- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] 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 NO.) 101 NORTH BROADWAY, PO BOX 231 55975-0231 SPRING VALLEY, MINNESOTA (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (507) 346-1100 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, PAR VALUE $.01 PER SHARE (TITLE OF CLASS) 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 twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days. YES X NO ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of March 5, 1999, the Registrant had issued and outstanding 5,247,104 shares of the Registrant's Common Stock. The aggregate market value of the voting stock held by non-affiliates of the Registrant as of March 5, 1999 was $52.7 million. (The exclusion from such amount of the market value of the shares owned by any person shall not be deemed an admission by the Registrant that such person is an affiliate of the Registrant.) DOCUMENTS INCORPORATED BY REFERENCE Parts of the Registrant's Annual Report for the year ended December 31, 1998, are incorporated by reference in Parts II and IV of this Form 10-K. Parts of the Registrant's Proxy Statement dated March 23, 1999, are incorporated by reference in Part III of this Form 10-K. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS PART I PAGE Item 1. Business..................................................................3 General.............................................................3 Lending Activities..................................................4 Investment Activities..............................................20 Sources of Funds...................................................24 Other Information Service Corporations.........................................28 Competition..................................................28 Other Corporations Owned by HMN..............................28 Employees....................................................29 Executive Officers...........................................29 Regulation.........................................................29 Taxation...........................................................38 Item 2. Properties...............................................................40 Item 3. Legal Proceedings........................................................41 Item 4. Submission of Matters to a Vote of Security Holders......................41 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters............................................................41 Item 6. Selected Financial Data..................................................41 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..............................................41 Item 7A. Quantitative and Qualitative Disclosure About Market Risk................41 Item 8. Financial Statements and Supplementary Data..............................41 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...............................................42 PART III Item 10. Directors and Executive Officers of the Registrant.......................42 Item 11. Executive Compensation...................................................42 Item 12. Security Ownership of Certain Beneficial Owners and Management...........42 Item 13. Certain Relationships and Related Transactions...........................42 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........43 Signatures.........................................................................46 Index to Exhibits..................................................................47 PART I ITEM 1. BUSINESS GENERAL HMN Financial, Inc. ("HMN" or the "Corporation"), was incorporated under the laws of the State of Delaware in March 1994 for the purpose of becoming the savings and loan holding company of Home Federal Savings Bank ("Home Federal" or the "Bank") in connection with the Bank's conversion from a federally chartered mutual savings bank to a federally chartered stock savings bank. Home Federal has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer financial planning products and services. HMN has two other wholly owned subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc. (MSI). SFC invests in commercial loans and commercial real-estate loans located throughout the United States which were originated by third parties. MSI operates a mortgage banking and mortgage brokerage facility located in Brooklyn Park, Minnesota. On December 5, 1997 HMN, through its wholly owned subsidiary, the Bank, completed its merger with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to Consolidated Financial Statements in the Annual Report for information on assets acquired in the merger, HMN's Current Report on Form 8-K dated December 5, 1997, filed on December 10, 1997 (file no. 0-24100) for a copy of the merger agreement and HMN's Current Report on Form 8-K dated December 5, 1997, filed on February 11, 1998 (file no. 0-24100) for a copy of financial statements of the acquired company and pro forma financial information. As a community-oriented financial institution, HMN seeks to serve the financial needs of communities in its market area. HMN's business involves attracting deposits from the general public and using such deposits to originate or purchase one-to-four family residential mortgage loans and, to a lesser extent, consumer, construction, commercial real estate, commercial business and multi-family loans. HMN also invests in mortgage-backed and related securities, investment securities (consisting primarily of U.S. government and government agency obligations) and other permissible investments. The executive offices of HMN are located at 101 N. Broadway, PO Box 231, Spring Valley, Minnesota 55975-0231. It's telephone number at that address is (507) 346-1100. MARKET AREA HMN serves the Minnesota counties of Fillmore, Freeborn, Houston, Mower, Olmsted and Winona and portions of Steele, Dodge, Goodhue and Wabasha Counties, Minnesota, through its main office located in Spring Valley, Minnesota and its six branch offices located in Albert Lea, Austin, LaCrescent, Rochester and Winona, Minnesota. The portion of HMN's market area consisting of Rochester and the contiguous communities is composed of primarily urban and suburban communities, while the balance of HMN's market area consists primarily of rural areas and small towns. Primary industries in HMN's market area include manufacturing, agriculture, health care, wholesale and retail trade, service industries and education. Major employers include IBM, the Mayo Clinic, Hormel, a food processing company, and various small industrial and other companies. HMN's market area is also the home of Winona State University, Rochester Community and Technical College, University of Minnesota - Rochester Center, Winona State University - Rochester Center and Austin's Riverland Community College. HMN serves the Iowa counties of Marshall and Tama through its branch offices located in Marshalltown and Toledo. Major industries in the area are Swift & Company - pork processors, Fisher Controls Int. - valve and regulator manufacturing, Lennox Industries - furnace and air conditioner manufacturing, Iowa Veterans Home - hospital care, Marshall Community School District - education, Marshall Medical & Surgical Center - hospital care and Meskwaki Casino - gaming operation. 3 Based upon information obtained from the Minnesota State Demographic Center for 1996, the population of the six primary counties in the Bank's Minnesota market area was as follows: Fillmore - 20,900; Freeborn - 33,000; Houston - 19,200; Mower - 37,700; Olmsted - 115,200; and Winona - 49,200. Total income per capita for 1996 in these six counties ranged from approximately $19,100 to $26,500. Based upon information obtained from the State Library of Iowa for 1996, the population of Marshall County was 38,700 and the population of Tama County was 17,600. Total income per capita of the above mentioned Iowa counties ranged from approximately $20,000 to $21,900. During the fourth quarter of 1996, HMN opened a mortgage banking and mortgage brokerage office which is currently located in Brooklyn Park, Minnesota. The office primarily originates single family residential loans for sale in the secondary market or purchases loans from third party originators located primarily in the seven county metropolitan area of Minneapolis and St. Paul and sells the loans in the secondary market. The office also has purchased mortgage servicing rights from third parties for the purpose of generating loan servicing income. LENDING ACTIVITIES GENERAL. Historically, HMN originated 30-year, fixed-rate mortgage loans secured by one-to-four family residences. Since 1979, in order to reduce its vulnerability to changes in interest rates, HMN has emphasized the origination or purchase of loans for the loan portfolio which have shorter terms to maturity such as 15 year, fixed rate residential loans and Graduated Equity Mortgages ("GEMs") which fully amortize in 15 to 20 years. HMN has also emphasized the origination and purchase of Adjustable Rate Mortgage loans ("ARMs") for portfolio which have interest rates which are fixed for an initial period of one, three or five years and then generally adjust annually, thereafter, based upon a treasury interest rate index plus a certain margin, subject to annual and lifetime rate adjustment limits. HMN offers a competitive home equity line of credit as well as other consumer loans. The home equity line of credit has an adjustable interest rate based upon the Wall Street Journal prime rate plus a margin. During 1998 HMN hired experienced commercial loan officers who actively pursued commercial real estate, commercial business and development loans in HMN's market area. 4 LOAN PORTFOLIO COMPOSITION. The following information concerning the composition of HMN's loan portfolio in dollar amounts and in percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated. December 31, -------------------------------------------------------------- 1998 1997 1996 ------------------- -------------------- ------------------ (DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent --------- ------- ---------- ------- --------- ------- REAL ESTATE LOANS: One-to-four family................. $ 365,496 79.31% $ 395,668 87.58% $ 321,340 90.19% Multi-family....................... 4,719 1.02 2,717 0.60 280 0.08 Commercial......................... 28,990 6.29 10,572 2.34 7,918 2.22 Construction or development........ 15,155 3.29 5,725 1.27 3,474 0.98 --------- ------ --------- ------ --------- ------ Total real estate loans......... 414,360 89.91 414,682 91.79 333,012 93.47 --------- ------ --------- ------ --------- ------ OTHER LOANS: Consumer loans: Savings account................... 994 0.22 1,362 0.30 938 0.26 Education......................... 118 0.03 123 0.03 467 0.13 Automobile........................ 2,897 0.63 2,438 0.54 566 0.16 Home equity line.................. 19,476 4.22 19,490 4.31 11,881 3.33 Home equity....................... 9,566 2.08 7,176 1.59 5,927 1.67 Home improvement.................. 436 0.09 652 0.14 585 0.16 Other............................. 1,313 0.28 624 0.14 568 --------- ------ --------- ------ --------- ------ Total consumer loans............ 34,800 7.55 31,865 7.05 20,932 5.87 Commercial business loans.......... 11,695 2.54 5,226 1.16 2,344 0.66 --------- ------ --------- ------ --------- ------ Total other loans............... 46,495 10.09 37,091 8.21 23,276 6.53 --------- ------ --------- ------ --------- ------ Total loans.................. 460,855 100.00% 451,773 100.00% 356,288 100.00% ------ ------ ------ ------ ------ ------ LESS: Loans in process................... 7,997 4,562 2,814 Unamortized discounts.............. 414 547 417 Net deferred loan fees............. 1,948 1,847 1,695 Allowance for losses on loans...... 3,041 2,748 2,340 --------- --------- --------- Total loans receivable, net.. $ 447,455 $ 442,069 $ 349,022 --------- --------- --------- --------- --------- --------- December 31, ------------------------------------------ 1995 1994 ------------------- -------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent --------- ------- --------- -------- REAL ESTATE LOANS: One-to-four family................. $ 292,497 90.62% $ 252,943 91.14% Multi-family....................... 361 0.11 311 0.11 Commercial......................... 8,744 2.71 8,316 3.00 Construction or development........ 5,082 1.58 2,799 1.01 --------- ------ --------- ------ Total real estate loans......... 306,684 95.02 264,369 95.26 --------- ------ --------- ------ OTHER LOANS: Consumer loans: Savings account................... 1,210 0.37 648 0.23 Education......................... 342 0.11 2,007 0.72 Automobile........................ 671 0.21 520 0.19 Home equity line.................. 3,509 1.09 0 0.00 Home equity....................... 7,997 2.47 7,716 2.78 Home improvement.................. 785 0.24 870 0.31 --------- ------ --------- ------ Total consumer loans............ 15,059 4.66 12,263 4.42 Commercial business loans.......... 1,018 0.32 897 0.32 --------- ------ --------- ------ Total other loans............... 16,077 4.98 13,160 4.74 --------- ------ --------- ------ Total loans.................. 322,761 100.00% 277,529 100.00% ------ ------ ------ ------ LESS: Loans in process................... 3,531 2,327 Unamortized discounts.............. 289 162 Net deferred loan fees............. 1,899 2,147 Allowance for losses on loans...... 2,191 1,893 --------- --------- Total loans receivable, net.. $ 314,851 $ 271,000 --------- --------- --------- --------- 5 The following table shows the composition of HMN's loan portfolio by fixed and adjustable rate loans at the dates indicated. December 31, ------------------------------------------------------------------------------------ 1998 1997 1996 ----------------------- ------------------------ ----------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent ----------- --------- ----------- --------- ----------- --------- FIXED-RATE LOANS Real estate: One-to-four family GEM...................................... $ 56,211 12.20% $ 53,258 11.79% $ 48,831 13.71% Other.................................... 227,790 49.43 256,263 56.72 187,519 52.63 ----------- --------- ----------- -------- ----------- -------- Total one-to-four family................ 284,001 61.63 309,521 68.51 236,350 66.34 Multi-family.............................. 3,509 0.76 2,490 0.55 223 0.06 Commercial................................ 17,768 3.86 1,914 0.42 1,276 0.36 Construction or development............... 9,366 2.03 3,180 0.71 2,970 0.83 ----------- --------- ----------- -------- ----------- -------- Total fixed-rate real estate loans...... 314,644 68.27 317,105 70.19 240,819 67.59 ----------- --------- ----------- -------- ----------- -------- Consumer loans: Savings................................... 994 0.22 1,362 0.30 938 0.26 Education................................. 0 0.00 0 0.00 434 0.12 Automobile................................ 2,897 0.63 2,437 0.54 566 0.16 Home equity............................... 9,384 2.04 6,701 1.48 5,338 1.50 Home improvement.......................... 436 0.09 652 0.14 585 0.16 Other..................................... 1,175 0.25 612 0.14 568 0.16 ----------- --------- ----------- -------- ----------- -------- Total consumer loans.................... 14,886 3.23 11,764 2.60 8,429 2.36 ----------- --------- ----------- -------- ----------- -------- Commercial business loans.................. 10,157 2.20 5,226 1.16 1,344 0.38 ----------- --------- ----------- -------- ----------- -------- Total other loans....................... 25,043 5.43 16,990 3.76 9,773 2.74 ----------- --------- ----------- -------- ----------- -------- Total fixed-rate loans.................. 339,687 73.71 334,095 73.95 250,592 70.33 ----------- --------- ----------- -------- ----------- -------- ADJUSTABLE-RATE LOANS Real estate: One-to-four family........................ 81,495 17.68 86,147 19.07 84,990 23.85 Multi-family.............................. 1,210 0.26 227 0.05 57 0.02 Commercial................................ 11,222 2.44 8,658 1.92 6,642 1.87 Construction or development............... 5,789 1.26 2,545 0.56 504 0.14 ----------- --------- ----------- -------- ----------- -------- Total adjustable-rate real estate loans. 99,716 21.64 97,577 21.60 92,193 25.88 Consumer................................... 19,914 4.32 20,101 4.45 12,503 3.51 Commercial business loans.................. 1,538 0.33 0 0.00 1,000 0.28 ----------- --------- ----------- -------- ----------- -------- Total adjustable-rate loans............. 121,168 26.29 117,678 26.05 105,696 29.67 ----------- --------- ----------- -------- ----------- -------- Total loans............................. 460,855 100.00% 451,773 100.00% 356,288 100.00% ----------- --------- ----------- -------- ----------- -------- --------- -------- -------- LESS Loans in process........................... 7,997 4,562 2,814 Unamortized discounts...................... 414 547 417 Net deferred loan fees..................... 1,948 1,847 1,695 Allowance for losses on loans.............. 3,041 2,748 2,340 ----------- ----------- ----------- Total loans receivable, net............. $ 447,455 $ 442,069 $ 349,022 ----------- ----------- ----------- ----------- ----------- ----------- December 31, --------------------------------------------------- 1995 1994 ----------------------- ---------------------- (DOLLARS IN THOUSANDS) Amount Percent Amount Percent ----------- --------- ----------- -------- FIXED-RATE LOANS Real estate: One-to-four family GEM...................................... $ 30,175 9.35% $ 24,769 8.93% Other.................................... 181,401 56.20 168,272 60.63 ----------- -------- ----------- ------- Total one-to-four family................ 211,576 65.55 193,041 69.56 Multi-family.............................. 302 0.10 311 0.11 Commercial................................ 1,518 0.47 1,612 0.58 Construction or development............... 4,848 1.50 1,008 0.37 ----------- -------- ----------- ------- Total fixed-rate real estate loans...... 218,244 67.62 195,972 70.62 ----------- -------- ----------- ------- Consumer loans: Savings................................... 1,210 0.37 648 0.23 Education................................. 299 0.09 1,278 0.46 Automobile................................ 671 0.21 520 0.19 Home equity............................... 7,254 2.25 7,258 2.62 Home improvement.......................... 785 0.24 870 0.31 Other..................................... 545 0.17 502 0.18 ----------- -------- ----------- ------- Total consumer loans.................... 10,764 3.33 11,076 3.99 ----------- -------- ----------- ------- Commercial business loans.................. 1,018 0.32 897 0.32 ----------- -------- ----------- ------- Total other loans....................... 11,782 3.65 11,973 4.31 ----------- -------- ----------- ------- Total fixed-rate loans.................. 230,026 71.27 207,945 74.93 ----------- -------- ----------- ------- ADJUSTABLE-RATE LOANS Real estate: One-to-four family........................ 80,921 25.07 59,901 21.58 Multi-family.............................. 59 0.02 0 0.00 Commercial................................ 7,226 2.24 6,704 2.42 Construction or development............... 234 0.07 1,792 0.64 ----------- -------- ----------- ------- Total adjustable-rate real estate loans. 88,440 27.40 68,397 24.64 Consumer................................... 4,295 1.33 1,187 0.43 Commercial business loans.................. 0 0.00 0 0.00 ----------- -------- ----------- ------- Total adjustable-rate loans............. 92,735 28.73 69,584 25.07 ----------- -------- ----------- ------- Total loans............................. 322,761 100.00% 277,529 100.00% ----------- -------- ----------- ------- -------- ------- LESS Loans in process........................... 3,531 2,327 Unamortized discounts...................... 289 162 Net deferred loan fees..................... 1,899 2,147 Allowance for losses on loans.............. 2,191 1,893 ----------- ----------- Total loans receivable, net............. $ 314,851 $ 271,000 ----------- ----------- ----------- ----------- 6 The following schedule illustrates the interest rate sensitivity of HMN's loan portfolio at December 31, 1998. Loans which have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. Scheduled repayments of principal are reflected in the year in which they are scheduled to be paid. Real Estate ------------------------------------------------------------------------------- Multi-family and One-to-four family Commercial Construction Consumer ------------------------ ------------------------ ------------------------ ------------------------ Weighted Weighted Weighted Weighted Average Average Average Average (DOLLARS IN THOUSANDS) Amount Rate Amount Rate Amount Rate Amount Rate ------------ -------- ----------- -------- ----------- -------- ----------- -------- Due During Years Ending December 31, - ----------------------- 1999(1)...................$ 23,681 7.03% $ 2,461 7.61% $ 2,873 8.49% $ 4,420 8.71% 2000...................... 21,871 7.34 1,289 8.53 304 8.32 2,518 8.57 2001...................... 21,345 7.29 1,403 8.71 221 8.23 2,239 8.48 2002 through 2003......... 41,134 7.24 4,860 8.82 260 7.99 2,846 8.30 2004 through 2008......... 97,120 7.22 10,683 8.36 1,411 8.37 21,950 8.35 2009 through 2023......... 145,862 7.18 13,013 8.14 7,676 7.98 827 8.84 2024 and following........ 14,483 7.06 0 0.00 2,410 7.23 0 0.00 ------------ ----------- ----------- ----------- $ 365,496 $ 33,709 $ 15,155 $ 34,800 ------------ ----------- ----------- ----------- ------------ ----------- ----------- ----------- Commercial Business Total ------------------------ ------------------------ Weighted Weighted Average Average (DOLLARS IN THOUSANDS) Amount Rate Amount Rate ------------ -------- ----------- -------- Due During Years Ending December 31, - ----------------------- 1999(1)...................$ 2,533 8.62% $ 35,968 7.50% 2000...................... 1,792 8.95 27,774 7.62 2001...................... 1,488 9.01 26,696 7.57 2002 through 2003......... 4,243 8.61 53,343 7.55 2004 through 2008......... 394 8.95 131,558 7.52 2009 through 2023......... 1,245 8.51 168,623 7.31 2024 and following........ 0 0.00 16,893 7.08 ------------ ----------- $ 11,695 $ 460,855 ------------ ----------- ------------ ----------- - ------------ (1) Includes demand loans, loans having no stated maturity, overdraft loans and education loans. The total amount of loans due after December 31, 2000 which have predetermined interest rates is $311.5 million, while the total amount of loans due after such dates which have floating or adjustable interest rates is $113.3 million. At December 31, 1998 construction or development loans for one-to-four family dwellings totaled $5.7 million, multi-family totaled $6.6 million, and non-residential totaled $2.9 million. 7 Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the aggregate amount of loans that the Bank is permitted to make to any one borrower is generally limited to 15% of unimpaired capital and surplus (25% if the security for such loan has a "readily ascertainable" value or 30% for certain residential development loans). At December 31, 1998, based upon the 15% limitation, the Bank's regulatory loans-to-one borrower limit was approximately $6.9 million. On the same date, the Bank had no borrowers with net outstanding balances in excess of this amount. At December 31, 1998, the largest dollar amount outstanding to one borrower or group of related borrowers was $6.35 million. This loan, which is secured by a shopping mall located in Winona, Minnesota, was performing in accordance with its terms at December 31, 1998. The Bank's Mortgage and Consumer Loan Committee is responsible for review and approval of all loans over the FHLMC/FNMA conforming loan dollar limits (the Limit) originated by the Bank. For the majority of 1998 the Limit was $227,150, compared to $214,600 for the majority of 1997. Approval of one member of the Loan Committee is required on all loans ranging from the Limit to $500,000. Loans greater than $500,000 must be approved by the Board of Directors of the Bank or its Executive Committee after review and preliminary approval by the Loan Committee. All loans closed each month are reviewed by the Board of Directors at the monthly meeting. During 1998, the Bank centralized its one-to-four family real estate loan processing, underwriting, and servicing functions in Spring Valley. Each of the branch's loan officers are responsible for taking the initial loan application. The application and other pertinent information is then forwarded to a central loan processor who is responsible for obtaining information relating to processing the loan application. A loan underwriter reviews the information obtained by the processor and determines whether the loan applicant is eligible to receive the loan in conformity with the Bank's written underwriting guidelines and other loan policies. All of the Bank's lending is subject to its written underwriting standards and to loan origination procedures. Decisions on loan applications are made on the basis of detailed applications and property valuations (consistent with the Bank's appraisal policy) by the Bank's staff appraiser or an independent appraiser. The loan applications are designed primarily to determine the borrower's ability to repay. The more significant items on the application are verified through use of credit reports, financial statements, tax returns and/or confirmations. During 1997 the Bank introduced the Home Credit Plus Program which relies on the credit score of the loan applicant instead of income, asset and employment verification procedures. The Bank also offers low or alternative documentation underwriting procedures which conform to FNMA underwriting guidelines. Generally, the Bank requires title insurance on its mortgage loans as well as fire and extended coverage casualty insurance in amounts at least equal to the principal amount of the loan or the value of improvements on the property, depending on the type of loan. The Bank also requires flood insurance to protect the property securing its interest when the property is located in a flood plain. ONE-TO-FOUR FAMILY RESIDENTIAL REAL ESTATE LENDING. At December 31, 1998 HMN's one-to-four family real estate loans totaled $365.5 million, or 79.3% of its total loan portfolio, and represented a decline of $30.2 million, compared to $395.7 million at December 31, 1997. In order to reduce its interest rate risk during 1998, HMN securitized and sold $27.9 million of one-to-four family residential loans out of its loan portfolio. It also sold approximately 44% of the Bank's one-to-four family residential loans that were originated or refinanced during 1998. The loan securitizations and the loan sales, when coupled with the accelerated prepayments experienced in the loan portfolio during 1998, caused the one-to-four family real estate loan portfolio to decline from December 31,1997 to December 31, 1998. See "Originations, Purchases and Sales of Loans and Mortgage-Backed and Related Securities". 8 On December 5, 1997 the Bank merged with Marshalltown Financial Corporation ("MFC"). The Loan Portfolio Composition table includes for December 31, 1997 $62.9 million of one-to-four family residential loans, $2.3 of multi-family residential, $2.1 million of commercial real estate and $2.6 million of consumer loans which were acquired in the MFC merger. Prior to 1979, the Bank originated for retention in its own portfolio 30-year fixed-rate loans secured by one-to-four family residential real estate. Beginning in 1979, the Bank began to emphasize the origination of fixed-rate loans with terms of 15 years or less for retention in its portfolio. In addition, in 1982, the Bank began to originate ARMs, subject to market conditions and consumer preference. Subsequently, the Bank also began to emphasize GEM originations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management" in the Annual Report attached as Exhibit 13 hereto (the "Annual Report"). The GEM loans require payments which increase after the first year. Under the GEM loans, the monthly payments required for the first year are established based on a 30-year amortization schedule. Depending upon the program selected, the payments may increase in the succeeding years by amounts ranging from 0% to 5%. Most of the GEM loans originated by HMN provide for at least three annual payment increases over the first five years of the loan. The increased payments required under GEM loans are applied to principal and have the effect of shortening the term to maturity; the GEM loans do not permit negative amortization. HMN has primarily offered two GEM programs, one with a contractual maturity of approximately 17 years and one with a contractual maturity of approximately 22 years. The GEMs are generally priced based upon loans with similar contractual maturities. The GEMs have been popular with consumers who anticipate future increases in income and who desire an amortization schedule of less than 30 years. HMN believes that GEMs may increase in popularity in the future if interest rates rise and consumers are less easily able to afford the higher monthly payments required by 15-year, fixed-rate loans. At December 31, 1998, HMN had $56.2 million of GEM loans which comprised 12.2% of the total loan portfolio and represented an increase of $2.9 million from GEM loans of $53.3 million at December 31, 1997. HMN currently offers conventional fixed-rate one-to-four family loans with maximum terms of up to 30 years. During 1998, HMN generally sold the majority of new loan originations or refinances with fixed rates and terms to maturity ranging from 15 years to 30 years that were eligible for sale in the secondary market. Loans which were originated under the First Time Home Buyers program were not sold because many of the loans did not conform to secondary market underwriting requirements. The interest rates charged on the fixed rate loan products are generally set based on the FNMA or FHLMC delivery rates, as well as other competitive factors. At December 31, 1998, HMN had $227.8 million of fixed rate one-to-four family other loans which comprised 49.4% of the total loan portfolio and represented a decrease of $28.5 million, from $256.3 million at December 31, 1997. HMN also offers one-year ARMs at a margin (generally 275 basis points) over the yield on the Average Monthly One Year U.S. Treasury Constant Maturity Index for terms of up to 30 years. The ARM loans currently offered by HMN allow the borrower to select (subject to pricing) an initial period of one year, three years, or five years between the loan origination and when the first interest rate change occurs. Generally, the ARMs provide for an up to 200 basis point annual interest rate change cap and a lifetime cap 600 basis points over or under the initial rate. Initial interest rates offered on the ARM loans during 1998 ranged from 4 to 186 basis points below the fully indexed loan rate. All borrowers are now qualified for the loan at the fully indexed rate. HMN's originated ARMs do not permit negative amortization of principal, do not contain prepayment penalties and generally are not convertible into fixed-rate loans. See "-Delinquencies and Non-Performing Assets." In the past, the Bank offered one-year ARMs with a margin of 200 to 235 basis points over a specified index and an average annual cap of 145 basis points. At December 31, 1998 the one-to-four family ARMs totaled $81.5 million, or 17.7% of the total loan portfolio and represented a decrease of $4.6 million from $86.1 million at December 31, 1997. 9 HMN has also originated a limited number of fixed-rate loans with terms up to 30 years which are insured by the Federal Housing Authority ("FHA"), Veterans Administration ("VA") and Minnesota Home Finance Administration ("MHFA"). In underwriting one-to-four family residential real estate loans, HMN evaluates both the borrower's credit history, ability to make principal, interest and escrow payments, the value of the property that will secure the loan and debt to income ratios. Properties securing one-to-four family residential real estate loans made by HMN are appraised by independent fee appraisers or by HMN's staff appraiser. HMN originates residential mortgage loans with loan-to-value ratios of up to 95% for owner-occupied homes and up to 70% for non-owner occupied homes; however, private mortgage insurance is required to reduce HMN's exposure to 80% or less. HMN generally seeks to underwrite its loans in accordance with secondary market standards. HMN's residential mortgage loans customarily include due-on-sale clauses giving it the right to declare the loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the property subject to the mortgage. COMMERCIAL REAL ESTATE AND MULTI-FAMILY LENDING. HMN originates permanent commercial real estate and multi-family loans secured by properties located in its market area. It also purchases commercial real estate loans outside of its market area that are guaranteed by the Small Business Administration ("SBA") or originated by other third parties. During 1998 HMN hired experienced commercial loan officers to originate commercial real estate and commercial business loans in HMN's market area. HMN also purchased commercial real estate and multi-family loans from third party originators during 1998. At December 31, 1998, commercial real estate loans were $29.0 million or 6.3% of the total loan portfolio and represented an increase of $18.4 million compared to $10.6 million at December 31, 1997. At December 31, 1998 multi-family residential loans were $4.7 million, or 1.0% of the total loan portfolio and represented an increase of $2.0 million compared to $2.7 million at December 31, 1997. The commercial real estate and multi-family loan portfolio includes loans secured by motels, hotels, apartment buildings, churches, small office buildings, small business facilities, shopping malls, nursing homes and other non-residential building properties primarily located in the upper Midwestern United States. Permanent commercial real estate and multi-family loans are generally originated for a maximum term of 15 years and may have longer amortization periods with balloon maturity features. The interest rates may be fixed for the term of the loan or have adjustable features which are tied to prime or a treasury index. Commercial real estate and multi-family loans are written in amounts of up to 75% of the lesser of the appraised value of the property or the purchase price and generally have a debt service coverage ratio of at least 120%. The debt service coverage is the ratio of net cash from operations before payment of debt to debt service. HMN may originate construction loans secured by commercial or multi-family real estate, or may purchase participation interests in third party originated construction loans secured by commercial or multi-family real estate. Appraisals on commercial real estate and multi-family real estate properties are performed by independent appraisers prior to the time the loan is made. All appraisals on commercial and multi-family real estate are reviewed and approved by the commercial loan officer. The Bank's underwriting procedures require verification of the borrower's credit history, income and financial statements, banking relationships, references and income projections for the property. All commercial real estate and multi-family loans must be approved by a majority of the commercial loan committee prior to closing. The commercial loan policy generally requires personal guarantees from the proposed borrowers. Once the loan is closed, HMN performs an annual on-site inspection on collateral properties for loans with balances in excess of $250,000 and also includes an annual review of the financial performance of the property to determine that it is performing as anticipated. 10 At December 31, 1998, HMN's two largest commercial real estate loans totaled $6.35 million and $4.9 million. The first loan is secured by a shopping mall in Winona, Minnesota and the second loan is secured by a hotel and other commercial real estate in St. Cloud, Minnesota. Both of these loans were performing at December 31, 1998. Multi-family and commercial real estate loans generally present a higher level of risk than loans secured by one-to-four family residences. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family and commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower's ability to repay the loan may be impaired. At December 31, 1998, HMN had one commercial real estate loan totaling $73,000 and no multi-family loans which were 90 days or more delinquent. CONSTRUCTION LENDING. HMN makes construction loans to individuals for the construction of their residences, and to a much lesser extent, to builders for the construction of one-to-four family residences. It also makes a very limited number of loans to builders for houses built on speculation. At December 31, 1998, HMN had $15.2 million of construction loans outstanding, representing 3.3% of its total loan portfolio which represents an increase of $9.5 million, compared to $5.7 million at December 31, 1997. Almost all loans to individuals for the construction of their residences are structured as permanent loans. Such loans are made on the same terms as residential loans, except that during the construction phase, which typically lasts up to seven months, the borrower pays interest only. Generally, the borrower also pays a construction fee up to $800 at the time of origination. Residential construction loans are underwritten pursuant to the same guidelines used for originating residential loans on existing properties. Construction loans to builders or developers of one-to-four family residences generally carry terms of 1 to 15 years with a construction phase of up to seven months. Such loans generally do not permit the payment of interest from loan proceeds. Construction loans to owner occupants are generally made in amounts of up to 95% of the lesser of cost or appraised value, but no more than 85% of the loan proceeds can be disbursed until the building is completed. The loan-to-value ratios on loans to builders are limited to 70%. Prior to making a commitment to fund a construction loan, HMN requires an appraisal of the property and financial data and verification of income on the borrower. HMN generally obtains personal guarantees for substantially all of its construction loans to builders. Personal financial statements of guarantors are also obtained as part of the loan underwriting process. Generally construction loans have been located in HMN's market area. Construction loans are obtained principally through continued business from builders and developers who have previously borrowed from the Bank, as well as referrals from existing customers and walk-in customers. The application process includes a submission to the Bank of accurate plans, specifications and costs of the project to be constructed. These items are used as a basis to determine the appraised value of the subject property. At December 31, 1998 construction loans on one-to-four family residential real estate totaled $5.7 million, construction on multi-family residential real estate totaled $6.6 million and construction on commercial real estate totaled $2.9 million. The nature of construction loans is such that they are more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value upon completion of the project and the estimated cost (including interest) of the project. If 11 the estimate of value proves to be inaccurate, HMN may be confronted, at or prior to the maturity of the loan, with a project having a value which is insufficient to assure full repayment and/or the possibility of having to make substantial investments to complete and sell the project. Because defaults in repayment may not occur during the construction period it may be difficult to identify problem loans at an early stage. In such cases, HMN may be required to modify the terms of the loan. CONSUMER LENDING. HMN originates a variety of different types of consumer loans, including home equity loans (open-end and closed-end), education, automobile, home improvement, deposit account and other loans for household and personal purposes. At December 31, 1998, consumer loans totaled $34.8 million, and represented 7.6% of total loans outstanding, compared to $31.9 million at December 31, 1997. Consumer loan terms vary according to the type and value of collateral, length of contract and creditworthiness of the borrower. HMN's consumer loans are made at fixed and adjustable interest rates, with terms of up to 20 years for secured loans and up to three years for unsecured loans. HMN's home equity loans are written so that the total commitment amount, when combined with the balance of any other outstanding mortgage liens, may not exceed 90% of the appraised value of the property. The closed-end home equity loans are written with fixed or adjustable rates with terms of up to 15 years. The open-end home equity lines are written with an adjustable rate with terms of up to 20 years, a 10 year draw period which requires "interest only" payments and a 10 year repayment period which fully amortizes the outstanding balance. The consumer may access the open-end home equity line either by making a withdrawal at the Bank or writing a check on the home equity line of credit account. At December 31, 1998, HMN's home equity loans totaled $9.6 million, or 2.1% of the total loan portfolio and the home equity lines totaled $19.5 million, or 4.2% of the total loan portfolio, compared to home equity loans of $7.2 million and home equity lines of $19.5 million at December 31, 1997. The underwriting standards employed by the Bank for consumer loans include a determination of the applicant's payment history on other debts and ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount. Consumer loans may entail greater credit risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. At December 31, 1998, $86,000 of the consumer loan portfolio was non-performing. There can be no assurance that delinquencies will not increase in the future. COMMERCIAL BUSINESS LENDING. In order to satisfy the demand for financial services available to individuals and businesses in its market area, HMN has maintained a portfolio of commercial business loans primarily to small retail operations, small manufacturing concerns and professional firms. Most of HMN's commercial business loans have terms ranging from six months to five years and carry fixed interest rates. HMN's commercial business loans generally include personal guarantees and are usually, but not always, secured by business assets such as inventory, equipment, fixtures, real estate and accounts receivables. The underwriting process for commercial business loans includes consideration of the borrower's financial statements, tax returns, projections of future business operations and inspection of the subject collateral, if any. HMN has also purchased participation interests in commercial business loans from third party originators. The underlying collateral for the loans are generally equipment and generally have repayment periods of less than ten years. At December 31, 1998, HMN had $11.7 million of commercial business loans outstanding, or 2.5% of the total loan portfolio compared to $5.2 million at December 31, 1997. 12 Unlike residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment and other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans are of higher risk and typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. At December 31, 1998, there were no delinquent commercial business loans. ORIGINATIONS, PURCHASES AND SALES OF LOANS AND MORTGAGE-BACKED AND RELATED SECURITIES Real estate loans are generally originated by HMN's staff of salaried and commissioned loan officers. Loan applications are taken in all branch offices. While HMN originates both fixed and adjustable-rate loans, its ability to originate loans is dependent upon the relative customer demand for loans in its market. Demand is affected by the interest rate environment. During the last several years, the dollar volume of conventional fixed-rate, one-to-four family loans has exceeded the dollar volume of GEMs and ARMs. In order to supplement loan demand in HMN's market area and geographically diversify its loan portfolio, HMN purchases real estate loans from selected sellers, with yields based upon current market rates. HMN carefully reviews and underwrites all loans to be purchased to ensure that they meet HMN's under-writing standards. The seller generally continues to service these purchased loans. During 1998, HMN originated $148.7 million of loans compared to $68.1 million and $56.8 million during the years ended December 31, 1997 and 1996, respectively. HMN purchased $71.0 million of loans during 1998 compared to $71.8 million and $57.3 million during the years ended December 31, 1997 and 1996, respectively. The majority of the purchased loans have interest rates that are fixed for a one, three or five year period and then adjust annually thereafter or were 15 year fixed rate loans. All purchased loans are reviewed to determine that each loan meets certain underwriting requirements. Refer to Note 5 of the Notes to Consolidated Financial Statements in the Annual Report for more information on purchased loans. HMN has substantial holdings of mortgage-backed and related securities which are held, depending on the investment intent, in the "available for sale" portfolio. During 1998, HMN purchased $1.8 million of mortgage-backed securities compared to $3.4 million and $7.2 million for the years ended December 31, 1997 and 1996. It also purchased $112.0 million of CMOs during 1998 compared to $24.0 million and $50.4 million for the years ended December 31, 1997 and 1996, respectively. See -"Investment Activities." During 1998, HMN sold $96.5 million of mortgage-backed and related securities compared to $67.9 million and $81.1 million for the years ended December 31, 1997 and 1996, respectively. 13 The following table shows the loan and mortgage-backed and related securities origination, purchase, sale and repayment activities of HMN for the periods indicated. (DOLLARS IN THOUSANDS) LOANS Year Ended December 31, ORIGINATIONS BY TYPE: 1998 1997 1996 -------- ------- ------- Adjustable-rate: Real estate - one-to-four family.................... $ 2,328 1,987 5,441 - commercial............................ 5,388 1,000 0 - construction or development........... 787 375 916 Non-real estate - consumer.......................... 15,689 16,871 12,012 - commercial business............... 176 0 0 -------- ------- ------- Total adjustable-rate......................... 24,368 20,233 18,369 -------- ------- ------- Fixed-rate: Real estate - one-to-four family.................... 44,413 32,024 27,036 - multi-family.......................... 1,694 263 145 - commercial............................ 16,882 50 30 - construction or development........... 10,626 6,539 6,181 Non-real estate - consumer.......................... 13,100 7,579 4,583 - commercial business............... 37,672 1,409 430 -------- ------- ------- Total fixed-rate.............................. 124,387 47,864 38,405 -------- ------- ------- Total loans originated........................ 148,755 68,097 56,774 -------- ------- ------- PURCHASES: Real estate - one-to-four family.................... 58,512 67,213 55,839 - multi-family.......................... 8,571 0 0 - commercial............................ 1,172 0 0 - construction or development........... 0 2,425 1,500 Non-real estate - commercial business............... 2,731 2,174 0 -------- ------- ------- Total purchased............................... 70,986 71,812 57,339 -------- ------- ------- ACQUISITION: Real estate - one-to-four family.................... 0 63,328 0 - multi-family.......................... 0 2,308 0 - commercial............................ 0 2,099 0 Non-real estate - consumer.......................... 0 2,599 0 -------- ------- ------- Total loans acquired........................... 0 70,334 0 -------- ------- ------- Transfers from loans held for sale..................... 0 96 0 SALES AND REPAYMENTS: Real estate - one-to-four family.................... 5,878 8,969 2,310 - commercial............................ 650 0 0 Non-real estate - consumer.......................... 238 339 176 -------- ------- ------- Total sales................................... 6,766 9,308 2,486 -------- ------- ------- Loans securitized and transferred to securities..... 27,953 16,526 15,412 Transfers to loans held for sale.................... 52,295 4,347 2,492 Principal repayments................................ 106,824 84,244 56,533 -------- ------- ------- Total reductions.............................. 193,838 114,425 76,923 -------- ------- ------- Decrease in other items, net........................ (20,517) (2,867) (3,019) -------- ------- ------- Net increase.................................. $ 5,386 93,047 34,171 -------- ------- ------- -------- ------- ------- 14 MORTGAGE-BACKED AND RELATED SECURITIES Loans securitized and transferred to securities... $ 27,953 16,526 15,441 PURCHASES: Mortgage-backed securities:(1) Adjustable-rate.................................... 0 0 0 Fixed-rate......................................... 1,766 3,426 7,266 CMOs and REMICs: Adjustable-rate.................................... 76,174 3,417 6,527 Fixed-rate......................................... 35,839 20,617 43,831 -------- ------- ------- Total purchases................................ 113,779 27,460 57,624 -------- ------- ------- ACQUISITION: Adjustable rate..................................... 0 12,522 0 Fixed rate.......................................... 0 25,738 0 -------- ------- ------- Total acquisitions............................. 0 38,260 0 -------- ------- ------- SALES: Mortgage-backed securities:(1) Adjustable-rate.................................... 24,955 9,535 0 Fixed-rate......................................... 46,432 344 24,786 CMOs and REMICs: Adjustable-rate.................................... 13,765 26,486 23,876 Fixed-rate......................................... 11,366 31,529 32,487 -------- ------- ------- Total sales..................................... 96,518 67,894 81,149 -------- ------- ------- PRINCIPAL REPAYMENTS: Decrease in other items, net......................... 38,003 13,578 28,915 -------- ------- ------- Net increase (decrease)........................... $ 7,211 774 (36,999) -------- ------- ------- -------- ------- ------- - --------------- (1) Consists of pass-through securities. DELINQUENCIES AND NON-PERFORMING ASSETS DELINQUENCY PROCEDURES. When a borrower fails to make a required payment on a loan, HMN attempts to cure the delinquency by contacting the borrower. A late notice is sent on all loans over 16 days delinquent. Additional written and verbal contacts may be made with the borrower between 30 and 60 days after the due date. If the loan is contractually delinquent 90 days, HMN usually sends a 30-day demand letter to the borrower and, after the loan is contractually delinquent 120 days, institutes appropriate action to foreclose on the property. If foreclosed, the property is sold at a sheriff's sale and may be purchased by HMN. Delinquent consumer loans are generally handled in a similar manner. HMN's procedures for repossession and sale of consumer collateral are subject to various requirements under state consumer protection laws. Real estate acquired by HMN as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate in judgement for six months to one year and thereafter as real estate owned until it is sold. When property is acquired or expected to be acquired by foreclosure or deed in lieu of foreclosure, it is recorded at the lower of cost or estimated fair value, less the estimated cost of disposition. After acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of fair value less disposition cost. 15 The following table sets forth HMN's loan delinquencies by type, by amount and by percentage of type at December 31, 1998. Loans Delinquent For: ------------------------------------------------------- Total Delinquent 60-89 Days 90 Days and Over Loans -------------------------- -------------------------- -------------------------- Percent Percent Percent of Loan of Loan of Loan (DOLLARS IN THOUSANDS) Number Amount Category Number Amount Category Number Amount Category ------ ------ -------- ------ ------ -------- ------ ------ -------- One-to-four family real estate........... 9 $297 0.08% 13 $630 0.17% 22 $ 927 0.25% Multi-family............ 0 0 0.00 0 0 0.00 0 0 0.00 Commercial.............. 0 0 0.00 1 73 0.25 1 73 0.25 Construction or development........... 0 0 0.00 0 0 0.00 0 0 0.00 Consumer................ 12 68 0.20 8 86 0.25 20 154 0.44 Commercial business.............. 0 0 0.00 0 0 0.00 0 0 0.00 -- ---- -- ---- -- ------ Total............... 21 $365 0.08% 22 $789 0.17% 43 $1,154 0.25% -- ---- -- ---- -- ------ -- ---- -- ---- -- ------ CLASSIFICATION OF ASSETS. Federal regulations require that each savings institution classify its own assets on a regular basis. In addition, in connection with examinations of savings institutions, OTS and FDIC examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: Substandard, Doubtful and Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset on the balance sheet of the institution is not warranted. Assets classified as Substandard or Doubtful require the institution to establish prudent general allowances for loan losses. If an asset or portion thereof is classified as Loss, the institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified as Loss, or charge off such amount. If an institution does not agree with an examiner's classification of an asset, it may appeal this determination to the District Director of the OTS. On the basis of management's review of its assets, at December 31, 1998, the Bank had classified a total of $879,000 of its loans and other assets as follows: Commercial Real One-to-Four Construction or Estate and Commercial (DOLLARS IN THOUSANDS) Family Development Multi-Family Consumer Business ----------- --------------- --------------- -------- ---------- Substandard............. $716 0 73 90 0 Doubtful................ 0 0 0 0 0 Loss.................... 0 0 0 0 0 ---- - -- -- - Total............... $716 0 73 90 0 ---- - -- -- - ---- - -- -- - The Bank's classified assets consist of the non-performing loans and loans and other assets of concern discussed herein. As of the date hereof, these asset classifications are materially consistent with those of the OTS and FDIC. NON-PERFORMING ASSETS. Loans are reviewed quarterly and any loan whose collectibility is doubtful is placed on non-accrual status. Loans are placed on nonaccrual status when either principal or interest is 90 days or more past due, unless, in the judgment of management, the loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectibility of the loan. 16 Restructured loans include the Bank's troubled debt restructurings (which involved forgiving a portion of interest or principal on any loans or making loans at a rate materially less than the market rate). Foreclosed assets include assets acquired in settlement of loans. The following table sets forth the amounts and categories of non-performing assets in the Bank's portfolio. December 31, ---------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 ----- ----- ----- ----- ----- Non-accruing loans: Real estate: One-to-four family............................ $ 317 177 235 196 178 Commercial real estate........................ 73 79 83 85 0 Consumer...................................... 86 7 7 32 57 Commercial business........................... 0 0 13 128 ----- ---- ----- ----- ----- Total....................................... 476 263 338 441 235 ----- ---- ----- ----- ----- Accruing loans delinquent 90 days or more: One-to-four family............................. 312 365 0 0 0 Consumer....................................... 0 37 0 0 0 ----- ---- ----- ----- ----- Total....................................... 312 402 0 0 0 ----- ---- ----- ----- ----- Restructured loans: Multi-family................................... 0 0 0 94 199 Foreclosed assets: Real estate: One-to-four family............................ 18 142 23 315 64 ----- ---- ----- ----- ----- Total....................................... 18 142 23 315 64 ----- ---- ----- ----- ----- Total non-performing assets...................... $ 806 807 361 850 498 ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total as a percentage of total assets............ 0.12% 0.12% 0.07% 0.16% 0.10% ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total non-performing loans....................... $ 788 665 $ 338 $ 535 $ 434 ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- Total as a percentage of total loans receivable, net........................... 0.18% 0.15% 0.10% 0.17% 0.16% ----- ---- ----- ----- ----- ----- ---- ----- ----- ----- For the year ended December 31, 1998, gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $49,382. The amounts that were included in interest income on such loans during 1998 were $28,618. Total non-performing assets were $806,000 at December 31, 1998, a decrease of $1,000, compared to $807,000 at December 31, 1997 and $361,000 at December 31, 1996. Non-performing assets had the following activity during 1998: sales of $142,000, transfers in of $389,000 and transfers out due to performance of $248,000. Non-performing assets had the following activity during 1997: sales of $42,000, charge-offs of $35,000, payments of $80,000 and net transfers to non-performing assets of $603,000. The increase in non-performing assets from 1996 to 1997 is primarily the result of three one-to-four family purchased loans totaling $365,000 that were behind on their payments by more than 90 days and the foreclosure of two one-to-four family mortgages totaling $142,000. The decrease in the non-accruing loans is the result of the normal inflow and outflow of delinquent loans caused by borrowers getting behind on their payments and then bringing the loans current again. Total non-performing assets were $361,000 at December 31, 1996, a decrease of $489,000, compared to $850,000 at December 31, 1995. The decrease in non-performing assets is the result of the sale of foreclosed assets of $315,000, the charge-off of $72,000 of commercial loans, and the normal inflow and outflow of delinquent loans caused by borrowers getting behind on their payments and then bringing the loans current again. 17 OTHER LOANS OF CONCERN. In addition to the non-performing assets set forth in the table above, as of December 31, 1998 there were $72,000 of loans with known information about the possible credit problems of the borrowers or the cash flows of the secured properties have caused management to have concerns as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories. Management has considered the Bank's non-performing and "of concern" assets in establishing its allowance for loan losses. ALLOWANCE FOR LOSSES ON LOANS. The following table sets forth an analysis of the Bank's allowance for loan losses for the year ended: (DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 ------ ------ ------ ------ ------ Balance at beginning of year................... $2,748 2,341 2,191 1,893 1,489 MFC allowance for losses acquired.............. 0 122 0 0 0 Provision for losses........................... 310 300 300 300 410 CHARGE-OFFS Real estate: One-to-four family........................... (2) (4) 0 0 0 Multi-family................................. 0 0 (88) 0 0 Consumer..................................... (17) (7) (1) (2) (6) Commercial business.......................... 0 (12) (61) 0 0 ------ ------ ------ ------ ------ (19) (23) (150) (2) (6) ------ ------ ------ ------ ------ RECOVERIES Real estate: Commercial business.......................... 2 8 0 0 0 ------ ------ ------ ------ ------ 2 8 0 0 0 ------ ------ ------ ------ ------ Net charge-offs................................ (17) (15) (150) (2) (6) ------ ------ ------ ------ ------ Balance at end of year......................... $3,041 2,748 2,341 2,191 1,893 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Ratio of net charge-offs during the year to average loans outstanding during the year..... 0.00% 0.01% 0.05% 0.00% 0.00% ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Ratio of allowance for losses on loans to total non-performing loans, at end of year.... 385.79% 413.17% 691.84% 409.13% 436.52% ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ 18 The distribution of the Bank's allowance for losses on loans at the dates indicated is summarized as follows: December 31, ------------------------------------------------------------------------------ 1998 1997 1996 -------------------- --------------------- ------------------------- Percent Percent Percent of Loans of Loans of Loans in Each in Each in Each Category Category Category to Total to Total to Total (DOLLARS IN THOUSANDS) Amount Loans Amount Loans Amount Loans --------- ---------- ---------- ---------- ---------- --------- Real Estate: One-to-four family.............. $ 544 79.31% $ 560 87.58% $ 496 90.19% Multi-family.................... 142 1.02 80 0.60 8 0.08 Commercial ..................... 797 6.29 198 2.34 113 2.22 Construction or development..... 455 3.29 172 1.27 104 0.98 Consumer.......................... 546 7.55 527 7.05 473 5.87 Commercial business............... 328 2.54 46 1.16 29 0.66 Unallocated....................... 229 0.00 1,165 0.00 1,118 0.00 --------- -------- ---------- -------- ---------- ------ Total....................... $ 3,041 100.00% $ 2,748 100.00% $ 2,341 100.00% --------- -------- ---------- -------- ---------- ------ --------- -------- ---------- -------- ---------- ------ 1995 1994 ------------------------- --------------------------- Percent Percent of Loans of Loans in Each in Each Category Category to Total to Total (DOLLARS IN THOUSANDS) Amount Loans Amount Loans -------- ----------- ----------- ----------- Real Estate: One-to-four family............. $ 452 90.62% $ 475 92.18% Multi-family................... 21 0.11 21 0.14 Commercial .................... 125 2.71 128 1.80 Construction or development.... 153 1.58 84 1.31 Consumer......................... 286 4.66 280 4.14 Commercial business.............. 37 0.32 27 0.43 Unallocated...................... 1,117 0.00 878 0.00 -------- -------- --------- -------- Total....................... $ 2,191 100.00% $ 1,893 100.00% -------- -------- --------- -------- -------- -------- --------- -------- 19 The allowance for losses on loans is established through a provision for losses on loans charged to earnings based on management's evaluation of the risk inherent in its entire loan portfolio and changes in the nature and volume of its loan activity. Such evaluation, which includes a review of all loans of which full collectibility may not be reasonably assured, considers specific occurrences, general and local economic conditions, loan portfolio composition, historical and local experience and other factors that warrant recognition in providing for an adequate allowance for loan losses. In determining the general reserves under these policies, historical charge-offs and recoveries, changes in the mix and levels of the various types of loans, the general level of non-performing assets and the anticipated net realizable values, the current loan portfolio and current economic conditions are considered. The Bank also requires additional reserves for all classified loans. While management believes that it uses the best information available to determine the allowance for losses on loans, unforeseen market conditions could result in adjustments to the allowance for losses on loans, and net earnings could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Refer to Management's Discussion and Analysis on Allowances for Loan and Real Estate Losses and Non-performing Assets in the Annual Report. INVESTMENT ACTIVITIES HMN and the Bank utilize the available for sale securities portfolio in virtually all aspects of asset/liability management strategy. In making investment decisions, the Investment/Asset - Liability Committee considers, among other things, the yield and interest rate objectives, the credit risk position and the projected cash flow requirements. The Bank must maintain minimum levels of investments that qualify as liquid assets under OTS regulations. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. At December 31, 1998, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings deposits and current borrowings) was 10.27%. The Bank's level of liquidity is a result of management's asset/liability strategy. See "Regulation - Liquidity." SECURITIES. Federally chartered savings institutions have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Subject to various restrictions, federally chartered savings institutions may also invest their assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly. The investment strategy of HMN and the Bank has been directed toward a mix of high-quality assets (primarily government and agency obligations) with short and intermediate terms to maturity. At December 31, 1998, HMN did not own any investment securities of a single issuer which exceeded 10% of HMN's stockholder's equity other than U.S. government or federal agency obligations. The Bank invests a portion of its liquid assets in interest-earning overnight deposits of the Federal Home Loan Bank ("FHLB") of Des Moines and various money market mutual funds. Other investments include high grade medium-term (up to three years) corporate debt securities, medium-term federal agency notes, and a variety of other types of mutual funds which invest in adjustable-rate, mortgage-backed securities, asset-backed securities, repurchase agreements and U.S. Treasury and agency obligations. HMN invests in the same type of investment securities as the Bank and also invests in taxable and tax exempt municipal obligations and corporate equities such as preferred and common stock. See Notes 3 and 4 of the Notes to Consolidated Financial Statements in the Annual Report for additional information regarding HMN's securities portfolio. 20 The following table sets forth the composition of HMN's securities portfolio, excluding mortgage-backed and related securities, at the dates indicated. December 31, ------------------------------------------------------------------------------------- 1998 1997 --------------------------------------------- ------------------------------------- Amortized Adjusted Market % of Amortized Adjusted Market % of (DOLLARS IN THOUSANDS) Cost To Value Total Cost To Value Total ----------- -------- ------ ------ ----------- -------- ------ ------ Securities available for sale: U.S. government and agency obligations....................... $ 17,379 12 17,391 25.11% $ 43,403 (60) 43,343 49.98% Municipal obligations............... 2,901 (5) 2,896 4.18 0 0 0 0.00 Corporate debt ..................... 4,232 (3) 4,229 6.10 2,903 0 2,903 3.35 Corporate equity(1)................. 8,271 (296) 7,975 11.51 8,017 1,021 9,038 10.42 Stock of federal agencies(1)........ 5,874 114 5,988 8.64 14,034 605 14,639 16.88 Securities held to maturity: Corporate debt...................... 0 0 0.00 0 0 0.00 --------- ------ ------ --------- ------ ------ Subtotal.......................... 38,657 38,479 55.54 68,357 69,923 80.63 FHLB stock............................ 9,838 9,838 14.20 7,432 7,432 8.57 --------- ------ ------ --------- ------ ------ Total investment securities and FHLB stock................... 48,495 48,317 69.74 75,789 77,355 89.20 --------- ------ ------ --------- ------ ------ Average remaining life of investment securities excluding FHLB stock.... 4.5 years 2.5 years Other Interest-earning Assets: Cash equivalents.................... 20,961 20,961 30.26 9,365 9,365 10.80 --------- ------ ------ --------- ------ ------ Total............................. $ 69,456 69,278 100.00% $ 85,154 86,720 100.00% --------- ------ ------ --------- ------ ------ --------- ------ ------ --------- ------ ------ Average remaining life or term to repricing of investment securities and other interest-earning assets, excluding FHLB stock................. 3.2 years 2.3 years 1996 ----------------------------------------- Amortized Adjusted Market % of (DOLLARS IN THOUSANDS) Cost To Value Total --------- -------- ------ ------ Securities available for sale: U.S. government and agency obligations....................... $ 29,600 (322) 29,278 49.93% Municipal obligations............... 0 0 0 0.00 Corporate debt ..................... 1,091 1 1,092 1.86 Corporate equity(1)................. 7,796 386 8,182 13.96 Stock of federal agencies(1)........ 3,874 49 3,923 6.69 Securities held to maturity: Corporate debt...................... 1,000 1,001 1.71 --------- ------ ------ Subtotal.......................... 43,361 43,476 74.15 FHLB stock............................ 5,434 5,434 9.27 --------- ------ ------ Total investment securities and FHLB stock................... 48,795 48,910 83.42 --------- ------ ------ Average remaining life of investment securities excluding FHLB stock.... 3.4 years Other Interest-earning Assets: Cash equivalents.................... 9,718 9,718 16.58 --------- ------ ------ Total............................. $ 58,513 58,628 100.00% --------- ------ ------ --------- ------ ------ Average remaining life or term to repricing of investment securities and other interest-earning assets, excluding FHLB stock................. 2.8 years (1) Average life assigned to corporate equity holdings and stock of federal agencies is five years. 21 The composition and maturities of the securities portfolio, excluding FHLB stock, mortgage-backed and other related securities, are indicated in the following table. December 31, 1998 ---------------------------------------------------------- After 1 After 5 1 Year through 5 through 10 Over No Stated or Less Years Years 10 Years Maturity --------- --------- --------- --------- --------- Amortized Amortized Amortized Amortized Amortized (DOLLARS IN THOUSANDS) Cost Cost Cost Cost Cost --------- --------- --------- --------- --------- Securities available for sale: U.S. government securities........ $ 0 9,887 0 7,492 0 Municipal obligations............. 0 0 0 2,901 0 Corporate debt.................... 1,152 2,520 560 0 0 Corporate equity.................. 0 0 0 0 8,271 Stock of federal agencies......... 0 0 0 0 5,874 -------- -------- -------- ------- -------- Total stock......................... $ 1,152 12,407 560 10,393 14,145 -------- -------- -------- ------- -------- -------- -------- -------- ------- -------- Weighted average yield.............. 6.50% 6.39% 8.00% 6.83% 5.34% December 31, 1998 -------------------------------- Total Securities -------------------------------- Amortized Adjusted Market (DOLLARS IN THOUSANDS) Cost to Value --------- -------- ------- Securities available for sale: U.S. government securities........ 17,379 12 17,391 Municipal obligations............. 2,901 (5) 2,896 Corporate debt.................... 4,232 (3) 4,229 Corporate equity.................. 8,271 (296) 7,975 Stock of federal agencies......... 5,874 114 5,988 -------- ------- Total stock......................... 38,657 38,479 -------- ------- -------- ------- Weighted average yield.............. 6.15% 22 MORTGAGE-BACKED AND RELATED SECURITIES. In order to supplement loan production (particularly those of interest rate sensitive loans) and achieve its asset/liability management goals, HMN invests in mortgage-backed and related securities. All of the mortgage-backed and related securities owned by HMN are issued, insured or guaranteed either directly or indirectly by a federal agency or are rated "AA" or higher. At December 31, 1998, HMN had $143.1 million of mortgage-backed and related securities all classified as available for sale, compared to $135.9 at December 31, 1997 and $135.2 million at December 31, 1996, of which $133.4 million were classified as available for sale. The contractual maturities of the mortgage-backed and related securities portfolio without any prepayment assumptions at December 31, 1998 is as follows: December 31, 1998 5 Years 5 to 10 10 to 20 Over 20 Balance (DOLLARS IN THOUSANDS) or Less Years Years Years Outstanding ------------ ---------- ------------ ----------- ------------ Securities available for sale: Federal Home Loan Mortgage Corporation........ $ 133 561 1,183 0 1,877 Federal National Mortgage Association......... 0 0 0 574 574 Government National Mortgage Association...... 0 13 108 1,366 1,487 Other mortgage-backed securities.............. 0 0 0 101 101 Collateralized Mortgage Obligations........... 1,028 2,208 18,928 116,943 139,107 ------------ ---------- ------------ ----------- ------------ Total...................................... $ 1,161 2,782 20,219 118,984 143,146 ------------ ---------- ------------ ----------- ------------ ------------ ---------- ------------ ----------- ------------ Weighted average yield........................ 7.50% 7.21% 7.03% 6.66% 6.73% At December 31, 1998, HMN did not have any non-agency mortgage-backed or related securities in excess of 10% of its stockholders' equity, except for a $11.9 million collateralized mortgage obligation issued by Bear Stearns with an AAA rating by Moody's. CMOs are securities derived by reallocating the cash flows from mortgage-backed securities or pools of mortgage loans in order to create multiple classes, or tranches, of securities with coupon rates and average lives that differ from the underlying collateral as a whole. The terms to maturity of any particular tranche is dependent upon the prepayment speed of the underlying collateral as well as the structure of the particular CMO. Although a significant proportion of HMN's CMOs are in tranches which have been structured (through the use of cash flow priority and "support" tranches) to give somewhat more predictable cash flows, the cash flow and hence the value of CMOs is subject to change. At December 31, 1998, HMN had $94.5 million invested in CMOs which have floating interest rates that change either monthly or quarterly, compared to $23.3 million at December 31, 1997 and $43.5 million at December 31, 1996. During 1998 HMN increased its investment in floating rate CMOs in order to reduce its overall interest rate risk exposure. At December 31, 1998 the projected duration (period of time until half the interest and half the principal is collected) of the $44.6 million fixed rate CMO portfolio is approximately 1.0 year using median prepayment speeds projected by the Bloomberg security system, compared to approximately 3.3 years for the $61.8 million fixed rate CMO security portfolio at December 31, 1997. Refer to Management's Discussion and Analysis-Market Risk in the Annual Report for information on changes in market value of the mortgage-backed or related securities under different rate shock environments. To assess price volatility, the Federal Financial Institutions Examination Council ("FFIEC") adopted a policy in 1992 which required an annual "stress" test of mortgage derivative securities. The policy, which was adopted by the OTS, required the Bank to annually test its CMOs and other mortgage-related securities to 23 determine whether they were "high-risk" or "nonhigh-risk securities". During 1998 the OTS adopted Thrift Bulletin 13A which no longer required that "high-risk" testing be performed on an institution's CMOs and other mortgage-related securities. Mortgage-backed and related securities can serve as collateral for borrowings and, through sales and repayments, as a source of liquidity. In addition, mortgage-backed and related securities available for sale can be sold to respond to changes in economic conditions. For information regarding the carrying and market values of HMN's mortgage-backed and related securities portfolio, see Notes 3 and 4 of the Notes to Consolidated Financial Statements in the Annual Report. MERGERS AND ACQUISITIONS. On December 5, 1997 HMN, through its wholly owned subsidiary, the Bank, completed its merger with Marshalltown Financial Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to Consolidated Financial Statements in the Annual Report for information on assets acquired in the merger. SOURCES OF FUNDS GENERAL. The Bank's primary sources of funds are deposits, payments (including prepayments) of loan principal, interest earned on loans and securities, repayments of securities, borrowings and other funds provided from operations. DEPOSITS. The Bank offers a variety of deposit accounts having a wide range of interest rates and terms. The Bank's deposits consist of passbook, NOW, money market, non-interest bearing checking and certificate accounts (including individual retirement accounts). The Bank relies primarily on competitive pricing policies and customer service to attract and retain these deposits. The variety of deposit accounts offered by the Bank has allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. As customers have become more interest rate conscious, the Bank has become more susceptible to short-term fluctuations in deposit flows. The Bank manages the pricing of its deposits in keeping with its asset/liability management, profitability and growth objectives. Based on its experience, the Bank believes that its passbook and NOW accounts are relatively stable sources of deposits. However, the ability of the Bank to attract and maintain certificate deposits, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions. The following table sets forth the savings flows at the Bank during the periods indicated. Year Ended December 31, ---------------------------------------- (DOLLARS IN THOUSANDS) 1998 1997 1996 --------- -------- -------- Opening balance............................. $ 467,348 362,477 373,539 MFC deposits acquired....................... 0 103,612 0 Deposits.................................... 536,135 370,761 351,330 Withdrawals................................. (588,662) (385,002) (378,009) Interest credited........................... 19,048 15,500 15,617 ---------- -------- -------- Ending balance............................ 433,869 467,348 362,477 ---------- -------- -------- Net increase (decrease)..................... $ (33,479) 104,871 (11,062) ---------- -------- -------- ---------- -------- -------- Percent increase (decrease)................. (7.16)% 28.93% (2.96)% ---------- -------- -------- ---------- -------- -------- 24 The following table sets forth the dollar amount of savings deposits in the various types of deposit programs offered by the Bank as of December 31: 1998 1997 1996 ---------------------------- -------------------------- ---------------------- Percent Percent Percent (DOLLARS IN THOUSANDS) Amount of Total Amount of Total AMOUNT of Total -------- -------- -------- -------- --------- -------- TRANSACTIONS AND SAVINGS DEPOSITS(1): Non-interest checking.................... $ 13,187 3.04% $ 3,833 0.82% $ 2,389 0.66% NOW Accounts - 1.00%(2).................. 25,459 5.87 23,144 4.95 17,589 4.85 Passbook Accounts - 2.00%(3)............. 35,766 8.24 36,199 7.75 30,070 8.29 Money Market Accounts - 3.19%(4)......... 29,419 6.78 24,807 5.31 16,533 4.56 ---------- -------- ---------- -------- --------- ------- Total Non-Certificates................. $ 103,831 23.93% $ 87,983 18.83% $ 66,581 18.36% ---------- -------- ---------- -------- --------- ------- CERTIFICATES: 3.00 - 3.99%........................... $ 1,943 0.45% $ 727 0.15% $ 425 0.12% 4.00 - 4.99%........................... 87,582 20.19 24,155 5.17 22,553 6.22 5.00 - 5.99%........................... 160,630 37.02 162,916 34.86 168,040 46.36 6.00 - 6.99%........................... 78,273 18.04 178,847 38.27 76,704 21.16 7.00 - 7.99%........................... 1,342 0.31 11,627 2.49 28,077 7.75 8.00 - 8.99%........................... 264 0.06 1,091 0.23 96 0.03 9.00% and over.......................... 4 0.00 2 0.00 1 0.00 ---------- -------- --------- ------- --------- ------- Total Certificates..................... 330,038 76.07 379,365 81.17 295,896 81.64 ---------- -------- ---------- -------- --------- ------- Total Deposits...................... $ 433,869 100.00% $ 467,348 100.00% $ 362,477 100.00% ---------- -------- ---------- ------- --------- ------ ---------- -------- ---------- ------- --------- ------ - ------------ (1) Reflects rates paid on transaction and savings deposits at December 31, 1998. (2) The rate on NOW Accounts for 1997 was 1.50% and 1996 was 2.01%. (3) The rate on Passbook Accounts for 1997 was 2.62% and 1996 was 2.50%. (4) The rate on Money Market Accounts for 1997 was 3.34% and 1996 was 2.83%. 25 The following table shows rate and maturity information for the Bank's certificates of deposit as of December 31, 1998. (DOLLARS IN THOUSANDS) Certificate accounts maturing in 2.00- 3.00- 4.00- 5.00- 6.00- quarter ending: 2.99% 3.99% 4.99% 5.99% 6.99% ------ ----- ------ ------- ------ March 31, 1999.......................... $ 0 1,322 12,578 30,572 21,601 June 30, 1999........................... 0 3 12,859 26,839 8,536 September 30, 1999...................... 100 43 22,019 19,162 5,520 December 31, 1999....................... 400 39 12,675 17,599 1,654 March 31, 2000.......................... 0 0 10,874 8,520 3,427 June 30, 2000........................... 0 2 2,964 4,397 1,736 September 30, 2000...................... 0 0 3,891 4,031 13,958 December 31, 2000....................... 0 33 4,040 7,124 6,575 March 31, 2001.......................... 0 0 278 9,072 2,832 June 30, 2001........................... 0 0 739 8,998 1,975 September 30, 2001...................... 0 0 2,638 5,243 2,230 December 31, 2001....................... 0 1 1,753 1,112 2,867 Thereafter.............................. 0 0 274 17,961 5,362 ------ ----- ------ ------- ------ Total................................ $ 500 1,443 87,582 160,630 78,273 ------ ----- ------ ------- ------ ------ ----- ------ ------- ------ Percent of total..................... 0.15% 0.44% 26.54% 48.66% 23.72% ------ ----- ------ ------- ------ ------ ----- ------ ------- ------ (DOLLARS IN THOUSANDS) Certificate accounts maturing in 7.00- 8.00- 9.00- Percent quarter ending: 7.99% 8.99% 9.99% Total of Total ----- ----- ----- ------- -------- March 31, 1999.......................... 477 253 0 66,803 20.25 June 30, 1999........................... 248 11 2 48,498 14.70 September 30, 1999...................... 358 0 0 47,202 14.30 December 31, 1999....................... 257 0 0 32,624 9.88 March 31, 2000.......................... 0 0 1 22,822 6.92 June 30, 2000........................... 0 0 0 9,099 2.76 September 30, 2000...................... 0 0 0 21,880 6.63 December 31, 2000....................... 0 0 0 17,772 5.38 March 31, 2001.......................... 0 0 0 12,182 3.69 June 30, 2001........................... 0 0 0 11,712 3.55 September 30, 2001...................... 0 0 1 10,112 3.06 December 31, 2001....................... 2 0 0 5,735 1.74 Thereafter.............................. 0 0 0 23,597 7.15 ----- ----- ----- ------- ------ Total................................ 1,342 264 4 330,038 100.00% ----- ----- ----- ------- ------ ----- ----- ----- ------- ------ Percent of total..................... 0.41% 0.08% 0.00% 100.00% ----- ----- ----- ------- ----- ----- ----- ------- 26 The following table indicates the amount of the Bank's certificates of deposit and other deposits by time remaining until maturity as of December 31, 1998. Maturity -------------------------------------------- Over Over 3 Months 3 to 6 6 to 12 Over or Less Months Months 12 Months Total -------- ------ ------- --------- ------- (DOLLARS IN THOUSANDS) Certificates of deposit less than $100,000........................................... $ 55,559 44,651 69,631 123,848 293,689 Certificates of deposit of $100,000 or more........................................ 5,520 2,100 5,568 10,717 23,905 Public funds(1).......................................... 5,725 1,747 4,627 345 12,444 -------- ------- ------- -------- ------- Total certificates of deposit.............................................. $ 66,804 48,498 79,826 134,910 330,038 -------- ------- ------- -------- ------- -------- ------- ------- -------- ------- - ------------ (1) Deposits from governmental and other public entities. For additional information regarding the composition of the Bank's deposits, see Note 12 of the Notes to Consolidated Financial Statements in the Annual Report. For additional information on certificate maturities and the impact on HMN's liquidity see Liquidity starting on page 21 of the Annual Report. BORROWINGS. The Bank's other available sources of funds include advances from the Federal Home Loan Bank ("FHLB") of Des Moines and other borrowings. As a member of the FHLB of Des Moines, the Bank is required to own capital stock in the FHLB of Des Moines and is authorized to apply for advances from the FHLB of Des Moines. Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB of Des Moines may prescribe the acceptable uses for these advances, as well as limitations on the size of the advances and repayment provisions. Consistent with its asset/liability management strategy, the Bank has utilized FHLB advances from time to time to extend the term to maturity of its liabilities. Also, the Bank has used FHLB borrowings to fund loan demand and other investment opportunities and to offset deposit outflows. At December 31, 1998, the Bank had $185.4 million of FHLB advances outstanding. On such date, the Bank had a collateral pledge arrangement with the FHLB of Des Moines pursuant to which the Bank may borrow up to an additional $60.0 million for liquidity purposes. See "Financial Review - Federal Home Loan Bank Advances" and Note 13 of the Notes to Consolidated Financial Statements in the Annual Report. During 1998, HMN has established a $2.5 million revolving line of credit with Norwest Bank Minnesota, N.A. The credit line matures September 15, 1999 and floats at the Federal Funds rate plus 250 basis points. The following table sets forth the maximum month-end balance and average balance of FHLB advances and the revolving line of credit ("Other Borrowings") for the periods indicated. Year Ended December 31, ----------------------------------------- 1998 1997 1996 ---------- ------- ------- (DOLLARS IN THOUSANDS) MAXIMUM BALANCE: FHLB advances and Other Borrowings........................ $ 195,829 128,007 106,436 FHLB short-term borrowings and Other Borrowings........... 46,893 60,429 64,429 AVERAGE BALANCE: FHLB advances and Other Borrowings........................ 172,232 112,500 89,656 FHLB short-term borrowings and Other Borrowings........... 32,320 45,598 47,949 27 The following table sets forth certain information as to the Bank's FHLB advances and Other Borrowings at the dates indicated. December 31, --------------------------- 1998 1997 1996 ------- ------ ------ (DOLLARS IN THOUSANDS) FHLB short-term borrowings and Other Borrowings....... $17,500 43,250 46,429 Weighted average interest rate of FHLB short-term borrowings and Other Borrowings..... 5.38% 5.85% 5.52% SERVICE CORPORATIONS OF THE BANK As a federally chartered savings bank, the Bank is permitted by OTS regulations to invest up to 2% of its assets in the stock of, or loans to, service corporation subsidiaries, and may invest an additional 1% of its assets in service corporations where such additional funds are used for inner-city or community development purposes. In addition to investments in service corporations, federal institutions are permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities which a federal savings bank may engage in directly. Osterud Insurance Agency, Inc. ("OIAI"), a Minnesota corporation, was organized in 1983. OIAI operated as an insurance agency until 1986 when its assets were sold. OIAI remained inactive until 1993 when it began offering credit life insurance, annuity products and mutual fund products to the Bank's customers and others. OIAI recorded net income of $29,000 for the year ended December 31, 1998. MSL Financial Corporation ("MSL") was acquired in the MFC merger. MSL offered annuity products to MFC customers and also has an investment in FHLMC preferred stock. COMPETITION The Bank faces strong competition both in originating real estate loans and in attracting deposits. Competition in originating loans comes primarily from mortgage bankers, commercial banks, credit unions and other savings institutions, which also make loans secured by real estate located in the Bank's market area and through internet banking operations which are throughout the continental United States. The Bank competes for loans principally on the basis of the interest rates and loan fees it charges, the types of loans it originates and the quality of services it provides to borrowers. Competition for deposits is principally from money market and mutual funds, securities firms, commercial banks and other savings institutions located in the same communities. The ability of the Bank to attract and retain deposits depends on its ability to provide an investment opportunity that satisfies the requirements of investors as to rate of return, liquidity, risk, convenient locations and other factors. The Bank competes for these deposits by offering a variety of deposit accounts at competitive rates, convenient business hours and a customer oriented staff. OTHER CORPORATIONS OWNED BY HMN HMN has two other wholly owned subsidiaries, HMN Mortgage Services, Inc. ("MSI") and Security Finance Corporation ("SFC"). MSI operates a mortgage banking and mortgage brokerage facility located in Brooklyn Park, Minnesota. Brooklyn Park is located in the Minneapolis/St. Paul Metropolitan area. MSI's primary function is to originate and/or purchase single family residential loans for resale on the secondary 28 market to FNMA, FHLMC or other third parties. It also from time to time purchases mortgage servicing rights from other lenders. SFC invests in commercial loans and commercial real estate loans located throughout the United States which were originated by third parties. EMPLOYEES At December 31, 1998, HMN had a total of 136 full-time equivalent employees. None of the employees of HMN or its subsidiaries are represented by any collective bargaining unit. Management considers its employee relations to be good. EXECUTIVE OFFICERS OF THE REGISTRANT WHO ARE NOT DIRECTORS Officers are elected annually by the Board of Directors of HMN and the Bank. The business experience of each executive officer of HMN and the Bank who is not also a director of HMN is set forth below. Unless otherwise indicated, such individuals have held their current positions for at least five years. MICHAEL MCNEIL. Mr. McNeil, age 51, has been the President and Chief Executive Officer of the Bank since January 1, 1999. From April 1, 1998 through December 1998, Mr. McNeil was the Senior Vice President Business Development of the Bank. Prior to joining the Bank, Mr. McNeil was the President and a director of Stearns Bank, N.A. in St. Cloud, Minnesota from August 1, 1991 until March 1, 1998. DWAIN C. JORGENSEN. Mr. Jorgensen, age 50, is Senior Vice President Operations of HMN and the Bank. Mr. Jorgensen has held such positions with the Bank since 1998. Prior to such time, he served as Vice President, Controller and Chief Accounting Officer of HMN and the Bank from 1989 to 1998. From 1983 to 1989, Mr. Jorgensen was an Assistant Vice President and Operations Officer with the Bank. TIMOTHY P. JOHNSON. Mr. Johnson, age 46, is Vice President and Treasurer of HMN and the Bank, a position he has held since 1997. He has also been Principal Accounting Officer since 1998. Prior to such time, he served as Treasurer from 1992 to 1997. From 1983 to 1992, Mr. Johnson was Chief Financial Officer of St. Louis Bank for Savings, Duluth, Minnesota. REGULATION GENERAL The Bank is a federally chartered savings bank, the deposits of which are federally insured and backed by the full faith and credit of the United States Government. Accordingly, the Bank is subject to broad federal regulation and oversight extending to all its operations. The Bank is a member of the FHLB of Des Moines and is subject to certain limited regulation by the Federal Reserve Board. The Bank is a member of the Savings Association Insurance Fund ("SAIF") and the deposits of the Bank are insured by the FDIC. As a result, the FDIC has certain regulatory and examination authority over the Bank. As the savings and loan holding company of the Bank, HMN also is subject to federal regulation and oversight. The purpose of the regulation of HMN and other holding companies is to protect subsidiary savings associations. Certain of these regulatory requirements and restrictions are discussed below. FEDERAL REGULATION OF SAVINGS ASSOCIATIONS The OTS has extensive authority over the operations of savings associations. As part of this authority, the Bank is required to file periodic reports with the OTS and is subject to periodic examinations by the OTS and the FDIC. The last regular OTS examination of the Bank was dated July of 1998. The Bank has not been scheduled for an examination in 1999, except for an on-site year 2000 examination which started 29 on March 1, 1999. When these examinations are conducted by the OTS and the FDIC, the examiners may require the Bank to provide for higher general or specific loan loss reserves. From time to time, financial institutions in various regions of the United States have been called upon by examiners to write down assets and to establish increased levels of reserves, primarily as a result of perceived weaknesses in real estate values and a more restrictive regulatory climate. The OTS has established a schedule for the assessment of fees upon all savings associations to fund the operations of the OTS. The general assessment, to be paid on a semi-annual basis, is computed upon the savings association's total assets as reported in the association's latest quarterly thrift financial report, the savings association's condition as reflected by its composite rating, and the complexity of the savings association's business determined by the amount of trust assets administered, assets subject to recourse or similar obligations and the principal amount of loans serviced by the savings association. Savings associations (unlike the Bank) with a composite rating of 3 receive a condition component equal to 25% of their size component and savings associations with a composite rating of 4 or 5 receive a condition component equal to 50% of their size component. The Bank's OTS assessment for the year ended December 31, 1998 was approximately $147,000. The OTS also has extensive enforcement authority over all savings institutions and their holding companies, including the Bank and HMN. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS. Except under certain circumstances, public disclosure of final enforcement actions by the OTS is required. In addition, the investment, lending and branching authority of the Bank is prescribed by federal laws and regulations, and it is prohibited from engaging in any activities not permitted by such laws and regulations. For instance, no savings institution may invest in non-investment grade corporate debt securities. In addition, unless approved by the OTS, the permissible level of investment by federal associations in loans secured by non-residential real property may not exceed 400% of regulatory capital. Federal savings associations are also generally authorized to branch nationwide. The Bank is in compliance with the noted restrictions. The Bank's general permissible lending limit for loans-to-one-borrower is equal to the greater of $500,000, or 15%, of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus). At December 31, 1998, the Bank's lending limit under this restriction was $6.9 million. The Bank is in compliance with the loans-to-one borrower limitation. In December 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted into law. FDICIA provides for, among other things, the recapitalization of the Bank Insurance Fund; adoption of safety and soundness standards; enhanced federal supervision of depository institutions, including greater authority for the appointment of a conservator or receiver for undercapitalized institutions; the establishment of risk-based deposit insurance premiums; liberalization of the qualified thrift lender test; greater restrictions on transactions with affiliates; and mandated consumer protection disclosures with respect to deposit accounts. See "- Insurance of Accounts and Regulation by the FDIC," "- Regulatory Capital Requirements" and "- Qualified Thrift Lender Test." The OTS, as well as the other federal banking agencies, have issued proposed safety and soundness standards on matters such as credit underwriting and loan documentation, internal controls and audit systems, interest rate risk exposure, asset growth and quality, compensation and other employee benefits and year 2000 issues. The proposal also establishes the maximum ratio of classified assets to total capital (which for this purpose 30 includes loss allowances exceeding the amount includable for regulatory capital purposes) at 100% and the minimum level of earnings sufficient to absorb losses without impairing capital. Earnings will be sufficient if the net income over the last four quarters is assumed to continue over the next four quarters and the institution would otherwise remain in capital compliance. Any institution which fails to comply with these standards must submit a compliance plan. A failure to submit a plan or to comply with an approved plan will subject the institution to further enforcement action. The Bank is subject to a wide array of other laws and regulations, both federal and state, including, but not limited to, usury laws, the Community Reinvestment Act and regulations thereunder, the Equal Credit Opportunity Act and Regulation B, Regulation E-Electronic Funds Transfer requirements, the Truth-in-Lending Act and Regulation Z, the Real Estate Settlement Procedures Act and Regulation X. The Bank is also subject to laws and regulations that may impose liability on lenders and owners for clean-up costs and other costs stemming from hazardous waste located on property securing real estate loans made by lenders or on real estate that is owned by lenders following a foreclosure or otherwise. INSURANCE OF ACCOUNTS AND REGULATION BY THE FDIC The Bank is a member of the SAIF, which is administered by the FDIC. Savings deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the SAIF. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition. FDICIA required the FDIC to implement a risk-based deposit insurance assessment system. Under the system, all insured depository institutions were placed into one of nine categories and assessed insurance premiums, ranging from .04% to .31% of deposits, based upon their level of capital and supervisory evaluation. Institutions classified as well capitalized (I.E., a core capital ratio of at least 5%, a ratio of Tier 1 or core capital to risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy would pay the lowest premium while institutions that are less than adequately capitalized (I.E., core and Tier 1 risk-based capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern would pay the highest premium. Risk classification of all insured institutions will be made by the FDIC for each semi-annual assessment period. The FDIC is authorized to increase assessment rates, on a semi-annual basis, if it determines that the reserve ratio of the SAIF will be less than the designated reserve ratio of 1.25% of SAIF insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. In addition, under FDICIA, the FDIC may impose special assessments on SAIF members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC. The Deposit Insurance Fund Act of 1996 (DIFA) was enacted on September 30, 1996. DIFA addressed the inadequate funding of the (SAIF). In order to recapitalize the SAIF, DIFA imposed a one-time assessment on all thrift institutions. The Bank's assessment was a pretax charge of $2,351,563 and was recognized in the third quarter of 1996. DIFA also addressed the funding for the Financing Corp. (FICO) bonds. Thrifts will pay 6.4 basis points per $100 of deposits from January 1, 1997 to December 31, 1999. From January 1, 2000 until the 31 FICO bonds are retired in 2019, the estimated assessment to retire the FICO bonds is expected to be 2.5 basis points per $100 of deposits. DIFA proposed that the Bank Insurance Fund (BIF) and SAIF be merged on January 1, 1999, provided no insurance depository institution is a savings association on that date. At this time, HMN does not know what effect, if any, the proposed legislation or charter revisions will have on future operations. REGULATORY CAPITAL REQUIREMENTS Federally insured savings associations, such as the Bank, are required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a tangible capital requirement, a leverage ratio (or core capital) requirement and a risk-based capital requirement applicable to such savings associations. These capital requirements must be generally as stringent as the comparable capital requirements for national banks. The OTS is also authorized to impose capital requirements in excess of these standards on individual associations on a case-by-case basis. The capital regulations require tangible capital of at least 1.5% of adjusted total assets (as defined by regulation). Tangible capital generally includes common stockholders' equity and retained earnings, and certain noncumulative perpetual preferred stock. In addition, all intangible assets, other than a limited amount of purchased mortgage servicing rights, must be deducted from tangible capital. At December 31, 1998, the Bank had goodwill and other intangibles of $5.6 million and $264,000 of mortgage servicing rights which were required to be deducted from stockholders' equity to arrive at tangible capital and Tier I capital. The OTS regulations establish special capitalization requirements for savings associations that own subsidiaries. Under these regulations certain subsidiaries are consolidated for capital purposes and others are excluded from assets and capital. In determining compliance with the capital requirements, all subsidiaries engaged solely in activities permissible for national banks or engaged in certain other activities solely as agent for its customers, or meeting other criteria, are "includable" subsidiaries that are consolidated for capital purposes in proportion to the association's level of ownership, including the assets of includable subsidiaries in which the association has a minority interest that is not consolidated for GAAP purposes. For excludable subsidiaries the debt and equity investments in such subsidiaries are deducted from assets and capital. The subsidiary of the Bank is an includable subsidiary. At December 31, 1998, the Bank had tangible capital of $42.8 million, or 6.4% of adjusted total assets, which is $16.0 million above the minimum requirement of 1.5% of adjusted total assets in effect on that date. The capital standards also require core capital or Tier I capital to equal at least 3% of adjusted total assets (as defined by regulation). Core capital generally consists of tangible capital plus certain intangible assets. As a result of the prompt corrective action provisions of FDICIA discussed below, however, a savings association must maintain a core capital ratio of at least 4% to be considered adequately capitalized unless its supervisory condition is such to allow it to maintain a 3% ratio. The OTS regulations only allow those savings associations rated a composite one (the highest rating) under the safety and soundness rating system for savings associations to be permitted to operate at or near the regulatory minimum leverage ratio of 3%. All other savings associations are required to maintain a Tier I capital to adjusted total assets of 4% to 5%. The OTS assesses each individual savings association through the supervisory process on a case-by-case basis to determine the applicable requirement. The Bank is also required to have a Tier I capital ratio to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. For example, the OTS has assigned a risk weight of 50% for prudently underwritten permanent one-to-four family first lien mortgage loans not more than 90 days delinquent and having a loan to value ratio of not more than 80% at origination 32 unless insured to such ratio by an insurer approved by the FNMA or the FHLMC. At December 31, 1998, the Bank had Tier I capital equal to $42.8 million, or 6.4%, of adjusted total assets, which is $16.0 million above the minimum Tier I ratio requirement of 4% based upon the Bank's composite rating. At December 31, 1998, the Bank had a Tier I capital to risk-weighted assets ratio of 12.9%, which is $29.5 million above the minimum requirement of $13.3 million. The OTS risk-based requirement requires savings associations to have total capital of at least 8% of risk-weighted assets. Total capital consists of core capital, as defined above, and supplementary capital. Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary capital may be used to satisfy the risk-based requirement only to the extent of core capital. At December 31, 1998, the Bank had $3.0 million of general loss reserves, which were included in capital. Certain exclusions from capital and assets are required to be made for the purpose of calculating total capital, in addition to the adjustments required for calculating core capital. Such exclusions consist of equity investments (as defined by regulation) and that portion of land loans and nonresidential construction loans in excess of an 80% loan-to-value ratio and reciprocal holdings of qualifying capital instruments. At December 31, 1998 the Bank had $22,000 of exclusions from capital. On December 31, 1998, the Bank had total "risk-based" capital of $45.8 million and risk-weighted assets of $332.7 million, or total capital of 13.8% of risk-weighted assets. This amount was $19.2 million above the 8% requirement in effect on that date. Under FDICIA, all the federal banking agencies, including the OTS, were required to revise their risk-based capital requirements to ensure that such requirements account for interest rate risk, concentration of credit risk and the risks of non-traditional activities, and that they reflect the actual performance of and expected loss on multi-family loans. Such standards were adopted with the enactment of FDICIA. The OTS had adopted a rule that required every savings association with more than normal interest rate risk to deduct from its total capital, for purposes of determining compliance with such requirement, an interest rate risk component ("IRR component") equal to 50% of its interest-rate risk exposure multiplied by the present value of its assets. The IRR component is a measure of the potential decline in the net portfolio value ("NPV") of a savings association, greater than 2% of the present value of its assets, based upon a hypothetical 200 basis point increase or decrease in interest rates (whichever results in a greater decline). NPV is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts. The rule provided for a two quarter lag between calculating interest rate risk and recognizing any deduction from capital. The OTS has decided not to require the IRR component to be deducted from the capital calculations of all institutions. It has reserved the right to take the IRR component into account in assessing the capital requirements for an individual institution. On December 1, 1998 the OTS issued Thrift Bulletin 13a ("TB 13a"), Management of Interest Rate Risk, Investment Securities, and Derivatives Activities, which among other things established guidelines for measuring an institution's sensitivity to market risk. TB 13a had a table which examiners should use as a starting point in their analysis of an institution's level of interest rate risk, assuming there were no deficiencies in the institution's risk management practices. Based upon an IRR exposure report prepared by OTS from data submitted by the Bank at December 31, 1998, the Bank was deemed to have "minimal interest rate risk" per the table. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management" in the Annual Report. Pursuant to FDICIA, the federal banking agencies, including the OTS, have adopted regulations authorizing the agencies to require a depository institution to maintain an additional amount of total capital to account for concentration of credit risk and the risk of non-traditional activities. 33 The OTS and the FDIC are authorized and, under certain circumstances, required to take certain actions against associations that fail to meet capital requirements. Effective December 19, 1992, the federal banking agencies, including the OTS, were given additional enforcement authority over undercapitalized depository institutions. The OTS is generally required to take action to restrict the activities of an "undercapitalized association" (generally defined to be one with less than either a 4% Tier 1 to adjusted total assets ratio, a 4% Tier 1 risked-based capital ratio or an 8% risk-based capital ratio). Any such association must submit a capital restoration plan and until such plan is approved by the OTS may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The OTS is authorized to impose the additional restrictions, discussed below, that are applicable to significantly undercapitalized associations. As a condition to the approval of the capital restoration plan, any company controlling an undercapitalized association must agree that it will enter into a limited capital maintenance guarantee with respect to the institution's achievement of its capital requirements. Any savings association that fails to comply with its capital plan or is "significantly undercapitalized" (I.E., Tier 1 risk-based or Tier I to adjusted total assets of less than 3% or a risk-based capital ratio of less than 6%) must be made subject to one or more additional specified actions and operating restrictions mandated by FDICIA. These actions and restrictions include requiring the issuance of additional voting securities; limitations on asset growth; mandated asset reduction; changes in senior management; divestiture, merger or acquisition of the association; restrictions on executive compensation; and any other action the OTS deems appropriate. An association that becomes "critically undercapitalized" (I.E., a tangible equity to total asset ratio of 2% or less) is subject to further mandatory restrictions on its activities in addition to those applicable to significantly undercapitalized associations. In addition, the OTS must appoint a receiver (or conservator with the concurrence of the FDIC) for a savings association, with certain limited exceptions, within 90 days after it becomes critically undercapitalized. Any undercapitalized association is also subject to other possible enforcement actions by the OTS or the FDIC. Such actions could include a capital directive, a cease-and-desist order, civil money penalties, the establishment of restrictions on all aspects of the association's operations, the appointment of a receiver or conservator or a forced merger into another institution. If the OTS determines that an association is in an unsafe or unsound condition, or is engaged in an unsafe or unsound practice, it is authorized to reclassify a well-capitalized association as an adequately capitalized association, and if the association is adequately capitalized, to impose the restrictions applicable to an undercapitalized association. If the association is undercapitalized, the OTS is authorized to impose the restrictions applicable to a significantly undercapitalized association. The imposition by the OTS or the FDIC of any of these measures on the Bank may have a substantial adverse effect on the Bank's operations and profitability and the value of HMN's stock. HMN shareholders do not have preemptive rights, and therefore, if HMN is directed by the OTS or the FDIC to issue additional shares of common stock, such issuance may result in the dilution in the percentage of ownership of existing stockholders of HMN. At December 31, 1998 the Bank would be considered to be "well capitalized" under the prompt corrective actions provisions mentioned above. See Note 20 "Federal Home Loan Bank Investment, Regulatory Liquidity and Regulatory Capital Requirements" in the Notes to Consolidated Financial Statements in the Annual Report for more information on the Bank's capital. 34 LIMITATIONS ON DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS OTS regulations impose various restrictions or requirements on associations with respect to their ability to pay dividends or make other distributions of capital. OTS regulations prohibit an association from declaring or paying any dividends or from repurchasing any of its stock if, as a result, the regulatory capital of the association would be reduced below the amount required to be maintained for the liquidation account established in connection with its mutual to stock conversion. The OTS utilizes a three-tiered approach to permit associations, based on their capital level and supervisory condition, to make capital distributions which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account. See "- Regulatory Capital Requirements." Generally, Tier 1 associations, which are associations that before and after the proposed distribution meet their fully phased-in capital requirements, may generally make capital distributions during any calendar year equal to the greater of 100% of net income for the year-to-date plus 50% of the amount by which the lesser of the association's tangible, core or risk-based capital exceeds its fully phased-in capital requirement for such capital component, as measured at the beginning of the calendar year, or the amount authorized for a Tier 2 association. However, a Tier 1 association deemed to be in need of more than normal supervision by the OTS may be downgraded to a Tier 2 or Tier 3 association as a result of such a determination. The Bank meets the requirements for a Tier 1 association and has not been notified of a need for more than normal supervision. Tier 2 associations, which include associations that before and after the proposed distribution meet their current minimum capital requirements, may generally make capital distributions of up to 75% of net income over the most recent four quarter period. Tier 3 associations (which are associations that do not meet current minimum capital requirements) that propose to make any capital distribution and Tier 2 associations that propose to make a capital distribution in excess of the noted safe harbor level must obtain OTS approval prior to making such distribution. Tier 2 associations proposing to make a capital distribution within the safe harbor provisions and Tier 1 associations proposing to make any capital distribution need only submit written notice to the OTS 30 days prior to such distribution. As a subsidiary of HMN, the Bank will also be required to give the OTS 30 days' notice prior to declaring any dividend on its stock. The OTS may object to the distribution during that 30-day period based on safety and soundness concerns. See "- Regulatory Capital Requirements." The OTS has promulgated regulations that revise the current capital distribution restrictions. These regulations become effective on April 1, 1999. The regulations eliminate the current tiered structure and the safe-harbor percentage limitations. Under the regulations, a savings association that is a subsidiary of a holding company, like the Bank, must file either a notice or an application 30 days before declaring a dividend or seeking board approval of a capital distribution. A notice is required unless a savings association (that is a holding company subsidiary) is not eligible for expedited treatment under OTS regulation or would not be adequately capitalized after the distribution, or the distribution would cause the association's distributions for the calendar year to exceed its net income for the year to date plus retained net income for the prior two years, or the distribution is otherwise contrary to statute, regulation or regulatory agreement or condition. If any of these conditions exist, then an application must be filed with the OTS. As under the current rule, the OTS may object to a capital distribution if it would constitute an unsafe or unsound practice. In March of 1999, the Bank received notification from the OTS that subject to certain restrictions (which could only be calculated at the time of distribution) a dividend from the Bank to HMN of $4.0 million could be paid during 1999 and not violate the dividend limitations mentioned above. 35 LIQUIDITY All savings associations, including the Bank, are required to maintain an average daily balance of liquid assets equal to a certain percentage of the sum of its average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. For a discussion of what the Bank includes in liquid assets, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity" in the Annual Report. This liquid asset ratio requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings associations. At the present time, the minimum liquid asset ratio is 4% or an amount that would be required to operate the Bank in a safe and sound manner. ACCOUNTING An OTS policy statement applicable to all savings associations clarifies and re-emphasizes that the investment activities of a savings association must be in compliance with approved and documented investment policies and strategies, and must be accounted for in accordance with GAAP. Under the policy statement, management must support its classification of and accounting for loans and securities (I.E., whether held to maturity, sale or trading) with appropriate documentation. The Bank is in compliance with these amended rules. The OTS has adopted an amendment to its accounting regulations, which may be made more stringent than GAAP, to require that transactions be reported in a manner that best reflects their underlying economic substance and inherent risk and that financial reports must incorporate any other accounting regulations or orders prescribed by the OTS. QUALIFIED THRIFT LENDER TEST All savings associations, including the Bank, are required to meet a qualified thrift lender ("QTL") test to avoid certain restrictions on their operations. This test requires a savings association to have at least 65% of its portfolio assets (which consists of total assets less intangibles, properties used to conduct the savings association's business and liquid assets not exceeding 20% of total assets) in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. For HMN such assets primarily consist of residential housing related loans and investments. At December 31, 1998, the Bank met the test and has always met the test since its effectiveness. Any savings association that fails to meet the QTL test must convert to a national bank charter, unless it requalifies as a QTL and thereafter remains a QTL. If an association does not requalify and converts to a national bank charter, it must remain SAIF-insured until the FDIC permits it to transfer to the Bank Insurance Fund. If an association that fails the test has not yet requalified and has not converted to a national bank, its new investments and activities are limited to those permissible for both a savings association and a national bank, and it is limited to national bank branching rights in its home state. In addition, the association is subject to national bank limits for payment of dividends. If such association has not requalified or converted to a national bank within three years after the failure, it must divest of all investments and cease all activities not permissible for a national bank. In addition, it may have to repay promptly any outstanding FHLB borrowings, which could result in prepayment penalties or purchase additional FHLB stock to meet the stockholder requirements of non-QTL members. If any association that fails the QTL test is controlled by a holding company, then within one year after the failure, the holding company must register as a bank holding company and become subject to all restrictions on bank holding companies. See "- Holding Company Regulation." 36 TRANSACTIONS WITH AFFILIATES Generally, transactions between a savings association or its subsidiaries and its affiliates are required to be on terms as favorable to the association as transactions with non-affiliates. In addition, certain of these transactions are restricted to a percentage of the association's capital. Affiliates of the Bank include HMN and any company which is under common control with the Bank. In addition, a savings association may not lend to any affiliate engaged in activities not permissible for a bank holding company, acquire the securities of most affiliates, or purchase low quality assets from affiliates. The Bank's subsidiaries are not deemed affiliates, however, the OTS has the discretion to treat subsidiaries of savings associations as affiliates on a case by case basis. Certain transactions with directors, officers or controlling persons are also subject to conflict of interest regulations enforced by the OTS. These conflict of interest regulations and other statutes also impose restrictions on loans to such persons and their related interests. Among other things, such loans must be made on terms substantially the same as for loans to unaffiliated individuals. HOLDING COMPANY REGULATION HMN is a unitary savings and loan holding company subject to regulatory oversight by the OTS. As such, HMN is registered and required to file reports with and subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over HMN and its non-savings association subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings association. As a unitary savings and loan holding company, HMN generally is not subject to activity restrictions. If HMN acquires control of another savings association as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of HMN and any of its subsidiaries (other than the Bank or any other SAIF-insured savings association) would become subject to such restrictions unless such other associations qualify as QTLs and were acquired in a supervisory acquisition. If the Bank fails the QTL test, HMN must obtain the approval of the OTS prior to continuing after such failure, directly or through its other subsidiaries, any business activity other than those approved for multiple savings and loan holding companies or their subsidiaries. In addition, within one year of such failure HMN must register as, and will become subject to, the restrictions applicable to bank holding companies. The activities authorized for a bank holding company are more limited than are the activities authorized for a unitary or multiple savings and loan holding company. See "- Qualified Thrift Lender Test." HMN must obtain approval from the OTS before acquiring control of any other SAIF-insured association. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings association. FEDERAL SECURITIES LAW The stock of HMN is registered with the SEC under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). HMN is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act. HMN stock held by persons who are affiliates (generally officers, directors and principal stockholders) of HMN may not be resold without registration or unless sold in accordance with certain resale restrictions. If HMN meets specified current public information requirements, each affiliate of HMN is able to sell in the public market, without registration, a limited number of shares in any three-month period. 37 FEDERAL RESERVE SYSTEM The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW and Super NOW checking accounts). At December 31, 1998, the Bank was in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements that may be imposed by the OTS. See "- Liquidity." Savings associations are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require associations to exhaust other reasonable alternative sources of funds, including FHLB borrowings, before borrowing from the Federal Reserve Bank. FEDERAL HOME LOAN BANK SYSTEM The Bank is a member of the FHLB of Des Moines, which is one of 12 regional FHLBs, that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (I.E., advances) in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. In addition, all long-term advances are required to provide funds for residential home financing. As a member, the Bank is required to purchase and maintain stock in the FHLB of Des Moines. At December 31, 1998, the Bank had $9.8 million in FHLB stock, which was in compliance with this requirement. In past years, the Bank has received dividends on its FHLB stock. Over the past five calendar years such dividends have averaged 7.07% and were 6.62% for calendar year 1998. For the year ended December 31, 1998, dividends paid by the FHLB of Des Moines to the Bank totaled $589,000. Under federal law the FHLBs are required to provide funds for the resolution of troubled savings associations and to contribute to low and moderately priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have affected adversely the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of the Bank's FHLB stock may result in a corresponding reduction in the Bank's capital. FEDERAL AND STATE TAXATION FEDERAL TAXATION. HMN and its subsidiaries file consolidated federal income tax returns on a calendar year basis using the accrual method of accounting. Prior to 1996, savings institutions were subject to special bad debt reserve rules and certain other rules. During this period of time, a savings institution that held 60% or more of its assets in "qualifying assets" (as defined in the Internal Revenue Code) was permitted to maintain reserves for bad debts and to make annual additions to such reserves that qualified as deductions from taxable income. HMN was in compliance with this requirement. A qualifying thrift institution could elect annually to compute its allowable additions to bad debt reserves under either the percentage of taxable income method or the experience method. The percentage of taxable income method of calculating bad debt reserves limited the applicable percentage deduction to 8% of taxable income and could not cause the reserves to exceed 6% of qualifying loans at the end of the taxable year. HMN used the experience method to calculate additions to tax bad debt reserves through tax year 1995. 38 Beginning in 1996, the favorable bad debt method described above was repealed putting savings institutions on the same tax bad debt method as commercial banks. This legislation required recapture of the amount of the tax bad debt reserves to the extent that they exceed the adjusted base year reserve ("the applicable excess reserves"). The applicable excess reserves are recaptured over a six-year period. This recapture period can be deferred for a period of up to two years to the extent that a certain residential lending test is met. HMN has previously provided taxes for the applicable excess reserves. In addition to the regular income tax, corporations, including savings associations such as the Bank, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20% on alternative minimum taxable income, which is the sum of a corporation's regular taxable income (with certain adjustments) and tax preference items, less any available exemption. The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax and net operating losses can offset no more than 90% of alternative minimum taxable income. To the extent earnings appropriated to a savings association's bad debt reserves for "qualifying real property loans" and deducted for federal income tax purposes before 1988 exceed the allowable amount of such reserves computed under the experience method and to the extent of the association's supplemental reserves for losses on loans ("Excess"), such Excess may not, without adverse tax consequences, be utilized for the payment of cash dividends or other distributions to a shareholder (including distributions on redemption, dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). As of December 31, 1998, the Bank's Excess for tax purposes totaled approximately $8.8 million. HMN was incorporated in 1994 and filed its first consolidated Federal income tax return with its subsidiaries for the year ended December 31, 1994. The return required to be filed for 1998 has been extended and will be filed by September 1999. The Bank and its consolidated subsidiaries have been audited by the IRS with respect to consolidated federal income tax returns through December 31, 1983. With respect to years examined by the IRS, either all deficiencies have been satisfied or sufficient reserves have been established to satisfy asserted deficiencies. In the opinion of management, any examination of still open returns (including returns of subsidiaries and predecessors of, or entities merged into, the Bank) would not result in a deficiency which could have a material adverse effect on the consolidated financial condition of HMN. MINNESOTA TAXATION. HMN and its subsidiaries that operate in Minnesota are subject to Minnesota state taxation. A Minnesota corporation's income or loss is allocated based on a three-factor apportionment of the corporation's Minnesota gross receipts, payroll and property over the total gross receipts, payroll and property of all corporations in the unitary group. The corporate tax rate in Minnesota is 9.8%. The Minnesota Alternative Minimum Tax rate is 5.8%. The Bank and it subsidiaries have not been audited by the Minnesota taxation authorities. IOWA TAXATION. On December 5, 1997 the Bank acquired MFC and its subsidiaries which were located in the state of Iowa. The Bank is now subject to Iowa Franchise tax on an apportionment basis weighted based upon deposits located within Iowa to total deposits of the Bank. Income apportioned to Iowa is subject to a 5% tax rate. DELAWARE TAXATION. As a Delaware holding company, HMN is exempted from Delaware corporate income tax but is required to file an annual report with and pay an annual fee to the State of Delaware. HMN is also subject to an annual franchise tax imposed by the State of Delaware. 39 ITEM 2. PROPERTIES The following table sets forth information concerning the main office and each branch office of HMN at December 31, 1998. At December 31, 1998, HMN's premises had an aggregate net book value of approximately $4.6 million. Year Owned or Net Book Value at Location Acquired Leased December 31, 1998(1) - -------------------------- -------- -------- -------------------- (In Thousands) CORPORATE OFFICE: 101 North Broadway 1975 Owned 336 Spring Valley, Minnesota FULL SERVICE BRANCHES: 715 North Broadway 1998 Owned 1,107 Spring Valley, Minnesota 201 Oakland Avenue 1960 Owned 157 Austin, Minnesota Crossroads Shopping Center 1962 Owned 481 Rochester, Minnesota 4th & Center (2) 1973 Owned 111 Winona, Minnesota 175 Center Street 1998 Owned 1,751 Winona, Minnesota 208 South Walnut 1975 Owned 86 LaCrescent, Minnesota 1110 6th St., NW 1982 Owned 849 Rochester, Minnesota 143 West Clark Street 1993 Owned 568 Albert Lea, Minnesota 303 W. Main St. 1997 Owned 694 Marshalltown, Iowa 110 W. High St. 1997 Leased 2 Toledo, Iowa 29 S. Center 1997 Owned 245 Marshalltown, Iowa MORTGAGE BANKING/BROKERAGE OFFICES: 7101 Northland Circle, Suite 105 1997 Leased -- Brooklyn Park, Minnesota - --------------- (1) Does not include $2,174,857 of net furniture and equipment distributed between all of the above offices or its subsidiaries. (2) The property is the old bank building in Winona and is currently being held for sale. The portions of the property are being rented on a month to month basis to tenants. 40 The Bank's depositor and borrower customer files are maintained by an independent data processing company. The net book value of the data processing and computer equipment utilized by the Bank at December 31, 1998 was approximately $462,882. ITEM 3. LEGAL PROCEEDINGS From time to time, the Bank and HMN are involved as plaintiff or defendant in various legal proceedings arising in the normal course of its business. While the ultimate outcome of these various legal proceedings cannot be predicted with certainty, it is the opinion of management that the resolution of these legal actions should not have a material effect on HMN's consolidated financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The information on pages 21, 52 and the back cover page of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA The information on page 11 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information on pages 12 through 28 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The information on pages 23 through 24 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information on pages 29 through 52 of the Annual Report to Security Holders for the year ended December 31, 1998 is incorporated herein by reference. 41 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information on pages 4 through 5 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein by reference. See "Business - Executive Officers" in Part I of the Form 10-K for information regarding executive officers. ITEM 11. EXECUTIVE COMPENSATION The information on pages 8 through 12 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein be reference, except for information contained under the heading "Compensation Committee Report on Executive Compensation". ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information on pages 2, 3 and 15 of the Registrant's definitive Proxy Statement dated March 23, 1999 is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS 1. Financial Statements The following information appearing in the Registrant's Annual Report to Security Holders for the year ended December 31, 1998, is incorporated by reference in this Form 10-K Annual Report as Exhibit 13. Pages in 1998 Annual Annual Report Section Report --------------------- ----------- Five Year Consolidated Financial Highlights 11 Consolidated Balance Sheets -- December 31, 1998 and 1997 29 Consolidated Statements of Income -- Each of the Years in the Three-Year Period Ended December 31, 1998 30 Consolidated Statements of Comprehensive Income -- Each of the Years in the Three-Year Period Ended December 31, 1998 30 Consolidated Statement of Stockholders' Equity -- Each of the Years in the Three-Year Period Ended December 31, 1998 31 Consolidated Statements of Cash Flows -- Each of the Years in the Three-Year Period Ended December 31, 1998 32 Notes to Consolidated Financial Statements 33 - 48 Independent Auditors' Report 49 Selected Quarterly Financial Data 50 - 51 Other Financial Data 52 Common Stock Price Information 52 2. Financial Statement Schedules All financial statement schedules have been omitted as information is not required under the related instructions, is not applicable or has been included in the Notes to Consolidated Financial Statements. 43 3. Exhibits 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-K Report - -------------- ------------------------------------------- --------------- ------------------- 2 Agreement and Plan of Merger 5* Not applicable dated July 1, 1997 3 (i) Articles of Incorporation 1* Not applicable Certificate of Incorporation as amended 7* on April 28, 1998 (ii) By-laws 6* Not applicable 4 Instruments defining the rights of security 1* Not applicable holders, including indentures 9 Voting trust agreement Not applicable Not applicable 10.1+ Employment Agreement for Mr. Weise 2* Not applicable dated June 29, 1994 Extension of Employment Contract 8* Not applicable 10.2+ Employment Agreement for Mr. Gardner 2* Not applicable dated June 29, 1994 Extension of Employment Contract 8* Not applicable 10.3+ Change in Control Severance Agreement 10.3 Filed electronically for Mr. McNeil dated April 1, 1998 10.4+ Directors Deferred Compensation Plan 2* Not applicable 10.5+ 1995 Recognition and Retention Plan 3* Not applicable Amended and Restated HMN Financial, Inc. 9* Not applicable Recognition and Retention Plan dated July 29, 1998 10.6+ 1995 Stock Option and Incentive Plan 3* Not applicable Amended and Restated HMN Financial, Inc. 9* Not applicable Stock Option and Incentive Plan dated July 29, 1998 11 Statement re: Computation of per share 11 Filed electronically earnings 12 Statement re: Computation of ratios Not applicable Not applicable +Management contract of compensatory arrangement. 44 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-K Report - -------------- ------------------------------------------- --------------- ------------------- 13 Annual Report to Security Holders 13 Filed electronically 16 Letter re: Change in certifying accountant Not applicable Not applicable 18 Letter re: Change in accounting principles Not applicable Not applicable 21 Subsidiaries of Registrant 21 Filed electronically 22 Published report regarding matters Not applicable Not applicable submitted to vote of security holders 23 Consent of KPMG Peat Marwick LLP 23 Filed electronically dated March 30, 1999 24 Power of Attorney Not applicable Not applicable 27 Financial Data Schedule 27 Filed electronically Year ended 1998 99 Additional exhibits None Not applicable - ------------------ 1* Filed April 1, 1994, as exhibits to the Registrant's Form S-1 registration statement (Registration No. 33-77212) pursuant to the Securities Act of 1933. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K. 2* Filed as an exhibit to the Registrant's Form 10-K for 1994 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 3* Filed as an exhibit to the Registrant's Form 10-K for 1995 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 4* Filed as an exhibit to the Registrant's Form 10-K for 1996 (file no. 0-24100). All previously filed documents are hereby incorporated by reference in accordance with Item 601 of Regulation S-K. 5* Filed as an exhibit to Current Report of Form 8-K dated July 1, 1997, filed on July 10, 1997. All previously filed documents are hereby incorporated by reference. 6* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of 1997 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 7* Filed as an exhibit to the Registrant's Form 10-Q for the first quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 8* Filed as an exhibit to the Registrant's Form 10-Q for the second quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 9* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of 1998 (file no. 0-24100). All previously filed documents are hereby incorporated by reference. 45 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Date: March 30, 1999 By: /s/ Roger P. Weise ----------------------------- ----------------------------- Roger P. Weise (Duly Authorized Representative) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By: /s/ Roger P. Weise By: /s/ James B. Gardner ----------------------------- ----------------------------- Roger P. Weise, Chairman of James B. Gardner, the Board, President and Chief Executive Vice President Executive Officer (Principal and Director Executive and Operating Officer) (Principal Financial Officer) Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ Irma R. Rathbun By: /s/ Timothy R. Geisler ----------------------------- ----------------------------- Irma R. Rathbun, Director Timothy R. Geisler, Director Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ M. F. Schumann By: /s/ Duane D. Benson ----------------------------- ----------------------------- M.F. Schumann, Director Duane D. Benson, Director Date: March 30, 1999 Date: March 30, 1999 ----------------------------- ----------------------------- By: /s/ Timothy P. Johnson ----------------------------- Timothy P. Johnson, Vice President and Treasurer (Principal Accounting Officer) Date: March 30, 1999 ----------------------------- 46 INDEX TO EXHIBITS Sequential Page Numbering Where Attached Exhibits Are Regulation S-K Located in This Exhibit Number Document Form 10-K Report - -------------- --------- ------------------- 10.3 Change in Control Severence Agreement for Filed electronically Michael McNeil dated April 1, 1998 11 Statement re: Computation of per share earnings Filed electronically 13 Annual Report to Security Holders Filed electronically 21 Subsidiaries of Registrant Filed electronically 23 Consent of KPMG Peat Marwick LLP Filed electronically dated March 30, 1999 27 Financial Data Schedule Filed electronically Year ended 1998