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HMNF > SEC Filings for HMNF > Form 10-Q on 10-May-2013All Recent SEC Filings

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Form 10-Q for HMN FINANCIAL INC


10-May-2013

Quarterly Report


Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Information

This quarterly report and other reports filed by the Company with the Securities and Exchange Commission may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as "expect," "intend," "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; our pursuit of alternatives to restructure or reacquire Preferred Stock; 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 and use of alternate funding sources; including FHLB advances, the payment of dividends; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve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 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 the Bank and the OCC and the 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 the FRB, as applicable, in accordance with the terms of the Company and the 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 the FRB, as applicable, under the supervisory agreements or other directives; the ability of the Bank to comply with its individual minimum capital requirement and other applicable regulatory capital requirements; enforcement activity of the OCC and the 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, cash inflows and deposit outflows, changes in credit or other risks posed by the Company's loan and investment portfolios, relative costs associated with alternate funding sources, 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 and the investment expectations of holders of our capital stock; 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 filings on Forms 10-K and 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the "Risk Factors" sections of the Company's Annual Report on Form 10-K for the year ended December 31, 2012 and Part II, Item 1A of its Quarterly Reports on Form 10-Q.


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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, FHLB advances, and 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.

Between 2008 and 2011, the Company's commercial business and commercial real estate loan portfolios required significant 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 was 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 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 loan charge-offs and expenses associated with real estate owned, and the allowances against 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. In 2012 and to date in 2013, commercial real estate values began to stabilize and fewer charge-offs were recorded than in the previous four years.

Between December 31, 2008 and December 31, 2012, the total assets of the Company decreased $492 million and in the first quarter of 2013 total assets declined an additional $26 million. The decrease in assets was primarily in the commercial loan portfolio, which occurred because of limited loan demand and the Company's focus on improving credit quality, reducing loan concentrations, managing interest rate risk, and improving capital ratios. The proceeds received from loan payments were primarily used to reduce the outstanding brokered deposits and FHLB advances and these funding sources decreased $364 million between December 31, 2008 and March 31, 2013. It is anticipated that assets will continue to decrease in the second quarter of 2013 as maturing FHLB advances are anticipated to be repaid with existing cash.

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.


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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


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the ultimate realizability of deferred tax assets. Positive evidence includes current financial performance, 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 environment. 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 March 31, 2013. 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 FIRST QUARTER ENDED MARCH 31, 2013 COMPARED TO FIRST QUARTER ENDED MARCH 31, 2012

Net Income

Net income was $0.7 million for the first quarter of 2013, a decrease of $2.1 million, compared to net income of $2.8 million for the first quarter of 2012. Net income available to common shareholders was $0.3 million for the first quarter of 2013, a decrease of $2.0 million from the net income available to common shareholders of $2.3 million for the first quarter of 2012. Diluted earnings per common share for the first quarter of 2013 were $0.06, a decrease of $0.52 from the diluted earnings per common share of $0.58 for the first quarter of 2012. The decrease in net income between the periods was due primarily to a $1.3 million decrease in net interest income as a result of a decrease in interest earning assets, a $0.6 million decrease in the gain recognized on the sales of branch offices, and a $0.2 million decrease in the gains recognized on loan sales due to a decrease in the sale of commercial government guaranteed loans.

Net Interest Income

Net interest income was $4.9 million for the first quarter of 2013, a decrease of $1.3 million, or 20.6%, compared to $6.2 million for the first quarter of 2012. Interest income was $6.3 million for the first quarter of 2013, a decrease of $2.0 million, or 23.6%, from $8.3 million for the first quarter of 2012. Interest income decreased between the periods primarily because of a $109 million decrease in the average interest-earning assets 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 limited loan demand and the Company's focus on improving credit quality, reducing loan concentrations, managing interest rate risk and improving capital ratios. Interest income also decreased because of lower average yields on loans and investment securities. The average yield earned on interest-earning assets was 4.28% for the first quarter of 2013, a decrease of 42 basis points from the 4.70% average yield for the first quarter of 2012.

Interest expense was $1.4 million for the first quarter of 2013, a decrease of $0.7 million, or 32.5%, compared to $2.1 million for the first quarter of 2012. Interest expense decreased primarily because of a $124 million decrease in the average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding brokered and retail certificates of deposits between the periods. The decrease in brokered and retail certificates of deposits between the periods was the result of using the proceeds from loan principal payments to fund maturing certificates. Interest expense also decreased because of the lower average interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the low interest rate environment that continued to exist during the first quarter of 2013. The average interest rate paid on interest-bearing liabilities was 1.01% for the first quarter of 2013, a decrease of 21 basis points from the 1.22% average interest rate paid in the first quarter of 2012.


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Net interest margin (net interest income divided by average interest earning assets) for the first quarter of 2013 was 3.34%, a decrease of 19 basis points compared to 3.53% for the first quarter of 2012. Net interest margin declined between the periods primarily because the yield on interest-earning assets decreased more than the rates paid on interest-bearing liabilities. The decrease in the yield earned on interest-earning assets is a result of the continued decline in market interest rates on loans and investments between the periods. The rates paid on deposit accounts reflected a smaller decrease because the entire change in market rate could not be reflected in the deposit rates due to the already low interest rates being paid on deposit accounts.

A summary of the Company's net interest margin for the three month periods ended March 31, 2013 and 2012 is as follows:

                                                                       For the three month period ended
                                                         March 31, 2013                                March 31, 2012
                                               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               $      90,862            233        1.04 %    $     105,257            442        1.69 %
Loans held for sale                                 2,428             19        3.17              2,784             21        3.11
Mortgage loans, net                                93,612          1,109        4.80            117,583          1,497        5.12
Commercial loans, net                             294,981          4,173        5.75            367,760          5,425        5.93
Consumer loans, net                                53,128            717        5.47             60,769            853        5.65
Cash equivalents                                   59,838             33        0.23             49,948             27        0.21
Federal Home Loan Bank stock                        4,063             29        2.79              4,174             10        0.92

Total interest-earning assets                     598,912          6,323        4.28            708,275          8,275        4.70
Interest-bearing liabilities and
noninterest bearing deposits:
NOW accounts                                       70,398              4        0.02             69,405             11        0.06
Savings accounts                                   43,920             11        0.10             39,051             17        0.18
Money market accounts                             113,595             95        0.34            111,336            129        0.47
Certificates                                      160,653            398        1.00            224,357            707        1.27
Brokered deposits                                  14,822             49        1.34             56,918            353        2.50
Federal Home Loan Bank advances                    70,000            835        4.84             70,000            845        4.85

Total interest-bearing liabilities                473,388                                       571,067
Non-interest checking                              81,548                                       108,028
Other noninterest bearing escrow deposits           1,264                                         1,340

Total interest-bearing liabilities and
non-interest bearing deposits               $     556,200          1,392        1.01      $     680,435          2,062        1.22

Net interest income                                           $    4,931                                    $    6,213

Net interest rate spread                                                        3.27 %                                        3.48 %

Net interest margin                                                             3.34 %                                        3.53 %

Provision for Loan Losses

The provision for loan losses was $0 for the first quarter of 2013, an increase of $0.1 million compared to ($0.1 million) for the first quarter of 2012. The provision for loan losses remained low in the first quarter of 2013 primarily because of a decrease in the required reserves for certain risk rated commercial loans. This decrease, however, was entirely offset by additional reserves on certain development loans. The additional reserves were the result of a decrease in the estimated value of the underlying collateral supporting these loans.


Table of Contents

A reconciliation of the Company's allowance for loan losses for the first quarters of 2013 and 2012 is summarized as follows:

                   (Dollars in thousands)     2013          2012
                   Balance at January 1,    $ 21,608      $ 23,888
                   Provision                       0          (128 )
                   Charge-offs:
                   Consumer                      (46 )        (265 )
                   Commercial business             0            (8 )
                   Commercial real estate       (337 )      (2,630 )
                   Recoveries                    716           567

                   Balance at March 31,     $ 21,941      $ 21,424

                   General allowance        $ 13,614      $ 13,913
                   Specific allowance          8,327         7,511

                                            $ 21,941      $ 21,424

Non-Interest Income

Non-interest income was $1.9 million for the first quarter of 2013, a decrease of $0.8 million, or 30.7%, from $2.7 million for the first quarter of 2012. Gain on sale of branch office decreased $0.6 million as a gain was realized on the sale of the Toledo, Iowa branch in the first quarter of 2012. Gain on sales of loans decreased $0.2 million between the periods due to a $0.3 million decrease in the gains recognized on the sale of commercial government guaranteed loans between the periods that was partially offset by a $0.1 million increase in the gains recognized on the sale of single family loans. The increase in the gains recognized on single family loans was due to an increase in loan originations and sales as a result of the low interest rate environment that continued to exist during the first quarter of 2013. Fees and service charges decreased $40,000 between the periods primarily because of a decrease in debit card and overdraft charges. Other non-interest income decreased $25,000 between the periods primarily because of a decrease in rental income realized on other real estate owned. Loan servicing fees increased $16,000 between the periods because . . .

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