UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 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 June 30, 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 (I.R.S. Employer incorporation or organization) Identification Number) 1016 Civic Center Drive NW, Rochester, Minnesota 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 classes of common stock, as of the latest practicable date. Class Outstanding at July 29, 2004 ----------------------------- ---------------------------- Common stock, $0.01 par value 4,456,864 HMN FINANCIAL, INC. CONTENTS PART I - FINANCIAL INFORMATION Page ---- Item 1: Financial Statements (unaudited) Consolidated Balance Sheets at June 30, 2004 and December 31, 2003............................. 3 Consolidated Statements of Income for the Three Months Ended and Six Months Ended June 30, 2004 and 2003.. 4 Consolidated Statements of Comprehensive Income for the Three Months Ended and Six Months Ended June 30, 2004 and 2003.. 5 Consolidated Statement of Stockholders' Equity for the Six Month Period Ended June 30, 2004.................... 5 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003..................... 6 Notes to Consolidated Financial Statements...................... 7-14 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations............................. 15-23 Item 3: Quantitative and Qualitative Disclosures about Market Risk Discussion included in Item 2 under Market Risk................. 21 Item 4: Controls and Procedures............................................. 23 PART II - OTHER INFORMATION Item 1: Legal Proceedings................................................... 24 Item 2: Changes in Securities and Use of Proceeds........................... 24 Item 3: Defaults Upon Senior Securities..................................... 24 Item 4: Submission of Matters to a Vote of Security Holders................. 24 Item 5: Other Information................................................... 25 Item 6: Exhibits and Reports on Form 8-K.................................... 25 Signatures ................................................................. 26 2 Part I - FINANCIAL INFORMATION Item 1: Financial Statements HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (unaudited) June 30, December 31, 2004 2003 ------------ ------------ ASSETS Cash and cash equivalents ................................. $ 41,638,817 30,496,823 Securities available for sale: Mortgage-backed and related securities (amortized cost $10,668,580 and $13,707,005) .......... 9,882,177 13,048,718 Other marketable securities (amortized cost $100,739,558 and $91,035,285) ........ 99,947,189 91,615,047 ------------ ------------ 109,829,366 104,663,765 ------------ ------------ Loans held for sale ....................................... 3,766,543 6,542,824 Loans receivable, net ..................................... 722,800,277 688,951,119 Accrued interest receivable ............................... 3,530,635 3,462,221 Real estate, net .......................................... 254,869 73,271 Federal Home Loan Bank stock, at cost ..................... 9,938,200 10,004,400 Mortgage servicing rights, net ............................ 3,335,516 3,447,843 Premises and equipment, net ............................... 12,454,962 12,110,151 Investment in limited partnerships ........................ 181,258 617,042 Goodwill .................................................. 3,800,938 3,800,938 Core deposit intangible, net .............................. 390,546 447,474 Prepaid expenses and other assets ......................... 1,519,082 2,108,575 Deferred tax assets ....................................... 656,800 0 ------------ ------------ Total assets .......................................... $914,097,809 866,726,446 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits .................................................. $627,304,925 551,687,995 Federal Home Loan Bank advances ........................... 198,900,000 203,900,000 Accrued interest payable .................................. 857,492 766,837 Customer escrows .......................................... 878,094 22,457,671 Accrued expenses and other liabilities .................... 5,028,548 6,952,600 Deferred tax liabilities .................................. 0 26,300 ------------ ------------ Total liabilities ..................................... 832,969,059 785,791,403 ------------ ------------ Commitments and contingencies Minority interest ......................................... 1,698 3,986 Stockholders' equity: Serial preferred stock ($.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 ................................ 57,673,514 57,863,726 Retained earnings, subject to certain restrictions ........ 88,424,074 85,364,657 Accumulated other comprehensive loss ...................... (1,021,573) (50,725) Unearned employee stock ownership plan shares ............. (4,641,172) (4,738,084) Treasury stock, at cost 4,671,798 and 4,616,010 shares .... (59,399,078) (57,599,804) ------------ ------------ Total stockholders' equity ............................ 81,127,052 80,931,057 ------------ ------------ Total liabilities and stockholders' equity ................ $914,097,809 866,726,446 ============ ============ See accompanying notes to consolidated financial statements. 3 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (unaudited) Three Months Ended Six Months Ended June 30, June 30, --------------------------- --------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Interest income: Loans receivable ......................... $11,486,417 10,243,717 22,977,681 19,883,641 Securities available for sale: Mortgage-backed and related ........... 92,428 (39,454) 211,292 102,759 Other marketable ...................... 766,391 690,848 1,449,798 1,252,067 Cash equivalents ......................... 40,042 56,980 66,340 85,897 Other .................................... 41,398 84,033 77,820 182,684 ----------- ----------- ----------- ----------- Total interest income ................. 12,426,676 11,036,124 24,782,931 21,507,048 ----------- ----------- ----------- ----------- Interest expense: Deposits ................................. 2,894,319 2,492,554 5,824,353 4,963,817 Federal Home Loan Bank advances .......... 2,165,680 2,615,630 4,354,635 5,094,302 ----------- ----------- ----------- ----------- Total interest expense ................ 5,059,999 5,108,184 10,178,988 10,058,119 ----------- ----------- ----------- ----------- Net interest income ................... 7,366,677 5,927,940 14,603,943 11,448,929 Provision for loan losses ................... 447,000 490,000 1,266,000 1,355,000 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses ..................... 6,919,677 5,437,940 13,337,943 10,093,929 ----------- ----------- ----------- ----------- Non-interest income: Fees and service charges ................. 704,651 555,036 1,273,201 987,176 Mortgage servicing fees .................. 290,849 238,729 578,080 455,305 Securities gains, net .................... 1,361 224,751 1,361 815,786 Gains on sales of loans .................. 506,862 1,526,558 919,231 2,991,790 Earnings (losses) in limited partnerships (6,500) 31,528 (13,117) (323,314) Other .................................... 183,048 114,694 457,797 335,794 ----------- ----------- ----------- ----------- Total non-interest income ............. 1,680,271 2,691,296 3,216,553 5,262,537 ----------- ----------- ----------- ----------- Non-interest expense: Compensation and benefits ................ 2,581,764 2,027,572 5,110,242 4,307,074 Occupancy ................................ 871,170 769,518 1,755,772 1,593,317 Deposit insurance premiums ............... 27,794 17,855 46,499 36,791 Advertising .............................. 87,850 100,988 175,396 185,852 Data processing .......................... 228,721 289,938 419,286 561,046 Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs ........................ 302,184 1,108,101 555,633 1,898,631 Other .................................... 897,762 867,136 1,860,336 1,811,687 ----------- ----------- ----------- ----------- Total non-interest expense ............ 4,997,245 5,181,108 9,923,164 10,394,398 ----------- ----------- ----------- ----------- Income before income tax expense ...... 3,602,703 2,948,128 6,631,332 4,962,068 Income tax expense .......................... 1,105,500 917,900 2,016,000 1,542,300 ----------- ----------- ----------- ----------- Income before minority interest ....... 2,497,203 2,030,228 4,615,332 3,419,768 Minority interest ........................... 43 0 (2,288) 0 ----------- ----------- ----------- ----------- Net income ............................ $ 2,497,160 2,030,228 4,617,620 3,419,768 =========== =========== =========== =========== Basic earnings per share .................... $ 0.65 0.54 1.19 0.91 =========== =========== =========== =========== Diluted earnings per share .................. $ 0.62 0.52 1.13 0.87 =========== =========== =========== =========== See accompanying notes to consolidated financial statements. 4 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003 (unaudited) Three Months Ended June 30, 2004 2003 --------------------------------------- ------------------------------------ Net income $ 2,497,160 2,030,228 Other comprehensive income, net of tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period (1,457,334) 598,561 Less: reclassification adjustment for gains included in net income 861 145,351 ---------- --------- Net unrealized gains (losses) on securities (1,458,195) 453,210 ---------- --------- Other comprehensive income (loss) (1,458,195) 453,210 ---------- --------- Comprehensive income $ 1,038,965 2,483,438 ========== ========= Six Months Ended June 30, 2004 2003 --------------------------------------- ------------------------------------ Net income $ 4,617,620 3,419,768 Other comprehensive income, net of tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising (969,987) 119,406 during period Less: reclassification adjustment for gains included in net income 861 527,386 ---------- --------- Net unrealized losses on securities (970,848) (407,980) ---------- --------- Other comprehensive loss (970,848) (407,980) ---------- --------- Comprehensive income $ 3,646,772 3,011,788 ========== ========= See accompanying notes to consolidated financial statements. HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 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 4,617,620 4,617,620 Other comprehensive loss (970,848) (970,848) Treasury stock purchases (2,180,650) (2,180,650) Employee stock options exercised (353,742) 381,376 27,634 Tax benefits of exercised stock options 19,548 19,548 Dividends paid (1,558,203) (1,558,203) Earned employee stock ownership plan shares 143,982 96,912 240,894 ----------- ----------- ----------- ------------- ----------- ----------- ----------- Balance, June 30, 2004 91,287 57,673,514 88,424,074 (1,021,573) (4,641,172) (59,399,078) 81,127,052 =========== =========== =========== ============= =========== =========== =========== See accompanying notes to consolidated financial statements. 5 HMN FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Six Months Ended June 30, ---------------------------- 2004 2003 ------------ ------------ Cash flows from operating activities: Net income .................................................................. $ 4,617,620 3,419,768 Adjustments to reconcile net income to cash provided by operating activities: Provision for loan losses ................................................. 1,266,000 1,355,000 Depreciation .............................................................. 777,836 799,618 Amortization of premiums (discounts), net ................................. (109,254) 440,052 Amortization of deferred loan fees ........................................ (572,132) (196,435) Amortization of core deposit intangible ................................... 56,928 55,601 Amortization of mortgage servicing rights and net valuation and servicing costs ........................................................... 555,633 1,898,631 Capitalized mortgage servicing rights ..................................... (443,307) (1,438,635) Deferred income taxes ..................................................... (153,700) 0 Securities gains, net ..................................................... (1,361) (815,786) Losses (gains) on sales of real estate .................................... 19,810 (117,042) Gains on sales of loans ................................................... (919,231) (2,991,790) Proceeds from sale of loans held for sale ................................. 50,943,298 165,333,116 Disbursements on loans held for sale ...................................... (47,263,609) (158,242,116) Principal collected on loans held for sale ................................ 0 11,521 Amortization of unearned ESOP shares ...................................... 96,912 96,714 Earned employee stock ownership shares priced above original cost ......... 143,982 72,356 Increase in accrued interest receivable ................................... (68,414) (251,463) Increase (decrease) in accrued interest payable ........................... 90,655 (429,926) Equity losses of limited partnerships ..................................... 13,117 323,314 Equity losses of minority interest ........................................ (2,288) 0 Decrease (increase) in other assets ....................................... 597,761 (367,797) Increase (decrease) in other liabilities .................................. (1,896,949) 1,221,906 Other, net ................................................................ (22,892) 83,512 ------------ ------------ Net cash provided by operating activities ............................... 7,726,415 10,260,119 ------------ ------------ Cash flows from investing activities: Proceeds from sales of securities available for sale ........................ 10,119,950 38,718,290 Principal collected on securities available for sale ........................ 3,152,402 23,346,740 Purchases of securities available for sale .................................. (19,955,262) (46,491,697) Redemption of interest in limited partnership ............................... 422,474 0 Purchase of Federal Home Loan Bank Stock .................................... (540,300) (84,500) Redemption of Federal Home Loan Bank Stock .................................. 606,500 0 Net increase in loans receivable ............................................ (34,996,464) (77,775,248) Proceeds from sale of real estate ........................................... 256,735 0 Proceeds from sale of premises .............................................. 0 221,313 Purchases of premises and equipment ......................................... (1,122,647) (634,383) ------------ ------------ Net cash used by investing activities .................................... (42,056,612) (62,699,485) ------------ ------------ Cash flows from financing activities: Increase in deposits ........................................................ 75,762,987 30,249,494 Purchase of treasury stock .................................................. (2,180,650) (1,384,560) Stock options exercised ..................................................... 27,634 876,305 Dividends to stockholders ................................................... (1,558,203) (1,351,340) Proceeds from Federal Home Loan Bank advances ............................... 16,500,000 116,000,000 Repayment of Federal Home Loan Bank advances ................................ (21,500,000) (99,000,000) Decrease in customer escrows ................................................ (21,579,577) (86,797) ------------ ------------ Net cash provided by financing activities ................................ 45,472,191 45,303,102 ------------ ------------ Increase (decrease) in cash and cash equivalents ......................... 11,141,994 (7,136,264) Cash and cash equivalents, beginning of period ................................. 30,496,823 27,729,007 ------------ ------------ Cash and cash equivalents, end of period ....................................... $ 41,638,817 20,592,743 ============ ============ Supplemental cash flow disclosures: Cash paid for interest ...................................................... $ 10,088,333 10,488,045 Cash paid for income taxes .................................................. 4,554,500 1,152,000 Supplemental noncash flow disclosures: Loans transferred to loans held for sale .................................... 0 3,077,578 Transfer of loans to real estate ............................................ 434,960 533,277 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) JUNE 30, 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 or Home Federal). 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. (OAI) 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) that 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) that performs mortgage title services for Bank customers. The Bank had a 51% owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), that was a mortgage banking and mortgage brokerage business located in Brooklyn Park, Minnesota. HFMS liquidated its assets during 2003 and 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, OAI, 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 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 that 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 and six-month periods ended June 30, 2004 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) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The Company has commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter. The Company intends to sell these commitments and refers to them as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, generally the Company simultaneously enters into commitments to sell the mortgage pipeline into the secondary market. The commitments to originate 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 June 30, 2004, the Company recorded a decrease in other assets of $17,050, a decrease in other liabilities of $8,855 and a net loss on sale of loans of $8,195. The current commitments to sell loans held for sale are derivative instruments 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 in loans held for sale of $24,016, an increase in other assets of $25,317 and an increase in other liabilities of $1,301. (4) 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. 7 The gross unrealized holding losses on securities for the second quarter of 2004 was $2,253,000, the income tax benefit would have been $795,000 and therefore, the net loss was $1,458,000. The gross reclassification adjustment for the second quarter of 2004 was $1,400, the income tax expense would have been $500 and therefore, the net gain was $900. The gross unrealized holding gains on securities for the second quarter of 2003 was $925,000, the income tax expense would have been $326,000 and therefore, the net gain was $599,000. The gross reclassification adjustment for the second quarter of 2003 was $225,000, the income tax expense would have been $80,000 and therefore, the net gain was $145,000. The gross unrealized holding losses on securities for the six month period ended June 30, 2004 was $1,499,000, the income tax benefit would have been $529,000 and therefore, the net loss was $970,000. The gross reclassification adjustment in the six month period ended June 30, 2004 was $1,400, the income tax expense would have been $500 and therefore, the net reclassification adjustment was $900. The gross unrealized holding gains on securities for the six month period ended June 30, 2003 was $184,000, the income tax expense would have been $65,000 and therefore, the net gain was $119,000. The gross reclassification adjustment in the six month period ended June 30, 2003 was $816,000, the income tax expense would have been $289,000 and therefore, the net reclassification adjustment was $527,000. (5) INVESTMENT IN LIMITED PARTNERSHIPS Investments in limited partnerships were as follows: June 30, December 31, Primary partnership activity 2004 2003 - ---------------------------- -------- ------------ Common stock of financial institutions 0 421,671 -------- ------- Low to moderate income housing 181,258 195,371 -------- ------- $181,258 617,042 ======== ======= During the second quarter of 2004 the Company recognized $6,500 of losses on the 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 second quarter of 2003 the Company's proportionate gains from the common stock investments in financial institutions was $38,027 and it recognized $6,500 of losses on the low income housing partnerships. During 2003 the Company received low-income housing credits totaling $84,000, of which $21,000 were credited to income tax benefits in the second quarter of 2003. During the six-month period ended June 30, 2004 the Company recognized $13,920 of losses on low-income housing partnerships. During 2004 the Company anticipates receiving low-income housing credits totaling $84,000 of which $42,000 were credited to current income tax benefits. During the six month period ended June 30, 2003 the Company's proportionate gains from common stock investments in financial institutions was $39,263 and it recognized $13,000 of losses on low income housing partnerships. During 2003 the Company received low-income housing credits totaling $84,000 of which $42,000 were credited to current income tax benefits in the first six month period of 2003. (6) 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 June 30, 2004. The Company has reviewed these securities and has concluded that the unrealized losses are temporary and no other-than-temporary impairment has occurred at June 30, 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 $ 7,745 (749) 1,522 (65) 9,267 (814) Other marketable securities: U.S. Agencies 59,809 (670) 0 0 59,809 (670) Corporate equity 0 0 3,094 (406) 3,094 (406) ------- ------- ------- ------- ------- ------- Total temporarily impaired securities $67,554 (1,419) 4,616 (471) 72,170 (1,890) ======= ======= ======= ======= ======= ======= (7) INVESTMENT IN MORTGAGE SERVICING RIGHTS A summary of mortgage servicing activity is as follows: Six Months ended Twelve Months ended Six Months ended June 30, 2004 December 31, 2003 June 30, 2003 ---------------- ------------------- ---------------- Mortgage servicing rights Balance, beginning of period ........ $ 3,447,843 2,701,031 2,701,031 Originations ........................ 443,307 2,522,231 1,438,635 Amortization ........................ (555,634) (1,775,419) (881,714) ----------- ---------- ---------- Balance, end of period .............. 3,335,516 3,447,843 3,257,952 ----------- ---------- ---------- Valuation reserve Balance, beginning of period .......... 0 (10,000) (10,000) Additions ............................. 0 (800,000) (800,000) ----------- ---------- ---------- Reductions ............................ 0 810,000 0 ----------- ---------- ---------- Balance, end of period ................ 0 0 (810,000) Mortgage servicing rights, net ........ $ 3,335,516 3,447,843 2,447,952 =========== ========== ========== Fair value of mortgage servicing rights $ 5,033,869 4,316,251 2,447,952 =========== ========== ========== Mortgage servicing costs, which include professional services for valuing mortgage servicing rights and guarantee fees on securitized mortgage loans were $4,000 in the first six months of 2004 and $216,917 for the same period in 2003. All of the loans being serviced were single family loans serviced for FNMA under the mortgage-backed security program or the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at June 30, 2004. Weighted Weighted Loan Principal Average Average Number of Balance Interest Rate Remaining Term Loans -------------- ------------- -------------- --------- Original term 30 year fixed rate $198,358,294 5.93% 344 1,776 Original term 15 year fixed rate 246,207,348 5.31% 164 2,939 Seven year balloon 120,910 5.75% 55 1 Adjustable rate 9,048,946 5.00% 339 79 9 (8) INTANGIBLE ASSETS The gross carrying amount of intangible assets and the associated accumulated amortization at June 30, 2004 is presented in the table below. Amortization expense for intangible assets was $612,561 for the six-month period ended June 30, 2004. Gross Unamortized Carrying Accumulated Valuation Intangible Amount Amortization Adjustment Assets ----------- ------------ ---------- ----------- Amortized intangible assets: Mortgage servicing rights $ 4,409,787 (1,074,271) 0 3,335,516 Core deposit intangible 1,567,000 (1,176,454) 0 390,546 ----------- ------------ ---------- --------- Total $ 5,976,787 (2,250,725) 0 3,726,062 =========== ============ ========== ========= 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 459,768 56,929 516,697 2005 867,957 113,857 981,814 2006 613,399 113,857 727,256 2007 432,002 105,903 537,905 2008 303,050 0 303,050 Projections of amortization are based on existing asset balances and the existing interest rate environment as of June 30, 2004. The Company's actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions. (9) EARNINGS PER SHARE The following table reconciles the weighted average shares outstanding and the income available to common shareholders used for basic and diluted EPS: Three Months Ended June 30, Six Months Ended June 30, --------------------------- ------------------------- 2004 2003 2004 2003 ---------- --------- --------- --------- Weighted average number of common shares outstanding used in basic earnings per common share calculation 3,870,299 3,763,325 3,892,672 3,755,511 Net dilutive effect of options 173,845 175,170 177,374 166,854 ---------- --------- --------- --------- Weighted average number of shares outstanding adjusted for effect of dilutive securities 4,044,144 3,938,495 4,070,046 3,922,365 ========== ========= ========= ========= Income available to common shareholders $2,497,160 2,030,228 4,617,620 3,419,768 Basic earnings per common share $ 0.65 0.54 1.19 0.91 Diluted earnings per common share $ 0.62 0.52 1.13 0.87 (10) 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 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. 10 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 June 30, 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 June 30, 2004 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized. On June 30, 2004 the Bank's tangible assets and adjusted total assets were $908.8 million and its risk-weighted assets were $719.7 million. The following table presents the Bank's capital amounts and ratios at June 30, 2004 for actual capital, required capital and excess capital, including ratios required to qualify as a well capitalized institution under the Prompt Corrective Actions regulations. Required to be To Be Well Capitalized Adequately Under Prompt Corrective Actual Capitalized Excess Capital Actions 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 ........ $ 77,006 Plus: Net unrealized loss on certain securities Available for sale 759 Less: Goodwill and other intangibles . 4,191 Excess mortgage servicing rights 70 -------- Tier I or core capital ........... 73,504 -------- Tier I capital to adjusted total assets ....................... 8.09% $ 36,352 4.00% $ 37,152 4.09% $ 45,440 5.00% Tier I capital to risk-weighted assets ....................... 10.21% $ 28,786 4.00% $ 44,718 6.21% $ 43,180 6.00% Plus: Allowable allowance for loan losses ....................... 7,037 -------- Risk-based capital ............... $ 80,541 $ 57,573 $ 22,968 $ 71,966 ======== Risk-based capital to risk- weighted assets ................ 11.19% 8.00% 3.19% 10.00% (1) Based upon the Bank's adjusted total assets for the purpose of the tangible and core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio. The tangible capital of the Bank was in excess of the minimum 2% required at June 30, 2004 but is not reflected in the table above. (11) 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 sale 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 of HMN for these guarantees and HMN 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. The Bank has not been required to purchase any loans under these guaranty agreements and no loans have been sold to the third parties since the third quarter of 2002. 11 The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The outstanding standby letters of credit expire over the next fifteen months and totaled approximately $2.7 million at June 30, 2004. The letters of credit were 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. (12) 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, HMN's net income and earnings per share would have been adjusted to the pro forma amounts indicated below: Quarter Ended Quarter Ended Six Months Ended Six Months Ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ---------------- ---------------- Net income: As reported ............................. $ 2,497,160 2,030,228 4,617,620 3,419,768 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects ..... 8,531 10,128 17,061 20,256 ----------- ----------- ----------- ----------- Pro forma ............................... 2,488,629 2,020,100 4,600,559 3,399,512 Earnings per Common share: As reported: Basic .................................. $ 0.65 0.54 1.19 0.91 Diluted ................................ 0.62 0.52 1.13 0.87 Pro forma: Basic .................................. 0.64 0.54 1.18 0.91 Diluted ................................ 0.62 0.51 1.13 0.87 (13) BUSINESS SEGMENTS The Bank has been identified as a reportable operating segment in accordance with the provisions of SFAS No. 131. SFC 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 segment's net income or loss, return on average assets and return on average equity. Each corporation has its own officers and board of directors. The following table sets forth certain information about the reconciliations of reported profit or loss and assets for each of the Company's reportable segments. 12 Home Federal (Dollars in thousands) Savings Bank Other Eliminations Consolidated Total ------------ ------- ------------ ------------------ AT OR FOR THE QUARTER ENDED JUNE 30, 2004: Interest income - external customers ......... $ 12,415 12 0 12,427 Non-interest income - external customers ..... 1,687 0 0 1,687 Loss on limited partnerships ................. (7) 0 0 (7) Intersegment interest income ................. 0 1 (1) 0 Intersegment non-interest income ............. 39 2,544 (2,583) 0 Interest expense ............................. 5,061 0 (1) 5,060 Amortization of mortgage servicing rights, net valuation adjustments, and servicing costs .. 302 0 0 302 Other non-interest expense ................... 4,567 167 (39) 4,695 Income tax expense (benefit) ................. 1,213 (107) 0 1,106 Minority interest ............................ 0 0 0 0 Net income ................................... 2,544 2,497 (2,544) 2,497 Goodwill ..................................... 3,801 0 0 3,801 Total assets ................................. 909,610 81,679 (77,191) 914,098 Net interest margin .......................... 3.46 % NM NM 3.45% Return on average assets ..................... 1.13 % NM NM 1.12% Return on average realized common equity ..... 13.31 % NM NM 12.06% AT OR FOR THE QUARTER ENDED JUNE 30, 2003: Interest income - external customers ......... $ 10,989 47 0 11,036 Non-interest income - external customers ..... 2,493 167 0 2,660 Earnings (loss) on limited partnerships ...... (7) 38 0 31 Intersegment interest income ................. 1 9 (10) 0 Intersegment non-interest income ............. 239 1,904 (2,143) 0 Interest expense ............................. 5,118 0 (10) 5,108 Amortization of mortgage servicing rights, net valuation adjustments, and servicing costs .. 1,177 0 (68) 1,109 Other non-interest expense ................... 4,027 132 (87) 4,072 Income tax expense ........................... 913 4 0 918 Net income ................................... 1,989 2,029 (1,988) 2,030 Goodwill ..................................... 3,801 0 0 3,801 Total assets ................................. 780,760 77,658 (72,508) 785,910 Net interest margin .......................... 3.22% NM NM 3.24% Return on average assets ..................... 1.00% NM NM 1.06% Return on average realized common equity ..... 10.97% NM NM 10.45% NM - Not meaningful 13 Home Federal (Dollars in thousands) Savings Bank Other Eliminations Consolidated Total ------------ ------- ------------ ------------------ AT OR FOR THE SIX - MONTHS ENDED JUNE 30, 2004: Interest income - external customers .......... $ 24,759 24 0 24,783 Non-interest income - external customers ...... 3,230 0 0 3,230 Earnings (loss) on limited partnerships ....... (14) 1 0 (13) Intersegment interest income .................. 0 9 (9) 0 Intersegment non-interest income .............. 108 4,696 (4,804) 0 Interest expense .............................. 10,188 0 (9) 10,179 Amortization of mortgage servicing rights, net valuation adjustments, and servicing costs 556 0 0 556 Other non-interest expense .................... 9,154 321 (108) 9,367 Income tax expense (benefit) .................. 2,223 (207) 0 2,016 Minority interest ............................. (2) 0 0 (2) Net income .................................... 4,698 4,616 (4,696) 4,618 Goodwill ...................................... 3,801 0 0 3,801 Total assets .................................. 909,610 81,679 (77,191) 914,098 Net interest margin ........................... 3.46% NM NM 3.46% Return on average assets ...................... 1.06% NM NM 1.04% Return on average realized common equity ...... 12.50% NM NM 11.14% AT OR FOR THE SIX-MONTHS ENDED JUNE 30, 2003: Interest income - external customers .......... $ 21,410 97 0 21,507 Non-interest income - external customers ...... 5,419 167 0 5,586 Earnings (loss) on limited partnerships ....... (363) 39 0 (324) Intersegment interest income .................. 28 22 (50) 0 Intersegment non-interest income .............. 508 3,289 (3,797) 0 Intersegment loan loss provision .............. 200 0 (200) 0 Interest expense .............................. 10,108 0 (50) 10,058 Amortization of mortgage servicing rights, net valuation adjustments, and servicing costs 2,039 3 (143) 1,899 Other non-interest expense .................... 8,395 265 (165) 8,495 Income tax expense (benefit) .................. 1,613 (71) 0 1,542 Net income .................................... 3,292 3,417 (3,289) 3,420 Goodwill ...................................... 3,801 0 0 3,801 Total assets .................................. 780,760 77,658 (72,508) 785,910 Net interest margin ........................... 3.20% NM NM 3.22% Return on average assets ...................... 0.88% NM NM 0.91% Return on average realized common equity ...... 9.63% NM NM 8.84% NM - Not meaningful 14 ITEM 2: HMN FINANCIAL, INC. 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, monetary and fiscal policies of the federal government or tax laws; 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 the 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. 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. Mortgage loan activity was significantly less in the first six months of 2004 than it was during the same period in 2003 due to increases in mortgage interest rates, and we expect this trend to continue. 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 complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used. 15 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 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. 16 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 The Company's net income was $2.5 million for the second quarter of 2004, an increase of $467,000, or 23.0%, from net income of $2.0 million for the second quarter of 2003. Basic earnings per share for the second quarter of 2004 were $0.65, an increase of $0.11, or 20.4%, from $0.54 basic earnings per share for the same quarter of 2003. Diluted earnings per common share for the second quarter of 2004 were $0.62, an increase of $0.10, or 19.2%, from $0.52 for the second quarter of 2003. Net income was $4.6 million for the six-month period ended June 30, 2004, an increase of $1.2 million, or 35.0%, compared to $3.4 million for the six-month period ended June 30, 2003. Basic earnings per share were $1.19 for the six months ended June 30, 2004, an increase of $0.28 per share, or 30.8%, from $0.91 for the same six month period in 2003. Diluted earnings per share for the six month period in 2004 were $1.13, an increase of $0.26, or 29.9%, from $0.87 for the same six month period in 2003. NET INTEREST INCOME Net interest income was $7.3 million for the second quarter of 2004, an increase of $1.4 million, or 24.3%, compared to $5.9 million for the second quarter of 2003. Interest income was $12.4 million for the second quarter of 2004, an increase of $1.4 million, or 12.6%, from $11.0 million for the same period in 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 $120 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 second quarter of 2004 when compared to the same period of 2003. The yield earned on interest-earning assets was 5.82% for the second quarter of 2004, a decrease of 21 basis points from the 6.03% yield for the second quarter of 2003. Interest expense was $5.1 million for the second quarter of 2004, a decrease of $48,000, or 0.9%, from the second quarter of 2003. Interest expense on deposits and Federal Home Loan Bank advances decreased by $1.1 million due to a decrease in the interest rates paid as maturing deposits and advances repriced at lower interest rates. Interest expense increased by $1.0 million due to the $128 million increase in the average outstanding balance of deposits and advances between the periods. The decrease in the interest rates paid is primarily the result of the $84 million in growth that was experienced in checking and money market accounts, which generally have lower interest rates than other deposit accounts. The average interest rate paid on interest-bearing liabilities was 2.50% for the second quarter of 2004, a decrease of 49 basis points from the 2.99% paid for the second quarter of 2003. Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2004 was 3.45%, a 21 basis point increase, compared to 3.24% for the second quarter of 2003. Net interest income was $14.6 million for the first six months of 2004, an increase of $3.2 million, or 27.6%, from $11.4 million for the same period in 2003. Interest income was $24.8 million for the six-month period ended June 30, 2004, an increase of $3.3 million, or 15.2%, from $21.5 million for the same six-month period in 2003. Interest income increased primarily because of an increase in interest-earning assets and because of a change in the 17 mix of assets between the periods. The increase in interest-earning assets was caused primarily by the $120 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 in the first six months of 2004 when compared to the same period in 2003. The yield earned on interest-earning assets was 5.86% for the first six months of 2004, a decrease of 19 basis points from the 6.05% yield for the first six months of 2003. Interest expense was $10.2 million for the six month period ended June 30, 2004, an increase of $121,000, or 1.2%, compared to $10.1 million for the same period of 2003. Interest expense on deposits and Federal Home Loan Bank advances decreased by $2.1 million due to a decline in the interest rates paid and increased by $2.2 million due to the $137 million increase in the average outstanding balance of deposits and advances between the periods. The average interest rate paid on interest-bearing liabilities was 2.54% for the first six months of 2004, a decrease of 49 basis points from the 3.03% paid for the first six months of 2003. Net interest margin (net interest income divided by average interest earning assets) for the six months ended June 30, 2004, was 3.46%, an increase of 24 basis points, compared to 3.22% for the same period 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 policies previously discussed. The provision for loan losses was $447,000 for the second quarter of 2004, a decrease of $43,000, or 8.8%, from $490,000 for the second quarter of 2003. The provision for loan losses was $1.3 million for the six-month period of 2004, a decrease of $89,000, or 6.7%, from $1.4 million for the same six-month period in 2003. The provision for loan losses decreased primarily because of the slower loan growth that was experienced in the first six months of 2004 when compared to the same period of 2003. Total non-performing assets were $3.5 million at June 30, 2004, a decrease of $1.5 million, or 31.1%, from $5.0 million at December 31, 2003. The decrease in non-performing assets was primarily due to the payoff of a $1.6 million commercial real estate loan and a reduction in non-performing consumer loans during the first six months of 2004. Charge offs during the first six months of 2004 increased by $298,000 over the same period in 2003 primarily because of increased charge offs in the single family and mobile home loan portfolios. A reconciliation of the Company's allowance for loan losses is summarized as follows: 2004 2003 ----------- ----------- Balance at January 1, $ 6,939,602 $ 4,824,217 Provision 1,266,000 1,355,000 Charge-offs (421,525) (123,976) Recoveries 8,720 33,228 ----------- ----------- Balance at June 30, $ 7,792,797 $ 6,088,469 =========== =========== NON-INTEREST INCOME Non-interest income was $1.7 million for the second quarter of 2004, a decrease of $1.0 million, or 37.6%, from $2.7 million for the same period in 2003. Non-interest income from security gains decreased by $223,000 because of the lower gains recognized on the sale of securities during the second quarter of 2004 when compared to the same quarter of 2003. Gains on sales of loans decreased by $1.0 million due to the significant decrease in mortgage loan activity in the second quarter of 2004 when compared to the same period in 2003. These decreases in non-interest income were partially offset by an increase of $150,000 in fees and service charges between the periods due to an increase in the number of deposit accounts and the fees charged. Mortgage servicing fees increased by $52,000 because of the increased size of the servicing portfolio. Other non-interest income increased by $68,000 primarily because of increased revenues from the sale of uninsured investment products. Non-interest income was $3.2 million for the first six months of 2004, a decrease of $2.1 million, or 38.9%, from $5.3 million for the same period of 2003. Non-interest income decreased by $814,000 because of lower gains on the sales of securities. Gains on sales of loans decreased by $2.1 million due to the significant decrease in mortgage loan activity in the first six months of 2004 when compared to the same period of 2003. These decreases in non-interest income were partially offset by the $310,000 decrease in limited partnership losses because the Company's investment in a limited partnership that invested in mortgage servicing rights was dissolved in the 18 second quarter of 2003. Interest rates on mortgage loans decreased during the first six months of 2003 which caused the value of the Company's investment in a limited partnership that owned mortgage loan servicing assets to decrease in value. The value of servicing rights generally decreases when mortgage rates decrease because of the anticipated increase in prepayments expected to be received on the mortgage servicing assets. Fees and service charges increased by $286,000 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 $123,000 due to the increased size of the servicing portfolio between the periods. Other non-interest income increased by $122,000 primarily because of increased revenues from the sale of uninsured investment products. NON-INTEREST EXPENSE Non-interest expense was $5.0 million for the second quarter of 2004, a decrease of $184,000, or 3.5%, from $5.2 million for the same period of 2003. Amortization expense on mortgage servicing rights decreased by $806,000 between the quarters because of a decrease in the prepayments on the mortgage loans being serviced. Prepayments of mortgage loans in the second quarter of 2003 resulted in a $640,000 impairment reserve that was reversed in the second half of 2003 when prepayment speeds slowed. Data processing costs decreased by $61,000 primarily because of the renegotiation of a third party service contract in the fourth quarter of 2003. Compensation expense increased by $554,000 primarily because of an increase in the number of employees and because of annual increases in salaries and employee benefit costs. Occupancy expense increased by $102,000 primarily because of increases in real estate taxes on existing facilities. Non-interest expense was $9.9 million for the first six months of 2004, a decrease of $471,000, or 4.5%, from $10.4 million for the same period of 2003. Amortization expense on mortgage servicing rights decreased by $1.3 million because of a decrease in the prepayments on the mortgage loans being serviced. Prepayments of mortgage loans in the second quarter of 2003 resulted in a $640,000 impairment reserve that was reversed in the second half of 2003 when prepayment speeds slowed. Data processing costs decreased by $142,000 primarily because of the renegotiation of a third party service contract in the fourth quarter of 2003. Compensation expense increased by $803,000 because of an increase in the number of employees and because of annual increases in salaries and employee benefit cost. Occupancy expense increased by $162,000 primarily because of increases in real estate taxes on existing facilities. INCOME TAX EXPENSE Income tax expense was $1.1 million for the second quarter of 2004, an increase of $188,000 compared to $918,000 for the second quarter of 2003. Income tax expense was $2.0 million for the six months ended June 30, 2004, an increase of $474,000 compared to $1.5 million for the same six month period of 2003. The increases in income taxes are primarily due to an increase in taxable income. NON-PERFORMING ASSETS The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio at June 30, 2004 and December 31, 2003. 19 June 30, December 31, (Dollars in Thousands) 2004 2003 -------- ------------ Non-Accruing Loans One-to-four family real estate $1,257 1,177 Commercial real estate 1,123 2,162 Consumer 214 1,050 Commercial business 261 186 ------ ------ Total 2,855 4,575 ------ ------ Accruing loans delinquent 90 days or more 0 114 Other assets 201 211 Foreclosed and Repossessed Assets One-to-four family real estate 254 73 Consumer 161 62 ------ ------ Total non-performing assets $3,471 $5,035 ====== ====== Total as a percentage of total assets 0.38% 0.58% ====== ====== Total non-performing loans $2,855 $4,689 ====== ====== Total as a percentage of total loans receivable, net 0.40% 0.68% ====== ====== Allowance for loan loss to non-performing loans 272.98% 147.99% Total non-performing assets at June 30, 2004 were $3.5 million, a decrease of $1.5 million, or 31.1%, from $5.0 million at December 31, 2003. The decrease in non-performing assets was primarily due to the payoff of a commercial real estate loan and a reduction in non-performing consumer loans during the first six months of 2004. During the first six months of 2004 the following activity occurred related to non-performing loans: $2.6 million of previously performing loans were classified as non-performing, $516,000 of loans were foreclosed or repossessed, a $1.6 million non-performing commercial loan was paid off, and $2.2 million in previously non-performing loans were reclassified to performing status. DIVIDENDS On July 27, 2004 the Company declared a cash dividend of $0.22 per share, payable on September 10, 2004 to shareholders of record on August 27, 2004. The Company has declared and paid dividends during 2004 as follows: Record date Pay date Dividend per share Dividend Payout Ratio ----------- -------- ------------------ --------------------- February 20, 2004 March 8, 2004 $0.20 37.74% May 21, 2004 June 8, 2004 $0.20 38.46% The annualized dividend payout ratio for the past four quarters, ending with the September 10, 2004 payment will be 33.74%. 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, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. LIQUIDITY For the six months ended June 30, 2004 the net cash provided by operating activities was $7.7 million. The Company collected $10.1 million from the sale of securities and $3.2 million from principal repayments on securities. It purchased securities available for sale of $20.0 million and premises and equipment of $1.1 million. Net loans receivable increased by $35.0 million due to increased commercial loan production. The Company had a net increase in deposit balances of $75.8 million and received $16.5 million in FHLB advance proceeds. It paid out $21.5 million on FHLB advances and $21.6 million on customer escrows due primarily to the payment of one large commercial loan escrow. The Company received $28,000 related to the exercise of HMN stock options, paid $1.6 million in dividends to its shareholders and paid $2.2 million to purchase treasury stock. 20 The Company has certificates of deposits with outstanding balances of $171.2 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 that 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 which mature beyond June 30, 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. The Company also has $28.0 million of FHLB advances that will mature during the next 12 months. Since the Company has the ability to request another advance to replace the advance that is being called or is maturing, 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 the Company's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located below 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 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. 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 June 30, 2004. 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 June 30, 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 $ 938,931 924,764 904,780 887,721 Total market risk sensitive liabilities 863,127 850,521 840,114 834,814 Off-balance sheet financial instruments (73) 0 83 160 --------- ------- -------- -------- Net market risk $ 75,731 74,243 64,749 53,067 ========= ======= ======== ======== Percentage change from current market value 2.00% 0.00% (12.79)% (28.52)% ========= ======= ======== ======== The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that 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 19% to 55%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 15% and 28%, depending on the note rate and the period to maturity. Growing Equity Mortgage loans were assumed to prepay at annual rates of between 26% and 47% depending on the note rate and the period to maturity. Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the 21 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 11.44% and money market accounts were assumed to decay at an annual rate of 12.67%. 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 The Company's management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following June 30, 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 39,151 13.55% +100 37,159 7.78% 0 34,478 0.00% -100 32,325 (6.24)% 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 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 sustained increase in interest rates which 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 Bank's interest rate risk position and projected profitability. The Committee makes adjustments to the asset liability position of the Bank which is reviewed by the Board of Directors of the Bank. This Committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In addition, 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. 22 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 portfolio lending program on loans that are saleable to third parties and only places fixed rate loans that 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. As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified insecurities and Exchange Commission rules and forms. Changes in internal controls. There was no change in the Company's internal control over financial reporting during the Company's most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 23 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 April 2004 25,000 26.05 25,000 297,000 May 2004 30,000 25.31 30,000 267,000 June 2004 0 0 0 267,000 ------ ------ ------- Total 83,000 $26.27 83,000 ====== ====== ======= (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. The Annual Meeting of Stockholders of the Company was held on April 27, 2004 at 10:00 a.m. The following is a record of the votes cast in the election of directors of the Company: Term expiring in 2007: For Withhold --- -------- Michael J. Fogarty 4,103,989 40,533 Susan K. Kolling 4,044,001 100,521 Malcolm W. McDonald 4,033,744 110,778 There were 0 broker non-votes and 0 abstentions for each of the directors. Accordingly the individuals named above were duly elected directors of the Company for terms to expire as stated above. The following is a record of the votes cast in respect of the proposal to ratify the appointment of KPMG LLP as the Company's auditors for the fiscal year ending December 31, 2004. 24 NUMBER PERCENTAGE OF OF VOTES VOTES ACTUALLY CAST -------- ------------------- FOR 4,098,822 98.89% AGAINST 38,160 0.92% ABSTAIN 7,540 0.18% BROKER NON-VOTE 0 0.00% Accordingly, the proposal described above was declared to be duly adopted by the stockholders of the Company. ITEM 5. Other Information. None. ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits. See Index to Exhibits on page 26 of this report (b) Reports on Form 8-K - 1) On April 28, 2004, HMN reported its financial results for its first fiscal quarter ended March 31, 2004. 2) On July 26, 2004, HMN reported its financial results for its second fiscal quarter ended June 30, 2004 25 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: August 10, 2004 By: /s/ Michael McNeil Michael McNeil, President (Duly Authorized Officer and Principal Executive Officer) Date: August 10, 2004 By: /s/ Jon Eberle Jon Eberle, Chief Financial Officer (Principal Financial Officer) 26 HMN FINANCIAL, INC. INDEX TO EXHIBITS FOR FORM 10-Q Reference Sequential to Prior Page Numbering Filing or Where Attached Exhibit Exhibits Are Regulation S-K Number Located in This Exhibit Number Document Attached Hereto Form 10-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 *3 N/A Including indentures 10 Form of Change in Control Agreement for 10 Filed electronically Executive Officers 31.1 Rule 13a-14(a)/15d-14(a) Certification of CEO 31.1 Filed electronically 31.2 Rule 13a-14(a)/15d-14(a) Certification of CFO 31.2 Filed electronically 32 Section 1350 Certification of CEO and CFO 32 Filed Electronically *1 Incorporated by reference to 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 Quarterly Report on Form 10-Q for the period ended September 30, 1997 (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). 27