UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 0-24100
HMN FINANCIAL, INC.
(Exact name of Registrant as specified in its Charter)
Delaware 41-1777397
- -------------------------------------------------------------- ---------------------------------------
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)
1016 Civic Center Drive N.W., Rochester, MN 55901
- -------------------------------------------------------------- ---------------------------------------
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (507) 535-1200
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes (X) No ( )
Indicate by check mark whether the registrant is an accelerated filer as defined
in Rule 12b-2 of the Exchange Act.
Yes ( ) No (X)
Indicate the number of shares outstanding of each of the issuer's common stock
as of the latest practicable date.
Class Outstanding at April 30, 2004
- ----------------------------- -----------------------------
Common stock, $0.01 par value 4,482,280
1
HMN FINANCIAL, INC.
CONTENTS
PART I - FINANCIAL INFORMATION
Page
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at March 31, 2004 and December 31, 2003 3
Consolidated Statements of Income for the Three Months Ended March 31, 2004 and 2003 4
Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2004 and 2003 5
Consolidated Statement of Stockholders' Equity for the Three Month Period Ended March 31, 2004 5
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2004 and 2003 6
Notes to Consolidated Financial Statements 7-13
Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations 14-21
Item 3: Quantitative and Qualitative Disclosures about Market Risk Discussion included in Item 2 under Market Risk 19
Item 4: Controls and Procedures 21
PART II - OTHER INFORMATION
Item 1: Legal Proceedings 22
Item 2: Changes in Securities, Use of Proceeds and Issuer Purchases of Securities 22
Item 3: Defaults Upon Senior Securities 22
Item 4: Submission of Matters to a Vote of Security Holders 22
Item 5: Other Information 22
Item 6: Exhibits and Reports on Form 8-K 22
Signatures 23
2
PART I - FINANCIAL INFORMATION
ITEM 1 : FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2004 2003
------------- ------------
(unaudited)
ASSETS
Cash and cash equivalents ........................................ $ 33,502,104 30,496,823
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $12,289,007 and $13,707,005) ................. 11,936,841 13,048,718
Other marketable securities
(amortized cost $96,038,784 and $91,035,285) ................ 97,065,773 91,615,047
------------- -----------
109,002,614 104,663,765
------------- -----------
Loans held for sale .............................................. 4,954,795 6,542,824
Loans receivable, net ............................................ 717,020,602 688,951,119
Accrued interest receivable ...................................... 3,816,944 3,462,221
Real estate, net ................................................. 339,011 73,271
Federal Home Loan Bank stock, at cost ............................ 9,938,100 10,004,400
Mortgage servicing rights, net ................................... 3,411,229 3,447,843
Premises and equipment, net ...................................... 12,387,533 12,110,151
Investment in limited partnerships ............................... 187,951 617,042
Goodwill ......................................................... 3,800,938 3,800,938
Core deposit intangible, net ..................................... 419,010 447,474
Prepaid expenses and other assets ................................ 943,937 1,818,156
------------- -----------
Total assets ................................................. $ 899,724,768 866,436,027
============= ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ......................................................... $ 611,656,186 551,687,995
Federal Home Loan Bank advances .................................. 198,900,000 203,900,000
Accrued interest payable ......................................... 895,541 766,837
Customer escrows ................................................. 1,079,512 22,457,671
Accrued expenses and other liabilities ........................... 5,177,864 6,952,600
Deferred tax liabilities ......................................... 138,600 26,300
------------- -----------
Total liabilities ............................................ 817,847,703 785,791,403
------------- -----------
Commitments and contingencies
Minority interest ................................................ (271,018) (286,433)
Stockholders' equity:
Serial preferred stock: ($.01 par value)
Authorized 500,000 shares; issued and outstanding none ...... 0 0
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662 .............. 91,287 91,287
Additional paid-in capital ....................................... 57,715,080 57,863,726
Retained earnings, subject to certain restrictions ............... 86,697,978 85,364,657
Accumulated other comprehensive income (loss) .................... 436,623 (50,725)
Unearned employee stock ownership plan shares .................... (4,689,628) (4,738,084)
Treasury stock, at cost 4,621,382 and 4,616,010 shares ........... (58,103,257) (57,599,804)
------------- -----------
Total stockholders' equity ................................... 82,148,083 80,931,057
------------- -----------
Total liabilities and stockholders' equity ....................... $ 899,724,768 866,436,027
============= ===========
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended
March 31,
2004 2003
------------ ----------
Interest income:
Loans receivable .......................................... $ 11,491,264 9,639,924
Securities available for sale:
Mortgage-backed and related ........................... 118,864 142,213
Other marketable ...................................... 683,407 561,219
Cash equivalents .......................................... 26,298 28,917
Other ..................................................... 36,422 98,651
------------ ----------
Total interest income ................................. 12,356,255 10,470,924
------------ ----------
Interest expense:
Deposits .................................................. 2,930,034 2,471,263
Federal Home Loan Bank advances ........................... 2,188,955 2,478,672
------------ ----------
Total interest expense ................................. 5,118,989 4,949,935
------------ ----------
Net interest income .................................... 7,237,266 5,520,989
Provision for loan losses ...................................... 819,000 865,000
------------ ----------
Net interest income after provision for loan losses .... 6,418,266 4,655,989
------------ ----------
Non-interest income:
Fees and service charges .................................. 568,550 432,140
Mortgage servicing fees ................................... 287,232 216,576
Securities gains, net ..................................... 0 591,035
Gain on sales of loans .................................... 412,369 1,465,232
Earnings (losses) in limited partnerships ................. (6,617) (354,842)
Other ..................................................... 274,749 221,100
------------ ----------
Total non-interest income .............................. 1,536,283 2,571,241
------------ ----------
Non-interest expense:
Compensation and benefits ................................. 2,528,478 2,279,502
Occupancy ................................................. 884,602 823,799
Federal deposit insurance premiums ........................ 18,705 18,936
Advertising ............................................... 87,546 84,864
Data processing ........................................... 190,565 271,108
Amortization of mortgage servicing rights, net of valuation
adjustments and servicing costs ......................... 253,449 790,530
Other ..................................................... 962,574 944,551
------------ ----------
Total non-interest expense ............................. 4,925,919 5,213,290
------------ ----------
Income before income tax expense ....................... 3,028,630 2,013,940
Income tax expense ............................................. 910,500 624,400
------------ ----------
Income before minority interest ........................ 2,118,130 1,389,540
Minority interest .............................................. (2,331) 0
------------ ----------
Net income ............................................. $ 2,120,461 1,389,540
============ ==========
Basic earnings per share ....................................... $ 0.54 0.37
============ ==========
Diluted earnings per share ..................................... $ 0.52 0.36
============ ==========
See accompanying notes to consolidated financial statements
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003
(unaudited)
Three Months Ended March 31,
2004 2003
------------------------------ -------------------------------
Net income $ 2,120,461 1,389,540
Other comprehensive income, net of tax:
Unrealized holding gains (losses) arising during period 487,348 (479,055)
Less: reclassification adjustment for gains
included in net income 0 382,135
------- --------
Net unrealized gains (losses) on securities 487,348 (861,190)
------- --------
Other comprehensive income (loss) 487,348 (861,190)
--------- ---------
Comprehensive income $ 2,607,809 528,350
========= =========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2004
(unaudited)
Unearned
Employee
Accumulated Stock Total
Additional Other Ownership Stock-
Common Paid-in Retained Comprehensive Plan Treasury Holders'
Stock Capital Earnings Income (Loss) Shares Stock Equity
----------- ----------- ----------- ------------- ----------- ----------- -----------
Balance, December 31, 2003 $ 91,287 57,863,726 85,364,657 (50,725) (4,738,084) (57,599,804) 80,931,057
Net income 2,120,461 2,120,461
Other comprehensive income 487,348 487,348
Treasury stock purchases (770,000) (770,000)
Employee stock options
exercised (238,900) 266,547 27,647
Tax benefits of exercised
stock options 19,548 19,548
Dividends paid (787,140) (787,140)
Earned employee stock
ownership plan shares 70,706 48,456 119,162
----------- ----------- ----------- ------------ ---------- ---------- ----------
Balance, March 31, 2004 $ 91,287 57,715,080 86,697,978 436,623 (4,689,628) (58,103,257) 82,148,083
=========== =========== =========== ============ ========== ========== ==========
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three Months Ended
March 31,
---------------------------
2004 2003
------------ -----------
Cash flows from operating activities:
Net income....................................................................................... $ 2,120,461 1,389,540
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses...................................................................... 819,000 865,000
Depreciation................................................................................... 380,097 425,466
Amortization of premiums, net.................................................................. (39,059) 216,634
Amortization of deferred loan fees............................................................. (220,725) (113,404)
Amortization of core deposit intangible........................................................ 28,464 26,473
Amortization of other purchase accounting adjustments.......................................... 94 (723)
Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs.... 253,449 790,530
Capitalized mortgage servicing rights.......................................................... (216,835) (720,166)
Deferred income taxes.......................................................................... (153,700) (470,800)
Securities gains, net.......................................................................... 0 (591,035)
Gain on sales of real estate................................................................... 0 (117,139)
Gain on sales of loans......................................................................... (412,369) (1,465,232)
Proceeds from sale of loans held for sale...................................................... 25,171,959 79,445,538
Disbursements on loans held for sale........................................................... (23,108,118) (73,912,448)
Principal collected on loans held for sale..................................................... 0 7,376
Amortization of unearned ESOP shares........................................................... 48,456 48,357
Earned employee stock ownership shares priced above original cost.............................. 70,706 32,334
Increase in accrued interest receivable........................................................ (354,723) (262,088)
Increase (decrease) in accrued interest payable................................................ 128,704 (179,084)
Equity losses of limited partnerships.......................................................... 6,617 354,842
Equity losses of minority interest............................................................. (2,331) 0
Decrease in other assets....................................................................... 853,479 291,304
Decrease in other liabilities.................................................................. (1,797,891) (2,795)
Other, net..................................................................................... 12,831 29,838
------------ -----------
Net cash provided by operating activities.................................................... 3,588,566 6,088,318
------------ -----------
Cash flows from investing activities:
Proceeds from sales of securities available for sale............................................. 0 37,780,477
Principal collected on securities available for sale............................................. 1,426,429 14,300,411
Purchases of securities available for sale....................................................... (5,023,437) (20,652,253)
Redemption of interest in limited partnership.................................................... 422,474 0
Purchases of Federal Home Loan Bank Stock........................................................ (456,700) 0
Redemption of Federal Home Loan Bank Stock....................................................... 523,000 0
Net increase in loans receivable................................................................. (28,946,445) (46,849,551)
Proceeds from sale of premises................................................................... 0 221,313
Purchases of premises and equipment.............................................................. (657,479) (389,488)
------------ -----------
Net cash used in investing activities......................................................... (32,712,158) (15,589,091)
------------ -----------
Cash flows from financing activities:
Increase in deposits............................................................................. 60,036,525 15,131,194
Purchase of treasury stock....................................................................... (770,000) (1,384,560)
Stock options exercised.......................................................................... 27,647 221,040
Dividends to stockholders........................................................................ (787,140) (669,837)
Proceeds from Federal Home Loan Bank advances.................................................... 0 10,000,000
Repayment of Federal Home Loan Bank advances..................................................... (5,000,000) (9,000,000)
Increase (decrease) in customer escrows.......................................................... (21,378,159) 268,633
------------ -----------
Net cash provided by financing activities..................................................... 32,128,873 14,566,470
------------ -----------
Increase in cash and cash equivalents......................................................... 3,005,281 5,065,697
Cash and cash equivalents, beginning of period...................................................... 30,496,823 27,729,007
------------ -----------
Cash and cash equivalents, end of period............................................................ $ 33,502,104 32,794,704
============ ===========
Supplemental cash flow disclosures:
Cash paid for interest........................................................................... $ 4,990,285 5,129,019
Cash paid for income taxes....................................................................... 2,532,500 0
Supplemental noncash flow disclosures:
Loans transferred to loans held for sale......................................................... 0 2,154,298
Transfer of loans to real estate................................................................. 260,825 320,919
Transfer of real estate to loans................................................................. 0 16,533
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
MARCH 31, 2004 AND 2003
(1) HMN FINANCIAL, INC.
HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company
that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a
community banking philosophy and operates retail banking facilities in Minnesota
and Iowa. The Bank has two wholly owned subsidiaries: Osterud Insurance Agency,
Inc. (OIA), which offers financial planning products and services and Home
Federal Holding, Inc. (HFH), which is the holding company for Home Federal REIT,
Inc. (HFREIT) which invests in real estate loans acquired from the Bank. HMN has
another wholly owned subsidiary, Security Finance Corporation (SFC), which acts
as an intermediary for the Bank in transacting like kind property exchanges for
Bank customers. The Bank has an 80% owned subsidiary, Federal Title Services,
LLC (FTS), which performs mortgage title services for Bank customers. The Bank
had a 51% owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), which
was a mortgage banking and mortgage brokerage business located in Brooklyn Park,
Minnesota. HFMS was dissolved in the first quarter of 2004.
The consolidated financial statements included herein are for HMN, SFC, the Bank
and the Bank's consolidated entities, OIA, HFH, HFREIT, and FTS. 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 statement of stockholders' equity and
consolidated statements of cash flows in conformity with generally accepted
accounting principles. However, all adjustments consisting of only normal
recurring adjustments which are, in the opinion of management, necessary for the
fair presentation of the interim financial statements have been included. The
statement of income for the three-month period ended March 31, 2004 is not
necessarily indicative of the results which may be expected for the entire year.
Certain amounts in the consolidated financial statements for prior periods have
been reclassified to conform with the current period presentation.
(3) NEW ACCOUNTING STANDARDS
In December 2003, the FASB issued a revised Interpretation No. 46, Consolidation
of Variable Interest Entities (FIN 46). FIN 46 addresses consolidation by
business enterprises of variable interest entities that have certain
characteristics. It requires a business enterprise that has a controlling
interest in a variable interest entity (as defined by FIN 46) to include the
assets, liabilities, and results of the activities of the variable interest
entity in the consolidated financial statements of the business enterprise. FIN
46 applies to a public entity that is not a small business issuer no later than
the end of the first reporting period that ends after March 15, 2004. The impact
of adopting FIN 46 on HMN's financial condition and results of operations was
not material.
(4) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company has commitments outstanding to extend credit to future borrowers or
to purchase loans that had not closed prior to the end of the quarter which it
intends to sell. These commitments are referred to as its mortgage pipeline. As
commitments to originate or purchase loans enter the mortgage pipeline,
generally the Company simultaneously enters into commitments to sell the
mortgage pipeline into the secondary market. The
7
commitments to originate, purchase, or sell loans are derivatives. As a result
of marking the mortgage pipeline and the related commitments to sell to market
for the period ended March 31, 2004, the Company recorded a decrease in other
assets of $20,740, a decrease in other liabilities of $19,549 and a net loss on
sale of loans of $1,191.
The current commitments to sell loans held for sale are derivatives that do not
qualify for hedge accounting. As a result, these derivatives are marked to
market. The loans held for sale that are not hedged are recorded at the lower of
cost or market. As a result of marking these loans, the Company recorded a lower
of cost or market adjustment of $1,300, an increase in other liabilities of
$62,252, and a net loss on sales of loans of $60,952.
(5) COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity during a period from
transactions and other events from nonowner sources. Comprehensive income is the
total of net income and other comprehensive income, which for the Company is
comprised of unrealized gains and losses on securities available for sale.
The gross unrealized holding gains on securities for the first quarter of 2004
was $753,348, the income tax expense would have been $266,000 and therefore, the
net gain was $487,348. There was no reclassification adjustment for the first
quarter of 2004 as no securities were sold during the quarter. The gross
unrealized holding losses on securities for the first quarter of 2003 was
$740,955, the income tax benefit would have been $261,900 and therefore, the net
loss was $479,055. The gross reclassification adjustment for the first quarter
of 2003 was $591,035, the income tax expense would have been $208,900 and
therefore, the net gain was $382,135.
(6) INVESTMENTS IN LIMITED PARTNERSHIPS
Investments in limited partnerships were as follows:
Primary partnership activity March 31, 2004 December 31, 2003
---------------------------- -------------- -----------------
Common stock of financial institutions $ 0 421,671
Low to moderate income housing 187,951 195,371
-------- -------
$187,951 617,042
======== =======
During the first quarter of 2004, the Company's proportionate gains from common
stock investments in financial institutions was $803 and it recognized $7,420 of
losses on low income housing partnerships. The Company's investment in a limited
partnership that invested in the common stock of financial institutions was
liquidated effective December 31, 2003. During 2004, the Company anticipates
receiving low-income housing credits totaling $84,000, of which $21,000 were
credited to current income tax benefits. During the first quarter of 2003, the
Company's proportionate loss from a mortgage servicing partnership was $349,577,
its proportionate share of gains from common stock investments in financial
institutions was $1,235 and it recognized $6,500 of losses on low income housing
partnerships. During 2003 the Company received low-income housing credits
totaling $84,000, of which $21,000 were credited to current income tax benefits
in the first quarter.
(7) SECURITIES AVAILABLE FOR SALE
The following table shows the securities available for sale portfolio's gross
unrealized losses and fair value, aggregated by investment category and length
of time that individual securities have been in a continuous loss position, at
March 31, 2004. HMN has reviewed these securities and has concluded that the
unrealized losses are temporary and no permanent impairment has occurred at
March 31, 2004.
8
Less than twelve months Twelve months or more Total
----------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized
(Dollars in thousands) Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Mortgage backed securities:
Collateralized mortgage obligations $ 11,361 (388) 0 0 11,361 (388)
Other marketable securities:
Corporate debt 0 0 152 (6) 152 (6)
Corporate equity 0 0 3,157 (343) 3,157 (343)
---------- ---- ----- ---- ------ ----
Total temporarily impaired securities $ 11,361 (388) 3,309 (349) 14,670 (737)
========== ==== ===== ==== ====== ====
(8) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Three months ended Twelve months ended Three months ended
March 31, 2004 December 31, 2003 March 31, 2003
------------------ ------------------- ------------------
Mortgage servicing rights
Balance, beginning of period.................. $ 3,447,843 2,701,031 2,701,031
Originations.................................. 216,835 2,522,231 720,166
Amortization.................................. (253,449) (1,775,419) (413,613)
----------- ---------- ---------
Balance, end of period........................ 3,411,229 3,447,843 3,007,584
----------- ---------- ---------
Valuation reserve
Balance, beginning of period.................. 0 (10,000) (10,000)
Additions..................................... 0 (800,000) (160,000)
Reductions.................................... 0 810,000 0
----------- ---------- ---------
Balance, end of period........................ 0 0 (170,000)
----------- ---------- ---------
Mortgage servicing rights, net................ $ 3,411,229 3,447,843 2,837,584
=========== ========== =========
Fair value of mortgage servicing rights....... $ 3,870,052 4,316,251 2,840,609
=========== ========== =========
Mortgage servicing costs, which include professional services related to valuing
mortgage servicing rights and guarantee fees on securitized mortgage loans, were
$2,000 in the first quarter of 2004 and $216,917 for the same period in 2003.
All of the loans being serviced were single family loans serviced for the
Federal National Mortgage Association (FNMA) under the mortgage-backed security
program or the individual loan sale program. The following is a summary of the
risk characteristics of the loans being serviced at March 31, 2004.
Weighted
Weighted Average Number
Loan Principal Average Remaining of
Balance Interest Rate Term Loans
-------------- ------------- --------- ------
Original term 30 year fixed rate $ 194,179,394 5.96% 346 1,753
Original term 15 year fixed rate 248,633,395 5.34% 166 2,966
Seven year balloon 121,208 5.75% 58 1
Adjustable rate 9,307,137 4.95% 341 82
-------------- ---- --- -----
9
(9) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at March 31, 2004 is presented in the table below. Amortization
expense for intangible assets was $281,913 for the period ended March 31, 2004.
Gross Unamortized
Carrying Accumulated Valuation Intangible
Amount Amortization Adjustment Assets
---------- ------------ ---------- -----------
Amortized intangible assets:
Mortgage servicing rights $4,389,525 (978,296) 0 3,411,229
Core deposit intangible 1,567,000 (1,147,990) 0 419,010
---------- ---------- - ---------
Total $5,956,525 (2,126,286) 0 3,830,239
========== ========== = =========
The following table indicates the estimated future amortization expense for
amortized intangible assets:
Mortgage Core
Servicing Deposit
Rights Intangible Total
--------- ---------- -------
Year ended December 31,
2004 733,829 85,393 819,222
2005 747,072 113,857 860,929
2006 546,258 113,857 660,115
2007 398,083 105,903 503,986
2008 288,992 0 288,992
------- ------- -------
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of March 31, 2004. The Company's actual
experience may be significantly different depending upon changes in mortgage
interest rates and other market conditions.
(10) EARNINGS PER SHARE
The following table reconciles the weighted average shares outstanding and the
income available to common shareholders used for basic and diluted EPS:
Three months ended March 31,
2004 2003
---------- ---------
Weighted average number of common shares outstanding
used in basic earnings per common share calculation 3,915,044 3,747,609
Net dilutive effect of options 182,734 158,538
---------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 4,097,778 3,906,147
========== =========
Income available to common shareholders $2,120,461 1,389,540
Basic earnings per common share $ 0.54 0.37
Diluted earnings per common share $ 0.52 0.36
(11) 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 the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance
10
sheet items as calculated under regulatory accounting practices. The Bank's
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulations to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
following table) of Tier I or Core capital, and Risk-based capital (as defined
in the regulations) to total assets (as defined). Management believes, as of
March 31, 2004, that the Bank meets all capital adequacy requirements to which
it is subject.
Management believes that based upon the Bank's capital calculations at March 31,
2004 and other conditions consistent with the Prompt Corrective Actions
Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
On March 31, 2004 the Bank's tangible assets and adjusted total assets were
$890.0 million and its risk-weighted assets were $705.6 million. The following
table presents the Bank's capital amounts and ratios at March 31, 2004 for
actual capital, required capital and excess capital including ratios in order to
qualify as being well capitalized under the Prompt Corrective Actions
regulations.
To Be Well Capitalized
Required to be Under Prompt
Adequately Corrective Actions
Actual Capitalized Excess Capital Provisions
-------------------- ------------------- ------------------- ----------------------
Percent of Percent of Percent of Percent of
(in thousands) Amount Assets(1) Amount Assets (1) Amount Assets(1) Amount Assets(1)
------- ---------- ------ ---------- ------ ---------- ------ ----------
Bank stockholder's equity..................... $75,920
Less:
Net unrealized gain on certain
securities available for sale.............. (659)
Goodwill and core deposit intangible........ (4,220)
------
Tier I or core capital 71,041
------
Tier I capital to adjusted total assets.... 7.98% 35,602 4.00% 35,439 3.98% 44,503 5.00%
Tier I capital to risk-weighted assets.....
10.07% 28,221 4.00% 42,820 6.07% 42,332 6.00%
Plus:
Allowable allowance for loan losses.......... 6,737
------
Risk-based capital............................ $77,778 56,443 21,335 70,554
======
Risk-based capital to risk-weighted assets.... 11.02% 8.00% 3.02% 10.00%
(1) Based upon the Bank's adjusted total assets for the tangible and
core capital ratios and risk-weighted assets for the risk-based
capital ratio.
The tangible capital of the Bank was in excess of the minimum 2% required at
March 31, 2004 but is not reflected in the table above.
(12) COMMITMENTS AND CONTINGENCIES
The Bank entered into two guaranty agreements with third parties in order for
Home Federal Mortgage Services, LLC (HFMS) to secure loan purchase agreements.
Under the agreements, the Bank guarantees to satisfy and discharge all
obligations of HFMS arising from transactions entered into between HFMS and the
third parties if HFMS fails to fulfill their obligations. The agreements are in
effect until the obligations of HFMS are fully satisfied and the Bank's guaranty
is limited to a combined maximum of $3 million. No liability has been recorded
in the consolidated financial statements for these guarantees and the Company is
not aware of any outstanding obligations of HFMS to either of the third parties
with whom a guarantee exists. There is the possibility that the Bank would be
required to purchase loans that were previously sold to the third parties by
HFMS if the loans did not meet the requirements in the loan purchase agreements.
If this were to occur, the proceeds from the subsequent sale of these loans
would enable the Bank to recover a portion of the amounts paid under the
guaranty. No loans
11
have been sold to either of the third parties holding the guaranty agreements
since the fourth quarter of 2002.
The Bank issued standby letters of credit which guarantee the performance of
customers to third parties. The standby letters of credit outstanding at March
31, 2004 expire over the next two years and totaled approximately $2.9 million.
The letters of credit are collateralized primarily with commercial real estate
mortgages. Since the conditions under which the Bank is required to fund the
standby letters of credit may not materialize, the cash requirements are
expected to be less than the total outstanding commitments.
(13) STOCK-BASED COMPENSATION
Effective January 1, 1996, HMN adopted SFAS No. 123, Accounting for Stock-Based
Compensation. It elected to continue using the accounting methods prescribed by
Accounting Principles Board (APB) Opinion No. 25 and related interpretations
which measure compensation cost using the intrinsic value method. Had
compensation cost for HMN's stock-based plan been determined in accordance with
the fair value method recommended by SFAS No. 123, the Company's net income and
earnings per share would have been adjusted to the pro forma amounts indicated
below:
Quarter Ended Quarter Ended
March 31, 2004 March 31, 2003
-------------- --------------
Net income:
As reported................................................................ $ 2,120,461 1,389,540
Deduct: Total stock-based employee compensation expense determined
under fair value method for all awards, net of related tax effects....... 8,531 10,128
----------- ---------
Pro forma.................................................................. 2,111,930 1,379,412
Earnings per Common share:
As reported:
Basic...................................................................... $ 0.54 0.37
Diluted.................................................................... 0.52 0.36
Pro forma:
Basic ..................................................................... 0.54 0.37
Diluted.................................................................... 0.52 0.35
(14) BUSINESS SEGMENTS
HMN's wholly owned subsidiary, Home Federal Savings Bank has been identified as
reportable operating segment in accordance with the provisions of SFAS 131.
Security Finance Corporation and HMN, the holding company, did not meet the
quantitative thresholds for determining reportable segments and therefore are
included in the "Other" category.
The Company evaluates performance and allocates resources based on the segments
net income or loss, return on average assets and return on average equity. Each
corporation has its own officers and board of directors.
12
The following table sets forth certain information about the reconciliations of
reported profit or loss and assets for each of HMN's reportable segments.
Home Federal
(Dollars in thousands) Savings Bank Other Eliminations Consolidated Total
------------ ------ ------------ ------------------
At or for the quarter ended March 31, 2004:
Interest income - external customers ..................... $ 12,344 12 0 12,356
Non-interest income - external customers ................. 1,543 0 0 1,543
Earnings (losses) on limited partnerships ................ (8) 1 0 (7)
Intersegment interest income ............................. 0 8 (8) 0
Intersegment non-interest income ......................... 69 2,152 (2,221) 0
Interest expense ......................................... 5,127 0 (8) 5,119
Amortization of mortgage servicing rights net of valuation
adjustments and servicing costs ....................... 253 0 0 253
Other non-interest expense ............................... 4,588 154 (69) 4,673
Income tax expense (benefit) ............................. 1,011 (100) 0 911
Minority interest ........................................ (2) 0 0 (2)
Net income (loss) ........................................ 2,153 2,119 (2,152) 2,120
Goodwill ................................................. 3,801 0 0 3,801
Total assets ............................................. 893,272 82,645 (76,192) 899,725
Net interest margin ...................................... 3.46% NM NM 3.46
Return on average assets (annualized) .................... 0.98% NM NM 0.96%
Return on average realized common equity (annualized) .... 11.55% NM NM 10.21%
At or for the quarter ended March 31, 2003:
Interest income - external customers ..................... $ 10,421 50 0 10,471
Non-interest income - external customers ................. 2,926 0 0 2,926
Earnings (losses) on limited partnerships ................ (356) 1 0 (355)
Intersegment interest income ............................. 27 13 (40) 0
Intersegment non-interest income ......................... 269 1,385 (1,654) 0
Intersegment loan loss provision ......................... 200 0 (200) 0
Interest expense ......................................... 4,990 0 (40) 4,950
Amortization of mortgage servicing rights net of valuation
adjustments and servicing costs ....................... 863 3 (75) 791
Other non-interest expense ............................... 4,368 133 (78) 4,423
Income tax expense (benefit) ............................. 700 (76) 0 624
Minority interest ........................................ 0 0 0 0
Net income (loss) ........................................ 1,303 1,388 (1,301) 1,390
Goodwill ................................................. 3,801 0 0 3,801
Total assets ............................................. 767,355 75,135 (81,091) 761,399
Net interest margin ...................................... 3.18% NM NM 3.20%
Return on average assets (annualized) .................... 0.76% NM NM 0.76%
Return on average realized common equity (annualized) .... 8.27% NM NM 7.21%
NM - Not meaningful
13
HMN FINANCIAL, INC.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING INFORMATION
This quarterly report and other reports filed with the Securities and
Exchange Commission may contain "forward-looking" statements that deal
with future results, plans or performance. In addition, the Company's
management may make such statements orally to the media, or to securities
analysts, investors or others. Forward looking statements deal with
matters that do not relate strictly to historical facts. The Company's
future results may differ materially from historical performance and
forward-looking statements about the Company's expected financial results
or other plans are subject to a number of risks and uncertainties. These
include but are not limited to possible legislative changes and adverse
economic, business and competitive developments such as shrinking interest
margins; deposit outflows; reduced demand for financial services and loan
products; changes in accounting policies and guidelines, or monetary and
fiscal policies of the federal government; changes in credit and other
risks posed by the Company's loan and investment portfolios;
technological, computer-related or operational difficulties; adverse
changes in securities markets; results of litigation or other significant
uncertainties.
GENERAL
The earnings of the Company are primarily dependant on the Bank's net
interest income, which is the difference between interest earned on its
loans and investments, and the interest paid on interest-bearing
liabilities such as deposits and Federal Home Loan Bank (FHLB) advances.
The difference between the average rate of interest earned on assets and
the average rate paid on liabilities is the "interest rate spread". Net
interest income is produced when interest-earning assets equal or exceed
interest-bearing liabilities and there is a positive interest rate spread.
The Company's interest rate spread has been enhanced by the increased
level of commercial loans placed in portfolio and the increased amount of
lower rate deposit products such as checking and money market accounts.
Net interest income and net interest rate spread 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. The
Company's net income is also affected by the generation of non-interest
income, which consists primarily of gains or losses from the sale of
securities, gains from the sale of loans, and the generation of fees and
service charges on deposit accounts. The Company's non-interest income has
been enhanced by increased fees and service charges on deposit accounts.
The Bank incurs expenses in addition to interest expense in the form of
salaries and benefits, occupancy expenses, provisions for loan losses and
amortization and valuation adjustments on mortgage servicing assets.
The earnings of financial institutions, such as the Bank, are
significantly affected by prevailing economic and competitive conditions,
particularly changes in interest rates, government monetary and fiscal
policies, and regulations of various regulatory authorities. Lending
activities are influenced by the demand for and supply of single family
and commercial properties, competition among lenders, the level of
interest rates and the availability of funds. Due to an anticipated
increase in mortgage interest rates, we expect that mortgage loan activity
will be slower in 2004 than it was in 2003. Deposit flows and costs of
deposits are influenced by prevailing market rates of interest on
competing investments, account maturities and the levels of personal
income and savings. The interest rates charged by the FHLB on advances to
the Bank also have a significant impact on the Bank's overall cost of
funds.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those policies that the Company's
management believes are the most important to understanding the Company's
financial condition and operating results. The Company has identified the
following policies as being critical because they require difficult,
subjective, and/or
14
complex judgments that are inherently uncertain. Therefore, actual
financial results could differ significantly depending upon the estimates
used.
Allowance for Loan Losses and Related Provision
The allowance for loan losses is based on periodic analysis of the loan
portfolio. In this analysis, management considers factors including, but
not limited to, specific occurrences of loan impairment, changes in the
size of the portfolios, national and regional economic conditions, such as
unemployment data, loan portfolio composition, loan delinquencies, local
construction permits, development plans, local economic growth rates,
historical experience and observations made by the Company's ongoing
internal audit and regulatory exam processes. The allowance for loan
losses is established for known problem loans, as well as for loans which
are not currently known to require specific allowances. Loans are charged
off to the extent they are deemed to be uncollectible. The Company has
established separate processes to determine the adequacy of the loan loss
allowance for its homogeneous and non-homogeneous loan portfolios. The
determination of the allowance for the non-homogeneous commercial,
commercial real estate, and multi-family loan portfolios involves
assigning standardized risk ratings and loss factors that are periodically
reviewed. The loss factors are estimated using a combination of the
Company's own loss experience and external industry data and are assigned
to all loans without identified credit weaknesses. The Company also
performs an individual analysis of impairment on each non-performing loan
that is based on the expected cash flows or the value of the assets
collateralizing the loans. The determination of the allowance on the
homogeneous single-family and consumer loan portfolios is calculated on a
pooled basis with individual determination of the allowance of all
non-performing loans.
The adequacy of the allowance for loan losses is dependent upon
management's estimates of variables affecting valuation, appraisals of
collateral, evaluations of performance and status, and the amounts and
timing of future cash flows expected to be received on impaired loans.
Such estimates, appraisals, evaluations and cash flows may be subject to
frequent adjustments due to changing economic prospects of borrowers or
properties. The estimates are reviewed quarterly and adjustments, if any,
are recorded in the provision for loan losses in the periods in which the
adjustments become known. The allowance is allocated to individual loan
categories based upon the relative risk characteristics of the loan
portfolios and the actual loss experience. The Company increases its
allowance for loan losses by charging the provision for loan losses
against income. The methodology for establishing the allowance for loan
losses takes into consideration probable losses that have been identified
in connection with specific loans as well as losses in the loan portfolio
for which specific reserves are not required. Although management believes
that the allowance for loan losses is maintained at an adequate amount to
provide for probable loan losses inherent in the portfolio as of the
balance sheet dates, future adjustments to the provision for loan losses
may be necessary if conditions differ substantially from those in the
assumptions used to determine the allowance for loan losses.
Mortgage Servicing Rights
The Company recognizes as an asset the rights to service mortgage loans
for others, which are referred to as mortgage servicing rights (MSRs).
MSRs are capitalized at the relative fair value of the servicing rights on
the date the mortgage loan is sold and are carried at the lower of the
capitalized amount, net of accumulated amortization, or fair value. MSRs
are capitalized and amortized in proportion to, and over the period of,
estimated net servicing income. Each quarter the Company evaluates its
MSRs for impairment in accordance with Statement of Financial Accounting
Standard (SFAS) No. 140. Loan type and interest rate are the predominant
risk characteristics of the underlying loans used to stratify the MSRs for
purposes of measuring impairment. If temporary impairment exists, a
valuation allowance is established for any excess of amortized cost over
the current fair value through a charge to income. If the Company later
determines that all or a portion of the temporary impairment no longer
exists, a reduction of the valuation allowance is recorded as an increase
to income. The valuation of the MSRs is based on various assumptions
including the estimated prepayment speeds and default rates of the
stratified portfolio. Changes in the mix of loans, interest rates,
prepayment speeds, or default rates from the estimates used in the
valuation of the mortgage servicing rights may have a material effect on
the amortization and valuation
15
of MSRs. Although management believes that the assumptions used and the
values determined are reasonable, future adjustments may be necessary if
economic conditions differ substantially from the economic conditions in
the assumptions used to determine the value of the MSRs. The Company does
not formally hedge its MSRs because they are hedged naturally by the
Company's mortgage origination volume. Generally, as interest rates rise
the origination volume declines and the value of MSRs increases and as
interest rates decline the origination volume increases and the value of
MSRs decreases.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years
in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes the
enactment date. These calculations are based on many complex factors
including estimates of the timing of reversals of temporary differences,
the interpretation of federal and state income tax laws, and a
determination of the differences between the tax and the financial
reporting basis of assets and liabilities. Actual results could differ
significantly from the estimates and interpretations used in determining
the current and deferred income tax liabilities.
NET INCOME
HMN's net income for the first quarter of 2004 was $2.1 million, an
increase of $731,000, or 52.6%, from net income of $1.4 million for the
first quarter of 2003. Basic earnings per share for the first quarter of
2004 were $0.54, an increase of $0.17, from $0.37 basic earnings per share
for the same quarter of 2003. Diluted earnings per common share for the
first quarter of 2004 were $0.52, up $0.16, from $0.36 for the first
quarter of 2003.
NET INTEREST INCOME
Net interest income was $7.2 million for the first quarter of 2004, an
increase of $1.7 million, or 31.1%, compared to $5.5 million for the first
quarter of 2003. Interest income was $12.4 million for the first quarter
of 2004, an increase of $1.9 million, or 18.0%, from $10.5 million for the
first quarter of 2003. Interest income increased primarily because of an
increase in interest-earning assets and because of a change in the mix of
assets between the periods. The increase in interest-earning assets was
caused primarily by the $131 million increase in commercial and consumer
loans between the periods. The increase in interest income on commercial
and consumer loans was partially offset by lower income on the
single-family loan portfolio due to a decrease in the outstanding balance
and lower interest rates of this portfolio in the first quarter of 2004
when compared to the same period in 2003. The yield earned on
interest-earning assets decreased from 6.07% at March 31, 2003 to 5.91% at
March 31, 2004.
Interest expense was $5.1 million for the first quarter of 2004, an
increase of $169,000, or 3.4%, compared to $4.9 million for the first
quarter of 2003. Interest expense on deposits and Federal Home Loan Bank
advances decreased by $1.0 million due to a decrease in the interest rates
paid and increased by $1.2 million due to the $144 million increase in the
average outstanding balance of deposits and advances between the periods.
The average interest rate paid on interest-bearing liabilities was 3.08%
during the first quarter of 2003, compared to 2.58% for the first quarter
of 2004.
Net interest margin (net interest income divided by average interest
earning assets) for the first quarter of 2004 was 3.46%, an increase of 26
basis points, compared to 3.20% for the first quarter of 2003.
PROVISION FOR LOAN LOSSES
The provision for loan losses is recorded to bring the allowance for loan
losses to a level deemed appropriate by management based on factors
disclosed in the critical accounting policy previously
16
discussed. The provision for loan losses was $819,000 for the first
quarter of 2004, a decrease of $46,000, from $865,000 for the first
quarter of 2003. The provision for loan losses decreased primarily because
of the slower loan growth that was experienced in the consumer and
commercial loan portfolios in the first quarter of 2004 when compared to
the first quarter of 2003. Total non-performing assets were $4.1 million
at March 31, 2004, a decrease of $962,000, from $5.0 million at December
31, 2003. The decrease in non-performing assets is primarily related to
the payoff of a commercial real estate loan in the first quarter of 2004
that had previously been classified as non-performing.
A reconciliation of HMN's allowance for loan losses is summarized as
follows:
2004 2003
----------- ---------
Balance at January 1, $ 6,939,602 4,824,217
Provision 819,000 865,000
Charged off (206,078) (39,103)
Recoveries 4,381 8,199
----------- ---------
Balance at March 31, $ 7,556,905 5,658,313
=========== =========
NON-INTEREST INCOME
Non-interest income was $1.5 million for the first quarter of 2004, a
decrease of $1.1 million, or 40.3%, from $2.6 million for the first
quarter of 2003. Non-interest income decreased by $591,000 because no
gains on sales of securities were recognized in the first quarter of 2004.
Gain on sales of loans decreased by $1.1 million due to the significant
decrease in mortgage loan activity in the first quarter of 2004 when
compared to the same period in 2003. The decrease in mortgage loan
activity is primarily the result of the lower interest rates on
residential mortgage loans in the first quarter of 2003, when compared to
the first quarter of 2004. During the last half of 2003 and the first
quarter of 2004, interest rates on residential mortgage increased. If this
trend continues, the amount of loan originations and sales to the
secondary market will likely decrease, which would result in a reduction
in the gain on sale of loans originated for sale in future periods. These
decreases in non-interest income were partially offset by a $348,000
decrease in limited partnership losses because the Company's investment in
a limited partnership that invested in mortgage servicing rights was
dissolved in the second quarter of 2003. Fees and service charges
increased by $136,000 between the periods due to an overdraft protection
program that was implemented during the second quarter of 2003 and because
of increases in the number of deposit accounts and the fees charged.
Mortgage servicing fees increased by $71,000 due to the increased size of
the servicing portfolio between the periods.
NON-INTEREST EXPENSE
Non-interest expense was $4.9 million for the first quarter of 2004, a
decrease of $287,000, or 5.5%, from $5.2 million for the first quarter of
2003. Amortization expense on mortgage servicing rights decreased by
$537,000, compared to the first quarter of 2003, because the increase in
mortgage interest rates caused prepayments to decrease on the mortgage
loans being serviced. Compensation expense increased by $249,000 because
of annual payroll cost increases and an increase in the number of
employees. Data processing costs decreased by $81,000 primarily due to the
renegotiation of a third party service contract in the fourth quarter of
2003. Income tax expense increased by $286,000 between the periods
primarily because of increased taxable income.
17
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of
non-performing assets in the Bank's portfolio at March 31, 2004 and
December 31, 2003.
March 31, December 31,
(Dollars in Thousands) 2004 2003
--------- ------------
Non-Accruing Loans
One-to-four family real estate $ 1,397 $ 1,177
Commercial real estate 1,123 2,162
Consumer 606 1,050
Commercial business 161 186
--------- ------------
Total 3,287 4,575
Accruing loans delinquent 90 days or more:
One-to-four Family 114 114
Other assets 211 211
Foreclosed and Repossessed Assets:
One-to-four family real estate 322 73
Consumer 139 62
--------- ------------
Total non-performing assets $ 4,073 $ 5,035
========= ============
Total as a percentage of total assets 0.45% 0.58%
========= ============
Total non-performing loans $ 3,401 $ 4,689
========= ============
Total as a percentage of total loans receivable, net 0.47% 0.68%
========= ============
Allowance for loan loss to non-performing loans 222.20% 147.99%
========= ============
Total non-performing assets at March 31, 2004 were $4.1 million, a
decrease of $962,000, from $5.0 million at December 31, 2003. The decrease
in non-performing assets relates primarily to one commercial real estate
loan that paid off in the first quarter of 2004 that was previously
classified as non-performing. During the first quarter of 2004, the
following activity occurred related to non-performing assets: $1.6 million
of previously performing loans were classified as non-performing, $298,000
in loans were foreclosed or repossessed, $191,000 in loans were charged
off as a loss, a $1.6 million non-performing commercial loan was paid off,
and $1.0 million in loans were classified as performing.
DIVIDENDS
On April 27, 2004 the Company declared a cash dividend of $0.20 per share,
payable on June 8, 2004 to shareholders of record on May 21, 2004.
During the first quarter of 2004, the Company declared and paid dividends
as follows:
Record date Payable date Dividend per share Dividend Payout Ratio
----------- ------------ ------------------ ---------------------
February 20, 2004 March 8, 2004 $0.20 37.74%
The annualized dividend payout ratio for the past four quarters, ending
with the June 8, 2004 payment will be 34.33%.
The declaration of dividends are subject to, among other things, the
Company's financial condition and results of operations, the Bank's
compliance with its regulatory capital requirements, including the fully
phased-in capital requirements, tax considerations, industry standards,
economic conditions, regulatory restrictions, general business practices
and other factors.
LIQUIDITY
For the quarter ended March 31, 2004, the net cash provided by operating
activities was $3.6 million. The Company collected $1.4 million in
principal repayments on securities during the quarter. It purchased $5.0
18
million in securities and $657,000 in premises and equipment and paid out
$28.9 million relating to an increase in net loans receivable. The Company
had a net increase in deposit balances of $60.0 million during the
quarter, paid out $21.4 million relating to a decrease in customer
escrows, received $8,000 related to the exercise of HMN stock options,
paid $787,000 in dividends to its shareholders and paid $770,000 to
purchase treasury stock.
The Company has certificates of deposits with outstanding balances of
$171.4 million that come due over the next 12 months. Based upon past
experience management anticipates that the majority of the deposits will
renew for another term. The Company believes that deposits which do not
renew will be replaced with deposits from other customers or brokers, or
funded with advances from the FHLB. Management does not anticipate that it
will have a liquidity problem due to maturing deposits.
The Company has $115.9 million of FHLB advances that mature beyond March
31, 2005 but have call features that can be exercised by the FHLB during
the next 12 months. If the call features are exercised, the Company has
the option of requesting any advance otherwise available to it pursuant to
the credit policy of the FHLB. Since the Company has the ability to
request another advance to replace the advance that is being called,
management does not anticipate that it will have a liquidity problem due
to advances being called by the FHLB during the next 12 month period.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
rates. The Company's market risk arises primarily from interest rate risk
inherent in its investing, lending and deposit taking activities.
Management actively monitors and manages its interest rate risk exposure.
The Company'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. The Company monitors the projected changes in net interest
income that occur if interest rates were to suddenly change up or down.
The Rate Shock Table located in the Asset/Liability Management section of
this report discloses the Company's projected changes in net interest
income based upon immediate interest rate changes called rate shocks.
The Company utilizes a model that uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate
the current market value of those assets and liabilities. The model also
calculates the changes in market value of the interest-earning assets and
interest-bearing liabilities due to different interest rate changes. The
Company believes that over the next twelve months interest rates could
conceivably fluctuate in a range of 200 basis points up or 100 basis
points down from where the rates were at March 31, 2004. The Company does
not have a trading portfolio. The following table discloses the projected
changes in market value to the Company's interest-earning assets and
interest-bearing liabilities based upon incremental 100 basis point
changes in interest rates from interest rates in effect on March 31, 2004.
Other than trading portfolio Market Value
---------------------------------------
(Dollars in thousands)
Basis point change in interest rates -100 0 +100 +200
- ---------------------------------------------- --------- ------- ------- -------
Total market risk sensitive assets............ $ 924,465 910,597 892,170 874,809
Total market risk sensitive liabilities....... 840,244 827,280 815,769 806,979
Off-balance sheet financial instruments....... (287) 0 170 311
--------- ------- ------- -------
Net market risk............................... $ 84,508 83,317 76,231 67,519
========= ======= ======= =======
Percentage change from current market value... 1.43% 0.00% -8.50% -18.96%
========= ======= ======= =======
19
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 7% to 48%, depending on the coupon and
period to maturity. Adjustable rate mortgages (ARMs) were assumed to
prepay at annual rates of between 11% and 17%, depending on coupon and the
period to maturity. Growing Equity Mortgage (GEM) loans were assumed to
prepay at annual rates of between 7% and 19% 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 and the related cash
flow priority of the CMO tranche owned. Certificate accounts were assumed
not to be withdrawn until maturity. Passbook accounts were assumed to
decay at an annual rate of 15% and money market accounts were assumed to
decay at an annual rate of 18%. FHLB advances were projected to be called
at the first call date where the projected interest rate on similar
remaining term advances exceeded the interest rate on the callable
advance.
Certain shortcomings are inherent in the method of analysis presented in
the foregoing table. The interest rates on certain types of assets and
liabilities may fluctuate in advance of changes in market interest rates,
while interest rates on other types of assets and liabilities may lag
behind changes in market interest rates. The model assumes that the
difference between the current interest rate being earned or paid compared
to a treasury instrument or other interest index with a similar term to
maturity (the Interest Spread) will remain constant over the interest
changes disclosed in the table. Changes in Interest Spread could impact
projected market value changes. Certain assets, such as ARMs, have
features which restrict changes in interest rates on a short-term basis
and over the life of the assets. The market value of the interest-bearing
assets which are approaching their lifetime interest rate caps could be
different from the values disclosed in the table. In the event of a change
in interest rates, prepayment and early withdrawal levels may deviate
significantly from those assumed in calculating the foregoing table. The
ability of many borrowers to service their debt may decrease in the event
of a substantial sustained interest rate 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 March
31, 2004 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 $ 35,679,000 9.77%
+100 33,817,000 4.04%
0 32,504,000 0.00%
-100 30,081,000 (7.45)%
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon
their review of historical prepayment speeds and future prepayment
projections prepared by third parties.
Certain shortcomings are inherent in the method of analysis presented in
the foregoing table. In the event of a change in interest rates,
prepayment and early withdrawal levels would likely deviate significantly
from those assumed in calculating the foregoing table. The ability of many
borrowers to service their debt may decrease in the event of a substantial
increase in interest rates and could impact net interest income.
In an attempt to manage its exposure to changes in interest rates,
management closely monitors interest rate risk. The Bank has an
Asset/Liability committee which meets frequently to discuss changes in the
interest rate risk position and projected profitability. The Committee
makes adjustments to the asset liability position of the Bank which are
reviewed by the Board of Directors of the Bank. This Committee also
20
reviews the Bank's portfolio, formulates investment strategies and
oversees the timing and implementation of transactions to assure
attainment of the Board's objectives in the most effective manner. In
addition, the Board reviews on a quarterly basis the Bank's
asset/liability position, including simulations of the effect on the
Bank's capital of various interest rate scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market
conditions and consumer preference, may place more emphasis on managing
net interest margin than on better matching the interest rate sensitivity
of its assets and liabilities in an effort to enhance net interest income.
Management believes that the increased net interest income resulting from
a mismatch in the maturity of its asset and liability portfolios can,
during periods of declining or stable interest rates, provide high enough
returns to justify the increased exposure to sudden and unexpected
increases in interest rates.
To the extent consistent with its interest rate spread objectives, the
Bank attempts to reduce its interest rate risk and has taken a number of
steps to restructure its assets and liabilities. The Bank has primarily
focused its fixed rate one-to-four family residential lending program on
loans that are saleable to third parties and only places fixed rate loans
the meet certain risk characteristics into its loan portfolio. The Bank
does place into portfolio adjustable rate single-family loans that reprice
over a one-year, three-year or five-year period. The Bank's commercial
loan production has primarily been in adjustable rate loans and the fixed
rate commercial loans placed in portfolio have been shorter-term loans,
usually with maturities of five years or less, in order to lower the
Company's interest rate risk exposure.
ITEM 4: Controls and Procedures
Evaluation of disclosure controls and procedures. The Company's principal
executive officer and its principal financial officer, after evaluating
the effectiveness of the Company's disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) on May 6, 2004,
have concluded that, as of such date, the Company's disclosure controls
and procedures were adequate and effective to ensure that material
information relating to the Company and its consolidated subsidiaries
would be made known to them by others within those entities.
Changes in internal controls. There were no significant changes in the
Company's internal controls or in other factors that could significantly
affect the Company's disclosure controls and procedures subsequent to the
date of their evaluation, nor were there any significant deficiencies or
material weaknesses in the Company's internal controls. As a result, no
corrective actions were required or undertaken.
21
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
None.
ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities.
(a)-(d) Not applicable
(a) Total (c) Total Number of (d) Maximum Number (or
Number of Shares (or Units) Approximate Dollar Value) of
Shares (or (b) Average Purchased as Part of Shares (or Units) that May Yet
Units) Price Paid per Publicly Announced Be Purchased Under the Plans or
Period Purchased Share (or Unit) Plans or Programs Programs
- ------------- ---------- --------------- -------------------- -------------------------------
January 2004 0 $ 0.00 0 213,400
February 2004 0 0.00 0 350,000
March 2004 28,000 27.50 28,000 322,000
------ ------ ------ -------
Total 28,000 $27.50 28,000 322,000
====== ====== ====== =======
(1) On August 27, 2002, the Board of Directors authorized the repurchase of up
to 350,000 shares of the Company's common stock. This repurchase program
expired on February 27, 2004. On February 24, 2004, the Board of Directors
authorized a repurchase program for 350,000 shares of the Company's common
stock. This program expires on August 24, 2005.
ITEM 3. Defaults Upon Senior Securities.
Not applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders.
None.
ITEM 5. Other Information.
None.
ITEM 6. Exhibits and Reports on Form 8-K.
(a) Exhibits. See Index to Exhibits on page 24 of this report.
(b) Reports on Form 8-K.
1) On January 22, 2004 HMN reported its financial results for its
fourth fiscal quarter ended December 31, 2003.
2) On April 22, 2004 HMN reported its financial results for its
first fiscal quarter ended March 31, 2004.
22
SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HMN FINANCIAL, INC.
Registrant
Date: May 10, 2004 /s/ Michael McNeil
Michael McNeil,
President and Chief Executive Officer
(Duly Authorized Officer and Principal
Executive Officer)
Date: May 10, 2004 /s/ Jon Eberle
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
23
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
Sequential
Reference Page Numbering
Regulation to Prior Where Attached
S-K Filing or Exhibits Are
Exhibit Exhibit Located in This
Number Document Attached Hereto Number Form 10-Q Report
- ---------- ---------------------------------------------- --------- --------------------
3.1 Amended and Restated Articles of Incorporation *1 N/A
3.2 Amended and Restated By-laws *2 N/A
4 Form of Common Stock including indentures *3 N/A
31.1 Rule 13a-14(a)/15d-14(a) Certification of CEO 31.1 Filed Electronically
31.2 Rule 13a-14(a)/15d14(a) Certification of CFO 31.2 Filed Electronically
32 Section 1350 Certification of CEO and CFO 32 Filed Electronically
- ----------
*1 Incorporated by reference to the same numbered exhibit to the Company's
Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File
No. 0-24100).
*2 Incorporated by reference to the same numbered exhibit to the Company's
Annual Report on Form 10-K for the period ended December 31, 2003 (File
0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's
Registration Statement on Form S-1 dated April 1, 1994 (File No.
33-77212).
24