HMN Financial, Inc. 2011 Annual Report Financial Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Letter to Shareholders and Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Five-year Consolidated Financial Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Management’s Discussion and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . .72 Other Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73 Selected Quarterly Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74 Common Stock Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76 Corporate and Shareholder Information . . . . . . . . . . . . . . . . . . . . . . . .Inside Back Cover Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Inside Back Cover HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal operates nine full-service banking facilities in Minnesota and two in Iowa. Home Federal Private Banking operates two branches in Rochester, Minnesota. F I N A N C I A L H I G H L I G H T S Operating Results: (Dollars in thousands, except per share data) At or For the Year Ended December 31, 2011 Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,541 11,135 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income (loss) after provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount 28,406 17,278 11,128 3,739 987 1,656 487 6,869 29,552 (11,555) 0 (11,555) (1,821) Net loss available to common shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (13,376) 2010 48,270 17,259 31,011 33,381 (2,370) 3,741 1,067 1,987 476 7,271 27,556 (22,655) 6,323 (28,978) (1,784) (30,762) 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home Federal Savings Bank regulatory capital ratios: $ $ (3.47) (3.47) 3.22 1.50 1.94 7.36 26.36% (1.39)% (16.94) 3.59 3.55 8.19 7.22 6.40 83.78 (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 December 31, 2011 $790,155 126,114 3,709 555,908 620,128 36,048 70,000 57,061 2010 880,618 151,564 2,728 664,241 683,230 0 122,500 69,547 Tier I or core capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tier I capital to risk weighted assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-based capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.14% 9.61 10.86 7.60% 9.72 10.97 NM – Not meaningful 1 Percentage Change (18.1)% (35.5) (8.4) (48.2) 569.5 (0.1) (7.5) (16.7) 2.3 (5.5) 7.2 49.0 (100.0) 60.1 (2.1) 56.5 53.4% 46.6 6.8 25.0 (12.9) (8.6) (33.3) 16.4 Percentage Change (10.3)% (16.8) 36.0 (16.3) (9.2) NM (42.9) (18.0) (6.1)% (1.1) (1.0) 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: 2011 was a year of transition for HMN Financial, Inc. and Home Federal Savings Bank. In April, we bid farewell to our longtime Chairman of the Board, Tim Geisler. Tim served on the HMN Financial, Inc. Board of Directors for fifteen years, serving as the Chairman for the last ten years. During his tenure, Tim also chaired the Audit Committee and served an important role on many other board committees. His dedication and hard work will be missed by all. Fortunately, Hugh Smith, who joined our board in 2009, was elected Chairman of the Board to succeed Tim Geisler. Hugh’s extensive management background, in a regulated industry, has proven very valuable to the Company as we navigate the ever changing regulatory environment of the financial services industry. More changes occurred in July, when our primary banking regulator, the Office of Thrift Supervision (OTS), was merged into the Office of the Comptroller of the Currency (OCC). While we are still operating under a thrift charter, the change in regulators required us to develop and implement new policies and procedures, particularly in the commercial lending area of the Bank, to more closely align them with other institutions regulated by the OCC. The mortgage industry continued to undergo a significant amount of change during the year as sweeping regulations set forth in the Dodd-Frank legislation were enacted. Some of the regulations that were implemented required that additional compliance procedures be performed on newly originated mortgage loans, as well as those loans being serviced by the Bank. This legislation has required extensive efforts by our retail lending department to remain in compliance with its requirements. In order to remain competitive in the mortgage marketplace, we restructured our mortgage origination delivery model in 2011, which enabled us to increase the number of sales staff qualified to serve our customers’ home mortgage needs, while at the same time enhancing the compliance aspects of the function. We continue to be pleased by the performance of our consumer and single family mortgage loan portfolios. Our delinquencies in these portfolios are well below national averages and speak to the solid underwriting that was maintained when these loans were originated. Our retail banking division also experienced a good year with strong gains in the number of new retail accounts for the year. Successful promotional campaigns were instrumental in bringing new customers to the Bank during the year and we look forward to deepening the relationships with these customers by cross selling them other products and services in the years to come. In the fall of 2011, we announced the pending sale of our branch office in Toledo, Iowa. Our office in Toledo has performed well over the years, however, after receiving a competitive offer for the branch from a local bank and considering our desire to improve the Bank’s regulatory capital ratios, the decision was made to sell this branch location. The sale transaction is scheduled to close in the first quarter of 2012. Our remaining Iowa office located in Marshalltown will be unaffected by the sale and we look forward to continuing to provide our Marshalltown customers with the same products and services that they have come to expect. 2 2011 continued to be a challenging year for the Company from a financial perspective with the costs associated with our high level of nonperforming assets weighed heavily on our financial performance. Likewise, the continued softness in the real estate market — most notably in the construction and development sectors — required us to recognize losses as a result of decreases in the estimated value of the real estate we are holding for sale. We continue to execute our collection strategy of aggressively gaining control and liquidating nonperforming assets as quickly and cost effectively as possible. Fortunately, we have seen some stabilization in the real estate values over the course of the year and the level of new loans migrating into the severe problem category has shown signs of improvement. Looking forward, we intend to continue to work aggressively to improve the asset quality and financial performance of the Company, while remaining focused on customer service and market share. We look forward to improved financial performance during the coming year. Thank you for your continued support and loyalty to our organization. Respectfully, Brad Krehbiel President 3 4 F I V E- Y E A R C O N S O L I D A T E D F I N A N C I A L H I G H L I G H T S Selected Operations Data: Year Ended December 31, (Dollars in thousands, except per share data) 2011 2010 2009 2008 2007 Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,541 11,135 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,406 17,278 11,128 3,739 987 0 1,656 487 6,869 48,270 17,259 31,011 33,381 (2,370) 3,741 1,067 0 1,987 476 7,271 57,771 23,868 33,903 26,699 7,204 4,137 1,042 5 2,273 625 8,082 66,512 32,796 33,716 26,696 7,020 4,269 955 479 651 749 7,103 Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,552 27,556 31,689 29,234 Income (loss) before income tax expense (benefit) . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,555) 0 (22,655) 6,323 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . . . . . . . . . . . . . . . . . . . . . (11,555) (1,821) (28,978) (1,784) (16,403) (5,607) (10,796) (1,747) (15,111) (4,984) (10,127) (37) Net income (loss) available to common shareholders . . . . . . . . . . . . . . $ (13,376) (30,762) (12,543) (10,164) Basic earnings (loss) per common share . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings (loss) per common share . . . . . . . . . . . . . . . . . . . . . . . Cash dividends per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (3.47) (3.47) 0.00 (8.17) (8.17) 0.00 (3.39) (3.39) 0.00 (2.78) (2.78) 0.75 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 Selected Financial Condition Data: December 31, (Dollars in thousands, except per share data) 2011 2010 2009 2008 2007 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 $790,155 126,114 3,709 555,908 620,128 36,048 70,000 57,061 7.36 13 1 880,618 151,564 2,728 664,241 683,230 0 122,500 69,547 10.51 14 1 1,036,241 159,602 2,965 799,256 796,011 0 132,500 99,938 17.94 14 2 1,145,480 175,145 2,548 900,889 880,505 0 142,500 112,213 21.31 16 2 1,117,054 186,188 3,261 865,088 888,118 0 112,500 98,128 23.50 15 2 7.22% 7.90% 8.19 9.40 9.64% 9.73 9.80% 8.58 8.78% 8.89 (ratio of net income (loss) to average equity) . . . . . . . . . . . . . . . . . . . . . . (16.94) (31.73) (10.33) (10.61) 11.53 Return (loss) on assets (ratio of net income (loss) to average assets) (1.39) (2.98) (1.00) (0.91) 1.03 Dividend payout ratio (ratio of dividends paid to net income (loss)) NM NM NM NM 34.72 (1) Average balances were calculated based upon amortized cost without the market value impact of ASC 320. NM — Not meaningful 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 our and potential strategies strategies 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 those relating to the include, but are not limited to, adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements, our expectations for core capital for and improvement thereof; changes in the size of the Bank’s loan portfolio; the recovery of the valuation allowance on deferred tax assets; the amount and mix of the Bank’s non-performing assets and the appropriateness of the allowance therefor; future losses on non-performing assets; the amount of interest-earning assets; the amount and mix of brokered and other deposits (including the the Company’s ability to renew brokered deposits); availability of alternate funding sources; the payment of dividends; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; the change in Company and Bank primary banking regulators from the Office of Thrift Supervision to the Office of the Comptroller of the Currency (OCC) the Bank’s and Federal Reserve Board compliance with generally regulatory (including the Bank’s status as “well-capitalized”), and individual minimum capital supervisory agreements, requirements or supervisory other requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the OCC and the Bank and the Company to any failure to comply with any such regulatory standard, agreement or requirement; and the anticipated timing of consummation of Iowa branch (Toledo Branch) transaction and the anticipated gain on sale, decrease in assets and increase in core capital therefrom. (FRB); standards the Toledo, directives or 6 to loans securing borrowers, A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate and other collateral possible legislative and regulatory changes, including changes in the degree and manner of regulatory supervision, the ability of the Company and the Bank to establish and adhere to plans and policies relating to, among other things, capital, business, non-performing assets, loan modifications, documentation of loan loss allowance and concentrations of credit that are satisfactory to the OCC and FRB, as applicable, in accordance with the terms of the Company and Bank supervisory agreements and to otherwise manage the operations of the Company and the Bank to ensure compliance with other requirements set forth in the supervisory agreements; the ability of the Company and the Bank to obtain required consents from the OCC and FRB, as applicable, under the supervisory agreements or other directives; the ability of the Bank to comply with its individual minimum capital requirement and other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard, agreement or requirement; adverse economic, business and competitive developments such as shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company’s loan and investment portfolios, changes in costs sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank, technological, computer-related or operational difficulties, results of litigation, and reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government economic developments; the Company’s access to and adverse for credit changes in securities markets; the market related assets; the timing of the Toledo Branch data conversion by a third party provider, the failure of either the Bank or Pinnacle to fulfill the terms and conditions of the Toledo Branch sale agreement required to be satisfied prior to closing and changes in assets and liabilities at the Toledo Branch prior to closing; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations associated with international alternate funding laws; tax or include those set forth in the Company’s most recent filings on Form 10-K and Form 10-Q with the Securities forward-looking and Exchange Commission. All statements are qualified by, and should be considered in such cautionary statements. For conjunction with, additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. 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 interest-earning assets 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 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 and competitive affected by prevailing economic conditions, rates, particularly government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, properties, and competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of commercial changes interest family single in deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. Beginning with the Company’s 2008 fiscal year, the Company’s commercial business and commercial real estate loan portfolios have required significant charge offs due primarily to decreases in the estimated value of the underlying collateral supporting the loans, as many of these loans were made to borrowers in or associated with the real estate industry. The decrease in the estimated collateral value is primarily the result of reduced demand for real estate, particularly as it relates to single-family and commercial land developments. More stringent lending standards implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments where the Company’s commercial loan portfolio has concentrations. Consequently, our level of non-performing assets and the related provision for loan losses and charge-offs increased significantly in the past relative to periods before 2008. The several years, increased levels of non-performing assets, related provisions for loan losses and loan charge-offs and and expenses allowances against deferred taxes arising from adverse results of operations, were the primary reasons for the net losses incurred by the Company in each of the years 2008 through 2011. associated with real estate owned, 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 establish adequate levels of liquidity and capital resources. In 2008, the Company obtained $26 million in additional capital through the sale of preferred stock to the United States Treasury, substantially all of which was contributed to the capital of the Bank. The Bank also began to reduce its asset size, which has been reduced $355 million since December 31, 2008, in order to enhance its capital ratios. The reduction in assets has primarily been in commercial loans and was accompanied by a corresponding reduction in interest- bearing liabilities, primarily because of a $235 million reduction in brokered deposits and a $72 million reduction in outstanding FHLB advances. In 2009, a new Bank President was appointed and additional personnel were 7 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S hired in the commercial loan area to work through the increased level of non-performing assets. In addition, the Bank lowered its internal limit on the size of a loan it would grant to an individual borrower in an effort to reduce concentrations of credit risk associated with large 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 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 loans being improve the credit quality of commercial added to the Bank’s portfolio and reduce loan and non-performing assets. A more concentrations 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 ongoing analysis of the Bank’s commercial loan charge off history resulted in higher reserve percentages for some risk rating classifications. A more aggressive and ongoing review process of existing loan files was also implemented. These commercial reviews 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 being taken loan loss reserves being established. and additional Additional also been 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 and determining available cash flows as well as testing the validity of, and adherence to, established action plans. In 2011, the Bank’s Edina branch office was closed in order to reduce costs and the Bank entered into a definitive purchase and assumption agreement to sell substantially all of the assets and deposit liabilities associated with its Toledo, Iowa branch in order to further reduce costs and improve capital ratios. The sale of the Toledo branch is anticipated to be consummated in the first quarter of 2012. The Company also began deferring the dividend payments on the outstanding preferred stock, beginning with the February 15, 2011 dividend payment in order to preserve cash for potential future needs. focused on evaluating collateral resources have levels the and, these levels Despite elevated of efforts, non-performing assets and related losses have persisted, primarily as a result of the relative weakness of the housing and commercial real estate markets that continues 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. Because of these issues, the Company and the Bank, effective February 22, 2011, each entered into a supervisory agreement “Company Supervisory (the Agreement” and the “Bank Supervisory Agreement”, respectively, “Supervisory collectively, Agreements”) with the Office of Thrift Supervision (the “OTS”), their primary federal regulator at the time. The Supervisory Agreements supersede 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 by January 31 of each year 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. In accordance with the Bank’s Supervisory Agreement, the Bank submitted an initial two year business plan that the to the OTS) accepted with the OCC (as successor expectation that the Bank would be in adherence with the OCC’s Notification of Establishment of Higher Minimum Capital Ratios, dated August 8, 2011, which required the Bank to establish and maintain a minimum core capital ratio of 8.5% by December 31, 2011, which was in excess of the Bank’s 7.14% core capital to adjusted total assets ratio at December 31, 2011. The Bank would have needed $10.8 million in additional capital at December 31, 2011 to meet the minimum core capital ratio set by the OCC. Subsequent to year end, the Bank submitted a revised two year business plan to the OCC. 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 also submitted a problem asset reduction plan that the OCC has accepted. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank has also revised its loan modification policies and its program for identifying, monitoring and controlling risk associated with concentrations of credit, and improved the 8 documentation relating to the allowance for loan and lease losses as required by the agreement. In addition, without the consent of the OCC, the Bank may not declare or pay any cash dividends, materially increase the total assets of the Bank, enter into any new contractual arrangement or renew or extend any existing arrangement related to compensation or benefits with any director or officer, make any golden parachute payments, or enter into any significant contracts with a third party service provider. In February 2012, the Bank received a notice from the OCC arising out of its failure to establish and maintain its individual minimum capital requirement (IMCR) of 8.5% core capital to adjusted total assets at December 31, 2011. By April 30, 2012, the Bank must submit to the OCC a further written capital plan of how it will achieve and maintain its IMCR, and a contingency plan in the event the IMCR is not achieved through the Bank’s primary plan. The Bank’s failure to comply with the terms of the IMCR is deemed an unsafe and unsound banking practice and could subject it to further limits on growth and such legal actions or sanctions as the OCC considers appropriate. For a complete description of the Supervisory “Item 1 — Agreements Business — Regulation and Supervision” and “Item 3 — Legal Proceedings” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. and IMCR, please see References to the OTS shall mean, with respect to the Federal the Company, beginning July 21, 2011, Reserve Board (FRB) and mean, with respect to the Bank, beginning July 21, 2011, the Comptroller of the Currency (OCC). On July 21, 2011, the OTS was integrated into the OCC and the primary banking regulator for the Company became the FRB. the Office of 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. its the loan loan local In this separate determine delinquencies, non-homogeneous to the loan loss allowance for Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis, loan portfolio. analysis of management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, 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 the established processes appropriateness of its homogeneous single-family and consumer loan portfolios and 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 an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans or portion thereof that are deemed uncollectable. The 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 for loan losses are consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses that was issued by the federal regulatory agencies in December 2006. financial The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the 9 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S for loan against periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision income. The losses 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 additional reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the loan losses and adjustments may be allowance for 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 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. temporary differences, reversals of The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses and net operating loss carryforwards. For income tax purposes, only net charge-offs are deductible, not the 10 includes evidence and business periods. Negative 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 conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the ability to implement tax planning strategies to accelerate taxable income recognition and the probability that taxable income will be generated in future the Company’s cumulative loss in the prior three year period, current financial performance, and the general business and economic trends. In the second quarter of 2010, the Company recorded a valuation allowance against the entire deferred tax asset balance and the Company continued to maintain a valuation reserve against the entire deferred tax asset balance at December 31, 2011. This determination was based primarily upon the existence of a three-year cumulative loss and continued operating losses in 2011. This three-year cumulative loss position is primarily attributable to significant provisions for loan losses incurred during the three years ended December 31, 2011. 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 and tax adjustments may be required in the future. allowance deferred assets on Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated. Results of Operations Comparison of 2011 with 2010 The net loss was $11.6 million for 2011, an improvement of $17.4 million, from the $29.0 million loss for 2010. The net loss available to common shareholders was $13.4 million for the year ended December 31, 2011, an improvement of $17.4 million, from the net loss available to common shareholders of $30.8 million for 2010. Diluted loss per common share for the year ended December 31, 2011 was $3.47, an improvement of $4.70 from the $8.17 diluted loss per common share for the year ended December 31, 2010. Net Interest Income income was $28.4 million for 2011, a interest Net decrease of $2.6 million, or 8.4%, from $31.0 million for 2010. Interest income was $39.5 million for 2011, a decrease of $8.8 million, or 18.1%, from $48.3 million for 2010. Interest income decreased between the periods primarily because of a $132 million decrease in the average interest-earning assets and 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 focus on improving credit quality, the Company’s interest margin and improving capital managing net ratios. The average yield earned on interest-earning assets was 5.00% for the year ended December 31, 2011, a decrease of 23 basis points from the 5.23% average yield for 2010. in average Interest expense was $11.1 million for the year ended December 31, 2011, a decrease of $6.2 million, or 35.5%, from $17.3 million for 2010. Interest expense decreased primarily because of a $115 million decrease in the average interest-bearing liabilities between the periods. The decrease interest-bearing liabilities is primarily the result of a decrease in the average outstanding borrowings and brokered deposits between the periods. The decrease in borrowings and brokered deposits between the periods was the result of using the proceeds from loan principal payments to fund Interest maturing borrowings and brokered deposits. expense also decreased because of the lower rates paid on retail money market accounts and certificates of deposits. The decreased rates were the result of the lower interest rate environment that existed during 2011. The average interest rate paid on interest-bearing liabilities was 1.47% for the year ended December 31, 2011, a decrease of 51 basis points from the 1.98% average rate paid for the same period of 2010. Net interest margin (net interest income divided by average interest-earning assets) was 3.59% for the year ended December 31, 2011, an increase of 23 basis points, from the 3.36% margin for 2010. 11 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S 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. (Dollars in thousands) 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 . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2011 2010 2009 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 $ 25,546 113,927 2,200 608,826 5,384 35,426 1,098 1,451 87 36,689 180 36 4.30% $ 42,117 1.27 112,573 3.95 2,561 6.03 740,324 3.34 7,262 0.10 18,626 1,813 2,023 117 44,131 182 4 4.30% $ 1.80 4.57 5.96 2.51 0.02 63,725 82,758 3,161 2,768 3,039 163 848,696 51,713 87 1 7,286 12,212 4.34% 3.67 5.16 6.09 1.19 0.01 Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $791,309 39,541 5.00 $923,463 48,270 5.23 $1,017,838 57,771 5.68 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 72,734 37,048 118,821 250,142 85,587 92,604 1,006 $657,942 101,230 57 57 746 3,841 2,146 4,288 0 0.08% $ 96,248 0.15 32,929 0.63 133,113 1.54 240,590 2.51 152,584 4.63 131,480 0.00 1,351 $788,295 85,585 110 45 1,341 5,415 4,370 5,978 0 0.11% $ 106,360 30,401 0.14 105,854 1.01 257,085 2.25 232,829 2.86 155,681 4.55 1,219 0.00 132 38 1,430 7,652 8,327 6,289 0 0.12% 0.12 1.35 2.98 3.58 4.04 0.02 $ 889,429 70,364 $759,172 11,135 1.47 $873,880 17,259 1.98 $ 959,793 23,868 2.49 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,406 31,011 33,903 Net interest rate spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,137 Net interest margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average interest-earning assets to average interest-bearing liabilities and noninterest-bearing deposits . . . . . . . . . . . . . . 3.53% 3.59% $ 49,583 3.26% 3.36% $ 58,045 3.19% 3.33% 104.23% 105.67% 106.05% (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 2011, $0.4 million for 2010, and $0.7 million for 2009. (2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve. Net interest margin increased to 3.59% in 2011 from 3.36% in 2010 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 deposits in 2011 when compared to 2010. Brokered deposits decreased in 2011 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 $17.5 million to $32.1 million in 2011 compared to $49.6 million for 2010. Net earning 12 assets decreased primarily because of increased loan charge offs during 2011. The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest- bearing liabilities. It quantifies the changes in interest income and interest expense related to changes in the average outstanding balances and those changes caused by fluctuating interest rates. For each category of interest-earning assets and interest-bearing changes is liabilities, 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). information (volume) provided on (Dollars in thousands) Interest-earning assets: Securities available for sale: Mortgage-backed and related securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing liabilities: NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Brokered deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2011 vs. 2010 Increase (Decrease) Due to Volume(1) Rate(1) Total Increase (Decrease) 2010 vs. 2009 Increase (Decrease) Due to Volume(1) Rate(1) Total Increase (Decrease) $ (713) 24 (16) (7,706) 4 (47) $(8,454) $ (37) 6 (149) (216) (1,918) (1,766) (4,080) (2) (596) (14) 265 27 45 (275) (16) 6 (447) (1,358) (305) 76 (2,044) (715) (572) (30) (7,441) 31 (2) (8,729) (53) 12 (596) (1,574) (2,223) (1,690) (6,124) (2,605) (939) 1,095 (31) (6,391) 1 0 (6,265) (19) 3 367 (651) (2,869) (166) (3,335) (2,930) (16) (2,111) (15) (1,192) 3 95 (3,236) (3) 4 (456) (1,587) (1,087) (145) (3,274) 38 (955) (1,016) (46) (7,583) 4 95 (9,501) (22) 7 (89) (2,238) (3,956) (311) (6,609) (2,892) Increase (decrease) in net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(4,374) 1,769 (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. 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 the date weighted average yields and rates as of indicated. Non-accruing loans have been included in the table as loans carrying a zero yield. At December 31, 2011 Weighted average rate on: Weighted average yield on: Securities available for sale: Mortgage-backed and related securities . . . . . . . . . . Other marketable securities . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . Other interest-earnings assets . . . . . . . . . . . . . . . . . . . . Combined weighted average yield on interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.21% 1.10 3.32 5.75 3.00 0.25 4.56 Provision for Loan Losses The provision for loan losses was $17.3 million for the year ended December 31, 2011, a decrease of $16.1 ended million, December 31, 2010. The provision decreased between the periods primarily because fewer loan losses were recognized due to fewer write downs on non-performing real estate loans in 2011 when compared to 2010. The from $33.4 million for the year 13 NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Passbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . Combined weighted average rate on interest-bearing 0.06% 0.17 0.46 1.66 4.77 liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.22 3.34 provision also decreased because of the $132 million decrease in the loan portfolio between the periods. Total non-performing at December 31, 2011, a decrease of $33.9 million, or 40.0%, from $84.5 million at December 31, 2010. Non-performing loans decreased $34.1 million and foreclosed and repossessed assets increased $0.2 million $50.6 million assets were M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S $34.1 million, Loans classified as non-performing during the year decreased from $68.1 million at December 31, 2010 to $34.0 million at December 31, 2011. The decrease in loans classified as non-performing reflects the decrease in additional loans being classified as non-performing as well as the Company’s increased level of charge-offs. during 2011. The non-performing loan and foreclosed and repossessed asset activity for 2011 was as follows: (Dollars in thousands) December 31, 2011 2010 Non-performing loans: Balance at beginning of year . . . . . . . . . . . . . Classified as non-performing . . . . . . . . . . . . Charge offs . . . . . . . . . . . . . . . . . . . . . . . . . . Principal payments received . . . . . . . . . . . . . Classified as accruing . . . . . . . . . . . . . . . . . . Transferred to real estate owned . . . . . . . . . . $ 68,074 28,615 (39,302) (9,552) (5,249) (8,593) 61,127 62,009 (15,231) (13,733) (10,972) (15,126) Balance at end of year . . . . . . . . . . . . . . . . . . $ 33,993 68,074 (Dollars in thousands) December 31, 2011 2010 Foreclosed and repossessed asset activity: Balance at beginning of year . . . . . . . . . . . . . Transferred from non-performing loans . . . . Other foreclosures/repossessions . . . . . . . . . Real estate sold . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of assets . . . . . . . . . . . . . . . Write downs . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,395 8,593 138 (5,444) 407 (3,473) 16,262 15,126 1,158 (14,448) 747 (2,450) Balance at end of year . . . . . . . . . . . . . . . . . . $ 16,616 16,395 The following table reflects the activity in the allowance for loan losses for 2011 and 2010. (Dollars in thousands) Balance at January 1, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge offs: 2011 2010 $42,828 17,278 $23,812 33,381 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Single family mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,512) (23,012) (270) (508) 3,084 (7,006) (7,095) (907) (254) 897 Balance at December 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23,888 $42,828 Unallocated allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allocated allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,255 6,633 $23,888 $17,794 25,034 $42,828 The allowance for loan losses decreased and charge offs increased in 2011 when compared to 2010 due primarily to two factors. The first factor was the modification in the fourth quarter of 2011 of our charge off policy on non-performing loans, which required the charge off of previously established specific valuation allowances (SVAs). Previously, when a collateral-dependent loan was characterized as a loss, the Company typically established an SVA based on the estimated fair value of the underlying collateral, less any related selling costs and the actual charge off of the loan was not recorded until the foreclosure process was complete. The gross 14 loan balance for these non-performing loans was reported as an outstanding loan with any associated SVAs the included in the financial statements as part of allowance for loan losses. Under the modified policy, which is also acceptable under Generally Accepted Accounting Principles, SVAs are no longer recognized and any losses on loans secured by real estate are charged off in the period the loans, or portion thereof, are deemed uncollectible. All of these charge offs were previously included in the Company’s loss history as part of the evaluation of the allowance for loan losses. Therefore, the additional charge offs did not affect the Company’s provision for loan losses or net loss for the period. The second factor was that in certain instances the borrower’s financial condition had deteriorated to the point that a charge off of the loan balance was warranted. Non-Interest Income Non-interest income was $6.9 million for the year ended December 31, 2011, a decrease of $0.4 million, or 5.5%, from $7.3 million for the year ended December 31, 2010. The components of non-interest income: following table presents the Year ended December 31, (Dollars in thousands) Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 $3,739 987 0 1,656 487 Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,869 2010 3,741 1,067 0 1,987 476 7,271 2009 4,137 1,042 5 2,273 625 8,082 Percentage Increase (Decrease) 2011/2010 2010/2009 (0.1)% (7.5) N/A (16.7) 2.3 (9.6)% 2.4 (100.0) (12.6) (23.8) (5.5) (10.0) Gain on sales of loans decreased $331,000 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. Loan servicing fees decreased $80,000 between the periods due primarily to a decrease in the number of commercial loans that are being serviced for others. (Dollars in thousands) Non-Interest Expense Non-interest expense was $29.6 million for the year ended December 31, 2011, an increase of $2.0 million, or 7.2%, from $27.6 million for the same period in 2010. The components of non-interest expense: following table presents the Year ended December 31, 2011 2010 2009 Percentage Increase (Decrease) 2011/2010 2010/2009 Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses on real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,553 2,681 3,741 1,255 1,221 7,101 13,516 1,165 4,082 1,933 1,040 5,820 13,432 3,873 4,084 1,973 1,182 7,145 0.3% 130.1 (8.4) (35.1) 17.4 22.0 Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $29,552 27,556 31,689 7.2 0.6% (69.9) (0.0) (2.0) (12.0) (18.5) (13.0) Losses on real estate owned increased $1.5 million between the periods primarily because of declines in the fair market value of other real estate. Other non-interest expenses increased $1.3 million primarily because of 15 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S increased real estate taxes and legal fees related to other real estate owned. Data processing expense increased $181,000 between the periods primarily because of a one time incentive that was received by the Company in the fourth quarter of 2010 when it changed its ATM and debit card vendor. Deposit insurance expense decreased $678,000 between the periods primarily because of a change in the FDIC’s insurance cost structure and also because of a decrease in assets between the periods. Occupancy primarily $341,000 decreased because of a decrease in depreciation expense. expense is subject Income Taxes The Company considers the calculation of current and deferred income taxes to be a critical accounting policy to significant estimates. Actual results that could differ estimates and significantly from the interpretations used in determining the current and deferred income tax assets and liabilities. Income tax expense decreased $6.3 million between the periods, from an expense of $6.3 million in 2010 to no expense in 2011. In the second quarter of 2010, the Company recorded a deferred tax asset valuation reserve against its entire deferred tax asset balance and the Company continued to maintain a valuation reserve against the entire deferred tax asset balance at December 31, 2011. the Since the valuation reserve is established against entire deferred tax asset balance, no income tax expense was recorded for 2011. 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 increasing to 9% thereafter, years of the investment, 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, May 15, 2011, August 15, 2011, November 15, 2011, and February 15, 2012 dividend payments on the preferred stock after consulting with their primary regulator. The determination to defer the dividend payment was made in order to preserve cash for potential the future needs. Under its Supervisory Agreement, Company may not pay any dividend on its outstanding preferred stock or common stock without the consent of the OCC. 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 to appoint two representatives to the loss available to Company’s board of directors. Net common stockholders is the net loss less the preferred dividends paid or accrued for the period. The net loss available to common shareholders was $13.4 million for the year ended December 31, 2011, an improvement of $17.4 million, from the net loss available to common shareholders of $30.8 million for 2010. The net loss available to common shareholders decreased primarily because of the decrease in the net loss between the periods. Comparison of 2010 with 2009 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 loss available to common shareholders was $30.8 net 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 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. 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 16 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 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 interest-bearing liabilities between the periods. The decrease in average interest- bearing 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. 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. average in the 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 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 increases the year from $26.7 million for in the estimated value of 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 in non-performing assets and loan charge offs during 2010. The provision for loan losses was $33.4 million for the year ended December 31, 2010, an increase of $6.7 ended million, 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 decreases the underlying 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 loans increased $7.0 million and foreclosed and repossessed assets increased $0.1 million during 2010. 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 relative classified weakness in the housing and commercial real estate markets that 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 the as Company’s increased level of internal loan reviews. non-performing loan payment requirements as well reflects the as The allowance for loan losses increased in 2010 the $13.0 million increase in primarily because of specific reserves established during the year due to decreases in the estimated value of the underlying collateral supporting the loans. The general allowance the also increased because a periodic analysis of commercial loan portfolio resulted in increased reserve percentages on performing loans due to the recent increase in charge off activity. Non-interest income was $7.3 million in 2010, a decrease of $0.8 million, or 10.0%, from $8.1 million for 2009. Fees and service charges decreased $396,000 between the periods primarily because of decreased overdraft fees and decreased ATM fees as a result of 17 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S 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. Non-interest expense was $27.6 million for 2010, a decrease of $4.1 million, or 13.0%, from $31.7 million for 2009. Losses on real estate owned decreased $2.7 million between the periods because of the decreases in recognized on real estate sold. Other the losses 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. is subject The Company considers the calculation of current and deferred income taxes to be a critical accounting to significant estimates. Actual policy that 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 reversed the unfavorable tax court ruling from 2009. Excluding these adjustments, the effective tax rate would have been 39.7% for 2010. 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, 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. from the net 18 Financial Condition Loans Receivable, Net The following table sets forth the information on the Company’s loan portfolio in dollar amounts and percentages (before deductions for loans in process, deferred fees and discounts and allowances for losses) as of the dates indicated: December 31, (Dollars in thousands) 2011 2009 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent 2007 2010 2008 Real Estate Loans: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . $119,066 35,517 Multi-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243,475 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial 10,922 Construction or development . . . . . . . . . . . . . . . . 20.52% $128,535 6.12 48,266 41.95 292,874 1.88 15,251 18.14% $144,631 59,266 6.81 312,714 41.34 40,412 2.15 17.54% $161,989 29,292 7.18 325,304 37.92 108,283 4.90 17.51% $152,974 29,073 3.17 281,822 35.16 111,034 11.70 17.33% 3.29 31.92 12.58 Total real estate loans . . . . . . . . . . . . . . . . . . 408,980 70.47 484,926 68.44 557,023 67.54 624,868 67.54 574,903 65.12 Other Loans: Consumer Loans: Automobile . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity line . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . Mobile home . . . . . . . . . . . . . . . . . . . . . . . . . . . Land/lot loans . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404 41,429 13,426 657 2,723 3,522 0.07 7.14 2.31 0.11 0.47 0.61 604 44,933 17,840 764 2,510 3,952 0.08 6.34 2.52 0.11 0.35 0.56 902 50,369 21,088 977 3,190 5,689 0.11 6.11 2.55 0.12 0.39 0.69 1,333 52,243 22,912 1,316 2,969 5,828 0.14 5.65 2.48 0.14 0.32 0.63 1,730 51,317 20,254 1,699 4,151 5,758 0.20 5.81 2.30 0.19 0.47 0.65 Total consumer loans . . . . . . . . . . . . . . . . . . Commercial business loans . . . . . . . . . . . . . . . . . 62,161 109,259 10.71 18.82 70,603 153,039 9.96 21.60 82,215 185,525 9.97 22.49 86,601 213,775 9.36 23.10 84,909 222,959 9.62 25.26 Total other loans . . . . . . . . . . . . . . . . . . . . . . Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . 171,420 580,400 100.00% 708,568 100.00% 824,763 100.00% 925,244 100.00% 882,771 100.00% 267,740 223,642 300,376 307,868 31.56 32.46 29.53 34.88 32.46 Less: Loans in process ** . . . . . . . . . . . . . . . . . . . . . . . Unamortized (premiums) discounts . . . . . . . . . . . Net deferred loan fees . . . . . . . . . . . . . . . . . . . . . . Allowance for losses . . . . . . . . . . . . . . . . . . . . . . . 0 93 511 23,888 . . . . . . . . . . . . . . $555,908 Total loans receivable, net 0 413 1,086 42,828 0 177 1,518 23,812 0 569 2,529 21,257 3,011 (11) 2,245 12,438 $664,241 $799,256 $900,889 $865,088 ** Core systems converted in 2008, loans in process after this date are reflected in loan amounts in table. In 2011, 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 2012. 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 OCC (as successor to OTS) approval. The business Company’s commercial and commercial real estate loan portfolios continue to be real estate, impacted by the reduced demand for particularly as it relates to single-family and commercial land developments as many of these loans were made to borrowers associated with the real estate industry. More stringent lending standards implemented by the mortgage industry in recent years have made it more difficult for some borrowers with marginal credit to qualify for a mortgage. This decrease in available credit and the overall weakness in the economy over the past several years reduced the demand for single family homes and the values of existing properties and developments and is reflected in the $50.6 million of Company assets that were classified as non-performing at December 31, 2011. 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 family real estate loans were $119.1 million at December 31, 2011, a decrease of $9.4 million, compared to $128.5 million at December 31, 2010. Mortgage loan refinance activity remained strong in 2011 due to the historically low mortgage rates experienced 19 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S and almost all of the 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 and subsequent sale was the primary reason for the decrease in the one-to-four family loan portfolio during 2011. Multi-family real estate loans were $35.5 million at December 31, 2011, a decrease of $12.8 million, compared to $48.3 million at December 31, 2010. The decrease in multi-family real estate loans in 2011 is primarily the result of one large multi-family loan that obtained alternative their outstanding loan with the Bank in 2011. financing and paid off and demand commercial Commercial real estate loans were $243.5 million at December 31, 2011, a decrease of $49.4 million, compared to $292.9 million at December 31, 2010. Commercial business loans were $109.3 million at December 31, 2011, a decrease of $43.7 million compared to $153.0 million at December 31, 2010. Decreased tighter loan underwriting and pricing guidelines resulted in a decrease in net 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 $49.1 million in 2011, compared to $59.8 million in 2010. 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 and charge offs were the primary reasons for the decrease in the commercial business and commercial real estate loan balances in 2011. Construction or development loans were $10.9 million at December 31, 2011, a decrease of $4.4 million, compared to $15.3 million at December 31, 2010. The decrease is primarily the result of three multi-family construction loans totaling $4.1 million where the projects were completed and the loans were moved to multi-family or single family real estate in 2011. These construction new construction loans due to a decrease in demand for construction and development loans in 2011. replaced with loans were not Home equity line loans were $41.4 million at December 31, 2011, a decrease of $3.5 million, compared to $44.9 million at December 31, 2010. The open-end home equity lines are written with an 20 adjustable rate and a 10 year draw period which requires “interest only” payments followed by a 10 year repayment period which fully amortizes the outstanding balance. Closed-end home equity loans are written with fixed or adjustable rates with terms up to 15 years. Home equity loans were $13.4 million at December 31, 2011, a decrease of $4.4 million, compared to $17.8 million at December 31, 2010. 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 2011. 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 on Company non-homogenous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to establish allowances on the basis of these reviews. risk-rating utilizes system a for loans against charges off Management actively monitors asset quality and, the when appropriate, allowance loan losses. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ 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 $23.9 million, or 4.12% of gross loans at December 31, 2011, compared to $42.8 million, or 6.04% of gross loans at December 31, 2010. The allowance for loan losses and the related ratios decreased in 2011 due primarily to two factors. The first factor was the modification of our charge off policy in 2011 relating to non-performing loans, as described in the provision for loan loss discussion, which required the charge off of previously established specific valuation allowances (SVAs). The second factor was that in certain the instances the borrower’s financial condition or underlying collateral value had deteriorated to the point that a charge off of the loan balance was warranted. The following table reflects the activity in the allowance for loan losses and selected statistics: (Dollars in thousands) Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs: December 31, 2011 $ 42,828 17,278 2010 23,812 33,381 2009 21,257 26,699 2008 12,438 26,696 2007 9,873 3,898 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (508) (270) (15,512) (23,012) 3,084 (254) (907) (7,006) (7,095) 897 (82) (1,980) (9,421) (13,548) 887 (78) (612) (13,784) (3,454) 51 (42) (840) (554) (245) 348 Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,218) (14,365) (24,144) (17,877) (1,333) Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 23,888 42,828 23,812 21,257 12,438 Year end allowance for loan losses as a percent of year end gross loan balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio of net loan charge-offs to average loans outstanding . . . . . . . . . . . . . . . . . . The following table reflects the allocation of the allowance for loan losses: 4.12% 6.04% 2.89% 2.30% 1.41% 5.62 2.76 1.98 1.87 0.16 2011 2010 December 31, 2009 2008 2007 Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans One-to-four family . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . Commercial busines . . . . . . . . . . . . . . 3.12% 20.52% 1.67% 18.14% 0.69% 17.54% 1.75% 17.51% 0.27% 17.33% 4.70 1.86 4.93 49.95 10.71 18.82 50.00 9.97 22.49 47.79 9.62 25.26 50.30 9.96 21.60 50.03 9.36 23.10 1.83 1.70 1.28 2.83 1.83 1.75 3.47 1.55 3.88 6.90 1.31 9.91 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.12 100.00% 6.04 100.00% 2.89 100.00% 2.30 100.00% 1.41 100.00% The allocated percentage for commercial real estate and commercial business loans decreased in 2011 due primarily to the change in policy relating to the use of SVA’s which resulted in an increase in charge offs and a decrease in the related allowances. See “Results of Operations — Comparison of 2011 with 2010 — Provision for Loan Losses” above for a discussion of this change in policy. The allocation of the allowance for loan losses increased in 2011 for one-to-four family loans due primarily to the increases in the reserve percentages on certain risk rated loans at December 31, 2011 when compared to 2010. The allocation of the allowance for 21 loan losses increased in 2011 for consumer loans due to an increase in the number of classified consumer loans. 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, or fair value less periodically estimated performs valuations and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. The balance in the allowance for real estate losses was $6.5 million at costs. Management selling M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S December 31, 2011 and $4.5 million at December 31, 2010. Non-performing Assets 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 judgment of management, the loan is well collateralized and in the process of collection. Interest the time a loan is placed on accrued and unpaid at interest income. non-accrual status is charged against Subsequent the applied are payments outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. Restructured loans include the either to that restructurings troubled debt Bank’s involved forgiving a portion of interest or principal or making loans at a rate materially less than the market rate to borrowers whose financial condition had deteriorated. Foreclosed and repossessed assets include assets acquired in settlement of loans. Total non-performing assets were $50.6 million at December 31, 2011, a decrease of $33.9 million from $84.5 million at December 31, 2010 primarily due to charge-offs recorded in 2011. Non-performing loans decreased $34.1 million and foreclosed and repossessed assets increased $0.2 million during 2011. The following table sets forth the amounts and the of categories Company’s portfolio: non-performing assets in (Dollars in thousands) Non-accruing loans: December 31, 2011 2010 2009 2008 2007 One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreclosed and repossessed assets: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,435 22,658 699 6,201 33,993 0 352 16,264 0 16,616 4,844 36,737 224 26,269 68,074 0 972 15,409 14 16,395 2,132 37,122 4,086 17,787 61,127 0 1,011 15,246 5 16,262 7,251 46,953 5,298 4,671 64,173 25 258 10,300 0 10,558 1,196 15,641 1,094 1,723 19,654 34 901 1,313 33 2,247 Total non-performing assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,609 $84,469 $77,389 $74,756 $21,935 Total as a percentage of total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.40% 9.59% 7.47% 6.53% 1.96% Total non-performing loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,993 $68,074 $61,127 $64,173 $19,654 Total as a percentage of total loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.10% 10.25% 7.65% 7.12% 2.27% Allowance for loan losses to non-performing loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70.27% 62.91% 38.95% 33.12% 63.28% The following table summarizes the number and property types of commercial real estate loans that were non-performing (the largest category of non-performing loans) at December 31, 2011, 2010 and 2009. For 2011, 2010 and 2009, gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $3.2 million for 2011, and $5.0 million for both 2010 and 2009. The amounts that were included in interest income on a cash basis for these loans were $0.7 million, $1.3 million and $0.9 million, respectively. 22 (Dollars in thousands) Property Type Developments/land . . . . . . . . . . . . . . . . . . . . . . . . . Single family homes . . . . . . . . . . . . . . . . . . . . . . . . Hotels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuel plants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shopping centers/retail Restaurants/bar . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . # of Relationships 10 0 0 0 2 1 1 3 Principal Amount of Loans at December 31, 2011 $17,465 0 0 0 1,315 616 2,325 937 # of Relationships 9 3 0 1 3 1 1 0 Principal Amount of Loans at December 31, 2010 $23,661 2,673 0 4,994 1,099 635 3,675 0 # of Relationships 7 2 1 2 2 4 1 0 Principal Amount of Loans at December 31, 2009 $12,030 3,088 4,999 12,834 1,136 2,436 599 0 17 $22,658 18 $36,737 19 $37,122 The Company had allocated reserves established against the above commercial real estate loans of $2.9 million, $13.3 million and $7.7 million, respectively, at December 31, 2011, 2010 and 2009. The following table summarizes the number of lending relationships and the industry of commercial business loans that were non-performing for the years ended December 31, 2011, 2010 and 2009. (Dollars in thousands) Industry Type Residential/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restaurant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Company had allocated reserves established against the above commercial business loans of $1.5 million, $10.7 million and $3.4 million, respectively, at December 31, 2011, 2010 and 2009. At December 31, 2011, 2010 and 2009, there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $29.2 million, $19.3 million and $5.3 million, respectively. For the loans that were restructured in 2011, $0.5 million were unclassified and performing, $2.0 million were classified and performing and $17.2 million were non-performing at December 31. The increase in troubled debt restructurings in 2011 relates primarily to multiple a two telecommunications company totaling $7.8 million. The loan restructurings and included rates to improve such restructuring repayment reducing schedules developers loans and to Principal Amount of Loans December 31, 2011 $2,061 0 0 82 1,149 23 2,792 0 94 $6,201 Principal Amount of Loans December 31, 2010 $ 9,148 248 0 2,504 8,223 315 4,614 1,217 0 $26,269 # 5 2 1 1 1 1 0 0 0 11 # 6 1 0 1 2 1 1 4 0 16 Principal Amount of Loans December 31, 2009 $ 4,094 8,764 756 32 3,248 893 0 0 0 $17,787 # 6 0 0 1 1 1 1 0 2 12 borrower’s cash flow and the addition of collateral by such borrower. Of the loans that were modified in 2011, $11.6 million related to commercial real estate loans and the remaining modifications related to single family, consumer and commercial loans. Of the loans that were modified in 2010, $14.9 million related to commercial real estate loans and the 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 23 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S two other losses potential in non-performing status; however, to occur but recognized a higher degree of all non-performing assets, as of December 31, 2011, there were problem loan relationships. Potential problem loans are loans that are not 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 that the Company expects management risk associated with these loans. The level of potential 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, 2011 are a $3.8 million loan to a financial institution and a group of loans totaling $5.0 million to a residential developer. At December 31, 2010, potential problem loans were a $6.0 loan and a group of million land development commercial loans to a related borrower totaling $0.5 million. At December 31, 2009, potential problem loans were a $5.0 million loan to a financial institution and a loans in which the personal $1.7 million group of guarantor’s financial condition had deteriorated. another predominant factor is Pursuant to the Bank Supervisory Agreement, the Bank submitted a problem asset reduction plan that was accepted by the OCC. 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 and internet deposits. The Bank has the ability to borrow additional funds from the FHLB or FRB by pledging additional to securities or 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. subject loans, 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. 2011: during activities investing Cash and cash equivalents at December 31, 2011 were $67.8 million, an increase of $46.8 million, compared to $21.0 million at December 31, 2010. Net cash provided by operating activities during 2011 was $17.3 million. The Company conducted the following major principal payments and maturity proceeds received on securities available for sale and FHLB stock were $171.9 million, purchases of securities available for sale and FHLB stock were $144.1 million, proceeds from the sale of premises real estate were $5.4 million, and loans and other receivable decreased $76.1 million. The Company spent $0.2 million for the purchase of equipment and updating its premises. Net cash provided by investing activities during 2011 was $109.2 million. The Company conducted the following major financing activities during 2011: received proceeds from borrowing and advances of $10.0 million, repaid advances and borrowings of $62.5 million and deposits decreased $27.3 million. Net cash used by financing activities was $79.7 million. The Company has certificates of deposit with outstanding balances of $187.5 million that mature during 2012, of which $51.8 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 the brokered deposits that are not anticipated to renew due to management’s 24 desire to reduce the amount of 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 OCC (as successor to 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 a combination of other customers’ deposits, FHLB advances or FRB borrowings. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits. The Company has deposits of $60.0 million in checking and money market accounts of customers that have relationship balances greater than $5 million. Approximately $20.7 million of the $60.0 million in deposits are expected to be sold as part of the Toledo branch sale that is to be completed in the first quarter of 2012. While the remaining 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 anticipated that they would be funded with available cash or replaced with FHLB advances, FRB borrowings or deposits from other customers. The Company has $70.0 million of FHLB advances with maturities beyond 2012 that have call features that may be exercised by the FHLB during 2012. 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. of the loans value collateralizing The credit policy of the FHLB relating to the collateral 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 2013. 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 2012 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 OCC (as successor to the OTS). Because FHLB advances are debt of the Bank, they are not affected by the Company’s restriction on incurring debt. it that except in 2011, The Holding 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, 2011, the Company had $1.4 million in cash and other assets that could readily be its turned into cash. The Company anticipates that liquidity requirements for 2012 will be similar to the liquidity requirements is anticipated that $34 million of the Bank’s cash will be used to fund the outflow of deposits in connection with the sale of the Toledo, Iowa branch in the first quarter of 2012. The Company believes that the Bank’s available liquidity is adequate to provide the cash needed for funding the branch sale and the payment of its operating expenses in 2012. The Company’s primary use of cash is the payment of expenses and dividends on the preferred stock issued to the United States Treasury Department as part of the TARP Capital Purchase Program. The amount of the dividend on the preferred stock accumulates at the rate of $325,000 per quarter through February 14, 2014 and $585,000 per quarter thereafter, if the shares of preferred stock are not redeemed. If the accumulated dividends on the preferred stock have not been paid for an aggregate of six quarterly dividend periods or more, whether or not consecutive, the number of authorized directors of the Company automatically will be increased by two, and the holders of the preferred shares (currently the United States Treasury) will have the right to elect two directors to fill the newly created directorships. The Company deferred the February 15, 2011, May 15, 2011, August 15, 2011, November 15, 2011 and February 15, 2012 regular quarterly cash dividends and the total amount of accrued but unpaid dividends totaled $1.3 million at December 31, 2011. The Company determined to defer such payments 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 25 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S notice to, and consent of, the OCC (as successor to the OTS). The previously authorized stock repurchase program expired on January 26, 2010. No treasury stock purchases were made in 2011 and none are anticipated in 2012 due to restrictions on stock repurchases by the United States Treasury in connection with its preferred stock 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 OCC (as successor to the OTS). Contractual Obligations and Commercial Commitments The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2011, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: (Dollars in thousands) Contractual Obligations: Total borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Branch sale obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annual rental commitments under non-cancellable operating leases . . . . . Other Commercial Commitments: Commercial lines of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments to lend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments Due by Period Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years $ 70,000 34,465 3,279 0 34,465 778 70,000 0 1,392 $107,744 35,243 71,392 0 0 1,103 1,103 0 0 6 6 Amount of Commitments -Expiring by Period $ 24,917 6,229 1,535 15,862 5,664 1,505 $ 32,681 23,031 6,650 20 30 6,700 2,405 146 0 2,551 0 399 0 399 regulators Regulatory Capital Requirements As a result of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), banking and thrift regulators are required to take prompt regulatory action against institutions which are undercapitalized. FDICIA requires banking and thrift to categorize institutions as “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized”, or “critically undercapitalized”. A savings institution will be deemed to be well capitalized if it: (i) has a total risk-based capital ratio of 10% or greater, (ii) has a Tier 1 (core) risk- based capital ratio of 6% or greater, (iii) has a leverage ratio of 5% or greater, and (iv) is not subject to any order or written directive by the OCC (as successor to the OTS) to meet and maintain a specific capital level for any capital measure. Refer to Note 16 of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to these capital requirements. by Supervisory Agreement, the Company submitted an updated two-year the Company required As the OCC has capital plan in January of 2012 that the Federal Reserve Board (as successor to 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, established 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 Effective December 31, 2011, the Bank was required to establish, and subsequently maintain, core capital at least equal to 8.5% of adjusted total assets, which was in excess of the Bank’s 7.14% core capital to adjusted total assets ratio at December 31, 2011. The Bank would have needed $10.8 million in additional capital at December 31, 2011 to meet the minimum core capital ratio set by the OCC. In February 2012, the Bank received a notice from the OCC arising out of its failure to establish and maintain its “well-capitalized.” classified as 26 IMCR of 8.5% core capital to adjusted total assets at December 31, 2011. By April 30, 2012, the Bank must submit to the OCC a further written capital plan of how it will achieve and maintain its IMCR, and a contingency plan in the event the IMCR is not achieved through the Bank’s primary plan. The Bank’s failure to comply with the terms of the IMCR is deemed an unsafe and unsound banking practice and could subject it to further limits on growth and such legal actions or sanctions as the OCC considers appropriate. Management believes that, as of December 31, 2011, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the prompt corrective action regulations described above. the Bank to satisfy the IMCR at The failure of December 31, 2011 does not by itself affect the Bank’s status as “well-capitalized” within the meaning of these prompt corrective action regulations. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well-capitalized” in the future. In order to improve its capital ratios and comply with its IMCR, the Bank is, among other things, working to improve its financial results, reduce non-performing assets, and decrease the asset size of the Bank. The Bank has and also entered into a definitive purchase assumption agreement relating to its Toledo, Iowa branch as more fully described below. In light of its current capital condition and its failure to comply with the IMCR at December 31, 2011, the Bank may also determine it to be necessary or prudent to dispose of other non-strategic assets. These actions have resulted, and may result in changes in the Bank’s assets, liabilities and earnings, some of which may be material, during the period in which the action is taken or is consummated or over a longer period of time. The Bank entered into a definitive purchase and assumption agreement on November 7, 2011 with Pinnacle Bank (Pinnacle) of Marshalltown, Iowa which provides for the sale to Pinnacle of substantially all of the assets associated with the Toledo, Iowa branch (the Branch) of the Bank (approximately $1.6 million at December 31, 2011) and the assumption by Pinnacle of the Branch substantially all deposit liabilities of 27 (approximately $36.0 million at December 31, 2011). The Bank will continue to own and operate its other Iowa and Minnesota branches. Regulatory approval for the transaction has been obtained, however, the transaction is subject to the scheduling of the required Branch data processing conversion. Subject to the foregoing and other the transaction is customary terms and conditions, anticipated to be consummated in the first quarter of 2012. The Bank anticipates that the transaction will be funded with available assets, result in a one time gain on sale in the first quarter of 2012, result in a decrease in the Bank’s overall assets of approximately $34 million, and improve the Bank’s core capital ratio by approximately 40 basis points. preferences The Company also serves as a source of capital, liquidity and financial support to the Bank. Based on the operating performance of the Bank or other capital demands, including the Bank’s failure to comply with the the Company may need, or be outstanding IMCR, required by supervising bank regulators, to raise additional capital. If the Company raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, given our current common stock trading price, would be expected to dilute the per share book value of the Company’s common stock and could result in a change of control of the Company and the Bank. New investors may also have rights, the Company’s current stockholders, which may adversely stockholders. The impact Company’s ability to raise additional capital through the issuance of equity securities, if needed, will depend on conditions in the capital markets at that time, which are outside of its control, and on the Company’s financial performance. Accordingly, the Company may not be able to raise additional capital, if needed, on favorable economic terms, or other terms acceptable to it. If the Company or the Bank cannot satisfactorily address their respective capital needs as they arise, the Company’s ability to maintain or expand its operations, their ability to meet the Company’s capital plan and the Bank IMCR, other operate without restrictions, and its operating results, could be materially adversely affected. the Company’s regulatory additional privileges current senior and or to M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S tax requirements, considerations, Dividends The declaration of dividends is subject to, among other things, the Company’s financial condition and results of operations, the Bank’s compliance with its regulatory capital 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 also suspended the past five regular quarterly cash dividends on the preferred stock issued to the Treasury as part of the TARP Capital Purchase Program. Under the terms of the certificate of designations for the preferred stock, dividend payments may be deferred without default, but the Company fails to pay dividends for six quarters, whether or not consecutive, the Treasury will have the right to appoint two representatives to the Company’s board of directors. As of February 15, 2012, the Company had failed to pay dividends for five quarters. Under the terms of the Company Supervisory Agreement, the Company may not declare or pay any cash dividends, or purchase or redeem any capital stock, without prior notice to, and to OTS). The consent of, Company does not anticipate requesting consent from the OCC (as successor to OTS) to make any payments of dividends on, or purchase of, its common or preferred stock in 2012. the dividend is cumulative and, the OCC (as successor if 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 28 not necessarily move in the same direction or to the same extent as the prices of goods and services. of credit quality are financing intended to enhance New Accounting Pronouncements In July 2010, the FASB issued ASU 2010-20, 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 receivables. The the requirements transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables 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 restructurings are 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 interim and annual reporting periods after December 15, 2010 and the related disclosures are included in Note 5 of the consolidated financial statements in this report. troubled debt a Is guidance In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310), A Creditor’s Determination of Troubled Debt Whether a Restructuring Restructuring. This ASU provides on evaluating whether a restructuring constitutes a troubled debt restructuring. It indicates that if a creditor separately concludes that a restructuring constitutes a concession and that the debtor is experiencing financial difficulties that the restructuring is a troubled debt restructuring. It also clarifies guidance on a creditor’s evaluation of the above two items. For public entities, such as HMN, the amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. In addition, this ASU requires that the disclosures about troubled debt restructurings that were delayed by ASU 2011-01 in January 2011 be disclosed for interim and annual periods beginning on or after June 15, 2011. The implementation of the guidance in this ASU and the related disclosures are included in Note 5 of this report. In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements. Topic 860, Transfers and Servicing, which prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repurchase agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred assets. The amendments in this ASU removed from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this ASU. This ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modification of existing transactions that occur on or after the effective date. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements. In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements in order to improve consistency in wording between U.S. GAAP and IFRS. This ASU is effective for interim or annual period beginning on or after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have impact on the Company’s consolidated financial statements other than to change the disclosures relating to fair value measurements. a material In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income. Current U.S. GAAP allows reporting entities three alternatives for presenting other comprehensive income and its components in financial statements. The first this information in a statement of comprehensive income or in two separate but consecutive statements. The third option, which is used by the two options are to present continuous single 29 is to present the components of other Company, comprehensive income as part of the statement of changes in stockholders’ equity. This ASU eliminates the third option and therefore the Company will have to adopt one of the two remaining methods for presentation. This ASU is effective for fiscal years, and interim periods beginning after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above. In September 2011, the FASB issued ASU 2011-09, Compensation — Retirement Benefits — Multiemployer Plans (Subtopic 715-80). The amendments in this ASU require additional disclosures about an employer’s participation in a multiemployer plan. For public entities, such as HMN, this ASU is effective for annual periods for fiscal years ending after December 15, 2011. The adoption of this ASU in the fourth quarter of 2011 did not have impact on the Company’s consolidated financial statements. The presentation of the additional disclosures relating to the multiemployer retirement plan (sponsored by the Financial Institutions Retirement Fund (FIRF)) in which the Company participates is included in Note 13 of this report. a material In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210). The objective of this ASU is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of rights of setoff associated with an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this ASU. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar in agreement, accordance with or Section 815-10-45. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods with those annual periods. The adoption of this ASU in the first quarter of 2013 is not anticipated to have any impact on the Company’s consolidated financial statements as it currently has no outstanding rights of setoff. irrespective of whether they are offset accordance with 210-20-45 Section either offset (1) in M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S (Topic Income Comprehensive In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220). The amendments in this ASU supersede certain pending paragraphs in ASU 220): 2011-5, Presentation of Comprehensive Income, to effectively defer only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. All other requirements in ASU 2011-05 are not affected by this ASU, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above. 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 activities. investing, Management actively monitors and manages its interest rate risk exposure. lending deposit taking and 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/Liability Management this Management’s Discussion and Analysis discloses the Company’s projected changes in net income based upon immediate interest rate changes called rate shocks. interest section of The Company utilizes a model that uses 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 the also calculates the changes in market value of 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 interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on December 31, 2011. (Dollars in thousands) Basis point change in interest rates Market Value -100 0 +100 +200 Total market-risk sensitive assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total market-risk sensitive liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . Off-balance sheet financial instruments . . . . . . . . . . . . . . . . . . . . . . . . $804,852 743,606 (435) Net market risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,681 796,019 731,694 0 64,325 783,763 719,454 (56) 768,623 706,703 (80) 64,365 62,000 Percentage change from current market value . . . . . . . . . . . . . . . . . . . (4.11)% 0.00% 0.06% (3.61)% assumptions The preceding table was prepared utilizing the (the Model Assumptions) following regarding prepayment and decay ratios that were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 8% 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 13% and 34%, depending on the note rate and the period to maturity. Mortgage-backed and Collateralized Mortgage Obligations securities (CMOs) were projected to have prepayments based upon the underlying collateral securing the instrument and the related cash flow priority of the CMO tranche owned. Certificate accounts were assumed not to be withdrawn 30 until maturity. Passbook and money market accounts were assumed to decay at annual rates of 22% and 28%, respectively. Non-interest checking and NOW accounts were assumed to decay at annual rates of 23% and 16%, respectively. Commercial non-interest checking was assumed to decay at an annual rate of 23%. Commercial NOW and MMDA accounts were assumed to decay at annual 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. rates of 16% and 28%, Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features that restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets that are approaching their lifetime interest rate caps 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 The Company’s management reviews the impact that interest changing interest rates will have on the net income projected for the twelve months following December 31, 2011 to determine if its current level of rate risk is acceptable. The following table interest income projects the estimated impact on net interest during the 12 month period ending December 31, 2012 of immediate interest rate changes called rate shocks: (Dollars in thousands) Rate Shock Table Rate Shock in Basis Points Net Interest Change Percent Change +200 +100 0 -100 $ 495 412 0 (983) 2.10% 1.75 0.00 (4.17) The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing rates, In the event of a change in interest table. 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 strategies and oversees the timing and implementation of transactions to assure attainment of the Bank’s objectives in the most effective manner. In addition, the Board reviews on a quarterly basis asset/liability position, including simulations of the effect on the Bank’s capital of various interest rate scenarios. the Bank’s 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 income resulting from a the increased net interest 31 M A N A G E M E N T D I S C U S S I ON A N D A N A L Y S I S mismatch in the 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. 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 2011, the Bank has family primarily focused its residential lending program on loans that are saleable to third parties and generally placed only those fixed rate loans fixed rate one-to-four 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. 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 discussed in Note 17 of the Notes to Consolidated Financial Statements. 32 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) ASSETS Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related securities 2011 2010 $ 67,840 20,981 (amortized cost $19,586 and $32,036) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,645 33,506 Other marketable securities (amortized cost $105,700 and $118,631) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,469 118,058 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,114 151,564 3,709 555,908 2,449 16,616 4,222 1,485 7,967 2,262 1,583 0 2,728 664,241 3,311 16,382 6,743 1,586 9,450 3,632 0 0 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $790,155 880,618 LIABILITIES AND STOCKHOLDERS’ EQUITY Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Customer escrows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $620,128 36,048 70,000 780 933 5,205 683,230 0 122,500 1,092 818 3,431 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733,094 811,071 Commitments and contingencies Stockholders’ equity: Serial preferred stock: ($.01 par value) Authorized 500,000 shares; issued shares 26,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,780 24,264 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 4,740,711 and 4,818,263 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 53,462 42,983 471 (3,191) (61,535) 91 56,420 55,838 541 (3,384) (64,223) Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,061 69,547 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $790,155 880,618 See accompanying notes to consolidated financial statements. 33 C O N S O L I D A T E D S T A T E M E N T S OF L O S S Years ended December 31 (Dollars in thousands) 2011 2010 2009 Interest income: Loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale: Mortgage-backed and related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other marketable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,776 44,248 51,876 1,098 1,451 36 180 1,813 2,023 4 182 2,768 3,039 1 87 Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,541 48,270 57,771 Interest expense: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances and Federal Reserve borrowings . . . . . . . . . . . . . . . . 6,847 4,288 11,281 5,978 17,579 6,289 Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,135 17,259 23,868 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,406 17,278 31,011 33,381 33,903 26,699 Net interest income (loss) after provision for loan losses . . . . . . . . . . . . . . . . . . . . . . 11,128 (2,370) 7,204 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 on real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,739 987 0 1,656 487 6,869 13,553 2,681 3,741 1,255 1,221 7,101 3,741 1,067 0 1,987 476 7,271 13,516 1,165 4,082 1,933 1,040 5,820 4,137 1,042 5 2,273 625 8,082 13,432 3,873 4,084 1,973 1,182 7,145 Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,552 27,556 31,689 Income tax expense (benefit) Loss before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,555) 0 (22,655) 6,323 (16,403) (5,607) Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends and discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(11,555) (1,821) (28,978) (1,784) (10,796) (1,747) Net loss available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(13,376) (30,762) (12,543) Basic loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ (3.47) (8.17) (3.39) (3.47) (8.17) (3.39) See accompanying notes to consolidated financial statements. 34 C O N S O L I D A T E D S T A T E M E N T S OF 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 Accumulated Other Comprehensive Income (Loss) Unearned Employee Stock Ownership Plan 2,091 (3,771) Total Stock- holders’ Equity Treasury Stock (68,336) 112,213 (10,796) Retained Earnings 98,067 (10,796) (Dollars in thousands) Preferred Stock Common Stock Additional Paid-in Capital Balance, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23,384 91 60,687 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401 (401) (2,181) 127 27 373 (56) Balance, December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23,785 91 58,576 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479 (479) 63 (2,237) 178 370 (51) Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,264 91 56,420 7 (1,163) 86,115 (28,978) 1 (1,300) 55,838 (11,555) 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . . . Earned employee stock ownership plan shares . . . . . . . . . . . . . . . . Preferred stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516 (516) 29 (2,700) 12 298 (81) (1,300) (861) 2,181 (127) (861) (11,657) 0 0 0 7 27 373 138 (1,163) 194 1,230 (3,577) (66,282) 99,938 (28,978) (689) (689) (29,667) 0 63 0 0 1 370 142 (1,300) 2,237 (178) 193 541 (3,384) (64,223) 69,547 (11,555) (70) (70) (11,625) 0 29 0 0 298 112 (1,300) 2,700 (12) 193 Balance, December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,780 91 53,462 42,983 471 (3,191) (61,535) 57,061 See accompanying notes to consolidated financial statements. 35 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: 2011 2010 2009 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net loss to cash provided by operating activities: $ (11,555) (28,978) (10,796) Provision for loan 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss 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 below original cost Stock option compensation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,278 1,267 297 (465) 562 (461) 0 0 2,681 (1,656) 64,890 (58,588) 298 193 (81) 29 862 (312) 1,342 380 379 33,381 1,593 571 (319) 482 (753) 12,043 0 1,165 (1,987) 90,797 (85,384) 370 193 (51) 63 713 (1,016) 3,084 (774) 362 26,699 1,837 465 (972) 556 (1,143) (2,516) (5) 3,731 (2,273) 122,491 (119,475) 373 194 (56) 27 1,544 (4,199) (2,041) 912 95 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,340 25,555 15,448 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 decrease in loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 12,466 156,900 (144,051) (17) 2,538 5,440 76,114 (201) 0 19,820 115,000 (128,059) (2,420) 2,963 14,532 82,591 (292) 2,141 22,213 78,350 (88,446) 0 0 10,749 56,329 (558) Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,189 104,135 80,778 Cash flows from financing activities: Decrease in deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid to preferred stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in customer escrows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (27,285) 0 10,002 (62,502) 115 (113,218) (1,300) 87,000 (97,000) (609) (85,162) (1,163) 1,099,000 (1,109,000) 788 Net cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (79,670) (125,127) (95,537) Increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,859 20,981 Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 67,840 Supplemental cash flow disclosures: Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,447 0 Supplemental noncash flow disclosures: Loans transferred to loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer of loans to real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets transferred to assets held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits transferred to deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,509 8,732 1,583 36,048 4,563 16,418 20,981 18,275 39 3,195 16,167 0 0 689 15,729 16,418 28,067 33 1,234 18,342 0 0 See accompanying notes to consolidated financial statements. 36 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, 2011, 2010 and 2009 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 Agency, Inc. (OIA), which offers financial planning products and services. HMN has another wholly owned subsidiary, Security Finance Corporation (SFC), which is currently not actively engaged in any activities. The consolidated financial included herein are for HMN, SFC, the Bank and OIA. All significant intercompany accounts and transactions have been eliminated in consolidation. statements The Company evaluated subsequent events through the filing date of our annual 10-K with the Securities and Exchange Commission on March 7, 2012. In preparing the Use of Estimates consolidated financial statements, management is required to make estimates and assumptions 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. that affect 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 appropriate to cover probable losses inherent in the portfolio at the date of the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions 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 to the allowance based on their require additions 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. 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 factors. Unrealized gains and losses, net of similar income taxes, are reported as a separate component of stockholders’ equity until realized. Gains and losses on the sale of securities available for sale are determined using the specific identification method and recognized on the trade date. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities available for sale reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established. 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, the market 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, impairment loss is recognized. an Loans Held for Sale Mortgage loans originated or purchased which are intended for sale in the secondary 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 lower of cost or estimated market are carried at 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. 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. loss experience. the obtains allowance independent The allowance for loan losses is maintained at an amount considered to be appropriate 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 loan portfolio composition and and building lots, In connection with the historical loan losses, determination of for management significant properties or other securing loan losses is delinquent established for known problem loans, as well as for loans which are not currently known to require an allowance. Loans are charged off to the extent they are deemed to be uncollectible. The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on appraisals, Such 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 loans. The allowance for appraisals estimates, collateral impaired loans. for provision for loan losses in the periods in which the adjustments become known. 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 subsequently is recognized as income to the extent cash is received when, in management’s judgment, principal is collectible. reversed from income. Interest is 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, the impaired amount is charged off. 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 non-accruing loans are reviewed for impairment on an individual basis. Included in loans receivable, net, are certain loans that have been modified in order to maximize collection of the loan balances. The Company evaluates all loan modifications and if the Company, for legal or economic reasons related to the borrower’s financial difficulties, grants a concession compared to the original terms and conditions of the loan that the Company would not otherwise consider, the modified loan is considered a troubled debt restructuring (TDR) and classified as an the TDR loan was performing impaired loan. If (accruing) prior to the modification, typically will remain accruing after the modification as long as it continues to perform according to the modified terms. If the TDR loan was non-performing (non-accruing) prior to the modification, it will remain non-accruing after the modification for a minimum of six months. If the loan performs according to the modified terms for a minimum of six months, it typically will be returned to accruing status. In general, there are two conditions in which a TDR loan is no longer considered to be a TDR and potentially not classified as impaired. The first condition it 38 is whether the loan is refinanced with terms that reflect normal terms for the type of credit involved. The second condition is whether the loan is repaid or charged off. 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 or the 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. its Toledo, Assets and Deposits Held for Sale In the fourth quarter of 2011, the Bank entered into a definitive purchase and to sell certain assets and the assumption agreement deposits of the Iowa branch. Until consummation of the sale, which is anticipated to be completed in the first quarter of 2012, these assets and deposits are reported as held for sale and are carried at the lower of their cost basis or estimated fair market value. Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of The Company reviews long- lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. credits for the Company. The Company accounted for the earnings or losses from the limited partnerships on the limited partnership equity method. The Company’s investments were liquidated in the fourth quarter of 2011. Stock Based Compensation The Company recognizes the grant-date fair value of stock option and restricted stock awards issued as compensation expense, amortized over the vesting period. Stock Ownership Plan Employee (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. Investment in Limited Partnerships The Company had investments in limited partnerships that invested in low to moderate income housing projects that generated tax 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 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 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 the five year period preceding the scheduled rate increase on the preferred stock in accordance with the requirements of ASC 505. 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 the entity. Options and shared in the earnings of 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. Segment Information The amount of each segment item reported is the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an enterprise’s general-purpose financial revenues, expenses and gains or losses are included in determining reported segment profit or loss if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets that are included in the measure of the segment’s assets that are used by the chief operating decision maker are reported for that segment. allocations of statements and New Accounting Pronouncements In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit 40 annual periods reporting interim and the allowance for credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures losses and the credit about quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables 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 debt restructurings are 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 were the consolidated financial included in Note 5 of statements in this report. In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310), A Creditor’s Determination of Troubled Debt a Restructuring Whether Restructuring. This ASU provides on evaluating whether a restructuring constitutes a troubled debt restructuring. It indicates that if a creditor separately concludes that a restructuring constitutes a concession and that the debtor is experiencing financial difficulties that the restructuring is a troubled debt restructuring. It also clarifies guidance on a creditor’s evaluation of the above two items. For public entities, such as HMN, the amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. In addition, this ASU requires that the disclosures about troubled debt restructurings that were delayed by ASU 2011-01 in January 2011 be disclosed for interim and annual periods beginning on or after June 15, 2011. The implementation of the guidance in this ASU and the related disclosures are included in Note 5 of this report. In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements. Topic 860, Transfers and Servicing, which prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repurchase agreements. That guidance Is a determination is based, in part, on whether the entity has maintained effective control over the transferred assets. in this ASU removed from the The amendments assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this ASU. This ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modification of existing transactions that occur on or after the effective date. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements. In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements in order to improve consistency in wording between U.S. GAAP and IFRS. This ASU is effective for interim or annual period beginning on or after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have impact on the Company’s consolidated financial statements other than to change the disclosures relating to fair value measurements. a material In June 2011, two options are to present the FASB issued ASU 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income. Current U.S. GAAP allows reporting entities three alternatives for presenting other comprehensive income and its components in financial statements. The first this statement of information in a comprehensive income or in two separate but consecutive statements. The third option, which is used by the Company, the components of other the statement of comprehensive income as part of changes in stockholders’ equity. This ASU eliminates the third option and therefore the Company will have to adopt one of the two remaining methods for presentation. This ASU is effective for fiscal years, and interim to present continuous single is periods beginning after December 15, 2011. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above. In September 2011, the FASB issued ASU 2011-09, Compensation — Retirement Benefits — Multiemployer Plans (Subtopic 715-80). The amendments in this ASU require additional disclosures about an employer’s participation in a multiemployer plan. For public entities, such as HMN, this ASU is effective for annual periods for fiscal years ending after December 15, 2011. The adoption of this ASU in the fourth quarter of 2011 did not have impact on the Company’s consolidated financial statements. The presentation of the additional disclosures relating to the multiemployer retirement plan (sponsored by the Financial Institutions Retirement Fund (FIRF)) in which the Company participates is included in Note 13 of this report. a material In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210). The objective of this ASU is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of rights of setoff associated with an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this ASU. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar in agreement, accordance with or Section 815-10-45. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods with those annual periods. The adoption of this ASU in the first quarter of 2013 is not anticipated to have any impact on the Company’s consolidated financial statements as it currently has no outstanding rights of setoff. irrespective of whether they are offset accordance with 210-20-45 Section either offset (1) in In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220). The amendments in this ASU supersede certain pending paragraphs in ASU 220): 2011-5, Presentation of Comprehensive Income, to effectively defer only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of Comprehensive Income (Topic 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 accumulated other comprehensive income. All other requirements in ASU 2011-05 are not affected by this ASU, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. The adoption of this ASU in the first quarter of 2012 did not have a material impact on the Company’s consolidated financial statements other than to change the presentation of other comprehensive income as discussed above. 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. NOTE 2 Other Comprehensive Loss The components of other comprehensive loss and the related tax effects were as follows: For the years ended December 31, 2011 Tax Effect Net of Tax Before Tax 2010 Tax Effect Net of Tax Before Tax 2009 Tax Effect 0 0 0 0 (70) 0 (70) (70) (1,142) 0 (453) 0 (689) 0 (1,490) 5 (632) 2 (1,142) (453) (689) (1,495) (634) (861) (1,142) (453) (689) (1,495) (634) (861) Net of Tax (858) 3 (Dollars in thousands) Securities available for sale: Gross unrealized losses arising during the period . . . . . . . . . . . . . . . . . Less reclassification of net gains included in net loss . . . . . . . . . . . . . . Net unrealized losses arising during the period . . . . . . . . . . . . . . . . . . . Before Tax $(70) 0 (70) Other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(70) 42 NOTE 3 Securities Available for Sale A summary of securities available for sale at December 31, 2011 and 2010 is as follows: (Dollars in thousands) December 31, 2011: Mortgage-backed securities: Amortized cost Gross unrealized gains Gross unrealized losses Fair value FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,310 7,670 Collateralized mortgage obligations: FHLMC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FNMA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 271 553 499 4 3 Other marketable securities: U.S. Government agency obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,586 1,059 105,000 700 105,700 294 0 294 $125,286 1,353 December 31, 2010: Mortgage-backed securities: 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 32,036 117,931 700 118,631 719 692 44 15 1,470 218 0 218 $ 150,667 1,688 0 0 0 0 0 0 (525) (525) (525) 0 0 0 0 0 11,863 8,169 339 274 20,645 105,294 175 105,469 126,114 18,274 13,492 1,343 397 33,506 (266) (525) (791) (791) 117,883 175 118,058 151,564 (Dollars in thousands) Amortized Cost Fair Value Due less than one year . . . . . . . . . . . . . . . . . . . . . . $ 44,912 79,148 Due after one year through five years . . . . . . . . . . 526 Due after five years through ten years . . . . . . . . . . 700 Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . 45,521 79,862 556 175 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $125,286 126,114 The allocation of mortgage-backed securities and collateralized mortgage obligations in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds. The Company did not hold any investments in European sovereign debt as of December 31, 2011. The Company did not sell any available for sale securities and did not recognize any gains or losses on investments in 2011 or 2010. Proceeds from securities available for sale which were sold in 2009 were $2.1 million resulting in gross gains of $5,000. The following table presents amortized cost and estimated fair value of securities available for sale at December 31, 2011 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: 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 The following table shows the gross unrealized losses and fair values for the securities available for sale portfolio aggregated by investment category and length time that of individual securities have been in a continuous unrealized loss position at December 31, 2011 and 2010: (Dollars in thousands) December 31, 2011 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 . . . . . . . . . . . . . . December 31, 2010 Other marketable securities: U.S. Government agency obligations . . . . . . . . . . . . . . . Corporate preferred stock . . . . . . . . . . . . . . . . . . . . . . . . Total temporarily impaired securities . . . . . . . . . . . . . . . . . 0 0 0 10 0 10 $ $ 0 0 0 0 0 0 $47,610 0 $47,610 (266) 0 (266) 0 1 1 0 1 1 $ 0 175 $175 $ 0 175 $175 0 (525) (525) $ $ 0 175 175 0 (525) (525) 0 (525) $47,610 175 (525) $47,785 (266) (525) (791) loan losses but still met the regulatory requirements to be considered “adequately capitalized” based on its most recent regulatory filing in 2011. In addition, the owners of the issuing bank appear to have the ability to make additional capital contributions to enhance the issuing 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, 2011. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time loss. recover Management 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. temporary sufficient the to 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 investment, the financial condition and near-term 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 reported for corporate preferred stock at December 31, 2011 relates to a single trust preferred security that was issued by the holding 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 over the past several years due to increased provisions for 44 NOTE 4 Loans Receivable, Net A summary of loans receivable at December 31 is as follows: (Dollars in thousands) Residential real estate loans: 2011 2010 1-4 family conventional . . . . . . . . . . . . . . . . . . . . 1-4 family FHA . . . . . . . . . . . . . . . . . . . . . . . . . . 1-4 family VA . . . . . . . . . . . . . . . . . . . . . . . . . . . $118,524 494 48 128,087 399 49 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 . . . . . . . . . . . . . . . . . . . . 119,066 128,535 31,905 80,436 6,455 45,197 8,326 3,102 18,882 16,555 4,926 1,156 4,840 8,557 6,058 35,517 18,002 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 19,502 289,914 356,391 404 41,429 13,426 1,409 2,723 576 657 1,537 62,161 604 44,933 17,840 1,304 2,510 534 764 2,114 70,603 Commercial business . . . . . . . . . . . . . . . . . . . . . . . . 109,259 153,039 Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580,400 708,568 Less: Unamortized discounts . . . . . . . . . . . . . . . . . . . . . Net deferred loan fees . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . 93 511 23,888 413 1,086 42,828 Total loans receivable, net . . . . . . . . . . . . $555,908 664,241 Commitments to originate or purchase loans . . . . . . Commitments to deliver loans to secondary market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted average contractual rate of loans in $ $ 5,925 629 7,263 3,413 portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.52% 5.52% Included in total commitments to originate or purchase loans are fixed rate loans aggregating $5.9 million and $0.6 million as of December 31, 2011 and 2010, rates on these loan 6.79% at commitments December 31, 2011 and from 3.88% to 5.13% at December 31, 2010. respectively. The interest from 3.00% to ranged December 31, 2011 and $4.1 million at December 31, 2010 and December 31, 2009. During 2011, repayments on loans to executive officers and directors were $86,000, new loans to executive officers and directors totaled $665,500 and sales of executive officer and director loans were $415,500. During 2010, the only activity was $12,000 in repayments on loans to executive officers and directors. All loans were made in the ordinary course of business on normal credit including interest rates and collateral, as those terms, prevailing at the time for comparable transactions with unrelated parties. At December 31, 2011, 2010 and 2009, the Company was servicing loans for others with aggregate unpaid principal balances of approximately $417.4 million, $508.0 million and $566.0 million, respectively. The Company originates residential, commercial real estate and other loans primarily in Minnesota and Iowa. At December 31, 2011 and 2010, the Company had in its portfolio single-family and multi-family residential loans located in the following states: 2011 2010 (Dollars in thousands) Amount Percent of Total Amount Percent of Total Iowa . . . . . . . . . . . . . . . . . . . . . . $ Minnesota . . . . . . . . . . . . . . . . . Wisconsin . . . . . . . . . . . . . . . . . Other states . . . . . . . . . . . . . . . . 4,664 109,632 2,130 2,640 3.9% $ 92.1 1.8 2.2 4,684 118,305 1,879 3,667 3.6% 92.0 1.5 2.9 Total . . . . . . . . . . . . . . . . . . . . $119,066 100.0% $128,535 100.0% Amounts under one million dollars in both years are included in “Other states”. At December 31, 2011 and 2010, the Company had in its portfolio commercial real estate loans located in the following states: 2011 2010 (Dollars in thousands) Amount California . . . . . . . . . . . . . . . . . . $ Florida . . . . . . . . . . . . . . . . . . . . Idaho . . . . . . . . . . . . . . . . . . . . . Indiana . . . . . . . . . . . . . . . . . . . . Iowa . . . . . . . . . . . . . . . . . . . . . . Kansas . . . . . . . . . . . . . . . . . . . . Minnesota . . . . . . . . . . . . . . . . . Nebraska . . . . . . . . . . . . . . . . . . North Carolina . . . . . . . . . . . . . . Tennessee . . . . . . . . . . . . . . . . . . Utah . . . . . . . . . . . . . . . . . . . . . . Wisconsin . . . . . . . . . . . . . . . . . Other states . . . . . . . . . . . . . . . . 4,943 2,792 4,423 7,206 6,139 1,036 244,798 0 7,075 326 1,324 8,413 1,439 Percent of Total Amount Percent of Total 1.7% $ 1.0 1.5 2.5 2.1 0.4 84.4 0.0 2.4 0.1 0.5 2.9 0.5 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 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 Total . . . . . . . . . . . . . . . . . . . . $289,914 100.0% $356,391 100.0% The aggregate amounts of loans to executive officers the Company was $4.0 million at and directors of Amounts under one million dollars in both years are included in “Other states”. 45 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 5 Allowance for Loan Losses and Credit Quality Information The allowance for loan losses is summarized as follows: Commercial Real Estate Consumer Commercial Business (Dollars in thousands) Balance, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-4 Family $ 2,830 (1,753) (82) 5 1,000 1,399 (254) 0 2,145 2,081 (508) 0 Balance, December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,718 Allocated to: Specific reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allocated to: Specific reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ 993 1,152 2,145 1,086 2,632 3,718 Loans receivable at December 31, 2010: Individually reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Collectively reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,729 121,806 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $128,535 Loans receivable at December 31, 2011: Individually reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Collectively reviewed for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,241 112,825 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,066 13,095 14,217 (13,548) 565 14,329 16,692 (7,095) 664 24,590 11,785 (23,012) 259 13,622 13,263 11,327 24,590 3,559 10,063 13,622 45,077 311,314 356,391 30,495 259,419 289,914 1,585 1,451 (1,980) 222 1,278 481 (907) 72 924 482 (270) 23 3,747 12,784 (9,421) 95 7,205 14,809 (7,006) 161 15,169 2,930 (15,512) 2,802 76 848 924 367 792 1,159 299 70,304 70,603 1,205 60,956 62,161 10,702 4,467 15,169 1,621 3,768 5,389 26,855 126,184 153,039 6,855 102,404 109,259 The following table summarizes the amount of classified and unclassified loans at December 31: 1,159 5,389 23,888 (Dollars in thousands) 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2011 Classified Unclassified Special Mention $ 8,870 Substandard Doubtful 738 11,129 Loss 0 444 0 5,789 39,709 0 19,607 1,113 0 0 0 0 0 Total 20,737 41,266 0 25,396 Total 98,329 11,480 18,882 192,890 0 857 224 124 1,205 60,956 62,161 0 0 3,203 2,722 3,750 8,056 $18,306 85,830 0 1,149 0 3,224 0 0 0 2,722 4,899 11,259 2,064 0 88,315 4,786 4,899 99,574 124 107,484 472,916 580,400 46 Total 21,257 26,699 (25,031) 887 23,812 33,381 (15,262) 897 42,828 17,278 (39,302) 3,084 25,034 17,794 42,828 6,633 17,255 23,888 78,960 629,608 708,568 44,796 535,604 580,400 Total Loans 119,066 52,746 18,882 218,286 (Dollars in thousands) December 31, 2010 Classified Unclassified Special Mention Substandard Doubtful Loss Total Total Total Loans 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: $ 7,395 8,228 Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other 8,373 0 6,268 34,515 11,069 6,614 0 0 0 0 0 0 0 0 15,623 112,912 128,535 42,888 11,069 12,882 44,218 20,054 225,280 87,106 31,123 238,162 Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other 0 248 31 27 306 70,297 70,603 1,776 0 4,712 $28,524 4,907 4,975 15,689 86,245 0 3,248 67 3,346 0 0 0 6,683 8,223 20,468 5,117 5,830 106,718 11,800 14,053 127,186 27 118,142 590,426 708,568 loans represent Classified special mention, performing 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. The aging of past due loans at December 31 are summarized as follows: (Dollars in thousands) 2011 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30-59 Days Past Due 60-89 Days Past Due 90 Days or More Past Due Total Past Due Current Loans Total Loans $1,876 107 0 350 658 286 0 351 305 290 0 79 374 0 0 112 1,297 3,478 115,588 119,066 8,211 0 5,184 387 0 1,149 2,877 8,608 0 5,613 1,419 286 1,149 3,340 44,138 18,882 212,673 52,746 18,882 218,286 60,742 62,161 4,500 3,750 96,234 4,786 4,899 99,574 $3,628 1,160 19,105 23,893 556,507 580,400 Loans 90 Days or More Past Due and Still Accruing 0 0 0 0 0 0 0 0 0 $2,313 695 3,500 6,508 122,027 128,535 178 444 0 75 446 0 0 311 3,899 0 264 163 0 0 45 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 4,809 8,223 8,232 6,991 5,830 118,954 11,800 14,053 127,186 $3,589 5,066 49,046 57,701 650,867 708,568 0 0 0 0 0 0 576 754 47 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 loans Impaired are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring. The following include loans that (Dollars in thousands) Loans with no related allowance recorded: table summarizes impaired loans and related allowances for the years ended December 31, 2011 and 2010: December 31, 2011 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,651 2,972 6,900 0 3,745 489 340 1,149 598 9,855 0 4,381 489 2,311 3,248 1,607 0 0 0 0 0 0 0 0 1,611 6,679 906 1,174 216 294 854 878 Loans with an allowance recorded: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,590 3,590 1,086 4,212 13,889 0 5,961 716 0 0 4,768 14,017 0 8,272 716 0 0 7,145 2,546 0 1,013 367 0 0 1,621 17,514 1,998 6,408 403 2,443 3,424 9,740 6,241 6,562 1,086 5,823 20,789 0 9,706 1,205 340 1,149 5,366 23,872 0 12,653 1,205 2,311 3,248 8,752 $44,796 58,603 2,546 0 1,013 367 0 0 1,621 6,633 24,193 2,904 7,582 619 2,737 4,278 10,618 58,754 91 94 0 144 21 0 0 19 157 373 0 97 54 0 0 45 248 467 0 241 75 0 0 64 1,095 48 (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: Residential developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 932 932 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total: 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 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 31, and 2010 2011, At December 2009, non-accruing loans totaled $34.0 million, $68.1 million and $61.1 million, respectively, for which the related allowance for loan losses was $5.2 million, $25.0 million and $12.1 million, respectively. Non-accruing loans for which no specific allowance has been recorded because management determined that the value of the collateral was sufficient to repay the loan totaled $14.8 million, $8.1 million and $15.3 million, respectively. Had the loans performed in accordance with their original terms, the Company would have recorded gross interest income on the loans of $3.2 million, $5.0 million and $5.0 million in 2011, 2010 and 2009, respectively. For the years ended December 31, 2011, 2010 and 2009, the Company recognized interest income on these loans of $0.7 million, $1.3 million and $0.9 million, respectively. All of income that was recognized for non-accruing loans was recognized using the cash basis the interest method of income recognition. Non-accrual loans also include some of the loans that have had terms modified in a troubled debt restructuring. The following table summarizes non-accrual loans at December 31: (Dollars in thousands) 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . Alternative fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Construction/development . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 $ 4,435 $ 4,844 13,412 0 9,246 699 340 1,149 4,712 25,980 4,994 5,763 224 4,907 8,223 13,139 $33,993 $68,074 49 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 Included in loans receivable, net, are certain loans that have been modified in order to maximize collection of loan balances. If the Company, for legal or economic reasons related to the borrower’s financial difficulties, grants a concession compared to the original terms and conditions of the loan, the modified loan is considered a troubled debt restructuring (TDR). During the third quarter of 2011, the Company adopted Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (Topic 310), which modified guidance for identifying restructurings of receivables that constitute a TDR. No additional loans modified since December 31, 2010 were identified as TDR’s as a result of adopting these provisions. At December 31, 2011 and 2010 there were loans included in loans receivable, net, with terms that had been modified in a troubled debt restructuring totaling $29.2 million and $19.3 million, respectively. Had these loans been performing in accordance with their original terms throughout 2011 and 2010, the Company would have recorded gross interest income of $2.5 million and $1.2 million, respectively. During 2011 and 2010, the Company recorded interest income of $0.6 million and $0.8 million on these loans, respectively. For the loans that were modified in 2011, $0.5 million are not classified and performing, $2.0 million are classified but performing, and $17.2 million are non-performing at December 31, 2011. The following table summarizes troubled debt restructurings at December 31: (Dollars in thousands) 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: 2011 2010 $ 3,805 2,589 14,460 5,598 578 14,209 662 75 Construction/development . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 4,378 100 1,656 for comparable risk loans, and the loan is interest performing in accordance with the terms of the restructured agreement. All loans classified as TDR’s are considered to be impaired. When a loan is modified as a TDR, there may be a direct, material impact on the loans within the Statements of Financial Condition, as principal balances may be partially forgiven. The financial effects of TDR’s are presented in the following table and represent the difference between the outstanding recorded balance pre-modification and post-modification, for the period ending December 31, 2011: (Dollars in thousands) Troubled debt restructurings: 1-4 family . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . Other . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . Commercial business: Construction /development . . . Other . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . Year ended December 31, 2011 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts 17 11 9 17 3 21 78 $ 4,567 8,118 7,473 626 2,361 10,316 4,246 7,908 6,432 598 1,096 8,849 $33,461 29,129 Loans that were restructured within the 12 months preceding December 31, 2011 and defaulted during the year are presented in the table below: (Dollars in thousands) Troubled debt restructurings that subsequently defaulted: 1-4 family . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate: Residential developments . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business: Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year ended December 31, 2011 Number of Contracts Outstanding Recorded Investment 1 5 3 1 3 $ 250 4,501 4,465 4 506 $9,726 $29,204 19,291 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 TDR concessions can include reduction of interest forgiveness of rates, extension of maturity dates, principal and/or interest due, or acceptance of real estate or other assets in full or partial satisfaction of the debt. Loan modifications are not reported as TDR’s after 12 months if the loan was modified at a market rate of The Company considers a loan to have defaulted when it becomes 90 or more days past due under the modified terms, when it is placed in non-accrual status, when it becomes other real estate owned, or when it becomes non-compliant with some other material requirement of the modification agreement. 50 Loans that were non-accrual prior to modification remain non-accrual for at least six months following have modification. Non-accrual TDR loans performed according to the modified terms for six months may be returned to accruing status. Loans that were accruing prior to modification remain on accrual status after the modification as long as the loan continues to perform under the new terms. that TDR’s are reviewed for impairment following the same methodology as other impaired loans. For loans that are collateral dependent, the value of the collateral is reviewed and additional reserves may be added as needed. Loans that are not collateral dependent may have additional reserves established if deemed necessary. The allocated allowance for TDR’s was $3.5 million, or 14.6%, of the total $23.9 million in allowance for loan losses at December 31, 2011, and $1.9 million, or 4.4%, of the total $42.8 million in loan loss reserves at December 31, 2010. NOTE 6 Accrued Interest Receivable Accrued interest summarized as follows: (Dollars in thousands) receivable at December 31 is 2011 2010 Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . Loans receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 553 1,896 626 2,685 $2,449 3,311 NOTE 7 Mortgage Servicing Rights, Net A summary of mortgage servicing activity is as follows: (Dollars in thousands) Mortgage servicing rights: 2011 2010 Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . Originations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,586 461 (562) $1,315 753 (482) Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . 1,485 1,586 Valuation reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 Mortgage servicing rights, net . . . . . . . . . . . . . . . . . . $1,485 $1,586 Fair value of mortgage servicing rights . . . . . . . . . . . $1,878 $2,263 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 51 summary of the risk characteristics of the loans being serviced at December 31, 2011: Loan Principal Balance Weighted Average Interest Rate Weighted Average Remaining Term (months) Number of Loans (Dollars in thousands) Original term 30 year fixed rate . . . . . . . . . . . . . . . . . . . $205,727 5.09% Original term 15 year fixed rate . . . . . . . . . . . . . . . . . . . Adjustable rate . . . . . . . . . . . . 98,645 598 4.40 3.25 298 128 285 1,803 1,395 9 The gross carrying amount of mortgage servicing rights and the associated accumulated amortization at December 31, 2011 and 2010 are presented in the following table. Amortization expense for mortgage servicing rights was $562,000 and $482,000 for the years ended December 31, 2011 and 2010, respectively. (Dollars in thousands) December 31, 2011 Gross Carrying Amount Accumulated Amortization Unamortized Intangible Assets Mortgage servicing rights . . . . $3,417 Total . . . . . . . . . . . . . . . . . . . . $3,417 December 31, 2010 Mortgage servicing rights . . . . . $4,172 Total . . . . . . . . . . . . . . . . . . . . $4,172 (1,932) (1,932) (2,586) (2,586) 1,485 1,485 1,586 1,586 The following table indicates the estimated future amortization expense for amortized intangible assets: (Dollars in thousands) Year ended December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage Servicing Rights $ 345 326 300 259 167 88 $1,485 Projections of amortization are based on asset balances and the interest rate environment that existed at December 31, 2011. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions. 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 2011 Commercial & Other Residential Total Residential $ 49 2,411 45 0 2,505 (556) 4,227 10,754 5,498 106 20,585 (5,918) 4,276 13,165 5,543 106 23,090 (6,474) $1,949 14,667 16,616 333 4,182 375 0 4,890 (979) 3,911 2010 Commercial & Other 0 10,536 5,307 106 15,949 (3,478) Total 333 14,718 5,682 106 20,839 (4,457) 12,471 16,382 NOTE 8 Real Estate A summary of real estate at December 31 is as follows: (Dollars in thousands) Real estate in judgement 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NOTE 9 Premises and Equipment A summary of premises and equipment at December 31 is as follows: (Dollars in thousands) 2011 2010 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment $ 1,978 8,637 12,558 2,070 9,199 12,985 Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . 23,173 (15,206) 24,254 (14,804) $ 7,967 9,450 NOTE 10 Deposits Deposits and their weighted average interest rates at December 31 are summarized as follows: (Dollars in thousands) Weighted Average Rate Noninterest checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.00% 0.06 0.17 0.46 Certificates: 0-0.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-1.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-2.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-3.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-4.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-5.99% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.60 0.87 2011 Amount $113,188 64,783 36,071 108,876 Percent of Total Weighted Average Rate 18.3% 10.4 5.8 17.6 0.00% 0.11 0.15 0.75 2010 Amount $ 96,581 94,205 33,973 114,357 Percent of Total 14.1% 13.8 5.0 16.7 322,918 52.1 339,116 49.6 72,768 134,567 65,842 22,583 1,450 0 297,210 11.7 21.8 10.6 3.6 0.2 0.0 47.9 $620,128 100.0% 2.07 1.20 41,311 142,742 105,126 50,529 4,113 293 344,114 6.1 20.9 15.4 7.4 0.6 0.0 50.4 $683,230 100.0% At December 31, 2011 and 2010, the Company had $264.5 million and $256.3 million, respectively, of deposit accounts with balances of $100,000 or more. At December 31, 2011 and 2010, the Company had $67.8 million and $107.5 million of certificate accounts, respectively, that had been acquired through a broker. The Company is currently restricted from renewing existing brokered deposits, or accepting new brokered deposits without the prior consent of the OCC. 52 Certificates had the following maturities at December 31: (Dollars in thousands) Remaining term to maturity 1-6 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-12 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over 36 months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 Weighted Average Rate Amount 1.78% $103,567 1.70 73,470 1.33 159,896 2.05 7,181 Weighted Average Rate 2.10% 1.77 2.18 2.44 Amount $100,513 87,031 103,791 5,875 $297,210 1.60 $344,114 2.07 At December 31, 2011, mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $28.9 million were pledged as collateral for certain deposits. An additional $1.0 million of letters of credit from the Federal Home Loan Bank (FHLB) were pledged as collateral on Bank deposits. Interest expense on deposits is summarized as follows for the years ended December 31: (Dollars in thousands) 2011 2010 2009 NOW accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 57 57 746 5,987 110 45 1,341 9,785 132 38 1,430 15,979 $6,847 11,281 17,579 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 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lines of Credit – Federal Reserve/Federal Home Loan Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 Amount Rate Amount Rate 70,000 4.77 70,000 0 4.77 0.00 $ 52,500 70,000 4.00% 4.77 122,500 0 4.44 0.00 $70,000 4.77 $122,500 4.44 that All of the outstanding advances at December 31, 2011 have quarterly call provisions which allow the the advance be paid back or FHLB to request refinanced at the rates then being offered by the FHLB. At December 31, 2011, the advances from the FHLB were collateralized by the Bank’s FHLB stock and mortgage loans and investments with a borrowing capacity of approximately $146.9 million. The Bank has the ability to draw additional borrowings of $75.9 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 $60.0 million from the Federal Reserve Bank, based upon the loans that are currently pledged with them, subject to approval from the FRB. 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 NOTE 12 Income Taxes Income tax expense (benefit) for the years ended December 31 is as follows: (Dollars in thousands) 2011 2010 2009 Current: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Total current . . . . . . . . . . . . . . . . . . . . . . 0 0 0 (3,956) (1,764) (4,551) 1,460 (5,720) (3,091) Deferred: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,010) (873) (2,773) (1,781) (1,213) (1,303) Total deferred . . . . . . . . . . . . . . . . . . . . . (4,883) (4,554) (2,516) Change in valuation allowance . . . . . . . . . . . 4,883 16,597 0 Income tax expense (benefit) . . . . . . . . . . . . . $ 0 6,323 (5,607) The reasons for the difference between expected income tax benefit utilizing the federal corporate tax rate of 34% for 2011 and 2010, and 35% for 2009 and the actual income tax expense are as follows: (Dollars in thousands) Expected federal income tax benefit . . . . . . . Items affecting federal income tax: State income taxes, net of federal income tax expense (benefit) . . . . . . . . . . . . . . . Tax exempt interest . . . . . . . . . . . . . . . . . . Increase in valuation allowance . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 2009 $(3,929) (7,703) (5,741) (645) (123) 4,883 (186) (2,474) (133) 16,597 36 170 (235) 0 199 Income tax expense (benefit) . . . . . . . . . . . . . $ 0 6,323 (5,607) A reconciliation of the change in the gross amount, before related tax effects, of unrecognized tax benefits for 2011 and 2010 is as follows: (Dollars in thousands) Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement of tax position . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 $0 0 $0 2,210 (2,210) 0 There were no unrecognized tax benefits for 2011. 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 54 $0.7 million reduction in other operating expenses in the the 2010 consolidated financial statements to reflect 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: 2011 2010 Allowances for loan and real estate losses . . . . $ 12,401 322 Deferred compensation costs . . . . . . . . . . . . . . . 702 Deferred ESOP loan asset . . . . . . . . . . . . . . . . . 130 Restricted stock expense . . . . . . . . . . . . . . . . . . 416 . . . . . . . . . . . . . . . . . Nonaccruing loan interest 5,936 Federal net operating loss carry forward . . . . . . 3,301 State net operating loss carry forward . . . . . . . . 162 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,088 314 682 164 84 5,043 3,295 88 Total gross deferred tax assets . . . . . . . . . . . . 23,370 18,758 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 317 407 607 231 356 263 636 648 258 Total gross deferred tax liabilities . . . . . . . . . . 1,890 2,161 Net deferred tax assets . . . . . . . . . . . . . . . . . . Valuation allowance . . . . . . . . . . . . . . . . . . . . . 21,480 16,597 (21,480) (16,597) Deferred tax assets, net of valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 0 The Company has cumulative federal net operating loss carryforwards of $19.6 million at December 31, 2011 that expire beginning in 2029. The Company also has state net operating loss carryforwards of $36.7 million at December 31, 2011 that expire beginning in 2023. taxes was made. This Retained earnings at December 31, 2011 included approximately $8.8 million for which no provision for income represents allocations of income to bad debt deductions for tax purposes. Reduction of amounts so allocated for purposes other than absorbing losses will create income for tax purposes, which will be subject to the then-current corporate income tax rate. 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 the future Company’s cumulative loss in the prior three year period, continued operating losses in 2011 and the general business 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, 2011. periods. Negative and economic evidence includes NOTE 13 Employee Benefits All eligible full-time employees of the Bank that were hired prior included in a to 2002 were noncontributory retirement plan sponsored by the Financial Institutions Retirement Fund (FIRF). The Home Federal Savings Bank (Employer #8006) plan participates in the Pentegra Defined Benefit Plan for Institutions (the Pentegra DB Plan). The Financial Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan number is 333. The Pentegra DB Plan operates a multi-employer plan for accounting purposes and as a multi-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective as bargaining agreements in place that require contributions to the Pentegra DB Plan. The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan, contributions made by the participating employer may be used to provide benefits to participants of other participating employers. 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 available at December 31, 2011 because such information is not accumulated for each participating institution. As of June 30, 2011, the Pentegra DB Plan valuation report reflected that the Bank was obligated to make a contribution totaling $291,000 which was expensed during 2011. Funded status (market value of plan assets divided by funding target) as of July 1 for the 2011 and 2010 plan years were 80.39% and 83.20%, respectively. Market value of plan assets reflects any contribution received through June 30, 2011. June Total employer contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $203,582,000 and $133,930,000 for the plan years ended June 30, 2010 and respectively. The Bank’s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan. There is no funding improvement plan or rehabilitation plan as part of this multi-employer plan. 2009, 30, The following contributions were paid by the Bank during the fiscal years ending December 31, (Dollars in thousands) 2011 2010 2009 Date Paid Amount Date Paid Amount Date Paid 10/14/2011 . . . . . . . . . . . . . . . . . . $57** 12/30/2010 . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . $57 $237 $237 12/29/2009 . . . . . . . . . . . . . . . . Amount $156 $156 ** - An additional contribution of $234,000 was accrued at December 31, 2011 and paid in the first quarter of 2012. a The Company has a qualified, tax-exempt savings plan with under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). All employees who have attained 18 years of age are eligible to participate in the 401(k) Plan. Participants qualifying deferred feature 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 2011. The Company matches 25% of each participant’s contributions up to a maximum of 8% of the 55 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 participant’s annual salary. Participant contributions and earnings fully and immediately vested. The Company’s contributions are vested on a three year cliff basis, are expensed over the vesting period, and were $159,000, $165,000 and $177,000, in 2011, 2010 and 2009, 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 the shares of HMN common stock to account 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 in 2011, 2010 and 2009. for 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, the shares pledged as collateral are reported as unearned ESOP shares in stockholders’ equity. As shares are determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations. ESOP compensation expense was $100,000, $109,000 respectively, for 2011, 2010 and 2009. $58,000, and 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 summary of the ESOP share allocation is as follows for the years ended: 2011 2010 2009 Shares allocated to participants beginning of the year . . . . . . . . . . . . . . . . . . . . . . . 335,453 24,317 42 (19,821) Shares allocated to participants . . . . . . . . . Shares purchased . . . . . . . . . . . . . . . . . . . . Shares distributed to participants . . . . . . . . 333,678 24,317 38 (22,580) 320,937 24,317 0 (11,576) Shares allocated to participants end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339,991 335,453 333,678 Unreleased shares beginning of the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425,769 (24,317) Shares released during year . . . . . . . . . . . . 450,086 (24,317) 474,403 (24,317) Unreleased shares end of year . . . . . . . . . . 401,452 425,769 450,086 Total ESOP shares end of year . . . . . . . . . 741,443 761,222 783,764 Fair value of unreleased shares at December 31 . . . . . . . . . . . . . . . . . . . . . $778,817 1,196,411 1,890,361 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, 2011, 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, 2011, there were 66,934 vested and 72,516 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. As of December 31, 2011, all shares of restricted stock granted under the 2001 Plan have vested. 56 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 proprietary interest in the Company will aid in attracting, motivating and retaining key personnel and advisors, including non-employee directors, and will align their the Company’s stockholders. interest with those of 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 are counted as 1.2 shares for purposes of determining the total shares available for issue under the 2009 Plan. 57 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 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, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 0 0 0 0 0 0 0 0 0 0 105,500 (65,000) 40,500 (25,500) 15,000 0 15,000 2001 Plan December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,353 Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Termination of new awards under plan . . . . . . . . . . . (155,353) Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 0 0 0 34,293 (4,734) 184,148 (33,777) (5,000) (15,044) 14,515 0 (170) (8,904) 145,371 (5,921) 0 $12.12 11.50 13.10 11.25 16.25 0 16.25 $19.43 16.13 27.64 19.91 16.13 0 0 0 0 0 0 0 141,088 (32,257) (6,000) 102,831 (5,921) (3,102) 93,808 0 (21,292) $ 0 0 0 0 0 0 0 $1.55 1.43 2.10 3.11 1.49 1.43 3.52 1.43 0 1.43 1.43 5,441 139,450 20.07 0 (5,441) 0 0 0 0 0 139,450 20.07 72,516 2009 Plan April 28, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 (15,000) (98,866) Granted May 6, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . Granted May 6, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 82,388 December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236,134 82,388 15,000 Granted January 26, 2010 . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (85,290) 7,118 5,921 0 71,075 (5,790) 0 (13,630) 0 0 0 0 December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163,883 134,043 15,000 Granted January 27, 2011 . . . . . . . . . . . . . . . . . . . . Forfeited/expired . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (93,600) 538 0 78,000 (448) (48,825) 0 0 0 December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,821 162,770 15,000 Total all plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,821 162,770 169,450 $ 4.77 N/A 4.77 N/A 4.77 N/A 4.77 $18.38 15,000 $4.41 15,000 4.41 5 years 3 years 3 years (3,000) 12,000 0 0 (3,000) 9,000 81,516 4.41 4.41 0 0 4.41 4.41 $1.76 58 The following table summarizes information about stock options outstanding at December 31, 2011: Exercise Price Number Outstanding $16.13 16.25 27.66 26.98 30.00 4.77 93,910 15,000 15,540 15,000 15,000 15,000 169,450 Weighted Average Remaining Contractual Life in Years 0.4 0.4 2.2 2.6 3.4 7.4 Number Exercisable Number Unexercisable 21,394 15,000 15,540 15,000 15,000 6,000 87,934 72,516 0 0 0 0 9,000 81,516 Unrecognized Compensation Expense $ 0 0 0 0 0 12,175 $12,175 Weighted Average Years Over Which Unrecognized Compensation will be Recognized N/A N/A N/A N/A N/A 2.4 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 2011, 2010 and 2009 relating to stock options over the vesting period. The 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 2011 or 2010. 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% NOTE 14 Loss per Common Share 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, 2011 2010 2009 Weighted average number of common shares outstanding used in basic earnings per common share calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,853,491 3,766,756 3,695,827 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 . . . . 3,853,491 3,766,756 3,695,827 Net loss available to common shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (13,376) (3.47) $ (3.47) $ (30,762) (8.17) (8.17) (12,543) (3.39) (3.39) 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 2011, 2010 or 2009. The Company suspended dividend payments on common stock in the fourth quarter of 2008 due to the net operating loss experienced and the challenging economic 59 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 environment. Because of the unknown duration of the economic slow down, the continued losses experienced in 2010 and 2011, 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. of the first certificate five years of The Company’s 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 Treasury’s capital purchase program under the 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 investment, increasing to 9% thereafter, unless HMN redeems the shares. The Company made all required dividend payments to the Treasury on the outstanding preferred stock in 2009 and 2010 but began deferring the payment of dividends beginning with the February 15, 2011 dividend date. The Company has since deferred payment of the May 15, 2011, August 15, 2011, November 15, 2011 and February 15, 2012 dividends. The amount of accrued but unpaid dividends totaled $1.3 million at December 31, 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 to appoint two representatives to the Company’s board of directors. 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 exercised at any time over its ten-year term. The discount on the common stock warrant is being amortized over five years and Treasury has agreed not to vote any shares of common stock acquired upon exercise of the warrant. Both the preferred securities and the warrant qualify as Tier 1 capital. Under the written Supervisory Agreements that the Company and the Bank each entered terms of the 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 OCC (as successor to the OTS). The Company does not anticipate requesting consent from the OCC to make any payments of dividends on, or purchase of, its common or preferred stock in 2012. The OCC has established an individual minimum capital requirement (IMCR) for the Bank as described in Note 16, which required the Bank to establish and maintain core capital at least equal to 8.5% of adjusted total assets at December 31, 2011. This was in excess of the Bank’s 7.14% core capital to adjusted total assets ratio at December 31, 2011. 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. NOTE 16 Regulatory Matters/Supervisory Agreements, IMCR 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, 2011. 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, 2011 and it was determined that it was not impaired. administered by the The Bank is subject to various regulatory capital federal banking requirements 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 60 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 as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative about components, risk weightings and other factors. and certain off-balance judgments by the regulators items sheet the replaced of Establishment 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 submitted a two year business plan in May of 2011 that the OCC (as successor to the OTS) accepted with the expectation that the Bank would be in adherence with the OCC’s Notification of Higher Minimum Capital Ratios, dated August 8, 2011, also known as an individual minimum capital requirement or IMCR, which required the Bank to establish and maintain a minimum core capital ratio of 8.5% by December 31, 2011. The IMCR and the Bank’s failure to achieve and maintain the IMCR are discussed more fully below. As the Bank required by the Supervisory Agreement, submitted an updated two year capital plan in January of 2012 that the OCC 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 also submitted a problem asset reduction plan that the OCC has accepted. The Bank must operate within the parameters of the final problem asset plan and is required to monitor and submit periodic reports on its compliance with the plan. The Bank has also revised its loan modification policies and its program for identifying, monitoring and controlling risk associated with concentrations of credit, and improved the documentation relating to the allowance for loan and lease losses as required by the agreement. In addition, the Bank may not without declare or pay any cash dividends, increase its total assets during any quarter in excess of the amount of the net interest credited on deposit liabilities during the prior quarter, enter into any new contractual arrangement or the consent of the OCC, renew or extend any existing 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 Bank believes it was in compliance with all requirements at December 31, 2011, with the exception that actual earnings performance and capital adequacy are not in adherence with the business plan. Supervisory Agreement its of into also entered The Company a written the OTS effective Supervisory Agreement with February 22, 2011. This agreement replaced the prior memorandum of understanding that the Company entered into with the OTS on December 9, 2009. As required by the Supervisory Agreement, the Company submitted an updated two year capital plan in January of 2012 that the Federal Reserve Board (as successor to 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 Federal Reserve Board, 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. The Company believes in compliance with all at requirements December 31, 2011, with the exception that actual earnings performance and capital adequacy were not in adherence with the capital plan. Supervisory Agreement it was its of References to the OTS shall mean, with respect to the Company, beginning July 21, 2011, the Federal Reserve Board (FRB) and mean, with respect to the Bank, beginning July 21, 2011, the Comptroller of the Currency (OCC). On July 21, 2011, the OTS was integrated into the OCC and the primary banking regulator for the Company became the FRB. It is not anticipated that the change in primary regulators as a the OTS being abolished will have any result of significant impact on the Company, the Bank, or our shareholders. the Office of Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain 61 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 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). At December 31, 2011 and 2010, 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: 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) (Dollars in thousands) December 31, 2011 Tier I or core capital . . . . . . . . . . . . . . . . . . . . . . . Tier I risk-based capital . . . . . . . . . . . . . . . . . . . . Risk-based capital to risk-weighted assets . . . . . $56,314 56,314 63,639 7.14% $31,560 23,441 9.61 46,883 10.86 4.00% $24,754 32,873 4.00 16,756 8.00 3.14% $39,450 35,162 5.61 58,603 2.86 5.00% 6.00 10.00 December 31, 2010 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 (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 was required to establish, The OCC has established 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 classified as “well-capitalized.” Effective December 31, 2011, and subsequently maintain, core capital at least equal to 8.5% of adjusted total assets, which is in excess of the Bank’s 7.14% core capital to adjusted total assets ratio at December 31, 2011. The Bank would have needed $10.8 million in additional capital at December 31, 2011 to meet the minimum core capital ratio set by the OCC. In February 2012, the Bank received a Notice of Failure from the OCC arising out of its failure to establish and maintain its IMCR of 8.5% core capital to adjusted total assets at December 31, 2011. By April 30, 2012, the Bank must submit to the OCC a further written capital plan of how it will achieve and maintain its IMCR, and a contingency plan in the event the IMCR is not achieved through the Bank’s primary plan. The Bank’s failure to comply with the terms of the IMCR is deemed an unsafe and unsound banking practice and could subject it to limits on growth and such legal actions or further sanctions as the OCC considers appropriate. Possible sanctions include among others (i) the imposition of one or more cease and desist orders requiring corrective action, which are enforceable directives that may address the Company or Bank management, any aspect of operations or capital, including requirements to change management, raise equity capital, dispose of assets or effect a change of control; (ii) civil money penalties; and (iii) downgrades in the capital adequacy status of the Company and the Bank. These regulatory actions may significantly restrict the ability of the Company and the Bank to take operating and strategic actions that may be in the best the Company and the Bank to take operating and strategic actions that are not potentially in the best interests of stockholders. interests of stockholders or compel Management believes that, as of December 31, 2011, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the prompt corrective action regulations referenced above. The failure of the Bank to satisfy the IMCR at December 31, 2011 does not by itself affect the Bank’s status as “well-capitalized” within the meaning of these prompt corrective action regulations. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well-capitalized” in the future. In order to improve its capital ratios and comply with its IMCR, the Bank is, among other things, working to improve its financial results, reduce non-performing assets, and decrease the asset size of the Bank. In 62 to assumption of November 2011, the Bank also entered into a definitive purchase and assumption agreement to sell substantially all the assets associated with its Toledo, Iowa branch, subject substantially all deposit liabilities of that branch as described in Note 21. In light of its current capital condition and its failure to comply with the IMCR at December 31, 2011, the Bank may also determine it to be necessary or prudent to dispose of other non-strategic assets. These actions have resulted, and may result, in changes in the Bank’s assets, liabilities and earnings, some of which may be material, during the period in which the action is taken or is consummated or over a longer period of time. Further, the Company may need, or be required by supervising banking regulators, to raise additional capital of which there can be no assurance that, if raised, it would be on terms favorable to the Company. If the Company raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, given our current common stock trading price, would be expected to dilute the per share book value of the Company’s common stock and could result in a change of control of the Company and the Bank. 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. instruments include commitments to These financial extend credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of these instruments reflect the extent of involvement by the Company. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial is instrument represented these of commitments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments. to extend credit commitments for by contract amount the (Dollars in thousands) Financial instruments whose contract amount represents credit risk: Commitments to originate, fund or purchase loans: December 31, Contract Amount 2011 2010 1-4 family mortgages . . . . . . . . . . . . . . . . . . . . . . Commercial real estate mortgages . . . . . . . . . . . . Undisbursed balance of loans closed . . . . . . . . . . Unused lines of credit . . . . . . . . . . . . . . . . . . . . . . Letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,554 2,371 7,209 76,444 1,535 629 0 12,659 76,670 2,355 Total commitments to extend credit . . . . . . . . . . . . . . . $91,113 92,313 Forward commitments . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,263 3,413 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates 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. creditworthiness customer’s each on 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 19 months and totaled $1.5 million at December 31, 2011 and $2.3 million at December 31, 2010. 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 63 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 those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. The Company accounts for its commitments in accordance with ASC 815, Accounting for Derivative Instruments and Hedging Activities. 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 enter the mortgage pipeline, the Company generally enters into commitments to sell the loans into the secondary market. The commitments loans are derivatives that are recorded at market value. As a result of marking these derivatives to market for the period ended December 31, 2011, the Company recorded an increase in other liabilities of $21,000, an increase in other assets of $29,000 and a net gain on the sales of loans of $8,000. to originate and sell As of December 31, 2011, 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 an increase in loans held for sale of $56,000, a decrease in other assets of $56,000, an increase in other liabilities of $72,000 and a net loss on the sales of loans $72,000. (Dollars in thousands) NOTE 19 Fair Value Measurement The Company has adopted ASC 820, Fair Value Measurements, which establishes a 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: 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. use that observable assumptions Level 3 — Valuation is generated from model-based techniques not significant observable in the market and are used only to the extent that available. These are 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. inputs not The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of December 31, 2011 and 2010. Carrying Value at December 31, 2011 Total Level 1 Level 2 Level 3 Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage loan commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,114 (94) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,020 613 0 613 125,501 (94) 125,407 0 0 0 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, 2010 Total Level 1 Level 2 Level 3 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 These generally accounting adjustments from the to fair value usually result application of the lower-of-cost-or-market accounting or principles. accepted write-downs of individual assets. For assets measured at fair value on a nonrecurring basis in 2011 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, 2011 and 2010. 64 (Dollars in thousands) Carrying Value at December 31, 2011 Total Level 1 Level 2 Level 3 Year Ended December 31, 2011 Total gains (losses) Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate, net(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,709 1,485 38,162 16,616 1,583 36,048 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $97,603 0 0 0 0 0 0 0 3,709 1,485 38,162 16,616 1,583 36,048 97,603 0 0 0 0 0 0 0 129 0 (4,167) (2,690) 0 0 (6,728) Carrying Value at December 31, 2010 Total Level 1 Level 2 Level 3 Year Ended December 31, 2010 Total losses Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate, net(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,728 1,586 43,039 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) (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 the Company’s financial ASC 825, Disclosures about Fair Values of Financial Instruments, requires disclosure of estimated instruments, fair values of including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value estimates are made as of December 31, 2011 and if 2010 based upon relevant market available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant financial are based upon instruments, judgments regarding future expected loss experience, current economic conditions, risk characteristics of instruments, and other factors. The various financial involve nature estimates the Company’s estimates portion of fair value information, subjective and are in uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. liabilities 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 financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates. considered that not are 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. 65 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 assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial liabilities: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Off-balance sheet financial instruments: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments to extend credit Commitments to sell loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . the using estimated maturity Cash and Cash Equivalents The carrying amount of cash and cash equivalents approximates their fair value. Securities Available for Sale The fair values of securities were based upon quoted market prices. Loans Held for Sale The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity. Loans Receivable The fair values of loans receivable were estimated for groups of loans with similar characteristics. The fair value of the loan portfolio, with the adjustable rate portfolio, was the exception of 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 The carrying amount of FHLB stock approximates its fair value. Accrued Interest Receivable The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns. Deposits The fair value of demand deposits, savings accounts and certain money market account deposits is 66 December 31, 2011 2010 Carrying Amount Estimated Fair Value Contract Amount Carrying Amount Estimated Fair Value Contract Amount $ 67,840 126,114 3,709 555,908 4,222 2,449 1,583 620,128 36,048 70,000 780 67,840 126,114 3,709 566,266 4,222 2,449 1,605 620,128 36,048 74,433 780 20,981 151,564 2,728 664,241 6,743 3,311 0 683,230 0 122,500 1,092 20,981 151,564 2,728 655,508 6,743 3,311 0 683,230 0 129,893 1,092 29 (94) 29 (94) 91,113 7,263 56 (1) 56 (1) 92,313 3,413 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. that results from the low cost The fair value estimate for deposits does not include the benefit 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, the taking into account remaining terms of the agreements and the present creditworthiness of the counter parties. Commitments to Sell Loans The fair values of commitments to sell loans are estimated using the quoted market prices for loans with similar interest rates and terms to maturity. NOTE 21 Assets and Deposits Held for Sale The Bank entered into a definitive purchase and assumption agreement on November 7, 2011 with Pinnacle Bank (Pinnacle) of Marshalltown, Iowa which provides for the sale to Pinnacle of substantially all of the assets associated with the Toledo, Iowa branch (the Branch) of the Bank and the assumption by Pinnacle of substantially all deposit liabilities of the Branch. The Bank will continue to own and operate its other Iowa and for Minnesota branches. Regulatory approval the transaction has been obtained and the transaction is anticipated to be consummated in the first quarter of 2012. The Bank anticipates that the transaction will be funded with available assets, the sale will result in a one time gain on sale in the first quarter of 2012 and a decrease in the Bank’s overall assets of approximately $34 million. 67 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 22 HMN Financial, Inc. Financial Information (Parent Company Only) The following are the statements for the parent (Dollars in thousands) Condensed Balance Sheets Assets: condensed financial company only as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009. 2011 2010 2009 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94 57,465 1,400 35 0 478 68,053 1,500 49 0 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,994 70,080 Liabilities and Stockholders’ Equity: Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,933 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,933 533 533 Serial preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unrealized gains on securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned employee stock ownership plan shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost, 4,740,711 and 4,818,263 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,780 91 53,462 42,983 471 (3,191) (61,535) 24,264 91 56,420 55,838 541 (3,384) (64,223) Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,061 69,547 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,994 70,080 Condensed Statements of Loss Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity losses of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4 (10,519) 0 (263) (24) (6) (747) 4 (27,833) 0 (236) (24) (6) (551) 15 (10,168) 2 (236) (24) (6) (470) Loss before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,555) 0 (28,646) 332 (10,887) (91) Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(11,555) (28,978) (10,796) Condensed Statements of Cash Flows Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net loss to cash provided (used) by operating activities: $(11,555) (28,978) (10,796) Equity losses of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earned employee stock ownership shares priced below original cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock option compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of restricted stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in unearned ESOP shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,519 0 (81) 29 298 193 101 13 (1) 27,833 172 (51) 63 370 193 (15) 791 1 10,168 220 (56) 27 373 194 (284) (829) 7 Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (484) 379 (976) 68 (Dollars in thousands) Cash flows from investing activities: Decrease in loans receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Dividends paid to preferred stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 2010 2009 100 100 1,200 1,200 1,700 1,700 0 0 (1,300) (1,163) (1,300) (1,163) Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (384) 478 Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94 279 199 478 (439) 638 199 NOTE 23 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. 69 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 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, 2011: Home Federal Savings Bank Other Eliminations Consolidated Total Interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest income — external customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain 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, 2010: 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: $ $ 39,541 6,863 6 0 186 11,139 562 28,127 0 (10,510) 790,115 48,270 7,302 (31) 0 174 17,263 482 26,423 5,991 (27,825) 880,570 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 57,770 8,134 (54) 0 174 23,883 556 30,563 (5,513) (10,163) 1,035,152 0 0 0 4 (10,519) 0 0 1,049 0 (11,564) 59,005 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 0 0 0 (4) 10,333 (4) 0 (186) 0 10,519 (58,965) 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) 39,541 6,863 6 0 0 11,135 562 28,990 0 (11,555) 790,155 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 70 [THIS PAGE INTENTIONALLY LEFT BLANK] 71 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, 2011 and 2010, 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, 2011. 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, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Minneapolis, Minnesota March 7, 2012 72 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, 2011 2010 2009 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,500 52,500 137,500 62,500 210,500 78,000 92,542 22,604 129,408 37,023 155,574 26,288 (Dollars in thousands) FHLB and FRB short-term borrowings . . . . . . . . . . . . . . . . . FHLB long-term advances . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 December 31, 2010 2009 Weighted Average Rate Weighted Average Rate Amount Weighted Average Rate Amount 0.00% $ 52,500 4.77 70,000 4.00% $ 10,000 122,500 4.77 6.48% 4.44 Amount $ 0 70,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000 4.77% $122,500 4.44% $132,500 4.59% Refer to Note 11 of the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and FRB borrowings. 73 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 . . . . . . . . . . . . . . . . . . . . . . $ 9,210 2,332 6,878 7,609 (731) Noninterest income: Fees and service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 912 240 672 151 9,572 2,488 7,084 4,260 2,824 978 247 188 106 10,045 3,046 6,999 3,463 3,536 925 250 301 113 December 31, 2011 September 30, 2011 June 30, 2011 Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,975 1,519 1,589 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,205 2,380 955 254 337 1,739 8,870 (7,626) 0 (7,626) (459) Net loss available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (8,085) Basic loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted loss per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ (2.08) (2.08) 3,276 111 930 190 326 1,565 6,398 (2,055) 0 (2,055) (456) (2,511) (0.65) (0.65) 3,512 143 916 407 305 2,209 7,492 (2,367) (76) (2,291) (457) (2,748) (0.72) (0.72) Financial Ratios: Loss on average assets(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on average common equity(1) Average equity to average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin(1)(2) (3.75)% (45.87) 8.19 3.55 (1.02)% (1.08)% (12.10) 8.20 3.71 (13.27) 8.11 3.48 (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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $790,155 818,384 807,374 20,645 105,469 3,709 555,908 620,128 70,000 57,061 23,681 120,452 4,031 591,265 630,606 70,000 65,169 26,780 107,467 1,075 601,787 647,115 85,000 67,571 (1) Annualized (2) Net interest income divided by average interest-earning assets. 74 March 31, 2011 10,714 3,269 7,445 1,946 5,499 924 250 495 117 1,786 3,560 47 940 404 253 1,588 6,792 493 76 417 (449) (32) (0.01) (0.01) 0.19% 2.41 8.05 3.62 878,756 29,641 128,002 1,624 634,282 688,078 115,000 69,641 December 31, 2010 September 30, 2010 10,834 3,547 7,287 10,542 (3,255) 1,007 261 655 101 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) 972 264 551 105 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) June 30, 2010 12,569 4,580 7,989 4,360 3,629 920 274 467 120 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) March 31, 2010 12,904 4,943 7,961 6,533 1,428 842 268 314 150 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) (4.41)% (49.64) 9.40 3.39 (3.89)% (42.01) 9.56 3.37 (3.12)% (32.14) 9.70 3.37 (0.73)% (7.50) 9.70 3.31 880,618 33,506 118,058 2,728 664,241 683,230 122,500 69,547 907,401 39,152 108,676 3,405 699,877 686,012 134,000 80,156 975,243 43,867 112,925 2,940 744,629 746,448 132,500 89,854 1,028,476 48,368 113,714 2,386 774,336 789,792 132,500 97,690 75 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, 2011, the Company had 9,128,662 shares of common stock issued and 4,740,711 shares in treasury stock. As of December 31, 2011, there were 603 stockholders of record and 864 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, 2011 and regressing back to March 31, 2010. December 31, 2011 September 30, 2011 June 30, 2011 March 31, 2011 December 31, 2010 September 30, 2010 June 30, 2010 March 31, 2010 HIGH . . . . . . . . . . . . . . . . . . . . . . . . . LOW . . . . . . . . . . . . . . . . . . . . . . . . . . CLOSE . . . . . . . . . . . . . . . . . . . . . . . . $2.37 1.61 1.94 3.22 1.50 1.88 3.01 2.35 2.45 3.14 2.02 2.75 3.80 2.47 2.81 5.00 3.06 3.16 6.78 4.28 4.58 5.99 4.02 5.50 The graph assumes that $100 was invested on December 31, 2006 and that all dividends were reinvested. Total Return Performance HMN Financial, Inc. NASDAQ Composite SNL Bank NASDAQ Index e u l a V x e d n I 175 150 125 100 75 50 25 0 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 Index HMN Financial, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NASDAQ Composite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SNL Bank NASDAQ Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12/31/06 100.00 100.00 100.00 12/31/07 73.53 110.66 78.51 12/31/08 13.04 66.42 57.02 12/31/09 13.10 96.54 46.25 12/31/10 8.76 114.06 54.57 12/31/11 6.04 113.16 48.42 Period Ending 76 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 24, 2012 at 10:00 a.m. (Central Time) at the Rochester Golf and Country Club, 3100 West Country Club Road, Rochester, Minnesota. LEGAL COUNSEL Faegre Baker Daniels 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 DIRECTORS HUGH C. SMITH Chairman of the Board HMN and Home Federal Savings Bank Retired Professor of Medicine, Mayo Clinic College of Medicine and Consultant in Cardiovascular Division, Mayo Clinic MAHLON C. SCHNEIDER Vice Chairman HMN and Home Federal Savings Bank Retired Senior Vice President External Affairs and General Counsel Hormel Foods Corporation ALLEN J. BERNING Director and Chief Executive Officer of Hardcore Computer, Inc. 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. BERNARD R. NIGON Retired Audit Partner with McGladrey & Pullen, LLP 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 and Chief Credit Officer 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 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 100 1st Avenue Bldg., Suite 200 Rochester, MN 55902 (507) 280-7256 2048 Superior Drive NW, Suite 400 Rochester, MN 55901 (507) 226-0800 1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 www.hmnf.com