael McNeil, President of the Company, and Jon Eberle, Senior Vice President and CFO of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1)	The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

Date: March 1, 2007	/s/ Michael McNeil
	Michael McNeil
	President/Chief Executive Officer (Principal Executive Officer)
	/s/ Jon Eberle
	Jon Eberle
	Senior Vice President/Chief Financial Officer (Principal Financial Officer)