T A B L E O F C O N T E N T S Financial Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 President’s Letter to Shareholders and Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Five-year Consolidated Financial Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Management’s Discussion and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Selected Quarterly Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Other Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Common Stock Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Corporate and Shareholder Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Inside Back Cover Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Inside Back Cover HMN Financial, Inc. (HMN) and Home Federal Savings Bank (the Bank) are headquartered in Rochester, Minnesota. Home Federal Savings Bank operates nine full-service banking facilities in southern Minnesota and two in Iowa. Eagle Crest Capital Bank, a division of Home Federal Savings Bank, operates branches in Edina and Rochester, Minnesota. F I N A N C I A L H I G H L I G H T S Operating Results: (Dollars in thousands, except per share data) Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses . . . . . . . . . . . . . . . Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains (losses), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses in limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before minority interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Per Common Share Information: Earnings per common share and common share equivalents Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock price (for the year) High . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Close . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Book value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Price to book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Ratios: Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend payout ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expense to average assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average equity to average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity to total assets at year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-performing assets to total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Efficiency ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance Sheet Data: (Dollars in thousands) Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home Federal Savings Bank regulatory capital ratios: Tier I or core capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tier I capital to risk weighted assets. . . . . . . . . . . . . . . . . . . . . . . . . . Risk-based capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 At or For the Year Ended December 31, 2004 $ 51,617 20,993 30,624 2,755 27,869 2,776 1,169 (535) 1,703 (26) 880 5,967 20,162 20,162 13,674 4,387 9,287 (3) 9,290 $ $ $ 2.40 2.31 33.50 23.25 32.99 18.95 174.09% 1.01% 11.03 36.36 3.50 2.19 9.17 8.72 0.51 55.10 2003 44,937 20,289 24,648 2,610 22,038 2,304 998 1,275 5,240 (243) 681 10,255 19,653 19,653 12,640 4,038 8,602 (3) 8,605 2.26 2.16 24.70 15.55 24.29 17.93 135.47% 1.10% 10.85 39.58 3.31 2.51 10.15 9.34 0.58 56.31 December 31, 2004 $960,673 103,672 2,712 783,213 698,902 170,900 83,771 7.8% 9.5 10.5 2003 866,726 104,664 6,543 688,951 551,688 203,900 80,931 8.0% 10.2 11.1 Percentage Change 14.9% 3.5 24.2 5.6 26.5 20.5 17.1 (142.0) (67.5) 89.3 29.2 (41.8) 2.6 2.6 8.2 8.6 8.0 0.0 8.0 (8.2)% 1.7 (8.1) 5.7 (12.7) (9.7) (6.6) (12.1) (2.1) Percentage Change 10.8% (0.9) (58.6) 13.7 26.7 (16.2) 3.5 (2.9)% (7.4) (5.5) T O O U R S H A R E H O L D E R S A N D C U S T O M E R S This past year was a historic year for HMN Financial, Inc. We marked the ten-year anniversary of becoming a public company, but even more significantly, we reached the seventy-year milestone of Home Federal Savings Bank. Established in Spring Valley in 1934 by John Osterud and a group of local businessmen, Home Federal opened its doors initially as a secure depository for customers’ savings and as a friendly, hometown place to get a home loan. With little more than $2,500 in capital to begin with, Home Federal greatly expanded its service offerings and has grown into a full service financial institution with $961 million in assets. We’re proud of our heritage and grateful to all those who have made our progress possible. The Company’s financial performance was also historic in 2004 as net income of $9.3 million, diluted earnings per share of $2.31, and return on equity of 11.03% are all records for the Company. HMN’s stock continued to perform well and has appreciated at an annual rate of 29% over the past five years. One key focus in 2004 was to replace the significant income generated from the gain on sale of mortgage loans that was experienced because of the refinance boom in 2003 with more stable net interest income. Net interest income increased by $6 million in 2004 and more than offset the $3.5 million decline in the gains recognized on the sale of mortgage loans from the previous year. A significant factor in the increased net interest income was the $105 million in growth that we experienced in our commercial and consumer loan portfolios. Net interest income was also enhanced because the loan growth was funded with a higher percentage of less expensive transaction deposits. The combination of loan growth and relatively less expensive depository sources led to a 19 basis point increase in the Company’s net interest margin in 2004. Our private banking concept, which operates as Eagle Crest Capital Bank, opened a new office in Rochester in mid 2003. This is an offshoot of the Edina Office opened in 2002. Private banking is structured to provide a high-touch, relationship-based banking experience to business owners, professionals and their families. We believe there are significant opportunities to attract private banking clientele throughout our branch network, especially in our headquarter city of Rochester. 2 While residential mortgage lending, percentage-wise, has become a smaller part of our organization, we continue to offer a full range of home loan products. We like to keep our customers for a lifetime and home loans help us accomplish that goal. Management’s philosophy is to expand in growth markets. We see those growth markets in the corridor between Rochester and St. Cloud; and, during 2004, we expanded our staff in the St. Cloud loan production office due to increased activity. We are committed to implementing the most efficient technologies and competitive products for the customers and markets we serve. Our retail e-banking and commercial cash management products have been well accepted. We recently began to offer on-line Health Savings Accounts (HSAs) which can be a potential tax saving opportunity for qualified customers. Even with all of the modern banking practices and products, something as simple as answering the telephone remains an important part of our customer service philosophy. We think answering the telephone can help us grow and responding to customer requests in a reasonable timeframe is a quality service requirement in our Company. People have become frustrated at the lack of focus on service in an increasingly high tech world. In today’s world of identity theft and fraud, we need to know our customer and we want them to know us, too. We want to grow but certainly not to the detriment of service. My gratitude goes out to our customers for banking with us, and to my colleagues in the Bank’s branches, on the management team, and on the board, whose energies and dedication were instrumental in achieving the 2004 financial results. Sincerely, Michael McNeil President and CEO 3 B O A R D O F D I R E C T O R S From left: Michael J. Fogarty, Susan K. Kolling, Allan R. DeBoer, Timothy R. Geisler, Michael McNeil and Malcolm W. McDonald. Seated: Mahlon C. Schneider and Duane D. Benson. TIMOTHY R. GEISLER Chairman of the Board HMN and Home Federal Savings Bank Unit Manager Foundation Accounting Mayo Foundation MICHAEL MCNEIL President and CEO HMN and Home Federal Savings Bank DUANE D. BENSON Retired Executive Director Minnesota Business Partnership ALLAN R. DEBOER Retired Chief Executive Officer RCS of Rochester MAHLON C. SCHNEIDER Retired Senior Vice President External Affairs and General Counsel Hormel Foods Corporation SUSAN K. KOLLING Senior Vice President HMN and Home Federal Savings Bank MICHAEL J. FOGARTY Chairman C.O. Brown Agency, Inc. MALCOLM W. MCDONALD Retired Senior Vice President Space Center, Inc 4 F I V E - Y E A R C O N S O L I D A T E D F I N A N C I A L H I G H L I G H T S Selected Operations Data: (Dollars in thousands, except per share data) Total interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses . . Fees and service charges. . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing fees. . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains (losses), net. . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses in limited partnerships . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before minority interest . . . . . . . . . . . . . . . . . . . Minority interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Per common share and common share equivalents: 2004 $51,617 20,993 30,624 2,755 27,869 2,776 1,169 (535) 1,703 (26) 880 5,967 20,162 20,162 4,387 9,287 (3) $ 9,290 Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.40 2.31 Selected Financial Condition Data: 2003 44,937 20,289 24,648 2,610 22,038 2,304 998 1,275 5,240 (243) 681 10,255 19,653 19,653 4,038 8,602 (3) 8,605 2.26 2.16 (Dollars in thousands, except per share data) Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $960,673 103,672 2,712 783,213 698,902 170,900 83,771 2003 866,726 104,664 6,543 688,951 551,688 203,900 80,931 Year Ended December 31, 2002 42,868 21,295 21,573 2,376 19,197 1,723 715 422 3,077 (659) 597 5,875 17,849 17,849 2,099 5,124 (142) 5,266 1.40 1.32 2001 51,468 30,444 21,024 1,150 19,874 1,563 470 (671) 2,934 (1,311) 599 3,584 15,749 15,749 2,634 5,075 (383) 5,458 1.45 1.37 2000 52,917 33,001 19,916 180 19,736 1,297 341 (23) 1,216 (121) 613 3,323 12,559 12,559 3,798 6,702 0 6,702 1.75 1.69 December 31, 2002 737,523 121,397 15,127 533,906 432,951 218,300 76,065 2001 721,114 119,895 68,018 471,668 421,843 217,800 72,161 2000 716,016 139,206 7,861 518,765 421,691 221,900 66,626 Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.95 17.93 17.28 16.41 15.17 Number of full service offices . . . . . . . . . . . . . . . . . . . . . Number of mortgage origination offices . . . . . . . . . . . . . 13 2 12 6 13 2 12 1 11 1 Key Ratios(1) Stockholders’ equity to total assets at year end . . . . . . . . Average stockholders’ equity to average assets. . . . . . . . . Return on stockholders’ equity (ratio of net income to average equity) . . . . . . . . . . . Return on assets (ratio of net income to average assets) . . . . . . . . . . . Dividend payout ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.72% 9.17 9.34% 10.15 10.31% 10.66 10.01% 9.91 9.31% 9.56 11.03 1.01 36.36 10.85 1.10 39.58 6.94 0.74 57.63 7.57 0.75 39.71 9.81 0.94 27.22 (1) Average balances were calculated based upon amortized cost without the market value impact of SFAS No. 115. 5 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S This Annual Report, other reports filed by the Company with the Securities and Exchange Commission, and the Company’s proxy statement may contain “forward-looking” statements that deal with future results, plans or performance. In addition, the Company’s management may make such statements orally to the media, or to securities analysts, investors or others. Forward-looking statements deal with matters that do not relate strictly to historical facts such as anticipated liquidity information. The Company’s future results may differ materially from historical performance and forward- looking statements about the Company’s expected financial results or other plans are subject to a number of risks and uncertainties. These include but are not limited to possible legislative changes and adverse economic, business and competitive developments such as shrinking interest margins; deposit outflows; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government; changes in credit and other risks posed by the Company’s loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation or other significant uncertainties. O V E R V I E W HMN Financial, Inc. (HMN or the Company) is the stock savings bank holding company for Home Federal Savings Bank (the Bank) which operates community retail banking facilities and loan production offices in southern Minnesota and Iowa. Eagle Crest Capital Bank, a division of Home Federal Savings Bank, provides private banking services to a diverse group of high net worth customers from offices in Edina and Rochester, Minnesota. The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on its loans and investments, and the interest paid on interest- bearing liabilities such as deposits and Federal Home Loan Bank (FHLB) advances. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the “interest rate spread”. Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. The Company’s interest rate spread has been enhanced by the increased level of commercial loans placed in portfolio and the increased amount of lower rate deposit products such as checking and money market accounts. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company’s net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses and amortization and valuation adjustments on mortgage servicing assets. The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. C r i t i c a l A c c o u n t i n g P o l i c i e s 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 three policies as being critical because they require difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used. Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company’s ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous portfolios. The determination of the allowance for the non- homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company’s own loss experience and external industry data and are assigned to all loans without identified credit weaknesses. The Company also performs an individual analysis of impairment on each non-performing loan that is based on the expected cash flows or the value of the assets collateralizing the loans. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans. The adequacy of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in 6 the provision for loan losses in the periods in which the adjustments become known. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio for which specific reserves are not required. Although management believes that 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 adjustments to the provision for loan losses may be necessary if conditions differ substantially from those in the assumptions used to determine the allowance for loan losses. Mortgage Servicing Rights The Company recognizes as an asset the rights to service mortgage loans for others, which are referred to as mortgage servicing rights (MSRs). MSRs are capitalized at the relative fair value of the servicing rights on the date the mortgage loan is sold and are carried at the lower of the capitalized amount, net of accumulated amortization, or fair value. MSRs are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. Each quarter the Company evaluates its MSRs for impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and interest rate are the predominant risk characteristics of the underlying loans used to stratify the MSRs for purposes of measuring impairment. If temporary impairment exists, a valuation allowance is established for any excess of amortized cost over the current fair value through a charge to income. If the Company later determines that all or a portion of the temporary impairment no longer exists, a reduction of the valuation allowance is recorded as an increase to income. The valuation is based on various assumptions including the estimated prepayment speeds and default rates of the stratified portfolio. Changes in the mix of loans, interest rates, prepayment speeds, or default rates from the estimates used in the valuation of the mortgage servicing rights may have a material effect on the amortization and valuation of MSRs. Although management believes that the assumptions used and the values determined are reasonable, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the value of the MSRs. The Company does not formally hedge its MSRs because they are hedged naturally by the Company’s origination volume. Generally, as interest rates rise the origination volume declines and the value of MSRs increases and as interest rates decline the origination volume increases and the value of MSRs decreases. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities. R e s u l t s o f O p e r a t i o n s Net income was $9.3 million for the year ended December 31, 2004, compared to $8.6 million for the year ended December 31, 2003. Diluted earnings per common share for the year ended December 31, 2004 were $2.31, compared to $2.16 for the year ended December 31, 2003. Return on average assets was 1.01% and 1.10% and return on average equity was 11.03% and 10.85% for the years ended December 31, 2004 and 2003, respectively. In comparing the year ended December 31, 2004 to the year ended December 31, 2003, net interest income increased by $6.0 million primarily because of an increase in interest- earning assets and because of a higher concentration of commercial and consumer loans and an increase in checking and money market deposit accounts. Non-interest income decreased by $4.3 million primarily due to decreases in the gains recognized on the sale of mortgage loans and securities. Non-interest expense increased by $500,000 primarily because of the $1.5 million increase in compensation and benefits costs due to increases in health insurance costs and the number of employees. This increase was partially offset by a $1.1 million decrease in the amortization of mortgage servicing rights that was primarily caused by a decrease in the prepayments of mortgage loans in 2004. Net Interest Income Net interest income for the year ended December 31, 2004 was $30.6 million, an increase of $6.0 million, compared to $24.6 million in 2003. Interest income was $51.6 million for the year ended December 31, 2004, an increase of $6.7 million, from $44.9 million for the same period in 2003. Interest income increased primarily because of an increase in average interest-earning assets and because of a change in the mix of assets between the periods. The increase in interest- earning assets was caused primarily by the $105 million increase in the commercial and consumer loan portfolios between the periods. During 2004, the Company’s commercial and consumer loan portfolios continued to increase and these portfolios represented 77.9% of the Company’s outstanding loans at December 31, 2004, 77 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S compared to 61.7% at December 31, 2003. The increase in interest income as a result of the increased interest-earning assets more than offset the decrease in the interest rates earned on the assets between the periods. The yield earned on interest-earning assets was 5.90% for the year ended December 31, 2004, a decrease of 14 basis points from the 6.04% yield for the same period of 2003. Interest expense was $21.0 million for the year ended December 31, 2004, an increase of $704,000, from the $20.3 million for the same period in 2003. Interest expense on deposits and Federal Home Loan Bank advances increased by $2.1 million due to the $132 million in growth in the average outstanding balance of deposits and advances between the periods. This increase was partially offset by a $1.4 million decrease in interest expense due to a decline in the interest rates paid. The decline in interest rates paid is due in part to the $90 million increase in the outstanding average balance of checking and money market accounts between the periods, which generally have lower interest rates than other deposit accounts. The average interest rate paid on interest-bearing liabilities was 2.53% for the year ended December 31, 2004, a decrease of 38 basis points from the 2.91% in 2003. 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. Average Outstanding Balance 2004 Interest Earned/ Paid Yield/ Rate (Dollars in thousands) Interest-earning assets: Securities available for sale: Mortgage-backed and Year Ended December 31, 2003 Interest Earned/ Paid Average Outstanding Balance Yield/ Rate Average Outstanding Balance 2002 Interest Earned/ Paid Yield/ Rate related securities . . . . . . . . . . . $ 11,225 97,508 4,349 Other marketable securities . . . . . Loans held for sale . . . . . . . . . . . . . . Loans receivable, net(1)(2) . . . . . . . . . . Federal Home Loan Bank stock . . . . Other, including 385 2,898 249 732,638 47,714 207 9,889 18,954 cash equivalents. . . . . . . . . . . . . . 164 Total interest-earning assets . . . . . . $874,563 51,617 Interest-bearing liabilities: 0 Noninterest checking . . . . . . . . . . . $ 38,862 638 88,559 NOW accounts . . . . . . . . . . . . . . . . 77 43,186 Passbooks . . . . . . . . . . . . . . . . . . . . 106,943 1,519 Money market accounts. . . . . . . . . . 354,811 10,163 Certificate accounts . . . . . . . . . . . . . Federal Home Loan 196,662 905 8,595 Bank advances . . . . . . . . . . . . . . . 1 Other interest-bearing liabilities . . . Total interest-bearing liabilities . . . $829,928 20,993 30,624 Net interest income . . . . . . . . . . . . Net interest rate spread . . . . . . . . . . Net earning assets . . . . . . . . . . . . . . $ 44,635 Net interest margin. . . . . . . . . . . . . Average interest-earning assets to 4.37 0.00 2.53 3.37% 3.50% 221,503 2,556 $697,539 $ 46,352 3.43% $ 21,885 74,487 2.97 12,899 5.73 602,653 6.51 11,464 2.10 272 2,387 748 41,052 349 1.24% $ 63,022 60,973 3.20 22,485 5.80 479,158 6.81 12,086 3.04 1,704 2,420 1,587 36,426 349 2.70% 3.97 7.06 7.60 2.89 0.87 5.90 20,503 $743,891 129 44,937 0.63 6.04 37,831 $675,555 382 42,868 1.01 6.35 0.00% $ 28,964 46,277 0.72 38,201 0.18 73,800 1.42 286,238 2.86 0 120 91 878 9,185 10,015 0 20,289 24,648 0 226 241 796 9,686 10,346 0 21,295 21,573 0.00% $ 19,095 39,625 0.26 35,847 0.24 47,593 1.19 270,482 3.21 4.52 0.00 2.91 3.13% 3.31% 215,623 1,544 $629,809 $ 45,746 0.00% 0.57 0.67 1.67 3.58 4.80 0.00 3.39 2.96% 3.19% average interest-bearing liabilities . . . . . . . . . . . . . . . . . 105.38% 106.65% 107.26% (1) Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis. The tax-exempt income was $1,000,300 for 2004, $837,343 for 2003 and $315,093 for 2002. (2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve. 8 Net interest margin increased to 3.50% in 2004 compared to 3.31% for 2003 primarily because of the growth in commercial and consumer loans and the increase in the outstanding average balance of checking and money market accounts. Average net earning assets were $44.6 million in 2004 compared to $46.4 million for 2003. Net earning assets were reduced because of the repurchase of HMN common stock, the payment of dividends, an increase in non-interest earning cash due to the operation of more ATM machines in 2004, and an increase in non-interest bearing reserve accounts required to be maintained because of the increase in transaction account deposits between the periods. During 2004 and 2003 the Company paid $3.3 million and $1.4 million to purchase its common stock in the open market and paid dividends to stockholders of $3.2 million and $2.9 million, respectively. Non-interest bearing cash amounts increased by $2.4 million and the required non-interest bearing reserve balance on transaction accounts grew by $1.4 million. The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It quantifies the changes in interest income and interest expense related to changes in the average outstanding balances (volume) and those changes caused by fluctuating 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). (Dollars in thousands) Interest-earning assets: Securities available for sale: 2004 vs. 2003 Increase (Decrease) Due to Volume(1) Rate(1) Mortgage-backed and related securities . . . . . . . Other marketable securities . . . . . . . . . . . . . . . . Loans held for sale, net . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . Other, including cash equivalents . . . . . . . . . . . . . Total interest-earning assets . . . . . . . . . . . . . . . . Interest-bearing liabilities: NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances. . . . . . . . . . . . . Other interest bearing liabilities . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . $ (184) 782 (489) 8,947 (43) (11) $9,002 $ 231 13 474 2,454 (1,094) 0 $2,078 297 (271) (10) (2,286) (99) 46 (2,323) 286 (26) 168 (1,478) (326) 1 (1,375) Year Ended December 31, 2003 vs. 2002 Increase (Decrease) Due to Volume(1) Rate(1) $ (784) 591 (592) 10,084 (18) (136) $9,145 $ 88 17 702 585 287 0 $1,679 (648) (620) (247) (5,457) 24 (128) (7,076) (194) (168) (622) (1,084) (617) 0 (2,685) Total Increase (Decrease) (1,432) (29) (839) 4,627 6 (264) 2,069 (106) (151) 80 (499) (330) 0 (1,006) $24,648 Total Increase (Decrease) 113 511 (499) 6,661 (142) 35 6,679 517 (13) 642 976 (1,420) 1 703 $30,624 (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. 9 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S The following table sets forth the weighted average yields on the Company’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. Weighted average yield on: . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: . . . . . . . . . . . . . . . . . . . . . . Weighted average rate on: At December 31, 2004 Mortgage-backed and related securities . . . . . . . . 3.71% Other marketable securities . . . . . . . . . . . . . . . . . 2.83 Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.56 Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 6.68 Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . 2.73 Other interest-earning assets . . . . . . . . . . . . . . . . . . . .1.13 Combined weighted average yield on . . . . . . . . . . . . . . . interest-earning assets . . . . . . . . . . . . . . . . . . . . . 6.12 NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.01% Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.19 Money market accounts . . . . . . . . . . . . . . . . . . . . . . . 1.72 Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.86 Federal Home Loan Bank advances . . . . . . . . . . . . . . . 4.20 Combined weighted average rate on interest-bearing liabilities . . . . . . . . . . . . . . . . . . . 2.46 Interest rate spread . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.66 Provision For Loan Losses The provision for loan losses is recorded to maintain the allowance for loan losses at a level deemed appropriate by management based on the factors disclosed in the critical accounting policy previously discussed. The provision for loan losses was $2.8 million for 2004 compared to $2.6 million for 2003. The provision for loan losses increased primarily because of an increase in the reserves established on two commercial lending relationships with combined outstanding balances of $10.4 million and loss reserves of $744,000 at December 31, 2004. The increased reserves were due to downgrades in the risk ratings assigned to these loans. Both of these loans were performing at December 31, 2004 and will continue to be monitored for changes in risk in accordance with the Company’s commercial credit policy. The increase in the provision because of these downgrades was partially offset by the $43 million decrease in loan growth that was experienced in the commercial and consumer loan portfolios during 2004 when compared to 2003. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans. Non-Interest Income Non-interest income was $6.0 million for the year ended December 31, 2004, a decrease of $4.3 million, from $10.3 million for the same period in 2003. The following table presents the components of non-interest income: (Dollars in thousands) Year Ended December 31, 2003 2004 Percentage Increase (Decrease) 2002 2004/2003 2003/2002 Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,776 1,169 Mortgage servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (535) Securities gains (losses), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,703 Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26) Losses in limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880 Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,967 2,304 998 1,275 5,240 (243) 681 10,255 1,723 715 422 3,077 (659) 597 5,875 20.5% 17.1 (142.0) (67.5) 89.3 29.2 (41.8) 33.7% 39.6 202.1 70.3 63.1 14.1 74.6 10 Fees and service charges earned in 2004 increased by $472,000 from those earned in 2003, primarily due to the full year effect of increased fees generated from an overdraft protection program that was implemented in the second quarter of 2003. The Company also increased the charges for some services and developed more retail and commercial checking account relationships during 2004, which created more fee income opportunities. The Company will continue to focus on deposit growth in checking and money market accounts in order to increase fee income opportunities and decrease its cost of funds. Mortgage servicing fees increased by $171,000 for the year ended December 31, 2004 due to the increased number of single-family loans that were serviced for others. The lower mortgage interest rates in 2003 resulted in increased loan originations and the majority of the loans were sold on the secondary mortgage market with the servicing rights retained. Security gains decreased by $1.8 million for the year ended December 31, 2004 as fewer investments were sold and because of the $539,000 write down of a Federal Home Loan Mortgage Corporation (FHLMC) preferred stock investment whose decline in value due to changes in interest rates was determined to be other than temporary. The ability to realize gains on the sale of securities is dependent on the type of securities in the securities portfolio and on changes in the general interest rate environment. The Company was able to recognize gains on both its debt and equity security portfolios in the declining interest rate conditions that existed during 2003, but was not able to do this in the rising rate environment that existed in 2004. Gains on the sale of single-family loans decreased by $3.5 million for the year ended December 31, 2004. Increases in interest rates from the historically low mortgage rates experienced during 2003 resulted in a significant decrease in mortgage loan origination activity in 2004 when compared to 2003. The majority of the fixed rate single- family loans that are originated are sold in the secondary mortgage market in order to reduce interest rate risk, increase non-interest income, and provide funding for the commercial and consumer loan growth. The Company expects mortgage interest rates to trend slightly higher in 2005, which may result in lower single-family loan originations and less gain on sales of loans than that experienced in 2004. Losses from limited partnerships decreased by $217,000 for the year ended December 31, 2004 primarily because the Company’s investment in a limited partnership that invested in mortgage servicing rights was dissolved in the second quarter of 2003. Generally, as interest rates rise the value of fixed rate mortgage servicing rights increases and as interest rates fall the value of mortgage servicing rights declines due to changes in the anticipated cash flows caused by prepayments on the loans being serviced. During 2003, declines in interest rates on single-family mortgages caused the Company to recognize losses on its investment in the mortgage servicing limited partnership. This partnership was dissolved in the second quarter of 2003 in order to eliminate future losses. For more information on investments in limited partnerships refer to Notes 1 and 9 of the Notes to Consolidated Financial Statements. Other non-interest income consists primarily of fees and commissions earned on the sale of financial planning and insurance products and the gains and losses from the sale of assets. For the year ended December 31, 2004, other non- interest income was $880,000 compared to $681,000 for 2003. The change in other non-interest income is principally due to increases in revenues from the sale of uninsured investment products. Non-Interest Expense Non-interest expense for the year ended December 31, 2004 was $20.2 million, compared to $19.7 million for the year ended in 2003. The following table presents the components of non-interest expense: (Dollars in thousands) Year Ended December 31, 2003 2004 2002 Percentage Increase (Decrease) 2004/2003 2003/2002 Compensation and benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,187 3,630 Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Deposit insurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 930 Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,061 3,828 Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,162 8,676 3,424 72 393 1,109 1,982 3,997 19,653 8,013 3,110 74 522 1,107 1,166 3,857 17,849 17.4% 6.0 33.3 9.4 (16.1) (46.5) (4.2) 2.6 8.3% 10.1 (2.7) (24.7) 0.2 70.0 3.6 10.1 11 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S Non-interest expense increased by $509,000 in 2004 primarily because of a $1.5 million increase in compensation and benefits expense due to increases in health insurance and payroll costs due to normal staffing growth during the year and annual salary increases. Occupancy expense increased by $206,000 primarily because of real estate tax increases on existing facilities and increased expenses related to the additional corporate facilities that were put in place in the first quarter of 2004. Amortization expense on mortgage servicing rights decreased by $921,000 between the periods because of a decrease in the prepayments on the mortgage loans being serviced. It is anticipated that prepayments will remain about the same in 2005 as they were in 2004 due to the reduced number of loans that are being refinanced compared to those that were refinanced in 2003. Data processing costs decreased by $179,000 primarily because of the renegotiation of a third party service contract in the fourth quarter of 2003. Income Taxes The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities. During 2004 and 2003 the Company recorded income tax expense of $4.4 million and $4.0 million, respectively. The change in income tax expense is primarily the result of changes in taxable income. Refer to Note 15 of the Notes to Consolidated Financial Statements for additional information relating to income taxes. C O M P A R I S O N O F 2 0 0 3 W I T H 2 0 0 2 Net income was $8.6 million for the year ended December 31, 2003, compared to $5.3 million for the year ended December 31, 2002. Diluted earnings per common share for the year ended December 31, 2003 were $2.16, compared to $1.32 for the year ended December 31, 2002. Return on average assets was 1.10% and 0.74% and return on average equity was 10.85% and 6.94% for the years ended December 31, 2003 and 2002, respectively. In comparing the year ended December 31, 2003 to the year ended December 31, 2002, net interest income increased by $3.1 million primarily because of an increase in interest- earning assets and because of a higher concentration of commercial and consumer loans and an increase in checking and money market deposit accounts. Non-interest income increased $4.4 million primarily due to increases in the gains recognized on the sale of mortgage loans and securities. Non- interest expense increased by $1.8 million primarily because of an increase in the amortization of mortgage servicing rights that was caused by the large number of loan prepayments during 2003. Non-interest expense also increased because of increases in compensation and benefits and occupancy expense primarily related to the growth in employees and facilities between the periods. Net interest income for the year ended December 31, 2003 was $24.6 million, an increase of $3.1 million, from $21.5 million in 2002. Interest income was $44.9 million for the year ended December 31, 2003, an increase of $2.0 million, from $42.9 million for the same period in 2002. Interest income increased primarily because of an increase in interest-earning assets and because of a higher concentration of commercial and consumer loans in portfolio. The commercial and consumer loan portfolios increased by $148 million between the periods. During 2003, the Company’s commercial and consumer loan portfolios continued to increase and the percentage of loans in these portfolios represented 61.7% of the Company’s outstanding loans at December 31, 2003, compared to 58.2% at December 31, 2002. The increase in interest-earning assets offsets the decrease in the interest rates earned on the assets between the periods. Interest expense was $20.3 million for the year ended December 31, 2003, a decrease of $1.0 million, from the $21.3 million for the same period in 2002. Interest expense declined primarily because of a decrease in the rates paid on deposits and Federal Home Loan Bank advances and because of a $45 million increase in the outstanding average balance of checking and money market accounts between the periods, which generally have lower interest rates than other deposit accounts. Net interest margin increased to 3.31% in 2003 compared to 3.19% for 2002 primarily because of the increased focus on commercial and consumer loans and the 12 increase in the outstanding average balance of checking and money market accounts. Average net earning assets were $46.4 million in 2003 compared to $45.7 million for 2002. The Company has actively purchased its common stock in the open market and has paid quarterly dividends to its stockholders, both of which reduce net interest earning assets. During 2003 and 2002 HMN paid $1.4 million and $1.5 million to purchase its common stock in the open market and paid dividends to stockholders of $2.9 million and $2.6 million, respectively. The increase in net interest earning assets in 2003 is primarily the result of net income exceeding stock repurchases, dividends on common stock, and fixed asset additions. The provision for loan losses for 2003 was $2.6 million compared to $2.4 million for 2002. The provision increased primarily because of the additional $33 million in growth experienced in the commercial and consumer loan portfolios in 2003. Commercial and consumer loans generally require a larger provision due to the greater inherent credit risk of these loans. The provision also increased because of increases in specific consumer loan reserves and increased instances of personal bankruptcies that resulted in an increase in non- accruing loans of $1.2 million between the periods. The Company incurred $494,000 of net loan charge-offs in 2003 compared to $1.3 million of net loan charge-offs in 2002. Non-interest income was $10.3 million for 2003, compared to $5.9 million for 2002. Fees and service charges earned for the year ended December 31, 2003 increased by $581,000 from those earned in 2002, primarily due to the increased fees generated from an overdraft protection program that was implemented in the second quarter of 2003. Mortgage servicing fees increased by $283,000 in 2003 due to the increased number of single-family loans that were serviced for others. Gains on the sale of securities increased by $853,000 in 2003 as investments were sold to fund a portion of the consumer and commercial loan growth that was experienced. Gains on the sale of single-family loans increased by $2.2 million for the year ended December 31, 2003. Low mortgage rates during 2003 resulted in higher single-family loan originations than in 2002 as consumers took advantage of the low interest rates to purchase a home or refinance their existing home mortgage. Losses from limited partnerships decreased by $416,000 for the year ended December 31, 2003 primarily because of lower losses on an investment in a limited partnership that invested in mortgage servicing rights. Generally, as interest rates rise the value of fixed rate mortgage servicing rights increases and as interest rates fall the value of mortgage servicing rights declines due to changes in the anticipated cash flows caused by prepayments on the loans being serviced. During 2003 and 2002, declines in interest rates on single-family mortgages caused the Company to recognize losses on its investment in the mortgage servicing limited partnership. This partnership was dissolved in the second quarter of 2003. Other non-interest income increased by $84,000 principally due to increases in the gains recognized on the sale of assets as the Company sold three former branch locations in 2003. Non-interest expense increased by $1.8 million in 2003 primarily because of an increase of $816,000 in the amortization of mortgage servicing rights which was caused by the large number of loan prepayments during the year. Because of the low interest rates in 2003, many loans that were being serviced by the Bank were refinanced. When a serviced loan was paid off, the remaining value of the right to service that loan was recorded as additional amortization expense in the month in which the loan was repaid. Compensation and benefits expense increased by $663,000 primarily because of an increase in the number of employees, annual payroll cost increases, and costs related to a separation agreement with a former executive officer. Occupancy expense increased by $314,000 due to the increased costs associated with operating and maintaining additional facilities in 2003, including loan production offices opened in Byron, Stewartville, and St. Cloud, Minnesota, as well as West Des Moines, Iowa. During 2003 and 2002 the Company recorded income tax expense of $4.0 million and $2.1 million, respectively. The change in income tax expense is the result of changes in taxable income and an increase in the Company’s effective tax rate caused primarily by lower state tax deductions as a percentage of income in 2003 when compared to 2002. 13 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S F i n a n c i a l C o n d i t i o n Loans Receivable, Net The following table sets forth the information on the Company’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. 2004 2003 December 31, 2002 2001 2000 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent (Dollars in thousands) Real Estate Loans: One-to-four family . . . $139,008 41,922 Multi-family . . . . . . . . Commercial . . . . . . . . . 224,945 Construction or 17.34% $144,315 20.37% $151,566 15,766 5.23 130,417 28.06 31,540 4.45 199,124 28.10 27.72% $215,448 44.73% $312,888 59.43% 14,369 2.88 2.98 70,768 14.69 23.85 12,090 2.30 61,654 11.71 development . . . . . . . 98,397 Total real estate . . . 504,272 12.28 62.91 95,346 13.45 470,325 66.37 61,336 359,085 11.22 65.67 46,977 9.75 347,562 72.15 20,211 3.84 406,843 77.28 Other Loans: Consumer Loans: Automobile . . . . . . . Home equity line . . . Home equity . . . . . . Mobile home . . . . . . Land/lot loans . . . . . . Other . . . . . . . . . . . . Total consumer 9,496 67,140 20,033 2,896 11,572 3,836 1.18 8.38 2.50 0.36 1.44 0.48 14,754 54,193 18,974 3,665 10,486 3,833 2.08 7.64 2.68 0.52 1.48 0.54 11,062 52,106 21,075 4,534 3,590 4,054 2.02 9.53 3.85 0.83 0.66 0.75 6,624 35,714 26,356 5,456 850 4,131 1.38 7.42 5.47 1.13 0.18 0.86 6,363 26,907 27,812 4,921 1,038 3,855 1.21 5.11 5.28 0.93 0.20 0.74 loans . . . . . . . . . . 114,973 14.34 105,905 14.94 96,421 17.64 79,131 16.44 70,896 13.47 Commercial business loans . . . . . . . . . . . . . 182,369 Total other loans . . 297,342 Total loans . . . . . . . 801,614 100.00% 22.75 37.09 Less: Loans in process . . . . . Unamortized discounts . . . . . . . . . Net deferred 7,561 63 loan fees . . . . . . . . . . Allowance for losses . . 1,781 8,996 Total loans 132,459 18.69 238,364 33.63 708,689 100.00% 546,766 100.00% 481,633 100.00% 526,499 100.00% 48,760 9.25 119,656 22.72 54,940 11.41 134,071 27.85 91,260 187,681 16.69 34.33 11,298 166 1,334 6,940 6,826 142 1,068 4,824 4,692 278 1,212 3,783 2,953 289 1,348 3,144 receivable, net . . . $783,213 $688,951 $533,906 $471,668 $518,765 The Company continues to manage interest rate risk and increase interest income by increasing its investment in shorter term and generally higher yielding commercial real estate and commercial business loans and reducing its investment in longer term one-to-four family real estate loans. The Company intends to continue to increase the size of its commercial real estate, commercial business and consumer loan portfolios while maintaining the one-to-four family loans held in portfolio. The one-to-four family real estate loans were $139.0 million at December 31, 2004, a decrease of $5.3 million, compared to $144.3 million at December 31, 2003. During 2004 loan originations decreased and the mortgage loans that were originated and placed in portfolio were not enough to offset the principal payments received on the loans already in the portfolio. The decrease in the amount of mortgage loans placed in portfolio was the primary reason for the decline in the one-to-four family loan portfolio during 2004. 14 Commercial real estate loans were $224.9 million at December 31, 2004, an increase of $25.8 million, compared to $199.1 million at December 31, 2003. Commercial business loans were $182.4 million at December 31, 2004, an increase of $49.9 million, compared to $132.5 million at December 31, 2003. The Company’s continued emphasis on commercial real estate and commercial business loans resulted in the origination or purchase of commercial real estate loans totaling $65.7 million in 2004 and $133.6 million in 2003. Commercial business loans originated or purchased were $127.7 million in 2004, compared to $142.6 million in 2003. Production volume was the principal reason for the increase in commercial real estate and commercial business loans in 2004. Home equity line loans were $67.1 million at December 31, 2004, compared to $54.2 million at December 31, 2003. The open-end home equity lines are written with an adjustable rate with terms of 20 years, a 10 year draw period which requires “interest only” payments and a 10 year repayment period which fully amortizes the outstanding balance. Closed-end home equity loans are written with fixed or adjustable rates with terms up to 15 years. Home equity loans were $20.0 million at December 31, 2004, compared to $19.0 million at December 31, 2003. Because many borrowers refinanced their home mortgage during the record low interest rates in 2003, many turned to home equity loans to finance their home improvement and other purchases as they did not want to refinance their first mortgage at the higher rates in effect during 2004. Allowance for Loan Losses The determination of the allowance for loan losses and the related provision is a critical accounting policy of the Company that is subject to significant estimates, as previously discussed. The current level of the allowance for loan losses is a result of management’s assessment of the risks within the portfolio based on the information obtained through the credit evaluation process. The Company utilizes a risk-rating system on non-homogenous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. 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 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 $9.0 million, or 1.12%, of gross loans at December 31, 2004, compared to $6.9 million, or 0.98%, of gross loans at December 31, 2003. The following table reflects the activity in the allowance for loan losses and selected statistics: (Dollars in thousands) 2004 Balance at the beginning of year . . . . . . . . . . . . . . . . . . . . . . . $6,940 2,755 Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business and real estate . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (331) (407) 0 39 (699) Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,996 Year end allowance for loan losses as a percent of year end 2003 4,824 2,610 (69) (226) (255) 56 (494) 6,940 December 31, 2002 3,783 2,376 (44) (310) (1,015) 34 (1,335) 4,824 2001 3,144 1,150 0 (170) (347) 6 (511) 3,783 2000 3,273 180 0 (59) (253) 3 (309) 3,144 gross loan balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio of net loan charge-offs to average loans outstanding . . . 1.12% 0.09 0.98% 0.08 0.88% 0.26 0.79% 0.10 0.60% 0.06 15 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S The following table reflects the allocation of the allowance for loan losses: 2004 2003 Percent Allocated of loans in each allowance as a % category to total of loan loans category Percent Allocated of loans allowance in each as a % category to total of loan loans category December 31, 2002 Percent Allocated of loans in each allowance as a % category to total of loan loans category 2001 2000 Percent Allocated of loans Allocated allowance in each allowance as a % category to total of loan loans category Percent of loans in each as a % category to total of loan loans category 0.17% 17.34% 0.12% 20.36% 0.06% 27.72% 0.10% 44.73% 0.10% 59.43% 1.67 1.60 2.30 11.71 2.88 23.88 4.45 28.10 5.23 28.06 2.98 14.69 1.30 1.55 1.34 1.42 1.41 1.28 0.92 1.30 12.28 14.34 22.75 1.07 0.81 1.36 1.12% 100.00% 0.98% 100.00% 0.88% 100.00% 0.79% 100.00% 0.60% 100.00% 11.22 17.63 16.67 9.75 16.44 11.41 3.84 13.47 9.25 13.45 14.95 18.69 0.97 0.56 1.48 1.19 0.71 2.44 0.92 0.98 1.20 2.02 0.58 2.72 (Dollars in thousands) Real estate loans: One-to-four family . . . . . . . . . . Multi-family . . . . . . . . . . . . . . Commercial real estate . . . . . . . Construction or development . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total The allocation of the allowance for loan losses increased in 2004 for one-to-four family, multi-family, commercial, construction or development, and commercial business loans primarily because management’s overall assessment of the risk of the individual loans in these categories increased between the years. The allocated percentage for the consumer loans decreased in 2004 primarily because of an increased percentage of home equity loans in the consumer loan mix in 2004. Allowance for Real Estate Losses 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. Management periodically performs valuations and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. There was limited activity in the allowance for real estate losses and the balance was zero at December 31, 2004 and December 31, 2003. Non-performing Assets Loans are reviewed at least quarterly and any loan whose collectibility is doubtful is placed on non-accrual status. Loans are placed on non-accrual 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. Restructured loans include the Bank’s troubled debt restructurings that involved forgiving a portion of interest or principal on any loans or making loans at a rate materially less than the market rate. Foreclosed and repossessed assets include assets acquired in settlement of loans. Non-performing assets is comprised of non-accrual loans, restructured loans, impaired securities, delinquent accounts receivable, real estate acquired through foreclosure, and repossessed assets and totaled $4.9 million at December 31, 2004, compared to $5.0 million at December 31, 2003. The $153,000 decrease in non-performing assets in 2004 relates primarily to a $350,000 decrease in non-performing loans and a $9,000 decrease in non-performing other assets that are partially offset by an increase of $206,000 in foreclosed and repossessed assets. The increase in this category is primarily related to an increase in the number of repossessed mobile homes at December 31, 2004. The following table sets forth the amounts and categories of non-performing assets in the Company’s portfolio: 16 (Dollars in thousands) Non-accruing loans: Real estate: 2004 2003 December 31, 2002 2001 2000 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,864 1,114 Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . 472 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,711 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accruing loans delinquent 90 days or more: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreclosed and repossessed assets: 628 201 Real estate: 141 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . 201 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . 342 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-performing assets . . . . . . . . . . . . . . . . . . . . . . . . . . $4,882 Total as a percentage of total assets . . . . . . . . . . . . . . . . . . . . . Total non-performing loans . . . . . . . . . . . . . . . . . . . . . . . . . . $4,339 0.55% Total as a percentage of total loans receivable, net . . . . . . . . . Allowance for loan losses to non-performing loans . . . . . . . . . 207.30% 0.51% 1,177 2,162 1,050 186 4,575 114 211 73 0 62 0 135 5,035 0.58% 4,689 0.68% 147.99% 695 1,719 495 427 3,336 171 866 300 127 107 0 534 4,907 0.67% 3,507 0.66% 134.60% 771 187 311 890 2,159 24 1,390 0 0 155 33 188 3,761 775 0 142 95 1,012 405 0 195 0 0 0 195 1,612 0.52% 2,183 0.46% 173.29% 0.23% 1,417 0.27% 221.87% For the year ended December 31, 2004, gross interest income which would have been recorded had the non- accruing loans been current in accordance with their original terms amounted to $271,071. The amounts that were included in interest income on a cash basis for such loans during 2004 were $158,767. For the year ended December 31, 2003, gross interest income which would have been recorded had the non- accruing loans been current in accordance with their original terms amounted to $458,473. The amounts that were included in interest income on a cash basis for such loans during 2003 were $163,044. In addition to the non-performing assets set forth in the table above, as of December 31, 2004 there were no loans with known information about the possible credit problems of the borrowers or the cash flows of the secured properties that have caused management to have concerns as to the ability of the borrowers to comply with present loan repayment terms 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. L i q u i d i t y a n d C a p i t a l R e s o u r c e s The Company 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 or sale of the asset. Liability liquidity is the ability of the Bank to attract retail or brokered deposits or to borrow funds from third parties such as the FHLB. The primary investing activities are the origination of loans and the purchase of securities. Principal and interest payments on loans and securities along with the proceeds from the sale of loans held for sale are the primary sources of cash for the Company. Additional cash can be obtained by selling securities from the available for sale portfolio or by selling loans or mortgage servicing rights. Loans could also be securitized and used as collateral for additional borrowings with the FHLB to generate additional cash. The primary financing activity is the attraction of retail and brokered 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 on existing collateral levels with the FHLB. Information on outstanding advance maturities and related early call features is also included in Note 13. The Company’s most liquid assets are cash and cash equivalents, which consist of short-term highly liquid investments with original maturities of less than three 17 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S 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, 2004 were $34.3 million, an increase of $3.8 million, compared to $30.5 million at December 31, 2003. Net cash provided by operating activities during 2004 was $15.4 million. The Company conducted the following major investing activities during 2004: proceeds from the sale of securities available for sale were $15.1 million, principal received on payments and maturities of securities available for sale was $19.4 million, purchases of securities available for sale were $34.9 million, and net loans receivable increased by $96.8 million. The Company spent $2.2 million for the purchase of equipment and updating its premises, and received $267,000 from the sale of real estate and old branch facilities. Net cash used by investing activities during 2004 was $98.0 million. The Company conducted the following major financing activities during 2004: purchase of treasury stock of $3.3 million, paid out $21.7 million in customer escrows, paid $3.2 million in dividends to HMN stockholders, proceeds from FHLB advances totaled $54.9 million, repayments of FHLB advances totaled $87.9 million, and increases in deposits were $147.6 million. Net cash provided by financing activities was $86.4 million. The Company has certificates of deposit with outstanding balances of $197.6 million that mature during 2005. Based upon past experience management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits that do not renew will be replaced with deposits from a combination of other customers or brokers. FHLB advances or the sale of securities could also be used to replace unanticipated outflows of deposits. Management does not anticipate that it will have a liquidity problem in 2005 due to maturing deposits. The Company has $10 million of FHLB advances that mature in 2005 and it has $110.9 million of FHLB advances with maturities beyond 2005 that have call features that may be exercised by the FHLB during 2005. If the call features are exercised, the Company has the option of requesting any advance otherwise available to it pursuant to the credit policy of the FHLB. Since the Company 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 2005. The credit policy of the FHLB may change such that the current collateral pledged to secure the advances is no longer acceptable or the formulas for determining the excess pledged collateral may change. If this were to happen the Bank may not have additional collateral to pledge to secure the existing advances which could cause the FHLB advances to become a liquidity problem during 2005. its that The Company liquidity anticipates requirements for 2005 will be similar to the cash flows it experienced in 2004 with the following exceptions: net increase in loans receivable is anticipated to be $27 million; net increase in customer escrows is anticipated to be $200,000; the funds provided from deposits and/or FHLB advances are anticipated to be $56 million; and the funds provided by security sales and/or principal collections on securities are anticipated to be $25 million. On February 24, 2004, the Company’s Board of Directors authorized the extension of the stock repurchase program to August 26, 2005. The plan authorized HMN to repurchase up to 350,000 shares of its common stock in the open market and as of December 31, 2004, there remained 227,000 shares authorized for repurchase. Contractual Obligations and Commercial Commitments The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2004, the aggregate contractual obligations (excluding bank deposits) and commercial commitments are as follows: (Dollars in thousands) Contractual Obligations: Total borrowings . . . . . . . . . . . . . . . . . . . . . . Annual rental commitments under non-cancelable operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Commercial Commitments: Commercial lines of credit . . . . . . . . . . . . . . Commitments to lend . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years Payments Due by Period $170,900 10,000 60,000 10,000 90,900 969 $171,869 517 10,517 452 60,452 0 10,000 0 90,900 Amount of Commitment-Expiration by Period 16,711 39,183 6,581 62,475 4,670 13,527 444 18,641 0 46 0 46 685 40,455 0 41,140 $ 22,066 93,211 7,025 $122,302 18 Regulatory Capital Requirements 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 ratio of 5% or greater, and (iv) is not subject to any order or written directive by the Office of Thrift Supervision (OTS) to meet and maintain a specific capital level for any capital measure. Management believes that, as of December 31, 2004, the Bank met all of the capital requirements to which it was subject and is well capitalized based on the regulatory definition described above. Refer to Note 19 of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to its capital requirements. Dividends The declaration of dividends is subject to, among other things, the Company’s financial condition and results of operations, the Bank’s compliance with its regulatory 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 the Company and additional information on dividends. The payment of dividends is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders. The Company does not anticipate a liquidity problem in 2005 relating to the payment of dividends. Impact of Inflation and Changing Prices The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’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. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued a revised SFAS No. 123, Share-Based Payment. This Statement is a revision of FASB Statement No. 123, Accounting for Stock Based Compensation and requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. It requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. The Statement also requires that the notes to financial statements disclose information to assist users of financial information to understand the nature of share-based payment transactions and the effects of those transactions on the financial statements. The impact of adopting the revised SFAS No. 123 in the third quarter of 2005 on the Company’s financial condition and results of operations will not be material. At its March 2004 meeting, the Emerging Issues Task Force revisited EITF Issue No. 03-1, The Meaning of Other- Than-Temporary Impairment and its Application to Certain Investments (EITF No. 03-1). Effective with reporting periods beginning after June 15, 2004, companies carrying certain types of debt and equity securities at amounts higher than the securities’ fair values would have to use more detailed criteria to evaluate whether to record a loss and would have to disclose additional information about unrealized losses. The FASB has since issued a statement of financial position deferring the effective date of the revised EITF No. 03-1 until further implementation issues are resolved. The impact on the Company’s financial position and results of operations cannot be determined until the final statement is issued. M a r k e t R i s k Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure. The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located in the Asset/Liability Management section of this Management’s Discussion and Analysis section discloses the Company’s projected changes in net interest income based upon immediate interest rate changes called rate shocks. The Company utilizes a model that uses the discounted 19 M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S 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 under different interest rate changes. The management of the Company believes that over the next twelve months interest rates could conceivably fluctuate in a range of 200 basis points up or 100 basis points down from where the rates were at December 31, 2004. The following table discloses the projected changes in market value to the Company’s interest-earning assets and interest- bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on December 31, 2004. (Dollars in thousands) Basis point change in interest rates Total market risk sensitive assets . . . . . . . . . . . . . . . . . . . . . . . . . Total market risk sensitive liabilities . . . . . . . . . . . . . . . . . . . . . . Off-balance sheet financial instruments . . . . . . . . . . . . . . . . . . . . Net market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage change from current market value . . . . . . . . . . . . . . . Market Value –100 $964,217 864,064 (43) $100,196 0 956,346 848,729 0 107,617 +100 945,265 833,726 227 111,312 +200 932,907 819,618 263 113,026 (6.90)% 0.00% 3.43% 5.03% 3.43% 5.03% The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that 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 5% and 75%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 10% and 33%, depending on the note rate and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 5% and 53% depending on the note rate and the period to maturity. Mortgage- backed securities and Collateralized Mortgage Obligations (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at an annual rate of 30%. Non-interest checking and NOW accounts were assumed to decay at an annual rate of 16%. Commercial NOW and MMDA accounts were assumed to decay at an annual rate of 30%. FHLB advances were projected to be called at the first call date where the projected interest rate on similar remaining term advances exceeded the interest rate on the callable advance. 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 that 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 that are approaching their lifetime interest rate caps could be different from the values calculated in the table. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial sustained interest rate increase. 20 Asset/Liability Management The Company’s management reviews the impact that changing interest rates will have on its net interest income projected for the twelve months following December 31, 2004 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. Rate Shock in Basis Points +200 +100 0 -100 Net Interest Income $36,434,000 $35,344,000 $33,971,000 $32,986,000 Percentage Change 7.25 % 4.04 % 0.00 % (2.90)% The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Company has an Asset/Liability Committee that meets frequently to discuss changes made to the interest rate risk position and projected profitability. The Committee makes adjustments to the asset-liability position of the Bank that are reviewed by 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 Bank’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 balance sheet in order to better match the maturities of its assets and liabilities. The Bank has primarily focused its fixed rate one- to-four family residential lending program on loans that are saleable to third parties and only places fixed rate loans that meet certain risk characteristics into its loan portfolio. The Bank does place into portfolio adjustable rate single-family loans that reprice over a one-year, three-year or five-year period. The Bank’s commercial loan production has primarily been in adjustable rate loans and the fixed rate commercial loans placed in portfolio have been shorter-term loans, usually with maturities of five years or less, in order to lower the Company’s interest rate risk exposure. 21 C O N S O L I D A T E D B A L A N C E S H E E T S December 31, 2004 and 2003 2004 2003 A S S E T S Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,298,394 Securities available for sale: 30,496,823 Mortgage-backed and related securities (amortized cost $9,509,377 and $13,707,005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,150,871 13,048,718 Other marketable securities (amortized cost $95,097,051 and $91,035,285) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill Core deposit intangible, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,521,512 103,672,383 2,711,760 783,213,262 3,694,133 140,608 9,292,800 3,231,242 12,464,265 168,258 3,800,938 333,617 2,638,681 1,012,700 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $960,673,041 L I A B I L I T I E S A N D S T O C K H O L D E R S ’ E Q U I T Y Deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $698,902,185 170,900,000 Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,314,356 Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762,737 Customer escrows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,022,927 Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 876,902,205 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments and contingencies Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders’ equity: Serial preferred stock: ($.01 par value) Authorized 500,000 shares; issued and outstanding none . . . . . . . . . . . . . . . . . . . . . . Common stock ($.01 par value): 0 0 91,615,047 104,663,765 6,542,824 688,951,119 3,462,221 73,271 10,004,400 3,447,843 12,110,151 617,042 3,800,938 447,474 2,108,575 0 866,726,446 551,687,995 203,900,000 766,837 22,457,671 6,952,600 26,300 785,791,403 3,986 0 Authorized 11,000,000 shares; issued 9,128,662. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings, subject to certain restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned employee stock ownership plan shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost 4,708,798 and 4,616,010 shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,287 57,875,595 91,408,028 (604,446) (4,544,300) (60,455,328) 83,770,836 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $960,673,041 91,287 57,863,726 85,364,657 (50,725) (4,738,084) (57,599,804) 80,931,057 866,726,446 See accompanying notes to consolidated financial statements. 22 C O N S O L I D A T E D S T A T E M E N T S O F I N C O M E Years ended December 31, 2004, 2003 and 2002 2004 2003 2002 Interest income: Loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, including cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense: Deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses . . . . . . . . . . . . . Non-interest income: Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains (losses), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses in limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense: Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 47,962,485 41,800,039 38,011,750 385,067 2,897,834 207,240 164,061 51,616,687 12,398,505 8,594,790 20,993,295 30,623,392 2,755,000 27,868,392 2,776,553 1,168,760 (535,188) 1,702,979 (26,118) 880,233 5,967,219 10,186,538 3,629,766 95,465 430,417 930,144 1,061,407 3,828,086 20,161,823 13,673,788 4,387,100 9,286,688 (3,109) $ 9,289,797 2.40 $ 2.31 $ 272,253 2,386,590 349,150 128,948 44,936,980 10,274,188 10,014,865 20,289,053 24,647,927 2,610,000 22,037,927 2,304,090 998,200 1,274,537 5,240,442 (243,305) 681,518 10,255,482 8,675,596 3,423,745 72,524 392,833 1,109,098 1,982,337 3,997,243 19,653,376 12,640,033 4,037,800 8,602,233 (3,014) 8,605,247 2.26 2.16 1,704,248 2,420,317 349,214 382,021 42,867,550 10,949,802 10,345,102 21,294,904 21,572,646 2,376,000 19,196,646 1,723,117 715,074 422,346 3,077,294 (659,378) 596,117 5,874,570 8,012,953 3,109,548 74,108 521,898 1,107,248 1,165,762 3,857,117 17,848,634 7,222,582 2,099,200 5,123,382 (142,274) 5,265,656 1.40 1.32 C O N S O L I D A T E D S T A T E M E N T S O F C O M P R E H E N S I V E I N C O M E Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income (loss), net of tax: Unrealized losses on hedging valuation . . . . . . . . . . . . . . . . . . . . . . . Less: minority interest in hedging valuation . . . . . . . . . . . . . . . . . . Net unrealized losses on hedging valuation . . . . . . . . . . . . . . . . . . Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during the year . . . . . . . . Less: reclassification adjustment $ 9,289,797 8,605,247 5,265,656 0 0 0 0 0 0 (35,795) (21,950) (13,845) (899,909) (801,965) 1,494,824 for gains (losses) included in net income . . . . . . . . . . . . . . . . . . . Net unrealized gains (losses) on securities . . . . . . . . . . . . . . . . . . . . Other comprehensive income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (346,188) (553,721) (553,721) $ 8,736,076 824,337 (1,626,302) (1,626,302) 6,978,945 273,146 1,221,678 1,207,833 6,473,489 See accompanying notes to consolidated financial statements. 23 C O N S O L I D A T E D S T A T E M E N T S O F S T O C K H O L D E R S ’ E Q U I T Y Common Stock Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Unearned Employee Stock Ownership Plan Shares Unearned Compensation Restricted Stock Awards Treasury Stock Total Stockholders’ Equity Balance, December 31, 2001. . . . . . $91,287 Net income . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . Treasury stock purchases . . Employee stock options exercised. . . . . . . . . . . . Tax benefits of exercised stock options . . . . . . . . Amortization of restricted stock awards . . Earned employee stock ownership plan shares. . Dividends paid . . . . . . . . Net income . . . . . . . . . . . . Other comprehensive loss . . . . . . . . . . . . . . . . . Treasury stock purchases . . Employee stock options exercised. . . . . . . . . . . . Tax benefits of exercised stock options . . . . . . . . Earned employee stock ownership plan shares. . Dividends paid . . . . . . . . 59,168,782 76,956,978 5,265,656 367,744 (5,124,746) (7,350) (59,291,344) 1,207,833 (1,496,111) 72,161,351 5,265,656 1,207,833 ( 1,496,111) (699,641) 272,534 143,604 1,570,772 871,131 7,350 193,361 (2,562,153) 79,660,481 8,605,247 1,575,577 (4,931,385) 0 (59,216,683) (1,626,302) (1,384,560) 272,534 7,350 336,965 ( 2,562,153) 76,064,556 8,605,247 (1,626,302) (1,384,560) (1,578,979) 376,969 180,457 (2,901,071) 193,301 3,001,439 1,422,460 376,969 373,758 ( 2,901,071) Balance, December 31, 2002. . . . . . $91,287 58,885,279 Balance, December 31, 2003. . . . . . $91,287 57,863,726 85,364,657 9,289,797 Net income . . . . . . . . . . . . Other comprehensive (50,725) (4,738,084) 0 (57,599,804) 80,931,057 9,289,797 loss . . . . . . . . . . . . . . . . . Treasury stock purchases . . . Employee stock options exercised. . . . . . . . . . . . Tax benefits of exercised stock options . . . . . . . . Earned employee stock ownership plan shares. . Dividends paid . . . . . . . . (394,392) 98,096 308,165 (553,721) (3,246,426) 193,784 (3,316,550) 461,026 (553,721) (3,316,550) 66,634 98,096 501,949 (3,246,426) Balance, December 31, 2004. . . . . . $91,287 57,875,595 91,408,028 (604,446) (4,544,300) 0 (60,455,328) 83,770,836 See accompanying notes to consolidated financial statements. 24 C O N S O L I D A T E D S T A T E M E N T S O F C A S H F L O W S Years ended December 31, 2004, 2003 and 2002 Cash flows from operating activities: 2004 2003 2002 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to cash provided by operating activities: $ 9,289,797 8,605,247 5,265,656 Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of (discounts) premiums, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of deferred loan fees. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of core deposit intangible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net of valuation adjustments and servicing costs . . . . . . . . . . . . . . . . . . . . . . . . . . Capitalized mortgage servicing rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities (gains) losses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss (gain) on sale of premises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss (gain) on sales of real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of real estate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Disbursements on loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal collected on loans held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of unearned ESOP Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earned employee stock ownership shares priced above original cost . . . . . . . . . . . . . Decrease (increase) in accrued interest receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in accrued interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity losses of limited partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity losses of minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Proceeds from sales of securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal collected on securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds collected on maturity of securities available for sale . . . . . . . . . . . . . . . . . . . . Purchases of securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Redemption of interest in limited partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Redemption of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in loans receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Increase in deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends to stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest in limited partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in customer escrows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental cash flow disclosures: 2,755,000 1,596,252 (353,598) (1,166,855) 113,857 1,061,407 (844,806) (737,200) 535,188 43,440 21,775 825,461 (1,702,979) 90,118,839 (84,592,187) 0 0 193,784 308,165 (231,912) 547,519 26,118 (3,109) (533,660) (1,820,633) (62,873) 15,386,790 15,129,325 4,354,497 15,000,000 (34,877,137) 422,474 (1,793,200) 2,504,800 (96,761,454) 0 266,972 (2,220,610) (97,974,333) 147,580,390 (3,316,550) 66,634 (3,246,426) 54,900,000 (87,900,000) 0 (21,694,934) 86,389,114 3,801,571 30,496,823 $ 34,298,394 Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,445,776 6,548,500 Supplemental noncash flow disclosures: Loans transferred to loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer of loans to real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer of real estate to loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 892,802 0 2,610,000 1,549,997 652,344 (690,176) 113,857 1,982,337 (2,522,231) (540,900) (1,274,537) (185,630) 115,710 740,194 (5,240,442) 297,862,680 (280,633,930) 11,521 0 193,301 180,457 (411,585) (82,590) 243,305 (3,014) 680,227 663,785 178,627 24,798,554 50,372,919 30,938,152 10,000,000 (76,410,791) 0 (768,900) 2,645,000 (161,455,973) 0 416,354 (1,046,235) (145,309,474) 118,784,449 (1,384,560) 1,422,460 (2,901,071) 161,000,000 (175,400,000) 7,000 21,750,458 123,278,736 2,767,816 27,729,007 30,496,823 20,371,643 2,141,000 3,741,477 769,584 47,802 2,376,000 1,460,636 501,945 (672,993) 124,178 1,165,762 (1,956,845) (158,700) (422,346) 85,434 (1,254) 151,453 (3,077,294) 283,485,340 (221,645,865) 120,621 7,350 193,361 143,604 458,192 (168,029) 659,378 (142,274) 126,663 629,031 366,903 69,075,907 18,036,553 25,481,396 19,900,000 (63,173,006) 0 0 364,500 (69,313,264) 33,032 655,465 (4,281,615) (72,296,939) 10,925,976 (1,496,111) 871,131 (2,562,153) 10,000,000 (9,500,000) 0 (308,357) 7,930,486 4,709,454 23,019,553 27,729,007 21,462,933 1,952,500 4,669,139 628,233 0 See accompanying notes to consolidated financial statements. 25 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S December 31, 2004, 2003 and 2002 NOTE 1 Description of the Business and Summary of Significant Accounting Policies HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking facilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI) which offers financial planning products and services and Home Federal Holding, Inc. (HFH) which is the holding company for Home Federal REIT, Inc. (HFREIT) which invests in real estate loans acquired from the Bank. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC) which acts as an intermediary for the Bank in transacting like kind property exchanges for Bank customers. The Bank had an 80% owned subsidiary, Federal Title Services, LLC (FTS), which performed mortgage title services for Bank customers. FTS stopped accepting title orders in the third quarter of 2004 and was dissolved. The Bank had a 51% owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), that was a mortgage banking and mortgage brokerage business until its assets were liquidated in 2003 and it was dissolved. The consolidated financial statements included herein are for HMN, SFC, the Bank and the Bank’s consolidated entities as described above. All significant intercompany accounts and transactions have been eliminated in consolidation. In preparing the consolidated financial Use of Estimates 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. Estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the valuation of mortgage servicing rights. Management believes that the allowance for loan losses is adequate to cover probable losses inherent in the portfolio at the date of the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance 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 allowance for loan losses. Such agencies may require additions to the allowance based on their judgment about information available to them at the time of their examination. Mortgage servicing rights are stratified by loan type and note rate and are valued quarterly using prepayment and default rate assumptions. While management believes that the assumptions used and the values determined are reasonable, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the value of the mortgage servicing rights. Cash and Cash Equivalents The Company considers highly liquid investments with original maturities of three months or less to be cash equivalents. Securities are accounted for according to their purpose Securities and holding period. The Company classifies its debt and equity securities in one of three categories: Trading Securities Securities held principally for resale in the near term are classified as trading securities and are recorded at their fair values. Unrealized gains and losses on trading securities are included in other income. Securities Held to Maturity Securities that the Company has the positive intent and ability to hold to maturity are reported at cost and adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities held to maturity reflecting a decline in value judged to be other than temporary are charged to income. Securities Available for Sale Securities available for sale consist of securities not classified as trading securities or as securities held to maturity. They 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. Unrealized gains and losses, net of income taxes, are reported as a separate component of stockholders’ equity until realized. Gains and losses on the sale of securities available for sale are determined using the specific identification method and recognized on the trade date. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities available for sale reflecting a decline in value judged to be other than temporary are charged to income, and a new cost basis is established. 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 the 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 inherent in the loan portfolio as of the balance sheet dates. The allowance for loan losses is based on a quarterly 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. In connection with the determination of the allowance for loan losses, management obtains independent 26 appraisals for significant properties. The allowance for loan losses is established for known 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 non-accrual 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 judgment, principal is collectible. All impaired loans are valued 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 value 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 the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all loans which are delinquent as to principal and interest for 90 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. The Company evaluates its capitalized mortgage servicing rights for impairment each quarter. Loan type and note rate are the predominant 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 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 reviewed quarterly 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 5 to 40 years for office buildings and improvements and 3 to 10 years for furniture and equipment. Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of The Company 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. in Limited Partnerships The Company has Investment investments in limited partnerships that invest in low to moderate income housing projects that generate tax credits for the Company. The Company accounts for the earnings or losses from the limited partnerships on the equity method. Intangible Assets Goodwill resulting from acquisitions is not amortized but is tested for impairment annually in accordance with the requirements of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Deposit base intangibles are amortized on an accelerated basis as the deposits run off. The Company reviews the recoverability of the carrying value of these assets annually or whenever an event occurs indicating that they may be impaired. Stock Based Compensation The Company accounts for stock based compensation in accordance with Accounting Principles Board (APB) Opinion No. 25 and related interpretations which measure compensation cost using the intrinsic value method. See Note 16 for additional information relating to stock based compensation. Had compensation cost for the Company’s stock based plan been determined in accordance with the fair value method recommended by SFAS No. 123, the Company’s net income and earnings per share would have been adjusted to the pro forma amounts indicated below: Net income: As reported . . . . . . . . . . . . . . . $9,289,797 8,605,247 5,265,656 2004 2003 2002 Deduct: Total stock-based employee compensation expense (benefit) determined under fair value based method for all awards, net of related tax effects . . . . . . 37,822 Pro forma . . . . . . . . . . . . . . . . $9,251,975 Earnings per common share: As reported: 44,935 42,960 8,560,312 5,222,696 Basic . . . . . . . . . . . . . . . . . . . $ Diluted . . . . . . . . . . . . . . . . . Pro forma: Basic . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . 2.40 2.31 2.39 2.30 2.26 2.16 2.25 2.15 1.40 1.32 1.39 1.31 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. 27 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S Earnings per Share Basic earnings per share (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 shared in the earnings of the entity. See Note 17 for disclosure of EPS calculations. Comprehensive Income Comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for the Company is comprised of unrealized gains and losses on securities available for sale and unrealized gains and losses on hedging valuations qualifying for cash flow hedge accounting treatment pursuant to SFAS No. 133. Segment Information The amount of each segment item reported is 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 are included in determining reported segment profit or loss 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 are used by the chief operating decision maker are reported for that segment. In December 2004, the Financial New Accounting Standards Accounting Standards Board (FASB) issued a revised SFAS No. 123, Share-Based Payment. This Statement is a revision of FASB Statement No. 123, Accounting for Stock Based Compensation and requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. It requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant- date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. The Statement also requires that the notes to financial statements disclose information to assist users of financial information to understand the nature of share-based payment transactions and the effects of those transactions on the financial statements. The impact of adopting the revised SFAS No. 123 in the third quarter of 2005 on the Company’s financial condition and results of operations will not be material. At its March 2004 meeting, the Emerging Issues Task Force revisited EITF Issue No. 03-1, The Meaning of Other-Than- Temporary Impairment and its Application to Certain Investments (EITF No. 03-1). Effective with reporting periods beginning after June 15, 2004, companies carrying certain types of debt and equity securities at amounts higher than the securities’ fair values would have to use more detailed criteria to evaluate whether to record a loss and would have to disclose additional information about unrealized losses. The FASB has since issued a statement of financial position deferring the effective date of the revised EITF No. 03-1 until further implementation issues may be resolved. The impact on the Company’s financial position and results of operations cannot be determined until the final statement is issued. Derivative Financial Instruments The Company uses derivative financial instruments in order to manage the interest rate risk on residential loans held for sale and its commitments to extend credit for residential loans. The Company may also use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments. See Note 21 for additional information concerning these derivative financial instruments. Reclassifications Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with the current year presentation. NOTE 2 Other Comprehensive Income The gross unrealized holding losses on securities for the year ended December 31, 2004 was $1,391,000, the income tax benefit would have been $491,000 and therefore, the net unrealized holding loss was $900,000. The gross reclassification adjustment for the year ended December 31, 2004 was $535,000, the income tax benefit would have been $189,000 and therefore, the net reclassification adjustment was $346,000. The gross unrealized holding losses on securities for the year ended December 31, 2003 was $1,241,000, the income tax benefit would have been $439,000 and therefore, the net unrealized holding loss was $802,000. The gross reclassification adjustment for the year ended December 31, 2003 was $1,274,000, the income tax expense would have been $450,000 and therefore, the net reclassification adjustment was $824,000. 28 NOTE 3 Securities Available for Sale A summary of securities available for sale at December 31, 2004 and 2003 is as follows: Amortized cost Gross unrealized gains Gross unrealized losses Fair value December 31, 2004: Mortgage-backed securities: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ GNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242,841 21,644 Collateralized mortgage obligations: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,661,962 5,582,930 9,509,377 Other marketable securities: U.S. Government and agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,371,119 Corporate debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,932 Corporate and agency preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,661,000 95,097,051 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $104,606,428 December 31, 2003: Mortgage-backed securities: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ GNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421,818 31,715 Collateralized mortgage obligations: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,697,157 8,556,315 13,707,005 Other marketable securities: 86,658,130 U.S. Government and agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . 177,155 Corporate debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200,000 Corporate and agency preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,035,285 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $104,742,290 Proceeds from securities available for sale which were sold during 2004 were $15,129,325, resulting in gross gains of $8,029 and gross losses of $4,217. The Company also recognized a loss of $539,000 resulting from an other than temporary impairment on a FHLMC preferred stock investment in 2004. The fair market value of the FHLMC preferred stock was $2,961,000 at December 31, 2004. Proceeds from securities available for sale which were sold during 2003 were $50,372,919, resulting in gross gains of $1,353,885 and gross losses of $79,348. Proceeds from securities available for sale which were sold during 2002 were $18,036,553, resulting in gross gains of $456,946 and gross losses of $34,600. The following table indicates amortized cost and estimated fair value of securities available for sale at December 31, 2004 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: 29 12,798 1,157 0 18,589 32,544 7,500 296 0 7,796 40,340 19,938 1,621 1,618 14,262 37,439 929,527 0 0 929,527 966,966 0 0 219,947 171,103 391,050 583,335 0 0 583,335 974,385 255,639 22,801 3,442,015 5,430,416 9,150,871 90,795,284 65,228 3,661,000 94,521,512 103,672,383 0 3 441,756 33,333 266,403 429,320 695,726 0 6,765 343,000 349,765 1,045,491 4,432,372 8,141,257 13,048,718 87,587,657 170,390 3,857,000 91,615,047 104,663,765 Amortized cost Fair value Due less than one year . . . . . . . . . . . . . $ 23,420,260 74,659,254 Due after one year through five years . . . 2,167,971 Due after five years through ten years . . 697,943 Due after ten years . . . . . . . . . . . . . . . . 3,661,000 No stated maturity . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . $104,606,428 23,333,181 73,944,940 2,072,310 660,952 3,661,000 103,672,383 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. The following table shows the gross unrealized losses and fair values for the securities available for sale portfolio aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2004: N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S (Dollars in thousands) Mortgage backed securities: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities: FNMA Debt . . . . . . . . . . . . . . . . . . . . . . FHLMC Debt . . . . . . . . . . . . . . . . . . . . . FHLB Debt . . . . . . . . . . . . . . . . . . . . . . . Total temporarily impaired securities . . . . . . Less than twelve months Twelve months or more Total # of Investments Fair Value Unrealized Losses # of Investments Fair Value Unrealized Losses Fair Value Unrealized Losses 1 0 3 2 11 17 $ 28 0 14,875 9,907 58,006 $82,816 0 0 (74) (41) (468) (583) 1 1 0 0 0 2 $3,413 4,142 0 0 0 $7,555 (220) (171) 0 0 0 (391) $ 3,441 4,142 14,875 9,907 58,006 $90,371 (220) (171) (74) (41) (468) (974) All of these fixed rate investments are temporarily impaired due to changes in interest rates. Mortgage backed securities have an average life of less than six years and the other marketable securities have an average life of less than two years. NOTE 4 Loans Receivable, Net A summary of loans receivable at December 31 is as follows: 2004 2003 Residential real estate loans: 1-4 family conventional . . . . . . . . . . . 1-4 family conventional - construction 1-4 family FHA . . . . . . . . . . . . . . . . . 1-4 family VA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 or more family . . . . . . . . . . . . . . . . 5 or more family - construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,841,355 647,006 408,074 $137,953,340 143,239,962 44,581,196 692,690 382,107 176,849,775 188,895,955 31,540,804 41,921,601 23,337,195 19,153,847 237,925,223 243,773,954 Commercial real estate: Lodging . . . . . . . . . . . . . . . . . . . . . . . Retail/office . . . . . . . . . . . . . . . . . . . . Nursing home/health care . . . . . . . . . Land developments . . . . . . . . . . . . . . Golf courses . . . . . . . . . . . . . . . . . . . . Restaurant/bar/café . . . . . . . . . . . . . . Ethanol plants . . . . . . . . . . . . . . . . . . Warehouse . . . . . . . . . . . . . . . . . . . . . Manufacturing . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other loans: Autos . . . . . . . . . . . . . . . . . . . . . . . . . Home equity line . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . Consumer - secured . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . Land/lot loans . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . Mobile home . . . . . . . . . . . . . . . . . . . Consumer - unsecured . . . . . . . . . . . . Total other loans . . . . . . . . . . . . . . . . Total loans . . . . . . . . . . . . . . . . . . . . . Less: 39,464,818 49,799,669 54,770,096 56,183,453 5,545,180 7,719,285 53,374,516 67,506,276 26,938,649 29,363,624 3,400,084 4,013,659 0 9,431,878 7,577,813 8,793,067 5,950,639 5,698,911 29,529,814 27,837,119 266,346,941 226,551,609 9,496,044 67,140,395 20,032,508 1,522,682 14,754,042 54,192,801 18,973,890 1,544,456 182,368,675 132,459,066 10,486,039 11,572,361 494,227 453,522 3,665,206 2,896,209 1,794,226 1,859,611 297,342,007 238,363,953 801,614,171 708,689,516 Unamortized discounts . . . . . . . . . . . Net deferred loan fees . . . . . . . . . . . . Allowance for losses . . . . . . . . . . . . . . Loans in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,377 1,781,018 8,995,892 7,560,622 166,364 1,334,284 6,939,602 11,298,147 $783,213,262 688,951,119 Commitments to originate or purchase loans . . . . . . . . . . . . . . . . $ 68,751,130 69,547,706 Commitments to deliver loans to secondary market . . . . . . . . . . . . . . $ 6,433,115 7,077,725 Weighted average contractual interest rate . . . . . . . . . . . . . . . . . . . . Loans serviced for others . . . . . . . . . . . . 6.26% 6.20% $523,635,219 483,620,394 Included in total commitments to originate or purchase loans are fixed rate loans aggregating $28,140,130 and $20,037,650 as of December 31, 2004 and 2003, respectively. The interest rates on these commitments ranged from 4.625% to 7.00% at December 31, 2004 and from 4.75% to 8.50% at December 31, 2003. At December 31, 2004, 2003 and 2002, loans on nonaccrual status totaled $3,710,807, $4,574,950 and $3,336,046, respectively. Had the loans performed in accordance with their original terms throughout 2004, the Company would have recorded gross interest income of $271,071 for these loans. For the years ended December 31, 2004, 2003 and 2002, the Company recognized interest income of $158,767, $163,044 and $551,542, respectively. At December 31, 2004 and 2003 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, 2004. At December 31, 2004, 2003 and 2002, the recorded investment in loans that are considered to be impaired was $4,339,450, $4,689,162, and $3,507,418 for which the related allowance for credit losses was $523,312, $1,045,495, and $904,840, respectively. The average investment in impaired loans during 2004, 2003 and 2002 was $3,646,340, $4,801,109 and $3,005,743, respectively. For the years ended December 31, 2004, 2003 and 2002, the Company recognized interest income on impaired loans of $158,767, $163,044 and $551,542, respectively. All of the interest income that was recognized for impaired loans was recognized using the cash basis method of income recognition. The aggregate amounts of loans to executive officers and directors of the Company was $706,869, $1,038,119 and $8,861,210 at December 31, 2004, 2003 and 2002, respectively. During 2004 repayments on loans to executive officers and directors were $579,699, new loans to executive officers and directors totaled $517,570, sales of executive officer and director loans were $240,000, and net loans removed from the executive officer listing due to change in status of the officer were $29,121. During 2003 repayments on loans to executive officers and directors were $7,891,091 and loans originated aggregated $490,500, and sales executive officer and director loans totaled $422.500. All loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated parties. 30 At December 31, 2004, 2003 and 2002, the Company was servicing real estate loans for others with aggregate unpaid principal balances of approximately $523,635,219, $483,620,394 and $337,490,407, respectively. The Company originates residential, commercial real estate and other loans primarily in southern Minnesota and Iowa. Prior to 2003, the Company also purchased loans from a third party broker located in the southeastern United States. At December 31, 2004 and 2003, the Company had in its portfolio single family and multi- family residential loans located in the following states: 2004 Percent of Total Amount Amount 2003 Alabama . . . . . . . . $ 1,544,742 Arizona . . . . . . . . 2,031,585 Colorado . . . . . . . 172,988 Florida . . . . . . . . . 2,204,299 Georgia . . . . . . . . 5,236,234 Illinois . . . . . . . . . 1,683,487 Iowa . . . . . . . . . . . 16,944,040 Massachusetts . . . . 1,252,635 Minnesota . . . . . . 189,770,503 2,450,469 North Carolina . . . South Carolina . . . 0 Texas . . . . . . . . . . 6,612,676 Wisconsin . . . . . . 4,548,029 Other states . . . . . 3,473,536 Total . . . . . . . . . $237,925,223 0.6% $ 2,084,425 1,559,579 0.9 1,794,321 0.1 5,206,942 0.9 7,338,911 2.2 3,914,175 0.7 16,106,426 7.1 2,647,058 0.5 178,051,169 79.8 3,243,818 1.0 4,335,467 0.0 5,826,905 2.8 4,977,308 1.9 6,687,450 1.5 100.0% $243,773,954 Percent of Total 0.9% 0.6 0.7 2.2 3.0 1.6 6.6 1.1 73.0 1.3 1.8 2.4 2.0 2.8 100.0% Amounts under one million dollars are included in “Other states”. At December 31, 2004 and 2003, the Company had in its portfolio commercial real estate loans located in the following states: 2004 2003 Arizona . . . . . . . . $ California . . . . . . . Colorado . . . . . . . Connecticut . . . . . Illinois . . . . . . . . . Indiana . . . . . . . . . Iowa . . . . . . . . . . . Minnesota . . . . . . Missouri . . . . . . . . Montana . . . . . . . . Nebraska . . . . . . . South Dakota . . . . Texas . . . . . . . . . . Utah . . . . . . . . . . Wisconsin . . . . . . Amount 3,346,259 1,000,000 1,674,433 0 658,800 660,435 25,144,085 219,937,723 4,376,886 2,114,048 947,905 1,603,132 0 1,892,340 2,990,895 Total . . . . . . . . $266,346,941 Percent of Total Amount 1.3% $ 12,967,520 0.3 0 3,255,512 0.6 2,481,462 0.0 0 0.3 0.3 0 14,390,247 9.4 168,828,643 82.6 4,447,653 1.6 2,186,326 0.8 947,905 0.4 8,499,929 0.6 3,459,878 0.0 1,848,385 0.7 3,238,149 1.1 100.0% $226,551,609 Percent of Total 5.7% 0.0 1.4 1.1 0.0 0.0 6.4 74.5 2.0 1.0 0.4 3.8 1.5 0.8 1.4 100.0% NOTE 5 Allowance for Loan Losses The allowance for loan losses is summarized as follows: Balance, December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . .$3,783,112 Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,376,000 Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,369,241) 34,346 Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . 4,824,217 Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,610,000 (550,580) Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,965 Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . 6,939,602 Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,755,000 (737,917) Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,207 Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . .$8,995,892 NOTE 6 Accrued Interest Receivable Accrued interest receivable at December 31 is summarized as follows: Securities available for sale . . . . . . . . . . . . . .$ 626,367 Loans receivable . . . . . . . . . . . . . . . . . . . . . . 3,067,766 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$3,694,133 2004 2003 609,913 2,852,308 3,462,221 NOTE 7 Investment in Mortgage Servicing Rights A summary of mortgage servicing activity is as follows: 2004 2003 Mortgage servicing rights Balance, beginning of year . . . . . . . . . . . .$3,447,843 Originations . . . . . . . . . . . . . . . . . . . . . . . 844,806 Amortization . . . . . . . . . . . . . . . . . . . . . . (1,061,407) Balance, end of year . . . . . . . . . . . . . . . . . 3,231,242 2,701,031 2,522,231 (1,775,419) 3,447,843 Valuation reserve Balance, beginning of year . . . . . . . . . . . . 0 Additions . . . . . . . . . . . . . . . . . . . . . . . . . 0 Reductions . . . . . . . . . . . . . . . . . . . . . . . . 0 Balance, end of year . . . . . . . . . . . . . . . . . 0 Mortgage servicing rights, net . . . . . . . . .$3,231,242 (10,000) (800,000) 810,000 0 3,447,843 Mortgage servicing costs, which include guarantee fees on securitized mortgage loans, were $0 and $216,918, respectively, in 2004 and 2003. 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, 2004: Loan Principal Balance Weighted Weighted Average Average Remaining Interest Term Rate Number of Loans Original term 30 year fixed rate . . . . . . . . . . . .$213,054,886 5.92% Original term 15 year fixed rate . . . . . . . . . . . . 235,580,973 8,748,528 Adjustable rate . . . . . . . . . . 5.29 4.97 341 160 337 1,876 2,859 77 31 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S NOTE 8 Real Estate A summary of real estate at December 31 is as follows: 2004 In-substance foreclosures . . . . . . . . . . . . . . . . $ 0 Real estate in judgment subject to redemption . . . . . . . . . . . . . . . . 116,000 Real estate acquired through foreclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for losses . . . . . . . . . . . . . . . . . . . 24,608 140,608 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,608 2003 73,271 0 0 73,271 0 73,271 NOTE 9 Investment in Limited Partnerships Investments in limited partnerships at December 31 were as follows: Primary partnership activity Common stock of 2004 2003 financial institutions . . . . . . . . . . . . . . . $ 0 421,671 Low to moderate income housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,258 $168,258 195,371 617,042 During 2004 the Company’s proportionate share of gains from the common stock investments in financial institutions was $803 and its proportionate loss on low income housing was $26,920. During 2004 the Company received low income housing credits totaling $84,000 which were credited to current income tax benefits. During 2003 the Company’s proportionate loss from the mortgage servicing partnership was $349,577, its proportionate share of gains from the common stock investments in financial institutions was $132,273 and its proportionate loss on low income housing was $26,000. During 2003 the Company received low income housing credits totaling $84,000 which were credited to current income tax benefits. During 2003 the limited partnership that invested in mortgage servicing rights was dissolved and in 2004 the limited partnership that invested in the common stock of financial institutions was liquidated. NOTE 10 Intangible Assets The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2004 and 2003 are presented in the following table. Amortization expense for intangible assets was $1,175,264 and $1,889,276 for the years ended December 31, 2004 and 2003, respectively. December 31, 2004 December 31, 2004 Amortized intangible assets: Gross Carrying Accumulated Amount Amortization Unamortized Intangible Assets Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Core deposit intangible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,555,552 1,567,000 $6,122,552 (1,324,311) (1,233,383) (2,557,694) 3,231,242 333,617 3,564,859 December 31, 2003 Amortized intangible assets: Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Core deposit intangible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,308,468 1,567,000 $5,875,468 (860,625) (1,119,526) (1,980,151) 3,447,843 447,474 3,895,317 The following table indicates the estimated future amortization expense for amortized intangible assets: Mortgage Servicing Rights Year ended December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $421,474 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353,091 305,119 260,401 242,354 Core Deposit Intangible 113,857 113,857 105,903 0 0 Total 535,331 466,948 411,022 260,401 242,354 Projections of amortization are based on existing asset balances and the existing interest rate environment as of December 31, 2004. The Company’s actual experiences may be significantly different depending upon changes in mortgage interest rates and other market conditions. 32 NOTE 11 Premises and Equipment A summary of premises and equipment at December 31 is as follows: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office buildings and improvements . . . . . . . . . Furniture and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 1,309,519 9,309,207 9,904,474 20,523,200 8,058,935 $12,464,265 2003 1,338,943 9,376,782 9,875,743 20,591,468 8,481,317 12,110,151 NOTE 12 Deposits Deposits and their weighted average interest rates at December 31 are summarized as follows: Noninterest checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates: 1-1.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-2.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-3.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-4.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-5.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-6.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-7.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted average rate 2004 Amount 0.00% $ 42,776,699 95,294,144 1.01 47,415,778 0.19 129,098,425 1.72 314,585,046 63,716,056 160,829,030 108,937,895 49,449,374 1,266,218 4,818 113,748 384,317,139 $698,902,185 2.86 2.01 Percent of total 6.1% 13.6 6.8 18.5 45.0 9.1 23.0 15.6 7.1 0.2 0.0 0.0 55.0 100.0% Weighted average rate 2003 Amount 0.00% $ 37,629,054 61,270,853 0.39 35,882,917 0.20 91,314,858 1.23 226,097,682 57,153,099 103,449,915 71,691,188 76,315,958 16,621,295 246,042 112,816 325,590,313 $551,687,995 3.11 2.09 Percent of total 6.8% 11.1 6.5 16.6 41.0 10.4 18.8 13.0 13.8 3.0 0.0 0.0 59.0 100.0% At December 31, 2004 and 2003, the Company had $207,354,351 and $117,733,801, respectively, of deposit accounts with balances at $100,000 or more. At December 31, 2004 and 2003, the Company had $128,722,313 and $66,003,390 of certificate accounts, respectively, that were acquired through a broker. Certificates had the following maturities at December 31: Remaining term to maturity 1-6 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-12 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over 36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 Amount (in thousands) $110,550 87,099 150,222 36,446 $384,317 Weighted average rate 2.54% 2.60 3.10 3.51 2.86 Amount (in thousands) $ 97,354 69,890 112,265 46,081 $325,590 Weighted average rate 2.81% 2.73 3.19 3.61 3.11 At December 31, 2004 mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $51,156,000 were pledged as collateral for certain deposits and $4,260,000 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: NOW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 702,102 77,293 645,153 10,973,957 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,398,505 2003 211,736 90,421 437,645 9,534,386 10,274,188 2002 181,073 241,397 589,406 9,937,926 10,949,802 33 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S NOTE 13 Federal Home Loan Bank Advances Fixed rate Federal Home Loan Bank advances consisted of the following at December 31, 2004 and 2003: 2004 2003 Year of Maturity 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000,000 40,000,000 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000,000 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000,000 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,900,000 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000,000 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,900,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Lines of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $170,900,000 Amount Rate 2.69% 2.91 3.83 6.48 4.81 4.75 4.20 4.20 Amount $ 33,000,000 10,000,000 40,000,000 20,000,000 10,000,000 10,900,000 80,000,000 203,900,000 0 $203,900,000 Rate 5.01% 2.69 2.91 3.83 6.48 4.81 4.75 4.33 4.33 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. As of December 31, 2004, the Company had advances from the FHLB with the following call features: At December 31, 2004 the advances from the FHLB were collateralized by the Bank’s FHLB stock and mortgage loans with unamortized principal balances of $208,195,000. The Bank has the ability to draw additional borrowings of $33,035,000 based upon the mortgage loans that are currently pledged subject to a requirement to purchase FHLB stock. Year of Maturity 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Callable Quarterly in Year 2005 $ 10,000,000 10,000,000 10,900,000 80,000,000 $110,900,000 NOTE 14 Other Borrowed Money The Company had a $2,500,000 revolving line of credit established with a bank that was not drawn at December 31, 2004 or 2003. The line of credit expires on November 29, 2005. NOTE 15 Income Taxes Income tax expense (benefit) for the years ended December 31 is as follows: Current: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,688,700 State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435,600 5,124,300 Total current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (683,200) State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (54,000) Total deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (737,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,387,100 4,080,500 498,200 4,578,700 (506,200) (34,700) (540,900) 4,037,800 2,223,300 34,600 2,257,900 1,400 (160,100) (158,700) 2,099,200 2004 2003 2002 34 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: Federal expected income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,651,300 Items affecting federal income tax: Dividend received deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non deductible portion of minority interest loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State income taxes, net of federal income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reduction of tax rate due to employee stock ownership plan dividends . . . . . . . . . . . . . . Low income housing credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax exempt interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,200) 0 247,900 (170,200) (84,000) (340,300) 98,600 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,387,100 2004 2003 4,297,600 (26,100) 0 249,700 (160,500) (84,000) (284,600) 45,700 4,037,800 2002 2,455,700 (145,200) 72,800 21,700 (149,100) (84,000) (107,000) 34,300 2,099,200 The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31: 2004 2003 Deferred tax assets: Allowances for loan and real estate losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Discounts on assets and liabilities acquired from Marshalltown Financial Corporation . . . . . . . . . . . . . . . . . . . Deferred compensation and pension costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impairment losses on securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unrealized loss on market value adjustments to securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . Total gross deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities: Premium on assets acquired from Marshalltown Financial Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred loan fees and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment basis difference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Originated mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total gross deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax assets (liabilities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,144,400 200 162,400 188,400 329,600 3,825,000 0 3,825,000 117,000 452,600 1,078,100 1,161,100 3,500 2,812,300 $1,012,700 2,453,000 400 181,500 0 27,800 2,662,700 0 2,662,700 158,100 458,600 852,800 1,218,700 800 2,689,000 (26,300) Retained earnings at December 31, 2004 included approximately $8,800,000 for which no provision for income taxes was made. This amount represents allocations of income to bad 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. The Company has, in its judgement, made reasonable assumptions relating to the realization of deferred tax assets. Based upon these assumptions, the Company has determined that no valuation allowance is required with respect to the deferred tax assets. 35 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S NOTE 16 Employee Benefits Prior to 2002, all eligible full-time employees of the Bank were included in a noncontributory retirement plan sponsored by the Financial Institutions Retirement Fund (FIRF). Effective September 1, 2002 the Bank froze the accrual of benefits for existing participants and no new enrollments are permitted into the plan. The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank’s employees is not available at December 31, 2004 because such information is not accumulated for each participating institution. As of June 30, 2004, the FIRF valuation report reflected that the Bank was obligated to make a contribution for the plan year ending June 30, 2004 totaling $83,355. The contribution was $36,014 in 2003 and $20,575 in 2002. The Company has a qualified, tax-exempt savings plan with a deferred feature qualifying under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). All employees who have attained 18 years of age are eligible to participate in the Plan. Participants are permitted to make contributions to the 401(k) Plan equal to the lesser of 50% of the participant’s annual salary or the maximum allowed by law, which was $13,000 for 2004. The Company matches 25% of each participant’s contributions up to a maximum of 8% of the participant’s annual salary. Employee contributions above 8% are not matched by the Company. Participant contributions and earnings are fully and immediately vested. The Company’s contributions made prior to January 1, 2002 are vested on a five year cliff basis and contributions made after December 31, 2001 are vested on a three year cliff basis. The Company’s matching contributions to the 401(k) plan are expensed when made and they totaled $118,665, $113,843, and $76,005 in 2004, 2003 and 2002, respectively. The Company has adopted an Employee Stock Ownership Plan (the ESOP) that meets 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 is empowered to borrow in order to finance purchases of the common stock of HMN. The ESOP borrowed $6,085,770 from the Company to purchase 912,866 shares of common stock in the initial public offering of HMN. As a result of a merger with Marshalltown Financial Corporation (MFC), 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%. The Company has committed to make quarterly contributions to the ESOP necessary to repay the loan including interest. The Company contributed $526,552 in 2004 and $525,224 for both of the years 2003 and 2002. As the debt is repaid, ESOP shares that were pledged as collateral for the debt are committed to be released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. The Company 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, the Company 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 $670,112, $472,108 and $418,700 respectively, for 2004, 2003 and 2002. 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: Shares allocated to participants beginning of the year . . . . . . . . Shares allocated to participants . . . Shares purchased with dividends from allocated shares . . . . . . . . Shares distributed to participants . Shares allocated to participants 2004 2003 2002 275,588 24,380 245,031 24,317 233,697 24,317 7,368 (36,452) 10,638 (4,398) 8,485 (21,468) end of year . . . . . . . . . . . . . . . . 270,884 275,588 245,031 Unreleased shares beginning of the year . . . . . . . . . . . . . . . . Shares released during year . . . . . . Unreleased shares end of year . . . . . . Total ESOP shares end of year . . . . Fair value of unreleased 596,113 (24,380) 571,733 842,617 620,430 (24,317) 596,113 871,701 644,747 (24,317) 620,430 865,461 shares at December 31 . . . . . . .$18,861,472 14,479,585 10,435,633 In June 1995, the Company adopted the 1995 Stock Option and Incentive Plan (1995 Plan). In April of 2002, options for 15,000 shares were granted to a director at an exercise price of $16.25. All options issued under this plan vest over a five year period and expire 10 years from the grant date. The 1995 Plan terminates on April 25, 2005, and no more options may be granted from the plan after that date. Outstanding options granted prior to the termination date may be exercised for ten years after their date of grant. In March 2001, the Company adopted the HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan). The purpose of the 2001 Plan is to promote the interests of the Company and its stockholders by providing key personnel with an opportunity to acquire a proprietary interest in the Company and reward them for achieving a high level of corporate performance and thereby develop a stronger incentive to put forth maximum effort for the success and growth of the Company. The total number of shares of HMN common stock available for distribution under the 2001 Plan in either restricted stock or stock options was 400,000 subject to adjustment for future stock splits, stock dividends and similar changes to the capitalization of the Company. In April 2002, the Company awarded 212,410 options at $16.13 per share which vest beginning in April of 2008 through April of 2012. In February of 2004, options for 5,000 shares of common stock were granted to an officer at an exercise price of $27.64. These options vest beginning in February of 2005 through February of 2008. In March of 2004, options for 20,000 shares of common stock were issued to certain officers at an exercise price of $27.66. These options vest beginning in March of 2005 through March of 2007. In July of 2004 options for 15,000 shares of common stock were issued to a director at an exercise price of $26.98. These options vest beginning in July of 2005 through July of 2009. 36 The Company 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 plans. 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 the Company’s stock-based plan been determined in accordance with the fair value method recommended by SFAS No. 123, the Company’s net income and earnings per share would have been adjusted to the pro forma amounts indicated below: Net income: 2004 2003 2002 As reported . . . . . . . . . . . Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects . . . Pro forma . . . . . . . . . . . . . $9,289,797 37,822 $9,251,975 8,605,247 5,265,656 44,935 8,560,312 42,960 5,222,696 Earnings per common share: As reported: Basic . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . $ Pro forma: Basic . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . 2.40 2.31 2.39 2.30 2.26 2.16 2.25 2.15 1.40 1.32 1.39 1.31 The preceding 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 is estimated on the date of the grant using the Option Designer Model. The model incorporated the following assumptions for each year of grant: Risk-free interest rate . . . . . . . . Expected life . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . Expected dividends . . . . . . . . . 2004 4.13% 9 years 10.63% 3.9% 2002 5.20% 9 years 13.00% 4.5% The fair value of the options granted under the 1995 Plan were $1.85 for 2002. The fair value of options granted under the 2001 Plan were $2.62, $2.10, $2.10, and $1.43 for July 2004, March 2004, February 2004, and 2002, respectively. A summary of activities under both plans for the past three years are as follows: 1995 Stock Option and Incentive Plan December 31, 2001 . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . Granted April 23, 2002 . . . . . December 31, 2002 . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . December 31, 2003 . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . December 31, 2004 . . . . . . . . . 2001 Omnibus Stock Plan December 31, 2001 . . . . . . . . . Granted April 16, 2002 . . . . . December 31, 2002 . . . . . . . . . Forfeited . . . . . . . . . . . . . . . . . December 31, 2003 . . . . . . . . . Granted February 13, 2004 . . . Granted March 3, 2004 . . . . . . Granted July 27, 2004 . . . . . . Forfeited . . . . . . . . . . . . . . . . . December 31, 2004 . . . . . . . . . Total both plans . . . . . . . . . . . . . . Options available for grant Options outstanding Weighted average exercise price 24,397 (15,000) 9,397 9,397 9,397 502,119 (109,871) 15,000 407,248 (228,493) 178,755 (43,814) 134,941 400,000 (212,410) 187,590 16,447 204,037 (5,000) (20,000) (15,000) 17,618 181,655 191,052 212,410 212,410 (16,447) 195,963 5,000 20,000 15,000 (17,618) 218,345 353,286 9.765 9.211 16.250 10.154 9.211 11.358 9.471 11.971 16.130 16.130 16.130 16.130 27.640 27.660 26.980 19.049 17.960 15.672 The following table summarizes information about stock options outstanding at December 31, 2004: Exercise price $ 9.211 13.007 11.500 11.250 16.250 16.130 27.640 27.660 26.980 Options Outstanding Options Exercisable Number outstanding Weighted average remaining contractual life in years Number Price 9,941 15,000 65,000 30,000 15,000 182,805 5,000 15,540 15,000 353,286 0.4 2.3 4.3 5.4 7.4 7.3 9.2 9.2 9.6 9,941 15,000 65,000 24,000 6,000 0 0 0 0 119,941 $ 9.211 13.007 11.500 11.250 16.250 16.130 27.640 27.660 26.980 37 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S 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: Year Ended December 31, 2003 2002 2004 Weighted average number of common shares outstanding used in basic earnings per common share calculation . . . . 3,868,223 Net dilutive effect of: 3,812,213 3,767,216 Options . . . . . . . . . . . . . . . . . Restricted stock awards . . . . . 159,442 0 169,171 0 217,576 36 Weighted average number of shares outstanding adjusted for effect of dilutive securities . . . 4,027,665 Income available to common 3,981,384 3,984,828 shareholders . . . . . . . . . . . . . . $9,289,797 8,605,247 5,265,656 Basic earnings per common share . . . . . . . . . . . . . $ 2.40 Diluted earnings per common share . . . . . . . . . . . . . $ 2.31 2.26 2.16 1.40 1.32 NOTE 18 Stockholders’ Equity The Company repurchased 123,000 shares of its common stock in the open market during 2004, 86,600 during 2003, and 92,300 shares during 2002 for $3,316,550, $1,384,560 and $1,496,111, respectively. The shares were placed in treasury stock. HMN declared and paid dividends as follows: Record date Payable date February 21, 2002 March 7, 2002 May 23, 2002 June 10, 2002 August 27, 2002 September 10, 2002 November 22, 2002 December 11, 2002 February 21, 2003 March 7, 2003 May 22, 2003 June 9, 2003 August 28, 2003 September 11, 2003 November 28, 2003 December 17, 2003 February 20, 2004 March 8, 2004 May 21, 2004 June 8, 2004 August 27, 2004 September 10, 2004 November 26, 2004 December 15, 2004 Dividend per share $0.14 $0.18 $0.18 $0.18 $0.18 $0.18 $0.20 $0.20 $0.20 $0.20 $0.22 $0.22 Dividend Payout Ratio 100.00% 36.00% 56.25% 81.82% 64.29% 50.00% 38.46% 26.32% 37.74% 38.46% 35.48% 34.38% On January 25, 2005 the Company declared a cash dividend of $0.22 per share payable on March 7, 2005, to stockholders of record on February 18, 2005. The annualized dividend payout ratios for 2004, 2003, and 2002 were 36.36%, 39.58%, and 57.63%, respectively. The Company’s certificate of incorporation authorizes 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 Bank may not declare or pay a cash dividend to the Company without filing a capital distribution application with the OTS if the total amount of the dividends for the year exceeds the Bank’s net income for the year plus the Bank’s retained net income for the preceding two years. 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 19 Federal Home Loan Bank Investment 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. The Bank has met the requirements as of December 31, 2004. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Tier I or Core capital, and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of December 31, 2004 and 2003, 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, 2004 and 2003 and other conditions consistent with the Prompt Corrective Actions Provisions of the OTS regulations, the Bank would be categorized as well capitalized. 38 At December 31, 2004 and 2003 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: Actual Required to be Adequately Capitalized Excess Capital To Be Well Capitalized Under Prompt Corrective Actions Provisions (in thousands) December 31, 2004 Amount Percent of Assets (1) Amount Percent of Assets (1) Amount Percent of Assets (1) Amount Tier I or core capital . . . . . . . . . . . $74,131 Tier I risk based capital . . . . . . . . $74,131 Risk-based capital to 7.77% 9.45% $38,150 $31,373 4.00% 4.00% $35,981 $42,758 3.77% 5.45% $47,687 $47,059 Percent of Assets (1) 5.00% 6.00% risk-weighted assets . . . . . . . . . $82,274 10.49% $62,746 8.00% $19,528 2.49% $78,432 10.00% December 31, 2003 Tier I or core capital . . . . . . . . . . . $69,030 Tier I risk based capital . . . . . . . . $69,030 Risk-based capital to 8.03% 10.19% $34,366 $27,088 4.00% 4.00% $34,664 $41,942 4.03% 6.19% $42,957 $40,633 5.00% 6.00% risk-weighted assets . . . . . . . . . $74,931 11.06% $54,177 8.00% $20,754 3.06% $67,721 10.00% (1) Based upon the Bank’s adjusted total assets for the purpose of the Tier I or core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratio. NOTE 20 Financial Instruments with Off-Balance Sheet Risk The Company 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 Company. The Company’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 Company uses the same credit policies in making commitments as it does for on-balance sheet instruments. (in thousands) Financial instruments whose contract amount represents credit risk: December 31, Contract amount 2004 2003 Commitments to originate, fund or purchase loans: $ 1-4 family mortgages . . . . . . . . . . . . . . . . Multi-family mortgages . . . . . . . . . . . . . . Commercial real estate mortgages . . . . . . Non-mortgage loans . . . . . . . . . . . . . . . . Undisbursed balance of loans closed . . . . . Unused lines of credit . . . . . . . . . . . . . . . Letters of credit . . . . . . . . . . . . . . . . . . . . Total commitments to extend credit . . . . Commitment of counter party to purchase loans . . . . . . . . . . . . . . . . . . . . . $ 3,723 12,000 26,593 26,435 100,772 78,930 7,025 $255,478 3,753 3,225 6,220 56,350 99,108 69,635 2,027 240,318 6,433 7,078 39 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 and commercial real estate and personal property. Commitments of a 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. The Bank entered into two guaranty agreements with third parties in order for Home Federal Mortgage Services, LLC (HFMS) to secure loan purchase agreements. Under the agreements, the Bank guaranteed to satisfy and discharge all obligations of HFMS arising from transactions entered into between HFMS and the third parties if HFMS failed to fulfill its obligations. The agreements are in effect until the obligations of HFMS are fully satisfied and the Bank’s guaranty is limited to a combined maximum of $3 million. No liability has been recorded in the consolidated financial statements of the Company for these guarantees and the Company is not aware of any outstanding obligations of HFMS to either of the third parties with whom a guarantee exists. HFMS ceased doing business with both third parties in 2002. There is the possibility that the Bank would be required to purchase loans that were previously sold to the third parties by HFMS prior to 2002 if the loans did not meet the requirements in the loan purchase N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S agreements. If this were to occur, the proceeds from the subsequent sale of these loans would enable the Bank to recover a portion of the amounts paid under the guaranty. The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding at December 31, 2004 expire over the next 30 months and totaled $1.6 million at December 31, 2004 and $2.5 million at December 31, 2003. The letters of credit were collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments. NOTE 21 Derivative Instruments and Hedging Activities The Company originates and purchases single family residential loans for sale into the secondary market and enters into commitments to sell or securitize those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. The Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in the first quarter of 2001. At the beginning of the second quarter of 2001, certain commitments to sell loans held for sale were designated as a cash flow hedge of a forecasted transaction and were accounted for in accordance with SFAS No. 133 with no ineffectiveness recognized in the income statement. In the second quarter of 2002 cash flow hedge accounting was discontinued because the Company ceased delivering loans under a mortgage backed security program. The mortgage banking operations in the Brooklyn Park location were eliminated in 2002 and some of the activity was moved to other branches within the Company. The Company has commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter, which is referred to as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, the Company generally enters into commitments to sell the loans into the secondary market. The commitments to originate and sell loans are derivatives that are recorded at market value. As a result of marking these derivatives to market for the period ended December 31, 2004 the Company recorded a decrease in other assets of $13,435, a decrease in other liabilities of $12,244, and a net gain on the sale of loans of $1,191. As of December 31, 2004 the commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market. The loans held for sale that are not hedged are recorded at the lower of cost or market. As a result of marking these loans, the Company recorded a decrease in loans held for sale of $8,582, an increase in other assets of $9,882, and a net increase in other liabilities of $1,300 NOTE 22 Fair Value of Financial Instruments SFAS No. 107, Disclosures about Fair Values of Financial Instruments, requires disclosure of estimated fair values of the Company’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, 2004 and 2003 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 the Company’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. The estimated fair value of the Company’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. 40 (in thousands) Financial assets: Carrying amount Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . $ 34,298 103,672 Securities available for sale . . . . . . . . . . . . . . . . . . . . 2,712 Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . 783,213 Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . 9,293 Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . 3,694 Accrued interest receivable . . . . . . . . . . . . . . . . . . . . Financial liabilities: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . 698,902 170,900 1,314 Off-balance sheet financial instruments: Contract amount 2004 Estimated fair value 34,298 103,672 2,712 785,533 9,293 3,694 672,757 175,973 1,314 December 31, Contract amount Carrying amount 30,497 104,664 6,543 688,951 10,004 3,462 551,688 203,900 767 2003 Estimated fair value 30,497 104,664 6,560 695,454 10,004 3,462 554,936 213,256 767 Commitments to extend credit . . . . . . . . . . . . . . . . . Commitments to sell loans . . . . . . . . . . . . . . . . . . . . 13 (3) 13 (3) 213,846 6,433 16 (14) 16 (14) 238,291 7,078 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 were based upon quoted market prices. Loans Held for Sale The fair values 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 the Company as of December 31, 2004 and 2003 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 the Company’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. Federal Home Loan Bank Advances The fair values of advances with fixed maturities are estimated based on discounted cash flow analysis using as discount rates the interest rates charged by the FHLB at December 31, 2004 and 2003 for borrowings of similar remaining maturities. Accrued Interest Payable The carrying amount of accrued interest payable approximates its fair value since it is short-term in nature. Commitments to Extend Credit The fair values of commitments to extend credit for 2004 and 2003 are estimated using the fees normally charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties. Commitments to Sell Loans The fair values of commitments to sell loans for 2004 and 2003 are estimated using the quoted market prices for loans with similar interest rates and terms to maturity. 41 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S NOTE 23 HMN Financial, Inc. Financial Information (Parent Company Only) The following are the condensed financial statements for the parent company only as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002. 2004 2003 2002 Condensed Balance Sheets Assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Stockholders’ Equity Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Serial preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unrealized loss on securities available for sale . . . . . . . . . . . . . . . . . . . . Unearned employee stock option plan shares . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost, 4,708,798 and 4,616,010 shares . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . Condensed Statements of Income Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity earnings of limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,608,727 0 78,236,806 0 8,462 320,787 162,000 $ 84,336,782 $ 565,946 565,946 0 91,287 57,875,595 91,408,028 (604,446) (4,544,300) (60,455,328) 83,770,836 $ 84,336,782 $ 69,936 0 9,453,280 803 0 (207,300) (14,400) 0 (2,600) (145) (409,377) 8,890,197 (399,600) $ 9,289,797 5,929,858 110,000 73,337,245 421,671 5,620 1,318,313 33,600 81,156,307 225,250 225,250 0 91,287 57,863,726 85,364,657 (50,725) (4,738,084) (57,599,804) 80,931,057 81,156,307 193,334 301,006 8,361,418 132,273 0 (42,100) (6,005) (2,500) (1,200) (8,009) (481,770) 8,446,447 (158,800) 8,605,247 365,202 118,238 5,095,784 23,441 15,514 (44,250) (6,000) 0 (1,200) (1,459) (523,314) 5,041,956 (223,700) 5,265,656 42 Condensed Statements of Cash Flows Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to cash provided by operating activities: Equity earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity earnings in limited partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of premiums, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earned employee stock ownership shares priced above original cost . . . . . Decrease in restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Increase) decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . Increase in accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Proceeds from sales of securities available for sale . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . Redemption of investment in limited partnership . . . . . . . . . . . . . . . . . . . . Net decrease (increase) in loans receivable from subsidiaries . . . . . . . . . . . . . Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends to stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from dividends on Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 2002 $ 9,289,797 8,605,247 5,265,656 (9,453,280) (803) 0 0 (128,400) 308,165 0 193,784 (2,842) 340,696 1,095,622 (2) 1,642,737 0 110,000 422,474 0 532,474 (3,316,550) 66,634 (3,246,426) 4,000,000 (2,496,342) (321,131) 5,929,858 $ 5,608,727 (8,361,418) (132,273) 0 (301,006) (3,200) 180,457 0 193,301 15,548 26,526 330,037 0 553,219 1,601,007 1,491,383 0 4,700,000 7,792,390 (1,384,560) 1,422,460 (2,901,071) 0 (2,863,171) 5,482,438 447,420 5,929,858 (5,095,784) (23,441) 31,028 (118,238) 257,600 143,604 7,350 193,361 98,659 199,219 (944,817) 1 14,198 6,296,788 (1,601,383) 0 (3,985,118) 710,287 (1,496,111) 871,131 (2,562,153) 0 (3,187,133) (2,462,648) 2,910,068 447,420 43 N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S NOTE 24 Business Segments The Bank has been identified as a reportable operating segment in accordance with the provisions of SFAS No. 131. SFC and HMN, the holding company, did not meet the quantitative thresholds for a reportable segment and therefore are included in the “Other” category. Prior to 2003, Home Federal Mortgage Services, (HFMS) was reported as a separate business segment. HFMS discontinued operations in 2002 and has been dissolved. Its segmented information has been included in the “Home Federal Savings Bank” category to conform with the current year presentation. The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets and return on average equity. Each corporation is managed separately with its own officers and board of directors. The following table sets forth certain information about the reconciliations of reported net income and assets for each of the Company’s reportable segments. (Dollars in thousands) At or for the year ended December 31, 2004: Home Federal Savings Bank Interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,568 5,993 Non-interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . (27) Earnings (losses) on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . 0 Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 Intersegment non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,014 Amortization of mortgage servicing rights and net valuation adjustments and servicing costs . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average realized common equity . . . . . . . . . . . . . . . . . . . . . . 1,061 18,633 4,790 (3) 9,458 3,801 954,779 3.51% 1.04 12.49 At or for the year ended December 31, 2003: Interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,775 10,198 Non-interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . (376) Earnings (losses) on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . 28 Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 868 Intersegment non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,348 Amortization of mortgage servicing rights and net valuation adjustments and servicing costs . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average realized common equity . . . . . . . . . . . . . . . . . . . . . . 2,298 17,456 4,200 (3) 8,584 3,801 860,510 3.30% 1.08 11.88 At or for the year ended December 31, 2002: Interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,550 6,401 Non-interest income – external customers . . . . . . . . . . . . . . . . . . . . . . . (683) Earnings (losses) on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . 517 Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305 Intersegment non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,859 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights and net valuation adjustments and servicing costs . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average realized common equity . . . . . . . . . . . . . . . . . . . . . . 1,364 16,643 2,368 (142) 4,728 3,801 732,769 3.13% 0.75 8.33 NM – Not meaningful 44 Other 49 0 1 21 9,453 0 0 642 (403) 0 9,285 0 84,391 NM NM NM 162 301 132 31 8,361 0 8 542 (162) 0 8,599 0 81,182 NM NM NM 318 134 23 47 5,168 0 1 583 (269) 0 5,269 0 76,436 NM NM NM Eliminations Consolidated Total 0 0 0 (21) (9,627) (21) 0 (174) 0 0 (9,453) 0 (78,497) NM NM NM 0 0 0 (59) (9,229) (59) (324) (327) 0 0 (8,578) 0 (74,966) NM NM NM 0 0 0 (564) (5,473) (564) (199) (543) 0 0 (4,731) 0 (71,682) NM NM NM 51,617 5,993 (26) 0 0 20,993 1,061 19,101 4,387 (3) 9,290 3,801 960,673 3.50% 1.01 11.03 44,937 10,499 (244) 0 0 20,289 1,982 17,671 4,038 (3) 8,605 3,801 866,726 3.31% 1.10 10.85 42,868 6,535 (660) 0 0 21,295 1,166 16,683 2,099 (142) 5,266 3,801 737,523 3.19% 0.74 6.94 R E P O R T O F I N D E P E N D E N T R E G I S T E R E D P U B L I C A C C O U N T I N G F I R M The Board of Directors HMN Financial, Inc.: We have audited the accompanying consolidated balance sheets of HMN Financial, Inc. and subsidiaries as of December 31, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight Board (United States). 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 as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of HMN Financial Inc.’s internal control over financial reporting as of December 31, 2004, based on Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 8, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting. KPMG LLP Minneapolis, Minnesota March 8, 2005 45 0 June 30, 2004 12,427 5,060 7,367 447 6,920 705 291 1 507 (7) 183 1,680 2,582 871 28 88 228 302 898 4,997 3,603 1,106 2,497 0 2,497 0.65 0.62 1.12 12.06 9.34 38.46 3.45 13,156 5,387 7,769 775 6,994 742 292 3 349 (7) 210 1,589 2,430 914 24 116 233 240 923 4,880 3,703 1,153 2,550 0 2,550 0.66 0.64 1.09 12.02 9.23 35.48 3.47 S E L E C T E D Q U A R T E R L Y F I N A N C I A L D A T A (Dollars in thousands, except per share data) December 31, September 30, 2004 2004 Selected Operations Data (3 months ended): Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses . . . . . . . . . . . . . . . $13,678 5,428 8,250 714 7,536 762 299 (539) 435 (7) 212 1,162 2,646 960 25 139 278 266 1,045 5,359 3,339 1,218 2,121 (1) $ 2,122 0.55 $ 0.53 $ 0.88% 9.85 9.17 34.38 3.62 Noninterest income: Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains (losses), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings (losses) in limited partnerships. . . . . . . . . . . . . . . . . . . . . . . Other noninterest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense: Compensation and benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights and net valuation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Ratios: Return on average assets(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average equity(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average equity to average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend payout ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin(1)(2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Dollars in thousands) Selected Financial Condition Data: Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related securities . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) Annualized (2) Net interest income divided by average interest-earning assets. 46 $960,673 955,335 914,098 9,151 94,522 2,712 783,213 698,902 170,900 83,771 9,393 95,404 3,652 766,063 666,752 198,900 82,791 9,882 99,947 3,767 722,800 627,305 198,900 81,127 March 31, 2004 12,355 5,118 7,237 819 6,418 568 287 0 412 (6) 275 1,536 2,528 885 19 87 191 253 962 4,925 3,029 910 2,119 (2) 2,121 0.54 0.52 0.96 10.21 9.42 37.74 3.46 899,725 11,937 97,066 4,955 717,021 611,656 198,900 82,148 December 31, 2003 September 30, 2003 11,922 5,165 6,757 710 6,047 691 282 41 648 70 167 1,899 2,283 1,025 18 115 238 277 974 4,930 3,016 874 2,142 (3) 2,145 0.55 0.53 1.03 10.45 10.15 26.32 3.39 866,726 13,049 91,615 6,543 688,951 551,688 203,900 80,931 11,507 5,065 6,442 545 5,897 626 261 417 1,601 10 179 3,094 2,085 806 18 92 311 (193) 1,211 4,330 4,661 1,621 3,040 0 3,040 0.79 0.76 1.53 15.12 10.27 38.46 3.41 807,043 16,327 72,201 17,634 645,715 490,088 229,300 79,467 47 June 30, 2003 11,036 5,108 5,928 490 5,438 555 239 225 1,526 31 115 2,691 2,028 769 18 101 290 1,108 867 5,181 2,948 918 2,030 0 2,030 0.54 0.52 1.06 10.45 10.34 50.00 3.24 785,910 21,121 84,510 13,855 606,931 463,185 235,300 77,522 March 31, 2003 10,472 4,951 5,521 865 4,656 432 216 592 1,465 (354) 220 2,571 2,278 824 19 85 271 791 944 5,212 2,015 625 1,390 0 1,390 0.37 0.36 0.76 7.21 10.59 64.29 3.20 761,399 15,049 83,982 12,999 577,542 448,083 219,300 74,894 O T H E R F I N A N C I A L D A T A The following table sets forth the maximum month-end balance and average balance of FHLB advances. (Dollars in thousands) Maximum Balance: Year Ended December 31, 2003 2002 2004 Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $214,800 43,900 241,800 69,400 218,300 64,400 Average Balance: Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196,008 29,918 221,510 41,169 215,673 36,290 The following table sets forth certain information as to the Bank’s Federal Home Loan Bank (FHLB) advances. (Dollars in thousands) 2004 Amount FHLB short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 160,900 FHLB long-term advances . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $170,900 December 31, 2003 2002 Weighted Average Rate 2.69 4.29 4.20 Amount 33,000 170,900 203,900 Weighted Average Rate 5.01% 4.20 4.33 Amount 64,400 153,900 218,300 Weighted Average Rate 3.20% 5.17 4.59 Refer to Note 13 of the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances. C O M M O N S T O C K I N F O R M A T I O N 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 4,708,798 shares are in treasury stock at December 31, 2004. As of December 31, 2004 there were 704 stockholders of record and 1,087 estimated beneficial stockholders. The following table represents the stock price information for HMN Financial, Inc. as furnished by Nasdaq for each quarter starting in December 31, 2004 and regressing back to March 31, 1999. Dec. 31, 2004 $33.50 27.35 32.99 Dec. 31, 2002 $18.14 15.78 16.82 Dec. 29, 2000 $13.25 $12.31 $13.06 HIGH . . . . . LOW . . . . . CLOSE . . . . HIGH . . . . . LOW . . . . . CLOSE . . . . HIGH . . . . . LOW . . . . . CLOSE . . . . Sept. 30, 2004 27.99 25.10 27.75 Sept. 30, 2002 19.31 16.50 17.46 Sept. 29, 2000 13.88 10.88 12.44 June 30, March 31, 2004 27.65 24.51 27.09 2004 28.19 23.25 27.48 June 28, March 29, 2002 20.25 15.90 19.06 2002 16.17 15.24 16.05 June 30, March 31, 2000 11.75 10.13 11.00 2000 12.13 9.63 10.13 48 Dec. 31, 2003 24.70 20.00 24.29 Dec. 31, 2001 15.85 13.27 15.49 Dec. 31, 1999 12.75 10.88 11.25 Sept. 30, 2003 21.63 19.36 21.50 Sept. 28, 2001 17.10 14.35 15.10 Sept. 30, 1999 13.50 11.88 12.25 June 30, March 31, 2003 20.04 15.85 19.40 2003 16.82 15.55 16.05 June 29, March 30, 2001 17.15 13.50 17.10 2001 15.06 13.00 14.75 June 30, March 31, 1999 13.13 10.50 11.63 1999 13.50 11.38 11.38 C O R P O R A T E A N D S H A R E H O L D E R I N F O R M A T I O N HMN FINANCIAL, INC. 1016 Civic Center Drive NW Rochester, MN 55901 (507) 535-1200 ANNUAL MEETING The annual meeting of shareholders will be held on Tuesday, April 26, 2005 at 10:00 a.m. (Central Time) at the Rochester Golf and Country Club, 3100 W. Country Club Road, Rochester, Minnesota. LEGAL COUNSEL Faegre & Benson LLP 2200 Wells Fargo Center 90 South Seventh St. Minneapolis, MN 55402-3901 INDEPENDENT AUDITORS KPMG LLP 4200 Wells Fargo Center 90 South Seventh St. Minneapolis, MN 55402-3900 INVESTOR INFORMATION AND FORM 10-K Additional information and HMN’s Form 10-K, filed with the Securities and Exchange Commission is available without charge upon request from: HMN Financial, Inc. Attn: Investor Relations 1016 Civic Center Drive NW Rochester, MN 55901 or at www.hmnf.com TRANSFER AGENT & REGISTRAR Inquiries regarding change of address, transfer requirements, and lost certificates should be directed to the transfer agent. Wells Fargo Bank, N.A. Shareowner Services 161 North Concord Exchange South St. Paul, MN 55075 www.wellsfargo.com/ shareownerservices (800) 468-9716 DIRECTORS TIMOTHY R. GEISLER Chairman of the Board HMN and Home Federal Savings Bank Unit Manager Foundation Accounting Mayo Foundation MICHAEL MCNEIL President and CEO HMN and Home Federal Savings Bank DUANE D. BENSON Retired Executive Director Minnesota Business Partnership ALLAN R. DEBOER Retired Chief Executive Officer RCS of Rochester MAHLON C. SCHNEIDER Retired Senior Vice President External Affairs and General Counsel Hormel Foods Corporation SUSAN K. KOLLING Senior Vice President HMN and Home Federal Savings Bank MICHAEL J. FOGARTY Chairman C.O. Brown Agency, Inc. MALCOLM W. MCDONALD Retired Senior Vice President Space Center, Inc. EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS JON J. EBERLE Senior Vice President, Chief Financial Officer and Treasurer DWAIN C. JORGENSEN Senior Vice President BRADLEY C. KREHBIEL Executive Vice President BRANCH OFFICES OF BANK Albert Lea 143 West Clark St. Albert Lea, MN 56007 (507) 377-3330 Austin 201 Oakland Avenue West Austin, MN 55912 (507) 433-2355 LaCrescent 208 South Walnut LaCrescent, MN 55947 (507) 895-4090 Marshalltown 303 West Main Street Marshalltown, IA 50158 (515) 754-6000 Rochester 1201 South Broadway Rochester, MN 55901 (507) 289-4025 1016 Civic Center Dr. NW Rochester, MN 55901 (507) 285-1707 3900 55th St. NW Rochester, MN 55901 (507) 535-3460 7389 Airport View Drive S.W. Rochester, MN 55901 (507) 536-6200 Spring Valley 715 North Broadway Spring Valley, MN 55975 (507) 346-7345 Toledo 1301 S. County Road Toledo, IA 52342 (641) 484-5141 Winona 175 Center Street Winona, MN 55987 (507) 453-6460 EAGLE CREST CAPITAL BANK, A DIVISION OF HOME FEDERAL SAVINGS BANK 5201 Eden Ave., Ste 170 Edina, MN 55436 (952) 848-5360 1016 Civic Center Dr. N.W. Rochester, MN 55901 (507) 280-7200