HMN Financial (HMNF) 10-Q 2011 Q1 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2011

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission File Number 0-24100

HMN FINANCIAL, INC.

(Exact name of Registrant as specified in its Charter)

Delaware	41-1777397
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)
1016 Civic Center Drive N.W., Rochester, MN	55901
(Address of principal executive offices)	(ZIP Code)

Registrant’s telephone number, including area code: (507) 535-1200

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Yesþ Noo

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

     Yeso Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o  Non-accelerated filer o
(Do not check if a smaller reporting company) Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

     Yeso Noþ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

Class	Outstanding at April 20, 2011
Common stock, $0.01 par value	4,388,399

HMN FINANCIAL, INC.
CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Item 1:	Financial Statements (unaudited)
	Consolidated Balance Sheets at March 31, 2011 and December 31, 2010		3
	Consolidated Statements of Income (Loss) for the Three Months Ended March 31, 2011 and 2010		4
	Consolidated Statement of Stockholders’ Equity and Comprehensive Income for the Three Month Period Ended March 31, 2011		5
	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010		6
	Notes to Consolidated Financial Statements		7
Item 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations		22
Item 3:	Quantitative and Qualitative Disclosures about Market Risk (Included in Item 2 under Market Risk)		30
Item 4:	Controls and Procedures		32
PART II — OTHER INFORMATION
Item 1:	Legal Proceedings		34
Item 1A:	Risk Factors		34
Item 2:	Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3:	Defaults Upon Senior Securities		34
Item 4:	[Removed and Reserved]		34
			��
Item 5:	Other Information		34
Item 6:	Exhibits		34
Signatures			35
EX-10.18
EX-31.1
EX-31.2
EX-32

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PART I — FINANCIAL INFORMATION

Item 1 : Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Balance Sheets

	March 31,			December 31,
(Dollars in thousands)	2011			2010
	(unaudited)
Assets
Cash and cash equivalents	$	39,976			20,981
Securities available for sale:
Mortgage-backed and related securities (amortized cost $28,284 and $32,036)		29,641			33,506
Other marketable securities (amortized cost $128,652 and $118,631)		128,002			118,058
		157,643			151,564
Loans held for sale		1,624			2,728
Loans receivable, net		634,282			664,241
Accrued interest receivable		3,221			3,311
Real estate, net		21,469			16,382
Federal Home Loan Bank stock, at cost		6,410			6,743
Mortgage servicing rights, net		1,575			1,586
Premises and equipment, net		9,123			9,450
Prepaid expenses and other assets		3,433			3,632
Deferred tax asset, net		0			0
Total assets	$	878,756			880,618
Liabilities and Stockholders’ Equity
Deposits	$	688,078			683,230
Federal Home Loan Bank advances and Federal Reserve borrowings		115,000			122,500
Accrued interest payable		917			1,092
Customer escrows		1,422			818
Accrued expenses and other liabilities		3,698			3,431
Total liabilities		809,115			811,071
Commitments and contingencies
Stockholders’ equity:
Serial preferred stock ($.01 par value):
Authorized 500,000 shares; issued shares 26,000		24,390			24,264
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662		91			91
Additional paid-in capital		53,662			56,420
Retained earnings, subject to certain restrictions		55,930			55,838
Accumulated other comprehensive income, net of tax		427			541
Unearned employee stock ownership plan shares		(3,336	)		(3,384	)
Treasury stock, at cost 4,740,263 and 4,818,263 shares		(61,523	)		(64,223	)
Total stockholders’ equity		69,641			69,547
Total liabilities and stockholders’ equity	$	878,756			880,618

See accompanying notes to consolidated financial statements.

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

	Three Months Ended
	March 31,
(Dollars in thousands)	2011			2010
Interest income:
Loans receivable	$	9,903			11,759
Securities available for sale:
Mortgage-backed and related		324			535
Other marketable		417			572
Cash equivalents		1			1
Other		69			37
Total interest income		10,714			12,904
Interest expense:
Deposits		1,940			3,421
Federal Home Loan Bank advances and Federal Reserve borrowings		1,329			1,522
Total interest expense		3,269			4,943
Net interest income		7,445			7,961
Provision for loan losses		1,946			6,533
Net interest income after provision for loan losses		5,499			1,428
Non-interest income:
Fees and service charges		924			842
Loan servicing fees		250			268
Gain on sales of loans		495			314
Other		117			150
Total non-interest income		1,786			1,574
Non-interest expense:
Compensation and benefits		3,560			3,449
Loss (gain) on real estate owned		47			(761	)
Occupancy		940			1,031
Deposit insurance		404			517
Data processing		253			276
Other		1,588			1,505
Total non-interest expense		6,792			6,017
Income (loss) before income tax expense (benefit)		493			(3,015	)
Income tax expense (benefit)		76			(1,168	)
Net income (loss)		417			(1,847	)
Preferred stock dividends and discount		(449	)		(440	)
Net loss available to common shareholders		(32	)		(2,287	)
Basic loss per common share	$	(0.01	)		(0.61	)
Diluted loss per common share	$	(0.01	)		(0.61	)

See accompanying notes to consolidated financial statements.

4

HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statement of Stockholders’ Equity and Comprehensive Income
For the Three Month Period Ended March 31, 2011
(unaudited)

														Unearned
														Employee
											Accumulated			Stock						Total
					Additional						Other			Ownership						Stock-
	Preferred		Common		Paid-in			Retained			Comprehensive			Plan			Treasury			Holders’
(Dollars in thousands)	Stock		Stock		Capital			Earnings			Income			Shares			Stock			Equity
Balance, December 31, 2010	$	24,264		91		56,420			55,838			541			(3,384	)		(64,223	)		69,547
Net income									417												417
Other comprehensive loss, net of tax:
Net unrealized losses on securities available for sale												(114	)								(114	)
Total comprehensive income																					303
Preferred stock discount amortization		126				(126	)														0
Stock compensation tax benefits						8															8
Unearned compensation restricted stock awards						(2,700	)											2,700			0
Amortization of restricted stock awards						79															79
Preferred stock dividends accrued									(325	)											(325	)
Earned employee stock ownership plan shares						(19	)								48						29
Balance, March 31, 2011	$	24,390		91		53,662			55,930			427			(3,336	)		(61,523	)		69,641

See accompanying notes to consolidated financial statements.

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

	Three Months Ended
	March 31,
(Dollars in thousands)	2011			2010
Cash flows from operating activities:
Net income (loss)	$	417			(1,847	)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Provision for loan losses		1,946			6,533
Depreciation		327			397
Amortization of premiums, net		69			186
Amortization of deferred loan fees		(236	)		(73	)
Amortization of mortgage servicing rights, net		98			109
Capitalized mortgage servicing rights		(87	)		(150	)
Deferred income tax expense (benefit)		76			(1,792	)
Loss (gain) on sales of real estate		47			(761	)
Gain on sales of loans		(495	)		(314	)
Proceeds from sale of loans held for sale		14,266			16,361
Disbursements on loans held for sale		(9,812	)		(14,348	)
Amortization of restricted stock awards		79			97
Amortization of unearned ESOP shares		48			48
Earned employee stock ownership shares priced below original cost		(19	)		(10	)
Stock option compensation		8			16
Decrease in accrued interest receivable		90			238
Decrease in accrued interest payable		(175	)		(361	)
Decrease in other assets		153			440
Increase (decrease) in other liabilities		(61	)		368
Other, net		41			1
Net cash provided by operating activities		6,780			5,138
Cash flows from investing activities:
Principal collected on securities available for sale		3,756			5,168
Proceeds collected on maturities of securities available for sale		30,000			17,000
Purchases of securities available for sale		(40,032	)		(25,072	)
Redemption of Federal Home Loan Bank stock		333			0
Proceeds from sales of real estate		1,055			5,431
Net decrease in loans receivable		19,212			16,251
Purchases of premises and equipment		0			(34	)
Net cash provided by investing activities		14,324			18,744
Cash flows from financing activities:
Increase (decrease) in deposits		4,787			(6,359	)
Dividends paid to preferred stockholders		0			(325	)
Proceeds from borrowings		0			5,000
Repayment of borrowings		(7,500	)		(5,000	)
Increase in customer escrows		604			685
Net cash used by financing activities		(2,109	)		(5,999	)
Increase in cash and cash equivalents		18,995			17,883
Cash and cash equivalents, beginning of period		20,981			16,418
Cash and cash equivalents, end of period	$	39,976			34,301
Supplemental cash flow disclosures:
Cash paid for interest	$	3,443			5,304
Cash paid for income taxes		0			39
Supplemental noncash flow disclosures:
Transfer of loans to real estate		6,231			1,138
Loans transferred to loans held for sale		2,806			1,072

See accompanying notes to consolidated financial statements.

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

March 31, 2011 and 2010

(1)HMN Financial, Inc.

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA), which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC), which is currently not actively engaged in any activities.

The consolidated financial statements included herein are for HMN, SFC, the Bank and OIA. All significant intercompany accounts and transactions have been eliminated in consolidation.

(2)Basis of Preparation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of income (loss), consolidated statement of stockholders’ equity and comprehensive income and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles. However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The results of operations for the three-month period ended March 31, 2011 is not necessarily indicative of the results which may be expected for the entire year.

Certain amounts in the consolidated financial statements for prior periods have been reclassified to conform with the current period presentation.

(3)New Accounting Standards

In July 2010, the FASB issued ASU 2010-20,Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings are also required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010 and the related disclosures were included in Note 5 in the Company’s December 31, 2010 notes to the consolidated financial statements and in Note 9 of this quarterly report.

In January 2011, the FASB issued ASU 2011-01,Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.The amendment temporarily delays the effective date of the disclosures about troubled debt restructurings in ASU No. 2010-20,Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Lossesfor public entities.

In April 2011, the FASB issued ASU 2011-02,Receivables (Topic 310),A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.This ASU provides guidance on evaluating whether a restructuring constitutes a troubled debt restructuring. It indicates that if a creditor separately concludes that a restructuring constitutes a concession and that the debtor is experiencing financial difficulties that the restructuring is a troubled debt restructuring. It also clarifies guidance on a creditor’s evaluation of the above two items. For public entities, such as HMN, the amendments in this ASU are effective for the first interim or annual

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period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. In addition, this ASU requires that the disclosures about troubled debt restructurings that were delayed by ASU 2011-01 in January 2011 be disclosed for interim and annual periods beginning on or after June 15, 2011. It is anticipated the implementation of the guidance in this ASU will result in more loan restructurings being classified as troubled debt restructurings.

(4)Derivative Instruments and Hedging Activities

The Company has commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter. The Company intends to sell these commitments, which are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, the Company generally enters into commitments to sell the mortgage pipeline into the secondary market on a firm commitment or best efforts basis. The commitments to originate, purchase or sell loans on a firm commitment basis are derivatives. As a result of marking to market the mortgage pipeline and the related firm commitments to sell for the period ended March 31, 2011, the Company recorded an increase in other assets of $4,000, an increase in other liabilities of $3,000 and a gain included in the gain on sales of loans of $1,000.

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market and the related loans held for sale are recorded at the lower of cost or market. The Company recorded a decrease in other assets of $50,000 and a decrease in the mark to market adjustment for loans held for sale of $50,000.

(5)Fair Value Measurements

ASC 820,Fair Value Measurementsestablishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of March 31, 2011 and December 31, 2010.

	Carrying value at March 31, 2011
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Securities available for sale	$	157,643			1,313		156,330			0
Mortgage loan commitments		(4	)		0		(4	)		0
Total	$	157,639			1,313		156,326			0

	Carrying value at December 31, 2010
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Securities available for sale	$	151,564			1,740		149,824			0
Mortgage loan commitments		(1	)		0		(1	)		0
Total	$	151,563			1,740		149,823			0

There were no transfers between Levels 1, 2, or 3 during the three months ended March 31, 2011.

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The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis that were still held at March 31, 2011 and December 31, 2010, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at March 31, 2011 and December 31, 2010.

									Three months ended
	Carrying value at March 31, 2011								March 31, 2011
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total Losses
Loans held for sale	$	1,624		0		1,624		0		(7	)
Mortgage servicing rights		1,575		0		1,575		0		0
Loans(1)		61,272		0		61,272		0		(2,082	)
Real estate, net(2)		21,469		0		21,469		0		(88	)
Total	$	85,940		0		85,940		0		(2,177	)

									Year ended
	Carrying value at December 31, 2010								December 31, 2010
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total Losses
Loans held for sale	$	2,728		0		2,728		0		(6	)
Mortgage servicing rights		1,586		0		1,586		0		0
Loans(1)		43,039		0		43,039		0		(18,855	)
Real estate, net (2)		16,385		0		16,385		0		(1,782	)
Total	$	63,738		0		63,738		0		(20,643	)

(1)	Represents carrying value and related write-downs of loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.
(2)	Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

(6)Fair Value of Financial Instruments

Generally accepted accounting principles require interim reporting period disclosure about the fair value of 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 based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. The estimated fair value of the Company’s financial instruments as of March 31, 2011 and December 31, 2010 are shown below.

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	March 31,								December 31,
	2011								2010
	Carrying			Estimated			Contract		Carrying			Estimated			Contract
(Dollars in thousands)	amount			fair value			amount		amount			fair value			amount
Financial assets:
Cash and cash equivalents	$	39,976			39,976					20,981			20,981
Securities available for sale		157,643			157,643					151,564			151,564
Loans held for sale		1,624			1,624					2,728			2,728
Loans receivable, net		634,282			625,565					664,241			655,508
Federal Home Loan Bank stock		6,410			6,410					6,743			6,743
Accrued interest receivable		3,221			3,221					3,311			3,311
Financial liabilities:
Deposits		688,078			688,078					683,230			683,230
Federal Home Loan Bank advances		115,000			120,976					122,500			129,893
Accrued interest payable		917			917					1,092			1,092
Off-balance sheet financial instruments:
Commitments to extend credit		(4	)		(4	)		94,594		56			56			92,313
Commitments to sell loans		11			11			3,419		(1	)		(1	)		3,413

(7)Other Comprehensive Loss

Other comprehensive loss is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income (loss) is the total of net income (loss) and other comprehensive loss, which for the Company is comprised of unrealized losses on securities available for sale. The components of other comprehensive loss and the related tax effects were as follows:

	For the period ended March 31,
	2011									2010
(Dollars in thousands)	Before tax			Tax effect			Net of tax			Before tax			Tax effect			Net of tax
Securities available for sale:
Net unrealized losses arising during the period	$	(190	)		(76	)		(114	)		(376	)		(149	)		(227	)
Other comprehensive loss	$	(190	)		(76	)		(114	)		(376	)		(149	)		(227	)

(8)Securities Available For Sale

The following table shows the gross unrealized losses and fair value for the securities available for sale portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010.

	March 31, 2011
	Less than twelve months							Twelve months or more							Total
	# of		Fair		Unrealized			# of		Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Investments		Value		Losses			Investments		Value		Losses			Value		Losses
Other marketable securities:
U.S. Government agency obligations		13	$	62,681		(225	)		0	$	0		0		$	62,681		(225	)
Corporate preferred stock		0		0		0			1		175		(525	)		175		(525	)
Total temporarily impaired securities		13	$	62,681		(225	)		1	$	175		(525	)	$	62,856		(750	)

	December 31, 2010
	Less than twelve months							Twelve months or more							Total
	# of		Fair		Unrealized			# of		Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Investments		Value		Losses			Investments		Value		Losses			Value		Losses
Other marketable securities:
U.S. Government agency obligations		10	$	47,610		(266	)		0	$	0		0		$	47,610		(266	)
Corporate preferred stock		0		0		0			1		175		(525	)		175		(525	)
Total temporarily impaired securities		10	$	47,610		(266	)		1	$	175		(525	)	$	47,785		(791	)

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes

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analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss. The unrealized losses on collateralized mortgage and agency obligations are primarily due to changes in interest rates and were not determined to be other-than-temporary. Mortgage backed securities in the table above had an average life of less than three years and the other marketable securities had an average life of less than two years at March 31, 2011.

The unrealized losses reported for corporate preferred stock at March 31, 2011 related to a single trust preferred security that was issued by the holding company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In October 2009, the issuer elected to defer its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses due to increased provisions for loan losses but still meets the regulatory requirements to be considered “adequately capitalized” based on its most recent regulatory filing. In addition, the owners of the issuing bank appear to have the ability to make additional capital contributions. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at March 31, 2011. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities and the deferral of interest by the issuer. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

A summary of securities available for sale at March 31, 2011 and December 31, 2010 is as follows:

			Gross		Gross
	Amortized		unrealized		unrealized			Fair
(Dollars in thousands)	cost		gains		losses			value
March 31, 2011:
Mortgage-backed securities:
FHLMC	$	15,708		705		0			16,413
FNMA		11,301		614		0			11,915
Collateralized mortgage obligations:
FHLMC		894		31		0			925
FNMA		381		7		0			388
		28,284		1,357		0			29,641
Other marketable securities:
U.S. Government agency obligations		127,952		100		(225	)		127,827
Corporate preferred stock		700		0		(525	)		175
		128,652		100		(750	)		128,002
	$	156,936		1,457		(750	)		157,643

11

			Gross		Gross
	Amortized		unrealized		unrealized			Fair
(Dollars in thousands)	cost		gains		losses			value
December 31, 2010:
Mortgage-backed securities:
FHLMC	$	17,555		719		0			18,274
FNMA		12,800		692		0			13,492
Collateralized mortgage obligations:
FHLMC		1,299		44		0			1,343
FNMA		382		15		0			397
		32,036		1,470		0			33,506
Other marketable securities:
U.S. Government agency obligations		117,931		218		(266	)		117,883
Corporate preferred stock		700		0		(525	)		175
		118,631		218		(791	)		118,058
	$	150,667		1,688		(791	)		151,564

The following table indicates amortized cost and estimated fair value of securities available for sale at March 31, 2011 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.

	Amortized		Fair
(Dollars in thousands)	cost		value
Due less than one year	$	100,701		101,228
Due after one year through five years		53,672		54,288
Due after five years through ten years		1,863		1,952
No stated maturity		700		175
Total	$	156,936		157,643

The allocation of mortgage-backed securities and collateralized mortgage obligations in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds. The allocation of other marketable securities that have call features is based on the anticipated cash flows to the call date if it is anticipated that the security will be called, or to the maturity date if it is not anticipated to be called.

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(9) Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:

				Commercial						Commercial
(Dollars in thousands)	1-4 Family			Real Estate			Consumer			Business			Total
Balance, December 31, 2010	$	2,145			24,590			924			15,169			42,828
Provision for losses		756			539			147			504			1,946
Charge-offs		(403	)		(7,576	)		(52	)		(2,308	)		(10,339	)
Recoveries		0			5			4			509			518
Balance, March 31, 2011	$	2,498			17,558			1,023			13,874			34,953
Allocated to:
Specific reserves	$	1,578			7,501			133			9,636			18,848
General reserves		920			10,057			890			4,238			16,105
Balance, March 31, 2011	$	2,498			17,558			1,023			13,874			34,953
Loans receivable at December 31, 2010:
Individually reviewed for impairment	$	6,729			45,077			299			26,855			78,960
Collectively reviewed for impairment		121,806			311,314			70,304			126,184			629,608
Ending balance	$	128,535			356,391			70,603			153,039			708,568
Loans receivable at March 31, 2011:
Individually reviewed for impairment	$	6,113			30,371			293			24,495			61,272
Collectively reviewed for impairment		121,509			296,735			67,655			123,452			609,351
Ending balance	$	127,622			327,106			67,948			147,947			670,623

The following table summarizes the amount of classified and unclassified loans at March 31, 2011 and December 31, 2010:

	March 31, 2011						December, 31, 2010
(Dollars in thousands)	Classified		Unclassified		Total		Classified		Unclassified		Total
1-4 family	$	15,096		112,526		127,622		15,623		112,912		128,535
Commercial real estate:
Residential developments		34,949		33,313		68,262		42,888		44,218		87,106
Alternative fuels		10,917		18,783		29,700		11,069		20,054		31,123
Other		13,459		215,685		229,144		12,882		225,280		238,162
Consumer		292		67,656		67,948		306		70,297		70,603
Commercial business:
Construction/development		6,207		5,319		11,526		6,683		5,117		11,800
Banking		8,223		5,829		14,052		8,223		5,830		14,053
Other		16,671		105,698		122,369		20,468		106,718		127,186
	$	105,814		564,809		670,623		118,142		590,426		708,568

Classified loans represent substandard and non-performing loans. Loans classified substandard are loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

The aging of past due loans at March 31, 2011 and December 31, 2010 are summarized as follows:

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													Loans 90
													Days or
													More Past
	30-59		60-89		90 Days								Due and
	Days		Days		or More		Total		Current		Total		Still
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Loans		Loans		Accruing
March 31, 2011
1-4 family	$	3,069		485		2,013		5,567		122,055		127,622		441
Commercial real estate:
Residential developments		351		2,776		331		3,458		64,804		68,262		0
Alternative fuels		0		0		4,994		4,994		24,706		29,700		0
Other		326		51		4,178		4,555		224,589		229,144		0
Consumer		641		1		238		880		67,068		67,948		83
Commercial business:
Construction/development		0		0		1,491		1,491		10,035		11,526		0
Banking		0		0		8,223		8,223		5,829		14,052		0
Other		589		75		6,971		7,635		114,734		122,369		0
	$	4,976		3,388		28,439		36,803		633,820		670,623		524
December 31, 2010
1-4 family	$	2,313		695		3,500		6,508		122,027		128,535		178
Commercial real estate:
Residential developments		444		3,899		15,523		19,866		67,240		87,106		0
Alternative fuels		0		0		4,994		4,994		26,129		31,123		0
Other		75		264		3,914		4,253		233,909		238,162		0
Consumer		446		163		207		816		69,787		70,603		0
Commercial business:
Construction/development		0		0		4,809		4,809		6,991		11,800		0
Banking		0		0		8,223		8,223		5,830		14,053		0
Other		311		45		7,876		8,232		118,954		127,186		576
	$	3,589		5,066		49,046		57,701		650,867		708,568		754

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled

14

debt restructuring. The following table summarizes impaired loans and related allowances as of March 31, 2011 and December 31, 2010:

	March 31, 2011
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
(Dollars in thousands)	Investment		Balance		Allowance		Investment		Recognized
Loans with no related allowance recorded:
1-4 family	$	1,372		1,372		0		686		20
Commercial real estate:
Residential developments		5,879		5,879		0		2,940		73
Alternative fuels		0		0		0		0		0
Other		655		655		0		328		4
Consumer		40		40		0		20		0
Commercial business:
Construction/development		346		346		0		173		2
Banking		0		0		0		0		0
Other		643		643		0		322		15
Loans with an allowance recorded:
1-4 family		4,741		4,741		1,578		2,371		41
Commercial real estate:
Residential developments		12,895		12,895		2,784		6,448		110
Alternative fuels		4,995		4,995		2,728		2,498		0
Other		5,947		6,902		1,989		2,974		14
Consumer		253		253		133		127		3
Commercial business:
Construction/development		3,986		3,986		1,495		1,992		3
Banking		8,223		8,223		5,535		4,112		0
Other		11,297		11,849		2,606		5,649		75
Total:
1-4 family		6,113		6,113		1,578		3,057		61
Commercial real estate:
Residential developments		18,774		18,774		2,784		9,387		183
Alternative fuels		4,995		4,995		2,728		2,498		0
Other		6,602		7,557		1,989		3,301		18
Consumer		293		293		133		147		3
Commercial business:
Construction/development		4,332		4,332		1,495		2,166		5
Banking		8,223		8,223		5,535		4,112		0
Other		11,940		12,492		2,606		5,970		90
	$	61,272		62,779		18,848		30,637		360

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	December 31, 2010
	Recorded		Unpaid Principal		Related
(Dollars in thousands)	Investment		Balance		Allowance
Loans with no related allowance recorded:
1-4 family	$	932		932		0
Commercial real estate:
Residential developments		6,486		6,486		0
Alternative fuels		0		0		0
Other		119		119		0
Consumer		104		104		0
Commercial business:
Construction/development		99		99		0
Banking		0		0		0
Other		397		397		0
Loans with an allowance recorded:
1-4 family		5,797		5,797		994
Commercial real estate:
Residential developments		27,147		27,147		9,673
Alternative fuels		4,994		4,994		2,441
Other		6,331		7,287		1,148
Consumer		195		195		76
Commercial business:
Construction/development		4,809		4,809		2,668
Banking		8,223		8,223		4,985
Other		13,327		13,878		3,049
Total:
1-4 family		6,729		6,729		994
Commercial real estate:
Residential developments		33,633		33,633		9,673
Alternative fuels		4,994		4,994		2,441
Other		6,450		7,406		1,148
Consumer		299		299		76
Commercial business:
Construction/development		4,908		4,908		2,668
Banking		8,223		8,223		4,985
Other		13,724		14,275		3,049
	$	78,960		80,467		25,034

At March 31, 2011 and December 31, 2010, non-accruing loans totaled $49.1 million and $68.1 million, respectively, for which the related allowance for loan losses was $17.2 million and $25.0 million, respectively. Non-accruing loans for which no specific allowance has been recorded because management determined that the value of the collateral was sufficient to repay the loan totaled $7.0 million and $8.1 million, respectively.

The non-accrual loans at March 31, 2011 and December 31, 2010 are summarized as follows:

16

(Dollars in thousands)	March 31, 2011		December 31, 2010
1-4 family	$	3,399	$	4,844
Commercial real estate:
Residential developments		10,674		25,980
Alternative fuels		4,994		4,994
Other		5,941		5,763
Consumer		245		224
Commercial business:
Construction/development		4,332		4,907
Banking		8,223		8,223
Other		11,274		13,139
	$	49,082	$	68,074

At March 31, 2011 and December 31, 2010 there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $21.4 million and $19.3 million, respectively. For the loans that were restructured in the first quarter of 2011, $2.5 million were classified but performing and $7.3 million were non-performing at March 31, 2011.

The following table summarizes troubled debt restructurings at March 31, 2011 and December 31, 2010:

(Dollars in thousands)			December 31,
	March 31, 2011		2010
Commercial real estate	$	14,752		14,871
Commercial business		3,070		1,756
1-4 family		3,464		2,589
Consumer		143		75
	$	21,429		19,291

There were no material commitments to lend additional funds to customers whose loans were restructured or classified as nonaccrual at March 31, 2011 or December 31, 2010.

(10)Investment in Mortgage Servicing Rights

A summary of mortgage servicing activity is as follows:

	Three months ended			Twelve months ended			Three months ended
(Dollars in thousands)	March 31, 2011			December 31, 2010			March 31, 2010
Mortgage servicing rights:
Balance, beginning of period	$	1,586			1,315			1,315
Originations		87			753			150
Amortization		(98	)		(482	)		(109	)
Balance, end of period		1,575			1,586			1,356
Fair value of mortgage servicing rights	$	2,636			2,263			2,357

17

All of the loans being serviced were single family loans under the FNMA mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at March 31, 2011.

			Weighted			Weighted
	Loan		Average			Average
	Principal		Interest			Remaining		Number
(Dollars in thousands)	Balance		Rate			Term		of Loans
Original term 30 year fixed rate	$	221,928		5.22	%		300		1,904
Original term 15 year fixed rate		100,761		4.66			124		1,493
Adjustable rate		640		3.08			303		8

The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at March 31, 2011 is presented in the following table. Amortization expense for mortgage servicing rights was $98,000 and $109,000 for the three months ended March 31, 2011 and 2010, respectively.

	Gross					Unamortized
	Carrying		Accumulated			Intangible
(Dollars in thousands)	Amount		Amortization			Assets
Mortgage servicing rights	$	4,140		(2,565	)		1,575
Total	$	4,140		(2,565	)		1,575

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

	Mortgage
	Servicing
(Dollars in thousands)	Rights
Year ending December 31,
2011	$	268
2012		326
2013		307
2014		277
2015		230
Thereafter		167

Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2011. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

(11)Loss per Common Share

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

	Three months ended March 31,
	2011			2010
Weighted average number of common shares outstanding used in basic earnings per common share calculation		3,816,686			3,736,852
Net dilutive effect of:
Options		0			0
Restricted stock awards		0			0
Weighted average number of shares outstanding adjusted for effect of dilutive securities		3,816,686			3,736,852
Loss available to common shareholders	$	(31,818	)		(2,287,581	)
Basic loss per common share	$	(0.01	)		(0.61	)
Diluted loss per common share	$	(0.01	)		(0.61	)

At March 31, 2011 and 2010, there were 125,647 and 186,145 common share equivalents outstanding,

18

respectively, that are not included in the calculation of diluted earnings per share as they are anti-dilutive.

(12)Regulatory Capital and Regulatory Oversight

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

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of March 31, 2011, that the Bank meets all capital adequacy requirements to which it is subject and that based upon the Bank’s capital calculations at March 31, 2011 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

On March 31, 2011, the Bank’s tangible assets and adjusted total assets were $877.7 million and its risk-weighted assets were $665.8 million. The following table presents the Bank’s capital amounts and ratios at March 31, 2011 for actual capital, required capital and excess capital including ratios required to qualify as a well capitalized institution under the Prompt Corrective Actions regulations.

							Required to be
							Adequately										To Be Well Capitalized Under Prompt
	Actual						Capitalized					Excess Capital					Corrective Action Provisions
				Percent of					Percent of					Percent of					Percent of
(Dollars in thousands)	Amount			Assets(1)			Amount		Assets(1)			Amount		Assets(1)			Amount		Assets(1)
Bank stockholder’s equity	$	68,610
Less:
Net unrealized gains on certain securities available for sale		(1,020	)
Disallowed servicing and tax assets		0
Tier I or core capital		67,590
Tier I capital to adjusted total assets					7.70	%	$	35,108		4.00	%	$	32,482		3.70	%	$	43,885		5.00	%
Tier I capital to risk-weighted assets					10.15	%	$	26,633		4.00	%	$	40,957		6.15	%	$	39,950		6.00	%
Plus:
Allowable allowance for loan losses		8,323
Risk-based capital	$	75,913					$	53,266				$	22,647				$	66,583
Risk-based capital to risk- weighted assets					11.40	%				8.00	%				3.40	%				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.

The Bank entered into a written Supervisory Agreement with its primary regulator, the OTS, effective February 22, 2011 that primarily relates to the Bank’s financial performance and credit quality issues. This agreement replaced the prior memorandum of understanding that the Bank entered into with the OTS on December 9, 2009. In accordance with the Supervisory Agreement, the Bank must submit a two year business plan that the OTS may make comments upon, and require revisions to. The Bank must operate within the parameters of the final business plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank must also submit a problem asset reduction plan that the OTS may make comments upon, and require revisions to. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank must also revise its loan modification policies and its program for identifying, monitoring and controlling risk associated with concentrations of credit, and improve the documentation of the allowance for loan and lease losses. In addition, without the consent of the OTS, the Bank may not declare or pay any cash dividends,

19

materially increase the total assets of the Bank, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider.

The Company also entered into a written Supervisory Agreement with the OTS effective February 22, 2011. This agreement replaced the prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. By May 31, 2011, in accordance with the Supervisory Agreement, the Company must submit a capital plan to the OTS through December 31, 2012 that the OTS may make comments upon, and to which it may require revisions. The Company must operate within the parameters of the final capital plan and is required to monitor and submit periodic reports on its compliance with the plan. In addition, without the consent of the OTS, the Company may not incur or issue any debt, guarantee the debt of any entity, declare or pay any cash dividends or repurchase any of the Company’s capital stock, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, or make any golden parachute payments.

The Bank has been informed by the OTS that it intends to impose an Individual Minimum Capital Requirement (“IMCR”) for the Bank. An IMCR requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be classified as “well-capitalized.” The Bank has not been informed by the OTS of the timing or capital levels that may be required.

(13)Commitments and Contingencies

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at March 31, 2011 were approximately $2.5 million, expire over the next two years, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

(14)Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. SFC and HMN did not meet the quantitative thresholds for determining reportable segments and therefore are included in the “Other” category.

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

20

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

	Home Federal									Consolidated
(Dollars in thousands)	Savings Bank			Other			Eliminations			Total
At or for the quarter ended March 31, 2011:
Interest income — external customers	$	10,714			0			0			10,714
Non-interest income — external customers		1,788			0			0			1,788
Loss on limited partnerships		(2	)		0			0			(2	)
Intersegment interest income		0			1			(1	)		0
Intersegment non-interest income		43			688			(731	)		0
Interest expense		3,270			0			(1	)		3,269
Amortization of mortgage servicing rights, net		98			0			0			98
Other non-interest expense		6,463			274			(43	)		6,694
Income tax expense		76			0		��	0			76
Net income		690			415			(688	)		417
Total assets		878,686			70,563			(70,493	)		878,756
At or for the quarter ended March 31, 2010:
Interest income — external customers	$	12,904			0			0			12,904
Non-interest income — external customers		1,582			0			0			1,582
Loss on limited partnerships		(8	)		0			0			(8	)
Intersegment interest income		0			1			(1	)		0
Intersegment non-interest income		43			(1,672	)		1,629			0
Interest expense		4,944			0			(1	)		4,943
Amortization of mortgage servicing rights, net		109			0			0			109
Other non-interest expense		5,748			203			(43	)		5,908
Income tax benefit		(1,143	)		(25	)		0			(1,168	)
Net loss		(1,670	)		(1,849	)		1,672			(1,847	)
Total assets		1,027,274			98,203			(97,001	)		1,028,476

21

HMN FINANCIAL, INC.

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

Forward-looking Information

This quarterly report, other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intent,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to the adequacy and amount of available liquidity and capital resources to the Bank, the Company’s liquidity and capital requirements, changes in the size of the Bank’s loan portfolio, the recovery of the valuation allowance on deferred tax assets, the amount and mix of the Bank’s non-performing assets and the adequacy of the allowance therefor, future losses on non-performing assets, the amount of interest-earning assets, the amount and mix of brokered and other deposits (including the Company’s ability to renew brokered deposits), the availability of alternate funding sources, the payment of dividends, the future outlook for the Company, and the Company’s and the Bank’s compliance with regulatory standards generally (including the Bank’s status as “well-capitalized”), and supervisory agreements, individual capital requirements or other supervisory directives or requirements to which the Company or the Bank are expressly subject, specifically. A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate securing loans to borrowers, possible legislative and regulatory changes, including changes in the degree and manner of regulatory supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss allowance and concentrations of credit that are satisfactory to the OTS in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OTS under the supervisory agreements or other directives; adverse economic, business and competitive developments such as shrinking interest margins; reduced collateral values; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments, changes in credit or other risks posed by the Company’s loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; collateral advance rates and policies of the FHLB; costs associated with alternate funding sources; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filings on Form 10-K with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 and Part II, Item 1A of this Quarterly Report on Form 10-Q.

General

The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits, Federal Home Loan Bank (FHLB) advances, and Federal Reserve Bank (FRB) borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the “interest rate spread”. Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company’s net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization of mortgage servicing assets. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and

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

Beginning with the onset of the 2007 recession and the Company’s 2008 fiscal year, the Company’s commercial business and commercial real estate loan portfolios have required significant allowances and charge offs due primarily to decreases in the estimated value of the underlying collateral supporting the loans, as many of these loans were made to borrowers in or associated with the real estate industry. The decrease in the estimated collateral value is primarily the result of reduced demand for real estate, particularly as it relates to single-family and commercial land developments. More stringent lending standards implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments where the Company’s commercial loan portfolio has concentrations. Consequently, our level of non-performing assets and the related provision for loan losses increased significantly in the past several years, relative to periods before 2008. The increased levels of non-performing assets, related provisions for loan losses and write offs of or allowances against goodwill and deferred taxes arising from adverse results of operations, were the primary reasons for the net losses incurred by the Company in each of the years 2008 through 2010.

Critical Accounting Policies

Critical accounting policies are those policies that the Company’s management believes are the most important to understanding the Company’s financial condition and operating results. The Company has identified the following policies as being critical because they require difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used.

Allowance for Loan Losses and Related Provision

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

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. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in

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connection with specific loans as well as probable losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet date, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

Income Taxes

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

The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating loss carry forwards. For income tax purposes, only net charge-offs and certain specific reserves are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company’s cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. At March 31, 2011, the Company recorded a valuation allowance against the entire deferred tax asset balance. This determination was based primarily upon the existence of a three year cumulative loss position that is primarily attributable to significant provisions for loan losses incurred during the last three years. The creation of the valuation allowance, although it increased tax expense and similarly reduced tangible book value, does not have an effect on the Company’s cash flows, and may be recoverable in subsequent periods if the Company were to realize certain sustained future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future.

Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.

RESULTS OF OPERATIONS FOR FIRST QUARTER ENDED MARCH 31, 2011 COMPARED TO FIRST QUARTER ENDED MARCH 31, 2010

Net Income

Net income for the first quarter of 2011 was $0.4 million, an improvement of $2.2 million compared to a net loss of $1.8 million for the first quarter of 2010. Net loss available to common shareholders was $32,000 for the first quarter of 2011, an improvement of $2.3 million, or 98.6%, from the net loss available to common shareholders of $2.3 million for the first quarter of 2010. Diluted loss per common share for the first quarter of 2011 was $0.01, an improvement of $0.60 from the diluted loss per common share of $0.61 for the first quarter of 2010. The improvement in net income was due primarily to a $4.6 million decrease in the provision for loan losses between the periods that was partially offset by a $1.2 million increase in income taxes and a $0.8 million increase in the losses recognized on the sale of real estate owned between the periods.

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Net Interest Income

Net interest income was $7.4 million for the first quarter of 2011, a decrease of $0.6 million, or 6.5%, compared to $8.0 million for the first quarter of 2010. Interest income was $10.7 million for the first quarter of 2011, a decrease of $2.2 million, or 17.0%, from $12.9 million for the first quarter of 2010. Interest income decreased between the periods primarily because of a $143 million decrease in average interest-earning assets between the periods. Average interest earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of declining loan demand and the Company’s focus on improving credit quality, reducing loan concentrations, managing interest rate risk and improving capital ratios. The average yield earned on interest-earning assets was 5.21% for the first quarter of 2011, a decrease of 15 basis points from the 5.36% average yield for the first quarter of 2010.

Interest expense was $3.3 million for the first quarter of 2011, a decrease of $1.6 million, or 33.9%, compared to $4.9 million for the first quarter of 2010. Interest expense decreased primarily because of a $124 million decrease in the average outstanding balance of interest-bearing liabilities and noninterest bearing deposits between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding borrowings and brokered certificates of deposits between the periods. The decrease in borrowings and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing borrowings and brokered deposits. Interest expense also decreased because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the first quarter of 2011. The average interest rate paid on interest-bearing liabilities was 1.66% for the first quarter of 2011, a decrease of 51 basis points from the 2.17% average interest rate paid in the first quarter of 2010.

Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2011 was 3.62%, an increase of 31 basis points, compared to 3.31% for the first quarter of 2010.

A summary of the Company’ net interest margin for the three month periods ended March 31, 2011 and 2010 is as follows:

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	For the three month period ended
	March 31, 2011							March 31, 2010
	Average		Interest					Average		Interest
	Outstanding		Earned/		Yield/			Outstanding		Earned/		Yield/
(Dollars in thousands)	Balance		Paid		Rate			Balance		Paid		Rate
Interest-earning assets:
Securities available for sale	$	149,928		741		2.00	%	$	159,759		1,107		2.81	%
Loans held for sale		1,537		17		4.49			1,785		21		4.77
Mortgage loans, net		128,307		1,763		5.57			143,667		2,097		5.92
Commercial loans, net		453,694		7,095		6.34			564,322		8,453		6.07
Consumer loans, net		68,666		1,028		6.07			80,991		1,188		5.95
Cash equivalents		24,444		1		0.02			18,591		1		0.02
Federal Home Loan Bank stock		6,692		69		4.18			7,286		37		2.06
Total interest-earning assets		833,268		10,714		5.22			976,401		12,904		5.36
Interest-bearing liabilities and noninterest bearing deposits:
NOW accounts		79,017		19		0.10			98,474		22		0.09
Savings accounts		34,676		13		0.15			31,821		10		0.13
Money market accounts		113,712		214		0.76			136,800		392		1.16
Certificates		254,148		1,057		1.69			243,180		1,476		2.46
Brokered deposits		100,801		637		2.56			199,257		1,521		3.10
Federal Home Loan Bank advances		119,833		1,329		4.50			132,611		1,522		4.65
Total interest-bearing liabilities		702,187							842,143
Noninterest checking		96,146							79,635
Other noninterest bearing escrow deposits		1,164							1,836
Total interest-bearing liabilities and noninterest bearing deposits	$	799,497		3,269		1.66		$	923,614		4,943		2.17
Net interest income			$	7,445						$	7,961
Net interest rate spread						3.56	%						3.19	%
Net interest margin						3.62	%						3.31	%

Provision for Loan Losses

The provision for loan losses was $1.9 million for the first quarter of 2011, a decrease of $4.6 million, or 70.2%, compared to $6.5 million for the first quarter of 2010. The provision for loan losses decreased in the first quarter of 2011 primarily because there were fewer decreases in the estimated value of the underlying collateral supporting commercial real estate loans that required specific allowances and there were fewer commercial loan risk rating downgrades when compared to the first quarter of 2010.

A reconciliation of the Company’s allowance for loan losses for the first quarters of 2011 and 2010 is summarized as follows:

(Dollars in thousands)	2011			2010
Balance at January 1,	$	42,828		$	23,811
Provision		1,946			6,533
Charge offs:
One-to-four family		(403	)		(51	)
Consumer		(52	)		(306	)
Commercial business		(2,308	)		(61	)
Commercial real estate		(7,576	)		(660	)
Recoveries		518			18
Balance at March 31,	$	34,953		$	29,284
General allowance	$	16,105		$	12,058
Specific allowance		18,848			17,226
	$	34,953		$	29,284

Charge offs increased in the first quarter of 2011, primarily because of four lending relationships totaling $9.3

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million where the collateral was moved to real estate owned or repossessed assets during the quarter and the previously established specific reserves were charged off.

Non-Interest Income

Non-interest income was $1.8 million for the first quarter of 2011, an increase of $0.2 million, or 13.5%, from $1.6 million for the first quarter of 2010. Gain on sales of loans increased $181,000 between the periods due to an increase in the gains recognized on the sale of commercial government guaranteed loans that was partially offset by a decrease in the gain recognized on the sale of single family loans due to a decrease in single family loan originations between the periods. Fees and service charges increased $82,000 between the periods primarily because of an increase in late fees and overdraft charges. Other non-interest income decreased $33,000 between the periods primarily because of decreased rental income on other real estate owned. Loan servicing fees decreased $18,000 between the periods primarily because of a decrease in the number of commercial loans that are being serviced for others.

Non-Interest Expense

Non-interest expense was $6.8 million for the first quarter of 2011, an increase of $0.8 million, or 12.9%, from $6.0 million for the first quarter of 2010. The loss on real estate owned increased $808,000 between the periods from a gain in the first quarter of 2010 to a loss in the first quarter of 2011. Compensation expense increased $111,000 primarily because of increased personnel in the commercial loan recovery area. Other non-interest expense increased $83,000 between the periods primarily because of increased legal expenses related to non-performing assets and regulatory compliance. Deposit insurance expense decreased $113,000 primarily because of the decrease in outstanding brokered deposits between the periods. Occupancy expense decreased $91,000 primarily because of a decrease in depreciation expense. Data processing expense decreased $23,000 primarily due to a decrease in debit card expenses as a result of changing vendors in the fourth quarter of 2010.

Income Taxes

The effect of income taxes changed $1.2 million between the periods from a benefit of $1.1 million in the first quarter of 2010 to an expense of $76,000 in the first quarter of 2011. The Company continues to record a valuation reserve against the entire deferred tax asset balance at March 31, 2011. Since the valuation reserve is established against the entire deferred tax asset balance, the only amount included as income tax expense for the first quarter of 2011 relates to the taxes on the change in the fair market value of the available for sale investment portfolio.

Net Loss Available to Common Shareholders

The net loss available to common shareholders was $32,000 for the first quarter of 2011, a decreased loss of $2.3 million from the $2.3 million net loss available to common shareholders in the first quarter of 2010. The net loss available to common shareholders decreased primarily because of the change in the net income (loss) between the periods. The Company deferred the February 15, 2011 regular quarterly cash dividend payment and has determined that it will defer the May 15, 2011 regular quarterly cash dividend payment on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The deferred dividend payments will continue to be accrued for payment in the future and will be reported for the deferral period as a preferred dividend requirement that is deducted from income (loss) available to common shareholders for financial statement purposes.

FINANCIAL CONDITION

Non-Performing Assets

The following table summarizes the amounts and categories of non-performing assets in the Bank’s portfolio and loan delinquency information as March 31, 2011 and December 31, 2010.

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	March 31,			December 31,
(Dollars in thousands)	2011			2010
Non-Accruing Loans:
One-to-four family real estate	$	3,399		$	4,844
Commercial real estate		21,609			36,737
Consumer		245			224
Commercial business		23,829			26,269
Total		49,082			68,074
Foreclosed and Repossessed Assets:
One-to-four family real estate		1,640			972
Consumer		14			14
Commercial real estate		19,829			15,409
Total non-performing assets	$	70,565		$	84,469
Total as a percentage of total assets		8.03	%		9.59	%
Total non-performing loans	$	49,082		$	68,074
Total as a percentage of total loans receivable, net		7.74	%		10.25	%
Allowance for loan loss to non-performing loans		71.21	%		62.91	%
Delinquency Data:
Delinquencies(1)
30+ days	$	4,940		$	4,021
90+ days		178			754
Delinquencies as a percentage of Loan and lease portfolio(1)
30+ days		0.76	%		0.59	%
90+ days		0.03	%		0.11	%

(1) Excludes non-accrual loans.

The Company had specific reserves established against the above non-accruing loans of $17.2 million and $25.0 million at March 31, 2011 and December 31, 2010, respectively.

Total non-performing assets were $70.6 million at March 31, 2011, a decrease of $13.9 million, or 16.5%, from $84.5 million at December 31, 2010. Non-performing loans decreased $19.0 million and foreclosed and repossessed assets increased $5.1 million during the first quarter of 2011. The non-performing loan and foreclosed and repossessed asset activity for the first quarter of 2011 was as follows:

(Dollars in thousands)
Non-performing loans
January 1, 2011	$	68,074
Classified as non-performing		2,445
Charge offs		(10,339	)
Principal payments received		(939	)
Classified as accruing		(3,928	)
Transferred to real estate owned		(6,231	)
March 31, 2011	$	49,082
Foreclosed and repossessed assets
January 1, 2011	$	16,395
Transferred from non-performing loans		6,231
Other foreclosures/repossessions		0
Real estate sold		(1,054	)
Net gain on sale of assets		81
Write downs		(170	)
March 31, 2011	$	21,483

Of the $10.3 million in charge offs recorded during the first quarter of 2011, $9.3 million related to the charge offs on four lending relationships where the collateral was moved to real estate owned or repossessed assets during the quarter and the previously established specific reserves were charged off.

The following table summarizes the number of lending relationships and industry of commercial business loans

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(the largest category of non-performing loans) that were non-performing at March 31, 2011 and December 31, 2010.

			Principal Amount				Principal Amount
(Dollars in thousands)			of Loans				of Loans
			March 31,				December 31,
Industry Type	#		2011		#		2010
Construction/development		5	$	6,205		6	$	9,148
Finance		1		244		1		248
Retail		3		3,129		1		2,504
Banking		2		8,223		2		8,223
Entertainment		1		309		1		315
Utilities		1		4,598		1		4,614
Restaurant		3		1,121		4		1,217
		16	$	23,829		16	$	26,269

The Company had specific reserves established against the above commercial business loans of $9.3 million and $10.7 million, respectively, at March 31, 2011 and December 31, 2010.

The following table summarizes the number of lending relationships and types of commercial real estate loans that were non-performing at March 31, 2011 and December 31, 2010.

						��
			Principal Amount				Principal Amount
(Dollars in thousands)			of Loans				of Loans
			March 31,				December 31,
Property Type	# of relationships		2011		# of relationships		2010
Residential developments		4	$	10,732		9	$	23,661
Single family homes		2		296		3		2,673
Alternative fuel plants		1		4,994		1		4,994
Shopping centers/retail		2		1,036		3		1,099
Restaurants/bar		1		614		1		635
Office buildings		2		3,937		1		3,675
		12	$	21,609		18	$	36,737

The Company had specific reserves established against the above commercial real estate loans of $6.9 million and $13.3 million, respectively, at March 31, 2011 and December 31, 2010. The decrease in the non-performing commercial real estate loans is due primarily to the $10.3 million in charge offs and $6.2 million in loans that were foreclosed on during the quarter and moved to other real estate owned.

Dividends

The declaration of dividends is subject to, among other things, the Company’s financial condition and results of operations, the Bank’s compliance with its regulatory capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. Under the Bank Supervisory Agreement, no dividends can be declared or paid by the Bank to the Company without prior regulatory approval. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders and, under the Company Supervisory Agreement, the Company may not declare or pay any cash dividends, or purchase or redeem any capital stock, without prior notice to, and consent of, the OTS. The Company suspended the dividend payments to common stockholders in the fourth quarter of 2008 due to the net operating losses experienced and the challenging economic environment. The Company deferred the February 15, 2011 regular quarterly cash dividend and has determined that it will defer the May 15, 2011 regular quarterly cash dividend on the preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program.

LIQUIDITY AND CAPITAL RESOURCES

For the quarter ended March 31, 2011, the net cash provided by operating activities was $6.8 million. The Company collected $33.8 million in principal repayments and maturities on securities during the quarter. It purchased $40.0 million of investment securities, redeemed $0.3 million in FHLB stock, received $1.1 million in proceeds from the sale of real estate, and received $19.2 million related to a decrease in net loans receivable. The Company had a net increase in deposit balances of $4.8 million during the quarter and received $0.6 million in

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customer escrows. It also paid off borrowings of $7.5 million.

The Company has certificates of deposits with outstanding balances of $177.4 million that come due over the next 12 months, of which $48.3 million were obtained from brokers. Based upon past experience, management anticipates that the majority of the non-brokered deposits will renew for another term. The Company believes that non-brokered deposits which do not renew will be replaced with deposits from other customers or brokers. FHLB advances, Federal Reserve borrowings, or proceeds from the sale of securities could also be used to replace unanticipated outflows of non-brokered deposits.

The Company has deposits of $57.6 million in checking and money market accounts with customers that have individual balances greater than $5.0 million. These funds may be withdrawn at any time, however, management does not anticipate that these deposits will be withdrawn from the Bank over the next twelve months. If these deposits were to be withdrawn, the Company believes they would be replaced with deposits from other customers or brokers. FHLB advances, Federal Reserve borrowings or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.

The Company has $45.0 million in advances with the FHLB that mature during the next twelve months. The Company has $70.0 million of FHLB advances that mature beyond March 31, 2012 that have call features that can be exercised by the FHLB during the next twelve months. If the call features are exercised, the Company has the option of requesting any advance otherwise available to it pursuant to the credit policy of the FHLB. Under the Company Supervisory Agreement, the Company may not incur or issue any debt without prior notice to, and the consent of, the OTS. Because FHLB advances are debt of the Bank, they are not affected by the Company’s restriction on incurring debt.

The primary source of cash for HMN is dividends from the Bank and the Bank is restricted under the Bank Supervisory Agreement from paying dividends to the Company without obtaining prior regulatory approval. At March 31, 2011, HMN had $1.9 million in cash and other assets that could readily be turned into cash. The primary use of cash by HMN is the payment of expenses and dividends on the preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The amount of the dividend on the preferred stock accumulates at the rate of $325,000 per quarter through February 14, 2014 and $585,000 per quarter thereafter, if the shares of preferred stock are not redeemed. If the accumulated dividends on the preferred stock have not been paid for an aggregate of six quarterly dividend periods or more, whether or not consecutive, the number of directors of the Company automatically will be increased by two, and the holders of the preferred shares (currently the United States Treasury) will have the right to elect two directors to fill the newly created directorships. The Company deferred the February 15, 2011 dividend payment and has determined that it will defer the May 15, 2011 payment.

HMN also serves as a source of capital, liquidity and financial support to the Bank. Based on the operating performance of the Bank or other capital demands, HMN may need to raise additional capital. If HMN raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and may dilute the per share book value of the Company’s common stock. New investors may also have rights, preferences and privileges senior to the Company’s current stockholders, which may adversely impact the Company’s current stockholders. HMN’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside of the Company’s control, and on the Company’s financial performance. Accordingly, HMN may not be able to raise additional capital, if needed, on favorable economic, or other terms acceptable to the Company. If HMN cannot raise additional capital when needed, the Company’s ability to maintain or expand its operations, its ability to operate without additional regulatory or other restrictions, and its operating results, could be materially adversely affected.

Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure.

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The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. TheRate Shock Tablelocated in the Asset/Liability Management section of this report, which follows, discloses the Company’s projected changes in net interest income based upon immediate interest rate changes called rate shocks.

The Company utilizes a model that uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. The following table discloses the projected changes in market value to the Company’s interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on March 31, 2011.

Other than trading portfolio
(Dollars in thousands)	Market Value
Basis point change in interest rates	-100			0			+100			+200
Total market risk sensitive assets	$	862,199			849,463			835,021			819,504
Total market risk sensitive liabilities		811,797			799,526			786,135			772,290
Off-balance sheet financial instruments		(176	)		0			35			79
Net market risk	$	50,578			49,937			48,851			47,135
Percentage change from current market value		1.28	%		0.00	%		(2.17	)%		(5.61	)%

The preceding table was prepared utilizing the model using 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 5% to 70%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 7% and 45%, depending on the note rate and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 12% and 34% depending on the note rate and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to be withdrawn until maturity. Passbook accounts were assumed to decay at an annual rate of 21% and money market accounts were assumed to decay at an annual rate of 23%. Retail non-interest checking accounts and NOW accounts were assumed to decay at an annual rate of 17%. Commercial NOW accounts and MMDA accounts were assumed to decay at annual rates of 17% and 23%, respectively. FHLB advances and callable investments were projected to be called at the first call date where the projected interest rate on similar remaining term instruments exceeded the interest rate on the callable advance or investment.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial sustained interest rate

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increase.

Asset/Liability Management

The Company’s management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following March 31, 2011 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated annual impact on net interest income of immediate interest rate changes called rate shocks.

			Projected
	Rate Shock		Change in Net
	in Basis		Interest			Percentage
(Dollars in thousands)	Points		Income			Change
		+200	$	1,062			3.70	%
		+100		790			2.75
		0		0			0.00
		-100		(1,447	)		(5.04	)

The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. The increase in interest income in a rising rate environment is primarily because more loans than deposits are scheduled to reprice in the next twelve months.

In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee which meets frequently to discuss changes in the interest rate risk position and projected profitability. The Committee makes adjustments to the asset-liability position of the Bank, which are reviewed by the Board of Directors of the Bank. This Committee also reviews the Bank’s portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board’s objectives in the most effective manner. In addition, each quarter the Board reviews the Bank’s asset/liability position, including simulations of the effect on the Bank’s capital of various interest rate scenarios.

In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, in certain situations, provide high enough returns to justify the increased exposure to sudden and unexpected changes in interest rates.

To the extent consistent with its interest rate spread objectives, the Bank attempts to manage its interest rate risk and has taken a number of steps to structure its balance sheet in order to better match the maturities of its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans that are saleable to third parties and generally places only those fixed rate loans that meet certain risk characteristics into its loan portfolio. The Bank’s commercial loan production has primarily been in adjustable rate loans while the fixed rate commercial loans placed in portfolio have been shorter-term loans, usually with maturities of five years or less, in order to manage the Company’s interest rate risk exposure.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business.

Item 4: Controls and Procedures

Evaluation of disclosure controls and procedures.As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (Exchange Act). Based on this evaluation, the

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principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal controls.There was no change in the Company’s internal controls over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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HMN FINANCIAL, INC.

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings.

From time to time, the Company is party to legal proceedings arising out of its lending and deposit operations. The Company is, and expects to become, engaged in a number of foreclosure proceedings and other collection actions as part of its collection activities. Litigation is often unpredictable and the actual results of litigation cannot be determined with any certainty.

ITEM 1A. Risk Factors.

See Part I, Item 1.A. of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for risk factors.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

ITEM 3. Defaults Upon Senior Securities.

The Company has deferred regular quarterly cash dividend payments on preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program. For additional information on these dividend deferrals, please see the Company’s current reports on Form 8-K filed with the Securities and Exchange Commission.

ITEM 4. [Removed and Reserved]

ITEM 5. Other Information.

None.

ITEM 6. Exhibits.

Incorporated by reference to the index to exhibits included with this report immediately following the signature page.

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SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	HMN FINANCIAL, INC. Registrant
Date: May 5, 2011	/s/ Bradley Krehbiel
	Bradley Krehbiel, President
	(Principal Executive Officer)
Date: May 5, 2011	/s/ Jon Eberle
	Jon Eberle,
	Chief Financial Officer (Principal Financial Officer)

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HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q

				Sequential
		Reference		Page Numbering
Regulation		to Prior		Where Attached
S-K		Filing or		Exhibits Are
Exhibit		Exhibit		Located in This
Number	Document Attached Hereto	Number		Form 10-Q Report
3.1	Amended and Restated Certificate of Incorporation		*1	N/A
3.2	Amended and Restated By-laws		*2	N/A
4	Form of Common Stock Certificate		*3	N/A
10.18	Description of Retention Awards for Certain Executive Officers		10.18	Filed Electronically
10.19	Supervisory Agreement between HMN Financial, Inc. and the Office of Thrift Supervision		*4	N/A
10.20	Supervisory Agreement between Home Federal Savings Bank and the Office of Thrift Supervision		*5	N/A
31.1	Rule 13a-14(a)/15d-14(a) Certification of CEO		31.1	Filed Electronically
31.2	Rule 13a-14(a)/15d-14(a) Certification of CFO		31.2	Filed Electronically
32	Section 1350 Certification of CEO and CFO		32	Filed Electronically

*1	Incorporated by reference to Exhibit 3(a) to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File No. 0-24100).
*2	Incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q, as amended, for the period ending September 30, 2008. (File No. 0-24100).
*3	Incorporated by reference to the same numbered exhibit to the Company’s Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212).
*4	Incorporated by reference to the same numbered exhibit to the Company’s Annual Report on Form 10-K for the period ended December 31, 2011 (File No. 0-24100).
*5	Incorporated by reference to the same numbered exhibit to the Company’s Annual Report on Form 10-K for the period ended December 31, 2011 (File No. 0-24100).