UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2007
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 0-24100
HMN FINANCIAL, INC.
(Exact name of Registrant as specified in its Charter)
Delaware 41-1777397
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) 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 [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
Class Outstanding at April 19 , 2007
----- ------------------------------
Common stock, $0.01 par value 4,307,169
1
HMN FINANCIAL, INC.
CONTENTS
Page
----
PART I - FINANCIAL INFORMATION
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at March 31, 2007 and
December 31, 2006 3
Consolidated Statements of Income for the Three Months Ended
March 31, 2007 and 2006 4
Consolidated Statement of Stockholders' Equity and
Comprehensive Income for the Three Month Period Ended
March 31, 2007 5
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2007 and 2006 6
Notes to Consolidated Financial Statements 7
Item 2: Management's Discussion and Analysis of Financial Condition
and Results of Operations 13
Item 3: Quantitative and Qualitative Disclosures about Market
Risk Discussion included in Item 2 under Market Risk 18
Item 4: Controls and Procedures 20
PART II - OTHER INFORMATION
Item 1: Legal Proceedings 21
Item 1A: Risk Factors 21
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 21
Item 3: Defaults Upon Senior Securities 21
Item 4: Submission of Matters to a Vote of Security Holders 21
Item 5: Other Information 21
Item 6: Exhibits 21
Signatures 22
2
PART I - FINANCIAL INFORMATION
ITEM 1 : FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(dollars in thousands) 2007 2006
----------- ------------
(unaudited)
ASSETS
Cash and cash equivalents........................................... $ 85,633 43,776
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $11,445 and $6,671)........................... 11,110 6,178
Other marketable securities
(amortized cost $179,694 and $119,940)........................ 179,931 119,962
---------- -------
191,041 126,140
---------- -------
Loans held for sale................................................. 1,412 1,493
Loans receivable, net............................................... 798,502 768,232
Accrued interest receivable......................................... 6,206 5,061
Real estate, net.................................................... 5,127 2,072
Federal Home Loan Bank stock, at cost............................... 7,511 7,956
Mortgage servicing rights, net...................................... 1,780 1,958
Premises and equipment, net......................................... 11,121 11,372
Goodwill............................................................ 3,801 3,801
Core deposit intangible, net........................................ 77 106
Prepaid expenses and other assets................................... 1,891 2,943
Deferred tax asset, net............................................. 2,941 2,879
---------- -------
Total assets..................................................... $1,117,043 977,789
========== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits............................................................ $ 871,929 725,959
Federal Home Loan Bank advances..................................... 140,900 150,900
Accrued interest payable............................................ 2,203 1,176
Customer escrows.................................................... 1,240 721
Accrued expenses and other liabilities.............................. 5,958 5,891
---------- -------
Total liabilities................................................ 1,022,230 884,647
---------- -------
Commitments and contingencies
Stockholders' equity:
Serial preferred stock ($.01 par value):
Authorized 500,000 shares; none issued and outstanding........ 0 0
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662................ 91 91
Additional paid-in capital.......................................... 57,537 57,914
Retained earnings, subject to certain restrictions.................. 105,715 103,643
Accumulated other comprehensive loss................................ (59) (284)
Unearned employee stock ownership plan shares....................... (4,110) (4,158)
Treasury stock, at cost 4,821,493 and 4,813,232 shares.............. (64,361) (64,064)
---------- -------
Total stockholders' equity .............................. ....... 94,813 93,142
---------- -------
Total liabilities and stockholders' equity ................. ....... $1,117,043 977,789
========== =======
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended
March 31,
------------------
(dollars in thousands) 2007 2006
------- ------
Interest income:
Loans receivable ..................................... $15,745 14,703
Securities available for sale:
Mortgage-backed and related ....................... 111 71
Other marketable .................................. 1,896 890
Cash equivalents ..................................... 443 256
Other ................................................ 84 63
------- ------
Total interest income ............................. 18,279 15,983
------- ------
Interest expense:
Deposits ............................................. 6,877 4,868
Federal Home Loan Bank advances ...................... 1,618 1,726
------- ------
Total interest expense ............................ 8,495 6,594
------- ------
Net interest income ............................... 9,784 9,389
Provision for loan losses ............................... 455 515
------- ------
Net interest income after provision for loan
losses.......................................... 9,329 8,874
------- ------
Non-interest income:
Fees and service charges ............................. 696 715
Mortgage servicing fees .............................. 271 303
Gain on sales of loans ............................... 796 246
Other ................................................ 305 222
------- ------
Total non-interest income ......................... 2,068 1,486
------- ------
Non-interest expense:
Compensation and benefits ............................ 3,361 3,259
Occupancy ............................................ 1,084 1,100
Advertising .......................................... 106 131
Data processing ...................................... 295 289
Amortization of mortgage servicing rights, net ....... 182 217
Other ................................................ 922 944
------- ------
Total non-interest expense ........................ 5,950 5,940
------- ------
Income before income tax expense .................. 5,447 4,420
Income tax expense ...................................... 2,179 1,680
------- ------
Net income ........................................ $ 3,268 2,740
======= ======
Basic earnings per share ................................ $ 0.87 0.71
======= ======
Diluted earnings per share .............................. $ 0.82 0.68
======= ======
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2007
(unaudited)
Unearned
Employee
Accumulated Stock Total
Additional Other Ownership Stock-
Common Paid-in Retained Comprehensive Plan Treasury Holders'
(dollars in thousands) Stock Capital Earnings Loss Shares Stock Equity
------ ---------- -------- ------------- --------- -------- --------
Balance, December 31, 2006 91 57,914 103,643 (284) (4,158) (64,064) 93,142
Net income 3,268 3,268
Other comprehensive income, net of tax:
Net unrealized gains on securities
available for sale 225 225
------
Total comprehensive income 3,493
Purchase of treasury stock (997) (997)
FIN 48 - Cumulative effect adjustment (250) (250)
Employee stock options exercised (143) 231 88
Tax benefits of exercised stock options 58 58
Unearned compensation restricted stock awards (469) 469 0
Stock compensation benefits 7 7
Amortization of restricted stock awards 76 76
Dividends paid (946) (946)
Earned employee stock ownership plan shares 94 48 142
--- ------ ------- ---- ------ ------- ------
Balance, March 31, 2007 91 57,537 105,715 (59) (4,110) (64,361) 94,813
=== ====== ======= ==== ====== ======= ======
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three Months Ended
March 31,
-------------------
(dollars in thousands) 2007 2006
--------- -------
Cash flows from operating activities:
Net income .................................................................. $ 3,268 2,740
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses ................................................ 455 515
Depreciation ............................................................. 483 469
Amortization of discounts, net ........................................... (730) (392)
Amortization of deferred loan fees ....................................... (208) (368)
Amortization of core deposit intangible .................................. 29 29
Amortization of mortgage servicing rights, net ........................... 182 217
Capitalized mortgage servicing rights .................................... (4) (48)
Gain on sales of real estate ............................................. (27) (1)
Gain on sales of loans ................................................... (796) (246)
Proceeds from sales of real estate ....................................... 361 42
Proceeds from sale of loans held for sale ................................ 18,764 14,785
Disbursements on loans held for sale ..................................... (7,556) (17,269)
Amortization of restricted stock awards .................................. 76 41
Amortization of unearned ESOP shares ..................................... 48 48
Earned employee stock ownership shares priced above original cost ........ 94 89
Stock option compensation ................................................ 7 16
Increase in accrued interest receivable .................................. (1,145) (358)
Increase (decrease) in accrued interest payable .......................... 1,027 (226)
Decrease (increase) in other assets ...................................... 617 (207)
Increase in other liabilities ............................................ 38 1,008
Other, net ............................................................... 124 0
--------- -------
Net cash provided by operating activities ............................. 15,107 884
--------- -------
Cash flows from investing activities:
Principal collected on securities available for sale ........................ 275 173
Proceeds collected on maturities of securities available for sale ........... 45,000 30,500
Purchases of securities available for sale .................................. (109,193) (34,605)
Purchases of Federal Home Loan Bank Stock ................................... (720) 0
Redemption of Federal Home Loan Bank Stock .................................. 1,165 0
Net (increase) decrease in loans receivable ................................. (44,351) 16,806
Purchases of premises and equipment ......................................... (238) (832)
--------- -------
Net cash (used) provided in investing activities ...................... (108,062) 12,042
--------- -------
Cash flows from financing activities:
Increase (decrease) in deposits ............................................. 146,090 (3,940)
Purchase of treasury stock .................................................. (997) (323)
Stock options exercised ..................................................... 88 49
Excess tax benefit from options exercised ................................... 58 48
Dividends to stockholders ................................................... (946) (929)
Proceeds from Federal Home Loan Bank advances ............................... 22,500 0
Repayment of Federal Home Loan Bank advances ................................ (32,500) 0
Proceeds from Federal Reserve Bank advances ................................. 2,000 1,000
Repayment of Federal Reserve Bank advances .................................. (2,000) (1,000)
Increase in customer escrows ................................................ 519 32
--------- -------
Net cash provided (used) by financing activities ...................... 134,812 (5,063)
--------- -------
Increase in cash and cash equivalents ................................. 41,857 7,863
Cash and cash equivalents, beginning of period ................................. 43,776 47,269
--------- -------
Cash and cash equivalents, end of period ....................................... $ 85,633 55,132
========= =======
Supplemental cash flow disclosures:
Cash paid for interest ...................................................... $ 7,468 6,820
Cash paid for income taxes .................................................. 1,010 1,676
Supplemental noncash flow disclosures:
Transfer of loans to real estate ............................................ 3,507 0
Loans transferred to loans held for sale .................................... 10,327 844
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
MARCH 31, 2007 AND 2006
(1) HMN FINANCIAL, INC.
HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company
that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a
community banking philosophy and operates retail banking and loan production
offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud
Insurance Agency, Inc. (OIA) which offers financial planning products and
services. HMN has another wholly owned subsidiary, Security Finance Corporation
(SFC) which acts as an intermediary for the Bank in transacting like-kind
property exchanges for Bank customers.
The consolidated financial statements included herein are for HMN, SFC, the Bank
and the Bank's consolidated entities as described above. All significant
intercompany accounts and transactions have been eliminated in consolidation.
(2) BASIS OF PREPARATION
The accompanying unaudited consolidated financial statements were prepared in
accordance with instructions for Form 10-Q and therefore, do not include all
disclosures necessary for a complete presentation of the consolidated balance
sheets, consolidated statements of income, consolidated statement of
stockholders' equity and comprehensive income and consolidated statements of
cash flows in conformity with generally accepted accounting principles. However,
all normal recurring adjustments which are, in the opinion of management,
necessary for the fair presentation of the interim financial statements have
been included. The statement of income for the three-month period ended March
31, 2007 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 June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
requires companies to recognize in their financial statements the impact of a
tax position, taken or expected to be taken, if it is more likely than not that
the position will be sustained on audit based on the technical merits of the
position. The Interpretation requires the use of a cumulative probability
methodology to determine the amounts and probabilities of all of the possible
outcomes that could be realized upon the ultimate settlement of a tax position
using the facts, circumstances, and information available at the reporting date.
It also requires that interest expense be accrued on the difference between the
tax position recognized in accordance with the Interpretation and the amount
previously taken or expected to be taken in a tax return. The provisions of FIN
48 were adopted by the Company on January 1, 2007 and as a result, the Company
recognized an increase in its liability recorded for tax exposure reserves. See
Note 12 Income Taxes for additional FIN 48 disclosures.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles, and expands disclosures about the
use of fair value to measure assets and liabilities. This Statement is effective
for financial statements issued for fiscal years beginning after November 15,
2007, and for interim periods within those fiscal years. The impact of adopting
SFAS No. 157 on January 1, 2008 is not anticipated to have a material impact on
the Company's financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, Including an amendment of FASB
Statement No. 115. This Statement permits entities to measure many
7
financial instruments and other items at fair value and most of the provisions
of the Statement apply only to entities that elect the fair value option. This
Statement is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and for interim periods within those fiscal
years. Early adoption is permitted as of the beginning of a fiscal year that
begins prior to the effective date, provided the entity also elects to apply the
provisions of FASB Statement No. 157, Fair Value Measurements. The impact of
adopting SFAS No. 159 on January 1, 2008 is not anticipated to have a material
impact on the Company's financial statements.
(4) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company has commitments outstanding to extend credit to future borrowers
that had not closed prior to the end of the quarter. The Company intends to sell
these commitments which are referred to as its mortgage pipeline. As commitments
to originate or purchase loans enter the mortgage pipeline, the Company
generally enters into commitments to sell the loans 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 March 31, 2007, the Company recorded an increase in other
liabilities of $29,000 and a loss in the gain on sales of loans of $29,000.
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 at March 31, 2007. The Company recorded a decrease in loans held for sale
of $24,000 and an increase in other assets of $24,000 due to the mark to market
adjustment on the commitments to sell loans held for sale.
(5) COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity during a period from
transactions and other events from nonowner sources. Comprehensive income is the
total of net income and other comprehensive income, which for the Company is
comprised of unrealized gains and losses on securities available for sale. The
components of other comprehensive income and the related tax effects were as
follows:
For the period ended March 31,
---------------------------------------------------
2007 2006
------------------------ ------------------------
Before Tax Net of Before Tax Net of
(Dollars in thousands) tax effect tax tax effect tax
------ ------ ------ ------ ------ ------
Securities available for sale:
Net unrealized gains arising
during the period $373 148 225 230 91 139
---- --- --- --- --- ---
Other comprehensive income $373 148 225 230 91 139
==== === === === === ===
(6) SECURITIES AVAILABLE FOR SALE
The following table shows the gross unrealized losses and fair value for the
securities available for sale portfolio, aggregated by investment category and
length of time that individual securities have been in a continuous unrealized
loss position, at March 31, 2007.
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
----------- ------- ---------- ----------- ------ ---------- ------- ----------
Mortgage backed
securities:
FHLMC 0 $ 0 0 2 $2,732 (196) 2,732 (196)
FNMA 0 0 0 3 3,116 (190) 3,116 (190)
Other marketable debt
securities:
FNMA 8 44,543 (26) 0 0 0 44,543 (26)
FHLMC 2 9,871 (5) 0 0 0 9,871 (5)
FHLB 7 44,817 (41) 0 0 0 44,817 (41)
--- ------- --- --- ------ ---- ------- ----
Total temporarily
impaired securities 17 $99,231 (72) 5 $5,848 (386) 105,079 (458)
=== ======= ==== === ====== ==== ======= ====
These fixed rate investments are temporarily impaired due to changes in interest
rates and the Company has the ability and intent to hold to maturity or until
the temporary loss is recovered. Mortgage backed securities in the
8
table above had an average life of less than nine years and the other marketable
securities had an average life of less than one year at March 31, 2007.
(7) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
Three months Twelve months Three months
ended ended ended
(Dollars in thousands) March 31, 2007 December 31, 2006 March 31, 2006
-------------- ----------------- --------------
Mortgage servicing rights:
Balance, beginning of period ....... $1,958 2,654 2,654
Originations ....................... 4 152 48
Amortization ....................... (182) (848) (217)
------ ----- -----
Balance, end of period ............. 1,780 1,958 2,485
------ ----- -----
Mortgage servicing rights, net ..... $1,780 1,958 2,485
====== ===== =====
Fair value of mortgage servicing
rights .......................... $3,809 3,823 4,420
====== ===== =====
All of the loans being serviced were single family loans serviced for the
Federal National Mortgage Association (FNMA) under the mortgage-backed security
program or the individual loan sale program. The following is a summary of the
risk characteristics of the loans being serviced at March 31, 2007.
Weighted Weighted
Loan Average Average
Principal Interest Remaining Number
(Dollars in thousands) Balance Rate Term of Loans
--------- -------- --------- --------
Original term 30 year fixed rate $197,842 5.93% 321 1,755
Original term 15 year fixed rate 170,004 5.27% 139 2,335
Adjustable rate 4,095 5.70% 312 38
(8) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at March 31, 2007 is presented in the table below. Amortization
expense for intangible assets was $182,000 for the period ended March 31, 2007.
Gross Unamortized
Carrying Accumulated Intangible
(Dollars in thousands) Amount Amortization Assets
-------- ------------ -----------
Amortized intangible assets:
Mortgage servicing rights $4,077 (2,297) 1,780
Core deposit intangible 1,567 (1,490) 77
------ ------ -----
Total $5,644 (3,787) 1,857
====== ====== =====
The following table indicates the estimated future amortization expense for
amortized intangible assets:
Mortgage Core
Servicing Deposit
(Dollars in thousands) Rights Intangible Total
--------- ---------- -----
Year ended December 31,
2007 $445 77 522
2008 552 0 552
2009 406 0 406
2010 221 0 221
2011 107 0 107
9
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of March 31, 2007. The Company's actual
experience may be significantly different depending upon changes in mortgage
interest rates and other market conditions.
(9) EARNINGS PER SHARE
The following table reconciles the weighted average shares outstanding and the
income available to common shareholders used for basic and diluted EPS:
Three months ended
March 31,
----------------------
2007 2006
---------- ---------
Weighted average number of common shares outstanding
used in basic earnings per common share
calculation 3,775,843 3,839,874
Net dilutive effect of:
Options 172,043 168,074
Restricted stock awards 19,541 12,877
---------- ---------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 3,967,427 4,020,825
========== =========
Income available to common shareholders $3,268,000 2,740,000
Basic earnings per common share $ 0.87 0.71
Diluted earnings per common share $ 0.82 0.68
(10) REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory and possibly additional discretionary actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities and certain off-balance sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulations to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
following table) of Tier I or Core capital, and Risk-based capital (as defined
in the regulations) to total assets (as defined). Management believes, as of
March 31, 2007, that the Bank meets all capital adequacy requirements to which
it is subject.
Management believes that based upon the Bank's capital calculations at March 31,
2007 and other conditions consistent with the Prompt Corrective Actions
Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
On March 31, 2007 the Bank's tangible assets and adjusted total assets were $1.1
billion and its risk-weighted assets were $844 million. The following table
presents the Bank's capital amounts and ratios at March 31, 2007 for actual
capital, required capital and excess capital including ratios in order to
qualify as being well capitalized under the Prompt Corrective Actions
regulations.
10
To Be Well
Capitalized
Required to be Under Prompt
Adequately Corrective
Actual Capitalized Excess Capital Actions Provisions
------------------- ------------------- ------------------ ------------------
Percent Percent Percent Percent
of of of of
(Dollars in thousands) Amount Assets(1) Amount Assets (1) Amount Assets(1) Amount Assets(1)
------- --------- ------ ---------- ------ --------- ------ ---------
Bank stockholder's equity ................... $90,278
Less:
Net unrealized losses on certain
securities available for sale ......... 59
Goodwill and core deposit intangible ..... (3,878)
Disallowed servicing and tax assets ...... (2,519)
-------
83,940
Tier I or core capital
Tier I capital to adjusted total assets .. 7.58% 44,295 4.00% 39,646 3.58% 55,369 5.00%
Tier I capital to risk-weighted assets ... 9.95% 33,750 4.00% 50,191 5.95% 50,625 6.00%
Plus:
Allowable allowance for loan losses ......... 9,404
-------
Risk-based capital .......................... $93,344 67,501 25,844 84,376
=======
Risk-based capital to risk-weighted assets .. 11.06% 8.00% 3.06% 10.00%
(1) Based upon the Bank's adjusted total assets for the tangible and core
capital ratios and risk-weighted assets for the risk-based capital ratio.
The tangible capital of the Bank was in excess of the minimum 2% required at
March 31, 2007 but is not reflected in the table above.
(11) COMMITMENTS AND CONTINGENCIES
The Bank issued standby letters of credit which guarantee the performance of
customers to third parties. The standby letters of credit issued and available
at March 31, 2007 were approximately $13.0 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.
In February 2007, the Minnesota Department of Revenue (MDR) assessed a
deficiency of $2.2 million against the Company's 2002 through 2004 Minnesota
state tax payments. The deficiency relates to the tax treatment of the
inter-company dividends paid to the Bank by a former subsidiary of the Company.
The Company filed a Notice of Appeal in the Minnesota Tax Court challenging that
assessment on March 2, 2007. The MDR has not yet filed a response to the Notice
of Appeal.
(12) INCOME TAXES
On January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting
for Uncertainty in Income Taxes (FIN 48). Implementation of FIN 48 resulted in a
$250,000 cumulative effect adjustment to retained earnings as of the date of
adoption. At January 1, 2007, the total amount of unrecognized tax benefits was
$600,000, of which $390,000 related to tax benefits that if recognized, would
impact the annual effective tax rate. We recognize both interest and penalties
as a component of income tax expense. The liability for unrecognized tax
benefits includes $69,000 of interest and no penalties. It is reasonably
possible that the total unrecognized tax benefit as of January 1, 2007 could
increase by $1.6 million or be reduced to zero within the next 12 month period.
It is also reasonably possible that any benefit may be substantially offset by
new matters arising during this same period. The Company files consolidated
federal and state income tax returns. With few exceptions, we are not subject to
federal income tax examinations for taxable years prior to 2003, or state
examinations prior to 2002.
The adoption of FIN 48 may result in increased volatility to our annual
effective tax rate because FIN 48 requires that any change in judgment or change
in measurement of a tax position taken in a prior annual period be
11
recognized as a discrete event in the period in which it occurs. The impact to
the rate in the first quarter amounted to a $9,000 increase in income tax
expense.
(13) BUSINESS SEGMENTS
The Bank has been identified as a reportable operating segment in accordance
with the provisions of SFAS No. 131. SFC and HMN 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 segments
net income. 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 reconciliations of
reported profit or loss and assets for each of the Company's reportable
segments.
Home
Federal
Savings Consolidated
(Dollars in thousands) Bank Other Eliminations Total
---------- ------ ------------ ------------
AT OR FOR THE QUARTER ENDED MARCH 31, 2007:
Interest income - external customers...... $ 18,258 21 0 18,279
Non-interest income - external customers.. 2,064 0 0 2,064
Earnings on limited partnerships.......... 4 0 0 4
Intersegment interest income.............. 0 41 (41) 0
Intersegment non-interest income.......... 44 3,325 (3,369) 0
Interest expense.......................... 8,536 0 (41) 8,495
Amortization of mortgage servicing
rights, net............................ 182 0 0 182
Other non-interest expense................ 5,641 170 (43) 5,768
Income tax expense (benefit).............. 2,229 (50) 0 2,179
Net income................................ 3,327 3,267 (3,326) 3,268
Goodwill.................................. 3,801 0 0 3,801
Total assets.............................. 1,112,136 95,417 (90,510) 1,117,043
AT OR FOR THE QUARTER ENDED MARCH 31, 2006:
Interest income - external customers...... $ 15,940 43 0 15,983
Non-interest income - external customers.. 1,493 0 0 1,493
Losses on limited partnerships............ (7) 0 0 (7)
Intersegment non-interest income.......... 34 2,808 (2,842) 0
Interest expense.......................... 6,594 0 0 6,594
Amortization of mortgage servicing
rights, net............................ 217 0 0 217
Other non-interest expense................ 5,599 157 (33) 5,723
Income tax expense (benefit).............. 1,725 (45) 0 1,680
Net income................................ 2,810 2,739 (2,809) 2,740
Goodwill.................................. 3,801 0 0 3,801
Total assets.............................. 985,107 93,269 (88,392) 989,984
12
HMN FINANCIAL, INC.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING INFORMATION
This quarterly Report and other reports filed by the Company with the Securities
and Exchange Commission may contain "forward-looking" statements that deal with
future results, plans or performance. In addition, the Company's management may
make such statements orally to the media, or to securities analysts, investors
or others. Forward-looking statements deal with matters that do not relate
strictly to historical facts. Words such as "anticipate", "believe", "expect",
"intend", "would", "could" and similar expressions, as they relate to us, are
intended to identify such forward-looking statements. The Company's future
results may differ materially from historical performance and forward-looking
statements about the Company's expected financial results or other plans are
subject to a number of risks and uncertainties. These include but are not
limited to possible legislative changes and adverse economic, business and
competitive developments such as shrinking interest margins; deposit outflows;
reduced demand for financial services and loan products; changes in accounting
policies and guidelines, or monetary and fiscal policies of the federal
government; changes in credit and other risks posed by the Company's loan and
investment portfolios; changes in loan repayment and prepayment patterns;
changes in loan terms and conditions; technological, computer-related or
operational difficulties; adverse changes in securities markets; results of
litigation or other significant uncertainties. For additional discussion of the
risks and uncertainties applicable to the Company, see the "Risk Factors"
section of the Company's Annual Report on Form 10-K for the year ended December
31, 2006.
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 and Federal Home Loan Bank (FHLB) advances. The difference between the
average rate of interest earned on assets and the average rate paid on
liabilities is the "interest rate spread". Net interest income is produced when
interest-earning assets equal or exceed interest-bearing liabilities and there
is a positive interest rate spread. The Company's interest rate spread has been
enhanced over the past several years by the increased level of commercial loans
placed in portfolio and the increased amount of lower rate deposit products such
as checking, savings and money market accounts. 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 and valuation adjustments on mortgage servicing assets. The
increased emphasis on commercial loans over the past several years has increased
the credit risk inherent in the loan portfolio and the provision for loan losses
has increased due to commercial loan charge offs.
The earnings of financial institutions, such as the Bank, are significantly
affected by prevailing economic and competitive conditions, particularly changes
in interest rates, government monetary and fiscal policies, and regulations of
various regulatory authorities. Lending activities are influenced by the demand
for and supply of single family and commercial properties, competition among
lenders, the level of interest rates and the availability of funds. Deposit
flows and costs of deposits are influenced by prevailing market rates of
interest on competing investments, account maturities and the levels of personal
income and savings. The interest rates charged by the FHLB on advances to the
Bank also have a significant impact on the Bank's overall cost of funds.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those policies that the Company's management
believes are the most important to understanding the Company's financial
condition and operating results. The Company has
13
identified the following policies as being critical because they require
difficult, subjective, and/or complex judgments that are inherently uncertain.
Therefore, actual financial results could differ significantly depending upon
the estimates used.
Allowance for Loan Losses and Related Provision
The allowance for loan losses is based on periodic analysis of the loan
portfolio. In this analysis, management considers factors including, but not
limited to, specific occurrences of loan impairment, changes in the size of the
portfolios, national and regional economic conditions such as unemployment data,
loan portfolio composition, loan delinquencies, local construction permits,
development plans, local economic growth rates, historical experience and
observations made by the Company's ongoing internal audit and regulatory exam
processes. Loans are charged off to the extent they are deemed to be
uncollectible. The Company has established separate processes to determine the
adequacy of the loan loss allowance for its homogeneous single-family and
consumer loan portfolios and its non-homogeneous loan portfolios. The
determination of the allowance for the non-homogeneous commercial, commercial
real estate, and multi-family loan portfolios involves assigning standardized
risk ratings and loss factors that are periodically reviewed. The loss factors
are estimated using a combination of the Company's own loss experience and
external industry data and are assigned to all loans without identified credit
weaknesses. The Company also performs an individual analysis of impairment on
each non-performing loan that is based on the expected cash flows or the value
of the assets collateralizing the loans. The determination of the allowance on
the homogeneous single-family and consumer loan portfolios is calculated on a
pooled basis with individual determination of the allowance of all
non-performing loans.
The adequacy of the allowance for loan losses is dependent upon management's
estimates of variables affecting valuation, appraisals of collateral,
evaluations of performance and status, and the amounts and timing of future cash
flows expected to be received on impaired loans. Such estimates, appraisals,
evaluations and cash flows may be subject to frequent adjustments due to
changing economic prospects of borrowers or properties. The estimates are
reviewed periodically and adjustments, if any, are recorded in the provision for
loan losses in the periods in which the adjustments become known. The allowance
is allocated to individual loan categories based upon the relative risk
characteristics of the loan portfolios and the actual loss experience. The
Company increases its allowance for loan losses by charging the provision for
loan losses against income. The methodology for establishing the allowance for
loan losses takes into consideration probable losses that have been identified
in connection with specific loans as well as losses in the loan portfolio for
which specific reserves are not required. Although management believes that
based on current conditions the allowance for loan losses is maintained at an
adequate amount to provide for probable loan losses inherent in the portfolio as
of the balance sheet dates, future conditions may differ substantially from
those anticipated in determining the allowance for loan losses and adjustments
may be required in the future.
Mortgage Servicing Rights
The Company recognizes as an asset the rights to service mortgage loans for
others, which are referred to as mortgage servicing rights (MSRs). MSRs are
capitalized at the fair value of the servicing rights on the date the mortgage
loan is sold and are carried at the lower of the capitalized amount, net of
accumulated amortization, or fair value. MSRs are capitalized and amortized in
proportion to, and over the period of, estimated net servicing income. Each
quarter the Company evaluates its MSRs for impairment in accordance with
Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and
interest rate are the predominant risk characteristics of the underlying loans
used to stratify the MSRs for purposes of measuring impairment. If temporary
impairment exists, a valuation allowance is established for any excess of
amortized cost over the current fair value through a charge to income. If the
Company later determines that all or a portion of the temporary impairment no
longer exists, a reduction of the valuation allowance is recorded as an increase
to income. The valuation is based on various assumptions, including the
estimated prepayment speeds and default rates of the stratified portfolio.
Changes in the mix of loans, interest rates, prepayment speeds, or default rates
from the estimates used in the valuation of the mortgage servicing rights may
have a material effect on the amortization and valuation of MSRs. Management
believes that the assumptions used and the values determined are reasonable
based on current conditions. However, future economic conditions may differ
substantially from those anticipated in determining the value of the MSRs and
adjustments may be required in the future. The Company does not formally hedge
its MSRs because they are hedged naturally by the Company's origination volume.
Generally, as interest rates rise the origination volume declines and the value
of MSRs increases and as interest rates decline the origination
14
volume increases and the value of MSRs decreases.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. These calculations are
based on many complex factors including estimates of the timing of reversals of
temporary differences, the interpretation of federal and state income tax laws,
and a determination of the differences between the tax and the financial
reporting basis of assets and liabilities. Actual results could differ
significantly from the estimates and interpretations used in determining the
current and deferred income tax liabilities.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). The
Company adopted FIN 48 effective January 1, 2007. FIN 48 requires the use of
estimates and management's best judgment to determine the amounts and
probabilities of all of the possible outcomes that could be realized upon the
ultimate settlement of a tax position using the facts, circumstances, and
information available. The application of FIN 48 requires significant judgment
in arriving at the amount of tax benefits to be recognized in the financial
statements for a given tax position. 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.
NET INCOME
Net income for the first quarter of 2007 was $3.3 million, up $528,000, or
19.3%, from net income of $2.7 million for the first quarter of 2006. Diluted
earnings per common share for the first quarter of 2007 were $0.82, up $0.14, or
20.6%, from $0.68 for the first quarter of 2006. The increase in net income was
due primarily to increases in net interest income and the gains recognized on
the sale of commercial loans.
NET INTEREST INCOME
Net interest income was $9.8 million for the first quarter of 2007, an increase
of $395,000, or 4.2%, compared to $9.4 million for the first quarter of 2006.
Interest income was $18.3 million for the first quarter of 2007, an increase of
$2.3 million, or 14.4%, from $16.0 million for the first quarter of 2006.
Interest income increased primarily because of an increase in the average
interest rate earned on loans and investments. Interest rates increased
primarily because of the 50 basis point increase in the prime interest rate
between the periods. Increases in the prime rate, which is the rate that banks
charge their prime business customers, generally increase the rates on
adjustable rate consumer and commercial loans in the portfolio and on new loans
originated. The average yield earned on interest-earning assets was 7.49% for
the first quarter of 2007, an increase of 51 basis points from the 6.98% average
yield for the first quarter of 2006. Interest income also increased because of
the $61 million increase in the average interest earning assets between the
periods.
Interest expense was $8.5 million for the first quarter of 2007, an increase of
$1.9 million, or 28.8%, compared to $6.6 million for the first quarter of 2006.
Interest expense increased because of the higher interest rates paid on deposits
which were caused by the 50 basis point increase in the federal funds rate
between the periods. Increases in the federal funds rate, which is the rate that
banks charge other banks for short term loans, generally increase the rates
banks pay for deposits. The average interest rate paid on interest-bearing
liabilities was 3.69% for the first quarter of 2007, an increase of 62 basis
points from the 3.07% average interest rate paid in the first quarter of 2006.
The average rate on interest bearing liabilities increased more than the average
yield on interest bearing assets primarily because most of the deposit growth
between the periods was in higher rate money market accounts while the majority
of the asset growth was in lower yielding investments.
Net interest margin (net interest income divided by average interest earning
assets) for the first quarter of 2007 was 4.01%, a decrease of 9 basis points,
compared to 4.10% for the first quarter of 2006.
15
PROVISION FOR LOAN LOSSES
The provision for loan losses was $455,000 for the first quarter of 2007, a
decrease of $60,000, compared to $515,000 for the first quarter of 2006. The
provision for loan losses decreased primarily because of a decrease in the
number of commercial loan risk rating downgrades in the first quarter of 2007
when compared to the same period of 2006. The decrease in the provision due to
fewer loan risk ratings downgrades was partially offset by the $33 million in
loan growth that was experienced in the first quarter of 2007.
A reconciliation of the Company's allowance for loan losses for the quarters
ended March 31, 2007 and 2006 is summarized as follows:
(in thousands) 2007 2006
------ ------
Balance at January 1, $9,873 $8,778
Provision 455 515
Charge offs:
Commercial real estate (42) 0
Consumer (580) (91)
Recoveries 50 47
------ ------
Balance at March 31, $9,756 $9,249
====== ======
The increase in consumer loan charge offs is primarily the result of a $508,000
charge off on a home equity loan in the first quarter of 2007 for which a
reserve was established in the fourth quarter of 2006.
NON-INTEREST INCOME
Non-interest income was $2.1 million for the first quarter of 2007, an increase
of $582,000, or 39.2%, from $1.5 million for the first quarter of 2006. Gain on
sale of loans increased $550,000 between the periods due to a $612,000 increase
in the gain recognized on the sale of government guaranteed commercial loans
that was primarily the result of the gain recognized on the sale of an $8.7
million USDA loan. The increase in commercial loan sales was partially offset by
a $62,000 decrease in the gain recognized on the sale of single family loans due
to a decrease in the volume and profit margins on the loans that were sold.
Competition in the single-family loan origination market continues to be very
strong and profit margins were lowered in order to remain competitive and
maintain origination volumes. Fees and service charges decreased $19,000 between
the periods primarily because of decreased late fees. Loan servicing fees
decreased $32,000 primarily because of a decrease in the number of single-family
loans that are being serviced for others. Other non-interest income increased
$83,000 primarily because of increased revenues from the sale of uninsured
investment products.
NON-INTEREST EXPENSE
Non-interest expense was $6.0 million for the first quarter of 2007, an increase
of $10,000, or 0.2%, from $5.9 million for the first quarter of 2006.
Compensation expense increased $102,000 primarily because of annual payroll cost
increases. Occupancy expense decreased $16,000 due primarily to a decrease in
real estate taxes. Advertising expense decreased $25,000 between the periods
primarily because of a decrease in the costs associated with promoting a new
branch and the introduction of new checking account offerings that occurred in
the first quarter of 2006. Mortgage servicing rights amortization decreased
$35,000 between the periods because there are fewer mortgage loans being
serviced.
INCOME TAX EXPENSE
Income tax expense increased $499,000 between the periods due to an increase in
taxable income and an effective tax rate that increased from 38.0% for the first
quarter of 2006 to 40.0% for the first quarter of 2007. The increase in the
effective tax rate was the result of changes in state tax allocations, a
decrease in low income tax credits and an increase in the federal tax rate due
to increased income.
16
NON-PERFORMING ASSETS
The following table summarizes the amounts and categories of non-performing
assets in the Bank's portfolio at March 31, 2007 and December 31, 2006.
March 31, December 31,
(Dollars in thousands) 2007 2006
--------- ------------
Non-Accruing Loans:
One-to-four family real estate $ 1,576 $ 1,364
Commercial real estate 4,290 5,296
Consumer 843 1,254
Commercial business 814 394
------- -------
Total 7,523 8,308
------- -------
Other assets 44 44
Foreclosed and Repossessed Assets:
One-to-four family real estate 4,477 1,422
Consumer 14 0
Commercial real estate 650 650
------- -------
Total non-performing assets $12,708 $10,424
======= =======
Total as a percentage of total assets 1.14% 1.07%
======= =======
Total non-performing loans $ 7,523 $ 8,308
======= =======
Total as a percentage of total loans receivable, net 0.94% 1.08%
======= =======
Allowance for loan loss to non-performing loans 129.68% 118.84%
======= =======
Total non-performing assets were $12.7 million at March 31, 2007, an increase of
$2.3 million, from $10.4 million at December 31, 2006. Non-performing loans
decreased $785,000 and foreclosed and repossessed assets increased $3.1 million
during the period. Of the increase in foreclosed and repossessed assets, $1.8
million was the result of purchasing the first mortgage on a previously
classified non-performing second mortgage loan in order to improve the Company's
lien position.
DIVIDENDS
On April 24, 2007 the Company declared a cash dividend of $0.25 per share,
payable on June 7, 2007 to shareholders of record on May 18, 2007.
During the first quarter of 2007, the Company declared and paid a dividend as
follows:
Record date Payable date Dividend per share Dividend Payout Ratio
----------- ------------ ------------------ ---------------------
February 16, 2007 March 7, 2007 $0.25 37.31%
The annualized dividend payout ratio for the past four quarters, ending with the
June 7, 2007 payment will be 44.64%.
The declaration of dividends are subject to, among other things, the Company's
financial condition and results of operations, the Bank's compliance with its
regulatory capital requirements including the fully phased-in capital
requirements, tax considerations, industry standards, economic conditions,
regulatory restrictions, general business practices and other factors.
LIQUIDITY
For the quarter ended March 31, 2007, the net cash provided by operating
activities was $15.1 million. The Company collected $45.3 million in principal
repayments and maturities on securities during the quarter. It purchased $109.9
million in securities and FHLB stock, $238,000 in premises and equipment and
funded $44.4 million relating to an increase in net loans receivable. The
Company had a net increase in deposit balances of $146.1 million during the
quarter, received $88,000 related to the exercise of HMN stock options, paid
$946,000 in dividends to its shareholders and purchased $997,000 of treasury
stock. It also received $24.5 million in
17
advance proceeds and paid off advances of $34.5 million.
The Company has certificates of deposits with outstanding balances of $335.4
million that come due over the next 12 months. Based upon past experience
management anticipates that the majority of the deposits will renew for another
term. The Company believes that deposits which do not renew will be replaced
with deposits from other customers or brokers. FHLB advances or proceeds from
the sale of securities could also be used to replace unanticipated outflows of
deposits.
The Company has deposits of $210.8 million in checking and money market accounts
with customers that have individual balances greater than $5 million. While
these funds may be withdrawn at any time, management anticipates that the
majority will remain on deposit with 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. FHLB advances 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 $30.0 million of FHLB advances that mature during the next
twelve months. The Company also has $100.9 million of FHLB advances that mature
beyond March 31, 2008 but have call features that can be exercised by the FHLB
during the next twelve months. If the call features are exercised, the Company
has the option of requesting any advance otherwise available to it pursuant to
the credit policy of the FHLB.
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 Company believes that
over the next twelve months interest rates could fluctuate in a range of 200
basis points up or down from where the rates were at March 31, 2007. 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 March
31, 2007.
Market Value
(Dollars in thousands) ------------------------------------------------------------
Basis point change in interest rates -200 -100 0 +100 +200
------------------------------------ ---------- --------- --------- --------- ---------
Total market risk sensitive assets............ $1,115,368 1,106,364 1,095,120 1,081,824 1,067,355
Total market risk sensitive liabilities....... 1,009,481 996,866 986,299 978,297 971,645
Off-balance sheet financial instruments....... (13) (2) 0 111 210
---------- --------- --------- --------- ---------
Net market risk............................... $ 105,900 109,500 108,821 103,416 95,500
========== ========= ========= ========= =========
Percentage change from current market value... (2.68)% 0.62% 0.00% (4.97)% (12.24)%
========== ========= ========= ========= =========
The preceding table was prepared utilizing the following assumptions (the Model
Assumptions) regarding prepayment and decay ratios which were determined by
management based upon their review of historical prepayment speeds and future
prepayment projections. Fixed rate loans were assumed to prepay at annual rates
of
18
between 7% to 70%, depending on the note rate and the period to maturity.
Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of
between 10% and 31%, depending on the note rate and the period to maturity.
Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of
between 6% and 49% 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 26% and money market
accounts were assumed to decay at an annual rate of 31%. Non-interest checking
accounts were assumed to decay at an annual rate of 33% and NOW accounts were
assumed to decay at an annual rate of 17%. 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 March
31, 2007 to determine if its current level of interest rate risk is acceptable.
The following table projects the estimated annual impact on net interest income
of immediate interest rate changes called rate shocks.
Projected
Rate Shock Change in Net
in Basis Interest Percentage
(Dollars in thousands) Points Income Change
---------- ------------- ----------
+200 $(1,717) (4.36)%
+100 (735) (1.87)%
0 0 0.00%
-100 18 0.05%
-200 (753) (1.91)%
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 decrease in interest income in a rising
rate environment is because some adjustable rate loans hit their interest rate
ceilings and will not reprice higher. In addition, the model assumes that
outstanding callable advances would be called in an up 100 basis point rate
shock scenario, which would increase the Bank's cost of funds and reduce net
interest income.
In an attempt to manage its exposure to changes in interest rates, management
closely monitors interest rate risk. The Bank has an Asset/Liability Committee
which meets frequently to discuss changes in the 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,
19
formulates investment strategies and oversees the timing and implementation of
transactions to assure attainment of the Board's objectives in the most
effective manner. In addition, each quarter the Board reviews the Bank's
asset/liability position, including simulations of the effect on the Bank's
capital of various interest rate scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market conditions and
consumer preference, may place more emphasis on managing net interest margin
than on better matching the interest rate sensitivity of its assets and
liabilities in an effort to enhance net interest income. Management believes
that the increased net interest income resulting from a mismatch in the maturity
of its asset and liability portfolios can, in certain situations, provide high
enough returns to justify the increased exposure to sudden and unexpected
changes in interest rates.
To the extent consistent with its interest rate spread objectives, the Bank
attempts to manage its interest rate risk and has taken a number of steps to
restructure its balance sheet in order to better match the maturities of its
assets and liabilities. The Bank has primarily focused its fixed rate
one-to-four family residential lending program on loans that are saleable to
third parties and generally places only those fixed rate loans that meet certain
risk characteristics into its loan portfolio. The Bank does place into portfolio
adjustable rate single-family loans that reprice over a one, three or five-year
period. The Bank's commercial loan production has primarily been in adjustable
rate loans 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.
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.
20
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
From time to time, the Bank and the Company are involved as plaintiff or
defendant in various legal proceedings arising in the normal course of its
business. While the ultimate outcome of these various legal proceedings cannot
be predicted with certainty, it is the opinion of management that the resolution
of these legal actions should not have a material effect on the Company's
consolidated financial condition or results of operations.
In February 2007, the Minnesota Department of Revenue (MDR) assessed a
deficiency of $2.2 million against the Company's 2002 through 2004 Minnesota
state tax payments. The deficiency relates to the tax treatment of the
inter-company dividends paid to the Bank by a former subsidiary of the Company.
The Company filed a Notice of Appeal in the Minnesota Tax Court challenging that
assessment on March 2, 2007. The MDR has not yet filed a response to the Notice
of Appeal.
ITEM 1A. Risk Factors.
No changes from risk factors previously disclosed in December 31, 2006 Form
10-K.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a) and (b) Not applicable
(c) Information Regarding Share Repurchases
(c) Total Number of
(a) Total (b) Average Shares Purchased as (d) Maximum Number
Number of Price Paid Part of Publicly of Shares that May Yet
Shares per Announced Plans or Be Purchased Under the
Period Purchased Share Programs Plans or Programs
------ --------- ----------- ------------------- ----------------------
January 1 through January 31, 2007 10,000 $34.32 10,000 290,000
February 1 through February 28, 2007 0 N/A 0 290,000
March 1 through March 31, 2007 19,000 34.42 19,000 271,000
------ ------ ------
Total 29,000 $34.37 29,000
====== ====== ======
(1) On January 23, 2007, the Board of Directors authorized the repurchase of up
to 300,000 shares of the Company's common stock. This program expires on
July 23, 2008.
ITEM 3. Defaults Upon Senior Securities.
Not applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders.
None.
ITEM 5. Other Information.
None.
ITEM 6. Exhibits.
See Index to Exhibits on page 24 of this report.
21
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: May 4, 2007 /s/ Michael McNeil
----------------------------------------
Michael McNeil,
President and Chief Executive Officer
(Principal Executive Officer)
(Duly Authorized Representative)
Date: May 4, 2007 /s/ Jon Eberle
----------------------------------------
Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
22
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
Sequential
Reference Page Numbering
Regulation to Prior Where Attached
S-K Filing or Exhibits Are
Exhibit Exhibit Located in This
Number Document Attached Hereto Number Form 10-Q Report
---------- ---------------------------------------------- --------- --------------------
3.1 Amended and Restated Articles of Incorporation *1 N/A
3.2 Amended and Restated By-laws *2 N/A
4 Form of Common Stock Certificates *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)/15d14(a) Certification of CFO 31.2 Filed Electronically
32 Section 1350 Certification of CEO and CFO 32 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 Exhibit 3 to the Company's Current Report on Form
8-K dated February 22, 2005, filed on February 23, 2005 (File 0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's
Registration Statement on Form S-1 dated April 1, 1994 (File No. 33-77212).
24