Summary of HMN FINANCIAL INC

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-looking Information
This quarterly report and other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as "expect," "intent," "look," "believe," "anticipate," "estimate," "project," "seek," "may," "will," "would," "could," "should," "trend," "target," and "goal" or similar statements or variations of such terms and include, but are not limited to those relating to the adequacy of the allowance for loan losses, the adequacy of available liquidity to the Bank, the future outlook for the Company, the Company's ability to realize the benefit of deferred tax assets and the Company's compliance with regulatory standards. A number of factors could cause actual results to differ materially from the Company's assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate securing loans to borrowers, possible legislative and regulatory changes and adverse economic, business and competitive developments such as shrinking interest margins; reduced collateral values; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments, changes in credit or other risks posed by the Company's loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; the Company's participation in the U.S. Treasury Department's Capital Purchase Program; the Company's use of the proceeds from the sale of securities to the U.S. Treasury Department or other significant uncertainties. Additional factors that may cause actual results to differ from the Company's assumptions and expectations include those set forth in the Company's most recent filing on Form 10-K and Form 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the "Risk Factors" section of the Company's Annual Report on Form 10-K for the year ended December 31, 2008 and Part II, Item 1A of this quarterly report on Form 10-Q.
General
The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits, Federal Home Loan Bank (FHLB) advances, and Federal Reserve borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company's net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization of mortgage servicing assets. Over the past several years, the Company has increased the emphasis on commercial and commercial real estate loans, which has increased the credit risk inherent in the loan portfolio. While HMN did not originate or hold subprime mortgages in its loan portfolio, purchase investments backed by subprime mortgages, or incur any write downs directly related to subprime mortgages, subprime credit issues indirectly impacted the Company by making it more difficult for some borrowers with marginal credit to qualify for a mortgage because most of the non-traditional mortgage products were eliminated by the banks and mortgage companies that were previously offering them. This decrease in available credit reduced the demand for single family homes as there were fewer qualified buyers in the marketplace. The decrease in demand for housing and building lots affected our level of loan charge offs and the risk ratings on some of our residential development loans. Consequently, the provision for loan losses has increased due to commercial real estate loan charge offs and risk rating downgrades due primarily to decreased demand for housing and building and a general decline in the economic conditions in our markets. In addition, our losses on other real estate owned also increased due to the factors discussed above.

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The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. The interest rates charged by the FHLB and Federal Reserve Bank (FRB) on advances to the Bank also have a significant impact on the Bank's overall cost of funds.
Critical Accounting Policies
Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company's financial condition and operating results. The Company has identified the following policies as being critical because they require difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used. Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, value of underlying collateral, historical experience and observations made by the Company's ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate components of its overall methodology to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company's own loss experience and external industry data and are generally assigned to all loans that are on performing status. The Company also performs an individual analysis of impairment on each non-performing loan that is based on the expected cash flows or the value of the assets collateralizing the loans. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans.
The adequacy of the allowance for loan losses is dependent upon management's estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status of the loans, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as probable losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future. Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on

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deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.
The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan losses. For income tax return purposes, only net charge-offs are deductible, not the provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizabilty of deferred tax assets. Positive evidence includes the existence of taxes paid in available carry-back years, the ability to implement tax planning strategies to accelerate taxable income recognition, and the probability that taxable income will be generated in future periods. Negative evidence includes the Company's cumulative loss in the prior three year period and the general business and economic trends. At June 30, 2009, the Company did not record a valuation allowance relating to our deferred tax assets. This determination was based largely, on the Company's ability to implement tax planning strategies to accelerate taxable income, its ability to generate future taxable income, and the utilization of taxes paid in available carry-back years. The Company believes, based on its internal earnings projections, that it will generate sufficient future taxable income that will result in the realization of the Company's deferred tax assets. This positive evidence was sufficient to overcome the negative evidence of a cumulative loss in the most recent three year period that was caused primarily by the significant loan loss provisions that have been realized in the past 12 months, including one specific $12.0 million provision and related charge-off in 2008 due to apparent fraudulent activities related to the collateral of one loan, and a $3.8 million non-cash goodwill impairment charge recorded in 2008. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future. FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48) requires the use of estimates and management's best judgment to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available. The application of FIN 48 requires significant judgment in arriving at the amount of tax benefits to be recognized in the financial statements for a given tax position. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.
Net Loss
Net loss for the second quarter of 2009 was $9.2 million, an increased loss of $7.2 million, or 354.5%, from a net loss of $2.0 million for the second quarter of 2008. Net loss available to common shareholders was $9.6 million for the second quarter of 2009, an increased loss of $7.6 million, or 376.2%, from the net loss available to common shareholders of $2.0 million for the second quarter of 2008. Diluted loss per common share for the second quarter of 2009 was $2.62, an increased loss of $2.06, or 367.9%, from diluted loss per share of $0.56 for the second quarter of 2008. The increase in the net loss for the quarter was primarily due to the $12.2 million increase in the provision for loan losses on commercial and commercial real estate loans. Net loss was also adversely affected by a $3.1 million increase in losses on other real estate owned when compared to the same period of 2008.
Net loss was $11.8 million for the six month period ended June 30, 2009, an increased loss of $11.3 million from the $537,000 loss for the six month period ended June 30, 2008. The net loss available to common shareholders was $12.7 million for the six month period ended June 30, 2009, an increased loss of $12.2 million, from the net loss available to common shareholders of $537,000 for the same period of 2008. Diluted loss per share for the six month period in 2009 was $3.45, an increased loss of $3.30, from the diluted loss per share of $0.15 for the same

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period in 2008. The increase in the net loss for the six month period was primarily due to the $17.2 million increase in the provision for loan losses on commercial and commercial real estate loans. Net loss was also adversely affected by a $4.2 million increase in losses on other real estate owned when compared to the same period of 2008.
Net Interest Income
Net interest income was $8.5 million for the second quarter of 2009, an increase of $0.3 million, or 3.8%, compared to $8.2 million for the second quarter of 2008. Interest income was $14.8 million for the second quarter of 2009, a decrease of $1.5 million, or 9.0%, from $16.3 million for the same period in 2008. Interest income decreased primarily because of a decrease in the average yields earned on loans and investments. Interest yields decreased primarily because of the 175 basis point decrease in the prime interest rate between the periods. Decreases in the prime rate, which is the rate that banks charge their prime business customers, generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. The average yield earned on interest-earning assets was 5.73% for the second quarter of 2009, a decrease of 53 basis points from the 6.26% average yield for the second quarter of 2008.
Interest expense was $6.3 million for the second quarter of 2009, a decrease of $1.8 million, or 22.0%, compared to $8.1 million for the second quarter of 2008. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 175 basis point decrease in the federal funds rate that occurred between the periods. Decreases in the federal funds rate, which is the rate that banks charge other banks for short term loans, generally have a lagging effect and decrease the rates banks pay for deposits. The lagging effect of deposit rate changes is because many of the Bank's deposits are in the form of certificates of deposit, which do not re-price immediately when the federal funds rate changes. The average interest rate paid on interest-bearing liabilities was 2.59% for the second quarter of 2009, a decrease of 74 basis points from the 3.33% average interest rate paid in the second quarter of 2008. Net interest margin (net interest income divided by average interest earning assets) for the second quarter of 2009 was 3.29%, an increase of 14 basis points, compared to 3.15% for the second quarter of 2008.
Net interest income was $17.3 million for the first six months of 2009, an increase of $410,000, or 2.43%, from $16.9 million for the same period in 2008. Interest income was $30.1 million for the six month period ended June 30, 2009, a decrease of $3.9 million, or 11.5%, from $34.0 million for the same six month period in 2008. Interest income decreased primarily because of the 175 basis point decrease in the prime interest rate between the periods. Decreases in the prime rate generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. The average yield earned on interest-earning assets was 5.74% for the first six months of 2009, a decrease of 75 basis points from the 6.49% average yield for the first six months of 2008.
Interest expense was $12.9 million for the first six months of 2009, a decrease of $4.3 million, or 25.1%, compared to $17.2 million for the first six months of 2008. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 175 basis point decrease in the federal funds rate that occurred between the periods. Decreases in the federal funds rate generally have a lagging effect and decrease the rates banks pay for deposits. The average interest rate paid on interest-bearing liabilities was 2.61% for the first six months of 2009, a decrease of 91 basis points from the 3.52% average interest rate paid in the first six months of 2008.
Net interest margin (net interest income divided by average interest earning assets) for the first six months of 2009 was 3.29%, an increase of 8 basis points, compared to 3.21% for the first six months of 2008.

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A summary of the Company's net interest margin for the six month period ended June 30, 2009 and June 30, 2008 is as follows:

                                                                          For the six month period ended
                                                   June 30, 2009                                             June 30, 2008
                                   Average           Interest                                   Average              Interest
                                 Outstanding          Earned/            Yield/               Outstanding             Earned/         Yield/
(Dollars in thousands)             Balance             Paid               Rate                  Balance                Paid            Rate

Interest-earning assets:
Securities available for
sale                             $    157,863            3,311                4.23 %       $          153,123            3,853           5.06 %
Loans held for sale                     3,898               99                5.12                      2,484               73           5.88
Mortgage loans, net                   155,433            4,496                5.83                    161,743            5,019           6.22
Commercial loans, net                 638,748           19,745                6.23                    632,565           21,875           6.95
Consumer loans, net                    84,236            2,495                5.97                     83,324            2,973           7.17
Cash equivalents                       10,727                1                0.02                     15,172              118           1.57
Federal Home Loan Bank
stock                                   7,286               (5 )             (0.14 )                    6,462              133           4.14

Total interest-earning
assets                              1,058,191           30,142                5.74                  1,054,873           34,044           6.49

Interest-bearing
liabilities:
NOW accounts                          113,439               78                0.14                    124,305              988           1.59
Savings accounts                       30,001               19                0.13                     41,287              239           1.16
Money market accounts                  98,834              712                1.45                    142,134            1,800           2.54
Certificates                          259,645            4,124                3.20                    245,068            5,177           4.25
Brokered deposits                     248,010            4,771                3.88                    269,270            6,505           4.86
Advances and other
borrowings                            176,221            3,169                3.63                    106,364            2,476           4.68

Total interest-bearing
liabilities                           926,150                                                         928,428
Non-interest checking                  66,733                                                          53,603
Other non-interest bearing
deposits                                1,315                                                           1,103

Total interest bearing
liabilities and
non-interest bearing
deposits                         $    994,198           12,873                2.61         $          983,134           17,185           3.52

Net interest income                                  $  17,269                                                       $  16,859

Net interest rate spread                                                      3.13 %                                                     2.98 %

Net interest margin                                                           3.29 %                                                     3.21 %

Provision for Loan Losses
The provision for loan losses was $13.3 million for the second quarter of 2009, an increase of $12.2 million, from $1.1 million for the second quarter of 2008. The provision for loan losses increased primarily as the result of an increase in the loan loss allowance recorded for specific commercial real estate loans due to decreases in the estimated value of the underlying collateral supporting the loans. An additional provision for loan losses of $2.9 million was recorded on two non-performing residential development loans and a $3.0 million provision for loan losses was established on two alternative fuel plants based on updated appraised values. An analysis of the loan portfolio during the quarter resulted in a $2.7 million increase in the loan loss provision for other risk rated loans. The loan loss provision for the second quarter of 2009 also includes a $3.7 million increase related to a commercial loan that was charged off after it was determined that the collateral supporting the loan did not exist or was inadequate. The apparently fraudulent actions by the borrower resulted in the same equipment being used as collateral on a number of different loans to various lenders. The borrower currently has a limited capacity to pay back the loan and there is substantial doubt that there will be any recovery related to the loan, therefore, the entire balance of the loan was charged off during the quarter.
The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed appropriate by management based on factors disclosed in the critical accounting policies previously discussed. The provision for loan losses was $19.9 million for the first six months of 2009, an increase of $17.2 million, or 638.8%, from $2.7 million for the same six month period in 2008. The increase was due primarily to decreases in the estimated value of the real estate collateral supporting the $42.4 million in commercial real estate loans classified as non-performing at June 30, 2009.

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A rollforward of the Company's allowance for loan losses for the three and six month periods ended June 30, 2009 and June 30, 2008 is summarized as follows:

                    (Dollars in thousands)     2009         2008
                    Balance at March 31,     $ 17,494     $ 13,913
                    Provision                  13,304        1,130
                    Charge offs:
                    Commercial                 (5,168 )         (0 )
                    Commercial real estate       (320 )        (75 )
                    One-to-four family            (65 )         (0 )
                    Consumer                     (412 )        (48 )
                    Recoveries                    570            4

                    Balance at June 30,      $ 25,403     $ 14,924




                    (Dollars in thousands)     2009         2008
                    Balance at January 1,    $ 21,257     $ 12,438
                    Provision                  19,873        2,690
                    Charge offs:
                    Commercial                 (5,352 )        (24 )
                    Commercial real estate     (9,781 )        (75 )
                    One-to-four family            (65 )        (60 )
                    Consumer                   (1,106 )        (69 )
                    Recoveries                    577           24

                    Balance at June 30,      $ 25,403     $ 14,924

Non-Interest Income
Non-interest income was $2.2 million for the second quarter of 2009, an increase of $440,000, or 25.1%, from $1.8 million for the same period in 2008. Gains on sales of loans increased $714,000 between the periods due to increased single family loan originations as a result of increased refinance activity. Fees and service charges decreased $78,000 between the periods primarily because of decreased service charges and overdraft fees. Loan servicing fees increased $16,000 between the periods primarily because of increased commercial loan servicing fees. Other non-interest income decreased $217,000 primarily because of decreased income from the sale of uninsured investment products. . . .