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HMNF > SEC Filings for HMNF > Form 10-Q on 7-Nov-2012All Recent SEC Filings

Show all filings for HMN FINANCIAL INC

Form 10-Q for HMN FINANCIAL INC


7-Nov-2012

Quarterly Report


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 increasing our core deposit relationships, reducing non-performing assets, reducing expense and generating improved financial results; the adequacy and amount of available liquidity and capital resources to the Bank; the Company's liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for improvement thereof; changes in the size of the Bank's loan portfolio; the recovery of the valuation allowance on deferred tax assets; the amount and mix of the Bank's non-performing assets and the appropriateness of the allowance therefor; future losses on non-performing assets; the amount of interest-earning assets; the amount and mix of brokered and other deposits (including the Company's ability to renew brokered deposits); the availability of alternate funding sources; the payment of dividends; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; and the Bank's compliance with regulatory standards generally (including the Bank's status as "well-capitalized"), and supervisory agreements, individual minimum capital requirements, the recently proposed regulatory capital rules that were jointly issued by the Federal Reserve Board, the FDIC, and the OCC in June 2012 (Proposed Rules), or other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the OCC and FRB and the Bank and the Company to any failure to comply with any such regulatory standard, agreement or requirement. 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 and other collateral securing loans to borrowers; federal and state regulation and enforcement, including restrictions set forth in the supervisory agreements between each of the Company and Bank and the OCC and FRB; possible legislative and regulatory changes, including changes in the degree and manner of regulatory supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss allowance and concentrations of credit that are satisfactory to the OCC and FRB, as applicable, in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OCC and FRB, as applicable, under the supervisory agreements or other directives; the ability of the Bank to comply with its individual minimum capital requirement, the Proposed Rules, and other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard, agreement or requirement; adverse economic, business and competitive developments such as shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company's loan and investment portfolios, changes in costs associated with alternate funding sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank, technological, computer-related or operational difficulties, results of litigation, and 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; the Company's access to and adverse changes in securities markets; the market for credit related assets; 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 with the Securities and Exchange Commission and the Company's subsequently filed Quarterly Reports on Form 10-Q. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the "Risk Factors" sections of the Company's Annual Report on Form 10-K for the year ended December 31, 2011 and Part II, Item 1A of its Quarterly Reports on Form 10-Q.

General

The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits, Federal Home Loan Bank (FHLB) advances, and Federal Reserve Bank (FRB) borrowings. The difference between


the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company's net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses, and amortization of mortgage servicing assets. The earnings of financial institutions, such as the Bank, are also 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.

Beginning with the Company's 2008 fiscal year, the Company's commercial business and commercial real estate loan portfolios have required significant allowances and charge offs due primarily to decreases in the estimated value of the underlying collateral supporting the loans, as many of these loans were made to borrowers in or associated with the real estate industry. The decrease in the estimated collateral value is primarily the result of reduced demand for real estate, particularly as it relates to single-family and commercial land developments. More stringent lending standards implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments where the Company's commercial loan portfolio has concentrations. Consequently, our level of non-performing assets and the related provision for loan losses increased significantly in the past several years, relative to periods before 2008. The increased levels of non-performing assets, related provisions for loan losses and write offs of or allowances against goodwill and deferred taxes arising from adverse results of operations, were the primary reasons for the net losses incurred by the Company in each of the years 2008 through 2011.

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. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company's financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used.

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local economic growth rates, historical experience and observations made by the Company's ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the appropriateness of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company's own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans or portion thereof that are deemed uncollectable.


The appropriateness of the allowance for loan losses is dependent upon management's estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as probable losses in the loan portfolio for which additional specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet date, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.

The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating loss carry forwards. For income tax purposes, only net charge-offs are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management's judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company's cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. In the second quarter of 2010, the Company recorded a valuation allowance against the entire deferred tax asset balance and the Company continued to maintain a valuation reserve against the entire deferred tax asset balance at September 30, 2012. This determination was based primarily upon the existence of a three year cumulative loss position that is primarily attributable to significant provisions for loan losses incurred during the last three years. The creation of the valuation allowance, although it increased tax expense and similarly reduced tangible book value, does not have an effect on the Company's cash flows, and may be recoverable in subsequent periods if the Company were to realize certain sustained future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future.

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


RESULTS OF OPERATIONS FOR THIRD QUARTER ENDED SEPTEMBER 30, 2012 COMPARED TO THIRD QUARTER ENDED SEPTEMBER 30, 2011

Net Income (Loss)

Net income was $0.6 million for the third quarter of 2012, an improvement of $2.7 million compared to a net loss of $2.1 million for the third quarter of 2011. Net income available to common shareholders was $0.2 million for the third quarter of 2012, an improvement of $2.7 million, or 106.8%, from the net loss available to common shareholders of $2.5 million for the third quarter of 2011. Diluted earnings per common share for the third quarter of 2012 was $0.04, an increase of $0.69, or 106.2%, from the diluted loss per common share of $0.65 for the third quarter of 2011. The improvement in net income for the third quarter of 2012 is due to a $2.7 million decrease in the provision for loan losses between the periods, a $0.6 million increase in noninterest income due primarily to an increase in the gain on sales of loans, and a $0.6 million decrease in noninterest expenses due primarily to the decrease in expenses related to real estate owned. These changes to net income were partially offset by a $1.2 million decrease in net interest income due primarily to a decrease in interest-earning assets between the periods.

Net income was $3.8 million for the nine-month period ended September 30, 2012, an improvement of $7.7 million, from the $3.9 million net loss for the nine-month period ended September 30, 2011. Net income available to common shareholders was $2.4 million for the nine-month period ended September 30, 2012, an improvement of $7.7 million, from the net loss available to common shareholders of $5.3 million for the same period of 2011. Diluted earnings per common share for the nine-month period in 2012 was $0.61, an improvement of $1.99, from the diluted loss per common share of $1.38 for the same period in 2011. The improvement in net income for the first nine months of 2012 is due to a $7.1 million decrease in the provision for loan losses between the periods, a $0.6 million gain on sale of the Bank's Toledo, Iowa branch, a $1.5 million increase in the gain on sales of loans, and a $2.3 million decrease in noninterest expenses due primarily to the decrease in expenses related to real estate owned. These improvements to net income were partially offset by a $3.4 million decrease in net interest income due primarily to a decrease in interest earning assets between the periods.

Net Interest Income

Net interest income was $5.9 million for the third quarter of 2012, a decrease of $1.2 million, or 16.8%, compared to $7.1 million for the third quarter of 2011. Interest income was $7.6 million for the third quarter of 2012, a decrease of $2.0 million, or 21.1%, from $9.6 million for the same period in 2011. Interest income decreased between the periods primarily because of a $145 million decrease in the average interest-earning assets and also because of a decrease in the average yields between the periods. Average interest-earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of low loan demand and the Company's focus on improving credit quality, managing net interest margin and improving capital ratios. The average yield earned on interest-earning assets was 4.89% for the third quarter of 2012, a decrease of 12 basis points from the 5.01% average yield for the third quarter of 2011. The decrease in the average yield is due to the continued low interest rate environment that existed during the third quarter of 2012.

Interest expense was $1.7 million for the third quarter of 2012, a decrease of $0.8 million, or 33.3%, compared to $2.5 million for the third quarter of 2011. Interest expense decreased primarily because of the $150 million decrease in the average interest-bearing liabilities between the periods. The decrease in the average interest-bearing liabilities is primarily the result of a decrease in the average outstanding certificates of deposits and brokered deposits between the periods and a decrease in other deposits as a result of the Bank's Toledo, Iowa branch sale that was completed in the first quarter of 2012. The decrease in certificates of deposits and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing certificates of deposit and brokered deposits. Interest expense also decreased because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the third quarter of 2012. The average interest rate paid on interest-bearing liabilities was 1.14% for the third quarter of 2012, a decrease of 22 basis points from the 1.36% average interest rate paid in the third quarter of 2011.

Net interest margin (net interest income divided by average interest- earning assets) for the third quarter of 2012 was 3.82%, an increase of 11 basis points, compared to 3.71% for the third quarter of 2011. Net interest margin improved between the periods primarily because the rate paid on interest-bearing liabilities decreased more than the yield on interest-earning assets. The decrease in the rates paid on interest-bearing liabilities is primarily the result of a change in the mix of deposits as lower rate deposits were held during the third quarter of 2012 when compared to the same period in 2011. The change in the liability mix is primarily the result of a decrease in certificates of deposits and brokered deposits which is anticipated to continue.


Net interest income was $18.2 million for the first nine months of 2012, a decrease of $3.3 million, or 15.7%, from $21.5 million for the same period in 2011. Interest income was $23.8 million for the nine-month period ended September 30, 2012, a decrease of $6.5 million, or 21.6%, from $30.3 million for the same period in 2011. Interest income decreased between the periods primarily because of a $141 million decrease in the average interest-earning assets and also because of a decrease in the average yields earned between the periods. Average interest-earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of low loan demand and the Company's focus on improving credit quality, managing net interest margin and improving capital ratios. The average yield earned on interest-earning assets was 4.82% for the nine-month period of 2012, a decrease of 26 basis points from the 5.08% average yield for the nine-month period of 2011. The decrease in the average yield is due to the continued low interest rate environment that existed during the first nine months of 2012.

Interest expense was $5.6 million for the nine-month period ended September 30, 2012, a decrease of $3.2 million, or 36.1%, from $8.8 million for the same period in 2011. Interest expense decreased primarily because of a $142 million decrease in the average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the average outstanding certificates of deposit and brokered deposits between the periods. The average interest rate paid on interest-bearing liabilities was 1.20% for the nine-month period of 2012, a decrease of 34 basis points from the 1.54% average rate paid for the same nine-month period of 2011.

Net interest margin (net interest income divided by average interest-earning assets) was 3.68% for the nine-month period of 2012, an increase of 8 basis points from the 3.60% margin for the same nine-month period of 2011. Net interest margin improved between the periods primarily because the rate paid on interest-bearing liabilities decreased more than the yield on interest-earning assets. The decrease in rates paid on interest-bearing liabilities is primarily the result of a change in the mix of deposits as lower rate deposits were held during the first nine months of 2012 when compared to the same period in 2011. The change in the liability mix is primarily the result of a decrease in certificates of deposit and brokered deposits between the periods which is anticipated to continue.


A summary of the Company's net interest margin for the three and nine-month periods ended September 30, 2012 and September 30, 2011 is as follows:

                                                                       For the three month period ended
                                                       September 30, 2012                            September 30, 2011
                                               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               $      76,631            292        1.52 %    $     121,286            567        1.85 %
Loans held for sale                                 3,559             28        3.16              1,498             16        4.24
Mortgage loans, net                               102,736          1,631        6.32            120,026          1,589        5.25
Commercial loans, net                             326,177          4,761        5.81            411,982          6,388        6.15
Consumer loans, net                                55,490            789        5.65             65,594            975        5.90
Cash equivalents                                   45,299             26        0.23             33,738              4        0.05
Federal Home Loan Bank stock                        4,063             24        2.36              4,486             33        2.96

Total interest-earning assets                     613,955          7,551        4.89            758,610          9,572        5.01

Interest-bearing liabilities:
NOW accounts                                       61,502              9        0.06             69,981             12        0.07
Savings accounts                                   39,998             16        0.16             38,205             15        0.16
Money market accounts                             110,649            109        0.39            123,267            184        0.59
Certificates                                      194,831            576        1.18            251,799            941        1.48
Brokered deposits                                  21,519             94        1.73             75,421            471        2.48
Advances and other borrowings                      70,000            855        4.86             70,978            865        4.84

Total interest-bearing liabilities                498,499                                       629,651
Non-interest checking                              77,281                                        96,614
Other non-interest bearing deposits                 1,139                                         1,148

Total interest-bearing liabilities and
non-interest bearing deposits               $     576,919          1,659        1.14      $     727,413          2,488        1.36

Net interest income                                           $    5,892                                    $    7,084
. . .
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