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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 September 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 Identification Number)
incorporation or organization)
1016 Civic Center Drive N.W., Rochester, MN 55901
- -------------------------------------------- ------------------
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (507) 535-1200
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's common stock,
as of the latest practicable date.
Class Outstanding at October 26, 2004
- ----------------------------- ---------------------------------------
Common stock, $0.01 par value 4,436,864
HMN FINANCIAL, INC.
CONTENTS
Page
----
PART I - FINANCIAL INFORMATION
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at September 30, 2004 and December 31, 2003 3
Consolidated Statements of Income for the Three Months Ended and Nine Months Ended
September 30, 2004 and 2003 4
Consolidated Statements of Comprehensive Income for the Three Months Ended and Nine
Months Ended September 30, 2004 and 2003 5
Consolidated Statement of Stockholders' Equity for the Nine-Month Period Ended
September 30, 2004 5
Consolidated Statements of Cash Flows for the Nine Months Ended
September 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: Unregistered Sales of Equity Securities and Use of Proceeds 24
Item 3: Defaults Upon Senior Securities 24
Item 4: Submission of Matters to a Vote of Security Holders 24
Item 5: Other Information 24
Item 6: Exhibits 24
Signatures 25
2
PART I - FINANCIAL STATEMENTS
ITEM 1: FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2004 2003
(unaudited)
------------- -----------
ASSETS
Cash and cash equivalents ................................. $ 43,102,740 30,496,823
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $10,073,233 and $13,707,005) .......... 9,392,905 13,048,718
Other marketable securities
(amortized cost $95,737,058 and $91,035,285) ......... 95,404,115 91,615,047
------------- -----------
104,797,020 104,663,765
------------- -----------
Loans held for sale ....................................... 3,652,495 6,542,824
Loans receivable, net ..................................... 766,062,706 688,951,199
Accrued interest receivable ............................... 3,927,166 3,462,221
Real estate, net .......................................... 424,142 73,271
Federal Home Loan Bank stock, at cost ..................... 9,938,300 10,004,400
Mortgage servicing rights, net ............................ 3,286,026 3,447,843
Premises and equipment, net ............................... 12,542,097 12,110,151
Investment in limited partnerships ........................ 174,758 617,042
Goodwill .................................................. 3,800,938 3,800,938
Core deposit intangible ................................... 362,081 447,474
Prepaid expenses and other assets ......................... 2,807,443 2,108,575
Deferred tax asset, net.................................... 457,200 0
------------- -----------
Total assets .......................................... $ 955,335,112 866,726,446
============= ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits .................................................. $ 666,752,426 551,687,995
Federal Home Loan Bank advances ........................... 198,900,000 203,900,000
Accrued interest payable .................................. 1,264,402 766,837
Customer escrows .......................................... 1,343,056 22,457,671
Accrued expenses and other liabilities .................... 4,282,512 6,952,600
Deferred tax liabilities, net ............................. 0 26,300
------------- -----------
Total liabilities ..................................... 872,542,396 785,791,403
------------- -----------
Commitments and contingencies
Minority interest ......................................... 1,614 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 ................................ 57,746,116 57,863,726
Retained earnings, subject to certain restrictions ........ 90,127,064 85,364,657
Accumulated other comprehensive loss ...................... (655,671) (50,725)
Unearned employee stock ownership plan shares ............. (4,592,716) (4,738,084)
Treasury stock, at cost 4,691,798 and 4,616,010 shares .... (59,924,978) (57,599,804)
------------- -----------
Total stockholders' equity ............................ 82,791,102 80,931,057
------------- -----------
Total liabilities and stockholders' equity ................ $ 955,335,112 866,726,446
============= ===========
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
------------ ---------- ---------- ----------
Interest income:
Loans receivable ..................... $ 12,242,408 10,744,663 35,220,089 30,628,304
Securities available for sale:
Mortgage-backed and related ...... 81,341 72,646 292,633 175,405
Other marketable ................. 730,727 591,292 2,180,525 1,843,359
Cash equivalents ..................... 40,410 12,762 160,750 98,659
Other ................................ 61,196 86,196 139,016 268,880
------------ ---------- ---------- ----------
Total interest income ............ 13,156,082 11,507,559 37,939,013 33,014,607
------------ ---------- ---------- ----------
Interest expense:
Deposits ............................. 3,190,799 2,474,680 9,015,152 7,438,497
Federal Home Loan Bank advances ...... 2,195,801 2,590,574 6,550,436 7,684,876
------------ ---------- ---------- ----------
Total interest expense ............ 5,386,600 5,065,254 15,565,588 15,123,373
------------ ---------- ---------- ----------
Net interest income ............... 7,769,482 6,442,305 22,373,425 17,891,234
Provision for loan losses ................. 775,000 545,000 2,041,000 1,900,000
------------ ---------- ---------- ----------
Net interest income after provision
for loan losses .................. 6,994,482 5,897,305 20,332,425 15,991,234
------------ ---------- ---------- ----------
Non-interest income:
Fees and service charges ............. 741,704 625,419 2,014,905 1,612,595
Mortgage servicing fees .............. 291,709 261,198 869,789 716,503
Securities gains, net ................ 2,451 417,443 3,812 1,233,229
Gain on sales of loans ............... 349,214 1,601,047 1,268,445 4,592,837
Earnings (losses) in limited
partnerships ....................... (6,500) 10,153 (19,617) (313,161)
Other ................................ 210,155 179,112 667,952 514,906
------------ ---------- ---------- ----------
Total non-interest income ......... 1,588,733 3,094,372 4,805,286 8,356,909
------------ ---------- ---------- ----------
Non-interest expense:
Compensation and benefits ............ 2,430,026 2,085,383 7,540,268 6,392,457
Occupancy ............................ 914,382 805,890 2,670,154 2,399,207
Deposit insurance premiums ........... 23,600 18,047 70,099 54,838
Advertising .......................... 116,195 92,161 291,591 278,013
Data processing ...................... 233,254 310,614 652,540 871,660
Amortization of mortgage servicing
rights, net of valuation adjustments
and servicing costs ................ 239,806 (193,287) 795,439 1,705,344
Other ................................ 923,135 1,211,288 2,783,471 3,022,975
------------ ---------- ---------- ----------
Total non-interest expense ........ 4,880,398 4,330,096 14,803,562 14,724,494
------------ ---------- ---------- ----------
Income before income tax expense .. 3,702,817 4,661,581 10,334,149 9,623,649
Income tax expense ........................ 1,152,700 1,621,300 3,168,700 3,163,600
------------ ---------- ---------- ----------
Income before minority interest ... 2,550,117 3,040,281 7,165,449 6,460,049
Minority interest ......................... (84) 0 (2,372) 0
------------ ---------- ---------- ----------
Net income ........................ $ 2,550,201 3,040,281 7,167,821 6,460,049
============ ========== ========== ==========
Basic earnings per share .................. $ 0.66 0.79 1.85 1.71
============ ========== ========== ==========
Diluted earnings per share ................ $ 0.64 0.76 1.77 1.63
============ ========== ========== ==========
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited)
Three Months Ended September 30,
2004 2003
---------------------------- ----------------------------
Net income $ 2,550,201 3,040,281
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during period 367,452 (598,636)
Less: reclassification adjustment for
gains included in net income 1,550 270,043
----------- --------
Net unrealized gains (losses) on securities 365,902 (868,679)
--------- ---------
Comprehensive income $ 2,916,103 2,171,602
========= =========
Nine Months Ended September 30,
2004 2003
---------------------------- ----------------------------
Net income $ 7,167,821 6,460,049
Other comprehensive income, net of tax:
Unrealized losses on securities:
Unrealized holding losses arising during
period (602,434) (479,029)
Less: reclassification adjustment for
gains included in net income 2,512 797,629
----------- --------
Net unrealized losses on securities (604,946) (1,276,658)
--------- ----------
Comprehensive income $ 6,562,875 5,183,391
========= ==========
See accompanying notes to consolidated financial statements.
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2004
(unaudited)
Unearned
Employee
Accumulated Stock Total
Additional Other Ownership Stock-
Common Paid-in Retained Comprehensive Plan Treasury Holders'
Stock Capital Earnings Income 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 7,167,821 7,167,821
Other comprehensive loss (604,946) (604,946)
Treasury stock purchases (2,706,550) (2,706,550)
Employee stock options
exercised (353,742) 381,376 27,634
Tax benefits of exercised
stock options 19,548 19,548
Dividends paid (2,405,414) (2,405,414)
Earned employee stock
ownership plan shares 216,584 145,368 361,952
----------------------------------------------------------------------------------------------
Balance, September 30, 2004 $ 91,287 57,746,116 90,127,064 (655,671) (4,592,716) (59,924,978) 82,791,102
==============================================================================================
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
September 30,
----------------------------------
2004 2003
----------------------------------
Cash flows from operating activities:
Net income .................................................................. $ 7,167,821 6,460,049
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses ................................................. 2,041,000 1,900,000
Depreciation .............................................................. 1,179,006 1,178,607
Amortization of (discounts) premiums, net ................................. (206,102) 572,084
Amortization of deferred loan fees ........................................ (826,890) (390,407)
Amortization of core deposit intangible ................................... 85,393 84,729
Amortization of mortgage servicing rights and net valuation and servicing
costs ................................................................... 795,439 1,705,343
Capitalized mortgage servicing rights ..................................... (633,622) (2,138,477)
Deferred income taxes ..................................................... (153,700) 0
Securities gains, net ..................................................... (3,812) (1,233,229)
Gains on sales of premises ................................................ 0 (175,883)
Losses on sales of real estate ............................................ 25,773 105,418
Gains on sales of loans ................................................... (1,268,445) (4,592,837)
Proceeds from sales of real estate ........................................ 422,316 423,295
Proceeds from sales of loans held for sale ................................ 69,813,836 251,287,444
Disbursements on loans held for sale ...................................... (65,639,383) (245,789,157)
Principal collected on loans held for sale ................................ 0 11,521
Amortization of unearned ESOP shares ...................................... 145,368 145,011
Earned employee stock ownership shares priced above original cost ......... 216,584 121,270
Increase in accrued interest receivable ................................... (464,945) (524,434)
Increase (decrease) in accrued interest payable ........................... 497,565 (420,706)
Equity losses of limited partnerships ..................................... 19,617 313,161
Equity losses of minority interest ........................................ (2,372) 0
Decrease (increase) in other assets ....................................... (708,976) 744,474
Decrease in other liabilities ............................................. (2,656,110) (154,792)
Other, net ................................................................ (16,465) 170,909
------------- ------------
Net cash provided by operating activities ................................ 9,828,896 9,803,393
------------- ------------
Cash flows from investing activities:
Proceeds from sales of securities available for sale ........................ 15,129,325 40,326,825
Principal collected on securities available for sale ........................ 3,754,368 27,772,873
Proceeds collected on securities available for sale ......................... 0 10,000,000
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 .................................... (1,198,000) (373,800)
Redemption of Federal Home Loan Bank stock .................................. 1,264,100 1,119,700
Net increase in loans receivable ............................................ (79,141,416) (117,617,414)
Proceeds from sale of premises .............................................. 0 291,117
Purchases of premises and equipment ......................................... (1,619,864) (790,012)
------------- ------------
Net cash used by investing activities .................................... (81,344,275) (85,762,408)
------------- ------------
Cash flows from financing activities:
Increase in deposits ........................................................ 115,320,241 57,162,876
Purchase of treasury stock .................................................. (2,706,550) (1,384,560)
Stock options exercised ..................................................... 27,634 1,153,364
Dividends to stockholders ................................................... (2,405,414) (2,132,464)
Proceeds from Federal Home Loan Bank advances ............................... 34,400,000 131,000,000
Repayment of Federal Home Loan Bank advances ................................ (39,400,000) (120,000,000)
Increase (decrease) in customer escrows ..................................... (21,114,615) 285,739
------------- ------------
Net cash provided by financing activities ................................ 84,121,296 66,084,955
------------- ------------
Increase (decrease) in cash and cash equivalents ......................... 12,605,917 (9,874,060)
Cash and cash equivalents, beginning of period ................................. 30,496,823 27,729,007
------------- ------------
Cash and cash equivalents, end of period ....................................... $ 43,102,740 17,854,947
============= ============
Supplemental cash flow disclosures:
Cash paid for interest ...................................................... $ 15,068,023 15,544,079
Cash paid for income taxes .................................................. 5,671,500 2,141,000
Supplemental noncash flow disclosures:
Loans transferred to loans held for sale .................................... 0 3,741,477
Transfer of loans to real estate ............................................ 773,799 575,606
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)
September 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).
Home Federal has a community banking philosophy and operates retail banking and
loan production facilities in Minnesota and Iowa. The Bank has two wholly owned
subsidiaries, Osterud Insurance Agency, Inc. (OAI) which offers financial
planning products and services and Home Federal Holding, Inc. (HFH) which is the
holding company for Home Federal REIT, Inc. (HFREIT) which invests in real
estate loans acquired from the Bank. HMN has another wholly owned subsidiary,
Security Finance Corporation (SFC) which acts as an intermediary for the Bank in
transacting like-kind property exchanges for Bank customers. The Bank has an 80%
owned subsidiary, Federal Title Services, LLC. (FTS), which performed mortgage
title services for Bank customers. FTS stopped accepting title orders in the
third quarter of 2004 and is in the process of completing the title orders
received prior to the termination of its operations. The Bank had a 51% owned
subsidiary, Home Federal Mortgage Services, LLC (HFMS), that was a mortgage
banking and mortgage brokerage business. HFMS liquidated its assets in 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, HFMS, 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 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-month and nine-month periods ended September 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 or
to purchase loans that had not closed prior to the end of the quarter which it
intends to sell. These commitments are referred to as its mortgage pipeline. As
commitments to originate or purchase loans enter the mortgage pipeline, the
Company generally enters into commitments to sell the mortgage loans into the
secondary market. The commitments to originate, purchase 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 September 30, 2004, the
Company recorded a decrease in other assets of $10,108, a decrease in other
liabilities of $8,917, and a net loss in gains or losses on sale of loans of
$1,191.
The current commitments to sell loans held for sale are derivatives that 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 to market, the
Company recorded a lower of cost or market adjustment of $1,300, an increase in
other liabilities of $14,487, and a net loss in gains or losses on sale of loans
of $13,187.
7
(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.
The gross unrealized holding gain on securities for the third quarter of 2004
was $568,000, the income tax expense would have been $201,000 and therefore, the
net gain was $367,000. The gross reclassification adjustment for the third
quarter of 2004 was $2,500, the income tax expense would have been $900 and
therefore, the net gain was $1,600. The gross unrealized holding losses on
securities for the third quarter of 2003 was $926,000, the income tax benefit
would have been $327,000 and therefore, the net loss was $599,000. The gross
reclassification adjustment in the third quarter of 2003 was $417,000, the
income tax expense would have been $147,000 and therefore, the net gain was
$270,000.
The gross unrealized holding losses on securities for the nine-month period
ended September 30, 2004 was $931,000, the income tax benefit would have been
$329,000 and therefore, the net loss was $602,000. The gross reclassification
adjustment in the nine-month period ended September 30, 2004 was $3,800, the
income tax expense would have been $1,300 and therefore, the net
reclassification adjustment was $2,500. The gross unrealized holding losses on
securities for the nine-month period ended September 30, 2003 was $742,000, the
income tax benefit would have been $263,000 and therefore, the net loss was
$479,000. The gross reclassification adjustment in the nine-month period ended
September 30, 2003 was $1,233,000, the income tax expense would have been
$435,000 and therefore, the net reclassification adjustment was $798,000.
(5) INVESTMENT IN LIMITED PARTNERSHIPS
Investments in limited partnerships were as follows:
September 30, December 31,
Primary partnership activity 2004 2003
------------- ------------
Common stock of financial institutions $ 0 421,671
174,758 195,371
-------- -------
Low to moderate income housing $174,758 617,042
======== =======
During the third quarter of 2004 the Company recognized $6,500 of losses on
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 will be
credited to current income tax benefits. During the third quarter of 2003 the
Company's proportionate gains from common stock investments in financial
institutions was $16,653 and it recognized $6,500 of losses on low income
housing partnerships. During 2003 the Company received low income housing
credits totaling $84,000, of which $21,000 were credited to current income tax
benefits.
During the nine-month period ended September 30, 2004, the Company recognized
$20,420 of losses on the low income housing partnerships. During 2004 the
Company anticipates receiving low income housing credits totaling $84,000, of
which $63,000 was credited to current income tax benefits. During the nine-month
period ended September 30, 2003, the Company's proportionate loss from a
mortgage servicing partnership was $349,577, its proportionate share of gains
from the common stock investments in financial institutions was $55,916 and it
recognized $19,500 of losses on the low income housing partnerships. During 2003
the Company received low income housing credits totaling $84,000, of which
$63,000 were credited to current income tax benefits. The Company's investment
in the limited partnership that invested in mortgage servicing rights was
written down to zero and dissolved in the second quarter of 2003.
(6) SECURITIES AVAILABLE FOR SALE
The following table shows the gross unrealized losses and fair value for the
securities available for sale portfolio,
8
aggregated by investment category and length of time that individual securities
have been in a continuous loss position, at September 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 September 30,
2004.
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 $ 0 0 7,511 (723) 7,511 (723)
Other marketable securities:
U.S. Agencies 45,387 (127) 0 0 45,387 (127)
Corporate equity 0 0 3,094 (406) 3,094 (406)
------- ---- ------ ------ ------ ------
Total temporarily impaired securities $45,387 (127) 10,605 (1,129) 55,992 (1,256)
======= ==== ====== ====== ====== ======
(7) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Nine Months ended Twelve Months ended Nine Months ended
Sept. 30, 2004 Dec. 31, 2003 Sept. 30, 2003
----------------- ------------------- -----------------
Mortgage servicing rights
Balance, beginning of period ............. $ 3,447,843 2,701,031 2,701,031
Originations ............................. 633,622 2,522,231 2,138,477
Amortization ............................. (795,439) (1,775,419) (1,498,426)
----------- ---------- ----------
Balance, end of period ................... 3,286,026 3,447,843 3,341,082
----------- ---------- ----------
Valuation reserve
Balance, beginning of period ............. 0 (10,000) (10,000)
Additions ................................ 0 (800,000) (800,000)
Reductions ............................... 0 810,000 810,000
----------- ---------- ----------
Balance, end of period ................... 0 0 0
----------- ---------- ----------
Mortgage servicing rights, net ........... $ 3,286,026 3,447,843 3,341,082
=========== ========== ==========
Fair value of mortgage servicing rights... $ 4,519,308 4,316,251 4,199,323
=========== ========== ==========
Mortgage servicing costs, which does not include professional services for
valuing mortgage servicing rights, were $0 at September 30, 2004, and $216,917
for the nine and twelve months ended in September and December of 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 September 30, 2004.
Weighted Weighted
Loan Average Average
Principal Interest Remaining Number
Balance Rate Term of Loans
------------ -------- --------- --------
Original term 30 year fixed rate $205,991,045 5.94% 343 1,830
Original term 15 year fixed rate 241,785,878 5.30% 162 2,913
Seven year balloon 120,458 5.75% 52 1
Adjustable rate 8,893,571 4.98% 336 79
9
(8) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at September 30, 2004 is presented in the table below. Amortization
expense for intangible assets was $880,832 for the nine-month period ended
September 30, 2004.
Gross Unamortized
Carrying Accumulated Intangible
Amount Amortization Assets
---------- ------------ -----------
Amortized intangible assets:
Mortgage servicing rights $4,493,609 (1,207,583) 3,286,026
Core deposit intangible 1,567,000 (1,204,919) 362,081
---------- ----------- ----------
Total $6,060,609 (2,412,502) 3,648,107
========== ========== =========
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 $ 133,933 28,464 162,397
2005 490,981 113,857 604,838
2006 426,021 113,857 539,878
2007 369,061 105,903 474,964
2008 319,151 0 319,151
---------- ---------- -------
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of September 30, 2004. The Company's
actual experience 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 September 30, Nine months ended September 30,
2004 2003 2004 2003
------------ ------------ ----------- ------------
Weighted average number of common shares outstanding
used in basic earnings per common share calculation 3,850,535 3,846,210 3,878,524 3,787,494
Net dilutive effect of options 147,823 160,141 167,524 166,797
---------- --------- --------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 3,998,358 4,006,351 4,046,048 3,954,291
========== ========= ========= =========
Income available to common shareholders $2,550,201 3,040,281 7,167,821 6,460,049
Basic earnings per common share $ 0.66 0.79 1.85 1.71
Diluted earnings per common share $ 0.64 0.76 1.77 1.63
(10) REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory and possibly additional discretionary actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures established by regulations to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
following table) of Tier I or Core capital and Risk-based capital (as defined in
10
the regulations) to total assets (as defined). Management believes, as of
September 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 September
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 September 30, 2004 the Bank's tangible assets and adjusted total assets were
$948.6 million and its risk-weighted assets were $768.3 million. The following
table presents the Bank's capital amounts and ratios at September 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.................... $ 77,966
Plus:
Net unrealized loss on certain securities
available for sale...................... 393
Less:
Goodwill and other intangibles............. (4,163)
Excess mortgage servicing rights........... (70)
--------
Tier I or core capital 74,126
--------
Tier I capital to adjusted total assets.... 7.81% $37,944 4.00% $36,182 3.81% $47,430 5.00%
Tier I capital to risk-weighted assets....... 9.65% $30,732 4.00% $43,394 5.65% $46,098 6.00%
Plus:
Allowable allowance for loan losses......... 7,589
--------
Risk-based capital........................... $ 81,715 $61,464 $20,251 $76,830
========
Risk-based capital to risk- weighted assets.. 10.64% 8.00% 2.64% 10.00%
(1) Based upon the Bank's adjusted total assets for the purpose of the tangible
and core capital ratios and risk-weighted assets for the purpose of the
risk-based capital ratio.
The tangible capital of the Bank was in excess of the minimum 2% required at
September 30, 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
HFMS to secure loan purchase 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 the Company for these guarantees and the Company 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 issued standby letters of credit which guarantee the performance of
customers to third parties. The outstanding standby letters of credit expire
over the next 2.7 years and totaled approximately $8.5 million at September 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
11
cash requirements are expected to be less than the total outstanding
commitments.
(12) STOCK-BASED COMPENSATION
Effective January 1, 1996, the Company adopted SFAS No. 123, Accounting for
Stock-Based Compensation. The Company 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 the Company's stock-based plan been
determined in accordance with the fair value method recommended by SFAS No. 123,
the Company's net income and earnings per share would have been adjusted to the
pro forma amounts indicated below:
Quarter Ended Quarter Ended Nine Months Ended Nine Months Ended
September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003
------------------ ------------------ ------------------ ------------------
Net income:
As reported.............................. $2,550,201 3,040,281 7,167,821 6,460,049
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects............. 11,371 10,128 28,432 30,383
---------- --------- --------- ---------
Pro forma................................ 2,538,830 3,030,153 7,139,389 6,429,666
Earnings per
Common share:
As reported:
Basic.................................... $ 0.66 0.79 1.85 1.71
Diluted.................................. 0.64 0.76 1.77 1.63
Pro forma:
Basic ................................... 0.66 0.79 1.84 1.70
Diluted.................................. 0.63 0.76 1.76 1.63
(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 a reportable segment and therefore are
included in the "Other" category.
The Company evaluates performance and allocates resources based on the segment's
net income, return on average assets and return on average equity. Each
corporation is managed separately with its own officers and board of directors.
The following table sets forth certain information about the reconciliations of
reported net income and assets for each of the Company's reportable segments.
12
Home Federal Consolidated
(Dollars in thousands) Savings Bank Other Eliminations Total
------------ ------ ------------ ------------
AT OR FOR THE QUARTER ENDED SEPTEMBER 30, 2004:
Interest income - external customers .............. $13,146 10 0 13,156
Non-interest income - external customers .......... 1,596 0 0 1,596
Loss on limited partnerships ...................... (7) 0 0 (7)
Intersegment interest income ...................... 0 3 (3) 0
Intersegment non-interest income .................. 32 2,592 (2,624) 0
Interest expense .................................. 5,390 0 (3) 5,387
Amortization of mortgage servicing rights,
net valuation adjustments, and servicing costs.. 240 0 0 240
Other non-interest expense ........................ 4,502 170 (32) 4,640
Income tax expense (benefit) ...................... 1,266 (113) 0 1,153
Net income ........................................ 2,594 2,548 (2,592) 2,550
Goodwill .......................................... 3,801 0 0 3,801
Total assets ...................................... 950,179 83,381 (78,225) 955,335
Net interest margin ............................... 3.47 NM NM 3.47
Return on average assets .......................... 1.12 NM NM 1.09
Return on average realized common equity .......... 13.39 NM NM 12.02
AT OR FOR THE QUARTER ENDED SEPTEMBER 30, 2003:
Interest income - external customers .............. $11,477 31 0 11,508
Non-interest income - external customers .......... 2,949 134 0 3,083
Earnings (loss) on limited partnerships ........... (6) 16 0 10
Intersegment interest income ...................... 0 4 (4) 0
Intersegment non-interest income .................. 161 2,967 (3,128) 0
Interest expense .................................. 5,069 0 (4) 5,065
Amortization of mortgage servicing rights,
net valuation adjustments, and servicing costs .. (113) 0 (80) (193)
Other non-interest expense ........................ 4,456 147 (80) 4,523
Income tax expense (benefit) ...................... 1,654 (33) 0 1,621
Net income ........................................ 2,968 3,040 (2,968) 3,040
Goodwill .......................................... 3,801 0 0 3,801
Total assets ...................................... 806,254 79,674 (78,885) 807,043
Net interest margin ............................... 3.41 NM NM 3.41
Return on average assets .......................... 1.51 NM NM 1.53
Return on average realized common equity .......... 16.67 NM NM 15.12
NM - Not meaningful
13
Home Federal Consolidated
(Dollars in thousands) Savings Bank Other Eliminations Total
------------ ------ ------------ ------------
AT OR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004:
Interest income - external customers ............ $ 37,905 34 0 37,939
Non-interest income - external customers ........ 4,825 0 0 4,825
Earnings (loss) on limited partnerships ......... (21) 1 0 (20)
Intersegment interest income .................... 0 12 (12) 0
Intersegment non-interest income ................ 140 7,288 (7,428) 0
Interest expense ................................ 15,578 0 (12) 15,566
Amortization of mortgage servicing rights, net
valuation adjustments, and servicing costs ... 795 0 0 795
Other non-interest expense ...................... 13,657 491 (140) 14,008
Income tax expense (benefit) .................... 3,489 (320) 0 3,169
Minority interest ............................... (2) 0 0 (2)
Net income ...................................... 7,292 7,164 (7,288) 7,168
Goodwill ........................................ 3,801 0 0 3,801
Total assets .................................... 950,179 83,381 (78,225) 955,335
Net interest margin ............................. 3.47 NM NM 3.46
Return on average assets ........................ 1.07 NM NM 1.06
Return on average realized common equity ........ 12.86 NM NM 11.44
AT OR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003:
Interest income - external customers ............ $ 32,887 128 0 33,015
Non-interest income - external customers ........ 8,369 301 0 8,670
Earnings (loss) on limited partnerships ......... (369) 56 0 (313)
Intersegment interest income .................... 28 26 (54) 0
Intersegment non-interest income ................ 669 6,256 (6,925) 0
Intersegment loan loss provision ................ 200 0 (200) 0
Interest expense ................................ 15,177 0 (54) 15,123
Amortization of mortgage servicing rights, net
valuation adjustments, and servicing costs .... 1,925 3 (223) 1,705
Other non-interest expense ...................... 12,853 412 (246) 13,019
Income tax expense (benefit) .................... 3,269 (105) 0 3,164
Net income ...................................... 6,260 6,457 (6,257) 6,460
Goodwill ........................................ 3,801 0 0 3,801
Total assets .................................... 806,254 79,674 (78,885) 807,043
Net interest margin ............................. 3.27 NM NM 3.29
Return on average assets ........................ 1.10 NM NM 1.13
Return on average realized common equity ........ 12.05 NM NM 10.99
NM - Not meaningful
14
HMN FINANCIAL, INC.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING INFORMATION
This quarterly report and other reports filed with the Securities and Exchange
Commission may contain "forward-looking" statements that deal with future
results, plans or performance. In addition, the Company's management may make
such statements orally to the media, or to securities analysts, investors or
others. Forward-looking statements deal with matters that do not relate strictly
to historical facts. The Company's future results may differ materially from
historical performance and forward-looking statements about the Company's
expected financial results or other plans are subject to a number of risks and
uncertainties. These include but are not limited to possible legislative changes
and adverse economic, business and competitive developments such as shrinking
interest margins; deposit outflows; reduced demand for financial services and
loan products; changes in accounting policies and guidelines, or monetary and
fiscal policies of the federal government or tax laws; changes in credit and
other risks posed by the Company's loan and investment portfolios;
technological, computer-related or operational difficulties; adverse changes in
securities markets; results of litigation or other significant uncertainties.
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 nine 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
16
origination volume declines and the value of MSRs increases and as interest
rates decline the origination volume increases and the value of MSRs decreases.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. These calculations are
based on many complex factors including estimates of the timing of reversals of
temporary differences, the interpretation of federal and state income tax laws,
and a determination of the differences between the tax and the financial
reporting basis of assets and liabilities. Actual results could differ
significantly from the estimates and interpretations used in determining the
current and deferred income tax liabilities.
NET INCOME
The Company's net income was $2.6 million for the third quarter of 2004, down
$490,000, or 16.1%, from net income of $3.0 million for the third quarter of
2003. Basic earnings per share for the third quarter of 2004 were $0.66, down
$0.13, or 16.5%, from $0.79 for the same quarter of 2003. Diluted earnings per
common share for the third quarter of 2004 were $0.64, down $0.12, or 15.8%,
from $0.76 for the third quarter of 2003.
Net income was $7.2 million for the nine-month period ended September 30, 2004,
an increase of $708,000, or 11.0%, compared to $6.5 million for the nine-month
period ended September 30, 2003. Basic earnings per share were $1.85 for the
nine-months ended September 30, 2004, an increase of $0.14, or 8.2%, from $1.71
for the same nine-month period of 2003. Diluted earnings per common share for
the nine-month period in 2004 were $1.77, up $0.14, or 8.6%, from $1.63 for the
same nine-month period in 2003.
NET INTEREST INCOME
Net interest income was $7.8 million for the third quarter of 2004, an increase
of $1.3 million, or 20.6%, compared to $6.4 million for the third quarter of
2003. Interest income was $13.1 million for the third quarter of 2004, an
increase of $1.6 million, or 14.3%, from $11.5 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
$131 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 in the single-family loan portfolio due to a decrease in
the outstanding balance and lower interest rates of this portfolio in the third
quarter of 2004 when compared to the same period in 2003. The yield earned on
interest-earning assets was 5.87% for the third quarter of 2004, a decrease of
23 basis points from the 6.10% yield for the third quarter of 2003.
Interest expense was $5.4 million for the third quarter of 2004, an increase of
$321,000, or 6.3%, compared to $5.1 million for the third quarter of 2003.
Interest expense increased primarily because of the $177 million in deposit
growth that was experienced between the periods. The increase in interest
expense caused by the increased deposits was partially offset by a decrease in
the average interest rate paid on deposits. The decrease in the average rate was
primarily the result of the $96 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 2.53% for the third quarter of 2004, a decrease of 34 basis
points from the 2.87% paid for the third quarter of 2003.
Net interest margin (net interest income divided by average interest earning
assets) for the third quarter of 2004 was 3.47%, an increase of 6 basis points,
compared to 3.41% for the third quarter of 2003.
Net interest income was $22.4 million for the first nine months of 2004, an
increase of $4.5 million, or 25.1%, from $17.9 million for the same period in
2003. Interest income was $37.9 million for the nine-month period of
17
2004, an increase of $4.9 million, or 14.9%, from $33.0 million for the same
nine-month 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 $131 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 nine months of 2004 when compared to the same period in 2003. The yield
earned on interest-earning assets was 5.87% for the first nine months of 2004, a
decrease of 19 basis points from the 6.06% yield for the first nine months of
2003.
Interest expense was $15.6 million for the nine-month period of 2004, an
increase of $442,000, or 2.9%, from the $15.1 million for the same period in
2003. Interest expense on deposits and FHLB advances decreased by $2.9 million
due to a decline in the interest rates paid and increased by $3.3 million due to
the $138 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 nine months of 2004, a decrease of 44 basis
points from the 2.98% paid for the same period in 2003.
Net interest margin (net interest income divided by average interest earning
assets) for the first nine months of 2004 was 3.46%, an increase of 17 basis
points, compared to 3.29% 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 $775,000 for the third quarter of 2004, an increase of $230,000, or 42.2%,
from $545,000 for the third quarter of 2003. The provision for loan losses
increased primarily because of the $11 million of additional commercial and
consumer loan growth that was experienced in the third quarter of 2004 when
compared to the third quarter of 2003.
The provision for loan losses was $2.0 million for the nine-month period of
2004, an increase of $141,000, or 7.4%, from $1.9 million for the same
nine-month period in 2003. The provision for loan losses increased primarily
because of the slightly higher growth experienced in the commercial and consumer
loan portfolios in the first nine-months of 2004 compared to the same period of
2003. Charge offs during the first nine months of 2004 increased by $335,000
over the same period in 2003 primarily because of increased charge offs in the
single-family, mobile home and auto 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 2,041,000 1,900,000
Commercial loan charge offs 0 (19,279)
Consumer loan charge offs (290,672) (134,025)
Single family mortgage loan
charge offs (231,055) (33,750)
Recoveries 12,137 54,652
----------- ---------
Balance at September 30, $ 8,471,012 6,591,815
=========== =========
NON-INTEREST INCOME
Non-interest income was $1.6 million for the third quarter of 2004, a decrease
of $1.5 million, or 48.7%, from $3.1 million for the same period in 2003. Gains
on sales of loans decreased by $1.3 million due to the significant decrease in
mortgage loan activity in the third quarter of 2004 when compared to the same
period in 2003. Non-interest income also decreased by $415,000 due to the lower
gains recognized on the sale of securities during the third quarter of 2004 when
compared to the same quarter in 2003. These decreases in non-interest income
were
18
partially offset by an increase of $116,000 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 $31,000 between the periods
because of the increased size of the mortgage loan servicing portfolio and other
non-interest income increased by $31,000 primarily because of increased revenues
from the sale of uninsured investment products.
Non-interest income was $4.8 million for the first nine months of 2004, a
decrease of $3.6 million, or 42.5%, from $8.4 million for the same period in
2003. Gains on sales of loans decreased by $3.3 million due to the significant
decrease in mortgage loan activity in the first nine months of 2004 when
compared to the same period of 2003. Non-interest income also decreased by $1.2
million because of lower gains on security sales. Fees and service charges
increased by $402,000 between the periods due primarily 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 $153,000 due to the increased size of the
mortgage loan servicing portfolio between the periods. Other non-interest income
increased by $153,000 primarily because of increased revenues from the sale of
uninsured investment products.
NON-INTEREST EXPENSE
Non-interest expense was $4.9 million for the third quarter of 2004, an increase
of $550,000, or 12.7%, from $4.3 million for the third quarter of 2003.
Amortization of mortgage servicing rights increased by $433,000, or 224.1%, due
primarily to the recapture of an $810,000 impairment reserve in the third
quarter of 2003 as a result of a slow down in mortgage loan prepayment speeds.
In comparison, no impairment reserves were established or recaptured in the
third quarter of 2004. Data processing costs decreased by $77,000 primarily
because of the renegotiation of a third party service contract in the fourth
quarter of 2003. Compensation expense increased by $345,000, or 16.5%, primarily
due to an increase in the number of employees and because of annual increases in
payroll and employee benefit costs. Other operating expenses decreased by
$288,000 primarily due to the reduction in costs associated with the decreased
mortgage loan production in the current quarter when compared to the same period
in 2003.
Non-interest expense was $14.8 million for the first nine months of 2004, an
increase of $79,000, or 0.5%, from $14.7 million for the same period in 2003.
Amortization expense on mortgage servicing rights decreased by $910,000 between
the periods because of a decrease in the prepayments on the mortgage loans being
serviced. Data processing costs decreased by $219,000 primarily because of the
renegotiation of a third party service contract in the fourth quarter of 2003.
Compensation expense increased by $1.1 million because of an increase in the
number of employees and because of annual payroll and benefit cost increases.
Occupancy expense increased by $271,000 primarily because of increases in real
estate taxes on existing facilities and increased expenses relating to
additional corporate facilities that were put in place in the first quarter of
2004.
INCOME TAX EXPENSE
Income tax expense was $1.2 million for the third quarter of 2004, a decrease of
$469,000, compared to $1.6 million for the same period of 2003. Income tax
expense was unchanged at $3.2 million for both nine-month periods despite the
increase in taxable income in 2004 primarily because of a decrease in the
effective tax rate in 2004 compared to 2003. The decrease in the effective tax
rate was caused in part by an increase in tax-exempt income and a change in the
apportionment of state taxes.
NON-PERFORMING ASSETS
The following table sets forth the amounts and categories of non-performing
assets in the Bank's portfolio at September 30, 2004 and December 31, 2003.
19
Sept. 30, Dec. 31,
(Dollars in Thousands) 2004 2003
------ ------
Non-Accruing Loans:
One-to-four family real estate $1,113 1,177
Commercial real estate 1,114 2,162
Consumer 424 1,050
Commercial business 260 186
------ ------
Total 2,911 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 424 73
Consumer 183 62
Commercial 0 0
------ ------
Total non-performing assets $3,719 $5,035
====== ======
Total as a percentage of total assets 0.39% 0.58%
====== ======
Total non-performing loans $2,911 $4,689
====== ======
Total as a percentage of total loans receivable, net 0.38% 0.68%
Allowance for loan loss to non-performing loans 291.04% 147.99%
Total non-performing assets at September 30, 2004 were $3.7 million, a decrease
of $1.3 million, or 26.1%, from $5.0 million at December 31, 2003. The decrease
in non-performing assets relates primarily to a $1.0 million decrease in
non-accruing commercial real estate loans, a $626,000 decrease in non-accruing
consumer loans, and a $472,000 increase in foreclosed and repossessed assets
during the first nine months of 2004. The following activity occurred during the
first nine months of 2004 related to non-performing loans: $3.4 million of
previously performing loans were classified as non-performing, $899,000 of loans
were foreclosed or repossessed, and $4.3 million in previously non-performing
loans paid off or were reclassified to performing status.
DIVIDENDS
On October 26, 2004 the Company declared a cash dividend of $0.22 per share,
payable on December 15, 2004 to shareholders of record on November 26, 2004.
During 2004, the Company has declared and paid dividends as follows:
Record date Payable 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%
August 27, 2004 September 10, 2004 $0.22 35.48%
The annualized dividend payout ratio for the past four quarters, ending with the
December 15, 2004 payment will be 36.36%.
The declaration of dividends are subject to, among other things, the Company's
financial condition and results of operations, the Bank's compliance with its
regulatory capital requirements, including the fully phased-in capital
requirements, tax considerations, industry standards, economic conditions,
regulatory restrictions, general business practices and other factors.
20
LIQUIDITY
For the nine months ended September 30, 2004, the net cash provided by operating
activities was $9.8 million. The Company collected $15.1 million from the sale
of securities, $3.8 million from principal repayments on securities and $422,000
in proceeds from the sale of real estate. It purchased premises and equipment of
$1.6 million, purchased securities available for sale of $20.0 million and net
loans receivable increased by $79.1 million due to loan growth primarily in the
commercial and consumer loan areas. The Company had a net increase in deposit
balances of $115.3 million for the nine-month period. It repaid $39.4 million of
FHLB advances and $21.1 million in customer escrows. The Company received
$28,000 related to the exercise of stock options, purchased $2.7 million of its
own stock, and paid $2.4 million in dividends to its shareholders.
The Company has certificates of deposits with outstanding balances of $186.7
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
or through the sale of securities. Management does not anticipate that it will
have a liquidity problem due to maturing deposits.
The Company has $110.9 million of FHLB advances which mature beyond September
30, 2005 but have call features that can be exercised by the FHLB during the
next twelve months. If the call features are exercised, the Company has the
option of requesting any advance otherwise available to it pursuant to the
credit policy of the FHLB. The Company also has $28.0 million of FHLB advances
that will mature during the next twelve months. Since the Company has the
ability to request another advance to replace the advance that is being called
or is maturing, management does not anticipate that it will have a liquidity
problem due to advances being called by the FHLB during the next twelve months.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. The Company's market risk arises primarily from interest rate
risk inherent in its investing, lending and deposit taking activities.
Management actively monitors and manages its interest rate risk exposure.
The Company's profitability is affected by fluctuations in interest rates. A
sudden and substantial change in interest rates may adversely impact the
Company's earnings to the extent that the interest rates borne by assets and
liabilities do not change at the same speed, to the same extent, or on the same
basis. The Company monitors the projected changes in net interest income that
occur if interest rates were to suddenly change up or down. The Rate Shock Table
that follows in the Asset/Liability Management section of this report discloses
the Company's projected changes in net interest income based upon immediate
interest rate changes called rate shocks.
The Company utilizes a model which uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate the
current market value of those assets and liabilities. The model also calculates
the changes in market value of the interest-earning assets and interest-bearing
liabilities due to different interest rate changes. The Company believes that
over the next twelve months interest rates could conceivably fluctuate in a
range of 200 basis points up or 100 basis points down from where the interest
rates were at September 30, 2004. The Company does not have a trading portfolio.
The following table discloses the projected changes in market value to the
Company's interest-earning assets and interest-bearing liabilities based upon
incremental 100 basis point changes in interest rates from interest rates in
effect on September 30, 2004.
21
Other than trading portfolio Market Value
----------------------------------------------------------------
(Dollars in thousands)
Basis point change in interest rates -100 0 +100 +200
---------- ------- ------- -------
Total market risk sensitive assets.................... $ 955,192 947,441 937,245 925,610
Total market risk sensitive liabilities............... 863,285 846,759 830,838 815,434
Off-balance sheet financial instruments............... (203) 0 139 275
---------- ------- ------- -------
Net market risk....................................... $ 92,110 100,682 106,268 109,901
========== ======= ======= =======
Percentage change from current market value........... (8.51)% 0.00% 5.55% 9.16%
========== ======= ======= =======
The preceding table was prepared utilizing the following assumptions (Model
Assumptions) regarding prepayment and decay ratios which were determined by
management based upon their review of historical prepayment speeds and future
prepayment projections. Fixed rate loans were assumed to prepay at annual rates
of between 5% to 75%, depending on the note rate and the period to maturity.
Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of
between 11% and 30%, depending on the note rate and the period to maturity.
Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of
between 5% and 52% depending on the note rate and the period to maturity.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were
projected to have prepayments based upon the underlying collateral securing the
instrument and the related cash flow priority of the CMO tranche owned.
Certificate accounts were assumed not to be withdrawn until maturity. Passbook
accounts were assumed to decay at an annual rate of 28% and money market
accounts were assumed to decay at an annual rate of 37%. FHLB advances were
projected to be called at the first call date where the projected interest rate
on similar remaining term advances exceeded the interest rate on the Company's
callable advance.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. The interest rates on certain types of assets and liabilities
may fluctuate in advance of changes in market interest rates, while interest
rates on other types of assets and liabilities may lag behind changes in market
interest rates. The model assumes that the difference between the current
interest rate being earned or paid compared to a treasury instrument or other
interest index with a similar term to maturity (Interest Spread) will remain
constant over the interest changes disclosed in the table. Changes in Interest
Spread could impact projected market value changes. Certain assets, such as
ARMs, have features which restrict changes in interest rates on a short-term
basis and over the life of the assets. The market value of the interest-bearing
assets which are approaching their lifetime interest rate caps could be
different from the values disclosed in the table. In the event of a change in
interest rates, prepayment and early withdrawal levels may deviate significantly
from those assumed in calculating the foregoing table. The ability of many
borrowers to service their debt may decrease in the event of a substantial
sustained interest rate increase.
ASSET/LIABILITY MANAGEMENT
The Company's management reviews the impact that changing interest rates will
have on its net interest income projected for the twelve months following
September 30, 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 37,334 10.24%
+100 35,717 5.47%
0 33,865 0.00%
-100 32,605 (3.72)%
22
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections
prepared by third parties.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. In the event of a change in interest rates, prepayment and
early withdrawal levels would likely deviate significantly from those assumed in
calculating the foregoing table. The ability of many borrowers to service their
debt may decrease in the event of a substantial sustained interest rate increase
and could impact net interest income.
In an attempt to manage its exposure to changes in interest rates, management
closely monitors interest rate risk. The Bank has an Asset/Liability Committee
which meets frequently to discuss changes in the Bank's interest rate risk
position and projected profitability. The Committee makes adjustments to the
asset/liability position of the Bank which are reviewed by the Board of
Directors of the Bank. This Committee also reviews the Bank's portfolio,
formulates investment strategies and oversees the timing and implementation of
transactions to assure attainment of the Board's objectives in the most
effective manner. In addition, 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.
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 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 one-year, three-year or
five-year periods. The Bank's commercial loan portfolio is primarily made up of
adjustable rate loans and fixed rate commercial loans placed into 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 (Exchange Act)). Based on this evaluation, the principal executive
officer and principal financial officer concluded that the Company's disclosure
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms.
Changes in internal controls. There was no change in the Company's internal
control over financial reporting during the Company's most recently completed
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, the Company's internal control over financial reporting.
23
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
None.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a)-(b) Not applicable
(a) Total (c) Total Number of (d) Maximum Number (or
Number of (b) Average Shares (or Units) Approximate Dollar Value) of
Shares (or Price Paid Purchased as Part of Shares (or Units) that May Yet
Units) per Share Publicly Announced Be Purchased Under the Plans
Period Purchased (or Unit) Plans or Programs or Programs
- -------------------------------------- ---------- ----------- -------------------- ------------------------------
July 1 through July 31, 2004 0 0 0 267,000
August 1 through August 31, 2004 20,000 26.30 20,000 247,000
September 1 through September 30, 2004 0 0 0 247,000
------ ------ ------
Total 20,000 $26.30 20,000
====== ====== ======
(1) 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.
None.
ITEM 5. Other Information.
None.
ITEM 6. Exhibits.
Exhibits. See Index to Exhibits on page 26 of this report.
24
SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HMN FINANCIAL, INC.
Registrant
Date: November 9, 2004 /s/ Michael McNeil
---------------------------------
Michael McNeil,
President/Chief Executive Officer
(Principal Executive Officer)
(Duly Authorized Representative)
Date: November 9, 2004 /s/ Jon Eberle
---------------------------------
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
25
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
Sequential
Reference Page Numbering
Regulation to Prior Where Attached
S-K Filing or Exhibits Are
Exhibit Exhibit Located in This
Number Document Attached Hereto Number Form 10-Q Report
- ---------- ---------------------------------------------- --------- --------------------
3.1 Amended and Restated Articles of Incorporation *1 N/A
3.2 Amended and Restated By-laws *2 N/A
4 Form of Common Stock *3 N/A
Including indentures
10.1 Form of Incentive Stock Option Agreement for 10.1 Filed Electronically
HMN Financial, Inc. 2001 Omnibus Stock Plan
10.2 Form of Non-Statutory Stock Option Agreement for 10.2 Filed Electronically
HMN Financial, Inc. 2001 Omnibus Stock Plan
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
Annual Report on Form 10-K for the period ended December 31, 2003 (File
No. 0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's
Registration Statement on Form S-1 dated April 1, 1994 (File No.
33-77212).
26