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 September 30, 2005
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 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 [X] No [ ]
Indicate by check mark whether the registrant is a shell company (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 October 24, 2005
----- -------------------------------
Common stock, $0.01 par value 4,408,494
HMN FINANCIAL, INC.
CONTENTS
Page
-----
PART I - FINANCIAL INFORMATION
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at September 30, 2005 and
December 31, 2004 3
Consolidated Statements of Income for the Three Months Ended
and Nine Months Ended September 30, 2005 and 2004 4
Consolidated Statement of Stockholders' Equity and
Comprehensive Income for the Nine-Month Period Ended
September 30, 2005 5
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2005 and 2004 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: Unregistered Sales of Equity 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 24
Item 6: Exhibits 24
Signatures 25
2
PART I - FINANCIAL STATEMENTS
Item 1: Financial Statements
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2005 2004
------------- ------------
(unaudited)
ASSETS
Cash and cash equivalents .............................................. $ 27,462,839 34,298,394
Securities available for sale, at fair value:
Mortgage-backed and related securities
(amortized cost $7,920,015 and $9,509,377) ....................... 7,481,261 9,150,871
Other marketable securities
(amortized cost $92,099,344 and $95,097,051) ..................... 91,030,938 94,521,512
------------ -----------
98,512,199 103,672,383
------------ -----------
Loans held for sale .................................................... 4,058,132 2,711,760
Loans receivable, net .................................................. 815,163,631 783,213,262
Accrued interest receivable ............................................ 4,513,397 3,694,133
Real estate, net ....................................................... 1,229,894 140,608
Federal Home Loan Bank stock, at cost .................................. 8,809,500 9,292,800
Mortgage servicing rights, net ......................................... 2,817,520 3,231,242
Premises and equipment, net ............................................ 12,177,193 12,464,265
Investment in limited partnerships ..................................... 147,548 168,258
Goodwill ............................................................... 3,800,938 3,800,938
Core deposit intangible, net ........................................... 248,224 333,617
Prepaid expenses and other assets ...................................... 1,905,066 2,638,681
Deferred tax asset ..................................................... 1,458,100 1,012,700
------------ -----------
Total assets ........................................................ $982,304,181 960,673,041
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ............................................................... $714,711,074 698,902,185
Federal Home Loan Bank advances ........................................ 170,900,000 170,900,000
Accrued interest payable ............................................... 2,142,442 1,314,356
Customer escrows ....................................................... 993,944 762,737
Accrued expenses and other liabilities ................................. 5,538,649 5,022,927
------------ -----------
Total liabilities ................................................... 894,286,109 876,902,205
------------ -----------
Commitments and contingencies
Stockholders' equity:
Serial preferred stock: ($.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 ............................................. 57,931,170 57,875,595
Retained earnings, subject to certain restrictions ..................... 96,393,416 91,408,028
Accumulated other comprehensive loss ................................... (912,561) (604,446)
Unearned employee stock ownership plan shares .......................... (4,399,289) (4,544,300)
Unearned compensation restricted stock awards .......................... (249,341) 0
Treasury stock, at cost 4,720,168 and 4,708,798 shares ................. (60,836,610) (60,455,328)
------------ -----------
Total stockholders' equity .......................................... 88,018,072 83,770,836
------------ -----------
Total liabilities and stockholders' equity ............................. $982,304,181 960,673,041
============ ===========
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ -----------------------
2005 2004 2005 2004
----------- ---------- ---------- ----------
Interest income:
Loans receivable ........................... $14,385,320 12,242,408 41,487,679 35,220,089
Securities available for sale:
Mortgage-backed and related ............. 78,645 81,341 252,701 292,633
Other marketable ........................ 645,871 730,727 1,941,809 2,180,525
Cash equivalents ........................... 114,872 40,410 342,812 106,750
Other ...................................... 13,525 61,196 182,285 139,016
----------- ---------- ---------- ----------
Total interest income ................... 15,238,233 13,156,082 44,207,286 37,939,013
----------- ---------- ---------- ----------
Interest expense:
Deposits ................................... 4,456,305 3,190,799 12,358,727 9,015,152
Federal Home Loan Bank advances ............ 1,836,269 2,195,801 5,485,461 6,550,436
----------- ---------- ---------- ----------
Total interest expense .................. 6,292,574 5,386,600 17,844,188 15,565,588
----------- ---------- ---------- ----------
Net interest income ..................... 8,945,659 7,769,482 26,363,098 22,373,425
Provision for loan losses ..................... 952,000 775,000 2,495,000 2,041,000
----------- ---------- ---------- ----------
Net interest income after provision
for loan losses ...................... 7,993,659 6,994,482 23,868,098 20,332,425
----------- ---------- ---------- ----------
Non-interest income:
Fees and service charges ................... 706,337 741,704 1,994,291 2,014,905
Mortgage servicing fees .................... 305,417 291,709 901,760 869,789
Securities gains, net ...................... 0 2,451 0 3,812
Gain on sales of loans ..................... 624,947 349,214 1,242,436 1,268,445
Earnings (losses) in limited partnerships .. (6,500) (6,500) (20,710) (19,617)
Other ...................................... 90,957 210,155 604,711 667,952
----------- ---------- ---------- ----------
Total non-interest income ............... 1,721,158 1,588,733 4,722,488 4,805,286
----------- ---------- ---------- ----------
Non-interest expense:
Compensation and benefits .................. 2,781,366 2,430,026 8,340,048 7,540,268
Occupancy .................................. 1,042,417 914,382 3,079,131 2,670,154
Deposit insurance premiums ................. 34,679 23,600 97,204 70,099
Advertising ................................ 101,775 116,195 291,448 291,591
Data processing ............................ 278,880 233,254 761,719 652,540
Amortization of mortgage servicing
rights, net of valuation adjustments .... 256,763 239,806 766,885 795,439
Other ...................................... 1,053,536 923,135 3,025,033 2,783,471
----------- ---------- ---------- ----------
Total non-interest expense .............. 5,549,416 4,880,398 16,361,468 14,803,562
----------- ---------- ---------- ----------
Income before income tax expense ........ 4,165,401 3,702,817 12,229,118 10,334,149
Income tax expense ............................ 1,889,000 1,152,700 4,638,200 3,168,700
----------- ---------- ---------- ----------
Income before minority interest ......... 2,276,401 2,550,117 7,590,918 7,165,449
Minority interest ............................. 0 (84) 0 (2,372)
----------- ---------- ---------- ----------
Net income .............................. $ 2,276,401 2,550,201 7,590,918 7,167,821
=========== ========= ========= =========
Basic earnings per share ...................... $ 0.59 0.66 1.98 1.85
=========== ========= ========= =========
Diluted earnings per share .................... $ 0.57 0.64 1.89 1.77
=========== ========= ========= =========
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2005
(unaudited)
Accumulated
Additional Other
Common Paid-in Retained Comprehensive
Stock Capital Earnings Income (Loss)
------- ---------- ---------- -------------
Balance, December 31, 2004 $91,287 57,875,595 91,408,028 (604,446)
Net income 7,590,918
Other comprehensive income, net of tax:
Net unrealized losses on securities
available for sale (308,115)
Total comprehensive income
Purchase of treasury stock
Employee stock options exercised (247,613)
Tax benefits of exercised stock options 29,907
Unearned compensation restricted stock awards 15,616
Restricted stock awards cancelled (286)
Amortization of restricted stock awards
Dividends paid (2,605,530)
Earned employee stock ownership plan shares 257,951
------- ---------- ---------- --------
Balance, September 30, 2005 $91,287 57,931,170 96,393,416 (912,561)
======= ========== ========== ========
Unearned
Employee
Stock Unearned Total
Ownership Compensation Stock-
Plan Restricted Treasury Holders'
Shares Stock Awards Stock Equity
---------- ------------ ----------- ----------
Balance, December 31, 2004 (4,544,300) 0 (60,455,328) 83,770,836
Net income 7,590,918
Other comprehensive income, net of tax:
Net unrealized losses on securities
available for sale (308,115)
----------
Total comprehensive income 7,282,803
Purchase of treasury stock (972,000) (972,000)
Employee stock options exercised 285,500 37,887
Tax benefits of exercised stock options 29,907
Unearned compensation restricted stock awards (326,528) 310,912 0
Restricted stock awards cancelled 5,980 (5,694) 0
Amortization of restricted stock awards 71,207 71,207
Dividends paid (2,605,530)
Earned employee stock ownership plan shares 145,011 402,962
---------- -------- ----------- ----------
Balance, September 30, 2005 (4,399,289) (249,341) (60,836,610) 88,018,072
========== ======== =========== ==========
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
September 30,
--------------------------
2005 2004
------------ -----------
Cash flows from operating activities:
Net income ................................................... $ 7,590,918 7,167,821
Adjustments to reconcile net income to cash provided by
operating activities:
Provision for loan losses ................................. 2,495,000 2,041,000
Depreciation .............................................. 1,306,622 1,179,006
Amortization of discounts, net ............................ (501,262) (206,102)
Amortization of deferred loan fees ........................ (774,907) (826,890)
Amortization of core deposit intangible ................... 85,393 85,393
Amortization of mortgage servicing rights ................. 766,885 795,439
Capitalized mortgage servicing rights ..................... (353,163) (633,622)
Deferred income taxes ..................................... (180,400) (153,700)
Securities gains, net ..................................... 0 (3,812)
Losses on sales of real estate ............................ 19,563 25,773
Gain on sales of loans .................................... (1,242,436) (1,268,445)
Proceeds from sales of real estate ........................ 590,790 422,316
Proceeds from sales of loans held for sale ................ 68,666,440 69,813,836
Disbursements on loans held for sale ...................... (65,325,644) (65,639,383)
Amortization of restricted stock awards ................... 71,207 0
Amortization of unearned ESOP shares ...................... 145,011 145,368
Earned employee stock ownership shares priced above
original cost .......................................... 257,951 216,584
Increase in accrued interest receivable ................... (819,264) (464,945)
Increase in accrued interest payable ...................... 828,086 497,565
Equity losses of limited partnerships ..................... 20,710 19,617
Equity losses of minority interest ........................ 0 (2,372)
Decrease (increase) in other assets ....................... 771,488 (708,976)
Increase (decrease) in other liabilities .................. 499,899 (2,656,110)
Other, net ................................................ 52,444 (16,465)
------------ -----------
Net cash provided by operating activities .............. 14,971,331 9,828,896
------------ -----------
Cash flows from investing activities:
Proceeds from sales of securities available for sale ......... 0 15,129,325
Principal collected on securities available for sale ......... 1,648,554 3,754,368
Proceeds from maturities of securities available for sale .... 8,000,000 0
Purchases of securities available for sale ................... (4,991,400) (19,955,262)
Redemption of interest in limited partnership ................ 0 422,474
Purchase of Federal Home Loan Bank stock ..................... (1,904,200) (1,198,000)
Redemption of Federal Home Loan Bank stock ................... 2,387,500 1,264,100
Net increase in loans receivable ............................. (38,865,360) (79,141,416)
Purchases of premises and equipment .......................... (1,015,189) (1,619,864)
------------ -----------
Net cash used by investing activities .................. (34,740,095) (81,344,275)
------------ -----------
Cash flows from financing activities:
Increase in deposits ......................................... 16,241,645 115,320,241
Purchase of treasury stock ................................... (972,000) (2,706,550)
Stock options exercised ...................................... 37,887 27,634
Dividends to stockholders .................................... (2,605,530) (2,405,414)
Proceeds from Federal Home Loan Bank advances ................ 57,000,000 34,400,000
Repayment of Federal Home Loan Bank advances ................. (57,000,000) (39,400,000)
Increase (decrease) in customer escrows ...................... 231,207 (21,114,615)
------------ -----------
Net cash provided by financing activities .............. 12,933,209 84,121,296
------------ -----------
(6,835,555) 12,605,917
Increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period .................. 34,298,394 30,496,823
------------ -----------
Cash and cash equivalents, end of period ........................ $ 27,462,839 43,102,740
============ ===========
Supplemental cash flow disclosures:
Cash paid for interest ....................................... $ 17,016,102 15,068,023
Cash paid for income taxes ................................... 5,183,494 5,671,500
Supplemental noncash flow disclosures:
Transfer of loans to real estate ............................. 15,951,620 773,799
Transfer of real estate to loans ............................. 14,195,361 0
Loans transferred to loans held for sale ..................... 3,436,875 0
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
September 30, 2005 and 2004
(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).
Home Federal has a community banking philosophy and operates retail banking and
loan production 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 invested in real
estate loans acquired from the Bank. HFH and HFREIT ceased operation in the
third quarter of 2005 and their assets were transferred to 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 had an 80% owned subsidiary, Federal Title Services,
LLC. (FTS), which performed mortgage title services for Bank customers. FTS
stopped accepting title orders in the third quarter of 2004 and was dissolved.
The consolidated financial statements included herein are for HMN, SFC, the Bank
and the Bank's consolidated entities as described above. 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 statement of
stockholders' equity and consolidated statements of cash flows in conformity
with generally accepted accounting principles. However, all normal recurring
adjustments that 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 nine-month period ended September 30, 2005 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 2004, the Financial Accounting Standards Board (FASB) issued a
revised SFAS No. 123, Share-Based Payment. This Statement is a revision of FASB
Statement No. 123, Accounting for Stock Based Compensation and requires that the
cost resulting from all share-based payment transactions be recognized in the
financial statements. It requires a public entity to measure the cost of
employee services received in exchange for an award of equity instruments based
on the grant-date fair value of the award. That cost will be recognized over the
period during which an employee is required to provide service in exchange for
the award. The Statement also requires that the notes to financial statements
disclose information to assist users of financial information to understand the
nature of share-based payment transactions and the effects of those transactions
on the financial statements. In April 2005, the effective date of this statement
was deferred until the beginning of the first annual period beginning after June
15, 2005. The Company does not expect the impact of adopting the revised SFAS
No. 123 in January of 2006 to be material on the Company's financial condition
and results of operations.
7
(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, the
Company generally enters into commitments to sell the mortgage pipeline into the
secondary market. The commitments to originate, purchase or sell loans are
derivatives. Derivatives which stipulate a fee for non-delivery are firm
commitments that are marked to market. As a result of marking the mortgage
pipeline and the related commitments to sell to market for the period ended
September 30, 2005, the Company recorded a decrease in other assets of $2,764,
an increase in other liabilities of $45,730 and a decrease in gain on sales of
loans of $48,494.
The current commitments to sell loans held for sale are derivatives that do not
qualify for hedge accounting and are marked to market. The loans held for sale
that are not hedged are recorded at the lower of cost or market. The Company
recorded a market adjustment and an increase in other assets of $40,637.
(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
components of other comprehensive income and the related tax effects were as
follows:
For the three months ended September 30,
---------------------------------------------------------------------------
2005 2004
------------------------------------ ------------------------------------
Before tax Tax effect Net of tax Before tax Tax effect Net of tax
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
Securities available for sale:
Gross unrealized gains (losses)
arising during the period $(200) (133) (67) 568 201 367
Less reclassification of net
gains included in net income 0 0 0 3 1 2
----- ---- --- --- --- ---
Net unrealized gains (losses)
arising during the period (200) (133) (67) 565 200 365
----- ---- --- --- --- ---
Other comprehensive income (loss) $(200) (133) (67) 565 200 365
===== ==== === === === ===
For the nine months ended September 30,
---------------------------------------------------------------------------
2005 2004
------------------------------------ ------------------------------------
Before tax Tax effect Net of tax Before tax Tax effect Net of tax
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
Securities available for sale:
Gross unrealized losses
arising during the period $(573) (265) (308) (931) (329) (602)
Less reclassification of net
gains included in net income 0 0 0 4 1 3
----- ---- --- --- --- ---
Net unrealized losses
arising during the period (573) (265) (308) (935) (330) (605)
----- ---- --- --- --- ---
Other comprehensive income (loss) $(573) (265) (308) (935) (330) (605)
===== ==== ==== ==== ==== ====
(6) INVESTMENT IN LIMITED PARTNERSHIPS
During the third quarter of 2005 the Company recognized $6,500 of losses on
low-income housing partnerships. During 2005 the Company anticipates receiving
low income housing credits totaling $42,000 of which $10,500 were credited to
current income tax benefits in the current quarter. During the third quarter of
2004 the Company recognized $6,500 of losses on low income housing partnerships.
During 2004 the Company received low income housing credits totaling $84,000, of
which $21,000 were credited to current income tax benefits.
During the nine-month period ended September 30, 2005, the Company recognized
$20,710 of losses on the low income housing partnerships. During 2005 the
Company anticipates receiving low income housing credits totaling $42,000, of
which $31,500 were credited to current income tax benefits in the first nine
months of 2005. During the nine-month period ended September 30, 2004, the
Company's proportionate share of gains from common stock investments in
financial institutions was $803 and it recognized $20,420 of losses on low
income housing
8
partnerships. During 2004, the Company received low income housing credits
totaling $84,000, of which $63,000 were credited to current income tax benefits.
(7) SECURITIES AVAILABLE FOR SALE
The following table shows the gross unrealized losses and fair value for the
securities available for sale portfolio, aggregated by investment category and
length of time that individual securities have been in a continuous loss
position at September 30, 2005. The Company has reviewed these securities and
has concluded that the unrealized losses are temporary and no
other-than-temporary impairment has occurred at September 30, 2005.
Less than twelve months Twelve months or more Total
----------------------- --------------------- -------------------
# of Fair Unrealized # of Fair Unrealized Fair Unrealized
Investments Value Losses Investments Value Losses Value Losses
----------- ------- ---------- ----------- ------- ----------- ------- ----------
(Dollars in thousands)
Mortgage backed securities:
FHLMC 1 $ 23 0 1 $ 2,969 (270) $ 2,992 (270)
FNMA 2 548 (10) 1 3,536 (172) 4,084 (182)
Other marketable securities:
FNMA Debt 2 9,884 (94) 1 4,947 (49) 14,831 (143)
FHLMC Debt 2 9,884 (89) 2 9,846 (154) 19,730 (243)
FHLB Debt 4 22,818 (157) 6 30,152 (364) 52,970 (521)
Corporate equity 1 2,800 (161) 0 0 0 2,800 (161)
--- ------- ---- --- ------- ------ ------- ------
Total temporarily impaired
securities 12 $45,957 (511) 11 $51,450 (1,009) $97,407 (1,520)
=== ======= ==== === ======= ====== ======= ======
(8) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Nine Months ended Twelve Months ended Nine Months ended
Sept. 30, 2005 Dec. 31, 2004 Sept. 30, 2004
----------------- ------------------- -----------------
Mortgage servicing rights
Balance, beginning of period ............ $3,231,242 3,447,843 3,447,843
Originations ............................ 353,163 844,806 633,622
Amortization ............................ (766,885) (1,061,407) (795,439)
---------- --------- ---------
Balance, end of period .................. 2,817,520 3,231,242 3,286,026
---------- --------- ---------
Valuation reserve ....................... 0 0 0
---------- --------- ---------
Mortgage servicing rights, net .......... $2,817,520 3,231,242 3,286,026
---------- --------- ---------
Fair value of mortgage servicing rights.. $4,137,210 4,494,724 4,519,308
========== ========= =========
All of the loans being serviced were single-family loans serviced for FNMA under
the mortgage-backed security or individual loan sale program. The following is a
summary of the risk characteristics of the loans being serviced at September 30,
2005.
Weighted Weighted
Loan Average Average
Principal Interest Remaining Number
Balance Rate Term of Loans
------------ -------- --------- --------
Original term 30 year fixed rate $214,371,056 5.89% 336 1,883
Original term 15 year fixed rate 214,121,466 5.27% 153 2,679
Adjustable rate 6,722,740 5.11% 327 63
(9) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at September 30, 2005 is presented in the table below. Amortization
expense for intangible assets was $852,278 for the nine-month period ended
September 30, 2005.
9
Gross Unamortized
Carrying Accumulated Valuation Intangible
Amount Amortization Adjustment Assets
---------- ------------ ---------- -----------
Amortized intangible assets:
Mortgage servicing rights $4,475,026 (1,657,506) 0 2,817,520
Core deposit intangible 1,567,000 (1,318,776) 0 248,224
---------- ---------- --- ---------
Total $6,042,026 (2,976,282) 0 3,065,744
========== ========== === =========
The following table indicates the estimated future amortization expense for
amortized intangible assets:
Mortgage Core
Servicing Deposit
Rights Intangible Total
--------- ---------- -------
Year ended December 31,
2005 $103,554 28,464 132,018
2006 384,091 113,857 497,948
2007 306,142 105,903 412,045
2008 266,473 0 266,473
2009 242,036 0 242,036
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of September 30, 2005. 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 Nine months
ended September 30, ended September 30,
---------------------- ---------------------
2005 2004 2005 2004
---------- --------- --------- ---------
Weighted average number of common shares outstanding
used in basic earnings per common share calculation 3,836,397 3,850,535 3,830,264 3,878,524
Net dilutive effect of:
Options 170,316 147,823 168,320 167,524
Restricted stock awards 8,172 0 8,064 0
---------- --------- --------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 4,014,885 3,998,358 4,006,648 4,046,048
========== ========= ========= =========
Income available to common shareholders $2,276,401 2,550,201 7,590,918 7,167,821
Basic earnings per common share $ 0.59 0.66 1.98 1.85
Diluted earnings per common share $ 0.57 0.64 1.89 1.77
(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 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
September 30, 2005, that the Bank meets all capital adequacy requirements to
which it is subject.
10
Management believes that based upon the Bank's capital calculations at September
30, 2005 and other conditions consistent with the Prompt Corrective Actions
Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
On September 30, 2005 the Bank's tangible assets and adjusted total assets were
$978.4 million and its risk-weighted assets were $820.2 million. The following
table presents the Bank's capital amounts and ratios at September 30, 2005 for
actual capital, required capital and excess capital including ratios required to
qualify as a well capitalized institution under the Prompt Corrective Actions
regulations.
Required to be
Adequately
Actual Capitalized
-------------------- --------------------
Percent of Percent of
Amount Assets(1) Amount Assets (1)
------- ---------- ------- ----------
(in thousands)
Bank stockholder's equity .................... $83,701
Plus:
Net unrealized loss on certain securities
available for sale ..................... 817
Less:
Goodwill and other intangibles ............ (4,049)
Excess mortgage servicing rights .......... (741)
-------
Tier I or core capital 79,728
-------
Tier I capital to adjusted total assets ... 8.15% $39,137 4.00%
Tier I capital to risk-weighted assets ....... 9.72% $32,810 4.00%
Plus:
Allowable allowance for loan losses ....... 8,518
-------
Risk-based capital ........................... $88,246 $65,620
=======
Risk-based capital to risk- weighted assets .. 10.76% 8.00%
To Be Well
Capitalized Under
Prompt Corrective
Excess Capital Action Provisions
-------------------- --------------------
Percent of Percent of
Amount Assets(1) Amount Assets(1)
------- ---------- ------- ----------
(in thousands)
Bank stockholder's equity ....................
Plus:
Net unrealized loss on certain securities
available for sale .....................
Less:
Goodwill and other intangibles ............
Excess mortgage servicing rights ..........
Tier I or core capital
Tier I capital to adjusted total assets ... $40,591 4.15% $48,921 5.00%
Tier I capital to risk-weighted assets ....... $46,918 5.72% $49,215 6.00%
Plus:
Allowable allowance for loan losses .......
Risk-based capital ........................... $22,626 $82,025
Risk-based capital to risk- weighted assets .. 2.76% 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
September 30, 2005 but is not reflected in the table above.
(12) COMMITMENTS AND CONTINGENCIES
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 2 years and totaled approximately $13.1 million at September 30,
2005. 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.
(13) STOCK-BASED COMPENSATION
The Company accounts for stock based compensation in accordance with Accounting
Principles Board (APB) Opinion No. 25 and related interpretations which measure
compensation cost using the intrinsic value method. Had compensation cost for
the Company'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:
11
Quarter Quarter Nine
Ended Ended Nine Months Ended Months Ended
September 30, September 30, September 30, September 30,
2005 2004 2005 2004
------------- ------------- ----------------- -------------
Net income:
As reported .................................... $2,276,401 2,550,201 7,590,918 7,167,821
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects ............... 13,655 11,371 33,771 28,432
---------- --------- --------- ---------
Pro forma ...................................... 2,262,746 2,538,830 7,557,147 7,139,389
========== ========= ========= =========
Earnings per
Common share:
As reported:
Basic ....................................... $ 0.59 0.66 1.98 1.85
Diluted ..................................... 0.57 0.64 1.89 1.77
Pro forma:
Basic ....................................... 0.59 0.66 1.97 1.84
Diluted ..................................... 0.57 0.63 1.89 1.76
(14) 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 a reportable segment and therefore are
included in the "Other" category.
The Company evaluates performance and allocates resources based on the segment's
net income, return on average assets and return on average equity. Each
corporation is managed separately with its own officers and board of directors.
The following table sets forth certain information about the reconciliations of
reported net income and assets for each of the Company's reportable segments.
12
Home Federal Consolidated
Savings Bank Other Eliminations Total
------------ ------ ------------ ------------
(Dollars in thousands)
AT OR FOR THE QUARTER ENDED SEPTEMBER 30, 2005:
Interest income - external customers ....... $ 15,224 14 0 15,238
Non-interest income - external customers ... 1,727 0 0 1,727
Loss on limited partnerships ............... (6) 0 0 (6)
Intersegment interest income ............... 0 10 (10) 0
Intersegment non-interest income ........... 34 2,441 (2,475) 0
Interest expense ........................... 6,303 0 (10) 6,293
Amortization of mortgage servicing rights,
net valuation adjustments ............... 257 0 0 257
Other non-interest expense ................. 5,150 176 (34) 5,292
Income tax expense ......................... 1,876 13 0 1,889
Net income ................................. 2,441 2,276 (2,441) 2,276
Goodwill ................................... 3,801 0 0 3,801
Total assets ............................... 979,706 88,667 (86,069) 982,304
Net interest margin ........................ 3.78% NM NM 3.79%
Return on average assets ................... 1.00% NM NM 0.92%
Return on average realized common equity ... 11.70% NM NM 10.02%
AT OR FOR THE QUARTER ENDED SEPTEMBER 30, 2004:
Interest income - external customers ....... $ 13,146 10 0 13,156
Non-interest income - external customers ... 1,596 0 0 1,596
Loss on limited partnerships ............... (7) 0 0 (7)
Intersegment interest income ............... 0 3 (3) 0
Intersegment non-interest income ........... 32 2,592 (2,624) 0
Interest expense ........................... 5,390 0 (3) 5,387
Amortization of mortgage servicing rights,
net valuation adjustments ............... 240 0 0 240
Other non-interest expense ................. 4,502 170 (32) 4,640
Income tax expense (benefit) ............... 1,266 (113) 0 1,153
Net income ................................. 2,594 2,548 (2,592) 2,550
Goodwill ................................... 3,801 0 0 3,801
Total assets ............................... 950,179 83,381 (78,225) 955,335
Net interest margin ........................ 3.47% NM NM 3.47%
Return on average assets ................... 1.12% NM NM 1.09%
Return on average realized common equity ... 13.39% NM NM 12.02%
NM - Not meaningful
13
Home Federal Consolidated
Savings Bank Other Eliminations Total
------------ ------ ------------ ------------
(Dollars in thousands)
AT OR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005:
Interest income - external customers ........... $ 44,159 48 0 44,207
Non-interest income - external customers ....... 4,743 0 0 4,743
Loss on limited partnerships ................... (21) 0 0 (21)
Intersegment interest income ................... 0 26 (26) 0
Intersegment non-interest income ............... 101 7,821 (7,922) 0
Interest expense ............................... 17,870 0 (26) 17,844
Amortization of mortgage servicing rights, net
valuation adjustments ....................... 767 0 0 767
Other non-interest expense ..................... 15,193 502 (101) 15,594
Income tax expense (benefit) ................... 4,832 (194) 0 4,638
Net income ..................................... 7,825 7,587 (7,821) 7,591
Goodwill ....................................... 3,801 0 0 3,801
Total assets ................................... 979,706 88,667 (86,069) 982,304
Net interest margin ............................ 3.75% NM NM 3.76%
Return on average assets ....................... 1.08% NM NM 1.03%
Return on average realized common equity ....... 12.89% NM NM 11.51%
AT OR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004:
Interest income - external customers ........... $ 37,905 34 0 37,939
Non-interest income - external customers ....... 4,825 0 0 4,825
Loss on limited partnerships ................... (21) 1 0 (20)
Intersegment interest income ................... 0 12 (12) 0
Intersegment non-interest income ............... 140 7,288 (7,428) 0
Interest expense ............................... 15,578 0 (12) 15,566
Interest expense ...............................
Amortization of mortgage servicing rights, net
valuation adjustments ....................... 795 0 0 795
Other non-interest expense ..................... 13,657 491 (140) 14,008
Income tax expense (benefit) ................... 3,489 (320) 0 3,169
Minority interest .............................. (2) 0 0 (2)
Net income ..................................... 7,292 7,164 (7,288) 7,168
Goodwill ....................................... 3,801 0 0 3,801
Total assets ................................... 950,179 83,381 (78,225) 955,335
Net interest margin ............................ 3.47% NM NM 3.46%
Return on average assets ....................... 1.07% NM NM 1.06%
Return on average realized common equity ....... 12.86% NM NM 11.44%
NM - Not meaningful
14
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. When used in this Form 10-Q, the words
"anticipates", "believes", "estimates", "expects", "intends" and similar
expressions, as they relate to the Company and its management, are intended to
identify such forward-looking statements. 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 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. For additional discussion of the risks and
uncertainties applicable to the Company, see the "Risk Factors" section of the
Company's Annual Report on Form 10-K for the year ended December 31, 2004.
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 deposits. 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 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. Single
family mortgage loan activity decreased in the first nine months of 2005 when
compared to the same period in 2004 due to a decline in refinancing activity,
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.
15
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.
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 probable losses inherent in the
loan portfolio for which specific reserves are not required. 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 portfolio which is
stratified by loan type and interest rate. 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
16
and valuation of MSRs. 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
The Company's net income was $2.3 million for the third quarter of 2005, down
$274,000, or 10.7%, from net income of $2.6 million for the third quarter of
2004. Basic earnings per share for the third quarter of 2005 were $0.59, down
$0.07, or 10.6%, from $0.66 for the same quarter of 2004. Diluted earnings per
common share for the third quarter of 2005 were $0.57, down $0.07, or 10.9%,
from $0.64 for the third quarter of 2004.
Net income was $7.6 million for the nine-month period ended September 30, 2005,
an increase of $423,000, or 5.9%, compared to $7.2 million for the nine-month
period ended September 30, 2004. Basic earnings per share were $1.98 for the
nine-months ended September 30, 2005, an increase of $0.13, or 7.0%, from $1.85
for the same nine-month period of 2004. Diluted earnings per common share for
the nine-month period in 2005 were $1.89, up $0.12, or 6.8%, from $1.77 for the
same period in 2004.
NET INTEREST INCOME
Interest income was $15.2 million for the third quarter of 2005, an increase of
$2.0 million, or 15.8%, from $13.2 million for the same period in 2004. Interest
income increased because of an increase in interest rates and an increase in the
average outstanding balance of interest-earning assets. Interest rates increased
primarily because of the 200 basis point increase in the prime interest rate
between the periods. Increases in the prime rate, which is the rate that banks
charge their prime business customers, generally increase the rates on
adjustable rate consumer and commercial loans in the portfolio and new loans
originated. The increase in interest-earning assets was caused primarily by the
$75 million increase in the average outstanding balance of commercial loans
between the periods which was partially offset by a decrease of $27 million in
other loans and investments. The average yield earned on interest-earning assets
was 6.45% for the third quarter of 2005, an increase of 58 basis points from the
5.87% average yield for the third quarter of 2004.
Interest expense was $6.3 million for the third quarter of 2005, an increase of
$906,000, or 16.8%, compared to $5.4 million for the third quarter of 2004.
Interest expense increased primarily because of higher interest rates paid on
deposits which were caused by the 200 basis point increase in the federal funds
rate between the periods. Increases in the federal funds rate, which is the rate
that banks charge other banks for short term loans, generally increase the rates
banks pay for deposits. Interest expense also increased because of the $38
million increase in the average outstanding balance of deposits and advances
between the periods due to an increase in transaction accounts and brokered
deposits. The average interest rate paid on interest-bearing liabilities was
2.82% for the third quarter of 2005, an increase of 29 basis points from the
2.53% average rate paid for the third quarter of 2004.
Net interest income was $8.9 million for the third quarter of 2005, an increase
of $1.1 million, or 15.1%, compared to $7.8 million for the third quarter of
2004. Net interest margin (net interest income divided by average interest-
17
earning assets) for the third quarter of 2005 was 3.79%, an increase of 32 basis
points, compared to 3.47% for the third quarter of 2004.
Interest income was $44.2 million for the nine-month period ended September 30,
2005, an increase of $6.3 million, or 16.5%, from $37.9 million for the same
period in 2004. Interest income increased primarily because of an increase in
average 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 $94 million increase in the average outstanding balance of
commercial loans between the periods which was partially offset by a decrease of
$21 million in other loans and investments. The yield earned on interest-earning
assets was 6.30% for the first nine months of 2005, an increase of 43 basis
points from the 5.87% yield for the same period in 2004.
Interest expense was $17.8 million for the nine-month period ended September 30,
2005, an increase of $2.2 million, or 14.6%, from the $15.6 million for the same
period in 2004. Interest expense increased primarily because of higher interest
rates paid on deposits, which were caused by the 200 basis point increase in the
federal funds rate between the periods. Interest expense also increased because
of the $67 million increase in the average outstanding balance of deposits and
advances between the periods due to an increase in transaction accounts and
brokered deposits. The average interest rate paid on interest-bearing
liabilities was 2.69% for the first nine-months of 2005, an increase of 15 basis
points from the 2.54% average rate paid for the same period of 2004.
Net interest income was $26.4 million for the first nine months of 2005, an
increase of $4.0 million, or 17.8%, from $22.4 million for the same period in
2004. Net interest margin for the first nine months of 2005 was 3.76%, an
increase of 30 basis points, compared to 3.46% for the same period of 2004.
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 $952,000 for the third quarter of 2005, an increase of $177,000, or 22.8%,
from $775,000 for the third quarter of 2004. The provision for loan losses was
$2.5 million for the nine-month period of 2005, an increase of $454,000, or
22.2%, from $2.0 million for the same nine-month period in 2004. The provision
for loan losses increased primarily because of increased commercial loan charge
offs during the period. The increase in the provision related to loan charge
offs was partially offset by less commercial loan growth in the first nine
months of 2005 when compared to the same period in 2004. Total non-performing
assets were $4.7 million at September 30, 2005, a decrease of $251,000, or
5.14%, from $4.9 million at December 31, 2004. Non-performing loans decreased
$1.4 million and foreclosed and repossessed assets increased $1.1 million during
the first nine months of 2005.
A reconciliation of the Company's allowance for loan losses is summarized as
follows:
2005 2004
----------- ---------
Balance at January 1, $ 8,995,892 6,939,602
Provision 2,495,000 2,041,000
Commercial loan charge offs (2,614,530) 0
Consumer loan charge offs (195,020) (290,672)
Single family mortgage loan
charge offs (230,934) (231,055)
Recoveries 182,921 12,137
----------- ---------
Balance at September 30, $ 8,633,329 8,471,012
=========== =========
NON-INTEREST INCOME
Non-interest income was $1.7 million for the third quarter of 2005, an increase
of $132,000, or 8.3%, from $1.6 million for the same period in 2004. Gains on
sales of loans increased $275,000 due primarily to the $232,000
18
increase in the gain recognized on the sale of government guaranteed commercial
loans in the third quarter of 2005 when compared to the same period in 2004.
Other non-interest income decreased $119,000 primarily because of increased
losses recognized on repossessed mobile homes in the third quarter of 2005.
Non-interest income was $4.7 million for the first nine months of 2005, a
decrease of $83,000, or 1.7%, from $4.8 million for the same period in 2004.
Gains on sales of loans decreased $26,000 primarily due to decreased mortgage
loan activity in the first nine months of 2005 when compared to the same period
of 2004. Other non-interest income decreased $63,000 primarily because of
increased losses recognized on repossessed mobile homes in 2005.
NON-INTEREST EXPENSE
Non-interest expense was $5.5 million for the third quarter of 2005, an increase
of $669,000, or 13.7%, from $4.9 million for the same period of 2004.
Compensation expense increased $351,000 between the periods because of annual
payroll cost increases and the increased number of employees. Occupancy expense
increased $128,000 primarily because of the additional corporate office space
occupied in the first quarter of 2005 and because of increased amortization
expense on various software upgrades that were implemented between the periods.
Data processing costs increased by $46,000 primarily because of increased
activity between the periods and an increase in the fees and services provided
by the third party service center. Other operating expenses increased $130,000
primarily because of increased costs on foreclosed commercial properties during
the third quarter of 2005 when compared to the same period in 2004.
Non-interest expense was $16.4 million for the first nine months of 2005, an
increase of $1.6 million, or 10.5%, from $14.8 million for the same period in
2004. Compensation expense increased $800,000 because of annual payroll cost
increases and the increased number of employees. Occupancy expense increased
$409,000 primarily because of the additional corporate office space occupied in
the first quarter of 2005 and because of increased amortization expense on
various software upgrades that were implemented between the periods. Data
processing costs increased by $109,000 primarily because of increased activity
and an increase in fees and services provided by the third party service center.
Other operating expenses increased $242,000 primarily because of increased costs
on foreclosed and repossessed assets during the first nine months of 2005 when
compared to the same period in 2004.
INCOME TAX EXPENSE
Income tax expense was $1.9 million for the third quarter of 2005, an increase
of $736,000, or 63.9%, compared to $1.2 million for the same period of 2004.
Income tax expense was $4.6 million for the first nine months of 2005, an
increase of $1.4 million, or 46.4%, compared to $3.2 million for the same period
of 2004. Income tax expense increased $962,000 due to an increase in taxable
income and $297,000 due to an increase in the effective tax rate because of
changes in state tax law that were retroactive to January 1, 2005.
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of non-performing
assets in the Company's portfolio at September 30, 2005 and December 31, 2004.
19
Sept. 30, Dec. 31,
2005 2004
--------- --------
(Dollars in Thousands)
Non-Accruing Loans:
One-to-four family real estate $ 246 1,864
Commercial real estate 948 1,114
Consumer 373 472
Commercial business 261 261
------ ------
Total 1,828 3,711
------ ------
Accruing loans delinquent 90 days or more:
One-to-four family real estate 1,154 628
Other assets 178 201
Foreclosed and Repossessed Assets:
One-to-four family real estate 530 141
Consumer 191 201
Commercial 750 0
------ ------
Total non-performing assets $4,631 $4,882
====== ======
Total as a percentage of total assets 0.47% 0.51%
====== ======
Total non-performing loans $2,982 $4,339
====== ======
Total as a percentage of total loans receivable, net 0.37% 0.55%
Allowance for loan loss to non-performing loans 289.51% 207.30%
Total non-performing assets were $4.6 million at September 30, 2005, a decrease
of $251,000, or 5.14%, from $4.9 million at December 31, 2004. Non-performing
loans decreased $1.4 million and foreclosed and repossessed assets increased
$1.1 million during the first nine months of 2005. The following activity
occurred during the first nine months of 2005 related to non-performing assets:
$16.0 million of previously performing loans were classified as non-performing,
$2.3 million in non-performing loans were foreclosed or repossessed, $3.1
million in loans were charged off as a loss, $676,000 in foreclosed assets were
sold, and $14.7 million in loans previously classified as non-performing were
paid off or were reclassified to performing status.
DIVIDENDS
On October 25, 2005 the Company declared a cash dividend of $0.24 per share,
payable on December 14, 2005 to shareholders of record on November 25, 2005.
During 2005, the Company has declared and paid dividends as follows:
Record date Payable date Dividend per share Dividend Payout Ratio
- ----------------- ----------------- ------------------ ---------------------
February 18, 2005 March 7, 2005 $0.22 41.51%
May 20, 2005 June 8, 2005 $0.22 31.43%
August 26, 2005 September 9, 2005 $0.24 38.71%
The annualized dividend payout ratio for the past four quarters, ending with the
December 14, 2005 payment will be 38.02%.
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.
20
LIQUIDITY
For the nine months ended September 30, 2005, the net cash provided by operating
activities was $15.0 million. The Company collected $8.0 million from the
maturities of securities, $1.6 million from principal repayments on securities,
and $231,000 of customer escrows. It purchased securities available for sale of
$5.0 million, FHLB stock of $1.9 million, and premises and equipment of $1.0
million. Net loans receivable increased $38.9 million due to commercial loan
growth. The Company had a net increase in deposit balances of $16.2 million,
received and repaid $57 million in FHLB advances and received $2.4 million from
the redemption of FHLB stock. The Company received $38,000 related to the
exercise of stock options, purchased $972,000 of its own stock, and paid $2.6
million in dividends to its shareholders.
The Company has certificates of deposits with outstanding balances of $178.0
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 $110.9 million of FHLB advances which mature beyond September
30, 2006 but have call features that can be exercised by the FHLB during the
next twelve months. If the call features are exercised, the Company has the
option of requesting any advance otherwise available to it pursuant to the
credit policy of the FHLB. The Company also has $10.0 million of FHLB advances
that will mature during the next twelve 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 twelve months.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest 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 change in interest rates may adversely impact the
Company's earnings to the extent that the interest rates borne by assets and
liabilities do not change at the same speed, to the same extent, or on the same
basis. The Company monitors the projected changes in net interest income that
occur if interest rates were to suddenly change up or down. The Rate Shock Table
that follows 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 fluctuate in a range of 200
basis points up or down from where the interest rates were at September 30,
2005. 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
September 30, 2005.
21
Other than trading portfolio Market Value
-------------------------------------------------
(Dollars in thousands)
Basis point change in interest rates -200 -100 0 +100 +200
- ------------------------------------ -------- ------- ------- ------- --------
Total market risk sensitive assets ........... $986,417 979,906 971,601 959,625 945,554
Total market risk sensitive liabilities ...... 891,022 875,136 859,753 846,513 835,237
Off-balance sheet financial instruments ...... (107) (44) 0 279 534
-------- ------- ------- ------- -------
Net market risk .............................. $ 95,502 104,814 111,848 112,833 109,783
======== ======= ======= ======= =======
Percentage change from current market value .. (14.61)% (6.29)% 0.00% 0.88% (1.85)%
======== ======= ======= ======= =======
The preceding table was prepared utilizing the following assumptions (Model
Assumptions) regarding prepayment and decay ratios which were determined by
management based upon their review of historical prepayment speeds and future
prepayment projections. Fixed rate loans were assumed to prepay at annual rates
of between 6% to 76%, depending on the note rate and the period to maturity.
Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of
between 11% and 30%, depending on the note rate and the period to maturity.
Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of
between 6% and 98% depending on the note rate and the period to maturity.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were
projected to have prepayments based upon the underlying collateral securing the
instrument and the related cash flow priority of the CMO tranche owned.
Certificate accounts were assumed not to be withdrawn until maturity. Passbook
accounts were assumed to decay at an annual rate of 28%, money market accounts
were assumed to decay at an annual rate of 31%, non-interest checking and NOW
accounts were assumed to decay at annual rates of 33% and 14%, respectively.
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 Company's 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 (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
September 30, 2005 to determine if its current level of interest rate risk is
acceptable. The following table projects the estimated annual impact on net
interest income of immediate interest rate changes called rate shocks.
Projected Change
Rate Shock in Net Interest Percentage
in Basis Points Income Change
- --------------- ---------------- ----------
+200 $2,343,000 6.09%
+100 1,449,000 3.77
0 0 0.00
-100 (2,568,000) (6.68)
-200 (5,635,000) (14.65)
22
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections
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 interest rate increase
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 reviews the Bank's portfolio, formulates investment
strategies and oversees the timing and implementation of transactions to assure
attainment of the Board's objectives in the most effective manner. In addition,
each quarter the Board reviews the Bank's asset/liability position, including
simulations of the effect on the Bank's capital of various interest rate
scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market conditions and
consumer preferences, may place more emphasis on managing net interest margin to
enhance net interest income than on matching the interest rate sensitivity of
its assets and liabilities. Management believes that the increased net interest
income resulting from a mismatch in the maturity of its asset and liability
portfolios can, in certain situations, provide high enough returns to justify
the increased exposure to sudden and unexpected changes in interest rates.
To the extent consistent with its interest rate spread objectives, the Bank
attempts to manage its interest rate risk and has taken a number of steps to
restructure its balance sheet in order to better match the maturities of its
assets and liabilities. The Bank has primarily focused its fixed rate
one-to-four family residential lending program on loans that are saleable to
third parties and only places fixed rate loans that meet certain risk
characteristics into its loan portfolio. The Bank does place into its portfolio
adjustable rate single-family loans that reprice over one, three, or five-year
period. The Bank's commercial loan production has primarily been in adjustable
rate loans and fixed rate commercial loans placed in portfolio have been
shorter-term loans, usually with maturities of five years or less, in order to
manage the Company's interest rate risk exposure.
ITEM 4: CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. As of the end of the period
covered by this report, the Company conducted an evaluation, under the
supervision and with the participation of the principal executive officer and
principal financial officer, of the Company's disclosure controls and procedures
(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934 (Exchange Act)). Based on this evaluation, the principal executive
officer and principal financial officer concluded that the Company's disclosure
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms.
Changes in internal controls. There was no change in the Company's internal
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. Unregistered Sales of Equity Securities and Use of Proceeds.
(a)-(b) Not applicable
(c) Information Regarding Share Repurchases
(c) Total Number of (d) Maximum Number (or
Shares (or Units) Approximate Dollar Value)
(a) Total Number (b) Average Purchased as Part of of Shares (or Units) that
of Shares (or Price Paid per Publicly Announced Plans May Yet Be Purchased Under
Period Units) Purchased Share (or Unit) or Programs the Plans or Programs
- ------ ---------------- --------------- ------------------------ --------------------------
July 1 through July 31, 2005 0 0 0 197,000
August 1 through August 31, 2005 0 0 0 197,000
September 1 through September 30, 2005 0 0 0 197,000
--- --- ---
Total 0 $0 0
=== === ===
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.
See Index to Exhibits on page 26 of this report.
24
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: November 4, 2005 /s/ Michael McNeil
----------------------------------------
Michael McNeil,
President/Chief Executive Officer
(Principal Executive Officer)
(Duly Authorized Representative)
Date: November 4, 2005 /s/ Jon Eberle
----------------------------------------
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
25
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 *3 N/A
Including indentures
14 HMN Code of Business Conduct and Ethics 14 Filed Electronically
Readopted August 23, 2005
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 Exhibit 3 to the Company's Current Report on
Form 8-K dated February 22, 2005, filed on February 23, 2005 (File No.
0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's
Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212).
26