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 September 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 classes of
common stock as of the latest practicable date.
Class Outstanding at November 6, 1998
- - ---------------------------------- ----------------------------------
Common stock, $0.01 par value 5,387,404
1
HMN FINANCIAL, INC.
CONTENTS
PART I - FINANCIAL INFORMATION
Page
----
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at
September 30, 1998 and December 31, 1997 3
Consolidated Statements of Income for the
Three Months Ended and Nine Months Ended
September 30, 1998 and 1997 4
Consolidated Statements of Comprehensive Income for the
Three Months and Nine Months Ended September 30, 1998 and 1997 5
Consolidated Statement of Stockholders' Equity
for the Nine Month Period Ended September 30, 1998 5
Consolidated Statements of Cash Flows for
the Nine Months Ended September 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 15
Item 3: Quantitative and Qualitative Disclosures about Market Risk
Discussion included in Item 2 under Market Risk 20
PART II - OTHER INFORMATION
Item 1: Legal Proceedings 29
Item 2: Changes in Securities 29
Item 3: Defaults Upon Senior Securities 29
Item 4: Submission of Matters to a Vote of Security Holders 29
Item 5: Other Information 29
Item 6: Exhibits and Reports on Form 8-K 29
Signatures 30
2
PART I - FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(unaudited)
ASSETS September 30, December 31,
1998 1997
----------- -----------
Cash and cash equivalents $ 7,476,007 9,364,635
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $138,279,816 and
$135,598,404) 137,315,620 135,935,482
Other marketable securities
(amortized cost $56,008,248 and
$68,356,926) 56,326,132 69,923,477
----------- -----------
193,641,752 205,858,959
----------- -----------
Loans held for sale 6,881,986 2,287,265
Loans receivable, net 466,470,932 442,068,600
Federal Home Loan Bank stock, at cost 9,403,800 7,432,200
Real estate, net 10,067 133,939
Premises and equipment, net 7,496,711 5,880,710
Accrued interest receivable 3,903,926 4,038,131
Investment in limited partnerships 2,556,453 5,989,399
Goodwill 4,386,192 4,500,873
Core deposit intangible 1,331,002 1,546,273
Investment in mortgage servicing rights 877,824 781,005
Prepaid expenses and other assets 1,832,575 1,349,521
----------- -----------
Total assets $ 706,269,227 691,231,510
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $ 446,332,538 467,347,688
Federal Home Loan Bank advances 184,578,583 127,650,021
Other borrowed money 100,000 0
Accrued interest payable 1,699,726 1,365,064
Advance payments by borrowers for
taxes and insurance 762,726 786,619
Accrued expenses and other liabilities 4,655,001 6,056,356
Due to stockholders of Marshalltown
Financial Corporation 48,082 3,555,352
----------- -----------
Total liabilities 638,176,656 606,761,100
----------- -----------
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 59,870,621 59,698,662
Retained earnings, subject to
certain restrictions 61,652,939 60,224,253
Accumulated other comprehensive
income (loss) (403,216) 1,129,818
Unearned employee stock ownership plan
shares (5,753,839) (4,554,280)
Unearned compensation restricted
stock awards (394,361) (600,668)
Treasury stock, at cost 3,752,509
and 2,912,111 shares (46,970,859) (31,518,661)
----------- -----------
Total stockholders' equity 68,092,571 84,470,410
----------- -----------
Total liabilities and
stockholders' equity $ 706,269,227 691,231,510
=========== ===========
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Income
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
----------------------- -----------------------
Interest Income:
Loans receivable $ 8,905,981 6,939,224 26,346,061 20,730,094
Securities available for sale:
Mortgage-backed and related 2,188,930 2,092,964 6,566,267 6,458,996
Other marketable 952,855 1,119,452 3,138,830 2,621,762
Securities held to maturity:
Mortgage-backed and related 0 0 0 33,400
Other marketable 0 0 0 10,032
Cash equivalents 90,067 55,643 362,014 225,237
Other 158,825 107,187 430,383 304,159
---------- ---------- ---------- ----------
Total interest income 12,296,658 10,314,470 36,843,555 30,383,680
---------- ---------- ---------- ----------
Interest expense:
Deposits 5,613,824 4,749,737 17,038,627 13,993,332
Federal Home Loan Bank advances 2,625,181 1,714,642 7,164,278 4,792,552
---------- ---------- ---------- ----------
Total interest expense 8,239,005 6,464,379 24,202,905 18,785,884
---------- ---------- ---------- ----------
Net interest income 4,057,653 3,850,091 12,640,650 11,597,796
Provision for loan losses 85,000 75,000 235,000 225,000
---------- ---------- ---------- ----------
Net interest income after
provision for loan losses 3,972,653 3,775,091 12,405,650 11,372,796
---------- ---------- ---------- ----------
Non-interest income (loss):
Fees and service charges 254,333 121,489 745,678 318,346
Securities gains, net 348,025 487,547 1,982,104 872,159
Gain on sales of loans 518,570 117,302 1,236,706 334,367
Earnings (loss) in limited
partnerships (2,676,458) 67,109 (3,614,071) 179,595
Other 128,341 85,121 403,265 278,191
---------- ---------- ---------- ----------
Total non-interest income
(loss) (1,427,189) 878,568 753,682 1,982,658
---------- ---------- ---------- ----------
Non-interest expense:
Compensation and benefits 1,581,907 1,431,853 5,314,221 4,106,699
Occupancy 361,191 245,202 1,083,951 718,801
Federal deposit insurance premiums 72,608 57,478 219,047 175,379
Advertising 124,067 62,763 353,020 214,557
Data processing 167,003 129,100 505,561 372,432
Provision for real estate losses 0 0 0 3,000
Other 929,928 302,449 2,457,387 879,374
--------- ---------- ---------- -----------
Total non-interest expense 3,236,704 2,228,845 9,933,187 6,470,242
--------- ---------- ---------- ----------
Income (loss) before income
tax expense (691,240) 2,424,814 3,226,145 6,885,212
Income taxes (257,000) 900,703 1,213,000 2,554,400
--------- ---------- ---------- ----------
Net income (loss) $ (434,240) 1,524,111 2,013,145 4,330,812
========= ========== ========== ==========
Basic earnings (loss) per share $ (0.09) 0.28 0.40 0.78
========= ========== ========== ==========
Diluted earnings (loss) per share$ (0.09) 0.26 0.37 0.73
========= ========== ========== ==========
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(unaudited)
Three Months Ended September 30,
1998 1997
--------------------- --------------------
Net income (loss) $ (434,240) 1,524,111
Other comprehensive income,
net of tax:
Unrealized gains (losses)
on securities:
Unrealized holding gains (losses)
arising during period (1,063,613) 1,275,488
Less: reclassification
adjustment for gains
included in net income 213,939 290,877
--------- ---------
Other comprehensive income (loss) (1,277,552) 984,611
--------- ---------
Comprehensive income (loss) $ (1,711,792) 2,508,722
========= =========
Nine Months Ended September 30,
1998 1997
---------------------- --------------------
Net income (loss) $ 2,013,145 4,330,812
Other comprehensive income,
net of tax:
Unrealized gains (losses)
on securities:
Unrealized holding gains (losses)
arising during period (314,587) 2,010,631
Less: reclassification adjustment
for gains included in net income 1,218,447 520,342
--------- ---------
Other comprehensive income (loss) (1,533,034) 1,490,289
--------- ---------
Comprehensive income (loss) $ 480,111 5,821,101
========= =========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statement of Stockholders' Equity
For the Nine Month Period Ended September 30, 1998
(unaudited)
Accumulated
Additional Other
Common Paid-in Retained Comprehensive
Stock Capital Earnings Income (Loss)
--------------------------------------------------------
Balance,
December 31, 1997 $ 91,286 59,698,662 60,224,253 1,129,818
Net income 2,013,145
Other comprehensive
income (loss) (1,533,034)
Treasury stock purchases
Amortization of
restricted stock awards
Restricted stock awards
cancelled
Tax benefits of restricted
stock awards 70,639
Shares purchased for
employee stock
ownership plan
Earned employee stock
ownership plan shares 218,777
Employee stock options
exercised (143,170)
Tax benefit of exercised
stock options 27,438
Dividends paid (584,459)
Fractional shares
purchased (1,725)
--------- ---------- ----------- ----------
Balance,
September 30, 1998 $ 91,286 59,870,621 61,652,939 (403,216)
========= ========== =========== ==========
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 2,013,145
Other comprehensive
income (loss) (1,533,034)
Treasury stock purchases (15,685,962) (15,685,962)
Amortization of
restricted stock awards 177,185 177,185
Restricted stock awards
cancelled 29,122 (29,122) 0
Tax benefits of restricted
stock awards 70,639
Shares purchased for
employee stock
ownership plan (1,476,000) (1,476,000)
Earned employee stock
ownership plan
shares 276,441 495,218
Employee stock options
exercised 262,877 119,707
Tax benefit of exercised
stock options 27,438
Dividends paid (584,459)
Fractional shares
purchased 9 (1,716)
---------- ---------- ----------- -----------
Balance,
September 30, 1998 $ (5,753,839) (394,361) (46,970,859) 68,092,571
========== ========== =========== ===========
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(unaudited)
Nine Months Ended
September 30,
1998 1997
----------------------------
Cash flows from operating activities:
Net income $ 2,013,145 4,330,812
Adjustments to reconcile net income to
cash provided by operating activities:
Provision for loan losses 235,000 225,000
Provision for real estate losses 0 3,000
Depreciation 455,195 314,248
Amortization of (discounts) premiums, net (99,108) (175,404)
Amortization of deferred loan fees (469,874) (297,964)
Amortization of goodwill 135,477 0
Amortization of core deposit intangible 215,271 0
Amortization of other purchase accounting
adjustments 582,961 0
Amortization of mortgage servicing rights 616,896 0
Provision for deferred income taxes 255,000 294,750
Securities gains, net (1,982,104) (872,159)
Gain on sales of real estate (21,777) (3,743)
Gain on sales of loans (1,236,706) (334,366)
Proceeds from sale of loans held for sale 108,788,891 14,425,602
Disbursements on loans held for sale (81,539,946) (11,548,571)
Amortization of restricted stock awards 177,185 173,472
Amortization of unearned ESOP shares 276,441 288,180
Earned employee stock ownership shares
priced above original cost 218,777 207,238
Decrease in accrued interest receivable 134,205 234,627
Increase (decrease) in accrued interest payable 334,662 (395,504)
Equity (earnings) loss of limited partnerships 3,614,071 (179,596)
Increase in other assets (483,054) (133,526)
Increase (decrease) in other liabilities (541,372) 377,696
Other, net (173,639) 11,970
----------- -----------
Net cash provided by operating activities 31,505,597 6,945,762
----------- -----------
Cash flows from investing activities:
Proceeds from sales of securities
available for sale 119,137,787 63,095,246
Principal collected on securities
available for sale 27,152,425 10,496,126
Proceeds collected on maturity of
securities available for sale 32,674,876 27,618,412
Purchases of securities available for sale (165,638,598) (95,055,935)
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 3,252,274 22,819,187
Purchases of mortgage servicing rights (550,532) (400,008)
Purchase of interest in limited partnerships (181,125) (2,438,750)
Purchase of Federal Home Loan Bank stock (1,971,600) (802,700)
Net increase in loans receivable (60,381,549) (40,150,202)
Proceeds from sale of real estate 152,415 35,627
Purchases of premises and equipment (2,071,196) (963,474)
Decrease in due to stockholders of
Marshalltown Financial Corporation (3,507,270) 0
----------- ----------
Net cash used by investing activities (51,932,093) (14,157,159)
----------- ----------
Cash flows from financing activities:
Increase (decrease) in deposits (20,838,371) 4,205,405
Purchase of treasury stock (15,685,962) (4,109,637)
Increase in unearned ESOP shares (1,476,000) 0
Stock options exercised 119,707 138
Dividends to stockholders (584,459) 0
Fractional shares purchased from stock split (1,716) 0
Proceeds from Federal Home Loan Bank advances 125,500,000 121,500,000
Repayment of Federal Home Loan Bank advances (68,571,438) (115,571,426)
Increase in other borrowed money 100,000 0
Decrease (increase) in advance payments by
borrowers for taxes and insurance (23,893) 239,156
----------- ----------
Net cash provided by financing activities 18,537,868 6,263,636
----------- ----------
Decrease in cash and cash equivalents (1,888,628) (947,761)
Cash and cash equivalents, beginning of period 9,364,635 10,583,717
----------- ----------
Cash and cash equivalents, end of period $ 7,476,007 9,635,956
=========== ==========
6
Supplemental cash flow disclosures:
Cash paid for interest $ 18,451,222 18,390,380
Cash paid for income taxes 1,724,441 2,255,500
Supplemental noncash flow disclosures:
Loans securitized and transferred to
securities available for sale $ 1,930,846 9,608,294
Securities held to maturity transferred
to securities available for sale 0 1,295,147
Loans transferred to loans held for sale 30,617,345 4,071,410
Transfer of loans to real estate 17,105 188,776
Transfer of real estate to loans 0 84,772
See accompanying notes to consolidated financial statements.
7
HMN FINANCIAL, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)
September 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
comprehensive 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 statements of income for the three month and nine month periods ended
September 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 losses for the third quarter of 1998 were $1.73
million, the income tax benefit would have been $667,000 and therefore, the net
losses were $1.06 million. The gross
8
reclassification adjustment for the third quarter of 1998 was $348,000, the
income tax expense would have been $134,000 and therefore, the net
reclassification adjustment was $214,000. The gross unrealized holding gains
for the third quarter of 1997 were $2.14 million, the income tax expense would
have been $863,000 and therefore, the net gain was $1.28 million. The gross
reclassification adjustment for the third quarter of 1997 was $488,000, the
income tax expense would have been $197,000 and therefore, the net
reclassification adjustment was $291,000.
The gross unrealized holding losses for the nine month period ended September
30, 1998 were $568,000, the income tax benefit would have been $253,000 and
therefore, the net losses were $315,000. The gross reclassification
adjustment for the first nine months of 1998 was $1.98 million, the income tax
expense would have been $764,000 and therefore, the net reclassification
adjustment was $1.22 million. The gross unrealized holding gains for the nine
month period ended September 30, 1997 were $3.37 million, the income tax
expense would have been $1.36 million and therefore, the net gain was $2.01
million. The gross reclassification adjustment for the first nine months of
1997 was $872,000, the income tax expense would have been $352,000 and
therefore, the net reclassification adjustment was $520,000.
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
9
transaction (referred to as a cash flow hedge), the effective portion
of the derivative's gain or loss is initially reported as a component
of other comprehensive income (outside earnings) and subsequently
reclassified into earnings when the forecasted transaction affects
earnings. The ineffective portion of the gain or loss is reported in
earnings immediately.
- - - For a derivative designated as hedging the foreign currency exposure
of a net investment in a foreign operation, the gain or loss is
reported in other comprehensive income (outside earnings) as part of
the cumulative translation adjustment. The accounting for a fair
value hedge described above applies to a derivative designated or an
available-for-sale security. Similarly, the accounting for a cash
flow hedge described above applies to a derivative designated as a
hedge of the foreign currency exposure of a foreign-currency-
denominated forecasted transaction.
- - - For a derivative not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change.
Under SFAS No. 133, an entity that elects to apply hedge accounting is required
to establish at the inception of the hedge the method it will use for assessing
the effectiveness of the hedging derivative and the measurement approach for
determining the ineffective aspect of the hedge. Those methods must be
consistent with the entity's approach to managing risk.
SFAS No. 133 precludes designating a nonderivative financial instrument as a
hedge of an asset, liability, unrecognized firm commitment, or forecasted
transaction except that a nonderivative instrument denominated in a foreign
currency may be designated as a hedge of the foreign currency exposure of an
unrecognized firm commitment denominated in a foreign currency or a net
investment in a foreign operation.
SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning
after June 15, 1999. Initial application should be as of the beginning of an
entity's fiscal quarter; on that date, hedging relationships must be designated
anew and documented pursuant to the provisions of FASB No. 133. HMN is
anticipating that it will adopt SFAS No. 133 in the first quarter of 2000 and
is currently studying the impact of adopting the statement on its financial
statements.
In October 1998, the FASB issued SFAS No. 134, ACCOUNTING FOR MORTGAGE-BACKED
SECURITIES RETAINED AFTER THE SECURITIZATION OF MORTGAGE LOANS HELD FOR SALE BY
A MORTGAGE BANKING ENTERPRISE, which amends SFAS No. 65 to require that after
the securitization of mortgage loans held for sale, an entity engaged in
mortgage banking activities classify the resulting mortgage-backed securities
or other retained interests based on its ability and intent to sell or hold
those investments.
SFAS No. 134 is effective for the first fiscal quarter beginning after December
15, 1998. Early application is encouraged and is permitted as of October of
1998. HMN anticipates adopting SFAS No. 134 in the first quarter of 1999 and
believes that it will not have a material impact on HMN's financial condition
or the results of its operations.
(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
9,128,568 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
10
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.
Cash dividends of $0.06 per share were paid on June 12, 1998 and September 10,
1998 to stockholders of record on May 27, 1998 and August 27, 1998,
respectively.
(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 nine months ended September 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 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 September 30, 1997
Pro Forma
------------------------------
HMN MFC Adjustments Combined
----------- ---------- ---------- ----------
Total interest income $ 10,314,470 2,235,881 (497,550) (1)(2) 12,052,801
Total interest expense 6,464,378 1,389,101 106,685 (3)(4) 7,960,164
---------- ---------- --------- ----------
Net interest income 3,850,092 846,780 (604,235) 4,092,637
Provision for loan losses 75,000 2,500 77,500
Non-interest income 878,567 4,412 882,979
Non-interest expense 2,228,845 582,195 123,560 (5)(6) 2,934,600
---------- ---------- --------- ----------
Income before income
tax expense 2,424,814 266,497 (727,795) 1,963,516
Income tax expense 900,703 86,022 (258,751) 727,974
---------- ---------- --------- ----------
Net income $ 1,524,111 180,475 (469,044) 1,235,542
========== ========== ========= ==========
Basic earnings per share $ 0.28 0.13 0.22
Diluted earnings
per share $ 0.26 0.12 0.21
Weighted average shares
outstanding:
Basic 5,533,211 1,411,475 5,533,211
Diluted 5,955,258 1,470,860 5,955,258
11
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENTS OF INCOME
Nine months ended September 30, 1997
Pro Forma
----------------------------
HMN MFC Adjustments Combined
----------- --------- ------------ ---------
Total interest income $ 30,383,679 6,644,813 (1,510,160) (1)(2) 35,518,332
Total interest expense 18,785,884 4,115,712 271,990 (3)(4) 23,173,586
---------- ---------- ----------- ----------
Net interest income 11,597,795 2,529,101 (1,782,150) 12,344,746
Provision for loan losses 225,000 7,500 232,500
Non-interest income 1,982,659 72,385 2,055,044
Non-interest expense 6,470,244 1,720,196 370,680 (5)(6) 8,561,120
---------- ---------- ----------- ----------
Income before income
tax expense 6,885,210 873,790 (2,152,830) 5,606,170
Income tax expense 2,554,400 246,526 (722,439) 2,078,488
---------- ---------- ----------- ----------
Net income $ 4,330,810 627,264 (1,430,392) 3,527,682
========== ========== =========== ==========
Basic earnings per share$ 0.78 0.44 0.64
Diluted earnings per share$ 0.73 0.43 0.60
Weighted average shares
outstanding:
Basic 5,532,155 1,411,475 5,532,155
Diluted 5,904,637 1,470,717 5,904,637
Description of adjustments:
(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.
Pursuant to the Merger and consistent with generally accepted accounting
principles (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 three months
and nine months ended September 30, 1997 for the anticipated cost savings.
(6) INVESTMENT IN LIMITED PARTNERSHIP AND MORTGAGE SERVICING IMPAIRMENT
RESERVES
During the third quarter of 1998 HMN increased valuation reserves on mortgage
servicing assets by $287,000 and recognized a $2.5 million decline in its
partnership investment as its proportionate share of losses after the
partnership increased valuation reserves on its mortgage servicing assets;
resulting in an aggregate pretax charge to HMN's third quarter income of $2.8
million. For the nine months ended September 30, 1998 year to date pretax
income was reduced by $421,000 related to
12
establishing valuation reserves on mortgage servicing assets and pretax income
was reduced by a $3.5 million charge which recognized HMN's proportionate share
of losses on its 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 Nine Months
ended Sept 30, ended Sept 30,
--------------------- ---------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
Weighted average number of common
shares outstanding used in basic
earnings per common share
calculation 4,625,803 5,533,211 5,038,496 5,532,155
Net dilutive effect of:
Options 0 348,039 358,514 293,476
Restricted stock awards 0 74,009 54,344 79,007
---------- --------- ---------- ----------
Weighted average number of shares
outstanding adjusted for effect of
dilutive securities 4,625,803 5,955,259 5,451,354 5,904,637
========== ========= ========== ==========
Income (loss) available to common
shareholders $ (434,240) 1,524,111 2,013,145 4,330,812
Basic earnings (loss) per common
share $ (0.09) 0.28 0.40 0.78
Diluted earnings (loss) per
common share $ (0.09) 0.26 0.37 0.73
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.
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 September 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
September 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 September 30, 1998 the Bank's tangible assets and adjusted total assets were
$678.7 million and its risk-weighted assets were $335.2 million. The following
table presents the Bank's capital amounts and ratios at September 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.
13
- - -----------------------------------------------------------------------------
Required to be
Adequately
Actual Capitalized
------------------------ -----------------------
(IN THOUSANDS) Amount Percent Amount Percent
------------------------------------------------
Bank stockholder's equity $ 46,377
Plus:
Net unrealized loss (gain)
on certain securities
available for sale 89
Less:
Goodwill and other
intangibles 5,717
Excess mortgage
servicing rights 238
------
Tier I or core capital 40,511 $27,148
------
Tier I capital to
adjusted total assets 5.97% 4.00%
Tier I capital to risk-
weighted assets 12.08%
Less:
Equity investments and
other assets required to
be deducted 22
Plus:
Allowable allowance for
loan losses 2,966
-------
Risk-based capital $ 43,455 $26,819
=======
Risk-based capital to risk-
weighted assets 12.96% 8.00%
- - -------------------------------------------------------------------------------
- - ------------------------------------------------------------------------------
To Be Well
Capitalized Under
Prompt Corrective
Excess Capital Actions Provisions
------------------------------------------------
(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 13,363 $33,936
Tier I capital to
adjusted total assets 1.97% 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 $ 16,636 33,524
Risk-based capital to risk-
weighted assets 4.96% 10.00%
- - -------------------------------------------------------------------------------
The tangible capital of the Bank was in excess of the minimum 2% required at
September 30, 1998, but is not reflected in the table above.
14
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 nine
month periods ended September 30, 1997 and the nine month period ended
September 30, 1998 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 (LOSS)
HMN's net loss for the third quarter of 1998 was $434,000, a decrease in
earnings of $1.96 million, compared to net income of $1.5 million for the third
quarter of 1997. The decrease in net income was primarily the result of a $2.3
million decline in non-interest income and a $1.0 million increase in non-
interest expense which was partially offset by a $208,000 increase in net
interest income. During the third quarter of 1998, HMN incurred a pretax
charge of $287,000 when it adjusted its valuation reserves on mortgage
servicing assets. HMN also incurred a pretax charge of $2.5 million when it
recognized its proportionate share of losses on a partnership investment after
the partnership
15
adjusted valuation reserves on its mortgage servicing assets. The combined
charges totalling $2.8 million decreased both basic earnings per share and
diluted earnings per share by $0.38 for the third quarter of 1998. Basic loss
per share for the third quarter of 1998 was $0.09, a decrease of $0.37,
compared to $0.28 basic earnings per share for the third quarter of 1997.
Diluted loss per share for the third quarter of 1998 was $0.09, a decrease of
$0.35, compared to $0.26 diluted earnings per share for the third quarter of
1997.
Net income for the nine-month period ended September 30, 1998 was $2.0 million,
a decrease of $2.3 million, compared to $4.3 million for the same nine month
period of 1997. The decrease in net income was the result of a $1.2 million
decrease in non-interest income and a $3.5 million increase in non-interest
expense which was partially offset by a $1.0 million increase in net interest
income. During the nine month period ended September 30, 1998, HMN recognized
an aggregate pretax charge of $421,000 relating to adjusting valuation reserves
on its mortgage servicing assets. HMN also recognized an aggregate pretax
charge of $3.5 million on its partnership investment after the partnership
adjusted the partnership's valuation reserves on its mortgage servicing assets.
The charges related to mortgage servicing assets decreased basic earning per
share and diluted earnings per share for the nine month period ended September
30, 1998 by $0.49 and $0.45, respectively. Basic earnings per share for the
nine month period ended September 30, 1998 were $0.40, compared to $0.78 for
the same nine month period in 1997. Diluted earnings per share for the nine
month period ended September 30, 1998 were $0.37, compared to $0.73 for the
same period of 1997.
NET INTEREST INCOME
Net interest income for the third quarter of 1998 was $4.1 million, an increase
of $208,000, or 5.4%, compared to $3.9 million for the same quarter of 1997.
Interest income for the third quarter of 1998 was $12.3 million, an increase of
$2.0 million, or 19.2%, compared to $10.3 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 $66.5 million increase in average outstanding Federal Home Loan Bank advances
from the third quarter of 1997 to the third quarter of 1998. The average
outstanding balances for interest-earning assets during the third quarter of
1998 compared to the third quarter of 1997 increased by $136.5 million. The
average outstanding balance for loans receivable including loans held for sale
increased by $124.2 million and the average outstanding balances for
securities, FHLB stock, and other interest-earning assets increased by $13.3
million. The increase in interest-earning assets caused interest income to
increase by $2.4 million and was partially offset by a decrease of $407,000 in
interest income due to declining yields earned on interest earning assets.
Interest expense for the third quarter of 1998 was $8.2 million, an increase of
$1.8 million, or 27.5%, compared to $6.5 million for the same quarter of 1997.
Average interest-bearing liabilities for the third quarter of 1998 were $639.0
million, an increase of $158.3 million, or 32.9%, compared to $480.7 million
for the third 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-earning assets, facilitate the HMN treasury stock
purchases, and purchase loan servicing assets. The increase in interest-
bearing liabilities caused interest expense for the third quarter of 1998 to
increase by $2.0 million and was partially offset by a $254,000 decline in
interest expense caused by a decline in the interest rates paid on borrowings
and deposits.
Net interest income for the nine months ended September 30, 1998 was $12.6
million, an increase of $1.0 million, or 9.0%, from $11.6 million for the same
period of 1997. Interest income for the nine month period ended September 30,
1998 was $36.8 million, an increase of $6.5 million, or 21.3%, compared to
$30.4 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 $57.4 million increase in average outstanding Federal Home Loan Bank advances
from the first nine months of 1997 to the same period of 1998. The
16
average outstanding balances for interest-earning assets during the first nine
months of 1998 compared to the same period of 1997 increased by $139.6 million.
The average outstanding balance for loans receivable including loans held for
sale increased by $111.9 million and the average outstanding balances for
securities, FHLB stock, and other interest-earning assets increased by $27.7
million. The increase in interest-earning assets caused interest income to
increase by $7.5 million and was partially offset by a decrease of $995,000 in
interest income due to declining yields earned on interest earning assets.
Interest expense for the nine months ended September 30, 1998 was $24.2
million, an increase of $5.4 million, or 28.8%, compared to $18.8 million for
the same nine month period of 1997. Average interest-bearing liabilities for
the nine months ended September 30, 1998 were $626.9 million, an increase of
$153.8 million, or 32.5%, compared to $473.1 million for the same period 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-earning
assets, facilitate the HMN treasury stock purchases, and purchase loan
servicing assets. The increase in interest-bearing liabilities caused interest
expense for the nine month period of 1998 to increase by $5.9 million and was
partially off set by a $506,000 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 third quarter ended September 30, 1998
was $85,000, an increase of $10,000, compared to $75,000 for the third quarter
of 1997. The provision for loan losses for the nine months ended September 30,
1998 was $235,000, an increase of $10,000, compared to $225,000 for the same
nine month period of 1997. 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 management's 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 significantly increase the provision for loan
losses during 1998 compared to 1997. Future economic conditions and other
unknown factors may 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 235,000 225,000
Charge-offs (18,599) (19,577)
Recoveries 1,615 7,500
Balance at September 30, $ 2,966,235 2,553,508
NON-INTEREST INCOME (LOSS)
Non-interest loss for the third quarter of 1998 was $1.4 million, a decrease of
$2.3 million from $879,000 of non-interest income for the same quarter of 1997.
The $2.3 million decrease in non-interest income was principally due to a $2.7
million decline in earnings from partnership investments and a $140,000 decline
in securities gains that were recognized. These declines were partially offset
by an aggregate increase in fees, service charges, recognized gains on the sale
of loans and other income of $577,000. During the third quarter of 1998, HMN
recognized a pretax charge of $2.5 million on a partnership investment after
the partnership adjusted the valuation reserves on its mortgage servicing
assets. Due to the substantial increase in seasoned mortgage loan prepayments
experienced during 1998 and the lack of buyers of seasoned mortgage servicing
assets, the value of many seasoned mortgage servicing assets declined at
September 30, 1998. HMN also recognized a $190,000 loss on a
* This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 25 of this discussion.
17
partnership investment which invests primarily in the stock of other financial
institutions. At September 30, 1998, the market value of the common stock of
many financial institutions declined due to market conditions which caused a
general decline in the market value of the stock of many public companies.
Non-interest income for the nine months ended September 30, 1998 was $754,000,
a decrease of $1.2 million, or 62.0%, from $2.0 million for the same period of
1997. The decrease in non-interest income was principally due to a $3.8
million decline in earnings from partnership investments that were partially
offset by an increase of $427,000 in fees and service charges earned, an
increase of $1.1 million in securities gains, an increase of $902,000 in
recognized gains on the sale of loans and an increase of $125,000 in other
income. For the nine months ended September 30, 1998, HMN recognized an
aggregate pretax charge of $3.5 million on a partnership investment after the
partnership adjusted the valuation reserves on its mortgage servicing assets.
Due to the substantial increase in seasoned mortgage loan prepayments
experienced during 1998 and the lack of buyers of seasoned mortgage servicing
assets, the value of many seasoned mortgage servicing assets declined at
September 30, 1998. During the same nine month period in 1998, HMN also
recognized a $67,000 loss on a partnership investment which invests primarily
in the stock of other financial institutions. At September 30, 1998, the
market value of the common stock of many financial institutions declined due to
market conditions which caused a general decline in the market value of the
stock of many public companies. The increase in fees is principally related to
an increase in mortgage servicing assets between the two periods and the
increase in service charge income is principally due to the additional deposit
accounts that were acquired through the MFC merger. The increase in the
security gains is the result of the favorable interest rate environment during
the first two quarters of 1998 which allowed HMN to sell many securities at a
gain. The general decline in interest rates during 1998 also enticed many
borrowers to purchase homes or refinance their existing home loans. The
increased loan activity when coupled with the fact that the Bank is now selling
the majority of its fixed rate 15 year and 30 year loan production has caused
the gain on the sale of loans to increase from 1997 to 1998.
NON-INTEREST EXPENSE
Non-interest expense was $3.2 million for the third quarter of 1998, an
increase of $1.0 million from $2.2 million for the third quarter of 1997.
Compensation and benefit expense increased by $150,000 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
$116,000 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 $627,000 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 aggregate charge of $287,000 in mortgage servicing
amortization or adjustments to impairment reserves on mortgage servicing
assets.
Non-interest expense for the nine months ended September 30, 1998 was $9.9
million, an increase of $3.4 million from $6.5 million for the nine months
ended September 30, 1997. Compensation and benefit expense increased by $1.2
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 $365,000 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.
Federal deposit insurance, advertising expense and data processing expense all
increased as a result of the MFC merger. Other non-interest expense increased
by $1.5 million partly due to additional operating costs incurred related to
the MFC merger, the mortgage banking
18
expansion in Brooklyn Park, amortization of goodwill and core deposit
intangibles of $351,000 related to the MFC merger and aggregate charges of
$570,000 for mortgage servicing asset amortization or adjustments to the
related impairment reserves.
In an effort to reduce operating costs, during the period from August 1, 1998
through October 30, 1998, HMN reduced its number of full-time equivalent
employees by 17%. The work force reduction was achieved through attrition and
layoffs.
INCOME TAX EXPENSE (BENEFIT)
Income tax benefit for the third quarter of 1998 was $257,000, a decrease of
$1.2 million, from income tax expense of $901,000 for the third quarter of
1997. The decrease is primarily due to a decrease in taxable income between
the two quarters. Income tax expense was $1.2 million for the nine month
period ended September 30, 1998, a decrease of $1.3 million, from $2.6 million
for the same period in 1997. The decrease is primarily due to a decrease in
taxable income between the two nine month periods.
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of non-performing
assets in the Bank's portfolio at September 30, 1998 and December 31, 1997.
September 30, December 31,
(DOLLARS IN THOUSANDS) 1998 1997
--------------- --------------
Non-Accruing Loans
One-to-four family real estate $ 216 177
Nonresidential real estate 75 79
Commercial business 27 0
Consumer 86 7
---- ----
Total 404 263
---- ----
Accruing loans delinquent 90
days or more 309 402
Foreclosed Assets
Real estate:
One-to-four family 18 142
---- ----
Total non-performing assets $ 731 $ 807
==== ====
Total as a percentage of total
assets 0.10% 0.12%
==== ====
Total non-performing loans $713 $665
==== ====
Total as a percentage of total
loans receivable, net 0.15% 0.15%
==== ====
Total non-performing assets at September 30, 1998 were $731,000, a decrease of
$76,000 from $807,000 at December 31, 1997. The decrease was the result of a
$141,000 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.
Cash dividends of $0.06 per share were paid on June 12, 1998 and September 10,
1998 to
19
stockholders of record on May 27, 1998 and August 27, 1998, respectively.
LIQUIDITY
For the nine month period ended September 30, 1998, the net cash provided by
operating activities was $31.5 million. HMN collected $119.1 million from the
sale of securities and it collected $59.8 million in principal repayments or on
the maturity of securities during the period. HMN also collected $3.3 million
on the sale of loans receivable during the period. It purchased $165.6 million
of securities, funded a net increase in loans receivable of $60.4 million,
purchased $2.0 million of FHLB stock, purchased premises and equipment of $2.1
million and paid $3.5 million to the MFC stockholders related to the MFC
merger. HMN experienced a net decrease in its deposit base of $20.8 million.
It had additional net borrowing from the FHLB of $56.9 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 $15.7 million to purchase its own common stock during the
first nine months of 1998.
*HMN has certificates of deposits with outstanding balances of $227.7 million
that come due over the next 12 months. HMN has also changed its approach to
pricing its deposit products which has resulted in a net outflow of deposits
during 1998. Despite the net outflow, 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 on September 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 September 30, 1998.
* This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 25 of this discussion.
20
- - ------------------------------------------------------------------------------
Other than trading portfolio Market Value
--------------------------------------------
(DOLLARS IN THOUSANDS)
Basis point change in interest rates -200 -100 0 +100 +200
- - ------------------------------------------------------------------------------
Cash equivalents $ 6,484 6,479 6,473 6,468 6,463
Fixed-rate CMOs 59,644 59,499 59,410 58,545 56,794
Variable-rate CMOs 70,599 70,764 71,315 70,393 68,603
Fixed-rate available for sale
mortgage-backed
and related securities 4,738 4,688 4,649 4,591 4,466
Variable-rate available for sale
mortgage-backed and related
securities 2,207 2,158 2,091 2,012 1,969
Fixed-rate available for sale other
marketable securities 74,636 71,874 69,157 66,555 64,068
Variable-rate available for sale
other marketable securities 857 855 853 851 849
Fixed-rate loans held for sale 6,898 6,893 6,887 6,881 6,876
Fixed-rate real estate loans 344,902 343,211 339,674 331,136 319,957
Variable-rate real estate loans 89,087 88,296 86,755 84,668 82,248
Fixed-rate other loans 28,542 28,305 28,033 27,650 27,304
Variable-rate other loans 37,359 37,320 37,355 37,466 37,540
Mortgage servicing 688 828 1,145 1,434 1,568
Limited partnerships 1,169 1,443 2,075 2,683 3,281
------- ------- ------- ------- -------
Total market risk sensitive assets 727,810 722,613 715,872 701,333 681,986
------- ------- ------- ------- -------
NOW deposits 30,014 29,989 29,965 29,940 29,915
Passbook deposits 37,603 35,922 34,385 32,974 31,674
Money market deposits 29,194 27,901 26,717 25,629 24,626
Certificate deposits 363,981 360,189 356,482 352,854 349,309
Fixed-rate Federal Home Loan Bank
advances 172,474 166,870 161,491 156,326 151,367
Variable-rate Federal Home Loan Bank
advances 29,054 29,029 29,006 28,981 28,957
Other borrowings 100 100 100 100 100
------- ------- ------- ------- -------
Total market risk sensitive
liabilities 662,420 650,000 638,146 626,804 615,948
------- ------- ------- ------- -------
Off-balance sheet financial
instruments:
Commitments to extend credit 61 61 60 58 57
------- ------- ------- ------- -------
Net market risk $ 65,451 72,674 77,786 74,587 66,095
======= ======= ======= ======= =======
Percentage change from current
market value (15.86)% (6.57)% 0.00% (4.11)% (15.03)%
======= ======== ======= ======= =======
- - ------------------------------------------------------------------------------
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 8% to 45%, depending on the coupon and period
to maturity. Adjustable rate mortgages ("ARMs") were assumed to prepay at
annual rates of between 12% and 30%, depending on coupon and the period to
maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual
rates of between 18% and 50% 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
21
interest rates on certain types of assets and liabilities may fluctuate in
advance of changes in market interest rates, while interest rates on other
types of assets and liabilities may lag behind changes in market interest
rates. The model assumes that the difference between the current interest rate
being earned or paid compared to a treasury instrument or other interest index
with a similar term to maturity (the "Interest Spread") will remain constant
over the interest changes disclosed in the table. Changes in Interest Spread
could impact projected market value changes. Certain assets, such as ARMs,
have features which restrict changes in interest rates on a short-term basis
and over the life of the assets. The market value of the interest-bearing
assets which are approaching their lifetime interest rate caps could be
different from the values disclosed in the table. In the event of a change in
interest rates, prepayment and early withdrawal levels may deviate
significantly from those assumed in calculating the foregoing table. The
ability of many borrowers to service their debt may decrease in the event of an
interest rate increase.
ASSET/LIABILITY MANAGEMENT
*HMN's management reviews the impact that changing interest rates will have on
its net interest income projected for the twelve months following September 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 20,112,000 2.52%
+100 20,006,000 1.98%
0 19,617,000 0.00%
-100 19,177,000 -2.24%
-200 18,105,000 -7.71%
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
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 25 of this discussion.
22
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 less. The Bank generally follows the practice
of selling all of its fixed rate single family loans with contractual
maturities of thirty years. During the third quarter of 1998 the Bank started
selling the majority of its 15 year fixed rate loan production in order to
reduce its interest rate risk.
23
*The following table sets forth the interest rate sensitivity of HMN's assets
and liabilities at September 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 $ 6,476 0 0 0
Securities available for sale:
Mortgage-backed and
related securities<F1> 96,916 15,674 14,805 4,227
Other marketable securities 4,639 857 7,407 34,800
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 6,882 0 0 0
Loans receivable, net:<F1><F2>
Fixed rate one-to-four
family<F3> 37,808 33,446 99,411 59,730
Adjustable rate one-to-four
family<F3> 25,785 15,743 21,735 26,809
Multi family 3,199 593 1,698 668
Fixed rate commercial
real estate 7,473 524 907 240
Adjustable rate commercial
real estate 4,560 491 689 0
Commercial business 3,124 1,370 2,816 674
Consumer loans 25,865 1,708 4,253 2,198
Federal Home Loan Bank stock 0 0 0 0
-------- -------- --------- --------
Total interest-earning
assets 222,727 70,406 153,721 129,346
-------- -------- --------- --------
Non-interest checking 8,395 0 0 0
NOW accounts 21,644 0 0 0
Passbooks 3,636 3,636 10,472 6,702
Money market accounts 2,851 2,851 8,213 5,257
Certificates 154,340 73,393 103,217 18,109
Federal Home Loan Bank advances 34,279 0 34,000 111,000
-------- -------- --------- --------
Total interest-bearing
liabilities 225,145 79,880 155,902 141,068
-------- -------- --------- --------
Interest-earning assets less
interest-bearing
liabilities $ (2,418) (9,474) (2,181) (11,722)
======== ======== ========= ========
Cumulative interest-rate
sensitivity gap $ (2,418) (11,892) (14,073) (25,795)
======== ======== ========= ========
Cumulative interest-rate gap
as a percentage of total
assets at September 30, 1998 (0.34)% (1.68)% (1.99)% (3.65)%
======== ======== ========= ========
Cumulative interest-rate gap
as a percentage of interest
-earning assets at December
31, 1997 (6.36) (15.38)
======== ========
<FN>
<F1> 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.
<F2> Loans receivable are presented net of loans in process and deferred loan
fees.
<F3> 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>
- - ------------------------------------------------------------------------------
Maturity or Repricing
------------------------------------------------------
Over 5 No Stated
(DOLLARS IN THOUSANDS) Years Maturity Total
- - ------------------------------------------------------------------------------
Cash equivalents $ 0 0 6,476
Securities available for
sale:
Mortgage-backed and
related securities<F1> 6,658 0 138,280
Other marketable securities 34 8,271 56,008
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 6,882
Loans receivable, net:<F1><F2>
Fixed rate one-to-four
family<F3> 81,931 0 312,326
Adjustable rate one-to-
four family<F3> 2,655 0 92,727
Multi family 522 0 6,680
Fixed rate commercial real
estate 18 0 9,162
Adjustable rate commercial
real estate 0 0 5,740
Commercial business 72 0 8,056
Consumer loans 722 0 34,746
Federal Home Loan Bank stock 0 9,404 9,404
------- ------- --------
Total interest-earning
assets 92,612 17,675 686,487
------- ------- --------
Non-interest checking 0 0 8,395
NOW accounts 0 0 21,644
Passbooks 11,914 0 36,360
Money market accounts 9,344 0 28,516
Certificates 2,360 0 351,419
Federal Home Loan Bank advances 5,400 0 184,679
------- ------- --------
Total interest-bearing
liabilities 29,018 0 631,013
------- ------- --------
Interest-earning assets less
interest-bearing
liabilities $ 63,594 17,675 55,474
======= ======= ========
Cumulative interest-rate
sensitivity gap $ 37,799 55,474 55,474
======= ======= ========
Cumulative interest-rate gap
as a percentage of total
assets at September 30, 1998 5.35% 7.85% 7.85 %
======= ======= ========
Cumulative interest-rate gap as a
percentage of interest-earning assets
at December 31, 1997
<FN>
<F1>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.
<F2>Loans receivable are presented net of loans in process and deferred loan
fees.
<F3>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 25 of this discussion.
24
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 December of 1998. The
assessment of non-computer equipment for year 2000 compliance indicated that
HMN did not have any significant issues in this area.
*The majority of the Bank's loan and deposit data is supported by a third party
data processing center. Other third party providers support the automated
teller machines owned by the Bank and process the check clearings for the
Bank's negotiable order of withdrawal accounts ("checking accounts"). The Bank
is also reliant upon the Federal Home Loan Bank of Des Moines and the Federal
Reserve System to properly and efficiently conduct its business.
Notwithstanding the Bank's efforts, the failure of any of these third party
vendors to address their year 2000 issues in a timely fashion may have an
adverse effect on the Bank's ability to conduct its business. The Bank's Year
2000 Committee (the "Committee") is working very closely with its data
processing center to ascertain that all software applications and hardware will
be year 2000 compliant by the second quarter of 1999. The Committee is also
monitoring the progress that other key third party providers are making toward
becoming year 2000 compliant.
*The Committee is in the process of developing a contingency plan which
incorporates the actions the Bank will take in situations where the data
processing center or other key third party providers are not able to become
year 2000 compliant and it will have a major impact on the Bank's business.
The contingency plan is anticipated to be completed in the fourth quarter of
1998.
FORWARD-LOOKING INFORMATION
The following paragraphs within Management's Discussion and Analysis of
Financial Condition and
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 25 of this discussion.
25
Results of Operations contain forward-looking statements and actual results may
differ materially from the expectations disclosed within this Discussion and
Analysis. These forward-looking statements are subject to risks and
uncertainties, including those discussed below. HMN assumes no obligations to
publicly release results of any revision or updates to these forward-looking
statements to reflect future events or unanticipated occurrences.
PROVISION FOR LOAN LOSSES
The provision for loan losses for the third quarter ended September 30,
1998 was $85,000 an increase of $10,000, compared to $75,000 for the third
quarter of 1997. The provision for loan losses for the nine months ended
September 30, 1998 was $235,000, an increase of $10,000, compared to
$225,000 for the same nine month period of 1997. 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
management's 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
significantly 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 $227.7
million that come due over the next 12 months. HMN has also changed its
approach to pricing its deposit products which has resulted in a net
outflow of deposits during 1998. 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 September 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 September 30, 1998.
Interest rates could fluctuate in a range of more than 200 basis points up
or down from where the rates were on September 30, 1998 due to the
influence of many unforeseen factors not
26
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 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
September 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 September 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-
27
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 December 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 second quarter of 1999. The Committee is also monitoring
the progress that other key third party providers are making toward
becoming year 2000 compliant.
The Committee is in the process of developing a contingency plan which
incorporates the actions the Bank will take in situations where the data
processing center or other key third party providers are not able to
become year 2000 compliant and it will have a major impact on the Banks
business. The contingency plan is anticipated to be completed in the
fourth quarter of 1998.
While HMN has inventoried and assessed its hardware, software and other
non-computer equipment other unforeseen 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.
28
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.
None.
ITEM 5. Other Information.
At its Board of Directors meeting held on July 29, 1998 the Board
amended the HMN Financial, Inc. 1995 Stock Option and Incentive Plan
(the "Incentive Plan") and the HMN Financial, Inc. 1995 Recognition
and Retention Plan (the "Retention Plan") to provide the Board of
Directors with the discretion to grant options or awards, as
applicable, to newly elected directors. Prior to its amendment, the
Incentive Plan provided that each newly elected director would
receive as of the date of such director's election to the Board of
Directors a non-qualified stock option to purchase 12,000 shares of
Common Stock of the Company and the Retention Plan provided that each
newly elected director would receive as of the date of such
director's election to the Board of Directors an award of 2,000
shares of restricted stock of the Company.
At its Board of Directors meeting held on August 17, 1998 the Board
authorized the change of transfer agents from Bank of Boston to
Norwest Transfer Services. Inquiries by shareholders should be
directed to Norwest Shareowner Services, PO Box 64854, St. Paul, MN
55164-0854, phone 800-468-9716. This change became effective
November 2, 1998.
At its Board of Directors meeting held on October 27, 1998 the date
for the next annual meeting of shareholders was set for Tuesday,
April 27, 1999 at 10:00 a.m. at the Best Western Apache Hotel, 1517
16th St. S.W., Rochester, Minnesota.
ITEM 6. Exhibits and Reports on Form 8-K.
(a) Exhibits. See Index to Exhibits on page 31 of this report.
29
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: 11/16/98 /s/ Roger P. Weise
-------------------- -----------------------------
Roger P. Weise,
Chairman, President and
Chief Executive Officer
(Duly Authorized Officer)
Date: 11/16/98 /s/ James B. Gardner
-------------------- ----------------------------
James B. Gardner,
Executive Vice President
(Principal Financial Officer)
30
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
Sequential
Page Numbering
Regulation Reference Where Attached
S-K to Prior Exhibits Are
Exhibit Filing if Located in This
Number Document Applicable Form 10-Q Report
- - -----------------------------------------------------------------------------
3(a) Articles of Incorporation *4 N/A
3(b) By-laws *3 N/A
4 Instruments defining the rights *1 N/A
of security holders, Including indentures
5(a) Amendment to the Home Federal Savings *2 N/A
Bank Employees' Savings & Profit
Sharing Plan dated January 28, 1997.
5(b) Amendment to the Adoption Agreement for *2 N/A
Home Federal Savings Bank Employees'
Savings & Profit Sharing Plan and
Trust effective June 17, 1997.
10.1(a)Amended Recognition and Retention Plan Filed electronically
10.1(b)Amended Stock Option and Incentive Plan Filed electronically
11 Computation of Earnings Per Common Share Filed electronically
27 Financial Data Schedule Filed electronically
*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-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.
*3 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.
*4 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.
32