Edgar Filing: HMN FINANCIAL INC

e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2011


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission File Number 0-24100

HMN FINANCIAL, INC.

(Exact name of Registrant as specified in its Charter)


Delaware		41-1777397

(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

1016 Civic Center Drive N.W., Rochester, MN		55901

(Address of principal executive offices)		(ZIP Code)

Registrant’s telephone number, including area code: (507) 535-1200

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer o		Accelerated filer o		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

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 22 , 2011

Common stock, $0.01 par value		4,387,951

HMN FINANCIAL, INC.

CONTENTS

PART I — FINANCIAL INFORMATION


	Page
Item 1: Financial Statements (unaudited)

Consolidated Balance Sheets at June 30, 2011 and December 31, 2010		3

Consolidated Statements of Loss for the Three Months Ended and Six Months Ended June 30, 2011 and 2010		4

Consolidated Statement of Stockholders’ Equity and Comprehensive Loss for the Six Month Period Ended June 30, 2011		5

Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and 2010		6

Notes to Consolidated Financial Statements		7

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations		23

Item 3: Quantitative and Qualitative Disclosures about Market Risk (Included in Item 2 under Market Risk)		34

Item 4: Controls and Procedures		36

PART II — OTHER INFORMATION

Item 1: Legal Proceedings		37

Item 1A: Risk Factors		38

Item 2: Unregistered Sales of Equity Securities and Use of Proceeds		41

Item 3: Defaults Upon Senior Securities		42

Item 4: [Removed and Reserved]		42

Item 5: Other Information		42

Item 6: Exhibits		42

Signatures		43
EX-31.1
EX-31.2
EX-32
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

Part I — FINANCIAL INFORMATION

Item 1: Financial Statements

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets


	June 30,			December 31,
(Dollars in thousands)	2011			2010
	(unaudited)
Assets
Cash and cash equivalents	$	26,724			20,981
Securities available for sale:
Mortgage-backed and related securities (amortized cost $25,410 and $32,036)		26,780			33,506
Other marketable securities (amortized cost $107,616 and $118,631)		107,467			118,058

		134,247			151,564


Loans held for sale		1,075			2,728
Loans receivable, net		601,787			664,241
Accrued interest receivable		2,932			3,311
Real estate, net		21,868			16,382
Federal Home Loan Bank stock, at cost		5,574			6,743
Mortgage servicing rights, net		1,520			1,586
Premises and equipment, net		8,925			9,450
Prepaid expenses and other assets		2,722			3,632
Deferred tax asset, net		0			0

Total assets	$	807,374			880,618


Liabilities and Stockholders’ Equity
Deposits	$	647,115			683,230
Federal Home Loan Bank advances and Federal Reserve borrowings		85,000			122,500
Accrued interest payable		898			1,092
Customer escrows		730			818
Accrued expenses and other liabilities		6,060			3,431

Total liabilities		739,803			811,071

Commitments and contingencies
Stockholders’ equity:
Serial preferred stock ($.01 par value):
authorized 500,000 shares; issued shares 26,000		24,517			24,264
Common stock ($.01 par value):
authorized 11,000,000; issued shares 9,128,662		91			91
Additional paid-in capital		53,607			56,420
Retained earnings, subject to certain restrictions		53,313			55,838
Accumulated other comprehensive income		865			541
Unearned employee stock ownership plan shares		(3,287	)		(3,384	)
Treasury stock, at cost 4,740,711 and 4,818,263 shares		(61,535	)		(64,223	)

Total stockholders’ equity		67,571			69,547

Total liabilities and stockholders’ equity	$	807,374			880,618

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Loss
(unaudited)


	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands, except per share data)	2011			2010			2011			2010
Interest income:
Loans receivable	$	9,301			11,461			19,204			23,220
Securities available for sale:
Mortgage-backed and related		290			479			614			1,014
Other marketable		407			591			824			1,163
Cash equivalents		2			1			3			2
Other		45			37			114			74

Total interest income		10,045			12,569			20,759			25,473


Interest expense:
Deposits		1,806			3,038			3,746			6,459
Federal Home Loan Bank advances		1,240			1,542			2,569			3,064

Total interest expense		3,046			4,580			6,315			9,523

Net interest income		6,999			7,989			14,444			15,950
Provision for loan losses		3,463			4,360			5,409			10,893

Net interest income after provision for loan losses		3,536			3,629			9,035			5,057


Non-interest income:
Fees and service charges		925			920			1,849			1,762
Mortgage servicing fees		250			274			500			542
Gains on sales of loans		301			467			796			781
Other		113			120			230			270

Total non-interest income		1,589			1,781			3,375			3,355


Non-interest expense:
Compensation and benefits		3,512			3,411			7,072			6,860
Loss (gain) on real estate owned		143			33			190			(728	)
Occupancy		916			1,035			1,856			2,066
Deposit insurance		407			519			811			1,036
Data processing		305			298			558			574
Other		2,209			1,034			3,797			2,539

Total non-interest expense		7,492			6,330			14,284			12,347

Loss before income tax expense (benefit)		(2,367	)		(920	)		(1,874	)		(3,935	)
Income tax expense (benefit)		(76	)		6,912			0			5,744

Net loss		(2,291	)		(7,832	)		(1,874	)		(9,679	)
Preferred stock dividends and discount		457			448			906			888

Net loss available to common shareholders	$	(2,748	)		(8,280	)		(2,780	)		(10,567	)

Basic loss per common share	$	(0.72	)		(2.20	)		(0.73	)		(2.82	)

Diluted loss per common share	$	(0.72	)		(2.20	)		(0.73	)		(2.82	)

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders’ Equity and Comprehensive Loss
For the Six-Month Period Ended June 30, 2011
(unaudited)


													Unearned
													Employee
											Accumulated		Stock						Total
					Additional						Other		Ownership						Stock-
	Preferred		Common		Paid-in			Retained			Comprehensive		Plan			Treasury			Holders’
(Dollars in thousands)	Stock		Stock		Capital			Earnings			Income		Shares			Stock			Equity

Balance, December 31, 2010	$	24,264		91		56,420			55,838			541		(3,384	)		(64,223	)		69,547

Net loss									(1,874	)										(1,874	)
Other comprehensive income, net of tax:
Net unrealized gains on securities available for sale												324								324

Total comprehensive loss																				(1,550	)
Preferred stock discount amortization		253				(253	)													0
Stock compensation tax benefits						14														14
Unearned compensation restricted stock awards						(2,700	)										2,700			0
Restricted stock awards forfeited						12											(12	)		0
Amortization of restricted stock awards						152														152
Preferred stock dividends accrued									(651	)										(651	)
Earned employee stock ownership plan shares						(38	)							97						59

Balance, June 30, 2011	$	24,517		91		53,607			53,313			865		(3,287	)		(61,535	)		67,571

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
(unaudited)


	Six Months Ended
	June 30,
(Dollars in thousands)	2011			2010
Cash flows from operating activities:
Net loss	$	(1,874	)		(9,679	)
Adjustments to reconcile net loss to cash provided by operating activities:
Provision for loan losses		5,409			10,893
Depreciation		640			837
Amortization of premiums, net		166			324
Amortization of deferred loan fees		(294	)		(114	)
Amortization of mortgage servicing rights, net		213			219
Capitalized mortgage servicing rights		(147	)		(333	)
Deferred income tax		0			11,625
Loss (gain) on real estate		190			(728	)
Gains on sales of loans		(796	)		(781	)
Proceeds from sale of loans held for sale		25,350			39,782
Disbursements on loans held for sale		(19,237	)		(35,981	)
Amortization of restricted stock awards		152			190
Amortization of unearned ESOP shares		97			96
Earned employee stock ownership shares priced below original cost		(38	)		(19	)
Stock option compensation		14			31
Decrease (increase) in accrued interest receivable		379			(282	)
Decrease in accrued interest payable		(194	)		(660	)
Decrease (increase) in other assets		867			(4,926	)
Increase (decrease) in accrued expenses and other liabilities		1,965			(482	)
Other, net		119			3

Net cash provided by operating activities		12,981			10,015

Cash flows from investing activities:
Principal collected on securities available for sale		6,635			9,803
Proceeds collected on maturities of securities available for sale		80,000			63,000
Purchases of securities available for sale		(69,028	)		(70,149	)
Purchase of Federal Home Loan Bank Stock		(17	)		(874	)
Redemption of Federal Home Loan Bank Stock		1,186			971
Proceeds from sales of real estate		2,463			13,616
Net decrease in loans receivable		45,473			32,695
Purchases of premises and equipment		(115	)		(64	)

Net cash provided by investing activities		66,597			48,998

Cash flows from financing activities:
Decrease in deposits		(36,247	)		(49,820	)
Dividends to preferred stockholders		0			(650	)
Proceeds from borrowings		0			5,000
Repayment of borrowings		(37,500	)		(5,000	)
Decrease in customer escrows		(88	)		(257	)

Net cash used by financing activities		(73,835	)		(50,727	)

Increase in cash and cash equivalents		5,743			8,286
Cash and cash equivalents, beginning of period		20,981			16,418

Cash and cash equivalents, end of period	$	26,724			24,704

Supplemental cash flow disclosures:
Cash paid for interest	$	6,509			10,182
Cash paid for income taxes		0			39
Supplemental noncash flow disclosures:
Transfer of loans to real estate		8,259			8,254
Loans transferred to loans held for sale		3,607			2,899

See accompanying notes to consolidated financial statements.

HMN FINANCIAL, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)

June 30, 2011 and 2010

(1) HMN Financial, Inc.

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance Agency, Inc. (OIA), which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC), which is currently not actively engaged in any activities.

The consolidated financial statements included herein are for HMN, SFC, the Bank and OIA. 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 loss, consolidated statement of stockholders’ equity and comprehensive loss and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles. However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The results of operations for the six-month period ended June 30, 2011 is not necessarily indicative of the results which may be expected for the entire year.

Certain amounts in the consolidated financial statements for prior periods have been reclassified to conform with the current period presentation.

(3) New Accounting Standards

In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings are also required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010 and the related disclosures were included in Note 5 in the Company’s December 31, 2010 notes to the consolidated financial statements and in Note 9 of this quarterly report.

In January 2011, the FASB issued ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. The amendment temporarily delays the effective date of the disclosures about troubled debt restructurings in ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses for public entities.

In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310), A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This ASU provides guidance on evaluating whether a restructuring constitutes a troubled debt restructuring. It indicates that if a creditor separately concludes that a restructuring constitutes a concession and that the debtor is experiencing financial difficulties that the restructuring is a troubled debt restructuring. It also clarifies guidance on a creditor’s evaluation of the above two items. For public entities, such as HMN, the amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. In addition, this ASU requires that the disclosures about troubled debt restructurings that

were delayed by ASU 2011-01 in January 2011 be disclosed for interim and annual periods beginning on or after June 15, 2011. It is anticipated the implementation of the guidance in this ASU will result in more loan restructurings being classified as troubled debt restructurings and will require additional disclosure when adopted in the third quarter of 2011.

In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements. Topic 860, Transfers and Servicing, prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repurchase agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred assets. The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this ASU. This ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modification of existing transaction that occur on or after the effective date. The adoption of this ASU in the first quarter of 2012 is not anticipated to have a material impact on the Company’s consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements in order to improve consistency in wording between U.S. GAAP and IFRS. This ASU is effective for interim or annual period beginning on or after December 15, 2011. The adoption of this ASU in the first quarter of 2012 is not anticipated to have a material impact on the Company’s consolidated financial statements other than to change the disclosures relating to fair value measurements.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income. Current U.S. GAAP allows reporting entities three alternatives for presenting other comprehensive income and its components in financial statements. The first two options are to present this information in a single continuous statement of comprehensive income or in two separate but consecutive statements. The third option, which is used by the Company, is to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This ASU eliminates the third option and therefore the Company will have to adopt one of the two remaining methods for presentation. This ASU is effective for fiscal years, and interim periods beginning after December 15, 2011. The adoption of this ASU in the first quarter of 2012 is not anticipated to have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above.

(4) Derivative Instruments and Hedging Activities

The Company has commitments outstanding to extend credit to future borrowers that have not closed prior to the end of the quarter. The Company intends to sell these commitments, which are referred to as its “mortgage pipeline.” As commitments to originate loans enter the mortgage pipeline, the Company generally enters into commitments to sell the mortgage pipeline into the secondary market on a firm commitment or best efforts basis. The commitments to originate, purchase or sell loans on a firm commitment basis are derivatives. As a result of marking to market the mortgage pipeline and the related firm commitments to sell for the period ended June 30, 2011, the Company recorded an increase in other assets of $10,000, an increase in other liabilities of $14,000 and a loss included in the gain on sales of loans of $4,000.

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market and the related loans held for sale are recorded at the lower of cost or market. The Company recorded a decrease in other assets of $53,000 and an increase in the mark to market adjustment for loans held for sale of $53,000.

(5) Fair Value Measurements

ASC 820, Fair Value Measurements establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are

traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following table summarizes the assets and liabilities of the Company for which fair values are determined on a recurring basis as of June 30, 2011 and December 31, 2010.


	Carrying value at June 30, 2011
(Dollars in thousands)	Total		Level 1		Level 2		Level 3

Securities available for sale	$	134,247		1,146		133,101		0
Mortgage loan commitments		10		0		10		0

Total	$	134,257		1,146		133,111		0


	Carrying value at December 31, 2010
(Dollars in thousands)	Total			Level 1		Level 2			Level 3

Securities available for sale	$	151,564			1,740		149,824			0
Mortgage loan commitments		(1	)		0		(1	)		0

Total	$	151,563			1,740		149,823			0

There were no transfers between Levels 1, 2, or 3 during the three or six month periods ended June 30, 2011.

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write-downs of individual assets.

For assets measured at fair value on a nonrecurring basis in the second quarter of 2011 that were still held at June 30, 2011, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at June 30, 2011 and December 31, 2010


	Carrying value at June 30, 2011
									Three months ended			Six months ended
									June 30, 2011			June 30, 2011
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total gains (losses)			Total gains (losses)
Loans held for sale	$	1,075		0		1,075		0		3			53
Mortgage servicing rights		1,520		0		1,520		0		0			0
Loans ⁽¹⁾		56,697		0		56,697		0		(3,248	)		(5,330	)

Real estate, net⁽²⁾		21,868		0		21,868		0		(54	)		(134	)


Total	$	81,160		0		81,160		0		(3,299	)		(5,411	)


	Carrying value at December 31, 2010
									Year ended
									December 31, 2010
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Total Losses
Loans held for sale	$	2,728		0		2,728		0		(6	)
Mortgage servicing rights		1,586		0		1,586		0		0
Loans ⁽¹⁾		43,039		0		43,039		0		(18,855	)
Real estate, net⁽²⁾		16,382		0		16,382		0		(1,782	)


Total	$	63,735		0		63,735		0		(20,643	)


(1)		Represents the carrying value and related specific reserves on loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.

(2)		Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

(6) Fair Value of Financial Instruments

Generally accepted accounting principles require interim reporting period disclosure about the fair value of financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value estimates are made based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. The estimated fair value of the Company’s financial instruments as of June 30, 2011 and December 31, 2010 are shown below.


	June 30, 2011						December 31, 2010
	Carrying		Estimated		Contract		Carrying			Estimated			Contract
(Dollars in thousands)	amount		fair value		amount		amount			fair value			amount

Financial assets:
Cash and cash equivalents	$	26,724		26,724				20,981			20,981
Securities available for sale		134,247		134,247				151,564			151,564
Loans held for sale		1,075		1,075				2,728			2,728
Loans receivable, net		601,787		598,597				664,241			655,508
Federal Home Loan Bank stock		5,574		5,574				6,743			6,743
Accrued interest receivable		2,932		2,932				3,311			3,311
Financial liabilities:
Deposits		647,115		647,115				683,230			683,230
Federal Home Loan Bank advances		85,000		90,546				122,500			129,893
Accrued interest payable		898		898				1,092			1,092
Off-balance sheet financial instruments:
Commitments to extend credit		10		10		94,313		56			56			92,313
Commitments to sell loans		12		12		3,066		(1	)		(1	)		3,413

(7) Other Comprehensive Income (Loss)

Other comprehensive income (loss) is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive loss is the total of net loss and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income (loss) and the related tax effects were as follows:


	For the three months ended June 30,
(Dollars in thousands)	2011						2010

Securities available for sale:	Before tax		Tax effect		Net of tax		Before tax		Tax effect		Net of tax

Net unrealized gains arising during the period	$	514		76		438		289		115		174

Other comprehensive income	$	514		76		438		289		115		174


	For the six months ended June 30,
(Dollars in thousands)	2011						2010

Securities available for sale:	Before tax		Tax effect		Net of tax		Before tax			Tax effect			Net of tax

Net unrealized gains (losses) arising during the period	$	324		0		324		(88	)		(35	)		(53	)

Other comprehensive income (loss)	$	324		0		324		(88	)		(35	)		(53	)

(8) Securities Available For Sale

The following table shows the gross unrealized losses and fair value for the securities available for sale portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2011 and December 31, 2010.


	June 30, 2011
	Less than twelve months						Twelve months or more							Total
	# of		Fair		Unrealized		# of		Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Investments		Value		Losses		Investments		Value		Losses			Value		Losses

Other marketable securities:
Corporate preferred stock		0	$	0		0		1	$	175		(525	)	$	175		(525	)

Total temporarily impaired securities		0	$	0		0		1	$	175		(525	)	$	175		(525	)


	December 31, 2010
	Less than twelve months							Twelve months or more							Total
	# of		Fair		Unrealized			# of		Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Investments		Value		Losses			Investments		Value		Losses			Value		Losses

Other marketable securities:
U.S. Government agency obligations		10	$	47,610		(266	)		0	$	0		0		$	47,610		(266	)
Corporate preferred stock		0		0		0			1		175		(525	)		175		(525	)

Total temporarily impaired Securities		10	$	47,610		(266	)		1	$	175		(525	)	$	47,785		(791	)

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss.

The unrealized losses reported for corporate preferred stock at June 30, 2011 related to a single trust preferred security that was issued by the holding company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In October 2009, the issuer elected to defer its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses due to increased provisions for loan losses but still meets the regulatory requirements to be considered “adequately capitalized” based on its most recent regulatory filing. Based on information furnished by the issuer, it is anticipated that the entity will improve its capital position and be “well capitalized” after a branch sale is completed, for which a sale agreement has been signed. In addition, the

owners of the issuing bank appear to have the ability to make additional capital contributions, if needed, to enhance the bank’s capital position. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at June 30, 2011. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities and the deferral of interest by the issuer. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

A summary of securities available for sale at June 30, 2011 and December 31, 2010 is as follows:


			Gross unrealized		Gross unrealized
(Dollars in thousands)	Amortized cost		gains		losses			Fair value

*June 30, 2011:*
Mortgage-backed securities:
FHLMC	$	14,274		705		0			14,979
FNMA		10,023		632		0			10,655
Collateralized mortgage obligations:
FHLMC		732		25		0			757
FNMA		381		8		0			389

		25,410		1,370		0			26,780

Other marketable securities:
U.S. Government agency obligations		106,916		376		0			107,292
Corporate preferred stock		700		0		(525	)		175

		107,616		376		(525	)		107,467

	$	133,026		1,746		(525	)		134,247


			Gross unrealized		Gross unrealized
(Dollars in thousands)	Amortized cost		gains		losses			Fair value

*December 31, 2010:*
Mortgage-backed securities:
FHLMC	$	17,555		719		0			18,274
FNMA		12,800		692		0			13,492
Collateralized mortgage obligations:
FHLMC		1,299		44		0			1,343
FNMA		382		15		0			397

		32,036		1,470		0			33,506

Other marketable securities:
U.S. Government agency obligations		117,931		218		(266	)		117,883
Corporate preferred stock		700		0		(525	)		175

		118,631		218		(791	)		118,058

	$	150,667		1,688		(791	)		151,564

The following table indicates amortized cost and estimated fair value of securities available for sale at June 30, 2011 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.


	Amortized		Fair
(Dollars in thousands)	cost		Value

Due less than one year	$	107,426		108,247
Due after one year through five years		23,477		24,325
Due after five years through ten years		1,423		1,500
Due after ten years		700		175

Total	$	133,026		134,247

The allocation of mortgage-backed securities and collateralized mortgage obligations in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds.

(9) Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:


				Commercial						Commercial
(Dollars in thousands)	1-4 Family			Real Estate			Consumer			Business			Total

For the three months ended June 30, 2011:
Balance, March 31, 2011	$	2,498			17,558			1,023			13,874			34,953

Provision for losses		954			2,376			159			(26	)		3,463
Charge-offs		(15	)		(4,633	)		(35	)		(6,249	)		(10,932	)
Recoveries		0			66			7			207			280

Balance, June 30, 2011	$	3,437			15,367			1,154			7,806			27,764


For the six months ended June 30, 2011:
Balance, December 31, 2010		2,145			24,590			924			15,169			42,828

Provision for losses		1,710			2,914			307			478			5,409
Charge-offs		(418	)		(12,209	)		(87	)		(8,557	)		(21,271	)
Recoveries		0			72			10			716			798

Balance, June 30, 2011	$	3,437			15,367			1,154			7,806			27,764


Allocated to:
Specific reserves	$	993			13,263			76			10,702			25,034
General reserves		1,152			11,327			848			4,467			17,794

Balance, December 31, 2010	$	2,145			24,590			924			15,169			42,828


Allocated to:
Specific reserves	$	1,430			6,354			293			4,070			12,147
General reserves		2,007			9,013			861			3,736			15,617

Balance, June 30, 2011	$	3,437			15,367			1,154			7,806			27,764


Loans receivable at December 31, 2010:
Individually reviewed for impairment	$	6,729			45,077			299			26,855			78,960
Collectively reviewed for impairment		121,806			311,314			70,304			126,184			629,608

Ending balance	$	128,535			356,391			70,603			153,039			708,568

Loans receivable at June 30, 2011:
Individually reviewed for impairment	$	4,653			34,260			664			17,120			56,697
Collectively reviewed for impairment		118,010			279,457			66,003			110,461			573,931

Ending balance	$	122,663			313,717			66,667			127,581			630,628

The following table summarizes the amount of classified and unclassified loans at June 30, 2011 and December 31, 2010:


	June 30, 2011
	Classified										Unclassified
	Special
(Dollars in thousands)	Mention		Substandard		Doubtful		Loss		Total		Total		Total Loans

1-4 family	$	8,385		5,105		359		250		14,099		108,564		122,663
Commercial real estate:
Residential developments		8,851		25,778		0		0		34,629		33,901		68,530
Alternative fuels		5,769		2,266		0		0		8,035		18,096		26,131
Other		5,784		7,534		0		0		13,318		205,738		219,056

Consumer		0		334		181		149		664		66,003		66,667
Commercial business:
Construction/development		0		3,046		0		0		3,046		2,976		6,022
Banking		0		675		1,299		0		1,974		5,580		7,554
Other		4,034		12,565		0		0		16,599		97,406		114,005

	$	32,823		57,303		1,839		399		92,364		538,264		630,628


	December 31, 2010
	Classified										Unclassified
	Special
(Dollars in thousands)	Mention		Substandard		Doubtful		Loss		Total		Total		Total Loans

1-4 family	$	7,395		8,228		0		0		15,623		112,912		128,535
Commercial real estate:
Residential developments		8,373		34,515		0		0		42,888		44,218		87,106
Alternative fuels		0		11,069		0		0		11,069		20,054		31,123
Other		6,268		6,614		0		0		12,882		225,280		238,162

Consumer		0		248		31		27		306		70,297		70,603
Commercial business:
Construction/development		1,776		4,907		0		0		6,683		5,117		11,800
Banking		0		4,975		3,248		0		8,223		5,830		14,053
Other		4,712		15,689		67		0		20,468		106,718		127,186

	$	28,524		86,245		3,346		27		118,142		590,426		708,568

Classified loans represent non-performing loans and loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

The aging of past due loans at June 30, 2011 and December 31, 2010 is summarized as follows:


	30-59		60-89		90 Days								Loans 90 Days or
	Days		Days		or More		Total						More Past Due and
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Current Loans		Total Loans		Still Accruing

June 30, 2011
1-4 family	$	2,485		1,341		453		4,279		118,384		122,663		0
Commercial real estate:
Residential developments		1,709		5,441		0		7,150		61,380		68,530		0
Alternative fuels		0		0		2,266		2,266		23,865		26,131		0
Other		1,291		0		0		1,291		217,765		219,056		0

Consumer		527		7		466		1,000		65,667		66,667		0
Commercial business:
Construction/development		0		0		0		0		6,022		6,022		0
Banking		0		0		1,974		1,974		5,580		7,554		0
Other		586		2,786		5,558		8,930		105,075		114,005		0

	$	6,598		9,575		10,717		26,890		603,738		630,628		0

December 31, 2010
1-4 family	$	2,313		695		3,500		6,508		122,027		128,535		178
Commercial real estate:
Residential developments		444		3,899		15,523		19,866		67,240		87,106		0
Alternative fuels		0		0		4,994		4,994		26,129		31,123		0
Other		75		264		3,914		4,253		233,909		238,162		0

Consumer		446		163		207		816		69,787		70,603		0
Commercial business:
Construction/development		0		0		4,809		4,809		6,991		11,800		0
Banking		0		0		8,223		8,223		5,830		14,053		0
Other		311		45		7,876		8,232		118,954		127,186		576

	$	3,589		5,066		49,046		57,701		650,867		708,568		754

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring. The following table summarizes impaired loans and related allowances as of June 30, 2011 and December 31, 2010:


	June 30, 2011						December 31, 2010
(Dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance

Loans with no related allowance recorded:
1-4 family	$	1,336		1,336		0		932		932		0
Commercial real estate:
Residential developments		5,716		5,716		0		6,486		6,486		0
Alternative fuels		2,266		4,994		0		0		0		0
Other		657		657		0		119		119		0
Consumer		224		224		0		104		104		0
Commercial business:
Construction/development		344		1,462		0		99		99		0
Banking		1,974		8,223		0		0		0		0
Other		665		865		0		397		397		0

Loans with an allowance recorded:
1-4 family		3,317		3,317		1,430		5,797		5,797		994
Commercial real estate:
Residential developments		18,756		18,756		4,887		27,147		27,147		9,673
Alternative fuels		0		0		0		4,994		4,994		2,441
Other		6,865		8,821		1,467		6,331		7,287		1,148
Consumer		440		440		293		195		195		76
Commercial business:
Construction/development		2,702		2,849		530		4,809		4,809		2,668
Banking		0		0		0		8,223		8,223		4,985
Other		11,435		11,987		3,540		13,327		13,878		3,049

Total:
1-4 family		4,653		4,653		1,430		6,729		6,729		994
Commercial real estate:
Residential developments		24,472		24,472		4,887		33,633		33,633		9,673
Alternative fuels		2,266		4,994		0		4,994		4,994		2,441
Other		7,522		9,478		1,467		6,450		7,406		1,148
Consumer		664		664		293		299		299		76
Commercial business:
Construction/development		3,046		4,311		530		4,908		4,908		2,668
Banking		1,974		8,223		0		8,223		8,223		4,985
Other		12,100		12,852		3,540		13,724		14,275		3,049

	$	56,697		69,647		12,147		78,960		80,467		25,034


	For the three months ended June 30, 2011				For the six months ended June 30, 2011
	Average Recorded		Interest Income		Average Recorded		Interest Income
(Dollars in thousands)	Investment		Recognized		Investment		Recognized

Loans with no related allowance recorded:
1-4 family	$	1,354		16		1,213		36
Commercial real estate:
Residential developments		5,798		14		6,027		88
Alternative fuels		1,133		0		755		0
Other		656		10		477		13
Consumer		132		0		123		2
Commercial business:
Construction/development		345		2		263		4
Banking		987		0		658		0
Other		654		3		568		17

Loans with an allowance recorded:
1-4 family		4,029		50		4,618		86
Commercial real estate:
Residential developments		15,826		192		19,599		431
Alternative fuels		2,498		0		3,330		0
Other		6,406		40		6,381		59
Consumer		347		5		296		10
Commercial business:
Construction/development		3,344		18		3,831		36
Banking		4,112		0		5,482		0
Other		11,366		63		12,020		147

Total:
1-4 family		5,383		66		5,831		122
Commercial real estate:
Residential developments		21,624		206		25,626		519
Alternative fuels		3,631		0		4,085		0
Other		7,062		50		6,858		72
Consumer		479		5		419		12
Commercial business:
Construction/development		3,689		20		4,094		40
Banking		5,099		0		6,140		0
Other		12,020		66		12,588		164

	$	58,987		413		65,641		929

At June 30, 2011 and December 31, 2010, non-accruing loans totaled $43.1 million and $68.1 million, respectively, for which the related allowance for loan losses was $10.2 million and $25.0 million, respectively. Interest is subsequently recognized as income to the extent cash is received when, in management’s judgment, principal is collectible. Non-accruing loans for which no specific allowance has been recorded, because management determined that the value of the collateral was sufficient to repay the loan, totaled $11.3 million and $8.1 million, respectively. Non-accrual loans also include certain loans that have had terms modified in a troubled debt restructuring.

The non-accrual loans at June 30, 2011 and December 31, 2010 are summarized as follows:


(Dollars in thousands)	June 30, 2011		December 31, 2010
1-4 family	$	2,039	$	4,844
Commercial real estate:
Residential developments		16,422		25,980
Alternative fuels		2,266		4,994
Other		6,506		5,763
Consumer		555		224
Commercial business:
Construction/development		3,046		4,907
Banking		1,974		8,223
Other		10,278		13,139

	$	43,086	$	68,074

At June 30, 2011 and December 31, 2010 there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $28.1 million and $19.3 million, respectively. For the loans that were restructured in the second quarter of 2011, $1.0 million were classified but performing and $6.3 million were non-performing at June 30, 2011.

The following table summarizes troubled debt restructurings at June 30, 2011 and December 31, 2010:


	June 30,		December 31,
(Dollars in thousands)	2011		2010
Commercial real estate	$	20,275		14,871
Commercial business		4,119		1,756
1-4 family		3,534		2,589
Consumer		200		75

	$	28,128		19,291

There were no material commitments to lend additional funds to customers whose loans were restructured or classified as nonaccrual at June 30, 2011 or December 31, 2010.

(10) Investment in Mortgage Servicing Rights
A summary of mortgage servicing activity is as follows:


	Six Months ended			Twelve Months ended			Six Months ended
(Dollars in thousands)	June 30, 2011			December 31, 2010			June 30, 2010
Mortgage servicing rights:
Balance, beginning of period	$	1,586			1,315			1,315
Originations		147			753			333
Amortization		(213	)		(482	)		(219	)

Balance, end of period	$	1,520			1,586			1,429

Fair value of mortgage servicing rights	$	2,297			2,263			2,331

All of the loans being serviced are single family loans serviced for the Federal National Mortgage Association (FNMA) under the mortgage-backed security program or the individual loan sale program. Loans are sold under general representations and warranties and based on insignificant requests for repurchase, a liability has not been recorded for repurchase requests from FNMA. The following is a summary of the risk characteristics of the loans being serviced at June 30, 2011.


	Loan Principal		Weighted Average			Weighted Average
(Dollars in thousands)	Balance		Interest Rate			Remaining Term		Number of Loans
Original term 30 year fixed rate	$	218,415		5.20	%		299		1,879
Original term 15 year fixed rate		97,291		4.63	%		123		1,445
Adjustable rate		693		3.13	%		269		9

The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at June 30, 2011 is presented in the table below.


	Gross		Accumulated			Unamortized
(Dollars in thousands)	Carrying Amount		Amortization			Intangible Assets
Mortgage servicing rights	$	4,067		(2,547	)		1,520

Total	$	4,067		(2,547	)		1,520

The following table indicates the estimated future amortization expense for mortgage servicing rights:


	Mortgage
(Dollars in thousands)	Servicing Rights
Year ended December 31,
2011	$	180
2012		330
2013		312
2014		282
2015		236
Thereafter		180

Projections of amortization are based on existing asset balances and the existing interest rate environment as of June 30, 2011. The Company’s actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions.

(11) Loss per Common Share

The following table reconciles the weighted average shares outstanding and the loss available to common shareholders used for basic and diluted loss per share:


	Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in thousands, except per share data)	2011			2010			2011			2010
Weighted average number of common shares outstanding used in basic loss per common share calculation		3,841			3,757			3,829			3,747
Net dilutive effect of:
Options		0			0			0			0
Restricted stock awards		0			0			0			0

Weighted average number of shares outstanding adjusted for effect of dilutive securities		3,841			3,757			3,829			3,747

Loss available to common shareholders	$	(2,748	)		(8,280	)		(2,780	)		(10,567	)
Basic loss per common share	$	(0.72	)		(2.20	)		(0.73	)		(2.82	)
Diluted loss per common share	$	(0.72	)		(2.20	)		(0.73	)		(2.82	)

At June 30, 2011 and June 30, 2010, there were 127,351 and 240,807 common share equivalents outstanding, respectively, that are not included in the calculation of diluted earnings per share as they are anti-dilutive.

(12) Regulatory Capital and Regulatory Oversight

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 adverse effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or core capital and risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of June 30, 2011, 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, 2011 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized.

The Bank’s tangible assets and adjusted total assets were $805.8 million and $879.5 million and its risk-weighted assets were $622.1 million and $687.7 million at June 30, 2011 and December 31, 2010, respectively. The following table presents the Bank’s capital amounts and ratios at June 30, 2011 and December 31, 2010 for actual capital, required capital and excess capital, including ratios in order to qualify as being well capitalized under the Prompt Corrective Actions regulations.


							Required to be
							Adequately										To Be Well Capitalized Under Prompt
	Actual						Capitalized					Excess Capital					Corrective Actions Provisions
				Percent of					Percent of					Percent of					Percent of
(Dollars in thousands)	Amount			Assets⁽¹⁾			Amount		Assets⁽¹⁾			Amount		Assets⁽¹⁾			Amount		Assets⁽¹⁾
June 30, 2011
Bank stockholder’s equity	$	67,070
Less:
Net unrealized gains on certain securities Available for sale		(1,533	)

		65,537

Tier I or core capital
Tier I capital to adjusted total assets					8.13	%	$	32,232		4.00	%	$	33,305		4.13	%	$	40,290		5.00	%
Tier I capital to risk-weighted assets					10.53	%	$	24,886		4.00	%	$	40,651		6.53	%	$	37,329		6.00	%
Plus:
Allowable allowance for loan losses		7,777

Risk-based capital	$	73,314					$	49,771				$	23,543				$	62,214

Risk-based capital to risk-weighted assets					11.78	%				8.00	%				3.78	%				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.


							Required to be
							Adequately										To Be Well Capitalized Under Prompt
	Actual						Capitalized					Excess Capital					Corrective Actions Provisions
				Percent of					Percent of					Percent of					Percent of
(Dollars in thousands)	Amount			Assets⁽¹⁾			Amount		Assets⁽¹⁾			Amount		Assets⁽¹⁾			Amount		Assets⁽¹⁾
December 31, 2010
Bank stockholder’s equity	$	68,034
Less:
Net unrealized gains on certain securities Available for sale		(1,210	)

		66,824

Tier I or core capital
Tier I capital to adjusted total assets					7.60	%	$	35,181		4.00	%	$	31,643		3.60	%	$	43,977		5.00	%
Tier I capital to risk-weighted assets					9.72	%	$	27,507		4.00	%	$	39,317		5.72	%	$	41,261		6.00	%
Plus:
Allowable allowance for loan losses		8,596

Risk-based capital	$	75,420					$	55,014				$	20,406				$	68,768

Risk-based capital to risk-weighted assets					10.97	%				8.00	%				2.97	%				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 Bank entered into a written Supervisory Agreement with its primary federal banking regulator, the Office of Thrift Supervision (OTS), effective February 22, 2011 that primarily relates to the Bank’s financial performance and credit quality issues. This agreement replaced the prior memorandum of understanding that the Bank entered into with the OTS on December 9, 2009. In accordance with the Supervisory Agreement, the Bank submitted a two year business plan that the OTS may make comments upon, and require revisions to. The Bank must operate within the parameters of the final business plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank also submitted a problem asset reduction plan that the OTS may make comments upon, and require revisions to. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank has also revised its loan modification policies and its program for identifying, monitoring and controlling risk associated with concentrations of credit, and improved the documentation relating to the allowance for loan and lease losses as required by the agreement. In addition, without the consent of the OCC (as successor to the OTS), the Bank may not declare or pay any cash dividends, materially increase the total assets of the Bank, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider.

The Company also entered into a written Supervisory Agreement with the OTS effective February 22, 2011. This agreement replaced the prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. In accordance with the Supervisory Agreement, the Company submitted a capital plan to the OTS through December 31, 2012 that the OTS may make comments upon, and to which it may require revisions. The Company must operate within the parameters of the final capital plan and is required to monitor and submit periodic reports on its compliance with the plan. In addition, without the consent of the OTS, the Company may not incur or issue any debt, guarantee the debt of any entity, declare or pay any cash dividends or repurchase any of the Company’s capital stock, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, or make any golden parachute payments.

The OTS proposed to the Bank as its Individual Minimum Capital Requirement (IMCR) a tier 1 capital to adjusted total assets requirement of 8.5% commencing September 30, 2011, which is in excess of the Bank’s tier 1 capital to adjusted total assets ratio at June 30, 2011. An IMCR requires a bank to establish and maintain levels of capital greater than those required for banks generally to be classified as “well-capitalized.” The Bank has submitted proposed modifications to the proposed IMCR and had discussions with the OTS (predecessor to the OCC, the Bank’s current primary banking regulator) related to the timing for implementation of the proposed IMCR. However, at the time of filing of this Quarterly Report on Form 10-Q, no IMCR has been imposed on the Bank.

References to the OTS shall mean, with respect to the Company, beginning July 21, 2011, the Federal Reserve Board (FRB) and mean, with respect to the Bank, beginning July 21, 2011, the Office of the Comptroller of the Currency (OCC). On July 21, 2011 the OTS was integrated into the OCC and the primary banking regulator for the Company became the FRB. It is not anticipated that the change in primary regulators as a result of the OTS being abolished will have any significant impact on the Company, the Bank, or our shareholders.

(13) Commitments and Contingencies

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at June 30, 2011 were approximately $1.6 million, expire over the next two years, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

(14) Business Segments
The Bank has been identified as a reportable operating segment in accordance with the provisions of
ASC 280. SFC and HMN 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, return on average assets and equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

The following table sets forth certain information about the reconciliation of reported profit or loss and assets for each of the Company’s reportable segments.


(Dollars in thousands)	Home Federal Savings Bank			Other			Eliminations			Consolidated Total

At or for the six months ended June 30, 2011:
Interest income — external customers	$	20,759			0			0			20,759
Non-interest income — external customers		3,380			0			0			3,380
Loss on limited partnerships		(5	)		0			0			(5	)
Intersegment interest income		0			2			(2	)		0
Intersegment non-interest income		87			(1,292	)		1,205			0
Interest expense		6,317			0			(2	)		6,315
Amortization of mortgage servicing rights, net		213			0			0			213
Other non-interest expense		13,569			589			(87	)		14,071
Income tax expense (benefit)		0			0			0			0
Net loss		(1,288	)		(1,878	)		1,292			(1,874	)
Total assets		807,307			68,934			(68,867	)		807,374

At or for the six months ended June 30, 2010:
Interest income — external customers	$	25,473			0			0			25,473
Non-interest income — external customers		3,370			0			0			3,370
Loss on limited partnerships		(15	)		0			0			(15	)
Intersegment interest income		0			2			(2	)		0
Intersegment non-interest income		87			(9,111	)		9,024			0
Interest expense		9,525			0			(2	)		9,523
Amortization of mortgage servicing rights, net		219			0			0			219
Other non-interest expense		11,812			403			(87	)		12,128
Income tax expense		5,573			171			0			5,744
Net loss		(9,107	)		(9,683	)		9,111			(9,679	)
Total assets		974,247			90,402			(89,406	)		975,243


At or for the quarter ended June 30, 2011:
Interest income — external customers	$	10,045			0			0			10,045
Non-interest income — external customers		1,592			0			0			1,592
Loss on limited partnerships		(3	)		0			0			(3	)
Intersegment interest income		0			1			(1	)		0
Intersegment non-interest income		44			(1,980	)		1,936			0
Interest expense		3,047			0			(1	)		3,046
Amortization of mortgage servicing rights, net		115			0			0			115
Other non-interest expense		7,106			315			(44	)		7,377
Income tax benefit		(76	)		0			0			(76	)
Net loss		(1,978	)		(2,293	)		1,980			(2,291	)
Total assets		807,307			68,934			(68,867	)		807,374

At or for the quarter ended June 30, 2010:
Interest income — external customers	$	12,569			0			0			12,569
Non-interest income — external customers		1,788			0			0			1,788
Loss on limited partnerships		(7	)		0			0			(7	)
Intersegment interest income		0			1			(1	)		0
Intersegment non-interest income		44			(7,439	)		7,395			0
Interest expense		4,581			0			(1	)		4,580
Amortization of mortgage servicing rights, net		110			0			0			110
Other non-interest expense		6,064			200			(44	)		6,220
Income tax expense		6,716			196			0			6,912
Net loss		(7,437	)		(7,834	)		7,439			(7,832	)
Total assets		974,247			90,402			(89,406	)		975,243

Item 2:

HMN FINANCIAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Information

This Quarterly Report, other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intent,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to the adequacy and amount of available liquidity and capital resources to the Bank, the Company’s liquidity and capital requirements, changes in the size of the Bank’s loan portfolio, the recovery of the valuation allowance on deferred tax assets, the amount and mix of the Bank’s non-performing assets and the appropriateness of the allowance therefore, future losses on non-performing assets, the amount of interest-earning assets, the amount and mix of brokered and other deposits (including the Company’s ability to renew brokered deposits), the availability of alternate funding sources, the payment of dividends, the future outlook for the Company, the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced, the projected changes in net interest income based on rate shocks, the range that interest rates may fluctuate over the next twelve months, the net market risk of interest rate shocks and the Company’s, the future outlook for the issuer trust preferred securities held by the Bank, expectations relating to the change in Company and Bank primary banking regulators from the OTS to the OCC and FRB, the uncertainty regarding amount and timing of any final IMCR which may be imposed upon the Bank, and the Bank’s compliance with regulatory standards generally (including the Bank’s status as “well-capitalized”), and supervisory agreements, individual minimum capital requirements or other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically. A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate securing loans to borrowers, possible legislative and regulatory changes, including changes in the degree and manner of regulatory supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss allowance and concentrations of credit that are satisfactory to the OCC and FRB, as applicable, in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OCC and FRB, as applicable, under the supervisory agreements or other directives; the amount and timing of any individual minimum capital requirement which may be imposed on the Bank; adverse economic, business and competitive developments such as shrinking interest margins; reduced collateral values; 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; international economic developments, changes in credit or 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; collateral advance rates and policies of the FHLB; costs associated with alternate funding sources; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filings on Form 10-K and Quarterly Reports on Form 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 and Part II, Item 1A of this Quarterly Report on Form 10-Q. We undertake no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q.

General

The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits, Federal Home Loan Bank (FHLB) advances, and Federal Reserve Bank (FRB) borrowings. 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. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and 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, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization of mortgage servicing assets. Since a commercial lending program was established in 1998, the Company has increased its emphasis on commercial and commercial real estate loans, which has increased the credit risk inherent in the loan portfolio. While HMN did not originate or hold subprime mortgages in its loan portfolio, purchase investments backed by subprime mortgages, or incur any write downs directly related to subprime mortgages, subprime credit issues indirectly impacted the Company by making it more difficult for some borrowers with marginal credit to qualify for a mortgage because most of the non-traditional mortgage products were eliminated by the banks and mortgage companies that were previously offering them. This decrease in available credit reduced the demand for single family homes as there were fewer qualified buyers in the marketplace. The decrease in demand for housing and building lots affected our level of loan charge offs and the risk ratings on many of our residential development loans. Consequently, our provision for loan losses significantly increased relative to periods before the current economic slowdown. The increase in the provision was due primarily to commercial loan charge offs and risk rating downgrades caused by continued weak demand for housing and building and general economic weakness in our markets. In addition, our losses on loans and other real estate owned increased due to the declining value of the real estate.

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 business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and levels of personal income and savings.

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, assumptions and other factors used.

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company’s ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate components of its overall methodology to determine the appropriateness of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance 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 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 based on the Company’s own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary specific reserves.

The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in

the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as probable losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet date, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

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.

The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating loss carry forwards. For income tax purposes, only net charge-offs and certain specific reserves are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company’s cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. At June 30, 2011, the Company recorded a valuation allowance against the entire deferred tax asset balance. This determination was based primarily upon the existence of a three year cumulative loss position that is primarily attributable to significant provisions for loan losses incurred during the last three years. The creation of the valuation allowance, although it increased tax expense and similarly reduced tangible book value, does not have an effect on the Company’s cash flows, and may be recoverable in subsequent periods if the Company were to realize certain sustained future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future.

Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.

RESULTS OF OPERATIONS FOR SECOND QUARTER ENDED JUNE 30, 2011 COMPARED TO SECOND QUARTER ENDED JUNE 30, 2010

Net Loss

Net loss for the second quarter of 2011 was $2.3 million, an improvement of $5.5 million, or 70.7%, compared to a net loss of $7.8 million for the second quarter of 2010. Net loss available to common shareholders was $2.7 million for the second quarter of 2011, an improvement of $5.6 million, or 66.8%, from the net loss available to common shareholders of $8.3 million for the second quarter of 2010. Diluted loss per common share for the

second quarter of 2011 was $0.72, an improvement of $1.48, or 67.3%, from the diluted loss per common share of $2.20 for the second quarter of 2010. The decrease in the net loss for the quarter was due primarily to a $7.0 million decrease in the provision for income taxes between the periods due primarily to a deferred tax asset valuation reserve that was established during the second quarter of 2010. The decrease in the net loss was also due to a $0.9 million decrease in the loan loss provision between the periods. These decreases in expense were partially offset by a $1.0 million decrease in net interest income due primarily to a decrease in interest earning assets that was partially offset by an increase in the net interest margin between the periods and a $1.2 million increase in expenses related to other real estate owned.

Net loss was $1.9 million for the six month period ended June 30, 2011, an improvement of $7.8 million, or 80.6%, compared to the net loss of $9.7 million for the six month period ended June 30, 2010. The net loss available to common shareholders was $2.8 million for the six month period ended June 30, 2011, an improvement of $7.8 million, or 73.7%, compared to the net loss available to common shareholders of $10.6 million for the same period of 2010. Diluted loss per share for the six month period in 2011 was $0.73, an improvement of $2.09 compared to the diluted loss per share of $2.82 for the same period in 2010. The decrease in the net loss for the six month period in 2011 was due to a $5.7 million decrease in the provision for income taxes between the periods due primarily to a deferred tax asset valuation reserve that was established during the second quarter of 2010 and also because of a $5.5 million decrease in the loan loss provision between the periods. These decreases in expense were partially offset by a $1.6 million decrease in net interest income due primarily to the decrease in interest earning assets between the periods and a $2.2 million increase in other expenses and losses related to other real estate owned.

Net Interest Income

Net interest income was $7.0 million for the second quarter of 2011, a decrease of $1.0 million, or 12.4%, compared to $8.0 million for the second quarter of 2010. Interest income was $10.0 million for the second quarter of 2011, a decrease of $2.6 million, or 20.1%, from $12.6 million for the same period in 2010. Interest income decreased between the periods primarily because of a $147 million decrease in the average interest-earning assets and also because of a decrease in average yields between the periods. Average interest earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of declining loan demand and the Company’s focus on improving credit quality, managing net interest margin and improving capital ratios. The average yield earned on interest-earning assets was 5.00% for the second quarter of 2011, a decrease of 29 basis points from the 5.29% average yield for the second quarter of 2010. The decrease in the yield on interest-earning assets is due to the continued low interest rate environment that existed during the second quarter of 2011.

Interest expense was $3.0 million for the second quarter of 2011, a decrease of $1.6 million, or 33.5%, compared to $4.6 million for the second quarter of 2010. Interest expense decreased primarily because of the $130 million decrease in the average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding borrowings and brokered certificates of deposits between the periods. The decrease in borrowings and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing borrowings and brokered certificates of deposits. Interest expense also decreased because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the second quarter of 2011. The average interest rate paid on interest-bearing liabilities was 1.58% for the second quarter of 2011, a decrease of 45 basis points from the 2.03% average interest rate paid in the second quarter of 2010.

Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2011 was 3.48%, an increase of 11 basis points, compared to 3.37% for the second quarter of 2010.

Net interest income was $14.4 million for the first six months of 2011, a decrease of $1.6 million, or 9.4%, from $16.0 million for the same period in 2010. Interest income was $20.8 million for the six month period ended June 30, 2011, a decrease of $4.7 million, or 18.5%, from $25.5 million for the same six month period in 2010. Interest income decreased between the periods primarily because of a $145 million decrease in the average interest-earning assets and also because of a decrease in average yields between the periods. Average interest-earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio,

which occurred because of declining loan demand and the Company’s focus on improving credit quality, managing net interest margin and improving capital ratios. The average yield earned on interest-earning assets was 5.11% for the first six months of 2011, a decrease of 22 basis points from the 5.33% average yield for the first six months of 2010. The decrease in the yield on interest-earning assets is due to the continued low interest rate environment that existed during the first six months of 2011.

Interest expense was $6.3 million for the first six months of 2011, a decrease of $3.2 million, or 33.7%, compared to $9.5 million for the first six months of 2010. Interest expense decreased primarily because of the $127 million decrease in the average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding borrowings and brokered certificates of deposits between the periods. The decrease in borrowings and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing borrowings and brokered certificates of deposits. Interest expense also decreased because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the first six months of 2011. The average interest rate paid on interest-bearing liabilities was 1.62% for the first six months of 2011, a decrease of 48 basis points from the 2.10% average interest rate paid in the first six months of 2010.

Net interest margin (net interest income divided by average interest earning assets) for the first six months of 2011 was 3.55%, an increase of 21 basis points, compared to 3.34% for the first six months of 2010.

A summary of the Company’s net interest margin for the three and six month periods ended June 30, 2011 and June 30, 2010 is as follows:


	For the three month period ended
	June 30, 2011							June 30, 2010
	Average		Interest					Average		Interest
	Outstanding		Earned/		Yield/			Outstanding		Earned/		Yield/
(Dollars in thousands)	Balance		Paid		Rate			Balance		Paid		Rate

Interest-earning assets:
Securities available for sale	$	153,600		697		1.82	%	$	165,887		1,070		2.59	%
Loans held for sale		1,689		18		4.27			2,946		37		5.04
Mortgage loans, net		123,550		1,693		5.50			139,117		1,948		5.62
Commercial loans, net		422,720		6,593		6.26			540,498		7,987		5.93
Consumer loans, net		66,725		997		5.99			77,121		1,489		7.74
Cash equivalents		31,220		1		0.01			19,225		1		0.02
Federal Home Loan Bank stock		6,174		46		2.99			7,428		37		2.00

Total interest-earning assets		805,678		10,045		5.00			952,222		12,569		5.29

Interest-bearing liabilities:
NOW accounts		70,287		14		0.08			103,052		30		0.12
Savings accounts		37,455		14		0.15			33,017		11		0.13
Money market accounts		113,928		205		0.72			143,394		371		1.04
Certificates		253,241		983		1.56			242,611		1,439		2.38
Brokered deposits		95,329		590		2.48			163,235		1,187		2.92
Advances and other borrowings		110,390		1,240		4.51			135,478		1,542		4.57

Total interest-bearing liabilities		680,630							820,787
Non-interest checking		92,553							81,440
Other non-interest bearing deposits		976							1,492

Total interest-bearing liabilities and non-interest bearing deposits	$	774,159		3,046		1.58		$	903,719		4,580		2.03

Net interest income			$	6,999						$	7,989

Net interest rate spread						3.42	%						3.26	%

Net interest margin						3.48	%						3.37	%


	For the six month period ended
	June 30, 2011							June 30, 2010
	Average		Interest					Average		Interest
	Outstanding		Earned/		Yield/			Outstanding		Earned/		Yield/
(Dollars in thousands)	Balance		Paid		Rate			Balance		Paid		Rate
Interest-earning assets:
Securities available for sale	$	151,774		1,438		1.91	%	$	162,840		2,177		2.70	%
Loans held for sale		1,614		35		4.37			2,369		58		4.94
Mortgage loans, net		125,915		3,456		5.53			141,380		4,045		5.77
Commercial loans, net		438,121		13,688		6.30			552,345		16,441		6.00
Consumer loans, net		67,690		2,025		6.03			79,045		2,676		6.83
Cash equivalents		27,851		3		0.02			18,910		2		0.02
Federal Home Loan Bank stock		6,432		114		3.57			7,357		74		2.03

Total interest-earning assets		819,397		20,759		5.11			964,246		25,473		5.33

Interest-bearing liabilities:
NOW accounts		74,628		34		0.09			100,775		52		0.10
Savings accounts		36,073		27		0.15			32,422		22		0.14
Money market accounts		113,821		418		0.74			140,115		762		1.10
Certificates		253,692		2,040		1.62			242,894		2,915		2.42
Brokered deposits		98,050		1,227		2.52			181,147		2,708		3.01
Advances and other borrowings		115,085		2,569		4.50			134,052		3,064		4.61

Total interest-bearing liabilities		691,349							831,405
Non-interest checking		94,339							80,544
Other non-interest bearing deposits		1,070							1,663

Total interest-bearing liabilities and non-interest bearing deposits	$	786,758		6,315		1.62		$	913,612		9,523		2.10

Net interest income			$	14,444						$	15,950

Net interest rate spread						3.49	%						3.23	%

Net interest margin						3.55	%						3.34	%

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 $3.5 million for the second quarter of 2011, a decrease of $0.9 million, or 20.6%, from $4.4 million for the second quarter of 2010. The decrease in the loan loss provision was primarily the result of stabilizing values of the real estate collateral supporting commercial real estate loans classified as non-performing, which resulted in fewer write downs in the second quarter of 2011 compared to the same period in 2010.

The provision for loan losses was $5.4 million for the first six months of 2011, a decrease of $5.5 million, or 50.3%, from $10.9 million for the same six month period in 2010. The decrease was primarily the result of the stabilizing values of the real estate collateral supporting commercial real estate loans, which resulted in fewer write downs on loans classified as non-performing in the first six months of 2011 compared to the same period in 2010.

A reconciliation of the Company’s allowance for loan losses for the three and six month periods ended June 30, 2011 and June 30, 2010 is summarized as follows:


(Dollars in thousands)	2011			2010

Balance at March 31,	$	34,953		$	29,284
Provision		3,463			4,360
Charge offs:
One-to-four family		(16	)		(117	)
Consumer		(34	)		(84	)
Commercial business		(6,249	)		(4,681	)
Commercial real estate		(4,633	)		(2,818	)
Recoveries		280			83

Balance at June 30,	$	27,764		$	26,027


General allowance	$	15,644		$	11,104
Specific allowance		12,120			14,923

	$	27,764		$	26,027


(Dollars in thousands)	2011			2010

Balance at January 1,	$	42,828		$	23,811
Provision		5,409			10,893
Charge offs:
One-to-four family		(419	)		(168	)
Consumer		(86	)		(390	)
Commercial business		(8,557	)		(4,742	)
Commercial real estate		(12,209	)		(3,478	)
Recoveries		798			101

Balance at June 30,	$	27,764		$	26,027

Non-Interest Income

Non-interest income was $1.6 million for the second quarter of 2011, a decrease of $0.2 million, or 10.8%, from $1.8 million for the same period in 2010. Gains on sales of loans decreased $166,000 between the periods as a result of decreased single family loan originations. Loan servicing fees decreased $24,000 between the periods primarily because of a decrease in the number of commercial loans that are being serviced for others.

Non-interest income was $3.4 million for the first six months of 2010, the same as for the first six months of 2010. Fees and service charges increased $87,000 between the periods primarily because of an increase in debit card income and overdraft fees. Gains on sales of loans increased $15,000 between the periods due to an increase in the gains recognized on the sale of commercial government guaranteed loans that was partially offset by a decrease in the gain recognized on the sale of single family loans due to a decrease in single family loan originations between the periods. Loan servicing fees decreased $42,000 between the periods primarily because of a decrease in the number of commercial loans that are being serviced for others. Other non-interest income decreased $40,000 primarily because of a decrease in rental income on real estate owned.

Non-Interest Expense

Non-interest expense was $7.5 million for the second quarter of 2011, an increase of $1.2 million, or 18.4%, from $6.3 million for the same period of 2010. Other non-interest expense increased $1.2 million primarily because of increased real estate taxes and legal fees related to other real estate owned and $110,000 because of an increase in the losses recognized on the sale of real estate owned between the periods. Compensation and benefits increased $101,000 between the periods primarily because of increased personnel in the commercial loan recovery area. Occupancy expense decreased $119,000 between the periods primarily because of a decrease in depreciation expense. Deposit insurance costs decreased $112,000 primarily because of a decrease in brokered deposits between the periods.

Non-interest expense was $14.3 million for the first six months of 2011, an increase of $2.0 million, or 15.7%, from $12.3 million for the same period of 2010. Non-interest expense increased $918,000 because of a $190,000 loss recognized on real estate owned in the first six months of 2011 compared to a $728,000 gain recognized on real estate owned in the first six months of 2010. Other non-interest expense increased $1.3 million because of increased real estate taxes and legal fees related to other real estate owned. Compensation and benefits increased $212,000 between the periods primarily because of increased personnel in the commercial loan recovery area. Deposit insurance costs decreased $225,000 between the periods primarily because of a decrease in brokered deposits. Occupancy expense decreased $210,000 between the periods primarily because of a decrease in depreciation expense.

Income Taxes

The effect of income taxes changed $7.0 million between the periods, from an expense of $6.9 million in the second quarter of 2010 to a benefit of $0.1 million in the second quarter of 2011. In the second quarter of 2010, income taxes were increased $8.5 million as a result of recording a deferred tax asset valuation reserve, which was partially offset by a $1.2 million tax benefit recorded as a result of a favorable Minnesota Supreme Court tax ruling during that quarter. The Company continues to maintain a valuation reserve against the entire deferred tax asset balance at June 30, 2011. Since the valuation reserve is established against the entire deferred tax asset balance, the only amount included as income tax benefit for the second quarter of 2011 relates to the reversal of taxes on the change in the fair market value of the available for sale investment portfolio that was recorded in the first quarter of 2011.

Income tax expense was $0 for the first six months of 2011, a decrease of $5.7 million from $5.7 million for the same period of 2010. In the second quarter of 2010, income taxes were increased $8.5 million as a result of recording a deferred tax asset valuation reserve, which was partially offset by a $1.2 million tax benefit recorded as a result of a favorable Minnesota Supreme Court tax ruling during that quarter. The Company continues to maintain a valuation reserve against the entire deferred tax asset balance at June 30, 2011. Since the valuation reserve is established against the entire deferred tax asset balance, no income tax expense or benefit was recorded for the first six months of 2011 and the taxes on the change in the fair market value of the available for sale investment portfolio are recorded as an adjustment to other comprehensive income.

Net Loss Available to Common Shareholders

The net loss available to common shareholders was $2.7 million for the second quarter of 2011, a decreased loss of $5.6 million from the $8.3 million net loss available to common shareholders in the second quarter of 2010. The net loss available to common shareholders was $2.8 million for the first six months of 2011, a decreased loss of $7.8 million from the $10.6 million net loss available to common shareholders in the first six months of 2010. The net loss available to common shareholders decreased for both the second quarter of 2011 and the six month period ending June 30, 2011 primarily because of the change in the net loss between the periods.

The Company deferred the February 15, 2011 and May 15, 2011 cash dividend payments and has determined that it will defer the August 15, 2011 dividend payment on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The deferred dividend payments have been accrued for payment in the future and are being reported for the deferral period as a preferred dividend requirement that is deducted from income (loss) available to common shareholders for financial statement purposes.

FINANCIAL CONDITION

Non-Performing Assets

The following table summarizes the amounts and categories of non-performing assets in the Bank’s portfolio and loan delinquency information as of the end of the three most recently completed quarters.


	June 30,			March 31,			December 31,
(Dollars in thousands)	2011			2011			2010

Non-Accruing Loans:
One-to-four family real estate	$	2,039		$	3,399		$	4,844
Commercial real estate		25,194			21,609			36,737
Consumer		555			245			224
Commercial business		15,298			23,829			26,269

Total		43,086			49,082			68,074


Other assets
Foreclosed and Repossessed Assets:
One-to-four family real estate		2,468			1,640			972
Consumer		3			14			14
Commercial real estate		19,400			19,829			15,409

Total non-performing assets	$	64,957		$	70,565		$	84,469

Total as a percentage of total assets		8.05	%		8.03	%		9.59	%

Total non-performing loans	$	43,086		$	49,082		$	68,074

Total as a percentage of total loans receivable, net		7.16	%		7.74	%		10.25	%

Allowance for loan loss to non-performing loans		64.44	%		71.21	%		62.91	%


Delinquency Data:
Delinquencies ⁽¹⁾
30+ days	$	8,861		$	4,940		$	4,021
90+ days		0			178			754
Delinquencies as a percentage of loan and lease portfolio ⁽¹⁾
30+ days		1.43	%		0.76	%		0.59	%
90+ days		0.00	%		0.03	%		0.11	%


(1)		Excludes non-accrual loans.

The increase in loans that were more than 30 days delinquent at June 30, 2011 relates primarily to two land loans totaling $2.1 million, four single family loans totaling $0.9 million, and two commercial loans totaling $0.8 million that were delinquent more than 30 days at June 30, 2011.

Total non-performing assets were $65.0 million at June 30, 2011, a decrease of $5.6 million, or 7.9%, from $70.6 million at March 31, 2011. Non-performing loans decreased $6.0 million and foreclosed and repossessed assets increased $0.4 million during the second quarter of 2011. The non-performing loan and foreclosed and repossessed asset activity for the quarter was as follows:


(Dollars in thousands)
Non-performing loans				Foreclosed and repossessed assets
March 31, 2011	$	49,082		March 31, 2011	$	21,483
Classified as non-performing		9,168		Transferred from non-performing loans		2,000
Charge offs		(10,932	)	Other foreclosures/repossessions		27
Principal payments received		(1,207	)	Real estate sold		(1,417	)
Classified as accruing		(1,025	)	Net loss on sale of assets		(87	)
Transferred to real estate owned		(2,000	)	Write downs and payments		(135	)

June 30, 2011	$	43,086		June 30, 2011	$	21,871

The decrease in non-performing loans during the quarter relates primarily to loans that were charged off during the period. Of the $10.9 million in charge offs recorded during the second quarter of 2011, $6.2 million related to two bank stock loans, $2.7 million was on an alternative fuel plant and $1.9 million related to two development loans. Of the $9.2 million in loans classified as non-performing during the second quarter of 2011, $3.7 million related to two development loans and $4.3 million related to a land loan that was classified as non-performing during the quarter. The largest remaining non-performing loan at June 30, 2011 was for $3.7 million and is secured by a residential development located in the Bank’s primary market.

Total non-performing assets were $65.0 million at June 30, 2011, a decrease of $19.5 million, or 23.1%, from $84.5 million at December 31, 2010. Non-performing loans decreased $25.0 million and foreclosed and repossessed assets increased $5.5 million during the first six months of 2011. The non-performing loan and foreclosed and repossessed asset activity for the first six months of 2011 was as follows:


(Dollars in thousands)
Non-performing loans				Foreclosed and repossessed assets
January 1, 2011	$	68,074		January 1, 2011	$	16,395
Classified as non-performing		11,641		Transferred from non-performing loans		8,231
Charge offs		(21,271	)	Other foreclosures/repossessions		28
Principal payments received		(2,146	)	Real estate sold		(2,472	)
Classified as accruing		(4,953	)	Net loss on sale of assets		(6	)
Transferred to real estate owned		(8,259	)	Write downs and payments		(305	)

June 30, 2011	$	43,086		June 30, 2011	$	21,871

The decrease in non-performing loans during the first six months of 2011 relates primarily to loans that were charged off. Of the $21.3 million in charge offs recorded during the first six months of 2011, $6.2 million related to two bank stock loans, $2.7 million was on an alternative fuel plant and $11.2 million related to six development loans.

The following table summarizes the number and types of commercial real estate loans (the largest category of non-performing loans) that were non-performing as of the end of the three most recently completed quarters.


			Principal				Principal				Principal
			Amount of				Amount of				Amount of
			Loans				Loans				Loans
(Dollars in thousands)			June 30,				March 31,				December 31,
Property Type	#		2011		#		2011		#		2010

Developments/land		6	$	17,946		4	$	10,732		9	$	23,661
Single family homes		0		0		2		296		3		2,673
Alternative fuel plants		1		2,266		1		4,994		1		4,994
Shopping centers/retail		3		1,378		2		1,036		3		1,099
Restaurants/bar		1		654		1		614		1		635
Office building		1		2,950		2		3,937		1		3,675

		12	$	25,194		12	$	21,609		18	$	36,737

The Company had specific reserves established against the above commercial real estate loans of $5.7 million, $6.9 million and $13.3 million at June 30, 2011, March 31, 2011 and December 31, 2010, respectively. The increase in the non-performing commercial real estate loans from March 31, 2011 is due primarily to two residential development loans totaling $3.7 million and a $4.3 million land loan that were classified as non-performing during the quarter that were partially offset by charge offs recorded in the second quarter of 2011.

The following table summarizes the number of lending relationships and industry of commercial business loans that were non-performing as of the end of the three most recently completed quarters.


			Principal				Principal				Principal
			Amount of				Amount of				Amount of
			Loans				Loans				Loans
(Dollars in thousands)			June 30,				March 31,				December 31,
Property Type	#		2011		#		2011		#		2010

Construction/development/land		4	$	4,768		5	$	6,205		6	$	9,148
Finance		1		181		1		244		1		248
Retail		4		3,061		3		3,129		1		2,504
Banking		2		1,974		2		8,223		2		8,223
Entertainment		1		239		1		309		1		315
Utilities		1		4,583		1		4,598		1		4,614
Restaurant		2		492		3		1,121		4		1,217

		15	$	15,298		16	$	23,829		16	$	26,269

The Company had specific reserves established against the above commercial business loans of $3.5 million, $9.3 million and $10.7 million at June 30, 2011, March 31, 2011 and December 31, 2010, respectively. The decrease in non-performing commercial business loans from March 31, 2011 is primarily related to the charge off of $6.2 million in non-performing commercial business loans against previously established reserves.

Dividends

The declaration of dividends is subject to, among other things, the Company’s financial condition and results of operations, the Bank’s compliance with its regulatory capital requirements, tax considerations, industry standards, economic conditions, regulatory restrictions, general business practices and other factors. Under the Bank Supervisory Agreement, no dividends can be declared or paid by the Bank to the Company without prior regulatory approval. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders and, under the Company Supervisory Agreement, the Company may not declare or pay any cash dividends, or purchase or redeem any capital stock, without prior notice to, and consent of, its primary banking regulator (FRB). The Company suspended the dividend payments to common stockholders in the fourth quarter of 2008 due to the net operating losses experienced and the challenging economic environment. The Company deferred the February 15, 2011 and May 15, 2011 regular quarterly cash dividend and has determined that it will defer the August 15, 2011 regular quarterly cash dividend on the preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program.

LIQUIDITY AND CAPITAL RESOURCES

For the six months ended June 30, 2011, the net cash provided by operating activities was $13.0 million. The Company collected $80.0 million from the maturities of securities, $1.5 million from sales of real estate, $6.6 million from principal repayments on securities, and $1.2 million from the redemption of FHLB stock. The Company purchased securities of $69.0 million, purchased FHLB stock of $17,000 and purchased premises and equipment of $115,000. Net loans receivable decreased $46.5 million due primarily to decreased commercial loan production. The Company had a net decrease in deposit balances of $36.2 million (primarily in brokered deposits) and paid out $88,000 in customer escrows. The Company also repaid $37.5 million of borrowings.

The Company has certificates of deposits with outstanding balances of $175.4 million that come due over the next 12 months, of which $48.0 million were obtained from brokers. Based upon past experience, management anticipates that the majority of the non-brokered deposits will renew for another term. The Company believes that the non-brokered deposits that do not renew will be replaced with deposits from other customers or brokers. FHLB advances, Federal Reserve borrowings or proceeds from the sale of securities could also be used to replace unanticipated outflows of non-brokered deposits.

The Company has deposits of $38.3 million in checking and money market accounts with customers that have individual balances greater than $5.0 million. These funds may be withdrawn at any time, however, management does not anticipate that these deposits will be withdrawn from the Bank over the next twelve months. If these deposits were to be withdrawn, they would be replaced with deposits from other customers or brokers, subject to regulatory approval. FHLB advances, Federal Reserve borrowings or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.

The Company has $70.0 million of FHLB advances which mature beyond June 30, 2012 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. Under the Company Supervisory Agreement, the Company may not incur or issue any debt without prior notice to, and the consent of, its primary regulator (FRB). Because FHLB advances are debt of the Bank, they are not affected by the Company’s restriction on incurring debt.

At June 30, 2011, the Bank had the ability to draw additional borrowings from the FHLB of $64.2 million based upon the collateral pledged, subject to a requirement to purchase additional FHLB stock and the FHLB agreeing to lend. The Bank also has the ability to draw additional borrowings of $58.1 million from the Federal Reserve Bank, based upon the loans pledged with them.

The primary source of cash for HMN is dividends from the Bank and the Bank is restricted under the Bank Supervisory Agreement from paying dividends to the Company without obtaining prior regulatory approval. At June 30, 2011, HMN had $1.8 million in cash and other assets that could readily be turned into cash. The primary use of cash by HMN is the payment of expenses and dividends on the preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The amount of the dividend on the preferred stock accumulates at the rate of $325,000 per quarter through February 14, 2014 and $585,000 per quarter thereafter, if the shares of preferred stock are not redeemed. If the accumulated dividends on the preferred stock have not been paid for an aggregate of six quarterly dividend periods or more, whether or not consecutive, the number of directors of the Company automatically will be increased by two, and the holders of the preferred shares (currently the United States Treasury) will have the right to elect two directors to fill the newly created directorships. The Company deferred the February 15, 2011 and May 15, 2011 dividend payment and has determined that it will defer the August 15, 2011 payment.

The OTS (predecessor prior to July 21, 2011 to the Office of the Comptroller of the Currency (OCC), the Bank’s primary banking regulator, and to the Federal Reserve Board (FRB), the Company’s primary banking regulator) proposed to the Bank as its Individual Minimum Capital Requirement (IMCR) a tier 1 capital to adjusted total assets requirement of 8.5% commencing September 30, 2011, which is in excess of the Bank’s tier 1 capital to adjusted total assets ratio at June 30, 2011. An IMCR requires a bank to establish and maintain levels of capital greater than those required for banks generally to be classified as “well-capitalized.” The Bank has submitted proposed modifications to the proposed IMCR and had discussions with the OTS related to the timing for implementation of the proposed IMCR. However, at the time of filing of this Quarterly Report on Form 10-Q, no IMCR has been imposed on the Bank.

HMN also serves as a source of capital, liquidity and financial support to the Bank. Based on the operating performance of the Bank or other capital demands, including potentially the proposed IMCR, HMN may need to raise additional capital. If HMN raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, given our current common stock trading price, would be expected to dilute the per share book value of the Company’s common stock and could result in a change of control of the Company and the Bank. New investors may also have rights, preferences and privileges senior to the Company’s current stockholders, which may adversely impact the Company’s current stockholders. HMN’s ability to raise additional capital through the issuance of equity securities, if needed, will depend on conditions in the capital markets at that time, which are outside of its control, and on the Company’s financial performance. Accordingly, HMN may not be able to raise additional capital, if needed, on favorable economic terms, or other terms acceptable to it. HMN may also find it necessary to employ other alternatives to meet applicable capital requirements, including sales of assets or other forms of recapitalization, which may have the effect of reducing its base of earning assets, or diluting or changing the ownership and control of the Company and the Bank. If HMN cannot raise additional capital when needed or otherwise satisfactorily address its capital needs as they arise, the Company’s ability to maintain or expand its operations, its ability to meet any Company capital plan or Bank IMCR, operate without additional regulatory or other restrictions, and its operating results, could be materially adversely affected.

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 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 located in the Asset/Liability Management section of this report, which follows, discloses the Company’s projected changes in net interest income based upon immediate interest rate changes called rate shocks.

The Company utilizes a model that uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities due to different interest rate changes. The 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, 2011.


Other than trading portfolio
(Dollars in thousands)	Market Value
Basis point change in interest rates		-100		0		+100		+200

Total market risk sensitive assets	$	795,488		784,887		772,983		758,596
Total market risk sensitive liabilities		743,960		733,395		721,342		709,056
Off-balance sheet financial instruments		(17	)	0		113		205

Net market risk	$	51,545		51,492		51,528		49,335

Percentage change from current market value		0.10	%	0.00	%	0.07	%	(4.19)	%

The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates from 6% to 71%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were

assumed to prepay at annual rates of between 12% and 34%, depending on the note rate and the period to maturity. Growing equity mortgage loans were assumed to prepay at annual rates of between 8% and 45% 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 21% and money market accounts were assumed to decay at an annual rate of 27%. Non-interest checking accounts were assumed to decay at an annual rate of 19% and NOW accounts were assumed to decay at an annual rate of 17%. Commercial NOW accounts and MMDA accounts were assumed to decay at annual rates of 17% and 27%, respectively. Commercial non-interest checking accounts were assumed to decay at an annual rate of 19%. 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, 2011 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.


(Dollars in thousands)
Rate Shock in Basis	Projected Change in Net
Points	Interest Income			Percentage Change
+200		1,424			5.24	%
+100		1,071			3.94	%
0		0			0.00	%
-100		(1,510	)		(5.56	)%

The preceding table was prepared utilizing the Model Assumptions. 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 increase in interest rates and could impact net interest income. The increase in interest income in a rising rate environment is primarily because more loans than deposits are scheduled to reprice in the next twelve months.

In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee which meets frequently to discuss changes in the interest rate risk position and projected profitability. The Committee makes adjustments to the asset-liability position of the Bank, which are reviewed by the Board of Directors of the Bank. This Committee also reviews the Bank’s portfolio, formulates investment strategies and oversees the timing and implementation of transactions to assure attainment of the Board’s objectives in the most effective manner. In addition, each quarter the Board reviews the Bank’s asset/liability position, including simulations of the effect on the Bank’s capital of various interest rate scenarios.

In managing its asset/liability mix, the Bank, at times, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, may place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net

interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, in certain situations, provide high enough returns to justify the increased exposure to sudden and unexpected changes in interest rates.

To the extent consistent with its interest rate spread objectives, the Bank attempts to manage its interest rate risk and has taken a number of steps to structure its balance sheet in order to better match the maturities of its assets and liabilities. The Bank has primarily focused its fixed rate one-to-four family residential lending program on loans that are saleable to third parties and generally places only those fixed rate loans that meet certain risk characteristics into its loan portfolio. The Bank’s commercial loan production has primarily been in adjustable rate loans while the fixed rate commercial loans placed in portfolio have been shorter-term loans, usually with maturities of five years or less, in order to manage the Company’s interest rate risk exposure.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business.

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 controls 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 controls over financial reporting.

HMN FINANCIAL, INC.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, the Company is party to legal proceedings arising out of its lending and deposit operations. The Company is, and expects to become, engaged in a number of foreclosure proceedings and other collection actions as part of its collection activities. Litigation is often unpredictable and the actual results of litigation cannot be determined with any certainty.

The Company entered into a written Supervisory Agreement with the OTS effective February 22, 2011. The Supervisory Agreement replaced the prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. The material requirements of the Company Supervisory Agreement are as follows:

	•		Submission of a written plan by May 31, 2011 for enhancing the consolidated capital of the Company for the period ending December 31, 2012 and review of performance no less than quarterly along with reports to the FRB (as successor to the OTS’ role as regulator of the Company) within 45 days after the end of each calendar quarter. The plan submitted by the Company by May 31, 2011 focuses on improvement in capital levels primarily through improved earnings, reduction in non-performing assets and reduction in total assets.

	•		The Company may not declare, make or pay any cash dividends or repurchase or redeem any of the Company’s equity stock without providing advance notice to the FRB and receiving written non-objection.

	•		The Company may not incur, issue, renew, rollover or pay interest or principal on any debt or commit to do so nor may it increase any current lines of credit or guarantee the debt of any entity without prior written notice and written non-objection of the FRB.

	•		Limits were placed on contractual arrangements related to compensation or benefits with any directors or officers and the Company is prevented from making any golden parachute payments to officers, directors or employees.

The Bank also entered into a written Supervisory Agreement with the OTS, effective February 22, 2011. The Bank Supervisory Agreement replaced the prior memorandum of understanding that the Bank entered into with the OTS on December 9, 2009. The material requirements of the Bank Supervisory Agreement are as follows:

	•		Submission of a business plan by May 31, 2011, addressing strategies for supporting the Bank’s risk profile, improving earnings and profitability and stress testing. The Bank’s Board is to review performance no less than quarterly and report to the OCC (as successor to the OTS’ role as regulator of the Bank) within 45 days after the end of each calendar quarter. The plan submitted by the Company by May 31, 2011 focuses on improvement in capital levels primarily through improved earnings, reduction in non-performing assets and reduction in total assets.

	•		Submission of a detailed written plan by March 31, 2011 to reduce the Bank’s problem assets. The plan submitted by the Bank by March 31, 2011 focuses on improvement in the level of problem assets as a result of continuing the actions taken in 2010 and early 2011 by the Board and management to improve credit quality and more effectively identify and manage problem loans in a proactive manner.

	•		Development of individual written specific workout plans for certain large adversely classified loans or groups of loans and for foreclosed real estate owned by the Bank within 30 days of the Supervisory Agreement effective date. The plans developed by the Bank focus on improving the ultimate collection of these items by improving the Bank’s collateral position or by an orderly liquidation of the collateral securing the assets.

	•		Beginning with the quarter ending June 30, 2011, the Bank is to submit quarterly asset reports to the OCC within 50 days of quarter end. The reports submitted by the Bank focus on status of workout plans, classified assets, actions taken to reduce problem assets and recommended revisions to the problem asset plan.

	•		Development by April 30, 2011, of a loan modification policy. The policy developed by the Bank focuses on enhanced supporting documentation and procedures relating to all loan restructurings, including those not determined to be Troubled Debt Restructurings.

	•		Revision of the Bank’s written credit concentration program and submission of the program by May 6, 2011 to the OTS. The plan addresses identifying, monitoring and controlling risk associated with concentrations of credit. The Bank has implemented the revisions and is monitoring the resulting information.

	•		Improvement of the documentation relating to the allowance for loan and lease losses to ensure that it addressed OTS concerns. The documentation improvements related primarily to the inclusion of established specific reserves into the commercial loan migration charge-off analysis.

	•		The Bank may not declare or pay any dividends or make any other capital distributions without providing advance request to the OCC and receiving written approval. The Supervisory Agreement also limits the Bank’s growth in total assets in excess of specified amounts without regulatory approval.

	•		Limits are placed on contractual arrangements with third parties and contracts dealing with compensation or benefits with any directors or officers and the Bank is prevented from making any golden parachute payments to directors, officers and employees.

The Company and Bank timely submitted all plans and programs required by the Supervisory Agreements and the Company believes that it and the Bank are in compliance with all provisions of the Supervisory Agreements. The applicable regulator may comment on and require revision of any submitted plan, program or policy. Neither the Company nor the Bank have taken any actions, or sought approval for such actions, where prior regulatory approval is required by the Supervisory Agreements.

Violations of these Supervisory Agreements may lead to more rigorous enforcement action, which could include civil money penalties, a cease and desist order or removal actions against officers and directors.

The foregoing is merely a summary of the material terms of the Supervisory Agreements and reference is made to the full text of the Supervisory Agreements which are set forth as Exhibits 10.1 and 10.2 to the Company’s Current Report on Form 8-K dated February 10, 2011.

Dissolution of the OTS is not expected to have any material impact on the Supervisory Agreements as the Supervisory Agreements will now be enforced by the FRB in the case of the Company’s Supervisory Agreement and the OCC in the case of the Bank’s Supervisory Agreement.

Item 1A. Risk Factors

The Company and the Bank are subject to the restrictions and conditions of the Supervisory Agreements with the Office of the Comptroller of the Currency (OCC) and the Federal Reserve Board (FRB). Failure to comply with the Supervisory Agreements could result in enforcement actions against us, including the imposition of monetary penalties.

The Company and the Bank each entered into Supervisory Agreements effective February 22, 2011 with the Office of Thrift Supervision (OTS) (predecessor prior to July 21, 2011 to the OCC, the Bank’s primary banking regulator, and to the FRB, the Company’s primary banking regulator). The Supervisory Agreements supersede the memoranda of understanding between the Company and the Bank and the OTS dated December 9, 2009. In accordance with the Company’s Supervisory Agreement, we submitted a two year capital plan by May 31, 2011 to the OTS upon which the FRB may make comments, and to which the FRB may require revisions. We must operate within the parameters of the final capital plan and are required to monitor and submit periodic reports on our compliance with the plan. Also under the Company’s Supervisory Agreement, without the consent of the FRB, we may not incur or issue any debt, guarantee the debt of any entity, declare or pay any cash dividends or repurchase any of our capital stock, enter into any new contractual arrangement or renew or extend any existing arrangement relating to compensation or benefits with any director or executive officer, or make any golden parachute payments.

The Bank’s Supervisory Agreement with the OCC primarily relates to the Bank’s financial performance and credit quality issues. In accordance with the Bank’s Supervisory Agreement, the Bank submitted a two year business plan and the OCC may make comments upon, and require revisions to, such plan. The Bank must operate within the parameters of the final business plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank also submitted a problem asset reduction plan that the OCC may make comments upon, and require revisions to. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank also revised its loan modification policies and their programs for identifying, monitoring and controlling risk associated with concentrations of credit and improve its documentation of the allowance for loan and lease losses. In addition, without the consent of the OCC, the Bank may not declare or pay any cash dividends, materially increase the total assets of the Bank, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider. If the Company or the Bank fails to comply with the terms of their respective agreements, the OCC or the FRB, as applicable, could take enforcement action against us, including the imposition of monetary penalties or the issuance of a cease and desist order requiring corrective action.

In addition, the OTS proposed to the Bank as its individual minimum capital requirements (IMCR) a Tier 1 capital to adjusted total assets requirement of 8.5% commencing September 30, 2011, which is in excess of the Bank’s Tier 1 capital to adjusted assets ratio at June 30, 2011 and in excess of the corresponding capital ratio forecast in our capital plan at the time we would be required to be in compliance with the proposed IMCR. An IMCR can require a bank to establish and maintain levels of capital greater than those generally required for a bank to be classified as well-capitalized. The Bank has submitted proposed modifications to the proposed IMCR and held discussions with the OTS related to the timing for implementation of the proposed IMCR. At the time of filing of this Quarterly Report on Form 10-Q, no IMCR has been imposed on the Bank. There can be no assurance as to the amount or timing of any final IMCR which may be imposed.

We may be required to raise additional capital in the future, but that capital may not be available when it is needed.

We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. Based on operating performance, regulatory requirements or other capital demands, we may at some point need to raise additional capital. Pursuant to the Company’s Supervisory Agreement, the Company submitted a capital plan prior to May 31, 2011 for approval by the OTS. The capital plan must include a proposed minimum tangible equity capital ratio commensurate with the Company’s consolidated risk profile and projections demonstrating the Company’s ability to attain and maintain such ratio. The OTS (predecessor prior to July 21, 2011 to the OCC, the Bank’s current primary federal banking regulator) proposed to the Bank as its individual minimum capital requirement (IMCR) a tier 1 capital to adjusted total assets requirement of 8.5% commencing September 30, 2011, which is in excess of the Bank’s tier 1 capital to adjusted total assets ratio at June 30, 2011 and in excess of the corresponding capital ratio forecast in our capital plan at the time we would be required to be in compliance with the proposed IMCR. An IMCR requires a bank to establish and maintain levels of capital greater than those required for a bank generally to be classified as “well-capitalized.” The Bank has submitted proposed modifications to the proposed IMCR and held discussions with the OTS related to the timing for implementation of the proposed IMCR. At the time of filing of this Quarterly Report on Form 10-Q, no IMCR has been imposed on the Bank.

Given the uncertainty surrounding the timing of the proposed IMCR and other factors, we cannot predict at this time what steps may be necessary, and whether they can be sufficient and timely, in order to address our consolidated and Bank capital requirements and comply with an IMCR. To date, we have reduced the asset size of the Bank in order to enhance its capital position. We are evaluating the feasibility of various other alternatives that may be necessary or advisable to address our capital needs and requirements.

If we find it necessary to raise capital through the issuance of additional shares of our common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, given our current common stock trading price, would be expected to dilute the per share book value of our common stock, and could result in a change in control of the Company and the Bank. New investors may also have rights, preferences and privileges senior to our current stockholders which may adversely impact our current stockholders.

Our ability to raise additional capital through the issuance of equity securities, if needed, will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we may not be able to raise additional capital, if needed, on favorable economic terms, or other terms acceptable to us. We may also find it necessary to employ other alternatives to meet applicable capital requirements, including sales of assets or other forms of recapitalization, which may have the effect of reducing our base of earning assets, or diluting or changing the ownership and control of the Company and the Bank. If we cannot raise additional capital when needed or otherwise satisfactorily address our capital needs as they arise, our ability to maintain or expand our operations, our ability to meet any Company capital plan or Bank IMCR, operate without additional regulatory or other restrictions, and our operating results, could be materially adversely affected.

We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations, including recent changes under federal law.

The Company and the Bank are subject to extensive examination, supervision and comprehensive regulation by federal bank regulatory agencies. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds, and the banking system as a whole, and not holders of our common stock. These regulations affect our lending practices, capital structure, investment practices, dividend policy, and growth, among other things.

On July 21, 2010, the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act is changing the current bank regulatory structure and affecting the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for months or years.

On July 21, 2011 (the “Transition Date”), Title III of the Dodd-Frank Act transferred to the Federal Reserve Board (“FRB”) the supervisory functions of the Office of Thrift Supervision (“OTS”) related to savings and loan holding companies, like the Company, and their nondepository subsidiaries.

The Dodd-Frank Act provides that all orders, resolutions, determinations, agreements, and regulations, interpretive rules, other interpretations, guidelines, and other advisory materials issued, made, prescribed, or allowed to become effective by the OTS on or before the transfer date with respect to savings and loan holding companies and their non-depository subsidiaries will remain in effect and shall be enforceable until modified, terminated, set aside, or superseded in accordance with applicable law by the FRB, by any court of competent jurisdiction, or by operation of law. Accordingly, the Supervisory Agreement entered into by the Company with the OTS will be enforced by the FRB.

In the near future, the FRB is expected to issue a final rule to effectuate the transition of OTS regulations to the FRB. The FRB has stated the rule will include technical, nomenclature, and other changes to certain OTS regulations to accommodate the transfer of supervisory authority from the OTS to the FRB and address modifications made by the Dodd-Frank Act. In the future, the FRB is also expected to propose substantive modifications to rules impacting savings and loan holding companies in order to address other modifications made by the Dodd-Frank Act (examples include adoption of rules to implement the “source of strength” requirement and changes regarding holding company minimum capital levels, which have future required implementation dates). The extent and timing of any substantive changes may have an impact on the Company’s capital requirements and liquidity but the effects are difficult to predict at this time.

As part of its new supervisory function for savings and loan holding companies, the FRB will begin direct oversight of the Company. The FRB has announced that it will assess the condition, performance and activities of savings and loan holding companies in a manner that is consistent with its established risk-based approach regarding bank holding company supervision to ensure that savings and loan holding companies are effectively supervised and can serve as a source of strength for, and do not threaten the soundness of, subsidiary depository institutions.

On the Transition Date, the Dodd-Frank Act transferred to the Office of the Comptroller of the Currency (“OCC”) the supervisory functions of the Bank’s former regulator, the OTS. The Dodd-Frank Act provides that all orders, resolutions, determinations, agreements, and regulations, interpretive rules, other interpretations, guidelines, and other advisory materials issued, made, prescribed, or allowed to become effective by the OTS on or before the transfer date with respect to savings associations will remain in effect and shall be enforceable until modified, terminated, set aside, or superseded in accordance with applicable law by the OCC, by any court of competent jurisdiction, or by operation of law. Accordingly, the Supervisory Agreement entered into by the Bank with the OTS will now be enforced by the OCC.

We do not expect that the transition of supervisory functions to the OCC and FRB to materially impact the Company, its shareholders or the Bank, but it is possible due to the change in regulators that the Company and Bank may experience qualitatively different and potentially more rigorous supervision and oversight of their activities.

Also effective on the Transition Date, a provision of the Dodd-Frank Act that eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on the Company’s interest expense.

Congress and federal regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including changes in interpretation or implementation of statutes, regulations, or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer, restrict mergers and acquisitions, investments, access to capital, the location of banking offices, or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputational damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.

Changes to federal law and regulations may also limit the Bank’s flexibility on financial products and fees which could result in additional operational costs and a reduction in our non-interest income.

Further, our regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws by financial institutions and holding companies in the performance of their supervisory and enforcement duties. Examples include limits on payment of dividends by banks and regulations governing compensation. Regulation of dividends would limit the liquidity of the Company and limits on compensation may adversely affect our ability to attract and retain employees. See the other risk factors included in this Item 1.A. of this Quarterly Report on Form 10-Q beginning on page 38 for a discussion of risks related to the Company’s and the Bank’s Supervisory Agreements to which we have become subject and for a discussion regarding a proposed IMCR.

See Part I, Item 1.A. of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for additional risk factors.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

The Company deferred its February 15, 2011 and May 15, 2011 regular quarterly cash dividend payments on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The Company has also determined that it will defer its August 15, 2011 dividend payment and following that deferral, the Company will have an aggregate arrearage of $975,000 with respect to the preferred stock.

Item 4. [Removed and Reserved]

Item 5. Other Information.

None.

Item 6. Exhibits.

Incorporated by reference to the index to exhibits included with this report immediately following the signature page.

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 4, 2011	By:	/s/ Bradley Krehbiel
		Bradley Krehbiel, President
		(Principal Executive Officer)


Date: August 4, 2011	By:	/s/ Jon Eberle
		Jon Eberle,
		Chief Financial Officer (Principal Financial Officer)

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	Certificate of Incorporation, as amended		*1	N/A

3.2	HMN Financial, Inc. Bylaws (as of March 22, 2011)		*2	N/A

4	Form of Common Stock Certificate		*3	N/A

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

101	Financial statements from the Quarterly Report on Form 10-Q of the Company for the period ended June 30, 2011, filed with the SEC on August 4, 2011, formatted in Extensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheet at June 30, 2011 and December 31, 2010, (ii) the Consolidated Statement of Loss for the Three Months and Six Months Ended June 30, 2011 and 2010, (iii) the Consolidated Statement of Stockholders’ Equity and Comprehensive Loss for the Six Month Period Ended June 30, 2011, (iv) the Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and 2010, and (v) Notes to Consolidated Financial Statements		101	Filed Electronically


*1		Incorporated by reference to Exhibit 3(a) to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 1998 (File No. 0-24100).

*2		Incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed March 25, 2011 (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).