SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------------------------------------- FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OF 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OF 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ Commission File Number 0-24100 HMN FINANCIAL, INC. ----------------------------------------------------- (Exact name of Registrant as specified in its Charter) Delaware 41-1777397 ---------------------------------- ------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 101 North Broadway, Spring Valley, Minnesota 55975-0231 ----------------------------------------------- -------------- (Address of principal executive offices) (ZIP Code) Registrant's telephone number, including area code: (507) 346-1100 ---------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate the number of shares outstanding of each of the issuer's common stock as of the latest practicable date. Class Outstanding at August 3, 1998 --------------------------------- ---------------------------------- Common stock, $0.01 par value 5,413,059 1 HMN FINANCIAL, INC. CONTENTS PART I - FINANCIAL INFORMATION Page Item 1:Financial Statements (unaudited) Consolidated Balance Sheets at June 30, 1998 and December 31, 1997 3 Consolidated Statements of Income for the Three Months Ended and Six Months Ended June 30, 1998 and 1997 4 Consolidated Statement of Comprehensive Income for the Three Months and Six Months Ended June 30, 1998 and 1997 5 Consolidated Statement of Stockholders' Equity for the Six Month Period Ended June 30, 1998 5 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 1998 and 1997 6-7 Notes to Consolidated Financial Statements 8 Item 2:Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3:Quantitative and Qualitative Disclosures about Market Risk Discussion included in Item 2 under Market Risk 19 PART II - OTHER INFORMATION Item 1:Legal Proceedings 27 Item 2:Changes in Securities 27 Item 3:Defaults Upon Senior Securities 27 Item 4:Submission of Matters to a Vote of Security Holders 27 Item 5:Other Information 28 Item 6:Exhibits and Reports on Form 8-K and Form 11-K 28 Signatures 29 2 PART I - FINANCIAL STATEMENTS HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Balance Sheets (unaudited) June 30, December 31, ASSETS 1998 1997 -------------- --------------- Cash and cash equivalents $ 9,243,228 9,364,635 Securities available for sale: Mortgage-backed and related securities (amortized cost $141,275,891 and $135,598,404) 141,834,917 135,935,482 Other marketable securities (amortized cost $68,660,843 and $68,356,926) 69,533,759 69,923,477 -------------- ------------- 211,368,676 205,858,959 -------------- ------------- Loans held for sale 8,090,619 2,287,265 Loans receivable, net 459,864,902 442,068,600 Federal Home Loan Bank stock, at cost 9,170,100 7,432,200 Real estate, net 9,105 133,939 Premises and equipment, net 6,853,179 5,880,710 Accrued interest receivable 4,554,699 4,038,131 Investment in limited partnerships 5,232,912 5,989,399 Goodwill 4,431,351 4,500,873 Core deposit intangible 1,402,759 1,546,273 Mortgage servicing rights 1,138,532 781,005 Prepaid expenses and other assets 767,990 1,349,521 Due from brokers 3,051,977 0 ------------- ------------- Total assets $ 725,180,029 691,231,510 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Deposits $ 467,133,087 467,347,688 Federal Home Loan Bank advances 177,935,737 127,650,021 Accrued interest payable 1,385,320 1,365,064 Advance payments by borrowers for taxes and insurance 752,713 786,619 Accrued expenses and other liabilities 5,118,915 6,056,356 Due to stockholders of Marshalltown Financial Corporation 59,464 3,555,352 Due to brokers 1,997,812 0 ------------- ------------- Total liabilities 654,383,048 606,761,100 ------------- ------------- Commitments and contingencies Stockholders' equity: Serial preferred stock: authorized 500,000 shares; issued and outstanding none 0 0 Common stock ($.01 par value): authorized 11,000,000 shares; issued 9,128,568 shares 91,286 91,286 Additional paid-in capital 59,882,524 59,698,662 Retained earnings, subject to certain restrictions 62,365,656 60,224,253 Accumulated other comprehensive income 874,336 1,129,818 Unearned employee stock ownership plan shares (5,802,564) (4,554,280) Unearned compensation restricted stock awards (450,698) (600,668) Treasury stock, at cost 3,698,309 and 2,912,111 shares (46,163,559) (31,518,661) ------------- ------------- Total stockholders' equity 70,796,981 84,470,410 ------------- ------------- Total liabilities and stockholders' equity $ 725,180,029 691,231,510 ============= ============= See accompanying notes to consolidated financial statements. 3 HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Income (unaudited) Three Months Ended Six Months Ended June 30, June 30, 1998 1997 1998 1997 ------------------------ ------------------------- Interest Income: Loans receivable $ 8,797,708 6,882,628 17,440,080 13,790,870 Securities available for sale: Mortgage-backed and related 2,158,639 2,176,822 4,377,337 4,366,032 Other marketable 1,229,503 917,067 2,185,975 1,502,309 Securities held to maturity: Mortgage-backed and related 0 0 0 33,400 Other marketable 0 0 0 10,032 Cash equivalents 110,623 87,434 271,947 169,594 Other 149,224 102,011 271,558 196,972 ----------- ----------- ----------- ----------- Total interest income 12,445,697 10,165,962 24,546,897 20,069,209 ----------- ----------- ----------- ----------- Interest expense: Deposits 5,721,279 4,670,797 11,424,803 9,243,595 Federal Home Loan Bank advances 2,454,631 1,626,510 4,539,097 3,077,910 ----------- ----------- ----------- ----------- Total interest expense 8,175,910 6,297,307 15,963,900 12,321,505 ----------- ----------- ----------- ----------- Net interest income 4,269,787 3,868,655 8,582,997 7,747,704 Provision for loan losses 75,000 75,000 150,000 150,000 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses 4,194,787 3,793,655 8,432,997 7,597,704 ----------- ----------- ----------- ----------- Non-interest income: Fees and service charges 257,589 100,445 491,345 196,857 Securities gains, net 737,632 113,695 1,634,079 384,612 Gain on sales of loans 351,892 63,614 718,136 217,064 Earnings (loss) in limited partnerships (989,556) 38,663 (937,613) 112,487 Other 161,145 89,379 274,924 193,070 ----------- ----------- ----------- ----------- Total non-interest income 518,702 405,796 2,180,871 1,104,090 ----------- ----------- ----------- ----------- Non-interest expense: Compensation and benefits 1,879,834 1,358,859 3,732,314 2,674,846 Occupancy 358,039 232,451 722,760 473,598 Federal deposit insurance premiums 72,608 58,924 146,439 117,901 Advertising 135,972 73,658 228,953 151,795 Data processing 164,503 118,803 338,558 243,332 Provision for real estate losses 0 1,000 0 3,000 Other 831,503 283,260 1,527,459 576,925 ----------- ----------- ----------- ----------- Total non-interest expense 3,442,459 2,126,955 6,696,483 4,241,397 ----------- ----------- ----------- ----------- Income before income tax expense 1,271,030 2,072,496 3,917,385 4,460,397 Income tax expense 487,000 740,276 1,470,000 1,653,697 ----------- ----------- ----------- ----------- Net income $ 784,030 1,332,220 2,447,385 2,806,700 =========== =========== =========== =========== Basic earnings per share $0.16 0.24 0.47 0.51 =========== =========== =========== =========== Diluted earnings per share $0.14 0.23 0.43 0.48 =========== =========== =========== =========== See accompanying notes to consolidated financial statements 4 HMN FINANCIAL, INC. Consolidated Statements of Comprehensive Income (unaudited) Three Months Ended June 30, 1998 1997 ------------------ ------------------ Net income $ 784,030 1,332,220 Other comprehensive income, net of tax: Unrealized gains on securities: Unrealized holding gains (losses) arising during period 295,168 1,481,372 Less: reclassification adjustment for gains included in net income 452,758 67,685 -------- --------- Other comprehensive income (loss) (157,590) 1,413,687 -------- --------- Comprehensive income $ 626,440 2,745,907 ======== ========= Six Months Ended June 30, 1998 1997 ------------------------------------- Net income $ 2,447,385 2,806,700 Other comprehensive income, net of tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period 747,516 734,014 Less: reclassification adjustment for gains included in net income 1,002,998 228,967 --------- -------- Other comprehensive income (255,482) 505,047 --------- --------- Comprehensive income $ 2,191,903 3,311,747 ========= ========= See accompanying notes to consolidated financial statements. HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity For the Six Month Period Ended June 30, 1998 (Unaudited) Accumulated Additional Other Common Paid-in Retained Comprehensive Stock Capital Earnings Income ---------------------------------------------------- Balance, December 31, 1997 $ 91,286 59,698,662 60,224,253 1,129,818 Net income 2,447,385 Other comprehensive income (255,482) Treasury stock purchases Amortization of restricted stock awards Restricted stock awards cancelled Restricted stock awards tax benefit 70,639 Shares purchased for employee stock ownership plan Earned employee stock ownership plan shares 194,458 Employee stock options exercised (101,765) Employee stock option plan tax benefit 22,255 Dividends (305,982) Fractional shares purchased (1,725) -------- ---------- ---------- --------- Balance, June 30, 1998 $ 91,286 59,882,524 62,365,656 874,336 ======== ========== ========== ========= Unearned Employee Stock Unearned Ownership Compensation Total Plan Restricted Treasury Stockholders' Shares Stock Awards Stock Equity ----------------------------------------------------- Balance, December 31, 1997 $(4,554,280) (600,668) (31,518,661) 84,470,410 Net income 2,447,385 Other comprehensive income (255,482) Treasury stock purchases (14,772,787) (14,772,787) Amortization of restricted stock awards 120,848 120,848 Restricted stock awards cancelled 29,122 (29,122) 0 Restricted stock awards tax benefit 70,639 Shares purchased for employee stock ownership plan (1,476,000) (1,476,000) Earned employee stock ownership plan shares 227,716 422,174 Employee stock options exercised 157,002 55,237 Employee stock option plan tax benefit 22,255 Dividends (305,982) Fractional shares purchased 9 (1,716) ---------- --------- ----------- ------------ Balance, June 30, 1998 $(5,802,564) (450,698) (46,163,559) 70,796,981 ========== ========= =========== ============ See accompanying notes to consolidated financial statements. 5 HMN FINANCIAL, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (unaudited) Six Months Ended June 30, 1998 1997 ------------------------------ Cash flows from operating activities: Net income $ 2,447,385 2,806,700 Adjustments to reconcile net income to cash provided by operating activities: Provision for loan losses 150,000 150,000 Provision for real estate losses 0 3,000 Depreciation 283,577 207,634 Amortization of (discounts) premiums, net (128,956) (107,808) Amortization of deferred loan fees (317,266) (183,614) Amortization of goodwill 90,318 0 Amortization of core deposit intangible 143,514 0 Amortization of other purchase accounting adjustments 382,014 0 Amortization of mortgage servicing rights 196,683 0 Provision for deferred income taxes 167,000 258,698 Securities gains, net (1,634,079) (384,612) Gain on sales of real estate (21,777) (3,743) Gain on sales of loans (718,136) (217,064) Proceeds from sale of loans held for sale 68,990,372 4,414,601 Disbursements on loans held for sale (53,532,026) (3,142,412) Amortization of restricted stock awards 120,848 115,324 Amortization of unearned ESOP shares 227,716 192,120 Earned employee stock ownership shares priced above original cost 194,458 124,410 Increase in accrued interest receivable (516,568) (347,067) Increase (decrease) in accrued interest payable 20,256 (335,232) Equity (earnings) loss of limited partnerships 937,613 (112,487) Decrease (increase) in other assets 581,531 (94,493) Decrease in other liabilities (795,342) (149,358) Other, net (6,171) 20,768 ----------- ----------- Net cash provided by operating activities 17,262,964 3,215,365 ----------- ----------- Cash flows from investing activities: Proceeds from sales of securities available for sale 91,763,992 33,311,951 Principal collected on securities available for sale 16,165,151 6,657,798 Proceeds collected on maturity of securities available for sale 23,100,000 15,868,412 Purchases of securities available for sale (136,566,747) (60,433,633) Proceeds from sales of securities held to maturity 0 348,871 Principal collected on securities held to maturity 0 240,441 Proceeds collected on maturity of securities held to maturity 0 1,000,000 Proceeds from sales of loans receivable 3,047,939 23,666,730 Purchases of mortgage servicing rights (557,536) (370,008) Purchase of interest in limited partnerships (181,125) (1,938,750) Purchase of Federal Home Loan Bank stock (1,737,900) (505,500) Net increase in loans receivable (41,486,818) (26,466,169) Proceeds from sale of real estate 152,415 35,627 Purchases of premises and equipment (1,256,046) (717,045) Decrease in due to stockholders of Marshalltown Financial Corporation (3,495,888) 0 ----------- ----------- Net cash used by investing activities (51,052,563) (9,301,275) ----------- ----------- Cash flows from financing activities: Increase (decrease) in deposits (82,370) 2,908,442 Purchase of treasury stock (14,772,787) (4,109,637) Increase in unearned ESOP shares (1,476,000) 0 Stock options exercised 55,237 138 Dividends to stockholders (305,982) 0 Fractional shares purchased from stock split (1,716) 0 Proceeds from Federal Home Loan Bank advances 92,500,000 74,800,000 Repayment of Federal Home Loan Bank advances (42,214,284) (66,514,284) Decrease in advance payments by borrowers for taxes and insurance (33,906) (12,643) ----------- ----------- Net cash provided by financing activities 33,668,192 7,072,016 ----------- ----------- Increase (decrease) in cash and cash equivalents(121,407) 986,106 Cash and cash equivalents, beginning of period 9,364,635 10,583,717 ----------- ----------- Cash and cash equivalents, end of period $ 9,243,228 11,569,823 =========== =========== 6 Supplemental cash flow disclosures: Cash paid for interest $ 15,943,644 12,656,737 Cash paid for income taxes 967,000 1,445,500 Supplemental noncash flow disclosures: Loans securitized and transferred to securities available for sale $ 0 4,781,034 Securities held to maturity transferred to securities available for sale 0 1,295,147 Loans transferred to loans held for sale 20,553,439 1,694,660 Transfer of loans to real estate 17,105 188,776 Transfer of real estate to loans 0 84,772 Securities purchased with liability due to broker 1,997,812 1,200,000 Securities sold with payment due from broker 3,051,977 0 See accompanying notes to consolidated financial statements. 7 HMN FINANCIAL, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) June 30, 1998 and 1997 (1) HMN FINANCIAL, INC. HMN Financial, Inc. (HMN) is a stock savings bank holding company which owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer financial planning products and services. HMN has two other wholly owned subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc. (MSI). SFC invests in commercial loans and commercial real-estate loans located throughout the United States which were originated by third parties. MSI operates mortgage banking and mortgage brokerage facilities located in Eden Prairie and Brooklyn Park, Minnesota. The consolidated financial statements included herein are for HMN, SFC, MSI, the Bank and the Bank's wholly owned subsidiaries, OAI and MSL. All significant intercompany accounts and transactions have been eliminated in consolidation. (2) BASIS OF PREPARATION The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of income, consolidated statements of stockholders' equity and consolidated statements of cash flows in conformity with generally accepted accounting principles. However, all adjustments consisting of only normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The statement of income for the three month and six month periods ended June 30, 1998 are 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 Effective January 1, 1998 HMN adopted Statement of Financial Accounting Standards ("SFAS") No. 130, REPORTING COMPREHENSIVE INCOME. The statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be disclosed in the financial statements. Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for HMN is comprised entirely of unrealized gains and losses on securities available for sale. The gross unrealized holding gains for the second quarter of 1998 were $482,000, the income tax expense would have been $187,000 and therefore, the net gain was $295,000. The gross reclassification adjustment for the second quarter of 1998 was $738,000, the income tax expense would have been $285,000 and therefore, the net reclassification adjustment was $453,000. The gross unrealized holding gains for the second quarter of 1997 were $2,468,000, the income tax expense would have been $987,000 and therefore, the net gain was $1,481,000. The gross reclassification adjustment for the second quarter of 1997 was $114,000, the income tax expense would have been $46,000 and therefore, the net reclassification adjustment was $68,000. 8 The gross unrealized holding gains for the six month period ended June 30, 1998 were $1,163,000, the income tax expense would have been $415,000 and therefore, the net gain was $748,000. The gross reclassification adjustment for the first six months of 1998 was $1,634,000, the income tax expense would have been $631,000 and therefore, the net reclassification adjustment was $1,003,000. The gross unrealized holding gains for the six month period ended June 30, 1997 were $1,233,000, the income tax expense would have been $499,000 and therefore, the net gain was $734,000. The gross reclassification adjustment for the first six months of 1997 was $385,000, the income tax expense would have been $156,000 and therefore, the net reclassification adjustment was $229,000. In February 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 132, EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS which revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans. It standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable, requires additional information on changes in the benefit obligation and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures that are no longer as useful as they were when FASB Statements No. 87, EMPLOYERS' ACCOUNTING FOR PENSIONS, NO. 88, EMPLOYERS' ACCOUNTING FOR SETTLEMENT AND CURTAILMENTS OF DEFINED BENEFIT PENSION PLANS AND FOR TERMINATION BENEFITS, and No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS, were issued. SFAS No. 132 suggests combined formats for presentation of pension and other postretirement benefit disclosures. It is effective for fiscal years beginning after December 15, 1997. Restatement of disclosures for earlier periods provided for comparative purposes is required unless the information is not readily available. Adopting the disclosure requirements of SFAS No. 132 will not have a material impact on HMN's financial condition or the results of its operations. In June 1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. - - For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. - - For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. - - For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. 9 - - For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Under FASB No. 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. FASB No. 133 precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation. FASB No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application should be as of the beginning of an entity's fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of FASB No. 133. HMN is anticipating that it will adopt FASB No. 133 in the first quarter of 2000 and is currently studying the impact of adopting the statement on its financial statements. (4) STOCK SPLIT AND CASH DIVIDEND In February of 1998 HMN authorized a three-for-two stock split in the form of a fifty percent stock dividend subject to stockholder approval to increase HMN's authorized common stock from 7.0 million shares to 11.0 million shares. At the annual meeting on April 28, 1998 the stockholders approved the increase in authorized common stock. The Board of Directors then declared that the stock dividend be distributed on May 22, 1998 to stockholders of record on May 8, 1998. The stock split increased HMN's outstanding common shares from 6,085,775 to 9,128,662 shares. Stockholders' equity has been restated to give retroactive effect to the stock split for all periods presented by reclassifying from additional paid-in capital to common stock the par value of the additional shares arising from the stock split. In addition all references in the Consolidated Financial Statements and Notes thereto to number of shares, per- share amounts, stock option data and market prices of HMN's common stock have been restated giving retroactive recognition to the stock split. A cash dividend of $0.06 per share was paid on June 12, 1998 to stockholders of record on May 27, 1998. (5) MERGERS AND ACQUISITIONS On December 5, 1997 HMN, through its wholly owned subsidiary, Home Federal, completed its merger (the Merger) with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. The aggregate consideration per the merger agreement was $24.8 million, consisting of $23.7 million for 1.35 million outstanding shares of MFC stock, or $17.51 per share, and $1.1 million for the outstanding MFC options. HMN owned 60,000 shares of MFC stock with a historical cost of $1.0 million which were cancelled upon the completion of the merger. The following Unaudited Pro Forma Condensed Combined Statements of Income for the three months and six months ended June 30, 1997 combine HMN's income statement with MFC's income statement. The statement is presented as if the Merger had been effective at the beginning of the period presented, after giving effect to certain pro forma adjustments described in the accompanying notes. The Unaudited Pro Forma Condensed Combined Statements of Income and notes thereto (the Information) reflect the application of the purchase method of accounting for the Merger. Under this method, the assets acquired and liabilities assumed from MFC and its subsidiaries are recorded at their fair market values on the date of the Merger. The amount of the purchase price in excess of the fair market value of the tangible and identifiable intangible assets acquired less the fair market value of the liabilities assumed is recorded as 10 goodwill. Certain historical information of the consolidated MFC has been reclassified to conform to HMN's financial statement presentation. The Information is not necessarily indicative of the results of future operations of the combined entity or the actual results that would have been achieved had the Merger of MFC been consummated prior to the period indicated. UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENTS OF INCOME Three months ended June 30, 1997 Pro Forma ---------------------------- HMN MFC Adjustments Combined ---------- ---------- ---------- ---------- Total interest income $ 10,165,962 2,208,600 (501,075)(1)(2)11,873,487 Total interest expense 6,297,307 1,361,923 96,893 (3)(4) 7,756,123 ---------- ---------- ---------- ---------- Net interest income 3,868,655 846,677 (597,968) 4,117,364 Provision for loan losses 75,000 2,500 77,500 Non-interest income 405,796 31,099 436,895 Non-interest expense 2,126,955 544,965 123,561 (5)(6) 2,795,481 ---------- ---------- ---------- ---------- Income before income tax expense 2,072,496 330,311 (721,529) 1,681,278 Income tax expense 740,276 126,600 (243,542) 623,334 ---------- ---------- ---------- ---------- Net income $ 1,332,220 203,711 (477,987) 1,057,944 ========== ========== ========== ========== Basic earnings per share $ 0.24 0.14 0.19 Diluted earnings per share $ 0.23 0.14 0.18 Weighted average shares outstanding: Basic 5,513,223 1,470,032 5,513,223 Diluted 5,870,132 1,470,860 5,870,132 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENTS OF INCOME Six months ended June 30, 1997 Pro Forma ---------------------------- HMN MFC Adjustments Combined ---------- ---------- ---------- ---------- Total interest income $ 20,069,209 4,408,932 (1,002,150)(1)(2) 23,475,991 Total interest expense 12,321,505 2,726,611 193,785 (3)(4) 15,241,901 ----------- ---------- ---------- ---------- Net interest income 7,747,704 1,682,321 (1,195,935) 8,234,090 Provision for loan losses 150,000 5,000 155,000 Non-interest income 1,104,090 67,973 1,172,063 Non-interest expense 4,241,397 1,138,001 247,121 (5)(6) 5,626,519 ----------- ---------- ---------- ---------- Income before income tax expense 4,460,397 607,293 (1,443,056) 3,624,634 Income tax expense 1,653,697 160,504 (470,368) 1,343,833 ----------- ---------- ---------- ---------- Net income $ 2,806,700 446,789 (972,688) 2,280,801 =========== ========== ========== ========== Basic earnings per share $ 0.51 0.30 0.41 Diluted earnings per share $ 0.48 0.30 0.39 Weighted average shares outstanding: Basic 5,531,618 1,469,910 5,531,618 Diluted 5,879,360 1,470,717 5,879,360 Pursuant to the Merger and consistent with GAAP, certain adjustments were recorded, primarily to accrue for specific, identified costs related to the merger of MFC. The amounts of the Merger related costs are subject to revisions as economic conditions change or as more information becomes available. HMN expects to achieve operating cost savings primarily through reductions in staff and the consolidation of certain functions such as data processing, investments and other back office operations at MFC. The operating cost savings are expected to be achieved in various amounts at various times during the years subsequent to the acquisition of MFC and not ratably over, or at the beginning or end of, such periods. No adjustment has been reflected in the Unaudited Pro Forma Condensed Combined Statement of Income for the 11 three months and six months ended June 30, 1997 for the anticipated cost savings. (1) Represents amortization of MFC mark-to-market adjustments under the purchase method of accounting for loans. (2) Represents amortization of MFC mark-to-market adjustments under the purchase method of accounting for securities, and the forgone interest income resulting from the planned sale of $15.8 million of securities. (3) Represents amortization of MFC mark-to-market adjustments under the purchase method of accounting for deposits. (4) Represents the net interest cost of borrowing $10.0 million to fund the MFC acquisition. (5) Represents amortization of goodwill and core deposit intangible. (6) Represents the additional depreciation on premises and equipment related to the MFC mark-to-market adjustments. (6) INVESTMENT IN LIMITED PARTNERSHIP AND MORTGAGE SERVICING IMPAIRMENT RESERVES During the second quarter of 1998 HMN established valuation reserves on mortgage servicing assets and recognized its proportionate share of losses on a partnership investment after the partnership established valuation reserves on its mortgage servicing assets; resulting in an aggregate pretax charge to HMN's second quarter income of $1.3 million. For the six months ended June 30, 1998 year to date pretax income was reduced by $132,000 related to establishing valuation reserves on mortgage servicing assets and pretax income was reduced by a $1.14 million charge which recognized HMN's proportionate share of losses on a partnership investment after the partnership established valuation reserves on its mortgage servicing assets. (7) EARNINGS PER SHARE The following table reconciles the weighted average shares outstanding and the income available to common shareholders used for basic and diluted EPS: Three months ended June 30, Six Months ended June 30, --------------------------- ------------------------ 1998 1997 1998 1997 ---------------------- ---------------------- Weighted average number of common shares outstanding used in basic earnings per common share calculation 5,051,205 5,513,223 5,248,262 5,531,618 Net dilutive effect of: Options 379,759 277,298 391,398 266,195 Restricted stock awards 54,197 79,611 57,773 81,548 --------- --------- --------- --------- Weighted average number of shares outstanding adjusted for effect of dilutive securities 5,485,161 5,870,132 5,697,433 5,879,361 ========= ========= ========= ========= Income available to common shareholders $ 784,030 1,332,220 2,447,385 2,806,700 Basic earnings per common share $ 0.16 0.24 0.47 0.51 Diluted earnings per common share $ 0.14 0.23 0.43 0.48 The earnings per share calculations reflected above are presented as if the split had been completed at the beginning of each period presented for the weighted average number of shares outstanding for each period. (8) REGULATORY CAPITAL The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on HMN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. 12 Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tangible, Tier I (Core), and Risk-based capital (as defined in the regulations) to adjusted total assets and risk-weighted assets (as defined). Management believes, as of June 30, 1998, that the Bank meets all capital adequacy requirements to which it is subject. Management believes that based upon the Bank's capital calculations at June 30, 1998 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized. On June 30, 1998 the Bank's tangible assets and adjusted total assets were $694.7 million and its risk-weighted assets were $329.4 million. The following table presents the Bank's capital amounts and ratios at June 30, 1998 for actual capital, required capital and excess capital including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations. - ---------------------------------------------------------------------------- Required to be Adequately Actual Capitalized ---------------------- ---------------------- (IN THOUSANDS) Amount Percent Amount Percent ---------- ----------- ---------- ----------- Bank stockholder's equity $ 47,619 Plus: Net unrealized loss (gain) on certain securities available for sale (659) Less: Goodwill and other intangibles 5,834 Excess mortgage servicing rights 434 ------ Tier I or core capital 40,692 $27,788 Tier I capital to adjusted total assets 5.86% 4.00% Tier I capital to risk- weighted assets 12.35% Less: Equity investments and other assets required to be deducted 222 Plus: Allowable allowance for loan losses 2,890 ------ Risk-based capital $43,360 $26,350 ====== Risk-based capital to risk- weighted assets 13.16% 8.00% - ---------------------------------------------------------------------------- Required to be To Be Well Capitalized Under Prompt Corrective Excess Capital Actions Provision ---------------------- ---------------------- (IN THOUSANDS) Amount Percent Amount Percent ---------- ----------- ---------- ----------- Bank stockholder's equity $ Plus: Net unrealized loss (gain) on certain securities available for sale Less: Goodwill and other intangibles Excess mortgage servicing rights Tier I or core capital $ 12,904 Tier I capital to adjusted total assets 1.86% 5.00% Tier I capital to risk- weighted assets 6.00% Less: Equity investments and other assets required to be deducted Plus: Allowable allowance for loan losses Risk-based capital $ 17,010 Risk-based capital to risk- weighted assets 5.16% 10.00% - ----------------------------------------------------------------------------- The tangible capital of the Bank was in excess of the minimum 2% required at June 30, 1998, but is not reflected in the table above. 13 HMN FINANCIAL, INC. Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL HMN's net income is dependent primarily on its net interest income, which is the difference between interest earned on its loans and investments and the interest paid on interest-bearing liabilities. Net interest income is determined by (i) the difference between the yield earned on interest-earning assets and rates paid on interest-bearing liabilities (interest rate spread) and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities. HMN's interest rate spread is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Net interest margin is calculated by dividing net interest income by the average interest-earning assets and is normally expressed as a percentage. Net interest income and net interest margin are affected by changes in interest rates, the volume and the mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. HMN's net income is also affected by the generation of non-interest income, which primarily consists of gains from the sale of securities, gains from sale of loans, service charges, fees and other income. In addition, net income is affected by the level of operating expenses and establishment of a provision for loan losses. The operations of financial institutions, including the Bank, are significantly affected by prevailing economic conditions, competition and the monetary and fiscal policies of governmental agencies. Lending activities are influenced by the demand for and supply of housing, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market rates of interest primarily on competing investments, account maturities and the levels of personal income and savings in the market area of the Bank. STOCK SPLIT In February of 1998 HMN announced that its Board of Directors had authorized a three-for-two stock split in the form of a fifty percent stock dividend subject to stockholder approval at the annual meeting of stockholders held on April 28, 1998 to increase HMN's authorized common stock from 7.0 million shares to 11.0 million shares. At the annual meeting the stockholders approved the increase in authorized common stock. The Board of Directors then declared that the split would be distributed on May 22, 1998 to shareholders of record on May 8, 1998. The financial statements included in this Form 10-Q for the quarter and six month period ended June 30, 1997 have been presented assuming that the stock split had taken place at the beginning of those periods. Earnings per share calculations included in the financial statements were based upon post split weighted average outstanding share information. NET INCOME HMN's net income for the second quarter of 1998 was $784,000, a decrease of $548,000, compared to net income of $1.3 million for the second quarter of 1997. The decrease in net income was the result of a $1.3 million increase in non-interest expense which was partially offset by a $401,000 increase in net interest income and an increase of $113,000 in non-interest income. During the second quarter of 1998, HMN established valuation reserves on mortgage servicing assets and recognized its proportionate share of losses on a partnership investment after the partnership established valuation reserves on its mortgage servicing assets; resulting in an aggregate pretax charge to HMN's income of $1.3 million. The charge decreased basic earnings per share and diluted earnings per share by $0.16 and $0.15, respectively for the second quarter of 1998. Basic earnings per share for the second quarter of 1998 were $0.16, a decrease of $0.08, compared to $0.24 basic earnings per share for the second quarter of 1997. Diluted earnings per share for the second quarter of 1998 were $0.14, a decrease of $0.09, compared to $0.23 diluted earnings per share for the second 14 quarter of 1997. Net income for the six-month period ended June 30, 1998 was $2.4 million, a decrease of $359,000, compared to $2.8 million for the same six month period of 1997. The decrease in net income was the result of a $2.5 million increase in non-interest expense which was partially offset by an $835,000 increase in net interest income and a $1.1 million increase in non-interest income. During the six month period ended June 30, 1998, HMN recognized a $132,000 pretax charge relating to establishing valuation reserves on its mortgage servicing assets. HMN also recognized a pretax charge of $1.14 million on a partnership investment which established a valuation reserve on the partnership's mortgage servicing assets. The charges related to mortgage servicing assets decreased basic earning per share and diluted earnings per share for the six month period ended June 30, 1998 by $0.16 and $0.14, respectively. Basic earnings per share for the six month period ended June 30, 1998 were $0.47, compared to $0.51 for the same six month period in 1997. Diluted earnings per share for the six month period ended June 30, 1998 were $0.43, compared to $0.48 for the same period of 1997. NET INTEREST INCOME Net interest income for the second quarter of 1998 was $4.3 million, an increase of $401,000, or 10.4%, compared to $3.9 million for the same quarter of 1997. Interest income for the second quarter of 1998 was $12.5 million, an increase of $2.3 million, or 22.4%, compared to $10.2 million for the same quarter of 1997. Interest income increased primarily due to the Marshalltown Financial Corporation ("MFC") merger which occurred on December 5, 1997 and the additional interest earning assets which were purchased with the proceeds from a $61.2 million increase in average outstanding Federal Home Loan Bank advances from the second quarter of 1997 to the second quarter of 1998. The average outstanding balances for interest-earning assets during the second quarter of 1998 compared to the second quarter of 1997 increased by $144.3 million. The average outstanding balance for loans receivable including loans held for sale increased by $112.6 million and the average outstanding balances for securities, FHLB stock, and other interest-earning assets increased by $31.7 million. The increase in interest-earning assets caused interest income to increase by $2.6 million and was partially off set by a decrease of $304,000 in interest income due to declining yields earned on interest earning assets. Interest expense for the second quarter of 1998 was $8.2 million, an increase of $1.9 million, or 29.8%, compared to $6.3 million for the same quarter of 1997. Average interest-bearing liabilities for the second quarter of 1998 were $633.9 million, an increase of $159.3 million, or 33.6%, compared to $474.6 million for the second quarter of 1997. The majority of the funds received from the increase in interest-bearing liabilities were used to purchase the net increase in average interest-bearing assets, facilitate the HMN stock repurchases, and purchase loan servicing assets. The increase in interest-bearing liabilities caused interest expense for the second quarter of 1998 to increase by $2.1 million and was partially off set by a $171,000 decline in interest expense caused by a decline in the interest rates paid on borrowings and deposits. Net interest income for the six months ended June 30, 1998 was $8.6 million, an increase of $835,000, or 10.8%, from $7.7 million for the same period of 1997. Interest income for the six month period ended June 30, 1998 was $24.5 million, an increase of $4.5 million, or 22.3%, compared to $20.1 million for the same period of 1997. Interest income increased primarily due to the MFC merger which occurred on December 5, 1997 and the additional interest earning assets which were purchased with the proceeds from a $52.8 million increase in average outstanding Federal Home Loan Bank advances from the first six months of 1997 to the same period of 1998. The average outstanding balances for interest- earning assets during the first six months of 1998 compared to the same period of 1997 increased by $140.7 million. The average outstanding balance for loans receivable including loans held for sale increased by $105.7 million and the average outstanding balances for securities, FHLB stock, and other interest- earning assets increased by $35.0 million. The increase in interest-earning assets caused interest income to increase by $5.0 million and was partially off set by a decrease of $558,000 in interest income due to declining yields earned on interest earning assets. Interest expense for the six months ended June 30, 1998 was $15.9 million, an increase of $3.6 million, or 29.6%, compared to $12.3 million for the same six month period of 1997. Average interest-bearing liabilities for the six months ended June 30, 1998 were $620.7 million, an increase of $151.5 million, or 32.3%, compared to $469.2 million for the same period of 1997. The majority of the funds received from the 15 increase in interest-bearing liabilities were used to purchase the net increase in average interest-bearing assets, facilitate the HMN stock repurchases, and purchase loan servicing assets. The increase in interest-bearing liabilities caused interest expense for the six month period of 1998 to increase by $3.9 million and was partially off set by a $249,000 decrease in interest expense caused by a decline in the interest rates paid on borrowings and deposits. PROVISION FOR LOAN LOSSES *The provision for loan losses for the second quarters ended June 30, 1998 and 1997 were both $75,000. The provision for loan losses for the six months ended June 30, 1998 and 1997 were both $150,000. The provision is the result of management's evaluation of the loan portfolio, a historically low level of non- performing loans, minimal loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located. Management's evaluation did not reveal conditions that would cause it to increase the provision for loan losses during 1998 compared to 1997. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods. A reconciliation of HMN's allowance for loan losses is summarized as follows: 1998 1997 --------- --------- Balance at January 1, $ 2,748,219 2,340,585 Provision 150,000 150,000 Charge-offs (8,099) (19,009) Recoveries 1,576 7,250 --------- --------- Balance at June 30, $ 2,891,696 2,478,826 ========= ========= NON-INTEREST INCOME Non-interest income for the second quarter of 1998 was $519,000, an increase of $113,000, or 27.8%, from $406,000 for the same quarter of 1997. The increase in non-interest income was principally due to a $157,000 increase in fees from mortgage banking activities and service charges, a $624,000 increase in gain on the sale of securities, a $288,000 increase in gain on the sale of loans and a $72,000 increase in other income. A general decline of interest rates during 1998 and other favorable economic conditions allowed HMN to sell securities and loans at a gain. The increases in non-interest income were offset by a $1.0 million decline in earnings from limited partnerships. During the second quarter of 1998, HMN recognized a charge of $1.14 million as its proportionate share of a valuation reserve on mortgage servicing assets which were established by the limited partnership. During the first six months of 1998 the interest rates charged on residential home loans in general have declined. The decline in rates has caused many borrowers to refinance their home loans which in turn has caused many mortgage loans to prepay faster than originally anticipated. The rapid prepayment of mortgage loans and the anticipation that rapid prepayments would continue into the near future, caused the estimated value of many mortgage loan servicing assets to decline during the second quarter of 1998. Non-interest income for the six months ended June 30, 1998 was $2.2 million, an increase of $1.1 million, or 97.5%, from $1.1 million for the same period of 1997. The increase in non-interest income was principally due to a $294,000 increase in fees from mortgage banking activities and service charges, a $1.2 million increase in gain on the sale of securities, a $501,000 increase in gain on the sale of loans and a $82,000 increase in other income. A general decline of interest rates during 1998 and other favorable economic conditions allowed HMN to sell securities and loans at a gain. The increases in non-interest income were offset by a $1.1 million decline in earnings from limited partnerships. In June of 1998, HMN recognized a charge of $1.14 million as its proportionate share of a valuation reserve on mortgage servicing assets which were established by the limited partnership. During the first six months of 1998 the interest rates charged on * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 16 residential home loans in general have declined. The decline in rates has caused many borrowers to refinance their home loans which in turn has caused many mortgage loans to be prepay faster than originally anticipated. The rapid prepayment of mortgage loans and the anticipation that rapid prepayments would continue into the near future, caused the estimated value of many mortgage loan servicing assets to decline during the second quarter of 1998. NON-INTEREST EXPENSE Non-interest expense was $3.4 million for the second quarter of 1998, an increase of $1.3 million, or 61.8%, from $2.1 million for the second quarter of 1997. Compensation and benefit expense increased by $521,000 primarily due to an increase in HMN's work force as a result of the MFC merger, increased staff added to the mortgage banking operations of MSI and the Bank and normal annual compensation increases to Bank employees. Occupancy costs increased by $126,000 due to three buildings added by the MFC merger, the addition of a mortgage banking office in Brooklyn Park, Minnesota and increased occupancy costs related to opening a new retail facility in Spring Valley. Other non- interest expense increased by $548,000 due to additional operating costs incurred related to the MFC merger, the mortgage banking expansion in Brooklyn Park, amortization of goodwill and core deposit intangibles of $117,000 related to the MFC merger and an increase of $165,000 to the mortgage servicing asset impairment reserve. Non-interest expense for the six months ended June 30, 1998 was $6.7 million, an increase of $2.5 million from $4.2 million for the six months ended June 30, 1997. Compensation and benefit expense increased by $1.1 million primarily due to an increase in HMN's work force as a result of the MFC merger, increased staff added to the mortgage banking operations of MSI and the Bank and normal annual compensation increases to Bank employees. Occupancy costs increased by $249,000 due to three buildings added by the MFC merger, the addition of a mortgage banking office in Brooklyn Park, Minnesota and increased occupancy costs related to opening a new retail facility in Spring Valley. Other non- interest expense increased by $950,000 partly due to additional operating costs incurred related to the MFC merger, the mortgage banking expansion in Brooklyn Park, amortization of goodwill and core deposit intangibles of $234,000 related to the MFC merger and an increase of $132,000 to the mortgage servicing asset impairment reserve. INCOME TAX EXPENSE Income tax expense was $487,000 for the second quarter of 1998, a decrease of $253,000, from $740,000 for the second quarter of 1997. The decrease is primarily due to a decrease in taxable income between the two quarters. Income tax expense was $1.5 million for the six month period ended June 30, 1998, a decrease of $184,000, from $1.7 million for the same period in 1997. The decrease is primarily due to a decrease in taxable income between the two six month periods. 17 NON-PERFORMING ASSETS The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at June 30, 1998 and December 31, 1997. June 30, December 31, (DOLLARS IN THOUSANDS) 1998 1997 ----------- ------------- Non-Accruing Loans One-to-four family real estate $ 182 177 Nonresidential real estate 76 79 Commercial business 27 0 Consumer 32 7 --- --- Total 317 263 --- --- Accruing loans delinquent 90 days or more 309 402 Foreclosed Assets Real estate: One-to-four family 17 142 --- --- Total non-performing assets $ 643 $ 807 === === Total as a percentage of total assets 0.09% 0.12% ==== ==== Total non-performing loans $ 626 $ 665 ==== ==== Total as a percentage of total loans receivable, net 0.14% 0.15% ==== ==== Total non-performing assets at June 30, 1998 were $643,000, a decrease of $164,000 from $807,000 at December 31, 1997. The decrease of $164,000 was the result of a $54,000 increase in non-accruing loans, a $93,000 decrease in accruing loans delinquent 90 days or more, and the sale or redemption of foreclosed residential homes. DIVIDENDS In February of 1998, the Board of Directors of HMN authorized a stock split in the form of a 50% stock dividend subject to HMN stockholder approval of an increase in the number of authorized shares of common stock from 7.0 million to 11.0 million. At the annual meeting of stockholders on April 28, 1998 the stockholders approved the stock split. HMN also declared a cash dividend of $.06 per share, payable on June 12, 1998 to shareholders of record on May 27, 1998. The net dividend was $305,982. LIQUIDITY For the six month period ended June 30, 1998, the net cash provided by operating activities was $17.3 million. HMN collected $91.8 million from the sale of securities, it collected $39.3 million in principal repayments or on the maturity of securities during the period. HMN also collected $3.0 million on the sale of loans receivable during the period. It purchased $136.6 million of securities, funded a net increase in loans receivable of $41.5 million, purchased $1.7 million of FHLB stock, purchased premises and equipment of $1.3 million and paid $3.5 million to the MFC stockholders related to the MFC merger. HMN had additional net borrowing from the FHLB of $50.3 million and loaned $1.48 million to its employee stock ownership plan to repurchase HMN stock for the purpose of providing a benefit to the employees added as a result of the MFC merger. HMN paid $14.8 million to purchase 791,800 shares of its own common stock during the first six months of 1998. *HMN has certificates of deposits with outstanding balances of $255.7 million that come due over the * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 18 next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. HMN's market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure. HMN's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact HMN's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. HMN monitors how its assets will mature or reprice in comparison to how its liabilities will mature or reprice. The MATURITY OR REPRICING TABLE located in the Asset/Liability Management section of this report is used as part of the monitoring process. HMN also monitors the projected changes in net interest income that would occur if interest rates were to suddenly change up or down. The RATE SHOCK TABLE located in the Asset/Liability Management section of this report discloses HMN's projected changes in net interest income based upon immediate interest rate changes called rate shocks. *HMN utilizes a model which uses the discounted cash flows from its interest- earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at June 30, 1998. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on June 30, 1998. * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 19 - ------------------------------------------------------------------------------- Other than trading portfolio Market Value -------------------------------------------- (DOLLARS IN THOUSANDS) Basis point change in interest rates -200 -100 0 +100 +20 - ------------------------------------------------------------------------------- Cash equivalents $ 8,248 8,244 8,234 8,228 8,221 Fixed-rate CMOs 68,588 66,540 66,230 64,813 62,503 Variable-rate CMOs 66,558 68,801 70,350 70,967 70,240 Fixed-rate available for sale mortgage-backed and related securities 5,181 5,122 5,062 4,944 4,774 Variable-rate available for sale mortgage-backed and related securities 168 164 160 158 157 Fixed-rate available for sale other marketable securities 85,323 82,340 79,427 76,622 73,923 Variable-rate available for sale other marketable securities 0 0 0 0 0 Fixed-rate loans held for sale 8,104 8,097 8,091 8,084 8,077 Fixed-rate real estate loans 342,080 338,865 331,664 321,160 309,660 Variable-rate real estate loans 84,636 83,222 81,253 78,973 76,477 Fixed-rate other loans 24,525 24,265 24,025 23,685 23,347 Variable-rate other loans 39,019 39,167 39,444 39,755 39,968 Mortgage servicing 643 793 1,138 1,427 1,561 Limited partnerships 2,606 3,265 4,790 5,420 6,031 ------- ------- ------- ------- ------- Total market risk sensitive assets 735,679 728,885 719,868 704,236 684,939 ------- ------- ------- ------- ------- NOW deposits 21,591 21,573 21,555 21,537 21,520 Passbook deposits 36,422 34,829 33,369 32,027 30,789 Money market deposits 41,725 40,296 38,993 37,799 36,703 Certificate deposits 379,057 375,320 371,667 368,088 364,586 Fixed-rate Federal Home Loan Bank advances 143,040 138,438 134,032 129,811 125,767 Variable-rate Federal Home Loan Bank advances 44,095 44,043 43,992 43,939 43,887 ------- ------- ------- ------- ------- Total market risk sensitive liabilities 665,930 654,499 643,608 633,201 623,252 ------- ------- ------- ------- ------- Off-balance sheet financial instruments: Commitments to extend credit 48 48 47 46 44 ------- ------- ------- ------- ------- Net market risk $ 69,797 74,434 76,307 71,081 61,731 ======= ======= ======= ======= ======= Percentage change from current market value (8.53)% (2.45)% 0.00% (6.85)%(19.10)% ======= ======= ======= ======= ======= - ------------------------------------------------------------------------------ The preceding table was prepared utilizing the following assumptions (the "Model Assumptions") regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 6% to 46%, depending on the coupon and period to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at annual rates of between 11% and 32%, depending on coupon and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 17% and 51% depending on the coupon and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 20%. 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. 20 The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the "Interest Spread") will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. ASSET/LIABILITY MANAGEMENT *HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following June 30, 1998 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. Rate Shock Net Interest Percentage in Basis Points Income Change ---------------- --------- ---------- +200 17,256 -4.86% +100 17,682 -2.51% 0 18,138 0.00% -100 18,001 -0.76% -200 17,603 -2.95% The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee consisting of executive officers which meets at least quarterly to review the interest rate risk position and projected profitability. The committee makes recommendations for adjustments to the asset liability position of the Bank to the Board of Directors of the Bank. This committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, the Board reviews on a quarterly basis the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios. In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, during periods of declining or stable interest rates, provide high enough returns to justify the increased exposure to sudden and unexpected increases in interest rates. To the extent consistent with its interest rate spread objectives, the Bank attempts to reduce its interest rate risk and has taken a number of steps to restructure its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans with contractual terms of 20 years or *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 21 less. The Bank generally follows the practice of selling all of its fixed rate single family loans with contractual maturities of thirty years. At times, depending on its interest rate sensitivity, the Bank may sell fixed rate single family loans with shorter contractual maturities than thirty years in order to reduce interest rate risk and record a gain on the sale of loans. *The following table sets forth the interest rate sensitivity of HMN's assets and liabilities at June 30, 1998, using certain assumptions that are described in more detail below: - ----------------------------------------------------------------------------- Maturing or Repricing ------------------------------------------------- Over 6 6 Months Months to Over 1-3 Over 3-5 (DOLLARS IN THOUSANDS) or Less One Year Years Years - ----------------------------------------------------------------------------- Cash equivalents $ 8,243 0 0 0 Securities available for sale: Mortgage-backed and related securities<F1> 77,859 8,619 33,295 13,946 Other marketable securities 970 443 7,022 37,934 Securities held to maturity: Mortgage-backed and related securities<F1> 0 0 0 0 Other marketable securities 0 0 0 0 Loans held for sale, net 8,091 0 0 0 Loans receivable, net:<F1><F2> Fixed rate one-to-four family<F3> 33,424 30,028 93,862 60,970 Adjustable rate one-to- four family<F3> 28,001 17,083 20,052 22,132 Multi family 1,269 1,047 2,563 571 Fixed rate commercial real estate 6,341 306 471 94 Adjustable rate commercial real estate 4,816 497 710 0 Commercial business 2,694 1,169 2,669 935 Consumer loans 23,023 1,395 3,702 1,741 Federal Home Loan Bank stock 0 0 0 0 ------- ------- ------- ------- Total interest-earning assets 194,731 60,587 164,346 138,323 ------- ------- ------- ------- Non-interest checking 11,135 0 0 0 NOW accounts 21,603 0 0 0 Passbooks 3,612 3,610 10,393 6,653 Money market accounts 2,868 2,866 8,253 5,283 Certificates 170,022 85,711 93,519 17,902 Federal Home Loan Bank advances 52,536 5,000 24,000 86,000 ------- ------- ------- ------- Total interest-bearing liabilities 261,776 97,187 136,165 115,838 ------- ------- ------- ------- Interest-earning assets less interest-bearing liabilities $ (67,045) (36,600) 28,181 22,485 ======= ======= ======= ======= Cumulative interest-rate sensitivity gap $ (67,045) (103,645) (75,464) (52,979) ======= ======= ======= ======= Cumulative interest-rate gap as a percentage of total assets at June 30, 1998 (9.25)% (14.29)% (10.41)% (7.31)% ======= ======= ======= ======= Cumulative interest-rate gap as a percentage of interest -earning assets at December 31, 1997 (6.36) (15.38) ======= ======= - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- Maturing or Repricing ------------------------------------------------- Over 5 No Stated (DOLLARS IN THOUSANDS) Years Maturity Total - ----------------------------------------------------------------------------- Cash equivalents $ 0 0 8,243 Securities available for sale: Mortgage-backed and related securities<F1> 7,557 0 141,276 Other marketable securities 12,844 9,448 68,661 Securities held to maturity: Mortgage-backed and related securities<F1> 0 0 0 Other marketable securities 0 0 0 Loans held for sale, net 0 0 8,091 Loans receivable, net:<F1><F2> Fixed rate one-to-four family<F3> 97,066 0 315,350 Adjustable rate one-to -four family<F3> 2,936 0 90,204 Multi family 452 0 5,902 Fixed rate commercial real estate 24 0 7,236 Adjustable rate commercial real estate 0 0 6,023 Commercial business 95 0 7,562 Consumer loans 619 0 30,480 Federal Home Loan Bank stock 0 9,170 9,170 -------- -------- -------- Total interest-earning assets 121,593 18,618 698,198 -------- -------- -------- Non-interest checking 0 0 11,135 NOW accounts 0 0 21,603 Passbooks 11,828 0 36,096 Money market accounts 9,388 0 28,658 Certificates 2,487 0 369,641 Federal Home Loan Bank advances 10,400 0 177,936 -------- -------- -------- Total interest-bearing liabilities 34,103 0 645,069 -------- -------- -------- Interest-earning assets less interest-bearing liabilities $ 87,490 18,618 53,129 ======== ======== ======== Cumulative interest-rate sensitivity gap $ 34,511 53,129 53,129 ======== ======== ======== Cumulative interest-rate gap as a percentage of total assets at June 30, 1998 4.76 % 7.33 % 7.33 % ======== ======== ======== Cumulative interest-rate gap as a percentage of interest-earning assets at December 31, 1997 <FN> <FN1>Schedule prepared based upon the earlier of contractual maturity or repricing date, if applicable, adjusted for scheduled repayments of principal and projected prepayments of principal based upon experience. <FN2>Loans receivable are presented net of loans in process and deferred loan fees. <FN3>Construction and development loans are all one-to-four family loans and therefore have been included in the fixed rate one-to-four family and adjustable rate one-to-four family lines. </FN> *This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 22 The preceding table was prepared utilizing the Model Assumptions regarding prepayment and decay ratios which were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. Although certain assets and liabilities may have similar maturities and periods of repricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable- rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. Refer to Regulatory Capital Requirements above for a discussion of the Bank's interest rate risk component. YEAR 2000 ISSUES *HMN has inventoried its computer hardware, computer software, third party vendors and its other non computer equipment and has assessed or is in the process of assessing whether the items are year 2000 compliant. The hardware testing has been completed and all non compliant hardware is scheduled for replacement during the fourth quarter of 1998 at a total estimated cost of $75,000. The computer software inventory indicated that certain programs were not compliant and those programs are scheduled to be replaced with year 2000 compliant software during the remainder of 1998 and through the second quarter of 1999 at an anticipated cost of $80,000. HMN will also test all computer software to determine that the software is year 2000 compliant. Actual testing of the software is scheduled to be completed during November of 1998. The assessment of non computer equipment for year 2000 compliance indicated that HMN did not have any issues in this area. *The majority of the Bank's loan and deposit data is supported by a third party data processing center. Other third party providers support the automated teller machines owned by the Bank and process the check clearings for the Bank's negotiable order of withdrawal accounts ("checking accounts"). The Bank is also reliant upon the Federal Home Loan Bank of Des Moines and the Federal Reserve System to properly and efficiently conduct its business. Notwithstanding the Bank's efforts, the failure of any of these third party vendors to address their year 2000 issues in a timely fashion may have an adverse effect on the Bank's ability to conduct its business. The Bank's Year 2000 Committee (the "Committee") is working very closely with its data processing center to ascertain that all software applications and hardware will be year 2000 compliant by the first or second quarter of 1999. The Committee is also monitoring the progress other key third party providers are making toward becoming year 2000 compliant. The Committee is in the process of developing a contingency plan which incorporates the actions the Bank will take in situations where the data processing center or other key third party providers are not able to become year 2000 compliant and it will have a major impact on the Bank's business. The contingency plan is anticipated to be completed in the fourth quarter of 1998. FORWARD-LOOKING INFORMATION The following paragraphs within Management's Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements and actual results may differ materially from the expectations disclosed within this Discussion and Analysis. These forward-looking statements are subject to risks and uncertainties, including those discussed below. HMN assumes no obligations to publicly release results of any revision or updates to these forward-looking statements to reflect future events or unanticipated occurrences. * This paragraph contains a forward-looking statement(s). Refer to information regarding Forward-looking Information on page 23 of this discussion. 23 PROVISION FOR LOAN LOSSES The provision for loan losses for the second quarters ended June 30, 1998 and 1997 were both $75,000. The provision for loan losses for the six months ended June 30, 1998 and 1997 were both $150,000. The provision is the result of management's evaluation of the loan portfolio, a historically low level of non-performing loans, minimal loan charge-off experience, and its assessment of the general economic conditions in the geographic area where properties securing the loan portfolio are located. Management's evaluation did not reveal conditions that would cause it to increase the provision for loan losses during 1998 compared to 1997. Future economic conditions and other unknown factors will impact the need for future provisions for loan losses. As a result, no assurances can be given that increases in the allowance for loan losses will not be required during future periods. LIQUIDITY HMN has certificates of deposits with outstanding balances of $255.7 million that come due over the next 12 months. Based upon past experience management anticipates that the majority of the deposits will renew for another term. HMN believes that deposits which do not renew will be replaced with deposits from other customers, or funded with advances from the FHLB, or will be funded through the sale of securities. Management does not anticipate that it will have a liquidity problem due to maturing deposits. Competitive pricing by other institutions, the desire of a competitor to pay interest rates on deposits that are above the current rates paid by HMN, or desire by customers to put more of their funds into nontraditional bank products such as stocks and bonds could be circumstances that would cause the maturing certificates to become a liquidity problem MARKET RISK HMN utilizes a model which uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. HMN believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or down from where the rates were at June 30, 1998. HMN does not have a trading portfolio. The following table discloses the projected changes in market value to HMN's interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on June 30, 1998. Interest rates could fluctuate in a range of more than 200 basis points up or down from where the rates were on June 30, 1998 due to the influence of many unforseen factors not now known to HMN's management. HMN's actual market value changes for interest earnings assets and interest bearing liabilities may differ from the projected market values disclosed in the table mentioned above. Certain shortcomings are inherent in the method of analysis in the 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 rate index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets which are approaching their life time interest rate caps could be different from 24 the values disclosed in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of an interest rate increase. ASSET/LIABILITY MANAGEMENT HMN's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following June 30, 1998 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on the net interest income of immediate interest rate changes called rate shock. HMN's actual net interest income caused by interest rate changes may differ from the amounts reflected in the table which projects the estimated impact on net interest income of immediate interest rate changes called rate shocks. Certain shortcomings are inherent in the method of analysis presented in the 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 table sets forth the interest rate sensitivity of HMN's assets and liabilities at June 30, 1998, using certain assumptions that described in more detail below: (A Maturity or Repricing table is presented in the Asset/Liability Management section.) HMN's actual maturity and repricing results of its interest-earning assets and interest-bearing liabilities may differ from the amounts reflected in the gap table. Certain shortcomings are inherent in the method of analysis presented in the 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 the payment streams on loans. Substantial changes in interest rates could also impact the early withdrawal assumptions on certificates and other deposit accounts. YEAR 2000 ISSUES HMN has inventoried its computer hardware, computer software, third party vendors and its other non computer equipment and has assessed or is in the process of assessing whether the items are year 2000 compliant. The hardware testing has been completed and all non compliant hardware is scheduled for replacement during the fourth quarter of 1998 at a total estimated cost of $75,000. The computer software inventory indicated that certain programs were not compliant and those programs are scheduled to be replaced with year 2000 compliant software during the remainder of 1998 and through the second quarter of 1999 at an anticipated cost of $80,000. HMN will also test all computer software to determine that the software is year 2000 compliant. Actual testing of the software is scheduled to be completed during November of 1998. The assessment of non computer equipment for year 2000 compliance indicated that HMN did not have any issues in this area. The majority of the Bank's loan and deposit data is supported by a third party data processing center. Other third party providers support the automated teller machines owned by the Bank and process the check clearings for the Bank's negotiable order of withdrawal accounts ("checking accounts"). The Bank is also reliant upon the Federal Home Loan Bank of Des Moines and the Federal Reserve System to properly and efficiently conduct its business. Notwithstanding the Bank's efforts, the failure of any of these third party vendors to address their year 2000 issues in a timely fashion may have an adverse effect on the Bank's ability to conduct its business. The Bank's Year 2000 Committee (the "Committee") is working very closely with its data processing center to ascertain that all software applications and hardware will be year 2000 compliant by the first or second quarter of 25 1999. The Committee is also monitoring the progress other key third party providers are making toward becoming year 2000 compliant. While HMN has inventoried and assessed its hardware, software and other non computer equipment other unforseen issues may come to light in the future with the above mentioned items that would cause HMN to incur additional costs in order to become year 2000 compliant. While HMN has identified and assessed the year 2000 risks related to each of its major third party vendors and providers, it is monitoring their activities related to becoming year 2000 compliant. It is still possible that the vendors and providers may not be year 2000 compliant and the contingency plan that HMN is developing would not have anticipated the problem. An example of this situation would be if all the telephone communication lines became in operative because of a year 2000 issue on September 9, 1999, the Bank would not be able to process its daily activity and servicing its customers would be difficult without the communication lines for any extended period of time. It would be difficult to have a contingency plan that would allow the Bank to conduct its business without using the communication lines to transmit its business activity. 26 HMN FINANCIAL, INC. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings. None. ITEM 2. Changes in Securities. Not applicable ITEM 3. Defaults Upon Senior Securities. Not applicable. ITEM 4. Submission of Matters to a Vote of Security Holders. The Annual Meeting of Stockholders of the Company was held on April 28, 1998 at 10:00 a.m.. The following is a record of the votes cast in the election of two directors of the Company each with a term to expire in 2001: BROKER FOR VOTE WITHHELD NON-VOTES ---------- ------------- ---------- M.F. Schumann 3,156,259 422,320 -- Roger P. Weise 3,152,463 426,116 -- Accordingly, the individuals named above were declared to be duly elected directors of the Company for terms to expire in 2001, respectively. Terms for directors continuing in office are as follows: TERM EXPIRES -------------- James B. Gardner 1999 Timothy R. Geisler 1999 Duane D. Benson 2000 Irma R. Rathbun 2000 The following is a record of the votes cast in respect of the proposal to amend the Company's Certificate of Incorporation, increasing the number of authorized share of Common Stock from 7 million to 11 million. NUMBER PERCENTAGE OF VOTES OF VOTES ACTUALLY CAST ------------ ------------------- FOR 3,443,833 96.24% AGAINST 110,631 3.09% ABSTAIN 24,115 .67% BROKER NON-VOTES -- 0% 27 Accordingly, the proposal described above was declared to be duly adopted by the stockholders of the Company. The following is a record of the votes cast in respect of the proposal to ratify the appointment of KPMG Peat Marwick, LLP as the Company's auditors for the fiscal year ending December 31, 1998. NUMBER PERCENTAGE OF VOTES OF VOTES ACTUALLY CAST ------------ ------------------- FOR 3,568,214 99.71% AGAINST 8,825 .25% ABSTAIN 1,540 .04% BROKER NON-VOTES -- 0% Accordingly, the proposal described above was declared to be duly adopted by the stockholders of the Company. ITEM 5. Other Information. None. ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits. See Index to Exhibits on page 30 of this report. 28 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: 8/13/98 /s/ Roger P. Weise Roger P. Weise, Chairman, President and Chief Executive Officer (Duly Authorized Officer) Date: 8/13/98 /s/ James B. Gardner James B. Gardner, Executive Vice President (Principal Financial Officer) 29 HMN FINANCIAL, INC. INDEX TO EXHIBITS FOR FORM 10-Q Reference Sequential to Prior Page Numbering Regulation Filing or Where Attached S-K Exhibit Exhibits Are Exhibit Number Located in This Number Document Attached Hereto Form 10-Q Report - --------------- ---------------------------- -------------- ------------------ 2 Plan of acquisition, reorganization, N/A N/A arrangement, liquidation or succession. 3(a) Articles of Incorporation *5 N/A 3(b) By-laws *4 N/A 4 Instruments defining the rights of *1 N/A security holders, Including indentures 5(a) Amendment to the Home Federal Savings *3 N/A Bank Employees' Savings & Profit Sharing Plan dated January 28, 1997. 5(b) Amendment to the Adoption Agreement for *3 N/A Home Federal Savings Bank Employees' Savings & Profit Sharing Plan and Trust effective June 17, 1997. 10.1(a) Employment agreement for Mr. Weise *2 N/A dated June 29, 1994 10.1(b) Extension of employment agreement to 10.1(b) Filed date of May Board Meeting in May 2001 electronically 10.2(a) Employment agreement for Mr. Gardner *2 N/A dated June 29, 1994 10.2(b) Extension of employment agreement to 10.2(b) Filed date of May Board Meeting in May 2001 electronically 11 Computation of Earnings Per Common 11 Filed Share electronically 27 Financial Data Schedule 27 Filed electronically 99.1 Financial Statements for Home *6 N/A Federal Savings Bank Employees' Savings and Profit Sharing Plan *1 Filed April 1, 1994, as exhibits to the Registrant's Form S-1 registration statement (Registration No. 33-77212) pursuant to the Securities Act of 1933. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K. *2 Filed as an exhibit to the Registrant's Form 10-K for 1994 (file No. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. *3 Filed as an exhibit to the Registrant's Form 10-Q for June 30, 1997 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. *4 Filed as an exhibit to Registrant's Form 10-Q for September 30, 1997 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. *5 Filed as an exhibit to Registrant's Form 10-Q for March 31, 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. *6 Filed as Form 11-K for December 31, 1997 on June 29, 1998 (file no. 0-24100). 30