-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, V+4XW4kfZ5G5u2WDGz9roiR6TgmnH4EIwbADA9N04vkwSynqngxToKoqbIhVelIt WY2eetOMrtHV6CGw8OxMBQ== 0001047469-99-012364.txt : 19990331 0001047469-99-012364.hdr.sgml : 19990331 ACCESSION NUMBER: 0001047469-99-012364 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HMN FINANCIAL INC CENTRAL INDEX KEY: 0000921183 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 411777397 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-24100 FILM NUMBER: 99578212 BUSINESS ADDRESS: STREET 1: 101 N BROADWAY CITY: SPRING VALLEY STATE: MN ZIP: 55975-1223 BUSINESS PHONE: 5073461100 10-K 1 10-K - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THE TRANSITION PERIOD FROM _____ TO ______ COMMISSION FILE NUMBER 0-24100. HMN FINANCIAL, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 41-1777397 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 101 NORTH BROADWAY, PO BOX 231 55975-0231 SPRING VALLEY, MINNESOTA (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (507) 346-1100 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, PAR VALUE $.01 PER SHARE (TITLE OF CLASS) 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 twelve 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 X NO ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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. [ ] As of March 5, 1999, the Registrant had issued and outstanding 5,247,104 shares of the Registrant's Common Stock. The aggregate market value of the voting stock held by non-affiliates of the Registrant as of March 5, 1999 was $52.7 million. (The exclusion from such amount of the market value of the shares owned by any person shall not be deemed an admission by the Registrant that such person is an affiliate of the Registrant.) DOCUMENTS INCORPORATED BY REFERENCE Parts of the Registrant's Annual Report for the year ended December 31, 1998, are incorporated by reference in Parts II and IV of this Form 10-K. Parts of the Registrant's Proxy Statement dated March 23, 1999, are incorporated by reference in Part III of this Form 10-K. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS PART I
PAGE Item 1. Business..................................................................3 General.............................................................3 Lending Activities..................................................4 Investment Activities..............................................20 Sources of Funds...................................................24 Other Information Service Corporations.........................................28 Competition..................................................28 Other Corporations Owned by HMN..............................28 Employees....................................................29 Executive Officers...........................................29 Regulation.........................................................29 Taxation...........................................................38 Item 2. Properties...............................................................40 Item 3. Legal Proceedings........................................................41 Item 4. Submission of Matters to a Vote of Security Holders......................41 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters............................................................41 Item 6. Selected Financial Data..................................................41 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..............................................41 Item 7A. Quantitative and Qualitative Disclosure About Market Risk................41 Item 8. Financial Statements and Supplementary Data..............................41 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...............................................42 PART III Item 10. Directors and Executive Officers of the Registrant.......................42 Item 11. Executive Compensation...................................................42 Item 12. Security Ownership of Certain Beneficial Owners and Management...........42 Item 13. Certain Relationships and Related Transactions...........................42 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........43 Signatures.........................................................................46 Index to Exhibits..................................................................47
PART I ITEM 1. BUSINESS GENERAL HMN Financial, Inc. ("HMN" or the "Corporation"), was incorporated under the laws of the State of Delaware in March 1994 for the purpose of becoming the savings and loan holding company of Home Federal Savings Bank ("Home Federal" or the "Bank") in connection with the Bank's conversion from a federally chartered mutual savings bank to a federally chartered stock savings bank. Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer financial planning products and services. HMN has two other wholly owned subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc. (MSI). SFC invests in commercial loans and commercial real-estate loans located throughout the United States which were originated by third parties. MSI operates a mortgage banking and mortgage brokerage facility located in Brooklyn Park, Minnesota. On December 5, 1997 HMN, through its wholly owned subsidiary, the Bank, completed its merger with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to Consolidated Financial Statements in the Annual Report for information on assets acquired in the merger, HMN's Current Report on Form 8-K dated December 5, 1997, filed on December 10, 1997 (file no. 0-24100) for a copy of the merger agreement and HMN's Current Report on Form 8-K dated December 5, 1997, filed on February 11, 1998 (file no. 0-24100) for a copy of financial statements of the acquired company and pro forma financial information. As a community-oriented financial institution, HMN seeks to serve the financial needs of communities in its market area. HMN's business involves attracting deposits from the general public and using such deposits to originate or purchase one-to-four family residential mortgage loans and, to a lesser extent, consumer, construction, commercial real estate, commercial business and multi-family loans. HMN also invests in mortgage-backed and related securities, investment securities (consisting primarily of U.S. government and government agency obligations) and other permissible investments. The executive offices of HMN are located at 101 N. Broadway, PO Box 231, Spring Valley, Minnesota 55975-0231. It's telephone number at that address is (507) 346-1100. MARKET AREA HMN serves the Minnesota counties of Fillmore, Freeborn, Houston, Mower, Olmsted and Winona and portions of Steele, Dodge, Goodhue and Wabasha Counties, Minnesota, through its main office located in Spring Valley, Minnesota and its six branch offices located in Albert Lea, Austin, LaCrescent, Rochester and Winona, Minnesota. The portion of HMN's market area consisting of Rochester and the contiguous communities is composed of primarily urban and suburban communities, while the balance of HMN's market area consists primarily of rural areas and small towns. Primary industries in HMN's market area include manufacturing, agriculture, health care, wholesale and retail trade, service industries and education. Major employers include IBM, the Mayo Clinic, Hormel, a food processing company, and various small industrial and other companies. HMN'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. HMN 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 Int. - 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 operation. 3 Based upon information obtained from the Minnesota State Demographic Center for 1996, the population of the six primary counties in the Bank's Minnesota market area was as follows: Fillmore - 20,900; Freeborn - 33,000; Houston - 19,200; Mower - 37,700; Olmsted - 115,200; and Winona - 49,200. Total income per capita for 1996 in these six counties ranged from approximately $19,100 to $26,500. Based upon information obtained from the State Library of Iowa for 1996, the population of Marshall County was 38,700 and the population of Tama County was 17,600. Total income per capita of the above mentioned Iowa counties ranged from approximately $20,000 to $21,900. During the fourth quarter of 1996, HMN opened a mortgage banking and mortgage brokerage office which is currently located in Brooklyn Park, Minnesota. The office primarily originates single family residential loans for sale in the secondary market or purchases loans from third party originators located primarily in the seven county metropolitan area of Minneapolis and St. Paul and sells the loans in the secondary market. The office also has purchased mortgage servicing rights from third parties for the purpose of generating loan servicing income. LENDING ACTIVITIES GENERAL. Historically, HMN originated 30-year, fixed-rate mortgage loans secured by one-to-four family residences. Since 1979, in order to reduce its vulnerability to changes in interest rates, HMN has emphasized the origination or purchase of loans for the loan portfolio which have shorter terms to maturity such as 15 year, fixed rate residential loans and Graduated Equity Mortgages ("GEMs") which fully amortize in 15 to 20 years. HMN has also emphasized the origination and purchase of Adjustable Rate Mortgage loans ("ARMs") for portfolio which have interest rates which are fixed for an initial period of one, three or five years and then generally adjust annually, thereafter, based upon a treasury interest rate index plus a certain margin, subject to annual and lifetime rate adjustment limits. HMN offers a competitive home equity line of credit as well as other consumer loans. The home equity line of credit has an adjustable interest rate based upon the Wall Street Journal prime rate plus a margin. During 1998 HMN hired experienced commercial loan officers who actively pursued commercial real estate, commercial business and development loans in HMN's market area. 4 LOAN PORTFOLIO COMPOSITION. The following information concerning the composition of HMN's loan portfolio in dollar amounts and in percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated.
December 31, -------------------------------------------------------------- 1998 1997 1996 ------------------- -------------------- ------------------ (DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent --------- ------- ---------- ------- --------- ------- REAL ESTATE LOANS: One-to-four family................. $ 365,496 79.31% $ 395,668 87.58% $ 321,340 90.19% Multi-family....................... 4,719 1.02 2,717 0.60 280 0.08 Commercial......................... 28,990 6.29 10,572 2.34 7,918 2.22 Construction or development........ 15,155 3.29 5,725 1.27 3,474 0.98 --------- ------ --------- ------ --------- ------ Total real estate loans......... 414,360 89.91 414,682 91.79 333,012 93.47 --------- ------ --------- ------ --------- ------ OTHER LOANS: Consumer loans: Savings account................... 994 0.22 1,362 0.30 938 0.26 Education......................... 118 0.03 123 0.03 467 0.13 Automobile........................ 2,897 0.63 2,438 0.54 566 0.16 Home equity line.................. 19,476 4.22 19,490 4.31 11,881 3.33 Home equity....................... 9,566 2.08 7,176 1.59 5,927 1.67 Home improvement.................. 436 0.09 652 0.14 585 0.16 Other............................. 1,313 0.28 624 0.14 568 --------- ------ --------- ------ --------- ------ Total consumer loans............ 34,800 7.55 31,865 7.05 20,932 5.87 Commercial business loans.......... 11,695 2.54 5,226 1.16 2,344 0.66 --------- ------ --------- ------ --------- ------ Total other loans............... 46,495 10.09 37,091 8.21 23,276 6.53 --------- ------ --------- ------ --------- ------ Total loans.................. 460,855 100.00% 451,773 100.00% 356,288 100.00% ------ ------ ------ ------ ------ ------ LESS: Loans in process................... 7,997 4,562 2,814 Unamortized discounts.............. 414 547 417 Net deferred loan fees............. 1,948 1,847 1,695 Allowance for losses on loans...... 3,041 2,748 2,340 --------- --------- --------- Total loans receivable, net.. $ 447,455 $ 442,069 $ 349,022 --------- --------- --------- --------- --------- --------- December 31, ------------------------------------------ 1995 1994 ------------------- -------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent --------- ------- --------- -------- REAL ESTATE LOANS: One-to-four family................. $ 292,497 90.62% $ 252,943 91.14% Multi-family....................... 361 0.11 311 0.11 Commercial......................... 8,744 2.71 8,316 3.00 Construction or development........ 5,082 1.58 2,799 1.01 --------- ------ --------- ------ Total real estate loans......... 306,684 95.02 264,369 95.26 --------- ------ --------- ------ OTHER LOANS: Consumer loans: Savings account................... 1,210 0.37 648 0.23 Education......................... 342 0.11 2,007 0.72 Automobile........................ 671 0.21 520 0.19 Home equity line.................. 3,509 1.09 0 0.00 Home equity....................... 7,997 2.47 7,716 2.78 Home improvement.................. 785 0.24 870 0.31 --------- ------ --------- ------ Total consumer loans............ 15,059 4.66 12,263 4.42 Commercial business loans.......... 1,018 0.32 897 0.32 --------- ------ --------- ------ Total other loans............... 16,077 4.98 13,160 4.74 --------- ------ --------- ------ Total loans.................. 322,761 100.00% 277,529 100.00% ------ ------ ------ ------ LESS: Loans in process................... 3,531 2,327 Unamortized discounts.............. 289 162 Net deferred loan fees............. 1,899 2,147 Allowance for losses on loans...... 2,191 1,893 --------- --------- Total loans receivable, net.. $ 314,851 $ 271,000 --------- --------- --------- ---------
5 The following table shows the composition of HMN's loan portfolio by fixed and adjustable rate loans at the dates indicated.
December 31, ------------------------------------------------------------------------------------ 1998 1997 1996 ----------------------- ------------------------ ----------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent ----------- --------- ----------- --------- ----------- --------- FIXED-RATE LOANS Real estate: One-to-four family GEM...................................... $ 56,211 12.20% $ 53,258 11.79% $ 48,831 13.71% Other.................................... 227,790 49.43 256,263 56.72 187,519 52.63 ----------- --------- ----------- -------- ----------- -------- Total one-to-four family................ 284,001 61.63 309,521 68.51 236,350 66.34 Multi-family.............................. 3,509 0.76 2,490 0.55 223 0.06 Commercial................................ 17,768 3.86 1,914 0.42 1,276 0.36 Construction or development............... 9,366 2.03 3,180 0.71 2,970 0.83 ----------- --------- ----------- -------- ----------- -------- Total fixed-rate real estate loans...... 314,644 68.27 317,105 70.19 240,819 67.59 ----------- --------- ----------- -------- ----------- -------- Consumer loans: Savings................................... 994 0.22 1,362 0.30 938 0.26 Education................................. 0 0.00 0 0.00 434 0.12 Automobile................................ 2,897 0.63 2,437 0.54 566 0.16 Home equity............................... 9,384 2.04 6,701 1.48 5,338 1.50 Home improvement.......................... 436 0.09 652 0.14 585 0.16 Other..................................... 1,175 0.25 612 0.14 568 0.16 ----------- --------- ----------- -------- ----------- -------- Total consumer loans.................... 14,886 3.23 11,764 2.60 8,429 2.36 ----------- --------- ----------- -------- ----------- -------- Commercial business loans.................. 10,157 2.20 5,226 1.16 1,344 0.38 ----------- --------- ----------- -------- ----------- -------- Total other loans....................... 25,043 5.43 16,990 3.76 9,773 2.74 ----------- --------- ----------- -------- ----------- -------- Total fixed-rate loans.................. 339,687 73.71 334,095 73.95 250,592 70.33 ----------- --------- ----------- -------- ----------- -------- ADJUSTABLE-RATE LOANS Real estate: One-to-four family........................ 81,495 17.68 86,147 19.07 84,990 23.85 Multi-family.............................. 1,210 0.26 227 0.05 57 0.02 Commercial................................ 11,222 2.44 8,658 1.92 6,642 1.87 Construction or development............... 5,789 1.26 2,545 0.56 504 0.14 ----------- --------- ----------- -------- ----------- -------- Total adjustable-rate real estate loans. 99,716 21.64 97,577 21.60 92,193 25.88 Consumer................................... 19,914 4.32 20,101 4.45 12,503 3.51 Commercial business loans.................. 1,538 0.33 0 0.00 1,000 0.28 ----------- --------- ----------- -------- ----------- -------- Total adjustable-rate loans............. 121,168 26.29 117,678 26.05 105,696 29.67 ----------- --------- ----------- -------- ----------- -------- Total loans............................. 460,855 100.00% 451,773 100.00% 356,288 100.00% ----------- --------- ----------- -------- ----------- -------- --------- -------- -------- LESS Loans in process........................... 7,997 4,562 2,814 Unamortized discounts...................... 414 547 417 Net deferred loan fees..................... 1,948 1,847 1,695 Allowance for losses on loans.............. 3,041 2,748 2,340 ----------- ----------- ----------- Total loans receivable, net............. $ 447,455 $ 442,069 $ 349,022 ----------- ----------- ----------- ----------- ----------- ----------- December 31, --------------------------------------------------- 1995 1994 ----------------------- ---------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent ----------- --------- ----------- -------- FIXED-RATE LOANS Real estate: One-to-four family GEM...................................... $ 30,175 9.35% $ 24,769 8.93% Other.................................... 181,401 56.20 168,272 60.63 ----------- -------- ----------- ------- Total one-to-four family................ 211,576 65.55 193,041 69.56 Multi-family.............................. 302 0.10 311 0.11 Commercial................................ 1,518 0.47 1,612 0.58 Construction or development............... 4,848 1.50 1,008 0.37 ----------- -------- ----------- ------- Total fixed-rate real estate loans...... 218,244 67.62 195,972 70.62 ----------- -------- ----------- ------- Consumer loans: Savings................................... 1,210 0.37 648 0.23 Education................................. 299 0.09 1,278 0.46 Automobile................................ 671 0.21 520 0.19 Home equity............................... 7,254 2.25 7,258 2.62 Home improvement.......................... 785 0.24 870 0.31 Other..................................... 545 0.17 502 0.18 ----------- -------- ----------- ------- Total consumer loans.................... 10,764 3.33 11,076 3.99 ----------- -------- ----------- ------- Commercial business loans.................. 1,018 0.32 897 0.32 ----------- -------- ----------- ------- Total other loans....................... 11,782 3.65 11,973 4.31 ----------- -------- ----------- ------- Total fixed-rate loans.................. 230,026 71.27 207,945 74.93 ----------- -------- ----------- ------- ADJUSTABLE-RATE LOANS Real estate: One-to-four family........................ 80,921 25.07 59,901 21.58 Multi-family.............................. 59 0.02 0 0.00 Commercial................................ 7,226 2.24 6,704 2.42 Construction or development............... 234 0.07 1,792 0.64 ----------- -------- ----------- ------- Total adjustable-rate real estate loans. 88,440 27.40 68,397 24.64 Consumer................................... 4,295 1.33 1,187 0.43 Commercial business loans.................. 0 0.00 0 0.00 ----------- -------- ----------- ------- Total adjustable-rate loans............. 92,735 28.73 69,584 25.07 ----------- -------- ----------- ------- Total loans............................. 322,761 100.00% 277,529 100.00% ----------- -------- ----------- ------- -------- ------- LESS Loans in process........................... 3,531 2,327 Unamortized discounts...................... 289 162 Net deferred loan fees..................... 1,899 2,147 Allowance for losses on loans.............. 2,191 1,893 ----------- ----------- Total loans receivable, net............. $ 314,851 $ 271,000 ----------- ----------- ----------- -----------
6 The following schedule illustrates the interest rate sensitivity of HMN's loan portfolio at December 31, 1998. 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.
Real Estate ------------------------------------------------------------------------------- Multi-family and One-to-four family Commercial Construction Consumer ------------------------ ------------------------ ------------------------ ------------------------ Weighted Weighted Weighted Weighted Average Average Average Average (DOLLARS IN THOUSANDS) Amount Rate Amount Rate Amount Rate Amount Rate ------------ -------- ----------- -------- ----------- -------- ----------- -------- Due During Years Ending December 31, - ----------------------- 1999(1)...................$ 23,681 7.03% $ 2,461 7.61% $ 2,873 8.49% $ 4,420 8.71% 2000...................... 21,871 7.34 1,289 8.53 304 8.32 2,518 8.57 2001...................... 21,345 7.29 1,403 8.71 221 8.23 2,239 8.48 2002 through 2003......... 41,134 7.24 4,860 8.82 260 7.99 2,846 8.30 2004 through 2008......... 97,120 7.22 10,683 8.36 1,411 8.37 21,950 8.35 2009 through 2023......... 145,862 7.18 13,013 8.14 7,676 7.98 827 8.84 2024 and following........ 14,483 7.06 0 0.00 2,410 7.23 0 0.00 ------------ ----------- ----------- ----------- $ 365,496 $ 33,709 $ 15,155 $ 34,800 ------------ ----------- ----------- ----------- ------------ ----------- ----------- ----------- Commercial Business Total ------------------------ ------------------------ Weighted Weighted Average Average (DOLLARS IN THOUSANDS) Amount Rate Amount Rate ------------ -------- ----------- -------- Due During Years Ending December 31, - ----------------------- 1999(1)...................$ 2,533 8.62% $ 35,968 7.50% 2000...................... 1,792 8.95 27,774 7.62 2001...................... 1,488 9.01 26,696 7.57 2002 through 2003......... 4,243 8.61 53,343 7.55 2004 through 2008......... 394 8.95 131,558 7.52 2009 through 2023......... 1,245 8.51 168,623 7.31 2024 and following........ 0 0.00 16,893 7.08 ------------ ----------- $ 11,695 $ 460,855 ------------ ----------- ------------ -----------
- ------------ (1) Includes demand loans, loans having no stated maturity, overdraft loans and education loans. The total amount of loans due after December 31, 2000 which have predetermined interest rates is $311.5 million, while the total amount of loans due after such dates which have floating or adjustable interest rates is $113.3 million. At December 31, 1998 construction or development loans for one-to-four family dwellings totaled $5.7 million, multi-family totaled $6.6 million, and non-residential totaled $2.9 million. 7 Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), 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, 1998, based upon the 15% limitation, the Bank's regulatory loans-to-one borrower limit was approximately $6.9 million. On the same date, the Bank had no borrowers with net outstanding balances in excess of this amount. At December 31, 1998, the largest dollar amount outstanding to one borrower or group of related borrowers was $6.35 million. This loan, which is secured by a shopping mall located in Winona, Minnesota, was performing in accordance with its terms at December 31, 1998. The Bank's Mortgage and Consumer Loan Committee is responsible for review and approval of all loans over the FHLMC/FNMA conforming loan dollar limits (the Limit) originated by the Bank. For the majority of 1998 the Limit was $227,150, compared to $214,600 for the majority of 1997. Approval of one member of the Loan Committee is required on all loans ranging from the Limit to $500,000. Loans greater than $500,000 must be approved by the Board of Directors of the Bank or its Executive Committee after review and preliminary approval by the Loan Committee. All loans closed each month are reviewed by the Board of Directors at the monthly meeting. During 1998, the Bank centralized its one-to-four family real estate loan processing, underwriting, and servicing functions in Spring Valley. Each of the branch's loan officers are responsible for taking the initial loan application. The application and other pertinent information is then forwarded to a central loan processor who is responsible for obtaining information relating to processing the loan application. A loan underwriter reviews the information obtained by the processor and determines whether the loan applicant is eligible to receive the loan in conformity with the Bank's written underwriting guidelines and other loan policies. 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 (consistent with the Bank's appraisal policy) by the Bank's staff appraiser or 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 use of credit reports, financial statements, tax returns and/or confirmations. During 1997 the Bank introduced 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 low or alternative documentation underwriting procedures which conform to FNMA underwriting guidelines. Generally, the Bank 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, depending on the type of loan. 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, 1998 HMN's one-to-four family real estate loans totaled $365.5 million, or 79.3% of its total loan portfolio, and represented a decline of $30.2 million, compared to $395.7 million at December 31, 1997. In order to reduce its interest rate risk during 1998, HMN securitized and sold $27.9 million of one-to-four family residential loans out of its loan portfolio. It also sold approximately 44% of the Bank's one-to-four family residential loans that were originated or refinanced during 1998. The loan securitizations and the loan sales, when coupled with the accelerated prepayments experienced in the loan portfolio during 1998, caused the one-to-four family real estate loan portfolio to decline from December 31,1997 to December 31, 1998. See "Originations, Purchases and Sales of Loans and Mortgage-Backed and Related Securities". 8 On December 5, 1997 the Bank merged with Marshalltown Financial Corporation ("MFC"). The Loan Portfolio Composition table includes for December 31, 1997 $62.9 million of one-to-four family residential loans, $2.3 of multi-family residential, $2.1 million of commercial real estate and $2.6 million of consumer loans which were acquired in the MFC merger. Prior to 1979, the Bank originated for retention in its own portfolio 30-year fixed-rate loans secured by one-to-four family residential real estate. Beginning in 1979, the Bank began to emphasize the origination of fixed-rate loans with terms of 15 years or less for retention in its portfolio. In addition, in 1982, the Bank began to originate ARMs, subject to market conditions and consumer preference. Subsequently, the Bank also began to emphasize GEM originations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management" in the Annual Report attached as Exhibit 13 hereto (the "Annual Report"). The GEM loans require payments which 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 5%. Most of the GEM loans originated by HMN provide for at least three 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. HMN has primarily offered two GEM programs, one with a contractual maturity of approximately 17 years and one with a contractual maturity of approximately 22 years. The GEMs are generally priced based upon loans with similar contractual maturities. The GEMs have been popular with consumers who anticipate future increases in income and who desire an amortization schedule of less than 30 years. HMN believes that GEMs may increase in popularity in the future if interest rates rise and consumers are less easily able to afford the higher monthly payments required by 15-year, fixed-rate loans. At December 31, 1998, HMN had $56.2 million of GEM loans which comprised 12.2% of the total loan portfolio and represented an increase of $2.9 million from GEM loans of $53.3 million at December 31, 1997. HMN currently offers conventional fixed-rate one-to-four family loans with maximum terms of up to 30 years. During 1998, HMN generally sold the majority of new loan originations or refinances with fixed rates and terms to maturity ranging from 15 years to 30 years that were eligible for sale in the secondary market. Loans which were originated under the First Time Home Buyers program were not sold because many of the loans did not conform to secondary market underwriting requirements. The interest rates charged on the fixed rate loan products are generally set based on the FNMA or FHLMC delivery rates, as well as other competitive factors. At December 31, 1998, HMN had $227.8 million of fixed rate one-to-four family other loans which comprised 49.4% of the total loan portfolio and represented a decrease of $28.5 million, from $256.3 million at December 31, 1997. HMN also offers one-year ARMs at a margin (generally 275 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 currently offered by HMN allow the borrower to select (subject to pricing) an initial period of one year, three years, or five years between the loan origination and when the first interest rate change occurs. Generally, the ARMs provide for an up to 200 basis point annual interest rate change cap and a lifetime cap 600 basis points over or under the initial rate. Initial interest rates offered on the ARM loans during 1998 ranged from 4 to 186 basis points below the fully indexed loan rate. All borrowers are now qualified for the loan at the fully indexed rate. HMN's originated ARMs do not permit negative amortization of principal, do not contain prepayment penalties and generally are not convertible into fixed-rate loans. See "-Delinquencies and Non-Performing Assets." In the past, the Bank offered one-year ARMs with a margin of 200 to 235 basis points over a specified index and an average annual cap of 145 basis points. At December 31, 1998 the one-to-four family ARMs totaled $81.5 million, or 17.7% of the total loan portfolio and represented a decrease of $4.6 million from $86.1 million at December 31, 1997. 9 HMN has also originated a limited number of fixed-rate loans with terms up to 30 years which are insured by the Federal Housing Authority ("FHA"), Veterans Administration ("VA") and Minnesota Home Finance Administration ("MHFA"). In underwriting one-to-four family residential real estate loans, HMN evaluates both 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 HMN are appraised by independent fee appraisers or by HMN's staff appraiser. HMN originates residential mortgage loans with loan-to-value ratios of up to 95% for owner-occupied homes and up to 70% for non-owner occupied homes; however, private mortgage insurance is required to reduce HMN's exposure to 80% or less. HMN generally seeks to underwrite its loans in accordance with secondary market standards. HMN'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. COMMERCIAL REAL ESTATE AND MULTI-FAMILY LENDING. HMN originates permanent commercial real estate and multi-family loans secured by properties located in its market area. It also purchases commercial real estate loans outside of its market area that are guaranteed by the Small Business Administration ("SBA") or originated by other third parties. During 1998 HMN hired experienced commercial loan officers to originate commercial real estate and commercial business loans in HMN's market area. HMN also purchased commercial real estate and multi-family loans from third party originators during 1998. At December 31, 1998, commercial real estate loans were $29.0 million or 6.3% of the total loan portfolio and represented an increase of $18.4 million compared to $10.6 million at December 31, 1997. At December 31, 1998 multi-family residential loans were $4.7 million, or 1.0% of the total loan portfolio and represented an increase of $2.0 million compared to $2.7 million at December 31, 1997. The commercial real estate and multi-family loan portfolio includes loans secured by motels, hotels, apartment buildings, churches, small office buildings, small business facilities, shopping malls, nursing homes and other non-residential building properties primarily located in the upper Midwestern United States. Permanent commercial real estate and multi-family loans are generally originated for a maximum term of 15 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 which are tied to prime or a treasury index. Commercial real estate and multi-family loans are written in amounts of up to 75% 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 is the ratio of net cash from operations before payment of debt to debt service. HMN may 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. All appraisals on commercial and multi-family real estate are reviewed and approved by the commercial loan officer. The Bank's underwriting procedures require verification of the borrower's credit history, income and financial statements, banking relationships, references and income projections for the property. All commercial real estate and multi-family loans 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. Once the loan is closed, HMN performs an annual on-site inspection on collateral properties for loans with balances in excess of $250,000 and also includes an annual review of the financial performance of the property to determine that it is performing as anticipated. 10 At December 31, 1998, HMN's two largest commercial real estate loans totaled $6.35 million and $4.9 million. The first loan is secured by a shopping mall in Winona, Minnesota and the second loan is secured by a hotel and other commercial real estate in St. Cloud, Minnesota. Both of these loans were performing at December 31, 1998. 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, 1998, HMN had one commercial real estate loan totaling $73,000 and no multi-family loans which were 90 days or more delinquent. CONSTRUCTION LENDING. HMN makes construction loans to individuals for the construction of their residences, and to a much lesser extent, to builders for the construction of one-to-four family residences. It also makes a very limited number of loans to builders for houses built on speculation. At December 31, 1998, HMN had $15.2 million of construction loans outstanding, representing 3.3% of its total loan portfolio which represents an increase of $9.5 million, compared to $5.7 million at December 31, 1997. 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 seven months, the borrower pays interest only. Generally, the borrower also pays a construction fee up to $800 at the time of origination. 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 1 to 15 years with a construction phase of up to seven months. Such loans generally do not permit the payment of interest from loan proceeds. Construction loans to owner occupants are generally made in amounts of 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 loan-to-value ratios on loans to builders are limited to 70%. Prior to making a commitment to fund a construction loan, HMN requires an appraisal of the property and financial data and verification of income on the borrower. HMN generally 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. Generally construction loans have been located in HMN's market area. 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. At December 31, 1998 construction loans on one-to-four family residential real estate totaled $5.7 million, construction on multi-family residential real estate totaled $6.6 million and construction on commercial real estate totaled $2.9 million. The nature of construction loans is such that they are 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 and the estimated cost (including interest) of the project. If 11 the estimate of value proves to be inaccurate, HMN may be confronted, at or prior to the maturity of the loan, with a project having a value which 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 such cases, HMN may be required to modify the terms of the loan. CONSUMER LENDING. HMN originates a variety of different types of consumer loans, including home equity loans (open-end and closed-end), education, automobile, home improvement, deposit account and other loans for household and personal purposes. At December 31, 1998, consumer loans totaled $34.8 million, and represented 7.6% of total loans outstanding, compared to $31.9 million at December 31, 1997. Consumer loan terms vary according to the type and value of collateral, length of contract and creditworthiness of the borrower. HMN's consumer loans are made at fixed and adjustable interest rates, with terms of up to 20 years for secured loans and up to three years for unsecured loans. HMN'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 90% of the appraised value of the property. The closed-end home equity loans are written with fixed or adjustable rates with terms of up to 15 years. The open-end home equity lines are written with an adjustable rate with terms of up to 20 years, a 10 year draw period which requires "interest only" payments and a 10 year repayment period which 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. At December 31, 1998, HMN's home equity loans totaled $9.6 million, or 2.1% of the total loan portfolio and the home equity lines totaled $19.5 million, or 4.2% of the total loan portfolio, compared to home equity loans of $7.2 million and home equity lines of $19.5 million at December 31, 1997. 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 which are unsecured or are secured by rapidly depreciable assets, such as automobiles. In such 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 which can be recovered on such loans. At December 31, 1998, $86,000 of the consumer loan portfolio was non-performing. There can be no assurance that delinquencies will not increase in the future. COMMERCIAL BUSINESS LENDING. In order to satisfy the demand for financial services available to individuals and businesses in its market area, HMN has maintained a portfolio of commercial business loans primarily to small retail operations, small manufacturing concerns and professional firms. Most of HMN's commercial business loans have terms ranging from six months to five years and carry fixed interest rates. HMN's commercial business loans generally include personal guarantees and are usually, but not always, secured by business assets such as inventory, equipment, fixtures, real estate and accounts receivables. 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. HMN has also purchased participation interests in commercial business loans from third party originators. The underlying collateral for the loans are generally equipment and generally have repayment periods of less than ten years. At December 31, 1998, HMN had $11.7 million of commercial business loans outstanding, or 2.5% of the total loan portfolio compared to $5.2 million at December 31, 1997. 12 Unlike residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment and other income, and which are secured by real property whose value tends to be more easily ascertainable, 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. Further, 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, 1998, there were no delinquent commercial business loans. ORIGINATIONS, PURCHASES AND SALES OF LOANS AND MORTGAGE-BACKED AND RELATED SECURITIES Real estate loans are generally originated by HMN's staff of salaried and commissioned loan officers. Loan applications are taken in all branch offices. While HMN originates both fixed and adjustable-rate loans, its ability to originate loans is dependent upon the relative customer demand for loans in its market. Demand is affected by the interest rate environment. During the last several years, the dollar volume of conventional fixed-rate, one-to-four family loans has exceeded the dollar volume of GEMs and ARMs. In order to supplement loan demand in HMN's market area and geographically diversify its loan portfolio, HMN purchases real estate loans from selected sellers, with yields based upon current market rates. HMN carefully reviews and underwrites all loans to be purchased to ensure that they meet HMN's under-writing standards. The seller generally continues to service these purchased loans. During 1998, HMN originated $148.7 million of loans compared to $68.1 million and $56.8 million during the years ended December 31, 1997 and 1996, respectively. HMN purchased $71.0 million of loans during 1998 compared to $71.8 million and $57.3 million during the years ended December 31, 1997 and 1996, respectively. The majority of the purchased loans have interest rates that are fixed for a one, three or five year period and then adjust annually thereafter or were 15 year fixed rate loans. All purchased loans are reviewed to determine that each loan meets certain underwriting requirements. Refer to Note 5 of the Notes to Consolidated Financial Statements in the Annual Report for more information on purchased loans. HMN has substantial holdings of mortgage-backed and related securities which are held, depending on the investment intent, in the "available for sale" portfolio. During 1998, HMN purchased $1.8 million of mortgage-backed securities compared to $3.4 million and $7.2 million for the years ended December 31, 1997 and 1996. It also purchased $112.0 million of CMOs during 1998 compared to $24.0 million and $50.4 million for the years ended December 31, 1997 and 1996, respectively. See -"Investment Activities." During 1998, HMN sold $96.5 million of mortgage-backed and related securities compared to $67.9 million and $81.1 million for the years ended December 31, 1997 and 1996, respectively. 13 The following table shows the loan and mortgage-backed and related securities origination, purchase, sale and repayment activities of HMN for the periods indicated.
(DOLLARS IN THOUSANDS) LOANS Year Ended December 31, ORIGINATIONS BY TYPE: 1998 1997 1996 -------- ------- ------- Adjustable-rate: Real estate - one-to-four family.................... $ 2,328 1,987 5,441 - commercial............................ 5,388 1,000 0 - construction or development........... 787 375 916 Non-real estate - consumer.......................... 15,689 16,871 12,012 - commercial business............... 176 0 0 -------- ------- ------- Total adjustable-rate......................... 24,368 20,233 18,369 -------- ------- ------- Fixed-rate: Real estate - one-to-four family.................... 44,413 32,024 27,036 - multi-family.......................... 1,694 263 145 - commercial............................ 16,882 50 30 - construction or development........... 10,626 6,539 6,181 Non-real estate - consumer.......................... 13,100 7,579 4,583 - commercial business............... 37,672 1,409 430 -------- ------- ------- Total fixed-rate.............................. 124,387 47,864 38,405 -------- ------- ------- Total loans originated........................ 148,755 68,097 56,774 -------- ------- ------- PURCHASES: Real estate - one-to-four family.................... 58,512 67,213 55,839 - multi-family.......................... 8,571 0 0 - commercial............................ 1,172 0 0 - construction or development........... 0 2,425 1,500 Non-real estate - commercial business............... 2,731 2,174 0 -------- ------- ------- Total purchased............................... 70,986 71,812 57,339 -------- ------- ------- ACQUISITION: Real estate - one-to-four family.................... 0 63,328 0 - multi-family.......................... 0 2,308 0 - commercial............................ 0 2,099 0 Non-real estate - consumer.......................... 0 2,599 0 -------- ------- ------- Total loans acquired........................... 0 70,334 0 -------- ------- ------- Transfers from loans held for sale..................... 0 96 0 SALES AND REPAYMENTS: Real estate - one-to-four family.................... 5,878 8,969 2,310 - commercial............................ 650 0 0 Non-real estate - consumer.......................... 238 339 176 -------- ------- ------- Total sales................................... 6,766 9,308 2,486 -------- ------- ------- Loans securitized and transferred to securities..... 27,953 16,526 15,412 Transfers to loans held for sale.................... 52,295 4,347 2,492 Principal repayments................................ 106,824 84,244 56,533 -------- ------- ------- Total reductions.............................. 193,838 114,425 76,923 -------- ------- ------- Decrease in other items, net........................ (20,517) (2,867) (3,019) -------- ------- ------- Net increase.................................. $ 5,386 93,047 34,171 -------- ------- ------- -------- ------- -------
14 MORTGAGE-BACKED AND RELATED SECURITIES Loans securitized and transferred to securities... $ 27,953 16,526 15,441 PURCHASES: Mortgage-backed securities:(1) Adjustable-rate.................................... 0 0 0 Fixed-rate......................................... 1,766 3,426 7,266 CMOs and REMICs: Adjustable-rate.................................... 76,174 3,417 6,527 Fixed-rate......................................... 35,839 20,617 43,831 -------- ------- ------- Total purchases................................ 113,779 27,460 57,624 -------- ------- ------- ACQUISITION: Adjustable rate..................................... 0 12,522 0 Fixed rate.......................................... 0 25,738 0 -------- ------- ------- Total acquisitions............................. 0 38,260 0 -------- ------- ------- SALES: Mortgage-backed securities:(1) Adjustable-rate.................................... 24,955 9,535 0 Fixed-rate......................................... 46,432 344 24,786 CMOs and REMICs: Adjustable-rate.................................... 13,765 26,486 23,876 Fixed-rate......................................... 11,366 31,529 32,487 -------- ------- ------- Total sales..................................... 96,518 67,894 81,149 -------- ------- ------- PRINCIPAL REPAYMENTS: Decrease in other items, net......................... 38,003 13,578 28,915 -------- ------- ------- Net increase (decrease)........................... $ 7,211 774 (36,999) -------- ------- ------- -------- ------- -------
- --------------- (1) Consists of pass-through securities. DELINQUENCIES AND NON-PERFORMING ASSETS DELINQUENCY PROCEDURES. When a borrower fails to make a required payment on a loan, HMN 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 may be made with the borrower between 30 and 60 days after the due date. If the loan is contractually delinquent 90 days, HMN usually 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 HMN. Delinquent consumer loans are generally handled in a similar manner. HMN's procedures for repossession and sale of consumer collateral are subject to various requirements under state consumer protection laws. Real estate acquired by HMN as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate in judgement for six months to one year 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. 15 The following table sets forth HMN's loan delinquencies by type, by amount and by percentage of type at December 31, 1998.
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........... 9 $297 0.08% 13 $630 0.17% 22 $ 927 0.25% Multi-family............ 0 0 0.00 0 0 0.00 0 0 0.00 Commercial.............. 0 0 0.00 1 73 0.25 1 73 0.25 Construction or development........... 0 0 0.00 0 0 0.00 0 0 0.00 Consumer................ 12 68 0.20 8 86 0.25 20 154 0.44 Commercial business.............. 0 0 0.00 0 0 0.00 0 0 0.00 -- ---- -- ---- -- ------ Total............... 21 $365 0.08% 22 $789 0.17% 43 $1,154 0.25% -- ---- -- ---- -- ------ -- ---- -- ---- -- ------
CLASSIFICATION OF ASSETS. Federal regulations require that each savings institution classify its own assets on a regular basis. In addition, in connection with examinations of savings institutions, OTS and FDIC examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: Substandard, Doubtful and Loss. Substandard assets 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. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses 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 examiner's classification of an asset, it may appeal this determination to the District Director of the OTS. On the basis of management's review of its assets, at December 31, 1998, the Bank had classified a total of $879,000 of its loans and other assets as follows:
Commercial Real One-to-Four Construction or Estate and Commercial (DOLLARS IN THOUSANDS) Family Development Multi-Family Consumer Business ----------- --------------- --------------- -------- ---------- Substandard............. $716 0 73 90 0 Doubtful................ 0 0 0 0 0 Loss.................... 0 0 0 0 0 ---- - -- -- - Total............... $716 0 73 90 0 ---- - -- -- - ---- - -- -- -
The Bank's classified assets consist of the non-performing loans and loans and other assets of concern discussed herein. As of the date hereof, these asset classifications are materially consistent with those of the OTS and FDIC. NON-PERFORMING ASSETS. Loans are reviewed quarterly and any loan whose collectibility is doubtful is placed on non-accrual status. Loans are placed on nonaccrual 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. 16 Restructured loans include the Bank's troubled debt restructurings (which involved forgiving a portion of interest or principal on any loans or making loans at a rate materially less than the market rate). Foreclosed assets include assets acquired in settlement of loans. The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio.
December 31, ---------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 ----- ----- ----- ----- ----- Non-accruing loans: Real estate: One-to-four family............................ $ 317 177 235 196 178 Commercial real estate........................ 73 79 83 85 0 Consumer...................................... 86 7 7 32 57 Commercial business........................... 0 0 13 128 ----- ---- ----- ----- ----- Total....................................... 476 263 338 441 235 ----- ---- ----- ----- ----- Accruing loans delinquent 90 days or more: One-to-four family............................. 312 365 0 0 0 Consumer....................................... 0 37 0 0 0 ----- ---- ----- ----- ----- Total....................................... 312 402 0 0 0 ----- ---- ----- ----- ----- Restructured loans: Multi-family................................... 0 0 0 94 199 Foreclosed assets: Real estate: One-to-four family............................ 18 142 23 315 64 ----- ---- ----- ----- ----- Total....................................... 18 142 23 315 64 ----- ---- ----- ----- ----- Total non-performing assets...................... $ 806 807 361 850 498 ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total as a percentage of total assets............ 0.12% 0.12% 0.07% 0.16% 0.10% ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total non-performing loans....................... $ 788 665 $ 338 $ 535 $ 434 ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total as a percentage of total loans receivable, net........................... 0.18% 0.15% 0.10% 0.17% 0.16% ----- ---- ----- ----- ----- ----- ---- ----- ----- -----
For the year ended December 31, 1998, gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $49,382. The amounts that were included in interest income on such loans during 1998 were $28,618. Total non-performing assets were $806,000 at December 31, 1998, a decrease of $1,000, compared to $807,000 at December 31, 1997 and $361,000 at December 31, 1996. Non-performing assets had the following activity during 1998: sales of $142,000, transfers in of $389,000 and transfers out due to performance of $248,000. Non-performing assets had the following activity during 1997: sales of $42,000, charge-offs of $35,000, payments of $80,000 and net transfers to non-performing assets of $603,000. The increase in non-performing assets from 1996 to 1997 is primarily the result of three one-to-four family purchased loans totaling $365,000 that were behind on their payments by more than 90 days and the foreclosure of two one-to-four family mortgages totaling $142,000. The decrease in the non-accruing loans is the result of the normal inflow and outflow of delinquent loans caused by borrowers getting behind on their payments and then bringing the loans current again. Total non-performing assets were $361,000 at December 31, 1996, a decrease of $489,000, compared to $850,000 at December 31, 1995. The decrease in non-performing assets is the result of the sale of foreclosed assets of $315,000, the charge-off of $72,000 of commercial loans, and the normal inflow and outflow of delinquent loans caused by borrowers getting behind on their payments and then bringing the loans current again. 17 OTHER LOANS OF CONCERN. In addition to the non-performing assets set forth in the table above, as of December 31, 1998 there were $72,000 of loans with known information about the possible credit problems of the borrowers or the cash flows of the secured properties have caused management to have concerns as to the ability of the borrowers to comply with present loan repayment terms and 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. ALLOWANCE FOR LOSSES ON LOANS. The following table sets forth an analysis of the Bank's allowance for loan losses for the year ended:
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 ------ ------ ------ ------ ------ Balance at beginning of year................... $2,748 2,341 2,191 1,893 1,489 MFC allowance for losses acquired.............. 0 122 0 0 0 Provision for losses........................... 310 300 300 300 410 CHARGE-OFFS Real estate: One-to-four family........................... (2) (4) 0 0 0 Multi-family................................. 0 0 (88) 0 0 Consumer..................................... (17) (7) (1) (2) (6) Commercial business.......................... 0 (12) (61) 0 0 ------ ------ ------ ------ ------ (19) (23) (150) (2) (6) ------ ------ ------ ------ ------ RECOVERIES Real estate: Commercial business.......................... 2 8 0 0 0 ------ ------ ------ ------ ------ 2 8 0 0 0 ------ ------ ------ ------ ------ Net charge-offs................................ (17) (15) (150) (2) (6) ------ ------ ------ ------ ------ Balance at end of year......................... $3,041 2,748 2,341 2,191 1,893 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Ratio of net charge-offs during the year to average loans outstanding during the year..... 0.00% 0.01% 0.05% 0.00% 0.00% ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Ratio of allowance for losses on loans to total non-performing loans, at end of year.... 385.79% 413.17% 691.84% 409.13% 436.52% ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
18 The distribution of the Bank's allowance for losses on loans at the dates indicated is summarized as follows:
December 31, ------------------------------------------------------------------------------ 1998 1997 1996 -------------------- --------------------- ------------------------- Percent Percent Percent of Loans of Loans of Loans in Each in Each in Each Category Category Category to Total to Total to Total (DOLLARS IN THOUSANDS) Amount Loans Amount Loans Amount Loans --------- ---------- ---------- ---------- ---------- --------- Real Estate: One-to-four family.............. $ 544 79.31% $ 560 87.58% $ 496 90.19% Multi-family.................... 142 1.02 80 0.60 8 0.08 Commercial ..................... 797 6.29 198 2.34 113 2.22 Construction or development..... 455 3.29 172 1.27 104 0.98 Consumer.......................... 546 7.55 527 7.05 473 5.87 Commercial business............... 328 2.54 46 1.16 29 0.66 Unallocated....................... 229 0.00 1,165 0.00 1,118 0.00 --------- -------- ---------- -------- ---------- ------ Total....................... $ 3,041 100.00% $ 2,748 100.00% $ 2,341 100.00% --------- -------- ---------- -------- ---------- ------ --------- -------- ---------- -------- ---------- ------ 1995 1994 ------------------------- --------------------------- Percent Percent of Loans of Loans in Each in Each Category Category to Total to Total (DOLLARS IN THOUSANDS) Amount Loans Amount Loans -------- ----------- ----------- ----------- Real Estate: One-to-four family............. $ 452 90.62% $ 475 92.18% Multi-family................... 21 0.11 21 0.14 Commercial .................... 125 2.71 128 1.80 Construction or development.... 153 1.58 84 1.31 Consumer......................... 286 4.66 280 4.14 Commercial business.............. 37 0.32 27 0.43 Unallocated...................... 1,117 0.00 878 0.00 -------- -------- --------- -------- Total....................... $ 2,191 100.00% $ 1,893 100.00% -------- -------- --------- -------- -------- -------- --------- --------
19 The allowance for losses on loans is established through a provision for losses on loans charged to earnings based on management's evaluation of the risk inherent in its entire loan portfolio and changes in the nature and volume of its loan activity. Such evaluation, which includes a review of all loans of which full collectibility may not be reasonably assured, considers specific occurrences, general and local economic conditions, loan portfolio composition, historical and local experience and other factors that warrant recognition in providing for an adequate allowance for loan losses. In determining the general reserves under these policies, historical charge-offs and recoveries, changes in the mix and levels of the various types of loans, the general level of non-performing assets and the anticipated net realizable values, the current loan portfolio and current economic conditions are considered. The Bank also requires additional reserves for all classified loans. While management believes that it uses the best information available to determine the allowance for losses on loans, unforeseen market conditions could result in adjustments to the allowance for losses on loans, and net earnings could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Refer to Management's Discussion and Analysis on Allowances for Loan and Real Estate Losses and Non-performing Assets in the Annual Report. INVESTMENT ACTIVITIES HMN and the Bank utilize the available for sale securities portfolio in virtually all aspects of asset/liability management strategy. 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 projected cash flow requirements. The Bank must maintain minimum levels of investments that qualify as liquid assets under OTS regulations. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. At December 31, 1998, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings deposits and current borrowings) was 10.27%. The Bank's level of liquidity is a result of management's asset/liability strategy. See "Regulation - Liquidity." 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. Subject to various restrictions, federally chartered savings institutions may also invest their 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 HMN and the Bank has been directed toward a mix of high-quality assets (primarily government and agency obligations) with short and intermediate terms to maturity. At December 31, 1998, HMN did not own any investment securities of a single issuer which exceeded 10% of HMN's stockholder's equity other than U.S. government or federal agency obligations. The Bank invests a portion of its liquid assets in interest-earning overnight deposits of the Federal Home Loan Bank ("FHLB") of Des Moines and various money market mutual funds. Other investments include high grade medium-term (up to three years) corporate debt securities, medium-term federal agency notes, and a variety of other types of mutual funds which invest in adjustable-rate, mortgage-backed securities, asset-backed securities, repurchase agreements and U.S. Treasury and agency obligations. HMN 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. See Notes 3 and 4 of the Notes to Consolidated Financial Statements in the Annual Report for additional information regarding HMN's securities portfolio. 20 The following table sets forth the composition of HMN's securities portfolio, excluding mortgage-backed and related securities, at the dates indicated.
December 31, ------------------------------------------------------------------------------------- 1998 1997 --------------------------------------------- ------------------------------------- Amortized Adjusted Market % of Amortized Adjusted Market % of (DOLLARS IN THOUSANDS) Cost To Value Total Cost To Value Total ----------- -------- ------ ------ ----------- -------- ------ ------ Securities available for sale: U.S. government and agency obligations....................... $ 17,379 12 17,391 25.11% $ 43,403 (60) 43,343 49.98% Municipal obligations............... 2,901 (5) 2,896 4.18 0 0 0 0.00 Corporate debt ..................... 4,232 (3) 4,229 6.10 2,903 0 2,903 3.35 Corporate equity(1)................. 8,271 (296) 7,975 11.51 8,017 1,021 9,038 10.42 Stock of federal agencies(1)........ 5,874 114 5,988 8.64 14,034 605 14,639 16.88 Securities held to maturity: Corporate debt...................... 0 0 0.00 0 0 0.00 --------- ------ ------ --------- ------ ------ Subtotal.......................... 38,657 38,479 55.54 68,357 69,923 80.63 FHLB stock............................ 9,838 9,838 14.20 7,432 7,432 8.57 --------- ------ ------ --------- ------ ------ Total investment securities and FHLB stock................... 48,495 48,317 69.74 75,789 77,355 89.20 --------- ------ ------ --------- ------ ------ Average remaining life of investment securities excluding FHLB stock.... 4.5 years 2.5 years Other Interest-earning Assets: Cash equivalents.................... 20,961 20,961 30.26 9,365 9,365 10.80 --------- ------ ------ --------- ------ ------ Total............................. $ 69,456 69,278 100.00% $ 85,154 86,720 100.00% --------- ------ ------ --------- ------ ------ --------- ------ ------ --------- ------ ------ Average remaining life or term to repricing of investment securities and other interest-earning assets, excluding FHLB stock................. 3.2 years 2.3 years 1996 ----------------------------------------- Amortized Adjusted Market % of (DOLLARS IN THOUSANDS) Cost To Value Total --------- -------- ------ ------ Securities available for sale: U.S. government and agency obligations....................... $ 29,600 (322) 29,278 49.93% Municipal obligations............... 0 0 0 0.00 Corporate debt ..................... 1,091 1 1,092 1.86 Corporate equity(1)................. 7,796 386 8,182 13.96 Stock of federal agencies(1)........ 3,874 49 3,923 6.69 Securities held to maturity: Corporate debt...................... 1,000 1,001 1.71 --------- ------ ------ Subtotal.......................... 43,361 43,476 74.15 FHLB stock............................ 5,434 5,434 9.27 --------- ------ ------ Total investment securities and FHLB stock................... 48,795 48,910 83.42 --------- ------ ------ Average remaining life of investment securities excluding FHLB stock.... 3.4 years Other Interest-earning Assets: Cash equivalents.................... 9,718 9,718 16.58 --------- ------ ------ Total............................. $ 58,513 58,628 100.00% --------- ------ ------ --------- ------ ------ Average remaining life or term to repricing of investment securities and other interest-earning assets, excluding FHLB stock................. 2.8 years
(1) Average life assigned to corporate equity holdings and stock of federal agencies is five years. 21 The composition and maturities of the securities portfolio, excluding FHLB stock, mortgage-backed and other related securities, are indicated in the following table.
December 31, 1998 ---------------------------------------------------------- After 1 After 5 1 Year through 5 through 10 Over No Stated or Less Years Years 10 Years Maturity --------- --------- --------- --------- --------- Amortized Amortized Amortized Amortized Amortized (DOLLARS IN THOUSANDS) Cost Cost Cost Cost Cost --------- --------- --------- --------- --------- Securities available for sale: U.S. government securities........ $ 0 9,887 0 7,492 0 Municipal obligations............. 0 0 0 2,901 0 Corporate debt.................... 1,152 2,520 560 0 0 Corporate equity.................. 0 0 0 0 8,271 Stock of federal agencies......... 0 0 0 0 5,874 -------- -------- -------- ------- -------- Total stock......................... $ 1,152 12,407 560 10,393 14,145 -------- -------- -------- ------- -------- -------- -------- -------- ------- -------- Weighted average yield.............. 6.50% 6.39% 8.00% 6.83% 5.34% December 31, 1998 -------------------------------- Total Securities -------------------------------- Amortized Adjusted Market (DOLLARS IN THOUSANDS) Cost to Value --------- -------- ------- Securities available for sale: U.S. government securities........ 17,379 12 17,391 Municipal obligations............. 2,901 (5) 2,896 Corporate debt.................... 4,232 (3) 4,229 Corporate equity.................. 8,271 (296) 7,975 Stock of federal agencies......... 5,874 114 5,988 -------- ------- Total stock......................... 38,657 38,479 -------- ------- -------- ------- Weighted average yield.............. 6.15%
22 MORTGAGE-BACKED AND RELATED SECURITIES. In order to supplement loan production (particularly those of interest rate sensitive loans) and achieve its asset/liability management goals, HMN invests in mortgage-backed and related securities. All of the mortgage-backed and related securities owned by HMN are issued, insured or guaranteed either directly or indirectly by a federal agency or are rated "AA" or higher. At December 31, 1998, HMN had $143.1 million of mortgage-backed and related securities all classified as available for sale, compared to $135.9 at December 31, 1997 and $135.2 million at December 31, 1996, of which $133.4 million were classified as available for sale. The contractual maturities of the mortgage-backed and related securities portfolio without any prepayment assumptions at December 31, 1998 is as follows:
December 31, 1998 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........ $ 133 561 1,183 0 1,877 Federal National Mortgage Association......... 0 0 0 574 574 Government National Mortgage Association...... 0 13 108 1,366 1,487 Other mortgage-backed securities.............. 0 0 0 101 101 Collateralized Mortgage Obligations........... 1,028 2,208 18,928 116,943 139,107 ------------ ---------- ------------ ----------- ------------ Total...................................... $ 1,161 2,782 20,219 118,984 143,146 ------------ ---------- ------------ ----------- ------------ ------------ ---------- ------------ ----------- ------------ Weighted average yield........................ 7.50% 7.21% 7.03% 6.66% 6.73%
At December 31, 1998, HMN did not have any non-agency mortgage-backed or related securities in excess of 10% of its stockholders' equity, except for a $11.9 million collateralized mortgage obligation issued by Bear Stearns with an AAA rating by Moody's. 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 HMN'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, 1998, HMN had $94.5 million invested in CMOs which have floating interest rates that change either monthly or quarterly, compared to $23.3 million at December 31, 1997 and $43.5 million at December 31, 1996. During 1998 HMN increased its investment in floating rate CMOs in order to reduce its overall interest rate risk exposure. At December 31, 1998 the projected duration (period of time until half the interest and half the principal is collected) of the $44.6 million fixed rate CMO portfolio is approximately 1.0 year using median prepayment speeds projected by the Bloomberg security system, compared to approximately 3.3 years for the $61.8 million fixed rate CMO security portfolio at December 31, 1997. Refer to Management's Discussion and Analysis-Market Risk in the Annual Report for information on changes in market value of the mortgage-backed or related securities under different rate shock environments. To assess price volatility, the Federal Financial Institutions Examination Council ("FFIEC") adopted a policy in 1992 which required an annual "stress" test of mortgage derivative securities. The policy, which was adopted by the OTS, required the Bank to annually test its CMOs and other mortgage-related securities to 23 determine whether they were "high-risk" or "nonhigh-risk securities". During 1998 the OTS adopted Thrift Bulletin 13A which no longer required that "high-risk" testing be performed on an institution's CMOs and other mortgage-related securities. 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. For information regarding the carrying and market values of HMN's mortgage-backed and related securities portfolio, see Notes 3 and 4 of the Notes to Consolidated Financial Statements in the Annual Report. MERGERS AND ACQUISITIONS. On December 5, 1997 HMN, through its wholly owned subsidiary, the Bank, completed its merger with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to Consolidated Financial Statements in the Annual Report for information on assets acquired in the merger. SOURCES OF FUNDS GENERAL. The Bank's primary sources of funds are deposits, payments (including prepayments) of loan principal, interest earned on loans and securities, repayments 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, NOW, money market, non-interest bearing checking and certificate accounts (including individual retirement accounts). 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 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) 1998 1997 1996 --------- -------- -------- Opening balance............................. $ 467,348 362,477 373,539 MFC deposits acquired....................... 0 103,612 0 Deposits.................................... 536,135 370,761 351,330 Withdrawals................................. (588,662) (385,002) (378,009) Interest credited........................... 19,048 15,500 15,617 ---------- -------- -------- Ending balance............................ 433,869 467,348 362,477 ---------- -------- -------- Net increase (decrease)..................... $ (33,479) 104,871 (11,062) ---------- -------- -------- ---------- -------- -------- Percent increase (decrease)................. (7.16)% 28.93% (2.96)% ---------- -------- -------- ---------- -------- --------
24 The following table sets forth the dollar amount of savings deposits in the various types of deposit programs offered by the Bank as of December 31:
1998 1997 1996 ---------------------------- -------------------------- ---------------------- Percent Percent Percent (DOLLARS IN THOUSANDS) Amount of Total Amount of Total AMOUNT of Total -------- -------- -------- -------- --------- -------- TRANSACTIONS AND SAVINGS DEPOSITS(1): Non-interest checking.................... $ 13,187 3.04% $ 3,833 0.82% $ 2,389 0.66% NOW Accounts - 1.00%(2).................. 25,459 5.87 23,144 4.95 17,589 4.85 Passbook Accounts - 2.00%(3)............. 35,766 8.24 36,199 7.75 30,070 8.29 Money Market Accounts - 3.19%(4)......... 29,419 6.78 24,807 5.31 16,533 4.56 ---------- -------- ---------- -------- --------- ------- Total Non-Certificates................. $ 103,831 23.93% $ 87,983 18.83% $ 66,581 18.36% ---------- -------- ---------- -------- --------- ------- CERTIFICATES: 3.00 - 3.99%........................... $ 1,943 0.45% $ 727 0.15% $ 425 0.12% 4.00 - 4.99%........................... 87,582 20.19 24,155 5.17 22,553 6.22 5.00 - 5.99%........................... 160,630 37.02 162,916 34.86 168,040 46.36 6.00 - 6.99%........................... 78,273 18.04 178,847 38.27 76,704 21.16 7.00 - 7.99%........................... 1,342 0.31 11,627 2.49 28,077 7.75 8.00 - 8.99%........................... 264 0.06 1,091 0.23 96 0.03 9.00% and over.......................... 4 0.00 2 0.00 1 0.00 ---------- -------- --------- ------- --------- ------- Total Certificates..................... 330,038 76.07 379,365 81.17 295,896 81.64 ---------- -------- ---------- -------- --------- ------- Total Deposits...................... $ 433,869 100.00% $ 467,348 100.00% $ 362,477 100.00% ---------- -------- ---------- ------- --------- ------ ---------- -------- ---------- ------- --------- ------
- ------------ (1) Reflects rates paid on transaction and savings deposits at December 31, 1998. (2) The rate on NOW Accounts for 1997 was 1.50% and 1996 was 2.01%. (3) The rate on Passbook Accounts for 1997 was 2.62% and 1996 was 2.50%. (4) The rate on Money Market Accounts for 1997 was 3.34% and 1996 was 2.83%. 25 The following table shows rate and maturity information for the Bank's certificates of deposit as of December 31, 1998.
(DOLLARS IN THOUSANDS) Certificate accounts maturing in 2.00- 3.00- 4.00- 5.00- 6.00- quarter ending: 2.99% 3.99% 4.99% 5.99% 6.99% ------ ----- ------ ------- ------ March 31, 1999.......................... $ 0 1,322 12,578 30,572 21,601 June 30, 1999........................... 0 3 12,859 26,839 8,536 September 30, 1999...................... 100 43 22,019 19,162 5,520 December 31, 1999....................... 400 39 12,675 17,599 1,654 March 31, 2000.......................... 0 0 10,874 8,520 3,427 June 30, 2000........................... 0 2 2,964 4,397 1,736 September 30, 2000...................... 0 0 3,891 4,031 13,958 December 31, 2000....................... 0 33 4,040 7,124 6,575 March 31, 2001.......................... 0 0 278 9,072 2,832 June 30, 2001........................... 0 0 739 8,998 1,975 September 30, 2001...................... 0 0 2,638 5,243 2,230 December 31, 2001....................... 0 1 1,753 1,112 2,867 Thereafter.............................. 0 0 274 17,961 5,362 ------ ----- ------ ------- ------ Total................................ $ 500 1,443 87,582 160,630 78,273 ------ ----- ------ ------- ------ ------ ----- ------ ------- ------ Percent of total..................... 0.15% 0.44% 26.54% 48.66% 23.72% ------ ----- ------ ------- ------ ------ ----- ------ ------- ------ (DOLLARS IN THOUSANDS) Certificate accounts maturing in 7.00- 8.00- 9.00- Percent quarter ending: 7.99% 8.99% 9.99% Total of Total ----- ----- ----- ------- -------- March 31, 1999.......................... 477 253 0 66,803 20.25 June 30, 1999........................... 248 11 2 48,498 14.70 September 30, 1999...................... 358 0 0 47,202 14.30 December 31, 1999....................... 257 0 0 32,624 9.88 March 31, 2000.......................... 0 0 1 22,822 6.92 June 30, 2000........................... 0 0 0 9,099 2.76 September 30, 2000...................... 0 0 0 21,880 6.63 December 31, 2000....................... 0 0 0 17,772 5.38 March 31, 2001.......................... 0 0 0 12,182 3.69 June 30, 2001........................... 0 0 0 11,712 3.55 September 30, 2001...................... 0 0 1 10,112 3.06 December 31, 2001....................... 2 0 0 5,735 1.74 Thereafter.............................. 0 0 0 23,597 7.15 ----- ----- ----- ------- ------ Total................................ 1,342 264 4 330,038 100.00% ----- ----- ----- ------- ------ ----- ----- ----- ------- ------ Percent of total..................... 0.41% 0.08% 0.00% 100.00% ----- ----- ----- ------- ----- ----- ----- -------
26 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, 1998.
Maturity -------------------------------------------- Over Over 3 Months 3 to 6 6 to 12 Over or Less Months Months 12 Months Total -------- ------ ------- --------- ------- (DOLLARS IN THOUSANDS) Certificates of deposit less than $100,000........................................... $ 55,559 44,651 69,631 123,848 293,689 Certificates of deposit of $100,000 or more........................................ 5,520 2,100 5,568 10,717 23,905 Public funds(1).......................................... 5,725 1,747 4,627 345 12,444 -------- ------- ------- -------- ------- Total certificates of deposit.............................................. $ 66,804 48,498 79,826 134,910 330,038 -------- ------- ------- -------- ------- -------- ------- ------- -------- -------
- ------------ (1) Deposits from governmental and other public entities. For additional information regarding the composition of the Bank's deposits, see Note 12 of the Notes to Consolidated Financial Statements in the Annual Report. For additional information on certificate maturities and the impact on HMN's liquidity see Liquidity starting on page 21 of the Annual Report. BORROWINGS. The Bank's other available sources of funds include advances from the Federal Home Loan Bank ("FHLB") of Des Moines and other borrowings. As a member of the FHLB of Des Moines, the Bank is required to own capital stock in the FHLB of Des Moines and is authorized to apply for advances from the FHLB of Des Moines. Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB of Des Moines 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 extend the term to maturity of its liabilities. Also, the Bank has used FHLB borrowings to fund loan demand and other investment opportunities and to offset deposit outflows. At December 31, 1998, the Bank had $185.4 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 $60.0 million for liquidity purposes. See "Financial Review - Federal Home Loan Bank Advances" and Note 13 of the Notes to Consolidated Financial Statements in the Annual Report. During 1998, HMN has established a $2.5 million revolving line of credit with Norwest Bank Minnesota, N.A. The credit line matures September 15, 1999 and floats at the Federal Funds rate plus 250 basis points. The following table sets forth the maximum month-end balance and average balance of FHLB advances and the revolving line of credit ("Other Borrowings") for the periods indicated.
Year Ended December 31, ----------------------------------------- 1998 1997 1996 ---------- ------- ------- (DOLLARS IN THOUSANDS) MAXIMUM BALANCE: FHLB advances and Other Borrowings........................ $ 195,829 128,007 106,436 FHLB short-term borrowings and Other Borrowings........... 46,893 60,429 64,429 AVERAGE BALANCE: FHLB advances and Other Borrowings........................ 172,232 112,500 89,656 FHLB short-term borrowings and Other Borrowings........... 32,320 45,598 47,949
27 The following table sets forth certain information as to the Bank's FHLB advances and Other Borrowings at the dates indicated.
December 31, --------------------------- 1998 1997 1996 ------- ------ ------ (DOLLARS IN THOUSANDS) FHLB short-term borrowings and Other Borrowings....... $17,500 43,250 46,429 Weighted average interest rate of FHLB short-term borrowings and Other Borrowings..... 5.38% 5.85% 5.52%
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 such 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 which a federal savings bank may engage in directly. Osterud Insurance Agency, Inc. ("OIAI"), a Minnesota corporation, was organized in 1983. OIAI operated as an insurance agency until 1986 when its assets were sold. OIAI remained inactive until 1993 when it began offering credit life insurance, annuity products and mutual fund products to the Bank's customers and others. OIAI recorded net income of $29,000 for the year ended December 31, 1998. MSL Financial Corporation ("MSL") was acquired in the MFC merger. MSL offered annuity products to MFC customers and also has an investment in FHLMC preferred stock. COMPETITION The Bank faces strong competition both in originating real estate loans and in attracting deposits. Competition in originating loans comes primarily from mortgage bankers, commercial banks, credit unions and other savings institutions, which also make loans secured by real estate located in the Bank's market area and through internet banking operations which are throughout the continental 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 money market and mutual funds, securities firms, commercial banks and other savings institutions located in the same communities. 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, convenient locations 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 HMN HMN has two other wholly owned subsidiaries, HMN Mortgage Services, Inc. ("MSI") and Security Finance Corporation ("SFC"). MSI operates a mortgage banking and mortgage brokerage facility located in Brooklyn Park, Minnesota. Brooklyn Park is located in the Minneapolis/St. Paul Metropolitan area. MSI's primary function is to originate and/or purchase single family residential loans for resale on the secondary 28 market to FNMA, FHLMC or other third parties. It also from time to time purchases mortgage servicing rights from other lenders. SFC invests in commercial loans and commercial real estate loans located throughout the United States which were originated by third parties. EMPLOYEES At December 31, 1998, HMN had a total of 136 full-time equivalent employees. None of the employees of HMN or its subsidiaries are represented by any collective bargaining unit. Management considers its employee relations to be good. EXECUTIVE OFFICERS OF THE REGISTRANT WHO ARE NOT DIRECTORS Officers are elected annually by the Board of Directors of HMN and the Bank. The business experience of each executive officer of HMN and the Bank who is not also a director of HMN is set forth below. Unless otherwise indicated, such individuals have held their current positions for at least five years. MICHAEL MCNEIL. Mr. McNeil, age 51, has been the President and Chief Executive Officer of the Bank since January 1, 1999. From April 1, 1998 through December 1998, Mr. McNeil was the Senior Vice President 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 August 1, 1991 until March 1, 1998. DWAIN C. JORGENSEN. Mr. Jorgensen, age 50, is Senior Vice President Operations of HMN and the Bank. Mr. Jorgensen has held such positions with the Bank since 1998. Prior to such time, he served as Vice President, Controller and Chief Accounting Officer of HMN and the Bank from 1989 to 1998. From 1983 to 1989, Mr. Jorgensen was an Assistant Vice President and Operations Officer with the Bank. TIMOTHY P. JOHNSON. Mr. Johnson, age 46, is Vice President and Treasurer of HMN and the Bank, a position he has held since 1997. He has also been Principal Accounting Officer since 1998. Prior to such time, he served as Treasurer from 1992 to 1997. From 1983 to 1992, Mr. Johnson was Chief Financial Officer of St. Louis Bank for Savings, Duluth, Minnesota. REGULATION GENERAL The Bank is a federally chartered savings bank, the deposits of which are federally insured and backed by the full faith and credit of the United States Government. Accordingly, the Bank is subject to broad federal regulation and oversight extending to all its operations. The Bank is a member of the FHLB of Des Moines and is subject to certain limited regulation by the Federal Reserve Board. The Bank is a member of the Savings Association Insurance Fund ("SAIF") and the deposits of the Bank are insured by the FDIC. As a result, the FDIC has certain regulatory and examination authority over the Bank. As the savings and loan holding company of the Bank, HMN also is subject to federal regulation and oversight. The purpose of the regulation of HMN and other holding companies is to protect subsidiary savings associations. Certain of these regulatory requirements and restrictions are discussed below. FEDERAL REGULATION OF SAVINGS ASSOCIATIONS The OTS has extensive authority over the operations of savings associations. As part of this authority, the Bank is required to file periodic reports with the OTS and is subject to periodic examinations by the OTS and the FDIC. The last regular OTS examination of the Bank was dated July of 1998. The Bank has not been scheduled for an examination in 1999, except for an on-site year 2000 examination which started 29 on March 1, 1999. When these examinations are conducted by the OTS and the FDIC, the examiners may require the Bank to provide for higher general or specific loan loss reserves. From time to time, financial institutions in various regions of the United States have been called upon by examiners to write down assets and to establish increased levels of reserves, primarily as a result of perceived weaknesses in real estate values and a more restrictive regulatory climate. The OTS has established a schedule for the assessment of fees upon all savings associations to fund the operations of the OTS. The general assessment, to be paid on a semi-annual basis, is computed upon the savings association's total assets as reported in the association's latest quarterly thrift financial report, the savings association's condition as reflected by its composite rating, and the complexity of the savings association's business determined by the amount of trust assets administered, assets subject to recourse or similar obligations and the principal amount of loans serviced by the savings association. Savings associations (unlike the Bank) with a composite rating of 3 receive a condition component equal to 25% of their size component and savings associations with a composite rating of 4 or 5 receive a condition component equal to 50% of their size component. The Bank's OTS assessment for the year ended December 31, 1998 was approximately $147,000. The OTS also has extensive enforcement authority over all savings institutions and their holding companies, including the Bank and HMN. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS. Except under certain circumstances, public disclosure of final enforcement actions by the OTS is required. In addition, the investment, lending and branching authority of the Bank is prescribed by federal laws and regulations, and it is prohibited from engaging in any activities not permitted by such laws and regulations. For instance, no savings institution may invest in non-investment grade corporate debt securities. In addition, unless approved by the OTS, the permissible level of investment by federal associations in loans secured by non-residential real property may not exceed 400% of regulatory capital. Federal savings associations are also generally authorized to branch nationwide. The Bank is in compliance with the noted restrictions. The Bank's general permissible lending limit for loans-to-one-borrower is equal to the greater of $500,000, or 15%, of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus). At December 31, 1998, the Bank's lending limit under this restriction was $6.9 million. The Bank is in compliance with the loans-to-one borrower limitation. In December 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted into law. FDICIA provides for, among other things, the recapitalization of the Bank Insurance Fund; adoption of safety and soundness standards; enhanced federal supervision of depository institutions, including greater authority for the appointment of a conservator or receiver for undercapitalized institutions; the establishment of risk-based deposit insurance premiums; liberalization of the qualified thrift lender test; greater restrictions on transactions with affiliates; and mandated consumer protection disclosures with respect to deposit accounts. See "- Insurance of Accounts and Regulation by the FDIC," "- Regulatory Capital Requirements" and "- Qualified Thrift Lender Test." The OTS, as well as the other federal banking agencies, have issued proposed safety and soundness standards on matters such as credit underwriting and loan documentation, internal controls and audit systems, interest rate risk exposure, asset growth and quality, compensation and other employee benefits and year 2000 issues. The proposal also establishes the maximum ratio of classified assets to total capital (which for this purpose 30 includes loss allowances exceeding the amount includable for regulatory capital purposes) at 100% and the minimum level of earnings sufficient to absorb losses without impairing capital. Earnings will be sufficient if the net income over the last four quarters is assumed to continue over the next four quarters and the institution would otherwise remain in capital compliance. Any institution which fails to comply with these standards must submit a compliance plan. A failure to submit a plan or to comply with an approved plan will subject the institution to further enforcement action. The Bank is subject to a wide array of other laws and regulations, both federal and state, including, but not limited to, usury laws, the Community Reinvestment Act and regulations thereunder, the Equal Credit Opportunity Act and Regulation B, Regulation E-Electronic Funds Transfer requirements, the Truth-in-Lending Act and Regulation Z, the Real Estate Settlement Procedures Act and Regulation X. The Bank is also subject to laws and regulations that may impose liability on lenders and owners for clean-up costs and other costs stemming from hazardous waste located on property securing real estate loans made by lenders or on real estate that is owned by lenders following a foreclosure or otherwise. INSURANCE OF ACCOUNTS AND REGULATION BY THE FDIC The Bank is a member of the SAIF, which is administered by the FDIC. Savings deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the SAIF. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition. FDICIA required the FDIC to implement a risk-based deposit insurance assessment system. Under the system, all insured depository institutions were placed into one of nine categories and assessed insurance premiums, ranging from .04% to .31% of deposits, based upon their level of capital and supervisory evaluation. Institutions classified as well capitalized (I.E., a core capital ratio of at least 5%, a ratio of Tier 1 or core capital to risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy would pay the lowest premium while institutions that are less than adequately capitalized (I.E., core and Tier 1 risk-based capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern would pay the highest premium. Risk classification of all insured institutions will be made by the FDIC for each semi-annual assessment period. The FDIC is authorized to increase assessment rates, on a semi-annual basis, if it determines that the reserve ratio of the SAIF will be less than the designated reserve ratio of 1.25% of SAIF insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. In addition, under FDICIA, the FDIC may impose special assessments on SAIF members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC. The Deposit Insurance Fund Act of 1996 (DIFA) was enacted on September 30, 1996. DIFA addressed the inadequate funding of the (SAIF). In order to recapitalize the SAIF, DIFA imposed a one-time assessment on all thrift institutions. The Bank's assessment was a pretax charge of $2,351,563 and was recognized in the third quarter of 1996. DIFA also addressed the funding for the Financing Corp. (FICO) bonds. Thrifts will pay 6.4 basis points per $100 of deposits from January 1, 1997 to December 31, 1999. From January 1, 2000 until the 31 FICO bonds are retired in 2019, the estimated assessment to retire the FICO bonds is expected to be 2.5 basis points per $100 of deposits. DIFA proposed that the Bank Insurance Fund (BIF) and SAIF be merged on January 1, 1999, provided no insurance depository institution is a savings association on that date. At this time, HMN does not know what effect, if any, the proposed legislation or charter revisions will have on future operations. REGULATORY CAPITAL REQUIREMENTS Federally insured savings associations, such as the Bank, are required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a tangible capital requirement, a leverage ratio (or core capital) requirement and a risk-based capital requirement applicable to such savings associations. These capital requirements must be generally as stringent as the comparable capital requirements for national banks. The OTS is also authorized to impose capital requirements in excess of these standards on individual associations on a case-by-case basis. The capital regulations require tangible capital of at least 1.5% of adjusted total assets (as defined by regulation). Tangible capital generally includes common stockholders' equity and retained earnings, and certain noncumulative perpetual preferred stock. In addition, all intangible assets, other than a limited amount of purchased mortgage servicing rights, must be deducted from tangible capital. At December 31, 1998, the Bank had goodwill and other intangibles of $5.6 million and $264,000 of mortgage servicing rights which were required to be deducted from stockholders' equity to arrive at tangible capital and Tier I capital. The OTS regulations establish special capitalization requirements for savings associations that own subsidiaries. Under these regulations certain subsidiaries are consolidated for capital purposes and others are excluded from assets and capital. In determining compliance with the capital requirements, all subsidiaries engaged solely in activities permissible for national banks or engaged in certain other activities solely as agent for its customers, or meeting other criteria, are "includable" subsidiaries that are consolidated for capital purposes in proportion to the association's level of ownership, including the assets of includable subsidiaries in which the association has a minority interest that is not consolidated for GAAP purposes. For excludable subsidiaries the debt and equity investments in such subsidiaries are deducted from assets and capital. The subsidiary of the Bank is an includable subsidiary. At December 31, 1998, the Bank had tangible capital of $42.8 million, or 6.4% of adjusted total assets, which is $16.0 million above the minimum requirement of 1.5% of adjusted total assets in effect on that date. The capital standards also require core capital or Tier I capital to equal at least 3% of adjusted total assets (as defined by regulation). Core capital generally consists of tangible capital plus certain intangible assets. As a result of the prompt corrective action provisions of FDICIA discussed below, however, a savings association must maintain a core capital ratio of at least 4% to be considered adequately capitalized unless its supervisory condition is such to allow it to maintain a 3% ratio. The OTS regulations only allow those savings associations rated a composite one (the highest rating) under the safety and soundness rating system for savings associations to be permitted to operate at or near the regulatory minimum leverage ratio of 3%. All other savings associations are required to maintain a Tier I capital to adjusted total assets of 4% to 5%. The OTS assesses each individual savings association through the supervisory process on a case-by-case basis to determine the applicable requirement. The Bank is also required to have a Tier I capital ratio to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. For example, the OTS has assigned a risk weight of 50% for prudently underwritten permanent one-to-four family first lien mortgage loans not more than 90 days delinquent and having a loan to value ratio of not more than 80% at origination 32 unless insured to such ratio by an insurer approved by the FNMA or the FHLMC. At December 31, 1998, the Bank had Tier I capital equal to $42.8 million, or 6.4%, of adjusted total assets, which is $16.0 million above the minimum Tier I ratio requirement of 4% based upon the Bank's composite rating. At December 31, 1998, the Bank had a Tier I capital to risk-weighted assets ratio of 12.9%, which is $29.5 million above the minimum requirement of $13.3 million. The OTS risk-based requirement requires savings associations to have total capital of at least 8% of risk-weighted assets. Total capital consists of core capital, as defined above, and supplementary capital. Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary capital may be used to satisfy the risk-based requirement only to the extent of core capital. At December 31, 1998, the Bank had $3.0 million of general loss reserves, which were included in capital. Certain exclusions from capital and assets are required to be made for the purpose of calculating total capital, in addition to the adjustments required for calculating core capital. Such exclusions consist of equity investments (as defined by regulation) and that portion of land loans and nonresidential construction loans in excess of an 80% loan-to-value ratio and reciprocal holdings of qualifying capital instruments. At December 31, 1998 the Bank had $22,000 of exclusions from capital. On December 31, 1998, the Bank had total "risk-based" capital of $45.8 million and risk-weighted assets of $332.7 million, or total capital of 13.8% of risk-weighted assets. This amount was $19.2 million above the 8% requirement in effect on that date. Under FDICIA, all the federal banking agencies, including the OTS, were required to revise their risk-based capital requirements to ensure that such requirements account for interest rate risk, concentration of credit risk and the risks of non-traditional activities, and that they reflect the actual performance of and expected loss on multi-family loans. Such standards were adopted with the enactment of FDICIA. The OTS had adopted a rule that required every savings association with more than normal interest rate risk to deduct from its total capital, for purposes of determining compliance with such requirement, an interest rate risk component ("IRR component") equal to 50% of its interest-rate risk exposure multiplied by the present value of its assets. The IRR component is a measure of the potential decline in the net portfolio value ("NPV") of a savings association, greater than 2% of the present value of its assets, based upon a hypothetical 200 basis point increase or decrease in interest rates (whichever results in a greater decline). NPV is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts. The rule provided for a two quarter lag between calculating interest rate risk and recognizing any deduction from capital. The OTS has decided not to require the IRR component to be deducted from the capital calculations of all institutions. It has reserved the right to take the IRR component into account in assessing the capital requirements for an individual institution. On December 1, 1998 the OTS issued Thrift Bulletin 13a ("TB 13a"), Management of Interest Rate Risk, Investment Securities, and Derivatives Activities, which among other things established guidelines for measuring an institution's sensitivity to market risk. TB 13a had a table which examiners should use as a starting point in their analysis of an institution's level of interest rate risk, assuming there were no deficiencies in the institution's risk management practices. Based upon an IRR exposure report prepared by OTS from data submitted by the Bank at December 31, 1998, the Bank was deemed to have "minimal interest rate risk" per the table. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management" in the Annual Report. Pursuant to FDICIA, the federal banking agencies, including the OTS, have adopted regulations authorizing the agencies to require a depository institution to maintain an additional amount of total capital to account for concentration of credit risk and the risk of non-traditional activities. 33 The OTS and the FDIC are authorized and, under certain circumstances, required to take certain actions against associations that fail to meet capital requirements. Effective December 19, 1992, the federal banking agencies, including the OTS, were given additional enforcement authority over undercapitalized depository institutions. The OTS is generally required to take action to restrict the activities of an "undercapitalized association" (generally defined to be one with less than either a 4% Tier 1 to adjusted total assets ratio, a 4% Tier 1 risked-based capital ratio or an 8% risk-based capital ratio). Any such association must submit a capital restoration plan and until such plan is approved by the OTS may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The OTS is authorized to impose the additional restrictions, discussed below, that are applicable to significantly undercapitalized associations. As a condition to the approval of the capital restoration plan, any company controlling an undercapitalized association must agree that it will enter into a limited capital maintenance guarantee with respect to the institution's achievement of its capital requirements. Any savings association that fails to comply with its capital plan or is "significantly undercapitalized" (I.E., Tier 1 risk-based or Tier I to adjusted total assets of less than 3% or a risk-based capital ratio of less than 6%) must be made subject to one or more additional specified actions and operating restrictions mandated by FDICIA. These actions and restrictions include requiring the issuance of additional voting securities; limitations on asset growth; mandated asset reduction; changes in senior management; divestiture, merger or acquisition of the association; restrictions on executive compensation; and any other action the OTS deems appropriate. An association that becomes "critically undercapitalized" (I.E., a tangible equity to total asset ratio of 2% or less) is subject to further mandatory restrictions on its activities in addition to those applicable to significantly undercapitalized associations. In addition, the OTS must appoint a receiver (or conservator with the concurrence of the FDIC) for a savings association, with certain limited exceptions, within 90 days after it becomes critically undercapitalized. Any undercapitalized association is also subject to other possible enforcement actions by the OTS or the FDIC. Such actions could include a capital directive, a cease-and-desist order, civil money penalties, the establishment of restrictions on all aspects of the association's operations, the appointment of a receiver or conservator or a forced merger into another institution. If the OTS determines that an association is in an unsafe or unsound condition, or is engaged in an unsafe or unsound practice, it is authorized to reclassify a well-capitalized association as an adequately capitalized association, and if the association is adequately capitalized, to impose the restrictions applicable to an undercapitalized association. If the association is undercapitalized, the OTS is authorized to impose the restrictions applicable to a significantly undercapitalized association. The imposition by the OTS or the FDIC of any of these measures on the Bank may have a substantial adverse effect on the Bank's operations and profitability and the value of HMN's stock. HMN shareholders do not have preemptive rights, and therefore, if HMN is directed by the OTS or the FDIC to issue additional shares of common stock, such issuance may result in the dilution in the percentage of ownership of existing stockholders of HMN. At December 31, 1998 the Bank would be considered to be "well capitalized" under the prompt corrective actions provisions mentioned above. See Note 20 "Federal Home Loan Bank Investment, Regulatory Liquidity and Regulatory Capital Requirements" in the Notes to Consolidated Financial Statements in the Annual Report for more information on the Bank's capital. 34 LIMITATIONS ON DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS OTS regulations impose various restrictions or requirements on associations with respect to their ability to pay dividends or make other distributions of capital. OTS regulations prohibit an association from declaring or paying any dividends or from repurchasing any of its stock if, as a result, the regulatory capital of the association would be reduced below the amount required to be maintained for the liquidation account established in connection with its mutual to stock conversion. The OTS utilizes a three-tiered approach to permit associations, based on their capital level and supervisory condition, to make capital distributions which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account. See "- Regulatory Capital Requirements." Generally, Tier 1 associations, which are associations that before and after the proposed distribution meet their fully phased-in capital requirements, may generally make capital distributions during any calendar year equal to the greater of 100% of net income for the year-to-date plus 50% of the amount by which the lesser of the association's tangible, core or risk-based capital exceeds its fully phased-in capital requirement for such capital component, as measured at the beginning of the calendar year, or the amount authorized for a Tier 2 association. However, a Tier 1 association deemed to be in need of more than normal supervision by the OTS may be downgraded to a Tier 2 or Tier 3 association as a result of such a determination. The Bank meets the requirements for a Tier 1 association and has not been notified of a need for more than normal supervision. Tier 2 associations, which include associations that before and after the proposed distribution meet their current minimum capital requirements, may generally make capital distributions of up to 75% of net income over the most recent four quarter period. Tier 3 associations (which are associations that do not meet current minimum capital requirements) that propose to make any capital distribution and Tier 2 associations that propose to make a capital distribution in excess of the noted safe harbor level must obtain OTS approval prior to making such distribution. Tier 2 associations proposing to make a capital distribution within the safe harbor provisions and Tier 1 associations proposing to make any capital distribution need only submit written notice to the OTS 30 days prior to such distribution. As a subsidiary of HMN, the Bank will also be required to give the OTS 30 days' notice prior to declaring any dividend on its stock. The OTS may object to the distribution during that 30-day period based on safety and soundness concerns. See "- Regulatory Capital Requirements." The OTS has promulgated regulations that revise the current capital distribution restrictions. These regulations become effective on April 1, 1999. The regulations eliminate the current tiered structure and the safe-harbor percentage limitations. Under the regulations, a savings association that is a subsidiary of a holding company, like the Bank, must file either a notice or an application 30 days before declaring a dividend or seeking board approval of a capital distribution. A notice is required unless a savings association (that is a holding company subsidiary) is not eligible for expedited treatment under OTS regulation or would not be adequately capitalized after the distribution, or the distribution would cause the association's distributions for the calendar year to exceed its net income for the year to date plus retained net income for the prior two years, or the distribution is otherwise contrary to statute, regulation or regulatory agreement or condition. If any of these conditions exist, then an application must be filed with the OTS. As under the current rule, the OTS may object to a capital distribution if it would constitute an unsafe or unsound practice. In March of 1999, the Bank received notification from the OTS that subject to certain restrictions (which could only be calculated at the time of distribution) a dividend from the Bank to HMN of $4.0 million could be paid during 1999 and not violate the dividend limitations mentioned above. 35 LIQUIDITY All savings associations, including the Bank, are required to maintain an average daily balance of liquid assets equal to a certain percentage of the sum of its average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. For a discussion of what the Bank includes in liquid assets, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity" in the Annual Report. This liquid asset ratio requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings associations. At the present time, the minimum liquid asset ratio is 4% or an amount that would be required to operate the Bank in a safe and sound manner. ACCOUNTING An OTS policy statement applicable to all savings associations clarifies and re-emphasizes that the investment activities of a savings association must be in compliance with approved and documented investment policies and strategies, and must be accounted for in accordance with GAAP. Under the policy statement, management must support its classification of and accounting for loans and securities (I.E., whether held to maturity, sale or trading) with appropriate documentation. The Bank is in compliance with these amended rules. The OTS has adopted an amendment to its accounting regulations, which may be made more stringent than GAAP, to require that transactions be reported in a manner that best reflects their underlying economic substance and inherent risk and that financial reports must incorporate any other accounting regulations or orders prescribed by the OTS. QUALIFIED THRIFT LENDER TEST All savings associations, including the Bank, are required to meet a qualified thrift lender ("QTL") test to avoid certain restrictions on their operations. This test requires a savings association to have at least 65% of its portfolio assets (which consists of total assets less intangibles, properties used to conduct the savings association's business and liquid assets not exceeding 20% of total assets) in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. For HMN such assets primarily consist of residential housing related loans and investments. At December 31, 1998, the Bank met the test and has always met the test since its effectiveness. Any savings association that fails to meet the QTL test must convert to a national bank charter, unless it requalifies as a QTL and thereafter remains a QTL. If an association does not requalify and converts to a national bank charter, it must remain SAIF-insured until the FDIC permits it to transfer to the Bank Insurance Fund. If an association that fails the test has not yet requalified and has not converted to a national bank, its new investments and activities are limited to those permissible for both a savings association and a national bank, and it is limited to national bank branching rights in its home state. In addition, the association is subject to national bank limits for payment of dividends. If such association has not requalified or converted to a national bank within three years after the failure, it must divest of all investments and cease all activities not permissible for a national bank. In addition, it may have to repay promptly any outstanding FHLB borrowings, which could result in prepayment penalties or purchase additional FHLB stock to meet the stockholder requirements of non-QTL members. If any association that fails the QTL test is controlled by a holding company, then within one year after the failure, the holding company must register as a bank holding company and become subject to all restrictions on bank holding companies. See "- Holding Company Regulation." 36 TRANSACTIONS WITH AFFILIATES Generally, transactions between a savings association or its subsidiaries and its affiliates are required to be on terms as favorable to the association as transactions with non-affiliates. In addition, certain of these transactions are restricted to a percentage of the association's capital. Affiliates of the Bank include HMN and any company which is under common control with the Bank. In addition, a savings association may not lend to any affiliate engaged in activities not permissible for a bank holding company, acquire the securities of most affiliates, or purchase low quality assets from affiliates. The Bank's subsidiaries are not deemed affiliates, however, the OTS has the discretion to treat subsidiaries of savings associations as affiliates on a case by case basis. Certain transactions with directors, officers or controlling persons are also subject to conflict of interest regulations enforced by the OTS. These conflict of interest regulations and other statutes also impose restrictions on loans to such persons and their related interests. Among other things, such loans must be made on terms substantially the same as for loans to unaffiliated individuals. HOLDING COMPANY REGULATION HMN is a unitary savings and loan holding company subject to regulatory oversight by the OTS. As such, HMN is registered and required to file reports with and subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over HMN and its non-savings association subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings association. As a unitary savings and loan holding company, HMN generally is not subject to activity restrictions. If HMN acquires control of another savings association as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of HMN and any of its subsidiaries (other than the Bank or any other SAIF-insured savings association) would become subject to such restrictions unless such other associations qualify as QTLs and were acquired in a supervisory acquisition. If the Bank fails the QTL test, HMN must obtain the approval of the OTS prior to continuing after such failure, directly or through its other subsidiaries, any business activity other than those approved for multiple savings and loan holding companies or their subsidiaries. In addition, within one year of such failure HMN must register as, and will become subject to, the restrictions applicable to bank holding companies. The activities authorized for a bank holding company are more limited than are the activities authorized for a unitary or multiple savings and loan holding company. See "- Qualified Thrift Lender Test." HMN must obtain approval from the OTS before acquiring control of any other SAIF-insured association. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings association. FEDERAL SECURITIES LAW The stock of HMN is registered with the SEC under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). HMN is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act. HMN stock held by persons who are affiliates (generally officers, directors and principal stockholders) of HMN may not be resold without registration or unless sold in accordance with certain resale restrictions. If HMN meets specified current public information requirements, each affiliate of HMN is able to sell in the public market, without registration, a limited number of shares in any three-month period. 37 FEDERAL RESERVE SYSTEM The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW and Super NOW checking accounts). At December 31, 1998, the Bank was in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements that may be imposed by the OTS. See "- Liquidity." Savings associations are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require associations to exhaust other reasonable alternative sources of funds, including FHLB borrowings, before borrowing from the Federal Reserve Bank. FEDERAL HOME LOAN BANK SYSTEM The Bank is a member of the FHLB of Des Moines, which is one of 12 regional FHLBs, that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (I.E., advances) in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. In addition, all long-term advances are required to provide funds for residential home financing. As a member, the Bank is required to purchase and maintain stock in the FHLB of Des Moines. At December 31, 1998, the Bank had $9.8 million in FHLB stock, which was in compliance with this requirement. In past years, the Bank has received dividends on its FHLB stock. Over the past five calendar years such dividends have averaged 7.07% and were 6.62% for calendar year 1998. For the year ended December 31, 1998, dividends paid by the FHLB of Des Moines to the Bank totaled $589,000. Under federal law the FHLBs are required to provide funds for the resolution of troubled savings associations and to contribute to low and moderately priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have affected adversely the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of the Bank's FHLB stock may result in a corresponding reduction in the Bank's capital. FEDERAL AND STATE TAXATION FEDERAL TAXATION. HMN and its subsidiaries file consolidated federal income tax returns on a calendar year basis using the accrual method of accounting. Prior to 1996, savings institutions were subject to special bad debt reserve rules and certain other rules. During this period of time, a savings institution that held 60% or more of its assets in "qualifying assets" (as defined in the Internal Revenue Code) was permitted to maintain reserves for bad debts and to make annual additions to such reserves that qualified as deductions from taxable income. HMN was in compliance with this requirement. A qualifying thrift institution could elect annually to compute its allowable additions to bad debt reserves under either the percentage of taxable income method or the experience method. The percentage of taxable income method of calculating bad debt reserves limited the applicable percentage deduction to 8% of taxable income and could not cause the reserves to exceed 6% of qualifying loans at the end of the taxable year. HMN used the experience method to calculate additions to tax bad debt reserves through tax year 1995. 38 Beginning in 1996, the favorable bad debt method described above was repealed putting savings institutions on the same tax bad debt method as commercial banks. This legislation required recapture of the amount of the tax bad debt reserves to the extent that they exceed the adjusted base year reserve ("the applicable excess reserves"). The applicable excess reserves are recaptured over a six-year period. This recapture period can be deferred for a period of up to two years to the extent that a certain residential lending test is met. HMN has previously provided taxes for the applicable excess reserves. In addition to the regular income tax, corporations, including savings associations such as the Bank, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20% on alternative minimum taxable income, which is the sum of a corporation's regular taxable income (with certain adjustments) and tax preference items, less any available exemption. The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax and net operating losses can offset no more than 90% of alternative minimum taxable income. To the extent earnings appropriated to a savings association's bad debt reserves for "qualifying real property loans" and deducted for federal income tax purposes before 1988 exceed the allowable amount of such reserves computed under the experience method and to the extent of the association's supplemental reserves for losses on loans ("Excess"), such Excess may not, without adverse tax consequences, be utilized for the payment of cash dividends or other distributions to a shareholder (including distributions on redemption, dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). As of December 31, 1998, the Bank's Excess for tax purposes totaled approximately $8.8 million. HMN was incorporated in 1994 and filed its first consolidated Federal income tax return with its subsidiaries for the year ended December 31, 1994. The return required to be filed for 1998 has been extended and will be filed by September 1999. The Bank and its consolidated subsidiaries have been audited by the IRS with respect to consolidated federal income tax returns through December 31, 1983. With respect to years examined by the IRS, either all deficiencies have been satisfied or sufficient reserves have been established to satisfy asserted deficiencies. In the opinion of management, any examination of still open returns (including returns of subsidiaries and predecessors of, or entities merged into, the Bank) would not result in a deficiency which could have a material adverse effect on the consolidated financial condition of HMN. MINNESOTA TAXATION. HMN and its subsidiaries that operate in Minnesota are subject to Minnesota state taxation. A Minnesota corporation's income or loss is allocated based on a three-factor apportionment of the corporation's Minnesota gross receipts, payroll and property over the total gross receipts, payroll and property of all corporations in the unitary group. The corporate tax rate in Minnesota is 9.8%. The Minnesota Alternative Minimum Tax rate is 5.8%. The Bank and it subsidiaries have not been audited by the Minnesota taxation authorities. IOWA TAXATION. On December 5, 1997 the Bank acquired MFC and its subsidiaries which were located in the state of Iowa. The Bank is now subject to Iowa Franchise tax on an apportionment basis weighted based upon deposits located within Iowa to total deposits of the Bank. Income apportioned to Iowa is subject to a 5% tax rate. DELAWARE TAXATION. As a Delaware holding company, HMN is exempted from Delaware corporate income tax but is required to file an annual report with and pay an annual fee to the State of Delaware. HMN is also subject to an annual franchise tax imposed by the State of Delaware. 39 ITEM 2. PROPERTIES The following table sets forth information concerning the main office and each branch office of HMN at December 31, 1998. At December 31, 1998, HMN's premises had an aggregate net book value of approximately $4.6 million.
Year Owned or Net Book Value at Location Acquired Leased December 31, 1998(1) - -------------------------- -------- -------- -------------------- (In Thousands) CORPORATE OFFICE: 101 North Broadway 1975 Owned 336 Spring Valley, Minnesota FULL SERVICE BRANCHES: 715 North Broadway 1998 Owned 1,107 Spring Valley, Minnesota 201 Oakland Avenue 1960 Owned 157 Austin, Minnesota Crossroads Shopping Center 1962 Owned 481 Rochester, Minnesota 4th & Center (2) 1973 Owned 111 Winona, Minnesota 175 Center Street 1998 Owned 1,751 Winona, Minnesota 208 South Walnut 1975 Owned 86 LaCrescent, Minnesota 1110 6th St., NW 1982 Owned 849 Rochester, Minnesota 143 West Clark Street 1993 Owned 568 Albert Lea, Minnesota 303 W. Main St. 1997 Owned 694 Marshalltown, Iowa 110 W. High St. 1997 Leased 2 Toledo, Iowa 29 S. Center 1997 Owned 245 Marshalltown, Iowa MORTGAGE BANKING/BROKERAGE OFFICES: 7101 Northland Circle, Suite 105 1997 Leased -- Brooklyn Park, Minnesota
- --------------- (1) Does not include $2,174,857 of net furniture and equipment distributed between all of the above offices or its subsidiaries. (2) The property is the old bank building in Winona and is currently being held for sale. The portions of the property are being rented on a month to month basis to tenants. 40 The Bank's depositor and borrower customer files are maintained by an independent data processing company. The net book value of the data processing and computer equipment utilized by the Bank at December 31, 1998 was approximately $462,882. ITEM 3. LEGAL PROCEEDINGS From time to time, the Bank and HMN 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 HMN's consolidated financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The information on pages 21, 52 and the back cover page of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA The information on page 11 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information on pages 12 through 28 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The information on pages 23 through 24 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information on pages 29 through 52 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. 41 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information on pages 4 through 5 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein by reference. See "Business - Executive Officers" in Part I of the Form 10-K for information regarding executive officers. ITEM 11. EXECUTIVE COMPENSATION The information on pages 8 through 12 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein be reference, except for information contained under the heading "Compensation Committee Report on Executive Compensation". ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information on pages 2, 3 and 15 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS 1. Financial Statements The following information appearing in the Registrant's Annual Report to Security Holders for the year ended December 31, 1998, is incorporated by reference in this Form 10-K Annual Report as Exhibit 13.
Pages in 1998 Annual Annual Report Section Report --------------------- ----------- Five Year Consolidated Financial Highlights 11 Consolidated Balance Sheets -- December 31, 1998 and 1997 29 Consolidated Statements of Income -- Each of the Years in the Three-Year Period Ended December 31, 1998 30 Consolidated Statements of Comprehensive Income -- Each of the Years in the Three-Year Period Ended December 31, 1998 30 Consolidated Statement of Stockholders' Equity -- Each of the Years in the Three-Year Period Ended December 31, 1998 31 Consolidated Statements of Cash Flows -- Each of the Years in the Three-Year Period Ended December 31, 1998 32 Notes to Consolidated Financial Statements 33 - 48 Independent Auditors' Report 49 Selected Quarterly Financial Data 50 - 51 Other Financial Data 52 Common Stock Price Information 52
2. Financial Statement Schedules All financial statement schedules have been omitted as information is not required under the related instructions, is not applicable or has been included in the Notes to Consolidated Financial Statements. 43 3. Exhibits
Reference Sequential to Prior Page Numbering Filing or Where Attached Exhibit Exhibits Are Regulation S-K Number Located in This Exhibit Number Document Attached Hereto Form 10-K Report - -------------- ------------------------------------------- --------------- ------------------- 2 Agreement and Plan of Merger 5* Not applicable dated July 1, 1997 3 (i) Articles of Incorporation 1* Not applicable Certificate of Incorporation as amended 7* on April 28, 1998 (ii) By-laws 6* Not applicable 4 Instruments defining the rights of security 1* Not applicable holders, including indentures 9 Voting trust agreement Not applicable Not applicable 10.1+ Employment Agreement for Mr. Weise 2* Not applicable dated June 29, 1994 Extension of Employment Contract 8* Not applicable 10.2+ Employment Agreement for Mr. Gardner 2* Not applicable dated June 29, 1994 Extension of Employment Contract 8* Not applicable 10.3+ Change in Control Severance Agreement 10.3 Filed electronically for Mr. McNeil dated April 1, 1998 10.4+ Directors Deferred Compensation Plan 2* Not applicable 10.5+ 1995 Recognition and Retention Plan 3* Not applicable Amended and Restated HMN Financial, Inc. 9* Not applicable Recognition and Retention Plan dated July 29, 1998 10.6+ 1995 Stock Option and Incentive Plan 3* Not applicable Amended and Restated HMN Financial, Inc. 9* Not applicable Stock Option and Incentive Plan dated July 29, 1998 11 Statement re: Computation of per share 11 Filed electronically earnings 12 Statement re: Computation of ratios Not applicable Not applicable
+Management contract of compensatory arrangement. 44
Reference Sequential to Prior Page Numbering Filing or Where Attached Exhibit Exhibits Are Regulation S-K Number Located in This Exhibit Number Document Attached Hereto Form 10-K Report - -------------- ------------------------------------------- --------------- ------------------- 13 Annual Report to Security Holders 13 Filed electronically 16 Letter re: Change in certifying accountant Not applicable Not applicable 18 Letter re: Change in accounting principles Not applicable Not applicable 21 Subsidiaries of Registrant 21 Filed electronically 22 Published report regarding matters Not applicable Not applicable submitted to vote of security holders 23 Consent of KPMG Peat Marwick LLP 23 Filed electronically dated March 30, 1999 24 Power of Attorney Not applicable Not applicable 27 Financial Data Schedule 27 Filed electronically Year ended 1998 99 Additional exhibits None Not applicable
- ------------------ 1* Filed April 1, 1994, as exhibits to the Registrant's Form S-1 registration statement (Registration No. 33-77212) pursuant to the Securities Act of 1933. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K. 2* Filed as an exhibit to the Registrant's Form 10-K for 1994 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 3* Filed as an exhibit to the Registrant's Form 10-K for 1995 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 4* Filed as an exhibit to the Registrant's Form 10-K for 1996 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 5* Filed as an exhibit to Current Report of Form 8-K dated July 1, 1997, filed on July 10, 1997. All previously filed documents are hereby incorporated by reference. 6* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of 1997 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 7* Filed as an exhibit to the Registrant's Form 10-Q for the first quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 8* Filed as an exhibit to the Registrant's Form 10-Q for the second quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 9* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 45 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 30, 1999 By: /s/ Roger P. Weise ----------------------------- ----------------------------- Roger P. Weise (Duly Authorized Representative) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By: /s/ Roger P. Weise By: /s/ James B. Gardner ----------------------------- ----------------------------- Roger P. Weise, Chairman of James B. Gardner, the Board, President and Chief Executive Vice President Executive Officer (Principal and Director Executive and Operating Officer) (Principal Financial Officer) Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ Irma R. Rathbun By: /s/ Timothy R. Geisler ----------------------------- ----------------------------- Irma R. Rathbun, Director Timothy R. Geisler, Director Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ M. F. Schumann By: /s/ Duane D. Benson ----------------------------- ----------------------------- M.F. Schumann, Director Duane D. Benson, Director Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ Timothy P. Johnson ----------------------------- Timothy P. Johnson, Vice President and Treasurer (Principal Accounting Officer) Date: March 30, 1999 ----------------------------- 46 INDEX TO EXHIBITS
Sequential Page Numbering Where Attached Exhibits Are Regulation S-K Located in This Exhibit Number Document Form 10-K Report - -------------- --------- ------------------- 10.3 Change in Control Severence Agreement for Filed electronically Michael McNeil dated April 1, 1998 11 Statement re: Computation of per share earnings Filed electronically 13 Annual Report to Security Holders Filed electronically 21 Subsidiaries of Registrant Filed electronically 23 Consent of KPMG Peat Marwick LLP Filed electronically dated March 30, 1999 27 Financial Data Schedule Filed electronically Year ended 1998
EX-10.3 2 EX 10.3 Exhibit 10.3 CHANGE IN CONTROL SEVERANCE AGREEMENT THIS CHANGE IN CONTROL SEVERANCE AGREEMENT ("Agreement") is made and entered into as of this 1st day of April 1998, by and between HOME FEDERAL SAVINGS BANK, a federally chartered savings institution (which, together with any successor thereto which executes and delivers the assumption agreement provided for in Section ll(a) hereof or which otherwise becomes bound by the terms and provisions of this Agreement by operation of law, is hereinafter referred to as the "Company"), and Michael McNeil (the "Employee"). WHEREAS, the Employee is currently serving as Senior Vice President of the Company; and WHEREAS, the Company is a federally chartered stock savings bank and the wholly-owned subsidiary of HMN Financial, Inc. (the "Holding Company"); and WHEREAS, the Board of Directors of the Company recognizes that, as is the case with publicly held corporations generally, the possibility of a change in control of the Company or Holding Company may exist and that such possibility, and the uncertainty and questions which it may raise among management, may result in the departure or distraction of key management personnel to the detriment of the Company, the Holding Company and their respective stockholders; and WHEREAS, the Board of Directors of the Company believes it is in the best interests of the Company to enter into this Agreement with the Employee in order to assure continuity of management of the Company and to reinforce and encourage the continued attention and dedication of the Employee to the Employee's assigned duties without distraction in the face of potentially disruptive circumstances arising from the possibility of a change in control of the Company or the Holding Company, although no such change is now contemplated; and WHEREAS, the Board of Directors of the Company has approved and authorized the execution of this Agreement with the Employee to take effect as stated in Section 1 hereof; NOW, THEREFORE, in consideration of the foregoing and of the respective covenants and agreements of the parties herein contained, it is AGREED as follows: 1. TERM OF AGREEMENT. The term of this Agreement shall be deemed to have commenced as of the date of the execution of this agreement and shall continue for a period of thirty (30) full calendar months thereafter. Commencing on the first anniversary of the execution of this agreement and on each anniversary thereafter, this Agreement shall be extended for a period of twelve (12) months in addition to the then-remaining term of employment under this Agreement, unless either the Company or the Employee gives contrary written notice to the other not less than 90 days in advance of the date on which the term of employment under this Agreement would otherwise be extended, and PROVIDED THAT no extension shall occur unless prior to each anniversary of the Execution Date, the Board of Directors of the Company has reviewed a formal evaluation of the Employee's performance during the year preceding such anniversary prepared by the disinterested members of the Board of Directors of the Company and explicitly approved such extension of the term of this Agreement. 2. PAYMENTS TO THE EMPLOYEE UPON CHANGE IN CONTROL. (a) Upon the occurrence of a Change in Control (as herein defined) of the Company or the Holding Company followed at any time during the term of this Agreement by the involuntary termination of the Employee's employment, other than for cause, as defined in Section 2(d) hereof, the provisions of Section 3 shall apply. (b) A "change in control" of the Company or the Holding Company is defined solely as any acquisition of control (other than by a trustee or other fiduciary holding securities under an employee benefit plan of the Holding Company or a subsidiary of the Holding Company), as defined in 12 C.F.R. Section 574.4, or any successor regulation, of the Company or Holding Company which would require the filing of an application for acquisition of control or notice of change in control in a manner as set forth in 12 C.F.R. Section 574.3, or any successor regulation. (c) The Employee's employment under this Agreement may be terminated at any time by the Board of Directors of the Company. The terms "involuntary termination" or "involuntarily terminated" in this Agreement shall refer to the termination of the employment of Employee without the Employee's express written consent. In addition, any of the following actions, shall constitute involuntary termination of employment unless consented to in writing by the Employee: (1) change in the principal workplace of the Employee to a location outside of a 20 mile radius from the Company's headquarters office as of the date hereof; (2) a material demotion of the Employee or material adverse change in the salary, perquisites, benefits, contingent benefits or vacation time which had theretofore been provided to the Employee, other than as part of an overall program applied uniformly and with equitable effect to all members of the senior management of the Company or-the Holding Company; and (3) a material permanent increase in the required hours of work or the workload of the Employee. (d) The Employee shall not have the right to receive termination benefits pursuant to Section 3 hereof upon termination for cause. For purposes of this Agreement, termination for "cause" shall include termination for personal dishonesty, incompetence, willful misconduct, breach of a fiduciary duty involving personal profit, intentional failure to perform stated duties, willful violation of any material law, rule, or regulation (other than a law, rule or regulation relating to a traffic violation or similar offense) or final cease-and-desist order, or material breach of any provision of this Agreement. 3. TERMINATION BENEFITS. (a) Upon the occurrence of a change in control, followed by the involuntary termination of the Employee's employment, other than for cause, the Company shall pay to the Employee in a lump sum in cash within 25 business days after the date of severance of employment an amount equal to 299 percent of the Employee's "base amount" of compensation, as defined in Section 280G(b)(3) of the Internal Revenue Code of 1986, as amended ("Code"). At the election of the Employee, such payment may be made, on a pro rata basis, semi-monthly during the twelve (12) months following the Employee's termination. (b) Upon the occurrence of a change in control of the Company or the Holding Company followed by the involuntary termination of the Employee's employment, other than for cause, the Company shall cause life and health insurance coverage substantially similar to the coverage maintained by the Company for the Employee immediately prior to such termination to be maintained for a period of twelve (12) months or for the remaining term of this Agreement, whichever is greater. 4. CERTAIN REDUCTION OF PAYMENTS BY THE COMPANY. (a) Anything in this Agreement to the contrary notwithstanding, in the event it shall be determined that any payment or distribution by the Company to or for the benefit of the Employee (whether paid or payable or distributed or distributable pursuant to the terms of this Agreement or otherwise) (a "Payment") would be nondeductible (in whole or part) by the Company for Federal income tax purposes because of Section 28OG of the Code, then the aggregate present value of amounts payable or distributable to or for the benefit of the Employee pursuant to this Agreement (such amounts payable or distributable pursuant to this Agreement are hereinafter referred to as "Agreement Payments") shall be reduced to the Reduced Amount. The "Reduced Amount" shall be an amount, not less than zero, expressed in present value which maximizes the aggregate present value of Agreement Payments without causing any Payment to be nondeductible by the Company because of Section 280G of the Code. For purposes of this Section 4, present value shall be determined in accordance with Section 280G(d)(4) of the Code. (b) All determinations required to be made under this Section 4 shall be made by the Company's independent auditors, or at the election of such auditors by such other firm or individuals of recognized expertise as such auditors may select (such auditors or, if applicable, such other firm or individual, are hereinafter referred to as the "Advisory Firm"). The Advisory Firm shall within ten business days of the Date of Termination, or at such earlier time as is requested by the Company, provide to both the Company and the Employee an opinion (and detailed supporting calculations) that the Company has substantial authority to deduct for federal income tax purposes the full amount of the Agreement Payments and that the Employee has substantial authority not to report on his/her federal income tax return any excise tax imposed by Section 4999 of the Code with respect to the Agreement Payments. Any such determination and opinion by the Advisory Firm shall be binding upon the Company and the Employee. The Employee shall determine which and how much, if any, of the Agreement Payments shall be eliminated or reduced consistent with the requirements of this Section 4, provided that, if the Employee does not make such determination within ten business days of the receipt of the calculations made by the Advisory Firm, the Company shall elect which and how much, if any, of the Agreement Payments shall be eliminated or reduced consistent with the requirements of this Section 4 and shall notify the Employee promptly of such election. Within five business days of the earlier of (i) the Company's receipt of the Employee's determination pursuant to the immediately preceding sentence of this Agreement or (ii) the Company's election in lieu of such determination, the Company shall pay to or distribute to or for the benefit of the Employee such amounts as are then due the Employee under this Agreement. The Company and the Employee shall cooperate fully with the Advisory Firm, including without limitation providing to the Advisory Firm all information and materials reasonably requested by it, in connection with the making of the determinations required under this Section 4. (c) As a result of uncertainty in application of Section 28OG of the Code at the time of the initial determination by the Advisory Firm hereunder, it is possible that Agreement Payments will have been made by the Company which should not have been made ("Overpayment") or that additional Agreement Payments will not have been made by the Company which should have been made ("Underpayment"), in each case, consistent with the calculations required to be made hereunder. In the event that the Advisory Firm, based upon the assertion by the Internal Revenue Service against the Employee of a deficiency which the Advisory Firm believes has a high probability of success determines that an Overpayment has been made, any such Overpayment paid or distributed by the Company to or for the benefit of Employee shall be treated for all purposes as a loan AB INITIO which the Employee shall repay to the Company together with interest at the applicable federal rate provided for in Section 7872(f)(2) of the Code; provided, however, that no such loan shall be deemed to have been made and no amount shall be payable by the Employee to the Company if and to the extent such deemed loan and payment would not either reduce the amount on which the Employee is subject to tax under Section 1 and Section 4999 of the Code or generate a refund of such taxes. In the event that the Advisory Firm, based upon controlling preceding or other substantial authority, determines that an Underpayment has occurred, any such Underpayment shall be promptly paid by the Company to or for the benefit of the Employee together with interest at the applicable federal rate provided for in Section 7872(f)(2) of the Code. 5. REQUIRED REGULATORY PROVISIONS. (a) The Company may terminate the Employee's employment at any time, but any termination by the Company, other than a termination for cause, shall not prejudice the Employee's right to compensation or other benefits under this Agreement. The Employee shall not have the right to receive compensation or other benefits for any period after a termination for cause as defined in Section 2(d) hereinabove. (b) If the Employee is suspended from office and/or temporarily prohibited from participating in the conduct of the Company's affairs by a notice served under Section 8(e)(3) or (g)(1) of the Federal Deposit Insurance Act ("FDIA"), 12 U.S.C. Section 1818(e)(3) and (g)(l), the Company's obligations under this Agreement shall be suspended as of the date of service, unless stayed by appropriate proceedings. If the charges in the notice are dismissed, the Company may in its discretion (i) pay the Employee all or part of the compensation withheld while its obligations under this Agreement were suspended, and (ii) reinstate in whole or in part any of the obligations which were suspended. (c) If the Employee is removed from office and/or permanently prohibited from participating in the conduct of the Company's affairs by an order issued under Section 8(e)(4) or (g)(l) of the FDIA, 12 U.S.C. Section 1818(e)(4) or (g)(l), all obligations of the Company under this Agreement shall terminate, as of the effective date of the order, but vested rights of the parties shall not be affected. (d) If the Company becomes in default (as defined in Section 3(x)(1) of the FDIA), all obligations under this Agreement shall terminate as of the date of default, but this provision shall not affect any vested rights of the parties. (e) All obligations under this Agreement may be terminated, except to the extent determined that continuation of this Agreement is necessary for the continued operation of the Company: (i) by the Director or his or her designee, at the time the Federal Deposit Insurance Corporation enters into an agreement to provide assistance to or on behalf of the Company under the authority contained in Section 13(c) of the FDIA, or (ii) by the Director of the Office of Thrift Supervision ("Director") or his or her designee at the time the Director or his or her designee approves a supervisory merger to resolve problems related to operation of the Company or when the Company is determined by the Director to be in an unsafe or unsound condition. Any rights of the parties that have already vested, however, shall not be affected by any such action. 6. REINSTATEMENT OF BENEFITS UNDER SECTION 5(b). In the event the Employee is suspended and/or temporarily prohibited from participating in the conduct of the Company's affairs by a notice described in Section 5(b) hereof (the "Notice") during the term of this Agreement and a change in control occurs, the Company will assume its obligation to pay and the Employee will be entitled to receive all of the termination benefits provided for under Section 3 of this Agreement upon the Company's receipt of a dismissal of charges in the Notice. 7. EFFECT ON PRIOR AGREEMENTS AND EXISTING BENEFIT PLANS. This Agreement contains the entire understanding between the parties hereto and supersedes any prior agreement between the Company and the Employee, except that this Agreement shall not affect or operate to reduce any benefit or compensation inuring to the Employee of a kind elsewhere provided. No provision of this Agreement shall be interpreted to mean that the Employee is subject to receiving fewer benefits than those available to him without reference to this Agreement. 8 NO ATTACHMENT. (a) Except as required by law, no right to receive payments under this Agreement shall be subject to anticipation, commutation, alienation, sale, assignment, encumbrance, charge, pledge, or hypothecation, or to execution, attachment, levy, or similar process or assignment by operation of law, and any attempt, voluntary or involuntary, to affect any such action shall be null, void, and of no effect. (b) This Agreement shall be binding upon, and inure to the benefit of, the Employee, the Company and their respective successors and assigns. 9. MODIFICATION AND WAIVER. (a) This Agreement may not be modified or amended except by an instrument in writing signed by the parties hereto. (b) No term or condition of this Agreement shall be deemed to have been waived, nor shall there be any estoppel against the enforcement of any provision of this Agreement, except by written instrument of the party charged with such waiver or estoppel. No such written waiver shall be deemed a continuing waiver unless specifically stated therein, and each such waiver shall operate only as to the specific term or condition waived and shall not constitute a waiver of such term or condition for the future or as to any act other than that specifically waived. 10. NO MITIGATION. The amount of any payment or benefit provided for in this Agreement shall not be reduced by any compensation earned by the Employee as the result of employment by another employer, by retirement benefits after the date of termination or otherwise. 11. NO ASSIGNMENTS. (a) This Agreement is personal to each of the parties hereto, and neither party may assign or delegate any of its rights or obligations hereunder without first obtaining the written consent of the other party; provided, however, that the Company will require any successor or assign (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company, by an assumption agreement in form and substance satisfactory to the Employee, to expressly assume and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession or assignment had taken place. Failure of the Company to obtain such an assumption agreement prior to the effectiveness of any such succession or assignment shall be a breach of this Agreement and shall entitle the Employee to compensation from the Company in the same amount and on the same terms as the compensation pursuant to Section 3 hereof. For purposes of implementing the provisions of this Section 11(a), the date on which any such succession becomes effective shall be deemed the Date of Termination. (b) This Agreement and all rights of the Employee hereunder shall inure to the benefit of and be enforceable by the Employee's personal and legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Employee should die while any amounts would still be payable to the Employee hereunder if the Employee had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to the Employee's devisee, legatee or other designee or if there is no such designee, to the Employee's estate. 12. NOTICE. For the purposes of this Agreement, notices and all other communications provided for in the Agreement shall be in writing and shall be deemed to have been duly given when personally delivered or sent by certified mail, return receipt requested, postage prepaid, addressed to the Company at its main office to the attention of the Board of Directors of the Company with a copy to the Secretary of the Company, or, if to the Employee, at such home or other address as the Employee has most recently furnished in writing to the Company. 13. AMENDMENTS. No amendments or additions to this Agreement shall be binding unless in writing and signed by both parties, except as herein otherwise provided. 14. PARAGRAPH HEADINGS. The paragraph headings used in this Agreement are included solely for convenience and shall not affect, or be used in connection with, the interpretation of this Agreement. 15. SEVERABILITY. The provisions of this Agreement shall be deemed severable and the invalidity or unenforceability of any provision shall not affect the validity or enforceability of the other provisions hereof. 16. GOVERNING LAW. This Agreement shall be governed by the laws of the United States to the extent applicable and otherwise by the laws of the State of Minnesota. 17. ARBITRATION. Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator's award in any court having jurisdiction. 18. REIMBURSEMENT. In the event the Company purports to terminate the Employee for cause, but it is determined by a court of competent jurisdiction or by an arbitrator pursuant to Section 17 that cause did not exist for such termination, or if in any event it is determined by any such court or arbitrator that the Company has failed to make timely payment of any amounts owed to the Employee under this Agreement, the Employee shall be entitled to reimbursement for all reasonable costs, including attorneys' fees, incurred in challenging such termination or collecting such amounts. Such reimbursement shall be in addition to all rights to which the Employee is otherwise entitled under this Agreement. IN WITNESS WHEREOF, the parties have executed this Agreement as of the day and year first above written. THIS AGREEMENT CONTAINS A BINDING ARBITRATION PROVISION WHICH MAY BE ENFORCED BY THE PARTIES. ATTEST: HOME FEDERAL SAVINGS BANK /s/ Roxanne M. Hellickson By: /s/ Roger P. Weise - ------------------------- --------------------------- Secretary WITNESS: EMPLOYEE /s/ Carol Thouin /s/ Michael McNeil - ------------------------- --------------------------- Michael McNeil EX-11 3 EX-11 EXHIBIT 11 HMN FINANCIAL, INC. COMPUTATION OF EARNINGS PER COMMON SHARE
Year Ended December 31, -------------------------------------------- Computation of Earnings Per Common Share: 1998 1997 1996 -------------------------------------------- Weighted average number of common shares out- standing used in basic earnings per common share calculation............................................ 4,923,392 5,525,033 6,473,115 Net dilutive effect of: Options...................................................... 323,593 314,082 82,257 Restricted stock awards...................................... 51,141 76,151 100,505 ---------- ----------- ---------- Weighted average number of shares outstanding adjusted for effect of dilutive securities .................. 5,298,126 5,915,266 6,655,877 ---------- ----------- ---------- ---------- ----------- ---------- Income available to common shareholders ..................... $ 4,057,680 5,578,866 4,274,349 Basic earnings per common share............................... $ 0.82 1.01 0.66 Diluted earnings per common share............................. $ 0.77 0.94 0.64
EX-13 4 EX-13 FIVE-YEAR CONSOLIDATED FINANCIAL HIGHLIGHTS
- -------------------------------------------------------------------------------------------------------------------------------- SELECTED OPERATIONS DATA:(1) Year Ended December 31, ------------------------------------------------------------ (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------------------- Total interest income. . . . . . . . . . . . . . . . . . . . . . $48,795 41,090 39,864 38,328 32,277 Total interest expense . . . . . . . . . . . . . . . . . . . . . 31,898 25,643 24,194 22,555 18,067 ------- ------- ------- ------- ------- Net interest income. . . . . . . . . . . . . . . . . . . . . . 16,897 15,447 15,670 15,773 14,210 Provision for loan losses. . . . . . . . . . . . . . . . . . . . 310 300 300 300 410 ------- ------- ------- ------- ------- Net interest income after provision for loan losses. . . . . . 16,587 15,147 15,370 15,473 13,800 ------- ------- ------- ------- ------- Fees and service charges . . . . . . . . . . . . . . . . . . . . 855 487 359 325 311 Securities gains, net. . . . . . . . . . . . . . . . . . . . . . 2,799 1,250 1,030 416 65 Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . 2,177 469 39 102 3 Earnings (loss) in limited partnerships. . . . . . . . . . . . . (3,725) 220 7 0 0 Other non-interest income. . . . . . . . . . . . . . . . . . . . 524 296 488 155 216 ------- ------- ------- ------- ------- Total non-interest income. . . . . . . . . . . . . . . . . . . 2,630 2,722 1,923 998 595 SAIF assessment. . . . . . . . . . . . . . . . . . . . . . . . . 0 0 2,352 0 0 Other non-interest expense . . . . . . . . . . . . . . . . . . . 13,160 9,022 8,157 7,470 6,574 ------- ------- ------- ------- ------- Total non-interest expense . . . . . . . . . . . . . . . . . . 13,160 9,022 10,509 7,470 6,574 Income tax expense . . . . . . . . . . . . . . . . . . . . . . . 1,999 3,268 2,510 3,381 3,116 ------- ------- ------- ------- ------- Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,058 5,579 4,274 5,620 4,705 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Per common share and common share equivalents: . . . . . . . . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.82 1.01 0.66 0.73 Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.77 0.94 0.64 0.73 Earnings (1994: June 29 through December 31) . . . . . . . . . 0.32 Pro forma earnings (January 1 through December 31) . . . . . . 0.57 SELECTED FINANCIAL CONDITION DATA:(1) December 31, ------------------------------------------------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------------------- Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $694,658 691,232 554,732 537,949 494,868 Securities available for sale. . . . . . . . . . . . . . . . . . 181,625 205,859 175,830 190,320 183,512 Securities held to maturity. . . . . . . . . . . . . . . . . . . 0 0 2,806 16,972 12,678 Loans held for sale. . . . . . . . . . . . . . . . . . . . . . . 13,095 2,287 739 0 0 Loans receivable, net. . . . . . . . . . . . . . . . . . . . . . 447,455 442,069 349,022 314,851 271,000 Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433,869 467,348 362,477 373,539 350,575 Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . 185,400 127,650 106,079 68,877 51,986 Stockholders' equity . . . . . . . . . . . . . . . . . . . . . . 68,445 84,470 82,099 91,687 89,047 Book value per share . . . . . . . . . . . . . . . . . . . . . . 12.93 13.59 12.34 11.53 9.75 Tangible book value per share. . . . . . . . . . . . . . . . . . 11.87 12.62 12.34 11.53 9.75 Number of full service offices . . . . . . . . . . . . . . . . . 10 10 7 7 7 Number of mortgage origination offices . . . . . . . . . . . . . 1 2 1 0 0 Key Ratios(2) Stockholders' equity to total assets at year end . . . . . . . . 9.85% 12.22% 14.80% 17.04% 17.99% Average stockholders' equity to average assets . . . . . . . . . 10.63 14.36 16.12 18.24 14.57 Return on stockholders' equity (ratio of net income to average equity). . . . . . . . . . . . 5.38 6.84 4.82 5.86 6.86 Return on assets (ratio of net income to average assets). . . . . . . . . . . . 0.57 0.98 0.78 1.07 1.00 Dividend payout ratio. . . . . . . . . . . . . . . . . . . . . . 36.62 0.00 0.00 0.00 0.00 - --------------------------------------------------------------------------------------------------------------------------------
(1) HMN Financial, Inc. (HMN) completed a public stock offering on June 29, 1994, which generated net proceeds of $59.2 million. HMN purchased all of the stock of Home Federal Savings Bank (the Bank) with a portion of the conversion proceeds. The information represents the financial condition and the results of operations for the consolidated HMN for 1998, 1997, 1996, 1995 and 1994. (2) Average balances were calculated based upon amortized cost without the market value impact of SFAS 115. On December 5, 1997 HMN acquired Marshalltown Financial Corporation, refer to Note 2 of the Notes to Consolidated Financial Statements for details on the acquisition. - ------------------------------------------------------------------------------- 11 MANAGEMENT'S DISCUSSION AND ANALYSIS FINANCIAL REVIEW The financial review presents management's discussion and analysis of the consolidated financial condition and results of operations of HMN Financial, Inc. and subsidiaries (HMN). This review should be read in conjunction with the consolidated financial statements and other financial data beginning on page 29. GENERAL HMN was incorporated under the laws of the State of Delaware for the purpose of becoming the savings and loan holding company of Home Federal Savings Bank (the Bank) in connection with the Bank's conversion from a federally chartered mutual savings bank to a federally chartered stock savings bank, pursuant to its plan of conversion. The conversion was completed on June 29, 1994. Refer to Note 19 of the Notes to Consolidated Financial Statements for more information regarding the Bank's stock conversion. HMN's net income is dependent primarily on its net interest income, which is the difference between interest earned on its loans and investments and the interest paid on interest-bearing liabilities. Net interest income is determined by (i) the difference between the yield earned on interest-earning assets and rates paid on interest-bearing liabilities (interest rate spread) and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities. HMN's interest rate spread is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Net interest margin is calculated by dividing net interest income by the average interest-earning assets and is normally expressed as a percentage. Net interest income and net interest margin are affected by changes in interest rates, the volume and the mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. HMN's net income is also affected by the generation of non-interest income, which primarily consists of gains from the sale of securities, gains from the sale of loans, service charges, fees, earnings or losses in limited partnership investments and other income. In addition, net income is also affected by the level of operating expenses, provisions made for loan losses and impairment reserve adjustments required on mortgage servicing assets. The operations of financial institutions, including the Bank, are significantly affected by prevailing economic conditions, competition and the monetary and fiscal policies of governmental agencies. Lending activities are influenced by the demand for and supply of housing, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest primarily on competing investments, account maturities and the levels of personal income and savings in the market area of the Bank. The interest rates charged by the Federal Home Loan Bank (FHLB) on advances to the Bank also have a significant impact on the Bank's overall cost of funds. In May of 1998, HMN completed a three-for-two stock split in the form of a fifty percent stock dividend to its stock holders. Refer to Notes 1 and 17 of the Notes to Consolidated Financial Statements for more information regarding the impact of the stock split. RESULTS OF OPERATIONS Net income for the year ended December 31, 1998 was $4.1 million, compared to $5.6 million for 1997 and $4.3 million for 1996. Basic earnings per share was $0.82 for the year ended December 31, 1998, compared to $1.01 for 1997 and $0.66 per share for 1996. Diluted earnings per share was $0.77 for the year ended December 31, 1998, compared to $0.94 for 1997 and $0.64 for 1996. During the majority of 1998 the interest rates that were being charged on first mortgage loans were extremely low. As a result of the low interest rate environment many people financed new home purchases or refinanced their current home. The new home purchase activity and the refinancing activity caused many existing mortgage loans to be paid off before the contractual maturity dates of the loans. The increased prepayments caused the projected value of many mortgage servicing assets to decline. As the result of the decline in value of mortgage servicing assets during 1998, HMN increased its valuation reserves on mortgage servicing assets, increased its amortization on mortgage servicing assets and recognized its proportionate share of losses on a limited partnership investment after the partnership established valuation reserves on its mortgage servicing assets; resulting in an aggregate pretax charge to income of $4.3 million. The charge reduced diluted earnings per share by $0.54. In comparing the year ended December 31, 1998 to the year ended December 31, 1997, net interest income increased by $1.4 million primarily due to the increase in interest-earning assets and interest-bearing liabilities that were acquired during the December 5, 1997 merger with Marshalltown Financial Corporation (MFC) and a low interest rate environment. Non-interest income for 1998 increased by $3.9 million due to an increase in fees, service charges and other income; increased net gains on the sale of securities and increased gain on the sale of loans. The increase in non-interest income was entirely offset by the increase in losses recognized on limited partnership investments of $3.9 million. Non-interest expense increased by $4.2 million primarily due to a larger work force, more retail banking locations and other increased operating costs primarily related to the MFC merger; the additional staff for a commercial lending office and the mortgage banking operations; and an increase in amortization expense on mortgage servicing assets. In comparing the year ended December 31, 1997 to the year ended December 31, 1996, net interest income declined by $223,000 primarily due to a decline in net interest-earning assets. Non-interest income increased by $800,000 primarily due to increased net gains recognized on the sale of loans and securities and increased revenue from fees and service charges. Non-interest expense declined by $1.4 million primarily due to reduced Federal Deposit Insurance Corporation (FDIC) premiums and the fact that there was not a Savings Association Insurance Fund (SAIF) charge in 1997, 12 while there was a large charge in 1996. In September of 1996, Congress enacted the SAIF legislation which assessed a one time charge against all SAIF insured institutions in order to recapitalize the fund. The Bank was assessed $2.35 million which was charged directly to earnings and reduced after tax earnings by $1.46 million. The decline in non-interest expense due to the FDIC premiums and the SAIF assessment was partially offset by increases in compensation and benefits, occupancy and other non-interest expenses. Return on average assets was 0.57%, 0.98%, and 0.78%, for 1998, 1997 and 1996, respectively. Return on average equity was 5.38%, 6.84%, and 4.82%, for 1998, 1997 and 1996, respectively. The impact of recording the $3.6 million loss on limited partnership investment caused 1998 return on average assets to decline by 0.34% and 1998 return on average equity to decline by 3.22%. The return on average assets for 1996, excluding the SAIF assessment, was 1.04%. NET INTEREST INCOME HMN's net income is dependent primarily on its net interest income, which is the difference between interest earned on securities, loans and other interest-earning assets (interest income) and interest paid respectively on deposits and Federal Home Loan Bank advances (interest expense). Net interest margin is calculated by dividing net interest income by the average interest-earning assets. The arithmetic difference between the yield on interest-earning assets and the cost of interest-bearing liabilities expressed as a percentage is referred to as the net interest rate spread. 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.
- ----------------------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ------------------------------------------------------------------------------------------ 1998 1997 1996 ----------------------------- ----------------------------- ---------------------------- Average Interest Average Interest Average Interest 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. . . . . . . . . $139,647 8,830 6.32% $121,805 8,256 6.78% $148,400 10,027 6.76% Other marketable securities(1) . . . . 64,222 3,869 6.02 61,977 3,699 5.97 40,549 2,425 5.98 Securities held to maturity: Mortgage-backed and related securities. . . . . . . . . 0 0 0.00 379 33 8.82 10,160 765 7.53 Other marketable securities. . . . . . 0 0 0.00 167 10 6.00 1,861 104 5.61 Loans held for sale. . . . . . . . . . . 6,832 387 5.67 2,426 175 7.22 107 8 7.61 Loans receivable, net(2) . . . . . . . . 453,292 34,687 7.65 355,657 28,154 7.92 324,851 25,713 7.92 Federal Home Loan Bank stock . . . . . . 8,898 589 6.62 6,007 421 7.00 4,671 328 7.01 Other interest-earning assets including cash equivalents . . . . . . 10,501 433 4.12 8,413 342 4.07 11,039 494 4.48 -------- ------ -------- ------ -------- ------ Total interest-earning assets. . . . . . $683,392 48,795 7.14 $556,831 41,090 7.38 $541,638 39,864 7.36 -------- ------ ---- -------- ------ ----- -------- ------ ----- -------- ------ -------- ------ -------- ------ INTEREST-BEARING LIABILITIES: Noninterest checking . . . . . . . . . . $ 7,297 0 0.00% $ 2,626 0 0.00% $ 2,016 0 0.00% NOW accounts . . . . . . . . . . . . . . 22,391 283 1.26 17,306 257 1.49 16,051 323 2.01 Passbooks. . . . . . . . . . . . . . . . 35,992 817 2.27 29,893 763 2.55 30,295 760 2.51 Money market accounts. . . . . . . . . . 28,020 964 3.44 16,879 490 2.90 17,724 501 2.83 Certificate accounts . . . . . . . . . . 359,239 20,034 5.58 303,926 17,546 5.77 299,903 17,366 5.79 Federal Home Loan Bank advances. . . . . . . . . . . . . 172,249 9,788 5.68 112,500 6,587 5.85 89,656 5,244 5.85 Other borrowed money . . . . . . . . . . 163 12 7.36 0 0 0.00 0 0 0.00 -------- ------- -------- ------ -------- ------ Total interest-bearing liabilities . . . $625,351 31,898 5.10 $483,130 25,643 5.31 $455,645 24,194 5.31 -------- ------- ---- -------- ------ ----- -------- ------ ----- -------- ------- -------- ------ -------- ------ Net interest income. . . . . . . . . . . 16,897 15,447 15,670 ------- ------ ------ ------- ------ ------ Net interest rate spread . . . . . . . . 2.04% 2.07% 2.05% ---- ---- ---- ---- ---- ---- Net earning assets . . . . . . . . . . . $ 58,041 $ 73,701 $ 85,993 -------- -------- -------- -------- -------- -------- Net interest margin. . . . . . . . . . . 2.47% 2.77% 2.89% ---- ---- ---- ---- ---- ---- Average interest-earning assets to average interest-bearing liabilities. . . . . . . . . . . . . . 109.28% 115.25% 118.87% ------ ------ ------ ------ ------ ------
(1) Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis. The tax exempt income was $9,800 for 1998 and $9,400 in 1997. There was no tax exempt income earned in 1996. (2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve. - -------------------------------------------------------------------------------- 13 MANAGEMENT'S DISCUSSION AND ANALYSIS Net interest income for the year ended December 31, 1998 was $16.9 million, an increase of $1.4 million, or 9.4%, from $15.4 million for the year ended in 1997. Interest income for 1998 was $48.8 million, an increase of $7.7 million, or 18.8%, compared to $41.1 million for 1997. The increase in interest income was primarily due to the additional interest-earning assets of $125.0 million that were added to HMN's balance sheet on the December 5, 1997 with the MFC merger, an increase in commercial lending activity and was offset partially by the low interest rate environment experienced during 1998. The average outstanding balance of interest-earning assets was $683.4 million for the year ended December 31, 1998, an increase of $126.6 million from $556.8 million for 1997. The increase in average outstanding interest-earning assets caused interest income for 1998 to increase by $9.1 million from interest income for 1997. During the majority of 1998, interest rates charged on first mortgage loans for single family dwellings were very low compared with prior years. The low interest rate environment caused many people to refinance their existing mortgages or purchase new homes which generally resulted in their current home mortgage being paid off. The refinancing and/or prepayment of mortgages which occurred during 1998 was the primary cause for the yield decline of 27 basis points in the loan portfolio from 7.92% for 1997 to 7.65% for 1998. The lower interest rate environment of 1998 also caused the yield earned on the securities available for sale portfolio to decline as the proceeds from the sales of securities were reinvested in lower yielding securities or as adjustable rate securities were repriced because the security's interest rate index adjusted downward. Interest income earned in 1998 decreased by $1.4 million from what was earned in 1997 due to lowering yields on interest-earning assets. Interest expense for the year ended December 31, 1998 was $31.9 million, an increase of $6.3 million, or 24.4%, from $25.6 million for 1997. For the year ended December 31, 1998 the average outstanding balance of interest-bearing liabilities was $625.35 million, an increase of $142.25 million, compared to $483.1 million for 1997. The average outstanding balance of deposits for 1998 was $452.9 million, an increase of $82.3 million from the average outstanding balance of deposits for 1997. The MFC merger increased HMN's outstanding deposits by $103.6 million. The average outstanding balance of deposits declined during the last six months of 1998 when HMN started to lower the rates it paid on deposit accounts which resulted in an outflow of deposits and therefore, the average outstanding deposits for 1998 increased by only $82.3 million. Interest expense on deposits for 1998 compared to 1997 increased by $3.6 million due to an increase in the average outstanding balance of deposits and it declined by $559,000 due to lower rates being paid on deposits. The average outstanding balance of FHLB advances at December 31, 1998 was $172.2 million, an increase of $59.7 million, compared to $112.5 million for 1997. The average outstanding FHLB advances were used by the Bank to replace deposit outflows and pay dividends to the holding company to assist in its purchase of treasury stock. Interest expense increased by $3.4 million as a result of the additional borrowings and it was partially offset by a $188,000 decline in interest expense due to the lower rate environment of 1998. Net interest income for the year ended December 31, 1997 was $15.4 million, a decrease of $223,000, or 1.4%, from $15.7 million for the year ended in 1996. Interest income for the year ended December 31, 1997 was $41.1 million, an increase of $1.2 million, or 3.1%, compared to $39.9 million for the year ended in 1996. The increased interest income was primarily due to increased loan purchases, originations and, to a minor extent, loans added as a result of the acquisition of MFC. Average outstanding loans receivable for 1997 increased by $30.8 million over average outstanding loans receivable for 1996. During 1997 HMN had been increasing its investment in loans in order to increase interest income. Interest income earned on the security portfolio decreased by $1.3 million primarily because securities were sold or matured and the proceeds were reinvested into loans or other assets. The average outstanding securities portfolio decreased by $16.7 million from $201.0 million at December 31, 1996 to $184.3 million at December 31, 1997. Interest expense for the year ended December 31, 1997 was $25.6 million, an increase of $1.4 million, or 6.0%, from $24.2 million for the year ended December 31, 1996. Interest expense increased during 1997 due to additional advances from the FHLB which were used to fund loan purchases and the purchase of MFC. The increase in interest expense totally offset the increase in interest income and therefore caused net interest income for the year ended December 31, 1997 to decline by $223,000 from the year ended December 31, 1996. Net interest margin was 2.47%, 2.77%, and 2.89% for the years ended December 31, 1998, 1997 and 1996, respectively. Average net earning assets were $58.0 million, $73.7 million, and $86.0 million for the years ended December 31, 1998, 1997 and 1996, respectively. During 1995 HMN began purchasing its own common stock in the open market and paid $17.1 million, $6.0 million, and $14.4 million during 1998, 1997 and 1996, respectively to purchase its own common stock in the open market. During 1996 and throughout 1997, HMN increased its investment in assets which were not interest-earning assets. The income or loss on these assets is included in non-interest income. The impact of the stock repurchase program, when coupled with purchasing investments which are not interest-earning assets, caused HMN's net interest-earning assets to decline, which in turn caused net interest margin to decline. 14 The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the increase related to higher outstanding balances and that due to the levels and volatility of 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).
- ------------------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, -------------------------------------------------------------------------------- 1998 vs. 1997 1997 vs. 1996 -------------------------------------------------------------------------------- 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 . . $1,060 (485) 575 (1,817) 44 (1,773) Other marketable securities. . . . . . . . 136 34 170 1,286 (11) 1,275 Securities held to maturity: Mortgage-backed and related securities . . (16) (17) (33) (890) 158 (732) Other marketable securities. . . . . . . . (5) (5) (10) (102) 8 (94) Loans held for sale, net . . . . . . . . . . 241 (29) 212 167 0 167 Loans receivable, net. . . . . . . . . . . . 7,435 (902) 6,533 2,439 2 2,441 Federal Home Loan Bank stock . . . . . . . . 191 (22) 169 94 0 94 Other, including cash equivalents. . . . . . 86 4 90 (110) (42) (152) ------ ------ ------- ----- ---- ------ Total interest-earning assets. . . . . . . $9,128 (1,422) 7,706 1,067 159 1,226 ------ ------ ------- ----- ---- ------ ------ ------ ------- ----- ---- ------ Interest-bearing liabilities: Noninterest checking . . . . . . . . . . . . $ 0 0 0 0 0 0 NOW accounts . . . . . . . . . . . . . . . . 52 (26) 26 28 (94) (66) Passbooks. . . . . . . . . . . . . . . . . . 119 (65) 54 (10) 13 3 Money market accounts. . . . . . . . . . . . 371 103 474 (26) 15 (11) Certificates . . . . . . . . . . . . . . . . 3,059 (571) 2,488 232 (52) 180 Federal Home Loan Bank advances. . . . . . . 3,390 (188) 3,202 1,337 6 1,343 Other borrowed money . . . . . . . . . . . . 6 6 12 0 0 0 ------ ------ ------- ----- ---- ------ Total interest-bearing liabilities . . . . $6,997 (741) 6,256 1,561 (112) 1,449 ------ ------ ------- ----- ---- ------ ------ ------ ------- ----- ---- ------ Net interest income. . . . . . . . . . . . . . $16,897 15,447 ------- ------ ------- ------
(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 HMN'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, 1998
- --------------------------------------------------------------------------------------------------------------------- Weighted average yield on: Weighted average rate on: Securities available for sale: Non-interest checking. . . . . . . . . . 0.00% Mortgage-backed and related securities. . . . . 5.94% NOW accounts . . . . . . . . . . . . . . 1.00 Other marketable securities . . . . . . . . . . 6.70 Passbooks. . . . . . . . . . . . . . . . 2.00 Loans held for sale. . . . . . . . . . . . . . . . 5.93 Money market accounts. . . . . . . . . . 3.19 Loans receivable, net. . . . . . . . . . . . . . . 7.43 Certificates . . . . . . . . . . . . . . 5.37 Federal Home Loan Bank stock . . . . . . . . . . . 6.50 Federal Home Loan Bank advances. . . . . 5.47 Other interest-earning assets. . . . . . . . . . . 3.70 Other borrowed money . . . . . . . . . . 7.13 Combined weighted average yield on Combined weighted average rate on interest-earning assets . . . . . . . . . . . . 6.93 interest-bearing liabilities. . . . . 4.80 Interest rate spread . . . . . . . . . . 2.13% - ---------------------------------------------------------------------------------------------------------------------
15 MANAGEMENT'S DISCUSSION AND ANALYSIS PROVISION FOR LOSSES ON LOANS *The provision for losses on loans is the result of management's evaluation of the loan portfolio including its evaluation of national and regional economic indicators (including the possibility at each year end that there would be an increase in general interest rates), such as national and regional unemployment data, single family loan delinquencies as reported separately by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank Mortgage Corporation (FHLMC), local single family construction permits and local economic growth rates and the current regulatory and general economic environment. HMN will continue to monitor and modify its allowance for losses as these conditions dictate. Although HMN maintains its allowance for losses at a level it considers adequate to provide for estimated losses, there can be no assurance that such losses will not exceed the estimated amount or that additional provisions for loan losses will not be required in future periods. The provision for losses on loans for 1998 was $310,000, for 1997 and 1996 it was $300,000 for each year. Based upon management's evaluation of the loan portfolio and its understanding of the economic conditions in the areas where it has a concentration of loans, the provision was deemed adequate for each of the years in the three year period ended December 31, 1998. HMN incurred $18,600 of loan charge-offs during 1998 and it recovered $1,865 of loans previously charged-off. HMN incurred $22,700 of loan charge-offs during 1997 and it also recovered $7,825 on loans previously charged-off. The loan charge-offs for 1998 and 1997 were not significant and general economic conditions in the markets served by HMN did not cause management to determine that a change in the provision was required during those years. HMN incurred $150,000 of loan charge-offs during 1996 which were primarily related to two loans which were not single-family residential loans. The charge-offs were not deemed to be indicative of a trend that would call for a higher loan loss provision. For information on the allowance for loan losses refer to Notes 1 and 6 of the Notes to Consolidated Financial Statements. NON-INTEREST INCOME Non-interest income was $2.6 million for 1998, compared to $2.7 million for 1997 and $1.9 million for 1996. The following table presents certain components of non-interest income:
- -------------------------------------------------------------------------------------------------------------------- Percentage Year Ended December 31, Increase (Decrease) ------------------------------------------------------------------- (DOLLARS IN THOUSANDS). . . . . . . . . 1998 1997 1996 1998/1997 1997/1996 - -------------------------------------------------------------------------------------------------------------------- Fees and service charges. . . . . . . . $ 855 487 359 75.6% 35.7% Securities gains, net . . . . . . . . . 2,799 1,250 1,030 123.9 21.4 Gain on sales of loans. . . . . . . . . 2,177 469 39 364.2 1,102.6 Earnings (loss) in limited partnerships (3,725) 220 7 (1,793.2) 3,042.9 Other non-interest income . . . . . . . 524 296 488 77.0 (39.3) ----- ----- ----- Total non-interest income. . . . . . $2,630 2,722 1,923 (3.4) 41.5 ----- ----- ----- ----- ----- ----- - --------------------------------------------------------------------------------------------------------------------
Fees and service charges earned for the year ended December 31, 1998 increased by $368,000 from the fees and service charges earned in 1997, primarily due to a $276,000 increase in mortgage loan servicing fees and a $92,000 increase in service charges on deposit related accounts, some of which is related to the increased number of deposit accounts from the MFC merger. Mortgage loan servicing fees increased during 1998 because the Bank was selling many of its fixed rate loans to FNMA and retaining the servicing. MSI also purchased additional mortgage loan servicing assets during 1998. Fees and service charges earned for the year ended December 31, 1997 increased by $128,000 over the amount earned in 1996 due to an increase in fees earned on loan servicing activities and increased fees charged on deposit accounts. The ability to realize gains on the sale of securities is dependent on the type of securities in the securities portfolio and upon changes in the general interest rate environment. During 1998, 1997 and 1996 economic conditions existed which allowed HMN to sell securities at a net gain of $2.8 million, $1.25 million and $1.0 million, respectively. The proceeds from the securities sold during 1998 and 1997 were invested in the loan portfolio, used to redeem the common stock of the MFC stockholders, invested in other assets, used to purchase treasury stock or reinvested in securities. During 1998, in order to reduce its interest rate risk and increase its other non-interest income, the Bank started selling many of its originated or refinanced fixed rate loans to FNMA. MSI also increased its mortgage origination and loan brokerage activity. For the year ended December 31, 1998 HMN recognized $2.18 million of net gains on the sale of $178.4 million of primarily single family mortgage loans. During 1997, HMN recognized $469,000 in net gain on the sale of $46.5 million of primarily single family mortgage loans. During 1996, HMN received $1.7 million in proceeds from the sale of primarily 30 year fixed rate single family loans and recognized a $39,000 net gain. For the year ended December 31, 1998 the loss from limited partnership investments was $3.7 million, a decrease of $3.9 million from earnings of $220,000 for 1997. HMN's *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 16 share of a limited partnership investment in mortgage servicing rights generated losses of $3.6 million when the market value of its mortgage servicing assets declined due to the rapid prepayment of loans being serviced. For more information on investments in limited partnerships refer to Note 10 of Notes to Consolidated Financial Statements. For the year ended December 31, 1998 other non-interest income was $524,000, compared to $296,000 for 1997 and $488,000 for 1996. The increase in other non-interest income of $228,000 for 1998 was principally due to an increase in fees and commissions earned on the sale of financial planning products and services. Other non-interest income declined during 1997 by $192,000, from $488,000 for 1996 because during 1996 HMN recorded miscellaneous non-recurring other income items. NON-INTEREST EXPENSE Non-interest expense for the year ended December 31, 1998 was $13.2 million compared to $9.0 million for the year ended in 1997 and $10.5 million for 1996. The following table presents the components of non-interest expense:
- --------------------------------------------------------------------------------------------------------------------- Percentage Year Ended December 31, Increase (Decrease) --------------------------------------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1998/1997 1997/1996 - --------------------------------------------------------------------------------------------------------------------- Compensation and benefits . . . . . . . $ 6,804 5,590 4,591 21.7% 21.8% Occupancy . . . . . . . . . . . . . . . 1,442 983 826 46.7 19.0 Federal deposit insurance premiums. . . 285 238 800 19.7 (70.3) SAIF assessment . . . . . . . . . . . . 0 0 2,352 N/A (100.0) Advertising . . . . . . . . . . . . . . 445 316 308 40.8 2.6 Data processing . . . . . . . . . . . . 674 509 489 32.4 4.1 Amortization of mortgage servicing rights and net valuation adjustments 889 105 0 746.7 105.0 Other . . . . . . . . . . . . . . . . . 2,621 1,282 1,143 104.4 12.2 ------ ------ ------ Total non-interest expense . . . . $13,160 9,023 10,509 45.8 (14.1) ------ ------ ------ ------ ------ ------ - ---------------------------------------------------------------------------------------------------------------------
The $4.1 million increase in non-interest expense from 1997 to 1998 was primarily due to the MFC merger which increased most of the above listed components of non-interest expense. The merger added over 30 employees, three retail banking facilities, plus data processing costs and deposit insurance premiums for the accounts that were acquired with the merger. Compensation and benefit costs also increased as the result of additional staff added in the mortgage banking operation of MSI and the commercial loan, mortgage loan and other back office areas of the Bank. During the second half of 1998 the Bank reorganized the focus of its operations by centralizing many functions in the corporate office and increasing its retail sales focus in each of the Bank's branches. At December 31, 1998 HMN's total work force, after taking into account the new hires discussed above, was 13% less than its work force was at June 30, 1998. Occupancy costs also increased as the result of opening two new retail banking buildings, one in Spring Valley and one in Winona. Other non-interest expense increased by $1.3 million in 1998, principally due to the increased amortization of goodwill and core deposit intangibles of $433,000; the cost of postage, office supplies, telephone and freight related to operating the MFC offices, when coupled with the increased loan activity of 1998, caused non-interest expense to increase by $368,000; and utilization of professionals for consultation on reorganization and other matters increased by $300,000. The $1.5 million decrease in non-interest expense from 1996 to 1997 was due to the one time SAIF assessment of $2.35 million not repeating itself in 1997. As a result of the SAIF assessment recapitalizing the SAIF, the FDIC insurance premium expense decreased by $561,000 from 1996 to 1997. The decrease in non-interest expense was partially offset by a $999,000 increase in compensation and benefits, an increase in occupancy of $158,000 and an increase in other expense of $139,000. Compensation and benefits expense increased as a result of adding new employees in mortgage banking activities, the purchase of MFC and normal merit and salary increases to existing employees. Occupancy increased for the year ended December 31, 1997 compared to 1996 because of the purchase of MFC and depreciation resulting from continued remodeling and updating of offices for new technological advances. INCOME TAXES HMN recorded income tax expense of $2.0 million in 1998, compared to $3.3 million and $2.5 million for 1997 and 1996, respectively. The decrease in income tax expense from 1997 to 1998 and the increase from 1996 to 1997 is primarily the result of changes in taxable income between the years. For more information on income taxes refer to Note 15 of the Notes to Consolidated Financial Statements. FINANCIAL CONDITION LOANS RECEIVABLE, NET The table on the following page sets forth the information on HMN's loan portfolio in dollar amounts and in percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated. 17 MANAGEMENT'S DISCUSSION AND ANALYSIS
- ----------------------------------------------------------------------------------------------------------------------------- December 31, ------------------ ------------------ ------------------ ------------------ ------------------ 1998 1997 1996 1995 1994 ------------------ ------------------ ------------------ ------------------ ------------------ (DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent - ----------------------------------------------------------------------------------------------------------------------------- REAL ESTATE LOANS: One-to-four family . . $365,496 79.31% $395,668 87.58% $321,340 90.19% $292,497 90.62% $252,943 91.14% Multi-family . . . . . 4,719 1.02 2,717 0.60 280 0.08 361 0.11 311 0.11 Commercial . . . . . . 28,990 6.29 10,572 2.34 7,918 2.22 8,744 2.71 8,316 3.00 Construction or development . . . . . 15,155 3.29 5,725 1.27 3,474 0.98 5,082 1.58 2,799 1.01 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Total real estate. . 414,360 89.91 414,682 91.79 333,012 93.47 306,684 95.02 264,369 95.26 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- OTHER LOANS: Consumer Loans: Savings account . . . 994 0.22 1,362 0.30 938 0.26 1,210 0.37 648 0.23 Education . . . . . . 118 0.03 123 0.03 467 0.13 342 0.11 2,007 0.72 Automobile. . . . . . 2,897 0.63 2,438 0.54 566 0.16 671 0.21 520 0.19 Home equity line. . . 19,476 4.22 19,490 4.31 11,881 3.33 3,509 1.09 0 0.00 Home equity . . . . . 9,566 2.08 7,176 1.59 5,927 1.67 7,997 2.47 7,716 2.78 Home improvement. . . 436 0.09 652 0.14 585 0.16 785 0.24 870 0.31 Other . . . . . . . . 1,313 0.28 624 0.14 568 0.16 545 0.17 502 0.19 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Total consumer loans . . . . . . . 34,800 7.55 31,865 7.05 20,932 5.87 15,059 4.66 12,263 4.42 Commercial business loans . . . . . . . . 11,695 2.54 5,226 1.16 2,344 0.66 1,018 0.32 897 0.32 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Total other loans. . 46,495 10.09 37,091 8.21 23,276 6.53 16,077 4.98 13,160 4.74 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Total loans. . . . . 460,855 100.00% 451,773 100.00% 356,288 100.00% 322,761 100.00% 277,529 100.00% -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- LESS: Loans in process . . . 7,997 4,562 2,814 3,531 2,327 Unamortized discounts . . . . . . 414 547 417 289 162 Net deferred loan fees . . . . . . 1,948 1,847 1,695 1,899 2,147 Allowance for losses . 3,041 2,748 2,340 2,191 1,893 -------- -------- -------- -------- -------- Total loans receivable, net . . $447,455 $442,069 $349,022 $314,851 $271,000 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- - -----------------------------------------------------------------------------------------------------------------------------
The one-to-four family real estate loans were $365.5 million at December 31, 1998, a decrease of $30.2 million, or 7.6%, compared to $395.7 million at December 31, 1997. In order to reduce interest rate risk and generate more income from loan sales, HMN sold approximately 44% of the one-to-four family real estate loans that were originated or refinanced by the Bank during 1998. The Bank also swapped $21.8 million of fixed rate one-to-four family loans for FNMA mortgage-backed securities and then sold the securities to reduce interest rate risk. During 1998 loan prepayments increased as a result of the low interest rate environment. The prepayments and the loan sales were the principal cause of the decline in the one-to-four family loan portfolio. As of December 31, 1997 one-to-four family real estate loans increased by $74.4 million, or 23.1%, compared to $321.3 million at December 31, 1996. During 1997 HMN had the following one-to-four family real estate loan activity: originated $34.0 million, purchased $67.2 million, securitized $16.6 million, acquired from MFC $63.3 million, sold $9.0 million and received principal repayments of $64.5 million. One-to-four family real estate loans were $321.3 million at December 31, 1996, an increase of $28.8 million, or 9.8%, compared to $292.5 million at December 31, 1995. During 1996 HMN had the following one-to-four family real estate loan activity: originated $32.5 million, purchased $55.8 million, securitized $15.4 million, sold $2.3 million and received principal repayments of $41.8 million. One-to-four family real estate loans increased $39.6 million to $292.5 million at December 31, 1995 from $252.9 million at December 31, 1994. During 1995 HMN had the following one-to-four family real estate loan activity: originated $25.7 million, purchased $47.1 million, sold $2.4 million and received principal repayments of $30.8 million. Commercial real estate loans were $29.0 million at December 31, 1998, an increase of $18.4 million compared to $10.6 million at December 31, 1997. Commercial business 18 loans were $11.7 million at December 31, 1998, an increase of $6.5 million compared to $5.2 million at December 31, 1997. The Bank is in the process of expanding its commercial loan and commercial deposit offerings in order to increase its investment in commercial real estate and commercial business loans. During 1998 the Bank expanded its commercial loan program by hiring people with experience in commercial lending and has added a full service commercial checking offering to its product list. Prior to 1998, HMN purchased commercial business loans and commercial real estate loans primarily from third party originators in the form of participation interests. The increase in commercial real estate loans and commercial business loans in the table above for years prior to 1998 is primarily due to the purchase of participation interests or loans acquired in 1997 in connection with the acquisition of MFC. Home equity line loans were $19.5 million at both December 31, 1998 and 1997, compared to $11.9 million at December 31, 1996 and $3.5 million at December 31, 1995. The home equity line did not increase during 1998 because many customers were refinancing into fixed rate loan products and did not draw on their home equity lines. During the second half of 1995 the Bank introduced the revolving home equity lines of credit which loan up to 90% of the equity in a home to the borrower. The interest rate has always been competitive and the customers have liked the convenient features of the program. ALLOWANCES FOR LOAN AND REAL ESTATE LOSSES HMN recognizes that credit losses will be experienced and that the risk of loss will vary with, among other things, the type of loans being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the collateral. It is management's policy to maintain an allowance for loan losses based on, among other things, the Bank's and the industry's historical loan loss experience, evaluation of economic conditions, regular reviews of delinquencies and loan portfolio quality and evolving standards imposed by OTS examiners. HMN 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 that have not yet been identified but can be expected to occur. Management conducts quarterly reviews of the loan portfolio and evaluates the need to establish general allowances on the basis of these reviews. *Management continues to actively monitor the 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 losses. The allowance for loan losses was $3.0 million, or 0.68% of total loans at December 31, 1998, compared to $2.7 million, or 0.62%, of total loans at December 31, 1997, $2.3 million, or 0.66% of total loans at December 31, 1996, $2.2 million, or 0.68% of total loans at December 31, 1995 and $1.9 million, or 0.68% of total loans at December 31, 1994. The following table reflects the activity in the allowance for loan losses and selected statistics:
- ------------------------------------------------------------------------------------------------------------------------- December 31, -------------------------------------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 - ------------------------------------------------------------------------------------------------------------------------- Balance at the beginning of year . . . . . . . . . $2,748 2,341 2,191 1,893 1,489 MFC allowance for loan losses acquired. . . . . 0 122 0 0 0 Provision for losses. . . . . . . . . . . . . . 310 300 300 300 410 Charge-offs: One-to-four family. . . . . . . . . . . . . . (2) (4) 0 0 0 Multi-family. . . . . . . . . . . . . . . . . 0 0 (88) 0 0 Consumer. . . . . . . . . . . . . . . . . . . (17) (7) (1) (2) (6) Commercial business . . . . . . . . . . . . . 0 (12) (61) 0 0 Recoveries. . . . . . . . . . . . . . . . . . . 2 8 0 0 0 ------ ------ ------ ------- ------ Net charge-offs . . . . . . . . . . . . . . . (17) (15) (150) (2) (6) ------ ------ ------ ------- ------ Balance at end of year . . . . . . . . . . . . . . $3,041 2,748 2,341 2,191 1,893 ------ ------ ------ ------- ------ ------ ------ ------ ------- ------ Year end allowance for loan losses as a percent of year end gross loan balance . . . . . . . . . . 0.68% 0.62% 0.66% 0.68% 0.68% Ratio of net loan charge-offs to average loans outstanding . . . . . . . . . . . . . . . . . . 0.00 0.01 0.05 0.00 0.00 Allowance for loan losses as a percentage of total assets at year end. . . . . . . . . . . . 0.44 0.40 0.42 0.41 0.38 - -------------------------------------------------------------------------------------------------------------------------
*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 19 MANAGEMENT'S DISCUSSION AND ANALYSIS The following table reflects the allocation of the allowance for loan losses:
- ----------------------------------------------------------------------------------------------------------------------------------- Allocations as a Percentage of Total At December 31, Loan Outstanding by Type ----------------------------------------------- ----------------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------------------------- Real estate loans: One-to-four family. . . . . $ 544 560 496 452 475 79.31% 87.58 90.19 90.62 92.18 Multi-family. . . . . . . . 142 80 8 21 21 1.02 0.60 0.08 0.11 0.14 Commercial. . . . . . . . . 797 198 113 125 128 6.29 2.34 2.22 2.71 1.80 Construction or development . . . . . . . 455 172 104 153 84 3.29 1.27 0.98 1.58 1.31 Consumer . . . . . . . . . . . 546 527 473 286 280 7.55 7.05 5.87 4.66 4.14 Commercial business. . . . . . 328 46 29 37 27 2.54 1.16 0.66 0.32 0.43 Unallocated. . . . . . . . . . 229 1,165 1,118 1,117 878 0.00 0.00 0.00 0.00 0.00 ------ ------ ------ ------ ------ ------- ------ ------ ------ ------ Total. . . . . . . . . . . . . $3,041 2,748 2,341 2,191 1,893 100.00% 100.00 100.00 100.00 100.00 ------ ------ ------ ------ ------ ------- ------ ------ ------ ------ ------ ------ ------ ------ ------ ------- ------ ------ ------ ------ - -----------------------------------------------------------------------------------------------------------------------------------
The allocation of the allowance for loan losses has increased from 1997 to 1998 for multi-family real estate, commercial real estate construction or development, and commercial business loans because HMN has experienced more loan activity in those categories. The allocation of the allowance for consumer loans also increased from 1997 to 1998 because of the level of charge-offs being experienced in the consumer category. The allocated one-to-four family real estate declined from 1997 to 1998 because of the one-to-four family loan portfolio decline and the potential for charge-offs declined due to the positive housing market in HMN's markets. The following table reflects the activity of the allowance for real estate losses:
- -------------------------------------------------------------------------------------------------------------------- December 31, ------------------------------------------------------------------ (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------- Balance at the beginning of year . . . . $ 8 2 35 37 126 Provision for losses. . . . . . . . . 0 18 2 9 0 Charge-offs . . . . . . . . . . . . . 0 (12) 0 (11) 0 Recoveries. . . . . . . . . . . . . . 0 0 0 0 0 ---- ---- ---- ---- ---- Net charge-offs . . . . . . . . . . 0 (12) 0 (11) 0 ---- ---- ---- ---- ---- Other . . . . . . . . . . . . . . . . 0 0 (35) 0 (89) ---- ---- ---- ---- ---- Balance at the end of year . . . . . . . $ 8 8 2 35 37 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- - --------------------------------------------------------------------------------------------------------------------
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. Valuations are periodically performed by management and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. NON-PERFORMING ASSETS Non-performing assets (comprised of non-accrual loans, restructured loans, and real estate acquired through foreclosure) totaled $806,000 at December 31, 1998, a decrease of $1,000 compared to $807,000 at December 31, 1997 and $361,000 at December 31, 1996. Non-performing assets had the following activity during 1998: sales of $142,000, transfers in of $389,000 and transfers out due to performance of $248,000. Non-performing assets had the following activity during 1997: sales of $42,000, charge-offs of $35,000, payments of $80,000 and net transfers to non-performing assets of $603,000. Non-performing assets at December 31, 1996 were $361,000, a decrease of $489,000, compared to $850,000 at December 31, 1995. Non-performing assets had the following activity during 1996: sales of $314,000, charge-offs of $61,000, payments of $128,000, and net transfers to non-performing assets of $14,000. 20 Non-performing assets are summarized in the following table:
- ----------------------------------------------------------------------------------------------------------------------------------- December 31, -------------------------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------------------------------- Non-accrual loans. . . . . . . . . . . . . . . . . . . . . . . . $476 263 338 441 235 Accruing loans delinquent 90 days or more . . . . . . . . . . 312 402 0 0 0 Restructured loans. . . . . . . . . . . . . . . . . . . . . . 0 0 0 94 199 Foreclosed assets . . . . . . . . . . . . . . . . . . . . . . 18 142 23 315 64 ---- ---- ---- ---- ---- Total non-performing assets . . . . . . . . . . . . . . . . $806 807 361 850 498 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Non-performing assets as a percentage of total assets. . . . . . 0.12% 0.12% 0.07% 0.16% 0.10% Total non-performing loans . . . . . . . . . . . . . . . . . . . $788 665 338 535 434 Non-performing loans as a percentage of loans receivable, net . . . . . . . . . . . . . . . . . . . . 0.18% 0.15% 0.10% 0.17% 0.16% Allowance for loan losses to non-performing loans. . . . . . . . 385.79% 413.17% 691.84% 409.13% 436.52% - -----------------------------------------------------------------------------------------------------------------------------------
The non-performing assets reflected above primarily consist of one-to-four family mortgage loans or consumer loans. REGULATORY CAPITAL REQUIREMENTS Federal savings institutions are required to satisfy three capital requirements: (i) a requirement that "tangible capital" equal or exceed 1.5% of adjusted total assets, (ii) a requirement that "core capital" equal or exceed 3% of adjusted total assets, and (iii) a requirement that "risk-based capital" equal or exceed 8% of risk-weighted assets. With certain exceptions, all three capital standards must generally conform to and be no less stringent than, the capital standards published by the Comptroller of the Currency for national banks. 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 (core) ratio of 5% or greater, and (iv) is not subject to any order or written directive by the OTS to meet and maintain a specific capital level for any capital measure. The Bank is of the opinion that it is considered well capitalized at December 31, 1998. Refer to Note 20 of the Notes to Consolidated Financial Statements for a table which reflects the Bank's capital compared to its capital requirements. DIVIDENDS Prior to 1998, HMN did not pay any dividends. In February of 1998, the Board of Directors declared a stock split in the form of a 50% stock dividend subject to HMN stockholder approval of an increase in the number of authorized shares of common stock from 7.0 million to 11.0 million. At the annual meeting of stockholders on April 28, 1998 the stockholders approved the stock split which was distributed on May 22, 1998 to holders of record on May 8, 1998. During 1998 HMN declared and paid dividends as follows:
- -------------------------------------------------------------------------------- Dividend Dividend Record date Payable date per share Payout Ratio - -------------------------------------------------------------------------------- May 27, 1998 June 12, 1998 $0.06 21.4 % August 27, 1998 September 10, 1998 $0.06 42.9 December 1, 1998 December 15, 1998 $0.06 (66.7) - --------------------------------------------------------------------------------
On February 2, 1999 HMN declared a cash dividend of $0.08 per share payable on March 10, 1999 to holders of record on February 24, 1999. The annualized dividend payout ratio for the past four quarters was 36.6%. The declaration of dividends are subject to, among other things, HMN's financial condition and results of operations, the Bank's compliance with its regulatory capital requirements, including the fully phased-in capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. Refer to Note 19 of the Notes to Consolidated Financial Statements for information on regulatory limitations on dividends from the Bank to HMN. LIQUIDITY *HMN 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 of the asset or the sale of the asset. Liability liquidity results from the ability of the Bank to attract depositors or borrow funds from third party sources such as the FHLB. The Bank is required by regulation to maintain a monthly average minimum asset liquidity ratio of 4%. The Bank has maintained an average monthly liquidity ratio in excess of the 4% requirement and does not anticipate that it will fall below the requirement in the future. The primary investing activities are the origination or purchase of loans and the purchase of securities. Principal and interest payments on mortgages and securities are a primary source of cash for HMN. Additional cash can be obtained by selling securities from the available for sale port- *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 21 MANAGEMENT'S DISCUSSION AND ANALYSIS folio or by selling loans. Loans could also be securitized by FNMA or FHLMC and used as collateral for additional borrowing with the FHLB. In December of 1997 HMN, through its wholly owned subsidiary, acquired MFC by purchasing MFC's outstanding stock with cash. Refer to Note 2 of the Notes to Financial Statements for more details related to the acquisition. The primary financing activity is the attraction of retail deposits. The Bank has the ability to borrow additional funds from the FHLB by pledging additional securities or loans. Refer to Note 13 of the Notes to Consolidated Financial Statements for more information on additional advances that could be drawn upon based upon existing collateral levels with the FHLB. Information on outstanding advance maturities is also included in Note 13. *HMN anticipates that its liquidity requirements for 1999 will be similar to the cash flows it experienced in 1998 with the exception of the redemption of the common stock of MFC which will require only $37,000. Construction disbursements will also be reduced because both the Spring Valley and Winona retail banking facilities were completed during 1998. Expenditures for premises and equipment are anticipated to be $1.0 million for 1999. The cash needed to fund the mortgage banking activities of HMN Mortgage Services, Inc. will range from $5.0 million to $20.0 million during 1999. HMN'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, 1998 were $21.0 million, an increase of $11.6 million, compared to $9.4 million at December 31, 1997. Net cash provided from operating activities during 1998 was $47.8 million. HMN conducted the following major investing activities during 1998: proceeds from the sale of securities available for sale were $172.6 million, principal received on payments and maturities of securities available for sale was $83.6 million, purchases were $204.9 million of securities available for sale, proceeds of sales of loans receivable were $3.3 million, purchases of mortgage servicing rights were $459,000, purchases of interests in limited partnerships were $181,000, purchase of FHLB stock was $2.4 million and net increase in loans receivable was due primarily to loan originations and loan purchases of $89.1 million. HMN spent $3.1 million for the purchase of premises and equipment and it expended net cash for the acquisition of MFC of $3.5 million. Net cash used by investing activities during 1998 was $44.1 million. HMN conducted the following major financing activities during 1998: decrease in deposits of $33.3 million, purchase of treasury stock of $17.1 million, advanced money to the ESOP of $1.5 million, received $436,000 from exercise of HMN common stock options, paid $858,000 in dividends to HMN stockholders, proceeds from FHLB advances of $163.1 million and repayments of FHLB advances totaled $105.4 million, proceeds from other borrowed money of $2.5 million. Net cash provided from financing activities was $7.8 million. *HMN has certificates of deposit with outstanding balances of $193.9 million that mature during 1999. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. *HMN has $19.0 million of FHLB advances which mature in 2001 but have call features which can be exercised by the FHLB on a semiannual basis. If the call features are exercised, HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. Since HMN has the ability to request another advance to replace the advance that is being called, Management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during 1999. MERGER AND ACQUISITIONS From time to time HMN reviews the possibility of acquiring or merging with different companies which would complement the business conducted by HMN. HMN's Board of Directors has adopted the policy of not disclosing to the public its intent to acquire or merge until a formal definitive agreement has been signed by all parties involved with the transaction except as otherwise required by law. On December 5, 1997 HMN, through its wholly owned subsidiary, Home Federal Savings Bank, completed its merger with Marshalltown Financial Corporation pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to Consolidated Financial Statements for more information on the merger. IMPACT OF INFLATION AND CHANGING PRICES The Consolidated Financial Statements and Notes presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operation results that are primarily in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of the assets and liabilities of HMN are monetary in nature. As a result, interest rates have a greater impact on HMN'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. On August 17, 1998 HMN's Board of Directors authorized the purchase of 400,000 shares of HMN's common stock. As of December 31, 1998 HMN had purchased 121,800 shares at an aggregate cost of $1.6 million. The existing Board authorization would allow HMN to purchase *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 22 278,200 shares of HMN common stock during 1999 at the then current market price. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. HMN's market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure. HMN's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact HMN's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. HMN monitors how its assets will mature or reprice in comparison to how its liabilities will mature or reprice. The MATURITY OR REPRICING TABLE located below in the Asset/Liability Management section of this report is used as part of the monitoring process. HMN also 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 below in the Asset/Liability Management section of this report discloses HMN's projected changes in net interest income based upon immediate interest rate changes called rate shocks. *HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at December 31, 1998. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on December 31, 1998.
- --------------------------------------------------------------------------------------------------------------------- Other than trading portfolio Market Value (DOLLARS IN THOUSANDS) ------------------------------------------------------------- Basis point change in interest rates -200 -100 0 +100 +200 - --------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents. . . . . . . . . . . . . $ 19,979 19,963 19,946 19,930 19,913 Securities available for sale: Fixed-rate CMOs . . . . . . . . . . . . . . . . 44,746 44,699 44,631 43,805 42,509 Variable-rate CMOs. . . . . . . . . . . . . . . 92,414 92,917 94,476 93,999 90,940 Fixed-rate available for sale mortgage-backed and related securities . . . . . . . . . . . . 4,128 4,084 4,052 3,987 3,867 Variable-rate available for sale mortgage- backed and related securities. . . . . . . . . 109 107 104 102 102 Fixed-rate available for sale other marketable securities. . . . . . . . . . . . . 55,242 52,997 50,841 48,845 46,987 Variable-rate available for sale other marketable securities. . . . . . . . . . . . . 769 767 765 764 762 Fixed-rate loans held for sale . . . . . . . . . . 13,122 13,111 13,101 13,090 13,079 Loans receivable, net: Fixed-rate real estate loans. . . . . . . . . . 307,010 305,553 301,084 292,574 282,452 Variable-rate real estate loans . . . . . . . . 86,153 85,387 83,824 81,821 79,267 Fixed-rate other loans. . . . . . . . . . . . . 41,939 41,516 40,889 40,059 39,293 Variable-rate other loans . . . . . . . . . . . 42,296 41,784 41,909 42,100 42,252 Mortgage servicing rights, net . . . . . . . . . . 327 654 1,006 1,178 1,296 Investment in limited partnerships . . . . . . . . 753 1,118 2,438 5,538 6,612 -------- -------- -------- -------- -------- Total market risk sensitive assets . . . . . . . . 708,987 704,657 699,066 687,792 669,331 -------- -------- -------- -------- -------- Deposits: NOW accounts. . . . . . . . . . . . . . . . . . 38,606 38,574 38,542 38,510 38,478 Passbooks . . . . . . . . . . . . . . . . . . . 36,640 35,016 33,530 32,165 30,906 Money market accounts . . . . . . . . . . . . . 29,860 28,547 27,345 26,240 25,220 Certificates. . . . . . . . . . . . . . . . . . 341,987 337,983 334,072 330,250 326,514 Federal Home Loan Bank advances: Fixed-rate advances . . . . . . . . . . . . . . 175,742 170,653 165,750 161,027 156,475 Variable-rate advances. . . . . . . . . . . . . 24,040 24,020 23,999 23,979 23,958 Other borrowings . . . . . . . . . . . . . . . . . 2,509 2,507 2,505 2,502 2,500 -------- -------- -------- -------- -------- Total market risk sensitive liabilities. . . . . . 649,384 637,300 625,743 614,673 604,051 -------- -------- -------- -------- -------- Off-balance sheet financial instruments: Commitments to extend credit. . . . . . . . . . 55 55 54 52 51 -------- -------- -------- -------- -------- Net market risk. . . . . . . . . . . . . . . . . . $ 59,658 67,412 73,377 73,171 65,331 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Percentage change from current market value. . . . (18.70)% (8.13)% 0.00% (0.28)% (10.96)% -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- - ---------------------------------------------------------------------------------------------------------------------
*This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 23 MANAGEMENT'S DISCUSSION AND ANALYSIS The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 9% to 37%, depending on the coupon and period to maturity. ARMs were assumed to prepay at annual rates of between 13% and 24%, depending on coupon and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 19% and 41% depending on the coupon and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 20%. FHLB advances were projected at their first call date. Refer to Note 13 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 which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. ASSET/LIABILITY MANAGEMENT *HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following December 31, 1998 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.
- -------------------------------------------------------------------------------- Rate Shock Net Interest Percentage in Basis Points Income Change - -------------------------------------------------------------------------------- +200 $22,815,000 10.26 % +100 21,923,000 5.95 % 0 20,692,000 0.00 % -100 19,479,000 (5.86)% -200 17,785,000 (14.05)% - --------------------------------------------------------------------------------
The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections prepared by third parties. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. HMN has an Asset/Liability Committee which meets at least on a monthly basis to discuss changes made to the interest rate risk position and projected profitability. The committee makes recommendations for adjustments to the asset liability position of the Bank to the Board of Directors of the Bank. This committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, the Board reviews on a quarterly basis the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios. In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, during periods of declining or stable interest rates, provide high enough returns to justify the increased exposure to sudden and unexpected increases in interest rates. To the extent consistent with its interest rate spread objectives, the Bank attempts to reduce its interest rate risk and has taken a number of steps to restructure its assets and liabilities. During 1998 the Bank sold approximately 44% of the one-to-four family loans that were originated or refinanced during 1998. The Bank also swapped $21.8 million of fixed rate one-to-four family loans for FNMA mortgage-backed securities and then sold the securities to *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 24 reduce interest rate risk. The Bank has primarily focused its fixed rate one-to- four family residential lending program on loans that are saleable to third parties and will portfolio only certain fixed rate loans that meet certain risk characteristics. The Bank will portfolio adjustable rate loans which reprice over a one year, three year and five year period. At times, depending on its interest rate sensitivity, the Bank may sell seasoned fixed rate single family loans with shorter contractual maturities than thirty years in order to reduce interest rate risk and record a gain on the sale of loans. The following gap table sets forth the interest rate sensitivity of HMN's assets and liabilities at December 31, 1998, using certain assumptions that are described in more detail below:
- ------------------------------------------------------------------------------------------------------------------------------ Maturing or Repricing ------------------------------------------------------------------------------------- Over 6 6 Months Months to Over 1-3 Over 3-5 Over 5 No Stated (DOLLARS IN THOUSANDS) or Less One Year Years Years Years Maturity Total - ------------------------------------------------------------------------------------------------------------------------------ Cash equivalents . . . . . . . . . . . . $ 19,961 0 0 0 0 0 19,961 Securities available for sale: Mortgage-backed and related securities(1) . . . . . . . 111,476 11,628 14,155 1,986 5,076 0 144,321 Other marketable securities . . . . . 13,780 1,910 2,109 5,115 7,472 8,271 38,657 Loans held for sale, net . . . . . . . . 13,095 0 0 0 0 0 13,095 Loans receivable, net:(1)(2) Fixed rate one-to-four family(3). . . 31,500 28,068 85,115 52,753 79,225 0 276,661 Adjustable rate one-to-four family(3) . . . . . . . 18,131 21,280 22,123 27,183 2,758 0 91,475 Multi family. . . . . . . . . . . . . 650 550 1,548 688 538 0 3,974 Fixed rate commercial real estate . . 9,018 1,268 2,948 1,099 561 0 14,894 Adjustable rate commercial real estate . . . . . . . . . . . . 8,826 3,414 4,755 1,417 0 0 18,412 Commercial business . . . . . . . . . 6,739 1,473 2,814 592 81 0 11,699 Consumer loans. . . . . . . . . . . . 23,595 1,815 4,513 2,169 1,289 0 33,381 Federal Home Loan Bank stock . . . . . . 0 0 0 0 0 9,838 9,838 -------- -------- -------- -------- -------- -------- -------- Total interest-earning assets . . . 256,771 71,406 140,080 93,002 97,000 18,109 676,368 -------- -------- -------- -------- -------- -------- -------- Non-interest checking. . . . . . . . . . 13,187 0 0 0 0 0 13,187 NOW accounts . . . . . . . . . . . . . . 25,459 0 0 0 0 0 25,459 Passbooks. . . . . . . . . . . . . . . . 3,576 3,576 10,302 6,592 11,720 0 35,766 Money market accounts. . . . . . . . . . 2,940 2,942 8,473 5,422 9,642 0 29,419 Certificates . . . . . . . . . . . . . . 113,285 80,566 113,647 20,464 2,076 0 330,038 Federal Home Loan Bank advances. . . . . 29,000 10,000 35,000 111,400 0 0 185,400 Other borrowed money . . . . . . . . . . 2,500 0 0 0 0 0 2,500 -------- -------- -------- -------- -------- -------- -------- Total interest-bearing liabilities. 189,947 97,084 167,422 143,878 23,438 0 621,769 -------- -------- -------- -------- -------- -------- -------- Interest-earning assets less interest-bearing liabilities. . . . . $ 66,824 (25,678) (27,342) (50,876) 73,562 18,109 54,599 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Cumulative interest-rate sensitivity gap $ 66,824 41,146 13,804 (37,072) 36,490 54,599 54,599 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Cumulative interest-rate gap as a percentage of total assets at December 31, 1998 . . . . . . . . . . 9.60% 5.91% 1.98% (5.33)% 5.24% 7.85% 7.85% -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Cumulative interest-rate gap as a percentage of total assets at December 31, 1997 . . . . . . . . . . (6.36) (15.38) -------- -------- -------- -------- - ------------------------------------------------------------------------------------------------------------------------------
(1) Schedule prepared based upon the earlier of contractual maturity or repricing date, if applicable, adjusted for scheduled repayments of principal and projected prepayments of principal based upon experience. (2) Loans receivable are presented net of loans in process and deferred loan fees. (3) Construction and development loans are all one-to-four family loans and therefore have been included in the fixed rate one-to-four family and adjustable rate one-to-four family lines. 25 MANAGEMENT'S DISCUSSION AND ANALYSIS The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 9% to 37%, depending on the coupon and period to maturity. ARMs were assumed to prepay at annual rates of between 13% and 24%, depending on coupon and the period to maturity. GEM loans were assumed to prepay at annual rates of between 19% and 41% depending on the coupon and the period to maturity. Mortgage-backed securities and CMOs were projected to have prepayments based upon the underlying collateral securing the instrument. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 20%. FHLB advances were projected at their first call date. Refer to Note 13 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. Although certain assets and liabilities may have similar maturities and periods of repricing, they may react in different degrees to changes in market interest rates. 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. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. 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 an interest rate increase. Refer to Regulatory Capital Requirements above for a discussion of the Bank's interest rate risk component. YEAR 2000 *HMN has inventoried its computer hardware, computer software, third party vendors and its other non-computer equipment and has assessed or is in the process of assessing whether the items are year 2000 compliant. The hardware testing has been completed. The majority of the non-compliant hardware was replaced during 1998 at a cost of $67,500. The remaining non-compliant hardware will be replaced at an approximate cost of $7,500 in the second quarter of 1999. The computer software inventory indicated that certain programs were not compliant. Some of those software programs were replaced during 1998 at a cost of $53,000. Other software programs are scheduled to be replaced with year 2000 compliant software during the second quarter of 1999 at an anticipated cost of $27,000. HMN is also in the process of testing all computer software to determine that the software is year 2000 compliant. The testing is scheduled to be completed during the second quarter of 1999. The assessment of non-computer equipment for year 2000 compliance indicated that HMN did not have any significant issues in this area. *The majority of the Bank's loan and deposit data is supported by a third party data processing center. Other third party providers support the automated teller machines owned by the Bank and process the check clearings for the Bank's negotiable order of withdrawal accounts ("checking accounts"). The Bank is also reliant upon the Federal Home Loan Bank of Des Moines and the Federal Reserve System to properly and efficiently conduct its business. Notwithstanding the Bank's efforts, the failure of any of these third party vendors to address their year 2000 issues in a timely fashion may have an adverse effect on the Bank's ability to conduct its business and/or process its customers' transactions. The Bank's Year 2000 Committee (the "Committee") is working very closely with its data processing center to ascertain that all software applications and hardware will be year 2000 compliant by the second quarter of 1999. The Committee is also monitoring the progress that other key third party providers are making toward becoming year 2000 compliant. *The Committee is in the process of developing a contingency plan which incorporates the actions the Bank will take in situations where the data processing center or other key third party providers are not able to become year 2000 compliant and it will have a major impact on the Bank's business. The contingency plan is anticipated to be completed in the second quarter of 1999. FORWARD-LOOKING INFORMATION The following paragraphs within Management's Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements and actual results may differ materially from the expectations disclosed within this Discussion and Analysis. These forward-looking statements are subject to risks and uncertainties, including those discussed below. HMN assumes no obligations to publicly release results of any revision or updates to these forward-looking statements to reflect future events or unanticipated occurrences. PROVISION FOR LOSSES ON LOANS The provision for losses on loans is the result of management's evaluation of the loan portfolio including its evaluation of national and regional economic indicators (including the possibility at each year end that there would be an increase in general interest rates), such as national and regional unemployment data, single family loan delinquencies as reported separately by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank Mortgage Corporation (FHLMC), local single family construction permits and local economic growth rates and the current regulatory and general *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 26 of this discussion. 26 economic environment. HMN will continue to monitor and modify its allowance for losses as these conditions dictate. Although HMN maintains its allowance for losses at a level it considers adequate to provide for estimated losses, there can be no assurance that such losses will not exceed the estimated amount or that additional provisions for loan losses will not be required in future periods. ALLOWANCE FOR LOAN AND REAL ESTATE LOSSES Management continues to actively monitor the 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 losses. LIQUIDITY HMN 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 of the asset or the sale of the asset. Liability liquidity results from the ability of the Bank to attract depositors or borrow funds from third party sources such as the FHLB. The Bank is required by regulation to maintain a monthly average minimum asset liquidity ratio of 4%. The Bank has maintained an average monthly liquidity ratio in excess of the 4% requirement and does not anticipate that it will fall below the requirement in the future. The Bank may fall below the 4% liquidity requirement if unforeseen economic conditions or unanticipated events occur which would cause our customers to draw abnormal amounts of cash from their accounts. HMN anticipates that its liquidity requirements for 1999 will be similar to the cash flows it experienced in 1998 with the exception of the redemption of the common stock of MFC which will require only $37,000. Construction disbursements will also be reduced because both the Spring Valley and Winona retail banking facilities were completed during 1998. Expenditures for premises and equipment are anticipated to be $1.0 million for 1999. The cash needed to fund the mortgage banking activities of HMN Mortgage Services, Inc. will range from $5.0 million to $20.0 million during 1999. The actual cash flows of HMN may be different than the anticipated cash flows discussed for 1999 due to unforeseen economic conditions or unanticipated events such as the desire of customers to close all of their accounts in anticipation of the year 2000. HMN has certificates of deposit with outstanding balances of $193.9 million that mature during 1999. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. Competitive pricing by other institutions, the desire of a competitor to pay interest rates on deposits that are above the current rates paid by HMN, or desire by customers to put more of their funds into nontraditional bank products such as stocks and bonds could be circumstances that would cause the maturing certificates to become a liquidity problem. HMN has $19.0 million of FHLB advances which mature in 2001 but have call features which can be exercised by the FHLB on a semiannual basis. If the call features are exercised HMN has the option of requesting any advance otherwise available to it pursuant to the Credit Policy of the FHLB. Since HMN has the ability to request another advance to replace the advance that is being called, Management does not anticipate that it will have a liquidity problem due to advances being called by the FHLB during 1999. MARKET RISK HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN's actual market value changes for interest earnings assets and interest bearing liabilities may differ from the projected market values disclosed in the table in the Market Risk Section. Certain shortcomings are inherent in the method of analysis in the table presented in the Market Risk section. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest rate index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest- bearing assets which are approaching their life time interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. 27 MANAGEMENT'S DISCUSSION AND ANALYSIS HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at December 31, 1998. HMN does not have a trading portfolio. The table in the Market Risk Section discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on December 31, 1998. Actual interest rates could fluctuate by more than 200 basis points up or down from rates in effect on December 31, 1998 due to unanticipated occurrences such as the start of another war in the gulf. Many Asian and European countries are experiencing economic difficulties which may have a larger impact on the economy of the United States than is currently anticipated and thereby cause general interest rates to fluctuate by more than 200 basis points. ASSET/LIABILITY MANAGEMENT HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following December 31, 1998 to determine if its current level of interest rate risk is acceptable. HMN's actual net interest income caused by interest rate changes may differ from the amounts reflected in the table which projects the estimated impact on net interest income of immediate interest rate changes called rate shocks. HMN's actual maturing and repricing results of its interest-earning assets and interest-bearing liabilities may differ from the amounts reflected in the gap table. Certain shortcomings are inherent in the method of analysis presented in each of the tables. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. YEAR 2000 HMN has inventoried its computer hardware, computer software, third party vendors and its other non-computer equipment and has assessed or is in the process of assessing whether the items are year 2000 compliant. The hardware testing has been completed. The majority of the non-compliant hardware was replaced during 1998 at a cost of $67,500. The remaining non- compliant hardware will be replaced at an approximate cost of $7,500 in the second quarter of 1999. The computer software inventory indicated that certain programs were not compliant. Some of those software programs were replaced during 1998 at a cost of $53,000. Other software programs are scheduled to be replaced with year 2000 compliant software during the second quarter of 1999 at an anticipated cost of $27,000. HMN is also in the process of testing all computer software to determine that the software is year 2000 compliant. The testing is scheduled to be completed during the second quarter of 1999. The assessment of non-computer equipment for year 2000 compliance indicated that HMN did not have any significant issues in this area. The majority of the Bank's loan and deposit data is supported by a third party data processing center. Other third party providers support the automated teller machines owned by the Bank and process the check clearings for the Bank's negotiable order of withdrawal accounts ("checking accounts"). The Bank is also reliant upon the Federal Home Loan Bank of Des Moines and the Federal Reserve System to properly and efficiently conduct its business. Notwithstanding the Bank's efforts, the failure of any of these third party vendors to address their year 2000 issues in a timely fashion may have an adverse effect on the Bank's ability to conduct its business and/or process its customers' transactions. The Bank's Year 2000 Committee (the "Committee") is working very closely with its data processing center to ascertain that all software applications and hardware will be year 2000 compliant by the second quarter of 1999. The Committee is also monitoring the progress that other key third party providers are making toward becoming year 2000 compliant. The Committee is in the process of developing a contingency plan which incorporates the actions the Bank will take in situations where the data processing center or other key third party providers are not able to become year 2000 compliant and it will have a major impact on the Bank's business. The contingency plan is anticipated to be completed in the second quarter of 1999. The estimated costs are dependent upon HMN's third party data processing center successfully converting its hardware and software to be year 2000 compliant. The data processing center may not successfully complete their conversion to all year 2000 hardware and software which may cause HMN's cost to substantially increase. The completion of all testing of computer software may determine that HMN will have to replace additional software at substantially higher costs than it currently anticipates. The contingency plan may not be completed or, when it is completed, may not address an unforeseen event that could occur and as a result of the event, HMN is not able to conduct its business. 28 CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997 1998 1997 - ----------------------------------------------------------------------------------------------------- ASSETS Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . $ 20,960,957 9,364,635 Securities available for sale: Mortgage-backed and related securities (amortized cost $144,320,926 and $135,598,404) . . . . . . . . . 143,146,165 135,935,482 Other marketable securities (amortized cost $38,657,193 and $68,356,926) . . . . . . . . . . 38,478,623 69,923,477 ------------ ------------ 181,624,788 205,858,959 ------------ ------------ Loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . 13,094,528 2,287,265 Loans receivable, net. . . . . . . . . . . . . . . . . . . . . . . . . 447,455,052 442,068,600 Accrued interest receivable. . . . . . . . . . . . . . . . . . . . . . 3,952,763 4,038,131 Federal Home Loan Bank stock, at cost. . . . . . . . . . . . . . . . . 9,837,900 7,432,200 Mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . 1,005,693 781,005 Real estate, net . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,602 133,939 Premises and equipment, net. . . . . . . . . . . . . . . . . . . . . . 8,382,136 5,880,710 Investment in limited partnerships . . . . . . . . . . . . . . . . . . 2,437,246 5,989,399 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,341,033 4,500,873 Core deposit intangible. . . . . . . . . . . . . . . . . . . . . . . . 1,259,245 1,546,273 Prepaid expenses and other assets. . . . . . . . . . . . . . . . . . . 295,829 1,349,521 ------------ ------------ Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $694,657,772 691,231,510 ------------ ------------ ------------ ------------ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $433,868,907 467,347,688 Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . . . 185,400,000 127,650,021 Other borrowed money . . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 0 Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . 1,086,013 1,365,064 Advance payments by borrowers for taxes and insurance. . . . . . . . . 657,089 786,619 Accrued expenses and other liabilities . . . . . . . . . . . . . . . . 2,663,373 6,056,356 Due to stockholders of Marshalltown Financial Corporation. . . . . . . 37,051 3,555,352 ------------ ------------ Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . 626,212,433 606,761,100 ------------ ------------ Commitments and contingencies Stockholders' equity: Serial preferred stock ($.01 par value): authorized 500,000 shares; issued and outstanding none. . . . . . . . . . . . . . . . . . . 0 0 Common stock ($.01 par value): authorized shares 11,000,000; issued shares 9,128,662. . . . . . . . . . . . . . . . . . . . . 91,287 91,287 Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . 59,739,020 59,698,661 Retained earnings, subject to certain restrictions. . . . . . . . . 63,424,378 60,224,253 Accumulated other comprehensive income (loss) . . . . . . . . . . . (837,838) 1,129,818 Unearned employee stock ownership plan shares . . . . . . . . . . . (5,705,152) (4,554,280) Unearned compensation restricted stock awards . . . . . . . . . . . (276,867) (600,668) Treasury stock, at cost 3,835,058 and 2,912,111 . . . . . . . . . . (47,989,489) (31,518,661) ------------ ------------ Total stockholders' equity . . . . . . . . . . . . . . . . . . . 68,445,339 84,470,410 ------------ ------------ Total liabilities and stockholders' equity. . . . . . . . . . . . . $694,657,772 691,231,510 ------------ ------------ ------------ ------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 29 CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 - ---------------------------------------------------------------------------------------------------------- Interest income: Loans receivable. . . . . . . . . . . . . . . . . . . . . $35,073,718 28,328,864 25,721,042 Securities available for sale: Mortgage-backed and related. . . . . . . . . . . . . . 8,830,278 8,255,402 10,027,438 Other marketable . . . . . . . . . . . . . . . . . . . 3,869,089 3,699,378 2,424,628 Securities held to maturity: Mortgage-backed and related. . . . . . . . . . . . . . 0 33,400 765,120 Other marketable . . . . . . . . . . . . . . . . . . . 0 10,032 104,448 Cash equivalents. . . . . . . . . . . . . . . . . . . . . 432,794 342,433 494,129 Other . . . . . . . . . . . . . . . . . . . . . . . . . . 589,426 420,722 327,520 ----------- ----------- ----------- Total interest income. . . . . . . . . . . . . . . . . 48,795,305 41,090,231 39,864,325 ----------- ----------- ----------- Interest expense: Deposits. . . . . . . . . . . . . . . . . . . . . . . . . 22,098,272 19,056,164 18,949,937 Federal Home Loan Bank advances . . . . . . . . . . . . . 9,788,443 6,586,855 5,243,853 Other borrowed money. . . . . . . . . . . . . . . . . . . 11,538 0 0 ----------- ----------- ----------- Total interest expense . . . . . . . . . . . . . . . . 31,898,253 25,643,019 24,193,790 ----------- ----------- ----------- Net interest income. . . . . . . . . . . . . . . . . . 16,897,052 15,447,212 15,670,535 Provision for loan losses. . . . . . . . . . . . . . . . . . 310,000 300,000 300,000 ----------- ----------- ----------- Net interest income after provision for loan losses . . . 16,587,052 15,147,212 15,370,535 ----------- ----------- ----------- Noninterest income: Fees and service charges. . . . . . . . . . . . . . . . . 855,654 487,085 359,249 Securities gains, net . . . . . . . . . . . . . . . . . . 2,798,575 1,249,569 1,029,638 Gain on sales of loans. . . . . . . . . . . . . . . . . . 2,176,924 469,461 39,306 Earnings (loss) in limited partnerships . . . . . . . . . (3,724,710) 220,278 7,400 Other . . . . . . . . . . . . . . . . . . . . . . . . . . 523,623 295,966 487,107 ----------- ----------- ----------- Total noninterest income . . . . . . . . . . . . . . . 2,630,066 2,722,359 1,922,700 ----------- ----------- ----------- Noninterest expense: Compensation and benefits . . . . . . . . . . . . . . . . 6,804,112 5,590,297 4,591,367 Occupancy . . . . . . . . . . . . . . . . . . . . . . . . 1,442,003 983,238 825,609 Federal deposit insurance premiums. . . . . . . . . . . . 285,388 238,654 799,890 SAIF assessment . . . . . . . . . . . . . . . . . . . . . 0 0 2,351,563 Advertising . . . . . . . . . . . . . . . . . . . . . . . 444,545 315,771 308,464 Data processing . . . . . . . . . . . . . . . . . . . . . 674,320 508,930 489,045 Amortization of mortgage servicing rights and net valuation adjustments. . . . . . . . . . . . . . . 888,885 104,538 0 Other . . . . . . . . . . . . . . . . . . . . . . . . . . 2,621,185 1,281,277 1,142,948 ----------- ----------- ----------- Total noninterest expense. . . . . . . . . . . . . . . 13,160,438 9,022,705 10,508,886 ----------- ----------- ----------- Income before income tax expense . . . . . . . . . . . 6,056,680 8,846,866 6,784,349 Income tax expense . . . . . . . . . . . . . . . . . . . . . 1,999,000 3,268,000 2,510,000 ----------- ----------- ----------- Net income . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349 ----------- ----------- ----------- ----------- ----------- ----------- Basic earnings per share . . . . . . . . . . . . . . . . . . $ 0.82 1.01 0.66 ----------- ----------- ----------- ----------- ----------- ----------- Diluted earnings per share . . . . . . . . . . . . . . . . . $ 0.77 0.94 0.64 ----------- ----------- ----------- ----------- ----------- ----------- CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349 Other comprehensive income, net of tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period (247,304) 2,473,373 281,609 Less: reclassification adjustment for gains included in net income. . . . . . . . . . 1,720,352 745,510 614,296 ----------- ----------- ----------- Other comprehensive income (loss). . . . . . . . . . . . . . (1,967,656) 1,727,863 (332,687) ----------- ----------- ----------- Comprehensive income . . . . . . . . . . . . . . . . . . . . $ 2,090,024 7,306,729 3,941,662 ----------- ----------- ----------- ----------- ----------- -----------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 30 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unearned Employee Accumulated Stock Unearned Additional Other Ownership Compensation Total YEARS ENDED DECEMBER 31, Common Paid-In Retained Comprehensive Plan Restricted Treasury Stockholders' 1998, 1997 AND 1996 Stock Capital Earnings Income (Loss) Shares Stock Awards Stock Equity - ---------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1995. . . . . . . $91,287 59,255,152 50,371,038 (265,358) (5,336,150) (1,050,305) (11,378,981) 91,686,683 Net income . . . . . . . . . 4,274,349 4,274,349 Other comprehensive loss . . . . . . . . . . . (332,687) (332,687) Treasury stock purchases. . . . . . . . . (14,364,754) (14,364,754) Stock options exercised. . . (10,817) 63,180 52,363 Restricted stock awards cancelled. . . . . . . . . (808) 25,968 (25,160) 0 Amortization of restricted stock awards. . 231,048 231,048 Restricted stock awards tax benefit . . . . 13,677 13,677 Earned employee stock ownership plan shares. . . 141,135 397,630 538,765 ------ ---------- ---------- --------- ---------- -------- ----------- ---------- Balance, December 31, 1996. . . . . . . 91,287 59,398,339 54,645,387 (598,045) (4,938,520) (793,289) (25,705,715) 82,099,444 Net income . . . . . . . . . 5,578,866 5,578,866 Other comprehensive income . . . . . . . . . . 1,727,863 1,727,863 Treasury stock purchases. . . . . . . . . (5,988,450) (5,988,450) Stock options exercised. . . (82,009) 138,754 56,745 Amortization of restricted stock awards. . 231,621 231,621 Recognition and retention awards granted . . . . . . 2,250 (39,000) 36,750 0 Restricted stock awards tax benefit. . . . . . . . 61,092 61,092 Stock option tax benefit . . 20,751 20,751 Earned employee stock ownership plan shares. . . 298,238 384,240 682,478 ------ ---------- ---------- --------- ---------- -------- ----------- ---------- Balance, December 31, 1997. . . . . . . 91,287 59,698,661 60,224,253 1,129,818 (4,554,280) (600,668) (31,518,661) 84,470,410 Net income . . . . . . . . . 4,057,680 4,057,680 Other comprehensive loss . . . . . . . . . . . (1,967,656) (1,967,656) Treasury stock purchases. . . . . . . . . (17,122,788) (17,122,788) Amortization of restricted stock awards. . 210,866 210,866 Restricted stock awards cancelled. . . . . . . . . (3,515) 112,935 (109,420) 0 Restricted stock awards tax benefit. . . . . . . . 70,639 70,639 Shares purchased for employee stock ownership plan . . . . . . (1,476,000) (1,476,000) Earned employee stock ownership plan shares. . . 235,989 325,128 561,117 Employee stock options exercised. . . . . . . . . (327,071) 763,096 436,025 Stock option tax benefit . . 64,317 64,317 Dividends paid . . . . . . . (857,555) (857,555) Fractional shares purchased. (1,716) (1,716) ------ ---------- ---------- --------- ---------- -------- ----------- ---------- Balance, December 31, 1998. . . . . . . $91,287 59,739,020 63,424,378 (837,838) (5,705,152) (276,867) (47,989,489) 68,445,339 ------ ---------- ---------- --------- ---------- -------- ----------- ---------- ------ ---------- ---------- --------- ---------- -------- ----------- ----------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 31 CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349 Adjustments to reconcile net income to cash provided by operating activities: Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . 310,000 300,000 300,000 Provision for real estate losses. . . . . . . . . . . . . . . . . . . . . . . 0 18,000 2,000 Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617,029 434,493 378,753 Amortization of (discounts) premiums, net . . . . . . . . . . . . . . . . . . (10,903) (216,978) (129,636) Amortization of deferred loan fees. . . . . . . . . . . . . . . . . . . . . . (626,312) (410,111) (440,580) Amortization of goodwill. . . . . . . . . . . . . . . . . . . . . . . . . . . 180,636 13,858 0 Amortization of core deposit intangible . . . . . . . . . . . . . . . . . . . 287,028 20,727 0 Amortization of other purchase accounting adjustments . . . . . . . . . . . . 728,959 38,379 0 Amortization of mortgage servicing rights and net valuation adjustments . . . 888,885 104,538 0 Capitalized mortgage servicing rights . . . . . . . . . . . . . . . . . . . . (654,871) (36,261) 0 Increase (decrease) in deferred income taxes. . . . . . . . . . . . . . . . . (1,615,600) 83,895 110,400 Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,798,575) (1,249,569) (1,029,638) Gain on sales of real estate. . . . . . . . . . . . . . . . . . . . . . . . . (21,777) (3,743) (46,625) Gain on sales of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,176,924) (469,461) (39,306) Proceeds from sales of loans held for sale. . . . . . . . . . . . . . . . . . 175,149,499 21,626,615 1,779,361 Disbursements on loans held for sale. . . . . . . . . . . . . . . . . . . . . (131,495,377) (18,753,844) 0 Principal collected on loans held for sale. . . . . . . . . . . . . . . . . . 0 (1,946) 0 Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . 210,866 231,621 231,048 Amortization of unearned ESOP shares. . . . . . . . . . . . . . . . . . . . . 325,128 384,240 397,630 Earned employee stock ownership shares priced above original cost . . . . . . 235,989 298,238 141,135 Decrease (increase) in accrued interest receivable. . . . . . . . . . . . . . 85,368 190,834 (33,645) Decrease in accrued interest payable. . . . . . . . . . . . . . . . . . . . . (279,051) (1,720,271) (19,574) Equity loss (earnings) of limited partnerships. . . . . . . . . . . . . . . . 3,733,278 (220,278) (7,400) Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . 1,053,692 (745,309) (48,974) Increase (decrease) in other liabilities. . . . . . . . . . . . . . . . . . . (353,123) 1,218,475 35,995 Other, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,992) (128,743) (56,470) ------------ ------------ ------------ Net cash provided by operating activities . . . . . . . . . . . . . . . . . 47,820,532 6,586,265 5,798,823 ------------ ------------ ------------ Cash flows from investing activities: Proceeds from sales of securities available for sale . . . . . . . . . . . . . . 172,640,058 94,462,303 101,157,643 Principal collected on securities available for sale . . . . . . . . . . . . . . 42,751,927 15,028,627 16,530,585 Proceeds collected on maturity of securities available for sale. . . . . . . . . 40,824,876 34,118,412 20,500,000 Purchases of securities available for sale . . . . . . . . . . . . . . . . . . . (204,938,051) (103,102,213) (107,860,451) Proceeds from sales of securities held to maturity . . . . . . . . . . . . . . . 0 348,871 0 Principal collected on securities held to maturity . . . . . . . . . . . . . . . 0 240,441 2,276,661 Proceeds collected on maturity of securities held to maturity. . . . . . . . . . 0 1,000,000 12,652,343 Purchases of securities held to maturity . . . . . . . . . . . . . . . . . . . . 0 0 (709,765) Proceeds from sales of loans receivable. . . . . . . . . . . . . . . . . . . . . 3,258,772 24,806,862 1,408,015 Purchases of mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . (458,702) (844,601) 0 Purchase interest in limited partnerships. . . . . . . . . . . . . . . . . . . . (181,125) (2,438,750) (2,880,125) Purchase of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . (2,405,700) (802,700) (1,632,100) Net increase in loans receivable . . . . . . . . . . . . . . . . . . . . . . . . (89,063,988) (68,579,885) (53,214,798) Proceeds from sale of real estate. . . . . . . . . . . . . . . . . . . . . . . . 152,415 35,627 379,789 Purchases of premises and equipment. . . . . . . . . . . . . . . . . . . . . . . (3,118,455) (1,856,365) (314,714) Acquisition of Marshalltown Financial Corporation, net of cash acquired. . . . . 0 (16,822,639) 0 Decrease in due to stockholders of Marshalltown Financial Corporation. . . . . . (3,518,301) 0 0 ------------ ------------ ------------ Net cash used by investing activities . . . . . . . . . . . . . . . . . . . (44,056,274) (24,406,010) (11,706,917) ------------ ------------ ------------ Cash flows from financing activities: Increase (decrease) in deposits. . . . . . . . . . . . . . . . . . . . . . . . . (33,266,351) 1,258,293 (11,062,524) Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,122,788) (6,350,950) (14,002,254) Increase in unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . (1,476,000) 0 0 Stock options exercised. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436,025 56,745 52,363 Dividends to stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . (857,555) 0 0 Fractional shares purchased from stock split . . . . . . . . . . . . . . . . . . (1,716) 0 0 Proceeds from Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . 163,100,000 151,800,000 130,000,000 Repayment of Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . (105,350,021) (130,228,568) (92,798,389) Increase in other borrowed money . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 0 0 Decrease (increase) in advance payments by borrowers for taxes and insurance . . (129,530) 65,143 (32,079) ------------ ------------ ------------ Net cash provided by financing activities . . . . . . . . . . . . . . . . . 7,832,064 16,600,663 12,157,117 ------------ ------------ ------------ Increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . 11,596,322 (1,219,082) 6,249,023 Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . . . . . . . 9,364,635 10,583,717 4,334,694 ------------ ------------ ------------ Cash and cash equivalents, end of year. . . . . . . . . . . . . . . . . . . . . . . . $ 20,960,957 9,364,635 10,583,717 ------------ ------------ ------------ ------------ ------------ ------------ Supplemental cash flow disclosures: Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,177,304 27,363,290 24,213,364 Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,824,441 3,000,500 2,725,433 Supplemental noncash flow disclosures: Loans securitized and transferred to securities available for sale . . . . . . . $ 27,952,547 16,526,399 15,411,803 Securities held to maturity transferred to securities available for sale . . . . 0 1,295,147 0 Loans transferred to loans held for sale . . . . . . . . . . . . . . . . . . . . 52,294,847 4,346,602 2,491,820 Loans transferred to loans held for investment . . . . . . . . . . . . . . . . . 0 95,503 0 Transfer of loans to real estate . . . . . . . . . . . . . . . . . . . . . . . . 17,105 232,071 188,054 Transfer of real estate to loans . . . . . . . . . . . . . . . . . . . . . . . . 0 84,772 161,954 Treasury stock purchased with liability due to broker. . . . . . . . . . . . . . 0 0 362,500 Due to stockholders of Marshalltown Financial Corporation. . . . . . . . . . . . 0 3,555,352 0
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 AND 1996 NOTE 1 DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES HMN Financial, Inc. (HMN) is a stock savings bank holding company which owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer financial planning products and services. HMN has two other wholly owned subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc. (MSI). SFC invests in commercial loans and commercial real-estate loans located throughout the United States which were originated by third parties. MSI operates mortgage banking and mortgage brokerage facilities located in Brooklyn Park, Minnesota. The consolidated financial statements included herein are for HMN, SFC, MSI, the Bank and the Bank's wholly owned subsidiaries, OAI and MSL. All significant intercompany accounts and transactions have been eliminated in consolidation. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles. The following items set forth the significant accounting policies which HMN follows in presenting its financial statements. MATERIAL ESTIMATES In preparing the 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. Material estimates that are particularly susceptible to change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and real estate losses, management obtains independent appraisals for significant properties. Management believes that the allowances for losses on loans and real estate are adequate. While management uses available information to recognize losses on loans and real estate, future additions to the allowances 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 allowances for losses on loans and real estate. Such agencies may require additions to the allowances based on their judgement about information available to them at the time of their examination. CASH EQUIVALENTS For purposes of the statements of cash flows, HMN considers highly liquid investments with original maturities of three months or less to be cash equivalents. SECURITIES HMN classifies its debt and equity securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Securities available for sale 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. Securities held to maturity represent securities which HMN has the positive intent and ability to hold to maturity. Securities available for sale are carried at market value. Net unrealized gains and losses, net of tax effect, are included as a separate component of stockholders' equity. Securities held to maturity are carried at cost, adjusted for amortization of premiums and discounts, as management has the ability and intent to hold them to maturity. Premiums and discounts are amortized using the level-yield method over the period to maturity. Gains and losses on the sale of securities are determined using the specific-identification method. 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 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. The allowance for losses on loans, including both the allocated and unallocated elements, is based on periodic analysis of the loan portfolio by management. 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. The allowance for loan losses is established for known or anticipated 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 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 nonaccrual 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 judgement, principal is collectible. 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS All impaired loans, including all loans that are restructured in a troubled debt restructuring involving a modification of terms, are measured 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 measure 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 a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are all loans which are delinquent as to principal and interest for 120 days or greater and all loans that are restructured in a troubled debt restructuring involving a modification of terms. All portfolio 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. HMN periodically evaluates its capitalized mortgage servicing rights for impairment. Loan type and note rate are predominate 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 properties 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 periodically performed 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 10 to 40 years for office buildings and improvements and 3 to 12 years for furniture and equipment. IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF HMN 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 HMN has investments in limited partnerships which invest in mortgage servicing assets, the common stock of other financial institutions and low to moderate income housing projects which generate tax credits for HMN. HMN generally accounts for the earnings or losses from the limited partnerships on the equity method with the exception of the limited partnership which invests in mortgage servicing assets. HMN adjusts its investment in this limited partnership recorded under the equity method for an amount that represents HMN's proportionate share of adjusting the mortgage servicing assets to the appraised market value of the mortgage servicing assets. INTANGIBLE ASSETS Goodwill resulting from acquisitions is amortized on a straight line basis over 25 years. Deposit base intangible is amortized on an accelerated basis as the certificates of deposit mature over the next eleven years following the merger. Management reviews intangible assets for impairment as events or circumstances indicate that the assets may not be recoverable. STOCK-BASED COMPENSATION Effective January 1, 1996, HMN adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION. It elected to continue using the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25 and related interpretations which measure compensation cost using the intrinsic value method. HMN has included in Note 16, "Employee Benefits" the impact of the fair value of employee stock-based compensation plans on net income and earnings per share on a pro forma basis for awards granted after January 1, 1995. 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 bases. 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 AND STOCK SPLIT Effective December 31, 1997 HMN adopted SFAS No. 128, EARNINGS PER SHARE. SFAS No. 128 established standards for computing and presenting earnings per share (EPS) and applies to entities with publicly held common stock or potential common stock. SFAS No. 128 simplified the standards for computing earnings per share previously found in APB Opinion No. 15, EARNINGS PER SHARE, and made them comparable to international EPS standards. It requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic 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 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 then shared in the earnings of the entity. Refer to Note 17 for disclosure of EPS calculations. In February of 1998 HMN authorized a three-for-two stock split in the form of a fifty percent stock dividend subject to stockholder approval to increase HMN's authorized common stock from 7.0 million shares to 11.0 million shares. At the annual meeting on April 28, 1998 the stockholders approved the increase in authorized common stock. The Board of Directors then declared that the stock dividend be distributed on May 22, 1998 to stockholders of record on May 8, 1998. The stock split increased HMN's outstanding common shares from 6,085,775 to 9,128,662 shares. Stockholders' equity has been 34 restated to give retroactive effect to the stock split for all periods presented by reclassifying from additional paid-in capital to common stock the par value of the additional shares arising from the stock split. In addition, all references in the Consolidated Financial Statements and Notes thereto to number of shares, per-share amounts, stock option data and market prices of HMN's common stock have been restated giving retroactive recognition to the stock split. NEW ACCOUNTING STANDARDS Effective January 1, 1998 HMN adopted SFAS No. 130, REPORTING COMPREHENSIVE INCOME. The statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be disclosed in the financial statements. Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for HMN is comprised entirely of unrealized gains and losses on securities available for sale. The gross unrealized holding losses for the year ended December 31, 1998 were $458,384, the income tax benefit would have been $211,080 and therefore, the net losses were $247,304. The gross reclassification adjustment for 1998 was $2,798,575, the income tax expense would have been $1,078,223 and therefore, the net reclassification adjustment was $1,720,352. The gross unrealized holding gains for the year ended December 31, 1997 were $4,157,775, the income tax expense would have been $1,684,402 and therefore, the net gain was $2,473,373. The gross reclassification adjustment for 1997 was $1,249,569, the income tax expense would have been $504,059 and therefore, the net reclassification adjustment was $745,510. The gross unrealized holding gains for the year ended December 31, 1996 were $470,801, the income tax expense would have been $189,192 and therefore, the net gains were $281,609. The gross reclassification adjustment for 1996 was $1,029,638, the income tax expense would have been $415,342 and therefore, the net reclassification adjustment was $614,296. Effective January 1, 1998 HMN adopted SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION which establishes new standards for determining a reportable segment and for disclosing information regarding each such segment. The amount of each segment item reported should be 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 should be included in determining reported segment profit or loss only 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 is used by the chief operating decision maker should be reported for that segment. The adoption of SFAS No. 131 did not impact HMN's results of operations or financial condition, but did require the disclosure of segment information. See Note 24 for the disclosure on segment information. Effective January 1, 1998 HMN adopted SFAS No. 132, EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS which revises employers' disclosures about pension and other post retirement benefit plans. It does not change the measurement or recognition of those plans. It standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable, requires additional information on changes in the benefit obligation and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures that are no longer as useful as they were when FASB Statements No. 87, EMPLOYERS' ACCOUNTING FOR PENSIONS, No. 88, EMPLOYERS' ACCOUNTING FOR SETTLEMENT AND CURTAILMENTS OF DEFINED BENEFIT PENSION PLANS AND FOR TERMINATION BENEFITS, and No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS, were issued. SFAS No. 132 suggests combined formats for presentation of pension and other postretirement benefit disclosures. Restatement of disclosures for earlier periods provided for comparative purposes is required unless the information is not readily available. The adoption of SFAS No. 132 did not impact HMN's results of operations or financial condition. Refer to Note 16 for the disclosure on Employee Benefits. In June 1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. - - For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. - - For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. - - For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. - - For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Under SFAS No. 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. SFAS No. 133 precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application should be as of the beginning of an entity's fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of FASB No. 133. HMN is anticipating that it will adopt SFAS No. 133 in the first quarter of 2000 and is currently studying the impact of adopting the statement on its financial statements. In October 1998, the FASB issued SFAS No. 134, ACCOUNTING FOR MORTGAGE-BACKED SECURITIES RETAINED AFTER THE SECURITIZATION OF MORTGAGE LOANS HELD FOR SALE BY A MORTGAGE BANKING ENTERPRISE, which amends SFAS No. 65 to require that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. SFAS No. 134 is effective for the first fiscal quarter beginning after December 15, 1998. Early application was encouraged and was permitted as of October of 1998. HMN anticipates adopting SFAS No. 134 in the first quarter of 1999 and believes that it will not have a material impact on HMN's financial condition or the results of its operations. RECLASSIFICATIONS Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with the current year presentation. NOTE 2 BUSINESS COMBINATIONS AND ACQUISITIONS On December 5, 1997 HMN, through its wholly owned subsidiary, Home Federal, completed its merger (the Merger) with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. The aggregate consideration per the merger agreement was $24.8 million, consisting of $23.7 million for 1.35 million outstanding shares of MFC stock, or $17.51 per share, and $1.1 million for the outstanding MFC options. HMN owned 60,000 shares of MFC stock with a historical cost of $1.0 million which were cancelled upon the completion of the merger. The purchase method of accounting was used to record the merger transaction. The transaction was funded through a combination of the sale of securities, and short-term borrowings from the Federal Home Loan Bank of Des Moines ("FHLB"). Pursuant to the merger agreement, the Bank is obligated to provide cash to MFC stockholders when they submit their MFC stock or outstanding MFC options. As of December 31, 1998 and 1997 MFC stockholders had not redeemed shares and/or options with a value of $37,051 and $3,555,352, respectively. The merger consideration of $24.8 million plus the cancellation of 60,000 shares of MFC common stock owned by HMN with a historical cost of $1.0 million was allocated as follows:
- -------------------------------------------------------------------------------- Cash and cash equivalents. . . . . . . . . . . . . . . . . . . $ 5,437,603 Investment securities. . . . . . . . . . . . . . . . . . . . . 48,580,533 Loans receivable, net. . . . . . . . . . . . . . . . . . . . . 69,759,162 Federal Home Loan Bank stock, at cost. . . . . . . . . . . . . 1,195,500 Premises and equipment . . . . . . . . . . . . . . . . . . . . 744,793 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,514,730 Core deposit intangible. . . . . . . . . . . . . . . . . . . . 1,567,000 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . 2,210,518 Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . (103,580,493) Net deferred tax liabilities . . . . . . . . . . . . . . . . . (1,003,330) Other liabilities. . . . . . . . . . . . . . . . . . . . . . . (3,578,464) ------------- Purchase price . . . . . . . . . . . . . . . . . . . . . . . $ 25,847,552 ------------- ------------- - --------------------------------------------------------------------------------
36 NOTE 3 SECURITIES AVAILABLE FOR SALE A summary of securities available for sale at December 31, 1998 and 1997 is as follows:
- --------------------------------------------------------------------------------------------------------------- Gross Gross Amortized unrealized unrealized Fair cost gains losses value - --------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1998: Mortgage-backed securities: FHLMC. . . . . . . . . . . . . . . . . . . . . $ 1,813,967 63,053 0 1,877,020 FNMA . . . . . . . . . . . . . . . . . . . . . 584,799 0 10,829 573,970 GNMA . . . . . . . . . . . . . . . . . . . . . 1,486,585 1,861 1,411 1,487,035 Other. . . . . . . . . . . . . . . . . . . . . 100,912 512 0 101,424 Collateralized mortgage obligations: FHLMC. . . . . . . . . . . . . . . . . . . . . 37,965,242 22,356 469,027 37,518,571 FNMA . . . . . . . . . . . . . . . . . . . . . 57,063,756 16,237 670,714 56,409,279 Other. . . . . . . . . . . . . . . . . . . . . 45,305,665 77,584 204,383 45,178,866 ------------ ------------ ------------ ------------ 144,320,926 181,603 1,356,364 143,146,165 ------------ ------------ ------------ ------------ Other marketable securities: U.S. Government and agency obligations . . . . 17,378,636 13,626 1,339 17,390,923 Corporate debt . . . . . . . . . . . . . . . . 7,133,405 941 9,524 7,124,822 Corporate equity . . . . . . . . . . . . . . . 14,145,152 276,333 458,607 13,962,878 ------------ ------------ ------------ ------------ 38,657,193 290,900 469,470 38,478,623 ------------ ------------ ------------ ------------ $182,978,119 472,503 1,825,834 181,624,788 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ DECEMBER 31, 1997: Mortgage-backed securities: FHLMC. . . . . . . . . . . . . . . . . . . . . $ 29,934,261 159,036 13,126 30,080,171 FNMA . . . . . . . . . . . . . . . . . . . . . 14,352,421 46,710 59,159 14,339,972 GNMA . . . . . . . . . . . . . . . . . . . . . 6,213,917 12,741 7,885 6,218,773 Other. . . . . . . . . . . . . . . . . . . . . 186,523 0 881 185,642 Collateralized mortgage obligations: FHLMC. . . . . . . . . . . . . . . . . . . . . 21,583,016 227,165 207,710 21,602,471 FNMA . . . . . . . . . . . . . . . . . . . . . 38,603,926 271,415 217,204 38,658,137 Other. . . . . . . . . . . . . . . . . . . . . 24,724,340 127,068 1,092 24,850,316 ------------ ------------ ------------ ------------ 135,598,404 844,135 507,057 135,935,482 ------------ ------------ ------------ ------------ Other marketable securities: U.S. Government and agency obligations . . . . 43,403,323 40,398 100,965 43,342,756 Corporate debt . . . . . . . . . . . . . . . . 2,903,330 0 182 2,903,148 Corporate equity . . . . . . . . . . . . . . . 22,050,273 1,632,826 5,526 23,677,573 ------------ ------------ ------------ ------------ 68,356,926 1,673,224 106,673 69,923,477 ------------ ------------ ------------ ------------ $203,955,330 2,517,359 613,730 205,858,959 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ - ---------------------------------------------------------------------------------------------------------------
Proceeds from securities available for sale which were sold during 1998 were $172,640,058, resulting in gross gains of $3,050,785 and gross losses of $252,210. Proceeds from securities available for sale which were sold during 1997 were $94,462,303, resulting in gross gains of $1,533,046 and gross losses of $283,477. Proceeds from securities available for sale which were sold during 1996 were $101,157,643, resulting in gross gains of $1,235,754 and gross losses of $206,116. The following table indicates amortized cost and estimated fair value of securities available for sale at December 31, 1998, 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 . . . . . . . . . . . . . . $136,687,972 135,739,879 Due after one year through five years. . . . . . . 19,659,996 19,523,631 Due after five years through ten years . . . . . . 7,287,000 7,236,455 After ten years. . . . . . . . . . . . . . . . . . 5,197,999 5,161,945 No stated maturity . . . . . . . . . . . . . . . . 14,145,152 13,962,878 ------------ ----------- Total. . . . . . . . . . . . . . . . . . . . . $182,978,119 181,624,788 ------------ ----------- ------------ ----------- - --------------------------------------------------------------------------------
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. NOTE 4 SECURITIES HELD TO MATURITY During the first quarter of 1997, HMN determined that it no longer had the intent to hold its securities classified as held to maturity to the actual maturity date of the securities. Therefore, it sold one security and on March 31, 1997 it transferred all the remaining securities in the held to maturity portfolio to the available for sale portfolio. The following information summarizes the sale and transfer of the securities held to maturity during 1997.
- ---------------------------------------------------------------------------------------------------------------------------------- Unrealized Unrealized Holding Gain, Amortized Fair Realized Holding Net of Tax, Cost Value Gain Gain in Equity - ---------------------------------------------------------------------------------------------------------------------------------- Security sold. . . . . . . . . . . . . . . . . . . . . $ 344,139 348,871 4,732 Securities transferred to available for sale . . . . . $1,223,753 1,295,147 71,394 42,641 - ----------------------------------------------------------------------------------------------------------------------------------
37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5 LOANS RECEIVABLE, NET A summary of loans receivable at December 31 is as follows:
- ------------------------------------------------------------------------------------------- 1998 1997 ----------------------------- Residential real estate loans: Conventional . . . . . . . . . . . . . . . . . . . . . . . $378,080,048 399,029,974 FHA. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,294,426 1,797,006 VA . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,298,967 1,857,827 ------------ ------------ 380,673,441 402,684,807 ------------ ------------ Other loans: Commercial real estate . . . . . . . . . . . . . . . . . . 33,686,778 11,997,014 Autos. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,897,281 2,437,516 Home equity line . . . . . . . . . . . . . . . . . . . . . 19,476,056 19,490,392 Home equity. . . . . . . . . . . . . . . . . . . . . . . . 9,565,652 7,176,253 Other consumer . . . . . . . . . . . . . . . . . . . . . . 1,071,555 411,100 Commercial business. . . . . . . . . . . . . . . . . . . . 11,695,354 5,226,095 Savings. . . . . . . . . . . . . . . . . . . . . . . . . . 994,168 1,362,186 Education. . . . . . . . . . . . . . . . . . . . . . . . . 118,351 123,313 Other. . . . . . . . . . . . . . . . . . . . . . . . . . . 676,838 864,238 ------------ ------------ 80,182,033 49,088,107 ------------ ------------ Total loans. . . . . . . . . . . . . . . . . . . . . . . 460,855,474 451,772,914 Less: Unamortized discounts. . . . . . . . . . . . . . . . . . . 414,495 547,007 Net deferred loan fees . . . . . . . . . . . . . . . . . . 1,947,778 1,846,692 Allowance for losses . . . . . . . . . . . . . . . . . . . 3,041,485 2,748,219 Loans in process . . . . . . . . . . . . . . . . . . . . . 7,996,664 4,562,396 ------------ ------------ $447,455,052 442,068,600 ------------ ------------ ------------ ------------ Weighted average contractual interest rate. . . . . . . . . . . . . . . . . . . . . . . 7.21% 7.39% Commitments to originate, fund or purchase loans . . . . . . . . . . . . . . . . . . $ 24,419,071 7,367,650 Commitments to deliver loans to secondary market. . . . . . . . . . . . . . . . . 6,505,374 0 Loans serviced for others. . . . . . . . . . . . . . . . . . 72,275,868 8,218,564 - -------------------------------------------------------------------------------------------
Included in total commitments to originate or purchase loans are fixed rate loans aggregating approximately $3,504,094 and $6,010,250 as of December 31, 1998 and 1997, respectively. The interest rates on these commitments ranged from 6.25% to 7.00% at December 31, 1998 and from 6.678% to 7.5% at December 31, 1997. At December 31, 1998 and 1997, loans on nonaccrual status totaled $475,649 and $263,329, respectively. Had the loans performed in accordance with their original terms throughout 1998, HMN would have recorded gross interest income of $49,382 for these loans. Interest income of $28,618 has been recorded on these loans for the year ended December 31, 1998. At December 31, 1998 and 1997 there were no loans included in loans receivable, net with terms that had been modified in a troubled debt restructuring. There were no material commitments to lend additional funds to customers whose loans were classified as restructured or nonaccrual at December 31, 1998. At December 31, 1998, 1997 and 1996, the recorded investment in loans that are considered to be impaired were $788,382, $665,151 and $338,310, respectively, for which the related allowance for credit losses were $39,613, $34,762 and $17,571, respectively. The average investment in impaired loans during 1998, 1997 and 1996 were $714,331, $443,754 and $423,042, respectively. For the years ended December 31, 1998, 1997 and 1996, HMN recognized interest income on impaired loans of $35,936, $36,564 and $24,662, respectively. All of the interest income that was recognized during 1998, 1997 and 1996 for impaired loans was recognized using the cash basis method of income recognition. The aggregate amount of loans to executive officers and directors of HMN were $814,609, $884,244 and $385,023, at December 31, 1998, 1997 and 1996, respectively. During 1998 repayments on loans to executive officers and directors were $366,059, new loans to executive officers and directors totaled $561,057 and loans removed from the executive officer listing due to change in status of the officer was $264,633. During 1997 repayments on loans to executive officers and directors aggregated $30,679 and loans originated aggregated $529,900. At December 31, 1998, 1997 and 1996, HMN was servicing real estate loans for others with aggregate unpaid principal balances of approximately $72,275,868, $8,218,564 and $1,417,954, respectively. HMN originates residential, commercial real estate and other loans primarily in southern Minnesota and after December 5, 1997 in Iowa. HMN also purchases loans from a third party broker located in the Southeastern United States. At December 31, 1998 and 1997, HMN owned single family and multi-family residential loans located in the following states:
- ------------------------------------------------------------------------------------------- 1998 1997 ---------------------------- -------------------------- Percent Percent Amount of Total Amount of Total - ------------------------------------------------------------------------------------------- Alabama. . . . . . . . . . . . $ 7,790,445 2.1% 4,462,834 1.1% California . . . . . . . . . . 5,235,023 1.4 9,054,681 2.2 Connecticut. . . . . . . . . . 1,941,298 0.5 1,097,827 0.3 Florida. . . . . . . . . . . . 1,614,802 0.4 1,000,598 0.3 Georgia. . . . . . . . . . . . 52,951,799 13.9 46,309,887 11.5 Iowa . . . . . . . . . . . . . 30,555,584 8.0 49,705,322 12.3 Maine. . . . . . . . . . . . . 1,807,902 0.5 1,328,897 0.3 Massachusetts. . . . . . . . . 5,826,593 1.5 1,256,811 0.3 Minnesota. . . . . . . . . . . 221,860,535 58.3 233,002,052 57.9 North Carolina . . . . . . . . 18,727,395 4.9 11,819,254 2.9 Ohio . . . . . . . . . . . . . 5,413,417 1.4 8,477,956 2.1 South Carolina . . . . . . . . 9,930,680 2.6 8,314,943 2.1 Tennessee. . . . . . . . . . . 5,234,694 1.4 4,288,917 1.1 Wisconsin. . . . . . . . . . . 8,375,398 2.2 20,130,423 5.0 Other states . . . . . . . . . 3,407,876 0.9 2,434,405 0.6 ------------ ------ ----------- ------ Total. . . . . . . . . . . . $380,673,441 100.0% 402,684,807 100.0% ------------ ------ ----------- ------ ------------ ------ ----------- ------ Amounts under one million dollars are included in "Other states". - -------------------------------------------------------------------------------------------
38 NOTE 6 ALLOWANCE FOR LOAN AND REAL ESTATE LOSSES The allowance for losses is summarized as follows:
- ---------------------------------------------------------------------------------------------------------- Loans Real estate Total - ---------------------------------------------------------------------------------------------------------- Balance, December 31, 1995. . . . . . . . . . . . . . . . . $2,190,664 35,000 2,225,664 Provision for losses . . . . . . . . . . . . . . . . . . 300,000 2,000 302,000 Charge-offs . . . . . . . . . . . . . . . . . . . . . . (150,136) 0 (150,136) Recoveries . . . . . . . . . . . . . . . . . . . . . . . 57 0 57 Other . . . . . . . . . . . . . . . . . . . . . . . . . 0 (35,000) (35,000) ---------- ------- --------- Balance, December 31, 1996 . . . . . . . . . . . . . . . . 2,340,585 2,000 2,342,585 Provision for losses . . . . . . . . . . . . . . . . . . 300,000 18,000 318,000 MFC allowance for losses acquired. . . . . . . . . . . . 122,500 0 122,500 Charge-offs . . . . . . . . . . . . . . . . . . . . . . (22,691) (12,000) (34,691) Recoveries . . . . . . . . . . . . . . . . . . . . . . . 7,825 0 7,825 ---------- ------- --------- Balance, December 31, 1997 . . . . . . . . . . . . . . . . 2,748,219 8,000 2,756,219 Provision for losses . . . . . . . . . . . . . . . . . . 310,000 0 310,000 Charge-offs . . . . . . . . . . . . . . . . . . . . . . (18,599) 0 (18,599) Recoveries . . . . . . . . . . . . . . . . . . . . . . . 1,865 0 1,865 ---------- ------- --------- Balance, December 31, 1998 . . . . . . . . . . . . . . . . $3,041,485 8,000 3,049,485 ---------- ------- --------- ---------- ------- --------- - ----------------------------------------------------------------------------------------------------------
NOTE 7 ACCRUED INTEREST RECEIVABLE Accrued interest receivable at December 31 is summarized as follows:
- ------------------------------------------------------------------------------- 1998 1997 ------------------------ Securities available for sale. . . . . . . . . . . $1,167,903 1,549,173 Loans receivable . . . . . . . . . . . . . . . . . 2,784,860 2,488,958 ---------- ---------- $3,952,763 4,038,131 ---------- ---------- ---------- ---------- - --------------------------------------------------------------------------------
NOTE 8 INVESTMENT IN MORTGAGE SERVICING RIGHTS A summary of mortgage servicing activity is as follows:
- -------------------------------------------------------------------------------- 1998 1997 ------------------------- Mortgage servicing rights Balance, beginning of year . . . . . . . . . . $ 845,517 4,681 Originations . . . . . . . . . . . . . . . . . 654,871 36,261 Purchases. . . . . . . . . . . . . . . . . . . 458,702 844,601 Amortization . . . . . . . . . . . . . . . . . (841,897) (40,026) ---------- --------- Balance, end of year . . . . . . . . . . . . . 1,117,193 845,517 ---------- --------- Valuation reserve Balance, beginning of year . . . . . . . . . . (64,512) 0 Additions. . . . . . . . . . . . . . . . . . . (165,583) (64,512) Reductions . . . . . . . . . . . . . . . . . . 118,595 0 ---------- --------- Balance, end of year . . . . . . . . . . . . . (111,500) (64,512) ---------- --------- Mortgage servicing rights, net . . . . . . . . 1,005,693 781,005 ---------- --------- ---------- --------- Fair value of mortgage servicing rights . . . $1,005,693 781,005 ---------- --------- ---------- --------- - --------------------------------------------------------------------------------
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, 1998:
- ------------------------------------------------------------------------------------------------ Weighted Weighted Loan Average Average Number Principal Interest Remaining of Balance Rate Term Loans --------------------------------------------------------- Original term 30 year fixed rate . . . . . . . . . . . $37,600,000 7.55% 333 500 Original term 15 year fixed rate . . . . . . . . . . . 48,200,000 6.83% 157 870 Seven year balloon. . . . . . . . . 1,000,000 6.79% 351 9 Adjustable rate . . . . . . . . . . 31,500,000 7.01% 347 230 - ------------------------------------------------------------------------------------------------
NOTE 9 REAL ESTATE A summary of real estate at December 31 is as follows:
- -------------------------------------------------------------------------------- 1998 1997 ----------------------- Real estate in judgement subject to redemption . . . . . . . . . . . . . . . . $18,602 0 Real estate acquired through foreclosure . . . . 0 141,939 ------- ------- 18,602 141,939 Allowance for losses . . . . . . . . . . . . . . 8,000 8,000 ------- ------- $10,602 133,939 ------- ------- ------- ------- - --------------------------------------------------------------------------------
NOTE 10 INVESTMENT IN LIMITED PARTNERSHIPS Investments in limited partnerships at December 31 were as follows:
- -------------------------------------------------------------------------------- Primary partnership activity 1998 1997 1996 - -------------------------------------------------------------------------------- Mortgage servicing rights . . $1,622,519 5,065,682 2,887,525 Common stock of financial institutions . . 415,189 480,871 0 Low to moderate income housing . . . . . . 399,538 442,846 0 ---------- --------- --------- $2,437,246 5,989,399 2,887,525 ---------- --------- --------- ---------- --------- --------- - --------------------------------------------------------------------------------
During 1998 HMN's proportionate loss from the mortgage servicing partnership was $3,624,000, its proportionate share of losses from the common stock investments in financial institutions was $65,682 and its proportionate loss on low income housing was $35,028. During 1998 HMN received low income housing credits totaling $80,000 which were credited to current income tax benefits. During 1997 HMN's proportionate revenue from the mortgage servicing partnership was $239,407, its proportionate share of losses from common stock investments in financial institutions was $19,129 and it did not recognize any revenue or loss from low income housing. HMN received low income housing credits totaling $80,000 which were credited to current income tax benefits during 1997. During 1996 HMN's proportionate revenue from the mortgage servicing partnership was $7,400. NOTE 11 PREMISES AND EQUIPMENT A summary of premises and equipment at December 31 is as follows:
- -------------------------------------------------------------------------------- 1998 1997 -------------------------- Land . . . . . . . . . . . . . . . . . . . . . . . $ 1,200,610 1,175,169 Office buildings and improvements. . . . . . . . . 6,957,158 5,196,656 Furniture and equipment. . . . . . . . . . . . . . 4,413,715 2,735,835 ----------- ---------- 12,571,483 9,107,660 Less accumulated depreciation. . . . . . . . . . . 4,189,347 3,226,950 ----------- ---------- $ 8,382,136 5,880,710 ----------- ---------- ----------- ---------- - --------------------------------------------------------------------------------
39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 DEPOSITS Deposits and their weighted average interest rates at December 31 are summarized as follows:
- ----------------------------------------------------------------------------------------------------------------------------------- 1998 1997 -------------------------------------------- ------------------------------------------- Weighted Percent of Weighted Percent of average rate Amount total average rate Amount total - ----------------------------------------------------------------------------------------------------------------------------------- Noninterest checking . . . . . . . . . . 0.00% $13,187,109 3.0% 0.00% $ 3,832,736 0.8% NOW accounts . . . . . . . . . . . . . . 1.00 25,458,607 5.9 1.50 23,143,564 5.0 Passbooks. . . . . . . . . . . . . . . . 2.00 35,766,129 8.2 2.62 36,198,890 7.6 Money market accounts. . . . . . . . . . 3.19 29,419,000 6.8 3.34 24,807,554 5.3 ------------ ----- ------------ ----- 103,830,845 23.9 87,982,744 18.7 ------------ ----- ------------ ----- Certificates: 3-3.99%. . . . . . . . . . . . . . . . . 1,943,048 0.4 726,629 0.2 4-4.99%. . . . . . . . . . . . . . . . . 87,581,623 20.2 24,155,281 5.2 5-5.99%. . . . . . . . . . . . . . . . . 160,630,490 37.1 162,916,038 34.9 6-6.99%. . . . . . . . . . . . . . . . . 78,273,256 18.0 178,847,401 38.3 7-7.99%. . . . . . . . . . . . . . . . . 1,341,583 0.3 11,627,046 2.5 Over 8.00% . . . . . . . . . . . . . . . 268,062 0.1 1,092,549 0.2 ------------ ----- ------------ ----- Total certificates . . . . . . . . . . . 5.37 330,038,062 76.1 5.81 379,364,944 81.3 ------------ ----- ------------ ----- Total deposits . . . . . . . . . . . . . 4.52 $433,868,907 100.0% 5.17 $467,347,688 100.0% ------------ ----- ------------ ----- ------------ ----- ------------ ----- - -----------------------------------------------------------------------------------------------------------------------------------
At December 31, 1998 and 1997, HMN had $37,285,235 and $41,718,775, respectively, of certificate accounts with balances at $100,000 or more. Certificates had the following maturities at December 31:
- --------------------------------------------------------------------------------------------------------------- 1998 1997 ---------------------------- ----------------------------- Weighted Weighted Amount Average Amount Average REMAINING TERM TO MATURITY (in thousands) rate (in thousands) rate - --------------------------------------------------------------------------------------------------------------- 1-6 MONTHS . . . . . . . . . . . . . . . . . . . . $115,301 5.41% $121,295 5.69% 7-12 months. . . . . . . . . . . . . . . . . . . . 79,826 5.04 138,235 5.86 13-36 months . . . . . . . . . . . . . . . . . . . 111,314 5.50 98,515 5.87 Over 36 months . . . . . . . . . . . . . . . . . . 23,597 5.62 21,320 5.92 -------- -------- $330,038 5.37 $379,365 5.81 -------- -------- -------- -------- - ---------------------------------------------------------------------------------------------------------------
At December 31, 1998 mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $33,608,000 were pledged as collateral for certain deposits and $2,179,000 of letters of credit from the Federal Home Loan Bank (FHLB) were pledged as additional collateral on Bank deposits. Interest expense on deposits is summarized as follows for the years ended December 31:
- ------------------------------------------------------------------------------------------------ 1998 1997 1996 ------------------------------------------ NOW. . . . . . . . . . . . . . . . . . . . . . . . $ 283,143 257,261 323,311 Passbook . . . . . . . . . . . . . . . . . . . . . 816,656 762,923 760,083 Money market . . . . . . . . . . . . . . . . . . . 964,230 490,223 500,811 Certificates . . . . . . . . . . . . . . . . . . . 20,034,243 17,545,757 17,365,732 ----------- ---------- ---------- $22,098,272 19,056,164 18,949,937 ----------- ---------- ---------- ----------- ---------- ---------- - ------------------------------------------------------------------------------------------------
NOTE 13 FEDERAL HOME LOAN BANK ADVANCES Federal Home Loan Bank advances consisted of the following at December 31, 1998 and 1997:
- --------------------------------------------------------------------------------------------------------------- 1998 1997 ---------------------------- ---------------------------- YEAR OF MATURITY Amount Rate Amount Rate - --------------------------------------------------------------------------------------------------------------- 1998 . . . . . . . . . . . . . . . . . . . . . . . $ 43,250,021 5.85% 1999 . . . . . . . . . . . . . . . . . . . . . . . $15,000,000 4.99% 15,000,000 5.42 2000 . . . . . . . . . . . . . . . . . . . . . . . 30,000,000 5.71 24,000,000 5.97 2001 . . . . . . . . . . . . . . . . . . . . . . . 19,000,000 5.42 19,000,000 5.86 2002 . . . . . . . . . . . . . . . . . . . . . . . 16,000,000 5.61 16,000,000 5.61 2003 . . . . . . . . . . . . . . . . . . . . . . . 15,400,000 5.86 10,400,000 5.89 2008 . . . . . . . . . . . . . . . . . . . . . . . 90,000,000 5.40 0 0.00 ------------ ------------ $185,400,000 5.47 $127,650,021 5.80 ------------ ------------ ------------ ------------ - ---------------------------------------------------------------------------------------------------------------
40 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. Call provisions are not included in the above listed advances. All of the $19,000,000 maturing in 2001 could be called on a semiannual basis during 1999 and of the $90,000,000 maturing in 2008, $10,000,000 could be called on a quarterly basis starting in the third quarter of 2001 and $80,000,000 could be called on a quarterly basis starting in 2003. At December 31, 1997 the Bank had an undrawn open line of credit agreement for $5,000,000 from the FHLB. At December 31, 1998 the advances and $2,179,000 of letters of credit from the FHLB were collateralized by the Bank's FHLB stock and mortgage loans with unamortized principal balances of approximately $325,000,000. The Bank has the ability to draw additional borrowings of $60,000,000 based upon the mortgage loans that are currently pledged subject to a requirement to purchase FHLB stock. NOTE 14 OTHER BORROWED MONEY HMN has established a $2,500,000 revolving line of credit with Norwest Bank Minnesota, N.A. The line of credit matures September 15, 1999. The interest rate on the line floats with the Federal Funds Rate plus 250 basis points. The line is secured by 140,000 shares of 7.50% non-cumulative guaranteed trust preferred securities of ABN AMRO Capital Funding Trust 1 with a carrying value of $3,612,000. NOTE 15 INCOME TAXES Income tax expense for the years ended December 31 is as follows:
- ------------------------------------------------------------------------------------------------ 1998 1997 1996 ------------------------------------------ Current: Federal . . . . . . . . . . . . . . . . . . . . $2,737,150 2,425,591 1,838,158 State . . . . . . . . . . . . . . . . . . . . . 877,450 758,814 561,442 ---------- ---------- ---------- Total current . . . . . . . . . . . . . . . . 3,614,600 3,184,405 2,399,600 ---------- ---------- ---------- Deferred: Federal . . . . . . . . . . . . . . . . . . . . (1,267,000) 65,395 83,833 State . . . . . . . . . . . . . . . . . . . . . (348,600) 18,200 26,567 ---------- ---------- ---------- Total deferred . . . . . . . . . . . . . . . (1,615,600) 83,595 110,400 ---------- ---------- ---------- $1,999,000 3,268,000 2,510,000 ---------- ---------- ---------- ---------- ---------- ---------- - ------------------------------------------------------------------------------------------------
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:
- ----------------------------------------------------------------------------------------------------- 1998 1997 1996 ------------------------------------------ Federal expected income tax expense. . . . . . . . . . $2,059,300 3,007,934 2,306,677 Items affecting federal income tax: Dividend received deduction . . . . . . . . . . . . (354,700) (229,800) (128,100) State income taxes, net of federal income tax benefit 321,300 512,829 388,086 Low income housing credits. . . . . . . . . . . . . (80,000) (80,000) 0 Other, net. . . . . . . . . . . . . . . . . . . . . 53,100 57,037 (56,663) ---------- --------- --------- $1,999,000 3,268,000 2,510,000 ---------- --------- --------- ---------- --------- --------- - -----------------------------------------------------------------------------------------------------
The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31:
- ----------------------------------------------------------------------------------------------------- 1998 1997 -------------------------- Deferred tax assets: Allowances for loan and real estate losses. . . . . . . . . . . . . $1,220,900 1,096,900 Investment in limited partnership . . . . . . . . . . . . . . . . . 764,700 0 Discounts on assets and liabilities acquired from MFC . . . . . . . 138,800 343,400 Deferred loan fees. . . . . . . . . . . . . . . . . . . . . . . . . 0 185,900 Deferred compensation and pension costs . . . . . . . . . . . . . . 232,500 143,250 Restricted stock awards . . . . . . . . . . . . . . . . . . . . . . 36,100 46,400 Mortgage loan servicing rights. . . . . . . . . . . . . . . . . . . 0 20,800 Net unrealized loss on securities available for sale. . . . . . . . 521,400 0 ---------- ---------- Total gross deferred tax assets . . . . . . . . . . . . . . . . . 2,914,400 1,836,650 Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . 0 0 ---------- ---------- Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . 2,914,400 1,836,650 ---------- ---------- Deferred tax liabilities: Tax bad debt reserve over base year . . . . . . . . . . . . . . . . 1,272,000 1,540,600 Premium on assets acquired from MFC . . . . . . . . . . . . . . . . 577,100 1,341,600 Net unrealized gain on securities available for sale. . . . . . . . 0 793,000 FHLB stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463,100 463,100 Deferred loan fees and costs. . . . . . . . . . . . . . . . . . . . 277,300 334,500 Premises and equipment basis difference . . . . . . . . . . . . . . 242,100 333,817 Originated mortgage servicing rights. . . . . . . . . . . . . . . . 252,500 0 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,300 144,733 Unamortized discount on loan sale . . . . . . . . . . . . . . . . . 54,600 92,900 ---------- ---------- Total gross deferred tax liabilities. . . . . . . . . . . . . . . 3,192,000 5,044,250 ---------- ---------- Net deferred tax liabilities. . . . . . . . . . . . . . . . . . . $ (277,600) (3,207,600) ---------- ---------- ---------- ---------- - -----------------------------------------------------------------------------------------------------
41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Retained earnings at December 31, 1998 included approximately $8,800,000 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. NOTE 16 EMPLOYEE BENEFITS Substantially all full-time employees of the Bank, except the employees acquired in the MFC merger, are included in a trusteed noncontributory retirement plan sponsored by the Financial Institutions Retirement Fund. The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank's employees is not available because such information is not accumulated for each participating institution. No contributions were required in 1998, 1997 or 1996 because the retirement plan is fully funded. The Bank's policy is to fund retirement plan costs accrued and there are no unfunded past service costs. For the years ended December 31, 1998, 1997 and 1996 the amounts charged to operating expenses were $4,900, $5,700, and $5,100, respectively. HMN has a qualified, tax-exempt savings plan with a cash or deferred feature qualifying under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). All employees who have attained age 21 and completed one month of employment are eligible to participate provided they work at least 1,000 hours in each plan year. Participants are permitted to make salary reduction contributions to the 401(k) Plan of up to 12% of the participant's annual salary. Each participant's salary reduction is matched by HMN in an amount equal to 25% of the participant's salary reduction up to a maximum contribution of 8%. Contributions above 8% are not matched by HMN. Generally all participant and HMN contributions and earnings are fully and immediately vested. Effective January 1, 1997, for new employees HMN's contributions are vested on a five year cliff basis. HMN's matching contributions are expensed when made. HMN's contributions to the 401(k) Plan were $65,900, $47,800, and $41,804, in 1998, 1997 and 1996, respectively. During 1994 HMN adopted an Employee Stock Ownership Plan (the ESOP) which met 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 was empowered to borrow in order to finance purchases of the common stock of HMN. The ESOP borrowed $6,085,770 from HMN to purchase 912,866 shares of common stock in the initial public offering of HMN. In December of 1997 the Bank merged with Marshalltown Financial Corporation (MFC). As a result of the merger, in February 1998, 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 at 7.52%. HMN has committed to make quarterly contributions to the ESOP necessary to repay the loan including interest. HMN contributed $673,336, $689,636 and $713,656 to the ESOP, respectively, during 1998, 1997 and 1996. As the debt is repaid, ESOP shares which were initially pledged as collateral for its debt, are committed to be released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. HMN 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, HMN 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 $721,755, $885,208, and $634,702, respectively, for 1998, 1997 and 1996. 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:
- ------------------------------------------------------------------------------------------- 1998 1997 1996 --------------------------------------- Shares allocated to participants beginning of the year. . . . . . . . . . . 217,293 162,631 112,443 Shares allocated to participants. . . . . . . 42,312 57,639 59,644 Shares purchased with dividends from allocated shares. . . . . . . . . . . 800 0 0 Shares distributed to participants. . . . . . (13,684) (2,977) (9,456) --------- ---------- --------- Shares allocated to participants end of year. . . . . . . . . . . . . . . . 246,721 217,293 162,631 --------- ---------- --------- Unreleased shares beginning of the year. . . . . . . . . . . . . . . . 683,142 740,781 800,425 Shares purchased. . . . . . . . . . . . . . . 76,933 0 0 Shares released during year . . . . . . . . . (42,312) (57,639) (59,644) --------- ---------- --------- Unreleased shares end of year . . . . . . . . 717,763 683,142 740,781 --------- ---------- --------- Total ESOP shares end of year . . . . . . . . 964,484 900,435 903,412 --------- ---------- --------- --------- ---------- --------- Fair value of unreleased shares at December 31. . . . . . . . . . . 8,433,715 14,801,410 8,951,067 - -------------------------------------------------------------------------------------------
In June of 1995, HMN as part of a Recognition and Retention Plan (RRP) awarded 126,729 shares of restricted common stock to its officers and directors. The shares vest over a five year period and were issued from treasury stock. Compensation and benefit expense related to the RRP was $210,866, $231,600 and $231,048 for 1998, 1997 and 1996. In April 1997, 3,000 shares of restricted common stock were awarded to a director. Those shares vest over a five year period beginning in 1998. In June 1995, HMN adopted its only stock option plan, the 1995 Stock Option and Incentive Plan (the SOP). During 1995, options exercisable for 821,569 shares of HMN common stock were granted to certain officers and directors at an exercise price of $9.211 per share. The options vest over a five year period and may be exercised within 10 years of the grant date. In December 1996, options exercisable for 1,500 shares of common stock were granted to officers at an exercise price of $12.089. In April 1997, options for 18,000 shares of common stock were granted to a director at an exercise price of $13.007. 42 No options were granted during 1998. The fair value of the options granted were $6.08, $5.55 and $4.49 for 1997, 1996 and 1995, respectively. A summary of stock option activity under the SOP is detailed as follows:
- --------------------------------------------------------------------------------------------------------- Weighted Options average available for Options exercise grant outstanding price ----------------------------------------------------- December 31, 1994. . . . . . . . . . . . . . . . . 0 0 Plan adopted . . . . . . . . . . . . . . . . . . . 912,865 Granted June 21, 1995. . . . . . . . . . . . . . . (821,569) 821,569 $ 9.211 ------- ------- December 31, 1995. . . . . . . . . . . . . . . . . 91,296 821,569 9.211 Exercised. . . . . . . . . . . . . . . . . . . . . (7,048) 9.211 Forfeited. . . . . . . . . . . . . . . . . . . . . 18,258 (18,258) 9.211 Granted December 11, 1996. . . . . . . . . . . . . (1,500) 1,500 12.089 ------- ------- December 31, 1996. . . . . . . . . . . . . . . . . 108,054 797,763 9.217 Granted April 22, 1997 . . . . . . . . . . . . . . (18,000) 18,000 13.007 Exercised. . . . . . . . . . . . . . . . . . . . . (13,563) 9.211 ------- ------- December 31, 1997. . . . . . . . . . . . . . . . . 90,054 802,200 9.302 Exercised. . . . . . . . . . . . . . . . . . . . . (53,209) 9.211 Forfeited. . . . . . . . . . . . . . . . . . . . . 21,745 (21,745) 9.310 ------- ------- December 31, 1998. . . . . . . . . . . . . . . . . 111,799 727,246 9.308 ------- ------- ------- ------- - ---------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options outstanding at December 31, 1998:
- ---------------------------------------------- ------------------------- Options Outstanding Options Exercisable - ------------------------------------------------------------------------- Weighted average Exercise Number remaining contractual price outstanding life in years Number Price - ------------------------------------------------------------------------- $ 9.211 708,496 6.4 409,994 $ 9.211 12.089 750 7.9 300 12.089 13.007 18,000 8.3 3,600 13.007 ------- 727,246 ------- ------- - -------------------------------------------------------------------------
HMN uses the intrinsic value method as described in APB Opinion No. 25 and related interpretations to account for its stock incentive plans. Accordingly, no compensation cost has been recognized for the option plan. Proceeds from stock options exercised are credited to common stock and additional paid-in capital. There are 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. Had compensation cost for HMN's stock-based plan been determined in accordance with the fair value method recommended by SFAS No. 123, HMN's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
- ---------------------------------------------------------------------------- 1998 1997 1996 --------------------------------------------- Net income: As reported ........... $4,057,680 5,578,866 4,274,349 Pro forma ............. 3,610,055 4,839,907 3,085,217 Earnings per common share: As reported: Basic ............... $ 0.82 1.01 0.66 Diluted ............. 0.77 0.94 0.64 Pro forma: Basic ............... 0.73 0.88 0.48 Diluted ............. 0.68 0.82 0.46 - ----------------------------------------------------------------------------
The above disclosed pro forma effects of applying SFAS No. 123 to compensation costs, may not be representative of the effects on reported pro forma net income for future years. The fair value for each option grant for the SOP is estimated on the date of the grant using the Option Designer Model. The model incorporated the following assumptions for each year of grant:
- --------------------------------------------------------------- 1997 1996 1995 ------------------------------ Risk-free interest rate... 6.80% 6.21% 6.28% Expected life ............ 10 years 10 years 10 years Expected volatility ...... 18.00% 18.00% 20.00% Expected dividends ....... None None None - ---------------------------------------------------------------
NOTE 17 EARNINGS PER SHARE The following table reconciles the weighted average shares outstanding and the income available to common shareholders used for basic and diluted EPS:
- ------------------------------------------------------------------------------ Year Ended December 31, ------------------------------------ 1998 1997 1996 ------------------------------------ Weighted average number of common shares outstanding used in basic earnings per common share calculation . . . . . . . 4,923,392 5,525,033 6,473,115 Net dilutive effect of: Options. . . . . . . . . . . . . . . . 323,593 314,082 82,257 Restricted stock awards. . . . . . . . 51,141 76,151 100,505 --------- --------- --------- Weighted average number of shares outstanding adjusted for effect of dilutive securities. . . . . 5,298,126 5,915,266 6,655,877 --------- --------- --------- --------- --------- --------- Income available to common shareholders . . . . . . . . . . . . . $4,057,680 5,578,866 4,274,349 Basic earnings per common share . . . . . . . . . . . . . $ 0.82 1.01 0.66 Diluted earnings per common share . . . . . . . . . . . . . $ 0.77 0.94 0.64 - ------------------------------------------------------------------------------
NOTE 18 SAIF ASSESSMENT The Deposit Insurance Fund Act of 1996 (DIFA) was enacted on September 30, 1996. DIFA addressed the inadequate funding of the Savings Association Insurance Fund (SAIF). In order to recapitalize the SAIF, DIFA imposed a one-time assessment on all thrift institutions. The Bank's assessment was a pretax charge of $2,351,563 and was recognized in the third quarter of 1996. 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 19 STOCKHOLDERS' EQUITY HMN was incorporated for the purpose of becoming the savings and loan holding company of the Bank in connection with the Bank's conversion from a federally chartered mutual savings bank to a federally chartered stock savings bank, pursuant to a Plan of Conversion adopted on February 10, 1994. HMN commenced on May 23, 1994, a Subscription and Community Offering of its shares in connection with the conversion of the Bank (the Offering). The Offering was closed on June 22, 1994, and the conversion was consummated on June 29, 1994, with the issuance of 9,128,662 shares of HMN's common stock at a price of $6.67 per share. Total proceeds from the conversion of $59,178,342 net of costs relating to the conversion of $1,679,408, have been recorded as common stock and additional paid-in capital. HMN received all of the capital stock of the Bank in exchange for 50% of the net proceeds of the conversion. Starting in 1995 and continuing throughout 1998, HMN has been repurchasing its own common stock in the open market. HMN purchased 960,800 shares during 1998, 298,334 shares during 1997 and 869,785 shares during 1996 for $17,122,788, $5,988,450, and $14,364,754, respectively. The shares were placed in treasury stock. Refer to Note 1 for disclosure of the stock split which occurred during the second quarter of 1998. During 1998 HMN declared and paid dividends as follows:
RECORD DATE PAYABLE DATE DIVIDEND PER SHARE ----------- ------------ ------------------ May 27, 1998 June 12, 1998 $0.06 August 27, 1998 September 10, 1998 $0.06 December 1, 1998 December 15, 1998 $0.06
On February 2, 1999 HMN declared a cash dividend of $0.08 per share payable on March 10, 1999 to holders of record on February 24, 1999. HMN's certificate of incorporation authorized 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 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 liquidation account of MFC was absorbed by the Bank as a result of the acquisition. The Bank may not declare or pay a cash dividend to HMN in excess of 100% of its net income to date during the current calendar year plus the amount that would reduce by one-half the Bank's surplus capital ratio at the beginning of the calendar year without prior notice to the OTS. 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 20 FEDERAL HOME LOAN BANK INVESTMENT, REGULATORY LIQUIDITY 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 is carried at cost, in the Federal Home Loan Bank of Des Moines. In addition, the Bank is required to maintain cash and other liquid assets in an amount equal to 4% of its deposit accounts and other obligations due within one year. The Bank has met these requirements as of December 31, 1998. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HMN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. 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 Tangible, Core, and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of December 31, 1998, that the Bank meets all capital adequacy requirements to which it is subject. Management believes that based upon the Bank's capital calculations at December 31, 1998 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized. 44 At December 31, 1998 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 (IN THOUSANDS) Amount Assets (1) Amount Assets (1) Amount Assets (1) Amount Assets (1) - ---------------------------------------------------------------------------------------------------------------------------------- Bank stockholder's equity ......... $47,997 Plus: Net unrealized loss on certain securities available for sale ........... 652 Less: Goodwill and other intangibles . 5,600 Excess mortgage servicing rights 264 ------ Tier I or core capital ............ 42,785 ------ Tier I capital to adjusted total assets ........ 6.40% $26,735 4.00% $16,050 2.40% $33,419 5.00% Tier I capital to risk-weighted assets ........... 12.86% 13,305 4.00% 29,480 8.86% 19,958 6.00% Less: Equity investments and other assets required to be deducted . 22 Plus: Allowable allowance for loan losses 3,041 ------ Risk-based capital ................ $45,804 $26,610 $19,194 $33,263 ------ ------ Risk-based capital to risk-weighted assets ........... 13.77% 8.00% 5.77% 10.00% (1) Based upon the Bank's adjusted total assets for the purpose of the tangible and core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio. - ----------------------------------------------------------------------------------------------------------------------------------
NOTE 21 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Bank 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 Bank. The Bank'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 Bank uses the same credit policies in making commitments as it does for on-balance sheet instruments.
- ---------------------------------------------------------------------- Contract amount -------------------- (IN THOUSANDS) 1998 1997 - ---------------------------------------------------------------------- Financial instruments whose contract amount represents credit risk: Commitments to extend credit ............. $54,145 53,681 Commitment of counter party to purchase loans .................... 6,505 2,201 Financial instruments whose contract amount represents interest rate risk: Commitment to purchase limited partnership interest in mortgage loan servicing rights 0 181 - ----------------------------------------------------------------------
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 real estate and personal property. Commitments of counter party to purchase loans represents commitments to sell loans to FNMA and are entered into in the normal course of business by the Bank. NOTE 22 FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS, requires disclosure of estimated fair values of HMN'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, 1998, and 1997 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 HMN'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. 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The estimated fair value of HMN'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, --------------------------------------------------------------------------- 1998 1997 ----------------------------------- ----------------------------------- Carrying Estimated Contract Carrying Estimated Contract (IN THOUSANDS) amount fair value amount amount fair value amount - --------------------------------------------------------------------------------------------------------------------------- Financial assets: Cash and cash equivalents . . . . . . . . . $ 20,961 20,961 9,365 9,365 Securities available for sale . . . . . . . 181,625 181,625 205,859 205,859 Loans held for sale . . . . . . . . . . . . 13,095 13,101 2,287 2,287 Loans receivable, net . . . . . . . . . . . 447,455 470,413 442,069 456,012 Federal Home Loan Bank stock. . . . . . . . 9,838 9,838 7,432 7,432 Accrued interest receivable . . . . . . . . 3,953 3,953 4,038 4,038 Financial liabilities: Deposits. . . . . . . . . . . . . . . . . . 433,869 433,566 467,348 464,670 Federal Home Loan Bank advances . . . . . . 185,400 189,749 127,650 127,147 Other borrowed money. . . . . . . . . . . . 2,500 2,505 0 0 Accrued interest payable. . . . . . . . . . 1,086 1,086 1,365 1,365 Off-balance sheet financial instruments: Commitments to extend credit. . . . . . . . 0 50 55,997 0 50 53,681 - ---------------------------------------------------------------------------------------------------------------------------
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 are based upon quoted market prices. LOANS HELD FOR SALE The fair value 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 HMN as of December 31, 1998 and 1997 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 HMN'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. ACCRUED INTEREST PAYABLE The carrying amount of accrued interest payable approximates its fair value since it is short-term in nature. FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWED MONEY The fair values of advances and other borrowed money with fixed maturities are estimated based on discounted cash flow analysis using as discount rates the interest rates charged by the FHLB or Norwest Bank Minnesota, N.A. at December 31, 1998 and 1997 for borrowings of similar remaining maturities. COMMITMENTS TO EXTEND CREDIT The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties. 46 NOTE 23 HMN FINANCIAL, INC. FINANCIAL INFORMATION (PARENT COMPANY ONLY) The parent company's principal assets are its investment in the Bank and securities. The following are the condensed financial statements for the parent company only as of December 31, 1998 and 1997 and for the years ended December 31, 1998, 1997 and 1996.
1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------------- Condensed Balance Sheets Assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . $ 23,167 944,925 Securities available for sale . . . . . . . . . . . . . . . . . . . . . . 7,974,562 14,287,978 Loans receivable from subsidiaries. . . . . . . . . . . . . . . . . . . . 12,434,632 7,050,570 Investment in subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . 50,091,852 62,278,302 Investment in limited partnership . . . . . . . . . . . . . . . . . . . . 415,189 480,871 Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . 344,915 67,883 Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . 711,094 11,615 ---------- ---------- Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $71,995,411 85,122,144 ---------- ---------- ---------- ---------- Liabilities and Stockholders' Equity Other borrowed money. . . . . . . . . . . . . . . . . . . . . . . . . . . $3,525,000 0 Accrued expenses and other liabilities. . . . . . . . . . . . . . . . . . 25,072 651,734 ---------- ---------- Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,550,072 651,734 ---------- ---------- Serial preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,287 91,287 Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . 59,739,020 59,698,661 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,424,378 60,224,253 Accumulated other comprehensive income (loss) . . . . . . . . . . . . . . (837,838) 1,129,818 Unearned employee stock option plan shares. . . . . . . . . . . . . . . . (5,705,152) (4,554,280) Unearned compensation restricted stock awards . . . . . . . . . . . . . . (276,867) (600,668) Treasury stock, at cost, 1,941,407 and 1,651,615 shares . . . . . . . . . (47,989,489) (31,518,661) ---------- ---------- Total stockholders' equity. . . . . . . . . . . . . . . . . . . . . . . 68,445,339 84,470,410 ---------- ---------- Total liabilities and stockholders' equity. . . . . . . . . . . . . . . $71,995,411 85,122,144 ---------- ---------- ---------- ---------- Condensed Statements of Income Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,342,134 1,071,818 1,105,218 Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (57,475) (13,515) (4,943) Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . 1,622,607 644,278 229,002 Equity in earnings of subsidiaries. . . . . . . . . . . . . . . . . . . . 2,586,843 4,512,080 3,565,441 Equity in losses of limited partnership . . . . . . . . . . . . . . . . . (65,682) (19,129) 0 Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . (24,256) (17,494) (17,233) Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000) (6,604) (6,868) Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (190) (159) (670) Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,383) (1,355) (1,271) Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (617,118) (477,030) (475,127) ---------- ---------- ---------- Income before income tax expense. . . . . . . . . . . . . . . . . . . . 4,779,480 5,692,890 4,393,549 Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . 721,800 114,024 119,200 ---------- ---------- ---------- Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349 ---------- ---------- ---------- Condensed Statements of Cash Flows Cash flows from operating activities: Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349 Adjustments to reconcile net income to cash provided by operating activities: Equity in earnings of subsidiaries . . . . . . . . . . . . . . . . . . (2,586,843) (4,512,080) (3,565,441) Equity in earnings of limited partnership. . . . . . . . . . . . . . . 65,682 19,129 0 Amortization of premiums (discounts), net. . . . . . . . . . . . . . . (56,038) (349) 9,727 Securities gains, net. . . . . . . . . . . . . . . . . . . . . . . . . (1,622,607) (644,278) (229,002) Provision for deferred income taxes. . . . . . . . . . . . . . . . . . (4,200) (800) (1,400) Earned employee stock ownership shares priced above original cost. . . 235,989 298,237 141,135 Decrease in restricted stock awards. . . . . . . . . . . . . . . . . . 210,866 231,621 231,048 Decrease in unearned ESOP shares . . . . . . . . . . . . . . . . . . . 325,128 384,240 397,630 (Increase) decrease in accrued interest receivable . . . . . . . . . . (277,032) 148,076 (63,071) Increase (decrease) in accrued expenses and other liabilities. . . . . 4,489 (165,370) 172,831 Decrease (increase) in other assets. . . . . . . . . . . . . . . . . . (699,479) 6,335 143,321 Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,957 65,035 9,737 ---------- ---------- ---------- Net cash provided (used) by operating activities . . . . . . . . . (211,408) 1,408,662 1,520,864 ---------- ---------- ---------- Cash flows from investing activities: Proceeds from sales of securities available for sale. . . . . . . . . . 21,650,412 9,384,529 5,412,430 Principal collected on securities available for sale. . . . . . . . . . 0 0 5,027,241 Proceeds collected on maturity of securities available for sale . . . . 8,574,876 4,018,412 1,500,000 Purchases of securities available for sale. . . . . . . . . . . . . . . (23,800,742) (15,900,938) (5,449,176) Investment in Home Federal Savings Bank . . . . . . . . . . . . . . . . 0 (1,016,063) 0 Investment in HMN Mortgage Services, Inc. . . . . . . . . . . . . . . . (1,253,800) (844,500) (250,000) Investment in limited partnership . . . . . . . . . . . . . . . . . . . 0 (500,000) 0 Net increase (decrease) in loans receivable from subsidiaries . . . . . (5,384,062) 283,430 (7,334,000) ---------- ---------- ---------- Net cash used by investing activities. . . . . . . . . . . . . . . (213,316) (4,575,130) (1,093,505) ---------- ---------- ---------- Cash flows from financing activities: Purchase of treasury stock. . . . . . . . . . . . . . . . . . . . . . . (17,122,788) (6,350,950) (14,002,254) Increase in unearned ESOP shares. . . . . . . . . . . . . . . . . . . . (1,476,000) 0 0 Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . 436,025 56,745 52,363 Dividends to stockholders . . . . . . . . . . . . . . . . . . . . . . . (857,555) 0 0 Fractional shares purchased from stock split. . . . . . . . . . . . . . (1,716) 0 0 Increase in other borrowed money. . . . . . . . . . . . . . . . . . . . 3,525,000 0 0 Proceeds from dividends on Bank stock . . . . . . . . . . . . . . . . . 15,000,000 6,750,000 15,600,000 ---------- ---------- ---------- Net cash provided (used) by financing activities . . . . . . . . . (497,034) 455,795 1,650,109 ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents . . . . . . . . . (921,758) (2,710,673) 2,077,468 Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . 944,925 3,655,598 1,578,130 ---------- ---------- ---------- Cash and cash equivalents, end of year. . . . . . . . . . . . . . . . . . $ 23,167 944,925 3,655,598 ---------- ---------- ---------- ---------- ---------- ----------
47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 24 BUSINESS SEGMENTS HMN's wholly owned subsidiaries, Home Federal Savings Bank, and Mortgage Services, Inc. have been identified as reportable operating segments in accordance with the provisions of SFAS 131. MSI was deemed to be a segment because it is a separate corporation which operates independently from the Bank and it is not regulated by the Office of Thrift Supervision. MSI has been segmented further into Mortgage Servicing Rights and Mortgage Banking activities. The mortgage servicing segment owns servicing rights on loans which have either been sold to FNMA or securitized into mortgage-backed instruments which were issued by FNMA. MSI receives a servicing fee which is based upon the outstanding balance of the loan being serviced and pays a subservicer a monthly fee to service the loan. MSI's mortgage banking activity includes an origination function and it also purchases loans from other loan originators. All loans acquired either by origination or by purchase are intended to be resold in the secondary loan market. Security Finance Corporation and HMN, the holding company, did not meet the quantitative thresholds for determining reportable segments and therefore are included in the "Other" category. HMN evaluates performance and allocates resources based on the segment's net income or loss, return on average assets and return on average equity. The segments follow generally accepted accounting principles as described in the summary of significant accounting policies. Each corporation is managed separately with its own president, who reports directly to HMN's chief operating decision maker, and board of directors. The following table sets forth certain information about the reconciliations of reported profit or loss and assets for each of HMN's reportable segments.
- ----------------------------------------------------------------------------------------------------------------------------------- HMN Mortgage Services, Inc. --------------------------- Mortgage Total Home Federal Servicing Mortgage Reportable Consolidated (DOLLARS IN THOUSANDS) Savings Bank Rights Banking Segments Other Eliminations Total - ----------------------------------------------------------------------------------------------------------------------------------- AT OR FOR THE YEAR ENDED DECEMBER 31, 1998: Interest income -- external customers. . $47,231 0 296 47,527 1,268 0 48,795 Non-interest income -- external customers 3,858 265 953 5,076 1,279 0 6,355 Earnings (loss) on limited partnerships. (3,725) 0 0 (3,725) 0 0 (3,725) Intersegment interest income . . . . . . 46 0 0 46 602 (648) 0 Intersegment non-interest income . . . . 0 0 0 0 2,779 (2,779) 0 Interest expense . . . . . . . . . . . . 31,887 0 307 32,194 352 (648) 31,898 Amortization of mortgage servicing rights and net valuation adjustments. . . . . 56 833 0 889 0 0 889 Other non-interest expense . . . . . . . 10,707 57 1,157 11,921 656 (306) 12,271 Income tax expense (benefit) . . . . . . 1,516 (251) (87) 1,178 821 0 1,999 Net income (loss). . . . . . . . . . . . 2,942 (374) (128) 2,440 4,204 (2,586) 4,058 Total assets . . . . . . . . . . . . . . 672,870 371 11,710 684,951 75,053 (65,346) 694,658 Net interest margin. . . . . . . . . . . 2.33% NM NM NM NM NM 2.47% Return on average assets . . . . . . . . 0.43 (64.93)% (2.31)% NM NM NM 0.57 Return on average realized common equity 5.78 (64.93) (13.54) NM NM NM 5.38 AT OR FOR THE YEAR ENDED DECEMBER 31, 1997: Interest income -- external customers. . $39,957 0 9 39,966 1,124 0 41,090 Non-interest income -- external customers 1,797 0 97 1,894 608 0 2,502 Earnings (loss) on limited partnerships. 220 0 0 220 0 0 220 Intersegment interest income . . . . . . 0 0 0 0 344 (344) 0 Intersegment non-interest income . . . . 0 0 0 0 5,137 (5,137) 0 Interest expense . . . . . . . . . . . . 25,720 0 8 25,728 259 (344) 25,643 Amortization of mortgage servicing rights 105 0 0 105 0 0 105 Other non-interest expense . . . . . . . 7,739 0 689 8,428 510 (20) 8,918 Income tax expense (benefit) . . . . . . 3,336 0 (241) 3,095 173 0 3,268 Net income (loss). . . . . . . . . . . . 4,775 0 (350) 4,425 5,666 (4,512) 5,579 Total assets . . . . . . . . . . . . . . 667,521 781 2,234 670,536 90,839 (70,143) 691,232 Net interest margin. . . . . . . . . . . 2.64% NM NM NM NM NM 2.77% Return on average assets . . . . . . . . 0.86 NM (96.38)% NM NM NM 0.98 Return on average realized common equity 7.72 NM (146.84) NM NM NM 6.84 AT OR FOR THE YEAR ENDED DECEMBER 31, 1996: Interest income -- external customers. . $38,788 4 38,792 1,072 0 39,864 Non-interest income -- external customers 1,705 0 1,705 218 0 1,923 Intersegment interest income . . . . . . 0 0 0 96 (96) 0 Intersegment non-interest income . . . . 0 0 0 3,577 (3,577) 0 Interest expense . . . . . . . . . . . . 24,259 0 24,259 31 (96) 24,194 Other non-interest expense . . . . . . . 9,942 70 10,012 508 12 10,532 Income tax expense (benefit) . . . . . . 2,406 (27) 2,379 131 0 2,510 Net income (loss). . . . . . . . . . . . 3,587 (40) 3,547 4,292 (3,565) 4,274 Total assets . . . . . . . . . . . . . . 537,870 211 538,081 85,648 (68,997) 554,732 Net interest margin. . . . . . . . . . . 2.77% NM NM NM NM 2.89% Return on average assets . . . . . . . . 0.67 (52.08)% NM NM NM 0.78 Return on average realized common equity 5.28 (52.11) NM NM NM 4.82
NM - Not meaningful 48 INDEPENDENT AUDITOR'S REPORT [LOGO] THE BOARD OF DIRECTORS HMN FINANCIAL, INC. SPRING VALLEY, MINNESOTA: We have audited the accompanying consolidated balance sheets of HMN Financial, Inc. and Subsidiaries (the Company) as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. 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 generally accepted auditing standards. 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 at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick LLP MINNEAPOLIS, MINNESOTA FEBRUARY 26, 1999 49 SELECTED QUARTERLY FINANCIAL DATA
December 31, September 30, June 30, (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1998 1998 - -------------------------------------------------------------------------------------------------------- Selected Operations Data (3 MONTHS ENDED): Interest income ........................................ $ 11,951 12,297 12,446 Interest expense ....................................... 7,695 8,239 8,176 --------- --------- --------- Net interest income ............................... 4,256 4,058 4,270 Provision for loan losses .............................. 75 85 75 --------- --------- --------- Net interest income after provision for loan losses 4,181 3,973 4,195 --------- --------- --------- Noninterest income: Fees and service charges .......................... 170 194 258 Securities gains (losses), net .................... 817 348 738 Gain on sales of loans ............................ 940 519 352 Earnings (loss) in limited partnerships ........... (111) (2,676) (2,090) Other noninterest income .......................... 120 128 161 --------- --------- --------- Total noninterest income ........................ 1,936 (1,487) (581) --------- --------- --------- Noninterest expense: Compensation and benefits ......................... 1,490 1,582 1,880 Occupancy ......................................... 358 361 358 Federal deposit insurance premiums ................ 66 73 73 Advertising ....................................... 91 124 136 Data processing ................................... 169 167 165 Amortization of mortgage servicing rights and net valuation adjustments ....................... 299 257 219 Other noninterest expense ......................... 813 613 612 --------- --------- --------- Total noninterest expense ....................... 3,286 3,177 3,443 --------- --------- --------- Income before income tax expense .................. 2,831 (691) 171 Income tax expense ..................................... 786 (257) 66 --------- --------- --------- Net income ........................................ $ 2,045 (434) 105 --------- --------- --------- --------- --------- --------- Basic earnings per share ............................... $ 0.45 (0.09) 0.02 --------- --------- --------- --------- --------- --------- Diluted earnings per share ............................. $ 0.42 (0.09) 0.02 --------- --------- --------- --------- --------- --------- Financial Ratios: Return on average assets(1) ............................ 1.17% (0.24) 0.44 Return on average equity(1) ............................ 11.74 (2.46) 4.03 Average equity to average assets ....................... 10.63 10.86 11.42 Dividend payout ratio .................................. 21.62 (66.67) 42.86 Net interest margin(1)(2) .............................. 2.50 2.35 2.47 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------------------------------- Selected Financial Condition Data: Total assets ........................................... $ 694,658 706,269 724,080 Securities available for sale: Mortgage-backed and related securities ............ 143,146 137,316 141,835 Other marketable securities ....................... 38,479 56,326 69,534 Loans held for sale .................................... 13,095 6,882 8,091 Loans receivable, net .................................. 447,455 466,471 459,865 Deposits ............................................... 433,869 446,333 467,133 Federal Home Loan Bank advances ........................ 185,400 184,579 177,936 Stockholders' equity ................................... 68,445 68,093 70,118 - -------------------------------------------------------------------------------------------------------- 50 March 31, December 31, September 30, June 30, March 31, (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1997 1997 1997 - ------------------------------------------------------------------------------------------------------------------------------ Selected Operations Data (3 MONTHS ENDED): Interest income ........................................ 12,101 10,706 10,315 10,166 9,903 Interest expense ....................................... 7,788 6,857 6,465 6,297 6,024 --------- --------- --------- --------- --------- Net interest income ............................... 4,313 3,849 3,850 3,869 3,879 Provision for loan losses .............................. 75 75 75 75 75 --------- --------- --------- --------- --------- Net interest income after provision for loan losses 4,238 3,774 3,775 3,794 3,804 --------- --------- --------- --------- --------- Noninterest income: Fees and service charges .......................... 202 169 122 100 96 Securities gains (losses), net .................... 896 377 488 114 271 Gain on sales of loans ............................ 366 135 117 64 153 Earnings (loss) in limited partnerships ........... 52 0 67 39 73 Other noninterest income .......................... 146 59 85 88 105 --------- --------- --------- --------- --------- Total noninterest income ........................ 1,662 740 879 405 698 --------- --------- --------- --------- --------- Noninterest expense: Compensation and benefits ......................... 1,852 1,484 1,432 1,359 1,316 Occupancy ......................................... 365 264 245 232 241 Federal deposit insurance premiums ................ 74 63 58 59 59 Advertising ....................................... 93 101 63 73 78 Data processing ................................... 174 137 129 119 125 Amortization of mortgage servicing rights and net valuation adjustments ....................... 105 102 3 0 0 Other noninterest expense ......................... 591 401 299 284 296 --------- --------- --------- --------- --------- Total noninterest expense ....................... 3,254 2,552 2,229 2,126 2,115 --------- --------- --------- --------- --------- Income before income tax expense .................. 2,646 1,962 2,425 2,073 2,387 Income tax expense ..................................... 983 714 901 740 913 --------- --------- --------- --------- --------- Net income ........................................ 1,663 1,248 1,524 1,333 1,474 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Basic earnings per share ............................... 0.31 0.23 0.28 0.24 0.27 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Diluted earnings per share ............................. 0.28 0.21 0.26 0.23 0.25 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Financial Ratios: Return on average assets(1) ............................ 0.96 0.84 1.06 0.95 1.09 Return on average equity(1) ............................ 7.98 6.09 7.29 6.58 7.43 Average equity to average assets ....................... 12.04 14.36 14.55 14.55 14.65 Dividend payout ratio .................................. 21.43 0.00 0.00 0.00 0.00 Net interest margin(1)(2) .............................. 2.59 2.60 2.76 2.83 2.92 (DOLLARS IN THOUSANDS) - --------------------------------------------------------------------------------------------------------------------------------- Selected Financial Condition Data: Total assets ........................................... 732,118 691,232 568,847 566,865 553,021 Securities available for sale: Mortgage-backed and related securities ............ 137,474 135,936 111,117 115,016 123,925 Other marketable securities ....................... 81,648 69,923 72,815 73,860 56,224 Loans held for sale .................................... 8,318 2,287 2,090 1,205 1,061 Loans receivable, net .................................. 450,210 442,069 352,925 345,516 341,104 Deposits ............................................... 466,998 467,348 366,682 365,385 364,123 Federal Home Loan Bank advances ........................ 167,293 127,650 112,007 114,364 105,721 Stockholders' equity ................................... 84,954 84,470 84,619 81,798 78,772 - ---------------------------------------------------------------------------------------------------------------------------------
(1) Annualized (2) Net interest income divided by average interest-earning assets. 51 OTHER FINANCIAL DATA The following table sets forth the maximum month-end balance and average balance of FHLB advances.
- ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, ----------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------------ Maximum Balance: Federal Home Loan Bank advances ............................................ $194,579 128,007 106,436 Federal Home Loan Bank short-term borrowings................................ 46,893 60,429 64,429 Average Balance: Federal Home Loan Bank advances ............................................ 172,232 112,500 89,656 Federal Home Loan Bank short-term borrowings................................ 32,145 45,598 47,949 - ------------------------------------------------------------------------------------------------------------------------
The following table sets forth certain information as to the Bank's FHLB advances.
- --------------------------------------------------------------------------------------------------------------------------- December 31, ------------------------------------------------------------------- 1998 1997 1996 -------------------- -------------------- ------------------- Weighted Weighted Weighted Average Average Average (DOLLARS IN THOUSANDS) Amount Rate Amount Rate Amount Rate - --------------------------------------------------------------------------------------------------------------------------- Federal Home Loan Bank short-term borrowings.......... $ 15,000 4.99% 43,250 5.85% 46,429 5.52% Other Federal Home Loan Bank long-term advances....... 170,400 5.51 84,400 5.77 59,650 5.74 ------- ------- ------- Total.............................................. $185,400 5.47 127,650 5.80 106,079 5.64 ------- ------- ------- ------- ------- ------- - ---------------------------------------------------------------------------------------------------------------------------
Refer to Note 13 of the Notes to Consolidated Financial Statements for more information on the Bank's FHLB advances. COMMON STOCK INFORMATION The common stock of HMN Financial, Inc. is listed on the Nasdaq Stock Market under the symbol: HMNF. The common stock outstanding is 9,128,662 shares of which 3,835,058 shares are in treasury stock at December 31, 1998. As of December 31, 1998 there are 851 stockholders of record and 1,150 estimated beneficial stockholders. The following table represents the stock price information for HMN Financial, Inc. as furnished by Nasdaq for each quarter starting in 1995 through December 31, 1998.
- ---------------------------------------------------------------------------------------------------------------- March 31, June 30, Sept. 29, Dec. 29, March 29, June 28, Sept. 30, Dec. 31, 1995 1995 1995 1995 1996 1996 1996 1996 ----------------------------------------------------------------------------------------------------- HIGH.... $9.00 9.33 10.42 10.83 10.75 11.00 11.00 12.42 LOW..... 7.17 8.33 9.08 9.92 9.67 9.75 10.08 10.67 CLOSE... 8.50 9.08 10.17 10.67 9.75 11.00 10.67 12.08 - ---------------------------------------------------------------------------------------------------------------- March 31, June 30, Sept. 30, Dec. 31, March 31, June 30, Sept. 30, Dec. 31, 1997 1997 1997 1997 1998 1998 1998 1998 ----------------------------------------------------------------------------------------------------- HIGH.... $16.50 16.25 17.33 21.67 21.33 20.67 16.06 14.75 LOW..... 12.00 12.42 14.58 16.17 17.50 15.50 13.25 10.38 CLOSE... 13.36 15.33 16.50 21.67 20.00 15.88 14.50 11.75
52 CORPORATE AND SHAREHOLDER INFORMATION HMN FINANCIAL, INC. DIRECTORS BRANCH OFFICES OF BANK 101 North Broadway Spring Valley, MN 55975 ROGER P. WEISE ALBERT LEA (507) 346-1100 CHAIRMAN OF THE BOARD 143 West Clark St. PRESIDENT AND CHIEF Albert Lea, MN 56007 ANNUAL MEETING EXECUTIVE OFFICER (507) 377-3330 The annual meeting of shareholders will be JAMES B. GARDNER AUSTIN held on Tuesday, April EXECUTIVE VICE PRESIDENT 201 Oakland Avenue West 27, 1999 at 10:00 a.m. AND CHIEF FINANCIAL Austin, MN 55912 (Central Time) at the OFFICER (507) 433-2355 Best Western Apache Hotel, 1517 16th St. IRMA R. RATHBUN LACRESCENT S.W., Rochester, RETIRED VICE PRESIDENT OF 208 South Walnut Minnesota. HOME FEDERAL SAVINGS BANK LaCrescent, MN 55947 (507) 895-4090 LEGAL COUNSEL M.F. SCHUMANN Faegre & Benson LLP LICENSED PUBLIC MARSHALLTOWN 2200 Norwest Center ACCOUNTANT 303 West Main Street 90 South Seventh St. SCHUMANN, GRANAHAN, HESSE Marshalltown, IA 50158 Minneapolis, MN 55402- & WILSON, LTD. (515) 754-6000 3901 TIMOTHY R. GEISLER 29 South Center Street INDEPENDENT AUDITORS MANAGER CORPORATE TAX Marshalltown, IA 50158 KPMG Peat Marwick LLP UNIT (515) 754-6040 4200 Norwest Center MAYO CLINIC 90 South Seventh St. ROCHESTER Minneapolis, MN 55402- DUANE D. BENSON Crossroads Shopping 3900 EXECUTIVE DIRECTOR Center MINNESOTA BUSINESS Rochester, MN 55901 INVESTOR INFORMATION AND PARTNERSHIP (507) 289-4025 FORM 10-K Additional information EXECUTIVE OFFICERS 1110 6th Street NW and HMN's Form 10-K, Rochester, MN 55901 filed with the ROGER P. WEISE (507) 285-1707 Securities and Exchange PRESIDENT AND Commission is available CHIEF EXECUTIVE OFFICER SPRING VALLEY without charge upon 715 North Broadway request from: JAMES B. GARDNER Spring Valley, MN 55975 HMN Financial, Inc. EXECUTIVE VICE PRESIDENT (507) 346-7345 Attn: Investor Relations AND CHIEF FINANCIAL 101 North Broadway OFFICER TOLEDO Spring Valley, MN 55975- 119 West High Street 0231 DWAIN C. JORGENSEN Toledo, IA 52342 SENIOR VICE PRESIDENT (515) 484-5141 TRANSFER AGENT AND REGISTRAR MICHAEL MCNEIL WINONA Inquiries regarding SENIOR VICE PRESIDENT 175 Center Street change of address, Winona, MN 55987 transfer requirements, TIMOTHY P. JOHNSON (507) 454-4912 and lost certificates VICE PRESIDENT AND should be directed to TREASURER HMN MORTGAGE SERVICES, the transfer agent. INC. Norwest Bank Minnesota, N.A. BROOKLYN PARK Shareowner Services Mortgage Origination and PO Box 64854 Mortgage Banking Office St. Paul, MN 55164-0854 7101 Northland Circle, (800) 468-9716 Suite 105 Brooklyn Park, MN 55427 (612) 533-2500 EX-21 5 EX-21 SUBSIDIARIES OF REGISTRANT EXHIBIT 21
Date and % of Voting Shares, Partnership Interests, Year & Voting Trust Certificates, Name & Address State Inc. Capital Contributions Description of Activity -------------- ---------- -------------------- ----------------------- Home Federal Savings Bank 1934 6/29/94 Federally Chartered Stock 101 North Broadway MN HMN owns 100% of voting Savings Bank Spring Valley, MN 55975 shares Osterud Insurance Agency, Inc. 1983 Bank owns 100% Offers credit life and annuity 101 North Broadway MN products to the Bank's customers Spring Valley, MN 55975 and others MSL Financial Corporation 1983 Bank owns 100% Offered annuity products to 101 North Broadway IA Marshalltown Financial Spring Valley, MN 55975 Security Finance Corporation 1929 12/29/95 Corporation invests in 101 North Broadway MN HMN owns 100% of voting securities and loans Spring Valley, MN 55975 shares HMN Mortgage Services, Inc. 1996 7/08/96 Mortgage Banking/ 7101 Northland Circle, Suite 105 MN HMN owns 100% of Brokerage Office Brooklyn Park, MN 55427 voting shares
EX-23 6 EX-23 Exhibit 23 KPMG Peat Marwick LLP 4200 Norwest Center 90 South Seventh Street Minneapolis, MN 55402 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS The Board of Directors HMN Financial, Inc.: We consent to incorporation by reference of our report dated February 26, 1999, relating to the consolidated balance sheets of HMN Financial, Inc. as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998, which report appears in the December 31, 1998 annual Report on Form 10-K of HMN Financial, Inc. in the following Registration Statements of HMN Financial, Inc.: Nos. 33-88228, 33- 94388, and 33-94386 on Form S-8. /s/KPMG Peat Marwick LLP ------------------------ KPMG PEAT MARWICK LLP Minneapolis, Minnesota March 30, 1999 EX-27 7 EXHIBIT 27
9 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1998 AND THE CONSOLIDATED STATEMENT OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 2,386 18,575 0 0 181,625 0 0 447,455 3,041 694,658 433,869 17,500 4,444 170,400 0 0 91 68,354 694,658 35,074 12,699 1,022 48,795 22,098 31,898 16,897 310 2,799 13,160 6,057 4,058 0 0 4,058 .82 .77 2.47 476 312 0 72 2,748 (19) 2 3,041 2,812 0 229
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