HMN Financial, Inc. 2010 Annual Report 1 Financial Highlights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Letter to Shareholders and Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Five-year Consolidated Financial Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management’s Discussion and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . 56 Other Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Selected Quarterly Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Common Stock Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Inside Back Cover Corporate and Shareholder Information . . . . . . . . . . . . . . . . . . . . . Inside Back Cover Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal operates ten full-service banking facilities in Minnesota and two in Iowa. Home Federal Private Banking operates branches in Rochester and Edina, 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 (loss) after provision for loan losses . . . . . . . . . . . . Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . . . . . . . . . . . . . . . . . . . . Net loss available to common shareholders . . . . . . . . . . . . . . . . . . . . . Per Common Share Information: Loss 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: Loss on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on average common equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings. . . . . . . . . . . . . . . . . . . . . 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, 2010 $ 48,270 17,259 31,011 33,381 (2,370) 3,741 1,067 0 1,987 476 7,271 27,556 (22,655) 6,323 (28,978) (1,784) $(30,762) $ (8.17) (8.17) $ 6.78 2.47 2.81 10.51 26.74% (2.98)% (31.73) 3.36 2.84 9.40 7.90 9.59 71.98 2009 57,771 23,868 33,903 26,699 7,204 4,137 1,042 5 2,273 625 8,082 31,689 (16,403) (5,607) (10,796) (1,747) (12,543) (3.39) (3.39) 6.85 1.52 4.20 17.94 23.41% (1.00)% (10.33) 3.33 2.95 9.73 9.64 7.47 75.48 December 31, 2010 $880,618 151,564 2,728 664,241 683,230 122,500 69,547 2009 1,036,241 159,602 2,965 799,256 796,011 132,500 99,938 7.60% 9.72 10.97 8.64% 10.87 12.12 Percentage Change (16.4)% (27.7) (8.5) 25.0 (132.9) (9.6) 2.4 (100.0) (12.6) (23.8) (10.0) (13.0) (38.1) 212.8 (168.4) (2.1) (145.3) (198.0)% (207.2) 0.9 (3.7) (3.4) (18.0) 28.4 (4.6) Percentage Change (15.0)% (5.0) (8.0) (16.9) (14.2) (7.5) (30.4) (12.0)% (10.6) (9.5) L E T T E R T O S H A R E H O L D E R S A N D C U S T O M E R S Dear Shareholder: 2010 presented our institution with several challenges, and the uncertain economic environment continues into 2011. Yet Home Federal Savings Bank remains steadfast in its mission to provide our customers with a secure financial institution to support their banking needs. Celebrating more than 75 years of doing business, we have survived a number of difficult situations and have seen several economic cycles. I’m confident that Home Federal is taking the steps to rebuild and refocus after the most recent recession. We will also benefit from the new policies and procedures we adopted this year. We believe that these will even further strengthen our community bank and its operations. Before I recap these changes, I would like to outline the situation we faced in 2010 and how it impacted Home Federal. The weak demand for single-family homes, which began in 2008, became more pronounced in the second half of 2010, largely attributable to the expiration of the First-Time Home Buyer Tax Credit program. Concurrently, the inventory of homes for sale in our markets continued to grow, due, in part, to the high number of foreclosed properties from other financial institutions. Although Home Federal’s portfolio of foreclosed single-family homes remained relatively low, the continuing weakness in the real estate marketplace negatively impacted our commercial loan portfolio, which strongly ties our bank to real estate developers, home builders and other businesses dependent on the housing market. As a result, the value of the real estate that secures some commercial loans declined, and our loan loss provision and level of nonperforming assets increased. Recognizing the unpredictable market and the continuing downward trends of our housing related loans, we developed and implemented a strategic plan of action that included the hiring of a Chief Credit Officer, a new position, in the first quarter of 2010. Our new Chief Credit Officer now oversees all lending activities for the organization, and has made improvements to our commercial lending policies and procedures to better ensure that all new loan requests are carefully analyzed in order to reduce our credit risk exposure. Moreover, Home Federal’s Risk Asset Department, which we launched in 2009, is now also overseen by the Chief Credit Officer. This department is responsible for preparing remediation plans for all large classified assets in order to improve the ultimate collection of these loans. In 2010, it successfully rehabilitated, collected, or liquidated more than $39 million of these assets. We also implemented new internal loan review and risk rating procedures as an early-warning system to identify potential performance and documentation issues. These have allowed us to react to adverse conditions much earlier than in the past. We proactively and aggressively implemented these new changes, among others, to better identify credit risk in the commercial loan portfolio. While this increased our provision for loan losses in the short term, we believe that identifying potential problems early will be beneficial to Home Federal as we progress, reducing the risks of future losses on these credits over the long-term. During the year, we also reviewed our loan portfolio for concentrations and exposures to industries posing higher credit risks, and installed a plan to reduce future investments in these types of assets. The reduction in these assets played a major role in positioning Home Federal to reduce our reliance on wholesale funding sources. During the year, we reduced our use of brokered deposits by more than $100 million. While we focused on implementing these measures to improve the credit quality of our commercial loan portfolio, 2010 was also a year of progress on several other fronts for Home Federal. Our retail deposit staff, for example, remained committed to building our core customer base, and our retail account relationships continued to grow throughout the year. Our staff also accepted a challenge at the beginning of the year to increase customer enrollment in our e-statement program. This delivery method improves customer data security while at the same time reducing postage and paper costs. Our efforts in this area resulted in a 70 percent increase in customer e-statement enrollment, placing Home 2 Federal well ahead of national enrollment averages. We also successfully converted our retail customer debit card system, whereas our previous system required two separate vendors to support the markets we serve, the new system reduces this to one vendor which has made the system less cumbersome for our customers while lessening support costs. We also recognized that we needed to augment our single family mortgage loan origination procedures in order to remain competitive and compliant with the sweeping regulatory changes that took place in 2010. This was achieved by refining our procedures, and enabled our mortgage division to deliver strong results both in term of revenues and margins. Finally, in order to improve the results in the Investment Services area, we changed our broker dealer during the year. We joined forces with Minnesota based PrimeVest, a company that works exclusively with community banks. Their state-of-the-art system has improved access to account information for our customers and has had the added benefit of reducing our back office administrative costs. Looking forward into 2011, I believe we have positioned ourselves for a return to more favorable results, largely through efforts we have already adopted — assembling the appropriate, skillful personnel; adopting additional procedures and safeguards; and dedicating the resources necessary to move beyond the economic recession. Home Federal remains a safe place for our customers to keep their checking accounts and save for the future. With a Tier 1 capital ratio of 7.60 percent and a risk- based capital ratio of 10.97 percent, at December 31, 2010, we were considered well-capitalized by current regulatory standards. On a final note, I would like to thank our shareholders for their loyalty, our talented team for their dedication and our customers for their continued support. Together, I believe that our future is bright and Home Federal will be successful. Respectfully, Bradley Krehbiel President 3 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 (loss) after provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . Fees and service charges . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . Total non-interest income. . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . Income (loss) before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . Net income (loss) available to common shareholders . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings (loss) per common share. . . . . Diluted earnings (loss) per common share . . . Cash dividends per common share . . . . . . . . . Year Ended December 31, 2010 $ 48,270 17,259 31,011 33,381 (2,370) 3,741 1,067 0 1,987 476 7,271 27,556 (22,655) 6,323 (28,978) (1,784) $(30,762) (8.17) $ (8.17) 0.00 2009 57,771 23,868 33,903 26,699 7,204 4,137 1,042 5 2,273 625 8,082 31,689 (16,403) (5,607) (10,796) (1,747) (12,543) (3.39) (3.39) 0.00 2008 66,512 32,796 33,716 26,696 7,020 4,269 955 479 651 749 7,103 29,234 (15,111) (4,984) (10,127) (37) (10,164) (2.78) (2.78) 0.75 2007 77,523 38,823 38,700 3,898 34,802 3,139 1,054 0 1,514 1,205 6,912 23,140 18,574 7,300 11,274 0 11,274 3.02 2.89 1.00 2006 67,527 28,841 38,686 8,878 29,808 3,111 1,172 48 1,255 856 6,442 22,596 13,654 5,226 8,428 0 8,428 2.20 2.10 0.98 Selected Financial Condition Data: December 31, (Dollars in thousands, except per share data) 2010 2009 2008 2007 2006 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . Book value per common share . . . . . . . . . . . . . . . . . Number of full service offices . . . . . . . . . . . . . . . . . Number of loan origination offices . . . . . . . . . . . . . . Key Ratios(1) Stockholders’ equity to total assets at year end . . . . . Average stockholders’ equity to average assets . . . . . Return (loss) on stockholders’ equity $880,618 151,564 2,728 664,241 683,230 122,500 69,547 10.51 14 1 1,036,241 159,602 2,965 799,256 796,011 132,500 99,938 17.94 14 2 1,145,480 175,145 2,548 900,889 880,505 142,500 112,213 21.31 16 2 1,117,054 186,188 3,261 865,088 888,118 112,500 98,128 23.50 15 2 977,789 126,140 1,493 768,232 725,959 150,900 93,142 21.58 14 2 7.90% 9.40 9.64% 9.73 9.80% 8.58 8.78% 8.89 (ratio of net income (loss) to average equity) . . . . (31.73) (10.33) (10.61) 11.53 Return (loss) on assets (ratio of net income (loss) to average assets) . . . (2.98) (1.00) (0.91) 1.03 Dividend payout ratio (ratio of dividends paid to net income (loss)). . . NM NM NM 34.72 42.61 (1) Average balances were calculated based upon amortized cost without the market value impact of ASC 320. NM — Not meaningful 4 9.53% 9.70 8.85 0.86 M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S of the assets adequacy 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 within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intent,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and limited to those relating to the include, but are not adequacy and amount of available liquidity and capital resources to the Bank, the Company’s liquidity and capital requirements, changes in the size of the Bank’s loan the valuation allowance on the recovery of portfolio, deferred tax assets, the amount and mix of the Bank’s non-performing the and allowance therefor, future losses on non-performing assets, the amount of interest-earning assets, the amount and mix of brokered and other deposits (including the Company’s ability to renew brokered deposits), the availability of alternate funding sources, the payment of dividends, the future outlook for the Company, and the Company’s and the Bank’s compliance with regulatory standards generally (including the Bank’s status as “well-capitalized”), agreements, individual capital requirements or other supervisory directives or requirements to which the Company or the Bank are expressly subject, specifically. A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate securing loans to borrowers, including possible legislative and regulatory changes, changes regulatory in the degree and manner of supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss that are allowance and concentrations of satisfactory to the OTS in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OTS under the supervisory agreements or other directives; adverse economic, business and competitive developments shrinking interest margins; reduced collateral values; deposit outflows; reduced demand for services and loan products; in accounting policies and guidelines, or changes monetary and fiscal policies of the federal government supervisory such as financial credit and or other funding sources; or tax laws; international economic developments, changes in credit or other risks posed by the Company’s loan and investment portfolios; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; collateral advance rates and policies of the FHLB; costs associated with significant alternate uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filings on Form 10-K with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Overview 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, private banking and loan production offices in Minnesota and Iowa. The earnings of the Company are primarily dependent on the Bank’s net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits 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. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and mix of and interest-bearing liabilities, and the level of non-performing assets. The Company’s net income (loss) is also affected by the income, which consists generation of non-interest 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, deposit insurance, and amortization of mortgage servicing assets. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply interest-earning assets 5 M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S single credit, family and commercial of business properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. Beginning with the onset of the 2007 recession and the Company’s 2008 fiscal year, the Company’s commercial business and commercial real estate loan portfolios have required significant allowances and charge offs due primarily to decreases in the estimated value of the underlying collateral supporting the loans, as many of these loans were made to borrowers associated with the real estate industry. The decrease in the estimated collateral value is primarily the result of reduced demand for real estate, particularly as it relates to single-family and commercial land developments. More stringent lending standards implemented by the mortgage industry in for some recent years have made it more difficult borrowers with marginal a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments where the Company’s commercial loan portfolio has concentrations. Consequently, our level of non-performing assets and the related provision for loan losses increased significantly in the past several years, relative to periods before 2008. The increased levels of non-performing assets, related provisions loan losses, and write offs of or allowances against intangible assets, including goodwill, and deferred taxes arising from adverse results of operations, were the primary reasons for the net losses incurred by the Company in each of the years 2008 through 2010. to qualify for credit for During this time, the Company has taken a number of measures to address its elevated level of non-performing assets and net losses and to seek to assure adequate levels of liquidity and capital resources. In 2008, the Company through the obtained $26 million in additional capital sale of preferred stock to the United States Treasury, substantially all of which was contributed to the capital of the Bank, and began to reduce the asset size of the Bank, which has been reduced $273 million as of December 31, 2010 from its peak in 2008, in order to enhance its capital position and ratios. The reduction in assets was primarily in commercial a and was corresponding reduction in interest-bearing liabilities, principally by means of a $220 million reduction in brokered deposits over the same time. In 2009, a new Bank President was appointed and additional personnel were hired in the commercial loan area to work through the increased level of non-performing assets. In addition, the accompanied loans by Bank lowered its internal limit on the size of loan it would grant to an individual borrower in an effort to reduce risk associated with large concentrations of credit borrowing relationships. The Bank also began the process of segmenting its loan portfolio and reduced lending in certain industries and loan types in order to further limit credit concentrations. In the first quarter of 2010, an experienced Chief Credit Officer was hired into a newly created position. Since that time, a new loan credit approval process and additional policies and procedures have been implemented in order to improve the credit quality of commercial loans being added to the Bank’s portfolio and reduce loan concentrations and non- performing assets. A more stringent commercial loan risk rating system was also implemented which resulted in some commercial loans being moved into a higher risk rating classification. In addition, an analysis of the Bank’s commercial loan charge off history was completed which resulted in higher reserve percentages for some risk rating classifications. A more aggressive and ongoing review process of existing commercial loan files was also implemented. These reviews have focused on performing loans in certain industries and loan types that management determined to have the highest risk of loss to the Bank and, in some cases, resulted in corrective or preventative action loan loss reserves being being taken and additional been established. Additional allocated to establishing and maintaining remediation plans on all classified loans in order to improve the monitoring and ultimate collection of these loans. The remediation plans have focused on evaluating collateral levels and determining available cash flows as well as testing the validity of, and adherence to, established action plans. The Company also deferred the dividend payment on the outstanding preferred stock that was due on February 15, 2011 in order to preserve cash for potential future needs. resources have also implementing many of Despite these efforts, elevated levels of non- performing assets and related losses have persisted, the primarily as a result of enhanced policies and practices noted above and the relative weakness of the housing and commercial real estate markets that continues to cause reductions in the the collateral supporting some loans and values of adversely affecting the ability of some borrowers to comply with their loan payment requirements. Because of these issues, the Company and the Bank, effective February 22, 2011, each entered into a supervisory agreement (the “Company Supervisory Agreement” and the “Bank Supervisory Agreement”, respectively, and, collectively, the “Supervisory Agreements”) with the Office of Thrift Supervision (the “OTS”), their primary federal regulator. The Supervisory Agreements supersede 6 the memorandum of understanding between each of the Company and the Bank entered into with the OTS in December 2009. The Company Supervisory Agreement requires the Company to submit a capital plan for approval by the OTS, and without the prior consent of the OTS, prohibits the payment of dividends on the Company’s outstanding stock, restricts the incurrence of debt and limits certain employment and compensation actions involving directors and executive officers. The Bank Supervisory Agreement requires the Bank to submit a business plan for approval by the OTS, as well as plans and policies to address “problem assets,” loan modification policies, concentrations of credit and the documentation of the allowance for loan and lease losses. and actions The Bank Supervisory Agreement also places limitations on the Bank’s ability to increase its total assets during any quarter and to engage in certain employment involving compensation directors and executive officers without the consent of the OTS. For a complete description of the Supervisory Agreements, please see “Item 1 — Business — Regulation and Supervision — Supervisory Agreements” in our Annual Report on Form 10-K for the fiscal year ended the Bank has been December 31, 2010. In addition, informed by the OTS that intends to impose an individual minimum capital requirement (“IMCR”) for the Bank. An IMCR requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be “well-capitalized.” The Bank has not been informed by the OTS of the timing or capital levels that may be required. The proposed IMCR would not affect the Bank’s status as “well-capitalized” within the meaning of the applicable regulations of the OTS. it Critical Accounting Estimates Critical accounting policies are those policies that the Company’s management believes are the most important to understanding the Company’s financial condition and operating results. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company’s financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used. Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, 7 economic conditions and regional national such as unemployment data, loan loan portfolio composition, local construction permits, development delinquencies, plans, local economic conditions, 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 loan portfolios. The determination of the allowance for the non- homogeneous commercial, commercial real estate and multi- family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company’s own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary specific reserves. 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 for all non-performing loans. The Company’s policies and procedures related to the allowance consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses that was issued by the federal financial regulatory agencies in December 2006. an individual loan losses are for 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 to frequent adjustments due to flows may be subject changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a impact on the loan loss provision. The significant 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 based on current conditions the allowance for loan losses is maintained at M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future. attributable tax consequences Income Taxes Deferred tax assets and liabilities are recognized for the future to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities. The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating losses. For income tax purposes, only net charge-offs and certain specific reserves are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. tax Positive evidence includes the ability to implement planning income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company’s cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. At December 31, 2010, the Company recorded a valuation allowance against the entire deferred tax asset balance. This determination was based primarily upon the existence of a three year cumulative loss and continued operating losses in 2010. This three year cumulative loss position is primarily attributable to accelerate strategies taxable to significant provisions for loan losses incurred during the three years ended December 31, 2010. The creation of the valuation allowance, although it increased tax expense and similarly reduced tangible book value, does not have an effect on the Company’s cash flows, and may be recoverable in subsequent periods if the Company were to realize certain sustained future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the need for a valuation allowance on deferred tax assets and adjustments may be required in the future. Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated. to loss common available Results of Operations The net loss was $29.0 million for 2010, an increased loss of $18.2 million, from the $10.8 million loss for 2009. The net shareholders was $30.8 million for the year ended December 31, 2010, an increased loss of $18.3 million, from the net loss available to common shareholders of $12.5 million for 2009. Diluted loss per common share for the year ended December 31, 2010 was $8.17, an increased loss of $4.78 from the $3.39 diluted loss per common share for the year ended December 31, 2009. Loss on average assets for 2010 was 2.98%, compared to a 1.00% loss for 2009. Loss on average common equity was 31.73% for 2010, compared to a 10.33% loss for 2009. Net Interest Income Net interest income was $31.0 million for 2010, a decrease of $2.9 million, or 8.5%, from $33.9 million for 2009. Interest income was $48.3 million for 2010, a decrease of $9.5 million, or 16.4%, from $57.8 million for 2009. Interest income decreased between the periods primarily because of a $94 million decrease in the average interest- earning assets and to a lesser degree a decrease in the average yields between the periods. Average interest- earning assets decreased between the periods primarily because of a decrease in the commercial loan portfolio, which occurred because of declining loan demand and the Company’s focus on improving credit quality, managing net interest margin and improving capital ratios and it is anticipated that this trend will continue in 2011. Interest income also decreased because of a decline in the average yields earned on loans and investments. The decreased average yields are the result of the 400 basis point decrease in the prime interest rate that occurred in 2008. Decreases in the prime rate decreased the rates on adjustable rate consumer and commercial loans in the portfolio and on the increasing percentage of new fixed rate loans and 8 investments placed into portfolio in the ensuing years as pre-2008 loans matured or were repaid. The average yield earned on interest-earning assets was 5.23% for the year ended December 31, 2010, a decrease of 45 basis points from the 5.68% average yield for 2009. Interest expense was $17.3 million for the year ended December 31, 2010, a decrease of $6.6 million, or 27.7%, from $23.9 million for 2009. Interest expense decreased because of the lower interest rates paid on money market accounts and certificates of deposit. The decreased rates were the result of the 400 basis point decrease in the federal funds rate that occurred in 2008. Decreases in the federal funds rate generally have a lagging effect and decrease the rates banks pay for deposits. The lagging effect of deposit rate changes is primarily due to the Bank’s deposits that are in the form of certificates of deposit, which do not re-price immediately when the federal funds rate changes. Interest expense also decreased because of an $86 million decrease in the average interest-bearing liabilities between the interest-bearing in periods. The decrease average liabilities is primarily the result of a decrease in the average outstanding brokered certificates of deposit between the periods. The decrease in brokered deposits in 2010 was the result of using the proceeds from loan principal payments to fund maturing brokered deposits and it is anticipated that this trend will continue as the asset size of the Bank is anticipated to decrease in 2011. The average interest rate paid on interest-bearing liabilities was 1.98% for the year ended December 31, 2010, a decrease of 51 basis points from the 2.49% average rate paid for the same period of 2009. Net interest margin (net interest income divided by average interest-earning assets) was 3.36% for the year ended December 31, 2010, an increase of 3 basis points, from the 3.33% margin for 2009. 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. Year Ended December 31, (Dollars in thousands) 2010 2009 2008 Average Outstanding Balance Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance Interest Earned/ Paid Average Yield/ Rate Interest-earning assets: Securities available for sale: Mortgage-backed and related securities . . . . . Other marketable securities . . . . . . . . . . . . . Loans held for sale. . . . . . . . . . . . . . . . . . . . . Loans receivable, net(1)(2) . . . . . . . . . . . . . . . . FHLB stock . . . . . . . . . . . . . . . . . . . . . . . . . Other, including cash equivalents . . . . . . . . . . . Total interest-earning assets . . . . . . . . . . . . . . . Interest-bearing liabilities: NOW accounts . . . . . . . . . . . . . . . . . . . . . . . Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . Certificate accounts . . . . . . . . . . . . . . . . . . . . Brokered deposits . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . . . . . . . . . Other interest-bearing liabilities . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . Noninterest checking . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities and noninterest bearing deposits . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . $ 42,117 112,573 2,561 740,324 7,262 18,626 $923,463 $ 96,248 32,929 133,113 240,590 152,584 131,480 1,351 $788,295 85,585 $873,880 Net interest rate spread . . . . . . . . . . . . . . . . . . Net earning assets . . . . . . . . . . . . . . . . . . . . . $ 49,583 Net interest margin. . . . . . . . . . . . . . . . . . . . . Average interest-earning assets to average interest-bearing liabilities and noninterest bearing deposits . . . . . . . . . . . . . . . . . . . . . 1,813 2,023 117 44,131 182 4 48,270 110 45 1,341 5,415 4,370 5,978 0 4.30% $ 1.80 4.57 5.96 2.51 0.02 5.23 63,725 82,758 3,161 2,768 3,039 163 848,696 51,713 87 1 57,771 7,286 12,212 $1,017,838 0.11% $ 106,360 0.14 30,401 1.01 105,854 2.25 257,085 2.86 232,829 4.55 0.00 155,681 1,219 $ 889,429 70,364 132 38 1,430 7,652 8,327 6,289 0 17,259 31,011 1.98 $ 959,793 23,868 33,903 3.26% 3.36% $ 58,045 4.34% $ 3.67 5.16 6.09 1.19 0.01 5.68 35,494 119,065 2,711 887,836 7,192 16,011 $1,068,309 0.12% $ 126,118 40,229 0.12 120,333 1.35 247,454 2.98 287,771 3.58 4.04 0.02 123,938 1,135 $ 946,978 56,164 2.49 $1,003,142 3.19% 3.33% $ 65,167 1,615 5,775 166 58,505 253 198 66,512 1,542 412 2,821 9,582 12,799 4.55% 4.85 6.12 6.59 3.52 1.24 6.23 1.22% 1.02 2.34 3.87 4.45 5,639 1 4.55 0.08 32,796 33,716 3.27 2.96% 3.16% 105.67% 106.05% 106.50% (1) Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis for any of the years presented. The tax-exempt income was $0.4 million for 2010, $0.7 million for 2009 and $1.0 million for 2008. (2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve. Net interest margin increased to 3.36% in 2010 from 3.33% in 2009 primarily because the cost of interest- bearing liabilities decreased at a faster rate than the yield on interest-earning assets due to the lagging effect 9 M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S of deposit price changes in relation to loan price changes. Net interest margin was also positively impacted by a change in the deposit mix as a lower percentage of deposits were in higher priced brokered certificates of deposits in 2010 when compared to 2009. Brokered deposits decreased in 2010 as the proceeds from loan payoffs were used to pay off the outstanding brokered deposits that matured during the year. Average net earning assets decreased $8.4 million to $49.6 million in 2010 compared to $58.0 million for 2009. Net earning assets decreased primarily because of increases in non- performing assets and loan charge offs during 2010. (Dollars in thousands) Interest-earning assets: Securities available for sale: 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 and those changes caused by fluctuating interest rates. For each category of interest-earning assets and interest-bearing liabilities, changes is 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). outstanding balances information (volume) provided on Year Ended December 31, 2010 vs. 2009 Increase (Decrease) Due to Volume(1) Rate(1) Total Increase (Decrease) 2009 vs. 2008 Increase (Decrease) Due to Volume(1) Rate(1) Total Increase (Decrease) Mortgage-backed and related securities . . . . . . . . . . . . . . Other marketable securities . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . $ (939) 1,095 (31) (6,391) 1 0 (16) (2,111) (15) (1,192) 3 95 $(6,265) (3,236) Interest-bearing liabilities: NOW accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Brokered deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings . . . . . . . . Other interest-bearing liabilities . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . . . . . . . . . Increase (decrease) in net interest income. . . . . . . . . . . . . . . . $ (19) 3 367 (651) (2,869) (166) 0 (3) 4 (456) (1,587) (1,087) (145) 0 (3,335) (3,274) $(2,930) 38 (955) (1,016) (46) (7,583) 4 95 (9,501) (22) 7 (89) (2,238) (3,956) (311) 0 (6,609) (2,892) 1,285 (1,761) 27 (2,510) (47) 3 (132) (975) (30) (4,282) (150) (169) 1,153 (2,736) (3) (6,792) (197) (166) (3,003) (5,738) (8,741) (405) (101) (422) 373 (2,446) 426 127 (1,005) (273) (969) (2,303) (2,026) 112 (16) (1,410) (374) (1,391) (1,930) (4,472) 538 111 (2,448) (6,480) (8,928) (555) 742 187 (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. 10 The following table sets forth the weighted average the rates on interest-bearing rate spread between the yields on the Company’s interest-earning assets, weighted average interest liabilities and the interest weighted average yields and rates as of the date indicated. Non-accruing loans have been included in the table as loans carrying a zero yield. At December 31, 2010 Weighted average rate on: Weighted average yield on: Securities available for sale: Mortgage-backed and related securities . . . . . . . . 4.14% Other marketable securities . . . . . . . . . . . . . . . . 1.27 Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . 4.27 Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . 6.33 Federal Home Loan Bank stock . . . . . . . . . . . . . . . 4.00 Other interest-earnings assets. . . . . . . . . . . . . . . . . 0.02 Combined weighted average yield on interest- earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . 5.38 Provision for Loan Losses The provision for loan losses was $33.4 million for the year ended December 31, 2010, an increase of $6.7 million, from $26.7 million for the year ended December 31, 2009. The provision for loan losses remained elevated in 2010 primarily because of the $25.9 million in additional reserves established on commercial real estate and commercial business loans primarily as a result of the underlying decreases in the estimated value of collateral supporting the loans, $1.6 million in additional reserves established on a commercial loan due to the borrower filing bankruptcy and a $4.3 million increase in the reserves required for other risk rated commercial loans as a result of an internal analysis of our loan portfolio. Total non-performing assets were $84.5 million at December 31, 2010, an increase of $7.1 million from $77.4 million at December 31, 2009. Non-performing increased $7.0 million and foreclosed and loans repossessed assets increased $0.1 million during 2010. The non-performing loan and foreclosed and repossessed asset activity for 2010 and 2009 was as follows: 11 NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.11% Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.15 Money market accounts . . . . . . . . . . . . . . . . . . . . 0.75 Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.08 Federal Home Loan Bank advances . . . . . . . . . . . . 4.44 Combined weighted average rate on interest- bearing liabilities . . . . . . . . . . . . . . . . . . . . . . . 1.69 Interest rate spread . . . . . . . . . . . . . . . . . . . . . . . . 3.69 (Dollars in thousands) December 31, 2010 2009 Non-performing loans: Balance at beginning of year . . . . . . . $ 61,127 62,009 Classified as non-performing . . . . . . . (15,231) Charge offs . . . . . . . . . . . . . . . . . . . (13,733) Principal payments received . . . . . . . (10,972) Classified as accruing . . . . . . . . . . . . (15,126) Transferred to real estate owned . . . . Balance at end of year . . . . . . . . . . . $ 68,074 64,173 44,632 (25,031) (4,322) (1,106) (17,219) 61,127 (Dollars in thousands) Foreclosed and repossessed asset activity: December 31, 2010 2009 Balance at beginning of year . . . . . . . $ 16,262 Transferred from non-performing loans . . . . . . . . . . . . . . . . . . . . . . . Other foreclosures/repossessions . . . . . Real estate sold . . . . . . . . . . . . . . . . . Net gain on sale of assets . . . . . . . . . . Write downs . . . . . . . . . . . . . . . . . . . 15,126 1,158 (14,448) 747 (2,450) Balance at end of year . . . . . . . . . . . . $ 16,395 10,583 17,219 1,237 (9,819) 1,436 (4,394) 16,262 Loans classified as non-performing during the year increased $17.4 million, from $44.6 million in 2009 to $62.0 million in 2010. The increase in loans classified as non-performing reflects the relative weakness in the that housing and commercial continued to cause reductions in the values of the collateral supporting some loans and adversely affecting the ability of some borrowers to comply with their loan payment requirements as well as the Company’s increased level of internal loan reviews. estate markets real M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S A rollforward of the allowance for loan losses for 2010 and 2009 is summarized as follows: (Dollars in thousands) Balance at January 1, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge offs: Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Single family mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 $23,812 33,381 (7,006) (7,095) (907) (254) 897 2009 21,257 26,699 (9,421) (13,548) (1,980) (82) 887 Balance at December 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,828 $ 23,812 General allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Specific allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,794 25,034 $42,828 $ 11,760 12,052 $ 23,812 The allowance for loan losses increased in 2010 primarily because of the $13.0 million increase in specific reserves established during the year due to decreases in the estimated value of the underlying collateral supporting the loans. The general allowance also increased because a periodic analysis of the commercial loan portfolio resulted in increased reserve percentages on performing loans due to the recent increase in charge off activity. Non-Interest Income Non-interest income was $7.3 million in 2010, a decrease of $0.8 million, or 10.0%, from $8.1 million for 2009. The following table presents the components of non-interest income: (Dollars in thousands) Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 $3,741 1,067 0 1,987 476 Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,271 2009 4,137 1,042 5 2,273 625 8,082 2008 4,269 955 479 651 749 7,103 Year Ended December 31, Percentage Increase (Decrease) 2010/2009 2009/2008 (9.6)% 2.4 (100.0) (12.6) (23.8) (10.0) (3.1)% 9.1 (99.0) 249.2 (16.6) 13.8 Fees and service charges decreased $396,000 between the periods primarily because of decreased overdraft fees and decreased ATM fees as a result of exiting a customer ATM relationship in the first quarter of 2010. Gain on sales of loans decreased $286,000 between the periods primarily because of a decrease in the gains recognized on the sale of single family mortgage loans caused by a decrease in loan originations and sales between the periods. Other income decreased $149,000 primarily as a result of increased losses on asset sales and decreased revenue from the sale of uninsured investment products. Loan servicing fees increased $25,000 between the periods due to an increase in the single-family mortgage loans being serviced. 12 Non-Interest Expense Non-interest expense was $27.6 million for 2010, a decrease of $4.1 million, or 13.0%, from $31.7 million for 2009. The following table presents the components of non-interest expense: Year Ended December 31, (Dollars in thousands) 2010 Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,516 1,165 Losses (gains) on real estate owned . . . . . . . . . . . . . . . . . . . . . 4,082 Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,933 Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,040 Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Goodwill impairment charge . . . . . . . . . . . . . . . . . . . . . . . . . . 5,820 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . $27,556 2009 13,432 3,873 4,084 1,973 1,182 0 7,145 31,689 2008 12,464 (187) 4,521 678 1,731 3,801 6,226 29,234 Percentage Increase (Decrease) 2010/2009 2009/2008 0.6% 7.8% (69.9) (0.0) (2.0) (12.0) N/A (18.5) (13.0) 2,171.1 (9.7) 191.0 (31.7) N/A 14.8 8.4 Losses on real estate owned decreased $2.7 million between the periods because of the decreases in the losses recognized on real estate sold. Other non-interest expenses decreased $1.3 million due primarily to the $1.2 million impact of the reversal of the accrued interest on a state tax assessment as a result of a favorable Minnesota Supreme Court ruling, a $122,000 decrease in item processing charges as a result of implementing improved clearing procedures and a $114,000 decrease in postage and printing supplies primarily as a result of increasing the number of customers receiving electronic statements. Compensation expense increased $84,000 between the periods primarily because of increased personnel in the commercial loan recovery area. Data processing expense decreased $142,000 between the periods primarily because of a change in the Company’s ATM and debit card vendor during the fourth quarter of 2010. 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 assets and liabilities. The effect of income taxes changed $11.9 million between the periods from a benefit of $5.6 million for 2009 to an expense of $6.3 million for 2010. During 2009, additional income tax expense of $1.0 million was recorded, which was a reduction of the overall tax benefit, as a result of an unfavorable tax court ruling related to the tax treatment of the inter-company dividends paid to the Bank by a former subsidiary in prior tax years. Excluding this adjustment, the effective tax rate would have been 40.3% for 2009. During 2010, income taxes increased $16.6 million as a result of recording a deferred tax asset valuation allowance, which was partially offset by a $1.2 million tax benefit recorded as a result of a favorable Minnesota Supreme Court tax ruling, which 13 reversed the unfavorable tax court ruling from 2009. Excluding these adjustments, the effective tax rate would have been 39.7% for 2010. Net Loss Available to Common Shareholders On December 23, 2008, the Company sold preferred stock and a related warrant to the United States Treasury for $26.0 million. The preferred shares are entitled to a 5% annual cumulative dividend for each of the first five years of the investment, increasing to 9% thereafter, unless HMN redeems the shares. The cumulative preferred dividends payable is $325,000 each quarter for the first five years the preferred shares are outstanding and increases to $585,000 each quarter after that if the shares are not redeemed. The Company paid all preferred dividends to the U.S. Treasury that were due in 2009 and 2010. The Company elected to defer the February 15, 2011 dividend payment on the preferred stock after consulting with the OTS. The determination to defer the dividend payment was made in order to preserve cash for potential future needs. Under its Supervisory Agreement, the Company may not pay any dividend on its outstanding preferred stock or common stock without the consent of the OTS. The dividends on the preferred stock are cumulative and, if the Company fails to pay dividends for six quarters, whether or not consecutive, the Treasury will have the right two representatives to the Company’s board of directors. Net loss available to common stockholders is the net loss less the preferred dividends paid or accrued for the period. to appoint The net loss available to common shareholders was $30.8 million for the year ended December 31, 2010, an increased loss of $18.3 million, from the net loss available to common shareholders of $12.5 million for 2009. The net loss available to common shareholders increased primarily because of the decrease in net income between the periods. M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S loss available Comparison of 2009 with 2008 The net loss was $10.8 million for 2009, an increased loss of $669,000, from the $10.1 million loss for 2008. Due to preferred stock dividends and discount accretion, there was a net to common shareholders of $12.5 million for the year ended December 31, 2009, an increased loss of $2.3 million from the net loss available to common shareholders of $10.2 million for 2008. Diluted loss per common share for the year ended December 31, 2009 was $3.39, an increased loss of $0.61 from the $2.78 the year ended diluted loss per common share for December 31, 2008. Loss on average assets for 2009 was 1.00% compared to a loss of 0.91% for 2008. Loss on average common equity was 10.33% for 2009, compared to 10.61% for 2008. Net interest income was $33.9 million for 2009, an increase of $187,000, or 0.6%, from $33.7 million for 2008. Interest income was $57.8 million for 2009, a decrease of $8.7 million, or 13.1%, from $66.5 million for 2008. Interest income decreased primarily because of a decrease in the average yields earned on loans and investments. The decreased average yields were the result of the 400 basis point decrease in the prime interest rate that occurred during 2008. Decreases in the prime rate, which is the rate that banks charge their prime business customers, generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. Interest income was also adversely affected by the decrease in the average net loans receivable of $39.1 million and the increase in the average non-performing assets between the periods. The decrease in outstanding loans in 2009 was a result of declining loan demand and the Company’s focus on improving credit quality, managing interest rate risk and improving capital ratios. The average yield earned on interest-earning assets was 5.68% for 2009, a decrease of 55 basis points from the 6.23% average yield for 2008. Interest expense was $23.9 million for 2009, a decrease of $8.9 million, or 27.2%, from $32.8 million for 2008. Interest expense decreased primarily because of lower interest rates paid on money market and certificates of deposit accounts. The decreased rates were the result of the 400 basis point decrease in the federal funds rate that occurred during 2008. Decreases in the federal funds rate generally have a lagging effect and decrease the rates banks pay for deposits. Interest expense also decreased because of a $43.3 million decrease in average interest-bearing liabilities between the periods. The decrease in average interest-bearing liabilities is primarily the result of a decrease in the outstanding brokered certificates of deposits between the periods. The decrease in brokered deposits in 2009 was the result of using the proceeds from loan principal payments to fund maturing brokered 14 deposits. The average interest rate paid on interest- bearing liabilities was 2.49% for 2009, a decrease of 78 basis points from the 3.27% paid for 2008. Net interest margin (net interest income divided by average interest earning assets) for 2009 was 3.33%, an increase of 17 basis points, compared to 3.16% for 2008. Net interest margin increased to 3.33% in 2009 from 3.16% in 2008 primarily because the cost of interest- bearing liabilities decreased at a faster rate than the yield on interest-earning assets due to the lagging effect of deposit price changes in relation to loan price changes. Net interest margin was also positively impacted by a change in the deposit mix as a lower percentage of deposits were in higher priced brokered certificates of in 2009 when compared to 2008. Brokered deposit deposits decreased in 2009 as the proceeds from loan payoffs were used to pay off the outstanding brokered deposits that matured during the year. Average net earning assets decreased $7.2 million to $58.0 million in 2009 compared to $65.2 million for 2008. Net earning assets decreased primarily because of increases in non- performing assets and loan charge offs during 2009. an additional The provision for loan losses was $26.7 million for 2009, the same as for 2008. The provision for loan losses remained elevated in 2009 primarily because of the high loan loss allowances recorded for specific commercial real estate loans due to decreases in the estimated value of the underlying collateral supporting the loans. The loan loss provision for 2009 includes a $6.9 million increase on two unrelated commercial loans that were charged off after it was determined that the collateral supporting the loans was inadequate due to the apparently fraudulent actions of the respective borrowers. In addition, a $3.0 million provision for loan losses was established on two alternative fuel plants during 2009 based on updated appraised values, and of provision $2.9 million was recorded on two non-performing residential development loans. An analysis of the loan portfolio during the year resulted in a $2.7 million increase in the loan loss provision for other risk-rated loans. An additional $1.0 million increase in the loan to financial loss provision related to two loans the to due institutions was deterioration of their financial condition. The loan loss provision for 2008 included a $12.0 million provision and related charge off due to apparently fraudulent activity on a loan. Total non-performing assets were commercial $77.4 million at December 31, 2009, an increase of $2.6 million, at December 31, 2008. Non-performing loans decreased $3.1 million to $61.1 million and foreclosed and repossessed assets increased $5.7 million to $16.3 million. from $74.8 million recorded losses 3.5%, 2009 loan for or in is subject to significant estimates. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities. The income tax benefit was $5.6 million for the year ended December 31, 2009, an increased benefit of $623,000, compared to a $5.0 million benefit for the year ended December 31, 2008. The increased income tax benefit was due to an increased taxable loss and an effective tax rate that increased from 33.0% for 2008 to 34.2% for 2009. The effective tax rate was lower in 2008 primarily due to the nondeductible goodwill impairment charge that was recorded in 2008. The Company is headquartered in Minnesota and files a state income tax return with the Minnesota Department of Revenue (MDR). In January 2007, the MDR proposed adjustments of $2.2 million to the Company’s Minnesota state tax liability related to the tax treatment of the inter- company dividends paid to the Bank by a former subsidiary in 2002, 2003 and 2004. The Company challenged the additional assessment and the case was heard by the Minnesota tax court, which ruled in favor of the MDR in the second quarter of 2009. The Company recorded additional income tax expense of $1.0 million and interest of $461,000 at that time. The Company appealed the tax court ruling to the Minnesota Supreme Court. The case was heard in the fourth quarter of 2009 and a favorable ruling was received in the second quarter of 2010. The Company had previously reserved for the entire amount of the proposed adjustment, the favorable ruling therefore, resulted in a reduction in income tax expense of $1.2 million and a reduction in other expense of $734,000 for accrued interest. The net loss available to common shareholders was $12.5 million for the year ended December 31, 2009, an increased loss of $2.3 million from the net loss available to common shareholders of $10.2 million for 2008. The net loss available to common shareholders increased primarily because of the $1.7 million increase in the preferred stock dividend and discount accretion costs between the periods. The increased preferred stock dividend and discount accretion costs in 2009 are the result of the preferred stock being outstanding for the entire year compared to only a partial year in 2008. Non-interest income was $8.1 million for 2009, an increase of $1.0 million, or 13.8%, from $7.1 million for 2008. Gain on sales of loans increased $1.6 million between the periods because of an increase in the sales of single family mortgages between the periods due to the low interest rate environment during 2009. Loan servicing fees increased $87,000 between the periods due to an increase in the single-family mortgage loans being serviced. Security gains decreased $474,000 because of decreased investment sales. Fees and service charges decreased $132,000 between the periods primarily because of decreased retail deposit account overdrafts and fees. Other non-interest income decreased $124,000 between the periods due primarily to a decrease in the sales of uninsured investment products. of premiums additional Non-interest expense was $31.7 million for 2009, an increase of $2.5 million, or 8.4%, from $29.2 million for 2008. Losses on real estate owned increased $4.1 million between 2008 and 2009 primarily because the losses recognized on three residential developments, caused by a decrease in their estimated value, exceeded the gains recognized on the sale of two commercial real estate increased insurance properties. Deposit $1.3 million due to increased FDIC insurance premium rates and a special FDIC assessment of $483,000 that was paid in 2009. Compensation and benefits expense increased $968,000 between the periods primarily the mortgage, because commercial and computer operations areas and costs associated with the employment agreement of a former executive officer. Other non-interest expenses increased $919,000 primarily because of an increase in the costs related to other real estate owned. These increases were offset by a $3.8 million decrease in goodwill impairment charges between the periods. Data processing costs decreased $549,000 between the periods primarily because of decreases in third party vendor charges for internet and other banking services as a result of the system conversion that occurred in the fourth quarter of 2008. Occupancy expense decreased $437,000 primarily because of a decrease in depreciation expense and non- capitalized software and equipment purchases. staffing in The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that 15 M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S Financial Condition Loans Receivable, Net The following table sets forth the information on the amounts Company’s and loans in process, percentages (before deductions for loan portfolio in dollar deferred fees and discounts and allowances for losses) as of the dates indicated: (Dollars in thousands) Real Estate Loans: 2010 Amount Percent 2009 Amount Percent December 31, 2008 Amount Percent 2007 Amount Percent 2006 Amount Percent One-to-four family . . . . . . . . . . $128,535 48,266 Multi-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292,874 Commercial 15,251 Construction or development . . . Total real estate loans . . . . 484,926 Other Loans: Consumer Loans: 18.14% $144,631 17.54% $161,989 17.51% $152,974 17.33% $134,269 17.10% 6.81 3.17 41.34 35.16 2.15 11.70 68.44 67.54 29,073 3.29 281,822 31.92 111,034 12.58 574,903 65.12 59,266 7.18 312,714 37.92 40,412 4.90 557,023 67.54 29,292 325,304 108,283 624,868 29,863 294,490 60,178 518,800 3.80 37.49 7.66 66.05 Automobile . . . . . . . . . . . . . Home equity line . . . . . . . . . Home equity . . . . . . . . . . . . Mobile home . . . . . . . . . . . . Land/lot loans . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . Total consumer loans . . . . 604 44,933 17,840 764 2,510 3,952 70,603 Commercial business loans . . . . 153,039 Total other loans . . . . . . . . 223,642 Total loans . . . . . . . . . . . . 708,568 100.00% 824,763 100.00% 925,244 100.00% 882,771 100.00% 785,418 100.00% 0.20 1,730 5.81 51,317 2.30 20,254 0.19 1,699 0.47 4,151 0.65 5,758 84,909 9.62 222,959 25.26 0.11 902 6.11 50,369 2.55 21,088 0.12 977 0.39 3,190 0.69 5,689 82,215 9.97 185,525 22.49 1,333 52,243 22,912 1,316 2,969 5,828 86,601 213,775 3,093 54,247 21,263 2,052 5,501 3,692 89,848 176,770 0.08 6.34 2.52 0.11 0.35 0.56 9.96 21.60 0.39 6.91 2.71 0.26 0.70 0.47 11.44 22.51 0.14 5.65 2.48 0.14 0.32 0.63 9.36 23.10 307,868 34.88 267,740 32.46 266,618 300,376 31.56 33.95 32.46 Less: Loans in process ** . . . . . . . . . Unamortized (premiums) discounts . . . . . . . . . . . . . . . . Net deferred loan fees . . . . . . . Allowance for losses . . . . . . . . 0 413 1,086 42,828 Total loans receivable, 0 177 1,518 23,812 0 569 2,529 21,257 3,011 (11) 2,245 12,438 5,252 40 2,021 9,873 net . . . . . . . . . . . . . . . . $664,241 $799,256 $900,889 $865,088 $768,232 ** Core systems converted in 2008, loans in process after this date are reflected in loan amounts in table. In 2010, the Company continued to focus on improving credit quality, managing interest rate risk and improving capital ratios which resulted in a decrease in outstanding loan balances. As a result of declining loan demand and the reasons noted above, it is anticipated that the size of our overall loan portfolio will continue to decline in 2011. Furthermore, pursuant to the Bank Supervisory Agreement, the Bank may not increase its total assets during any quarter in excess of the amount of net interest credited on deposit liabilities during the prior quarter, without OTS approval. The Company’s commercial business and commercial real estate loan portfolios continue to be impacted by the reduced demand for real estate, particularly as it relates to single-family and commercial land developments as many of these loans were made to borrowers associated with the lending standards real estate industry. More stringent 16 implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments and is reflected in the $84.5 million of Company assets that were classified as non-performing at the end of 2010. We continue to work with the borrowers in order to resolve the non-performing status of these loans in the most cost effective manner. Because cash flow is dependent, in many cases, on the sale of the properties, it will take some time to reduce some of the non-performing assets due to the limited demand for the properties. One-to-four loans were $128.5 million at December 31, 2010, a decrease of at $16.1 million, $144.6 million compared family estate real to December 31, 2009. Mortgage loan refinance activity remained strong in 2010 due to the historically low the mortgage rates experienced and almost all of refinanced loans originated were sold into the secondary market and were not placed in the portfolio in order to manage the Company’s interest rate risk position. The increase in the amount of mortgage loans refinancing was the decrease in the one-to-four family loan portfolio during 2010. the primary reason for Multi-family real estate loans were $48.3 million at December 31, 2010, a decrease of $11.0 million, compared to $59.3 million at December 31, 2009. The decrease in multi-family real estate loans in 2010 is primarily the result of two large multi-family loans that obtained alternative financing and paid off their outstanding loans with the Bank in 2010. a decrease of $32.5 million, Commercial real estate loans were $292.9 million at December 31, 2010, a decrease of $19.8 million, compared to $312.7 million at December 31, 2009. Commercial business loans were $153.0 million at December 31, 2010, compared to $185.5 million at December 31, 2009. Decreased commercial loan demand and tighter underwriting and pricing guidelines in net resulted in a decrease commercial loan production and an increase in loan payoffs. Net commercial loan production, which is the principal amount retained by the Bank after deducting sold loan participations, was $59.8 million in 2010, compared to $74.1 million in 2009. Loan participations are sold in most cases in order to comply with lending limit restrictions and/or reduce loan concentrations. The decrease in net production along with the increase in loan payoffs was the primary reason for the decrease in the commercial business and commercial real estate loan balances in 2010. Construction were $15.3 million at December 31, 2010, a decrease of $25.1 million, at December 31, 2009. The decrease is primarily the result totaling of $14.1 million where the projects were completed and the loans were moved to multi-family real estate in 2010 and two construction loans totaling $7.1 million that were foreclosed on during the year. These construction loans were not replaced with new construction loans due to a decrease in demand for construction and development loans in 2010. five multi-family $40.4 million development construction compared loans loans or to Home equity line loans were $44.9 million at December 31, 2010, a decrease of $5.5 million, compared to $50.4 million at December 31, 2009. The open-end home equity lines are written with an adjustable rate and a 10 year draw period which requires “interest only” payments followed by a 10 year repayment period 17 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 $17.8 million at December 31, 2010, a decrease of $3.3 million, at December 31, 2009. The decreases in the open and closed end equity loans is related primarily to a decrease in the originations of these type of loans and an increase in loan payoffs as a result of borrowers rolling these loan amounts into their first mortgages when they refinanced in 2010. $21.1 million compared to 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 non-homogenous commercial real estate and commercial business loans reviews to identify and that quantify portfolio. the Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to establish general allowances and specific reserves on the basis of these reviews. includes regular credit risk system on commercial risk-rating the in a off loans against charges appropriate, for Management actively monitors asset quality and, the when loan losses. Although management allowance 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 economic conditions in the assumptions used to determine the size of the allowance for loan losses. substantially from the The allowance for loan losses was $42.8 million, or 6.04% of gross loans at December 31, 2010, compared to $23.8 million, or 2.89% of gross loans at December 31, 2009. The allowance for loan losses and the related ratios increased in 2010 primarily because of the $13.0 million increase in specific reserves established during the year due to decreases in the estimated value of the underlying collateral supporting the loans. The general allowance also increased during 2010 because an analysis of the commercial loan portfolio resulted in increased reserve percentages on performing loans due to the recent increase in charge off activity. The allowance for loan losses at December 31, 2010 increased $3.1 million related to increased general reserve percentages from the prior year. The following table reflects the activity in the allowance for loan losses and selected statistics: M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S (Dollars in thousands) Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs: One-to-four family. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 $ 23,812 33,381 (254) (907) (7,006) (7,095) 897 (14,365) $ 42,828 Year end allowance for loan losses as a percent of year end gross December 31, 2009 21,257 26,699 2008 12,438 26,696 (82) (1,980) (9,421) (13,548) 887 (24,144) 23,812 (78) (612) (13,784) (3,454) 51 (17,877) 21,257 2007 9,873 3,898 (42) (840) (554) (245) 348 (1,333) 12,438 2006 8,778 8,878 (150) (269) (188) (7,242) 66 (7,783) 9,873 loan balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio of net loan charge-offs to average loans outstanding . . . . . . . . . . . . . 6.04% 2.89% 1.87 2.76 2.30% 1.41% 1.26% 0.16 1.98 0.98 The following table reflects the allocation of the allowance for loan losses: 2010 2009 December 31, 2008 2007 2006 Allocated Allowance as a % of Loan Category 1.67% 6.90 1.31 9.91 6.04 Percent of Loans in Each Category to Total Loans 18.14% 50.30 9.96 Allocated Allowance as a % of Loan Category 0.69% 3.47 1.55 Percent of Loans in Each Category to Total Loans 17.54% 50.00 9.97 Allocated Allowance as a % of Loan Category 1.75% 2.83 1.83 Percent of Loans in Each Category to Total Loans 17.51% 50.03 9.36 Allocated Allowance as a % of Loan Category 0.27% 1.83 1.70 Percent of Loans in Each Category to Total Loans 17.33% 47.79 9.62 Allocated Allowance as a % of Loan Category 0.22% 1.58 1.59 21.60 100.00% 3.88 2.89 22.49 100.00% 1.75 2.30 23.10 100.00% 1.28 1.41 25.26 100.00% 1.18 1.26 Percent of Loans in Each Category to Total Loans 17.10% 48.95 11.44 22.51 100.00% One-to-four family . . . . . Commercial real estate . . Consumer loans . . . . . . . Commercial business loans . . . . . . . . . . . . Total . . . . . . . . . . . . . . The allocated percentage for commercial real estate and commercial business loans increased in 2010 due to management’s assessment of the risk and assignment of risk ratings of certain individual loans in these categories and increases in specific reserves. The allocation of the allowance for loan losses increased in 2010 for one-to-four family loans due primarily to the increases in the specific reserves at December 31, 2010 when compared to 2009. The allocation of the allowance for loan losses decreased in 2010 for consumer loans due to a decrease in the specific reserves and a decrease in the outstanding balances of loan categories with higher reserve ratios. 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 18 costs. The balance in the allowance for real estate losses was $4.5 million at December 31, 2010 and $4.9 million at December 31, 2009. Non-performing Assets the judgment of management, Loans are reviewed at least quarterly and any loan whose collectability 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 loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non- income. charged against accrual Subsequent the to either are outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. Restructured loans include the Bank’s troubled debt restructurings that involved forgiving a portion of interest or principal or making loans at a rate materially less than the market rate. Foreclosed and repossessed assets include assets acquired in settlement is payments interest applied status of loans. Total non-performing assets were $84.5 million at December 31, 2010, an increase of $7.1 million from $77.4 million at December 31, 2009. Non-performing increased $7.0 million and foreclosed and loans following table repossessed assets increased $0.1 million during 2010. The and categories of non-performing assets in the Company’s portfolio: forth the amounts sets (Dollars in thousands) Non-accruing loans: 2010 2009 December 31, 2008 2007 2006 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,844 36,737 Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,269 Commercial business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,074 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreclosed and repossessed assets: Total 972 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,409 Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,395 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-performing assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,469 Total 2,132 37,122 4,086 17,787 61,127 0 1,011 15,246 5 16,262 $77,389 7,251 46,953 5,298 4,671 64,173 25 258 10,300 0 10,558 $74,756 1,196 15,641 1,094 1,723 19,654 34 901 1,313 33 2,247 $21,935 1,364 5,296 1,254 394 8,308 44 1,422 650 0 2,072 $10,424 Total as a percentage of total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.59% 7.47% 6.53% 1.96% 1.07% Total non-performing loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $68,074 $61,127 $64,173 $19,654 $ 8,308 Total as a percentage of total loans receivable, net . . . . . . . . . . . . . . . . 10.25% 7.65% 7.12% 2.27% 1.08% Allowance for loan losses to non-performing loans . . . . . . . . . . . . . . . . 62.91% 38.95% 33.12% 63.28% 118.84% The following table summarizes the number and real estate loans (the at property types of commercial largest December 31, 2010, 2009, and 2008. non-performing category loans) of For 2010, 2009 and 2008, gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $5.0 million for both 2010 and 2009, and $5.5 million for 2008. The amounts that were included in interest income on a cash basis for these loans were $1.3 million, $0.9 million and $1.9 million, respectively. (Dollars in thousands) Property Type Residential developments . . One-to-four family . . . . . . . Condominiums . . . . . . . . . . Hotels . . . . . . . . . . . . . . . . Alternative fuel plants . . . . . Shopping centers/retail . . . . Elderly care facilities . . . . . Restaurants/bar . . . . . . . . . . Office building . . . . . . . . . . # of Relationships 9 3 0 0 1 3 0 1 1 18 Principal Amount of Loans at December 31, 2010 $23,661 2,673 0 0 4,994 1,099 0 635 3,675 $36,737 # of Relationships 7 2 0 1 2 2 0 4 1 19 Principal Amount of Loans at December 31, 2009 $12,030 3,088 0 4,999 12,834 1,136 0 2,436 599 $37,122 # of Relationships 6 4 1 1 2 2 3 0 1 20 Principal Amount of Loans at December 31, 2008 $17,681 898 5,440 4,999 12,492 1,237 4,037 0 169 $46,953 The Company had specific reserves established real estate loans of $6.2 million, and the above commercial against $7.7 million $13.3 million, respectively, at December 31, 2010, 2009 and 2008. 19 The following table summarizes the number of lending commercial business loans that were non-performing for the years ended December 31, 2010 and 2009. and industry of relationships M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S (Dollars in thousands) Property Type Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restaurant # of Relationships 6 1 0 1 2 1 1 0 0 4 16 Principal Amount of Loans December 31, 2010 $ 9,148 248 0 2,504 8,223 315 4,614 0 0 1,217 $26,269 # of Relationships 5 2 1 1 1 1 0 0 0 0 11 Principal Amount of Loans December 31, 2009 $ 4,094 8,764 756 32 3,248 893 0 0 0 0 $17,787 The Company had specific reserves established loans of at commercial $3.4 million, against $10.7 million December 31, 2010 and 2009. above and respectively, business the the and real loans estate At December 31, 2010, 2009 and 2008, there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $8.2 million, $19.3 million, and $5.3 million respectively. For the loans that were restructured in 2010, $0.8 million were unclassified and performing, $10.1 million were classified and performing and $8.4 million were non-performing at December 31. The increase in troubled debt restructurings in 2010 relates primarily to multiple loans to two developers totaling $17.2 million that were restructured during the year in order to improve the borrowers cash flow. Of the loans that were modified in 2010, $14.9 million related to commercial remaining modifications related to single family, consumer, and commercial loans. Of the loans that were modified in 2009, $4.3 million related to a commercial real estate loan and the remaining loans related to single family and consumer loans. Some of these loans were not classified as non-performing as it is anticipated that the borrowers will be able to make all of the required principal and interest payments under the modified terms of the loan. In addition to the troubled debt restructurings and the non-performing loans set forth in the table above of all non- performing assets, as of December 31, 2010, there were two other potential problem loan relationships. Potential problem loans are loans that are not in non-performing status; however, there are circumstances present to create doubt as to the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that the Company expects losses to occur but that management recognized a higher degree of risk associated with these loans. The level of potential is factor another predominant problem loans in determining the relative level of the allowance for loan losses. The two loan relationships that have been reported as potential problem loans at December 31, 2010 are a loan and a group of $6.0 million land development commercial totaling loans $0.5 million. At December 31, 2009, potential problem loans were a $5.0 million loan to a financial institution and a $1.7 million group of loans in which the personal guarantor’s financial condition had deteriorated. related borrower to a Pursuant to the Bank Supervisory Agreement, the Bank must submit a problem asset reduction plan upon which the OTS may make comments, and to which it may require revisions. Liquidity and Capital Resources The Company manages its liquidity position so 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, internet or brokered deposits or to borrow funds from third parties such as the Federal Home Loan Bank (FHLB) or the Federal Reserve Bank (FRB). 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. Unpledged securities could also be pledged and used as collateral for additional borrowings with the FHLB or FRB to generate additional cash. The primary financing activity is the attraction of retail, internet and brokered deposits. The Bank has the ability to borrow additional funds from the FHLB or FRB to by pledging additional securities or loans, subject 20 applicable borrowing base and collateral requirements. Refer to Note 11 of the Notes to Consolidated Financial Statements for more information on additional advances that could be drawn based upon existing collateral levels with the FHLB and the FRB. Information on outstanding advance maturities and related early call features is also included in Note 11. In 2008, the United States Treasury also invested $26.0 million in preferred stock and related warrant of the Company. 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 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, 2010 were $21.0 million, an increase of $4.6 million, compared to $16.4 million at December 31, 2009. Net cash provided by operating activities during 2010 was $25.6 million. The Company conducted the following major investing activities during 2010: principal payments and maturity proceeds received on securities available for sale and FHLB stock were $137.8 million, purchases of securities available for sale and FHLB stock were $130.5 million, proceeds from the sale of premises and other real estate were $14.5 million, and loans receivable decreased $82.6 million. The Company spent $0.3 million for the purchase of equipment and updating its premises. Net cash provided by investing activities during 2010 was $104.1 million. The Company conducted the following received major proceeds from borrowing and advances of $87.0 million, repaid advances and borrowings of $97.0 million and deposits decreased $113.2 million. Net cash used by financing activities was $125.1 million. financing activities during 2010: The Company has certificates of deposit with outstanding balances of $177.0 million that mature during 2011, of which $55.7 million were obtained from brokers. Based upon past experience, management anticipates that the majority of the deposits will renew for another term, with the exception of some brokered that are not anticipated to renew due to deposits of reduce management’s outstanding brokered deposits. In addition, based on an OTS directive, the Bank may not renew existing brokered deposits, or accept new brokered deposits without the prior consent of the OTS. The Company believes that deposits that do not renew will be paid off with the proceeds from loan principal payments or replaced with deposits from a combination of other customers, FHLB advances, FRB borrowings, or the sale of securities could also be used to replace unanticipated outflows of deposits. amount desire the to The Company has deposits of $65.6 million in checking and money market accounts of customers that have relationship balances greater than $5 million. While these funds may be withdrawn at any time, management anticipates that the majority of these deposits will remain on deposit with the Bank over the next twelve months based on past experience. If these deposits are withdrawn, it is they would be replaced with FHLB anticipated that advances, FRB borrowings or deposits from other customers or brokers. The Company has $52.5 million in FHLB advances that mature in 2011 and it has $70.0 million of FHLB advances with maturities beyond 2011 that have call features that may be exercised by the FHLB during 2011. 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. The credit policy of the FHLB relating to the collateral value of the loans collateralizing the outstanding advances with 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 and the Bank may have to find alternative funding sources to replace some of the FHLB advances maturing in 2011. The FHLB could also reduce the amount of funds it will lend to the Bank. It is not anticipated that the Bank will need to find alternative funding sources in 2011 to replace the outstanding FHLB advances, but if needed, excess collateral currently pledged to the FHLB could be pledged to the FRB and the Bank could borrow additional funds from the FRB based on the increased collateral levels or obtain additional deposits. Under the Company Supervisory Agreement, the Company may not incur or issue any debt without prior notice to, and the consent of, the OTS. Because FHLB advances are debt of the Bank, they are not affected by the Company’s restriction on incurring debt. The Company’s primary source of cash is dividends from the Bank and the Bank is restricted under the Bank Supervisory Agreement from paying dividends to the Company without obtaining prior regulatory approval. At December 31, 2010, the Company had $2.0 million in cash and other assets that could readily be turned into cash. The Company anticipates liquidity requirements for 2011 will be similar to the liquidity the $1.3 million in requirements in 2010, except that preferred dividends that were paid in 2010 are not anticipated to be made in 2011 due to the Company’s suspension of these payments beginning with the payment due in the first quarter of 2011. The Company believes that its available liquidity is adequate to provide that its 21 M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S the cash needed for the payment of its operating expenses in 2011. In order to preserve cash at the holding company for potential future needs, the Company suspended the February 15, 2011 regular quarterly cash dividend on the preferred stock issued to the Treasury as part of the TARP Capital Purchase Program. The Company determined to defer such payment following discussions with its primary regulator. In addition, under the terms of the Company’s Supervisory Agreement, the Company may not declare or pay any cash dividends without prior notice to, and consent of, the OTS. The previously authorized stock repurchase program expired on January 26, 2010. No treasury stock purchases were made in 2010 and none are anticipated in 2011 due to (Dollars in thousands) Contractual Obligations: Total borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annual rental commitments under non-cancellable operating in connection with restrictions on stock repurchases by the United States stock Treasury investment in the Company. In addition, under the terms of the Company’s Supervisory Agreement, the Company may not repurchase or redeem any capital stock without prior notice to, and consent of, the OTS. preferred its Contractual Obligations and Commercial Commitments The Company has certain obligations and commitments to make future payments under existing contracts. At December contractual the obligations (excluding bank deposits) and commercial commitments were as follows: aggregate 2010, 31, Payments Due by Period Total Less than 1 Year 1-3 Years 4-5 Years $122,500 52,500 70,000 leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722 546 $123,222 53,046 119 70,119 0 34 34 Other Commercial Commitments: Commercial lines of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments to lend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amount of Commitments -Expiring by Period $22,714 11,761 2,355 $36,830 15,394 4,187 2,354 21,935 4,268 1,807 1 6,076 2,152 281 0 2,433 After 5 Years 0 23 23 900 5,486 0 6,386 “well capitalized”, 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 regulators to categorize requires banking and thrift “adequately institutions as capitalized”, “significantly “undercapitalized”, 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 OTS to meet and maintain a specific capital level for any capital measure. Management believes that, as of December 31, 2010, the Bank met all of the capital requirements to which it was subject and was “well capitalized” based on the regulatory definition described above. Refer to Note 16 of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to its capital requirements. Under the terms of the Company Supervisory Agreement, the Company must submit to the OTS by May 31, 2011 a capital plan through December 31, 2012, upon which the OTS may make comments, and to which it may require revisions. The capital plan must establish a minimum tangible capital ratio of tangible equity capital to total tangible assets commensurate with the Company’s consolidated risk profile. Following approval by the OTS, the Company must operate within the parameters of the capital plan. The Company is also required to monitor and submit periodic reports on its compliance with the plan and to periodically update the plan. In addition, the Bank has been informed by the OTS that it intends to impose an individual minimum capital requirement (“IMCR”) for the Bank. An IMCR requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be “well- capitalized.” The Bank has not been informed by the OTS of the timing or capital levels that may be required. The proposed IMCR is not expected to affect the Bank’s status as “well-capitalized” within the meaning of the applicable capital regulations of the OTS. 22 tax requirements, considerations, Dividends The declaration of dividends is subject to, among other things, the Company’s financial condition and results of the Bank’s compliance with its regulatory operations, capital industry standards, economic conditions, regulatory restrictions, general business practices and other factors. Under the Bank Supervisory Agreement, no dividends can be declared or paid by the Bank to the Company without prior regulatory approval. Refer to Note 15 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 by the Company 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 suspended the dividend payments to common stockholders in the fourth quarter of 2008 due to the net operating loss experienced and the challenging economic environment. The Company has suspended the February 15, 2011 regular quarterly cash dividend on the preferred stock issued to the Treasury as part of the TARP Capital Purchase Program. Under the the terms of the Company may Company Supervisory Agreement, not declare or pay any cash dividends, or purchase or redeem any capital stock, without prior notice to, and consent of, the OTS. The Company does not anticipate requesting consent from the OTS to make any payments of dividends on, or purchase of, its common or preferred stock in 2011. 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 June 2009, the FASB issued SFAS No. 167 (ASC 810), Amendments to FASB Interpretation No. 46(R). This Statement amends FASB 46(R) to require an enterprise to perform an analysis and ongoing reassessments to determine whether the enterprise’s variable interest or interests give it a controlling financial in a variable interest entity and amends certain guidance for determining whether an entity is a variable interest entity. It also requires enhanced disclosures that provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. This Statement is effective as of the beginning of interest 23 each reporting entity’s first annual reporting period that begins after November 15, 2009 and for all interim reporting periods after that and its adoption in 2010 did not have any impact on the Company’s consolidated financial statements as the Company has no interests in any variable interest entities. In June 2009, the FASB issued SFAS No. 166 (ASC 860), Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140. This Statement amends SFAS 140 and removes the concept of a qualifying special-purpose entity from SFAS 140 and eliminates the exception from applying FASB Interpretation No. 46 (revised December 2003) (ASC 810), Consolidation of Variable Interest Entities, on is qualifying special-purpose entities. This Statement effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter and its adoption in 2010 did not have a material impact on the Company’s consolidated financial statements. In January 2010, the Financial Accounting Standards issued ASU 2010-06, Fair Value Board (FASB) Measurements and Disclosures (Topic 820), Improving Disclosures about Fair Value Measurements. This ASU requires new investment fair market disclosures in order to increase the transparency in the financial reporting of investments. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, sales, except issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this ASU in 2010 did not have a material impact financial on statements. about purchases, the Company’s the disclosures consolidated for the FASB issued ASU 2010-20, In July 2010, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance losses and the credit quality of financing for credit receivables. The requirements are intended to enhance losses and the credit transparency regarding credit quality of this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled loan and lease receivables. Under receivables financing impaired M A N A G E M E N T D I S C U S S I O N A N D A N A L Y S I S debt restructurings were also required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for after December 15, 2010 and the related disclosures are included in the Company’s notes to the consolidated financial statements. interim and reporting periods annual In January 2011, the FASB issued ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. The amendments temporarily delay the effective date of the restructurings in ASU disclosures about troubled debt No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses for public entities. The delay is intended to allow the Board time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new troubled debt restructurings for public disclosures about entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Market Risk 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. is affected profitability The Company’s rates may adversely impact by fluctuations in interest rates. A sudden and substantial the change in interest 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/ this Management’s Liability Management section of the Company’s Discussion and Analysis discloses projected changes in net income based upon immediate interest rate changes called rate shocks. interest that uses The Company utilizes a model the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest- earning assets and interest-bearing liabilities under different interest rate changes. The following table discloses the projected changes in market value to the Company’s interest-earning assets and incremental interest-bearing 100 basis point changes in interest rates from interest rates in effect on December 31, 2010. liabilities based upon (Dollars in thousands) Basis point change in interest rates Total market-risk sensitive assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $874,747 812,838 Total market-risk sensitive liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Off-balance sheet financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (117) Net market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 62,026 -100 Market Value 0 861,314 803,127 0 58,187 +100 847,276 790,643 252 56,381 +200 830,561 776,801 480 53,280 Percentage change from current market value . . . . . . . . . . . . . . . . . . . . . . . . . 6.60% 0.00% (3.10)% (8.43)% assumptions and decay ratios The preceding table was prepared utilizing the (the Model Assumptions) following regarding prepayment 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 7% and 71%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 12% and 34%, depending on the note rate and the period to maturity. Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of between 9% and 45% depending on the note rate and the period to maturity. Mortgage-backed securities and (CMOs) were Collateralized Mortgage Obligations the upon prepayments have projected underlying collateral securing the instrument and the based to 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 annual rates of 21% and 23%, respectively. Non-interest checking and NOW accounts were assumed to decay at annual rates of 16% and 17%, respectively. Commercial NOW and MMDA accounts were assumed to decay at annual rates of 17% and 23%, respectively. 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 11 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 24 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 or floors could be different from the values calculated in the table. Certain liabilities, such as certificates of deposit, have fixed rates that restrict interest rate changes until maturity. 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 increase in interest rates. Asset/Liability Management that The Company’s management reviews the impact interest changing interest rates will have on the net income projected for following December 31, 2010 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on net interest income during the 12 month period ending December 31, 2011 of immediate interest rate changes called rate shocks: the twelve months (Dollars in thousands) Rate Shock Table Rate Shock in Basis Points +200 +100 0 -100 Net Interest Change $160 328 0 (694) Percent Change 0.53 1.09 0.00 (2.31) 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. The increase in interest income in a rising rate environment is because there are more adjustable rate loans that would reprice to higher interest rates in the next twelve months than there are certificates of deposit that would reprice. 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 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. and oversees strategies the In managing its asset/liability mix, the Bank may, at times, depending on the relationship between long and short-term interest rates, market conditions and consumer preference, 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 income resulting from a mismatch in the net maturity of its asset and liability portfolios can, in certain situations, provide high enough returns to justify the increased exposure to sudden and unexpected changes in interest rates. interest To the extent consistent with its interest rate spread objectives, the Bank attempts to manage 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. In the past, more fixed rate loans were placed into the single family loan portfolio. In 2010, the Bank has primarily focused its fixed rate one-to-four lending program on loans that are family residential saleable to third parties and generally placed only those fixed rate loans that met certain risk characteristics into its loan portfolio. The Bank’s commercial loan production continued to be primarily in adjustable rate loans with minimum interest rate floors; however, more of these loans were structured to reprice every one, two, or three years. In addition, the duration of the Bank’s certificates of deposits that were issued in 2010 were lengthened in order to manage the Company’s interest rate risk exposure. Off-Balance Sheet Arrangements The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business which are more fully the Notes to Consolidated discussed in Note 17 of Financial Statements. 25 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 (Dollars in thousands) A S S E T S Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related securities (amortized cost $32,036 and $51,840) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities (amortized cost $118,631 and $105,723) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax assets, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . . . . . Accrued interest payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Customer escrows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments and contingencies Stockholders’ equity: Serial preferred stock: ($.01 par value) 2010 2009 $ 20,981 16,418 33,506 53,559 118,058 151,564 2,728 664,241 3,311 16,382 6,743 1,586 9,450 3,632 0 $880,618 $683,230 122,500 1,092 818 3,431 811,071 106,043 159,602 2,965 799,256 4,024 16,257 7,286 1,315 10,766 6,762 11,590 1,036,241 796,011 132,500 2,108 1,427 4,257 936,303 Authorized 500,000 shares; issued shares 26,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,264 23,785 Common stock ($.01 par value): Authorized 11,000,000; issued shares 9,128,662 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings, subject to certain restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned employee stock ownership plan shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost 4,818,263 and 4,883,378 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 56,420 55,838 541 (3,384) (64,223) 69,547 $880,618 91 58,576 86,115 1,230 (3,577) (66,282) 99,938 1,036,241 See accompanying notes to consolidated financial statements. 26 C O N S O L I D A T E D S T A T E M E N T S O F L O S S Years ended December 31 (Dollars in thousands) 2010 2009 2008 Interest income: Loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances and Federal Reserve borrowings . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income (loss) after provision for loan losses . . . . . . . . . . . . Non-interest income: Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense: Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses (gains) on real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill impairment charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . Basic loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,248 51,876 58,671 1,813 2,023 4 182 48,270 11,281 5,978 17,259 31,011 33,381 (2,370) 3,741 1,067 0 1,987 476 7,271 13,516 1,165 4,082 1,933 1,040 0 5,820 27,556 (22,655) 6,323 $(28,978) (1,784) $(30,762) $ $ (8.17) (8.17) 2,768 3,039 1 87 57,771 17,579 6,289 23,868 33,903 26,699 7,204 4,137 1,042 5 2,273 625 8,082 13,432 3,873 4,084 1,973 1,182 0 7,145 31,689 (16,403) (5,607) (10,796) (1,747) (12,543) (3.39) (3.39) 1,615 5,775 198 253 66,512 27,157 5,639 32,796 33,716 26,696 7,020 4,269 955 479 651 749 7,103 12,464 (187) 4,521 678 1,731 3,801 6,226 29,234 (15,111) (4,984) (10,127) (37) (10,164) (2.78) (2.78) See accompanying notes to consolidated financial statements. 27 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 A N D C O M P R E H E N S I V E L O S S (Dollars in thousands) Balance, December 31, 2007 . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive loss, net of tax: Net unrealized gains on securities available for sale . . . . Total comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . Preferred stock and warrant issued . . . . . . . . . . . . . . . . . Treasury stock purchases . . . . . . . . . . . . . . . . . . . . . . . Unearned compensation restricted stock awards . . . . . . . . . Restricted stock awards forfeited . . . . . . . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . Earned employee stock ownership plan shares. . . . . . . . . . Common stock dividends paid . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive loss, net of tax: Net unrealized losses on securities available for sale . . . . Total comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . Preferred stock discount amortization . . . . . . . . . . . . . . . Unearned compensation restricted stock awards . . . . . . . . . Restricted stock awards forfeited . . . . . . . . . . . . . . . . . . Restricted stock awards dividend forfeited . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . Earned employee stock ownership plan shares. . . . . . . . . . Preferred stock dividends paid . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive loss, net of tax: Net unrealized losses on securities available for sale . . Total comprehensive loss . . . . . . . . . . . . . . . . . . . . . . Preferred stock discount amortization . . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . . . . . . . . . . Unearned compensation restricted stock awards . . . . . . Restricted stock awards forfeited . . . . . . . . . . . . . . . . . Restricted stock awards dividend forfeited . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . Earned employee stock ownership plan shares . . . . . . . . Preferred stock dividends paid . . . . . . . . . . . . . . . . . . Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . Preferred Stock Common Stock Additional Paid-in Capital $ 0 91 58,049 Retained Earnings 110,943 (10,127) Accumulated Other Comprehensive Income (Loss) Unearned Employee Stock Ownership Plan Treasury Stock 1,167 (3,965) (68,157) Total Stock- holders’ Equity 98,128 (10,127) 23,384 2,616 (550) 6 33 415 118 $23,384 91 60,687 924 194 2,091 (3,771) (2,749) 98,067 (10,796) (861) (723) 550 (6) 924 (9,203) 26,000 (723) 0 0 33 415 312 (2,749) (68,336) 112,213 (10,796) 401 (401) (2,181) 127 27 373 (56) $23,785 91 58,576 479 (479) 63 (2,237) 178 370 (51) $24,264 91 56,420 7 (1,163) 86,115 (28,978) 1 (1,300) 55,838 2,181 (127) 194 1,230 (3,577) (66,282) (689) 2,237 (178) 193 541 (3,384) (64,223) (861) (11,657) 0 0 0 7 27 373 138 (1,163) 99,938 (28,978) (689) (29,667) 0 63 0 0 1 370 142 (1,300) 69,547 See accompanying notes to consolidated financial statements. 28 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 (Dollars in thousands) Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net loss to cash provided by operating activities: Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for real estate losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of premiums, net Amortization of deferred loan fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capitalized mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of real estate and premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Disbursements on loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earned ESOP shares priced above (below) original cost . . . . . . . . . . . . . . . . . . . . . Stock option compensation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill impairment charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Redemption of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of real estate and premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net (increase) decrease in loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Decrease in deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid to preferred stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock and warrant issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in customer escrows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash (used) provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental cash flow disclosures: Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental noncash flow disclosures: Loans transferred to loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer of loans to real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 2009 2008 $ (28,978) (10,796) (10,127) 33,381 1,873 1,593 571 (319) 482 (753) 12,043 0 (708) (1,987) 90,797 (85,384) 370 193 (51) 63 713 (1,016) 0 3,084 (774) 362 25,555 0 19,820 115,000 (128,059) (2,420) 2,963 14,532 82,591 (292) 104,135 (113,218) 0 0 (1,300) 0 87,000 (97,000) (609) (125,127) 4,563 16,418 $ 20,981 $ 18,275 39 3,195 16,167 26,699 4,877 1,837 465 (972) 556 (1,143) (2,516) (5) (1,146) (2,273) 122,491 (119,475) 373 194 (56) 27 1,544 (4,199) 0 (2,041) 912 95 15,448 2,141 22,213 78,350 (88,446) 0 0 10,749 56,329 (558) 80,778 (85,162) 0 0 (1,163) 0 1,099,000 (1,109,000) 788 (95,537) 689 15,729 16,418 28,067 33 1,234 18,342 26,696 0 1,796 672 (808) 570 (28) (4,568) (479) (187) (651) 60,566 (56,925) 415 194 118 33 1,326 (3,207) 3,801 (2,761) (4,618) 34 11,862 10,442 7,246 110,000 (114,405) (7,180) 6,092 6,563 (78,654) (3,772) (63,668) (8,484) (723) (2,749) 0 26,000 631,300 (601,300) (227) 43,817 (7,989) 23,718 15,729 36,003 5,247 2,238 14,727 See accompanying notes to consolidated financial statements. 29 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 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, 2010, 2009 and 2008 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 and loan production facilities in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud Insurance (OIA), which offers financial planning Agency, products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC), which acts as an intermediary for the Bank in completing certain real estate transactions. Inc. The consolidated financial statements included herein are for HMN, SFC, the Bank and OIA. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company evaluated subsequent events through the filing date of our annual 10-K with the Securities and Exchange Commission on March 4, 2011. Use of Estimates In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. the date of An estimate that is particularly susceptible to change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate to cover probable losses inherent in the portfolio at 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 and other factors. 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. Cash and Cash Equivalents The Company considers highly liquid investments with original maturities of three months or less to be cash equivalents. Securities Securities are accounted for according to their purpose 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 and a new cost basis is established. are reported as 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 rates, changes in prepayment risk, or similar income factors. Unrealized gains and losses, net of taxes, component of a 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. separate the investment Management monitors security portfolio for impairment on an individual security basis and has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves analyzing the length of time and extent to which the fair value has been less than the amortized cost basis, liquidity for the security, the financial condition and near-term prospects of the issuer, expected cash flows, and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the temporary loss, including determining whether it is more-likely-than-not that the Company will be required to sell the security prior to recovery. To the extent it is determined that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. the market 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 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 on the sale of loans are recognized on the settlement date. Net unrealized losses are recognized through a valuation allowance by charges to income. 30 Loans Receivable, net Loans receivable, net 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 purchased loans are amortized into interest income using the interest method over the period to contractual maturity, adjusted for estimated prepayments. the allowance for 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. 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, demand for single family homes, demand for commercial real estate and building lots, loan portfolio composition and historical experience. In connection with loan losses, the determination of independent for obtains management properties significant securing other or delinquent loan losses is loans. The allowance for 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. appraisals collateral Interest income is recognized on an accrual basis except when collectability 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 on non-accrual, delinquent as to principal and interest for 90 days or greater or restructured in a troubled debt restructuring involving a modification of terms. All for loans impairment on an individual basis. non-accruing reviewed are Mortgage Servicing Rights Mortgage servicing rights are capitalized at fair value 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 foreclosure is 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- for lived assets and certain identifiable intangibles impairment in changes circumstances indicate that the carrying amount of an asset may not be recoverable. whenever events or Investment in Limited Partnerships The Company has investments in limited partnerships that invested in low to moderate income housing projects that generated 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 ASC 350, 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 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 value of these assets annually or whenever an event occurs indicating that they may be impaired. During 2008, HMN’s to book value. stock traded at a substantial discount Therefore, an analysis was performed and it was determined that the carrying value of goodwill was impaired and the entire goodwill amount of $3.8 million was charged off. Stock Based Compensation The Company recognizes the grant-date fair value of stock option awards issued as compensation expense. Employee Stock Ownership Plan (ESOP) The Company has an ESOP that borrowed funds from the Company and purchased shares of HMN common stock. The Company makes quarterly principal and interest payments on the ESOP loan. As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral and allocated to eligible employees based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with ASC 718, 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. 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. A valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax asset is subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Preferred Stock Dividends and Discount The proceeds received from the preferred stock and warrant issued to the U.S. Treasury were allocated between the preferred stock and the warrant based on their relative fair values at the time of issuance in accordance with the requirements of ASC 470, Accounting for Convertible Debt Issued with Stock Purchase Warrants. Because of the increasing rate dividend feature of the preferred shares, the discount on the warrant is amortized using the constant effective yield method over five year period preceding the scheduled rate increase on the preferred stock in accordance with the requirements of ASC 505. the Loss per Share Basic loss per common share excludes dilution and is computed by dividing the loss available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted loss per common share 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. Options and restricted stock awards are excluded from the loss per share calculation when a net loss is incurred as their inclusion in the calculation would be anti-dilutive and result in a lower loss per common share. Comprehensive Income (Loss) Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income (loss) is the total of net loss and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. an enterprise’s 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 financial statements and allocations of revenues, expenses and gains or losses are included in determining reported segment profit or 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. general-purpose loss if New Accounting Pronouncements In June 2009, the FASB issued SFAS No. 167 (ASC 810), Amendments to FASB Interpretation No. 46(R). This Statement amends FASB 46(R) to require an enterprise to perform an analysis and ongoing reassessments to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity and amends certain guidance for determining whether an entity is a variable interest entity. It also requires enhanced disclosures that provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. This Statement is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 32 statements as 2009 and for all interim reporting periods after that and its adoption in 2010 did not have any impact on the the Company’s consolidated financial Company has no interests in any variable interest entities. In June 2009, the FASB issued SFAS No. 166 (ASC 860), Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140. This Statement amends SFAS 140 and removes the concept of a qualifying special-purpose entity from SFAS 140 and eliminates the exception from applying FASB Interpretation No. 46 (revised December 2003) (ASC 810), Consolidation of Variable Interest Entities, on qualifying special-purpose entities. This Statement is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter and its adoption in 2010 did not have a material impact on the Company’s consolidated financial statements. Fair about reporting of Improving Disclosures In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, Fair Value Measurements and Disclosures (Topic Value 820), Measurements. This ASU requires new investment fair market disclosures in order to increase the transparency in the financial investments. The new disclosures and clarifications of existing disclosures are reporting periods effective for the beginning after December 15, 2009, except disclosures and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this ASU in 2010 did not have a material impact on the Company’s consolidated financial statements. for issuances, interim and annual about purchases, sales, the FASB issued ASU 2010-20, In July 2010, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance losses and the credit transparency regarding credit this quality of loan and lease receivables. Under impaired financing receivables statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality and information, nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings were also required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective after for December 15, 2010 and the related disclosures are included in Note 5 in the Company’s notes to the consolidated financial statements. interim and reporting periods annual In January 2011, the FASB issued ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. The amendments temporarily delay the effective date of the disclosures about troubled debt restructurings in ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses for public entities. The delay is intended to allow the Board time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of troubled debt restructurings for public entities and the guidance for debt a constitutes determining what restructuring will then be coordinated. the new disclosures troubled about 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 from time to time use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments. Reclassifications Certain amounts in the consolidated financial been reclassified to conform with the current year presentation. statements years prior have for NOTE 2 Other Comprehensive Income (Loss) The components of other comprehensive income (loss) and the related tax effects were as follows: For the Years Ended December 31, (Dollars in thousands) Securities available for sale: 2010 Tax Effect Before Tax Net of Tax Before Tax Gross unrealized gains (losses) arising during the period . . . . . . . . . . . $(1,142) 0 Less reclassification of net gains included in net gain (loss) . . . . . . . . . (1,142) Net unrealized gains (losses) arising during the period . . . . . . . . . . . . Other comprehensive income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . $(1,142) (453) 0 (453) (453) (689) 0 (689) (689) (1,490) 5 (1,495) (1,495) 2009 Tax Effect (632) 2 (634) (634) Net of Tax Before Tax 3 (858) 2,040 479 (861) 1,561 (861) 1,561 2008 Tax Effect 806 169 637 637 Net of Tax 1,234 310 924 924 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 3 Securities Available for Sale A summary of securities available for sale at December 31, 2010 and 2009 is as follows: (Dollars in thousands) December 31, 2010: Mortgage-backed securities: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,555 12,800 Collateralized mortgage obligations: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities: U.S. Government agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,299 382 32,036 117,931 700 118,631 $150,667 December 31, 2009: Mortgage-backed securities: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,209 19,399 Collateralized mortgage obligations: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities: U.S. Government agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,846 386 51,840 105,023 700 105,723 $157,563 719 692 44 15 1,470 218 0 218 1,688 933 796 137 12 1,878 881 0 881 2,759 0 0 0 0 0 (266) (525) (791) (791) 0 0 (159) 0 (159) (36) (525) (561) (720) Fair Value 18,274 13,492 1,343 397 33,506 117,883 175 118,058 151,564 27,142 20,195 5,824 398 53,559 105,868 175 106,043 159,602 losses on investments. Proceeds The Company did not sell any available for sale securities during 2010 and did not recognize any gains or from securities sale which were sold in 2009 were available for $2.1 million resulting in gross gains of $5,000. Proceeds from securities available for sale which were sold during 2008 were $10.4 million resulting in gross gains of $479,000. The following table presents amortized cost and estimated fair value of securities available for sale at December 31, 2010 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: (Dollars in thousands) Due less than one year . . . . . . . . . . . . . . . . . Due after one year through five years . . . . . . . Due after five years through ten years. . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortized Cost $131,431 17,176 1,360 700 $150,667 Fair Value 131,995 17,970 1,424 175 151,564 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. 34 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, 2010 and 2009: (Dollars in thousands) December 31, 2010 Other marketable 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 U.S. Government agency obligations . . . . . . . Corporate preferred stock . . . . . . . . . . . . . . Total temporarily impaired securities . . . . . . . . . 10 0 10 $47,610 0 $47,610 (266) 0 (266) 0 1 1 $ 0 175 $175 0 (525) (525) $47,610 175 $47,785 (266) (525) (791) (Dollars in thousands) December 31, 2009 Collateralized mortgage obligations: 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 FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities: U.S. Government agency obligations . . . . . . . . . . Corporate preferred stock . . . . . . . . . . . . . . . . . Total temporarily impaired securities . . . . . . . . . . . 1 6 0 7 $ 1,248 30,000 0 $31,248 (159) (36) 0 (195) 0 0 1 1 $ 0 0 175 $175 0 $ 1,248 0 (525) (525) 30,000 175 $31,423 (159) (36) (525) (720) We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the financial condition and near-term the investment, prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss. The unrealized losses on collateralized mortgage and agency obligations are primarily due to changes in interest rates and were not determined to be other-than-temporary. Mortgage backed securities in the table above had an average life of less than three years and the other marketable securities had an average life of less than one year at December 31, 2010. The unrealized losses reported for corporate preferred stock at December 31, 2010 relates to a single trust issued by the holding preferred security that was company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In October 2009, the issuer elected to defer its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses due to increased provisions for loan losses and meets the regulatory requirements to be considered “adequately capitalized” based on its most recent regulatory filing. In addition, the owners of the issuing bank appear to have the ability to make additional capital contributions to enhance the bank’s capital position. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at December 31, 2010. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time to recover the temporary loss. Management sufficient believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities and the deferral of interest by the issuer. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods. 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 4 Loans Receivable, Net A summary of loans receivable at December 31 is as follows: (Dollars in thousands) Residential real estate loans: 2010 2009 1-4 family conventional . . . . . . . . . . . . . . $128,087 399 1-4 family FHA . . . . . . . . . . . . . . . . . . . 49 1-4 family VA . . . . . . . . . . . . . . . . . . . . 144,368 212 51 128,535 144,631 Commercial real estate: Lodging . . . . . . . . . . . . . . . . . . . . . . . . Retail/office . . . . . . . . . . . . . . . . . . . . . . Nursing home/health care . . . . . . . . . . . . . Land developments . . . . . . . . . . . . . . . . . Golf courses. . . . . . . . . . . . . . . . . . . . . . Restaurant/bar/café . . . . . . . . . . . . . . . . . Alternative fuel plants . . . . . . . . . . . . . . . Warehouse . . . . . . . . . . . . . . . . . . . . . . . Construction: 1-4 family builder . . . . . . . . . . . . . . . . Multi family . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . Manufacturing . . . . . . . . . . . . . . . . . . . . Churches/community service . . . . . . . . . . . Multi family. . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer: Autos . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity line . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . Consumer – secured . . . . . . . . . . . . . . . . . Land/lot loans . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . Mobile home . . . . . . . . . . . . . . . . . . . . . Consumer – unsecured . . . . . . . . . . . . . . . 34,447 86,768 5,512 72,810 8,161 2,684 31,123 17,197 10,684 3,874 693 8,538 6,132 48,266 19,502 37,732 65,209 5,841 84,594 10,477 4,501 42,053 29,733 14,562 9,678 16,172 10,315 4,369 59,266 17,890 356,391 412,392 604 44,933 17,840 1,304 2,510 534 764 2,114 70,603 902 50,369 21,088 1,083 3,190 324 977 4,282 82,215 Commercial business. . . . . . . . . . . . . . . . . . 153,039 185,525 Total loans . . . . . . . . . . . . . . . . . . . . . 708,568 824,763 Less: Unamortized premiums . . . . . . . . . . . . . . Net deferred loan fees . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . 413 1,086 42,828 Total loans receivable, net . . . . . . . . $664,241 177 1,518 23,812 799,256 Commitments to originate or purchase loans . . $ Commitments to deliver loans to secondary 629 7,330 market . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,413 6,278 Weighted average contractual rate of loans in portfolio . . . . . . . . . . . . . . . . . . . . . . . . 5.52% 5.78% are rate fixed loans Included in total commitments to originate or aggregating purchase $0.6 million and $3.3 million as of December 31, 2010 and 2009, respectively. The interest rates on these loan commitments 5.13% at December 31, 2010 and from 4.00% to 5.25% at December 31, 2009. from 3.88% to ranged loans The aggregate amounts of loans to executive officers and directors of the Company was $4.1 million at each of December 31, 2010, 2009 and 2008. During 2010, the only activity was $12,000 in repayments on loans to executive officers and directors. During 2009, repayments on loans to executive officers and directors were $3,000, new loans to executive officers and directors totaled $573,000 and sales of executive officer and director loans were $473,000. 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. At December 31, 2010, 2009 and 2008, the Company was servicing loans for others with aggregate unpaid principal balances of approximately $508.0 million, $566.0 million and $557.7 million, respectively. The Company originates residential, commercial real estate and other loans primarily in Minnesota and Iowa. At December 31, 2010 and 2009, the Company had in its portfolio single-family and multi-family residential loans located in the following states: 2010 2009 (Dollars in thousands) Amount Iowa. . . . . . . . . . . . Minnesota . . . . . . . . Wisconsin . . . . . . . . Other states . . . . . . . Total . . . . . . . . . . $ 4,684 118,305 1,879 3,667 $128,535 Percent of Total Amount 3.6% $ 92.0 1.5 2.9 5,840 132,775 2,241 3,775 100.0% $144,631 Percent of Total 4.0% 91.9 1.5 2.6 100.0% Amounts under one million dollars in both years are included in “Other states”. At December 31, 2010 and 2009, the Company had in its portfolio commercial real estate loans located in the following states: (Dollars in thousands) Amount Percent of Total Amount Percent of Total 2010 2009 Arizona . . . . . . . . . California . . . . . . . . Florida . . . . . . . . . . Idaho . . . . . . . . . . . Indiana . . . . . . . . . . Iowa. . . . . . . . . . . . Kansas . . . . . . . . . . Minnesota . . . . . . . . Nebraska. . . . . . . . . North Carolina . . . . . Tennessee . . . . . . . . Utah. . . . . . . . . . . . Wisconsin . . . . . . . . Other states . . . . . . . Total . . . . . . . . . . $ 0 4,916 2,855 4,483 7,694 11,160 1,064 303,101 4,994 7,303 1,700 1,414 5,087 620 $356,391 0.0% $ 1.4 0.8 1.3 2.2 3.1 0.3 85.0 1.4 2.0 0.5 0.4 1.4 0.2 6,691 4,662 2,908 5,040 11,692 15,853 1,855 342,935 4,992 7,512 0 1,727 5,589 936 100.0% $412,392 1.6% 1.1 0.7 1.2 2.8 3.9 0.5 83.2 1.2 1.8 0.0 0.4 1.4 0.2 100.0% Amounts under one million dollars in both years are included in “Other states”. 36 NOTE 5 Allowance for Loan Losses and Credit Quality Information The allowance for loan losses is summarized as follows: (Dollars in thousands) Commercial Real Estate 1-4 Family Consumer Commercial Business Total Balance, December 31, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 417 2,491 (78) 0 2,830 (1,753) (82) 5 1,000 1,399 (254) 0 2,145 7,724 8,811 (3,454) 14 13,095 14,217 (13,548) 565 14,329 16,692 (7,095) 664 24,590 1,441 719 (612) 37 1,585 1,451 (1,980) 222 1,278 481 (907) 72 924 2,856 14,675 (13,784) 0 3,747 12,784 (9,421) 95 7,205 14,809 (7,006) 161 15,169 12,438 26,696 (17,928) 51 21,257 26,699 (25,031) 887 23,812 33,381 (15,262) 897 42,828 Allocated to: Specific reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ General reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 993 1,152 2,145 13,263 11,327 24,590 76 848 924 10,702 4,467 15,169 25,034 17,794 42,828 Loans receivable at December 31, 2009: Individually reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,740 Collectively reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,891 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $144,631 41,438 370,954 412,392 Loans receivable at December 31, 2010: 6,729 Individually reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Collectively reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121,806 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $128,535 45,077 311,314 356,391 4,412 77,803 82,215 299 70,304 70,603 17,787 167,738 185,525 66,377 758,386 824,763 26,855 126,184 153,039 78,960 629,608 708,568 The following table summarizes the amount of classified and unclassified loans at December 31: (Dollars in thousands) 2010 2009 Classified Unclassified Total Classified Unclassified Total 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,623 Commercial real estate: 112,912 128,535 6,117 138,514 144,631 Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,888 11,069 12,882 44,218 20,054 225,280 87,106 31,123 238,162 34,735 19,473 20,308 66,678 22,580 248,618 101,413 42,053 268,926 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 70,297 70,603 4,413 77,802 82,215 6,683 8,223 20,468 $118,142 5,117 5,830 106,718 590,426 11,800 6,656 14,053 8,233 127,186 30,850 708,568 130,785 8,348 5,958 125,480 693,978 15,004 14,191 156,330 824,763 Classified loans represent substandard and non- performing loans. Loans classified substandard are loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. 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 The aging of past due loans at December 31 are summarized as follows: (Dollars in thousands) 30-59 Days Past Due 60-89 Days Past Due 90 Days or More Past Due Total Past Due Current Loans Total Loans Loans 90 Days or More Past Due and Still Accruing 2010 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,313 Commercial real estate: 695 3,500 6,508 122,027 128,535 178 Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444 0 75 446 0 0 311 $3,589 3,899 0 264 163 0 0 45 5,066 15,523 4,994 3,914 19,866 4,994 4,253 67,240 26,129 233,909 87,106 31,123 238,162 207 816 69,787 70,603 4,809 8,223 7,876 49,046 4,809 8,223 8,232 57,701 6,991 5,830 118,954 650,867 11,800 14,053 127,186 708,568 2009 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,705 Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,161 0 465 736 1,720 4,161 140,470 144,631 1,109 0 674 13,425 12,492 6,734 19,695 12,492 7,873 81,718 101,413 42,053 29,561 268,926 261,053 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414 500 3,853 4,767 77,448 82,215 0 0 50 $7,795 1,802 0 0 4,821 773 0 8,960 47,957 2,575 0 9,010 60,573 12,429 14,191 147,320 764,190 15,004 14,191 156,330 824,763 0 0 0 0 0 0 576 754 0 886 0 0 0 0 0 100 986 38 Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring. The following table summarizes impaired loans and related allowances for the years ended December 31, 2010 and 2009: (Dollars in thousands) Loans with no related allowance recorded: December 31, 2010 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Commercial real estate: 932 932 Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,486 0 119 104 99 0 397 6,486 0 119 104 99 0 397 0 0 0 0 0 0 0 0 721 8,674 148 3,356 1,354 793 0 1,293 Loans with an allowance recorded: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,797 5,797 994 3,207 27,147 4,994 6,331 195 4,809 8,223 13,327 27,147 4,994 7,287 195 4,809 8,223 13,878 9,673 2,441 1,148 76 2,668 4,985 3,049 16,720 7,993 5,812 571 3,937 7,232 12,154 Total: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,729 6,729 994 3,928 33,633 4,994 6,450 299 4,908 8,223 13,724 $78,960 33,633 4,994 7,406 299 4,908 8,223 14,275 80,467 9,673 2,441 1,148 76 2,668 4,985 3,049 25,034 25,394 8,141 9,168 1,925 4,730 7,232 13,447 73,965 28 220 0 4 7 5 0 5 272 557 0 156 13 0 0 478 300 777 0 160 20 5 0 483 1,745 39 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, 2009 Loans with no related allowance recorded: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 237 237 7,953 342 5,778 3,252 984 0 1,078 7,953 342 5,778 3,252 984 0 1,078 0 0 0 0 0 0 0 0 672 3,209 2,169 5,537 2,733 204 0 4,008 Loans with an allowance recorded: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,503 2,503 487 2,941 11,407 12,492 3,466 1,160 2,597 3,248 9,880 11,407 12,492 4,421 1,160 2,597 3,248 9,880 4,414 2,635 625 517 375 1,000 2,005 13,616 10,495 4,842 2,356 1,163 650 6,839 Total 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,740 2,740 487 3,613 19,360 12,834 9,244 4,412 3,581 3,248 10,958 $66,377 19,360 12,834 10,199 4,412 3,581 3,248 10,958 67,332 4,414 2,635 625 517 375 1,000 2,005 12,058 16,825 12,664 10,379 5,089 1,367 650 10,847 61,434 9 333 0 51 7 0 0 121 118 159 0 68 53 139 212 30 127 492 0 119 60 139 212 151 1,300 and losses was $15.3 million $61.1 million for which the $68.1 million, respectively, loan At December 31, 2010, 2009 and 2008, non-accruing and totaled loans related $64.2 million, $25.0 million, allowance for $12.1 million and $10.2 million, respectively. Non- accruing loans for which no specific allowance has been recorded because management determined that the value of to repay the loan totaled the collateral was sufficient $8.1 million, $19.3 million, respectively. Had the loans performed in accordance the Company would have with their original recorded gross loans of income on the $5.0 million, $5.0 million and $5.5 million in 2010, the years ended 2009 and 2008, respectively. For the Company December 31, 2010, 2009 and 2008, recognized of loans $1.3 million, $0.9 million and $1.9 million, respectively. All of the interest income that was recognized for non- accruing loans was recognized using the cash basis method of income recognition. Non-accrual loans also include some of the loans that have had terms modified in a troubled debt restructuring. interest income interest terms, these on The non-accrual summarized as follows: loans at December 31 are (Dollars in thousands) 2010 2009 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,844 Commercial real estate: $ 2,132 Residential developments . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,980 4,994 5,763 224 4,907 8,223 13,139 15,105 12,835 9,182 4,086 3,581 3,248 10,958 $68,074 $61,127 At December 31, 2010, there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $19.3 million. Had these loans been performing in accordance with their the Company would original have recorded gross interest income of $1.2 million. During 2010, the Company recorded gross interest income of $0.8 million on these loans. For the loans that were restructured in 2010, $75,000 were performing, terms throughout 2010, 40 $10.8 million were classified but performing and $8.4 million were non-performing at December 31. At there were loans of December 31, 2009 and 2008, $5.3 million and $8.2 million, respectively, included in loans receivable, net, with terms that had been modified in a troubled debt restructuring. The following table summarizes troubled debt restructurings for the years ended December 31: (Dollars in thousands) 2010 Commercial real estate . . . . . . . . . . . . . . . . . . . . . $14,871 1,756 Commercial business. . . . . . . . . . . . . . . . . . . . . . . 2,589 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Land/lot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 4,315 0 610 132 251 19 $19,291 5,327 There were no material commitments to lend loans were additional restructured or classified as nonaccrual at December 31, 2010 or December 31, 2009. to customers whose funds NOTE 6 Accrued Interest Receivable Accrued interest receivable at December 31 is summarized as follows: (Dollars in thousands) 2010 2009 Securities available for sale . . . . . . . . . . . . . . . . . . . $ 626 2,685 Loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 916 3,108 All of the single family loans sold where the Company continues to service the loans are 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, 2010: (Dollars in thousands) Loan Principal Balance Weighted Average Interest Rate Weighted Average Remaining Term (months) Original term 30 year fixed rate . . . . . . . . $222,725 Original term 15 year fixed rate . . . . . . . . Adjustable rate . . . . . . 102,799 654 5.25% 4.69 3.11 301 124 266 Number of Loans 1,919 1,523 8 The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at December 31, 2010 and 2009 are presented in the following table. Amortization expense for mortgage servicing rights was $0.5 million and $0.6 million for the years ended December 31, 2010 and 2009. (Dollars in thousands) December 31, 2010 Mortgage servicing rights . . Total . . . . . . . . . . . . . . . December 31, 2009 Mortgage servicing rights . . . Total . . . . . . . . . . . . . . . Gross Carrying Amount $4,172 $4,172 $4,172 $4,172 Accumulated Amortization Unamortized Intangible Assets (2,586) (2,586) (2,857) (2,857) 1,586 1,586 1,315 1,315 $3,311 4,024 The following table indicates the estimated future amortization expense for amortized intangible assets: NOTE 7 Mortgage Servicing Rights, Net A summary of mortgage servicing activity is as follows: (Dollars in thousands) Mortgage servicing rights: 2010 2009 Balance, beginning of year . . . . . . . . . . . . $1,315 753 Originations . . . . . . . . . . . . . . . . . . . . . . (482) Amortization . . . . . . . . . . . . . . . . . . . . . $ 728 1,143 (556) Balance, end of year . . . . . . . . . . . . . . . . 1,586 1,315 Valuation reserve . . . . . . . . . . . . . . . . . . 0 0 Mortgage servicing rights, net. . . . . . . . . . $1,586 $1,315 Fair value of mortgage servicing rights . . . $2,263 $2,138 (Dollars in thousands) Year Ended December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage Servicing Rights $ 349 313 294 263 216 151 $1,586 Projections of amortization are based on asset balances and the interest rate environment that existed at December 31, 2010. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions. 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 8 Real Estate NOTE 9 Premises and Equipment A summary of real estate at December 31 is as A summary of premises and equipment at December follows: (Dollars in thousands) Real estate in judgment subject to redemption . . . . . Real estate acquired through foreclosure . . . . . . . . . Real estate acquired through deed in lieu of foreclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate acquired in satisfaction of debt . . . . . . . . Allowance for losses . . . . . . . . . . . . . . . . . . . . . . 2010 2009 $ 333 14,718 1,637 12,666 5,682 106 6,725 106 20,839 (4,457) 21,134 (4,877) $16,382 16,257 31 is as follows: (Dollars in thousands) 2010 2009 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office buildings and improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment $ 2,070 9,199 12,985 2,070 9,148 12,796 Accumulated depreciation. . . . . . . . . . . . . . . . . . 24,254 (14,804) 24,014 (13,248) $ 9,450 10,766 NOTE 10 Deposits Deposits and their weighted average interest rates at December 31 are summarized as follows: (Dollars in thousands) Noninterest checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates: 0-0.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-1.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-2.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-3.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-4.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-5.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, 2010 and 2009, the Company had $256.3 million and $254.2 million, respectively, of deposit accounts with balances of $100,000 or more. At December 31, 2010 and 2009, the Company had certificate $107.5 million and $211.0 million of accounts, respectively, that had been acquired through a (Dollars in thousands) Remaining term to maturity 2010 2009 Weighted Average Rate Amount Percent of Total Weighted Average Rate Amount Percent of Total 0.00% $ 96,581 94,205 0.11 33,973 0.15 114,357 0.75 339,116 14.1% 0.00% $ 80,330 13.8 103,998 5.0 31,068 16.7 125,008 49.6 340,404 0.08 0.13 1.25 41,311 142,742 105,126 50,529 4,113 293 344,114 $683,230 6.1 20.9 15.4 7.4 0.6 0.0 50.4 2.81 100.0% 1.82 16,615 113,916 135,311 138,152 47,692 3,921 455,607 $796,011 2.07 1.20 10.1% 13.0 3.9 15.7 42.7 2.1 14.3 17.0 17.4 6.0 0.5 57.3 100.0% broker. Based on an OTS directive, the Bank may not renew existing brokered deposits, or accept new brokered deposits without the prior consent of the OTS. Certificates had the following maturities at December 31: 2010 2009 Weighted Average Rate Amount Amount Weighted Average Rate 3.07% 2.77 2.66 2.96 1-6 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $103,567 73,470 7-12 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,896 13-36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,181 Over 36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10% $124,050 1.77 138,389 2.18 186,929 2.44 6,239 At December 31, 2010, mortgage loans and mortgage- backed and related securities with an amortized cost of approximately $75.5 million were pledged as collateral for certain deposits. An additional $1.6 million of letters of credit from the Federal Home Loan Bank (FHLB) were pledged as collateral on Bank deposits. $344,114 2.07 $455,607 2.81 42 Interest expense on deposits is summarized as follows for the years ended December 31: (Dollars in thousands) NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 2009 2008 $ 110 45 1,341 9,785 $11,281 132 38 1,430 15,979 17,579 1,543 412 2,821 22,381 27,157 NOTE 11 Federal Home Loan Bank Advances and Federal Reserve Borrowings Fixed and variable rate Federal Home Loan Bank advances and Federal Reserve borrowings consisted of the following at December 31: (Dollars in thousands) Year of Maturity 2010 2009 Amount Rate Amount Rate 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 52,500 70,000 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lines of Credit — Federal Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,500 0 $122,500 $ 10,000 52,500 70,000 132,500 0 $132,500 4.00% 4.77 4.44 0.00 4.44 6.48% 4.00 4.77 4.59 0.00 4.59 Certain of the advances listed above have call the that provisions which allow the FHLB to request advance be paid back or refinanced at the rates then being offered by the FHLB. As of December 31, 2010, the Company had $70 million in advances from the FHLB with a final maturity in 2013 that are callable quarterly. At December 31, 2010, the advances from the FHLB were collateralized by the Bank’s FHLB stock and mortgage loans and investments with a borrowing capacity of approximately $155.9 million. The Bank has the ability to draw additional borrowings of $31.8 million from the FHLB, based upon the mortgage loans and securities that are currently pledged, subject to approval from the FHLB and a requirement to purchase additional FHLB stock. The Bank also has the ability to draw additional borrowings of $66.0 million from the Federal Reserve Bank, based upon the loans that are currently pledged with them. NOTE 12 Income Taxes Income tax expense (benefit) for the years ended December 31 is as follows: (Dollars in thousands) 2010 2009 2008 Current: Federal . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . Total current . . . . . . . . . . . . . $ (3,956) (1,764) (5,720) (4,551) 1,460 (3,091) (415) (1) (416) Deferred: Federal . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . Total deferred . . . . . . . . . . . . Change in valuation allowance . . . . (2,773) (1,781) (4,554) 16,597 $ 6,323 (1,213) (1,303) (2,516) 0 (5,607) (3,575) (993) (4,568) 0 (4,984) The reasons for the difference between “expected” income tax benefit utilizing the federal corporate tax rate of 35% for 2009 and 34% for 2010 and 2008 and the actual income tax expense are as follows: (Dollars in thousands) 2010 2009 2008 Expected federal income tax benefit . . . . . . . . . . . . . . . . . . . $ (7,703) (5,741) (5,138) Items affecting federal income tax: State income taxes, net of federal income tax expense (benefit) . . . Tax exempt interest . . . . . . . . . . . Goodwill impairment charge . . . . . Increase in valuation allowance . . . . . . . . . . . . . . . . . . . . Other, net (2,474) (133) 0 16,597 36 $ 6,323 170 (235) 0 0 199 (5,607) (642) (490) 1,293 0 (7) (4,984) 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 A reconciliation of the change in the gross amount, before related tax effects, of unrecognized tax benefits for 2010 and 2009 is as follows: (Dollars in thousands) 2010 2009 Balance at January 1 . . . . . . . . . . . . . . . . . . $ 2,210 (2,210) Settlement of tax position . . . . . . . . . . . . . Increases for tax positions related to prior 600 0 years . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . $ 0 0 1,610 2,210 The $2.2 million decrease in unrecognized tax benefits during 2010 relates to the tax benefits recorded as a result of a favorable Minnesota Supreme Court tax ruling in 2010, which reversed an unfavorable tax court ruling from 2009. Of the $2.2 million benefit recorded in 2010, $1.4 million affected the effective tax rate as the remaining $0.8 million related to the federal tax impact of the state tax benefit. The Company also recognized a $0.7 million reduction in other operating expenses in the consolidated financial statements to reflect the reversal of the accrued interest that had been recorded on the previously unrecognized tax benefits. The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31: (Dollars in thousands) Deferred tax assets: 2010 2009 Allowances for loan and real estate losses . . . . . . . . . . . . . . . . . . . . . . . $ 9,088 314 682 164 84 5,043 3,295 88 18,758 (16,597) Deferred compensation costs . . . . . . . . . Deferred ESOP loan asset . . . . . . . . . . . Restricted stock expense . . . . . . . . . . . . Nonaccruing loan interest . . . . . . . . . . . . Federal net operating loss carry forward . . State net operating loss carry forward . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . Total gross deferred tax assets . . . . . . . Valuation allowance . . . . . . . . . . . . . . . Deferred tax assets, net of valuation 9,724 337 657 139 2,620 0 891 49 14,417 0 allowance . . . . . . . . . . . . . . . . . . . 2,161 14,417 Deferred tax liabilities: Net unrealized gain on securities available for sale . . . . . . . . . . . . . . . . . . . . . . Deferred loan fees and costs . . . . . . . . . . Premises and equipment basis difference . . . . . . . . . . . . . . . . . . . . . Originated mortgage servicing rights . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . Total gross deferred tax liabilities . . . Net deferred tax assets . . . . . . . . . . $ 356 263 636 648 258 2,161 0 809 258 950 537 273 2,827 11,590 The Company has cumulative federal net operating loss carryforwards of $15.8 million at December 31, 2010 that expire beginning in 2029. The Company also has state net operating loss carryforwards of $34.5 million at December 31, 2010 that expire beginning in 2023. 44 taxes was made. This Retained earnings at December 31, 2010 included approximately $8.8 million for which no provision for represents income allocations of income to bad debt deductions for tax purposes. Reduction of 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. amounts amount The Company considers the determination of the deferred tax asset amount and the need for any valuation reserve to be a critical accounting policy that requires significant judgment. The Company has, in its judgment, made reasonable assumptions and considered both positive and negative evidence relating to the ultimate realization of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future periods. Negative evidence includes the Company’s cumulative loss in the prior three year period, continued operating losses in 2010 and the general business and economic trends. Based upon this evaluation, the Company determined that a full valuation allowance was required with respect to the net deferred tax assets at December 31, 2010. NOTE 13 Employee Benefits Fund (FIRF). Retirement All eligible full-time employees of the Bank that were hired prior to 2002 were included in a noncontributory multi-employer retirement plan sponsored by the Financial Institutions Effective September 1, 2002, the accrual of benefits for existing participants was frozen and no new enrollments were permitted into the plan. The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank’s employees was not such available information is not accumulated for each participating institution. As of June 30, 2010, the FIRF valuation report reflected that the Bank was obligated to make a contribution totaling $237,000 which was paid in the fourth quarter of 2010. The required contribution was $167,000 and $55,000 in 2009 and 2008, respectively. at December because 2010 31, a feature deferred qualifying The Company has a qualified, tax-exempt savings under plan with 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 401(k) 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 $16,500 for 2010. The Company matches 25% of each participant’s the contributions up to a maximum of 8% of participant’s annual salary. Participant contributions and earnings are fully and immediately vested. The Company’s contributions are vested on a three year cliff basis, are expensed over the vesting period, and were $165,000, $177,000 and $166,000, in 2010, 2009 and 2008, respectively. The Company has adopted an Employee Stock Ownership Plan (the ESOP) that meets the requirements of Section 4975(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 $6.1 million 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 $1.5 million to purchase an additional 76,933 shares of HMN common stock to account for the additional employees and avoid dilution of the benefit provided by the ESOP. 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 loans including interest. The Company contributed $525,000, $525,000 and $527,000 in 2010, 2009 and 2008, respectively. the As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral and allocated to eligible employees based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with ASU 718, Employers’ Accounting for Employee Stock Ownership Plans. Accordingly, are reported as unearned ESOP shares in stockholders’ equity. As shares are determined to be ratably released the Company reports compensation from collateral, expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations. ESOP compensation expense was $109,000, $100,000 and $380,000, respectively, for 2010, 2009 and 2008. shares pledged as collateral All employees of the Bank are eligible to participate in the ESOP after they attain age 18 and complete one year of service during which they worked at least 1,000 hours. A 45 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 2010 2009 2008 333,678 24,317 320,937 24,317 296,086 24,379 38 0 12,078 participants . . . . . . . . . . . . . . (22,580) (11,576) (11,606) Shares allocated to participants end of year . . . . . . . . . . . . . . 335,453 333,678 320,937 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 shares at 450,086 (24,317) 425,769 761,222 474,403 (24,317) 450,086 783,764 498,782 (24,379) 474,403 795,340 December 31 . . . . . . . . . . . . $1,196,411 1,890,361 1,983,005 In June 1995, the Company adopted the 1995 Stock Option and Incentive Plan (1995 Plan). The provisions of the 1995 Plan expired on April 25, 2005 and options may no longer be granted from the 1995 Plan. At December 31, 2010, there were 15,000 vested options under the 1995 Plan that remained unexercised. These options expire 10 years from the date of grant and have an exercise price of $16.25. In March 2001, the Company adopted the HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan). In April 2009, this plan was superseded by the HMN Financial, Inc. 2009 Equity and Incentive Plan (2009 Plan) and options or restricted shares may no longer be awarded from the 2001 Plan. As of December 31, 2010, there were 45,642 vested and 93,808 unvested options under the 2001 Plan that remained unexercised. These options expire 10 years from the date of grant and have an average exercise price of $20.07. There are also 5,441 shares of restricted stock previously granted to current employees that as of December 31, 2010 remained unvested. in the Company will In April 2009, the Company adopted the 2009 Plan. The purpose of the 2009 Plan is to provide key personnel and advisors with an opportunity to acquire a proprietary interest in the Company. The opportunity to acquire a aid in proprietary interest attracting, motivating and retaining key personnel and including non-employee directors, and will advisors, align their the Company’s stockholders. 350,000 shares of HMN common stock were initially available for distribution under the 2009 Plan in either restricted stock or stock options, subject to adjustment for future stock splits, stock dividends and similar changes to the capitalization of the Company. Additionally, shares of restricted stock that are awarded interest with those of 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 are counted as 1.2 shares for purposes of determining the total shares available for issue under the 2009 Plan. A summary of activities under all plans for the past three years is as follows: Shares Available for Grant Restricted Shares Outstanding Options Outstanding Award Value/ Weighted Average Exercise Price Number Weighted Average Grant Date Fair Value Vesting Period Unvested Options 1995 Plan December 31, 2007 . . . . . . . . . . . . . . . . December 31, 2008 . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . December 31, 2009 . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . December 31, 2010 . . . . . . . . . . . . . . . . 2001 Plan December 31, 2007 . . . . . . . . . . . . . . . . Granted January 25, 2008 . . . . . . . . . . . . Forfeited . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . December 31, 2008 . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . Termination of new awards under plan . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . December 31, 2009 . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . Vested. . . . . . . . . . . . . . . . . . . . . . December 31, 2010 . . . . . . . . . . . . . . . . 2009 Plan April 28, 2009. . . . . . . . . . . . . . . . . . . . Granted May 6, 2009 . . . . . . . . . . . . Granted May 6, 2009 . . . . . . . . . . . . December 31, 2009 . . . . . . . . . . . . . . . . Granted January 26, 2010 . . . . . . . Forfeited/expired . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . Vested. . . . . . . . . . . . . . . . . . . . . . December 31, 2010 . . . . . . . . . . . . . . . . Total all plans . . . . . . . . . . . . . . . . . . . 0 0 0 0 0 0 171,619 (22,182) 5,916 155,353 (155,353) 0 0 0 0 350,000 (15,000) (98,866) 236,134 (85,290) 7,118 5,921 0 163,883 163,883 0 0 0 0 0 0 22,771 22,182 (169) (10,491) 34,293 (4,734) (15,044) 14,515 0 (170) (8,904) 5,441 82,388 82,388 71,075 (5,790) 0 (13,630) 134,043 139,484 105,500 105,500 (65,000) 40,500 (25,500) 15,000 189,895 0 (5,747) 184,148 (33,777) (5,000) 145,371 (5,921) 0 $12.12 12.12 11.50 13.10 11.25 16.25 19.33 N/A 16.13 19.43 16.13 27.64 19.91 16.13 139,450 20.07 15,000 15,000 0 0 0 0 15,000 169,450 $ 4.77 N/A 4.77 N/A $ 4.77 $18.38 0 0 0 0 0 0 $ 0 0 0 0 0 0 155,605 $1.61 3 years (5,747) (8,770) 141,088 (32,257) (6,000) 102,831 (5,921) (3,102) 93,808 1.43 2.67 1.55 1.43 2.10 3.11 1.49 1.43 3.52 1.43 15,000 $4.41 15,000 4.41 5 years 3 years 3 years (3,000) 12,000 105,808 4.41 4.41 $1.77 The following table summarizes information about stock options outstanding at December 31, 2010: Exercise Price $16.13 16.25 27.66 26.98 30.00 4.77 Number Outstanding 93,910 15,000 15,540 15,000 15,000 15,000 169,450 Weighted Average Remaining Contractual Life In Years 1.4 1.4 3.2 3.6 4.4 8.4 Number Exercisable 102 15,000 15,540 15,000 15,000 3,000 63,642 46 Number Unexercisable 93,808 0 0 0 0 12,000 Unrecognized Compensation Expense $16,313 0 0 0 0 24,817 105,808 $41,130 Weighted Average Years Over Which Unrecognized Compensation Will Be Recognized 1.0 N/A N/A N/A N/A 3.4 The Company will issue shares from treasury upon the exercise of outstanding options. Prior to January 1, 2006, the Company used the intrinsic value method as described in APB Opinion No. 25 and related interpretations to account for its stock incentive plans. Accordingly, there were 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. On January 1, 2006, the Company adopted FAS No. 123(R) (ASC 718), which replaced FAS No. 123 and supersedes APB Opinion No. 25. In accordance with this standard, the Company recognized compensation expense in 2010, 2009 and 2008 relating to stock options over the vesting period. The NOTE 14 Loss per Common Share amount of the expense was determined under the fair value method. The fair value for each option grant is estimated on the date of the grant using a Black Scholes option valuation model. There were no options granted in 2010 or 2008. The following table shows the assumptions that were used in determining the fair value of options granted during 2009: Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 3.15% 9 years 114.0% 0.0% The following table reconciles the weighted average shares outstanding and net loss for basic and diluted loss per common share: (Dollars in thousands, except per share data) Year Ended December 31, 2010 2009 2008 Weighted average number of common shares outstanding used in basic earnings per common share calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,766,756 3,695,827 3,655,078 Net dilutive effect of : Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 0 0 Weighted average number of common shares outstanding adjusted for effect of dilutive securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,766,756 3,695,827 3,655,078 Net loss available to common shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (30,762) (8.17) Basic loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (8.17) Diluted loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (12,543) (3.39) (3.39) (10,164) (2.78) (2.78) Options and restricted stock awards are excluded from the loss per share calculation when a net loss is incurred as their inclusion in the calculation would be anti-dilutive and result in a lower loss per common share. Therefore, options and restricted stock awards are zero in all of the above loss per common share calculations. NOTE 15 Stockholders’ Equity The Company did not repurchase any shares of its common stock in the open market during 2010 or 2009, but did repurchase 30,000 shares during 2008 for $723,500. The repurchased shares were placed in treasury stock. HMN declared and paid common stock dividends as follows: Record Date Payable Date Dividend Per Share Quarterly Dividend Payout Ratio February 15, 2008 May 16, 2008 August 25, 2008 NM — not meaningful March 7, 2008 June 6, 2008 September 8, 2008 $0.25 $0.25 $0.25 34.25% 64.10% NM The Company suspended dividend payments on common stock in the fourth quarter of 2008 due to the 47 environment. Because net operating loss experienced and the challenging unknown the of economic duration of the economic slow down, the continued losses experienced in 2009 and 2010, and the limitation on the payment of dividends set forth in the Supervisory Agreements (as described below and in Note 16), it is not known when any future dividends may be paid by the Company. The Company’s certificate of incorporation authorizes the issuance of up to 500,000 shares of preferred stock, and on December 23, 2008, the Company completed the sale of 26,000 shares of cumulative perpetual preferred stock to the United States Treasury. The preferred stock has a liquidation value of $1,000 per share and a related warrant was also issued to purchase 833,333 shares of HMN common stock at an exercise price of $4.68 per share. The transaction was part of the United States the Treasury’s Emergency Economic Stabilization Act of 2008. Under the terms of the sale, the preferred shares are entitled to a 5% annual cumulative dividend for each of the first five years of the investment, increasing to 9% thereafter, unless HMN redeems the shares. The Company made all required program under purchase capital 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 to appoint dividend payments to the Treasury on the outstanding preferred stock in 2010 but deferred the payment of the dividend that was due on February 15, 2011. Under the terms of the certificate of designations for the preferred stock, dividend payments may be deferred without default, but the dividend is cumulative and, if the Company fails to pay dividends for six quarters, whether or not consecutive, the Treasury will have the right two representatives to the Company’s board of directors. The preferred stock cannot be redeemed for a period of three years from the date of the Treasury investment, except with the proceeds of certain qualifying offerings of Tier 1 capital. After three years, the preferred stock may be redeemed in whole or in part, at par plus accrued and unpaid dividends. The preferred stock is non-voting, other than certain class voting rights. The warrant may be term. The exercised at any time over discount on the is being amortized over five years and Treasury has agreed not to vote any shares of common stock acquired upon exercise of the warrant. Without the consent of Treasury, for three years following issuance of the preferred stock, HMN cannot (i) increase the rate at which it pays dividends on its common stock in excess of the rate at which it last declared a quarterly common stock dividend, or $0.25 per share, or (ii) subject to certain exceptions, repurchase any shares of HMN common stock outstanding. Both the preferred securities and the warrant qualify as Tier 1 capital. common stock warrant its ten-year terms of the written Supervisory Under the Agreements that the Company and the Bank each entered into with the Office of Thrift Supervision (OTS) effective February 22, 2011 as described in Note 16, neither the Company or the Bank may declare or pay any cash dividends, or repurchase or redeem any capital stock, without prior notice to, and consent of, the OTS. In order to grant a priority to eligible accountholders in the event of future liquidation, the Bank, at the time of conversion to a stock savings bank, 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 decrease as the balance of eligible accountholders is reduced subsequent to the conversion, based on an annual determination of such balance. 48 NOTE 16 Regulatory Matters/Supervisory Agreements and Federal Home Loan Bank Investment 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 are carried at cost, in the Federal Home Loan Bank of Des Moines. The Bank met this requirement at December 31, 2010. The capital stock investment in the Federal Home Loan Bank of Des Moines was reviewed for any other than temporary impairment as of December 31, 2010 and it was determined that it was not impaired. administered by the The Bank is subject to various regulatory capital requirements 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 items as calculated under certain off-balance sheet 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. the replaced The Bank entered into a written Supervisory Agreement with its primary regulator, the OTS, effective February 22, 2011 that primarily relates to the Bank’s financial performance and credit quality issues. This agreement prior memorandum of understanding that the Bank entered into with the OTS on December 9, 2009. In accordance with the agreement, the Bank must submit a two year business plan that the OTS may make comments upon, and require revisions to. The Bank must operate within the parameters of the final business plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank must also submit a problem asset reduction plan that the OTS may make comments upon, and require to. The Bank must operate within the revisions parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank must also revise its loan modification policies and its program for identifying, monitoring associated with concentrations of credit, and improve the documentation of the allowance for loan and lease losses. In addition, without the consent of the OTS, the Bank may not declare or pay any cash dividends, materially increase the total into any new contractual assets of existing arrangement the Bank, enter renew or controlling extend risk and any or arrangement related to compensation or benefits with any directors or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider. the replaced The Company also entered into a written Supervisory Agreement with the OTS effective February 22, 2011. This agreement prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. By May 31, 2011, in the Company must accordance with the agreement, submit a capital plan to the OTS through December 31, 2012 that the OTS may make comments upon, and to which it may require revisions. The Company must operate within the parameters of the final capital plan and is required to monitor and submit periodic reports on its compliance with the plan. In addition, without the consent of the OTS, the Company may not incur or issue any debt, guarantee the debt of any entity, declare or pay any cash dividends or repurchase any of the Company’s capital stock, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any directors or officer, or make any golden parachute payments. 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 (Core) capital, and Risk-based capital (as defined in the regulations) to total assets (as defined). Management believes, as of December 31, 2010 and 2009, adequacy all requirements to which it was subject. the Bank met capital that Management believes that based upon the Bank’s capital calculations at December 31, 2010 and 2009 and other conditions consistent with the Prompt Corrective Actions provisions of the OTS regulations, the Bank would be categorized as “well-capitalized.” At December 31, 2010 and 2009, the Bank’s capital amounts and ratios are 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: (Dollars in thousands) December 31, 2010 Actual Required to be Adequately Capitalized Excess Capital To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Percent of Assets(1) Amount Percent of Assets(1) Amount Percent of Assets(1) Amount Percent of Assets(1) Tier I or core capital . . . . . . . . . . . . . . . . . . Tier I risk-based capital . . . . . . . . . . . . . . . . Risk-based capital to risk-weighted assets . . . $66,824 66,824 75,420 7.60% $35,181 27,507 9.72 55,014 10.97 4.00% $31,643 39,317 4.00 20,406 8.00 3.60% $43,977 41,261 5.72 68,768 2.97 5.00% 6.00 10.00 December 31, 2009 Tier I or core capital . . . . . . . . . . . . . . . . . . . Tier I risk-based capital . . . . . . . . . . . . . . . . . Risk-based capital to risk-weighted assets . . . . . $88,723 88,723 98,925 8.64% $41,054 32,648 10.87 65,296 12.12 4.00% $47,669 56,075 4.00 33,629 8.00 4.64% $51,317 48,972 6.87 81,620 4.12 5.00% 6.00 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. The Bank has been informed by the OTS that it to impose an Individual Minimum Capital intends Requirement (“IMCR”) for the Bank. An IMCR requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be classified as “well-capitalized.” The Bank has not been informed by the OTS of the timing or capital levels that may be required. NOTE 17 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 49 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 is credit represented these of commitments. The Company uses the same credit policies in making commitments as it does for on- balance sheet instruments. extend amount commitments for by contract the to 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) Financial instruments whose contract amount represents credit risk: Commitments to originate, fund or purchase December 31, Contract Amount 2010 2009 loans: 1-4 family mortgages . . . . . . . . . . . . . . . . . . $ Commercial real estate mortgages . . . . . . . . . Undisbursed balance of loans closed . . . . . . . . Unused lines of credit . . . . . . . . . . . . . . . . . Letters of credit . . . . . . . . . . . . . . . . . . . . . 629 0 12,659 76,670 2,355 3,263 4,067 20,179 102,011 3,823 Total commitments to extend credit. . . . . . . . . . . . $92,313 133,343 Forward commitments . . . . . . . . . . . . . . . . . . . . $ 3,413 6,278 or have fixed dates expiration 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 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. Forward commitments represent commitments to sell loans to a third party and are entered into in the normal course of business by the Bank. The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding expire over the next 36 months and totaled $2.3 million at December 31, 2010 and $3.8 million at December 31, 2009. The letters of credit are 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 18 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 they are sold. The Company holding the loans until accounts in accordance with for ASC 815, Accounting for Derivative Instruments and Hedging Activities. its commitments 50 The Company had commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the year, which is referred to as its mortgage pipeline. As commitments to originate loans the Company generally enter the mortgage pipeline, the loans into the enters into commitments to sell 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, 2010, the Company recorded a decrease in other liabilities of $51,000, a decrease in other assets of $52,000 and a net loss on the sales of loans of $1,000. As of December 31, 2010, the current 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 $6,000 and an increase in other assets of $6,000. NOTE 19 Fair Value Measurement The Company has adopted ASC 820, Fair Value Measurements, which establishes framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: a Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access. Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of December 31, 2010 and 2009. (Dollars in thousands) Carrying Value at December 31, 2010 Total Level 1 Level 2 Level 3 Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage loan commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,564 (1) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,563 1,740 0 1,740 149,824 (1) 149,823 0 0 0 Carrying Value at December 31, 2009 Total Level 2 Level 1 Level 3 Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,602 (53) Mortgage loan commitments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,549 6,222 0 6,222 153,380 (53) 153,327 0 0 0 The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result the from the lower-of-cost-or-market accounting or write-downs of application of individual assets. For assets measured at fair value on a nonrecurring basis in 2010 that were still held at December 31, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at December 31, 2010 and 2009. (Dollars in thousands) Carrying Value at December 31, 2010 Total Level 2 Level 1 Level 3 Year Ended December 31, 2010 Total Losses Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,728 1,586 Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,039 Real estate, net(2) 16,382 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,735 0 0 0 0 0 2,728 1,586 43,039 16,382 63,735 0 0 0 0 0 (6) 0 (18,855) (1,782) (20,643) Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate, net(2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,965 1,315 49,074 16,257 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $69,611 0 0 0 0 0 2,965 1,315 49,074 16,257 69,611 0 0 0 0 0 Carrying Value at December 31, 2009 Total Level 1 Level 2 Level 3 Year Ended December 31, 2009 Total Losses (50) 0 (6,493) (3,873) (10,416) (1) Represents carrying value and related specific reserves on loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero. (2) Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets. NOTE 20 Fair Value of Financial Instruments instruments, ASC 825, Disclosures about Fair Values of Financial Instruments, requires disclosure of estimated fair values of including assets, the Company’s financial is liabilities and off-balance sheet practicable to estimate fair value. The fair value estimates are made as of December 31, 2010 and 2009 based upon relevant market information, if available, and instruments upon the characteristics of themselves. Because no market exists for a significant items for which it the financial 51 instruments, expected loss the Company’s financial current experience, risk characteristics of various fair portion of value estimates are based upon judgments regarding economic future financial conditions, are instruments, 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. factors. The and other estimates 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 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 (Dollars in thousands) Financial assets: 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. December 31, 2010 2009 Carrying Amount Estimated Fair Value Contract Amount Carrying Amount Estimated Fair Value Contract Amount Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,981 151,564 2,728 664,241 6,743 3,311 Financial liabilities: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances. . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683,230 122,500 1,092 Off-balance sheet financial instruments: 20,981 151,564 2,728 655,508 6,743 3,311 683,230 129,893 1,092 16,418 159,602 2,965 799,256 7,286 4,024 796,011 132,500 2,108 16,418 159,602 2,965 799,849 7,286 4,024 796,011 141,791 2,108 Commitments to extend credit . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments to sell loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 (1) 56 (1) 92,313 3,413 103 (53) 103 (53) 133,343 6,278 the estimated maturity The fair values of The carrying amount of estimated for groups of Cash and Cash Equivalents cash and cash equivalents approximates their fair value. Securities Available for Sale 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 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 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. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820, Fair Value Measurements and Disclosures. Federal Home Loan Bank Stock of FHLB stock approximates its fair value. Accrued Interest Receivable The carrying amount of accrued interest receivable approximates its fair value since The carrying amount using it is short-term in nature and does not present unanticipated credit concerns. Deposits The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value. 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 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 are estimated using the fees normally charged to enter into similar agreements, 52 taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties. Commitments commitments to sell The fair values of loans are estimated using the to Sell Loans quoted market prices for loans with similar interest rates and terms to maturity. NOTE 21 HMN Financial, Inc. Financial Information (Parent Company Only) The following are the condensed financial statements for the parent company only as of December 31, 2010 and 2009 and for the years ended December 31, 2010, 2009 and 2008. (Dollars in thousands) 2010 2009 2008 Condensed Balance Sheets Assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 478 68,053 1,500 49 0 199 96,575 2,700 839 172 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,080 100,485 Liabilities and Stockholders’ Equity: Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Serial preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unrealized gain on securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned employee stock ownership plan shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost, 4,818,263 and 4,883,378 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 533 24,264 91 56,420 55,838 541 (3,384) (64,223) 69,547 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,080 Condensed Statements of Loss Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity losses of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4 (27,833) 0 (236) (24) (6) (551) (28,646) 332 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(28,978) 547 547 23,785 91 58,576 86,115 1,230 (3,577) (66,282) 99,938 100,485 15 (10,168) 2 (236) (24) (6) (470) (10,887) (91) (10,796) 98 (9,693) 2 (243) (24) (6) (466) (10,332) (205) (10,127) Condensed Statements of Cash Flows Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net loss to cash provided by operating activities: Equity losses of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earned employee stock ownership shares priced above (below) original cost . . . . . . . . . . . . . Stock option compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(28,978) (10,796) (10,127) 27,833 172 (51) 63 370 193 0 (15) 791 1 379 10,168 220 (56) 27 373 194 0 (284) (829) 7 (976) 9,693 16 118 33 415 194 20 134 (7) (1) 488 53 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) Cash flows from investing activities: Investment in subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid to preferred stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from preferred stock and warrant issued. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from dividends on Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash (used) provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2010 2009 2008 0 1,200 1,200 0 0 (1,300) 0 0 (1,300) 279 199 478 0 1,700 1,700 0 0 (1,163) 0 0 (1,163) (439) 638 199 (25,000) (400) (25,400) (723) (2,749) 0 26,000 2,000 24,528 (384) 1,022 638 NOTE 22 Business Segments The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. SFC and HMN, the holding company, did not meet the quantitative thresholds for a reportable segment and therefore are included in the “Other” category. 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. 54 The following table sets forth certain information about the reconciliations of reported net loss and assets for each of the Company’s reportable segments. (Dollars in thousands) At or for the year ended December 31, 2010: Home Federal Savings Bank Other Eliminations Consolidated Total Interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment non-interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At or for the year ended December 31, 2009: Interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At or for the year ended December 31, 2008: Interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on limited partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intersegment non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of mortgage servicing rights, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,270 7,302 (31) 0 174 17,263 482 26,423 5,991 (27,825) 880,570 $ 57,770 8,134 (54) 0 174 23,883 556 30,563 (5,513) (10,163) 1,035,152 $ 66,496 7,108 (8) 0 174 32,877 570 28,091 (4,776) (9,688) 1,144,738 0 0 0 4 (27,833) 0 0 825 332 (28,986) 70,100 1 2 0 15 (10,168) 0 0 744 (94) (10,801) 100,515 16 3 0 81 (9,693) 0 0 747 (208) (10,132) 113,078 0 0 0 (4) 27,659 (4) 0 (174) 0 27,833 (70,052) 0 0 0 (15) 9,994 (15) 0 (174) 0 10,168 (99,426) 0 0 0 (81) 9,519 (81) 0 (174) 0 9,693 (112,336) 48,270 7,302 (31) 0 0 17,259 482 27,074 6,323 (28,978) 880,618 57,771 8,136 (54) 0 0 23,868 556 31,133 (5,607) (10,796) 1,036,241 66,512 7,111 (8) 0 0 32,796 570 28,664 (4,984) (10,127) 1,145,480 55 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 and Stockholders HMN Financial, Inc.: We have audited the accompanying consolidated balance sheets of HMN Financial, Inc. (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of loss, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2010. 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. as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, 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), HMN Financial, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 4, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. KPMG LLP Minneapolis, Minnesota March 4, 2011 56 O T H E R F I N A N C I A L D A T A The following tables set forth certain information as to the Bank’s Federal Home Loan Bank (FHLB) advances and Federal Reserve Bank (FRB) borrowings. (Dollars in thousands) Year Ended December 31, 2009 2010 2008 Maximum Balance: FHLB and FRB advances and borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB and FRB short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average Balance: FHLB and FRB advances and borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB and FRB short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $137,500 62,500 210,500 78,000 165,000 43,000 129,408 37,023 155,574 26,288 122,338 11,249 (Dollars in thousands) 2010 Weighted Average Rate Amount December 31, 2009 Weighted Average Rate Amount 2008 Amount FHLB and FRB short-term borrowings . . . . . . . . . FHLB long-term advances . . . . . . . . . . . . . . . . . . $ 52,500 70,000 4.00% $ 10,000 4.77 122,500 6.48% $ 10,000 132,500 4.44 Weighted Average Rate 0.50% 4.59 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,500 4.44 $132,500 4.59 $142,500 4.31 Refer to Note 11 of the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and FRB borrowings. 57 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) Selected Operations Data (3 months ended): Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income (loss) after provision for loan losses . . . . . . . . . . . . Noninterest income: Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense: Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses (gains) on real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income (loss) before income tax expense (benefit) . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) available to common stockholders . . . . . . . . . . . . . . . Basic earnings (loss) per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings (loss) per common share . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Ratios: Return (loss) on average assets(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return (loss) on average common equity(1) . . . . . . . . . . . . . . . . . . . . . . . . . Average equity to average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 and Federal Reserve borrowing . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) Annualized (2) Net interest income divided by average interest-earning assets. December 31, 2010 September 30, 2010 June 30, 2010 $ 10,834 3,547 7,287 10,542 (3,255) 1,007 261 0 655 101 2,024 3,300 1,509 961 439 174 1,836 8,219 (9,450) 482 (9,932) (449) $ (10,381) $ $ (2.73) (2.73) 11,963 4,189 7,774 11,946 (4,172) 972 264 0 551 105 1,892 3,356 384 1,055 458 292 1,445 6,990 (9,270) 97 (9,367) (447) (9,814) (2.60) (2.60) 12,569 4,580 7,989 4,360 3,629 920 274 0 467 120 1,781 3,411 33 1,035 519 298 1,034 6,330 (920) 6,912 (7,832) (448) (8,280) (2.20) (2.20) (4.41)% (49.64) 9.40 3.39 (3.89)% (42.01) 9.56 3.37 (3.12)% (32.14) 9.70 3.37 $880,618 907,401 975,243 33,506 118,058 2,728 664,241 683,230 122,500 69,547 39,152 108,676 3,405 699,877 686,012 134,000 80,156 43,867 112,925 2,940 744,629 746,448 132,500 89,854 58 March 31, 2010 December 31, 2009 September 30, 2009 June 30, 2009 March 31, 2009 12,904 4,943 7,961 6,533 1,428 842 268 0 314 150 1,574 3,449 (761) 1,031 517 276 1,505 6,017 (3,015) (1,168) (1,847) (440) (2,287) (0.61) (0.61) (0.73)% (7.50) 9.70 3.31 13,304 5,260 8,044 3,445 4,599 1,066 272 0 415 327 2,080 3,119 61 1,013 445 294 1,690 6,622 57 (92) 149 (441) (292) (0.08) (0.08) 0.06% 0.59 9.73 3.28 14,325 5,735 8,590 3,381 5,209 1,034 262 0 493 94 1,883 3,180 (357) 970 371 298 1,574 6,036 1,056 175 881 (438) 443 0.12 0.12 0.34% 3.52 9.73 3.46 14,789 6,302 8,487 13,304 (4,817) 1,010 256 5 942 73 2,286 3,284 3,066 1,009 826 311 2,107 10,603 (13,134) (3,930) (9,204) (439) (9,643) (2.62) (2.62) 15,353 6,571 8,782 6,569 2,213 1,027 252 0 423 131 1,833 3,849 1,103 1,092 331 279 1,774 8,428 (4,382) (1,760) (2,622) (429) (3,051) (0.83) (0.83) (3.37)% (34.23) 9.83 3.29 (0.94)% (9.57) 9.81 3.30 1,028,476 1,036,241 1,032,717 1,053,618 1,113,359 48,368 113,714 2,386 774,336 789,792 132,500 97,690 53,559 106,043 2,965 799,256 796,011 132,500 99,938 64,144 71,722 5,029 836,493 809,965 132,500 99,716 72,702 87,167 3,880 877,309 798,369 192,500 109,381 58,737 76,847 3,279 818,897 781,574 142,500 100,446 59 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. As of December 31, 2010, the Company had 9,128,662 shares of common stock issued and 4,818,263 shares in treasury stock. As of December 31, 2010 there were 625 stockholders of record and 925 estimated beneficial stockholders. The following table represents the stock price information for HMN Financial, Inc. as furnished by Nasdaq for each quarter starting with the quarter ended December 31, 2010 and regressing back to March 31, 2009. HIGH . . . . . . . . . . . . . . . LOW. . . . . . . . . . . . . . . . CLOSE . . . . . . . . . . . . . . December 31, 2010 $3.80 2.47 2.81 September 30, 2010 5.00 3.06 3.16 June 30, 2010 6.78 4.28 4.58 March 31, 2010 5.99 4.02 5.50 December 31, 2009 6.85 3.20 4.20 September 30, 2009 5.79 3.35 3.75 June 30, 2009 6.00 3.05 3.51 March 31, 2009 4.76 1.52 3.10 Total Return Performance HMN Financial, Inc. NASDAQ Composite SNL Bank NASDAQ Index e u l a V x e d n I 200 160 120 80 40 0 12/31/05 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10 Index HMN Financial, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . NASDAQ Composite . . . . . . . . . . . . . . . . . . . . . . . . . . . . SNL Bank NASDAQ Index . . . . . . . . . . . . . . . . . . . . . . . . 12/31/05 100.00 100.00 100.00 12/31/06 120.44 110.39 112.27 Period Ending 12/31/07 88.55 122.15 88.14 12/31/08 15.70 73.32 64.01 12/31/09 15.78 106.57 51.93 12/31/10 10.55 125.91 61.27 60 BOARD OF DIRECTORS From left: Malcolm W. McDonald, Michael J. Fogarty, Karen L. Himle, Hugh C. Smith, Susan K. Kolling Seated: Bradley C. Krehbiel, Timothy R. Geisler, Mahlon C. Schneider, Allan R. DeBoer TIMOTHY R. GEISLER Chairman of the Board HMN and Home Federal Savings Bank Mayo Clinic Public Affairs ALLAN R. DEBOER Independent Business Consultant MICHAEL J. FOGARTY Vice President C.O. Brown Agency, Inc. KAREN L. HIMLE Former Vice President University Relations University of Minnesota SUSAN K. KOLLING Senior Vice President HMN and Home Federal Savings Bank BRADLEY C. KREHBIEL President HMN and Home Federal Savings Bank MALCOLM W. MCDONALD Retired Senior Vice President Space Center, Inc. MAHLON C. SCHNEIDER Retired Senior Vice President External Affairs and General Counsel Hormel Foods Corporation HUGH C. SMITH Professor of Medicine, Mayo Clinic College of Medicine Consultant in Cardiovascular Division, Mayo Clinic Former CEO, Mayo Clinic 61 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, 2011 at 10:00 a.m. (Central Time) at the Rochester Golf and Country Club, 3100 West Country Club Road, Rochester, Minnesota. DIRECTORS Timothy R. Geisler Chairman of the Board HMN and Home Federal Savings Bank Mayo Clinic Public Affairs ALLAN R. DEBOER Independent Business Consultant MICHAEL J. FOGARTY Chairman C.O. Brown Agency, Inc. LEGAL COUNSEL Faegre & Benson LLP 2200 Wells Fargo Center 90 South Seventh Street Minneapolis, MN 55402-3901 INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM KPMG LLP 4200 Wells Fargo Center 90 South Seventh Street 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 AND REGISTRAR Inquiries regarding change of address, transfer requirements, and lost certificates should be directed to HMN’s 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 KAREN L. HIMLE Former Vice President University Relations University of Minnesota SUSAN K. KOLLING Senior Vice President HMN and Home Federal Savings Bank BRADLEY C. KREHBIEL President HMN and Home Federal Savings Bank MALCOLM W. MCDONALD Retired Senior Vice President Space Center, Inc. MAHLON C. SCHNEIDER Retired Senior Vice President External Affairs and General Counsel Hormel Foods Corporation HUGH C. SMITH Professor of Medicine, Mayo Clinic College of Medicine and Consultant in Cardiovascular Division, Mayo Clinic Executive Officers Who Are Not Directors Jon J. Eberle Senior Vice President, Chief Financial Officer and Treasurer of HMN and Home Federal Savings Bank Dwain C. Jorgensen Senior Vice President of HMN and Home Federal Savings Bank Lawrence D. McGraw Senior Vice President Home Federal Savings Bank Branch Offices of Bank Albert Lea 143 West Clark Street Albert Lea, MN 56007 (507) 379-2551 Austin 201 Oakland Avenue West Austin, MN 55912 (507) 434-2500 Eagan 2805 Dodd Road, Suite 160 Eagan, MN 55121 (651) 405-2000 LaCrescent 208 South Walnut LaCrescent, MN 55947 (507) 895-9200 Marshalltown 303 West Main Street Marshalltown, IA 50158 (641) 754-6198 Rochester 1201 South Broadway Rochester, MN 55901 (507) 536-2416 1016 Civic Center Drive NW Rochester, MN 55901 (507) 535-1309 3900 55th Street NW Rochester, MN 55901 (507) 535-3460 2048 Superior Drive NW, Suite 400 Rochester, MN 55901 (507) 226-0800 Spring Valley 715 North Broadway Spring Valley, MN 55975 (507) 346-9709 Toledo 1301 South County Road Toledo, IA 52342 (641) 484-7303 Winona 175 Center Street Winona, MN 55987 (507) 453-6460 Home Federal Private Banking 5201 Eden Avenue, Suite 170 Edina, MN 55436 (952) 848-5360 100 1st Avenue Bldg., Suite 200 Rochester, MN 55902 (507) 280-7256 1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 www.hmnf.com