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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, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 0-24100
HMN FINANCIAL, INC.
(Exact name of Registrant as specified in its Charter)
Delaware 41-1777397
- --------------------------------------------- ---------------------------------
(State or other jurisdiction of incorporation (I.R.S. Employer Identification
or organization) Number)
1016 Civic Center Drive N.W., Rochester, MN 55901
- --------------------------------------------- ---------------------------------
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area (507) 535-1200
code:
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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
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 classes of
common stock as of the latest practicable date.
Class Outstanding at July 21, 2006
- ----------------------------- ----------------------------
Common stock, $0.01 par value 4,379,964
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1
HMN FINANCIAL, INC.
CONTENTS
PART I - FINANCIAL INFORMATION
Page
-----
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at
June 30, 2006 and December 31, 2005............................... 3
Consolidated Statements of Income for the
Three Months Ended and Six Months Ended June 30, 2006 and 2005.... 4
Consolidated Statement of Stockholders' Equity and Comprehensive
Income for the Six Month Period Ended June 30, 2006............... 5
Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2006 and 2005....................... 6
Notes to Consolidated Financial Statements........................ 7-13
Item 2: Management's Discussion and Analysis of Financial
Condition and Results of Operations............................... 14-21
Item 3: Quantitative and Qualitative Disclosures about Market Risk........ 21
Item 4: Controls and Procedures........................................... 21
PART II - OTHER INFORMATION
Item 1: Legal Proceedings................................................. 22
Item 1A: Risk Factors...................................................... 22
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds....... 22
Item 3: Defaults Upon Senior Securities................................... 22
Item 4: Submission of Matters to a Vote of Security Holders............... 22
Item 5: Other Information................................................. 23
Item 6: Exhibits.......................................................... 23
Signatures.................................................................... 24
2
PART I - FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
2006 2005
---------------- ------------
(unaudited)
ASSETS
Cash and cash equivalents.......................................... $ 62,608,169 47,268,795
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $7,055,100 and $7,428,504)..................... 6,267,160 6,879,756
Other marketable securities
(amortized cost $139,615,255 and $113,749,841)................ 138,953,180 112,778,813
---------------- ------------
145,220,340 119,658,569
---------------- ------------
Loans held for sale................................................ 7,128,570 1,435,141
Loans receivable, net.............................................. 757,621,273 785,678,461
Accrued interest receivable........................................ 4,396,521 4,460,014
Real estate, net................................................... 1,101,060 1,214,621
Federal Home Loan Bank stock, at cost.............................. 8,400,700 8,364,600
Mortgage servicing rights, net..................................... 2,296,433 2,653,635
Premises and equipment, net........................................ 12,025,027 11,941,863
Investment in limited partnerships................................. 125,489 141,048
Goodwill........................................................... 3,800,938 3,800,938
Core deposit intangible, net....................................... 162,831 219,760
Prepaid expenses and other assets.................................. 2,530,750 1,854,948
Deferred tax asset................................................. 2,516,800 2,544,400
---------------- ------------
Total assets................................................... $ 1,009,934,901 991,236,793
================ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits........................................................... $ 748,355,396 731,536,560
Federal Home Loan Bank advances.................................... 160,900,000 160,900,000
Accrued interest payable........................................... 1,568,173 2,085,573
Advance payments by borrowers for taxes and insurance.............. 779,722 1,038,575
Accrued expenses and other liabilities............................. 4,707,906 4,947,816
---------------- ------------
Total liabilities.............................................. 916,311,197 900,508,524
---------------- ------------
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......................................... 57,689,740 58,011,099
Retained earnings, subject to certain restrictions................. 102,784,471 98,951,777
Accumulated other comprehensive loss............................... (875,415) (917,577)
Unearned employee stock ownership plan shares...................... (4,254,285) (4,350,999)
Unearned compensation restricted stock awards...................... 0 (182,521)
Treasury stock, at cost 4,748,698 and 4,721,402 shares............. (61,812,094) (60,874,797)
---------------- ------------
Total stockholders' equity..................................... 93,623,704 90,728,269
---------------- ------------
Total liabilities and stockholders' equity......................... $ 1,009,934,901 991,236,793
================ ============
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,
--------------------------------- ----------------------------
2006 2005 2006 2005
--------------- ----------- ----------- -----------
Interest income:
Loans receivable............................... $ 15,081,511 13,769,340 29,784,291 27,102,359
Securities available for sale:
Mortgage-backed and related................. 68,869 84,288 139,431 174,056
Other marketable............................ 1,322,547 654,182 2,212,178 1,295,938
Cash equivalents............................... 452,434 175,671 708,860 227,940
Other.......................................... 85,984 89,232 148,805 168,760
--------------- ----------- ----------- -----------
Total interest income....................... 17,011,345 14,772,713 32,993,565 28,969,053
--------------- ----------- ----------- -----------
Interest expense:
Deposits....................................... 5,516,428 4,199,791 10,384,109 7,902,422
Federal Home Loan Bank advances................ 1,744,879 1,826,501 3,470,735 3,649,192
--------------- ----------- ----------- -----------
Total interest expense...................... 7,261,307 6,026,292 13,854,844 11,551,614
--------------- ----------- ----------- -----------
Net interest income......................... 9,750,038 8,746,421 19,138,721 17,417,439
Provision for loan losses......................... 980,000 907,000 1,495,000 1,543,000
--------------- ----------- ----------- -----------
Net interest income after provision
for loan losses........................... 8,770,038 7,839,421 17,643,721 15,874,439
--------------- ----------- ----------- -----------
Non-interest income:
Fees and service charges....................... 795,808 685,357 1,510,586 1,287,954
Mortgage servicing fees........................ 301,259 303,363 604,934 596,343
Securities gains, net.......................... 48,122 0 48,122 0
Gain on sales of loans......................... 302,608 324,173 548,585 617,489
Losses in limited partnerships................. (9,059) (6,500) (15,559) (14,210)
Other.......................................... 327,223 268,206 555,627 513,754
--------------- ----------- ----------- -----------
Total non-interest income................... 1,765,961 1,574,599 3,252,295 3,001,330
--------------- ----------- ----------- -----------
Non-interest expense:
Compensation and benefits...................... 3,117,702 2,784,578 6,376,573 5,558,682
Occupancy...................................... 1,103,392 1,041,460 2,203,684 2,036,714
Deposit insurance premiums..................... 24,792 34,619 55,989 62,525
Advertising.................................... 107,501 105,765 238,159 189,673
Data processing ............................... 287,043 245,351 575,758 482,839
Amortization of mortgage servicing rights, net. 236,551 271,089 453,091 510,122
Other.......................................... 886,648 1,038,805 1,799,786 1,971,497
--------------- ----------- ----------- -----------
Total non-interest expense.................. 5,763,629 5,521,667 11,703,040 10,812,052
--------------- ----------- ----------- -----------
Income before income tax expense............ 4,772,370 3,892,353 9,192,976 8,063,717
Income tax expense 1,829,000 1,392,900 3,509,200 2,749,200
--------------- ----------- ----------- -----------
Net income.................................. $ 2,943,370 2,499,453 5,683,776 5,314,517
=============== =========== =========== ===========
Basic earnings per share.......................... $ 0.77 0.65 1.48 1.39
=============== =========== =========== ===========
Diluted earnings per share........................ $ 0.73 0.62 1.41 1.33
=============== =========== =========== ===========
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 2006
(unaudited)
Unearned
Employee
Accumulated Stock Unearned Total
Additional Other Ownership Compensation Stock-
Common Paid-in Retained Comprehensive Plan Restricted Treasury Holders'
Stock Capital Earnings Income (Loss) Shares Stock Awards Stock Equity
-------- ---------- ----------- ------------- ---------- ------------ ----------- ----------
Balance, December 31, 2005 $ 91,287 58,011,099 98,951,777 (917,577) (4,350,999) (182,521) (60,874,797) 90,728,269
Net income 5,683,776 5,683,776
Other comprehensive income,
net of tax:
Net unrealized gains on
securities available for sale 42,162 42,162
----------
Total comprehensive income 5,725,938
Purchase of treasury stock (1,511,850) (1,511,850)
Employee stock options exercised (156,112) 237,360 81,248
Tax benefits of exercised stock
options 47,648 47,648
Unearned compensation restricted
stock awards (337,193) 337,193 0
Stock compensation expense 32,211 32,211
Reclassification for FAS 123R
adoption (182,521) 182,521 0
Amortization of restricted stock
awards 90,682 90,682
Dividends paid (1,851,082) (1,851,082)
Earned employee stock ownership
plan shares 183,926 96,714 280,640
-------- ---------- ----------- ------------- ---------- ------------ ----------- ----------
Balance, June 30, 2006 $ 91,287 57,689,740 102,784,471 (875,415) (4,254,285) 0 (61,812,094) 93,623,704
======== ========== =========== ============= ========== ============ =========== ==========
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Six Months Ended
June 30,
-------------------------------
2006 2005
--------------- -------------
Cash flows from operating activities:
Net income................................................................... $ 5,683,776 5,314,517
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses.................................................. 1,495,000 1,543,000
Depreciation............................................................... 952,250 867,160
Amortization of discounts, net............................................. (588,264) (324,753)
Amortization of deferred loan fees......................................... (780,662) (373,394)
Amortization of core deposit intangible.................................... 56,929 56,928
Amortization of mortgage servicing rights.................................. 453,091 510,122
Capitalized mortgage servicing rights...................................... (95,889) (241,395)
Securities gains, net...................................................... (48,122) 0
Losses (gains) on sales of real estate..................................... 19,058 (8,220)
Gain on sales of loans..................................................... (548,585) (617,489)
Proceeds from sale of real estate.......................................... 347,457 364,978
Proceeds from sale of loans held for sale.................................. 34,975,519 36,598,189
Disbursements on loans held for sale....................................... (38,907,907) (37,540,037)
Amortization of restricted stock awards.................................... 90,682 45,351
Amortization of unearned ESOP shares....................................... 96,714 96,714
Earned employee stock ownership shares priced above original cost.......... 183,926 182,196
Stock compensation......................................................... 32,211 0
Decrease (increase) in accrued interest receivable......................... 63,493 (435,309)
(Decrease) increase in accrued interest payable............................ (517,400) 590,082
Equity losses of limited partnerships...................................... 15,559 14,210
(Increase) decrease in other assets........................................ (511,888) 264,105
Increase (decrease) in other liabilities................................... (330,897) 321,753
Other, net................................................................. 8,686 (3,647)
--------------- -------------
Net cash provided by operating activities................................ 2,144,737 7,225,061
--------------- -------------
Cash flows from investing activities:
Proceeds from sales of securities available for sale......................... 2,988,122 0
Principal collected on securities available for sale......................... 370,534 1,064,052
Proceeds collected on maturities of securities available for sale............ 55,500,000 8,000,000
Purchases of securities available for sale................................... (83,464,555) (4,991,400)
Purchase of Federal Home Loan Bank Stock..................................... (36,100) (1,904,100)
Redemption of Federal Home Loan Bank Stock................................... 0 1,568,700
Net decrease (increase) in loans receivable.................................. 25,805,241 (38,897,415)
Purchases of premises and equipment.......................................... (1,045,223) (725,547)
--------------- -------------
Net cash provided (used) by investing activities......................... 118,019 (35,885,710)
--------------- -------------
Cash flows from financing activities:
Increase in deposits......................................................... 16,569,507 21,602,586
Purchase of treasury stock................................................... (1,511,850) (972,000)
Stock options exercised...................................................... 81,248 24,887
Excess tax benefits from options exercised................................... 47,648 22,240
Dividends to stockholders.................................................... (1,851,082) (1,685,674)
Proceeds from Federal Home Loan Bank advances................................ 0 48,500,000
Repayment of Federal Home Loan Bank advances................................. 0 (48,500,000)
Proceeds from Federal Reserve Bank advances.................................. 1,000,000 0
Repayment of Federal Reserve Bank advances................................... (1,000,000) 0
Decrease in customer escrows................................................. (258,853) (113,100)
--------------- -------------
Net cash provided by financing activities................................ 13,076,618 18,878,939
--------------- -------------
Increase (decrease) in cash and cash equivalents.......................... 15,339,374 (9,781,710)
Cash and cash equivalents, beginning of period.................................. 47,268,795 34,298,394
--------------- -------------
Cash and cash equivalents, end of period........................................ $ 62,608,169 24,516,684
=============== =============
Supplemental cash flow disclosures:
Cash paid for interest....................................................... $ 14,372,244 10,961,532
Cash paid for income taxes................................................... 4,889,238 3,642,000
Supplemental noncash flow disclosures:
Transfer of loans to real estate............................................. 251,812 1,006,259
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
JUNE 30, 2006 AND 2005
(1) HMN FINANCIAL, INC.
HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company
that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a
community banking philosophy and operates retail banking and loan production
offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud
Insurance Agency, Inc. (OIA) which offers financial planning products and
services. 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. During the 2005 period for which
financial information is presented in this Form 10-Q, the Bank had one other
subsidiary that is no longer operating. Home Federal Holding, Inc. (HFH), a
wholly owned subsidiary, was the holding company for Home Federal REIT, Inc.
(HFREIT) which invested in real estate loans acquired from the Bank. HFH and
HFREIT were both dissolved in 2005.
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 which are, in the opinion of management, necessary for the fair
presentation of the interim financial statements have been included. The
statement of income for the six-month period ended June 30, 2006 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
As of January 1, 2006, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) which
requires companies to recognize in compensation expense the grant-date fair
value of stock awards issued. The Company adopted FAS 123R using the modified
prospective transition method. In accordance with the modified prospective
transition method, the Company's Consolidated Financial Statements for prior
periods have not been restated to reflect the impact of FAS 123R. As a result of
applying FAS 123R, the Company recognized share-based compensation expense of
$32,211 for the six months ended June 30, 2006 (for additional information see
Note 12).
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 156, Accounting for Servicing of
Financial Assets - an amendment of FASB Statement No. 140. Effective as of the
beginning of an entity's first fiscal year that begins after September 15, 2006,
an entity is required to recognize a servicing asset or liability each time it
undertakes an obligation to service a financial asset. SFAS No. 156 requires
that all separately recognized servicing assets and liabilities be initially
measured at fair value and permits, but does not require, the subsequent
measurement of servicing assets and liabilities at fair value. It also permits a
one-time reclassification, at the time of initial adoption, of
available-for-sale securities to trading securities by entities with recognized
servicing rights, without calling into question the treatment of other
available-for-sale securities under Statement 115, provided that the
available-for-sale securities are identified in some manner as offsetting the
entity's exposure to changes in the fair value of servicing assets or
liabilities that a servicer elects to subsequently measure at fair value.
Separate presentation of servicing assets and liabilities subsequently measured
at fair value are required to be disclosed in the statement of financial
position. The impact of adopting SFAS No. 156 in the first quarter of 2007 is
not anticipated to have a material impact on the Company's financial statements.
7
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
requires companies to recognize in their financial statements the impact of a
tax position, taken or expected to be taken, if that position is more likely
than not of being sustained on audit based on the technical merits of the
position. The provisions of FIN 48 are effective as of January 1, 2007 and are
not anticipated to have a material impact on the Company's financial statements.
(4) 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 which 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 on a firm commitment or best efforts basis. The commitments to
originate, purchase or sell loans on a firm commitment basis are derivatives. As
a result of marking to market the mortgage pipeline and the related firm
commitments to sell for the period ended June 30, 2006, the Company recorded an
increase in other assets of $3,928, an increase in other liabilities of $90,987
and a loss included in the gain on sales of loans of $87,059.
The current commitments to sell loans held for sale are derivatives that do not
qualify for hedge accounting. As a result, these derivatives are marked to
market and the related loans held for sale are recorded at the lower of cost or
market. The Company recorded a decrease in loans held for sale of $159,986 and
an increase in other assets of $159,986 due to the mark to market adjustment on
the commitments to sell loans held for sale.
(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 June 30,
--------------------------------------------------------------------------
2006 2005
-------------------------------------- ----------------------------------
(Dollars in thousands) Before tax Tax effect Net of tax Before tax Tax effect Net of tax
- ------------------------------ ------------- ----------- ---------- ---------- ---------- ----------
Securities available for sale:
Gross unrealized gains
(losses) arising
during the period $ (113) (47) (66) 386 136 250
Reclassification of net
gains included in
net income 48 17 31 0 0 0
------------- ----------- ---------- ---------- ---------- ----------
Net unrealized gains
(losses) arising
during the period (161) (64) (97) 386 136 250
------------- ----------- ---------- ---------- ---------- ----------
Other comprehensive income $ (161) (64) (97) 386 136 250
============= =========== ========== ========== ========== ==========
For the six months ended June 30,
--------------------------------------------------------------------------
2006 2005
-------------------------------------- ----------------------------------
(Dollars in thousands) Before tax Tax effect Net of tax Before tax Tax effect Net of tax
- ------------------------------ ------------- ----------- ---------- ---------- ---------- ----------
Securities available for sale:
Gross unrealized gains
(losses) arising during
the period $ 118 45 73 (373) (132) (241)
Reclassification of net
gains included in net
income 48 17 31 0 0 0
------------- ----------- ---------- ---------- ---------- ----------
Net unrealized gains (losses)
arising during the period 70 28 42 (373) (132) (241)
------------- ----------- ---------- ---------- ---------- ----------
Other comprehensive income $ 70 28 42 (373) (132) (241)
============= =========== ========== ========== ========== ==========
(6) 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 June 30, 2006. 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, 2006.
8
Less than twelve months Twelve months or more Total
---------------------------------- -------------------------------- --------------------
# of Fair Unrealized # of Fair Unrealized Fair Unrealized
(Dollars in thousands) Investments Value Losses Investment Value Losses Value Losses
----------- -------- ---------- ---------- ------- ---------- ------- ----------
Mortgage backed securities:
FHLMC $ 0 0 2 $ 2,582 (467) 2,582 (467)
FNMA 1 357 (24) 2 2,974 (300) 3,331 (324)
Other marketable debt
securities:
FNMA 8 39,439 (65) 1 4,952 (45) 44,391 (110)
FHLMC 6 29,404 (66) 3 14,889 (108) 44,293 (174)
FHLB 4 19,884 (62) 6 29,686 (316) 49,570 (378)
--- -------- ---- --- ------- ------ ------- ------
Total temporarily
impaired securities 19 $ 89,084 (217) 14 $55,083 (1,236) 144,167 (1,453)
=== ======== ==== === ======= ====== ======= ======
These fixed rate investments are temporarily impaired due to changes in interest
rates and the Company has the ability and intent to hold to maturity or until
the temporary loss is recovered. Mortgage backed securities in the table above
had an average remaining life of less than five years and the other marketable
securities had an average remaining life of less than one year at June 30, 2006.
(7) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Six Months ended Twelve Months ended Six Months ended
(Dollars in thousands) June 30, 2006 December 31, 2005 June 30, 2005
- -------------------------------------------- ---------------- ------------------- -----------------
Mortgage servicing rights:
Balance, beginning of period.............. $ 2,654 3,231 3,231
Originations.............................. 95 442 241
Amortization.............................. (453) (1,019) (510)
---------------- ------ -----
Balance, end of period.................... $ 2,296 2,654 2,962
---------------- ------ -----
Fair value of mortgage servicing rights... $ 4,458 4,599 4,054
================ ====== =====
All of the loans being serviced were single family loans serviced for the
Federal National Mortgage Association (FNMA) under the mortgage-backed security
program or the individual loan sale program. The following is a summary of the
risk characteristics of the loans being serviced at June 30, 2006.
Weighted Weighted
Loan Principal Average Average Number of
(Dollars in thousands) Balance Interest Rate Remaining Term Loans
- -------------------------------- -------------- -------------- -------------- ---------
Original term 30 year fixed rate $ 206,590 5.91% 329 months 1,826
Original term 15 year fixed rate 191,293 5.28% 146 months 2,505
Adjustable rate 5,194 5.47% 318 months 49
-------------- ---- ---------- -----
(8) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at June 30, 2006 is presented in the table below. Amortization
expense for intangible assets was $510,019 for the six month period ended June
30, 2006.
Gross Unamortized
Carrying Accumulated Intangible
(Dollars in thousands) Amount Amortization Assets
- ------------------------------ ---------- ------------ -----------
Amortized intangible assets:
Mortgage servicing rights $ 4,273 (1,977) 2,296
Core deposit intangible 1,567 (1,404) 163
---------- ------ -----
Total $ 5,840 (3,381) 2,459
========== ====== =====
9
The following table indicates the estimated future amortization expense for
amortized intangible assets:
Mortgage Core
Servicing Deposit
(Dollars in thousands) Rights Intangible Total
- ----------------------- ---------- ---------- ------
Year ended December 31,
2006 $ 219 57 276
2007 383 106 489
2008 319 0 319
2009 266 0 266
2010 221 0 221
---------- ---------- ------
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of June 30, 2006. 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,
--------------------------- -------------------------
2006 2005 2006 2005
------------ --------- ----------- ---------
Weighted average number of common shares
outstanding used in basic earnings per
common share calculation 3,842,994 3,829,413 3,849,078 3,827,147
Net dilutive effect of:
Options 174,480 160,855 169,670 167,321
Restricted stock awards 14,303 8,994 13,593 8,010
------------ --------- ----------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 4,031,777 3,999,262 4,032,341 4,002,478
============ ========= =========== =========
Income available to common shareholders $ 2,943,370 2,499,453 5,683,776 5,314,517
Basic earnings per common share $ 0.77 0.65 1.48 1.39
Diluted earnings per common share $ 0.73 0.62 1.41 1.33
(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. 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
in the regulations). Management believes, as of June 30, 2006, 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,
2006 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, 2006 the Bank's tangible assets and adjusted total assets were
$1.006 billion and its risk-weighted assets were $796 million. The following
table presents the Bank's capital amounts and ratios at June 30, 2006 for actual
capital, required capital and excess capital including ratios in order to
qualify as being well capitalized under the Prompt Corrective Actions
regulations.
10
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
(Dollars in thousands) Amount Assets(1) Amount Assets(1) Amount Assets (1) Amount Assets(1)
---------- ---------- -------- ---------- -------- ---------- ------- ----------
Bank stockholder's equity............... $ 91,125
Plus:
Net unrealized loss on certain
securities available for sale....... 875
Less:
Goodwill and core deposit
intangibles......................... (3,964)
Disallowed assets..................... (1,747)
----------
Tier I or core capital 86,289
----------
Tier I capital to adjusted total
assets.............................. 8.58% $ 40,227 4.00% $ 46,062 4.58% $50,284 5.00%
Tier I capital to risk-weighted
assets.............................. 10.84% $ 31,842 4.00% $ 54,447 6.84% $47,763 6.00%
Plus:
Allowable allowance for loan losses... 10,066
----------
Risk-based capital...................... $ 96,355 $ 63,683 $ 32,672 $79,604
==========
Risk-based capital to risk- weighted
assets................................ 12.10% 8.00% 4.10% 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.
In addition, the tangible capital of the Bank was in excess of the minimum 2%
required at June 30, 2006.
(11) COMMITMENTS AND CONTINGENCIES
The Bank issued standby letters of credit which guarantee the performance of
customers to third parties. The standby letters of credit outstanding at June
30, 2006 were approximately $18.6 million, expire over the next two years, and
are collateralized primarily with commercial real estate mortgages. Since the
conditions under which the Bank is required to fund the standby letters of
credit may not materialize, the cash requirements are expected to be less than
the total outstanding commitments.
(12) STOCK-BASED COMPENSATION
The Company has a stock option and incentive plan for certain key employees and
directors whereby shares of common stock have been reserved for awards in the
form of stock options or restricted stock. Under the plan, the aggregate number
of options and shares granted cannot exceed 400,000 shares with no more than
100,000 of shares issued in the form of restricted stock. The Compensation
Committee of the Board of Directors grants options from the plan at prices equal
to the fair value of the stock at the date of the grant. The options expire 10
years from the date of the grant and typically vest over a 3 to 5 year period
from the date of grant.
The Company adopted Statement of Financial Accounting Standards No. 123 (revised
2004), Share-Based Payment (FAS 123R) on January 1, 2006 using the modified
prospective transition method. Under the modified prospective transition method,
option awards that are granted, modified or settled beginning at the date of
adoption are measured and accounted for in accordance with FAS 123R. In
addition, expense is recognized in the statement of income for unvested option
awards that were granted prior to the date of adoption based on the fair value
of the award as determined at the grant date. The consolidated financial
statements as of and for the six months ended June 30, 2006 reflect $32,211 of
additional compensation expense as a result of implementing FAS 123R. In
accordance with the modified prospective transition method, the Consolidated
Financial Statements for prior periods have not been restated. Therefore, the
results for the second quarter and first six months of 2006 are not directly
comparable to the same periods in 2005.
11
Stock option information as of June 30, 2006 is as follows:
Aggregate
Weighted-Average Weighted-Average Remaining Intrinsic Value
Options Exercise Price Contractual Term (years) (in thousands)
------- ---------------- -------------------------- ----------------
Outstanding at June 30, 2006 342,540 $ 16.53 5.3 $ 801
Options exercisable at June 30, 2006 138,100 14.34 4.0 462
------- --------- --- -----
At June 30, 2006, 154,127 shares were available for issuance under the plan. No
stock options were granted and 8,266 options were exercised in the first six
months of 2006.
At June 30, 2006, there was $174,000 in unrecognized compensation cost for stock
options granted under the plan. This cost is expected to be recognized over a
weighted-average period of 2.6 years.
Prior to January 1, 2006, the Company applied the existing accounting rules
under APB Opinion No. 25, which provided that no compensation expense was
charged for options granted at an exercise price equal to the market value of
the underlying common stock on the date of the grant. If the fair value
recognition provisions of FAS 123R had been applied to stock-based compensation
for the three and six months ended June 30, 2005, the Company's pro forma net
income and earnings per share would have been as follows:
Quarter Ended Six Months Ended
June 30, 2005 June 30, 2005
------------- ----------------
Net income:
As reported................ $ 2,499,453 5,314,517
Deduct: Total stock-based
employee compensation
expense determined under
fair value based method for
all awards, net of related
tax effects................. 13,655 22,514
------------- ----------------
Pro forma..................... 2,485,798 5,292,003
============= ================
Earnings per common share:
As reported:
Basic......................... $ 0.65 1.39
Diluted....................... 0.62 1.33
Pro forma:
Basic ........................ 0.65 1.38
Diluted....................... 0.62 1.33
------------- ----------------
The Company utilizes the Black-Scholes valuation model to determine the fair
value of stock options on the date of grant. The model derives the fair value of
stock options based on certain assumptions related to the expected stock price
volatility, expected option life, risk-free rate of return and dividend yield of
the stock. The expected lives of options granted are estimated based on
historical employee exercise behavior. The risk-free rate of return coincides
with the expected life of the options and is based on the 10 year Treasury note
rate at the time the options are issued. The historical volatility levels of the
Company's common stock are used to estimate the stock price volatility. The set
dividend yield is used to estimate the expected dividend yield on the stock.
(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 and return on average assets and equity. Each corporation is managed
separately with its own officers and board of directors, some of whom may
overlap between the corporations.
12
The following table sets forth certain information about the reconciliation of
reported profit or loss and assets for each of the Company's reportable
segments.
Home Federal
(Dollars in thousands) Savings Bank Other Eliminations Consolidated Total
- --------------------------------------------------- -------------- ------- -------------- -------------------
AT OR FOR THE QUARTER ENDED JUNE 30, 2006:
Interest income - external customers............. $ 16,979 32 0 17,011
Non-interest income - external customers......... 1,775 0 0 1,775
Loss on limited partnerships..................... (9) 0 0 (9)
Intersegment non-interest income................. 33 3,021 (3,054) 0
Interest expense................................. 7,261 0 0 7,261
Amortization of mortgage servicing rights, net... 236 0 0 236
Other non-interest expense....................... 5,400 162 (34) 5,528
Income tax expense (benefit)..................... 1,880 (51) 0 1,829
Net income....................................... 3,022 2,941 (3,020) 2,943
Goodwill ........................................ 3,801 0 0 3,801
Total assets..................................... 1,006,973 94,271 (91,309) 1,009,935
AT OR FOR THE QUARTER ENDED JUNE 30, 2005:
Interest income - external customers............. $ 14,749 24 0 14,773
Non-interest income - external customers......... 1,582 0 0 1,582
Loss on limited partnerships..................... (7) 0 0 (7)
Intersegment non-interest income................. 33 2,533 (2,566) 0
Interest expense................................. 6,026 0 0 6,026
Amortization of mortgage servicing rights, net.. 271 0 0 271
Other non-interest expense....................... 5,120 164 (33) 5,251
Income tax expense (benefit)..................... 1,497 (104) 0 1,393
Net income....................................... 2,535 2,498 (2,533) 2,500
Goodwill......................................... 3,801 0 0 3,801
Total assets..................................... 981,979 87,156 (83,473) 985,662
AT OR FOR THE SIX MONTHS ENDED JUNE 30, 2006:
Interest income - external customers............. $ 32,918 76 0 32,994
Non-interest income - external customers......... 3,268 0 0 3,268
Loss on limited partnerships..................... (16) 0 0 (16)
Intersegment non-interest income................. 67 5,829 (5,896) 0
Interest expense................................. 13,855 0 0 13,855
Amortization of mortgage servicing rights, net... 453 0 0 453
Other non-interest expense....................... 10,998 319 (67) 11,250
Income tax expense (benefit)..................... 3,605 (96) 0 3,509
Net income....................................... 5,832 5,681 (5,829) 5,684
Goodwill......................................... 3,801 0 0 3,801
Total assets..................................... 1,006,973 94,271 (91,309) 1,009,935
AT OR FOR THE SIX MONTHS ENDED JUNE 30, 2005:
Interest income - external customers............. $ 28,935 34 0 28,969
Non-interest income - external customers......... 3,016 0 0 3,016
Loss on limited partnerships..................... (14) 0 0 (14)
Intersegment interest income..................... 0 16 (16) 0
Intersegment non-interest income................. 67 5,380 (5,447) 0
Interest expense................................. 11,568 0 (16) 11,552
Amortization of mortgage servicing rights, net... 510 0 0 510
Other non-interest expense....................... 10,043 326 (67) 10,302
Income tax expense (benefit)..................... 2,956 (207) 0 2,749
Net income....................................... 5,383 5,312 (5,380) 5,315
Goodwill......................................... 3,801 0 0 3,801
Total assets..................................... 981,979 87,156 (83,473) 985,662
13
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. When used in this Form 10-Q, the words
"anticipates", "believes", "estimates", "expects", "intends" and similar
expressions, as they relate to the Company, the Bank 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 Item 1A. "Risk Factors" of Part I
of the Company's Annual Report on Form 10-K for the year ended December 31,
2005.
GENERAL
The earnings of the Company are primarily dependent on the Bank's net interest
income, which is the difference between interest earned on its loans and
investments, and the interest paid on interest-bearing liabilities such as
deposits and Federal Home Loan Bank (FHLB) advances. The difference between the
average rate of interest earned on assets and the average rate paid on
liabilities is the "interest rate spread". Net interest income is produced when
interest-earning assets equal or exceed interest-bearing liabilities and there
is a positive interest rate spread. The Company's interest rate spread has been
enhanced by the increased level of commercial loans placed in portfolio and the
increased amount of lower rate 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 expense 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. Commercial
real estate loan activity was down in the first six months of 2006 when compared
to the same period of 2005 due to increased rate competition on long term fixed
rate loans 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.
14
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. 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 single-family and
consumer loan portfolios and its 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 periodically 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. Future conditions may differ
substantially from those anticipated in determining the allowance for loan
losses and adjustments may be required in the future.
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 Standards (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 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. Future
economic conditions may differ substantially from those anticipated in
determining the value of the MSRs and adjustments may be required in the future.
The Company does not formally hedge its MSRs because they are hedged naturally
by the Company's 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.
15
NET INCOME
The Company's net income was $2.9 million for the second quarter of 2006, up
$444,000, or 17.8%, over net income of $2.5 million for the second quarter of
2005. Basic earnings per share for the second quarter of 2006 were $0.77, up
$0.12, or 18.5%, from $0.65 for the second quarter of 2005. Diluted earnings per
common share for the second quarter of 2006 were $0.73, up $0.11, or 17.7%, from
$0.62 for the second quarter of 2005.
Net income was $5.7 million for the six month period ended June 30, 2006, an
increase of $369,000, or 6.9%, compared to $5.3 million for the six month period
ended June 30, 2005. Basic earnings per share were $1.48, up $.09, or 6.5%, from
$1.39 for the same six month period in 2005. Diluted earnings per share for the
six month period in 2006 were $1.41, up $0.08, or 6.0%, from $1.33 for the same
period in 2005.
NET INTEREST INCOME
Net interest income was $9.7 million for the second quarter of 2006, an increase
of $1.0 million, or 11.5%, compared to $8.7 million for the second quarter of
2005. Interest income was $17.0 million for the second quarter of 2006, an
increase of $2.2 million, or 15.2%, from $14.8 million for the same period in
2005. Interest income increased because of an increase in the average interest
rates earned on loans and investments. 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 on new loans originated.
Adjustable rate loans continue to represent a substantial portion of the
Company's consumer and commercial loan portfolio. The increase in interest
income due to increased rates was partially offset by a $37 million decrease in
the average outstanding loan portfolio balances between the periods. The
reduction in loan growth was the result of management's decision not to pursue
long-term, low fixed-rate commercial loans in an environment of rising
short-term interest rates. The average yield earned on interest-earning assets
was 7.11% for the second quarter of 2006, an increase of 86 basis points from
the 6.25% average yield for the second quarter of 2005.
Interest expense was $7.3 million for the second quarter of 2006, an increase of
$1.3 million, or 20.5%, compared to $6.0 million for the second quarter of 2005.
Interest expense increased because of the 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. The average interest rate paid on interest-bearing
liabilities was 3.23% for the second quarter of 2006, an increase of 53 basis
points from the 2.70% average interest rate paid in the second quarter of 2005.
Net interest margin (net interest income divided by average interest earning
assets) for the second quarter of 2006 was 4.08%, an increase of 38 basis
points, compared to 3.70% for the second quarter of 2005.
Net interest income was $19.1 million for the first six months of 2006, an
increase of $1.7 million, or 9.9%, from $17.4 million for the same period in
2005. Interest income was $33.0 million for the six month period ended June 30,
2006, an increase of $4.0 million, or 13.9%, from $29.0 million for the same six
month period in 2005. Interest income increased because of an increase in the
average interest rates earned on loans and investments. Interest rates increased
primarily because of the 200 basis point increase in the prime interest rate
between the periods. The increase in interest income due to increased rates was
partially offset by a $30 million decrease in the average outstanding loan
portfolio balance between the periods. The reduction in loan growth was the
result of management's decision not to pursue long-term, low fixed-rate
commercial loans in an environment of rising short-term interest rates. The
average yield earned on interest-earning assets was 7.05% for the first six
months of 2006, an increase of 82 basis points from the 6.23% average yield for
the first six months of 2005.
Interest expense was $13.9 million for the first six months of 2006, an increase
of $2.3 million, or 19.9%, compared to $11.6 million for the first six months of
2005. Interest expense increased because of the higher interest rates paid on
deposits which were caused by the 200 basis point increase in the federal funds
rate between the periods. The average interest rate paid on interest-bearing
liabilities was 3.15% for the first six months of 2006, an increase of 52 basis
points from the 2.63% average interest rate paid in the first six months of
2005.
Net interest margin (net interest income divided by average interest earning
assets) for the first six months of 2006 was 4.09%, an increase of 34 basis
points, compared to 3.75% for the first six months of 2005.
16
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 $980,000 for the second quarter of 2006, an increase of $73,000, or 8.0%,
from $907,000 for the second quarter of 2005. The provision for loan losses was
$1.5 million for the first six months of 2006 and for the same six month period
in 2005. The provision for loan losses increased during the second quarter
primarily because $10.0 million of related commercial real estate loans that
were downgraded and classified as non-accruing during the second quarter of
2006. The increase in the provision related to the commercial loan risk rating
downgrades was partially offset by a decrease in the provision related to the
$11 million reduction in the commercial loan portfolio in the second quarter of
2006 compared to the $12 million in growth that was experienced in the second
quarter of 2005.
A reconciliation of the Company's allowance for loan losses is summarized as
follows:
(in thousands) 2006 2005
-------- ------
Balance at January 1, $ 8,778 8,996
Provision 1,495 1,543
Charge offs (109) (352)
Recoveries 52 36
-------- ------
Balance at June 30, $ 10,216 10,223
======== ======
NON-INTEREST INCOME
Non-interest income was $1.8 million for the second quarter of 2006, an increase
of $191,000, or 12.2%, from $1.6 million for the same period in 2005. Fees and
service charges increased $110,000 between the periods primarily because of
increased retail deposit account activity and fees. Security gains increased
$48,000 due to increased security sales. Gain on sale of loans decreased $22,000
between the periods due to a decrease in the number of single-family mortgage
loans sold and a decrease in the profit margins realized on the loans that were
sold. Competition in the single-family loan origination market has increased as
the overall market has slowed and profit margins have been lowered in order to
remain competitive and maintain origination volumes. Other non-interest income
increased $59,000 primarily because of increased revenues from the sale of
uninsured investment products.
Non-interest income was $3.3 million for the first six months of 2006, an
increase of $251,000, or 8.4%, from $3.0 million for the same period in 2005.
Fees and service charges increased $223,000 between the periods primarily
because of increased retail deposit account activity and fees. Security gains
increased $48,000 due to increased security sales. Gain on sale of loans
decreased $69,000 between the periods due to a decrease in the number of
single-family mortgage loans sold and a decrease in the profit margins realized
on the loans that were sold. Other non-interest income increased $42,000
primarily because of increased revenues from the sale of uninsured investment
products.
NON-INTEREST EXPENSE
Non-interest expense was $5.8 million for the second quarter of 2006, an
increase of $242,000, or 4.4%, from $5.6 million for the same period of 2005.
Compensation expense increased $333,000 primarily because of annual payroll
increases and increased pension costs. Occupancy expense increased $62,000 due
primarily to additional costs associated with new branch and loan origination
offices opened in Rochester in the first quarter of 2006. Data processing costs
increased $42,000 due to increases in internet and other banking services
provided by the Bank's third party processor between the periods. Other
non-interest expense decreased $152,000 primarily because of decreased mortgage
loan expenses and professional fees incurred during the second quarter of 2006.
Non-interest expense was $11.7 million for the first six months of 2006, an
increase of $891,000, or 8.2%, from $10.8 million for the same period of 2005.
Compensation expense increased $818,000 primarily because of annual payroll
increases and increased pension costs. Occupancy expense increased $167,000 due
primarily to costs associated with additional corporate office facilities
occupied in the first quarter of 2005 and the new branch and loan origination
offices opened in Rochester in the first quarter of 2006. Data processing costs
increased $93,000 due to increases in internet and other banking services
provided by the Bank's third party processor between the periods. Other
non-interest expense decreased $172,000 primarily because of a decrease in
mortgage loan expenses and professional fees.
17
INCOME TAX EXPENSE
Income tax expense was $1.8 million for the second quarter of 2006, an increase
of $436,000, compared to $1.4 million for the second quarter of 2005. Income tax
expense was $3.5 million, an increase of $760,000, or 27.6%, compared to $2.7
million for the first six months of 2005. Income tax expense increased between
the periods due to an increase in taxable income and an effective tax rate that
increased from 34.1% for the first six months of 2005 to 38.2% for the first six
months of 2006. The increase in the effective tax rate was primarily the result
of state tax law changes that were enacted in the third quarter of 2005. In the
first six months of 2005, the Company had a Real Estate Investment Trust (REIT)
and related company that acquired and held mortgage assets and other authorized
investments to generate income. The tax laws relating to these entities were
changed, retroactively to January 1, 2005, in the third quarter of 2005. The
changes reduced the tax benefits of a REIT and a tax adjustment was recorded in
the third quarter of 2005 to account for the increase in tax for the first two
quarters of 2005. Because of this adjustment, quarterly tax expense for the
first three quarters of 2006 will not be comparable to the tax expense for same
periods in 2005.
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of non-performing
assets in the Bank's portfolio at June 30, 2006 and December 31, 2005.
June 30, December 31,
(Dollars in thousands) 2006 2005
- ----------------------- --------- ------------
Non-Accruing Loans:
One-to-four family real estate $ 315 626
Commercial real estate 10,921 948
Consumer 258 496
Commercial business 309 259
--------- --------
Total 11,803 2,329
--------- --------
Accruing Loans Delinquent 90 Days or More:
One-to-four family real estate 515 0
Other assets 72 178
Foreclosed and Repossessed Assets:
One-to-four family real estate 351 565
Commercial real estate 750 750
Consumer 0 61
--------- --------
Total non-performing assets $ 13,491 $ 3,883
========= ========
Total as a percentage of total assets 1.34% 0.39%
========= ========
Total non-performing loans $ 12,318 $ 2,329
========= ========
Total as a percentage of total loans receivable, net 1.62% 0.30%
========= ========
Allowance for loan loss to non-performing loans 82.93% 376.88%
========= ========
Total non-performing assets were $13.5 million at June 30, 2006, an increase of
$9.6 million from $3.9 million at December 31, 2005. Non-performing loans
increased $10.0 million, foreclosed and repossessed assets decreased $275,000
and other non-performing assets decreased $106,000 during the period.
DIVIDENDS
On July 25, 2006 the Company declared a cash dividend of $0.25 per share,
payable on September 8, 2006 to shareholders of record on August 25, 2006.
18
The Company has declared and paid dividends during 2006 as follows:
Record date Pay date Dividend per share Dividend Payout Ratio
----------- ------------- ------------------ ---------------------
February 17, 2006 March 7, 2006 $0.24 27.59%
May 19, 2006 June 7, 2006 $0.24 35.29%
The annualized dividend payout ratio for the past four quarters, ending with the
September 8, 2006 payment will be 34.04%.
The declaration of dividends is 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, 2006 the net cash provided by operating
activities was $2.2 million. The Company collected $55.5 million from the
maturities of securities, $3.0 million from the sale of securities and $371,000
from principal repayments on securities. It purchased securities available for
sale of $83.5 million and premises and equipment of $1.0 million. Net loans
receivable decreased $25.8 million due to decreased commercial loan production.
The Company had a net increase in deposit balances of $16.6 million and received
$1.0 million in Federal Reserve advance proceeds. It paid out $1.0 million on
Federal Reserve advances and $259,000 on customer escrows. The Company received
$81,000 related to the exercise of HMN stock options, paid $1.9 million in
dividends to its shareholders and paid $1.5 million to purchase treasury stock.
The Company has certificates of deposits with outstanding balances of $237.2
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. FHLB advances or proceeds from the
sale of securities could also be used to replace unanticipated outflows of
deposits.
The Company has $110.9 million of FHLB advances which mature beyond June 30,
2007 but have call features that can be exercised by the FHLB during the next 12
months. The Company also has $40.0 million of FHLB advances that will mature
during the next 12 months. As the advances mature or 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.
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 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 in the Asset/Liability Management section of this report, which follows,
discloses the Company's projected changes in net interest income based upon
immediate interest rate changes called rate shocks.
The Company utilizes a model that uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate the
current market value of those assets and liabilities. The model also calculates
the changes in market value of the interest-earning assets and interest-bearing
liabilities due to different interest rate changes. The Company believes that
over the next twelve months interest rates could fluctuate in a range of 200
basis points up or down from where the rates were at June 30, 2006. 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, 2006.
19
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 $ 1,020,125 1,013,372 1,003,877 992,286 979,285
Total market risk sensitive liabilities 886,687 874,243 864,652 856,617 849,364
Off-balance sheet financial instruments (443) (205) 0 424 808
----------- --------- --------- ------- -------
Net market risk $ 133,881 139,334 139,225 135,245 129,113
=========== ========= ========= ======= =======
Percentage change from current market value (3.84)% (0.08)% 0.00% (2.86)% (7.26)%
=========== ========= ========= ======= =======
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
from 7% 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 31%, depending on the note rate and the period to maturity.
Growing Equity Mortgage loans were assumed to prepay at annual rates of between
6% and 48% 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 20% and money market
accounts were assumed to decay at an annual rate of 28%. Non-interest checking
accounts were assumed to decay at an annual rate of 33% and NOW accounts were
assumed to decay at an annual rate of 14%. 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, 2006 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 in
Rate Shock Net Interest Percentage
(Dollars in thousands) in Basis Points Income Change
--------------- ------ ------
+200 432 1.06%
+100 371 0.91%
0 0 0.00%
-100 (685) (1.68)%
-200 (1,889) (4.64)%
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.
20
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 order 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 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, 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 portfolio
adjustable rate single-family loans that reprice over a one, three 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
manage the Company's interest rate risk exposure.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Incorporated by reference to Item 2 "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Market Risk."
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.
21
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
None.
ITEM 1A. Risk Factors
There have been no material changes in the risk factors disclosed in the
Company's December 31, 2005 Form 10-K.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a) and (b) Not applicable
(c) Information Regarding Share Repurchases
(a) Total (c) Total Number of (d) Maximum Number
Number of Shares Purchased as Part of Shares that May Yet
Shares (b) Average Price of Publicly Announced Be Purchased Under the Plans
Period Purchased Paid per Share Plans or Programs or Programs
- ------ ----------- ----------------- ------------------------ ----------------------------
April 1 through April 30, 2006 15,000 $33.55 15,000 172,000
May 1 through May 31, 2006 0 0.00 0 172,000
June 1 through June 30, 2006 20,000 34.28 20,000 152,000
------ ------ ------
Total 35,000 $33.97 35,000
====== ====== ======
(1) On July 26, 2005 the Board of Directors extended the existing repurchase
program for 197,000 shares of the Company's common stock until February
25, 2007.
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 25,
2006 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 2009:
For Withhold
--- --------
Michael McNeil 3,908,635 34,798
Duane Benson 3,915,668 27,765
Mahlon Schneider 3,907,984 35,449
Accordingly the individuals named above were duly elected directors of the
Company for terms to expire as stated above.
22
The following directors have terms of office that expire at dates following the
2006 annual meeting and continued in office:
Director Term of Office Expires
-------- ----------------------
Michael Fogarty 2007
Susan Kolling 2007
Malcolm McDonald 2007
Allan DeBoer 2008
Timothy Geisler 2008
Karen Himle 2008
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 independent auditors for the fiscal
year ending December 31, 2006.
NUMBER PERCENTAGE OF
OF VOTES VOTES ACTUALLY CAST
--------- -------------------
FOR 3,910,443 99.16%
AGAINST 19,024 0.48%
ABSTAIN 13,966 0.35%
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.
See Index to Exhibits on page 25 of this report
23
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 2, 2006 By: /s/ Michael McNeil
--------------------------------------
Michael McNeil,
President and Chief Executive Officer
(Principal Executive Officer)
(Duly Authorized Representative)
Date: August 2, 2006 By: /s/ Jon Eberle
--------------------------------------
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
24
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
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 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).
25