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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [NO FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM _____ TO ______
COMMISSION FILE NUMBER 0-24100.
HMN FINANCIAL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 41-1777397
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
101 NORTH BROADWAY, PO BOX 231 55975-0231
SPRING VALLEY, MINNESOTA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (507) 346-1100
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
(TITLE OF CLASS)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
requirements for the past 90 days. YES X NO ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein,
and will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]
As of March 5, 1999, the Registrant had issued and outstanding 5,247,104
shares of the Registrant's Common Stock. The aggregate market value of the
voting stock held by non-affiliates of the Registrant as of March 5, 1999 was
$52.7 million. (The exclusion from such amount of the market value of the shares
owned by any person shall not be deemed an admission by the Registrant that such
person is an affiliate of the Registrant.)
DOCUMENTS INCORPORATED BY REFERENCE
Parts of the Registrant's Annual Report for the year ended December 31, 1998,
are incorporated by reference in Parts II and IV of this Form 10-K. Parts of
the Registrant's Proxy Statement dated March 23, 1999, are incorporated by
reference in Part III of this Form 10-K.
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<PAGE>
TABLE OF CONTENTS
PART I
<TABLE>
<CAPTION>
PAGE
<S> <C>
Item 1. Business..................................................................3
General.............................................................3
Lending Activities..................................................4
Investment Activities..............................................20
Sources of Funds...................................................24
Other Information
Service Corporations.........................................28
Competition..................................................28
Other Corporations Owned by HMN..............................28
Employees....................................................29
Executive Officers...........................................29
Regulation.........................................................29
Taxation...........................................................38
Item 2. Properties...............................................................40
Item 3. Legal Proceedings........................................................41
Item 4. Submission of Matters to a Vote of Security Holders......................41
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters............................................................41
Item 6. Selected Financial Data..................................................41
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations..............................................41
Item 7A. Quantitative and Qualitative Disclosure About Market Risk................41
Item 8. Financial Statements and Supplementary Data..............................41
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure...............................................42
PART III
Item 10. Directors and Executive Officers of the Registrant.......................42
Item 11. Executive Compensation...................................................42
Item 12. Security Ownership of Certain Beneficial Owners and Management...........42
Item 13. Certain Relationships and Related Transactions...........................42
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........43
Signatures.........................................................................46
Index to Exhibits..................................................................47
</TABLE>
<PAGE>
PART I
ITEM 1. BUSINESS
GENERAL
HMN Financial, Inc. ("HMN" or the "Corporation"), was incorporated under
the laws of the State of Delaware in March 1994 for the purpose of becoming the
savings and loan holding company of Home Federal Savings Bank ("Home Federal" or
the "Bank") in connection with the Bank's conversion from a federally chartered
mutual savings bank to a federally chartered stock savings bank. Home Federal
has a community banking philosophy and operates retail banking facilities in
Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud
Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer
financial planning products and services. HMN has two other wholly owned
subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc.
(MSI). SFC invests in commercial loans and commercial real-estate loans located
throughout the United States which were originated by third parties. MSI
operates a mortgage banking and mortgage brokerage facility located in Brooklyn
Park, Minnesota.
On December 5, 1997 HMN, through its wholly owned subsidiary, the Bank,
completed its merger with Marshalltown Financial Corporation (MFC) pursuant to a
merger agreement dated July 1, 1997. Refer to Note 2 of the Notes to
Consolidated Financial Statements in the Annual Report for information on assets
acquired in the merger, HMN's Current Report on Form 8-K dated December 5, 1997,
filed on December 10, 1997 (file no. 0-24100) for a copy of the merger agreement
and HMN's Current Report on Form 8-K dated December 5, 1997, filed on February
11, 1998 (file no. 0-24100) for a copy of financial statements of the acquired
company and pro forma financial information.
As a community-oriented financial institution, HMN seeks to serve the
financial needs of communities in its market area. HMN's business involves
attracting deposits from the general public and using such deposits to originate
or purchase one-to-four family residential mortgage loans and, to a lesser
extent, consumer, construction, commercial real estate, commercial business and
multi-family loans. HMN also invests in mortgage-backed and related securities,
investment securities (consisting primarily of U.S. government and government
agency obligations) and other permissible investments. The executive offices of
HMN are located at 101 N. Broadway, PO Box 231, Spring Valley, Minnesota
55975-0231. It's telephone number at that address is (507) 346-1100.
MARKET AREA
HMN serves the Minnesota counties of Fillmore, Freeborn, Houston, Mower,
Olmsted and Winona and portions of Steele, Dodge, Goodhue and Wabasha Counties,
Minnesota, through its main office located in Spring Valley, Minnesota and its
six branch offices located in Albert Lea, Austin, LaCrescent, Rochester and
Winona, Minnesota. The portion of HMN's market area consisting of Rochester and
the contiguous communities is composed of primarily urban and suburban
communities, while the balance of HMN's market area consists primarily of rural
areas and small towns. Primary industries in HMN's market area include
manufacturing, agriculture, health care, wholesale and retail trade, service
industries and education. Major employers include IBM, the Mayo Clinic, Hormel,
a food processing company, and various small industrial and other companies.
HMN's market area is also the home of Winona State University, Rochester
Community and Technical College, University of Minnesota - Rochester Center,
Winona State University - Rochester Center and Austin's Riverland Community
College.
HMN serves the Iowa counties of Marshall and Tama through its branch
offices located in Marshalltown and Toledo. Major industries in the area are
Swift & Company - pork processors, Fisher Controls Int. - valve and regulator
manufacturing, Lennox Industries - furnace and air conditioner manufacturing,
Iowa Veterans Home - hospital care, Marshall Community School District -
education, Marshall Medical & Surgical Center - hospital care and Meskwaki
Casino - gaming operation.
3
<PAGE>
Based upon information obtained from the Minnesota State Demographic
Center for 1996, the population of the six primary counties in the Bank's
Minnesota market area was as follows: Fillmore - 20,900; Freeborn - 33,000;
Houston - 19,200; Mower - 37,700; Olmsted - 115,200; and Winona - 49,200.
Total income per capita for 1996 in these six counties ranged from
approximately $19,100 to $26,500.
Based upon information obtained from the State Library of Iowa for 1996,
the population of Marshall County was 38,700 and the population of Tama County
was 17,600. Total income per capita of the above mentioned Iowa counties ranged
from approximately $20,000 to $21,900.
During the fourth quarter of 1996, HMN opened a mortgage banking and
mortgage brokerage office which is currently located in Brooklyn Park,
Minnesota. The office primarily originates single family residential loans
for sale in the secondary market or purchases loans from third party
originators located primarily in the seven county metropolitan area of
Minneapolis and St. Paul and sells the loans in the secondary market. The
office also has purchased mortgage servicing rights from third parties for
the purpose of generating loan servicing income.
LENDING ACTIVITIES
GENERAL. Historically, HMN originated 30-year, fixed-rate mortgage loans
secured by one-to-four family residences. Since 1979, in order to reduce its
vulnerability to changes in interest rates, HMN has emphasized the origination
or purchase of loans for the loan portfolio which have shorter terms to maturity
such as 15 year, fixed rate residential loans and Graduated Equity Mortgages
("GEMs") which fully amortize in 15 to 20 years. HMN has also emphasized the
origination and purchase of Adjustable Rate Mortgage loans ("ARMs") for
portfolio which have interest rates which are fixed for an initial period of
one, three or five years and then generally adjust annually, thereafter, based
upon a treasury interest rate index plus a certain margin, subject to annual and
lifetime rate adjustment limits. HMN offers a competitive home equity line of
credit as well as other consumer loans. The home equity line of credit has an
adjustable interest rate based upon the Wall Street Journal prime rate plus a
margin. During 1998 HMN hired experienced commercial loan officers who actively
pursued commercial real estate, commercial business and development loans in
HMN's market area.
4
<PAGE>
LOAN PORTFOLIO COMPOSITION. The following information concerning the
composition of HMN's loan portfolio in dollar amounts and in percentages (before
deductions for loans in process, deferred fees and discounts and allowances for
losses) as of the dates indicated.
<TABLE>
<CAPTION>
December 31,
--------------------------------------------------------------
1998 1997 1996
------------------- -------------------- ------------------
(DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent
--------- ------- ---------- ------- --------- -------
<S> <C> <C> <C> <C> <C> <C>
REAL ESTATE LOANS:
One-to-four family................. $ 365,496 79.31% $ 395,668 87.58% $ 321,340 90.19%
Multi-family....................... 4,719 1.02 2,717 0.60 280 0.08
Commercial......................... 28,990 6.29 10,572 2.34 7,918 2.22
Construction or development........ 15,155 3.29 5,725 1.27 3,474 0.98
--------- ------ --------- ------ --------- ------
Total real estate loans......... 414,360 89.91 414,682 91.79 333,012 93.47
--------- ------ --------- ------ --------- ------
OTHER LOANS:
Consumer loans:
Savings account................... 994 0.22 1,362 0.30 938 0.26
Education......................... 118 0.03 123 0.03 467 0.13
Automobile........................ 2,897 0.63 2,438 0.54 566 0.16
Home equity line.................. 19,476 4.22 19,490 4.31 11,881 3.33
Home equity....................... 9,566 2.08 7,176 1.59 5,927 1.67
Home improvement.................. 436 0.09 652 0.14 585 0.16
Other............................. 1,313 0.28 624 0.14 568
--------- ------ --------- ------ --------- ------
Total consumer loans............ 34,800 7.55 31,865 7.05 20,932 5.87
Commercial business loans.......... 11,695 2.54 5,226 1.16 2,344 0.66
--------- ------ --------- ------ --------- ------
Total other loans............... 46,495 10.09 37,091 8.21 23,276 6.53
--------- ------ --------- ------ --------- ------
Total loans.................. 460,855 100.00% 451,773 100.00% 356,288 100.00%
------ ------ ------
------ ------ ------
LESS:
Loans in process................... 7,997 4,562 2,814
Unamortized discounts.............. 414 547 417
Net deferred loan fees............. 1,948 1,847 1,695
Allowance for losses on loans...... 3,041 2,748 2,340
--------- --------- ---------
Total loans receivable, net.. $ 447,455 $ 442,069 $ 349,022
--------- --------- ---------
--------- --------- ---------
<CAPTION>
December 31,
------------------------------------------
1995 1994
------------------- --------------------
(DOLLARS IN THOUSANDS) Amount Percent Amount Percent
--------- ------- --------- --------
<S> <C> <C> <C> <C>
REAL ESTATE LOANS:
One-to-four family................. $ 292,497 90.62% $ 252,943 91.14%
Multi-family....................... 361 0.11 311 0.11
Commercial......................... 8,744 2.71 8,316 3.00
Construction or development........ 5,082 1.58 2,799 1.01
--------- ------ --------- ------
Total real estate loans......... 306,684 95.02 264,369 95.26
--------- ------ --------- ------
OTHER LOANS:
Consumer loans:
Savings account................... 1,210 0.37 648 0.23
Education......................... 342 0.11 2,007 0.72
Automobile........................ 671 0.21 520 0.19
Home equity line.................. 3,509 1.09 0 0.00
Home equity....................... 7,997 2.47 7,716 2.78
Home improvement.................. 785 0.24 870 0.31
--------- ------ --------- ------
Total consumer loans............ 15,059 4.66 12,263 4.42
Commercial business loans.......... 1,018 0.32 897 0.32
--------- ------ --------- ------
Total other loans............... 16,077 4.98 13,160 4.74
--------- ------ --------- ------
Total loans.................. 322,761 100.00% 277,529 100.00%
------ ------
------ ------
LESS:
Loans in process................... 3,531 2,327
Unamortized discounts.............. 289 162
Net deferred loan fees............. 1,899 2,147
Allowance for losses on loans...... 2,191 1,893
--------- ---------
Total loans receivable, net.. $ 314,851 $ 271,000
--------- ---------
--------- ---------
</TABLE>
5
<PAGE>
The following table shows the composition of HMN's loan portfolio by fixed
and adjustable rate loans at the dates indicated.
<TABLE>
<CAPTION>
December 31,
------------------------------------------------------------------------------------
1998 1997 1996
----------------------- ------------------------ -----------------------
(DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent
----------- --------- ----------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
FIXED-RATE LOANS
Real estate:
One-to-four family
GEM...................................... $ 56,211 12.20% $ 53,258 11.79% $ 48,831 13.71%
Other.................................... 227,790 49.43 256,263 56.72 187,519 52.63
----------- --------- ----------- -------- ----------- --------
Total one-to-four family................ 284,001 61.63 309,521 68.51 236,350 66.34
Multi-family.............................. 3,509 0.76 2,490 0.55 223 0.06
Commercial................................ 17,768 3.86 1,914 0.42 1,276 0.36
Construction or development............... 9,366 2.03 3,180 0.71 2,970 0.83
----------- --------- ----------- -------- ----------- --------
Total fixed-rate real estate loans...... 314,644 68.27 317,105 70.19 240,819 67.59
----------- --------- ----------- -------- ----------- --------
Consumer loans:
Savings................................... 994 0.22 1,362 0.30 938 0.26
Education................................. 0 0.00 0 0.00 434 0.12
Automobile................................ 2,897 0.63 2,437 0.54 566 0.16
Home equity............................... 9,384 2.04 6,701 1.48 5,338 1.50
Home improvement.......................... 436 0.09 652 0.14 585 0.16
Other..................................... 1,175 0.25 612 0.14 568 0.16
----------- --------- ----------- -------- ----------- --------
Total consumer loans.................... 14,886 3.23 11,764 2.60 8,429 2.36
----------- --------- ----------- -------- ----------- --------
Commercial business loans.................. 10,157 2.20 5,226 1.16 1,344 0.38
----------- --------- ----------- -------- ----------- --------
Total other loans....................... 25,043 5.43 16,990 3.76 9,773 2.74
----------- --------- ----------- -------- ----------- --------
Total fixed-rate loans.................. 339,687 73.71 334,095 73.95 250,592 70.33
----------- --------- ----------- -------- ----------- --------
ADJUSTABLE-RATE LOANS
Real estate:
One-to-four family........................ 81,495 17.68 86,147 19.07 84,990 23.85
Multi-family.............................. 1,210 0.26 227 0.05 57 0.02
Commercial................................ 11,222 2.44 8,658 1.92 6,642 1.87
Construction or development............... 5,789 1.26 2,545 0.56 504 0.14
----------- --------- ----------- -------- ----------- --------
Total adjustable-rate real estate loans. 99,716 21.64 97,577 21.60 92,193 25.88
Consumer................................... 19,914 4.32 20,101 4.45 12,503 3.51
Commercial business loans.................. 1,538 0.33 0 0.00 1,000 0.28
----------- --------- ----------- -------- ----------- --------
Total adjustable-rate loans............. 121,168 26.29 117,678 26.05 105,696 29.67
----------- --------- ----------- -------- ----------- --------
Total loans............................. 460,855 100.00% 451,773 100.00% 356,288 100.00%
----------- --------- ----------- -------- ----------- --------
--------- -------- --------
LESS
Loans in process........................... 7,997 4,562 2,814
Unamortized discounts...................... 414 547 417
Net deferred loan fees..................... 1,948 1,847 1,695
Allowance for losses on loans.............. 3,041 2,748 2,340
----------- ----------- -----------
Total loans receivable, net............. $ 447,455 $ 442,069 $ 349,022
----------- ----------- -----------
----------- ----------- -----------
<CAPTION>
December 31,
---------------------------------------------------
1995 1994
----------------------- ----------------------
(DOLLARS IN THOUSANDS) Amount Percent Amount Percent
----------- --------- ----------- --------
<S> <C> <C> <C> <C>
FIXED-RATE LOANS
Real estate:
One-to-four family
GEM...................................... $ 30,175 9.35% $ 24,769 8.93%
Other.................................... 181,401 56.20 168,272 60.63
----------- -------- ----------- -------
Total one-to-four family................ 211,576 65.55 193,041 69.56
Multi-family.............................. 302 0.10 311 0.11
Commercial................................ 1,518 0.47 1,612 0.58
Construction or development............... 4,848 1.50 1,008 0.37
----------- -------- ----------- -------
Total fixed-rate real estate loans...... 218,244 67.62 195,972 70.62
----------- -------- ----------- -------
Consumer loans:
Savings................................... 1,210 0.37 648 0.23
Education................................. 299 0.09 1,278 0.46
Automobile................................ 671 0.21 520 0.19
Home equity............................... 7,254 2.25 7,258 2.62
Home improvement.......................... 785 0.24 870 0.31
Other..................................... 545 0.17 502 0.18
----------- -------- ----------- -------
Total consumer loans.................... 10,764 3.33 11,076 3.99
----------- -------- ----------- -------
Commercial business loans.................. 1,018 0.32 897 0.32
----------- -------- ----------- -------
Total other loans....................... 11,782 3.65 11,973 4.31
----------- -------- ----------- -------
Total fixed-rate loans.................. 230,026 71.27 207,945 74.93
----------- -------- ----------- -------
ADJUSTABLE-RATE LOANS
Real estate:
One-to-four family........................ 80,921 25.07 59,901 21.58
Multi-family.............................. 59 0.02 0 0.00
Commercial................................ 7,226 2.24 6,704 2.42
Construction or development............... 234 0.07 1,792 0.64
----------- -------- ----------- -------
Total adjustable-rate real estate loans. 88,440 27.40 68,397 24.64
Consumer................................... 4,295 1.33 1,187 0.43
Commercial business loans.................. 0 0.00 0 0.00
----------- -------- ----------- -------
Total adjustable-rate loans............. 92,735 28.73 69,584 25.07
----------- -------- ----------- -------
Total loans............................. 322,761 100.00% 277,529 100.00%
----------- -------- ----------- -------
-------- -------
LESS
Loans in process........................... 3,531 2,327
Unamortized discounts...................... 289 162
Net deferred loan fees..................... 1,899 2,147
Allowance for losses on loans.............. 2,191 1,893
----------- -----------
Total loans receivable, net............. $ 314,851 $ 271,000
----------- -----------
----------- -----------
</TABLE>
6
<PAGE>
The following schedule illustrates the interest rate sensitivity of
HMN's loan portfolio at December 31, 1998. Loans which have adjustable or
renegotiable interest rates are shown as maturing in the period during which
the contract is due. Scheduled repayments of principal are reflected in the
year in which they are scheduled to be paid.
<TABLE>
<CAPTION>
Real Estate
-------------------------------------------------------------------------------
Multi-family and
One-to-four family Commercial Construction Consumer
------------------------ ------------------------ ------------------------ ------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
(DOLLARS IN THOUSANDS) Amount Rate Amount Rate Amount Rate Amount Rate
------------ -------- ----------- -------- ----------- -------- ----------- --------
Due During
Years Ending
December 31,
- -----------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1999(1)...................$ 23,681 7.03% $ 2,461 7.61% $ 2,873 8.49% $ 4,420 8.71%
2000...................... 21,871 7.34 1,289 8.53 304 8.32 2,518 8.57
2001...................... 21,345 7.29 1,403 8.71 221 8.23 2,239 8.48
2002 through 2003......... 41,134 7.24 4,860 8.82 260 7.99 2,846 8.30
2004 through 2008......... 97,120 7.22 10,683 8.36 1,411 8.37 21,950 8.35
2009 through 2023......... 145,862 7.18 13,013 8.14 7,676 7.98 827 8.84
2024 and following........ 14,483 7.06 0 0.00 2,410 7.23 0 0.00
------------ ----------- ----------- -----------
$ 365,496 $ 33,709 $ 15,155 $ 34,800
------------ ----------- ----------- -----------
------------ ----------- ----------- -----------
<CAPTION>
Commercial
Business Total
------------------------ ------------------------
Weighted Weighted
Average Average
(DOLLARS IN THOUSANDS) Amount Rate Amount Rate
------------ -------- ----------- --------
Due During
Years Ending
December 31,
- -----------------------
<S> <C> <C> <C> <C>
1999(1)...................$ 2,533 8.62% $ 35,968 7.50%
2000...................... 1,792 8.95 27,774 7.62
2001...................... 1,488 9.01 26,696 7.57
2002 through 2003......... 4,243 8.61 53,343 7.55
2004 through 2008......... 394 8.95 131,558 7.52
2009 through 2023......... 1,245 8.51 168,623 7.31
2024 and following........ 0 0.00 16,893 7.08
------------ -----------
$ 11,695 $ 460,855
------------ -----------
------------ -----------
</TABLE>
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(1) Includes demand loans, loans having no stated maturity, overdraft loans and
education loans.
The total amount of loans due after December 31, 2000 which have
predetermined interest rates is $311.5 million, while the total amount of
loans due after such dates which have floating or adjustable interest rates
is $113.3 million.
At December 31, 1998 construction or development loans for one-to-four
family dwellings totaled $5.7 million, multi-family totaled $6.6 million, and
non-residential totaled $2.9 million.
7
<PAGE>
Under the Financial Institutions Reform, Recovery and Enforcement Act of
1989 ("FIRREA"), the aggregate amount of loans that the Bank is permitted to
make to any one borrower is generally limited to 15% of unimpaired capital
and surplus (25% if the security for such loan has a "readily ascertainable"
value or 30% for certain residential development loans). At December 31,
1998, based upon the 15% limitation, the Bank's regulatory loans-to-one
borrower limit was approximately $6.9 million. On the same date, the Bank had
no borrowers with net outstanding balances in excess of this amount. At
December 31, 1998, the largest dollar amount outstanding to one borrower or
group of related borrowers was $6.35 million. This loan, which is secured by
a shopping mall located in Winona, Minnesota, was performing in accordance
with its terms at December 31, 1998.
The Bank's Mortgage and Consumer Loan Committee is responsible for
review and approval of all loans over the FHLMC/FNMA conforming loan dollar
limits (the Limit) originated by the Bank. For the majority of 1998 the Limit
was $227,150, compared to $214,600 for the majority of 1997. Approval of one
member of the Loan Committee is required on all loans ranging from the Limit
to $500,000. Loans greater than $500,000 must be approved by the Board of
Directors of the Bank or its Executive Committee after review and preliminary
approval by the Loan Committee. All loans closed each month are reviewed by
the Board of Directors at the monthly meeting.
During 1998, the Bank centralized its one-to-four family real estate
loan processing, underwriting, and servicing functions in Spring Valley. Each
of the branch's loan officers are responsible for taking the initial loan
application. The application and other pertinent information is then
forwarded to a central loan processor who is responsible for obtaining
information relating to processing the loan application. A loan underwriter
reviews the information obtained by the processor and determines whether the
loan applicant is eligible to receive the loan in conformity with the Bank's
written underwriting guidelines and other loan policies.
All of the Bank's lending is subject to its written underwriting
standards and to loan origination procedures. Decisions on loan applications
are made on the basis of detailed applications and property valuations
(consistent with the Bank's appraisal policy) by the Bank's staff appraiser
or an independent appraiser. The loan applications are designed primarily to
determine the borrower's ability to repay. The more significant items on the
application are verified through use of credit reports, financial statements,
tax returns and/or confirmations. During 1997 the Bank introduced the Home
Credit Plus Program which relies on the credit score of the loan applicant
instead of income, asset and employment verification procedures. The Bank
also offers low or alternative documentation underwriting procedures which
conform to FNMA underwriting guidelines.
Generally, the Bank requires title insurance on its mortgage loans as
well as fire and extended coverage casualty insurance in amounts at least
equal to the principal amount of the loan or the value of improvements on the
property, depending on the type of loan. The Bank also requires flood
insurance to protect the property securing its interest when the property is
located in a flood plain.
ONE-TO-FOUR FAMILY RESIDENTIAL REAL ESTATE LENDING. At December 31, 1998
HMN's one-to-four family real estate loans totaled $365.5 million, or 79.3%
of its total loan portfolio, and represented a decline of $30.2 million,
compared to $395.7 million at December 31, 1997. In order to reduce its
interest rate risk during 1998, HMN securitized and sold $27.9 million of
one-to-four family residential loans out of its loan portfolio. It also sold
approximately 44% of the Bank's one-to-four family residential loans that
were originated or refinanced during 1998. The loan securitizations and the
loan sales, when coupled with the accelerated prepayments experienced in the
loan portfolio during 1998, caused the one-to-four family real estate loan
portfolio to decline from December 31,1997 to December 31, 1998. See
"Originations, Purchases and Sales of Loans and Mortgage-Backed and Related
Securities".
8
<PAGE>
On December 5, 1997 the Bank merged with Marshalltown Financial
Corporation ("MFC"). The Loan Portfolio Composition table includes for
December 31, 1997 $62.9 million of one-to-four family residential loans, $2.3
of multi-family residential, $2.1 million of commercial real estate and $2.6
million of consumer loans which were acquired in the MFC merger.
Prior to 1979, the Bank originated for retention in its own portfolio
30-year fixed-rate loans secured by one-to-four family residential real
estate. Beginning in 1979, the Bank began to emphasize the origination of
fixed-rate loans with terms of 15 years or less for retention in its
portfolio. In addition, in 1982, the Bank began to originate ARMs, subject to
market conditions and consumer preference. Subsequently, the Bank also began
to emphasize GEM originations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Asset/Liability Management"
in the Annual Report attached as Exhibit 13 hereto (the "Annual Report").
The GEM loans require payments which increase after the first year.
Under the GEM loans, the monthly payments required for the first year are
established based on a 30-year amortization schedule. Depending upon the
program selected, the payments may increase in the succeeding years by
amounts ranging from 0% to 5%. Most of the GEM loans originated by HMN
provide for at least three annual payment increases over the first five years
of the loan. The increased payments required under GEM loans are applied to
principal and have the effect of shortening the term to maturity; the GEM
loans do not permit negative amortization. HMN has primarily offered two GEM
programs, one with a contractual maturity of approximately 17 years and one
with a contractual maturity of approximately 22 years. The GEMs are generally
priced based upon loans with similar contractual maturities. The GEMs have
been popular with consumers who anticipate future increases in income and who
desire an amortization schedule of less than 30 years. HMN believes that GEMs
may increase in popularity in the future if interest rates rise and consumers
are less easily able to afford the higher monthly payments required by
15-year, fixed-rate loans. At December 31, 1998, HMN had $56.2 million of GEM
loans which comprised 12.2% of the total loan portfolio and represented an
increase of $2.9 million from GEM loans of $53.3 million at December 31, 1997.
HMN currently offers conventional fixed-rate one-to-four family loans
with maximum terms of up to 30 years. During 1998, HMN generally sold the
majority of new loan originations or refinances with fixed rates and terms to
maturity ranging from 15 years to 30 years that were eligible for sale in the
secondary market. Loans which were originated under the First Time Home
Buyers program were not sold because many of the loans did not conform to
secondary market underwriting requirements. The interest rates charged on the
fixed rate loan products are generally set based on the FNMA or FHLMC
delivery rates, as well as other competitive factors. At December 31, 1998,
HMN had $227.8 million of fixed rate one-to-four family other loans which
comprised 49.4% of the total loan portfolio and represented a decrease of
$28.5 million, from $256.3 million at December 31, 1997.
HMN also offers one-year ARMs at a margin (generally 275 basis points)
over the yield on the Average Monthly One Year U.S. Treasury Constant
Maturity Index for terms of up to 30 years. The ARM loans currently offered
by HMN allow the borrower to select (subject to pricing) an initial period of
one year, three years, or five years between the loan origination and when
the first interest rate change occurs. Generally, the ARMs provide for an up
to 200 basis point annual interest rate change cap and a lifetime cap 600
basis points over or under the initial rate. Initial interest rates offered
on the ARM loans during 1998 ranged from 4 to 186 basis points below the
fully indexed loan rate. All borrowers are now qualified for the loan at the
fully indexed rate. HMN's originated ARMs do not permit negative amortization
of principal, do not contain prepayment penalties and generally are not
convertible into fixed-rate loans. See "-Delinquencies and Non-Performing
Assets." In the past, the Bank offered one-year ARMs with a margin of 200 to
235 basis points over a specified index and an average annual cap of 145
basis points. At December 31, 1998 the one-to-four family ARMs totaled $81.5
million, or 17.7% of the total loan portfolio and represented a decrease of
$4.6 million from $86.1 million at December 31, 1997.
9
<PAGE>
HMN has also originated a limited number of fixed-rate loans with terms
up to 30 years which are insured by the Federal Housing Authority ("FHA"),
Veterans Administration ("VA") and Minnesota Home Finance Administration
("MHFA").
In underwriting one-to-four family residential real estate loans, HMN
evaluates both the borrower's credit history, ability to make principal,
interest and escrow payments, the value of the property that will secure the
loan and debt to income ratios. Properties securing one-to-four family
residential real estate loans made by HMN are appraised by independent fee
appraisers or by HMN's staff appraiser. HMN originates residential mortgage
loans with loan-to-value ratios of up to 95% for owner-occupied homes and up
to 70% for non-owner occupied homes; however, private mortgage insurance is
required to reduce HMN's exposure to 80% or less. HMN generally seeks to
underwrite its loans in accordance with secondary market standards.
HMN's residential mortgage loans customarily include due-on-sale clauses
giving it the right to declare the loan immediately due and payable in the
event that, among other things, the borrower sells or otherwise disposes of
the property subject to the mortgage.
COMMERCIAL REAL ESTATE AND MULTI-FAMILY LENDING. HMN originates
permanent commercial real estate and multi-family loans secured by properties
located in its market area. It also purchases commercial real estate loans
outside of its market area that are guaranteed by the Small Business
Administration ("SBA") or originated by other third parties. During 1998 HMN
hired experienced commercial loan officers to originate commercial real
estate and commercial business loans in HMN's market area. HMN also purchased
commercial real estate and multi-family loans from third party originators
during 1998. At December 31, 1998, commercial real estate loans were $29.0
million or 6.3% of the total loan portfolio and represented an increase of
$18.4 million compared to $10.6 million at December 31, 1997. At December 31,
1998 multi-family residential loans were $4.7 million, or 1.0% of the total
loan portfolio and represented an increase of $2.0 million compared to $2.7
million at December 31, 1997.
The commercial real estate and multi-family loan portfolio includes
loans secured by motels, hotels, apartment buildings, churches, small office
buildings, small business facilities, shopping malls, nursing homes and other
non-residential building properties primarily located in the upper Midwestern
United States.
Permanent commercial real estate and multi-family loans are generally
originated for a maximum term of 15 years and may have longer amortization
periods with balloon maturity features. The interest rates may be fixed for
the term of the loan or have adjustable features which are tied to prime or a
treasury index. Commercial real estate and multi-family loans are written in
amounts of up to 75% of the lesser of the appraised value of the property or
the purchase price and generally have a debt service coverage ratio of at
least 120%. The debt service coverage is the ratio of net cash from
operations before payment of debt to debt service. HMN may originate
construction loans secured by commercial or multi-family real estate, or may
purchase participation interests in third party originated construction loans
secured by commercial or multi-family real estate.
Appraisals on commercial real estate and multi-family real estate
properties are performed by independent appraisers prior to the time the loan
is made. All appraisals on commercial and multi-family real estate are
reviewed and approved by the commercial loan officer. The Bank's underwriting
procedures require verification of the borrower's credit history, income and
financial statements, banking relationships, references and income
projections for the property. All commercial real estate and multi-family
loans must be approved by a majority of the commercial loan committee prior
to closing. The commercial loan policy generally requires personal guarantees
from the proposed borrowers. Once the loan is closed, HMN performs an annual
on-site inspection on collateral properties for loans with balances in excess
of $250,000 and also includes an annual review of the financial performance
of the property to determine that it is performing as anticipated.
10
<PAGE>
At December 31, 1998, HMN's two largest commercial real estate loans
totaled $6.35 million and $4.9 million. The first loan is secured by a
shopping mall in Winona, Minnesota and the second loan is secured by a hotel
and other commercial real estate in St. Cloud, Minnesota. Both of these loans
were performing at December 31, 1998.
Multi-family and commercial real estate loans generally present a higher
level of risk than loans secured by one-to-four family residences. This
greater risk is due to several factors, including the concentration of
principal in a limited number of loans and borrowers, the effects of general
economic conditions on income producing properties and the increased
difficulty of evaluating and monitoring these types of loans. Furthermore,
the repayment of loans secured by multi-family and commercial real estate is
typically dependent upon the successful operation of the related real estate
project. If the cash flow from the project is reduced (for example, if leases
are not obtained or renewed), the borrower's ability to repay the loan may be
impaired. At December 31, 1998, HMN had one commercial real estate loan
totaling $73,000 and no multi-family loans which were 90 days or more
delinquent.
CONSTRUCTION LENDING. HMN makes construction loans to individuals for
the construction of their residences, and to a much lesser extent, to
builders for the construction of one-to-four family residences. It also makes
a very limited number of loans to builders for houses built on speculation.
At December 31, 1998, HMN had $15.2 million of construction loans
outstanding, representing 3.3% of its total loan portfolio which represents
an increase of $9.5 million, compared to $5.7 million at December 31, 1997.
Almost all loans to individuals for the construction of their residences
are structured as permanent loans. Such loans are made on the same terms as
residential loans, except that during the construction phase, which typically
lasts up to seven months, the borrower pays interest only. Generally, the
borrower also pays a construction fee up to $800 at the time of origination.
Residential construction loans are underwritten pursuant to the same
guidelines used for originating residential loans on existing properties.
Construction loans to builders or developers of one-to-four family
residences generally carry terms of 1 to 15 years with a construction phase
of up to seven months. Such loans generally do not permit the payment of
interest from loan proceeds.
Construction loans to owner occupants are generally made in amounts of
up to 95% of the lesser of cost or appraised value, but no more than 85% of
the loan proceeds can be disbursed until the building is completed. The
loan-to-value ratios on loans to builders are limited to 70%. Prior to making
a commitment to fund a construction loan, HMN requires an appraisal of the
property and financial data and verification of income on the borrower. HMN
generally obtains personal guarantees for substantially all of its
construction loans to builders. Personal financial statements of guarantors
are also obtained as part of the loan underwriting process. Generally
construction loans have been located in HMN's market area.
Construction loans are obtained principally through continued business
from builders and developers who have previously borrowed from the Bank, as
well as referrals from existing customers and walk-in customers. The
application process includes a submission to the Bank of accurate plans,
specifications and costs of the project to be constructed. These items are
used as a basis to determine the appraised value of the subject property.
At December 31, 1998 construction loans on one-to-four family
residential real estate totaled $5.7 million, construction on multi-family
residential real estate totaled $6.6 million and construction on commercial
real estate totaled $2.9 million.
The nature of construction loans is such that they are more difficult to
evaluate and monitor. The risk of loss on a construction loan is dependent
largely upon the accuracy of the initial estimate of the property's value
upon completion of the project and the estimated cost (including interest) of
the project. If
11
<PAGE>
the estimate of value proves to be inaccurate, HMN may be confronted, at or
prior to the maturity of the loan, with a project having a value which is
insufficient to assure full repayment and/or the possibility of having to
make substantial investments to complete and sell the project. Because
defaults in repayment may not occur during the construction period it may be
difficult to identify problem loans at an early stage. In such cases, HMN may
be required to modify the terms of the loan.
CONSUMER LENDING. HMN originates a variety of different types of
consumer loans, including home equity loans (open-end and closed-end),
education, automobile, home improvement, deposit account and other loans for
household and personal purposes. At December 31, 1998, consumer loans totaled
$34.8 million, and represented 7.6% of total loans outstanding, compared to
$31.9 million at December 31, 1997.
Consumer loan terms vary according to the type and value of collateral,
length of contract and creditworthiness of the borrower. HMN's consumer loans
are made at fixed and adjustable interest rates, with terms of up to 20 years
for secured loans and up to three years for unsecured loans.
HMN's home equity loans are written so that the total commitment amount,
when combined with the balance of any other outstanding mortgage liens, may
not exceed 90% of the appraised value of the property. The closed-end home
equity loans are written with fixed or adjustable rates with terms of up to
15 years. The open-end home equity lines are written with an adjustable rate
with terms of up to 20 years, a 10 year draw period which requires "interest
only" payments and a 10 year repayment period which fully amortizes the
outstanding balance. The consumer may access the open-end home equity line
either by making a withdrawal at the Bank or writing a check on the home
equity line of credit account. At December 31, 1998, HMN's home equity loans
totaled $9.6 million, or 2.1% of the total loan portfolio and the home equity
lines totaled $19.5 million, or 4.2% of the total loan portfolio, compared to
home equity loans of $7.2 million and home equity lines of $19.5 million at
December 31, 1997.
The underwriting standards employed by the Bank for consumer loans
include a determination of the applicant's payment history on other debts and
ability to meet existing obligations and payments on the proposed loan.
Although creditworthiness of the applicant is of primary consideration, the
underwriting process also includes a comparison of the value of the security,
if any, in relation to the proposed loan amount. Consumer loans may entail
greater credit risk than do residential mortgage loans, particularly in the
case of consumer loans which are unsecured or are secured by rapidly
depreciable assets, such as automobiles. In such cases, any repossessed
collateral for a defaulted consumer loan may not provide an adequate source
of repayment of the outstanding loan balance as a result of the greater
likelihood of damage, loss or depreciation. In addition, consumer loan
collections are dependent on the borrower's continuing financial stability,
and thus are more likely to be affected by adverse personal circumstances.
Furthermore, the application of various federal and state laws, including
bankruptcy and insolvency laws, may limit the amount which can be recovered
on such loans. At December 31, 1998, $86,000 of the consumer loan portfolio
was non-performing. There can be no assurance that delinquencies will not
increase in the future.
COMMERCIAL BUSINESS LENDING. In order to satisfy the demand for
financial services available to individuals and businesses in its market
area, HMN has maintained a portfolio of commercial business loans primarily
to small retail operations, small manufacturing concerns and professional
firms. Most of HMN's commercial business loans have terms ranging from six
months to five years and carry fixed interest rates. HMN's commercial
business loans generally include personal guarantees and are usually, but not
always, secured by business assets such as inventory, equipment, fixtures,
real estate and accounts receivables. The underwriting process for commercial
business loans includes consideration of the borrower's financial statements,
tax returns, projections of future business operations and inspection of the
subject collateral, if any. HMN has also purchased participation interests in
commercial business loans from third party originators. The underlying
collateral for the loans are generally equipment and generally have repayment
periods of less than ten years. At December 31, 1998, HMN had $11.7 million
of commercial business loans outstanding, or 2.5% of the total loan portfolio
compared to $5.2 million at December 31, 1997.
12
<PAGE>
Unlike residential mortgage loans, which generally are made on the basis
of the borrower's ability to make repayment from his or her employment and
other income, and which are secured by real property whose value tends to be
more easily ascertainable, commercial business loans are of higher risk and
typically are made on the basis of the borrower's ability to make repayment
from the cash flow of the borrower's business. As a result, the availability
of funds for the repayment of commercial business loans may be substantially
dependent on the success of the business itself. Further, the collateral
securing the loans may depreciate over time, may be difficult to appraise and
may fluctuate in value based on the success of the business. At December 31,
1998, there were no delinquent commercial business loans.
ORIGINATIONS, PURCHASES AND SALES OF LOANS AND MORTGAGE-BACKED AND RELATED
SECURITIES
Real estate loans are generally originated by HMN's staff of salaried
and commissioned loan officers. Loan applications are taken in all branch
offices.
While HMN originates both fixed and adjustable-rate loans, its ability
to originate loans is dependent upon the relative customer demand for loans
in its market. Demand is affected by the interest rate environment. During
the last several years, the dollar volume of conventional fixed-rate,
one-to-four family loans has exceeded the dollar volume of GEMs and ARMs.
In order to supplement loan demand in HMN's market area and
geographically diversify its loan portfolio, HMN purchases real estate loans
from selected sellers, with yields based upon current market rates. HMN
carefully reviews and underwrites all loans to be purchased to ensure that
they meet HMN's under-writing standards. The seller generally continues to
service these purchased loans. During 1998, HMN originated $148.7 million of
loans compared to $68.1 million and $56.8 million during the years ended
December 31, 1997 and 1996, respectively. HMN purchased $71.0 million of
loans during 1998 compared to $71.8 million and $57.3 million during the
years ended December 31, 1997 and 1996, respectively. The majority of the
purchased loans have interest rates that are fixed for a one, three or five
year period and then adjust annually thereafter or were 15 year fixed rate
loans. All purchased loans are reviewed to determine that each loan meets
certain underwriting requirements. Refer to Note 5 of the Notes to
Consolidated Financial Statements in the Annual Report for more information
on purchased loans.
HMN has substantial holdings of mortgage-backed and related securities
which are held, depending on the investment intent, in the "available for
sale" portfolio. During 1998, HMN purchased $1.8 million of mortgage-backed
securities compared to $3.4 million and $7.2 million for the years ended
December 31, 1997 and 1996. It also purchased $112.0 million of CMOs during
1998 compared to $24.0 million and $50.4 million for the years ended December
31, 1997 and 1996, respectively. See -"Investment Activities." During 1998,
HMN sold $96.5 million of mortgage-backed and related securities compared to
$67.9 million and $81.1 million for the years ended December 31, 1997 and
1996, respectively.
13
<PAGE>
The following table shows the loan and mortgage-backed and related
securities origination, purchase, sale and repayment activities of HMN for
the periods indicated.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
LOANS Year Ended December 31,
ORIGINATIONS BY TYPE: 1998 1997 1996
-------- ------- -------
<S> <C> <C> <C>
Adjustable-rate:
Real estate - one-to-four family.................... $ 2,328 1,987 5,441
- commercial............................ 5,388 1,000 0
- construction or development........... 787 375 916
Non-real estate - consumer.......................... 15,689 16,871 12,012
- commercial business............... 176 0 0
-------- ------- -------
Total adjustable-rate......................... 24,368 20,233 18,369
-------- ------- -------
Fixed-rate:
Real estate - one-to-four family.................... 44,413 32,024 27,036
- multi-family.......................... 1,694 263 145
- commercial............................ 16,882 50 30
- construction or development........... 10,626 6,539 6,181
Non-real estate - consumer.......................... 13,100 7,579 4,583
- commercial business............... 37,672 1,409 430
-------- ------- -------
Total fixed-rate.............................. 124,387 47,864 38,405
-------- ------- -------
Total loans originated........................ 148,755 68,097 56,774
-------- ------- -------
PURCHASES:
Real estate - one-to-four family.................... 58,512 67,213 55,839
- multi-family.......................... 8,571 0 0
- commercial............................ 1,172 0 0
- construction or development........... 0 2,425 1,500
Non-real estate - commercial business............... 2,731 2,174 0
-------- ------- -------
Total purchased............................... 70,986 71,812 57,339
-------- ------- -------
ACQUISITION:
Real estate - one-to-four family.................... 0 63,328 0
- multi-family.......................... 0 2,308 0
- commercial............................ 0 2,099 0
Non-real estate - consumer.......................... 0 2,599 0
-------- ------- -------
Total loans acquired........................... 0 70,334 0
-------- ------- -------
Transfers from loans held for sale..................... 0 96 0
SALES AND REPAYMENTS:
Real estate - one-to-four family.................... 5,878 8,969 2,310
- commercial............................ 650 0 0
Non-real estate - consumer.......................... 238 339 176
-------- ------- -------
Total sales................................... 6,766 9,308 2,486
-------- ------- -------
Loans securitized and transferred to securities..... 27,953 16,526 15,412
Transfers to loans held for sale.................... 52,295 4,347 2,492
Principal repayments................................ 106,824 84,244 56,533
-------- ------- -------
Total reductions.............................. 193,838 114,425 76,923
-------- ------- -------
Decrease in other items, net........................ (20,517) (2,867) (3,019)
-------- ------- -------
Net increase.................................. $ 5,386 93,047 34,171
-------- ------- -------
-------- ------- -------
</TABLE>
14
<PAGE>
<TABLE>
<S> <C> <C> <C>
MORTGAGE-BACKED AND RELATED SECURITIES
Loans securitized and transferred to securities... $ 27,953 16,526 15,441
PURCHASES:
Mortgage-backed securities:(1)
Adjustable-rate.................................... 0 0 0
Fixed-rate......................................... 1,766 3,426 7,266
CMOs and REMICs:
Adjustable-rate.................................... 76,174 3,417 6,527
Fixed-rate......................................... 35,839 20,617 43,831
-------- ------- -------
Total purchases................................ 113,779 27,460 57,624
-------- ------- -------
ACQUISITION:
Adjustable rate..................................... 0 12,522 0
Fixed rate.......................................... 0 25,738 0
-------- ------- -------
Total acquisitions............................. 0 38,260 0
-------- ------- -------
SALES:
Mortgage-backed securities:(1)
Adjustable-rate.................................... 24,955 9,535 0
Fixed-rate......................................... 46,432 344 24,786
CMOs and REMICs:
Adjustable-rate.................................... 13,765 26,486 23,876
Fixed-rate......................................... 11,366 31,529 32,487
-------- ------- -------
Total sales..................................... 96,518 67,894 81,149
-------- ------- -------
PRINCIPAL REPAYMENTS:
Decrease in other items, net......................... 38,003 13,578 28,915
-------- ------- -------
Net increase (decrease)........................... $ 7,211 774 (36,999)
-------- ------- -------
-------- ------- -------
</TABLE>
- ---------------
(1) Consists of pass-through securities.
DELINQUENCIES AND NON-PERFORMING ASSETS
DELINQUENCY PROCEDURES. When a borrower fails to make a required
payment on a loan, HMN attempts to cure the delinquency by contacting the
borrower. A late notice is sent on all loans over 16 days delinquent.
Additional written and verbal contacts may be made with the borrower between
30 and 60 days after the due date. If the loan is contractually delinquent
90 days, HMN usually sends a 30-day demand letter to the borrower and, after
the loan is contractually delinquent 120 days, institutes appropriate action
to foreclose on the property. If foreclosed, the property is sold at a
sheriff's sale and may be purchased by HMN. Delinquent consumer loans are
generally handled in a similar manner. HMN's procedures for repossession and
sale of consumer collateral are subject to various requirements under state
consumer protection laws.
Real estate acquired by HMN as a result of foreclosure or by deed in
lieu of foreclosure is classified as real estate in judgement for six months
to one year and thereafter as real estate owned until it is sold. When
property is acquired or expected to be acquired by foreclosure or deed in
lieu of foreclosure, it is recorded at the lower of cost or estimated fair
value, less the estimated cost of disposition. After acquisition, all costs
incurred in maintaining the property are expensed. Costs relating to the
development and improvement of the property, however, are capitalized to the
extent of fair value less disposition cost.
15
<PAGE>
The following table sets forth HMN's loan delinquencies by type, by
amount and by percentage of type at December 31, 1998.
<TABLE>
<CAPTION>
Loans Delinquent For:
------------------------------------------------------- Total Delinquent
60-89 Days 90 Days and Over Loans
-------------------------- -------------------------- --------------------------
Percent Percent Percent
of Loan of Loan of Loan
(DOLLARS IN THOUSANDS) Number Amount Category Number Amount Category Number Amount Category
------ ------ -------- ------ ------ -------- ------ ------ --------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
One-to-four family
real estate........... 9 $297 0.08% 13 $630 0.17% 22 $ 927 0.25%
Multi-family............ 0 0 0.00 0 0 0.00 0 0 0.00
Commercial.............. 0 0 0.00 1 73 0.25 1 73 0.25
Construction or
development........... 0 0 0.00 0 0 0.00 0 0 0.00
Consumer................ 12 68 0.20 8 86 0.25 20 154 0.44
Commercial
business.............. 0 0 0.00 0 0 0.00 0 0 0.00
-- ---- -- ---- -- ------
Total............... 21 $365 0.08% 22 $789 0.17% 43 $1,154 0.25%
-- ---- -- ---- -- ------
-- ---- -- ---- -- ------
</TABLE>
CLASSIFICATION OF ASSETS. Federal regulations require that each savings
institution classify its own assets on a regular basis. In addition, in
connection with examinations of savings institutions, OTS and FDIC examiners
have authority to identify problem assets and, if appropriate, require them
to be classified. There are three classifications for problem assets:
Substandard, Doubtful and Loss. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the Bank
will sustain some loss if the deficiencies are not corrected. Doubtful
assets have the weaknesses of Substandard assets, with the additional
characteristics that the weaknesses make collection or liquidation in full on
the basis of currently existing facts, conditions and values questionable,
and there is a high possibility of loss. An asset classified as Loss is
considered uncollectible and of such little value that continuance as an
asset on the balance sheet of the institution is not warranted. Assets
classified as Substandard or Doubtful require the institution to establish
prudent general allowances for loan losses. If an asset or portion thereof is
classified as Loss, the institution must either establish specific allowances
for loan losses in the amount of 100% of the portion of the asset classified
as Loss, or charge off such amount. If an institution does not agree with an
examiner's classification of an asset, it may appeal this determination to
the District Director of the OTS. On the basis of management's review of its
assets, at December 31, 1998, the Bank had classified a total of $879,000 of
its loans and other assets as follows:
<TABLE>
<CAPTION>
Commercial Real
One-to-Four Construction or Estate and Commercial
(DOLLARS IN THOUSANDS) Family Development Multi-Family Consumer Business
----------- --------------- --------------- -------- ----------
<S> <C> <C> <C> <C> <C>
Substandard............. $716 0 73 90 0
Doubtful................ 0 0 0 0 0
Loss.................... 0 0 0 0 0
---- - -- -- -
Total............... $716 0 73 90 0
---- - -- -- -
---- - -- -- -
</TABLE>
The Bank's classified assets consist of the non-performing loans and
loans and other assets of concern discussed herein. As of the date hereof,
these asset classifications are materially consistent with those of the OTS
and FDIC.
NON-PERFORMING ASSETS. Loans are reviewed quarterly and any loan whose
collectibility is doubtful is placed on non-accrual status. Loans are placed on
nonaccrual status when either principal or interest is 90 days or more past due,
unless, in the judgment of management, the loan is well collateralized and in
the process of collection. Interest accrued and unpaid at the time a loan is
placed on non-accrual status is charged against interest income. Subsequent
payments are either applied to the outstanding principal balance or recorded as
interest income, depending on the assessment of the ultimate collectibility of
the loan.
16
<PAGE>
Restructured loans include the Bank's troubled debt restructurings (which
involved forgiving a portion of interest or principal on any loans or making
loans at a rate materially less than the market rate). Foreclosed assets
include assets acquired in settlement of loans. The following table sets
forth the amounts and categories of non-performing assets in the Bank's
portfolio.
<TABLE>
<CAPTION>
December 31,
----------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994
----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C>
Non-accruing loans:
Real estate:
One-to-four family............................ $ 317 177 235 196 178
Commercial real estate........................ 73 79 83 85 0
Consumer...................................... 86 7 7 32 57
Commercial business........................... 0 0 13 128
----- ---- ----- ----- -----
Total....................................... 476 263 338 441 235
----- ---- ----- ----- -----
Accruing loans delinquent 90 days or more:
One-to-four family............................. 312 365 0 0 0
Consumer....................................... 0 37 0 0 0
----- ---- ----- ----- -----
Total....................................... 312 402 0 0 0
----- ---- ----- ----- -----
Restructured loans:
Multi-family................................... 0 0 0 94 199
Foreclosed assets:
Real estate:
One-to-four family............................ 18 142 23 315 64
----- ---- ----- ----- -----
Total....................................... 18 142 23 315 64
----- ---- ----- ----- -----
Total non-performing assets...................... $ 806 807 361 850 498
----- ---- ----- ----- -----
----- ---- ----- ----- -----
Total as a percentage of total assets............ 0.12% 0.12% 0.07% 0.16% 0.10%
----- ---- ----- ----- -----
----- ---- ----- ----- -----
Total non-performing loans....................... $ 788 665 $ 338 $ 535 $ 434
----- ---- ----- ----- -----
----- ---- ----- ----- -----
Total as a percentage of total
loans receivable, net........................... 0.18% 0.15% 0.10% 0.17% 0.16%
----- ---- ----- ----- -----
----- ---- ----- ----- -----
</TABLE>
For the year ended December 31, 1998, gross interest income which would
have been recorded had the non-accruing loans been current in accordance with
their original terms amounted to $49,382. The amounts that were included in
interest income on such loans during 1998 were $28,618.
Total non-performing assets were $806,000 at December 31, 1998, a
decrease of $1,000, compared to $807,000 at December 31, 1997 and $361,000 at
December 31, 1996. Non-performing assets had the following activity during
1998: sales of $142,000, transfers in of $389,000 and transfers out due to
performance of $248,000. Non-performing assets had the following activity
during 1997: sales of $42,000, charge-offs of $35,000, payments of $80,000
and net transfers to non-performing assets of $603,000. The increase in
non-performing assets from 1996 to 1997 is primarily the result of three
one-to-four family purchased loans totaling $365,000 that were behind on
their payments by more than 90 days and the foreclosure of two one-to-four
family mortgages totaling $142,000. The decrease in the non-accruing loans is
the result of the normal inflow and outflow of delinquent loans caused by
borrowers getting behind on their payments and then bringing the loans
current again.
Total non-performing assets were $361,000 at December 31, 1996, a
decrease of $489,000, compared to $850,000 at December 31, 1995. The
decrease in non-performing assets is the result of the sale of foreclosed
assets of $315,000, the charge-off of $72,000 of commercial loans, and the
normal inflow and outflow of delinquent loans caused by borrowers getting
behind on their payments and then bringing the loans current again.
17
<PAGE>
OTHER LOANS OF CONCERN. In addition to the non-performing assets set
forth in the table above, as of December 31, 1998 there were $72,000 of loans
with known information about the possible credit problems of the borrowers or
the cash flows of the secured properties have caused management to have
concerns as to the ability of the borrowers to comply with present loan
repayment terms and which may result in the future inclusion of such items in
the non-performing asset categories.
Management has considered the Bank's non-performing and "of concern"
assets in establishing its allowance for loan losses.
ALLOWANCE FOR LOSSES ON LOANS. The following table sets forth an
analysis of the Bank's allowance for loan losses for the year ended:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994
------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C>
Balance at beginning of year................... $2,748 2,341 2,191 1,893 1,489
MFC allowance for losses acquired.............. 0 122 0 0 0
Provision for losses........................... 310 300 300 300 410
CHARGE-OFFS
Real estate:
One-to-four family........................... (2) (4) 0 0 0
Multi-family................................. 0 0 (88) 0 0
Consumer..................................... (17) (7) (1) (2) (6)
Commercial business.......................... 0 (12) (61) 0 0
------ ------ ------ ------ ------
(19) (23) (150) (2) (6)
------ ------ ------ ------ ------
RECOVERIES
Real estate:
Commercial business.......................... 2 8 0 0 0
------ ------ ------ ------ ------
2 8 0 0 0
------ ------ ------ ------ ------
Net charge-offs................................ (17) (15) (150) (2) (6)
------ ------ ------ ------ ------
Balance at end of year......................... $3,041 2,748 2,341 2,191 1,893
------ ------ ------ ------ ------
------ ------ ------ ------ ------
Ratio of net charge-offs during the year to
average loans outstanding during the year..... 0.00% 0.01% 0.05% 0.00% 0.00%
------ ------ ------ ------ ------
------ ------ ------ ------ ------
Ratio of allowance for losses on loans to
total non-performing loans, at end of year.... 385.79% 413.17% 691.84% 409.13% 436.52%
------ ------ ------ ------ ------
------ ------ ------ ------ ------
</TABLE>
18
<PAGE>
The distribution of the Bank's allowance for losses on loans at the dates
indicated is summarized as follows:
<TABLE>
<CAPTION>
December 31,
------------------------------------------------------------------------------
1998 1997 1996
-------------------- --------------------- -------------------------
Percent Percent Percent
of Loans of Loans of Loans
in Each in Each in Each
Category Category Category
to Total to Total to Total
(DOLLARS IN THOUSANDS) Amount Loans Amount Loans Amount Loans
--------- ---------- ---------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Real Estate:
One-to-four family.............. $ 544 79.31% $ 560 87.58% $ 496 90.19%
Multi-family.................... 142 1.02 80 0.60 8 0.08
Commercial ..................... 797 6.29 198 2.34 113 2.22
Construction or development..... 455 3.29 172 1.27 104 0.98
Consumer.......................... 546 7.55 527 7.05 473 5.87
Commercial business............... 328 2.54 46 1.16 29 0.66
Unallocated....................... 229 0.00 1,165 0.00 1,118 0.00
--------- -------- ---------- -------- ---------- ------
Total....................... $ 3,041 100.00% $ 2,748 100.00% $ 2,341 100.00%
--------- -------- ---------- -------- ---------- ------
--------- -------- ---------- -------- ---------- ------
<CAPTION>
1995 1994
------------------------- ---------------------------
Percent Percent
of Loans of Loans
in Each in Each
Category Category
to Total to Total
(DOLLARS IN THOUSANDS) Amount Loans Amount Loans
-------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Real Estate:
One-to-four family............. $ 452 90.62% $ 475 92.18%
Multi-family................... 21 0.11 21 0.14
Commercial .................... 125 2.71 128 1.80
Construction or development.... 153 1.58 84 1.31
Consumer......................... 286 4.66 280 4.14
Commercial business.............. 37 0.32 27 0.43
Unallocated...................... 1,117 0.00 878 0.00
-------- -------- --------- --------
Total....................... $ 2,191 100.00% $ 1,893 100.00%
-------- -------- --------- --------
-------- -------- --------- --------
</TABLE>
19
<PAGE>
The allowance for losses on loans is established through a provision for
losses on loans charged to earnings based on management's evaluation of the risk
inherent in its entire loan portfolio and changes in the nature and volume of
its loan activity. Such evaluation, which includes a review of all loans of
which full collectibility may not be reasonably assured, considers specific
occurrences, general and local economic conditions, loan portfolio composition,
historical and local experience and other factors that warrant recognition in
providing for an adequate allowance for loan losses. In determining the general
reserves under these policies, historical charge-offs and recoveries, changes in
the mix and levels of the various types of loans, the general level of
non-performing assets and the anticipated net realizable values, the current
loan portfolio and current economic conditions are considered. The Bank also
requires additional reserves for all classified loans.
While management believes that it uses the best information available to
determine the allowance for losses on loans, unforeseen market conditions
could result in adjustments to the allowance for losses on loans, and net
earnings could be significantly affected, if circumstances differ
substantially from the assumptions used in making the final determination.
Refer to Management's Discussion and Analysis on Allowances for Loan and Real
Estate Losses and Non-performing Assets in the Annual Report.
INVESTMENT ACTIVITIES
HMN and the Bank utilize the available for sale securities portfolio in
virtually all aspects of asset/liability management strategy. In making
investment decisions, the Investment/Asset - Liability Committee considers,
among other things, the yield and interest rate objectives, the credit risk
position and the projected cash flow requirements.
The Bank must maintain minimum levels of investments that qualify as
liquid assets under OTS regulations. Liquidity may increase or decrease
depending upon the availability of funds and comparative yields on
investments in relation to the return on loans. Cash flow projections are
regularly reviewed and updated to assure that adequate liquidity is
maintained. At December 31, 1998, the Bank's liquidity ratio (liquid assets
as a percentage of net withdrawable savings deposits and current borrowings)
was 10.27%. The Bank's level of liquidity is a result of management's
asset/liability strategy. See "Regulation - Liquidity."
SECURITIES. Federally chartered savings institutions have the authority
to invest in various types of liquid assets, including United States Treasury
obligations, securities of various federal agencies, certain certificates of
deposit of insured banks and savings institutions, certain bankers'
acceptances, repurchase agreements and federal funds. Subject to various
restrictions, federally chartered savings institutions may also invest their
assets in commercial paper, investment grade corporate debt securities and
mutual funds whose assets conform to the investments that a federally
chartered savings institution is otherwise authorized to make directly.
The investment strategy of HMN and the Bank has been directed toward a
mix of high-quality assets (primarily government and agency obligations) with
short and intermediate terms to maturity. At December 31, 1998, HMN did not
own any investment securities of a single issuer which exceeded 10% of HMN's
stockholder's equity other than U.S. government or federal agency obligations.
The Bank invests a portion of its liquid assets in interest-earning
overnight deposits of the Federal Home Loan Bank ("FHLB") of Des Moines and
various money market mutual funds. Other investments include high grade
medium-term (up to three years) corporate debt securities, medium-term
federal agency notes, and a variety of other types of mutual funds which
invest in adjustable-rate, mortgage-backed securities, asset-backed
securities, repurchase agreements and U.S. Treasury and agency obligations.
HMN invests in the same type of investment securities as the Bank and also
invests in taxable and tax exempt municipal obligations and corporate
equities such as preferred and common stock. See Notes 3 and 4 of the Notes
to Consolidated Financial Statements in the Annual Report for additional
information regarding HMN's securities portfolio.
20
<PAGE>
The following table sets forth the composition of HMN's securities portfolio,
excluding mortgage-backed and related securities, at the dates indicated.
<TABLE>
<CAPTION>
December 31,
-------------------------------------------------------------------------------------
1998 1997
--------------------------------------------- -------------------------------------
Amortized Adjusted Market % of Amortized Adjusted Market % of
(DOLLARS IN THOUSANDS) Cost To Value Total Cost To Value Total
----------- -------- ------ ------ ----------- -------- ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Securities available for sale:
U.S. government and agency
obligations....................... $ 17,379 12 17,391 25.11% $ 43,403 (60) 43,343 49.98%
Municipal obligations............... 2,901 (5) 2,896 4.18 0 0 0 0.00
Corporate debt ..................... 4,232 (3) 4,229 6.10 2,903 0 2,903 3.35
Corporate equity(1)................. 8,271 (296) 7,975 11.51 8,017 1,021 9,038 10.42
Stock of federal agencies(1)........ 5,874 114 5,988 8.64 14,034 605 14,639 16.88
Securities held to maturity:
Corporate debt...................... 0 0 0.00 0 0 0.00
--------- ------ ------ --------- ------ ------
Subtotal.......................... 38,657 38,479 55.54 68,357 69,923 80.63
FHLB stock............................ 9,838 9,838 14.20 7,432 7,432 8.57
--------- ------ ------ --------- ------ ------
Total investment securities
and FHLB stock................... 48,495 48,317 69.74 75,789 77,355 89.20
--------- ------ ------ --------- ------ ------
Average remaining life of investment
securities excluding FHLB stock.... 4.5 years 2.5 years
Other Interest-earning Assets:
Cash equivalents.................... 20,961 20,961 30.26 9,365 9,365 10.80
--------- ------ ------ --------- ------ ------
Total............................. $ 69,456 69,278 100.00% $ 85,154 86,720 100.00%
--------- ------ ------ --------- ------ ------
--------- ------ ------ --------- ------ ------
Average remaining life or term
to repricing of investment securities
and other interest-earning assets,
excluding FHLB stock................. 3.2 years 2.3 years
<CAPTION>
1996
-----------------------------------------
Amortized Adjusted Market % of
(DOLLARS IN THOUSANDS) Cost To Value Total
--------- -------- ------ ------
<S> <C> <C> <C> <C>
Securities available for sale:
U.S. government and agency
obligations....................... $ 29,600 (322) 29,278 49.93%
Municipal obligations............... 0 0 0 0.00
Corporate debt ..................... 1,091 1 1,092 1.86
Corporate equity(1)................. 7,796 386 8,182 13.96
Stock of federal agencies(1)........ 3,874 49 3,923 6.69
Securities held to maturity:
Corporate debt...................... 1,000 1,001 1.71
--------- ------ ------
Subtotal.......................... 43,361 43,476 74.15
FHLB stock............................ 5,434 5,434 9.27
--------- ------ ------
Total investment securities
and FHLB stock................... 48,795 48,910 83.42
--------- ------ ------
Average remaining life of investment
securities excluding FHLB stock.... 3.4 years
Other Interest-earning Assets:
Cash equivalents.................... 9,718 9,718 16.58
--------- ------ ------
Total............................. $ 58,513 58,628 100.00%
--------- ------ ------
--------- ------ ------
Average remaining life or term
to repricing of investment securities
and other interest-earning assets,
excluding FHLB stock................. 2.8 years
</TABLE>
(1) Average life assigned to corporate equity holdings and stock of federal
agencies is five years.
21
<PAGE>
The composition and maturities of the securities portfolio, excluding
FHLB stock, mortgage-backed and other related securities, are indicated in
the following table.
<TABLE>
<CAPTION>
December 31, 1998
----------------------------------------------------------
After 1 After 5
1 Year through 5 through 10 Over No Stated
or Less Years Years 10 Years Maturity
--------- --------- --------- --------- ---------
Amortized Amortized Amortized Amortized Amortized
(DOLLARS IN THOUSANDS) Cost Cost Cost Cost Cost
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Securities available for sale:
U.S. government securities........ $ 0 9,887 0 7,492 0
Municipal obligations............. 0 0 0 2,901 0
Corporate debt.................... 1,152 2,520 560 0 0
Corporate equity.................. 0 0 0 0 8,271
Stock of federal agencies......... 0 0 0 0 5,874
-------- -------- -------- ------- --------
Total stock......................... $ 1,152 12,407 560 10,393 14,145
-------- -------- -------- ------- --------
-------- -------- -------- ------- --------
Weighted average yield.............. 6.50% 6.39% 8.00% 6.83% 5.34%
<CAPTION>
December 31, 1998
--------------------------------
Total
Securities
--------------------------------
Amortized Adjusted Market
(DOLLARS IN THOUSANDS) Cost to Value
--------- -------- -------
<S> <C> <C> <C>
Securities available for sale:
U.S. government securities........ 17,379 12 17,391
Municipal obligations............. 2,901 (5) 2,896
Corporate debt.................... 4,232 (3) 4,229
Corporate equity.................. 8,271 (296) 7,975
Stock of federal agencies......... 5,874 114 5,988
-------- -------
Total stock......................... 38,657 38,479
-------- -------
-------- -------
Weighted average yield.............. 6.15%
</TABLE>
22
<PAGE>
MORTGAGE-BACKED AND RELATED SECURITIES. In order to supplement loan
production (particularly those of interest rate sensitive loans) and achieve
its asset/liability management goals, HMN invests in mortgage-backed and
related securities. All of the mortgage-backed and related securities owned
by HMN are issued, insured or guaranteed either directly or indirectly by a
federal agency or are rated "AA" or higher. At December 31, 1998, HMN had
$143.1 million of mortgage-backed and related securities all classified as
available for sale, compared to $135.9 at December 31, 1997 and $135.2
million at December 31, 1996, of which $133.4 million were classified as
available for sale.
The contractual maturities of the mortgage-backed and related securities
portfolio without any prepayment assumptions at December 31, 1998 is as
follows:
<TABLE>
<CAPTION>
December 31,
1998
5 Years 5 to 10 10 to 20 Over 20 Balance
(DOLLARS IN THOUSANDS) or Less Years Years Years Outstanding
------------ ---------- ------------ ----------- ------------
<S> <C> <C> <C> <C> <C>
Securities available for sale:
Federal Home Loan Mortgage Corporation........ $ 133 561 1,183 0 1,877
Federal National Mortgage Association......... 0 0 0 574 574
Government National Mortgage Association...... 0 13 108 1,366 1,487
Other mortgage-backed securities.............. 0 0 0 101 101
Collateralized Mortgage Obligations........... 1,028 2,208 18,928 116,943 139,107
------------ ---------- ------------ ----------- ------------
Total...................................... $ 1,161 2,782 20,219 118,984 143,146
------------ ---------- ------------ ----------- ------------
------------ ---------- ------------ ----------- ------------
Weighted average yield........................ 7.50% 7.21% 7.03% 6.66% 6.73%
</TABLE>
At December 31, 1998, HMN did not have any non-agency mortgage-backed or
related securities in excess of 10% of its stockholders' equity, except for a
$11.9 million collateralized mortgage obligation issued by Bear Stearns with
an AAA rating by Moody's.
CMOs are securities derived by reallocating the cash flows from
mortgage-backed securities or pools of mortgage loans in order to create
multiple classes, or tranches, of securities with coupon rates and average
lives that differ from the underlying collateral as a whole. The terms to
maturity of any particular tranche is dependent upon the prepayment speed of
the underlying collateral as well as the structure of the particular CMO.
Although a significant proportion of HMN's CMOs are in tranches which have
been structured (through the use of cash flow priority and "support"
tranches) to give somewhat more predictable cash flows, the cash flow and
hence the value of CMOs is subject to change.
At December 31, 1998, HMN had $94.5 million invested in CMOs which have
floating interest rates that change either monthly or quarterly, compared to
$23.3 million at December 31, 1997 and $43.5 million at December 31, 1996.
During 1998 HMN increased its investment in floating rate CMOs in order to
reduce its overall interest rate risk exposure.
At December 31, 1998 the projected duration (period of time until half
the interest and half the principal is collected) of the $44.6 million fixed
rate CMO portfolio is approximately 1.0 year using median prepayment speeds
projected by the Bloomberg security system, compared to approximately 3.3
years for the $61.8 million fixed rate CMO security portfolio at December 31,
1997.
Refer to Management's Discussion and Analysis-Market Risk in the Annual
Report for information on changes in market value of the mortgage-backed or
related securities under different rate shock environments.
To assess price volatility, the Federal Financial Institutions
Examination Council ("FFIEC") adopted a policy in 1992 which required an
annual "stress" test of mortgage derivative securities. The policy, which was
adopted by the OTS, required the Bank to annually test its CMOs and other
mortgage-related securities to
23
<PAGE>
determine whether they were "high-risk" or "nonhigh-risk securities". During
1998 the OTS adopted Thrift Bulletin 13A which no longer required that
"high-risk" testing be performed on an institution's CMOs and other
mortgage-related securities.
Mortgage-backed and related securities can serve as collateral for
borrowings and, through sales and repayments, as a source of liquidity. In
addition, mortgage-backed and related securities available for sale can be
sold to respond to changes in economic conditions. For information regarding
the carrying and market values of HMN's mortgage-backed and related
securities portfolio, see Notes 3 and 4 of the Notes to Consolidated
Financial Statements in the Annual Report.
MERGERS AND ACQUISITIONS. On December 5, 1997 HMN, through its wholly
owned subsidiary, the Bank, completed its merger with Marshalltown Financial
Corporation (MFC) pursuant to a merger agreement dated July 1, 1997. Refer to
Note 2 of the Notes to Consolidated Financial Statements in the Annual Report
for information on assets acquired in the merger.
SOURCES OF FUNDS
GENERAL. The Bank's primary sources of funds are deposits, payments
(including prepayments) of loan principal, interest earned on loans and
securities, repayments of securities, borrowings and other funds provided
from operations.
DEPOSITS. The Bank offers a variety of deposit accounts having a wide
range of interest rates and terms. The Bank's deposits consist of passbook,
NOW, money market, non-interest bearing checking and certificate accounts
(including individual retirement accounts). The Bank relies primarily on
competitive pricing policies and customer service to attract and retain these
deposits.
The variety of deposit accounts offered by the Bank has allowed it to be
competitive in obtaining funds and to respond with flexibility to changes in
consumer demand. As customers have become more interest rate conscious, the
Bank has become more susceptible to short-term fluctuations in deposit flows.
The Bank manages the pricing of its deposits in keeping with its
asset/liability management, profitability and growth objectives. Based on its
experience, the Bank believes that its passbook and NOW accounts are
relatively stable sources of deposits. However, the ability of the Bank to
attract and maintain certificate deposits, and the rates paid on these
deposits, has been and will continue to be significantly affected by market
conditions.
The following table sets forth the savings flows at the Bank during the
periods indicated.
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996
--------- -------- --------
<S> <C> <C> <C>
Opening balance............................. $ 467,348 362,477 373,539
MFC deposits acquired....................... 0 103,612 0
Deposits.................................... 536,135 370,761 351,330
Withdrawals................................. (588,662) (385,002) (378,009)
Interest credited........................... 19,048 15,500 15,617
---------- -------- --------
Ending balance............................ 433,869 467,348 362,477
---------- -------- --------
Net increase (decrease)..................... $ (33,479) 104,871 (11,062)
---------- -------- --------
---------- -------- --------
Percent increase (decrease)................. (7.16)% 28.93% (2.96)%
---------- -------- --------
---------- -------- --------
</TABLE>
24
<PAGE>
The following table sets forth the dollar amount of savings deposits in
the various types of deposit programs offered by the Bank as of December 31:
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------- -------------------------- ----------------------
Percent Percent Percent
(DOLLARS IN THOUSANDS) Amount of Total Amount of Total AMOUNT of Total
-------- -------- -------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C>
TRANSACTIONS AND SAVINGS DEPOSITS(1):
Non-interest checking.................... $ 13,187 3.04% $ 3,833 0.82% $ 2,389 0.66%
NOW Accounts - 1.00%(2).................. 25,459 5.87 23,144 4.95 17,589 4.85
Passbook Accounts - 2.00%(3)............. 35,766 8.24 36,199 7.75 30,070 8.29
Money Market Accounts - 3.19%(4)......... 29,419 6.78 24,807 5.31 16,533 4.56
---------- -------- ---------- -------- --------- -------
Total Non-Certificates................. $ 103,831 23.93% $ 87,983 18.83% $ 66,581 18.36%
---------- -------- ---------- -------- --------- -------
CERTIFICATES:
3.00 - 3.99%........................... $ 1,943 0.45% $ 727 0.15% $ 425 0.12%
4.00 - 4.99%........................... 87,582 20.19 24,155 5.17 22,553 6.22
5.00 - 5.99%........................... 160,630 37.02 162,916 34.86 168,040 46.36
6.00 - 6.99%........................... 78,273 18.04 178,847 38.27 76,704 21.16
7.00 - 7.99%........................... 1,342 0.31 11,627 2.49 28,077 7.75
8.00 - 8.99%........................... 264 0.06 1,091 0.23 96 0.03
9.00% and over.......................... 4 0.00 2 0.00 1 0.00
---------- -------- --------- ------- --------- -------
Total Certificates..................... 330,038 76.07 379,365 81.17 295,896 81.64
---------- -------- ---------- -------- --------- -------
Total Deposits...................... $ 433,869 100.00% $ 467,348 100.00% $ 362,477 100.00%
---------- -------- ---------- ------- --------- ------
---------- -------- ---------- ------- --------- ------
</TABLE>
- ------------
(1) Reflects rates paid on transaction and savings deposits at
December 31, 1998.
(2) The rate on NOW Accounts for 1997 was 1.50% and 1996 was 2.01%.
(3) The rate on Passbook Accounts for 1997 was 2.62% and 1996 was 2.50%.
(4) The rate on Money Market Accounts for 1997 was 3.34% and 1996 was 2.83%.
25
<PAGE>
The following table shows rate and maturity information for the Bank's
certificates of deposit as of December 31, 1998.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
Certificate accounts maturing in 2.00- 3.00- 4.00- 5.00- 6.00-
quarter ending: 2.99% 3.99% 4.99% 5.99% 6.99%
------ ----- ------ ------- ------
<S> <C> <C> <C> <C> <C>
March 31, 1999.......................... $ 0 1,322 12,578 30,572 21,601
June 30, 1999........................... 0 3 12,859 26,839 8,536
September 30, 1999...................... 100 43 22,019 19,162 5,520
December 31, 1999....................... 400 39 12,675 17,599 1,654
March 31, 2000.......................... 0 0 10,874 8,520 3,427
June 30, 2000........................... 0 2 2,964 4,397 1,736
September 30, 2000...................... 0 0 3,891 4,031 13,958
December 31, 2000....................... 0 33 4,040 7,124 6,575
March 31, 2001.......................... 0 0 278 9,072 2,832
June 30, 2001........................... 0 0 739 8,998 1,975
September 30, 2001...................... 0 0 2,638 5,243 2,230
December 31, 2001....................... 0 1 1,753 1,112 2,867
Thereafter.............................. 0 0 274 17,961 5,362
------ ----- ------ ------- ------
Total................................ $ 500 1,443 87,582 160,630 78,273
------ ----- ------ ------- ------
------ ----- ------ ------- ------
Percent of total..................... 0.15% 0.44% 26.54% 48.66% 23.72%
------ ----- ------ ------- ------
------ ----- ------ ------- ------
<CAPTION>
(DOLLARS IN THOUSANDS)
Certificate accounts maturing in 7.00- 8.00- 9.00- Percent
quarter ending: 7.99% 8.99% 9.99% Total of Total
----- ----- ----- ------- --------
<S> <C> <C> <C> <C> <C>
March 31, 1999.......................... 477 253 0 66,803 20.25
June 30, 1999........................... 248 11 2 48,498 14.70
September 30, 1999...................... 358 0 0 47,202 14.30
December 31, 1999....................... 257 0 0 32,624 9.88
March 31, 2000.......................... 0 0 1 22,822 6.92
June 30, 2000........................... 0 0 0 9,099 2.76
September 30, 2000...................... 0 0 0 21,880 6.63
December 31, 2000....................... 0 0 0 17,772 5.38
March 31, 2001.......................... 0 0 0 12,182 3.69
June 30, 2001........................... 0 0 0 11,712 3.55
September 30, 2001...................... 0 0 1 10,112 3.06
December 31, 2001....................... 2 0 0 5,735 1.74
Thereafter.............................. 0 0 0 23,597 7.15
----- ----- ----- ------- ------
Total................................ 1,342 264 4 330,038 100.00%
----- ----- ----- ------- ------
----- ----- ----- ------- ------
Percent of total..................... 0.41% 0.08% 0.00% 100.00%
----- ----- ----- -------
----- ----- ----- -------
</TABLE>
26
<PAGE>
The following table indicates the amount of the Bank's certificates of
deposit and other deposits by time remaining until maturity as of December 31,
1998.
<TABLE>
<CAPTION>
Maturity
--------------------------------------------
Over Over
3 Months 3 to 6 6 to 12 Over
or Less Months Months 12 Months Total
-------- ------ ------- --------- -------
<S> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Certificates of deposit less
than $100,000........................................... $ 55,559 44,651 69,631 123,848 293,689
Certificates of deposit of
$100,000 or more........................................ 5,520 2,100 5,568 10,717 23,905
Public funds(1).......................................... 5,725 1,747 4,627 345 12,444
-------- ------- ------- -------- -------
Total certificates of
deposit.............................................. $ 66,804 48,498 79,826 134,910 330,038
-------- ------- ------- -------- -------
-------- ------- ------- -------- -------
</TABLE>
- ------------
(1) Deposits from governmental and other public entities.
For additional information regarding the composition of the Bank's deposits, see
Note 12 of the Notes to Consolidated Financial Statements in the Annual Report.
For additional information on certificate maturities and the impact on HMN's
liquidity see Liquidity starting on page 21 of the Annual Report.
BORROWINGS. The Bank's other available sources of funds include advances
from the Federal Home Loan Bank ("FHLB") of Des Moines and other borrowings. As
a member of the FHLB of Des Moines, the Bank is required to own capital stock in
the FHLB of Des Moines and is authorized to apply for advances from the FHLB of
Des Moines. Each FHLB credit program has its own interest rate, which may be
fixed or variable, and range of maturities. The FHLB of Des Moines may
prescribe the acceptable uses for these advances, as well as limitations on the
size of the advances and repayment provisions. Consistent with its
asset/liability management strategy, the Bank has utilized FHLB advances from
time to time to extend the term to maturity of its liabilities. Also, the Bank
has used FHLB borrowings to fund loan demand and other investment opportunities
and to offset deposit outflows. At December 31, 1998, the Bank had $185.4
million of FHLB advances outstanding. On such date, the Bank had a collateral
pledge arrangement with the FHLB of Des Moines pursuant to which the Bank may
borrow up to an additional $60.0 million for liquidity purposes. See "Financial
Review - Federal Home Loan Bank Advances" and Note 13 of the Notes to
Consolidated Financial Statements in the Annual Report.
During 1998, HMN has established a $2.5 million revolving line of credit
with Norwest Bank Minnesota, N.A. The credit line matures September 15, 1999
and floats at the Federal Funds rate plus 250 basis points.
The following table sets forth the maximum month-end balance and average
balance of FHLB advances and the revolving line of credit ("Other Borrowings")
for the periods indicated.
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------
1998 1997 1996
---------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
MAXIMUM BALANCE:
FHLB advances and Other Borrowings........................ $ 195,829 128,007 106,436
FHLB short-term borrowings and Other Borrowings........... 46,893 60,429 64,429
AVERAGE BALANCE:
FHLB advances and Other Borrowings........................ 172,232 112,500 89,656
FHLB short-term borrowings and Other Borrowings........... 32,320 45,598 47,949
</TABLE>
27
<PAGE>
The following table sets forth certain information as to the Bank's FHLB
advances and Other Borrowings at the dates indicated.
<TABLE>
<CAPTION>
December 31,
---------------------------
1998 1997 1996
------- ------ ------
<S> <C> <C> <C>
(DOLLARS IN THOUSANDS)
FHLB short-term borrowings and Other Borrowings....... $17,500 43,250 46,429
Weighted average interest rate of
FHLB short-term borrowings and Other Borrowings..... 5.38% 5.85% 5.52%
</TABLE>
SERVICE CORPORATIONS OF THE BANK
As a federally chartered savings bank, the Bank is permitted by OTS
regulations to invest up to 2% of its assets in the stock of, or loans to,
service corporation subsidiaries, and may invest an additional 1% of its
assets in service corporations where such additional funds are used for
inner-city or community development purposes. In addition to investments in
service corporations, federal institutions are permitted to invest an
unlimited amount in operating subsidiaries engaged solely in activities which
a federal savings bank may engage in directly.
Osterud Insurance Agency, Inc. ("OIAI"), a Minnesota corporation, was
organized in 1983. OIAI operated as an insurance agency until 1986 when its
assets were sold. OIAI remained inactive until 1993 when it began offering
credit life insurance, annuity products and mutual fund products to the
Bank's customers and others. OIAI recorded net income of $29,000 for the year
ended December 31, 1998.
MSL Financial Corporation ("MSL") was acquired in the MFC merger. MSL
offered annuity products to MFC customers and also has an investment in FHLMC
preferred stock.
COMPETITION
The Bank faces strong competition both in originating real estate loans
and in attracting deposits. Competition in originating loans comes primarily
from mortgage bankers, commercial banks, credit unions and other savings
institutions, which also make loans secured by real estate located in the
Bank's market area and through internet banking operations which are
throughout the continental United States. The Bank competes for loans
principally on the basis of the interest rates and loan fees it charges, the
types of loans it originates and the quality of services it provides to
borrowers.
Competition for deposits is principally from money market and mutual
funds, securities firms, commercial banks and other savings institutions
located in the same communities. The ability of the Bank to attract and
retain deposits depends on its ability to provide an investment opportunity
that satisfies the requirements of investors as to rate of return, liquidity,
risk, convenient locations and other factors. The Bank competes for these
deposits by offering a variety of deposit accounts at competitive rates,
convenient business hours and a customer oriented staff.
OTHER CORPORATIONS OWNED BY HMN
HMN has two other wholly owned subsidiaries, HMN Mortgage Services, Inc.
("MSI") and Security Finance Corporation ("SFC"). MSI operates a mortgage
banking and mortgage brokerage facility located in Brooklyn Park, Minnesota.
Brooklyn Park is located in the Minneapolis/St. Paul Metropolitan area. MSI's
primary function is to originate and/or purchase single family residential
loans for resale on the secondary
28
<PAGE>
market to FNMA, FHLMC or other third parties. It also from time to time
purchases mortgage servicing rights from other lenders. SFC invests in
commercial loans and commercial real estate loans located throughout the
United States which were originated by third parties.
EMPLOYEES
At December 31, 1998, HMN had a total of 136 full-time equivalent
employees. None of the employees of HMN or its subsidiaries are represented
by any collective bargaining unit. Management considers its employee
relations to be good.
EXECUTIVE OFFICERS OF THE REGISTRANT WHO ARE NOT DIRECTORS
Officers are elected annually by the Board of Directors of HMN and the
Bank. The business experience of each executive officer of HMN and the Bank
who is not also a director of HMN is set forth below. Unless otherwise
indicated, such individuals have held their current positions for at least
five years.
MICHAEL MCNEIL. Mr. McNeil, age 51, has been the President and Chief
Executive Officer of the Bank since January 1, 1999. From April 1, 1998
through December 1998, Mr. McNeil was the Senior Vice President Business
Development of the Bank. Prior to joining the Bank, Mr. McNeil was the
President and a director of Stearns Bank, N.A. in St. Cloud, Minnesota from
August 1, 1991 until March 1, 1998.
DWAIN C. JORGENSEN. Mr. Jorgensen, age 50, is Senior Vice President
Operations of HMN and the Bank. Mr. Jorgensen has held such positions with
the Bank since 1998. Prior to such time, he served as Vice President,
Controller and Chief Accounting Officer of HMN and the Bank from 1989 to
1998. From 1983 to 1989, Mr. Jorgensen was an Assistant Vice President and
Operations Officer with the Bank.
TIMOTHY P. JOHNSON. Mr. Johnson, age 46, is Vice President and
Treasurer of HMN and the Bank, a position he has held since 1997. He has also
been Principal Accounting Officer since 1998. Prior to such time, he served
as Treasurer from 1992 to 1997. From 1983 to 1992, Mr. Johnson was Chief
Financial Officer of St. Louis Bank for Savings, Duluth, Minnesota.
REGULATION
GENERAL
The Bank is a federally chartered savings bank, the deposits of which
are federally insured and backed by the full faith and credit of the United
States Government. Accordingly, the Bank is subject to broad federal
regulation and oversight extending to all its operations. The Bank is a
member of the FHLB of Des Moines and is subject to certain limited regulation
by the Federal Reserve Board. The Bank is a member of the Savings
Association Insurance Fund ("SAIF") and the deposits of the Bank are insured
by the FDIC. As a result, the FDIC has certain regulatory and examination
authority over the Bank. As the savings and loan holding company of the
Bank, HMN also is subject to federal regulation and oversight. The purpose
of the regulation of HMN and other holding companies is to protect subsidiary
savings associations.
Certain of these regulatory requirements and restrictions are discussed
below.
FEDERAL REGULATION OF SAVINGS ASSOCIATIONS
The OTS has extensive authority over the operations of savings
associations. As part of this authority, the Bank is required to file
periodic reports with the OTS and is subject to periodic examinations by the
OTS and the FDIC. The last regular OTS examination of the Bank was dated
July of 1998. The Bank has not been scheduled for an examination in 1999,
except for an on-site year 2000 examination which started
29
<PAGE>
on March 1, 1999. When these examinations are conducted by the OTS and the
FDIC, the examiners may require the Bank to provide for higher general or
specific loan loss reserves. From time to time, financial institutions in
various regions of the United States have been called upon by examiners to
write down assets and to establish increased levels of reserves, primarily as
a result of perceived weaknesses in real estate values and a more restrictive
regulatory climate.
The OTS has established a schedule for the assessment of fees upon all
savings associations to fund the operations of the OTS. The general
assessment, to be paid on a semi-annual basis, is computed upon the savings
association's total assets as reported in the association's latest quarterly
thrift financial report, the savings association's condition as reflected by
its composite rating, and the complexity of the savings association's
business determined by the amount of trust assets administered, assets
subject to recourse or similar obligations and the principal amount of loans
serviced by the savings association. Savings associations (unlike the Bank)
with a composite rating of 3 receive a condition component equal to 25% of
their size component and savings associations with a composite rating of 4 or
5 receive a condition component equal to 50% of their size component. The
Bank's OTS assessment for the year ended December 31, 1998 was approximately
$147,000.
The OTS also has extensive enforcement authority over all savings
institutions and their holding companies, including the Bank and HMN. This
enforcement authority includes, among other things, the ability to assess
civil money penalties, to issue cease-and-desist or removal orders and to
initiate injunctive actions. In general, these enforcement actions may be
initiated for violations of laws and regulations and unsafe or unsound
practices. Other actions or inactions may provide the basis for enforcement
action, including misleading or untimely reports filed with the OTS. Except
under certain circumstances, public disclosure of final enforcement actions
by the OTS is required.
In addition, the investment, lending and branching authority of the Bank
is prescribed by federal laws and regulations, and it is prohibited from
engaging in any activities not permitted by such laws and regulations. For
instance, no savings institution may invest in non-investment grade corporate
debt securities. In addition, unless approved by the OTS, the permissible
level of investment by federal associations in loans secured by
non-residential real property may not exceed 400% of regulatory capital.
Federal savings associations are also generally authorized to branch
nationwide. The Bank is in compliance with the noted restrictions.
The Bank's general permissible lending limit for loans-to-one-borrower
is equal to the greater of $500,000, or 15%, of unimpaired capital and
surplus (except for loans fully secured by certain readily marketable
collateral, in which case this limit is increased to 25% of unimpaired
capital and surplus). At December 31, 1998, the Bank's lending limit under
this restriction was $6.9 million. The Bank is in compliance with the
loans-to-one borrower limitation.
In December 1991, the Federal Deposit Insurance Corporation Improvement
Act of 1991 ("FDICIA") was enacted into law. FDICIA provides for, among
other things, the recapitalization of the Bank Insurance Fund; adoption of
safety and soundness standards; enhanced federal supervision of depository
institutions, including greater authority for the appointment of a
conservator or receiver for undercapitalized institutions; the establishment
of risk-based deposit insurance premiums; liberalization of the qualified
thrift lender test; greater restrictions on transactions with affiliates; and
mandated consumer protection disclosures with respect to deposit accounts.
See "- Insurance of Accounts and Regulation by the FDIC," "- Regulatory
Capital Requirements" and "- Qualified Thrift Lender Test."
The OTS, as well as the other federal banking agencies, have issued
proposed safety and soundness standards on matters such as credit
underwriting and loan documentation, internal controls and audit systems,
interest rate risk exposure, asset growth and quality, compensation and
other employee benefits and year 2000 issues. The proposal also establishes
the maximum ratio of classified assets to total capital (which for this
purpose
30
<PAGE>
includes loss allowances exceeding the amount includable for regulatory
capital purposes) at 100% and the minimum level of earnings sufficient to
absorb losses without impairing capital. Earnings will be sufficient if the
net income over the last four quarters is assumed to continue over the next
four quarters and the institution would otherwise remain in capital
compliance. Any institution which fails to comply with these standards must
submit a compliance plan. A failure to submit a plan or to comply with an
approved plan will subject the institution to further enforcement action.
The Bank is subject to a wide array of other laws and regulations, both
federal and state, including, but not limited to, usury laws, the Community
Reinvestment Act and regulations thereunder, the Equal Credit Opportunity Act
and Regulation B, Regulation E-Electronic Funds Transfer requirements, the
Truth-in-Lending Act and Regulation Z, the Real Estate Settlement Procedures
Act and Regulation X. The Bank is also subject to laws and regulations that
may impose liability on lenders and owners for clean-up costs and other costs
stemming from hazardous waste located on property securing real estate loans
made by lenders or on real estate that is owned by lenders following a
foreclosure or otherwise.
INSURANCE OF ACCOUNTS AND REGULATION BY THE FDIC
The Bank is a member of the SAIF, which is administered by the FDIC.
Savings deposits are insured up to applicable limits by the FDIC and such
insurance is backed by the full faith and credit of the United States
Government. As insurer, the FDIC imposes deposit insurance premiums and is
authorized to conduct examinations of and to require reporting by
FDIC-insured institutions. It also may prohibit any FDIC-insured institution
from engaging in any activity the FDIC determines by regulation or order to
pose a serious risk to the SAIF. The FDIC also has the authority to initiate
enforcement actions against savings associations, after giving the OTS an
opportunity to take such action, and may terminate the deposit insurance if
it determines that the institution has engaged or is engaging in unsafe or
unsound practices, or is in an unsafe or unsound condition.
FDICIA required the FDIC to implement a risk-based deposit insurance
assessment system. Under the system, all insured depository institutions were
placed into one of nine categories and assessed insurance premiums, ranging
from .04% to .31% of deposits, based upon their level of capital and
supervisory evaluation. Institutions classified as well capitalized (I.E., a
core capital ratio of at least 5%, a ratio of Tier 1 or core capital to
risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a
risk-based capital ratio of at least 10%) and considered healthy would pay
the lowest premium while institutions that are less than adequately
capitalized (I.E., core and Tier 1 risk-based capital ratios of less than 4%
or a risk-based capital ratio of less than 8%) and considered of substantial
supervisory concern would pay the highest premium. Risk classification of
all insured institutions will be made by the FDIC for each semi-annual
assessment period.
The FDIC is authorized to increase assessment rates, on a semi-annual
basis, if it determines that the reserve ratio of the SAIF will be less than
the designated reserve ratio of 1.25% of SAIF insured deposits. In setting
these increased assessments, the FDIC must seek to restore the reserve ratio
to that designated reserve level, or such higher reserve ratio as established
by the FDIC. In addition, under FDICIA, the FDIC may impose special
assessments on SAIF members to repay amounts borrowed from the United States
Treasury or for any other reason deemed necessary by the FDIC.
The Deposit Insurance Fund Act of 1996 (DIFA) was enacted on September
30, 1996. DIFA addressed the inadequate funding of the (SAIF). In order to
recapitalize the SAIF, DIFA imposed a one-time assessment on all thrift
institutions. The Bank's assessment was a pretax charge of $2,351,563 and
was recognized in the third quarter of 1996.
DIFA also addressed the funding for the Financing Corp. (FICO) bonds.
Thrifts will pay 6.4 basis points per $100 of deposits from January 1, 1997
to December 31, 1999. From January 1, 2000 until the
31
<PAGE>
FICO bonds are retired in 2019, the estimated assessment to retire the FICO
bonds is expected to be 2.5 basis points per $100 of deposits.
DIFA proposed that the Bank Insurance Fund (BIF) and SAIF be merged on
January 1, 1999, provided no insurance depository institution is a savings
association on that date. At this time, HMN does not know what effect, if
any, the proposed legislation or charter revisions will have on future
operations.
REGULATORY CAPITAL REQUIREMENTS
Federally insured savings associations, such as the Bank, are required
to maintain a minimum level of regulatory capital. The OTS has established
capital standards, including a tangible capital requirement, a leverage ratio
(or core capital) requirement and a risk-based capital requirement applicable
to such savings associations. These capital requirements must be generally
as stringent as the comparable capital requirements for national banks. The
OTS is also authorized to impose capital requirements in excess of these
standards on individual associations on a case-by-case basis.
The capital regulations require tangible capital of at least 1.5% of
adjusted total assets (as defined by regulation). Tangible capital generally
includes common stockholders' equity and retained earnings, and certain
noncumulative perpetual preferred stock. In addition, all intangible assets,
other than a limited amount of purchased mortgage servicing rights, must be
deducted from tangible capital. At December 31, 1998, the Bank had goodwill
and other intangibles of $5.6 million and $264,000 of mortgage servicing
rights which were required to be deducted from stockholders' equity to arrive
at tangible capital and Tier I capital.
The OTS regulations establish special capitalization requirements for
savings associations that own subsidiaries. Under these regulations certain
subsidiaries are consolidated for capital purposes and others are excluded
from assets and capital. In determining compliance with the capital
requirements, all subsidiaries engaged solely in activities permissible for
national banks or engaged in certain other activities solely as agent for its
customers, or meeting other criteria, are "includable" subsidiaries that are
consolidated for capital purposes in proportion to the association's level of
ownership, including the assets of includable subsidiaries in which the
association has a minority interest that is not consolidated for GAAP
purposes. For excludable subsidiaries the debt and equity investments in
such subsidiaries are deducted from assets and capital. The subsidiary of the
Bank is an includable subsidiary.
At December 31, 1998, the Bank had tangible capital of $42.8 million, or
6.4% of adjusted total assets, which is $16.0 million above the minimum
requirement of 1.5% of adjusted total assets in effect on that date.
The capital standards also require core capital or Tier I capital to
equal at least 3% of adjusted total assets (as defined by regulation).
Core capital generally consists of tangible capital plus certain intangible
assets. As a result of the prompt corrective action provisions of FDICIA
discussed below, however, a savings association must maintain a core capital
ratio of at least 4% to be considered adequately capitalized unless its
supervisory condition is such to allow it to maintain a 3% ratio.
The OTS regulations only allow those savings associations rated a
composite one (the highest rating) under the safety and soundness rating
system for savings associations to be permitted to operate at or near the
regulatory minimum leverage ratio of 3%. All other savings associations are
required to maintain a Tier I capital to adjusted total assets of 4% to 5%.
The OTS assesses each individual savings association through the supervisory
process on a case-by-case basis to determine the applicable requirement.
The Bank is also required to have a Tier I capital ratio to risk-weighted
assets of 4%. In determining the amount of risk-weighted assets, all
assets, including certain off-balance sheet items, will be multiplied by a
risk weight, ranging from 0% to 100%, based on the risk inherent in the type
of asset. For example, the OTS has assigned a risk weight of 50% for
prudently underwritten permanent one-to-four family first lien mortgage loans
not more than 90 days delinquent and having a loan to value ratio of not more
than 80% at origination
32
<PAGE>
unless insured to such ratio by an insurer approved by the FNMA or the FHLMC.
At December 31, 1998, the Bank had Tier I capital equal to $42.8
million, or 6.4%, of adjusted total assets, which is $16.0 million above the
minimum Tier I ratio requirement of 4% based upon the Bank's composite
rating. At December 31, 1998, the Bank had a Tier I capital to risk-weighted
assets ratio of 12.9%, which is $29.5 million above the minimum requirement
of $13.3 million.
The OTS risk-based requirement requires savings associations to have
total capital of at least 8% of risk-weighted assets. Total capital consists
of core capital, as defined above, and supplementary capital. Supplementary
capital consists of certain permanent and maturing capital instruments that
do not qualify as core capital and general valuation loan and lease loss
allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary
capital may be used to satisfy the risk-based requirement only to the extent
of core capital. At December 31, 1998, the Bank had $3.0 million of general
loss reserves, which were included in capital.
Certain exclusions from capital and assets are required to be made for
the purpose of calculating total capital, in addition to the adjustments
required for calculating core capital. Such exclusions consist of equity
investments (as defined by regulation) and that portion of land loans and
nonresidential construction loans in excess of an 80% loan-to-value ratio and
reciprocal holdings of qualifying capital instruments. At December 31, 1998
the Bank had $22,000 of exclusions from capital.
On December 31, 1998, the Bank had total "risk-based" capital of $45.8
million and risk-weighted assets of $332.7 million, or total capital of 13.8%
of risk-weighted assets. This amount was $19.2 million above the 8%
requirement in effect on that date.
Under FDICIA, all the federal banking agencies, including the OTS, were
required to revise their risk-based capital requirements to ensure that such
requirements account for interest rate risk, concentration of credit risk and
the risks of non-traditional activities, and that they reflect the actual
performance of and expected loss on multi-family loans. Such standards were
adopted with the enactment of FDICIA.
The OTS had adopted a rule that required every savings association with
more than normal interest rate risk to deduct from its total capital, for
purposes of determining compliance with such requirement, an interest rate
risk component ("IRR component") equal to 50% of its interest-rate risk
exposure multiplied by the present value of its assets. The IRR component is
a measure of the potential decline in the net portfolio value ("NPV") of a
savings association, greater than 2% of the present value of its assets,
based upon a hypothetical 200 basis point increase or decrease in interest
rates (whichever results in a greater decline). NPV is the present value of
expected cash flows from assets, liabilities and off-balance sheet contracts.
The rule provided for a two quarter lag between calculating interest rate
risk and recognizing any deduction from capital. The OTS has decided not to
require the IRR component to be deducted from the capital calculations of all
institutions. It has reserved the right to take the IRR component into
account in assessing the capital requirements for an individual institution.
On December 1, 1998 the OTS issued Thrift Bulletin 13a ("TB 13a"), Management
of Interest Rate Risk, Investment Securities, and Derivatives Activities,
which among other things established guidelines for measuring an
institution's sensitivity to market risk. TB 13a had a table which examiners
should use as a starting point in their analysis of an institution's level of
interest rate risk, assuming there were no deficiencies in the institution's
risk management practices. Based upon an IRR exposure report prepared by OTS
from data submitted by the Bank at December 31, 1998, the Bank was deemed to
have "minimal interest rate risk" per the table. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -
Asset/Liability Management" in the Annual Report.
Pursuant to FDICIA, the federal banking agencies, including the OTS,
have adopted regulations authorizing the agencies to require a depository
institution to maintain an additional amount of total capital to account for
concentration of credit risk and the risk of non-traditional activities.
33
<PAGE>
The OTS and the FDIC are authorized and, under certain circumstances,
required to take certain actions against associations that fail to meet
capital requirements. Effective December 19, 1992, the federal banking
agencies, including the OTS, were given additional enforcement authority over
undercapitalized depository institutions. The OTS is generally required to
take action to restrict the activities of an "undercapitalized association"
(generally defined to be one with less than either a 4% Tier 1 to adjusted
total assets ratio, a 4% Tier 1 risked-based capital ratio or an 8%
risk-based capital ratio). Any such association must submit a capital
restoration plan and until such plan is approved by the OTS may not increase
its assets, acquire another institution, establish a branch or engage in any
new activities, and generally may not make capital distributions. The OTS is
authorized to impose the additional restrictions, discussed below, that are
applicable to significantly undercapitalized associations.
As a condition to the approval of the capital restoration plan, any
company controlling an undercapitalized association must agree that it will
enter into a limited capital maintenance guarantee with respect to the
institution's achievement of its capital requirements.
Any savings association that fails to comply with its capital plan or is
"significantly undercapitalized" (I.E., Tier 1 risk-based or Tier I to
adjusted total assets of less than 3% or a risk-based capital ratio of less
than 6%) must be made subject to one or more additional specified actions and
operating restrictions mandated by FDICIA. These actions and restrictions
include requiring the issuance of additional voting securities; limitations
on asset growth; mandated asset reduction; changes in senior management;
divestiture, merger or acquisition of the association; restrictions on
executive compensation; and any other action the OTS deems appropriate. An
association that becomes "critically undercapitalized" (I.E., a tangible
equity to total asset ratio of 2% or less) is subject to further mandatory
restrictions on its activities in addition to those applicable to
significantly undercapitalized associations. In addition, the OTS must
appoint a receiver (or conservator with the concurrence of the FDIC) for a
savings association, with certain limited exceptions, within 90 days after it
becomes critically undercapitalized.
Any undercapitalized association is also subject to other possible
enforcement actions by the OTS or the FDIC. Such actions could include a
capital directive, a cease-and-desist order, civil money penalties, the
establishment of restrictions on all aspects of the association's operations,
the appointment of a receiver or conservator or a forced merger into another
institution.
If the OTS determines that an association is in an unsafe or unsound
condition, or is engaged in an unsafe or unsound practice, it is authorized
to reclassify a well-capitalized association as an adequately capitalized
association, and if the association is adequately capitalized, to impose the
restrictions applicable to an undercapitalized association. If the
association is undercapitalized, the OTS is authorized to impose the
restrictions applicable to a significantly undercapitalized association.
The imposition by the OTS or the FDIC of any of these measures on the
Bank may have a substantial adverse effect on the Bank's operations and
profitability and the value of HMN's stock. HMN shareholders do not have
preemptive rights, and therefore, if HMN is directed by the OTS or the FDIC
to issue additional shares of common stock, such issuance may result in the
dilution in the percentage of ownership of existing stockholders of HMN.
At December 31, 1998 the Bank would be considered to be "well
capitalized" under the prompt corrective actions provisions mentioned above.
See Note 20 "Federal Home Loan Bank Investment, Regulatory Liquidity and
Regulatory Capital Requirements" in the Notes to Consolidated Financial
Statements in the Annual Report for more information on the Bank's capital.
34
<PAGE>
LIMITATIONS ON DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS
OTS regulations impose various restrictions or requirements on
associations with respect to their ability to pay dividends or make other
distributions of capital. OTS regulations prohibit an association from
declaring or paying any dividends or from repurchasing any of its stock if,
as a result, the regulatory capital of the association would be reduced below
the amount required to be maintained for the liquidation account established
in connection with its mutual to stock conversion.
The OTS utilizes a three-tiered approach to permit associations, based
on their capital level and supervisory condition, to make capital
distributions which include dividends, stock redemptions or repurchases,
cash-out mergers and other transactions charged to the capital account. See
"- Regulatory Capital Requirements."
Generally, Tier 1 associations, which are associations that before and
after the proposed distribution meet their fully phased-in capital
requirements, may generally make capital distributions during any calendar
year equal to the greater of 100% of net income for the year-to-date plus 50%
of the amount by which the lesser of the association's tangible, core or
risk-based capital exceeds its fully phased-in capital requirement for such
capital component, as measured at the beginning of the calendar year, or the
amount authorized for a Tier 2 association. However, a Tier 1 association
deemed to be in need of more than normal supervision by the OTS may be
downgraded to a Tier 2 or Tier 3 association as a result of such a
determination. The Bank meets the requirements for a Tier 1 association and
has not been notified of a need for more than normal supervision. Tier 2
associations, which include associations that before and after the proposed
distribution meet their current minimum capital requirements, may generally
make capital distributions of up to 75% of net income over the most recent
four quarter period.
Tier 3 associations (which are associations that do not meet current
minimum capital requirements) that propose to make any capital distribution
and Tier 2 associations that propose to make a capital distribution in excess
of the noted safe harbor level must obtain OTS approval prior to making such
distribution. Tier 2 associations proposing to make a capital distribution
within the safe harbor provisions and Tier 1 associations proposing to make
any capital distribution need only submit written notice to the OTS 30 days
prior to such distribution. As a subsidiary of HMN, the Bank will also be
required to give the OTS 30 days' notice prior to declaring any dividend on
its stock. The OTS may object to the distribution during that 30-day period
based on safety and soundness concerns. See "- Regulatory Capital
Requirements."
The OTS has promulgated regulations that revise the current capital
distribution restrictions. These regulations become effective on April 1,
1999. The regulations eliminate the current tiered structure and the
safe-harbor percentage limitations. Under the regulations, a savings
association that is a subsidiary of a holding company, like the Bank, must
file either a notice or an application 30 days before declaring a dividend or
seeking board approval of a capital distribution. A notice is required unless
a savings association (that is a holding company subsidiary) is not eligible
for expedited treatment under OTS regulation or would not be adequately
capitalized after the distribution, or the distribution would cause the
association's distributions for the calendar year to exceed its net income
for the year to date plus retained net income for the prior two years, or the
distribution is otherwise contrary to statute, regulation or regulatory
agreement or condition. If any of these conditions exist, then an
application must be filed with the OTS. As under the current rule, the OTS
may object to a capital distribution if it would constitute an unsafe or
unsound practice.
In March of 1999, the Bank received notification from the OTS that
subject to certain restrictions (which could only be calculated at the time
of distribution) a dividend from the Bank to HMN of $4.0 million could be
paid during 1999 and not violate the dividend limitations mentioned above.
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<PAGE>
LIQUIDITY
All savings associations, including the Bank, are required to maintain
an average daily balance of liquid assets equal to a certain percentage of
the sum of its average daily balance of net withdrawable deposit accounts and
borrowings payable in one year or less. For a discussion of what the Bank
includes in liquid assets, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity" in the Annual
Report. This liquid asset ratio requirement may vary from time to time
(between 4% and 10%) depending upon economic conditions and savings flows of
all savings associations. At the present time, the minimum liquid asset ratio
is 4% or an amount that would be required to operate the Bank in a safe and
sound manner.
ACCOUNTING
An OTS policy statement applicable to all savings associations clarifies
and re-emphasizes that the investment activities of a savings association
must be in compliance with approved and documented investment policies and
strategies, and must be accounted for in accordance with GAAP. Under the
policy statement, management must support its classification of and
accounting for loans and securities (I.E., whether held to maturity, sale or
trading) with appropriate documentation. The Bank is in compliance with these
amended rules.
The OTS has adopted an amendment to its accounting regulations, which
may be made more stringent than GAAP, to require that transactions be
reported in a manner that best reflects their underlying economic substance
and inherent risk and that financial reports must incorporate any other
accounting regulations or orders prescribed by the OTS.
QUALIFIED THRIFT LENDER TEST
All savings associations, including the Bank, are required to meet a
qualified thrift lender ("QTL") test to avoid certain restrictions on their
operations. This test requires a savings association to have at least 65% of
its portfolio assets (which consists of total assets less intangibles,
properties used to conduct the savings association's business and liquid
assets not exceeding 20% of total assets) in qualified thrift investments on
a monthly average for nine out of every 12 months on a rolling basis. For HMN
such assets primarily consist of residential housing related loans and
investments. At December 31, 1998, the Bank met the test and has always
met the test since its effectiveness.
Any savings association that fails to meet the QTL test must convert to
a national bank charter, unless it requalifies as a QTL and thereafter
remains a QTL. If an association does not requalify and converts to a
national bank charter, it must remain SAIF-insured until the FDIC permits it
to transfer to the Bank Insurance Fund. If an association that fails the test
has not yet requalified and has not converted to a national bank, its new
investments and activities are limited to those permissible for both a
savings association and a national bank, and it is limited to national bank
branching rights in its home state. In addition, the association is subject
to national bank limits for payment of dividends. If such association has not
requalified or converted to a national bank within three years after the
failure, it must divest of all investments and cease all activities not
permissible for a national bank. In addition, it may have to repay promptly
any outstanding FHLB borrowings, which could result in prepayment penalties
or purchase additional FHLB stock to meet the stockholder requirements of
non-QTL members. If any association that fails the QTL test is controlled by
a holding company, then within one year after the failure, the holding
company must register as a bank holding company and become subject to all
restrictions on bank holding companies. See "- Holding Company Regulation."
36
<PAGE>
TRANSACTIONS WITH AFFILIATES
Generally, transactions between a savings association or its
subsidiaries and its affiliates are required to be on terms as favorable to
the association as transactions with non-affiliates. In addition, certain of
these transactions are restricted to a percentage of the association's
capital. Affiliates of the Bank include HMN and any company which is under
common control with the Bank. In addition, a savings association may not lend
to any affiliate engaged in activities not permissible for a bank holding
company, acquire the securities of most affiliates, or purchase low quality
assets from affiliates. The Bank's subsidiaries are not deemed affiliates,
however, the OTS has the discretion to treat subsidiaries of savings
associations as affiliates on a case by case basis.
Certain transactions with directors, officers or controlling persons are
also subject to conflict of interest regulations enforced by the OTS. These
conflict of interest regulations and other statutes also impose restrictions
on loans to such persons and their related interests. Among other things,
such loans must be made on terms substantially the same as for loans to
unaffiliated individuals.
HOLDING COMPANY REGULATION
HMN is a unitary savings and loan holding company subject to regulatory
oversight by the OTS. As such, HMN is registered and required to file reports
with and subject to regulation and examination by the OTS. In addition, the
OTS has enforcement authority over HMN and its non-savings association
subsidiaries which also permits the OTS to restrict or prohibit activities
that are determined to be a serious risk to the subsidiary savings
association.
As a unitary savings and loan holding company, HMN generally is not
subject to activity restrictions. If HMN acquires control of another savings
association as a separate subsidiary, it would become a multiple savings and
loan holding company, and the activities of HMN and any of its subsidiaries
(other than the Bank or any other SAIF-insured savings association) would
become subject to such restrictions unless such other associations qualify as
QTLs and were acquired in a supervisory acquisition.
If the Bank fails the QTL test, HMN must obtain the approval of the OTS
prior to continuing after such failure, directly or through its other
subsidiaries, any business activity other than those approved for multiple
savings and loan holding companies or their subsidiaries. In addition, within
one year of such failure HMN must register as, and will become subject to,
the restrictions applicable to bank holding companies. The activities
authorized for a bank holding company are more limited than are the
activities authorized for a unitary or multiple savings and loan holding
company. See "- Qualified Thrift Lender Test."
HMN must obtain approval from the OTS before acquiring control of any
other SAIF-insured association. Such acquisitions are generally prohibited if
they result in a multiple savings and loan holding company controlling
savings associations in more than one state. However, such interstate
acquisitions are permitted based on specific state authorization or in a
supervisory acquisition of a failing savings association.
FEDERAL SECURITIES LAW
The stock of HMN is registered with the SEC under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"). HMN is subject to
the information, proxy solicitation, insider trading restrictions and other
requirements of the SEC under the Exchange Act.
HMN stock held by persons who are affiliates (generally officers,
directors and principal stockholders) of HMN may not be resold without
registration or unless sold in accordance with certain resale restrictions.
If HMN meets specified current public information requirements, each
affiliate of HMN is able to sell in the public market, without registration,
a limited number of shares in any three-month period.
37
<PAGE>
FEDERAL RESERVE SYSTEM
The Federal Reserve Board requires all depository institutions to
maintain non-interest bearing reserves at specified levels against their
transaction accounts (primarily checking, NOW and Super NOW checking
accounts). At December 31, 1998, the Bank was in compliance with these
reserve requirements. The balances maintained to meet the reserve
requirements imposed by the Federal Reserve Board may be used to satisfy
liquidity requirements that may be imposed by the OTS. See "- Liquidity."
Savings associations are authorized to borrow from the Federal Reserve
Bank "discount window," but Federal Reserve Board regulations require
associations to exhaust other reasonable alternative sources of funds,
including FHLB borrowings, before borrowing from the Federal Reserve Bank.
FEDERAL HOME LOAN BANK SYSTEM
The Bank is a member of the FHLB of Des Moines, which is one of 12
regional FHLBs, that administers the home financing credit function of
savings associations. Each FHLB serves as a reserve or central bank for its
members within its assigned region. It is funded primarily from proceeds
derived from the sale of consolidated obligations of the FHLB System. It
makes loans to members (I.E., advances) in accordance with policies and
procedures established by the board of directors of the FHLB. These policies
and procedures are subject to the regulation and oversight of the Federal
Housing Finance Board. All advances from the FHLB are required to be fully
secured by sufficient collateral as determined by the FHLB. In addition, all
long-term advances are required to provide funds for residential home
financing.
As a member, the Bank is required to purchase and maintain stock in the
FHLB of Des Moines. At December 31, 1998, the Bank had $9.8 million in FHLB
stock, which was in compliance with this requirement. In past years, the Bank
has received dividends on its FHLB stock. Over the past five calendar years
such dividends have averaged 7.07% and were 6.62% for calendar year 1998. For
the year ended December 31, 1998, dividends paid by the FHLB of Des Moines to
the Bank totaled $589,000.
Under federal law the FHLBs are required to provide funds for the
resolution of troubled savings associations and to contribute to low and
moderately priced housing programs through direct loans or interest subsidies
on advances targeted for community investment and low- and moderate-income
housing projects. These contributions have affected adversely the level of
FHLB dividends paid and could continue to do so in the future. These
contributions could also have an adverse effect on the value of FHLB stock in
the future. A reduction in value of the Bank's FHLB stock may result in a
corresponding reduction in the Bank's capital.
FEDERAL AND STATE TAXATION
FEDERAL TAXATION. HMN and its subsidiaries file consolidated federal
income tax returns on a calendar year basis using the accrual method of
accounting. Prior to 1996, savings institutions were subject to special bad
debt reserve rules and certain other rules. During this period of time, a
savings institution that held 60% or more of its assets in "qualifying
assets" (as defined in the Internal Revenue Code) was permitted to maintain
reserves for bad debts and to make annual additions to such reserves that
qualified as deductions from taxable income. HMN was in compliance with this
requirement.
A qualifying thrift institution could elect annually to compute its
allowable additions to bad debt reserves under either the percentage of
taxable income method or the experience method. The percentage of taxable
income method of calculating bad debt reserves limited the applicable
percentage deduction to 8% of taxable income and could not cause the reserves
to exceed 6% of qualifying loans at the end of the taxable year. HMN used the
experience method to calculate additions to tax bad debt reserves through tax
year 1995.
38
<PAGE>
Beginning in 1996, the favorable bad debt method described above was
repealed putting savings institutions on the same tax bad debt method as
commercial banks. This legislation required recapture of the amount of the
tax bad debt reserves to the extent that they exceed the adjusted base year
reserve ("the applicable excess reserves"). The applicable excess reserves
are recaptured over a six-year period. This recapture period can be deferred
for a period of up to two years to the extent that a certain residential
lending test is met. HMN has previously provided taxes for the applicable
excess reserves.
In addition to the regular income tax, corporations, including savings
associations such as the Bank, generally are subject to a minimum tax. An
alternative minimum tax is imposed at a minimum tax rate of 20% on
alternative minimum taxable income, which is the sum of a corporation's
regular taxable income (with certain adjustments) and tax preference items,
less any available exemption. The alternative minimum tax is imposed to the
extent it exceeds the corporation's regular income tax and net operating
losses can offset no more than 90% of alternative minimum taxable income.
To the extent earnings appropriated to a savings association's bad debt
reserves for "qualifying real property loans" and deducted for federal income
tax purposes before 1988 exceed the allowable amount of such reserves
computed under the experience method and to the extent of the association's
supplemental reserves for losses on loans ("Excess"), such Excess may not,
without adverse tax consequences, be utilized for the payment of cash
dividends or other distributions to a shareholder (including distributions on
redemption, dissolution or liquidation) or for any other purpose (except to
absorb bad debt losses). As of December 31, 1998, the Bank's Excess for tax
purposes totaled approximately $8.8 million.
HMN was incorporated in 1994 and filed its first consolidated Federal
income tax return with its subsidiaries for the year ended December 31, 1994.
The return required to be filed for 1998 has been extended and will be filed
by September 1999. The Bank and its consolidated subsidiaries have been
audited by the IRS with respect to consolidated federal income tax returns
through December 31, 1983. With respect to years examined by the IRS, either
all deficiencies have been satisfied or sufficient reserves have been
established to satisfy asserted deficiencies. In the opinion of management,
any examination of still open returns (including returns of subsidiaries and
predecessors of, or entities merged into, the Bank) would not result in a
deficiency which could have a material adverse effect on the consolidated
financial condition of HMN.
MINNESOTA TAXATION. HMN and its subsidiaries that operate in Minnesota
are subject to Minnesota state taxation. A Minnesota corporation's income or
loss is allocated based on a three-factor apportionment of the corporation's
Minnesota gross receipts, payroll and property over the total gross receipts,
payroll and property of all corporations in the unitary group. The corporate
tax rate in Minnesota is 9.8%. The Minnesota Alternative Minimum Tax rate is
5.8%.
The Bank and it subsidiaries have not been audited by the Minnesota
taxation authorities.
IOWA TAXATION. On December 5, 1997 the Bank acquired MFC and its
subsidiaries which were located in the state of Iowa. The Bank is now subject
to Iowa Franchise tax on an apportionment basis weighted based upon deposits
located within Iowa to total deposits of the Bank. Income apportioned to Iowa
is subject to a 5% tax rate.
DELAWARE TAXATION. As a Delaware holding company, HMN is exempted from
Delaware corporate income tax but is required to file an annual report with
and pay an annual fee to the State of Delaware. HMN is also subject to an
annual franchise tax imposed by the State of Delaware.
39
<PAGE>
ITEM 2. PROPERTIES
The following table sets forth information concerning the main office
and each branch office of HMN at December 31, 1998. At December 31, 1998,
HMN's premises had an aggregate net book value of approximately $4.6 million.
<TABLE>
<CAPTION>
Year Owned or Net Book Value at
Location Acquired Leased December 31, 1998(1)
- -------------------------- -------- -------- --------------------
(In Thousands)
<S> <C> <C> <C>
CORPORATE OFFICE:
101 North Broadway 1975 Owned 336
Spring Valley, Minnesota
FULL SERVICE BRANCHES:
715 North Broadway 1998 Owned 1,107
Spring Valley, Minnesota
201 Oakland Avenue 1960 Owned 157
Austin, Minnesota
Crossroads Shopping Center 1962 Owned 481
Rochester, Minnesota
4th & Center (2) 1973 Owned 111
Winona, Minnesota
175 Center Street 1998 Owned 1,751
Winona, Minnesota
208 South Walnut 1975 Owned 86
LaCrescent, Minnesota
1110 6th St., NW 1982 Owned 849
Rochester, Minnesota
143 West Clark Street 1993 Owned 568
Albert Lea, Minnesota
303 W. Main St. 1997 Owned 694
Marshalltown, Iowa
110 W. High St. 1997 Leased 2
Toledo, Iowa
29 S. Center 1997 Owned 245
Marshalltown, Iowa
MORTGAGE BANKING/BROKERAGE OFFICES:
7101 Northland Circle, Suite 105 1997 Leased --
Brooklyn Park, Minnesota
</TABLE>
- ---------------
(1) Does not include $2,174,857 of net furniture and equipment distributed
between all of the above offices or its subsidiaries.
(2) The property is the old bank building in Winona and is currently being
held for sale. The portions of the property are being rented on a month
to month basis to tenants.
40
<PAGE>
The Bank's depositor and borrower customer files are maintained by an
independent data processing company. The net book value of the data
processing and computer equipment utilized by the Bank at December 31, 1998
was approximately $462,882.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Bank and HMN are involved as plaintiff or
defendant in various legal proceedings arising in the normal course of its
business. While the ultimate outcome of these various legal proceedings
cannot be predicted with certainty, it is the opinion of management that the
resolution of these legal actions should not have a material effect on HMN's
consolidated financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY
HOLDER MATTERS
The information on pages 21, 52 and the back cover page of the Annual
Report to Security Holders for the year ended December 31, 1998 is
incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
The information on page 11 of the Annual Report to Security Holders for
the year ended December 31, 1998 is incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The information on pages 12 through 28 of the Annual Report to Security
Holders for the year ended December 31, 1998 is incorporated herein by
reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The information on pages 23 through 24 of the Annual Report to Security
Holders for the year ended December 31, 1998 is incorporated herein by
reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information on pages 29 through 52 of the Annual Report to Security
Holders for the year ended December 31, 1998 is incorporated herein by
reference.
41
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information on pages 4 through 5 of the Registrant's definitive
Proxy Statement dated March 23, 1999 is incorporated herein by reference.
See "Business - Executive Officers" in Part I of the Form 10-K for
information regarding executive officers.
ITEM 11. EXECUTIVE COMPENSATION
The information on pages 8 through 12 of the Registrant's definitive
Proxy Statement dated March 23, 1999 is incorporated herein be reference,
except for information contained under the heading "Compensation Committee
Report on Executive Compensation".
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information on pages 2, 3 and 15 of the Registrant's definitive
Proxy Statement dated March 23, 1999 is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
42
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS
1. Financial Statements
The following information appearing in the Registrant's Annual Report
to Security Holders for the year ended December 31, 1998, is
incorporated by reference in this Form 10-K Annual Report as Exhibit
13.
<TABLE>
<CAPTION>
Pages in
1998 Annual
Annual Report Section Report
--------------------- -----------
<S> <C>
Five Year Consolidated Financial Highlights 11
Consolidated Balance Sheets --
December 31, 1998 and 1997 29
Consolidated Statements of Income --
Each of the Years in the Three-Year
Period Ended December 31, 1998 30
Consolidated Statements of Comprehensive Income --
Each of the Years in the Three-Year
Period Ended December 31, 1998 30
Consolidated Statement of Stockholders'
Equity -- Each of the Years in the
Three-Year Period Ended December 31, 1998 31
Consolidated Statements of Cash Flows --
Each of the Years in the Three-Year
Period Ended December 31, 1998 32
Notes to Consolidated Financial Statements 33 - 48
Independent Auditors' Report 49
Selected Quarterly Financial Data 50 - 51
Other Financial Data 52
Common Stock Price Information 52
</TABLE>
2. Financial Statement Schedules
All financial statement schedules have been omitted as information is
not required under the related instructions, is not applicable or has
been included in the Notes to Consolidated Financial Statements.
43
<PAGE>
3. Exhibits
<TABLE>
<CAPTION>
Reference Sequential
to Prior Page Numbering
Filing or Where Attached
Exhibit Exhibits Are
Regulation S-K Number Located in This
Exhibit Number Document Attached Hereto Form 10-K Report
- -------------- ------------------------------------------- --------------- -------------------
<S> <C> <C> <C>
2 Agreement and Plan of Merger 5* Not applicable
dated July 1, 1997
3 (i) Articles of Incorporation 1* Not applicable
Certificate of Incorporation as amended 7*
on April 28, 1998
(ii) By-laws 6* Not applicable
4 Instruments defining the rights of security 1* Not applicable
holders, including indentures
9 Voting trust agreement Not applicable Not applicable
10.1+ Employment Agreement for Mr. Weise 2* Not applicable
dated June 29, 1994
Extension of Employment Contract 8* Not applicable
10.2+ Employment Agreement for Mr. Gardner 2* Not applicable
dated June 29, 1994
Extension of Employment Contract 8* Not applicable
10.3+ Change in Control Severance Agreement 10.3 Filed electronically
for Mr. McNeil dated April 1, 1998
10.4+ Directors Deferred Compensation Plan 2* Not applicable
10.5+ 1995 Recognition and Retention Plan 3* Not applicable
Amended and Restated HMN Financial, Inc. 9* Not applicable
Recognition and Retention Plan dated
July 29, 1998
10.6+ 1995 Stock Option and Incentive Plan 3* Not applicable
Amended and Restated HMN Financial, Inc. 9* Not applicable
Stock Option and Incentive Plan dated
July 29, 1998
11 Statement re: Computation of per share 11 Filed electronically
earnings
12 Statement re: Computation of ratios Not applicable Not applicable
</TABLE>
+Management contract of compensatory arrangement.
44
<PAGE>
<TABLE>
<CAPTION>
Reference Sequential
to Prior Page Numbering
Filing or Where Attached
Exhibit Exhibits Are
Regulation S-K Number Located in This
Exhibit Number Document Attached Hereto Form 10-K Report
- -------------- ------------------------------------------- --------------- -------------------
<S> <C> <C> <C>
13 Annual Report to Security Holders 13 Filed electronically
16 Letter re: Change in certifying accountant Not applicable Not applicable
18 Letter re: Change in accounting principles Not applicable Not applicable
21 Subsidiaries of Registrant 21 Filed electronically
22 Published report regarding matters Not applicable Not applicable
submitted to vote of security holders
23 Consent of KPMG Peat Marwick LLP 23 Filed electronically
dated March 30, 1999
24 Power of Attorney Not applicable Not applicable
27 Financial Data Schedule 27 Filed electronically
Year ended 1998
99 Additional exhibits None Not applicable
</TABLE>
- ------------------
1* Filed April 1, 1994, as exhibits to the Registrant's Form S-1 registration
statement (Registration No. 33-77212) pursuant to the Securities Act of
1933. All of such previously filed documents are hereby incorporated
herein by reference in accordance with Item 601 of Regulation S-K.
2* Filed as an exhibit to the Registrant's Form 10-K for 1994 (file no.
0-24100). All previously filed documents are hereby incorporated by
reference in accordance with Item 601 of Regulation S-K.
3* Filed as an exhibit to the Registrant's Form 10-K for 1995 (file no.
0-24100). All previously filed documents are hereby incorporated by
reference in accordance with Item 601 of Regulation S-K.
4* Filed as an exhibit to the Registrant's Form 10-K for 1996 (file no.
0-24100). All previously filed documents are hereby incorporated by
reference in accordance with Item 601 of Regulation S-K.
5* Filed as an exhibit to Current Report of Form 8-K dated July 1, 1997, filed
on July 10, 1997. All previously filed documents are hereby incorporated by
reference.
6* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of
1997 (file no. 0-24100). All previously filed documents are hereby
incorporated by reference.
7* Filed as an exhibit to the Registrant's Form 10-Q for the first quarter of
1998 (file no. 0-24100). All previously filed documents are hereby
incorporated by reference.
8* Filed as an exhibit to the Registrant's Form 10-Q for the second quarter of
1998 (file no. 0-24100). All previously filed documents are hereby
incorporated by reference.
9* Filed as an exhibit to the Registrant's Form 10-Q for the third quarter of
1998 (file no. 0-24100). All previously filed documents are hereby
incorporated by reference.
45
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
HMN FINANCIAL, INC.
Date: March 30, 1999 By: /s/ Roger P. Weise
----------------------------- -----------------------------
Roger P. Weise
(Duly Authorized Representative)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
By: /s/ Roger P. Weise By: /s/ James B. Gardner
----------------------------- -----------------------------
Roger P. Weise, Chairman of James B. Gardner,
the Board, President and Chief Executive Vice President
Executive Officer (Principal and Director
Executive and Operating Officer) (Principal Financial Officer)
Date: March 30, 1999 Date: March 30, 1999
----------------------------- -----------------------------
By: /s/ Irma R. Rathbun By: /s/ Timothy R. Geisler
----------------------------- -----------------------------
Irma R. Rathbun, Director Timothy R. Geisler, Director
Date: March 30, 1999 Date: March 30, 1999
----------------------------- -----------------------------
By: /s/ M. F. Schumann By: /s/ Duane D. Benson
----------------------------- -----------------------------
M.F. Schumann, Director Duane D. Benson, Director
Date: March 30, 1999 Date: March 30, 1999
----------------------------- -----------------------------
By: /s/ Timothy P. Johnson
-----------------------------
Timothy P. Johnson,
Vice President and Treasurer
(Principal Accounting Officer)
Date: March 30, 1999
-----------------------------
46
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Sequential
Page Numbering
Where Attached
Exhibits Are
Regulation S-K Located in This
Exhibit Number Document Form 10-K Report
- -------------- --------- -------------------
<S> <C> <C>
10.3 Change in Control Severence Agreement for Filed electronically
Michael McNeil dated April 1, 1998
11 Statement re: Computation of per share earnings Filed electronically
13 Annual Report to Security Holders Filed electronically
21 Subsidiaries of Registrant Filed electronically
23 Consent of KPMG Peat Marwick LLP Filed electronically
dated March 30, 1999
27 Financial Data Schedule Filed electronically
Year ended 1998
</TABLE>
<PAGE>
Exhibit 10.3
CHANGE IN CONTROL SEVERANCE AGREEMENT
THIS CHANGE IN CONTROL SEVERANCE AGREEMENT ("Agreement") is made and
entered into as of this 1st day of April 1998, by and between HOME FEDERAL
SAVINGS BANK, a federally chartered savings institution (which, together with
any successor thereto which executes and delivers the assumption agreement
provided for in Section ll(a) hereof or which otherwise becomes bound by the
terms and provisions of this Agreement by operation of law, is hereinafter
referred to as the "Company"), and Michael McNeil (the "Employee").
WHEREAS, the Employee is currently serving as Senior Vice President of the
Company; and
WHEREAS, the Company is a federally chartered stock savings bank and the
wholly-owned subsidiary of HMN Financial, Inc. (the "Holding Company"); and
WHEREAS, the Board of Directors of the Company recognizes that, as is the
case with publicly held corporations generally, the possibility of a change in
control of the Company or Holding Company may exist and that such possibility,
and the uncertainty and questions which it may raise among management, may
result in the departure or distraction of key management personnel to the
detriment of the Company, the Holding Company and their respective stockholders;
and
WHEREAS, the Board of Directors of the Company believes it is in the best
interests of the Company to enter into this Agreement with the Employee in order
to assure continuity of management of the Company and to reinforce and encourage
the continued attention and dedication of the Employee to the Employee's
assigned duties without distraction in the face of potentially disruptive
circumstances arising from the possibility of a change in control of the Company
or the Holding Company, although no such change is now contemplated; and
WHEREAS, the Board of Directors of the Company has approved and authorized
the execution of this Agreement with the Employee to take effect as stated in
Section 1 hereof;
NOW, THEREFORE, in consideration of the foregoing and of the respective
covenants and agreements of the parties herein contained, it is AGREED as
follows:
1. TERM OF AGREEMENT.
The term of this Agreement shall be deemed to have commenced as of the date
of the execution of this agreement and shall continue for a period of thirty
(30) full calendar months thereafter. Commencing on the first anniversary of
the execution of this agreement and on each anniversary thereafter, this
<PAGE>
Agreement shall be extended for a period of twelve (12) months in addition to
the then-remaining term of employment under this Agreement, unless either the
Company or the Employee gives contrary written notice to the other not less than
90 days in advance of the date on which the term of employment under this
Agreement would otherwise be extended, and PROVIDED THAT no extension shall
occur unless prior to each anniversary of the Execution Date, the Board of
Directors of the Company has reviewed a formal evaluation of the Employee's
performance during the year preceding such anniversary prepared by the
disinterested members of the Board of Directors of the Company and explicitly
approved such extension of the term of this Agreement.
2. PAYMENTS TO THE EMPLOYEE UPON CHANGE IN CONTROL.
(a) Upon the occurrence of a Change in Control (as herein defined) of the
Company or the Holding Company followed at any time during the term of this
Agreement by the involuntary termination of the Employee's employment, other
than for cause, as defined in Section 2(d) hereof, the provisions of Section 3
shall apply.
(b) A "change in control" of the Company or the Holding Company is defined
solely as any acquisition of control (other than by a trustee or other fiduciary
holding securities under an employee benefit plan of the Holding Company or a
subsidiary of the Holding Company), as defined in 12 C.F.R. Section 574.4, or
any successor regulation, of the Company or Holding Company which would require
the filing of an application for acquisition of control or notice of change in
control in a manner as set forth in 12 C.F.R. Section 574.3, or any successor
regulation.
(c) The Employee's employment under this Agreement may be terminated at
any time by the Board of Directors of the Company. The terms "involuntary
termination" or "involuntarily terminated" in this Agreement shall refer to the
termination of the employment of Employee without the Employee's express written
consent. In addition, any of the following actions, shall constitute involuntary
termination of employment unless consented to in writing by the Employee: (1)
change in the principal workplace of the Employee to a location outside of a 20
mile radius from the Company's headquarters office as of the date hereof; (2) a
material demotion of the Employee or material adverse change in the salary,
perquisites, benefits, contingent benefits or vacation time which had
theretofore been provided to the Employee, other than as part of an overall
program applied uniformly and with equitable effect to all members of the senior
management of the Company or-the Holding Company; and (3) a material permanent
increase in the required hours of work or the workload of the Employee.
(d) The Employee shall not have the right to receive termination benefits
pursuant to Section 3 hereof upon termination for cause. For purposes of this
Agreement, termination for "cause" shall include termination for personal
dishonesty, incompetence, willful misconduct, breach of a fiduciary duty
involving personal
<PAGE>
profit, intentional failure to perform stated duties, willful violation of any
material law, rule, or regulation (other than a law, rule or regulation relating
to a traffic violation or similar offense) or final cease-and-desist order, or
material breach of any provision of this Agreement.
3. TERMINATION BENEFITS.
(a) Upon the occurrence of a change in control, followed by the
involuntary termination of the Employee's employment, other than for cause, the
Company shall pay to the Employee in a lump sum in cash within 25 business days
after the date of severance of employment an amount equal to 299 percent of the
Employee's "base amount" of compensation, as defined in Section 280G(b)(3) of
the Internal Revenue Code of 1986, as amended ("Code"). At the election of
the Employee, such payment may be made, on a pro rata basis, semi-monthly during
the twelve (12) months following the Employee's termination.
(b) Upon the occurrence of a change in control of the Company or the
Holding Company followed by the involuntary termination of the Employee's
employment, other than for cause, the Company shall cause life and health
insurance coverage substantially similar to the coverage maintained by the
Company for the Employee immediately prior to such termination to be maintained
for a period of twelve (12) months or for the remaining term of this Agreement,
whichever is greater.
4. CERTAIN REDUCTION OF PAYMENTS BY THE COMPANY.
(a) Anything in this Agreement to the contrary notwithstanding, in the
event it shall be determined that any payment or distribution by the Company
to or for the benefit of the Employee (whether paid or payable or distributed
or distributable pursuant to the terms of this Agreement or otherwise) (a
"Payment") would be nondeductible (in whole or part) by the Company for
Federal income tax purposes because of Section 28OG of the Code, then the
aggregate present value of amounts payable or distributable to or for the
benefit of the Employee pursuant to this Agreement (such amounts payable or
distributable pursuant to this Agreement are hereinafter referred to as
"Agreement Payments") shall be reduced to the Reduced Amount. The "Reduced
Amount" shall be an amount, not less than zero, expressed in present value
which maximizes the aggregate present value of Agreement Payments without
causing any Payment to be nondeductible by the Company because of Section
280G of the Code. For purposes of this Section 4, present value shall be
determined in accordance with Section 280G(d)(4) of the Code.
(b) All determinations required to be made under this Section 4 shall be
made by the Company's independent auditors, or at the election of such auditors
by such other firm or individuals of recognized expertise as such auditors may
select (such auditors or, if applicable, such other firm or individual, are
hereinafter
<PAGE>
referred to as the "Advisory Firm"). The Advisory Firm shall within ten business
days of the Date of Termination, or at such earlier time as is requested by the
Company, provide to both the Company and the Employee an opinion (and detailed
supporting calculations) that the Company has substantial authority to deduct
for federal income tax purposes the full amount of the Agreement Payments and
that the Employee has substantial authority not to report on his/her federal
income tax return any excise tax imposed by Section 4999 of the Code with
respect to the Agreement Payments. Any such determination and opinion by the
Advisory Firm shall be binding upon the Company and the Employee. The Employee
shall determine which and how much, if any, of the Agreement Payments shall be
eliminated or reduced consistent with the requirements of this Section 4,
provided that, if the Employee does not make such determination within ten
business days of the receipt of the calculations made by the Advisory Firm, the
Company shall elect which and how much, if any, of the Agreement Payments shall
be eliminated or reduced consistent with the requirements of this Section 4 and
shall notify the Employee promptly of such election. Within five business days
of the earlier of (i) the Company's receipt of the Employee's determination
pursuant to the immediately preceding sentence of this Agreement or (ii) the
Company's election in lieu of such determination, the Company shall pay to or
distribute to or for the benefit of the Employee such amounts as are then due
the Employee under this Agreement. The Company and the Employee shall cooperate
fully with the Advisory Firm, including without limitation providing to the
Advisory Firm all information and materials reasonably requested by it, in
connection with the making of the determinations required under this Section 4.
(c) As a result of uncertainty in application of Section 28OG of the Code
at the time of the initial determination by the Advisory Firm hereunder, it is
possible that Agreement Payments will have been made by the Company which should
not have been made ("Overpayment") or that additional Agreement Payments will
not have been made by the Company which should have been made ("Underpayment"),
in each case, consistent with the calculations required to be made hereunder.
In the event that the Advisory Firm, based upon the assertion by the Internal
Revenue Service against the Employee of a deficiency which the Advisory Firm
believes has a high probability of success determines that an Overpayment has
been made, any such Overpayment paid or distributed by the Company to or for the
benefit of Employee shall be treated for all purposes as a loan AB INITIO which
the Employee shall repay to the Company together with interest at the applicable
federal rate provided for in Section 7872(f)(2) of the Code; provided, however,
that no such loan shall be deemed to have been made and no amount shall be
payable by the Employee to the Company if and to the extent such deemed loan and
payment would not either reduce the amount on which the Employee is subject to
tax under Section 1 and Section 4999 of the Code or generate a refund of such
taxes. In the event that the Advisory Firm, based upon controlling preceding
or other substantial authority, determines that an Underpayment has
<PAGE>
occurred, any such Underpayment shall be promptly paid by the Company to or for
the benefit of the Employee together with interest at the applicable federal
rate provided for in Section 7872(f)(2) of the Code.
5. REQUIRED REGULATORY PROVISIONS.
(a) The Company may terminate the Employee's employment at any time, but
any termination by the Company, other than a termination for cause, shall not
prejudice the Employee's right to compensation or other benefits under this
Agreement. The Employee shall not have the right to receive compensation or
other benefits for any period after a termination for cause as defined in
Section 2(d) hereinabove.
(b) If the Employee is suspended from office and/or temporarily prohibited
from participating in the conduct of the Company's affairs by a notice served
under Section 8(e)(3) or (g)(1) of the Federal Deposit Insurance Act ("FDIA"),
12 U.S.C. Section 1818(e)(3) and (g)(l), the Company's obligations under this
Agreement shall be suspended as of the date of service, unless stayed by
appropriate proceedings. If the charges in the notice are dismissed, the
Company may in its discretion (i) pay the Employee all or part of the
compensation withheld while its obligations under this Agreement were suspended,
and (ii) reinstate in whole or in part any of the obligations which were
suspended.
(c) If the Employee is removed from office and/or permanently
prohibited from participating in the conduct of the Company's affairs by an
order issued under Section 8(e)(4) or (g)(l) of the FDIA, 12 U.S.C. Section
1818(e)(4) or (g)(l), all obligations of the Company under this Agreement
shall terminate, as of the effective date of the order, but vested rights of
the parties shall not be affected.
(d) If the Company becomes in default (as defined in Section 3(x)(1) of
the FDIA), all obligations under this Agreement shall terminate as of the date
of default, but this provision shall not affect any vested rights of the
parties.
(e) All obligations under this Agreement may be terminated, except to the
extent determined that continuation of this Agreement is necessary for the
continued operation of the Company: (i) by the Director or his or her
designee, at the time the Federal Deposit Insurance Corporation enters into an
agreement to provide assistance to or on behalf of the Company under the
authority contained in Section 13(c) of the FDIA, or (ii) by the Director of the
Office of Thrift Supervision ("Director") or his or her designee at the time the
Director or his or her designee approves a supervisory merger to resolve
problems related to operation of the Company or when the Company is determined
by the Director to be in an unsafe or unsound condition. Any rights of the
parties that have already vested, however, shall not be affected by any such
action.
<PAGE>
6. REINSTATEMENT OF BENEFITS UNDER SECTION 5(b).
In the event the Employee is suspended and/or temporarily prohibited
from participating in the conduct of the Company's affairs by a notice
described in Section 5(b) hereof (the "Notice") during the term of this
Agreement and a change in control occurs, the Company will assume its
obligation to pay and the Employee will be entitled to receive all of the
termination benefits provided for under Section 3 of this Agreement upon the
Company's receipt of a dismissal of charges in the Notice.
7. EFFECT ON PRIOR AGREEMENTS AND EXISTING BENEFIT PLANS.
This Agreement contains the entire understanding between the parties hereto
and supersedes any prior agreement between the Company and the Employee, except
that this Agreement shall not affect or operate to reduce any benefit or
compensation inuring to the Employee of a kind elsewhere provided. No provision
of this Agreement shall be interpreted to mean that the Employee is subject to
receiving fewer benefits than those available to him without reference to this
Agreement.
8 NO ATTACHMENT.
(a) Except as required by law, no right to receive payments under this
Agreement shall be subject to anticipation, commutation, alienation, sale,
assignment, encumbrance, charge, pledge, or hypothecation, or to execution,
attachment, levy, or similar process or assignment by operation of law, and
any attempt, voluntary or involuntary, to affect any such action shall be null,
void, and of no effect.
(b) This Agreement shall be binding upon, and inure to the benefit of,
the Employee, the Company and their respective successors and assigns.
9. MODIFICATION AND WAIVER.
(a) This Agreement may not be modified or amended except by an instrument
in writing signed by the parties hereto.
(b) No term or condition of this Agreement shall be deemed to have been
waived, nor shall there be any estoppel against the enforcement of any provision
of this Agreement, except by written instrument of the party charged with such
waiver or estoppel. No such written waiver shall be deemed a continuing waiver
unless specifically stated therein, and each such waiver shall operate only as
to the specific term or condition waived and shall not constitute a waiver of
such term or condition for the future or as to any act other than that
specifically waived.
10. NO MITIGATION.
The amount of any payment or benefit provided for in this
<PAGE>
Agreement shall not be reduced by any compensation earned by the Employee as the
result of employment by another employer, by retirement benefits after the date
of termination or otherwise.
11. NO ASSIGNMENTS.
(a) This Agreement is personal to each of the parties hereto, and
neither party may assign or delegate any of its rights or obligations
hereunder without first obtaining the written consent of the other party;
provided, however, that the Company will require any successor or assign
(whether direct or indirect, by purchase, merger, consolidation or otherwise)
to all or substantially all of the business and/or assets of the Company, by
an assumption agreement in form and substance satisfactory to the Employee,
to expressly assume and agree to perform this Agreement in the same manner
and to the same extent that the Company would be required to perform it if no
such succession or assignment had taken place. Failure of the Company to
obtain such an assumption agreement prior to the effectiveness of any such
succession or assignment shall be a breach of this Agreement and shall
entitle the Employee to compensation from the Company in the same amount and
on the same terms as the compensation pursuant to Section 3 hereof. For
purposes of implementing the provisions of this Section 11(a), the date on
which any such succession becomes effective shall be deemed the Date of
Termination.
(b) This Agreement and all rights of the Employee hereunder shall inure to
the benefit of and be enforceable by the Employee's personal and legal
representatives, executors, administrators, successors, heirs, distributees,
devisees and legatees. If the Employee should die while any amounts would
still be payable to the Employee hereunder if the Employee had continued to
live, all such amounts, unless otherwise provided herein, shall be paid in
accordance with the terms of this Agreement to the Employee's devisee, legatee
or other designee or if there is no such designee, to the Employee's estate.
12. NOTICE.
For the purposes of this Agreement, notices and all other communications
provided for in the Agreement shall be in writing and shall be deemed to have
been duly given when personally delivered or sent by certified mail, return
receipt requested, postage prepaid, addressed to the Company at its main office
to the attention of the Board of Directors of the Company with a copy to the
Secretary of the Company, or, if to the Employee, at such home or other address
as the Employee has most recently furnished in writing to the Company.
13. AMENDMENTS.
No amendments or additions to this Agreement shall be binding unless in
writing and signed by both parties, except as herein otherwise provided.
<PAGE>
14. PARAGRAPH HEADINGS.
The paragraph headings used in this Agreement are included solely for
convenience and shall not affect, or be used in connection with, the
interpretation of this Agreement.
15. SEVERABILITY.
The provisions of this Agreement shall be deemed severable and the
invalidity or unenforceability of any provision shall not affect the validity or
enforceability of the other provisions hereof.
16. GOVERNING LAW.
This Agreement shall be governed by the laws of the United States to the
extent applicable and otherwise by the laws of the State of Minnesota.
17. ARBITRATION.
Any dispute or controversy arising under or in connection with this
Agreement shall be settled exclusively by arbitration in accordance with the
rules of the American Arbitration Association then in effect. Judgment may be
entered on the arbitrator's award in any court having jurisdiction.
18. REIMBURSEMENT.
In the event the Company purports to terminate the Employee for cause, but
it is determined by a court of competent jurisdiction or by an arbitrator
pursuant to Section 17 that cause did not exist for such termination, or if in
any event it is determined by any such court or arbitrator that the Company has
failed to make timely payment of any amounts owed to the Employee under this
Agreement, the Employee shall be entitled to reimbursement for all reasonable
costs, including attorneys' fees, incurred in challenging such termination
or collecting such amounts. Such reimbursement shall be in addition to all
rights to which the Employee is otherwise entitled under this Agreement.
<PAGE>
IN WITNESS WHEREOF, the parties have executed this Agreement as of the day
and year first above written.
THIS AGREEMENT CONTAINS A BINDING ARBITRATION PROVISION WHICH
MAY BE ENFORCED BY THE PARTIES.
ATTEST: HOME FEDERAL SAVINGS BANK
/s/ Roxanne M. Hellickson By: /s/ Roger P. Weise
- ------------------------- ---------------------------
Secretary
WITNESS: EMPLOYEE
/s/ Carol Thouin /s/ Michael McNeil
- ------------------------- ---------------------------
Michael McNeil
<PAGE>
EXHIBIT 11
HMN FINANCIAL, INC.
COMPUTATION OF EARNINGS PER COMMON SHARE
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------
Computation of Earnings Per Common Share: 1998 1997 1996
--------------------------------------------
<S> <C> <C> <C>
Weighted average number of common shares out-
standing used in basic earnings per common
share calculation............................................ 4,923,392 5,525,033 6,473,115
Net dilutive effect of:
Options...................................................... 323,593 314,082 82,257
Restricted stock awards...................................... 51,141 76,151 100,505
---------- ----------- ----------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities .................. 5,298,126 5,915,266 6,655,877
---------- ----------- ----------
---------- ----------- ----------
Income available to common shareholders ..................... $ 4,057,680 5,578,866 4,274,349
Basic earnings per common share............................... $ 0.82 1.01 0.66
Diluted earnings per common share............................. $ 0.77 0.94 0.64
</TABLE>
<PAGE>
FIVE-YEAR CONSOLIDATED FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------------------
SELECTED OPERATIONS DATA:(1)
Year Ended December 31,
------------------------------------------------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Total interest income. . . . . . . . . . . . . . . . . . . . . . $48,795 41,090 39,864 38,328 32,277
Total interest expense . . . . . . . . . . . . . . . . . . . . . 31,898 25,643 24,194 22,555 18,067
------- ------- ------- ------- -------
Net interest income. . . . . . . . . . . . . . . . . . . . . . 16,897 15,447 15,670 15,773 14,210
Provision for loan losses. . . . . . . . . . . . . . . . . . . . 310 300 300 300 410
------- ------- ------- ------- -------
Net interest income after provision for loan losses. . . . . . 16,587 15,147 15,370 15,473 13,800
------- ------- ------- ------- -------
Fees and service charges . . . . . . . . . . . . . . . . . . . . 855 487 359 325 311
Securities gains, net. . . . . . . . . . . . . . . . . . . . . . 2,799 1,250 1,030 416 65
Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . 2,177 469 39 102 3
Earnings (loss) in limited partnerships. . . . . . . . . . . . . (3,725) 220 7 0 0
Other non-interest income. . . . . . . . . . . . . . . . . . . . 524 296 488 155 216
------- ------- ------- ------- -------
Total non-interest income. . . . . . . . . . . . . . . . . . . 2,630 2,722 1,923 998 595
SAIF assessment. . . . . . . . . . . . . . . . . . . . . . . . . 0 0 2,352 0 0
Other non-interest expense . . . . . . . . . . . . . . . . . . . 13,160 9,022 8,157 7,470 6,574
------- ------- ------- ------- -------
Total non-interest expense . . . . . . . . . . . . . . . . . . 13,160 9,022 10,509 7,470 6,574
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . 1,999 3,268 2,510 3,381 3,116
------- ------- ------- ------- -------
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,058 5,579 4,274 5,620 4,705
------- ------- ------- ------- -------
------- ------- ------- ------- -------
Per common share and common share equivalents: . . . . . . . . .
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.82 1.01 0.66 0.73
Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.77 0.94 0.64 0.73
Earnings (1994: June 29 through December 31) . . . . . . . . . 0.32
Pro forma earnings (January 1 through December 31) . . . . . . 0.57
<CAPTION>
SELECTED FINANCIAL CONDITION DATA:(1)
December 31,
-------------------------------------------------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $694,658 691,232 554,732 537,949 494,868
Securities available for sale. . . . . . . . . . . . . . . . . . 181,625 205,859 175,830 190,320 183,512
Securities held to maturity. . . . . . . . . . . . . . . . . . . 0 0 2,806 16,972 12,678
Loans held for sale. . . . . . . . . . . . . . . . . . . . . . . 13,095 2,287 739 0 0
Loans receivable, net. . . . . . . . . . . . . . . . . . . . . . 447,455 442,069 349,022 314,851 271,000
Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433,869 467,348 362,477 373,539 350,575
Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . 185,400 127,650 106,079 68,877 51,986
Stockholders' equity . . . . . . . . . . . . . . . . . . . . . . 68,445 84,470 82,099 91,687 89,047
Book value per share . . . . . . . . . . . . . . . . . . . . . . 12.93 13.59 12.34 11.53 9.75
Tangible book value per share. . . . . . . . . . . . . . . . . . 11.87 12.62 12.34 11.53 9.75
Number of full service offices . . . . . . . . . . . . . . . . . 10 10 7 7 7
Number of mortgage origination offices . . . . . . . . . . . . . 1 2 1 0 0
Key Ratios(2)
Stockholders' equity to total assets at year end . . . . . . . . 9.85% 12.22% 14.80% 17.04% 17.99%
Average stockholders' equity to average assets . . . . . . . . . 10.63 14.36 16.12 18.24 14.57
Return on stockholders' equity
(ratio of net income to average equity). . . . . . . . . . . . 5.38 6.84 4.82 5.86 6.86
Return on assets
(ratio of net income to average assets). . . . . . . . . . . . 0.57 0.98 0.78 1.07 1.00
Dividend payout ratio. . . . . . . . . . . . . . . . . . . . . . 36.62 0.00 0.00 0.00 0.00
- --------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) HMN Financial, Inc. (HMN) completed a public stock offering on June 29,
1994, which generated net proceeds of $59.2 million. HMN purchased all of
the stock of Home Federal Savings Bank (the Bank) with a portion of the
conversion proceeds. The information represents the financial condition and
the results of operations for the consolidated HMN for 1998, 1997, 1996,
1995 and 1994.
(2) Average balances were calculated based upon amortized cost without the
market value impact of SFAS 115.
On December 5, 1997 HMN acquired Marshalltown Financial Corporation, refer to
Note 2 of the Notes to Consolidated Financial Statements for details on the
acquisition.
- -------------------------------------------------------------------------------
11
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
FINANCIAL REVIEW
The financial review presents management's discussion and analysis of the
consolidated financial condition and results of operations of HMN Financial,
Inc. and subsidiaries (HMN). This review should be read in conjunction with the
consolidated financial statements and other financial data beginning on page 29.
GENERAL
HMN was incorporated under the laws of the State of Delaware for the purpose of
becoming the savings and loan holding company of Home Federal Savings Bank (the
Bank) in connection with the Bank's conversion from a federally chartered mutual
savings bank to a federally chartered stock savings bank, pursuant to its plan
of conversion. The conversion was completed on June 29, 1994. Refer to Note 19
of the Notes to Consolidated Financial Statements for more information regarding
the Bank's stock conversion.
HMN's net income is dependent primarily on its net interest income, which
is the difference between interest earned on its loans and investments and the
interest paid on interest-bearing liabilities. Net interest income is determined
by (i) the difference between the yield earned on interest-earning assets and
rates paid on interest-bearing liabilities (interest rate spread) and (ii) the
relative amounts of interest-earning assets and interest-bearing liabilities.
HMN's interest rate spread is affected by regulatory, economic and competitive
factors that influence interest rates, loan demand and deposit flows. Net
interest margin is calculated by dividing net interest income by the average
interest-earning assets and is normally expressed as a percentage. Net interest
income and net interest margin are affected by changes in interest rates, the
volume and the mix of interest-earning assets and interest-bearing liabilities,
and the level of non-performing assets. HMN's net income is also affected by the
generation of non-interest income, which primarily consists of gains from the
sale of securities, gains from the sale of loans, service charges, fees,
earnings or losses in limited partnership investments and other income. In
addition, net income is also affected by the level of operating expenses,
provisions made for loan losses and impairment reserve adjustments required on
mortgage servicing assets.
The operations of financial institutions, including the Bank, are
significantly affected by prevailing economic conditions, competition and the
monetary and fiscal policies of governmental agencies. Lending activities are
influenced by the demand for and supply of housing, 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
primarily on competing investments, account maturities and the levels of
personal income and savings in the market area of the Bank. The interest rates
charged by the Federal Home Loan Bank (FHLB) on advances to the Bank also have a
significant impact on the Bank's overall cost of funds.
In May of 1998, HMN completed a three-for-two stock split in the form of a
fifty percent stock dividend to its stock holders. Refer to Notes 1 and 17 of
the Notes to Consolidated Financial Statements for more information regarding
the impact of the stock split.
RESULTS OF OPERATIONS
Net income for the year ended December 31, 1998 was $4.1 million, compared to
$5.6 million for 1997 and $4.3 million for 1996. Basic earnings per share was
$0.82 for the year ended December 31, 1998, compared to $1.01 for 1997 and $0.66
per share for 1996. Diluted earnings per share was $0.77 for the year ended
December 31, 1998, compared to $0.94 for 1997 and $0.64 for 1996.
During the majority of 1998 the interest rates that were being charged on
first mortgage loans were extremely low. As a result of the low interest rate
environment many people financed new home purchases or refinanced their current
home. The new home purchase activity and the refinancing activity caused many
existing mortgage loans to be paid off before the contractual maturity dates of
the loans. The increased prepayments caused the projected value of many mortgage
servicing assets to decline. As the result of the decline in value of mortgage
servicing assets during 1998, HMN increased its valuation reserves on mortgage
servicing assets, increased its amortization on mortgage servicing assets and
recognized its proportionate share of losses on a limited partnership investment
after the partnership established valuation reserves on its mortgage servicing
assets; resulting in an aggregate pretax charge to income of $4.3 million. The
charge reduced diluted earnings per share by $0.54.
In comparing the year ended December 31, 1998 to the year ended December
31, 1997, net interest income increased by $1.4 million primarily due to the
increase in interest-earning assets and interest-bearing liabilities that were
acquired during the December 5, 1997 merger with Marshalltown Financial
Corporation (MFC) and a low interest rate environment. Non-interest income for
1998 increased by $3.9 million due to an increase in fees, service charges and
other income; increased net gains on the sale of securities and increased gain
on the sale of loans. The increase in non-interest income was entirely offset by
the increase in losses recognized on limited partnership investments of $3.9
million. Non-interest expense increased by $4.2 million primarily due to a
larger work force, more retail banking locations and other increased operating
costs primarily related to the MFC merger; the additional staff for a commercial
lending office and the mortgage banking operations; and an increase in
amortization expense on mortgage servicing assets.
In comparing the year ended December 31, 1997 to the year ended December
31, 1996, net interest income declined by $223,000 primarily due to a decline in
net interest-earning assets. Non-interest income increased by $800,000 primarily
due to increased net gains recognized on the sale of loans and securities and
increased revenue from fees and service charges. Non-interest expense declined
by $1.4 million primarily due to reduced Federal Deposit Insurance Corporation
(FDIC) premiums and the fact that there was not a Savings Association Insurance
Fund (SAIF) charge in 1997,
12
<PAGE>
while there was a large charge in 1996. In September of 1996, Congress enacted
the SAIF legislation which assessed a one time charge against all SAIF insured
institutions in order to recapitalize the fund. The Bank was assessed $2.35
million which was charged directly to earnings and reduced after tax earnings by
$1.46 million. The decline in non-interest expense due to the FDIC premiums and
the SAIF assessment was partially offset by increases in compensation and
benefits, occupancy and other non-interest expenses.
Return on average assets was 0.57%, 0.98%, and 0.78%, for 1998, 1997 and
1996, respectively. Return on average equity was 5.38%, 6.84%, and 4.82%, for
1998, 1997 and 1996, respectively. The impact of recording the $3.6 million loss
on limited partnership investment caused 1998 return on average assets to
decline by 0.34% and 1998 return on average equity to decline by 3.22%. The
return on average assets for 1996, excluding the SAIF assessment, was 1.04%.
NET INTEREST INCOME
HMN's net income is dependent primarily on its net interest income, which is the
difference between interest earned on securities, loans and other
interest-earning assets (interest income) and interest paid respectively on
deposits and Federal Home Loan Bank advances (interest expense). Net interest
margin is calculated by dividing net interest income by the average
interest-earning assets. The arithmetic difference between the yield on
interest-earning assets and the cost of interest-bearing liabilities expressed
as a percentage is referred to as the net interest rate spread.
The following table presents the total dollar amount of interest income
from average interest-earning assets and the resultant yields, as well as the
interest expense on average interest-bearing liabilities, expressed both in
dollars and rates. Non-accruing loans have been included in the table as loans
carrying a zero yield.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------------------------------------------------------------
1998 1997 1996
----------------------------- ----------------------------- ----------------------------
Average Interest Average Interest Average Interest
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(DOLLARS IN THOUSANDS) Balance Paid Rate Balance Paid Rate Balance Paid Rate
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING ASSETS:
Securities available for sale:
Mortgage-backed and
related securities. . . . . . . . . $139,647 8,830 6.32% $121,805 8,256 6.78% $148,400 10,027 6.76%
Other marketable securities(1) . . . . 64,222 3,869 6.02 61,977 3,699 5.97 40,549 2,425 5.98
Securities held to maturity:
Mortgage-backed and
related securities. . . . . . . . . 0 0 0.00 379 33 8.82 10,160 765 7.53
Other marketable securities. . . . . . 0 0 0.00 167 10 6.00 1,861 104 5.61
Loans held for sale. . . . . . . . . . . 6,832 387 5.67 2,426 175 7.22 107 8 7.61
Loans receivable, net(2) . . . . . . . . 453,292 34,687 7.65 355,657 28,154 7.92 324,851 25,713 7.92
Federal Home Loan Bank stock . . . . . . 8,898 589 6.62 6,007 421 7.00 4,671 328 7.01
Other interest-earning assets
including cash equivalents . . . . . . 10,501 433 4.12 8,413 342 4.07 11,039 494 4.48
-------- ------ -------- ------ -------- ------
Total interest-earning assets. . . . . . $683,392 48,795 7.14 $556,831 41,090 7.38 $541,638 39,864 7.36
-------- ------ ---- -------- ------ ----- -------- ------ -----
-------- ------ -------- ------ -------- ------
INTEREST-BEARING LIABILITIES:
Noninterest checking . . . . . . . . . . $ 7,297 0 0.00% $ 2,626 0 0.00% $ 2,016 0 0.00%
NOW accounts . . . . . . . . . . . . . . 22,391 283 1.26 17,306 257 1.49 16,051 323 2.01
Passbooks. . . . . . . . . . . . . . . . 35,992 817 2.27 29,893 763 2.55 30,295 760 2.51
Money market accounts. . . . . . . . . . 28,020 964 3.44 16,879 490 2.90 17,724 501 2.83
Certificate accounts . . . . . . . . . . 359,239 20,034 5.58 303,926 17,546 5.77 299,903 17,366 5.79
Federal Home Loan
Bank advances. . . . . . . . . . . . . 172,249 9,788 5.68 112,500 6,587 5.85 89,656 5,244 5.85
Other borrowed money . . . . . . . . . . 163 12 7.36 0 0 0.00 0 0 0.00
-------- ------- -------- ------ -------- ------
Total interest-bearing liabilities . . . $625,351 31,898 5.10 $483,130 25,643 5.31 $455,645 24,194 5.31
-------- ------- ---- -------- ------ ----- -------- ------ -----
-------- ------- -------- ------ -------- ------
Net interest income. . . . . . . . . . . 16,897 15,447 15,670
------- ------ ------
------- ------ ------
Net interest rate spread . . . . . . . . 2.04% 2.07% 2.05%
---- ---- ----
---- ---- ----
Net earning assets . . . . . . . . . . . $ 58,041 $ 73,701 $ 85,993
-------- -------- --------
-------- -------- --------
Net interest margin. . . . . . . . . . . 2.47% 2.77% 2.89%
---- ---- ----
---- ---- ----
Average interest-earning assets to
average interest-bearing
liabilities. . . . . . . . . . . . . . 109.28% 115.25% 118.87%
------ ------ ------
------ ------ ------
</TABLE>
(1) Tax exempt income was not significant; therefore, the yield was not
presented on a tax equivalent basis. The tax exempt income was $9,800 for
1998 and $9,400 in 1997. There was no tax exempt income earned in 1996.
(2) Calculated net of deferred loan fees, loan discounts, loans in process and
loss reserve.
- --------------------------------------------------------------------------------
13
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
Net interest income for the year ended December 31, 1998 was $16.9 million,
an increase of $1.4 million, or 9.4%, from $15.4 million for the year ended in
1997. Interest income for 1998 was $48.8 million, an increase of $7.7 million,
or 18.8%, compared to $41.1 million for 1997. The increase in interest income
was primarily due to the additional interest-earning assets of $125.0 million
that were added to HMN's balance sheet on the December 5, 1997 with the MFC
merger, an increase in commercial lending activity and was offset partially by
the low interest rate environment experienced during 1998. The average
outstanding balance of interest-earning assets was $683.4 million for the year
ended December 31, 1998, an increase of $126.6 million from $556.8 million for
1997. The increase in average outstanding interest-earning assets caused
interest income for 1998 to increase by $9.1 million from interest income for
1997. During the majority of 1998, interest rates charged on first mortgage
loans for single family dwellings were very low compared with prior years. The
low interest rate environment caused many people to refinance their existing
mortgages or purchase new homes which generally resulted in their current home
mortgage being paid off. The refinancing and/or prepayment of mortgages which
occurred during 1998 was the primary cause for the yield decline of 27 basis
points in the loan portfolio from 7.92% for 1997 to 7.65% for 1998. The lower
interest rate environment of 1998 also caused the yield earned on the securities
available for sale portfolio to decline as the proceeds from the sales of
securities were reinvested in lower yielding securities or as adjustable rate
securities were repriced because the security's interest rate index adjusted
downward. Interest income earned in 1998 decreased by $1.4 million from what was
earned in 1997 due to lowering yields on interest-earning assets. Interest
expense for the year ended December 31, 1998 was $31.9 million, an increase of
$6.3 million, or 24.4%, from $25.6 million for 1997.
For the year ended December 31, 1998 the average outstanding balance of
interest-bearing liabilities was $625.35 million, an increase of $142.25
million, compared to $483.1 million for 1997. The average outstanding balance of
deposits for 1998 was $452.9 million, an increase of $82.3 million from the
average outstanding balance of deposits for 1997. The MFC merger increased HMN's
outstanding deposits by $103.6 million. The average outstanding balance of
deposits declined during the last six months of 1998 when HMN started to lower
the rates it paid on deposit accounts which resulted in an outflow of deposits
and therefore, the average outstanding deposits for 1998 increased by only $82.3
million. Interest expense on deposits for 1998 compared to 1997 increased by
$3.6 million due to an increase in the average outstanding balance of deposits
and it declined by $559,000 due to lower rates being paid on deposits. The
average outstanding balance of FHLB advances at December 31, 1998 was $172.2
million, an increase of $59.7 million, compared to $112.5 million for 1997. The
average outstanding FHLB advances were used by the Bank to replace deposit
outflows and pay dividends to the holding company to assist in its purchase of
treasury stock. Interest expense increased by $3.4 million as a result of the
additional borrowings and it was partially offset by a $188,000 decline in
interest expense due to the lower rate environment of 1998.
Net interest income for the year ended December 31, 1997 was $15.4 million,
a decrease of $223,000, or 1.4%, from $15.7 million for the year ended in 1996.
Interest income for the year ended December 31, 1997 was $41.1 million, an
increase of $1.2 million, or 3.1%, compared to $39.9 million for the year ended
in 1996. The increased interest income was primarily due to increased loan
purchases, originations and, to a minor extent, loans added as a result of the
acquisition of MFC. Average outstanding loans receivable for 1997 increased by
$30.8 million over average outstanding loans receivable for 1996. During 1997
HMN had been increasing its investment in loans in order to increase interest
income. Interest income earned on the security portfolio decreased by $1.3
million primarily because securities were sold or matured and the proceeds were
reinvested into loans or other assets. The average outstanding securities
portfolio decreased by $16.7 million from $201.0 million at December 31, 1996 to
$184.3 million at December 31, 1997. Interest expense for the year ended
December 31, 1997 was $25.6 million, an increase of $1.4 million, or 6.0%, from
$24.2 million for the year ended December 31, 1996. Interest expense increased
during 1997 due to additional advances from the FHLB which were used to fund
loan purchases and the purchase of MFC. The increase in interest expense totally
offset the increase in interest income and therefore caused net interest income
for the year ended December 31, 1997 to decline by $223,000 from the year ended
December 31, 1996.
Net interest margin was 2.47%, 2.77%, and 2.89% for the years ended
December 31, 1998, 1997 and 1996, respectively. Average net earning assets were
$58.0 million, $73.7 million, and $86.0 million for the years ended December 31,
1998, 1997 and 1996, respectively. During 1995 HMN began purchasing its own
common stock in the open market and paid $17.1 million, $6.0 million, and $14.4
million during 1998, 1997 and 1996, respectively to purchase its own common
stock in the open market. During 1996 and throughout 1997, HMN increased its
investment in assets which were not interest-earning assets. The income or loss
on these assets is included in non-interest income. The impact of the stock
repurchase program, when coupled with purchasing investments which are not
interest-earning assets, caused HMN's net interest-earning assets to decline,
which in turn caused net interest margin to decline.
14
<PAGE>
The following schedule presents the dollar amount of changes in interest
income and interest expense for major components of interest-earning assets and
interest-bearing liabilities. It distinguishes between the increase related to
higher outstanding balances and that due to the levels and volatility of
interest rates. For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable to
(i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii)
changes in rate (i.e., changes in rate multiplied by old volume).
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
--------------------------------------------------------------------------------
1998 vs. 1997 1997 vs. 1996
--------------------------------------------------------------------------------
Increase (Decrease) Increase (Decrease)
Due to Due to
---------------------------- ------------------------
Total Total
Increase Increase
(DOLLARS IN THOUSANDS) Volume(1) Rate(1) (Decrease) Volume(1) Rate(1) (Decrease)
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities . . $1,060 (485) 575 (1,817) 44 (1,773)
Other marketable securities. . . . . . . . 136 34 170 1,286 (11) 1,275
Securities held to maturity:
Mortgage-backed and related securities . . (16) (17) (33) (890) 158 (732)
Other marketable securities. . . . . . . . (5) (5) (10) (102) 8 (94)
Loans held for sale, net . . . . . . . . . . 241 (29) 212 167 0 167
Loans receivable, net. . . . . . . . . . . . 7,435 (902) 6,533 2,439 2 2,441
Federal Home Loan Bank stock . . . . . . . . 191 (22) 169 94 0 94
Other, including cash equivalents. . . . . . 86 4 90 (110) (42) (152)
------ ------ ------- ----- ---- ------
Total interest-earning assets. . . . . . . $9,128 (1,422) 7,706 1,067 159 1,226
------ ------ ------- ----- ---- ------
------ ------ ------- ----- ---- ------
Interest-bearing liabilities:
Noninterest checking . . . . . . . . . . . . $ 0 0 0 0 0 0
NOW accounts . . . . . . . . . . . . . . . . 52 (26) 26 28 (94) (66)
Passbooks. . . . . . . . . . . . . . . . . . 119 (65) 54 (10) 13 3
Money market accounts. . . . . . . . . . . . 371 103 474 (26) 15 (11)
Certificates . . . . . . . . . . . . . . . . 3,059 (571) 2,488 232 (52) 180
Federal Home Loan Bank advances. . . . . . . 3,390 (188) 3,202 1,337 6 1,343
Other borrowed money . . . . . . . . . . . . 6 6 12 0 0 0
------ ------ ------- ----- ---- ------
Total interest-bearing liabilities . . . . $6,997 (741) 6,256 1,561 (112) 1,449
------ ------ ------- ----- ---- ------
------ ------ ------- ----- ---- ------
Net interest income. . . . . . . . . . . . . . $16,897 15,447
------- ------
------- ------
</TABLE>
(1) For purposes of this table, changes attributable to both rate and volume
which cannot be segregated, have been allocated proportionately to the
change due to volume and the change due to rate.
- --------------------------------------------------------------------------------
The following table sets forth the weighted average yields on HMN's
interest-earning assets, the weighted average interest rates on interest-bearing
liabilities and the interest rate spread between the weighted average yields and
rates as of the date indicated. Non-accruing loans have been included in the
table as loans carrying a zero yield.
- --------------------------------------------------------------------------------
At December 31, 1998
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Weighted average yield on: Weighted average rate on:
Securities available for sale: Non-interest checking. . . . . . . . . . 0.00%
Mortgage-backed and related securities. . . . . 5.94% NOW accounts . . . . . . . . . . . . . . 1.00
Other marketable securities . . . . . . . . . . 6.70 Passbooks. . . . . . . . . . . . . . . . 2.00
Loans held for sale. . . . . . . . . . . . . . . . 5.93 Money market accounts. . . . . . . . . . 3.19
Loans receivable, net. . . . . . . . . . . . . . . 7.43 Certificates . . . . . . . . . . . . . . 5.37
Federal Home Loan Bank stock . . . . . . . . . . . 6.50 Federal Home Loan Bank advances. . . . . 5.47
Other interest-earning assets. . . . . . . . . . . 3.70 Other borrowed money . . . . . . . . . . 7.13
Combined weighted average yield on Combined weighted average rate on
interest-earning assets . . . . . . . . . . . . 6.93 interest-bearing liabilities. . . . . 4.80
Interest rate spread . . . . . . . . . . 2.13%
- ---------------------------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
PROVISION FOR LOSSES ON LOANS
*The provision for losses on loans is the result of management's evaluation of
the loan portfolio including its evaluation of national and regional economic
indicators (including the possibility at each year end that there would be an
increase in general interest rates), such as national and regional unemployment
data, single family loan delinquencies as reported separately by the Federal
National Mortgage Association (FNMA) and the Federal Home Loan Bank Mortgage
Corporation (FHLMC), local single family construction permits and local economic
growth rates and the current regulatory and general economic environment. HMN
will continue to monitor and modify its allowance for losses as these conditions
dictate. Although HMN maintains its allowance for losses at a level it considers
adequate to provide for estimated losses, there can be no assurance that such
losses will not exceed the estimated amount or that additional provisions for
loan losses will not be required in future periods.
The provision for losses on loans for 1998 was $310,000, for 1997 and 1996
it was $300,000 for each year. Based upon management's evaluation of the loan
portfolio and its understanding of the economic conditions in the areas where it
has a concentration of loans, the provision was deemed adequate for each of the
years in the three year period ended December 31, 1998. HMN incurred $18,600 of
loan charge-offs during 1998 and it recovered $1,865 of loans previously
charged-off. HMN incurred $22,700 of loan charge-offs during 1997 and it also
recovered $7,825 on loans previously charged-off. The loan charge-offs for 1998
and 1997 were not significant and general economic conditions in the
markets served by HMN did not cause management to determine that a change in the
provision was required during those years. HMN incurred $150,000 of loan
charge-offs during 1996 which were primarily related to two loans which were not
single-family residential loans. The charge-offs were not deemed to be
indicative of a trend that would call for a higher loan loss provision. For
information on the allowance for loan losses refer to Notes 1 and 6 of the Notes
to Consolidated Financial Statements.
NON-INTEREST INCOME
Non-interest income was $2.6 million for 1998, compared to $2.7 million for 1997
and $1.9 million for 1996. The following table presents certain components of
non-interest income:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Percentage
Year Ended December 31, Increase (Decrease)
-------------------------------------------------------------------
(DOLLARS IN THOUSANDS). . . . . . . . . 1998 1997 1996 1998/1997 1997/1996
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fees and service charges. . . . . . . . $ 855 487 359 75.6% 35.7%
Securities gains, net . . . . . . . . . 2,799 1,250 1,030 123.9 21.4
Gain on sales of loans. . . . . . . . . 2,177 469 39 364.2 1,102.6
Earnings (loss) in limited partnerships (3,725) 220 7 (1,793.2) 3,042.9
Other non-interest income . . . . . . . 524 296 488 77.0 (39.3)
----- ----- -----
Total non-interest income. . . . . . $2,630 2,722 1,923 (3.4) 41.5
----- ----- -----
----- ----- -----
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
Fees and service charges earned for the year ended December 31, 1998
increased by $368,000 from the fees and service charges earned in 1997,
primarily due to a $276,000 increase in mortgage loan servicing fees and a
$92,000 increase in service charges on deposit related accounts, some of which
is related to the increased number of deposit accounts from the MFC merger.
Mortgage loan servicing fees increased during 1998 because the Bank was selling
many of its fixed rate loans to FNMA and retaining the servicing. MSI also
purchased additional mortgage loan servicing assets during 1998. Fees and
service charges earned for the year ended December 31, 1997 increased by
$128,000 over the amount earned in 1996 due to an increase in fees earned on
loan servicing activities and increased fees charged on deposit accounts.
The ability to realize gains on the sale of securities is dependent on the
type of securities in the securities portfolio and upon changes in the general
interest rate environment. During 1998, 1997 and 1996 economic conditions
existed which allowed HMN to sell securities at a net gain of $2.8 million,
$1.25 million and $1.0 million, respectively. The proceeds from the securities
sold during 1998 and 1997 were invested in the loan portfolio, used to redeem
the common stock of the MFC stockholders, invested in other assets, used to
purchase treasury stock or reinvested in securities.
During 1998, in order to reduce its interest rate risk and increase its
other non-interest income, the Bank started selling many of its originated or
refinanced fixed rate loans to FNMA. MSI also increased its mortgage origination
and loan brokerage activity. For the year ended December 31, 1998 HMN recognized
$2.18 million of net gains on the sale of $178.4 million of primarily single
family mortgage loans. During 1997, HMN recognized $469,000 in net gain on the
sale of $46.5 million of primarily single family mortgage loans. During 1996,
HMN received $1.7 million in proceeds from the sale of primarily 30 year fixed
rate single family loans and recognized a $39,000 net gain.
For the year ended December 31, 1998 the loss from limited partnership
investments was $3.7 million, a decrease of $3.9 million from earnings of
$220,000 for 1997. HMN's
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
16
<PAGE>
share of a limited partnership investment in mortgage servicing rights generated
losses of $3.6 million when the market value of its mortgage servicing assets
declined due to the rapid prepayment of loans being serviced. For more
information on investments in limited partnerships refer to Note 10 of Notes to
Consolidated Financial Statements.
For the year ended December 31, 1998 other non-interest income was
$524,000, compared to $296,000 for 1997 and $488,000 for 1996. The increase in
other non-interest income of $228,000 for 1998 was principally due to an
increase in fees and commissions earned on the sale of financial planning
products and services. Other non-interest income declined during 1997 by
$192,000, from $488,000 for 1996 because during 1996 HMN recorded miscellaneous
non-recurring other income items.
NON-INTEREST EXPENSE
Non-interest expense for the year ended December 31, 1998 was $13.2 million
compared to $9.0 million for the year ended in 1997 and $10.5 million for 1996.
The following table presents the components of non-interest expense:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------
Percentage
Year Ended December 31, Increase (Decrease)
---------------------------------------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1998/1997 1997/1996
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Compensation and benefits . . . . . . . $ 6,804 5,590 4,591 21.7% 21.8%
Occupancy . . . . . . . . . . . . . . . 1,442 983 826 46.7 19.0
Federal deposit insurance premiums. . . 285 238 800 19.7 (70.3)
SAIF assessment . . . . . . . . . . . . 0 0 2,352 N/A (100.0)
Advertising . . . . . . . . . . . . . . 445 316 308 40.8 2.6
Data processing . . . . . . . . . . . . 674 509 489 32.4 4.1
Amortization of mortgage servicing
rights and net valuation adjustments 889 105 0 746.7 105.0
Other . . . . . . . . . . . . . . . . . 2,621 1,282 1,143 104.4 12.2
------ ------ ------
Total non-interest expense . . . . $13,160 9,023 10,509 45.8 (14.1)
------ ------ ------
------ ------ ------
- ---------------------------------------------------------------------------------------------------------------------
</TABLE>
The $4.1 million increase in non-interest expense from 1997 to 1998 was
primarily due to the MFC merger which increased most of the above listed
components of non-interest expense. The merger added over 30 employees, three
retail banking facilities, plus data processing costs and deposit insurance
premiums for the accounts that were acquired with the merger. Compensation and
benefit costs also increased as the result of additional staff added in the
mortgage banking operation of MSI and the commercial loan, mortgage loan and
other back office areas of the Bank. During the second half of 1998 the Bank
reorganized the focus of its operations by centralizing many functions in the
corporate office and increasing its retail sales focus in each of the Bank's
branches. At December 31, 1998 HMN's total work force, after taking into account
the new hires discussed above, was 13% less than its work force was at June 30,
1998. Occupancy costs also increased as the result of opening two new retail
banking buildings, one in Spring Valley and one in Winona. Other non-interest
expense increased by $1.3 million in 1998, principally due to the increased
amortization of goodwill and core deposit intangibles of $433,000; the cost of
postage, office supplies, telephone and freight related to operating the MFC
offices, when coupled with the increased loan activity of 1998, caused
non-interest expense to increase by $368,000; and utilization of professionals
for consultation on reorganization and other matters increased by $300,000.
The $1.5 million decrease in non-interest expense from 1996 to 1997 was due
to the one time SAIF assessment of $2.35 million not repeating itself in 1997.
As a result of the SAIF assessment recapitalizing the SAIF, the FDIC insurance
premium expense decreased by $561,000 from 1996 to 1997. The decrease in
non-interest expense was partially offset by a $999,000 increase in compensation
and benefits, an increase in occupancy of $158,000 and an increase in other
expense of $139,000. Compensation and benefits expense increased as a result of
adding new employees in mortgage banking activities, the purchase of MFC and
normal merit and salary increases to existing employees. Occupancy increased for
the year ended December 31, 1997 compared to 1996 because of the purchase of MFC
and depreciation resulting from continued remodeling and updating of offices for
new technological advances.
INCOME TAXES
HMN recorded income tax expense of $2.0 million in 1998, compared to $3.3
million and $2.5 million for 1997 and 1996, respectively. The decrease in income
tax expense from 1997 to 1998 and the increase from 1996 to 1997 is primarily
the result of changes in taxable income between the years. For more information
on income taxes refer to Note 15 of the Notes to Consolidated Financial
Statements.
FINANCIAL CONDITION
LOANS RECEIVABLE, NET
The table on the following page sets forth the information on HMN's loan
portfolio in dollar amounts and in percentages (before deductions for loans in
process, deferred fees and discounts and allowances for losses) as of the dates
indicated.
17
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
December 31,
------------------ ------------------ ------------------ ------------------ ------------------
1998 1997 1996 1995 1994
------------------ ------------------ ------------------ ------------------ ------------------
(DOLLARS IN THOUSANDS) Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
REAL ESTATE LOANS:
One-to-four family . . $365,496 79.31% $395,668 87.58% $321,340 90.19% $292,497 90.62% $252,943 91.14%
Multi-family . . . . . 4,719 1.02 2,717 0.60 280 0.08 361 0.11 311 0.11
Commercial . . . . . . 28,990 6.29 10,572 2.34 7,918 2.22 8,744 2.71 8,316 3.00
Construction or
development . . . . . 15,155 3.29 5,725 1.27 3,474 0.98 5,082 1.58 2,799 1.01
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total real estate. . 414,360 89.91 414,682 91.79 333,012 93.47 306,684 95.02 264,369 95.26
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
OTHER LOANS:
Consumer Loans:
Savings account . . . 994 0.22 1,362 0.30 938 0.26 1,210 0.37 648 0.23
Education . . . . . . 118 0.03 123 0.03 467 0.13 342 0.11 2,007 0.72
Automobile. . . . . . 2,897 0.63 2,438 0.54 566 0.16 671 0.21 520 0.19
Home equity line. . . 19,476 4.22 19,490 4.31 11,881 3.33 3,509 1.09 0 0.00
Home equity . . . . . 9,566 2.08 7,176 1.59 5,927 1.67 7,997 2.47 7,716 2.78
Home improvement. . . 436 0.09 652 0.14 585 0.16 785 0.24 870 0.31
Other . . . . . . . . 1,313 0.28 624 0.14 568 0.16 545 0.17 502 0.19
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total consumer
loans . . . . . . . 34,800 7.55 31,865 7.05 20,932 5.87 15,059 4.66 12,263 4.42
Commercial business
loans . . . . . . . . 11,695 2.54 5,226 1.16 2,344 0.66 1,018 0.32 897 0.32
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total other loans. . 46,495 10.09 37,091 8.21 23,276 6.53 16,077 4.98 13,160 4.74
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
Total loans. . . . . 460,855 100.00% 451,773 100.00% 356,288 100.00% 322,761 100.00% 277,529 100.00%
-------- -------- -------- -------- --------
-------- -------- -------- -------- --------
LESS:
Loans in process . . . 7,997 4,562 2,814 3,531 2,327
Unamortized
discounts . . . . . . 414 547 417 289 162
Net deferred
loan fees . . . . . . 1,948 1,847 1,695 1,899 2,147
Allowance for losses . 3,041 2,748 2,340 2,191 1,893
-------- -------- -------- -------- --------
Total loans
receivable, net . . $447,455 $442,069 $349,022 $314,851 $271,000
-------- -------- -------- -------- --------
-------- -------- -------- -------- --------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
The one-to-four family real estate loans were $365.5 million at December
31, 1998, a decrease of $30.2 million, or 7.6%, compared to $395.7 million at
December 31, 1997. In order to reduce interest rate risk and generate more
income from loan sales, HMN sold approximately 44% of the one-to-four family
real estate loans that were originated or refinanced by the Bank during 1998.
The Bank also swapped $21.8 million of fixed rate one-to-four family loans for
FNMA mortgage-backed securities and then sold the securities to reduce interest
rate risk. During 1998 loan prepayments increased as a result of the low
interest rate environment. The prepayments and the loan sales were the principal
cause of the decline in the one-to-four family loan portfolio.
As of December 31, 1997 one-to-four family real estate loans increased by
$74.4 million, or 23.1%, compared to $321.3 million at December 31, 1996. During
1997 HMN had the following one-to-four family real estate loan activity:
originated $34.0 million, purchased $67.2 million, securitized $16.6 million,
acquired from MFC $63.3 million, sold $9.0 million and received principal
repayments of $64.5 million.
One-to-four family real estate loans were $321.3 million at December 31,
1996, an increase of $28.8 million, or 9.8%, compared to $292.5 million at
December 31, 1995. During 1996 HMN had the following one-to-four family real
estate loan activity: originated $32.5 million, purchased $55.8 million,
securitized $15.4 million, sold $2.3 million and received principal repayments
of $41.8 million.
One-to-four family real estate loans increased $39.6 million to $292.5
million at December 31, 1995 from $252.9 million at December 31, 1994. During
1995 HMN had the following one-to-four family real estate loan activity:
originated $25.7 million, purchased $47.1 million, sold $2.4 million and
received principal repayments of $30.8 million.
Commercial real estate loans were $29.0 million at December 31, 1998, an
increase of $18.4 million compared to $10.6 million at December 31, 1997.
Commercial business
18
<PAGE>
loans were $11.7 million at December 31, 1998, an increase of $6.5 million
compared to $5.2 million at December 31, 1997. The Bank is in the process of
expanding its commercial loan and commercial deposit offerings in order to
increase its investment in commercial real estate and commercial business loans.
During 1998 the Bank expanded its commercial loan program by hiring people with
experience in commercial lending and has added a full service commercial
checking offering to its product list. Prior to 1998, HMN purchased commercial
business loans and commercial real estate loans primarily from third party
originators in the form of participation interests. The increase in commercial
real estate loans and commercial business loans in the table above for years
prior to 1998 is primarily due to the purchase of participation interests or
loans acquired in 1997 in connection with the acquisition of MFC.
Home equity line loans were $19.5 million at both December 31, 1998 and
1997, compared to $11.9 million at December 31, 1996 and $3.5 million at
December 31, 1995. The home equity line did not increase during 1998 because
many customers were refinancing into fixed rate loan products and did not draw
on their home equity lines. During the second half of 1995 the Bank introduced
the revolving home equity lines of credit which loan up to 90% of the equity in
a home to the borrower. The interest rate has always been competitive and the
customers have liked the convenient features of the program.
ALLOWANCES FOR LOAN AND REAL ESTATE LOSSES
HMN recognizes that credit losses will be experienced and that the risk of loss
will vary with, among other things, the type of loans being made, the
creditworthiness of the borrower over the term of the loan, general economic
conditions and, in the case of a secured loan, the quality of the collateral. It
is management's policy to maintain an allowance for loan losses based on, among
other things, the Bank's and the industry's historical loan loss experience,
evaluation of economic conditions, regular reviews of delinquencies and loan
portfolio quality and evolving standards imposed by OTS examiners. HMN 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 that have not yet been
identified but can be expected to occur. Management conducts quarterly reviews
of the loan portfolio and evaluates the need to establish general allowances on
the basis of these reviews.
*Management continues to actively monitor the asset quality and to charge
off loans against the allowance for loan losses when appropriate. Although
management believes it uses the best information available to make
determinations with respect to the allowance for loan losses, future adjustments
may be necessary if economic conditions differ substantially from the economic
conditions in the assumptions used to determine the size of the allowance for
losses.
The allowance for loan losses was $3.0 million, or 0.68% of total loans at
December 31, 1998, compared to $2.7 million, or 0.62%, of total loans at
December 31, 1997, $2.3 million, or 0.66% of total loans at December 31, 1996,
$2.2 million, or 0.68% of total loans at December 31, 1995 and $1.9 million, or
0.68% of total loans at December 31, 1994. The following table reflects the
activity in the allowance for loan losses and selected statistics:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------
December 31,
--------------------------------------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance at the beginning of year . . . . . . . . . $2,748 2,341 2,191 1,893 1,489
MFC allowance for loan losses acquired. . . . . 0 122 0 0 0
Provision for losses. . . . . . . . . . . . . . 310 300 300 300 410
Charge-offs:
One-to-four family. . . . . . . . . . . . . . (2) (4) 0 0 0
Multi-family. . . . . . . . . . . . . . . . . 0 0 (88) 0 0
Consumer. . . . . . . . . . . . . . . . . . . (17) (7) (1) (2) (6)
Commercial business . . . . . . . . . . . . . 0 (12) (61) 0 0
Recoveries. . . . . . . . . . . . . . . . . . . 2 8 0 0 0
------ ------ ------ ------- ------
Net charge-offs . . . . . . . . . . . . . . . (17) (15) (150) (2) (6)
------ ------ ------ ------- ------
Balance at end of year . . . . . . . . . . . . . . $3,041 2,748 2,341 2,191 1,893
------ ------ ------ ------- ------
------ ------ ------ ------- ------
Year end allowance for loan losses as a percent of
year end gross loan balance . . . . . . . . . . 0.68% 0.62% 0.66% 0.68% 0.68%
Ratio of net loan charge-offs to average loans
outstanding . . . . . . . . . . . . . . . . . . 0.00 0.01 0.05 0.00 0.00
Allowance for loan losses as a percentage of
total assets at year end. . . . . . . . . . . . 0.44 0.40 0.42 0.41 0.38
- -------------------------------------------------------------------------------------------------------------------------
</TABLE>
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
19
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
The following table reflects the allocation of the allowance for loan
losses:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
Allocations as a Percentage of Total
At December 31, Loan Outstanding by Type
----------------------------------------------- -----------------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Real estate loans:
One-to-four family. . . . . $ 544 560 496 452 475 79.31% 87.58 90.19 90.62 92.18
Multi-family. . . . . . . . 142 80 8 21 21 1.02 0.60 0.08 0.11 0.14
Commercial. . . . . . . . . 797 198 113 125 128 6.29 2.34 2.22 2.71 1.80
Construction or
development . . . . . . . 455 172 104 153 84 3.29 1.27 0.98 1.58 1.31
Consumer . . . . . . . . . . . 546 527 473 286 280 7.55 7.05 5.87 4.66 4.14
Commercial business. . . . . . 328 46 29 37 27 2.54 1.16 0.66 0.32 0.43
Unallocated. . . . . . . . . . 229 1,165 1,118 1,117 878 0.00 0.00 0.00 0.00 0.00
------ ------ ------ ------ ------ ------- ------ ------ ------ ------
Total. . . . . . . . . . . . . $3,041 2,748 2,341 2,191 1,893 100.00% 100.00 100.00 100.00 100.00
------ ------ ------ ------ ------ ------- ------ ------ ------ ------
------ ------ ------ ------ ------ ------- ------ ------ ------ ------
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The allocation of the allowance for loan losses has increased from 1997 to
1998 for multi-family real estate, commercial real estate construction or
development, and commercial business loans because HMN has experienced more loan
activity in those categories. The allocation of the allowance for consumer loans
also increased from 1997 to 1998 because of the level of charge-offs being
experienced in the consumer category. The allocated one-to-four family real
estate declined from 1997 to 1998 because of the one-to-four family loan
portfolio decline and the potential for charge-offs declined due to the positive
housing market in HMN's markets.
The following table reflects the activity of the allowance for real estate
losses:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
December 31,
------------------------------------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance at the beginning of year . . . . $ 8 2 35 37 126
Provision for losses. . . . . . . . . 0 18 2 9 0
Charge-offs . . . . . . . . . . . . . 0 (12) 0 (11) 0
Recoveries. . . . . . . . . . . . . . 0 0 0 0 0
---- ---- ---- ---- ----
Net charge-offs . . . . . . . . . . 0 (12) 0 (11) 0
---- ---- ---- ---- ----
Other . . . . . . . . . . . . . . . . 0 0 (35) 0 (89)
---- ---- ---- ---- ----
Balance at the end of year . . . . . . . $ 8 8 2 35 37
---- ---- ---- ---- ----
---- ---- ---- ---- ----
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
Real estate properties acquired or expected to be acquired through loan
foreclosures are initially recorded at the lower of the related loan balance,
less any specific allowance for loss, or fair value less estimated selling
costs. Valuations are periodically performed by management and an allowance for
losses is established if the carrying value of a property exceeds its fair value
less estimated selling costs.
NON-PERFORMING ASSETS
Non-performing assets (comprised of non-accrual loans, restructured loans, and
real estate acquired through foreclosure) totaled $806,000 at December 31, 1998,
a decrease of $1,000 compared to $807,000 at December 31, 1997 and $361,000 at
December 31, 1996. Non-performing assets had the following activity during 1998:
sales of $142,000, transfers in of $389,000 and transfers out due to performance
of $248,000. Non-performing assets had the following activity during 1997: sales
of $42,000, charge-offs of $35,000, payments of $80,000 and net transfers to
non-performing assets of $603,000.
Non-performing assets at December 31, 1996 were $361,000, a decrease of
$489,000, compared to $850,000 at December 31, 1995. Non-performing assets had
the following activity during 1996: sales of $314,000, charge-offs of $61,000,
payments of $128,000, and net transfers to non-performing assets of $14,000.
20
<PAGE>
Non-performing assets are summarized in the following table:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
December 31,
--------------------------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Non-accrual loans. . . . . . . . . . . . . . . . . . . . . . . . $476 263 338 441 235
Accruing loans delinquent 90 days or more . . . . . . . . . . 312 402 0 0 0
Restructured loans. . . . . . . . . . . . . . . . . . . . . . 0 0 0 94 199
Foreclosed assets . . . . . . . . . . . . . . . . . . . . . . 18 142 23 315 64
---- ---- ---- ---- ----
Total non-performing assets . . . . . . . . . . . . . . . . $806 807 361 850 498
---- ---- ---- ---- ----
---- ---- ---- ---- ----
Non-performing assets as a percentage of total assets. . . . . . 0.12% 0.12% 0.07% 0.16% 0.10%
Total non-performing loans . . . . . . . . . . . . . . . . . . . $788 665 338 535 434
Non-performing loans as a percentage of
loans receivable, net . . . . . . . . . . . . . . . . . . . . 0.18% 0.15% 0.10% 0.17% 0.16%
Allowance for loan losses to non-performing loans. . . . . . . . 385.79% 413.17% 691.84% 409.13% 436.52%
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The non-performing assets reflected above primarily consist of one-to-four
family mortgage loans or consumer loans.
REGULATORY CAPITAL REQUIREMENTS
Federal savings institutions are required to satisfy three capital requirements:
(i) a requirement that "tangible capital" equal or exceed 1.5% of adjusted total
assets, (ii) a requirement that "core capital" equal or exceed 3% of adjusted
total assets, and (iii) a requirement that "risk-based capital" equal or exceed
8% of risk-weighted assets. With certain exceptions, all three capital standards
must generally conform to and be no less stringent than, the capital standards
published by the Comptroller of the Currency for national banks.
As a result of the Federal Deposit Insurance Corporation Improvement Act of
1991 (FDICIA), banking and thrift regulators are required to take prompt
regulatory action against institutions which are undercapitalized. FDICIA
requires banking and thrift regulators to categorize institutions as "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," or "critically undercapitalized". A savings institution will
be deemed to be well capitalized if it: (i) has a total risk-based capital ratio
of 10% or greater, (ii) has a Tier 1 (core) risk-based capital ratio of 6% or
greater, (iii) has a leverage (core) ratio of 5% or greater, and (iv) is not
subject to any order or written directive by the OTS to meet and maintain a
specific capital level for any capital measure. The Bank is of the opinion that
it is considered well capitalized at December 31, 1998. Refer to Note 20 of the
Notes to Consolidated Financial Statements for a table which reflects the Bank's
capital compared to its capital requirements.
DIVIDENDS
Prior to 1998, HMN did not pay any dividends. In February of 1998, the Board of
Directors declared a stock split in the form of a 50% stock dividend subject
to HMN stockholder approval of an increase in the number of authorized
shares of common stock from 7.0 million to 11.0 million. At the annual meeting
of stockholders on April 28, 1998 the stockholders approved the stock split
which was distributed on May 22, 1998 to holders of record on May 8, 1998.
During 1998 HMN declared and paid dividends as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Dividend Dividend
Record date Payable date per share Payout Ratio
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
May 27, 1998 June 12, 1998 $0.06 21.4 %
August 27, 1998 September 10, 1998 $0.06 42.9
December 1, 1998 December 15, 1998 $0.06 (66.7)
- --------------------------------------------------------------------------------
</TABLE>
On February 2, 1999 HMN declared a cash dividend of $0.08 per share payable
on March 10, 1999 to holders of record on February 24, 1999. The annualized
dividend payout ratio for the past four quarters was 36.6%.
The declaration of dividends are subject to, among other things, HMN'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. Refer to
Note 19 of the Notes to Consolidated Financial Statements for information on
regulatory limitations on dividends from the Bank to HMN.
LIQUIDITY
*HMN manages its liquidity position to ensure that the funding needs of
borrowers and depositors are met timely and in the most cost effective manner.
Asset liquidity is the ability to convert assets to cash through the maturity of
the asset or the sale of the asset. Liability liquidity results from the ability
of the Bank to attract depositors or borrow funds from third party sources such
as the FHLB. The Bank is required by regulation to maintain a monthly average
minimum asset liquidity ratio of 4%. The Bank has maintained an average monthly
liquidity ratio in excess of the 4% requirement and does not anticipate that it
will fall below the requirement in the future.
The primary investing activities are the origination or purchase of loans
and the purchase of securities. Principal and interest payments on mortgages and
securities are a primary source of cash for HMN. Additional cash can be obtained
by selling securities from the available for sale port-
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
21
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
folio or by selling loans. Loans could also be securitized by FNMA or FHLMC and
used as collateral for additional borrowing with the FHLB. In December of 1997
HMN, through its wholly owned subsidiary, acquired MFC by purchasing MFC's
outstanding stock with cash. Refer to Note 2 of the Notes to Financial
Statements for more details related to the acquisition.
The primary financing activity is the attraction of retail deposits. The
Bank has the ability to borrow additional funds from the FHLB by pledging
additional securities or loans. Refer to Note 13 of the Notes to Consolidated
Financial Statements for more information on additional advances that could be
drawn upon based upon existing collateral levels with the FHLB. Information on
outstanding advance maturities is also included in Note 13.
*HMN anticipates that its liquidity requirements for 1999 will be similar
to the cash flows it experienced in 1998 with the exception of the redemption of
the common stock of MFC which will require only $37,000. Construction
disbursements will also be reduced because both the Spring Valley and Winona
retail banking facilities were completed during 1998. Expenditures for premises
and equipment are anticipated to be $1.0 million for 1999. The cash needed to
fund the mortgage banking activities of HMN Mortgage Services, Inc. will range
from $5.0 million to $20.0 million during 1999.
HMN's most liquid assets are cash and cash equivalents, which consist of
short-term highly liquid investments with original maturities of less than three
months that are readily convertible to known amounts of cash and
interest-bearing deposits. The level of these assets is dependent on the
operating, financing, and investing activities during any given period.
Cash and cash equivalents at December 31, 1998 were $21.0 million, an
increase of $11.6 million, compared to $9.4 million at December 31, 1997. Net
cash provided from operating activities during 1998 was $47.8 million. HMN
conducted the following major investing activities during 1998: proceeds from
the sale of securities available for sale were $172.6 million, principal
received on payments and maturities of securities available for sale was $83.6
million, purchases were $204.9 million of securities available for sale,
proceeds of sales of loans receivable were $3.3 million, purchases of mortgage
servicing rights were $459,000, purchases of interests in limited partnerships
were $181,000, purchase of FHLB stock was $2.4 million and net increase in loans
receivable was due primarily to loan originations and loan purchases of $89.1
million. HMN spent $3.1 million for the purchase of premises and equipment and
it expended net cash for the acquisition of MFC of $3.5 million. Net cash used
by investing activities during 1998 was $44.1 million. HMN conducted the
following major financing activities during 1998: decrease in deposits of $33.3
million, purchase of treasury stock of $17.1 million, advanced money to the ESOP
of $1.5 million, received $436,000 from exercise of HMN common stock options,
paid $858,000 in dividends to HMN stockholders, proceeds from FHLB advances of
$163.1 million and repayments of FHLB advances totaled $105.4 million, proceeds
from other borrowed money of $2.5 million. Net cash provided from financing
activities was $7.8 million.
*HMN has certificates of deposit with outstanding balances of $193.9
million that mature during 1999. Based upon past experience management
anticipates that the majority of the deposits will renew for another term. HMN
believes that deposits which do not renew will be replaced with deposits from
other customers, or funded with advances from the FHLB, or will be funded
through the sale of securities. Management does not anticipate that it will have
a liquidity problem due to maturing deposits.
*HMN has $19.0 million of FHLB advances which mature in 2001 but have call
features which can be exercised by the FHLB on a semiannual basis. If the call
features are exercised, HMN has the option of requesting any advance otherwise
available to it pursuant to the Credit Policy of the FHLB. Since HMN has the
ability to request another advance to replace the advance that is being called,
Management does not anticipate that it will have a liquidity problem due to
advances being called by the FHLB during 1999.
MERGER AND ACQUISITIONS
From time to time HMN reviews the possibility of acquiring or merging with
different companies which would complement the business conducted by HMN. HMN's
Board of Directors has adopted the policy of not disclosing to the public its
intent to acquire or merge until a formal definitive agreement has been signed
by all parties involved with the transaction except as otherwise required by
law.
On December 5, 1997 HMN, through its wholly owned subsidiary, Home Federal
Savings Bank, completed its merger with Marshalltown Financial Corporation
pursuant to a merger agreement dated July 1, 1997. Refer to Note 2 of the Notes
to Consolidated Financial Statements for more information on the merger.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes presented herein have been
prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operation results that are
primarily in terms of historical dollars without considering the changes in the
relative purchasing power of money over time due to inflation. The impact of
inflation is reflected in the increased cost of operations. Unlike most
industrial companies, nearly all of the assets and liabilities of HMN are
monetary in nature. As a result, interest rates have a greater impact on HMN's
performance than do the effects of general levels of inflation. Interest rates
do not necessarily move in the same direction or to the same extent as the
prices of goods and services.
On August 17, 1998 HMN's Board of Directors authorized the purchase of
400,000 shares of HMN's common stock. As of December 31, 1998 HMN had purchased
121,800 shares at an aggregate cost of $1.6 million. The existing Board
authorization would allow HMN to purchase
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
22
<PAGE>
278,200 shares of HMN common stock during 1999 at the then current market price.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates.
HMN'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.
HMN's profitability is affected by fluctuations in interest rates. A sudden
and substantial increase in interest rates may adversely impact HMN'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. HMN monitors
how its assets will mature or reprice in comparison to how its liabilities will
mature or reprice. The MATURITY OR REPRICING TABLE located below in the
Asset/Liability Management section of this report is used as part of the
monitoring process. HMN also monitors the projected changes in net interest
income that occur if interest rates were to suddenly change up or down. The RATE
SHOCK TABLE located below in the Asset/Liability Management section of this
report discloses HMN's projected changes in net interest income based upon
immediate interest rate changes called rate shocks.
*HMN utilizes a model which uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate the
current market value of those assets and liabilities. The model also calculates
the changes in market value of the interest-earning assets and interest-bearing
liabilities due to different interest rate changes. HMN believes that over the
next twelve months interest rates could conceivably fluctuate in a range of 200
basis points up or down from where the rates were at December 31, 1998. HMN does
not have a trading portfolio. The following table discloses the projected
changes in market value to HMN's interest-earning assets and interest-bearing
liabilities based upon incremental 100 basis point changes in interest rates
from interest rates in effect on December 31, 1998.
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------
Other than trading portfolio Market Value
(DOLLARS IN THOUSANDS) -------------------------------------------------------------
Basis point change in interest rates -200 -100 0 +100 +200
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents. . . . . . . . . . . . . $ 19,979 19,963 19,946 19,930 19,913
Securities available for sale:
Fixed-rate CMOs . . . . . . . . . . . . . . . . 44,746 44,699 44,631 43,805 42,509
Variable-rate CMOs. . . . . . . . . . . . . . . 92,414 92,917 94,476 93,999 90,940
Fixed-rate available for sale mortgage-backed
and related securities . . . . . . . . . . . . 4,128 4,084 4,052 3,987 3,867
Variable-rate available for sale mortgage-
backed and related securities. . . . . . . . . 109 107 104 102 102
Fixed-rate available for sale other
marketable securities. . . . . . . . . . . . . 55,242 52,997 50,841 48,845 46,987
Variable-rate available for sale other
marketable securities. . . . . . . . . . . . . 769 767 765 764 762
Fixed-rate loans held for sale . . . . . . . . . . 13,122 13,111 13,101 13,090 13,079
Loans receivable, net:
Fixed-rate real estate loans. . . . . . . . . . 307,010 305,553 301,084 292,574 282,452
Variable-rate real estate loans . . . . . . . . 86,153 85,387 83,824 81,821 79,267
Fixed-rate other loans. . . . . . . . . . . . . 41,939 41,516 40,889 40,059 39,293
Variable-rate other loans . . . . . . . . . . . 42,296 41,784 41,909 42,100 42,252
Mortgage servicing rights, net . . . . . . . . . . 327 654 1,006 1,178 1,296
Investment in limited partnerships . . . . . . . . 753 1,118 2,438 5,538 6,612
-------- -------- -------- -------- --------
Total market risk sensitive assets . . . . . . . . 708,987 704,657 699,066 687,792 669,331
-------- -------- -------- -------- --------
Deposits:
NOW accounts. . . . . . . . . . . . . . . . . . 38,606 38,574 38,542 38,510 38,478
Passbooks . . . . . . . . . . . . . . . . . . . 36,640 35,016 33,530 32,165 30,906
Money market accounts . . . . . . . . . . . . . 29,860 28,547 27,345 26,240 25,220
Certificates. . . . . . . . . . . . . . . . . . 341,987 337,983 334,072 330,250 326,514
Federal Home Loan Bank advances:
Fixed-rate advances . . . . . . . . . . . . . . 175,742 170,653 165,750 161,027 156,475
Variable-rate advances. . . . . . . . . . . . . 24,040 24,020 23,999 23,979 23,958
Other borrowings . . . . . . . . . . . . . . . . . 2,509 2,507 2,505 2,502 2,500
-------- -------- -------- -------- --------
Total market risk sensitive liabilities. . . . . . 649,384 637,300 625,743 614,673 604,051
-------- -------- -------- -------- --------
Off-balance sheet financial instruments:
Commitments to extend credit. . . . . . . . . . 55 55 54 52 51
-------- -------- -------- -------- --------
Net market risk. . . . . . . . . . . . . . . . . . $ 59,658 67,412 73,377 73,171 65,331
-------- -------- -------- -------- --------
-------- -------- -------- -------- --------
Percentage change from current market value. . . . (18.70)% (8.13)% 0.00% (0.28)% (10.96)%
-------- -------- -------- -------- --------
-------- -------- -------- -------- --------
- ---------------------------------------------------------------------------------------------------------------------
</TABLE>
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
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 between 9% to 37%, depending on the coupon and period to maturity. ARMs were
assumed to prepay at annual rates of between 13% and 24%, depending on coupon
and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to
prepay at annual rates of between 19% and 41% depending on the coupon 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. Certificate accounts were assumed not to be
withdrawn until maturity. Passbook and money market accounts were assumed to
decay at an annual rate of 20%. FHLB advances were projected at their first call
date. Refer to Note 13 of the Notes to Consolidated Financial Statements for
more information on call provisions of the FHLB advances.
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 an interest
rate increase.
ASSET/LIABILITY MANAGEMENT
*HMN's management reviews the impact that changing interest rates will have on
its net interest income projected for the twelve months following December 31,
1998 to determine if its current level of interest rate risk is acceptable. The
following table projects the estimated impact on net interest income of
immediate interest rate changes called rate shocks.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Rate Shock Net Interest Percentage
in Basis Points Income Change
- --------------------------------------------------------------------------------
<S> <C> <C>
+200 $22,815,000 10.26 %
+100 21,923,000 5.95 %
0 20,692,000 0.00 %
-100 19,479,000 (5.86)%
-200 17,785,000 (14.05)%
- --------------------------------------------------------------------------------
</TABLE>
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections
prepared by third parties.
Certain shortcomings are inherent in the method of analysis presented in
the foregoing table. In the event of a change in interest rates, prepayment and
early withdrawal levels would likely deviate significantly from those assumed in
calculating the foregoing table. The ability of many borrowers to service their
debt may decrease in the event of a substantial increase in interest rates and
could impact net interest income.
In an attempt to manage its exposure to changes in interest rates,
management closely monitors interest rate risk. HMN has an Asset/Liability
Committee which meets at least on a monthly basis to discuss changes made to the
interest rate risk position and projected profitability. The committee makes
recommendations for adjustments to the asset liability position of the Bank to
the Board of Directors of the Bank. This committee also reviews the Bank's
portfolio, formulates investment strategies and oversees the timing and
implementation of transactions to assure attainment of the Board's objectives in
the most effective manner. In addition, the Board reviews on a quarterly basis
the Bank's asset/liability position, including simulations of the effect on the
Bank's capital of various interest rate scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market conditions and
consumer preference, may place more emphasis on managing net interest margin
than on better matching the interest rate sensitivity of its assets and
liabilities in an effort to enhance net interest income. Management believes
that the increased net interest income resulting from a mismatch in the maturity
of its asset and liability portfolios can, during periods of declining or stable
interest rates, provide high enough returns to justify the increased exposure to
sudden and unexpected increases in interest rates.
To the extent consistent with its interest rate spread objectives, the Bank
attempts to reduce its interest rate risk and has taken a number of steps to
restructure its assets and liabilities. During 1998 the Bank sold approximately
44% of the one-to-four family loans that were originated or refinanced during
1998. The Bank also swapped $21.8 million of fixed rate one-to-four family loans
for FNMA mortgage-backed securities and then sold the securities to
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
24
<PAGE>
reduce interest rate risk. The Bank has primarily focused its fixed rate one-to-
four family residential lending program on loans that are saleable to third
parties and will portfolio only certain fixed rate loans that meet certain risk
characteristics. The Bank will portfolio adjustable rate loans which reprice
over a one year, three year and five year period. At times, depending on its
interest rate sensitivity, the Bank may sell seasoned fixed rate single family
loans with shorter contractual maturities than thirty years in order to reduce
interest rate risk and record a gain on the sale of loans.
The following gap table sets forth the interest rate sensitivity of HMN's
assets and liabilities at December 31, 1998, using certain assumptions that are
described in more detail below:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------
Maturing or Repricing
-------------------------------------------------------------------------------------
Over 6
6 Months Months to Over 1-3 Over 3-5 Over 5 No Stated
(DOLLARS IN THOUSANDS) or Less One Year Years Years Years Maturity Total
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Cash equivalents . . . . . . . . . . . . $ 19,961 0 0 0 0 0 19,961
Securities available for sale:
Mortgage-backed and
related securities(1) . . . . . . . 111,476 11,628 14,155 1,986 5,076 0 144,321
Other marketable securities . . . . . 13,780 1,910 2,109 5,115 7,472 8,271 38,657
Loans held for sale, net . . . . . . . . 13,095 0 0 0 0 0 13,095
Loans receivable, net:(1)(2)
Fixed rate one-to-four family(3). . . 31,500 28,068 85,115 52,753 79,225 0 276,661
Adjustable rate
one-to-four family(3) . . . . . . . 18,131 21,280 22,123 27,183 2,758 0 91,475
Multi family. . . . . . . . . . . . . 650 550 1,548 688 538 0 3,974
Fixed rate commercial real estate . . 9,018 1,268 2,948 1,099 561 0 14,894
Adjustable rate commercial
real estate . . . . . . . . . . . . 8,826 3,414 4,755 1,417 0 0 18,412
Commercial business . . . . . . . . . 6,739 1,473 2,814 592 81 0 11,699
Consumer loans. . . . . . . . . . . . 23,595 1,815 4,513 2,169 1,289 0 33,381
Federal Home Loan Bank stock . . . . . . 0 0 0 0 0 9,838 9,838
-------- -------- -------- -------- -------- -------- --------
Total interest-earning assets . . . 256,771 71,406 140,080 93,002 97,000 18,109 676,368
-------- -------- -------- -------- -------- -------- --------
Non-interest checking. . . . . . . . . . 13,187 0 0 0 0 0 13,187
NOW accounts . . . . . . . . . . . . . . 25,459 0 0 0 0 0 25,459
Passbooks. . . . . . . . . . . . . . . . 3,576 3,576 10,302 6,592 11,720 0 35,766
Money market accounts. . . . . . . . . . 2,940 2,942 8,473 5,422 9,642 0 29,419
Certificates . . . . . . . . . . . . . . 113,285 80,566 113,647 20,464 2,076 0 330,038
Federal Home Loan Bank advances. . . . . 29,000 10,000 35,000 111,400 0 0 185,400
Other borrowed money . . . . . . . . . . 2,500 0 0 0 0 0 2,500
-------- -------- -------- -------- -------- -------- --------
Total interest-bearing liabilities. 189,947 97,084 167,422 143,878 23,438 0 621,769
-------- -------- -------- -------- -------- -------- --------
Interest-earning assets less
interest-bearing liabilities. . . . . $ 66,824 (25,678) (27,342) (50,876) 73,562 18,109 54,599
-------- -------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- -------- --------
Cumulative interest-rate sensitivity gap $ 66,824 41,146 13,804 (37,072) 36,490 54,599 54,599
-------- -------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- -------- --------
Cumulative interest-rate gap as a
percentage of total assets at
December 31, 1998 . . . . . . . . . . 9.60% 5.91% 1.98% (5.33)% 5.24% 7.85% 7.85%
-------- -------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- -------- --------
Cumulative interest-rate gap as a
percentage of total assets at
December 31, 1997 . . . . . . . . . . (6.36) (15.38)
-------- --------
-------- --------
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Schedule prepared based upon the earlier of contractual maturity or
repricing date, if applicable, adjusted for scheduled repayments of
principal and projected prepayments of principal based upon experience.
(2) Loans receivable are presented net of loans in process and deferred loan
fees.
(3) Construction and development loans are all one-to-four family loans and
therefore have been included in the fixed rate one-to-four family and
adjustable rate one-to-four family lines.
25
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections. Fixed
rate loans were assumed to prepay at annual rates of between 9% to 37%,
depending on the coupon and period to maturity. ARMs were assumed to prepay at
annual rates of between 13% and 24%, depending on coupon and the period to
maturity. GEM loans were assumed to prepay at annual rates of between 19% and
41% depending on the coupon and the period to maturity. Mortgage-backed
securities and CMOs were projected to have prepayments based upon the underlying
collateral securing the instrument. Certificate accounts were assumed not to be
withdrawn until maturity. Passbook and money market accounts were assumed to
decay at an annual rate of 20%. FHLB advances were projected at their first call
date. Refer to Note 13 of the Notes to Consolidated Financial Statements for
more information on call provisions of the FHLB advances.
Certain shortcomings are inherent in the method of analysis presented in
the foregoing table. Although certain assets and liabilities may have similar
maturities and periods of repricing, they may react in different degrees to
changes in market interest rates. 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. Certain assets, such as adjustable-rate
mortgages, have features which restrict changes in interest rates on a
short-term basis and over the life of the asset. 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 an interest
rate increase.
Refer to Regulatory Capital Requirements above for a discussion of the
Bank's interest rate risk component.
YEAR 2000
*HMN has inventoried its computer hardware, computer software, third party
vendors and its other non-computer equipment and has assessed or is in the
process of assessing whether the items are year 2000 compliant. The hardware
testing has been completed. The majority of the non-compliant hardware was
replaced during 1998 at a cost of $67,500. The remaining non-compliant hardware
will be replaced at an approximate cost of $7,500 in the second quarter of 1999.
The computer software inventory indicated that certain programs were not
compliant. Some of those software programs were replaced during 1998 at a cost
of $53,000. Other software programs are scheduled to be replaced with year 2000
compliant software during the second quarter of 1999 at an anticipated cost of
$27,000. HMN is also in the process of testing all computer software to
determine that the software is year 2000 compliant. The testing is scheduled to
be completed during the second quarter of 1999. The assessment of non-computer
equipment for year 2000 compliance indicated that HMN did not have any
significant issues in this area.
*The majority of the Bank's loan and deposit data is supported by a third
party data processing center. Other third party providers support the automated
teller machines owned by the Bank and process the check clearings for the Bank's
negotiable order of withdrawal accounts ("checking accounts"). The Bank is also
reliant upon the Federal Home Loan Bank of Des Moines and the Federal Reserve
System to properly and efficiently conduct its business. Notwithstanding the
Bank's efforts, the failure of any of these third party vendors to address their
year 2000 issues in a timely fashion may have an adverse effect on the Bank's
ability to conduct its business and/or process its customers' transactions. The
Bank's Year 2000 Committee (the "Committee") is working very closely with its
data processing center to ascertain that all software applications and hardware
will be year 2000 compliant by the second quarter of 1999. The Committee is also
monitoring the progress that other key third party providers are making toward
becoming year 2000 compliant.
*The Committee is in the process of developing a contingency plan which
incorporates the actions the Bank will take in situations where the data
processing center or other key third party providers are not able to become year
2000 compliant and it will have a major impact on the Bank's business. The
contingency plan is anticipated to be completed in the second quarter of 1999.
FORWARD-LOOKING INFORMATION
The following paragraphs within Management's Discussion and Analysis of
Financial Condition and Results of Operations contain forward-looking statements
and actual results may differ materially from the expectations disclosed within
this Discussion and Analysis. These forward-looking statements are subject to
risks and uncertainties, including those discussed below. HMN assumes no
obligations to publicly release results of any revision or updates to these
forward-looking statements to reflect future events or unanticipated
occurrences.
PROVISION FOR LOSSES ON LOANS
The provision for losses on loans is the result of management's evaluation
of the loan portfolio including its evaluation of national and regional
economic indicators (including the possibility at each year end that there
would be an increase in general interest rates), such as national and
regional unemployment data, single family loan delinquencies as reported
separately by the Federal National Mortgage Association (FNMA) and the
Federal Home Loan Bank Mortgage Corporation (FHLMC), local single family
construction permits and local economic growth rates and the current
regulatory and general
*This paragraph contains a forward-looking statement(s). Refer to information
regarding Forward-looking Information on page 26 of this discussion.
26
<PAGE>
economic environment. HMN will continue to monitor and modify its allowance
for losses as these conditions dictate. Although HMN maintains its
allowance for losses at a level it considers adequate to provide for
estimated losses, there can be no assurance that such losses will not
exceed the estimated amount or that additional provisions for loan losses
will not be required in future periods.
ALLOWANCE FOR LOAN AND REAL ESTATE LOSSES
Management continues to actively monitor the asset quality and to charge
off loans against the allowance for loan losses when appropriate. Although
management believes it uses the best information available to make
determinations with respect to the allowance for loan losses, future
adjustments may be necessary if economic conditions differ substantially
from the economic conditions in the assumptions used to determine the size
of the allowance for losses.
LIQUIDITY
HMN manages its liquidity position to ensure that the funding needs of
borrowers and depositors are met timely and in the most cost effective
manner. Asset liquidity is the ability to convert assets to cash through
the maturity of the asset or the sale of the asset. Liability liquidity
results from the ability of the Bank to attract depositors or borrow funds
from third party sources such as the FHLB. The Bank is required by
regulation to maintain a monthly average minimum asset liquidity ratio of
4%. The Bank has maintained an average monthly liquidity ratio in excess of
the 4% requirement and does not anticipate that it will fall below the
requirement in the future.
The Bank may fall below the 4% liquidity requirement if unforeseen
economic conditions or unanticipated events occur which would cause our
customers to draw abnormal amounts of cash from their accounts.
HMN anticipates that its liquidity requirements for 1999 will be
similar to the cash flows it experienced in 1998 with the exception of the
redemption of the common stock of MFC which will require only $37,000.
Construction disbursements will also be reduced because both the Spring
Valley and Winona retail banking facilities were completed during 1998.
Expenditures for premises and equipment are anticipated to be $1.0 million
for 1999. The cash needed to fund the mortgage banking activities of HMN
Mortgage Services, Inc. will range from $5.0 million to $20.0 million
during 1999.
The actual cash flows of HMN may be different than the anticipated
cash flows discussed for 1999 due to unforeseen economic conditions or
unanticipated events such as the desire of customers to close all of their
accounts in anticipation of the year 2000.
HMN has certificates of deposit with outstanding balances of $193.9
million that mature during 1999. Based upon past experience management
anticipates that the majority of the deposits will renew for another term.
HMN believes that deposits which do not renew will be replaced with
deposits from other customers, or funded with advances from the FHLB, or
will be funded through the sale of securities. Management does not
anticipate that it will have a liquidity problem due to maturing deposits.
Competitive pricing by other institutions, the desire of a competitor
to pay interest rates on deposits that are above the current rates paid by
HMN, or desire by customers to put more of their funds into nontraditional
bank products such as stocks and bonds could be circumstances that would
cause the maturing certificates to become a liquidity problem.
HMN has $19.0 million of FHLB advances which mature in 2001 but have
call features which can be exercised by the FHLB on a semiannual basis. If
the call features are exercised HMN has the option of requesting any
advance otherwise available to it pursuant to the Credit Policy of the
FHLB. Since HMN has the ability to request another advance to replace the
advance that is being called, Management does not anticipate that it will
have a liquidity problem due to advances being called by the FHLB during
1999.
MARKET RISK
HMN utilizes a model which uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate
the current market value of those assets and liabilities. The model also
calculates the changes in market value of the interest-earning assets and
interest-bearing liabilities due to different interest rate changes.
HMN's actual market value changes for interest earnings assets and
interest bearing liabilities may differ from the projected market values
disclosed in the table in the Market Risk Section.
Certain shortcomings are inherent in the method of analysis in the
table presented in the Market Risk section. 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 rate 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 life time 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 an interest rate increase.
27
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
HMN believes that over the next twelve months interest rates could
conceivably fluctuate in a range of 200 basis points up or down from where
the rates were at December 31, 1998. HMN does not have a trading portfolio.
The table in the Market Risk Section discloses the projected changes in
market value to HMN's interest-earning assets and interest-bearing
liabilities based upon incremental 100 basis point changes in interest
rates from interest rates in effect on December 31, 1998.
Actual interest rates could fluctuate by more than 200 basis points up
or down from rates in effect on December 31, 1998 due to unanticipated
occurrences such as the start of another war in the gulf. Many Asian and
European countries are experiencing economic difficulties which may have a
larger impact on the economy of the United States than is currently
anticipated and thereby cause general interest rates to fluctuate by more
than 200 basis points.
ASSET/LIABILITY MANAGEMENT
HMN's management reviews the impact that changing interest rates will have
on its net interest income projected for the twelve months following
December 31, 1998 to determine if its current level of interest rate risk
is acceptable. HMN's actual net interest income caused by interest rate
changes may differ from the amounts reflected in the table which projects
the estimated impact on net interest income of immediate interest rate
changes called rate shocks. HMN's actual maturing and repricing results of
its interest-earning assets and interest-bearing liabilities may differ
from the amounts reflected in the gap table.
Certain shortcomings are inherent in the method of analysis presented
in each of the tables. 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.
YEAR 2000
HMN has inventoried its computer hardware, computer software, third party
vendors and its other non-computer equipment and has assessed or is in the
process of assessing whether the items are year 2000 compliant. The
hardware testing has been completed. The majority of the non-compliant
hardware was replaced during 1998 at a cost of $67,500. The remaining non-
compliant hardware will be replaced at an approximate cost of $7,500 in the
second quarter of 1999. The computer software inventory indicated that
certain programs were not compliant. Some of those software programs were
replaced during 1998 at a cost of $53,000. Other software programs are
scheduled to be replaced with year 2000 compliant software during the
second quarter of 1999 at an anticipated cost of $27,000. HMN is also in
the process of testing all computer software to determine that the software
is year 2000 compliant. The testing is scheduled to be completed during the
second quarter of 1999. The assessment of non-computer equipment for year
2000 compliance indicated that HMN did not have any significant issues in
this area.
The majority of the Bank's loan and deposit data is supported by a
third party data processing center. Other third party providers support the
automated teller machines owned by the Bank and process the check clearings
for the Bank's negotiable order of withdrawal accounts ("checking
accounts"). The Bank is also reliant upon the Federal Home Loan Bank of Des
Moines and the Federal Reserve System to properly and efficiently conduct
its business. Notwithstanding the Bank's efforts, the failure of any of
these third party vendors to address their year 2000 issues in a timely
fashion may have an adverse effect on the Bank's ability to conduct its
business and/or process its customers' transactions. The Bank's Year 2000
Committee (the "Committee") is working very closely with its data
processing center to ascertain that all software applications and hardware
will be year 2000 compliant by the second quarter of 1999. The Committee is
also monitoring the progress that other key third party providers are
making toward becoming year 2000 compliant.
The Committee is in the process of developing a contingency plan which
incorporates the actions the Bank will take in situations where the data
processing center or other key third party providers are not able to become
year 2000 compliant and it will have a major impact on the Bank's business.
The contingency plan is anticipated to be completed in the second quarter
of 1999.
The estimated costs are dependent upon HMN's third party data
processing center successfully converting its hardware and software to be
year 2000 compliant. The data processing center may not successfully
complete their conversion to all year 2000 hardware and software which may
cause HMN's cost to substantially increase.
The completion of all testing of computer software may determine that
HMN will have to replace additional software at substantially higher costs
than it currently anticipates.
The contingency plan may not be completed or, when it is completed,
may not address an unforeseen event that could occur and as a result of the
event, HMN is not able to conduct its business.
28
<PAGE>
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31, 1998 AND 1997 1998 1997
- -----------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . $ 20,960,957 9,364,635
Securities available for sale:
Mortgage-backed and related securities
(amortized cost $144,320,926 and $135,598,404) . . . . . . . . . 143,146,165 135,935,482
Other marketable securities
(amortized cost $38,657,193 and $68,356,926) . . . . . . . . . . 38,478,623 69,923,477
------------ ------------
181,624,788 205,858,959
------------ ------------
Loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . 13,094,528 2,287,265
Loans receivable, net. . . . . . . . . . . . . . . . . . . . . . . . . 447,455,052 442,068,600
Accrued interest receivable. . . . . . . . . . . . . . . . . . . . . . 3,952,763 4,038,131
Federal Home Loan Bank stock, at cost. . . . . . . . . . . . . . . . . 9,837,900 7,432,200
Mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . 1,005,693 781,005
Real estate, net . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,602 133,939
Premises and equipment, net. . . . . . . . . . . . . . . . . . . . . . 8,382,136 5,880,710
Investment in limited partnerships . . . . . . . . . . . . . . . . . . 2,437,246 5,989,399
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,341,033 4,500,873
Core deposit intangible. . . . . . . . . . . . . . . . . . . . . . . . 1,259,245 1,546,273
Prepaid expenses and other assets. . . . . . . . . . . . . . . . . . . 295,829 1,349,521
------------ ------------
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $694,657,772 691,231,510
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $433,868,907 467,347,688
Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . . . 185,400,000 127,650,021
Other borrowed money . . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 0
Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . 1,086,013 1,365,064
Advance payments by borrowers for taxes and insurance. . . . . . . . . 657,089 786,619
Accrued expenses and other liabilities . . . . . . . . . . . . . . . . 2,663,373 6,056,356
Due to stockholders of Marshalltown Financial Corporation. . . . . . . 37,051 3,555,352
------------ ------------
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . 626,212,433 606,761,100
------------ ------------
Commitments and contingencies
Stockholders' equity:
Serial preferred stock ($.01 par value): authorized 500,000 shares;
issued and outstanding none. . . . . . . . . . . . . . . . . . . 0 0
Common stock ($.01 par value): authorized shares 11,000,000;
issued shares 9,128,662. . . . . . . . . . . . . . . . . . . . . 91,287 91,287
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . 59,739,020 59,698,661
Retained earnings, subject to certain restrictions. . . . . . . . . 63,424,378 60,224,253
Accumulated other comprehensive income (loss) . . . . . . . . . . . (837,838) 1,129,818
Unearned employee stock ownership plan shares . . . . . . . . . . . (5,705,152) (4,554,280)
Unearned compensation restricted stock awards . . . . . . . . . . . (276,867) (600,668)
Treasury stock, at cost 3,835,058 and 2,912,111 . . . . . . . . . . (47,989,489) (31,518,661)
------------ ------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . 68,445,339 84,470,410
------------ ------------
Total liabilities and stockholders' equity. . . . . . . . . . . . . $694,657,772 691,231,510
------------ ------------
------------ ------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
29
<PAGE>
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Interest income:
Loans receivable. . . . . . . . . . . . . . . . . . . . . $35,073,718 28,328,864 25,721,042
Securities available for sale:
Mortgage-backed and related. . . . . . . . . . . . . . 8,830,278 8,255,402 10,027,438
Other marketable . . . . . . . . . . . . . . . . . . . 3,869,089 3,699,378 2,424,628
Securities held to maturity:
Mortgage-backed and related. . . . . . . . . . . . . . 0 33,400 765,120
Other marketable . . . . . . . . . . . . . . . . . . . 0 10,032 104,448
Cash equivalents. . . . . . . . . . . . . . . . . . . . . 432,794 342,433 494,129
Other . . . . . . . . . . . . . . . . . . . . . . . . . . 589,426 420,722 327,520
----------- ----------- -----------
Total interest income. . . . . . . . . . . . . . . . . 48,795,305 41,090,231 39,864,325
----------- ----------- -----------
Interest expense:
Deposits. . . . . . . . . . . . . . . . . . . . . . . . . 22,098,272 19,056,164 18,949,937
Federal Home Loan Bank advances . . . . . . . . . . . . . 9,788,443 6,586,855 5,243,853
Other borrowed money. . . . . . . . . . . . . . . . . . . 11,538 0 0
----------- ----------- -----------
Total interest expense . . . . . . . . . . . . . . . . 31,898,253 25,643,019 24,193,790
----------- ----------- -----------
Net interest income. . . . . . . . . . . . . . . . . . 16,897,052 15,447,212 15,670,535
Provision for loan losses. . . . . . . . . . . . . . . . . . 310,000 300,000 300,000
----------- ----------- -----------
Net interest income after provision for loan losses . . . 16,587,052 15,147,212 15,370,535
----------- ----------- -----------
Noninterest income:
Fees and service charges. . . . . . . . . . . . . . . . . 855,654 487,085 359,249
Securities gains, net . . . . . . . . . . . . . . . . . . 2,798,575 1,249,569 1,029,638
Gain on sales of loans. . . . . . . . . . . . . . . . . . 2,176,924 469,461 39,306
Earnings (loss) in limited partnerships . . . . . . . . . (3,724,710) 220,278 7,400
Other . . . . . . . . . . . . . . . . . . . . . . . . . . 523,623 295,966 487,107
----------- ----------- -----------
Total noninterest income . . . . . . . . . . . . . . . 2,630,066 2,722,359 1,922,700
----------- ----------- -----------
Noninterest expense:
Compensation and benefits . . . . . . . . . . . . . . . . 6,804,112 5,590,297 4,591,367
Occupancy . . . . . . . . . . . . . . . . . . . . . . . . 1,442,003 983,238 825,609
Federal deposit insurance premiums. . . . . . . . . . . . 285,388 238,654 799,890
SAIF assessment . . . . . . . . . . . . . . . . . . . . . 0 0 2,351,563
Advertising . . . . . . . . . . . . . . . . . . . . . . . 444,545 315,771 308,464
Data processing . . . . . . . . . . . . . . . . . . . . . 674,320 508,930 489,045
Amortization of mortgage servicing rights and
net valuation adjustments. . . . . . . . . . . . . . . 888,885 104,538 0
Other . . . . . . . . . . . . . . . . . . . . . . . . . . 2,621,185 1,281,277 1,142,948
----------- ----------- -----------
Total noninterest expense. . . . . . . . . . . . . . . 13,160,438 9,022,705 10,508,886
----------- ----------- -----------
Income before income tax expense . . . . . . . . . . . 6,056,680 8,846,866 6,784,349
Income tax expense . . . . . . . . . . . . . . . . . . . . . 1,999,000 3,268,000 2,510,000
----------- ----------- -----------
Net income . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349
----------- ----------- -----------
----------- ----------- -----------
Basic earnings per share . . . . . . . . . . . . . . . . . . $ 0.82 1.01 0.66
----------- ----------- -----------
----------- ----------- -----------
Diluted earnings per share . . . . . . . . . . . . . . . . . $ 0.77 0.94 0.64
----------- ----------- -----------
----------- ----------- -----------
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period (247,304) 2,473,373 281,609
Less: reclassification adjustment
for gains included in net income. . . . . . . . . . 1,720,352 745,510 614,296
----------- ----------- -----------
Other comprehensive income (loss). . . . . . . . . . . . . . (1,967,656) 1,727,863 (332,687)
----------- ----------- -----------
Comprehensive income . . . . . . . . . . . . . . . . . . . . $ 2,090,024 7,306,729 3,941,662
----------- ----------- -----------
----------- ----------- -----------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
30
<PAGE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Unearned
Employee
Accumulated Stock Unearned
Additional Other Ownership Compensation Total
YEARS ENDED DECEMBER 31, Common Paid-In Retained Comprehensive Plan Restricted Treasury Stockholders'
1998, 1997 AND 1996 Stock Capital Earnings Income (Loss) Shares Stock Awards Stock Equity
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance,
December 31, 1995. . . . . . . $91,287 59,255,152 50,371,038 (265,358) (5,336,150) (1,050,305) (11,378,981) 91,686,683
Net income . . . . . . . . . 4,274,349 4,274,349
Other comprehensive
loss . . . . . . . . . . . (332,687) (332,687)
Treasury stock
purchases. . . . . . . . . (14,364,754) (14,364,754)
Stock options exercised. . . (10,817) 63,180 52,363
Restricted stock awards
cancelled. . . . . . . . . (808) 25,968 (25,160) 0
Amortization of
restricted stock awards. . 231,048 231,048
Restricted stock
awards tax benefit . . . . 13,677 13,677
Earned employee stock
ownership plan shares. . . 141,135 397,630 538,765
------ ---------- ---------- --------- ---------- -------- ----------- ----------
Balance,
December 31, 1996. . . . . . . 91,287 59,398,339 54,645,387 (598,045) (4,938,520) (793,289) (25,705,715) 82,099,444
Net income . . . . . . . . . 5,578,866 5,578,866
Other comprehensive
income . . . . . . . . . . 1,727,863 1,727,863
Treasury stock
purchases. . . . . . . . . (5,988,450) (5,988,450)
Stock options exercised. . . (82,009) 138,754 56,745
Amortization of
restricted stock awards. . 231,621 231,621
Recognition and retention
awards granted . . . . . . 2,250 (39,000) 36,750 0
Restricted stock awards
tax benefit. . . . . . . . 61,092 61,092
Stock option tax benefit . . 20,751 20,751
Earned employee stock
ownership plan shares. . . 298,238 384,240 682,478
------ ---------- ---------- --------- ---------- -------- ----------- ----------
Balance,
December 31, 1997. . . . . . . 91,287 59,698,661 60,224,253 1,129,818 (4,554,280) (600,668) (31,518,661) 84,470,410
Net income . . . . . . . . . 4,057,680 4,057,680
Other comprehensive
loss . . . . . . . . . . . (1,967,656) (1,967,656)
Treasury stock
purchases. . . . . . . . . (17,122,788) (17,122,788)
Amortization of
restricted stock awards. . 210,866 210,866
Restricted stock awards
cancelled. . . . . . . . . (3,515) 112,935 (109,420) 0
Restricted stock awards
tax benefit. . . . . . . . 70,639 70,639
Shares purchased for
employee stock
ownership plan . . . . . . (1,476,000) (1,476,000)
Earned employee stock
ownership plan shares. . . 235,989 325,128 561,117
Employee stock options
exercised. . . . . . . . . (327,071) 763,096 436,025
Stock option tax benefit . . 64,317 64,317
Dividends paid . . . . . . . (857,555) (857,555)
Fractional shares purchased. (1,716) (1,716)
------ ---------- ---------- --------- ---------- -------- ----------- ----------
Balance,
December 31, 1998. . . . . . . $91,287 59,739,020 63,424,378 (837,838) (5,705,152) (276,867) (47,989,489) 68,445,339
------ ---------- ---------- --------- ---------- -------- ----------- ----------
------ ---------- ---------- --------- ---------- -------- ----------- ----------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
31
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . 310,000 300,000 300,000
Provision for real estate losses. . . . . . . . . . . . . . . . . . . . . . . 0 18,000 2,000
Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617,029 434,493 378,753
Amortization of (discounts) premiums, net . . . . . . . . . . . . . . . . . . (10,903) (216,978) (129,636)
Amortization of deferred loan fees. . . . . . . . . . . . . . . . . . . . . . (626,312) (410,111) (440,580)
Amortization of goodwill. . . . . . . . . . . . . . . . . . . . . . . . . . . 180,636 13,858 0
Amortization of core deposit intangible . . . . . . . . . . . . . . . . . . . 287,028 20,727 0
Amortization of other purchase accounting adjustments . . . . . . . . . . . . 728,959 38,379 0
Amortization of mortgage servicing rights and net valuation adjustments . . . 888,885 104,538 0
Capitalized mortgage servicing rights . . . . . . . . . . . . . . . . . . . . (654,871) (36,261) 0
Increase (decrease) in deferred income taxes. . . . . . . . . . . . . . . . . (1,615,600) 83,895 110,400
Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,798,575) (1,249,569) (1,029,638)
Gain on sales of real estate. . . . . . . . . . . . . . . . . . . . . . . . . (21,777) (3,743) (46,625)
Gain on sales of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,176,924) (469,461) (39,306)
Proceeds from sales of loans held for sale. . . . . . . . . . . . . . . . . . 175,149,499 21,626,615 1,779,361
Disbursements on loans held for sale. . . . . . . . . . . . . . . . . . . . . (131,495,377) (18,753,844) 0
Principal collected on loans held for sale. . . . . . . . . . . . . . . . . . 0 (1,946) 0
Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . 210,866 231,621 231,048
Amortization of unearned ESOP shares. . . . . . . . . . . . . . . . . . . . . 325,128 384,240 397,630
Earned employee stock ownership shares priced above original cost . . . . . . 235,989 298,238 141,135
Decrease (increase) in accrued interest receivable. . . . . . . . . . . . . . 85,368 190,834 (33,645)
Decrease in accrued interest payable. . . . . . . . . . . . . . . . . . . . . (279,051) (1,720,271) (19,574)
Equity loss (earnings) of limited partnerships. . . . . . . . . . . . . . . . 3,733,278 (220,278) (7,400)
Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . 1,053,692 (745,309) (48,974)
Increase (decrease) in other liabilities. . . . . . . . . . . . . . . . . . . (353,123) 1,218,475 35,995
Other, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,992) (128,743) (56,470)
------------ ------------ ------------
Net cash provided by operating activities . . . . . . . . . . . . . . . . . 47,820,532 6,586,265 5,798,823
------------ ------------ ------------
Cash flows from investing activities:
Proceeds from sales of securities available for sale . . . . . . . . . . . . . . 172,640,058 94,462,303 101,157,643
Principal collected on securities available for sale . . . . . . . . . . . . . . 42,751,927 15,028,627 16,530,585
Proceeds collected on maturity of securities available for sale. . . . . . . . . 40,824,876 34,118,412 20,500,000
Purchases of securities available for sale . . . . . . . . . . . . . . . . . . . (204,938,051) (103,102,213) (107,860,451)
Proceeds from sales of securities held to maturity . . . . . . . . . . . . . . . 0 348,871 0
Principal collected on securities held to maturity . . . . . . . . . . . . . . . 0 240,441 2,276,661
Proceeds collected on maturity of securities held to maturity. . . . . . . . . . 0 1,000,000 12,652,343
Purchases of securities held to maturity . . . . . . . . . . . . . . . . . . . . 0 0 (709,765)
Proceeds from sales of loans receivable. . . . . . . . . . . . . . . . . . . . . 3,258,772 24,806,862 1,408,015
Purchases of mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . (458,702) (844,601) 0
Purchase interest in limited partnerships. . . . . . . . . . . . . . . . . . . . (181,125) (2,438,750) (2,880,125)
Purchase of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . (2,405,700) (802,700) (1,632,100)
Net increase in loans receivable . . . . . . . . . . . . . . . . . . . . . . . . (89,063,988) (68,579,885) (53,214,798)
Proceeds from sale of real estate. . . . . . . . . . . . . . . . . . . . . . . . 152,415 35,627 379,789
Purchases of premises and equipment. . . . . . . . . . . . . . . . . . . . . . . (3,118,455) (1,856,365) (314,714)
Acquisition of Marshalltown Financial Corporation, net of cash acquired. . . . . 0 (16,822,639) 0
Decrease in due to stockholders of Marshalltown Financial Corporation. . . . . . (3,518,301) 0 0
------------ ------------ ------------
Net cash used by investing activities . . . . . . . . . . . . . . . . . . . (44,056,274) (24,406,010) (11,706,917)
------------ ------------ ------------
Cash flows from financing activities:
Increase (decrease) in deposits. . . . . . . . . . . . . . . . . . . . . . . . . (33,266,351) 1,258,293 (11,062,524)
Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,122,788) (6,350,950) (14,002,254)
Increase in unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . (1,476,000) 0 0
Stock options exercised. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436,025 56,745 52,363
Dividends to stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . (857,555) 0 0
Fractional shares purchased from stock split . . . . . . . . . . . . . . . . . . (1,716) 0 0
Proceeds from Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . 163,100,000 151,800,000 130,000,000
Repayment of Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . (105,350,021) (130,228,568) (92,798,389)
Increase in other borrowed money . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 0 0
Decrease (increase) in advance payments by borrowers for taxes and insurance . . (129,530) 65,143 (32,079)
------------ ------------ ------------
Net cash provided by financing activities . . . . . . . . . . . . . . . . . 7,832,064 16,600,663 12,157,117
------------ ------------ ------------
Increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . 11,596,322 (1,219,082) 6,249,023
Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . . . . . . . 9,364,635 10,583,717 4,334,694
------------ ------------ ------------
Cash and cash equivalents, end of year. . . . . . . . . . . . . . . . . . . . . . . . $ 20,960,957 9,364,635 10,583,717
------------ ------------ ------------
------------ ------------ ------------
Supplemental cash flow disclosures:
Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,177,304 27,363,290 24,213,364
Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,824,441 3,000,500 2,725,433
Supplemental noncash flow disclosures:
Loans securitized and transferred to securities available for sale . . . . . . . $ 27,952,547 16,526,399 15,411,803
Securities held to maturity transferred to securities available for sale . . . . 0 1,295,147 0
Loans transferred to loans held for sale . . . . . . . . . . . . . . . . . . . . 52,294,847 4,346,602 2,491,820
Loans transferred to loans held for investment . . . . . . . . . . . . . . . . . 0 95,503 0
Transfer of loans to real estate . . . . . . . . . . . . . . . . . . . . . . . . 17,105 232,071 188,054
Transfer of real estate to loans . . . . . . . . . . . . . . . . . . . . . . . . 0 84,772 161,954
Treasury stock purchased with liability due to broker. . . . . . . . . . . . . . 0 0 362,500
Due to stockholders of Marshalltown Financial Corporation. . . . . . . . . . . . 0 3,555,352 0
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
32
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
NOTE 1 DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
HMN Financial, Inc. (HMN) is a stock savings bank holding company which owns 100
percent of Home Federal Savings Bank (the Bank or Home Federal). Home Federal
has a community banking philosophy and operates retail banking facilities in
Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud
Insurance Agency, Inc. (OAI) and MSL Financial Corporation (MSL), which offer
financial planning products and services. HMN has two other wholly owned
subsidiaries, Security Finance Corporation (SFC) and HMN Mortgage Services, Inc.
(MSI). SFC invests in commercial loans and commercial real-estate loans located
throughout the United States which were originated by third parties. MSI
operates mortgage banking and mortgage brokerage facilities located in Brooklyn
Park, Minnesota.
The consolidated financial statements included herein are for HMN, SFC,
MSI, the Bank and the Bank's wholly owned subsidiaries, OAI and MSL. All
significant intercompany accounts and transactions have been eliminated in
consolidation. The consolidated financial statements have been prepared in
conformity with generally accepted accounting principles. The following items
set forth the significant accounting policies which HMN follows in presenting
its financial statements.
MATERIAL ESTIMATES In preparing the financial statements, management is
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities as of the date of the balance sheet and revenues and
expenses for the period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to change relate to
the determination of the allowance for losses on loans and the valuation of real
estate acquired in connection with foreclosures or in satisfaction of loans. In
connection with the determination of the allowances for loan and real estate
losses, management obtains independent appraisals for significant properties.
Management believes that the allowances for losses on loans and real estate
are adequate. While management uses available information to recognize losses on
loans and real estate, future additions to the allowances may be necessary based
on changes in economic conditions. In addition, various regulatory agencies, as
an integral part of their examination process, periodically review the
allowances for losses on loans and real estate. Such agencies may require
additions to the allowances based on their judgement about information available
to them at the time of their examination.
CASH EQUIVALENTS For purposes of the statements of cash flows, HMN considers
highly liquid investments with original maturities of three months or less to be
cash equivalents.
SECURITIES HMN classifies its debt and equity securities in one of three
categories: trading, available for sale, or held to maturity. Trading securities
are bought and held principally for the purpose of selling them in the near
term. Securities available for sale include securities that management intends
to use as part of its asset/liability strategy or that may be sold in response
to changes in interest rate, changes in prepayment risk, or similar factors.
Securities held to maturity represent securities which HMN has the positive
intent and ability to hold to maturity.
Securities available for sale are carried at market value. Net unrealized
gains and losses, net of tax effect, are included as a separate component of
stockholders' equity.
Securities held to maturity are carried at cost, adjusted for amortization
of premiums and discounts, as management has the ability and intent to hold them
to maturity.
Premiums and discounts are amortized using the level-yield method over the
period to maturity. Gains and losses on the sale of securities are determined
using the specific-identification method.
LOANS HELD FOR SALE Mortgage loans originated or purchased which are intended
for sale in the secondary market are carried at the lower of cost or estimated
market value in the aggregate. Net fees and costs associated with acquiring
and/or originating loans held for sale are deferred and included in the basis of
the loan in determining the gain or loss on the sale of the loans. Gains are
recognized on settlement date. Net unrealized losses are recognized through a
valuation allowance by charges to income.
LOANS RECEIVABLE, NET Loans receivable, net are considered long-term
investments and, accordingly, are carried at amortized cost. Loan origination
fees received, net of certain loan origination costs, are deferred as an
adjustment to the carrying value of the related loans, and are amortized into
income using the interest method over the estimated life of the loans.
Premiums and discounts on loans are amortized into interest income using
the interest method over the period to contractual maturity, adjusted for
estimated prepayments.
The allowance for loan losses is maintained at an amount considered
adequate by management to provide for probable losses. The allowance for losses
on loans, including both the allocated and unallocated elements, is based on
periodic analysis of the loan portfolio by management. In this analysis,
management considers factors including, but not limited to, specific occurrences
which include loan impairment, changes in the size of the portfolios, general
economic conditions, loan portfolio composition and historical experience. The
allowance for loan losses is established for known or anticipated problem loans,
as well as for loans which are not currently known to require specific
allowances. Loans are charged off to the extent they are deemed to be
uncollectible. The 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.
Interest income is recognized on an accrual basis except when
collectibility is in doubt. When loans are placed on a nonaccrual basis,
generally when the loan is 90 days past due, previously accrued but unpaid
interest is reversed from income. Interest is subsequently recognized as income
to the extent cash is received when, in management's judgement, principal is
collectible.
33
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
All impaired loans, including all loans that are restructured in a troubled
debt restructuring involving a modification of terms, are measured at the
present value of expected future cash flows discounted at the loan's initial
effective interest rate. The fair value of the collateral of an impaired
collateral-dependent loan or an observable market price, if one exists, may be
used as an alternative to discounting. If the measure of the impaired loan is
less than the recorded investment in the loan, impairment will be recognized
through the allowance for loan losses. A loan is considered impaired when, based
on current information and events, it is probable that a creditor will be unable
to collect all amounts due according to the contractual terms of the loan
agreement. Impaired loans are all loans which are delinquent as to principal and
interest for 120 days or greater and all loans that are restructured in a
troubled debt restructuring involving a modification of terms. All portfolio
loans are reviewed for impairment on an individual basis.
MORTGAGE SERVICING RIGHTS Mortgage servicing rights are capitalized and
amortized in proportion to, and over the period of, estimated net servicing
income. HMN periodically evaluates its capitalized mortgage servicing rights for
impairment. Loan type and note rate are predominate risk characteristics of the
underlying loans used to stratify capitalized mortgage servicing rights for
purposes of measuring impairment. Any impairment is recognized through a
valuation allowance.
REAL ESTATE, NET Real estate properties acquired through loan foreclosures are
initially recorded at the lower of the related loan balance, less any specific
allowance for loss, or fair value less estimated selling costs. Valuations are
periodically performed by management and an allowance for losses is established
if the carrying value of a property exceeds its fair value less estimated
selling costs.
PREMISES AND EQUIPMENT Land is carried at cost. Office buildings, improvements,
furniture and equipment are carried at cost less accumulated depreciation.
Depreciation is computed on a straight-line basis over estimated useful
lives of 10 to 40 years for office buildings and improvements and 3 to 12 years
for furniture and equipment.
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF HMN
reviews long-lived assets and certain identifiable intangibles for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable.
INVESTMENT IN LIMITED PARTNERSHIPS HMN has investments in limited partnerships
which invest in mortgage servicing assets, the common stock of other financial
institutions and low to moderate income housing projects which generate tax
credits for HMN. HMN generally accounts for the earnings or losses from the
limited partnerships on the equity method with the exception of the limited
partnership which invests in mortgage servicing assets. HMN adjusts its
investment in this limited partnership recorded under the equity method for an
amount that represents HMN's proportionate share of adjusting the mortgage
servicing assets to the appraised market value of the mortgage servicing assets.
INTANGIBLE ASSETS Goodwill resulting from acquisitions is amortized on a
straight line basis over 25 years. Deposit base intangible is amortized on an
accelerated basis as the certificates of deposit mature over the next eleven
years following the merger. Management reviews intangible assets for impairment
as events or circumstances indicate that the assets may not be recoverable.
STOCK-BASED COMPENSATION Effective January 1, 1996, HMN adopted SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION. It elected to continue using the
accounting methods prescribed by Accounting Principles Board (APB) Opinion No.
25 and related interpretations which measure compensation cost using the
intrinsic value method. HMN has included in Note 16, "Employee Benefits" the
impact of the fair value of employee stock-based compensation plans on net
income and earnings per share on a pro forma basis for awards granted after
January 1, 1995.
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 bases. 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.
EARNINGS PER SHARE AND STOCK SPLIT Effective December 31, 1997 HMN adopted
SFAS No. 128, EARNINGS PER SHARE. SFAS No. 128 established standards for
computing and presenting earnings per share (EPS) and applies to entities with
publicly held common stock or potential common stock. SFAS No. 128 simplified
the standards for computing earnings per share previously found in APB Opinion
No. 15, EARNINGS PER SHARE, and made them comparable to international EPS
standards. It requires dual presentation of basic and diluted EPS on the face of
the income statement for all entities with complex capital structures and
requires a reconciliation of the numerator and denominator of the basic EPS
computation to the numerator and denominator of the diluted EPS computation.
Basic EPS excludes dilution and is computed by dividing income available to
common stockholders by the weighted-average number of common shares outstanding
for the period. Diluted EPS reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock or resulted in the issuance of common stock that then shared
in the earnings of the entity. Refer to Note 17 for disclosure of
EPS calculations.
In February of 1998 HMN authorized a three-for-two stock split in the form
of a fifty percent stock dividend subject to stockholder approval to increase
HMN's authorized common stock from 7.0 million shares to 11.0 million shares. At
the annual meeting on April 28, 1998 the stockholders approved the increase in
authorized common stock. The Board of Directors then declared that the stock
dividend be distributed on May 22, 1998 to stockholders of record on May 8,
1998.
The stock split increased HMN's outstanding common shares from 6,085,775 to
9,128,662 shares. Stockholders' equity has been
34
<PAGE>
restated to give retroactive effect to the stock split for all periods presented
by reclassifying from additional paid-in capital to common stock the par value
of the additional shares arising from the stock split. In addition, all
references in the Consolidated Financial Statements and Notes thereto to number
of shares, per-share amounts, stock option data and market prices of HMN's
common stock have been restated giving retroactive recognition to the
stock split.
NEW ACCOUNTING STANDARDS Effective January 1, 1998 HMN adopted SFAS No. 130,
REPORTING COMPREHENSIVE INCOME. The statement establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements. The statement requires that all items
that are required to be recognized under accounting standards as components of
comprehensive income be disclosed in the financial statements. 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 HMN is comprised entirely of
unrealized gains and losses on securities available for sale.
The gross unrealized holding losses for the year ended December 31, 1998
were $458,384, the income tax benefit would have been $211,080 and therefore,
the net losses were $247,304. The gross reclassification adjustment for 1998 was
$2,798,575, the income tax expense would have been $1,078,223 and therefore, the
net reclassification adjustment was $1,720,352. The gross unrealized holding
gains for the year ended December 31, 1997 were $4,157,775, the income tax
expense would have been $1,684,402 and therefore, the net gain was $2,473,373.
The gross reclassification adjustment for 1997 was $1,249,569, the income tax
expense would have been $504,059 and therefore, the net reclassification
adjustment was $745,510. The gross unrealized holding gains for the year ended
December 31, 1996 were $470,801, the income tax expense would have been $189,192
and therefore, the net gains were $281,609. The gross reclassification
adjustment for 1996 was $1,029,638, the income tax expense would have been
$415,342 and therefore, the net reclassification adjustment was $614,296.
Effective January 1, 1998 HMN adopted SFAS No. 131, DISCLOSURES ABOUT
SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION which establishes new
standards for determining a reportable segment and for disclosing information
regarding each such segment. The amount of each segment item reported should be
the measure reported to the chief operating decision maker for purposes of
making decisions about allocating resources to the segment and assessing its
performance. Adjustments and eliminations made in preparing an enterprise's
general-purpose financial statements and allocations of revenues, expenses and
gains or losses should be included in determining reported segment profit or
loss only if they are included in the measure of the segment's profit or loss
that is used by the chief operating decision maker. Similarly, only those assets
that are included in the measure of the segment's assets that is used by the
chief operating decision maker should be reported for that segment. The adoption
of SFAS No. 131 did not impact HMN's results of operations or financial
condition, but did require the disclosure of segment information. See Note 24
for the disclosure on segment information.
Effective January 1, 1998 HMN adopted SFAS No. 132, EMPLOYERS' DISCLOSURES
ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS which revises employers'
disclosures about pension and other post retirement benefit plans. It does not
change the measurement or recognition of those plans. It standardizes the
disclosure requirements for pensions and other postretirement benefits to the
extent practicable, requires additional information on changes in the benefit
obligation and fair values of plan assets that will facilitate financial
analysis, and eliminates certain disclosures that are no longer as useful as
they were when FASB Statements No. 87, EMPLOYERS' ACCOUNTING FOR PENSIONS, No.
88, EMPLOYERS' ACCOUNTING FOR SETTLEMENT AND CURTAILMENTS OF DEFINED BENEFIT
PENSION PLANS AND FOR TERMINATION BENEFITS, and No. 106, EMPLOYERS' ACCOUNTING
FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS, were issued. SFAS No. 132
suggests combined formats for presentation of pension and other postretirement
benefit disclosures. Restatement of disclosures for earlier periods provided
for comparative purposes is required unless the information is not readily
available. The adoption of SFAS No. 132 did not impact HMN's results of
operations or financial condition. Refer to Note 16 for the disclosure on
Employee Benefits.
In June 1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts (collectively referred to as derivatives), and for
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. If certain conditions are met, a derivative may
be specifically designated as (a) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment, (b)
a hedge of the exposure to variable cash flows of a forecasted transaction, or
(c) a hedge of the foreign currency exposure of a net investment in a foreign
operation, an unrecognized firm commitment, an available-for-sale security, or a
foreign-currency-denominated forecasted transaction.
The accounting for changes in the fair value of a derivative (that is,
gains and losses) depends on the intended use of the derivative and the
resulting designation.
- - For a derivative designated as hedging the exposure to changes in the fair
value of a recognized asset or liability or a firm commitment (referred to
as a fair value hedge), the gain or loss is recognized in earnings in the
period of change together with the offsetting loss or gain on the hedged
item attributable to the risk being hedged. The effect of that accounting
is to reflect in earnings the extent to which the hedge is not effective in
achieving offsetting changes in fair value.
- - For a derivative designated as hedging the exposure to variable cash flows
of a forecasted transaction (referred to as a cash flow hedge), the
effective portion of the derivative's gain or loss is initially reported as
a component of other comprehensive income (outside earnings) and
subsequently reclassified into earnings when the forecasted transaction
affects earnings. The ineffective portion of the gain or loss is reported
in earnings immediately.
- - For a derivative designated as hedging the foreign currency exposure of a
net investment in a foreign operation, the gain or loss is reported in
other comprehensive income (outside earnings) as part of the cumulative
translation adjustment. The accounting for a fair value hedge described
above applies to a derivative designated or an available-for-sale security.
Similarly, the accounting for a cash flow hedge described above applies to
a derivative designated as a hedge of the foreign currency exposure of a
foreign-currency-denominated forecasted transaction.
- - For a derivative not designated as a hedging instrument, the gain or loss
is recognized in earnings in the period of change.
Under SFAS No. 133, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the
35
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ineffective aspect of the hedge. Those methods must be consistent with the
entity's approach to managing risk.
SFAS No. 133 precludes designating a nonderivative financial instrument as
a hedge of an asset, liability, unrecognized firm commitment, or forecasted
transaction except that a nonderivative instrument denominated in a foreign
currency may be designated as a hedge of the foreign currency exposure of an
unrecognized firm commitment denominated in a foreign currency or a net
investment in a foreign operation.
SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning
after June 15, 1999. Initial application should be as of the beginning of an
entity's fiscal quarter; on that date, hedging relationships must be designated
anew and documented pursuant to the provisions of FASB No. 133. HMN is
anticipating that it will adopt SFAS No. 133 in the first quarter of 2000 and is
currently studying the impact of adopting the statement on its financial
statements.
In October 1998, the FASB issued SFAS No. 134, ACCOUNTING FOR
MORTGAGE-BACKED SECURITIES RETAINED AFTER THE SECURITIZATION OF MORTGAGE LOANS
HELD FOR SALE BY A MORTGAGE BANKING ENTERPRISE, which amends SFAS No. 65 to
require that after the securitization of mortgage loans held for sale, an entity
engaged in mortgage banking activities classify the resulting mortgage-backed
securities or other retained interests based on its ability and intent to sell
or hold those investments.
SFAS No. 134 is effective for the first fiscal quarter beginning after
December 15, 1998. Early application was encouraged and was permitted as of
October of 1998. HMN anticipates adopting SFAS No. 134 in the first quarter of
1999 and believes that it will not have a material impact on HMN's financial
condition or the results of its operations.
RECLASSIFICATIONS Certain amounts in the consolidated financial statements for
prior years have been reclassified to conform with the current year
presentation.
NOTE 2 BUSINESS COMBINATIONS AND ACQUISITIONS
On December 5, 1997 HMN, through its wholly owned subsidiary, Home Federal,
completed its merger (the Merger) with Marshalltown Financial Corporation (MFC)
pursuant to a merger agreement dated July 1, 1997. The aggregate consideration
per the merger agreement was $24.8 million, consisting of $23.7 million for 1.35
million outstanding shares of MFC stock, or $17.51 per share, and $1.1 million
for the outstanding MFC options. HMN owned 60,000 shares of MFC stock with a
historical cost of $1.0 million which were cancelled upon the completion of the
merger. The purchase method of accounting was used to record the merger
transaction.
The transaction was funded through a combination of the sale of securities,
and short-term borrowings from the Federal Home Loan Bank of Des Moines
("FHLB"). Pursuant to the merger agreement, the Bank is obligated to provide
cash to MFC stockholders when they submit their MFC stock or outstanding MFC
options. As of December 31, 1998 and 1997 MFC stockholders had not redeemed
shares and/or options with a value of $37,051 and $3,555,352, respectively.
The merger consideration of $24.8 million plus the cancellation of 60,000
shares of MFC common stock owned by HMN with a historical cost of $1.0 million
was allocated as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
<S> <C>
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . $ 5,437,603
Investment securities. . . . . . . . . . . . . . . . . . . . . 48,580,533
Loans receivable, net. . . . . . . . . . . . . . . . . . . . . 69,759,162
Federal Home Loan Bank stock, at cost. . . . . . . . . . . . . 1,195,500
Premises and equipment . . . . . . . . . . . . . . . . . . . . 744,793
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,514,730
Core deposit intangible. . . . . . . . . . . . . . . . . . . . 1,567,000
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . 2,210,518
Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . (103,580,493)
Net deferred tax liabilities . . . . . . . . . . . . . . . . . (1,003,330)
Other liabilities. . . . . . . . . . . . . . . . . . . . . . . (3,578,464)
-------------
Purchase price . . . . . . . . . . . . . . . . . . . . . . . $ 25,847,552
-------------
-------------
- --------------------------------------------------------------------------------
</TABLE>
36
<PAGE>
NOTE 3 SECURITIES AVAILABLE FOR SALE
A summary of securities available for sale at December 31, 1998 and 1997 is as
follows:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
DECEMBER 31, 1998:
Mortgage-backed securities:
FHLMC. . . . . . . . . . . . . . . . . . . . . $ 1,813,967 63,053 0 1,877,020
FNMA . . . . . . . . . . . . . . . . . . . . . 584,799 0 10,829 573,970
GNMA . . . . . . . . . . . . . . . . . . . . . 1,486,585 1,861 1,411 1,487,035
Other. . . . . . . . . . . . . . . . . . . . . 100,912 512 0 101,424
Collateralized mortgage obligations:
FHLMC. . . . . . . . . . . . . . . . . . . . . 37,965,242 22,356 469,027 37,518,571
FNMA . . . . . . . . . . . . . . . . . . . . . 57,063,756 16,237 670,714 56,409,279
Other. . . . . . . . . . . . . . . . . . . . . 45,305,665 77,584 204,383 45,178,866
------------ ------------ ------------ ------------
144,320,926 181,603 1,356,364 143,146,165
------------ ------------ ------------ ------------
Other marketable securities:
U.S. Government and agency obligations . . . . 17,378,636 13,626 1,339 17,390,923
Corporate debt . . . . . . . . . . . . . . . . 7,133,405 941 9,524 7,124,822
Corporate equity . . . . . . . . . . . . . . . 14,145,152 276,333 458,607 13,962,878
------------ ------------ ------------ ------------
38,657,193 290,900 469,470 38,478,623
------------ ------------ ------------ ------------
$182,978,119 472,503 1,825,834 181,624,788
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
DECEMBER 31, 1997:
Mortgage-backed securities:
FHLMC. . . . . . . . . . . . . . . . . . . . . $ 29,934,261 159,036 13,126 30,080,171
FNMA . . . . . . . . . . . . . . . . . . . . . 14,352,421 46,710 59,159 14,339,972
GNMA . . . . . . . . . . . . . . . . . . . . . 6,213,917 12,741 7,885 6,218,773
Other. . . . . . . . . . . . . . . . . . . . . 186,523 0 881 185,642
Collateralized mortgage obligations:
FHLMC. . . . . . . . . . . . . . . . . . . . . 21,583,016 227,165 207,710 21,602,471
FNMA . . . . . . . . . . . . . . . . . . . . . 38,603,926 271,415 217,204 38,658,137
Other. . . . . . . . . . . . . . . . . . . . . 24,724,340 127,068 1,092 24,850,316
------------ ------------ ------------ ------------
135,598,404 844,135 507,057 135,935,482
------------ ------------ ------------ ------------
Other marketable securities:
U.S. Government and agency obligations . . . . 43,403,323 40,398 100,965 43,342,756
Corporate debt . . . . . . . . . . . . . . . . 2,903,330 0 182 2,903,148
Corporate equity . . . . . . . . . . . . . . . 22,050,273 1,632,826 5,526 23,677,573
------------ ------------ ------------ ------------
68,356,926 1,673,224 106,673 69,923,477
------------ ------------ ------------ ------------
$203,955,330 2,517,359 613,730 205,858,959
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
Proceeds from securities available for sale which were sold during 1998
were $172,640,058, resulting in gross gains of $3,050,785 and gross losses of
$252,210. Proceeds from securities available for sale which were sold during
1997 were $94,462,303, resulting in gross gains of $1,533,046 and gross losses
of $283,477. Proceeds from securities available for sale which were sold during
1996 were $101,157,643, resulting in gross gains of $1,235,754 and gross losses
of $206,116.
The following table indicates amortized cost and estimated fair value of
securities available for sale at December 31, 1998, based upon contractual
maturity adjusted for scheduled repayments of principal and projected
prepayments of principal based upon current economic conditions and interest
rates. Actual maturities may differ from the maturities in the following table
because obligors may have the right to call or prepay obligations with or
without call or prepayment penalties:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Amortized Fair
cost value
- --------------------------------------------------------------------------------
<S> <C> <C>
Due less than one year . . . . . . . . . . . . . . $136,687,972 135,739,879
Due after one year through five years. . . . . . . 19,659,996 19,523,631
Due after five years through ten years . . . . . . 7,287,000 7,236,455
After ten years. . . . . . . . . . . . . . . . . . 5,197,999 5,161,945
No stated maturity . . . . . . . . . . . . . . . . 14,145,152 13,962,878
------------ -----------
Total. . . . . . . . . . . . . . . . . . . . . $182,978,119 181,624,788
------------ -----------
------------ -----------
- --------------------------------------------------------------------------------
</TABLE>
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.
NOTE 4 SECURITIES HELD TO MATURITY
During the first quarter of 1997, HMN determined that it no longer had the
intent to hold its securities classified as held to maturity to the actual
maturity date of the securities. Therefore, it sold one security and on March
31, 1997 it transferred all the remaining securities in the held to maturity
portfolio to the available for sale portfolio. The following information
summarizes the sale and transfer of the securities held to maturity during 1997.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
Unrealized
Unrealized Holding Gain,
Amortized Fair Realized Holding Net of Tax,
Cost Value Gain Gain in Equity
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Security sold. . . . . . . . . . . . . . . . . . . . . $ 344,139 348,871 4,732
Securities transferred to available for sale . . . . . $1,223,753 1,295,147 71,394 42,641
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
37
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 LOANS RECEIVABLE, NET
A summary of loans receivable at December 31 is as follows:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------
1998 1997
-----------------------------
<S> <C> <C>
Residential real estate loans:
Conventional . . . . . . . . . . . . . . . . . . . . . . . $378,080,048 399,029,974
FHA. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,294,426 1,797,006
VA . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,298,967 1,857,827
------------ ------------
380,673,441 402,684,807
------------ ------------
Other loans:
Commercial real estate . . . . . . . . . . . . . . . . . . 33,686,778 11,997,014
Autos. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,897,281 2,437,516
Home equity line . . . . . . . . . . . . . . . . . . . . . 19,476,056 19,490,392
Home equity. . . . . . . . . . . . . . . . . . . . . . . . 9,565,652 7,176,253
Other consumer . . . . . . . . . . . . . . . . . . . . . . 1,071,555 411,100
Commercial business. . . . . . . . . . . . . . . . . . . . 11,695,354 5,226,095
Savings. . . . . . . . . . . . . . . . . . . . . . . . . . 994,168 1,362,186
Education. . . . . . . . . . . . . . . . . . . . . . . . . 118,351 123,313
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . 676,838 864,238
------------ ------------
80,182,033 49,088,107
------------ ------------
Total loans. . . . . . . . . . . . . . . . . . . . . . . 460,855,474 451,772,914
Less:
Unamortized discounts. . . . . . . . . . . . . . . . . . . 414,495 547,007
Net deferred loan fees . . . . . . . . . . . . . . . . . . 1,947,778 1,846,692
Allowance for losses . . . . . . . . . . . . . . . . . . . 3,041,485 2,748,219
Loans in process . . . . . . . . . . . . . . . . . . . . . 7,996,664 4,562,396
------------ ------------
$447,455,052 442,068,600
------------ ------------
------------ ------------
Weighted average contractual
interest rate. . . . . . . . . . . . . . . . . . . . . . . 7.21% 7.39%
Commitments to originate,
fund or purchase loans . . . . . . . . . . . . . . . . . . $ 24,419,071 7,367,650
Commitments to deliver
loans to secondary market. . . . . . . . . . . . . . . . . 6,505,374 0
Loans serviced for others. . . . . . . . . . . . . . . . . . 72,275,868 8,218,564
- -------------------------------------------------------------------------------------------
</TABLE>
Included in total commitments to originate or purchase loans are fixed rate
loans aggregating approximately $3,504,094 and $6,010,250 as of December 31,
1998 and 1997, respectively. The interest rates on these commitments ranged from
6.25% to 7.00% at December 31, 1998 and from 6.678% to 7.5% at December 31,
1997.
At December 31, 1998 and 1997, loans on nonaccrual status totaled $475,649
and $263,329, respectively. Had the loans performed in accordance with their
original terms throughout 1998, HMN would have recorded gross interest income of
$49,382 for these loans. Interest income of $28,618 has been recorded on these
loans for the year ended December 31, 1998.
At December 31, 1998 and 1997 there were no loans included in loans
receivable, net with terms that had been modified in a troubled debt
restructuring.
There were no material commitments to lend additional funds to customers
whose loans were classified as restructured or nonaccrual at December 31, 1998.
At December 31, 1998, 1997 and 1996, the recorded investment in loans that
are considered to be impaired were $788,382, $665,151 and $338,310,
respectively, for which the related allowance for credit losses were $39,613,
$34,762 and $17,571, respectively. The average investment in impaired loans
during 1998, 1997 and 1996 were $714,331, $443,754 and $423,042, respectively.
For the years ended December 31, 1998, 1997 and 1996, HMN recognized interest
income on impaired loans of $35,936, $36,564 and $24,662, respectively. All of
the interest income that was recognized during 1998, 1997 and 1996 for impaired
loans was recognized using the cash basis method of income recognition.
The aggregate amount of loans to executive officers and directors of HMN
were $814,609, $884,244 and $385,023, at December 31, 1998, 1997 and 1996,
respectively. During 1998 repayments on loans to executive officers and
directors were $366,059, new loans to executive officers and directors totaled
$561,057 and loans removed from the executive officer listing due to change in
status of the officer was $264,633. During 1997 repayments on loans to executive
officers and directors aggregated $30,679 and loans originated aggregated
$529,900.
At December 31, 1998, 1997 and 1996, HMN was servicing real estate loans
for others with aggregate unpaid principal balances of approximately
$72,275,868, $8,218,564 and $1,417,954, respectively.
HMN originates residential, commercial real estate and other loans
primarily in southern Minnesota and after December 5, 1997 in Iowa. HMN also
purchases loans from a third party broker located in the Southeastern United
States. At December 31, 1998 and 1997, HMN owned single family and multi-family
residential loans located in the following states:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------
1998 1997
---------------------------- --------------------------
Percent Percent
Amount of Total Amount of Total
- -------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Alabama. . . . . . . . . . . . $ 7,790,445 2.1% 4,462,834 1.1%
California . . . . . . . . . . 5,235,023 1.4 9,054,681 2.2
Connecticut. . . . . . . . . . 1,941,298 0.5 1,097,827 0.3
Florida. . . . . . . . . . . . 1,614,802 0.4 1,000,598 0.3
Georgia. . . . . . . . . . . . 52,951,799 13.9 46,309,887 11.5
Iowa . . . . . . . . . . . . . 30,555,584 8.0 49,705,322 12.3
Maine. . . . . . . . . . . . . 1,807,902 0.5 1,328,897 0.3
Massachusetts. . . . . . . . . 5,826,593 1.5 1,256,811 0.3
Minnesota. . . . . . . . . . . 221,860,535 58.3 233,002,052 57.9
North Carolina . . . . . . . . 18,727,395 4.9 11,819,254 2.9
Ohio . . . . . . . . . . . . . 5,413,417 1.4 8,477,956 2.1
South Carolina . . . . . . . . 9,930,680 2.6 8,314,943 2.1
Tennessee. . . . . . . . . . . 5,234,694 1.4 4,288,917 1.1
Wisconsin. . . . . . . . . . . 8,375,398 2.2 20,130,423 5.0
Other states . . . . . . . . . 3,407,876 0.9 2,434,405 0.6
------------ ------ ----------- ------
Total. . . . . . . . . . . . $380,673,441 100.0% 402,684,807 100.0%
------------ ------ ----------- ------
------------ ------ ----------- ------
Amounts under one million dollars are included in "Other states".
- -------------------------------------------------------------------------------------------
</TABLE>
38
<PAGE>
NOTE 6 ALLOWANCE FOR LOAN AND REAL ESTATE LOSSES
The allowance for losses is summarized as follows:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Loans Real estate Total
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Balance, December 31, 1995. . . . . . . . . . . . . . . . . $2,190,664 35,000 2,225,664
Provision for losses . . . . . . . . . . . . . . . . . . 300,000 2,000 302,000
Charge-offs . . . . . . . . . . . . . . . . . . . . . . (150,136) 0 (150,136)
Recoveries . . . . . . . . . . . . . . . . . . . . . . . 57 0 57
Other . . . . . . . . . . . . . . . . . . . . . . . . . 0 (35,000) (35,000)
---------- ------- ---------
Balance, December 31, 1996 . . . . . . . . . . . . . . . . 2,340,585 2,000 2,342,585
Provision for losses . . . . . . . . . . . . . . . . . . 300,000 18,000 318,000
MFC allowance for losses acquired. . . . . . . . . . . . 122,500 0 122,500
Charge-offs . . . . . . . . . . . . . . . . . . . . . . (22,691) (12,000) (34,691)
Recoveries . . . . . . . . . . . . . . . . . . . . . . . 7,825 0 7,825
---------- ------- ---------
Balance, December 31, 1997 . . . . . . . . . . . . . . . . 2,748,219 8,000 2,756,219
Provision for losses . . . . . . . . . . . . . . . . . . 310,000 0 310,000
Charge-offs . . . . . . . . . . . . . . . . . . . . . . (18,599) 0 (18,599)
Recoveries . . . . . . . . . . . . . . . . . . . . . . . 1,865 0 1,865
---------- ------- ---------
Balance, December 31, 1998 . . . . . . . . . . . . . . . . $3,041,485 8,000 3,049,485
---------- ------- ---------
---------- ------- ---------
- ----------------------------------------------------------------------------------------------------------
</TABLE>
NOTE 7 ACCRUED INTEREST RECEIVABLE
Accrued interest receivable at December 31 is summarized as follows:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------
1998 1997
------------------------
<S> <C> <C>
Securities available for sale. . . . . . . . . . . $1,167,903 1,549,173
Loans receivable . . . . . . . . . . . . . . . . . 2,784,860 2,488,958
---------- ----------
$3,952,763 4,038,131
---------- ----------
---------- ----------
- --------------------------------------------------------------------------------
</TABLE>
NOTE 8 INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
1998 1997
-------------------------
<S> <C> <C>
Mortgage servicing rights
Balance, beginning of year . . . . . . . . . . $ 845,517 4,681
Originations . . . . . . . . . . . . . . . . . 654,871 36,261
Purchases. . . . . . . . . . . . . . . . . . . 458,702 844,601
Amortization . . . . . . . . . . . . . . . . . (841,897) (40,026)
---------- ---------
Balance, end of year . . . . . . . . . . . . . 1,117,193 845,517
---------- ---------
Valuation reserve
Balance, beginning of year . . . . . . . . . . (64,512) 0
Additions. . . . . . . . . . . . . . . . . . . (165,583) (64,512)
Reductions . . . . . . . . . . . . . . . . . . 118,595 0
---------- ---------
Balance, end of year . . . . . . . . . . . . . (111,500) (64,512)
---------- ---------
Mortgage servicing rights, net . . . . . . . . 1,005,693 781,005
---------- ---------
---------- ---------
Fair value of mortgage servicing rights . . . $1,005,693 781,005
---------- ---------
---------- ---------
- --------------------------------------------------------------------------------
</TABLE>
All of the loans being serviced were single family loans serviced for FNMA
under the mortgage-backed security program or the individual loan sale program.
The following is a summary of the risk characteristics of the loans being
serviced at December 31, 1998:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
Weighted Weighted
Loan Average Average Number
Principal Interest Remaining of
Balance Rate Term Loans
---------------------------------------------------------
<S> <C> <C> <C> <C>
Original term 30 year
fixed rate . . . . . . . . . . . $37,600,000 7.55% 333 500
Original term 15 year
fixed rate . . . . . . . . . . . 48,200,000 6.83% 157 870
Seven year balloon. . . . . . . . . 1,000,000 6.79% 351 9
Adjustable rate . . . . . . . . . . 31,500,000 7.01% 347 230
- ------------------------------------------------------------------------------------------------
</TABLE>
NOTE 9 REAL ESTATE
A summary of real estate at December 31 is as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
1998 1997
-----------------------
<S> <C> <C>
Real estate in judgement subject
to redemption . . . . . . . . . . . . . . . . $18,602 0
Real estate acquired through foreclosure . . . . 0 141,939
------- -------
18,602 141,939
Allowance for losses . . . . . . . . . . . . . . 8,000 8,000
------- -------
$10,602 133,939
------- -------
------- -------
- --------------------------------------------------------------------------------
</TABLE>
NOTE 10 INVESTMENT IN LIMITED PARTNERSHIPS
Investments in limited partnerships at December 31 were as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Primary partnership activity 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Mortgage servicing rights . . $1,622,519 5,065,682 2,887,525
Common stock of
financial institutions . . 415,189 480,871 0
Low to moderate
income housing . . . . . . 399,538 442,846 0
---------- --------- ---------
$2,437,246 5,989,399 2,887,525
---------- --------- ---------
---------- --------- ---------
- --------------------------------------------------------------------------------
</TABLE>
During 1998 HMN's proportionate loss from the mortgage servicing
partnership was $3,624,000, its proportionate share of losses from the common
stock investments in financial institutions was $65,682 and its proportionate
loss on low income housing was $35,028. During 1998 HMN received low income
housing credits totaling $80,000 which were credited to current income tax
benefits. During 1997 HMN's proportionate revenue from the mortgage servicing
partnership was $239,407, its proportionate share of losses from common stock
investments in financial institutions was $19,129 and it did not recognize any
revenue or loss from low income housing. HMN received low income housing credits
totaling $80,000 which were credited to current income tax benefits during 1997.
During 1996 HMN's proportionate revenue from the mortgage servicing partnership
was $7,400.
NOTE 11 PREMISES AND EQUIPMENT
A summary of premises and equipment at December 31 is as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
1998 1997
--------------------------
<S> <C> <C>
Land . . . . . . . . . . . . . . . . . . . . . . . $ 1,200,610 1,175,169
Office buildings and improvements. . . . . . . . . 6,957,158 5,196,656
Furniture and equipment. . . . . . . . . . . . . . 4,413,715 2,735,835
----------- ----------
12,571,483 9,107,660
Less accumulated depreciation. . . . . . . . . . . 4,189,347 3,226,950
----------- ----------
$ 8,382,136 5,880,710
----------- ----------
----------- ----------
- --------------------------------------------------------------------------------
</TABLE>
39
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12 DEPOSITS
Deposits and their weighted average interest rates at December 31 are summarized
as follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
1998 1997
-------------------------------------------- -------------------------------------------
Weighted Percent of Weighted Percent of
average rate Amount total average rate Amount total
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Noninterest checking . . . . . . . . . . 0.00% $13,187,109 3.0% 0.00% $ 3,832,736 0.8%
NOW accounts . . . . . . . . . . . . . . 1.00 25,458,607 5.9 1.50 23,143,564 5.0
Passbooks. . . . . . . . . . . . . . . . 2.00 35,766,129 8.2 2.62 36,198,890 7.6
Money market accounts. . . . . . . . . . 3.19 29,419,000 6.8 3.34 24,807,554 5.3
------------ ----- ------------ -----
103,830,845 23.9 87,982,744 18.7
------------ ----- ------------ -----
Certificates:
3-3.99%. . . . . . . . . . . . . . . . . 1,943,048 0.4 726,629 0.2
4-4.99%. . . . . . . . . . . . . . . . . 87,581,623 20.2 24,155,281 5.2
5-5.99%. . . . . . . . . . . . . . . . . 160,630,490 37.1 162,916,038 34.9
6-6.99%. . . . . . . . . . . . . . . . . 78,273,256 18.0 178,847,401 38.3
7-7.99%. . . . . . . . . . . . . . . . . 1,341,583 0.3 11,627,046 2.5
Over 8.00% . . . . . . . . . . . . . . . 268,062 0.1 1,092,549 0.2
------------ ----- ------------ -----
Total certificates . . . . . . . . . . . 5.37 330,038,062 76.1 5.81 379,364,944 81.3
------------ ----- ------------ -----
Total deposits . . . . . . . . . . . . . 4.52 $433,868,907 100.0% 5.17 $467,347,688 100.0%
------------ ----- ------------ -----
------------ ----- ------------ -----
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
At December 31, 1998 and 1997, HMN had $37,285,235 and $41,718,775,
respectively, of certificate accounts with balances at $100,000 or more.
Certificates had the following maturities at December 31:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------
1998 1997
---------------------------- -----------------------------
Weighted Weighted
Amount Average Amount Average
REMAINING TERM TO MATURITY (in thousands) rate (in thousands) rate
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
1-6 MONTHS . . . . . . . . . . . . . . . . . . . . $115,301 5.41% $121,295 5.69%
7-12 months. . . . . . . . . . . . . . . . . . . . 79,826 5.04 138,235 5.86
13-36 months . . . . . . . . . . . . . . . . . . . 111,314 5.50 98,515 5.87
Over 36 months . . . . . . . . . . . . . . . . . . 23,597 5.62 21,320 5.92
-------- --------
$330,038 5.37 $379,365 5.81
-------- --------
-------- --------
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
At December 31, 1998 mortgage loans and mortgage-backed and related
securities with an amortized cost of approximately $33,608,000 were pledged as
collateral for certain deposits and $2,179,000 of letters of credit from the
Federal Home Loan Bank (FHLB) were pledged as additional collateral on Bank
deposits.
Interest expense on deposits is summarized as follows for the years ended
December 31:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------------------
<S> <C> <C> <C>
NOW. . . . . . . . . . . . . . . . . . . . . . . . $ 283,143 257,261 323,311
Passbook . . . . . . . . . . . . . . . . . . . . . 816,656 762,923 760,083
Money market . . . . . . . . . . . . . . . . . . . 964,230 490,223 500,811
Certificates . . . . . . . . . . . . . . . . . . . 20,034,243 17,545,757 17,365,732
----------- ---------- ----------
$22,098,272 19,056,164 18,949,937
----------- ---------- ----------
----------- ---------- ----------
- ------------------------------------------------------------------------------------------------
</TABLE>
NOTE 13 FEDERAL HOME LOAN BANK ADVANCES
Federal Home Loan Bank advances consisted of the following at December 31, 1998
and 1997:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------
1998 1997
---------------------------- ----------------------------
YEAR OF MATURITY Amount Rate Amount Rate
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
1998 . . . . . . . . . . . . . . . . . . . . . . . $ 43,250,021 5.85%
1999 . . . . . . . . . . . . . . . . . . . . . . . $15,000,000 4.99% 15,000,000 5.42
2000 . . . . . . . . . . . . . . . . . . . . . . . 30,000,000 5.71 24,000,000 5.97
2001 . . . . . . . . . . . . . . . . . . . . . . . 19,000,000 5.42 19,000,000 5.86
2002 . . . . . . . . . . . . . . . . . . . . . . . 16,000,000 5.61 16,000,000 5.61
2003 . . . . . . . . . . . . . . . . . . . . . . . 15,400,000 5.86 10,400,000 5.89
2008 . . . . . . . . . . . . . . . . . . . . . . . 90,000,000 5.40 0 0.00
------------ ------------
$185,400,000 5.47 $127,650,021 5.80
------------ ------------
------------ ------------
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
40
<PAGE>
Many of the advances listed above have call provisions which allow the FHLB
to request that the advance be paid back or refinanced at the rates then being
offered by the FHLB. Call provisions are not included in the above listed
advances. All of the $19,000,000 maturing in 2001 could be called on a
semiannual basis during 1999 and of the $90,000,000 maturing in 2008,
$10,000,000 could be called on a quarterly basis starting in the third quarter
of 2001 and $80,000,000 could be called on a quarterly basis starting in 2003.
At December 31, 1997 the Bank had an undrawn open line of credit agreement
for $5,000,000 from the FHLB.
At December 31, 1998 the advances and $2,179,000 of letters of credit from
the FHLB were collateralized by the Bank's FHLB stock and mortgage loans with
unamortized principal balances of approximately $325,000,000. The Bank has the
ability to draw additional borrowings of $60,000,000 based upon the mortgage
loans that are currently pledged subject to a requirement to purchase FHLB
stock.
NOTE 14 OTHER BORROWED MONEY
HMN has established a $2,500,000 revolving line of credit with Norwest Bank
Minnesota, N.A. The line of credit matures September 15, 1999. The interest rate
on the line floats with the Federal Funds Rate plus 250 basis points. The line
is secured by 140,000 shares of 7.50% non-cumulative guaranteed trust preferred
securities of ABN AMRO Capital Funding Trust 1 with a carrying value of
$3,612,000.
NOTE 15 INCOME TAXES
Income tax expense for the years ended December 31 is as follows:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------------------
<S> <C> <C> <C>
Current:
Federal . . . . . . . . . . . . . . . . . . . . $2,737,150 2,425,591 1,838,158
State . . . . . . . . . . . . . . . . . . . . . 877,450 758,814 561,442
---------- ---------- ----------
Total current . . . . . . . . . . . . . . . . 3,614,600 3,184,405 2,399,600
---------- ---------- ----------
Deferred:
Federal . . . . . . . . . . . . . . . . . . . . (1,267,000) 65,395 83,833
State . . . . . . . . . . . . . . . . . . . . . (348,600) 18,200 26,567
---------- ---------- ----------
Total deferred . . . . . . . . . . . . . . . (1,615,600) 83,595 110,400
---------- ---------- ----------
$1,999,000 3,268,000 2,510,000
---------- ---------- ----------
---------- ---------- ----------
- ------------------------------------------------------------------------------------------------
</TABLE>
The reasons for the difference between "expected" income tax expense
utilizing the federal corporate tax rate of 34% and the actual income tax
expense are as follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------------------
<S> <C> <C> <C>
Federal expected income tax expense. . . . . . . . . . $2,059,300 3,007,934 2,306,677
Items affecting federal income tax:
Dividend received deduction . . . . . . . . . . . . (354,700) (229,800) (128,100)
State income taxes, net of federal income tax benefit 321,300 512,829 388,086
Low income housing credits. . . . . . . . . . . . . (80,000) (80,000) 0
Other, net. . . . . . . . . . . . . . . . . . . . . 53,100 57,037 (56,663)
---------- --------- ---------
$1,999,000 3,268,000 2,510,000
---------- --------- ---------
---------- --------- ---------
- -----------------------------------------------------------------------------------------------------
</TABLE>
The tax effects of temporary differences that give rise to the deferred tax
assets and deferred tax liabilities are as follows at December 31:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------
1998 1997
--------------------------
<S> <C> <C>
Deferred tax assets:
Allowances for loan and real estate losses. . . . . . . . . . . . . $1,220,900 1,096,900
Investment in limited partnership . . . . . . . . . . . . . . . . . 764,700 0
Discounts on assets and liabilities acquired from MFC . . . . . . . 138,800 343,400
Deferred loan fees. . . . . . . . . . . . . . . . . . . . . . . . . 0 185,900
Deferred compensation and pension costs . . . . . . . . . . . . . . 232,500 143,250
Restricted stock awards . . . . . . . . . . . . . . . . . . . . . . 36,100 46,400
Mortgage loan servicing rights. . . . . . . . . . . . . . . . . . . 0 20,800
Net unrealized loss on securities available for sale. . . . . . . . 521,400 0
---------- ----------
Total gross deferred tax assets . . . . . . . . . . . . . . . . . 2,914,400 1,836,650
Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . 0 0
---------- ----------
Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . 2,914,400 1,836,650
---------- ----------
Deferred tax liabilities:
Tax bad debt reserve over base year . . . . . . . . . . . . . . . . 1,272,000 1,540,600
Premium on assets acquired from MFC . . . . . . . . . . . . . . . . 577,100 1,341,600
Net unrealized gain on securities available for sale. . . . . . . . 0 793,000
FHLB stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463,100 463,100
Deferred loan fees and costs. . . . . . . . . . . . . . . . . . . . 277,300 334,500
Premises and equipment basis difference . . . . . . . . . . . . . . 242,100 333,817
Originated mortgage servicing rights. . . . . . . . . . . . . . . . 252,500 0
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,300 144,733
Unamortized discount on loan sale . . . . . . . . . . . . . . . . . 54,600 92,900
---------- ----------
Total gross deferred tax liabilities. . . . . . . . . . . . . . . 3,192,000 5,044,250
---------- ----------
Net deferred tax liabilities. . . . . . . . . . . . . . . . . . . $ (277,600) (3,207,600)
---------- ----------
---------- ----------
- -----------------------------------------------------------------------------------------------------
</TABLE>
41
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Retained earnings at December 31, 1998 included approximately $8,800,000
for which no provision for income taxes was made. This amount represents
allocations of income to bad debt deductions for tax purposes. Reduction of
amounts so allocated for purposes other than absorbing losses will create income
for tax purposes, which will be subject to the then-current corporate income tax
rate.
NOTE 16 EMPLOYEE BENEFITS
Substantially all full-time employees of the Bank, except the employees acquired
in the MFC merger, are included in a trusteed noncontributory retirement plan
sponsored by the Financial Institutions Retirement Fund. The actuarial present
value of accumulated plan benefits and net assets available for benefits
relating to the Bank's employees is not available because such information is
not accumulated for each participating institution. No contributions were
required in 1998, 1997 or 1996 because the retirement plan is fully funded. The
Bank's policy is to fund retirement plan costs accrued and there are no unfunded
past service costs. For the years ended December 31, 1998, 1997 and 1996 the
amounts charged to operating expenses were $4,900, $5,700, and $5,100,
respectively.
HMN has a qualified, tax-exempt savings plan with a cash or deferred
feature qualifying under Section 401(k) of the Internal Revenue Code (the 401(k)
Plan). All employees who have attained age 21 and completed one month of
employment are eligible to participate provided they work at least 1,000 hours
in each plan year. Participants are permitted to make salary reduction
contributions to the 401(k) Plan of up to 12% of the participant's annual
salary. Each participant's salary reduction is matched by HMN in an amount equal
to 25% of the participant's salary reduction up to a maximum contribution of 8%.
Contributions above 8% are not matched by HMN. Generally all participant and HMN
contributions and earnings are fully and immediately vested. Effective January
1, 1997, for new employees HMN's contributions are vested on a five year cliff
basis. HMN's matching contributions are expensed when made. HMN's contributions
to the 401(k) Plan were $65,900, $47,800, and $41,804, in 1998, 1997 and 1996,
respectively.
During 1994 HMN adopted an Employee Stock Ownership Plan (the ESOP) which
met the requirements of Section(e)(7) of the Internal Revenue Code and Section
407(d)(6) of the Employee Retirement Income Security Act of 1974, as amended
(ERISA) and, as such the ESOP was empowered to borrow in order to finance
purchases of the common stock of HMN. The ESOP borrowed $6,085,770 from HMN to
purchase 912,866 shares of common stock in the initial public offering of HMN.
In December of 1997 the Bank merged with Marshalltown Financial Corporation
(MFC). As a result of the merger, in February 1998, the ESOP borrowed $1,476,000
to purchase 76,933 shares of HMN common stock to provide the employees from MFC
with an ESOP benefit. The ESOP debt requires quarterly payments of principal
plus interest at 7.52%. HMN has committed to make quarterly contributions to the
ESOP necessary to repay the loan including interest. HMN contributed $673,336,
$689,636 and $713,656 to the ESOP, respectively, during 1998, 1997 and 1996.
As the debt is repaid, ESOP shares which were initially pledged as
collateral for its debt, are committed to be released from collateral and
allocated to active employees, based on the proportion of debt service paid in
the year. HMN accounts for its ESOP in accordance with Statement of Position
93-6, EMPLOYERS' ACCOUNTING FOR EMPLOYEE STOCK OWNERSHIP PLANS. Accordingly, the
shares pledged as collateral are reported as unearned ESOP shares in
stockholders' equity. As shares are determined to be ratably released from
collateral, HMN reports compensation expense equal to the current market price
of the shares, and the shares become outstanding for earnings per share
computations. ESOP compensation benefit expense was $721,755, $885,208, and
$634,702, respectively, for 1998, 1997 and 1996.
All employees of the Bank are eligible to participate in the ESOP after
they attain age 21 and complete one year of service during which they worked at
least 1,000 hours. A summary of the ESOP share allocation is as follows for the
years ended:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------
1998 1997 1996
---------------------------------------
<S> <C> <C> <C>
Shares allocated to participants
beginning of the year. . . . . . . . . . . 217,293 162,631 112,443
Shares allocated to participants. . . . . . . 42,312 57,639 59,644
Shares purchased with dividends
from allocated shares. . . . . . . . . . . 800 0 0
Shares distributed to participants. . . . . . (13,684) (2,977) (9,456)
--------- ---------- ---------
Shares allocated to participants
end of year. . . . . . . . . . . . . . . . 246,721 217,293 162,631
--------- ---------- ---------
Unreleased shares beginning
of the year. . . . . . . . . . . . . . . . 683,142 740,781 800,425
Shares purchased. . . . . . . . . . . . . . . 76,933 0 0
Shares released during year . . . . . . . . . (42,312) (57,639) (59,644)
--------- ---------- ---------
Unreleased shares end of year . . . . . . . . 717,763 683,142 740,781
--------- ---------- ---------
Total ESOP shares end of year . . . . . . . . 964,484 900,435 903,412
--------- ---------- ---------
--------- ---------- ---------
Fair value of unreleased
shares at December 31. . . . . . . . . . . 8,433,715 14,801,410 8,951,067
- -------------------------------------------------------------------------------------------
</TABLE>
In June of 1995, HMN as part of a Recognition and Retention Plan (RRP)
awarded 126,729 shares of restricted common stock to its officers and directors.
The shares vest over a five year period and were issued from treasury stock.
Compensation and benefit expense related to the RRP was $210,866, $231,600 and
$231,048 for 1998, 1997 and 1996. In April 1997, 3,000 shares of restricted
common stock were awarded to a director. Those shares vest over a five year
period beginning in 1998.
In June 1995, HMN adopted its only stock option plan, the 1995 Stock Option
and Incentive Plan (the SOP). During 1995, options exercisable for 821,569
shares of HMN common stock were granted to certain officers and directors at an
exercise price of $9.211 per share. The options vest over a five year period and
may be exercised within 10 years of the grant date. In December 1996, options
exercisable for 1,500 shares of common stock were granted to officers at an
exercise price of $12.089. In April 1997, options for 18,000 shares of common
stock were granted to a director at an exercise price of $13.007.
42
<PAGE>
No options were granted during 1998. The fair value of the options granted
were $6.08, $5.55 and $4.49 for 1997, 1996 and 1995, respectively. A summary of
stock option activity under the SOP is detailed as follows:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------
Weighted
Options average
available for Options exercise
grant outstanding price
-----------------------------------------------------
<S> <C> <C> <C>
December 31, 1994. . . . . . . . . . . . . . . . . 0 0
Plan adopted . . . . . . . . . . . . . . . . . . . 912,865
Granted June 21, 1995. . . . . . . . . . . . . . . (821,569) 821,569 $ 9.211
------- -------
December 31, 1995. . . . . . . . . . . . . . . . . 91,296 821,569 9.211
Exercised. . . . . . . . . . . . . . . . . . . . . (7,048) 9.211
Forfeited. . . . . . . . . . . . . . . . . . . . . 18,258 (18,258) 9.211
Granted December 11, 1996. . . . . . . . . . . . . (1,500) 1,500 12.089
------- -------
December 31, 1996. . . . . . . . . . . . . . . . . 108,054 797,763 9.217
Granted April 22, 1997 . . . . . . . . . . . . . . (18,000) 18,000 13.007
Exercised. . . . . . . . . . . . . . . . . . . . . (13,563) 9.211
------- -------
December 31, 1997. . . . . . . . . . . . . . . . . 90,054 802,200 9.302
Exercised. . . . . . . . . . . . . . . . . . . . . (53,209) 9.211
Forfeited. . . . . . . . . . . . . . . . . . . . . 21,745 (21,745) 9.310
------- -------
December 31, 1998. . . . . . . . . . . . . . . . . 111,799 727,246 9.308
------- -------
------- -------
- ---------------------------------------------------------------------------------------------------------
</TABLE>
The following table summarizes information about stock options outstanding
at December 31, 1998:
<TABLE>
<CAPTION>
- ---------------------------------------------- -------------------------
Options Outstanding Options Exercisable
- -------------------------------------------------------------------------
Weighted average
Exercise Number remaining contractual
price outstanding life in years Number Price
- -------------------------------------------------------------------------
<S> <C> <C> <C> <C>
$ 9.211 708,496 6.4 409,994 $ 9.211
12.089 750 7.9 300 12.089
13.007 18,000 8.3 3,600 13.007
-------
727,246
-------
-------
- -------------------------------------------------------------------------
</TABLE>
HMN uses the intrinsic value method as described in APB Opinion No. 25 and
related interpretations to account for its stock incentive plans. Accordingly,
no compensation cost has been recognized for the option plan. Proceeds from
stock options exercised are credited to common stock and additional paid-in
capital. There are no charges or credits to expense with respect to the granting
or exercise of options since the options were issued at fair value on the
respective grant dates. Had compensation cost for HMN's stock-based plan been
determined in accordance with the fair value method recommended by SFAS No. 123,
HMN's net income and earnings per share would have been reduced to the pro forma
amounts indicated below:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------
1998 1997 1996
---------------------------------------------
<S> <C> <C> <C>
Net income:
As reported ........... $4,057,680 5,578,866 4,274,349
Pro forma ............. 3,610,055 4,839,907 3,085,217
Earnings per common share:
As reported:
Basic ............... $ 0.82 1.01 0.66
Diluted ............. 0.77 0.94 0.64
Pro forma:
Basic ............... 0.73 0.88 0.48
Diluted ............. 0.68 0.82 0.46
- ----------------------------------------------------------------------------
</TABLE>
The above disclosed pro forma effects of applying SFAS No. 123 to
compensation costs, may not be representative of the effects on reported pro
forma net income for future years.
The fair value for each option grant for the SOP is estimated on the date
of the grant using the Option Designer Model. The model incorporated the
following assumptions for each year of grant:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------
1997 1996 1995
------------------------------
<S> <C> <C> <C>
Risk-free interest rate... 6.80% 6.21% 6.28%
Expected life ............ 10 years 10 years 10 years
Expected volatility ...... 18.00% 18.00% 20.00%
Expected dividends ....... None None None
- ---------------------------------------------------------------
</TABLE>
NOTE 17 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:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------
1998 1997 1996
------------------------------------
<S> <C> <C> <C>
Weighted average number of
common shares outstanding
used in basic earnings per
common share calculation . . . . . . . 4,923,392 5,525,033 6,473,115
Net dilutive effect of:
Options. . . . . . . . . . . . . . . . 323,593 314,082 82,257
Restricted stock awards. . . . . . . . 51,141 76,151 100,505
--------- --------- ---------
Weighted average number of
shares outstanding adjusted for
effect of dilutive securities. . . . . 5,298,126 5,915,266 6,655,877
--------- --------- ---------
--------- --------- ---------
Income available to common
shareholders . . . . . . . . . . . . . $4,057,680 5,578,866 4,274,349
Basic earnings per
common share . . . . . . . . . . . . . $ 0.82 1.01 0.66
Diluted earnings per
common share . . . . . . . . . . . . . $ 0.77 0.94 0.64
- ------------------------------------------------------------------------------
</TABLE>
NOTE 18 SAIF ASSESSMENT
The Deposit Insurance Fund Act of 1996 (DIFA) was enacted on September 30, 1996.
DIFA addressed the inadequate funding of the Savings Association Insurance Fund
(SAIF). In order to recapitalize the SAIF, DIFA imposed a one-time assessment on
all thrift institutions. The Bank's assessment was a pretax charge of $2,351,563
and was recognized in the third quarter of 1996.
43
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 19 STOCKHOLDERS' EQUITY
HMN was incorporated for the purpose of becoming the savings and loan holding
company of the Bank in connection with the Bank's conversion from a federally
chartered mutual savings bank to a federally chartered stock savings bank,
pursuant to a Plan of Conversion adopted on February 10, 1994. HMN commenced on
May 23, 1994, a Subscription and Community Offering of its shares in connection
with the conversion of the Bank (the Offering). The Offering was closed on June
22, 1994, and the conversion was consummated on June 29, 1994, with the issuance
of 9,128,662 shares of HMN's common stock at a price of $6.67 per share. Total
proceeds from the conversion of $59,178,342 net of costs relating to the
conversion of $1,679,408, have been recorded as common stock and additional
paid-in capital. HMN received all of the capital stock of the Bank in exchange
for 50% of the net proceeds of the conversion.
Starting in 1995 and continuing throughout 1998, HMN has been repurchasing
its own common stock in the open market. HMN purchased 960,800 shares during
1998, 298,334 shares during 1997 and 869,785 shares during 1996 for $17,122,788,
$5,988,450, and $14,364,754, respectively. The shares were placed in treasury
stock.
Refer to Note 1 for disclosure of the stock split which occurred during the
second quarter of 1998.
During 1998 HMN declared and paid dividends as follows:
<TABLE>
<CAPTION>
RECORD DATE PAYABLE DATE DIVIDEND PER SHARE
----------- ------------ ------------------
<S> <C> <C>
May 27, 1998 June 12, 1998 $0.06
August 27, 1998 September 10, 1998 $0.06
December 1, 1998 December 15, 1998 $0.06
</TABLE>
On February 2, 1999 HMN declared a cash dividend of $0.08 per share payable
on March 10, 1999 to holders of record on February 24, 1999.
HMN's certificate of incorporation authorized the issuance of up to 500,000
shares of preferred stock, but to date no shares have been issued.
In order to grant a priority to eligible accountholders in the event of
future liquidation, the Bank, at the time of conversion established a
liquidation account equal to its regulatory capital as of September 30, 1993. In
the event of future liquidation of the Bank, an eligible accountholder who
continues to maintain their deposit account shall be entitled to receive a
distribution from the liquidation account. The total amount of the liquidation
account will be decreased as the balance of eligible accountholders are reduced
subsequent to the conversion, based on an annual determination of such balance.
The liquidation account of MFC was absorbed by the Bank as a result of the
acquisition.
The Bank may not declare or pay a cash dividend to HMN in excess of 100% of
its net income to date during the current calendar year plus the amount that
would reduce by one-half the Bank's surplus capital ratio at the beginning of
the calendar year without prior notice to the OTS. Additional limitations on
dividends declared or paid on, or repurchases of, the Bank's capital stock are
tied to the Bank's level of compliance with its regulatory capital requirements.
NOTE 20 FEDERAL HOME LOAN BANK INVESTMENT, REGULATORY LIQUIDITY AND REGULATORY
CAPITAL REQUIREMENTS
The Bank, as a member of the Federal Home Loan Bank System, is required to hold
a specified number of shares of capital stock, which is carried at cost, in the
Federal Home Loan Bank of Des Moines. In addition, the Bank is required to
maintain cash and other liquid assets in an amount equal to 4% of its deposit
accounts and other obligations due within one year. The Bank has met these
requirements as of December 31, 1998.
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 HMN'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 Tangible, Core, and Risk-based capital (as defined in the
regulations) to total assets (as defined). Management believes, as of December
31, 1998, that the Bank meets all capital adequacy requirements to which it is
subject.
Management believes that based upon the Bank's capital calculations at
December 31, 1998 and other conditions consistent with the Prompt Corrective
Actions Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
44
<PAGE>
At December 31, 1998 the Bank's capital amounts and ratios are also
presented for actual capital, required capital, and excess capital including
amounts and ratios in order to qualify as being well capitalized under the
Prompt Corrective Actions regulations:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
To Be Well Capitalized
Required to Under Prompt
be Adequately Corrective Actions
Actual Capitalized Excess Capital Provisions
---------------------- --------------------- --------------------- --------------------
Percent of Percent of Percent of Percent of
(IN THOUSANDS) Amount Assets (1) Amount Assets (1) Amount Assets (1) Amount Assets (1)
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Bank stockholder's equity ......... $47,997
Plus:
Net unrealized loss on
certain securities
available for sale ........... 652
Less:
Goodwill and other intangibles . 5,600
Excess mortgage servicing rights 264
------
Tier I or core capital ............ 42,785
------
Tier I capital to
adjusted total assets ........ 6.40% $26,735 4.00% $16,050 2.40% $33,419 5.00%
Tier I capital to
risk-weighted assets ........... 12.86% 13,305 4.00% 29,480 8.86% 19,958 6.00%
Less:
Equity investments and other
assets required to be deducted . 22
Plus:
Allowable allowance for loan losses 3,041
------
Risk-based capital ................ $45,804 $26,610 $19,194 $33,263
------
------
Risk-based capital to
risk-weighted assets ........... 13.77% 8.00% 5.77% 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.
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
NOTE 21 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Bank is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit. These instruments
involve, to varying degrees, elements of credit and interest rate risk in excess
of the amounts recognized in the balance sheet. The contract amounts of these
instruments reflect the extent of involvement by the Bank.
The Bank's exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for commitments to extend credit is
represented by the contract amount of these commitments. The Bank uses the same
credit policies in making commitments as it does for on-balance sheet
instruments.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------
Contract amount
--------------------
(IN THOUSANDS) 1998 1997
- ----------------------------------------------------------------------
<S> <C> <C>
Financial instruments whose contract amount
represents credit risk:
Commitments to extend credit ............. $54,145 53,681
Commitment of counter party
to purchase loans .................... 6,505 2,201
Financial instruments whose contract amount
represents interest rate risk:
Commitment to purchase limited partnership
interest in mortgage loan servicing rights 0 181
- ----------------------------------------------------------------------
</TABLE>
Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Since a portion of the commitments are
expected to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements. The Bank evaluates each
customer's creditworthiness on a case-by-case basis. The amount of collateral
obtained, if deemed necessary by the Bank upon extension of credit, is based on
the loan type and on management's credit evaluation of the borrower. Collateral
consists primarily of residential real estate and personal property.
Commitments of counter party to purchase loans represents commitments to
sell loans to FNMA and are entered into in the normal course of business by the
Bank.
NOTE 22 FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS, requires
disclosure of estimated fair values of HMN's 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 as of December 31, 1998,
and 1997 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 HMN'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 estimates are subjective in nature and
involve uncertainties and matters of significant judgment and therefore cannot
be determined with precision. Changes in assumptions could significantly affect
the estimates.
Fair value estimates are based only on existing financial instruments
without attempting to estimate the value of anticipated future business or the
value of assets and liabilities that are not considered financial instruments.
In addition, the tax ramifications related to the realization of the unrealized
gains and losses can have a significant effect on the fair value estimates and
have not been considered in any of the estimates.
45
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The estimated fair value of HMN's financial instruments are shown below.
Following the table, there is an explanation of the methods and assumptions used
to estimate the fair value of each class of financial instruments.
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------
December 31,
---------------------------------------------------------------------------
1998 1997
----------------------------------- -----------------------------------
Carrying Estimated Contract Carrying Estimated Contract
(IN THOUSANDS) amount fair value amount amount fair value amount
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Financial assets:
Cash and cash equivalents . . . . . . . . . $ 20,961 20,961 9,365 9,365
Securities available for sale . . . . . . . 181,625 181,625 205,859 205,859
Loans held for sale . . . . . . . . . . . . 13,095 13,101 2,287 2,287
Loans receivable, net . . . . . . . . . . . 447,455 470,413 442,069 456,012
Federal Home Loan Bank stock. . . . . . . . 9,838 9,838 7,432 7,432
Accrued interest receivable . . . . . . . . 3,953 3,953 4,038 4,038
Financial liabilities:
Deposits. . . . . . . . . . . . . . . . . . 433,869 433,566 467,348 464,670
Federal Home Loan Bank advances . . . . . . 185,400 189,749 127,650 127,147
Other borrowed money. . . . . . . . . . . . 2,500 2,505 0 0
Accrued interest payable. . . . . . . . . . 1,086 1,086 1,365 1,365
Off-balance sheet financial instruments:
Commitments to extend credit. . . . . . . . 0 50 55,997 0 50 53,681
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
CASH AND CASH EQUIVALENTS The carrying amount of cash and cash equivalents
approximates their fair value.
SECURITIES AVAILABLE FOR SALE The fair values of securities are based upon
quoted market prices.
LOANS HELD FOR SALE The fair value of loans held for sale were based upon
quoted market prices for loans with similar interest rates and terms to
maturity.
LOANS RECEIVABLE The fair values of loans receivable were estimated for groups
of loans with similar characteristics. The fair value of the loan portfolio,
with the exception of the adjustable rate portfolio, was calculated by
discounting the scheduled cash flows through the estimated maturity using
anticipated prepayment speeds and using discount rates that reflect the credit
and interest rate risk inherent in each loan portfolio. The fair value of the
adjustable loan portfolio was estimated by grouping the loans with similar
characteristics and comparing the characteristics of each group to the prices
quoted for similar types of loans in the secondary market.
FEDERAL HOME LOAN BANK STOCK The carrying amount of FHLB stock approximates its
fair value.
ACCRUED INTEREST RECEIVABLE The carrying amount of accrued interest receivable
approximates its fair value since it is short-term in nature and does not
present unanticipated credit concerns.
DEPOSITS Under SFAS No. 107, the fair value of deposits with no stated maturity
such as checking, savings and money market accounts, is equal to the amount
payable on demand. The fair value of certificates of deposit is based on the
discounted value of contractual cash flows using as discount rates the rates
that were offered by HMN as of December 31, 1998 and 1997 for deposits with
maturities similar to the remaining maturities of the existing certificates of
deposit. The fair value estimate for deposits does not include the benefit that
results from the low cost funding provided by HMN's existing deposits and
long-term customer relationships compared to the cost of obtaining different
sources of funding. This benefit is commonly referred to as the core deposit
intangible.
ACCRUED INTEREST PAYABLE The carrying amount of accrued interest payable
approximates its fair value since it is short-term in nature.
FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWED MONEY The fair values of
advances and other borrowed money with fixed maturities are estimated based on
discounted cash flow analysis using as discount rates the interest rates charged
by the FHLB or Norwest Bank Minnesota, N.A. at December 31, 1998 and 1997 for
borrowings of similar remaining maturities.
COMMITMENTS TO EXTEND CREDIT The fair value of commitments to extend credit is
estimated using the fees currently charged to enter into similar agreements,
taking into account the remaining terms of the agreements and the present
creditworthiness of the counter parties.
46
<PAGE>
NOTE 23 HMN FINANCIAL, INC. FINANCIAL INFORMATION (PARENT COMPANY ONLY)
The parent company's principal assets are its investment in the Bank and
securities. The following are the condensed financial statements for the parent
company only as of December 31, 1998 and 1997 and for the years ended December
31, 1998, 1997 and 1996.
<TABLE>
<CAPTION>
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Condensed Balance Sheets
Assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . $ 23,167 944,925
Securities available for sale . . . . . . . . . . . . . . . . . . . . . . 7,974,562 14,287,978
Loans receivable from subsidiaries. . . . . . . . . . . . . . . . . . . . 12,434,632 7,050,570
Investment in subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . 50,091,852 62,278,302
Investment in limited partnership . . . . . . . . . . . . . . . . . . . . 415,189 480,871
Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . 344,915 67,883
Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . 711,094 11,615
---------- ----------
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $71,995,411 85,122,144
---------- ----------
---------- ----------
Liabilities and Stockholders' Equity
Other borrowed money. . . . . . . . . . . . . . . . . . . . . . . . . . . $3,525,000 0
Accrued expenses and other liabilities. . . . . . . . . . . . . . . . . . 25,072 651,734
---------- ----------
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,550,072 651,734
---------- ----------
Serial preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,287 91,287
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . 59,739,020 59,698,661
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,424,378 60,224,253
Accumulated other comprehensive income (loss) . . . . . . . . . . . . . . (837,838) 1,129,818
Unearned employee stock option plan shares. . . . . . . . . . . . . . . . (5,705,152) (4,554,280)
Unearned compensation restricted stock awards . . . . . . . . . . . . . . (276,867) (600,668)
Treasury stock, at cost, 1,941,407 and 1,651,615 shares . . . . . . . . . (47,989,489) (31,518,661)
---------- ----------
Total stockholders' equity. . . . . . . . . . . . . . . . . . . . . . . 68,445,339 84,470,410
---------- ----------
Total liabilities and stockholders' equity. . . . . . . . . . . . . . . $71,995,411 85,122,144
---------- ----------
---------- ----------
Condensed Statements of Income
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,342,134 1,071,818 1,105,218
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (57,475) (13,515) (4,943)
Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . 1,622,607 644,278 229,002
Equity in earnings of subsidiaries. . . . . . . . . . . . . . . . . . . . 2,586,843 4,512,080 3,565,441
Equity in losses of limited partnership . . . . . . . . . . . . . . . . . (65,682) (19,129) 0
Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . (24,256) (17,494) (17,233)
Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000) (6,604) (6,868)
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (190) (159) (670)
Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,383) (1,355) (1,271)
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (617,118) (477,030) (475,127)
---------- ---------- ----------
Income before income tax expense. . . . . . . . . . . . . . . . . . . . 4,779,480 5,692,890 4,393,549
Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . 721,800 114,024 119,200
---------- ---------- ----------
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349
---------- ---------- ----------
Condensed Statements of Cash Flows
Cash flows from operating activities:
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,057,680 5,578,866 4,274,349
Adjustments to reconcile net income to cash provided by operating
activities:
Equity in earnings of subsidiaries . . . . . . . . . . . . . . . . . . (2,586,843) (4,512,080) (3,565,441)
Equity in earnings of limited partnership. . . . . . . . . . . . . . . 65,682 19,129 0
Amortization of premiums (discounts), net. . . . . . . . . . . . . . . (56,038) (349) 9,727
Securities gains, net. . . . . . . . . . . . . . . . . . . . . . . . . (1,622,607) (644,278) (229,002)
Provision for deferred income taxes. . . . . . . . . . . . . . . . . . (4,200) (800) (1,400)
Earned employee stock ownership shares priced above original cost. . . 235,989 298,237 141,135
Decrease in restricted stock awards. . . . . . . . . . . . . . . . . . 210,866 231,621 231,048
Decrease in unearned ESOP shares . . . . . . . . . . . . . . . . . . . 325,128 384,240 397,630
(Increase) decrease in accrued interest receivable . . . . . . . . . . (277,032) 148,076 (63,071)
Increase (decrease) in accrued expenses and other liabilities. . . . . 4,489 (165,370) 172,831
Decrease (increase) in other assets. . . . . . . . . . . . . . . . . . (699,479) 6,335 143,321
Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,957 65,035 9,737
---------- ---------- ----------
Net cash provided (used) by operating activities . . . . . . . . . (211,408) 1,408,662 1,520,864
---------- ---------- ----------
Cash flows from investing activities:
Proceeds from sales of securities available for sale. . . . . . . . . . 21,650,412 9,384,529 5,412,430
Principal collected on securities available for sale. . . . . . . . . . 0 0 5,027,241
Proceeds collected on maturity of securities available for sale . . . . 8,574,876 4,018,412 1,500,000
Purchases of securities available for sale. . . . . . . . . . . . . . . (23,800,742) (15,900,938) (5,449,176)
Investment in Home Federal Savings Bank . . . . . . . . . . . . . . . . 0 (1,016,063) 0
Investment in HMN Mortgage Services, Inc. . . . . . . . . . . . . . . . (1,253,800) (844,500) (250,000)
Investment in limited partnership . . . . . . . . . . . . . . . . . . . 0 (500,000) 0
Net increase (decrease) in loans receivable from subsidiaries . . . . . (5,384,062) 283,430 (7,334,000)
---------- ---------- ----------
Net cash used by investing activities. . . . . . . . . . . . . . . (213,316) (4,575,130) (1,093,505)
---------- ---------- ----------
Cash flows from financing activities:
Purchase of treasury stock. . . . . . . . . . . . . . . . . . . . . . . (17,122,788) (6,350,950) (14,002,254)
Increase in unearned ESOP shares. . . . . . . . . . . . . . . . . . . . (1,476,000) 0 0
Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . 436,025 56,745 52,363
Dividends to stockholders . . . . . . . . . . . . . . . . . . . . . . . (857,555) 0 0
Fractional shares purchased from stock split. . . . . . . . . . . . . . (1,716) 0 0
Increase in other borrowed money. . . . . . . . . . . . . . . . . . . . 3,525,000 0 0
Proceeds from dividends on Bank stock . . . . . . . . . . . . . . . . . 15,000,000 6,750,000 15,600,000
---------- ---------- ----------
Net cash provided (used) by financing activities . . . . . . . . . (497,034) 455,795 1,650,109
---------- ---------- ----------
Increase (decrease) in cash and cash equivalents . . . . . . . . . (921,758) (2,710,673) 2,077,468
Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . 944,925 3,655,598 1,578,130
---------- ---------- ----------
Cash and cash equivalents, end of year. . . . . . . . . . . . . . . . . . $ 23,167 944,925 3,655,598
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
47
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 24 BUSINESS SEGMENTS
HMN's wholly owned subsidiaries, Home Federal Savings Bank, and Mortgage
Services, Inc. have been identified as reportable operating segments in
accordance with the provisions of SFAS 131. MSI was deemed to be a segment
because it is a separate corporation which operates independently from the Bank
and it is not regulated by the Office of Thrift Supervision. MSI has been
segmented further into Mortgage Servicing Rights and Mortgage Banking
activities. The mortgage servicing segment owns servicing rights on loans which
have either been sold to FNMA or securitized into mortgage-backed instruments
which were issued by FNMA. MSI receives a servicing fee which is based upon the
outstanding balance of the loan being serviced and pays a subservicer a monthly
fee to service the loan. MSI's mortgage banking activity includes an origination
function and it also purchases loans from other loan originators. All loans
acquired either by origination or by purchase are intended to be resold in the
secondary loan market.
Security Finance Corporation and HMN, the holding company, did not meet the
quantitative thresholds for determining reportable segments and therefore are
included in the "Other" category.
HMN evaluates performance and allocates resources based on the segment's
net income or loss, return on average assets and return on average equity. The
segments follow generally accepted accounting principles as described in the
summary of significant accounting policies.
Each corporation is managed separately with its own president, who reports
directly to HMN's chief operating decision maker, and board of directors.
The following table sets forth certain information about the
reconciliations of reported profit or loss and assets for each of HMN's
reportable segments.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
HMN Mortgage Services, Inc.
---------------------------
Mortgage Total
Home Federal Servicing Mortgage Reportable Consolidated
(DOLLARS IN THOUSANDS) Savings Bank Rights Banking Segments Other Eliminations Total
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
AT OR FOR THE YEAR ENDED DECEMBER 31, 1998:
Interest income -- external customers. . $47,231 0 296 47,527 1,268 0 48,795
Non-interest income -- external customers 3,858 265 953 5,076 1,279 0 6,355
Earnings (loss) on limited partnerships. (3,725) 0 0 (3,725) 0 0 (3,725)
Intersegment interest income . . . . . . 46 0 0 46 602 (648) 0
Intersegment non-interest income . . . . 0 0 0 0 2,779 (2,779) 0
Interest expense . . . . . . . . . . . . 31,887 0 307 32,194 352 (648) 31,898
Amortization of mortgage servicing rights
and net valuation adjustments. . . . . 56 833 0 889 0 0 889
Other non-interest expense . . . . . . . 10,707 57 1,157 11,921 656 (306) 12,271
Income tax expense (benefit) . . . . . . 1,516 (251) (87) 1,178 821 0 1,999
Net income (loss). . . . . . . . . . . . 2,942 (374) (128) 2,440 4,204 (2,586) 4,058
Total assets . . . . . . . . . . . . . . 672,870 371 11,710 684,951 75,053 (65,346) 694,658
Net interest margin. . . . . . . . . . . 2.33% NM NM NM NM NM 2.47%
Return on average assets . . . . . . . . 0.43 (64.93)% (2.31)% NM NM NM 0.57
Return on average realized common equity 5.78 (64.93) (13.54) NM NM NM 5.38
AT OR FOR THE YEAR ENDED DECEMBER 31, 1997:
Interest income -- external customers. . $39,957 0 9 39,966 1,124 0 41,090
Non-interest income -- external customers 1,797 0 97 1,894 608 0 2,502
Earnings (loss) on limited partnerships. 220 0 0 220 0 0 220
Intersegment interest income . . . . . . 0 0 0 0 344 (344) 0
Intersegment non-interest income . . . . 0 0 0 0 5,137 (5,137) 0
Interest expense . . . . . . . . . . . . 25,720 0 8 25,728 259 (344) 25,643
Amortization of mortgage servicing rights 105 0 0 105 0 0 105
Other non-interest expense . . . . . . . 7,739 0 689 8,428 510 (20) 8,918
Income tax expense (benefit) . . . . . . 3,336 0 (241) 3,095 173 0 3,268
Net income (loss). . . . . . . . . . . . 4,775 0 (350) 4,425 5,666 (4,512) 5,579
Total assets . . . . . . . . . . . . . . 667,521 781 2,234 670,536 90,839 (70,143) 691,232
Net interest margin. . . . . . . . . . . 2.64% NM NM NM NM NM 2.77%
Return on average assets . . . . . . . . 0.86 NM (96.38)% NM NM NM 0.98
Return on average realized common equity 7.72 NM (146.84) NM NM NM 6.84
AT OR FOR THE YEAR ENDED DECEMBER 31, 1996:
Interest income -- external customers. . $38,788 4 38,792 1,072 0 39,864
Non-interest income -- external customers 1,705 0 1,705 218 0 1,923
Intersegment interest income . . . . . . 0 0 0 96 (96) 0
Intersegment non-interest income . . . . 0 0 0 3,577 (3,577) 0
Interest expense . . . . . . . . . . . . 24,259 0 24,259 31 (96) 24,194
Other non-interest expense . . . . . . . 9,942 70 10,012 508 12 10,532
Income tax expense (benefit) . . . . . . 2,406 (27) 2,379 131 0 2,510
Net income (loss). . . . . . . . . . . . 3,587 (40) 3,547 4,292 (3,565) 4,274
Total assets . . . . . . . . . . . . . . 537,870 211 538,081 85,648 (68,997) 554,732
Net interest margin. . . . . . . . . . . 2.77% NM NM NM NM 2.89%
Return on average assets . . . . . . . . 0.67 (52.08)% NM NM NM 0.78
Return on average realized common equity 5.28 (52.11) NM NM NM 4.82
</TABLE>
NM - Not meaningful
48
<PAGE>
INDEPENDENT AUDITOR'S REPORT
[LOGO]
THE BOARD OF DIRECTORS
HMN FINANCIAL, INC.
SPRING VALLEY, MINNESOTA:
We have audited the accompanying consolidated balance sheets of HMN Financial,
Inc. and Subsidiaries (the Company) as of December 31, 1998 and 1997, and the
related consolidated statements of income, comprehensive income, stockholders'
equity and cash flows for each of the years in the three-year period ended
December 31, 1998. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of HMN
Financial, Inc. and Subsidiaries at December 31, 1998 and 1997, and the results
of their operations and their cash flows for each of the years in the three-year
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ KPMG Peat Marwick LLP
MINNEAPOLIS, MINNESOTA
FEBRUARY 26, 1999
49
<PAGE>
SELECTED QUARTERLY FINANCIAL DATA
<TABLE>
<CAPTION>
December 31, September 30, June 30,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1998 1998
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Selected Operations Data (3 MONTHS ENDED):
Interest income ........................................ $ 11,951 12,297 12,446
Interest expense ....................................... 7,695 8,239 8,176
--------- --------- ---------
Net interest income ............................... 4,256 4,058 4,270
Provision for loan losses .............................. 75 85 75
--------- --------- ---------
Net interest income after provision for loan losses 4,181 3,973 4,195
--------- --------- ---------
Noninterest income:
Fees and service charges .......................... 170 194 258
Securities gains (losses), net .................... 817 348 738
Gain on sales of loans ............................ 940 519 352
Earnings (loss) in limited partnerships ........... (111) (2,676) (2,090)
Other noninterest income .......................... 120 128 161
--------- --------- ---------
Total noninterest income ........................ 1,936 (1,487) (581)
--------- --------- ---------
Noninterest expense:
Compensation and benefits ......................... 1,490 1,582 1,880
Occupancy ......................................... 358 361 358
Federal deposit insurance premiums ................ 66 73 73
Advertising ....................................... 91 124 136
Data processing ................................... 169 167 165
Amortization of mortgage servicing rights and
net valuation adjustments ....................... 299 257 219
Other noninterest expense ......................... 813 613 612
--------- --------- ---------
Total noninterest expense ....................... 3,286 3,177 3,443
--------- --------- ---------
Income before income tax expense .................. 2,831 (691) 171
Income tax expense ..................................... 786 (257) 66
--------- --------- ---------
Net income ........................................ $ 2,045 (434) 105
--------- --------- ---------
--------- --------- ---------
Basic earnings per share ............................... $ 0.45 (0.09) 0.02
--------- --------- ---------
--------- --------- ---------
Diluted earnings per share ............................. $ 0.42 (0.09) 0.02
--------- --------- ---------
--------- --------- ---------
Financial Ratios:
Return on average assets(1) ............................ 1.17% (0.24) 0.44
Return on average equity(1) ............................ 11.74 (2.46) 4.03
Average equity to average assets ....................... 10.63 10.86 11.42
Dividend payout ratio .................................. 21.62 (66.67) 42.86
Net interest margin(1)(2) .............................. 2.50 2.35 2.47
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------------------------------
Selected Financial Condition Data:
Total assets ........................................... $ 694,658 706,269 724,080
Securities available for sale:
Mortgage-backed and related securities ............ 143,146 137,316 141,835
Other marketable securities ....................... 38,479 56,326 69,534
Loans held for sale .................................... 13,095 6,882 8,091
Loans receivable, net .................................. 447,455 466,471 459,865
Deposits ............................................... 433,869 446,333 467,133
Federal Home Loan Bank advances ........................ 185,400 184,579 177,936
Stockholders' equity ................................... 68,445 68,093 70,118
- --------------------------------------------------------------------------------------------------------
<CAPTION>
50
<PAGE>
March 31, December 31, September 30, June 30, March 31,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1997 1997 1997
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Selected Operations Data (3 MONTHS ENDED):
Interest income ........................................ 12,101 10,706 10,315 10,166 9,903
Interest expense ....................................... 7,788 6,857 6,465 6,297 6,024
--------- --------- --------- --------- ---------
Net interest income ............................... 4,313 3,849 3,850 3,869 3,879
Provision for loan losses .............................. 75 75 75 75 75
--------- --------- --------- --------- ---------
Net interest income after provision for loan losses 4,238 3,774 3,775 3,794 3,804
--------- --------- --------- --------- ---------
Noninterest income:
Fees and service charges .......................... 202 169 122 100 96
Securities gains (losses), net .................... 896 377 488 114 271
Gain on sales of loans ............................ 366 135 117 64 153
Earnings (loss) in limited partnerships ........... 52 0 67 39 73
Other noninterest income .......................... 146 59 85 88 105
--------- --------- --------- --------- ---------
Total noninterest income ........................ 1,662 740 879 405 698
--------- --------- --------- --------- ---------
Noninterest expense:
Compensation and benefits ......................... 1,852 1,484 1,432 1,359 1,316
Occupancy ......................................... 365 264 245 232 241
Federal deposit insurance premiums ................ 74 63 58 59 59
Advertising ....................................... 93 101 63 73 78
Data processing ................................... 174 137 129 119 125
Amortization of mortgage servicing rights and
net valuation adjustments ....................... 105 102 3 0 0
Other noninterest expense ......................... 591 401 299 284 296
--------- --------- --------- --------- ---------
Total noninterest expense ....................... 3,254 2,552 2,229 2,126 2,115
--------- --------- --------- --------- ---------
Income before income tax expense .................. 2,646 1,962 2,425 2,073 2,387
Income tax expense ..................................... 983 714 901 740 913
--------- --------- --------- --------- ---------
Net income ........................................ 1,663 1,248 1,524 1,333 1,474
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Basic earnings per share ............................... 0.31 0.23 0.28 0.24 0.27
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Diluted earnings per share ............................. 0.28 0.21 0.26 0.23 0.25
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Financial Ratios:
Return on average assets(1) ............................ 0.96 0.84 1.06 0.95 1.09
Return on average equity(1) ............................ 7.98 6.09 7.29 6.58 7.43
Average equity to average assets ....................... 12.04 14.36 14.55 14.55 14.65
Dividend payout ratio .................................. 21.43 0.00 0.00 0.00 0.00
Net interest margin(1)(2) .............................. 2.59 2.60 2.76 2.83 2.92
(DOLLARS IN THOUSANDS)
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Financial Condition Data:
Total assets ........................................... 732,118 691,232 568,847 566,865 553,021
Securities available for sale:
Mortgage-backed and related securities ............ 137,474 135,936 111,117 115,016 123,925
Other marketable securities ....................... 81,648 69,923 72,815 73,860 56,224
Loans held for sale .................................... 8,318 2,287 2,090 1,205 1,061
Loans receivable, net .................................. 450,210 442,069 352,925 345,516 341,104
Deposits ............................................... 466,998 467,348 366,682 365,385 364,123
Federal Home Loan Bank advances ........................ 167,293 127,650 112,007 114,364 105,721
Stockholders' equity ................................... 84,954 84,470 84,619 81,798 78,772
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Annualized
(2) Net interest income divided by average interest-earning assets.
51
<PAGE>
OTHER FINANCIAL DATA
The following table sets forth the maximum month-end balance and average balance
of FHLB advances.
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
-----------------------------------
(DOLLARS IN THOUSANDS) 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Maximum Balance:
Federal Home Loan Bank advances ............................................ $194,579 128,007 106,436
Federal Home Loan Bank short-term borrowings................................ 46,893 60,429 64,429
Average Balance:
Federal Home Loan Bank advances ............................................ 172,232 112,500 89,656
Federal Home Loan Bank short-term borrowings................................ 32,145 45,598 47,949
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
The following table sets forth certain information as to the Bank's FHLB
advances.
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------
December 31,
-------------------------------------------------------------------
1998 1997 1996
-------------------- -------------------- -------------------
Weighted Weighted Weighted
Average Average Average
(DOLLARS IN THOUSANDS) Amount Rate Amount Rate Amount Rate
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Federal Home Loan Bank short-term borrowings.......... $ 15,000 4.99% 43,250 5.85% 46,429 5.52%
Other Federal Home Loan Bank long-term advances....... 170,400 5.51 84,400 5.77 59,650 5.74
------- ------- -------
Total.............................................. $185,400 5.47 127,650 5.80 106,079 5.64
------- ------- -------
------- ------- -------
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
Refer to Note 13 of the Notes to Consolidated Financial Statements for more
information on the Bank's FHLB advances.
COMMON STOCK INFORMATION
The common stock of HMN Financial, Inc. is listed on the Nasdaq Stock Market
under the symbol: HMNF. The common stock outstanding is 9,128,662 shares of
which 3,835,058 shares are in treasury stock at December 31, 1998. As of
December 31, 1998 there are 851 stockholders of record and 1,150 estimated
beneficial stockholders. The following table represents the stock price
information for HMN Financial, Inc. as furnished by Nasdaq for each quarter
starting in 1995 through December 31, 1998.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
March 31, June 30, Sept. 29, Dec. 29, March 29, June 28, Sept. 30, Dec. 31,
1995 1995 1995 1995 1996 1996 1996 1996
-----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
HIGH.... $9.00 9.33 10.42 10.83 10.75 11.00 11.00 12.42
LOW..... 7.17 8.33 9.08 9.92 9.67 9.75 10.08 10.67
CLOSE... 8.50 9.08 10.17 10.67 9.75 11.00 10.67 12.08
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
March 31, June 30, Sept. 30, Dec. 31, March 31, June 30, Sept. 30, Dec. 31,
1997 1997 1997 1997 1998 1998 1998 1998
-----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
HIGH.... $16.50 16.25 17.33 21.67 21.33 20.67 16.06 14.75
LOW..... 12.00 12.42 14.58 16.17 17.50 15.50 13.25 10.38
CLOSE... 13.36 15.33 16.50 21.67 20.00 15.88 14.50 11.75
</TABLE>
52
<PAGE>
CORPORATE AND SHAREHOLDER INFORMATION
HMN FINANCIAL, INC. DIRECTORS BRANCH OFFICES OF BANK
101 North Broadway
Spring Valley, MN 55975 ROGER P. WEISE ALBERT LEA
(507) 346-1100 CHAIRMAN OF THE BOARD 143 West Clark St.
PRESIDENT AND CHIEF Albert Lea, MN 56007
ANNUAL MEETING EXECUTIVE OFFICER (507) 377-3330
The annual meeting of
shareholders will be JAMES B. GARDNER AUSTIN
held on Tuesday, April EXECUTIVE VICE PRESIDENT 201 Oakland Avenue West
27, 1999 at 10:00 a.m. AND CHIEF FINANCIAL Austin, MN 55912
(Central Time) at the OFFICER (507) 433-2355
Best Western Apache
Hotel, 1517 16th St. IRMA R. RATHBUN LACRESCENT
S.W., Rochester, RETIRED VICE PRESIDENT OF 208 South Walnut
Minnesota. HOME FEDERAL SAVINGS BANK LaCrescent, MN 55947
(507) 895-4090
LEGAL COUNSEL M.F. SCHUMANN
Faegre & Benson LLP LICENSED PUBLIC MARSHALLTOWN
2200 Norwest Center ACCOUNTANT 303 West Main Street
90 South Seventh St. SCHUMANN, GRANAHAN, HESSE Marshalltown, IA 50158
Minneapolis, MN 55402- & WILSON, LTD. (515) 754-6000
3901
TIMOTHY R. GEISLER 29 South Center Street
INDEPENDENT AUDITORS MANAGER CORPORATE TAX Marshalltown, IA 50158
KPMG Peat Marwick LLP UNIT (515) 754-6040
4200 Norwest Center MAYO CLINIC
90 South Seventh St. ROCHESTER
Minneapolis, MN 55402- DUANE D. BENSON Crossroads Shopping
3900 EXECUTIVE DIRECTOR Center
MINNESOTA BUSINESS Rochester, MN 55901
INVESTOR INFORMATION AND PARTNERSHIP (507) 289-4025
FORM 10-K
Additional information EXECUTIVE OFFICERS 1110 6th Street NW
and HMN's Form 10-K, Rochester, MN 55901
filed with the ROGER P. WEISE (507) 285-1707
Securities and Exchange PRESIDENT AND
Commission is available CHIEF EXECUTIVE OFFICER SPRING VALLEY
without charge upon 715 North Broadway
request from: JAMES B. GARDNER Spring Valley, MN 55975
HMN Financial, Inc. EXECUTIVE VICE PRESIDENT (507) 346-7345
Attn: Investor Relations AND CHIEF FINANCIAL
101 North Broadway OFFICER TOLEDO
Spring Valley, MN 55975- 119 West High Street
0231 DWAIN C. JORGENSEN Toledo, IA 52342
SENIOR VICE PRESIDENT (515) 484-5141
TRANSFER AGENT AND
REGISTRAR MICHAEL MCNEIL WINONA
Inquiries regarding SENIOR VICE PRESIDENT 175 Center Street
change of address, Winona, MN 55987
transfer requirements, TIMOTHY P. JOHNSON (507) 454-4912
and lost certificates VICE PRESIDENT AND
should be directed to TREASURER HMN MORTGAGE SERVICES,
the transfer agent. INC.
Norwest Bank Minnesota,
N.A. BROOKLYN PARK
Shareowner Services Mortgage Origination and
PO Box 64854 Mortgage Banking Office
St. Paul, MN 55164-0854 7101 Northland Circle,
(800) 468-9716 Suite 105
Brooklyn Park, MN 55427
(612) 533-2500
<PAGE>
SUBSIDIARIES OF REGISTRANT
EXHIBIT 21
<TABLE>
<CAPTION>
Date and % of Voting
Shares, Partnership Interests,
Year & Voting Trust Certificates,
Name & Address State Inc. Capital Contributions Description of Activity
-------------- ---------- -------------------- -----------------------
<S> <C> <C> <C>
Home Federal Savings Bank 1934 6/29/94 Federally Chartered Stock
101 North Broadway MN HMN owns 100% of voting Savings Bank
Spring Valley, MN 55975 shares
Osterud Insurance Agency, Inc. 1983 Bank owns 100% Offers credit life and annuity
101 North Broadway MN products to the Bank's customers
Spring Valley, MN 55975 and others
MSL Financial Corporation 1983 Bank owns 100% Offered annuity products to
101 North Broadway IA Marshalltown Financial
Spring Valley, MN 55975
Security Finance Corporation 1929 12/29/95 Corporation invests in
101 North Broadway MN HMN owns 100% of voting securities and loans
Spring Valley, MN 55975 shares
HMN Mortgage Services, Inc. 1996 7/08/96 Mortgage Banking/
7101 Northland Circle, Suite 105 MN HMN owns 100% of Brokerage Office
Brooklyn Park, MN 55427 voting shares
</TABLE>
<PAGE>
Exhibit 23
KPMG Peat Marwick LLP
4200 Norwest Center
90 South Seventh Street
Minneapolis, MN 55402
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors
HMN Financial, Inc.:
We consent to incorporation by reference of our report dated February 26, 1999,
relating to the consolidated balance sheets of HMN Financial, Inc. as of
December 31, 1998 and 1997, and the related consolidated statements of income,
comprehensive income, stockholders' equity and cash flows for each of the years
in the three-year period ended December 31, 1998, which report appears in the
December 31, 1998 annual Report on Form 10-K of HMN Financial, Inc. in the
following Registration Statements of HMN Financial, Inc.: Nos. 33-88228, 33-
94388, and 33-94386 on Form S-8.
/s/KPMG Peat Marwick LLP
------------------------
KPMG PEAT MARWICK LLP
Minneapolis, Minnesota
March 30, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 9
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1998 AND THE CONSOLIDATED STATEMENT
OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1998, AND IS QUALIFIED IN ITS ENTIRETY
BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 2,386
<INT-BEARING-DEPOSITS> 18,575
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 181,625
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 447,455
<ALLOWANCE> 3,041
<TOTAL-ASSETS> 694,658
<DEPOSITS> 433,869
<SHORT-TERM> 17,500
<LIABILITIES-OTHER> 4,444
<LONG-TERM> 170,400
0
0
<COMMON> 91
<OTHER-SE> 68,354
<TOTAL-LIABILITIES-AND-EQUITY> 694,658
<INTEREST-LOAN> 35,074
<INTEREST-INVEST> 12,699
<INTEREST-OTHER> 1,022
<INTEREST-TOTAL> 48,795
<INTEREST-DEPOSIT> 22,098
<INTEREST-EXPENSE> 31,898
<INTEREST-INCOME-NET> 16,897
<LOAN-LOSSES> 310
<SECURITIES-GAINS> 2,799
<EXPENSE-OTHER> 13,160
<INCOME-PRETAX> 6,057
<INCOME-PRE-EXTRAORDINARY> 4,058
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,058
<EPS-PRIMARY> .82
<EPS-DILUTED> .77
<YIELD-ACTUAL> 2.47
<LOANS-NON> 476
<LOANS-PAST> 312
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 72
<ALLOWANCE-OPEN> 2,748
<CHARGE-OFFS> (19)
<RECOVERIES> 2
<ALLOWANCE-CLOSE> 3,041
<ALLOWANCE-DOMESTIC> 2,812
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 229
</TABLE>
