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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
OR
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 0-24100
HMN FINANCIAL, INC.
(Exact name of Registrant as specified in its Charter)
Delaware 41-1777397
- -------------------------------- ----------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
1016 Civic Center Drive NW, Rochester, Minnesota 55901
------------------------------------------------ -----
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (507) 535-1200
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes |X| No | |
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes | | No |X|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at July 29, 2004
----------------------------- ----------------------------
Common stock, $0.01 par value 4,456,864
HMN FINANCIAL, INC.
CONTENTS
PART I - FINANCIAL INFORMATION
Page
----
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at
June 30, 2004 and December 31, 2003............................. 3
Consolidated Statements of Income for the
Three Months Ended and Six Months Ended June 30, 2004 and 2003.. 4
Consolidated Statements of Comprehensive Income for the
Three Months Ended and Six Months Ended June 30, 2004 and 2003.. 5
Consolidated Statement of Stockholders' Equity
for the Six Month Period Ended June 30, 2004.................... 5
Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2004 and 2003..................... 6
Notes to Consolidated Financial Statements...................... 7-14
Item 2: Management's Discussion and Analysis of Financial
Condition and Results of Operations............................. 15-23
Item 3: Quantitative and Qualitative Disclosures about Market Risk
Discussion included in Item 2 under Market Risk................. 21
Item 4: Controls and Procedures............................................. 23
PART II - OTHER INFORMATION
Item 1: Legal Proceedings................................................... 24
Item 2: Changes in Securities and Use of Proceeds........................... 24
Item 3: Defaults Upon Senior Securities..................................... 24
Item 4: Submission of Matters to a Vote of Security Holders................. 24
Item 5: Other Information................................................... 25
Item 6: Exhibits and Reports on Form 8-K.................................... 25
Signatures ................................................................. 26
2
Part I - FINANCIAL INFORMATION
Item 1: Financial Statements
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)
June 30, December 31,
2004 2003
------------ ------------
ASSETS
Cash and cash equivalents ................................. $ 41,638,817 30,496,823
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $10,668,580 and $13,707,005) .......... 9,882,177 13,048,718
Other marketable securities
(amortized cost $100,739,558 and $91,035,285) ........ 99,947,189 91,615,047
------------ ------------
109,829,366 104,663,765
------------ ------------
Loans held for sale ....................................... 3,766,543 6,542,824
Loans receivable, net ..................................... 722,800,277 688,951,119
Accrued interest receivable ............................... 3,530,635 3,462,221
Real estate, net .......................................... 254,869 73,271
Federal Home Loan Bank stock, at cost ..................... 9,938,200 10,004,400
Mortgage servicing rights, net ............................ 3,335,516 3,447,843
Premises and equipment, net ............................... 12,454,962 12,110,151
Investment in limited partnerships ........................ 181,258 617,042
Goodwill .................................................. 3,800,938 3,800,938
Core deposit intangible, net .............................. 390,546 447,474
Prepaid expenses and other assets ......................... 1,519,082 2,108,575
Deferred tax assets ....................................... 656,800 0
------------ ------------
Total assets .......................................... $914,097,809 866,726,446
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits .................................................. $627,304,925 551,687,995
Federal Home Loan Bank advances ........................... 198,900,000 203,900,000
Accrued interest payable .................................. 857,492 766,837
Customer escrows .......................................... 878,094 22,457,671
Accrued expenses and other liabilities .................... 5,028,548 6,952,600
Deferred tax liabilities .................................. 0 26,300
------------ ------------
Total liabilities ..................................... 832,969,059 785,791,403
------------ ------------
Commitments and contingencies
Minority interest ......................................... 1,698 3,986
Stockholders' equity:
Serial preferred stock ($.01 par value):
Authorized 500,000 shares; issued and outstanding none 0 0
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662 ....... 91,287 91,287
Additional paid-in capital ................................ 57,673,514 57,863,726
Retained earnings, subject to certain restrictions ........ 88,424,074 85,364,657
Accumulated other comprehensive loss ...................... (1,021,573) (50,725)
Unearned employee stock ownership plan shares ............. (4,641,172) (4,738,084)
Treasury stock, at cost 4,671,798 and 4,616,010 shares .... (59,399,078) (57,599,804)
------------ ------------
Total stockholders' equity ............................ 81,127,052 80,931,057
------------ ------------
Total liabilities and stockholders' equity ................ $914,097,809 866,726,446
============ ============
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- ---------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Interest income:
Loans receivable ......................... $11,486,417 10,243,717 22,977,681 19,883,641
Securities available for sale:
Mortgage-backed and related ........... 92,428 (39,454) 211,292 102,759
Other marketable ...................... 766,391 690,848 1,449,798 1,252,067
Cash equivalents ......................... 40,042 56,980 66,340 85,897
Other .................................... 41,398 84,033 77,820 182,684
----------- ----------- ----------- -----------
Total interest income ................. 12,426,676 11,036,124 24,782,931 21,507,048
----------- ----------- ----------- -----------
Interest expense:
Deposits ................................. 2,894,319 2,492,554 5,824,353 4,963,817
Federal Home Loan Bank advances .......... 2,165,680 2,615,630 4,354,635 5,094,302
----------- ----------- ----------- -----------
Total interest expense ................ 5,059,999 5,108,184 10,178,988 10,058,119
----------- ----------- ----------- -----------
Net interest income ................... 7,366,677 5,927,940 14,603,943 11,448,929
Provision for loan losses ................... 447,000 490,000 1,266,000 1,355,000
----------- ----------- ----------- -----------
Net interest income after provision
for loan losses ..................... 6,919,677 5,437,940 13,337,943 10,093,929
----------- ----------- ----------- -----------
Non-interest income:
Fees and service charges ................. 704,651 555,036 1,273,201 987,176
Mortgage servicing fees .................. 290,849 238,729 578,080 455,305
Securities gains, net .................... 1,361 224,751 1,361 815,786
Gains on sales of loans .................. 506,862 1,526,558 919,231 2,991,790
Earnings (losses) in limited partnerships (6,500) 31,528 (13,117) (323,314)
Other .................................... 183,048 114,694 457,797 335,794
----------- ----------- ----------- -----------
Total non-interest income ............. 1,680,271 2,691,296 3,216,553 5,262,537
----------- ----------- ----------- -----------
Non-interest expense:
Compensation and benefits ................ 2,581,764 2,027,572 5,110,242 4,307,074
Occupancy ................................ 871,170 769,518 1,755,772 1,593,317
Deposit insurance premiums ............... 27,794 17,855 46,499 36,791
Advertising .............................. 87,850 100,988 175,396 185,852
Data processing .......................... 228,721 289,938 419,286 561,046
Amortization of mortgage servicing
rights, net of valuation adjustments and
servicing costs ........................ 302,184 1,108,101 555,633 1,898,631
Other .................................... 897,762 867,136 1,860,336 1,811,687
----------- ----------- ----------- -----------
Total non-interest expense ............ 4,997,245 5,181,108 9,923,164 10,394,398
----------- ----------- ----------- -----------
Income before income tax expense ...... 3,602,703 2,948,128 6,631,332 4,962,068
Income tax expense .......................... 1,105,500 917,900 2,016,000 1,542,300
----------- ----------- ----------- -----------
Income before minority interest ....... 2,497,203 2,030,228 4,615,332 3,419,768
Minority interest ........................... 43 0 (2,288) 0
----------- ----------- ----------- -----------
Net income ............................ $ 2,497,160 2,030,228 4,617,620 3,419,768
=========== =========== =========== ===========
Basic earnings per share .................... $ 0.65 0.54 1.19 0.91
=========== =========== =========== ===========
Diluted earnings per share .................. $ 0.62 0.52 1.13 0.87
=========== =========== =========== ===========
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(unaudited)
Three Months Ended June 30,
2004 2003
--------------------------------------- ------------------------------------
Net income $ 2,497,160 2,030,228
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during period (1,457,334) 598,561
Less: reclassification adjustment for gains
included in net income 861 145,351
---------- ---------
Net unrealized gains (losses) on securities (1,458,195) 453,210
---------- ---------
Other comprehensive income (loss) (1,458,195) 453,210
---------- ---------
Comprehensive income $ 1,038,965 2,483,438
========== =========
Six Months Ended June 30,
2004 2003
--------------------------------------- ------------------------------------
Net income $ 4,617,620 3,419,768
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising (969,987) 119,406
during period
Less: reclassification adjustment for gains
included in net income 861 527,386
---------- ---------
Net unrealized losses on securities (970,848) (407,980)
---------- ---------
Other comprehensive loss (970,848) (407,980)
---------- ---------
Comprehensive income $ 3,646,772 3,011,788
========== =========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 2004
(unaudited)
Unearned
Employee
Accumulated Stock Total
Additional Other Ownership Stock-
Common Paid-in Retained Comprehensive Plan Treasury Holders'
Stock Capital Earnings Income (Loss) Shares Stock Equity
----------- ----------- ----------- ------------- ----------- ----------- -----------
Balance, December 31, 2003 $ 91,287 57,863,726 85,364,657 (50,725) (4,738,084) (57,599,804) 80,931,057
Net income 4,617,620 4,617,620
Other comprehensive loss (970,848) (970,848)
Treasury stock purchases (2,180,650) (2,180,650)
Employee stock options
exercised (353,742) 381,376 27,634
Tax benefits of exercised
stock options 19,548 19,548
Dividends paid (1,558,203) (1,558,203)
Earned employee stock
ownership plan shares 143,982 96,912 240,894
----------- ----------- ----------- ------------- ----------- ----------- -----------
Balance, June 30, 2004 91,287 57,673,514 88,424,074 (1,021,573) (4,641,172) (59,399,078) 81,127,052
=========== =========== =========== ============= =========== =========== ===========
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Six Months Ended
June 30,
----------------------------
2004 2003
------------ ------------
Cash flows from operating activities:
Net income .................................................................. $ 4,617,620 3,419,768
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses ................................................. 1,266,000 1,355,000
Depreciation .............................................................. 777,836 799,618
Amortization of premiums (discounts), net ................................. (109,254) 440,052
Amortization of deferred loan fees ........................................ (572,132) (196,435)
Amortization of core deposit intangible ................................... 56,928 55,601
Amortization of mortgage servicing rights and net valuation and
servicing costs ........................................................... 555,633 1,898,631
Capitalized mortgage servicing rights ..................................... (443,307) (1,438,635)
Deferred income taxes ..................................................... (153,700) 0
Securities gains, net ..................................................... (1,361) (815,786)
Losses (gains) on sales of real estate .................................... 19,810 (117,042)
Gains on sales of loans ................................................... (919,231) (2,991,790)
Proceeds from sale of loans held for sale ................................. 50,943,298 165,333,116
Disbursements on loans held for sale ...................................... (47,263,609) (158,242,116)
Principal collected on loans held for sale ................................ 0 11,521
Amortization of unearned ESOP shares ...................................... 96,912 96,714
Earned employee stock ownership shares priced above original cost ......... 143,982 72,356
Increase in accrued interest receivable ................................... (68,414) (251,463)
Increase (decrease) in accrued interest payable ........................... 90,655 (429,926)
Equity losses of limited partnerships ..................................... 13,117 323,314
Equity losses of minority interest ........................................ (2,288) 0
Decrease (increase) in other assets ....................................... 597,761 (367,797)
Increase (decrease) in other liabilities .................................. (1,896,949) 1,221,906
Other, net ................................................................ (22,892) 83,512
------------ ------------
Net cash provided by operating activities ............................... 7,726,415 10,260,119
------------ ------------
Cash flows from investing activities:
Proceeds from sales of securities available for sale ........................ 10,119,950 38,718,290
Principal collected on securities available for sale ........................ 3,152,402 23,346,740
Purchases of securities available for sale .................................. (19,955,262) (46,491,697)
Redemption of interest in limited partnership ............................... 422,474 0
Purchase of Federal Home Loan Bank Stock .................................... (540,300) (84,500)
Redemption of Federal Home Loan Bank Stock .................................. 606,500 0
Net increase in loans receivable ............................................ (34,996,464) (77,775,248)
Proceeds from sale of real estate ........................................... 256,735 0
Proceeds from sale of premises .............................................. 0 221,313
Purchases of premises and equipment ......................................... (1,122,647) (634,383)
------------ ------------
Net cash used by investing activities .................................... (42,056,612) (62,699,485)
------------ ------------
Cash flows from financing activities:
Increase in deposits ........................................................ 75,762,987 30,249,494
Purchase of treasury stock .................................................. (2,180,650) (1,384,560)
Stock options exercised ..................................................... 27,634 876,305
Dividends to stockholders ................................................... (1,558,203) (1,351,340)
Proceeds from Federal Home Loan Bank advances ............................... 16,500,000 116,000,000
Repayment of Federal Home Loan Bank advances ................................ (21,500,000) (99,000,000)
Decrease in customer escrows ................................................ (21,579,577) (86,797)
------------ ------------
Net cash provided by financing activities ................................ 45,472,191 45,303,102
------------ ------------
Increase (decrease) in cash and cash equivalents ......................... 11,141,994 (7,136,264)
Cash and cash equivalents, beginning of period ................................. 30,496,823 27,729,007
------------ ------------
Cash and cash equivalents, end of period ....................................... $ 41,638,817 20,592,743
============ ============
Supplemental cash flow disclosures:
Cash paid for interest ...................................................... $ 10,088,333 10,488,045
Cash paid for income taxes .................................................. 4,554,500 1,152,000
Supplemental noncash flow disclosures:
Loans transferred to loans held for sale .................................... 0 3,077,578
Transfer of loans to real estate ............................................ 434,960 533,277
Transfer of real estate to loans ............................................ 0 16,533
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
JUNE 30, 2004 AND 2003
(1) HMN FINANCIAL, INC.
HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company
that owns 100 percent of Home Federal Savings Bank (the Bank or Home Federal).
The Bank has a community banking philosophy and operates retail banking
facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries,
Osterud Insurance Agency, Inc. (OAI) which offers financial planning products
and services and Home Federal Holding, Inc. (HFH) which is the holding company
for Home Federal REIT, Inc. (HFREIT) which invests in real estate loans acquired
from the Bank. HMN has another wholly owned subsidiary, Security Finance
Corporation (SFC) that acts as an intermediary for the Bank in transacting
like-kind property exchanges for Bank customers. The Bank has an 80% owned
subsidiary, Federal Title Services, LLC (FTS) that performs mortgage title
services for Bank customers. The Bank had a 51% owned subsidiary, Home Federal
Mortgage Services, LLC (HFMS), that was a mortgage banking and mortgage
brokerage business located in Brooklyn Park, Minnesota. HFMS liquidated its
assets during 2003 and was dissolved in the first quarter of 2004.
The consolidated financial statements included herein are for HMN, SFC, the Bank
and the Bank's consolidated entities, OAI, HFH, HFREIT and FTS. All significant
intercompany accounts and transactions have been eliminated in consolidation.
(2) BASIS OF PREPARATION
The accompanying unaudited consolidated financial statements were prepared in
accordance with instructions for Form 10-Q and therefore, do not include all
disclosures necessary for a complete presentation of the consolidated balance
sheets, consolidated statements of income, consolidated statements of
comprehensive income, consolidated statements of stockholders' equity and
consolidated statements of cash flows in conformity with generally accepted
accounting principles. However, all adjustments consisting of only normal
recurring adjustments that are, in the opinion of management, necessary for the
fair presentation of the interim financial statements have been included. The
statements of income for the three and six-month periods ended June 30, 2004 are
not necessarily indicative of the results which may be expected for the entire
year.
Certain amounts in the consolidated financial statements for prior periods have
been reclassified to conform with the current period presentation.
(3) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company has commitments outstanding to extend credit to future borrowers
that had not closed prior to the end of the quarter. The Company intends to sell
these commitments and refers to them as its mortgage pipeline. As commitments to
originate loans enter the mortgage pipeline, generally the Company
simultaneously enters into commitments to sell the mortgage pipeline into the
secondary market. The commitments to originate or sell loans are derivatives. As
a result of marking the mortgage pipeline and the related commitments to sell to
market for the period ended June 30, 2004, the Company recorded a decrease in
other assets of $17,050, a decrease in other liabilities of $8,855 and a net
loss on sale of loans of $8,195.
The current commitments to sell loans held for sale are derivative instruments
that do not qualify for hedge accounting. As a result, these derivatives are
marked to market. The loans held for sale that are not hedged are recorded at
the lower of cost or market. As a result of marking these loans, the Company
recorded a lower of cost or market adjustment in loans held for sale of $24,016,
an increase in other assets of $25,317 and an increase in other liabilities of
$1,301.
(4) COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity during a period from
transactions and other events from nonowner sources. Comprehensive income is the
total of net income and other comprehensive income, which for the Company is
comprised of unrealized gains and losses on securities available for sale.
7
The gross unrealized holding losses on securities for the second quarter of 2004
was $2,253,000, the income tax benefit would have been $795,000 and therefore,
the net loss was $1,458,000. The gross reclassification adjustment for the
second quarter of 2004 was $1,400, the income tax expense would have been $500
and therefore, the net gain was $900. The gross unrealized holding gains on
securities for the second quarter of 2003 was $925,000, the income tax expense
would have been $326,000 and therefore, the net gain was $599,000. The gross
reclassification adjustment for the second quarter of 2003 was $225,000, the
income tax expense would have been $80,000 and therefore, the net gain was
$145,000.
The gross unrealized holding losses on securities for the six month period ended
June 30, 2004 was $1,499,000, the income tax benefit would have been $529,000
and therefore, the net loss was $970,000. The gross reclassification adjustment
in the six month period ended June 30, 2004 was $1,400, the income tax expense
would have been $500 and therefore, the net reclassification adjustment was
$900. The gross unrealized holding gains on securities for the six month period
ended June 30, 2003 was $184,000, the income tax expense would have been $65,000
and therefore, the net gain was $119,000. The gross reclassification adjustment
in the six month period ended June 30, 2003 was $816,000, the income tax expense
would have been $289,000 and therefore, the net reclassification adjustment was
$527,000.
(5) INVESTMENT IN LIMITED PARTNERSHIPS
Investments in limited partnerships were as follows:
June 30, December 31,
Primary partnership activity 2004 2003
- ---------------------------- -------- ------------
Common stock of financial institutions 0 421,671
-------- -------
Low to moderate income housing 181,258 195,371
-------- -------
$181,258 617,042
======== =======
During the second quarter of 2004 the Company recognized $6,500 of losses on the
low-income housing partnerships. The Company's investment in a limited
partnership that invested in the common stock of financial institutions was
liquidated effective December 31, 2003. During 2004 the Company anticipates
receiving low-income housing credits totaling $84,000, of which $21,000 were
credited to current income tax benefits. During the second quarter of 2003 the
Company's proportionate gains from the common stock investments in financial
institutions was $38,027 and it recognized $6,500 of losses on the low income
housing partnerships. During 2003 the Company received low-income housing
credits totaling $84,000, of which $21,000 were credited to income tax benefits
in the second quarter of 2003.
During the six-month period ended June 30, 2004 the Company recognized $13,920
of losses on low-income housing partnerships. During 2004 the Company
anticipates receiving low-income housing credits totaling $84,000 of which
$42,000 were credited to current income tax benefits. During the six month
period ended June 30, 2003 the Company's proportionate gains from common stock
investments in financial institutions was $39,263 and it recognized $13,000 of
losses on low income housing partnerships. During 2003 the Company received
low-income housing credits totaling $84,000 of which $42,000 were credited to
current income tax benefits in the first six month period of 2003.
(6) SECURITIES AVAILABLE FOR SALE
The following table shows the securities available for sale portfolio's gross
unrealized losses and fair value, aggregated by investment category and length
of time that individual securities have been in a continuous loss position, at
June 30, 2004. The Company has reviewed these securities and has concluded that
the unrealized losses are temporary and no other-than-temporary impairment has
occurred at June 30, 2004.
8
Less than twelve months Twelve months or more Total
----------------------- ----------------------- -----------------------
Unrealized Unrealized Unrealized
(Dollars in thousands) Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Mortgage backed securities:
Collateralized mortgage obligations $ 7,745 (749) 1,522 (65) 9,267 (814)
Other marketable securities:
U.S. Agencies 59,809 (670) 0 0 59,809 (670)
Corporate equity 0 0 3,094 (406) 3,094 (406)
------- ------- ------- ------- ------- -------
Total temporarily impaired securities $67,554 (1,419) 4,616 (471) 72,170 (1,890)
======= ======= ======= ======= ======= =======
(7) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Six Months ended Twelve Months ended Six Months ended
June 30, 2004 December 31, 2003 June 30, 2003
---------------- ------------------- ----------------
Mortgage servicing rights
Balance, beginning of period ........ $ 3,447,843 2,701,031 2,701,031
Originations ........................ 443,307 2,522,231 1,438,635
Amortization ........................ (555,634) (1,775,419) (881,714)
----------- ---------- ----------
Balance, end of period .............. 3,335,516 3,447,843 3,257,952
----------- ---------- ----------
Valuation reserve
Balance, beginning of period .......... 0 (10,000) (10,000)
Additions ............................. 0 (800,000) (800,000)
----------- ---------- ----------
Reductions ............................ 0 810,000 0
----------- ---------- ----------
Balance, end of period ................ 0 0 (810,000)
Mortgage servicing rights, net ........ $ 3,335,516 3,447,843 2,447,952
=========== ========== ==========
Fair value of mortgage servicing rights $ 5,033,869 4,316,251 2,447,952
=========== ========== ==========
Mortgage servicing costs, which include professional services for valuing
mortgage servicing rights and guarantee fees on securitized mortgage loans were
$4,000 in the first six months of 2004 and $216,917 for the same period in 2003.
All of the loans being serviced were single family loans serviced for FNMA under
the mortgage-backed security program or the individual loan sale program. The
following is a summary of the risk characteristics of the loans being serviced
at June 30, 2004.
Weighted Weighted
Loan Principal Average Average Number of
Balance Interest Rate Remaining Term Loans
-------------- ------------- -------------- ---------
Original term 30 year fixed rate $198,358,294 5.93% 344 1,776
Original term 15 year fixed rate 246,207,348 5.31% 164 2,939
Seven year balloon 120,910 5.75% 55 1
Adjustable rate 9,048,946 5.00% 339 79
9
(8) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at June 30, 2004 is presented in the table below. Amortization
expense for intangible assets was $612,561 for the six-month period ended June
30, 2004.
Gross Unamortized
Carrying Accumulated Valuation Intangible
Amount Amortization Adjustment Assets
----------- ------------ ---------- -----------
Amortized intangible assets:
Mortgage servicing rights $ 4,409,787 (1,074,271) 0 3,335,516
Core deposit intangible 1,567,000 (1,176,454) 0 390,546
----------- ------------ ---------- ---------
Total $ 5,976,787 (2,250,725) 0 3,726,062
=========== ============ ========== =========
The following table indicates the estimated future amortization expense for
amortized intangible assets:
Mortgage Core
Servicing Deposit
Rights Intangible Total
---------- ---------- --------
Year ended December 31,
2004 459,768 56,929 516,697
2005 867,957 113,857 981,814
2006 613,399 113,857 727,256
2007 432,002 105,903 537,905
2008 303,050 0 303,050
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of June 30, 2004. The Company's actual
experiences may be significantly different depending upon changes in mortgage
interest rates and other market conditions.
(9) EARNINGS PER SHARE
The following table reconciles the weighted average shares outstanding and the
income available to common shareholders used for basic and diluted EPS:
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- -------------------------
2004 2003 2004 2003
---------- --------- --------- ---------
Weighted average number of common shares outstanding
used in basic earnings per common share calculation 3,870,299 3,763,325 3,892,672 3,755,511
Net dilutive effect of options 173,845 175,170 177,374 166,854
---------- --------- --------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 4,044,144 3,938,495 4,070,046 3,922,365
========== ========= ========= =========
Income available to common shareholders $2,497,160 2,030,228 4,617,620 3,419,768
Basic earnings per common share $ 0.65 0.54 1.19 0.91
Diluted earnings per common share $ 0.62 0.52 1.13 0.87
(10) REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory and possibly additional discretionary actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.
10
Quantitative measures established by regulations to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
following table) of Tier I or Core Capital and Risk-Based Capital (as defined in
the regulations) to total assets (as defined). Management believes, as of June
30, 2004, that the Bank meets all capital adequacy requirements to which it is
subject.
Management believes that based upon the Bank's capital calculations at June 30,
2004 and other conditions consistent with the Prompt Corrective Actions
Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
On June 30, 2004 the Bank's tangible assets and adjusted total assets were
$908.8 million and its risk-weighted assets were $719.7 million. The following
table presents the Bank's capital amounts and ratios at June 30, 2004 for actual
capital, required capital and excess capital, including ratios required to
qualify as a well capitalized institution under the Prompt Corrective Actions
regulations.
Required to be To Be Well Capitalized
Adequately Under Prompt Corrective
Actual Capitalized Excess Capital Actions Provisions
--------------------- --------------------- -------------------- -----------------------
Percent of Percent of Percent of Percent of
(in thousands) Amount Assets(1) Amount Assets (1) Amount Assets(1) Amount Assets(1)
-------- ---------- -------- ---------- -------- ---------- -------- ----------
Bank stockholder's equity ........ $ 77,006
Plus:
Net unrealized loss on certain
securities Available for sale 759
Less:
Goodwill and other intangibles . 4,191
Excess mortgage servicing rights 70
--------
Tier I or core capital ........... 73,504
--------
Tier I capital to adjusted total
assets ....................... 8.09% $ 36,352 4.00% $ 37,152 4.09% $ 45,440 5.00%
Tier I capital to risk-weighted
assets ....................... 10.21% $ 28,786 4.00% $ 44,718 6.21% $ 43,180 6.00%
Plus:
Allowable allowance for loan
losses ....................... 7,037
--------
Risk-based capital ............... $ 80,541 $ 57,573 $ 22,968 $ 71,966
========
Risk-based capital to risk-
weighted assets ................ 11.19% 8.00% 3.19% 10.00%
(1) Based upon the Bank's adjusted total assets for the purpose of the
tangible and core capital ratios and risk-weighted assets for the purpose
of the risk-based capital ratio.
The tangible capital of the Bank was in excess of the minimum 2% required at
June 30, 2004 but is not reflected in the table above.
(11) COMMITMENTS AND CONTINGENCIES
The Bank entered into two guaranty agreements with third parties in order for
Home Federal Mortgage Services, LLC (HFMS) to secure loan sale agreements. Under
the agreements, the Bank guarantees to satisfy and discharge all obligations of
HFMS arising from transactions entered into between HFMS and the third parties
if HFMS fails to fulfill their obligations. The agreements are in effect until
the obligations of HFMS are fully satisfied and the Bank's guaranty is limited
to a combined maximum of $3 million. No liability has been recorded in the
consolidated financial statements of HMN for these guarantees and HMN is not
aware of any outstanding obligations of HFMS to either of the third parties with
whom a guarantee exists. There is the possibility that the Bank would be
required to purchase loans that were previously sold to the third parties by
HFMS if the loans did not meet the requirements in the loan purchase agreements.
If this were to occur, the proceeds from the subsequent sale of these loans
would enable the Bank to recover a portion of the amounts paid under the
guaranty. The Bank has not been required to purchase any loans under these
guaranty agreements and no loans have been sold to the third parties since the
third quarter of 2002.
11
The Bank issued standby letters of credit which guarantee the performance of
customers to third parties. The outstanding standby letters of credit expire
over the next fifteen months and totaled approximately $2.7 million at June 30,
2004. The letters of credit were collateralized primarily with commercial real
estate mortgages. Since the conditions under which the Bank is required to fund
the standby letters of credit may not materialize, the cash requirements are
expected to be less than the total outstanding commitments.
(12) STOCK-BASED COMPENSATION
Effective January 1, 1996, HMN adopted SFAS No. 123, Accounting for Stock-Based
Compensation. It elected to continue using the accounting methods prescribed by
Accounting Principles Board (APB) Opinion No. 25 and related interpretations
which measure compensation cost using the intrinsic value method. Had
compensation cost for HMN's stock-based plan been determined in accordance with
the fair value method recommended by SFAS No. 123, HMN's net income and earnings
per share would have been adjusted to the pro forma amounts indicated below:
Quarter Ended Quarter Ended Six Months Ended Six Months Ended
June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003
------------- ------------- ---------------- ----------------
Net income:
As reported ............................. $ 2,497,160 2,030,228 4,617,620 3,419,768
Deduct: Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects ..... 8,531 10,128 17,061 20,256
----------- ----------- ----------- -----------
Pro forma ............................... 2,488,629 2,020,100 4,600,559 3,399,512
Earnings per
Common share:
As reported:
Basic .................................. $ 0.65 0.54 1.19 0.91
Diluted ................................ 0.62 0.52 1.13 0.87
Pro forma:
Basic .................................. 0.64 0.54 1.18 0.91
Diluted ................................ 0.62 0.51 1.13 0.87
(13) BUSINESS SEGMENTS
The Bank has been identified as a reportable operating segment in accordance
with the provisions of SFAS No. 131. SFC and HMN, the holding company, did not
meet the quantitative thresholds for determining reportable segments and
therefore are included in the "Other" category.
The Company evaluates performance and allocates resources based on the segment's
net income or loss, return on average assets and return on average equity. Each
corporation has its own officers and board of directors.
The following table sets forth certain information about the reconciliations of
reported profit or loss and assets for each of the Company's reportable
segments.
12
Home Federal
(Dollars in thousands) Savings Bank Other Eliminations Consolidated Total
------------ ------- ------------ ------------------
AT OR FOR THE QUARTER ENDED JUNE 30, 2004:
Interest income - external customers ......... $ 12,415 12 0 12,427
Non-interest income - external customers ..... 1,687 0 0 1,687
Loss on limited partnerships ................. (7) 0 0 (7)
Intersegment interest income ................. 0 1 (1) 0
Intersegment non-interest income ............. 39 2,544 (2,583) 0
Interest expense ............................. 5,061 0 (1) 5,060
Amortization of mortgage servicing rights, net
valuation adjustments, and servicing costs .. 302 0 0 302
Other non-interest expense ................... 4,567 167 (39) 4,695
Income tax expense (benefit) ................. 1,213 (107) 0 1,106
Minority interest ............................ 0 0 0 0
Net income ................................... 2,544 2,497 (2,544) 2,497
Goodwill ..................................... 3,801 0 0 3,801
Total assets ................................. 909,610 81,679 (77,191) 914,098
Net interest margin .......................... 3.46 % NM NM 3.45%
Return on average assets ..................... 1.13 % NM NM 1.12%
Return on average realized common equity ..... 13.31 % NM NM 12.06%
AT OR FOR THE QUARTER ENDED JUNE 30, 2003:
Interest income - external customers ......... $ 10,989 47 0 11,036
Non-interest income - external customers ..... 2,493 167 0 2,660
Earnings (loss) on limited partnerships ...... (7) 38 0 31
Intersegment interest income ................. 1 9 (10) 0
Intersegment non-interest income ............. 239 1,904 (2,143) 0
Interest expense ............................. 5,118 0 (10) 5,108
Amortization of mortgage servicing rights, net
valuation adjustments, and servicing costs .. 1,177 0 (68) 1,109
Other non-interest expense ................... 4,027 132 (87) 4,072
Income tax expense ........................... 913 4 0 918
Net income ................................... 1,989 2,029 (1,988) 2,030
Goodwill ..................................... 3,801 0 0 3,801
Total assets ................................. 780,760 77,658 (72,508) 785,910
Net interest margin .......................... 3.22% NM NM 3.24%
Return on average assets ..................... 1.00% NM NM 1.06%
Return on average realized common equity ..... 10.97% NM NM 10.45%
NM - Not meaningful
13
Home Federal
(Dollars in thousands) Savings Bank Other Eliminations Consolidated Total
------------ ------- ------------ ------------------
AT OR FOR THE SIX - MONTHS ENDED JUNE 30, 2004:
Interest income - external customers .......... $ 24,759 24 0 24,783
Non-interest income - external customers ...... 3,230 0 0 3,230
Earnings (loss) on limited partnerships ....... (14) 1 0 (13)
Intersegment interest income .................. 0 9 (9) 0
Intersegment non-interest income .............. 108 4,696 (4,804) 0
Interest expense .............................. 10,188 0 (9) 10,179
Amortization of mortgage servicing rights,
net valuation adjustments, and servicing costs 556 0 0 556
Other non-interest expense .................... 9,154 321 (108) 9,367
Income tax expense (benefit) .................. 2,223 (207) 0 2,016
Minority interest ............................. (2) 0 0 (2)
Net income .................................... 4,698 4,616 (4,696) 4,618
Goodwill ...................................... 3,801 0 0 3,801
Total assets .................................. 909,610 81,679 (77,191) 914,098
Net interest margin ........................... 3.46% NM NM 3.46%
Return on average assets ...................... 1.06% NM NM 1.04%
Return on average realized common equity ...... 12.50% NM NM 11.14%
AT OR FOR THE SIX-MONTHS ENDED JUNE 30, 2003:
Interest income - external customers .......... $ 21,410 97 0 21,507
Non-interest income - external customers ...... 5,419 167 0 5,586
Earnings (loss) on limited partnerships ....... (363) 39 0 (324)
Intersegment interest income .................. 28 22 (50) 0
Intersegment non-interest income .............. 508 3,289 (3,797) 0
Intersegment loan loss provision .............. 200 0 (200) 0
Interest expense .............................. 10,108 0 (50) 10,058
Amortization of mortgage servicing rights,
net valuation adjustments, and servicing costs 2,039 3 (143) 1,899
Other non-interest expense .................... 8,395 265 (165) 8,495
Income tax expense (benefit) .................. 1,613 (71) 0 1,542
Net income .................................... 3,292 3,417 (3,289) 3,420
Goodwill ...................................... 3,801 0 0 3,801
Total assets .................................. 780,760 77,658 (72,508) 785,910
Net interest margin ........................... 3.20% NM NM 3.22%
Return on average assets ...................... 0.88% NM NM 0.91%
Return on average realized common equity ...... 9.63% NM NM 8.84%
NM - Not meaningful
14
ITEM 2:
HMN FINANCIAL, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING INFORMATION
This quarterly report and other reports filed with the Securities and Exchange
Commission may contain "forward-looking" statements that deal with future
results, plans or performance. In addition, the Company's management may make
such statements orally to the media, or to securities analysts, investors or
others. Forward-looking statements deal with matters that do not relate strictly
to historical facts. The Company's future results may differ materially from
historical performance and forward-looking statements about the Company's
expected financial results or other plans are subject to a number of risks and
uncertainties. These include but are not limited to possible legislative changes
and adverse economic, business and competitive developments such as shrinking
interest margins; deposit outflows; reduced demand for financial services and
loan products; changes in accounting policies and guidelines, monetary and
fiscal policies of the federal government or tax laws; changes in credit and
other risks posed by the Company's loan and investment portfolios;
technological, computer-related or operational difficulties; adverse changes in
securities markets; results of litigation or other significant uncertainties.
GENERAL
The earnings of the Company are primarily dependant on the Bank's net interest
income, which is the difference between interest earned on its loans and
investments, and the interest paid on interest-bearing liabilities such as
deposits and Federal Home Loan Bank (FHLB) advances. The difference between the
average rate of interest earned on assets and the average rate paid on
liabilities is the "interest rate spread". Net interest income is produced when
interest-earning assets equal or exceed interest-bearing liabilities and there
is a positive interest rate spread. The Company's interest rate spread has been
enhanced by the increased level of commercial loans placed in the portfolio and
the increased amount of lower rate deposit products such as checking and money
market accounts. Net interest income and net interest rate spread are affected
by changes in interest rates, the volume and the mix of interest-earning assets
and interest-bearing liabilities, and the level of non-performing assets. The
Company's net income is also affected by the generation of non-interest income,
which consists primarily of gains or losses from the sale of securities, gains
from the sale of loans, and the generation of fees and service charges. The
Company's non-interest income has been enhanced by increased fees and service
charges on deposit accounts. The Bank incurs expenses in addition to interest
expense in the form of salaries and benefits, occupancy expenses, provisions for
loan losses and amortization and valuation adjustments on mortgage servicing
assets.
The earnings of financial institutions, such as the Bank, are significantly
affected by prevailing economic and competitive conditions, particularly changes
in interest rates, government monetary and fiscal policies, and regulations of
various regulatory authorities. Lending activities are influenced by the demand
for and supply of single family and commercial properties, competition among
lenders, the level of interest rates and the availability of funds. Mortgage
loan activity was significantly less in the first six months of 2004 than it was
during the same period in 2003 due to increases in mortgage interest rates, and
we expect this trend to continue. Deposit flows and costs of deposits are
influenced by prevailing market rates of interest on competing investments,
account maturities and the levels of personal income and savings. The interest
rates charged by the FHLB on advances to the Bank also have a significant impact
on the Bank's overall cost of funds.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those policies that the Company's management
believes are the most important to understanding the Company's financial
condition and operating results. The Company has identified the following
policies as being critical because they require difficult, subjective, and/or
complex judgments that are inherently uncertain. Therefore, actual financial
results could differ significantly depending upon the estimates used.
15
Allowance for Loan Losses and Related Provision
The allowance for loan losses is based on periodic analysis of the loan
portfolio. In this analysis, management considers factors including, but not
limited to, specific occurrences of loan impairment, changes in the size of the
portfolios, national and regional economic conditions, such as unemployment
data, loan portfolio composition, loan delinquencies, local construction
permits, development plans, local economic growth rates, historical experience
and observations made by the Company's ongoing internal audit and regulatory
exam processes. The allowance for loan losses is established for known problem
loans, as well as for loans which are not currently known to require specific
allowances. Loans are charged off to the extent they are deemed to be
uncollectible. The Company has established separate processes to determine the
adequacy of the loan loss allowance for its homogeneous and non-homogeneous loan
portfolios. The determination of the allowance for the non-homogeneous
commercial, commercial real estate, and multi-family loan portfolios involves
assigning standardized risk ratings and loss factors that are periodically
reviewed. The loss factors are estimated using a combination of the Company's
own loss experience and external industry data and are assigned to all loans
without identified credit weaknesses. The Company also performs an individual
analysis of impairment on each non-performing loan that is based on the expected
cash flows or the value of the assets collateralizing the loans. The
determination of the allowance on the homogeneous single-family and consumer
loan portfolios is calculated on a pooled basis with individual determination of
the allowance of all non-performing loans.
The adequacy of the allowance for loan losses is dependent upon management's
estimates of variables affecting valuation, appraisals of collateral,
evaluations of performance and status, and the amounts and timing of future cash
flows expected to be received on impaired loans. Such estimates, appraisals,
evaluations and cash flows may be subject to frequent adjustments due to
changing economic prospects of borrowers or properties. The estimates are
reviewed quarterly and adjustments, if any, are recorded in the provision for
loan losses in the periods in which the adjustments become known. The allowance
is allocated to individual loan categories based upon the relative risk
characteristics of the loan portfolios and the actual loss experience. The
Company increases its allowance for loan losses by charging the provision for
loan losses against income. The methodology for establishing the allowance for
loan losses takes into consideration probable losses that have been identified
in connection with specific loans as well as losses in the loan portfolio for
which specific reserves are not required. Although management believes that the
allowance for loan losses is maintained at an adequate amount to provide for
probable loan losses inherent in the portfolio as of the balance sheet dates,
future adjustments to the provision for loan losses may be necessary if
conditions differ substantially from those in the assumptions used to determine
the allowance for loan losses.
Mortgage Servicing Rights
The Company recognizes as an asset the rights to service mortgage loans for
others, which are referred to as mortgage servicing rights (MSRs). MSRs are
capitalized at the relative fair value of the servicing rights on the date the
mortgage loan is sold and are carried at the lower of the capitalized amount,
net of accumulated amortization, or fair value. MSRs are capitalized and
amortized in proportion to, and over the period of, estimated net servicing
income. Each quarter the Company evaluates its MSRs for impairment in accordance
with Statement of Financial Accounting Standard (SFAS) No. 140. Loan type and
interest rate are the predominant risk characteristics of the underlying loans
used to stratify the MSRs for purposes of measuring impairment. If temporary
impairment exists, a valuation allowance is established for any excess of
amortized cost over the current fair value through a charge to income. If the
Company later determines that all or a portion of the temporary impairment no
longer exists, a reduction of the valuation allowance is recorded as an increase
to income. The valuation of the MSRs is based on various assumptions including
the estimated prepayment speeds and default rates of the stratified portfolio.
Changes in the mix of loans, interest rates, prepayment speeds, or default rates
from the estimates used in the valuation of the mortgage servicing rights may
have a material effect on the amortization and valuation of MSRs. Although
management believes that the assumptions used and the values determined are
reasonable, future adjustments may be necessary if economic conditions differ
substantially from the economic conditions in the assumptions used to determine
the value of the MSRs. The Company does not formally hedge its MSRs because they
are hedged naturally by the Company's mortgage origination volume. Generally, as
interest rates rise the origination volume declines and the value of MSRs
increases and as interest rates decline the origination volume increases and the
value of MSRs decreases.
16
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. These calculations are
based on many complex factors including estimates of the timing of reversals of
temporary differences, the interpretation of federal and state income tax laws,
and a determination of the differences between the tax and the financial
reporting basis of assets and liabilities. Actual results could differ
significantly from the estimates and interpretations used in determining the
current and deferred income tax liabilities.
NET INCOME
The Company's net income was $2.5 million for the second quarter of 2004, an
increase of $467,000, or 23.0%, from net income of $2.0 million for the second
quarter of 2003. Basic earnings per share for the second quarter of 2004 were
$0.65, an increase of $0.11, or 20.4%, from $0.54 basic earnings per share for
the same quarter of 2003. Diluted earnings per common share for the second
quarter of 2004 were $0.62, an increase of $0.10, or 19.2%, from $0.52 for the
second quarter of 2003.
Net income was $4.6 million for the six-month period ended June 30, 2004, an
increase of $1.2 million, or 35.0%, compared to $3.4 million for the six-month
period ended June 30, 2003. Basic earnings per share were $1.19 for the six
months ended June 30, 2004, an increase of $0.28 per share, or 30.8%, from $0.91
for the same six month period in 2003. Diluted earnings per share for the six
month period in 2004 were $1.13, an increase of $0.26, or 29.9%, from $0.87 for
the same six month period in 2003.
NET INTEREST INCOME
Net interest income was $7.3 million for the second quarter of 2004, an increase
of $1.4 million, or 24.3%, compared to $5.9 million for the second quarter of
2003. Interest income was $12.4 million for the second quarter of 2004, an
increase of $1.4 million, or 12.6%, from $11.0 million for the same period in
2003. Interest income increased primarily because of an increase in
interest-earning assets and because of a change in the mix of assets between the
periods. The increase in interest-earning assets was caused primarily by the
$120 million increase in commercial and consumer loans between the periods. The
increase in interest income on commercial and consumer loans was partially
offset by lower income on the single-family loan portfolio due to a decrease in
the outstanding balance and lower interest rates of this portfolio in the second
quarter of 2004 when compared to the same period of 2003. The yield earned on
interest-earning assets was 5.82% for the second quarter of 2004, a decrease of
21 basis points from the 6.03% yield for the second quarter of 2003.
Interest expense was $5.1 million for the second quarter of 2004, a decrease of
$48,000, or 0.9%, from the second quarter of 2003. Interest expense on deposits
and Federal Home Loan Bank advances decreased by $1.1 million due to a decrease
in the interest rates paid as maturing deposits and advances repriced at lower
interest rates. Interest expense increased by $1.0 million due to the $128
million increase in the average outstanding balance of deposits and advances
between the periods. The decrease in the interest rates paid is primarily the
result of the $84 million in growth that was experienced in checking and money
market accounts, which generally have lower interest rates than other deposit
accounts. The average interest rate paid on interest-bearing liabilities was
2.50% for the second quarter of 2004, a decrease of 49 basis points from the
2.99% paid for the second quarter of 2003.
Net interest margin (net interest income divided by average interest earning
assets) for the second quarter of 2004 was 3.45%, a 21 basis point increase,
compared to 3.24% for the second quarter of 2003.
Net interest income was $14.6 million for the first six months of 2004, an
increase of $3.2 million, or 27.6%, from $11.4 million for the same period in
2003. Interest income was $24.8 million for the six-month period ended June 30,
2004, an increase of $3.3 million, or 15.2%, from $21.5 million for the same
six-month period in 2003. Interest income increased primarily because of an
increase in interest-earning assets and because of a change in the
17
mix of assets between the periods. The increase in interest-earning assets was
caused primarily by the $120 million increase in commercial and consumer loans
between the periods. The increase in interest income on commercial and consumer
loans was partially offset by lower income on the single-family loan portfolio
in the first six months of 2004 when compared to the same period in 2003. The
yield earned on interest-earning assets was 5.86% for the first six months of
2004, a decrease of 19 basis points from the 6.05% yield for the first six
months of 2003.
Interest expense was $10.2 million for the six month period ended June 30, 2004,
an increase of $121,000, or 1.2%, compared to $10.1 million for the same period
of 2003. Interest expense on deposits and Federal Home Loan Bank advances
decreased by $2.1 million due to a decline in the interest rates paid and
increased by $2.2 million due to the $137 million increase in the average
outstanding balance of deposits and advances between the periods. The average
interest rate paid on interest-bearing liabilities was 2.54% for the first six
months of 2004, a decrease of 49 basis points from the 3.03% paid for the first
six months of 2003.
Net interest margin (net interest income divided by average interest earning
assets) for the six months ended June 30, 2004, was 3.46%, an increase of 24
basis points, compared to 3.22% for the same period of 2003.
PROVISION FOR LOAN LOSSES
The provision for loan losses is recorded to bring the allowance for loan losses
to a level deemed appropriate by management based on factors disclosed in the
critical accounting policies previously discussed. The provision for loan losses
was $447,000 for the second quarter of 2004, a decrease of $43,000, or 8.8%,
from $490,000 for the second quarter of 2003. The provision for loan losses was
$1.3 million for the six-month period of 2004, a decrease of $89,000, or 6.7%,
from $1.4 million for the same six-month period in 2003. The provision for loan
losses decreased primarily because of the slower loan growth that was
experienced in the first six months of 2004 when compared to the same period of
2003. Total non-performing assets were $3.5 million at June 30, 2004, a decrease
of $1.5 million, or 31.1%, from $5.0 million at December 31, 2003. The decrease
in non-performing assets was primarily due to the payoff of a $1.6 million
commercial real estate loan and a reduction in non-performing consumer loans
during the first six months of 2004. Charge offs during the first six months of
2004 increased by $298,000 over the same period in 2003 primarily because of
increased charge offs in the single family and mobile home loan portfolios.
A reconciliation of the Company's allowance for loan losses is summarized as
follows:
2004 2003
----------- -----------
Balance at January 1, $ 6,939,602 $ 4,824,217
Provision 1,266,000 1,355,000
Charge-offs (421,525) (123,976)
Recoveries 8,720 33,228
----------- -----------
Balance at June 30, $ 7,792,797 $ 6,088,469
=========== ===========
NON-INTEREST INCOME
Non-interest income was $1.7 million for the second quarter of 2004, a decrease
of $1.0 million, or 37.6%, from $2.7 million for the same period in 2003.
Non-interest income from security gains decreased by $223,000 because of the
lower gains recognized on the sale of securities during the second quarter of
2004 when compared to the same quarter of 2003. Gains on sales of loans
decreased by $1.0 million due to the significant decrease in mortgage loan
activity in the second quarter of 2004 when compared to the same period in 2003.
These decreases in non-interest income were partially offset by an increase of
$150,000 in fees and service charges between the periods due to an increase in
the number of deposit accounts and the fees charged. Mortgage servicing fees
increased by $52,000 because of the increased size of the servicing portfolio.
Other non-interest income increased by $68,000 primarily because of increased
revenues from the sale of uninsured investment products.
Non-interest income was $3.2 million for the first six months of 2004, a
decrease of $2.1 million, or 38.9%, from $5.3 million for the same period of
2003. Non-interest income decreased by $814,000 because of lower gains on the
sales of securities. Gains on sales of loans decreased by $2.1 million due to
the significant decrease in mortgage loan activity in the first six months of
2004 when compared to the same period of 2003. These decreases in non-interest
income were partially offset by the $310,000 decrease in limited partnership
losses because the Company's investment in a limited partnership that invested
in mortgage servicing rights was dissolved in the
18
second quarter of 2003. Interest rates on mortgage loans decreased during the
first six months of 2003 which caused the value of the Company's investment in a
limited partnership that owned mortgage loan servicing assets to decrease in
value. The value of servicing rights generally decreases when mortgage rates
decrease because of the anticipated increase in prepayments expected to be
received on the mortgage servicing assets. Fees and service charges increased by
$286,000 between the periods due to an overdraft protection program that was
implemented during the second quarter of 2003 and because of increases in the
number of deposit accounts and the fees charged. Mortgage servicing fees
increased by $123,000 due to the increased size of the servicing portfolio
between the periods. Other non-interest income increased by $122,000 primarily
because of increased revenues from the sale of uninsured investment products.
NON-INTEREST EXPENSE
Non-interest expense was $5.0 million for the second quarter of 2004, a decrease
of $184,000, or 3.5%, from $5.2 million for the same period of 2003.
Amortization expense on mortgage servicing rights decreased by $806,000 between
the quarters because of a decrease in the prepayments on the mortgage loans
being serviced. Prepayments of mortgage loans in the second quarter of 2003
resulted in a $640,000 impairment reserve that was reversed in the second half
of 2003 when prepayment speeds slowed. Data processing costs decreased by
$61,000 primarily because of the renegotiation of a third party service contract
in the fourth quarter of 2003. Compensation expense increased by $554,000
primarily because of an increase in the number of employees and because of
annual increases in salaries and employee benefit costs. Occupancy expense
increased by $102,000 primarily because of increases in real estate taxes on
existing facilities.
Non-interest expense was $9.9 million for the first six months of 2004, a
decrease of $471,000, or 4.5%, from $10.4 million for the same period of 2003.
Amortization expense on mortgage servicing rights decreased by $1.3 million
because of a decrease in the prepayments on the mortgage loans being serviced.
Prepayments of mortgage loans in the second quarter of 2003 resulted in a
$640,000 impairment reserve that was reversed in the second half of 2003 when
prepayment speeds slowed. Data processing costs decreased by $142,000 primarily
because of the renegotiation of a third party service contract in the fourth
quarter of 2003. Compensation expense increased by $803,000 because of an
increase in the number of employees and because of annual increases in salaries
and employee benefit cost. Occupancy expense increased by $162,000 primarily
because of increases in real estate taxes on existing facilities.
INCOME TAX EXPENSE
Income tax expense was $1.1 million for the second quarter of 2004, an increase
of $188,000 compared to $918,000 for the second quarter of 2003. Income tax
expense was $2.0 million for the six months ended June 30, 2004, an increase of
$474,000 compared to $1.5 million for the same six month period of 2003. The
increases in income taxes are primarily due to an increase in taxable income.
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of non-performing
assets in the Bank's portfolio at June 30, 2004 and December 31, 2003.
19
June 30, December 31,
(Dollars in Thousands) 2004 2003
-------- ------------
Non-Accruing Loans
One-to-four family real estate $1,257 1,177
Commercial real estate 1,123 2,162
Consumer 214 1,050
Commercial business 261 186
------ ------
Total 2,855 4,575
------ ------
Accruing loans delinquent 90
days or more 0 114
Other assets 201 211
Foreclosed and Repossessed Assets
One-to-four family real estate 254 73
Consumer 161 62
------ ------
Total non-performing assets $3,471 $5,035
====== ======
Total as a percentage of total assets 0.38% 0.58%
====== ======
Total non-performing loans $2,855 $4,689
====== ======
Total as a percentage of total
loans receivable, net 0.40% 0.68%
====== ======
Allowance for loan loss to non-performing
loans 272.98% 147.99%
Total non-performing assets at June 30, 2004 were $3.5 million, a decrease of
$1.5 million, or 31.1%, from $5.0 million at December 31, 2003. The decrease in
non-performing assets was primarily due to the payoff of a commercial real
estate loan and a reduction in non-performing consumer loans during the first
six months of 2004. During the first six months of 2004 the following activity
occurred related to non-performing loans: $2.6 million of previously performing
loans were classified as non-performing, $516,000 of loans were foreclosed or
repossessed, a $1.6 million non-performing commercial loan was paid off, and
$2.2 million in previously non-performing loans were reclassified to performing
status.
DIVIDENDS
On July 27, 2004 the Company declared a cash dividend of $0.22 per share,
payable on September 10, 2004 to shareholders of record on August 27, 2004.
The Company has declared and paid dividends during 2004 as follows:
Record date Pay date Dividend per share Dividend Payout Ratio
----------- -------- ------------------ ---------------------
February 20, 2004 March 8, 2004 $0.20 37.74%
May 21, 2004 June 8, 2004 $0.20 38.46%
The annualized dividend payout ratio for the past four quarters, ending with the
September 10, 2004 payment will be 33.74%.
The declaration of dividends are subject to, among other things, the Company's
financial condition and results of operations, the Bank's compliance with its
regulatory capital requirements, tax considerations, industry standards,
economic conditions, regulatory restrictions, general business practices and
other factors.
LIQUIDITY
For the six months ended June 30, 2004 the net cash provided by operating
activities was $7.7 million. The Company collected $10.1 million from the sale
of securities and $3.2 million from principal repayments on securities. It
purchased securities available for sale of $20.0 million and premises and
equipment of $1.1 million. Net loans receivable increased by $35.0 million due
to increased commercial loan production. The Company had a net increase in
deposit balances of $75.8 million and received $16.5 million in FHLB advance
proceeds. It paid out $21.5 million on FHLB advances and $21.6 million on
customer escrows due primarily to the payment of one large commercial loan
escrow. The Company received $28,000 related to the exercise of HMN stock
options, paid $1.6 million in dividends to its shareholders and paid $2.2
million to purchase treasury stock.
20
The Company has certificates of deposits with outstanding balances of $171.2
million that come due over the next 12 months. Based upon past experience
management anticipates that the majority of the deposits will renew for another
term. The Company believes that deposits that do not renew will be replaced with
deposits from other customers or brokers, or funded with advances from the FHLB.
Management does not anticipate that it will have a liquidity problem due to
maturing deposits.
The Company has $115.9 million of FHLB advances which mature beyond June 30,
2005 but have call features that can be exercised by the FHLB during the next 12
months. If the call features are exercised, the Company has the option of
requesting any advance otherwise available to it pursuant to the Credit Policy
of the FHLB. The Company also has $28.0 million of FHLB advances that will
mature during the next 12 months. Since the Company has the ability to request
another advance to replace the advance that is being called or is maturing,
management does not anticipate that it will have a liquidity problem due to
advances being called by the FHLB during the next 12-month period.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates.
The Company's market risk arises primarily from interest rate risk inherent in
its investing, lending and deposit-taking activities. Management actively
monitors and manages its interest rate risk exposure.
The Company's profitability is affected by fluctuations in interest rates. A
sudden and substantial increase in interest rates may adversely impact the
Company's earnings to the extent that the interest rates borne by assets and
liabilities do not change at the same speed, to the same extent, or on the same
basis. The Company monitors the projected changes in net interest income that
occur if interest rates were to suddenly change up or down. The Rate Shock Table
located below in the Asset/Liability Management section of this report discloses
the Company's projected changes in net interest income based upon immediate
interest rate changes called rate shocks.
The Company utilizes a model which uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate the
current market value of those assets and liabilities. The model also calculates
the changes in market value of the interest-earning assets and interest-bearing
liabilities due to different interest rate changes. The Company believes that
over the next twelve months interest rates could conceivably fluctuate in a
range of 200 basis points up or 100 basis points down from where the rates were
at June 30, 2004. The following table discloses the projected changes in market
value to the Company's interest-earning assets and interest-bearing liabilities
based upon incremental 100 basis point changes in interest rates from interest
rates in effect on June 30, 2004.
Other than trading portfolio Market Value
-------------------------------------------------------
(Dollars in thousands)
Basis point change in interest rates -100 0 +100 +200
--------------------------------------------------------------------------------------------------------
Total market risk sensitive assets $ 938,931 924,764 904,780 887,721
Total market risk sensitive liabilities 863,127 850,521 840,114 834,814
Off-balance sheet financial instruments (73) 0 83 160
--------- ------- -------- --------
Net market risk $ 75,731 74,243 64,749 53,067
========= ======= ======== ========
Percentage change from current market value 2.00% 0.00% (12.79)% (28.52)%
========= ======= ======== ========
The preceding table was prepared utilizing the following assumptions (the Model
Assumptions) regarding prepayment and decay ratios that were determined by
management based upon their review of historical prepayment speeds and future
prepayment projections. Fixed rate loans were assumed to prepay at annual rates
of between 19% to 55%, depending on the note rate and the period to maturity.
Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of
between 15% and 28%, depending on the note rate and the period to maturity.
Growing Equity Mortgage loans were assumed to prepay at annual rates of between
26% and 47% depending on the note rate and the period to maturity.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were
projected to have prepayments based upon the underlying collateral securing the
21
instrument and the related cash flow priority of the CMO tranche owned.
Certificate accounts were assumed not to be withdrawn until maturity. Passbook
accounts were assumed to decay at an annual rate of 11.44% and money market
accounts were assumed to decay at an annual rate of 12.67%. FHLB advances were
projected to be called at the first call date where the projected interest rate
on similar remaining term advances exceeded the interest rate on the callable
advance.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. The interest rates on certain types of assets and liabilities
may fluctuate in advance of changes in market interest rates, while interest
rates on other types of assets and liabilities may lag behind changes in market
interest rates. The model assumes that the difference between the current
interest rate being earned or paid compared to a treasury instrument or other
interest index with a similar term to maturity (the Interest Spread) will remain
constant over the interest changes disclosed in the table. Changes in Interest
Spread could impact projected market value changes. Certain assets, such as
ARMs, have features which restrict changes in interest rates on a short-term
basis and over the life of the assets. The market value of the interest-bearing
assets which are approaching their lifetime interest rate caps could be
different from the values disclosed in the table. In the event of a change in
interest rates, prepayment and early withdrawal levels may deviate significantly
from those assumed in calculating the foregoing table. The ability of many
borrowers to service their debt may decrease in the event of a substantial
sustained interest rate increase.
ASSET/LIABILITY MANAGEMENT
The Company's management reviews the impact that changing interest rates will
have on its net interest income projected for the twelve months following June
30, 2004 to determine if its current level of interest rate risk is acceptable.
The following table projects the estimated annual impact on net interest income
of immediate interest rate changes called rate shocks.
Rate Shock Net Interest Percentage
in Basis Points Income Change
--------------- ------ ------
+200 39,151 13.55%
+100 37,159 7.78%
0 34,478 0.00%
-100 32,325 (6.24)%
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections
prepared by third parties.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. In the event of a change in interest rates, prepayment and
early withdrawal levels would likely deviate significantly from those assumed in
calculating the foregoing table. The ability of many borrowers to service their
debt may decrease in the event of a substantial sustained increase in interest
rates which could impact net interest income.
In an attempt to manage its exposure to changes in interest rates, management
closely monitors interest rate risk. The Bank has an Asset/Liability Committee
which meets frequently to discuss changes in the Bank's interest rate risk
position and projected profitability. The Committee makes adjustments to the
asset liability position of the Bank which is reviewed by the Board of Directors
of the Bank. This Committee also reviews the Bank's portfolio, formulates
investment strategies and oversees the timing and implementation of transactions
to assure attainment of the Board's objectives in the most effective manner. In
addition, the Board reviews on a quarterly basis the Bank's asset/liability
position, including simulations of the effect on the Bank's capital of various
interest rate scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market conditions and
consumer preference, may place more emphasis on managing net interest margin
than on better matching the interest rate sensitivity of its assets and
liabilities in an effort to enhance net interest income. Management believes
that the increased net interest income resulting from a mismatch in the maturity
of its asset and liability portfolios can, during periods of declining or stable
interest rates, provide high enough returns to justify the increased exposure to
sudden and unexpected increases in interest rates.
22
To the extent consistent with its interest rate spread objectives, the Bank
attempts to reduce its interest rate risk and has taken a number of steps to
restructure its assets and liabilities. The Bank has primarily focused its fixed
rate one-to-four family residential portfolio lending program on loans that are
saleable to third parties and only places fixed rate loans that meet certain
risk characteristics into its loan portfolio. The Bank does place into portfolio
adjustable rate single-family loans that reprice over a one-year, three-year or
five-year period. The Bank's commercial loan production has primarily been in
adjustable rate loans and the fixed rate commercial loans placed in portfolio
have been shorter-term loans, usually with maturities of five years or less, in
order to lower the Company's interest rate risk exposure.
ITEM 4: CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. As of the end of the period
covered by this report, the Company conducted an evaluation, under the
supervision and with the participation of the principal executive officer and
principal financial officer, of the Company's disclosure controls and procedures
(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934 (the "Exchange Act")). Based on this evaluation, the principal executive
officer and principal financial officer concluded that the Company's disclosure
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified insecurities and Exchange Commission rules and forms.
Changes in internal controls. There was no change in the Company's internal
control over financial reporting during the Company's most recently completed
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, the Company's internal control over financial reporting.
23
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
None.
ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities. (a)-(d) Not applicable
(a) Total (c) Total Number of (d) Maximum Number (or
Number of Shares (or Units) Approximate Dollar Value) of
Shares (or (b) Average Purchased as Part of Shares (or Units) that May Yet
Units) Price Paid per Publicly Announced Be Purchased Under the Plans or
Period Purchased Share (or Unit) Plans or Programs Programs
- ------------- --------- --------------- -------------------- -------------------------------
January 2004 0 $0.00 0 213,400
February 2004 0 0.00 0 350,000
March 2004 28,000 27.50 28,000 322,000
April 2004 25,000 26.05 25,000 297,000
May 2004 30,000 25.31 30,000 267,000
June 2004 0 0 0 267,000
------ ------ -------
Total 83,000 $26.27 83,000
====== ====== =======
(1) On August 27, 2002, the Board of Directors authorized the repurchase of up
to 350,000 shares of the Company's common stock. This repurchase program
expired on February 27, 2004. On February 24, 2004, the Board of Directors
authorized a repurchase program for 350,000 shares of the Company's common
stock. This program expires on August 24, 2005.
ITEM 3. Defaults Upon Senior Securities.
Not applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders.
The Annual Meeting of Stockholders of the Company was held on April 27,
2004 at 10:00 a.m.
The following is a record of the votes cast in the election of directors
of the Company:
Term expiring in 2007:
For Withhold
--- --------
Michael J. Fogarty 4,103,989 40,533
Susan K. Kolling 4,044,001 100,521
Malcolm W. McDonald 4,033,744 110,778
There were 0 broker non-votes and 0 abstentions for each of the directors.
Accordingly the individuals named above were duly elected directors of the
Company for terms to expire as stated above.
The following is a record of the votes cast in respect of the proposal to ratify
the appointment of KPMG LLP as the Company's auditors for the fiscal year ending
December 31, 2004.
24
NUMBER PERCENTAGE OF
OF VOTES VOTES ACTUALLY CAST
-------- -------------------
FOR 4,098,822 98.89%
AGAINST 38,160 0.92%
ABSTAIN 7,540 0.18%
BROKER NON-VOTE 0 0.00%
Accordingly, the proposal described above was declared to be duly adopted by the
stockholders of the Company.
ITEM 5. Other Information.
None.
ITEM 6. Exhibits and Reports on Form 8-K.
(a) Exhibits. See Index to Exhibits on page 26 of this report
(b) Reports on Form 8-K -
1) On April 28, 2004, HMN reported its financial
results for its first fiscal quarter ended March
31, 2004.
2) On July 26, 2004, HMN reported its financial
results for its second fiscal quarter ended June
30, 2004
25
SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HMN FINANCIAL, INC.
Registrant
Date: August 10, 2004 By: /s/ Michael McNeil
Michael McNeil,
President
(Duly Authorized Officer and Principal
Executive Officer)
Date: August 10, 2004 By: /s/ Jon Eberle
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
26
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
Reference Sequential
to Prior Page Numbering
Filing or Where Attached
Exhibit Exhibits Are
Regulation S-K Number Located in This
Exhibit Number Document Attached Hereto Form 10-Q Report
3.1 Amended and Restated Articles of Incorporation *1 N/A
3.2 Amended and Restated By-laws *2 N/A
4 Form of Common Stock *3 N/A
Including indentures
10 Form of Change in Control Agreement for 10 Filed electronically
Executive Officers
31.1 Rule 13a-14(a)/15d-14(a) Certification of CEO 31.1 Filed electronically
31.2 Rule 13a-14(a)/15d-14(a) Certification of CFO 31.2 Filed electronically
32 Section 1350 Certification of CEO and CFO 32 Filed Electronically
*1 Incorporated by reference to the same numbered exhibit to the Company's
Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File No.
0-24100).
*2 Incorporated by reference to the same numbered exhibit to the Company's
Quarterly Report on Form 10-Q for the period ended September 30, 1997 (File
0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's
Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212).
27