HMN Financial Inc. Annual Report 2013

FY2013 Annual Report · HMN Financial Inc.

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1
Financial Highlights .............................................................................................................................................................
2
Letter to Shareholders and Customers ..................................................................................................................................
3
Board of Directors ................................................................................................................................................................
4
Five-year Consolidated Financial Highlights .......................................................................................................................
Management Discussion and Analysis .................................................................................................................................
5
Consolidated Financial Statements ...................................................................................................................................... 27
Notes to Consolidated Financial Statements ........................................................................................................................ 31
Report of Independent Registered Public Accounting Firm ................................................................................................. 61
Other Financial Data ............................................................................................................................................................ 62
Selected Quarterly Financial Data ........................................................................................................................................ 63
Common Stock Information ................................................................................................................................................. 65
Inside Back Cover
Corporate and Shareholder Information ....................................................................................................
Inside Back Cover
Directors and Officers ...............................................................................................................................

HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal
Savings Bank operates nine full service offices in Minnesota located in Albert Lea, Austin, Eagan, La Crescent, Rochester
(3), Spring Valley and Winona; one full service office in Iowa located in Marshalltown; one loan origination office in
Sartell, Minnesota; and two Private Banking offices in Rochester, Minnesota.

FINANCIAL HIGHLIGHTS

Operating Results:
(Dollars in thousands, except per share data)
Total interest income ............................................................................................ $
Total interest expense ..........................................................................................
Net interest income ..........................................................................................
Provision for loan losses ......................................................................................
Net interest income after provision for loan losses ..........................................
Fees and service charges ......................................................................................
Loan servicing fees ..............................................................................................
Gain on sales of loans ..........................................................................................
Gain on sale of branch .........................................................................................
Other non-interest income ....................................................................................
Total non-interest income ................................................................................
Total non-interest expense ...............................................................................
Income before income tax (benefit) expense ........................................................
Income tax (benefit) expense ...............................................................................
Net income .......................................................................................................
Preferred stock dividends and discount ............................................................
Net income available to common shareholders ................................................ $

Per Common Share Information:
Earnings per common share and common share equivalents

Basic ................................................................................................................ $
Diluted .............................................................................................................

Stock price (for the year)

High ................................................................................................................. $
Low ..................................................................................................................
Close ................................................................................................................
Book value ...........................................................................................................
Price to book value...............................................................................................

Financial Ratios:
Return on average assets ......................................................................................
Return on average common equity.......................................................................
Net interest margin ...............................................................................................
Operating expenses to average assets ...................................................................
Average equity to average assets .........................................................................
Equity to total assets at year end ..........................................................................
Non-performing assets to total assets ...................................................................
Efficiency ratio ....................................................................................................

At or For the Year Ended
December 31,

2013

2012

Percentage

Change

22,983
3,289
19,694
(7,881)
27,575
3,513
1,029
2,102
0
668
7,312
22,623
12,264
(14,406)
26,670
(2,068)
24,602

6.15
5.71

10.98
2.99
10.57
13.49
78.35%

4.55%
42.22
3.51
3.86
10.77
13.21
3.76
83.77

30,816
7,139
23,677
2,544
21,133
3,325
964
3,574
552
575
8,990
24,670
5,453
132
5,321
(1,861)
3,460

0.88
0.86

3.80
1.61
3.47
8.02
43.27%

0.79%
8.94
3.67
3.65
8.81
9.31
6.21
75.52

(25.4)%
(53.9)
(16.8)
(409.8)
30.5
5.7
6.7
(41.2)
(100.0)
16.2
(18.7)
(8.3)
124.9

401.2
(11.1)
611.0

475.9%
372.3
(4.4)
5.8
22.2
41.9
(39.5)
10.9

Balance Sheet Data:
(Dollars in thousands)
Total assets ........................................................................................................... $
Securities available for sale ..................................................................................
Loans held for sale ...............................................................................................
Loans receivable, net ...........................................................................................
Deposits ...............................................................................................................
FHLB advances ....................................................................................................
Stockholders’ equity ............................................................................................
Home Federal Savings Bank regulatory capital ratios:

Tier I or core capital .........................................................................................
Tier I capital to risk weighted assets ................................................................
Risk-based capital ............................................................................................

December 31,

Percentage

2013

2012

Change

648,622
107,956
1,502
384,615
553,930
0
85,675

12.22%
19.51
20.78

653,327
85,891
2,584
454,045
514,951
70,000
60,834

9.68%
14.23
15.52

(0.7)%
25.7
(41.9)
(15.3)
7.6
(100.0)
40.8

26.2%
37.1
33.9

NM – Not meaningful

LETTER TO SHAREHOLDERS AND CLIENTS

I am very pleased with the financial performance that HMN Financial, Inc. reported for 2013. The
results reflect countless hours of hard work by our talented and dedicated staff to execute our strategic
plan and return the Bank to profitability.

During the year, management continued its focus to improve the Bank’s capital position and credit
quality. By year end, the Bank’s core capital position had improved to 12.22% of total adjusted assets.
This represented 7.22%, or $46.0 million, over the amount of core capital needed to be considered a
“well capitalized” bank by current regulatory standards and positions the Bank to comply with the new
Basel III capital requirements which the Bank will need to be in compliance with by January 1, 2015.

Credit quality also improved during the year, and non-performing assets levels declined in every
quarter of 2013. Criticized assets, those assets classified as less than satisfactory credit quality by regulatory standards, also
showed continued improvement in 2013, falling to 70.2% of capital plus the allowance for loan losses at year-end. Finally, our
past due loan ratio, an important measurement of loan quality, remained very low. The improvements in credit quality, combined
with the improved financial outlook for the Bank, enabled the Company to recover the entire valuation allowance on our deferred
tax asset that was established in 2011. Just as importantly, the improvement in credit quality enabled the Company to reverse
provisions for loan losses that were made in earlier years for potential losses on our loan portfolio.

During the year, the Bank’s reliance on wholesale funding sources continued to decline while our level of core deposits increased.
The funds necessary to repay these wholesale sources of funds were generated primarily by increasing core deposits and reducing
the size of our commercial loan portfolio. Our commercial lenders worked very diligently to ensure that the lending relationships
that left the Bank were either of higher credit risk or were in asset categories in which the Bank had an asset concentration.

This past year we added three experienced commercial lenders to our existing lending staff. Two of these individuals were hired
as Market Presidents, in communities outside of Rochester. In addition, two of our existing Market Presidents in outlying
communities were cross trained in commercial lending during the year. These changes enabled the Bank to offer our full range of
products and services in four more communities and will, over time, bring new commercial lending and deposit relationships to
the Bank.

While the rising rate environment for residential mortgage loans softened the market for refinancing loans late in the year, our
home mortgage division experienced another strong year. During 2013, we increased our focus on developing new borrower
relationships to better position the Bank to increase our market share of the mortgage business for home purchases.

Regulatory relations continue to improve as well. In July of 2013, the Office of Comptroller of the Currency conducted a
Community Reinvestment Act compliance examination. I am pleased to inform you that the Bank received a satisfactory rating
with an outstanding rating assigned to our lending activities. The Community Reinvestment Act regulations set forth an
institution’s responsibilities to reinvest local deposits and capital back into the communities it serves with a special emphasis on
low to moderate income housing. The ratings we received in this exam demonstrate our commitment to reinvesting in the
communities we serve.

Finally, I am pleased to inform you that on February 11, 2014, the Office of Comptroller of the Currency terminated the
Supervisory Agreement under which the Bank has operated since February 22, 2011. The agreement restricted the operation of
the Bank in a variety of ways making it very difficult to compete with other institutions and required considerable effort to
comply with the additional reporting requirements. With renewed enthusiasm and focus, our management team looks forward to
the opportunity to compete on an even playing field, while prudently managing the Bank for long term financial performance.

Thank you for all of your loyalty and support.

Respectfully,

Brad Krehbiel
President and Chief Executive Officer

FIVE-YEAR CONSOLIDATED FINANCIAL HIGHLIGHTS

Selected Operations Data:
(Dollars in thousands, except per share data)
Total interest income ..................................................... $
Total interest expense ...................................................
Net interest income ...................................................
Provision for loan losses ...............................................
Net interest income (loss) after provision for loan

losses ......................................................................
Fees and service charges ...............................................
Loan servicing fees .......................................................
Gain on sales of loans ...................................................
Gain on sale of branch office ........................................
Other non-interest income .............................................
Total non-interest income .........................................
Total non-interest expense ........................................
Income (loss) before income tax (benefit) expense ...
Income tax (benefit) expense .......................................
Net income (loss) .....................................................
Preferred stock dividends and discount .....................
Net income (loss) available to common

2013

Year Ended December 31,
2011

2012

2010

22,983
3,289
19,694
(7,881)

27,575
3,513
1,029
2,102
0
668
7,312
22,623
12,264
(14,406)
26,670
(2,068)

30,816
7,139
23,677
2,544

21,133
3,325
964
3,574
552
575
8,990
24,670
5,453
132
5,321
(1,861)

39,541
11,135
28,406
17,278

11,128
3,739
987
1,656
0
487
6,869
29,552
(11,555)
0
(11,555)
(1,821)

48,270
17,259
31,011
33,381

(2,370)
3,741
1,067
1,987
0
476
7,271
27,556
(22,655)
6,323
(28,978)
(1,784)

2009

57,771
23,868
33,903
26,699

7,204
4,137
1,042
2,273
0
630
8,082
31,689
(16,403)
(5,607)
(10,796)
(1,747)

shareholders ............................................................ $

24,602

3,460

(13,376)

(30,762)

(12,543)

Basic earnings (loss) per common share ................... $
Diluted earnings (loss) per common share ................

6.15
5.71

0.88
0.86

(3.47)
(3.47)

(8.17)
(8.17)

(3.39)
(3.39)

Selected Financial Condition Data:
(Dollars in thousands, except per share data)
Total assets ................................................................... $
Securities available for sale ...........................................
Loans held for sale ........................................................
Loans receivable, net ....................................................
Deposits ........................................................................
FHLB advances .............................................................
Stockholders’ equity .....................................................
Book value per common share ......................................

2013
648,622
107,956
1,502
384,615
553,930
0
85,675
13.49

2012
653,327
85,891
2,584
454,045
514,951
70,000
60,834
8.02

December 31,
2011
790,155
126,114
3,709
555,908
656,176
70,000
57,061
7.36

2010
880,618
151,564
2,728
664,241
683,230
122,500
69,547
10.51

2009
1,036,241
159,602
2,965
799,256
796,011
132,500
99,938
17.94

Number of full service offices .......................................
Number of loan origination offices ...............................

11
1

12
1

13
1

14
1

14
2

Key Ratios (1) ................................................................
Stockholders’ equity to total assets at year end .............
Average stockholders’ equity to average assets ............
Return (loss) on stockholders’ equity

13.21%
10.77

9.31%
8.81

7.22%
8.19

7.90%
9.40

9.64%
9.73

(ratio of net income (loss) to average equity) ............

42.22

Return (loss) on assets

(ratio of net income (loss) to average assets) ...........

4.55

8.94

0.79

(16.94)

(31.73)

(10.33)

(1.39)

(2.98)

(1.00)

(1) Average balances were calculated based upon amortized cost without the market value impact of ASC 320.

MANAGEMENT DISCUSSION AND ANALYSIS

the Bank;

forward-looking

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
terminology as
“expect,” “intend,” “look,” “believe,” “anticipate,”
“estimate,” “project,” “seek,” “may,” “will,” “would,”
“could,” “should,” “trend,” “target,” and “goal” or
similar statements or variations of such terms and
include, but are not limited to, those relating to increasing
our core deposit relationships, reducing non-performing
assets, reducing expense and generating
improved
financial results; the adequacy and amount of available
liquidity and capital resources
the
Company’s
liquidity and capital requirements; our
expectations for core capital and our strategies and
potential strategies for improvement thereof; changes in
the size of the Bank’s loan portfolio; the amount and mix
of
the
the Bank’s non-performing assets and
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; the availability of alternate funding sources; the
payment of dividends; the future outlook for the Company;
the amount of deposits that will be withdrawn from
checking and money market accounts and how the
withdrawn deposits will be replaced; the projected
changes in net interest income based on rate shocks; the
range that interest rates may fluctuate over the next
twelve months; the net market risk of interest rate shocks;
the future outlook for the issuer of the trust preferred
securities held by the Bank; the ability to request and pay
dividends to HMN and the redemption of any outstanding
preferred stock; the ability to remain well capitalized
under revised capital rules; and compliance by the
the Bank with regulatory standards
Company and
generally
the Bank’s status as “well-
capitalized”), and the Company’s supervisory agreement,
or other supervisory directives or requirements to which
the Company or the Bank are or may become expressly
subject, specifically, and possible responses of the Office
of the Comptroller of the Currency (OCC) and Federal
Reserve Bank (FRB) and the Bank and the Company to
any failure to comply with any such regulatory standard,
agreement or requirement.

(including

from

A number of factors could cause actual results to differ
the Company’s assumptions and
materially
expectations. These include but are not limited to the
adequacy and marketability of real estate and other
collateral securing loans to borrowers; federal and state
regulation and enforcement, including restrictions set
forth in the supervisory agreement between the Company
and the FRB; possible legislative and regulatory changes,
including changes to regulatory capital rules, the ability

capital

regulatory

of the Company to establish and adhere to plans and
policies that are satisfactory to the FRB, in accordance
with the terms of the Company supervisory agreement and
to otherwise manage the operations of the Company to
ensure compliance with other requirements set forth in the
supervisory agreement; the ability of the Company and
the Bank to obtain required consents from the OCC and
FRB, as applicable, under the supervisory agreement or
other directives; the ability of the Bank to comply with
requirements;
other applicable
enforcement activity of the OCC and FRB in the event of
our non-compliance with any applicable regulatory
standard, agreement or requirement; adverse economic,
business and competitive developments such as shrinking
interest margins, reduced collateral values, deposit
outflows, changes in credit or other risks posed by the
Company’s loan and investment portfolios, changes in
costs associated with alternate funding sources, including
changes in collateral advance rates and policies of the
Federal Home Loan Bank, technological, computer-
related or operational difficulties, results of litigation, and
reduced demand for financial services and loan products;
in accounting policies and guidelines, or
changes
monetary and fiscal policies of the federal government or
tax
the
Company’s access to and adverse changes in securities
markets; the market for credit related assets; or other
significant uncertainties. Additional factors that may
cause actual results to differ from the Company’s
assumptions and expectations include those set forth in
the Company’s most recent filings on Forms 10-K and 10-
Q with the Securities and Exchange Commission. All
forward-looking statements are qualified by, and should
be considered in conjunction with, such cautionary
statements. For additional discussion of the risks and
uncertainties applicable to the Company, see the “Risk
Factors” sections of the Company’s Annual Report on
Form 10-K for the year ended December 31, 2013.

international economic developments;

laws;

All statements in this Annual Report, including forward-
looking statements, speak only as of the date hereof, and
we undertake no duty to update any of the forward-
looking statements after the date of this Annual Report.

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
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

interest earned on

MANAGEMENT DISCUSSION AND ANALYSIS

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 earnings are also affected by the
generation of non-interest
income, which consists
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, amortization of mortgage
servicing assets, and income taxes. The earnings of
financial
the Bank, are also
significantly affected by prevailing economic and
competitive conditions, particularly changes in interest
rates, government monetary and fiscal policies, and
regulations of various regulatory authorities. Lending
activities are influenced by the demand for and supply of
business credit, single family and commercial properties,
competition among lenders, the level of interest rates and
the availability of funds. Deposit flows and costs of
deposits are influenced by prevailing market rates of
interest on competing investments, account maturities and
the levels of personal income and savings.

institutions, such as

Between 2008 and 2011, the Company’s commercial
business and commercial real estate loan portfolios
required significant charge offs due primarily to decreases
in the estimated value of the underlying collateral
supporting the loans, as many of these loans were made to
borrowers in or associated with the real estate industry.
The decrease in the estimated collateral value was
primarily the result of reduced demand for real estate,
particularly as it relates to single-family and commercial
land developments. More stringent lending standards
implemented by the mortgage industry in those years
made it more difficult for some borrowers with marginal
credit to qualify for a mortgage. This decrease in available
credit and the overall weakness in the economy reduced
the demand for single family homes and the values of
existing properties and developments where
the
Company’s commercial loan portfolio had concentrations.
Consequently, our level of non-performing assets and the
related provision for loan losses and charge-offs increased
significantly during these years, relative to prior periods.
The increased levels of non-performing assets, related
provisions for loan losses and loan charge-offs, expenses
associated with real estate owned, and the valuation
allowance established against deferred tax assets arising
from the adverse operating results, were the primary
reasons for the net losses incurred by the Company in
each of the years 2008 through 2011. In 2012 and

continuing into 2013, commercial real estate values
stabilized and fewer charge offs were recorded than in the
2008-2011 period. In addition, non-performing assets and
expenses associated with real estate owned declined in
2012 and 2013, which had a positive effect on earnings.

The Company took a number of measures during the past
five years to address its elevated level of non-performing
assets, improve operating results, and establish adequate
levels of liquidity and capital resources. Those measures
included, among others, obtaining $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’s asset
size was also reduced by decreasing the outstanding
wholesale funding amounts and selling or closing
branches. These changes contributed to net assets being
reduced $497 million from December 31, 2008 to
December 31, 2013, which improved its capital ratios.
The Company also hired additional experienced
commercial credit review staff, implemented new loan
credit approval processes, updated credit policies and
procedures, and implemented additional commercial loan
review procedures in order to improve the credit quality of
commercial loans being added to the Bank’s portfolio and
loan concentrations and non-
reduce commercial
resources were also
performing assets. Additional
allocated to establishing and maintaining remediation
plans on all classified loans in order to improve the
monitoring and ultimate collection of these loans. The
Company also began deferring the dividend payments on
the outstanding preferred stock, beginning with the
February 15, 2011 dividend payment in order to improve
its liquidity position. Because of these efforts, and the
relative stabilization of commercial real estate values, the
level of non-performing assets and related loan losses
have continued to decline compared to the four years prior
to 2012. The Company’s financial results in 2012 and
2013 also improved which resulted in the reversal of the
entire valuation reserve against its deferred tax asset in
2013.

Because of the losses incurred and elevated levels of non-
performing assets, the Company and the Bank, effective
February 22, 2011, each entered into a supervisory
agreement (the “Company Supervisory Agreement” and
the “Bank Supervisory Agreement”, respectively, and,
collectively, the “Supervisory Agreements”) with the
Office of Thrift Supervision (the “OTS”), their primary
federal regulator at the time. The Supervisory Agreements
superseded the memorandum of understanding between
each of the Company and the Bank that were entered into
with the OTS in December 2009. As required by the
Company Supervisory Agreement,
the Company
submitted an initial consolidated capital plan in May of
2011 and updated two year capital plans in January of

MANAGEMENT DISCUSSION AND ANALYSIS

2012, 2013, and 2014 that the Federal Reserve Board may
make comments upon, and to which it may require
revisions. The Company must operate within
the
parameters of the 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 director or officer, or
make any golden parachute payments.

In August 2011, the OCC 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, the Bank was required to establish, and
subsequently maintain, core capital at least equal to 8.50%
of adjusted total assets. The Bank’s core capital to
to 12.22% at
adjusted
December 31, 2013.

total assets ratio

improved

On February 11, 2014 the Bank was notified by the OCC
that the Bank Supervisory Agreement and IMCR to which
the Bank was a party or was subject were terminated. As a
result, from February 11, 2014, the capital ratio and
periodic reporting requirements, asset growth restrictions,
longer
and significant contract restrictions are no
applicable to the Bank. The dividend and compensation
restrictions expressly set forth in the Bank Supervisory
Agreement also terminated, although the Bank remains
subject to generally applicable limitations on dividends
and certain compensation arrangements under federal
banking laws and regulations. For further discussion and a
complete description of the Supervisory Agreements,
IMCR, and termination by the OCC of the Bank
Supervisory Agreement and IMCR, see “Note 16
Regulatory Matters/Supervisory Agreements and IMCR”
in the Notes to the Consolidated Financial Statements and
“Item 1 – Business – Regulation and Supervision” and
“Item 3 – Legal Proceedings” in our Annual Report on
Form 10-K for the fiscal year ended December 31, 2013.

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
the following critical
accounting policies that management believes involve the
most difficult, subjective, and/or complex judgments that

identified

are inherently uncertain. Therefore, actual financial results
could differ significantly depending upon the estimates,
assumptions and other factors used.

its

the

historical

experience

conditions,

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

non-homogeneous

loan

The appropriateness of the allowance for loan losses is
dependent upon management’s estimates of variables
affecting valuation, appraisals of collateral, evaluations of
performance and status, and the amounts and timing of
future cash flows expected to be received on impaired
loans. Such estimates, appraisals, evaluations and cash
flows may be subject to frequent adjustments due to
changing economic prospects of borrowers or properties.
The estimates are reviewed periodically and adjustments,
if any, are recorded in the provision for loan losses in the
periods in which the adjustments become known. Because
of the size of some loans, changes in estimates can have a
significant impact on the loan loss provision. The
allowance is allocated to individual loan categories based
upon the relative risk characteristics of the loan portfolios
and the actual loss experience. The Company increases its
allowance for loan losses by charging the provision for
loan losses against income and decreases its allowance by
crediting the provision for loan losses. A review of the

MANAGEMENT DISCUSSION AND ANALYSIS

loan

takes

losses

allowance in 2012 and 2013 resulted in a reduction in the
required allowance and a corresponding credit to the loan
loss provision. The methodology for establishing the
allowance for
into consideration
probable losses that have been identified in connection
with specific loans as well as losses in the loan portfolio
that have not been specifically identified. 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
in
determining the allowance for loan losses and adjustments
may be required in the future.

those anticipated

tax consequences attributable

Income Taxes
Deferred tax assets and liabilities are recognized for the
temporary
future
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 assets and liabilities.

temporary differences,

reversals of

income

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
tax
loss carryforwards. For
net operating
purposes, only net charge-offs are deductible, not the
entire provision for loan losses. Under generally accepted
accounting principles, a valuation allowance is required to
be recognized if it is “more likely than not” that the
deferred tax asset will not be realized. The determination
of the realizability of the deferred tax assets is highly
subjective and dependent upon management’s judgment
and evaluation of both positive and negative evidence,
including the forecasts of future income, tax planning
strategies, and assessments of the current and future
economic and business conditions. The Company
considers both positive and negative evidence regarding
the ultimate realizability of deferred tax assets. Positive
evidence includes the Company’s cumulative net income
in the prior three year period, the ability to implement tax
income
planning

to accelerate

strategies

taxable

the entire deferred

recognition, and the probability that taxable income will
be generated in future periods. Negative evidence includes
the general business and economic environment. In the
second quarter of 2010, the Company recorded a valuation
allowance against the entire deferred tax asset balance and
the Company continued to maintain a valuation reserve
against
tax asset balance until
December 31, 2013 when the entire valuation reserve was
eliminated. The determination to eliminate the valuation
reserve was based primarily upon the existence of a three-
year cumulative net income and expectations of future
taxable income. It is possible that future conditions may
differ substantially from those anticipated in eliminating
the valuation allowance on deferred tax assets and
adjustments may be required in the future.

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

Results of Operations

Comparison of 2013 with 2012
Net income was $26.7 million for 2013, an improvement
of $21.4 million, from $5.3 million for 2012. Net income
available to common shareholders was $24.6 million for
the year ended December 31, 2013, an improvement of
$21.1 million, from net income available to common
shareholders of $3.5 million for 2012. Diluted earnings
per common share for the year ended December 31, 2013
was $5.71, an improvement of $4.85 from $0.86 diluted
earnings per common share for the year ended December
31, 2012. The improvement in net income in 2013 is due
primarily to a $14.5 million increase in income tax benefit
as a result of eliminating the valuation reserve against the
Company’s deferred tax asset, a $10.4 million decrease in
the provision for loan losses, a $1.0 million increase in the
gains recognized on the sale of real estate owned, and a
$0.7 million decrease in other non-interest expenses
primarily related to legal and professional services. These
improvements to net income were partially offset by a
$4.0 million decrease in net interest income due primarily
to a decrease in interest earning assets between the periods
and a $1.5 million decrease in the gain on sale of loans
due to a decrease in mortgage loan originations and sales.

Net Interest Income
Net interest income was $19.7 million for 2013, a
decrease of $4.0 million, or 16.8%, from $23.7 million for
2012. Interest income was $23.0 million for 2013, a
decrease of $7.8 million, or 25.4%, from $30.8 million for
2012. Interest income decreased between the periods

MANAGEMENT DISCUSSION AND ANALYSIS

primarily because of an $84 million decrease in the
average interest-earning assets and also because of a
decrease in the average yields between the periods.
Average interest-earning assets decreased between the
periods primarily because of a $69 million decrease in the
commercial loan portfolio, which occurred because loan
payoffs exceeded loan production as a result of the
Company’s focus on improving credit quality, managing
net interest margin, and improving capital ratios. The
average yield earned on interest-earning assets was 4.09%
for the year ended December 31, 2013, a decrease of 69
basis points from the 4.78% average yield for 2012. The
decrease in the average yield is due to the continued low
interest rate environment that existed during 2013 and also
because of the $15 million increase in the average assets
that were held in lower earning cash and investments in
2013 when compared to 2012.

Interest expense was $3.3 million for the year ended
December 31, 2013, a decrease of $3.8 million, or 53.9%,
from $7.1 million for 2012. Interest expense decreased
primarily because of a $96 million decrease in the average
the periods. The
interest-bearing
decrease in the average interest-bearing liabilities is
the average
primarily

the result of a decrease

liabilities between

outstanding retail and brokered certificates of deposits and
Federal Home Loan Bank advances between the periods.
The decrease in certificates of deposits and advances
between the periods was the result of using the proceeds
from loan principal payments to fund the maturing
certificates of deposits and advances. The $126 million
decrease in the average balances of certificates of deposits
and advances was partially offset by the $30 million
increase in the average balance of retail and commercial
the
checking and money market accounts between
periods. Interest expense also decreased because of the
lower interest rates paid on deposits as a result of the low
interest rate environment that continued to exist during
2013. The average interest rate paid on interest-bearing
liabilities was 0.64% for the year ended December 31,
2013, a decrease of 53 basis points from the 1.17%
average interest rate paid for 2012.

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 average outstanding loan balance in the table as
loans carrying a zero yield.

Average
Outstanding
Balance

2013
Interest
Earned/
Paid

Average
Yield/
Rate

Average
Outstanding
Balance

2012
Interest
Earned/
Paid

Average
Yield/
Rate

Average
Outstanding
Balance

2011
Interest
Earned/
Paid

Average
Yield/
Rate

Year Ended December 31,

(Dollars in thousands)
Interest-earning assets:
Securities available for sale:
Mortgage-backed and

related securities ......... $

6,968

299

4.30 % $

14,275

604

4.23% $

25,546

1,098

4.30 %

Other marketable

securities .....................
Loans held for sale .................
Loans receivable, net(1) (2) .......
FHLB stock ............................
Other, including cash

equivalents ........................
Total interest-earning assets ... $

Interest-bearing liabilities:
NOW accounts ....................... $
Passbooks ...............................
Money market accounts .........
Certificate accounts ................
Brokered deposits ...................
FHLB advances and Federal

Reserve borrowings ..........

Other interest-bearing

liabilities ...........................

Total interest-bearing

liabilities ........................... $
Noninterest checking ..............
Total interest-bearing

liabilities and noninterest-
bearing deposits ................ $
Net interest income .................
Net interest rate spread ...........

Net earning assets ................... $
Net interest margin .................
Average interest-earning

assets to average interest-
bearing liabilities and
noninterest-bearing
deposits .............................

85,947
1,964
408,383
2,191

55,909
561,362

69,675
44,113
120,782
140,254
10,647

614
72
21,816
53

129
22,983

15
34
372
1,236
147

30,427

1,485

963

416,861
97,613

0.71
3.67
5.34
2.42

0.23
4.09

0.02 % $
0.08
0.31
0.88
1.38

4.88

0.00

73,329
3,257
503,668
4,098

46,495
645,122

65,566
40,139
110,665
202,082
35,161

737
103
29,154
117

101
30,816

35
67
447
2,413
779

70,000

3,398

1,019

1.01
3.16
5.79
2.85

0.22
4.78

0.05% $
0.17
0.40
1.19
2.22

4.85

0.00

113,927
2,200
608,826
5,384

35,426
791,309

72,734
37,048
118,821
250,142
85,587

1,451
87
36,689
180

36
39,541

57
57
746
3,841
2,146

92,604

4,288

1,006

524,632
85,525

657,942
101,230

514,474

3,289
19,694

0.64% $

610,157

7,139
23,677

1.17% $

759,172

11,135
28,406

46,888

34,965

32,137

3.51 %

3.67%

3.45 %

3.61%

1.27
3.95
6.03
3.34

0.10
5.00

0.08 %
0.15
0.63
1.54
2.51

4.63

0.00

1.47%

3.53 %

3.59 %

109.11%

105.73%

104.23%

(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 $0.2 million for 2013, $0.3 million

for 2012 and $0.4 million for 2011.

(2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserve.

MANAGEMENT DISCUSSION AND ANALYSIS

Net interest margin decreased to 3.51% in 2013 from
3.67% in 2012 primarily because the yield on interest-
earning assets decreased at a faster rate than the cost of
interest-bearing liabilities. Net interest margin was also
negatively impacted by a change in the asset mix as a
higher percentage of interest-earning assets were in lower
yielding cash and investments in 2013 when compared to
2012. Average net earning assets increased $11.9 million
to $46.9 million in 2013 compared to $35.0 million for
2012 primarily because the income realized in 2013 was
reinvested in interest-earning assets.

interest

income and

The following table presents the dollar amount of changes
in
interest expense for major
components of interest-earning assets and interest-bearing
liabilities. It quantifies the changes in interest income and
interest expense related to changes in the average
outstanding balances (volume) and those changes caused
by fluctuating interest rates. For each category of interest-
earning assets and interest-bearing liabilities, information
is provided on changes attributable to (i) changes in
volume (i.e., changes in volume multiplied by old rate)
and (ii) changes in rate (i.e., changes in rate multiplied by
old volume).

Year Ended December 31,

2013 vs. 2012
Increase
(Decrease)
Due to

2012 vs. 2011
Increase
(Decrease)
Due to

Volume(1)

Rate(1)

Total
Increase
(Decrease) Volume(1)

Rate(1)

Total
Increase
(Decrease)

(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 ..................................
Total interest-bearing liabilities .........
Decrease in net interest income .......... $

(309)
127
(41)
(5,556)
21
(55)
(5,813)

2
7
26
(727)
(543)
(1,923)
(3,158)
(2,655)

4
(250)
10
(1,782)
7
(9)
(2,020)

(22)
(40)
(101)
(450)
(89)
10
(692)
(1,328)

(305)
(123)
(31)
(7,338)
28
(64)
(7,833)

(20)
(33)
(75)
(1,177)
(632)
(1,913)
(3,850)
(3,983)

(485)
(517)
42
(6,427)
11
(43)
(7,419)

(7)
5
(44)
(753)
(1,264)
(1,047)
(3,110)
(4,309)

(9)
(197)
(26)
(1,108)
54
(20)
(1,306)

(15)
5
(254)
(676)
(103)
157
(886)
(420)

(494)
(714)
16
(7,535)
65
(63)
(8,725)

(22)
10
(298)
(1,429)
(1,367)
(890)
(3,996)
(4,729)

(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.

MANAGEMENT DISCUSSION AND ANALYSIS

The following table sets forth the weighted average
yields on the Company's interest-earning assets, the
weighted average interest rates on interest-bearing
liabilities and the interest rate spread between the

weighted average yields and rates as of the date
indicated. Non-accruing loans have been included in the
average outstanding loan balances in the table as loans
carrying a zero yield.

Weighted average yield on:

Securities available for sale:

At December 31, 2013

Weighted average rate on:

Mortgage-backed and related securities .................... 4.27%
Other marketable securities ....................................... 0.78

NOW accounts .............................................................
Passbooks .....................................................................
Loans held for sale ........................................................ 4.26 Money market accounts ...............................................
Certificates ...................................................................
Loans receivable, net ..................................................... 5.09
Federal Home Loan Bank stock .................................... 0.50
Federal Home Loan Bank advances .............................
Combined weighted average rate on
Other interest-earnings assets ........................................ 0.24
interest-bearing liabilities ...........................................
Combined weighted average yield
Interest rate spread .......................................................
on interest-earning assets ............................................ 3.42

0.03%
0.07
0.28
0.78
0.00

0.26
3.16

December 31,
Foreclosed and repossessed assets:
(Dollars in thousands)
2013 2012
Balance at beginning of year ........................... $ 10,595 16,616
876 2,242
Transferred from non-performing loans ..........
Other foreclosures/repossessions ....................
117
687
Real estate sold ............................................... (5,827) (7,558)
(752)
Net gain (loss) on sale of assets ...................... 1,587
Write downs .................................................... (1,020)
(70)
Balance at end of year ..................................... $ 6,898 10,595

Loans classified as non-performing during 2013 decreased
$12.5 million, from $30.0 million at December 31, 2012 to
$17.5 million at December 31, 2013. The decrease in loans
classified as non-performing during 2013
reflects
continued stabilization of the value of the real estate
collateral securing the loan portfolio which resulted in
fewer loans being classified as non-performing. Principal
payments received on non-performing loans during the
year decreased $2.8 million, from $13.8 million in 2012 to
$11.0 million in 2013 which is primarily the result of
having
in 2013 when
compared to 2012.

fewer non-performing

loans

Foreclosed and repossessed assets decreased $3.7 million
during 2013 primarily because of the $5.8 million in real
estate sales during the year.

improving values of

Provision for Loan Losses
The provision for loan losses was ($7.9 million) for the
year ended December 31, 2013, a decrease of $10.4
million, from $2.5 million for the year ended December
31, 2012. The provision decreased between the periods
primarily because of
the
underlying collateral supporting commercial real estate
loans in 2013 when compared to 2012. The provision
the
also decreased because of a
outstanding loan portfolio balances, a decrease in the
reserve percentages on certain risk classifications as a
result of an internal analysis of recent loan charge-off
history, an improvement in the classifications of certain
risk rated loans, and the recoveries received during
2013 on previously charged off loans. Total non-
performing assets were $24.4 million at December 31,
2013, a decrease of $16.2 million, or 39.9%, from
$40.6 million at December 31, 2012. The non-
performing loan and foreclosed and repossessed asset
activity for 2013 was as follows:

reduction

December 31,
Non-performing loans:
(Dollars in thousands)
2013 2012
Balance at beginning of year .......................... $ 29,975 33,993
Classified as non-performing ......................... 6,295 23,785
Charge offs ..................................................... (5,002) (9,317)
Principal payments received .......................... (11,043) (13,823)
Classified as accruing .................................... (1,853) (2,421)
Transferred to real estate owned ....................
(876) (2,242)
Balance at end of year .................................... $ 17,496 29,975

MANAGEMENT DISCUSSION AND ANALYSIS

The following table reflects the activity in the allowance for loan losses for 2013 and 2012.

(Dollars in thousands)
Balance at January 1, ...................................................................................................................... $
Provision .........................................................................................................................................
Charge offs:

Commercial .................................................................................................................................
Commercial real estate ................................................................................................................
Consumer ....................................................................................................................................
Single family mortgage ..............................................................................................................
Recoveries .......................................................................................................................................
Balance at December 31, ................................................................................................................ $

General allowance ........................................................................................................................... $
Specific allowance ..........................................................................................................................
$

2013

2012

21,608
(7,881)

(651)
(3,711)
(484)
(200)
2,720
11,401

7,623
3,778
11,401

23,888
2,544

(2,464)
(5,719)
(1,071)
(63)
4,493
21,608

16,795
4,813
21,608

The allowance for loan losses and charge offs decreased in
2013 when compared to 2012 because of three factors.
The first factor was there were fewer decreases in the
value of the underlying collateral supporting commercial
real estate loans that required additional allowances or
charge offs in 2013 when compared to 2012. The second
factor was that the loan portfolio decreased $80 million
between the periods which reduced the amount of the
required allowance. The third factor was that required
reserve percentages for certain risk rated loan categories

decreased as a result of the periodic internal analysis of
recent loan charge-off history that was performed in 2013.

Non-Interest Income
Non-interest income was $7.3 million for the year ended
December 31, 2013, a decrease of $1.7 million, or 18.7%,
from $9.0 million for the year ended December 31, 2012.

The following table presents the components of non-
interest income:

(Dollars in thousands)
Fees and service charges ................................................ $
Loan servicing fees ........................................................
Gain on sales of loans ....................................................
Gain on sale of branch office .........................................
Other non-interest income ..............................................
Total non-interest income .......................................... $

Year ended December 31,
2012

2011

2013

Percentage
Increase (Decrease)

2013/2012

2012/2011

3,513
1,029
2,102
0
668
7,312

3,325
964
3,574
552
575
8,990

3,739
987
1,656
0
487
6,869

5.7%
6.7
(41.2)
(100.0)
16.2
(18.7)

(11.1)%
(2.3)
115.8

N/A
18.1
30.9

Gain on sales of loans decreased $1.5 million, or 41.2%,
between 2013 and 2012 primarily because of a decrease in
single family loan originations and sales. Gain on sale of
branch office was $0 for 2013, compared to $0.6 million
in 2012 as a result of the sale of the Toledo, Iowa branch
in the first quarter of 2012. Fees and service charges
increased $0.2 million primarily because of an increase in
overdraft charges related to a combination of an increase
in the number of overdrafts and an increase in the amount
charged per overdraft between 2013 and 2012. Other non-
interest income increased $0.1 million due to an increase

in the sale of non-insured investment products. Mortgage
servicing fees increased $0.1 million as a result of
servicing more single family loans.

Non-Interest Expense
Non-interest expense was $22.6 million for the year
ended December 31, 2013, a decrease of $2.1 million, or
8.3%, from $24.7 million for the same period in 2012.
The following table presents the components of non-
interest expense:

MANAGEMENT DISCUSSION AND ANALYSIS

(Dollars in thousands)
Compensation and benefits ........................................... $
(Gains) losses on real estate owned ...............................
Occupancy ....................................................................
Deposit insurance ..........................................................
Data processing ............................................................
Other .............................................................................
Total non-interest expense ........................................ $

Year ended December 31,
2012

2011

2013

Percentage
Increase (Decrease)

2013/2012

2012/2011

12,680
(830)
3,338
868
1,177
5,390
22,623

12,452
181
3,358
1,255
1,332
6,092
24,670

13,553
2,681
3,741
1,255
1,221
7,101
29,552

1.8%

(558.6)
(0.6)
(30.8)
(11.6)
(11.5)
(8.3)

(8.1)%
(93.2)
(10.2)
0.0
9.1
(14.2)
(16.5)

Gains on real estate owned increased $1.0 million
between 2013 and 2012 primarily because there were
more gains realized on the sale of real estate and fewer
write downs in the value of the real estate owned in 2013
when compared to 2012. Deposit insurance expense
decreased $0.4 million because of a decrease in total
assets and insurance rates between the periods. Data
processing expense decreased $0.2 million due to a
decrease in hardware and software depreciation expense.
Other non-interest expenses decreased $0.7 million
between 2013 and 2012 primarily because of a decrease in
legal and other professional services. These decreases in
noninterest expense were partially offset by a $0.2 million
increase in compensation expense between 2013 and 2012
primarily because of an increase in employee incentives
and pension benefit costs.

Income Taxes
The Company considers the calculation of current and
deferred income taxes to be a critical accounting policy
that is subject to significant estimates. Actual results could
differ significantly from the estimates and interpretations
used in determining the current and deferred income tax
assets and liabilities. Income tax benefit was $14.4 million
in 2013, an increase of $14.5 million from $0.1 million in
income tax expense for 2012. 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, 2012. Since the valuation reserve was established
against the entire deferred tax asset balance, no regular
income tax expense was recorded for 2012. The income
tax expense that was recorded in 2012 related to
alternative minimum tax amounts that were due since only
a portion of the outstanding net operating loss carry
forwards can be used to offset current income under the
current alternative minimum tax rules. Due to the
Company’s improved financial performance, the valuation
reserve against the deferred tax asset was eliminated in the
fourth quarter of 2013 which resulted in a $14.4 million
income tax benefit for the year ended December 31, 2013.

Net Income Available to Common Shareholders
Net income available to common shareholders was $24.6
million for the year ended December 31, 2013, an
improvement of $21.1 million, from the net income
available to common shareholders of $3.5 million for
2012. Net income available to common shareholders
increased primarily because of the increase in net income
between the periods.

On December 23, 2008, the Company sold 26,000 shares
of Fixed Rate Cumulative Perpetual Preferred Stock,
Series A with a $1,000 liquidation preference (“Preferred
Stock”) and a related warrant to the United States
Department of Treasury (“Treasury”) for $26.0 million as
part of the Treasury’s Capital Purchase Program. On
February 8, 2013, Treasury sold the Preferred Stock to
unaffiliated third party investors in a private transaction
for $18.8 million. The shares of Preferred Stock were
entitled to a 5% annual cumulative dividend for each of
the first five years of the investment, which increased to
9% on February 15, 2014. The increase in the dividend
rate on the Preferred Stock will adversely affect net
income available to common shareholders in 2014 and
thereafter, unless and until
is
repurchased or redeemed. The cumulative preferred
dividends payable was $325,000 each quarter for the first
five years the Preferred Stock was outstanding and
increased to $585,000 each quarter after that until the
shares are redeemed or repurchased. The Company made
all required dividend payments on
the outstanding
preferred stock in 2009 and 2010.

the Preferred Stock

Beginning with the February 15, 2011 dividend payment,
the Company has deferred the last thirteen quarterly
dividend payments, on its Preferred Stock. Under the
terms of the certificate of designations for the Preferred
Stock, dividend payments may be deferred but the
dividend is cumulative and compounds quarterly while
unpaid. The deferred dividend payments have been
accrued for payment in the future and are being reported
for the deferral period as a preferred dividend requirement
that is deducted from net income for financial statement
purposes to arrive at the net income available to common
shareholders. In addition, since the Company failed to pay

MANAGEMENT DISCUSSION AND ANALYSIS

dividends for six quarters, the holders of Preferred Stock
have the right to appoint two representatives to the
Company’s board of directors. The Company, however,
has been advised that the current holders of substantially
all of the Preferred Stock have entered into agreements
with the FRB pursuant to which they have each agreed not
to take actions, without the consent of the FRB, which
might be construed as exercising or attempting to exercise
a controlling influence over the management or policies of
the Company or the Bank, including exercise of any right
to elect any representatives to the Company’s board of
directors.

Under applicable federal banking laws and regulations and
the terms of the Company’s Supervisory Agreement with
the FRB, neither the Company nor the Bank may declare
or pay any cash dividends, or purchase or redeem any
capital stock, without prior notice to, and non-objection of
these regulators.

Comparison of 2012 with 2011
Net income was $5.3 million for 2012, an improvement of
$16.9 million, from the $11.6 million loss for 2011. Net
income available to common shareholders was $3.5
million for the year ended December 31, 2012, an
improvement of $16.9 million, from the net loss available
to common shareholders of $13.4 million for 2011.
Diluted earnings per common share for the year ended
December 31, 2012 was $0.86, an improvement of $4.33
from the $3.47 diluted loss per common share for the year
ended December 31, 2011. The improvement in net
income in 2012 was due primarily to a $14.8 million
decrease in the provision for loan losses between the
periods, a $1.9 million increase in the gain on sale of
loans, and a $4.9 million decrease in noninterest expenses
due primarily to the decrease in expenses and losses
recognized on real estate owned between the periods.
These improvements to net income were partially offset
by a $4.7 million decrease in net interest income due
primarily to a decrease in interest earning assets between
the periods.

Net interest income was $23.7 million for 2012, a
decrease of $4.7 million, or 16.6%, from $28.4 million for
2011. Interest income was $30.8 million for 2012, a
decrease of $8.7 million, or 22.1%, from $39.5 million for
2011. Interest income decreased between the periods
primarily because of a $146 million decrease in the
average interest-earning assets and also because of a
decrease in the average yields earned between the periods.
Average interest-earning assets decreased between the
periods primarily because of a decrease in the commercial
loan portfolio, which occurred because of low loan
demand and the Company’s focus on improving credit
quality, managing net interest margin, and improving
capital ratios. The average yield earned on interest-earning

assets was 4.78% for the year ended December 31, 2012, a
decrease of 22 basis points from the 5.00% average yield
for 2011. The decrease in the average yield was due to the
low interest rate environment that existed during 2012.

the result of a decrease

Interest expense was $7.1 million for the year ended
December 31, 2012, a decrease of $4.0 million, or 35.9%,
from $11.1 million for 2011. Interest expense decreased
primarily because of a $149 million decrease in the
average interest-bearing liabilities between the periods.
The decrease in average interest-bearing liabilities is
primarily
the average
outstanding retail and brokered certificates of deposits
between the periods and a decrease in other deposits as a
result of the Bank’s Toledo, Iowa branch sale that was
completed in the first quarter of 2012. The decrease in
retail and brokered certificates of deposits between the
periods was the result of using the proceeds from loan
principal payments to fund maturing certificates of
deposits. Interest expense also decreased because of the
lower rates paid on retail money market accounts and
certificates of deposit. The decreased rates were the result
of the low interest rate environment that continued to exist
during 2012. The average interest rate paid on interest-
bearing liabilities was 1.17% for the year ended December
31, 2012, a decrease of 30 basis points from the 1.47%
average rate paid for the same period of 2011. Net interest
margin (net interest income divided by average interest-
earning assets) was 3.67% for the year ended December
31, 2012, an increase of 8 basis points, from the 3.59%
margin for 2011.

Net interest margin increased to 3.67% in 2012 from
3.59% in 2011 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 advances and brokered
certificates of deposits in 2012 when compared to 2011.
Advances and brokered deposits decreased in 2012 as the
proceeds from loan payoffs were used to pay off the
outstanding advances and brokered deposits that matured
during the year. Average net earning assets increased $2.9
million to $35.0 million in 2012 compared to $32.1
million for 2011. Net earning assets increased primarily
because of the net income realized during 2012.

The provision for loan losses was $2.5 million for the year
ended December 31, 2012, a decrease of $14.8 million,
from $17.3 million for the year ended December 31, 2011.
The provision decreased between the periods primarily
because there were fewer decreases in the estimated value
of the underlying collateral supporting commercial real
estate loans that required additional allowances or charge

MANAGEMENT DISCUSSION AND ANALYSIS

offs in 2012 when compared to 2011. The provision also
decreased because of the $106 million decrease in the loan
portfolio between the periods. Total non-performing
assets were $40.6 million at December 31, 2012, a
decrease of $10.0 million, or 19.8%, from $50.6 million at
December 31, 2011. Non-performing loans decreased $4.0
million and foreclosed and repossessed assets decreased
$6.0 million during 2012.

Loans classified as non-performing during the year
decreased $4.0 million, from $34.0 million in 2011 to
$30.0 million in 2012. The decrease in loans classified as
non-performing during 2012 reflects some stabilization of
the value of the real estate collateral securing the loan
portfolio which resulted in fewer loans being classified as
non-performing. Principal payments received on non-
performing loans during the year increased $4.2 million,
from $9.6 million in 2011 to $13.8 million in 2012. The
increase in the principal payments received on non-
performing loans is primarily the result of some non-
performing loans paying off during the year and also
because of an increase in the regular loan payments
received on non-performing loans that were applied to the
principal balance of the loan during the year. The increase
in regular loan payments being applied to the principal
balance of the loan is the result of classifying certain
commercial real estate loans that continued to make their
regular monthly payments as non-performing. These loans
were classified as non-performing because the cash flows
from the financed project were not sufficient to support
the required payments on the loans and the borrower
continued to make the loan payments from other sources
of cash.

The allowance for loan losses and charge offs decreased in
2012 when compared to 2011 because of three 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
these non-
performing loans was reported as an outstanding loan with
any associated SVAs included in the financial statements
as part of the allowance for loan losses. Under the
modified policy, which is also acceptable under Generally
Accepted Accounting Principles, SVAs are generally 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. The second factor was
that there were fewer decreases in the value of the
underlying collateral supporting commercial real estate

loan balance for

loans that required additional allowances or charge offs in
2012 when compared to 2011. The third factor was that
the loan portfolio decreased $106 million between the
periods which reduced the amount of the required
allowance.

Non-interest income was $9.0 million for the year ended
December 31, 2012, an increase of $2.1 million, or 30.9%,
from $6.9 million for the year ended December 31, 2011.
Gains on sales of loans increased $1.9 million, or 115.8%,
between the periods primarily because of an increase in
single family loan originations and sales. Gain on sale of
branch office increased $0.6 million as a result of the sale
of the Toledo, Iowa branch in the first quarter of 2012.
Fees and service charges decreased $0.4 million primarily
because of a decrease in overdraft charges between the
periods as a result of the sale of the Toledo, Iowa branch
in the first quarter of 2012.

Non-interest expense was $24.7 million for the year ended
December 31, 2012, a decrease of $4.9 million, or 16.5%,
from $29.6 million for the same period in 2011. Losses on
real estate owned decreased $2.5 million between the
periods primarily because there were fewer losses realized
on the sale of real estate and there were fewer write downs
in the value of the real estate owned in 2012 when
compared to 2011. Compensation and benefits expense
decreased $1.1 million between the periods primarily as a
result of having fewer employees and also because of a
decrease in pension benefit costs. Other non-interest
expenses decreased $1.0 million between the periods
primarily because of a decrease in real estate taxes and
legal fees related to other real estate owned. Occupancy
expense decreased $0.4 million primarily because of a
decrease in depreciation and other expenses as a result of
having fewer branch facilities.

The Company considers the calculation of current and
deferred income taxes to be a critical accounting policy
that is subject to significant estimates. Actual results could
differ significantly from the estimates and interpretations
used in determining the current and deferred income tax
assets and liabilities. Income tax expense was $0.1 million
in 2012, an increase of $0.1 million from 2011 when no
income tax expense was recorded. 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, 2012. Since the valuation reserve was established
against the entire deferred tax asset balance, no regular
income tax expense was recorded in 2012. The income tax
expense that was recorded in 2012 related to alternative
minimum tax amounts that were due since only a portion
of the outstanding net operating loss carry forwards could

MANAGEMENT DISCUSSION AND ANALYSIS

be used to offset current income under the alternative
minimum tax rules.

Net income available to common shareholders was $3.5
million for the year ended December 31, 2012, an
improvement of $16.9 million, from the net loss available

to common shareholders of $13.4 million for 2011. Net
income available to common shareholders increased
primarily because of the change in net income (loss)
between the periods.

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 deferred fees and discounts and allowances for losses as of the dates indicated:

2013

2012

December 31,
2011

2010

2009

Amount Percent Amount Percent

Amount Percent

Amount Percent Amount Percent

(Dollars in thousands)
Real Estate Loans:

One-to-four family ....... $ 76,467
Multi-family .................
8,113
Commercial .................. 178,486
Construction or

19.31% $ 97,037 20.40% $ 119,066 20.52% $ 128,535 18.14 % $ 144,631 17.54%
7.18
2.05
220,721 46.39 243,475 41.95 292,874 41.34 312,714 37.92
45.06

48,266

59,266

11,756

35,517

6.81

2.47

6.12

development ..............
Total real estate

7,851

1.98

12,430

2.61

10,922

1.88

15,251

2.15

40,412

4.90

loans .................. 270,917

68.40

341,944 71.87 408,980 70.47 484,926 68.44 557,023 67.54

Other Loans:

Consumer Loans:

Automobile ...............
971
Home equity line ...... 36,178
Home equity ............. 11,629
Mobile home ...........
360
Land/lot loans ...........
1,827
Other ........................
2,458
Total consumer

0.25
9.13
2.94
0.09
0.46
0.62

623
36,521
11,390
449
2,246
2,746

0.13
7.68
2.39
0.10
0.47
0.58

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

loans .................. 53,423

13.49

53,975 11.35

62,161 10.71

70,603

9.96

82,215

9.97

Commercial business

79,854 16.78 109,259 18.82 153,039 21.60 185,525 22.49
loans .......................... 71,709
Total other loans ... 125,132
133,829 28.13 171,420 29.53 223,642 31.56 267,740 32.46
Total loans ............ 396,049 100.00% 475,773 100.00% 580,400 100.00% 708,568 100.00 % 824,763 100.00%

18.11
31.60

Less:

33
Unamortized discounts .
Net deferred loan fees ...
0
Allowance for losses ..... 11,401

Total loans

33
87
21,608

93
511
23,888

413
1,086
42,828

177
1,518
23,812

receivable, net ... $ 384,615

$ 454,045

$ 555,908

$ 664,241

$ 799,256

In 2013, 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 the Company’s focus on
improving credit quality, managing net interest margin,
and improving capital ratios, it is anticipated that the size
of our overall loan portfolio will continue to decline in
2014.

The Company’s commercial business and commercial real
estate loan portfolios continue to be impacted by the
diminished 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 has
reduced the demand for single-family homes and the
values of existing properties and developments and is
reflected in the $24.4 million of Company assets that were
classified as non-performing at December 31, 2013. We
continue to work to resolve the non-performing status of
these assets 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.

MANAGEMENT DISCUSSION AND ANALYSIS

One-to-four family real estate loans were $76.5 million at
December 31, 2013, a decrease of $20.5 million,
compared to $97.0 million at December 31, 2012.
Mortgage loan refinance activity remained strong in the
first half of 2013 due to the historically low mortgage
rates experienced and almost all of the refinanced loans
originated were sold into the secondary market and were
not placed in the loan portfolio in order to manage the
Company’s interest rate risk position. The amount of
mortgage loans refinanced and their subsequent sale was
the primary reason for the decrease in the one-to-four
family loan portfolio during 2013.

Multi-family real estate loans were $8.1 million at
December 31, 2013, a decrease of $3.7 million, compared
to $11.8 million at December 31, 2012. The decrease in
multi-family real estate loans in 2013 is primarily the
result of several multi-family loans being repaid or
reclassified
limited
to other
originations of these types of loans.

loan categories and

Commercial real estate loans were $178.5 million at
December 31, 2013, a decrease of $42.2 million,
compared to $220.7 million at December 31, 2012.
Commercial business
loans were $71.7 million at
December 31, 2013, a decrease of $8.2 million, compared
to $79.9 million at December 31, 2012. Decreased
commercial loan demand and tighter underwriting and
pricing guidelines resulted in an increase in loan payoffs
and a decrease
the commercial business and
commercial real estate loan balances in 2013.

Construction or development loans were $7.9 million at
December 31, 2013, a decrease of $4.5 million, compared
to $12.4 million at December 31, 2012. The decrease is
primarily the result of a $3.8 million decrease in multi-
family construction loans and $1.4 million decrease in
non-residential construction loans that were partially
offset by a $0.7 million increase in new single-family
construction loans.

Home equity line loans were $36.2 million at December
31, 2013, a decrease of $0.3 million, compared to $36.5
million at December 31, 2012. The open-end home equity
lines are written with an adjustable rate and a 10 year
draw period which requires interest only payments
followed by a 10 year repayment period 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 $11.6
million at December 31, 2013, an increase of $0.2 million,
compared to $11.4 million at December 31, 2012. The
decrease in the open-end equity lines and increase in the
closed-end equity loans is related primarily to borrowers’
desire to lock in closed-end equity loans at fixed rates.

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
system on non-
Company utilizes a
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 adjust the allowance
balance on the basis of these reviews.

risk-rating

Management actively monitors asset quality and, when
appropriate, charges off loans against the allowance for
loan losses. Although management believes it uses the
best information available to make determinations with
respect
future
adjustments may be necessary if economic conditions
differ substantially from the economic conditions in the
assumptions used to determine the size of the allowance
for loan losses.

the allowance

losses,

loan

for

The allowance for loan losses was $11.4 million, or 2.88%
of gross loans at December 31, 2013, compared to $21.6
million, or 4.54% of gross loans at December 31, 2012.
The allowance for loan losses decreased primarily because
of the $79.7 million decrease in the loan portfolio between
the periods. The allowance for loan losses also decreased
because of lower reserve percentages used for certain risk
rated commercial loans as a result of an internal analysis
of the most recent charge-off history that was performed
during the year, as well as a decrease in allocated reserves
for impaired loans.

MANAGEMENT DISCUSSION AND ANALYSIS

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:

One-to-four family .................................................
Consumer ...............................................................
Commercial business .............................................
Commercial real estate ...........................................
Recoveries ..................................................................
Net charge-offs .......................................................
Balance at end of year .................................................... $
Year end allowance for loan losses as a percent of year
end gross loan balance .................................................

Ratio of net loan charge-offs to average loans

2013

2012

December 31,
2011

2010

2009

21,608
(7,881)

(200)
(484)
(651)
(3,711)
2,720
(2,326)
11,401

23,888
2,544

42,828
17,278

23,812
33,381

(63)
(1,071)
(2,464)
(5,719)
4,493
(4,824)
21,608

(508)
(270)
(15,512)
(23,012)
3,084
(36,218)
23,888

(254)
(907)
(7,006)
(7,095)
897
(14,365)
42,828

21,257
26,699

(82)
(1,980)
(9,421)
(13,548)
887
(24,144)
23,812

2.88%

4.54%

4.12%

6.04%

2.89%

outstanding ..................................................................

0.53

0.91

5.62

1.87

2.76

The following table reflects the allocation of the allowance for loan losses:

2013

2012

December 31,
2011

2010

2009

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
business ........
Total ................

2.13%

19.31%

2.91%

20.40%

3.12%

20.52%

1.67%

18.14%

0.69%

17.54%

3.32
2.07

3.08
2.88

49.09
13.49

5.55
2.12

51.47
11.35

4.70
1.86

49.95
10.71

6.90
1.31

50.30
9.96

3.47
1.55

50.00
9.97

18.11
100.00%

5.08
4.54 100.00%

16.78

4.93
18.82
4.12 100.00%

9.91
6.04

21.60
100.00%

3.88
2.89

22.49
100.00%

The allocated reserve percentages for commercial real
estate and commercial business loan categories decreased
in 2013 due primarily to the decrease in the reserve
percentages used as a result of an internal analysis
performed during the year of the Company’s portfolio and
loan loss history. The allocation of the allowance for loan
losses decreased in 2013 for one-to-four family loans due
primarily to the decreases in the reserve percentages on
certain risk rated loans in 2013 when compared to 2012.
The allocation of the allowance for loan losses decreased
in 2013 for consumer loans due to an improvement in the
collateral position 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 fair
value
costs. Management
periodically performs valuations and an allowance for
losses is established if the carrying value of a property
exceeds its fair value less estimated selling costs. The

estimated

selling

less

balance in the allowance for real estate losses was $2.4
million at December 31, 2013 and $4.2 million at
December 31, 2012.

the

judgment of management,

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
is well
collateralized and in the process of collection. Interest
accrued and unpaid at the time a loan is placed on non-
accrual status
income.
is charged against
Subsequent payments are either applied to the outstanding
principal balance or
income,
depending on the assessment of the ultimate collectability
of the loan. Restructured loans include the Bank's troubled
debt restructurings that involved forgiving a portion of
interest or principal or making a loan at a rate materially
less than the market rate to borrowers whose financial

recorded as

interest

loan

MANAGEMENT DISCUSSION AND ANALYSIS

condition had deteriorated. Foreclosed and repossessed
assets include assets acquired in settlement of loans. Total
non-performing assets were $24.4 million at December
31, 2013, a decrease of $16.2 million from $40.6 million
at December 31, 2012. Non-performing loans decreased
$12.5 million and foreclosed and repossessed assets
decreased $3.7 million during 2013. The decrease in non-

performing loans is primarily due to principal payments
received and charge-offs recorded in 2013 on non-
performing loans as well as having fewer existing loans
classified as non-performing during 2013 when compared
to 2012. The following table sets forth the amounts and
categories of non-performing assets in the Company’s
portfolio:

(Dollars in thousands)
Non-performing loans:

2013

2012

December 31,
2011

2010

2009

One-to-four family ....................................................... $
Commercial real estate .................................................
Consumer .....................................................................
Commercial business ...................................................
Total .........................................................................

1,602
14,549
737
608
17,496

2,492
25,543
300
1,640
29,975

4,435
22,658
699
6,201
33,993

4,844
36,737
224
26,269
68,074

Foreclosed and repossessed assets:

One-to-four family .......................................................
Commercial real estate .................................................
Consumer .....................................................................
Total .........................................................................
Total non-performing assets ............................................ $
Total as a percentage of total assets ................................
Total non-performing loans............................................. $
Total as a percentage of total loans receivable, net .........
Allowance for loan losses to non-performing loans ........

0
6,898
0
6,898
24,394

17,496

$
3.76%
$
4.55%
65.17%

1,595
9,000
0
10,595
40,570

29,975

$
6.21%
$
6.60%
72.09%

352

972

16,264
0
16,616
50,609

33,993

$
6.40%
$
6.10%
70.27%

15,409
14
16,395
84,469

68,074

$
9.59%
$
10.25%
62.91%

2,132
37,122
4,086
17,787
61,127

1,011
15,246
5
16,262
77,389
7.47%
61,127
7.65%
38.95%

Gross interest income which would have been recorded
had the non-accruing loans been current in accordance
with their original terms amounted to $1.8 million for
2013, $2.4 million for 2012, and $3.2 million for 2011.
The amounts that were included in interest income on a
cash basis for these loans were $0.1 million, $0.5 million,
and $0.7 million, respectively.

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, 2013, 2012 and 2011.

Principal
Amount
of Loans at
December
31, 2013

Principal
Amount
of Loans at
December
31, 2012

(Dollars in thousands)
Property Type
Developments/land .............................
Retail ...................................................
Other buildings ...................................

# of
Relationships
9
0
0
9

# of
Relationships
9
2
4
15

# of
Relationships
10
2
5
17

24,339
386
818
25,543

Principal
Amount
of Loans at
December
31, 2011

17,465
1,315
3,878
22,658

14,549
0
0
14,549

MANAGEMENT DISCUSSION AND ANALYSIS

The Company had allocated reserves established against
the above commercial real estate loans of $2.2 million,
$2.4 million, and $2.9 million, respectively, at December
31, 2013, 2012, and 2011.

At December 31, 2013, 2012, and 2011, there were loans
included in loans receivable, net, with terms that had been
modified in a troubled debt restructuring totaling $19.2
million, $33.1 million, and $29.2 million, respectively.
For the loans that had been modified in 2013, $0.3 million
were unclassified and performing and $0.8 million were
non-performing at December 31, 2013. The decrease in
troubled debt restructurings in 2013 relates primarily to
two commercial development loans for which $3.6 million
in charge-offs were recorded during the year due to a
decrease in the estimated value of the collateral supporting
the loans. Troubled debt restructurings also decreased
during the year by $4.0 million due to the paydown or
payoff of four other unrelated commercial development
loans, as well as $1.0 million due to the repossession and
sale of collateral related to a consumer equity loan. For the
loans that were restructured in 2012, $5.7 million were
unclassified and performing and $13.7 million were non-
performing at December 31. The restructurings included
reducing loan rates and restructuring repayment schedules
to improve the borrower’s cash flow. Additional collateral
was also obtained for some loans. Of the loans that were
modified in 2013, $0.6 million related to loans secured by
first or second mortgages on 1-4 family property, and the
remaining modifications related
to other consumer,
commercial real estate or commercial business loans. Of
the loans that were modified in 2012, $14.0 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
2011, $11.6 million related to commercial real estate loans
and the remaining modifications related to single family,
consumer and commercial loans. Some of these loans
were not classified as non-performing as it is anticipated
that the borrowers will be able to make all of the required
principal and interest payments under the modified terms
of the loan.

In addition to the troubled debt restructurings and the non-
performing loans set forth in the table above of all non-
performing assets, as of December 31, 2013, there were
five other potential problem loan relationships. Potential
problem loans are loans that are not in non-performing
status, however, there are circumstances present to create
doubt as to the ability of the borrower to comply with
present repayment terms. The decision of management to
include performing loans in potential problem loans does
not necessarily mean that the Company expects losses to
occur but that management recognized a higher degree of
risk associated with these loans. The level of potential
in
problem

is another predominant

factor

loans

determining the relative level of the allowance for loan
losses. The five loan relationships that have been reported
as potential problem loans at December 31, 2013 are a
$0.7 million loan secured by an auto salvage business, and
four other loans to unrelated borrowers totaling $0.9
million that are secured by restaurant business assets. The
two loan relationships reported as potential problem loans
at December 31, 2012 were a $1.4 million loan for a retail
commercial development and a $0.2 million loan for a
loan relationships
manufacturing business. The
reported as potential problem loans at December 31, 2011
were a $3.8 million loan to a financial institution and a
group of loans totaling $5.0 million to a residential
developer.

two

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 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 securities or loans, subject to 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.

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.

MANAGEMENT DISCUSSION AND ANALYSIS

the following major

Cash and cash equivalents at December 31, 2013 were
$120.7 million, an increase of $37.0 million, compared to
$83.7 million at December 31, 2012. Net cash provided by
operating activities during 2013 was $18.9 million. The
investing
Company conducted
activities during 2013: principal payments and maturity
proceeds received on securities available for sale and
FHLB stock were $29.4 million, purchases of securities
available for sale and FHLB stock were $49.3 million,
proceeds from the sale of premises and other real estate
were $5.8 million, and loans receivable decreased $63.9
million. The Company disbursed $0.4 million for the
purchase of equipment and updating its premises. Net
cash provided by investing activities during 2013 was
$49.4 million. The Company conducted the following
major financing activities during 2013: customer escrows
decreased $0.2 million, proceeds from borrowings were
$12.0 million, repayment of borrowings was $82.0
million, and deposits increased $39.0 million. Net cash
used by financing activities was $31.3 million.

The Company has certificates of deposit with outstanding
balances of $87.1 million that mature during 2014, of
which $7.6 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 desire to reduce
the amount of outstanding brokered deposits. The
Company believes that deposits that do not renew will be
repaid with the proceeds from loan principal payments or
replaced with a combination of other customers’ deposits
and FHLB advances. Proceeds from the sale of securities
could also be used to fund unanticipated outflows of
deposits.

The Company has deposits of $109.8 million in checking
and money market accounts of customers that have
relationship balances greater than $5 million. These funds
time and management
may be withdrawn at any
anticipates that the majority of these deposits will be
withdrawn from the Bank over the next twelve months
due to the anticipated cash needs of the customers. If these
deposits are withdrawn, it is anticipated that they would
be funded with available cash or replaced with deposits
from other customers or FHLB advances.

the Company Supervisory Agreement,

Under
the
Company may not incur or issue any debt without prior
notice to, and the consent of, the FRB. Because FHLB
advances are debt of the Bank, they are not affected by the
Company’s restriction on incurring debt.

The Company’s primary source of cash in recent years has
been a portion of the proceeds from the Company’s
December 2008 issuance of preferred stock. Historically,

dividends from the Bank have been the Company’s
primary source of cash. The Bank is restricted under
applicable federal banking law from paying dividends to
the Company without prior notice to and non-objection of
the applicable regulator. In the third quarter of 2013, the
Bank paid a dividend to the Company of $1.0 million to
fund the ongoing operating expenses of the Company. At
December 31, 2013, the Company had $1.1 million in
cash and other assets that could readily be turned into
cash. The Company’s primary use of cash is the payment
of holding company
the
payment of director and management fees as well as legal
expenses and other regulatory costs.

level expenses,

including

Subject to regulatory restrictions, an additional use of cash
by the Company was, prior to 2011, the payment of
dividends on the Company’s outstanding Preferred Stock.
The amount of the dividend on the Preferred Stock
accumulated at the rate of $325,000 per quarter through
February 14, 2014 and will accumulate at the rate of
$585,000 per quarter thereafter, until the shares of
Preferred Stock are redeemed or repurchased. The
Company has deferred the last thirteen quarterly dividend
payments, beginning with the February 15, 2011 dividend
payment. The deferred dividend payments have been
accrued for payment in the future and are being reported
for the deferral period as a preferred dividend requirement
that is deducted from income for financial statement
purposes to arrive at the net income available to common
shareholders. Under the terms of the certificate of
designations for the Preferred Stock, dividend payments
may be deferred, but the dividend is cumulative and
compounds quarterly while unpaid. In addition, since the
Company failed to pay dividends for six quarters, the
holders of Preferred Stock have the right to appoint two
representatives to the Company’s board of directors. The
Company, however, has been advised that the current
holders of substantially all of the Preferred Stock have
entered into agreements with the FRB pursuant to which
they have each agreed not to take actions, without the
consent of the FRB, which might be construed as
to exercise a controlling
exercising or attempting
influence over
the
Company or the Bank, including exercise of any right to
elect any representatives to the Company’s board of
directors.

the management or policies of

At February 15, 2014, accrued and unpaid dividends
(including applicable compounding) aggregated $4.6
million. In view of the Company’s improved capital
position, the Company and the Bank are evaluating
possible payment in whole or in part of these accrued and
unpaid dividends on the Preferred Stock, funded by a
dividend in like amount from the Bank. There is no
assurance that the Bank and the Company would satisfy
applicable regulatory requirements necessary to effect any

MANAGEMENT DISCUSSION AND ANALYSIS

such dividends. Further, any determination as to whether,
when and in what amount to declare and pay any such
dividends would be subject to the discretion of the boards
of directors of the Bank and the Company and would
depend on numerous factors, including the results of
operations, financial condition and cash flow requirements
of the Company and the Bank. The Company also
routinely evaluates other strategic alternatives regarding
the outstanding Preferred Stock, including its possible
repurchase or redemption, in whole or in part, from
internal or external
funds or other
consideration. As with dividends, any such action would

sources of

be subject to the discretion of the board of directors of the
Company and would depend on numerous factors,
including applicable regulatory requirements, results of
operations, financial condition and cash flow requirements
of the Company and the Bank.

Contractual Obligations and Commercial Commitments
The Company has certain obligations and commitments to
make future payments under existing contracts. At
December 31, 2013, the aggregate contractual obligations
(excluding bank deposits) and commercial commitments
were as follows:

(Dollars in thousands)
Contractual Obligations:
Annual rental commitments under non-cancellable

Payments Due by Period

Total

Less than 1
Year

1-3 Years

4-5 Years

After 5 Years

operating leases ........................................................... $
$

2,194
2,194

798
798

1,300
1,300

96
96

0
0

Other Commercial Commitments:
Commercial lines of credit ............................................. $
Commitments to lend .....................................................
Standby letters of credit .................................................
$

34,765
6,829
1,017
42,611

25,834
4,540
1,017
31,391

2,577
720
0
3,297

1,753
441
0
2,194

4,601
1,128
0
5,729

Amount of Commitments -Expiring by Period

Regulatory Capital Requirements
As a result of the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA), banking and thrift
regulators are required to take prompt regulatory action
against institutions which are undercapitalized. FDICIA
requires banking and thrift regulators to categorize
institutions as "well capitalized", "adequately capitalized",
"undercapitalized", "significantly undercapitalized", or
"critically undercapitalized". A savings institution will be
deemed to be well capitalized if it: (i) has a total risk-
based capital ratio of 10% or greater, (ii) has a Tier 1
(core) risk-based capital ratio of 6% or greater, (iii) has a
leverage ratio of 5% or greater, and (iv) is not subject to
any order or written directive by the OCC to meet and
maintain a specific capital level for any capital measure.
Management believes that, as of December 31, 2013, the
Bank’s capital ratios were in excess of those quantitative
capital ratio standards set forth under
the 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.
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.

As required by the Company Supervisory Agreement, the
Company submitted an updated two-year capital plan in
January 2014 that the FRB may make comments upon,
and to which it may require revisions. The Company must
operate within the parameters of the capital plan and is
required to monitor and submit periodic reports on its
compliance with the plan. In addition, the OCC had
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, the Bank was
required to establish, and subsequently maintain, core
capital at least equal to 8.50% of adjusted total assets. The
Bank’s core capital to adjusted total assets ratio was
12.22% at December 31, 2013. The OCC terminated the
IMCR effective February 11, 2014.

The Company also serves as a source of capital, liquidity
and financial support to the Bank. Depending upon the
operating performance of the Bank and the Company’s
other liquidity and capital needs, including potentially
Company-level expenses, accumulating and unpaid
dividends on the Company’s Preferred Stock, the stated
rate of which increased from 5% to 9% per annum,
compounding quarterly, beginning on February 15, 2014,
and repurchase or redemption of the Preferred Stock, the

MANAGEMENT DISCUSSION AND ANALYSIS

Company may find it prudent subject to prevailing capital
market conditions and other factors to raise additional
capital through issuance of its common stock or other
equity securities. In addition, regulators have placed
increasing emphasis on the amount of common equity as a
component of core bank capital, and revised capital
regulations (described below) incorporating specific levels
of common equity capital both at the Bank and the
Company. Additional capital would also potentially
permit the Company to implement a strategy of growing
Bank assets. Depending on the circumstances, if it were to
raise capital, the Company may deploy it to the Bank for
general banking purposes, or may retain some or all of it
for use by 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, if issued at less than the
Company’s book value would dilute the per share book
value of the Company’s common stock, dilute the
Company’s earnings per share, and could result in a
change of control of the Company and the Bank. New
investors may also have rights, preferences and privileges
senior to the Company’s current stockholders, which may
adversely impact the Company’s current stockholders.
The Company’s ability to raise additional capital through
the issuance of equity securities, if deemed prudent, will
depend on, among other factors, conditions in the capital
markets at that time, which are outside of its control, and
on the Company’s financial performance and plans.
Accordingly, the Company may not be able to raise
additional capital, if deemed prudent, 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, maintain
compliance with the regulatory capital requirements, to
address the accumulation of unpaid Preferred Stock
dividends on the Company’s outstanding Preferred Stock
and the relatively high cost of such capital, to operate
without additional regulatory or other restrictions, and its
operating results, could be materially adversely affected.

integrated

The capital requirements of the Company and the Bank
will be affected by regulatory capital changes issued in
July 2013 by the FRB, the FDIC and the OCC. The
changes establish an
regulatory capital
framework for implementing the Basel Committee on
Banking Supervision’s Basel III regulatory capital reforms
and implement the changes required by the Dodd-Frank
Wall Street Reform and Consumer Protection Act of
2010. The new capital requirements are effective for the
Company beginning January 1, 2015, and among other
things, apply a strengthened set of capital requirements to
both the Bank and the Company and revise the rules for

calculating risk-weighted assets for purposes of such
requirements. The Company is still in the process of
evaluating the full impact that these new capital standards
will have on the Bank’s and Company’s capital positions
when they are implemented on January 1, 2015. See “Item
1 – Business – Regulation and Supervision” in our Form
10-K for the fiscal year ended December 31, 2013 for
additional information on the new regulatory capital rules.

tax

the

dividend

payments

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
industry
capital
standards, economic conditions, the outstanding Company
Supervisory Agreement and other regulatory restrictions,
general business practices and other factors. Under
applicable federal banking laws and regulations, no
dividends can be declared or paid by the Bank to the
Company without notice to and non-objection from the
applicable banking regulator. 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
common
stockholders in the fourth quarter of 2008 due to the net
the challenging
losses experienced and
operating
economic environment. In addition,
the Company’s
outstanding Preferred Stock bears a stated dividend rate,
which accumulated at the rate of $325,000 per quarter
through February 14, 2014 and accumulates at the rate of
$585,000 per quarter thereafter. The Company has
deferred the past thirteen regular quarterly cash dividends
on the Preferred Stock issued 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, but the dividend is cumulative and
compounds quarterly while unpaid. In addition, the
holders of the Preferred Stock have the right to appoint
two representatives to the Company’s board of directors
because the Company failed to pay dividends for six
quarters. The Company, however, has been advised that
the current holders of substantially all of the Preferred
Stock have entered into agreements with the FRB
pursuant to which they have each agreed not to take
actions, without the consent of the FRB, which might be
construed as exercising or attempting to exercise a
controlling influence over the management or policies of
the Company or the Bank, including exercise of any right
to elect any representatives to the Company’s board of
directors. Further, while Preferred Stock dividends are in
arrears ($4.6 million at February 15, 2014), no dividend
may be paid on common stock of the Company. Under the
terms of the Company’s Supervisory Agreement, the
Company may not declare or pay any cash dividends, or
purchase or redeem any capital stock, without prior notice

MANAGEMENT DISCUSSION AND ANALYSIS

to, and consent of, the Federal Reserve Board. In view of
the Company’s improved capital position, the Company
and the Bank are evaluating possible payment in whole or
in part of these accrued and unpaid dividends on the
Preferred Stock, funded by a dividend in like amount from
the Bank. There is no assurance that the Bank and the
Company would
regulatory
requirements necessary to effect any such dividends.
Further, any determination as to whether, when and in
what amount to declare and pay any such dividends would
be subject to the discretion of the boards of directors of
the Bank and the Company and would depend on
numerous factors, including the results of operations,
financial condition and cash flow requirements of the
Company and the Bank.

applicable

satisfy

Impact of Inflation and Changing Prices
The impact of inflation is reflected in the increased cost of
operations. Unlike most industrial companies, nearly all of
the assets and liabilities of the Company are monetary in
nature. As a result, interest rates have a greater impact on
the Company's performance than do the effects of general
levels of inflation. Interest rates do not necessarily move
in the same direction or to the same extent as the prices of
goods and services.

to derivatives

New Accounting Pronouncements
In January 2013, the FASB issued ASU 2013-01, Balance
Sheet (Topic 210). The objective of this ASU is to clarify
that the scope of ASU 2011-11, Balance Sheet (Topic
including bifurcated
210), applies
embedded derivatives, repurchase agreements and reverse
repurchase agreements, and securities borrowing and
securities lending transactions that are either offset in
accordance with Section 210-20-45 or Section 815-10-45
or are subject to a master netting arrangement or similar
agreement. This ASU is the final version of proposed
ASU 2011-11, Balance Sheet (Topic 210) which has been
deleted. An entity is required to apply the amendments for
fiscal years beginning on or after January 1, 2013, and
interim periods within those annual periods. The adoption
of this ASU in the first quarter of 2013 did not have any
impact on
financial
statements as it has no outstanding rights of setoff.

the Company’s consolidated

replace

In February 2013, the FASB issued ASU 2013-02, Other
Comprehensive Income (Topic 220). The amendments in
this ASU supersede and
the presentation
requirements of reclassifications out of accumulated other
comprehensive income in ASU’s 2011-05 (issued in June
2011) and 2011-12 (issued in December 2011) for all
public and private organizations. The amendments require
information about
an entity
reclassifications out of accumulated other comprehensive
income. For public entities, the amendments are effective
prospectively for reporting periods beginning after

to provide additional

December 15, 2012. The adoption of this ASU in the first
quarter of 2013 did not have a material impact on the
Company’s consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04,
Receivables – Troubled Debt Restructurings by Creditors
(Subtopic 310-40) Reclassification of Residential Real
Estate Collateralized Consumer Mortgage Loans upon
Foreclosure. The amendments in this ASU clarify when a
repossession or foreclosure occurs, and a creditor is
considered to have received physical possession of
residential real estate property collateralizing a consumer
mortgage loan. Under the amendment, physical possession
occurs, upon either (1) the creditor obtaining legal title to
the residential real estate property upon completion of a
foreclosure or (2) the borrower conveying all interest in
the residential real estate property to the creditor to satisfy
that loan through completion of a deed in lieu of
foreclosure or through a similar legal agreement. The
ASU is intended to reduce diversity in practice and is
effective for public business entities for annual periods,
and
those annual periods,
beginning after December 15, 2014. The adoption of this
ASU in the first quarter of 2015 is not anticipated to have
a material
the Company’s consolidated
financial statements.

interim periods within

impact on

Market Risk
Market risk is the risk of loss from adverse changes in
market prices and rates. The Company's market risk arises
primarily from interest rate risk inherent in its investing,
lending and deposit
taking activities. Management
actively monitors and manages its interest rate risk
exposure.

The Company's profitability is affected by fluctuations in
interest rates. A sudden and substantial change in interest
rates may adversely impact the Company's earnings to the
extent that the interest rates borne by assets and liabilities
do not change at the same speed, to the same extent, or on
the same basis. The Company monitors the projected
changes in net interest income that occur if interest rates
were to suddenly change up or down. The Rate Shock
Table located in the Asset/Liability Management section
of this Management’s Discussion and Analysis discloses
the Company's projected changes in net interest income
based upon immediate interest rate changes called rate
shocks.

MANAGEMENT DISCUSSION AND ANALYSIS

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 also calculates the
changes in market value of the interest-earning assets and
interest-bearing liabilities under different interest rate
changes.

The following table discloses the projected changes in
market value to the Company’s interest-earning assets and
interest-bearing liabilities based upon incremental 100
basis point changes in interest rates from interest rates in
effect on December 31, 2013.

(Dollars in thousands)
Basis point change in interest rates
Total market-risk sensitive assets ............................................................ $
Total market-risk sensitive liabilities ......................................................
Off-balance sheet financial instruments ..................................................
Net market risk ........................................................................................ $
Percentage change from current market value ........................................

-100
638,946
527,383
(83)
111,646

0
631,199
500,926
0
130,273

+100
621,944
484,445
47
137,452

(14.30)%

0.00%

5.51%

+200
609,280
468,107
101
141,072
8.29%

Market Value

(the Model Assumptions)

The preceding table was prepared utilizing the following
assumptions
regarding
prepayment and decay ratios that were determined by
management based upon
their review of historical
prepayment speeds and future prepayment projections.
Fixed rate loans were assumed to prepay at annual rates of
between 5% and 61%, depending on the note rate and the
period to maturity. Adjustable rate mortgages (ARMs)
were assumed to prepay at annual rates of between 18%
and 138%, depending on the note rate and the period to
maturity. Mortgage-backed securities were projected to
have prepayments based upon the underlying collateral
securing
instrument. Certificate accounts were
assumed not to be withdrawn until maturity. Passbook and
money market accounts were assumed to decay at annual
rates of 6% and 9%, respectively. Non-interest checking
and NOW accounts were both assumed to decay at an
annual rate of 4%. Commercial non-interest checking and
NOW accounts were assumed to decay at an annual rate
of 9%. Commercial MMDA accounts were assumed to
decay at annual rates of 14%.

the

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 also decrease in the event of a substantial
sustained increase in interest rates.

Asset/Liability Management
The Company's management reviews the impact that
changing interest rates will have on the net interest
income projected for
twelve months following
December 31, 2013 to determine if its current level of
interest rate risk is acceptable. The following table
projects the estimated impact on net interest income
during the 12 month period ending December 31, 2014 of
immediate interest rate changes called rate shocks:

the

(Dollars in thousands)

Rate Shock Table

Rate Shock
in
Basis Points
+200
+100
0
-100

Net
Interest
Change
2,278
1,197
0
(1,546)

Percent
Change
11.96%
6.28
0.00
(8.11)

The preceding table was prepared utilizing the Model
Assumptions. Certain shortcomings are inherent in the
method of analysis presented in the foregoing table. In the
event of a change in interest rates, prepayment and early

MANAGEMENT DISCUSSION AND ANALYSIS

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 deposits 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 in 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
timing and
implementation of transactions to assure attainment of the
Bank's objectives in the most effective manner. In
addition, the Board reviews, on a quarterly basis, the
Bank's asset/liability position, including simulations of the
effect on the Bank's capital of various interest rate
scenarios.

the

In managing its asset/liability mix, the Bank may, at
times, depending on the relationship between long and
short-term interest rates, market conditions and consumer
preference, place more emphasis on managing net interest
margin than on better matching the interest rate sensitivity

of its assets and liabilities in an effort to enhance net
interest income. Management believes that the increased
net interest income resulting from a 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 2013,
the Bank has primarily focused its fixed rate one-to-four
family residential lending program on loans that are
saleable to third parties and generally placed only those
fixed rate loans that met certain risk characteristics into its
loan portfolio. A significant portion of the Bank’s
commercial loan production continued to be 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.

CONSOLIDATED BALANCE SHEETS

December 31 (Dollars in thousands)

ASSETS
Cash and cash equivalents .......................................................................................................... $
Securities available for sale:

Mortgage-backed and related securities
(amortized cost $4,899 and $9,825) ....................................................................................
Other marketable securities
(amortized cost $103,788 and $75,759) .............................................................................

Loans held for sale .....................................................................................................................
Loans receivable, net .................................................................................................................
Accrued interest receivable ........................................................................................................
Real estate, net ...........................................................................................................................
Federal Home Loan Bank stock, at cost .....................................................................................
Mortgage servicing rights, net ....................................................................................................
Premises and equipment, net .....................................................................................................
Prepaid expenses and other assets ..............................................................................................
Deferred tax asset, net ................................................................................................................
Total assets ............................................................................................................................. $

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits ..................................................................................................................................... $
Federal Home Loan Bank advances ...........................................................................................
Accrued interest payable ............................................................................................................
Customer escrows ......................................................................................................................
Accrued expenses and other liabilities .......................................................................................
Total liabilities .......................................................................................................................

Commitments and contingencies
Stockholders’ equity:

Serial preferred stock: ($.01 par value)

2013

2012

120,686

83,660

5,213

102,743
107,956

1,502
384,615
1,953
6,898
784
1,708
6,711
698
15,111
648,622

553,930
0
146
614
8,257
562,947

10,421

75,470
85,891

2,584
454,045
2,018
10,595
4,063
1,732
7,173
1,566
0
653,327

514,951
70,000
247
830
6,465
592,493

Authorized 500,000 shares; issued shares 26,000 ..............................................................

26,000

Common stock ($.01 par value):

Authorized 16,000,000; issued shares 9,128,662 ...............................................................
Additional paid-in capital ...........................................................................................................
Retained earnings, subject to certain restrictions .......................................................................
Accumulated other comprehensive loss .....................................................................................
Unearned employee stock ownership plan shares ......................................................................
Treasury stock, at cost 4,704,313 and 4,705,073 shares.............................................................
Total stockholders’ equity ......................................................................................................
Total liabilities and stockholders’ equity ................................................................................... $

91
51,175
72,211
(674)
(2,804)
(60,324)
85,675
648,622

25,336

91
51,795
47,004

(49)
(2,997)
(60,346)
60,834
653,327

See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Years ended December 31 (Dollars in thousands)
Interest income:

Loans receivable ........................................................................................ $
Securities available for sale:

Mortgage-backed and related .................................................................
Other marketable ....................................................................................
Cash equivalents ........................................................................................
Other ..........................................................................................................
Total interest income ..............................................................................

Interest expense:

Deposits .....................................................................................................
Federal Home Loan Bank advances ...........................................................
Total interest expense .............................................................................
Net interest income ............................................................................
Provision for loan losses ...............................................................................
Net interest income after provision for loan losses ............................

Non-interest income:

Fees and service charges ............................................................................
Loan servicing fees ....................................................................................
Gain on sales of loans ................................................................................
Gain on sale of branch office .....................................................................
Other ..........................................................................................................
Total non-interest income ......................................................................

Non-interest expense:

Compensation and benefits .......................................................................
(Gains) losses on real estate owned ............................................................
Occupancy .................................................................................................
Deposit insurance .......................................................................................
Data processing ..........................................................................................
Other ..........................................................................................................
Total noninterest expense .......................................................................
Income (loss) before income tax (benefit) expense ...........................
Income tax (benefit) expense ........................................................................
Net income (loss) ...................................................................................
Preferred stock dividends and discount .........................................................
Net income (loss) available to common stockholders ............................ $
Other comprehensive loss, net of tax ............................................................
Comprehensive income (loss) attributable to common shareholders ............ $
Basic earnings (loss) per common share ....................................................... $
Diluted earnings (loss) per common share .................................................... $

See accompanying notes to consolidated financial statements.

2013

2012

2011

21,887

29,257

300
614
129
53
22,983

1,804
1,485
3,289
19,694
(7,881)
27,575

3,513
1,029
2,102
0
668
7,312

12,680

(830)
3,338
868
1,177
5,390
22,623
12,264
(14,406)
26,670
(2,068)
24,602

(625)

23,977
6.15
5.71

604
737
101
117
30,816

3,741
3,398
7,139
23,677
2,544
21,133

3,325
964
3,574
552
575
8,990

12,452
181
3,358
1,255
1,332
6,092
24,670
5,453
132
5,321
(1,861)
3,460
(520)
2,940
0.88
0.86

36,776

1,098
1,451
36
180
39,541

6,847
4,288
11,135
28,406
17,278
11,128

3,739
987
1,656
0
487
6,869

13,553
2,681
3,741
1,255
1,221
7,101
29,552
(11,555)
0
(11,555)
(1,821)
(13,376)
(70)
(13,446)
(3.47)
(3.47)

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Preferred Common
Stock

Stock

Additional
Paid-in
Capital

Accumulated

Other

Comprehensive

Retained
Earnings

Income
(Loss)

Unearned
Employee

Stock

Total
Stock-
Ownership Treasury holders’
Equity
Stock

Plan

24,264

56,420

55,838
(11,555)

541

(3,384)

(64,223)

(70)

(Dollars in thousands)
Balance, December 31, 2010... $
Net loss ................................
Other comprehensive loss ...
Preferred stock discount

amortization .....................

516

Stock compensation

expense .............................

Unearned compensation

restricted stock awards .....

Restricted stock awards

forfeited ............................

Amortization of restricted

stock awards .....................

Preferred stock dividends

accrued .............................

Earned employee stock

ownership plan shares ......
Balance, December 31, 2011... $
Net income ..........................
Other comprehensive loss ...
Preferred stock discount

24,780

amortization .....................

556

Stock compensation

expense .............................

Unearned compensation

restricted stock awards .....

Restricted stock awards

forfeited ............................

Amortization of restricted

stock awards .....................

Preferred stock dividends

accrued .............................

Earned employee stock

ownership plan shares ......
Balance, December 31, 2012... $
Net income .........................
Other comprehensive loss
Preferred stock discount

25,336

amortization ...................

664

Stock compensation

expense ............................

Unearned compensation

restricted stock awards ..

Restricted stock awards

forfeited ...........................

Amortization of restricted

stock awards ...................

Preferred stock dividends

accrued ............................

Earned employee stock

(516)

(2,700)

298

(81)
53,462

(556)

(1,199)

233

(162)
51,795

(664)

(349)

208

202

(1,300)

42,983
5,321

(1,300)

47,004
26,670

(1,463)

2,700

(12)

193
(3,191)

(61,535)

471

(520)

1,199

(10)

194
(2,997)

(60,346)

(49)

(625)

349

(327)

ownership plan shares ...
Balance, December 31, 2013 . $

26,000

(21)
51,175

72,211

(674)

193
(2,804)

(60,324)

See accompanying notes to consolidated financial statements.

69,547
(11,555)
(70)

298

(1,300)

112
57,061
5,321
(520)

233

(1,300)

32
60,834
26,670
(625)

(119)

202

(1,463)

172
85,675

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31 (Dollars in thousands)
Cash flows from operating activities:

Net income (loss) ....................................................................................... $
Adjustments to reconcile net income to cash provided by operating

activities:
Provision for loan losses ........................................................................
Depreciation ...........................................................................................
Amortization of discounts, net ...............................................................
Amortization of deferred loan fees .........................................................
Amortization of mortgage servicing rights .............................................
Capitalized mortgage servicing rights ....................................................
Deferred income tax benefit ...................................................................
(Gains) losses 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 .................................................
Cancellation of vested restricted stock awards .......................................
Earned ESOP shares priced below original cost ....................................
Stock option compensation expense .......................................................
Gain on sale of branch office ................................................................
Decrease in accrued interest receivable ..................................................
Decrease in accrued interest payable ......................................................
Decrease in other assets .........................................................................
Increase (decrease) in other liabilities ....................................................
Other, net ...............................................................................................
Net cash provided by operating activities...........................................

Cash flows from investing activities:

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 ...............................................................
Payment on sale of branch office ...............................................................
Purchases of premises and equipment ........................................................
Net cash provided by investing activities ...........................................

Cash flows from financing activities:

Increase (decrease) in deposits ...................................................................
Proceeds from borrowings .........................................................................
Repayment of borrowings ..........................................................................
Increase (decrease) in customer escrows ....................................................
Net cash used by financing activities .................................................
Increase in cash and cash equivalents ................................................
Cash and cash equivalents, beginning of year ................................................
Cash and cash equivalents, end of year .......................................................... $
Supplemental cash flow disclosures:

Cash paid for interest ................................................................................. $
Cash paid for income taxes ........................................................................

Supplemental noncash flow disclosures:

Loans transferred to loans held for sale ......................................................
Transfer of loans to real estate ...................................................................
Assets transferred to assets held for sale ....................................................
Deposits transferred to deposits held for sale .............................................

See accompanying notes to consolidated financial statements.

2013

2012

2011

26,670

5,321

(11,555)

(7,881)
880
80
(249)
592
(568)
(14,464)
(830)
(2,102)
84,718
(69,347)
202
193
(119)
(21)
4
0
65
(101)
842
364
64
18,992

4,933
21,000
(49,090)
(178)
3,457
5,786
63,814
0
(425)

49,297

38,953
12,000
(82,000)
(216)
(31,263)
37,026
83,660
120,686

3,390
205

12,183
1,563
0
0

2,544
1,091
98
(528 )
732
(979 )
0
181
(3,574 )
131,494
(118,661 )
233
194
0
(162 )
7
(552 )
431
(533 )
696
(1,776 )
580
16,837

9,770
108,000
(78,072 )
0
159
7,503
89,591
(36,981 )
(295 )
99,675

(100,591 )
1
(1 )
(101 )
(100,692 )
15,820
67,840
83,660

7,672
60

8,196
2,225
0
0

17,278
1,267
297
(465)
561
(461)
0
2,681
(1,656)
64,890
(58,588)
297
193
0
(81)
29
0
862
(312)
1,342
380
381
17,340

12,466
156,900
(144,051)
(17)
2,538
5,440
76,114
0
(201)
109,189

(27,285)
10,002
(62,502)
115
(79,670)
46,859
20,981
67,840

11,447
0

5,509
8,732
1,583
36,048

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2013, 2012 and 2011

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 two wholly owned subsidiaries,
Osterud Insurance Agency, Inc. (OIA), which offers
financial planning products and services and HFSB
Property Holdings, LLC (HPH), which acts as an
intermediary for the Bank in holding and operating certain
foreclosed properties.

The consolidated financial statements included herein are
for HMN, the Bank, OIA, and HPH. All significant
intercompany accounts and
transactions have been
eliminated in consolidation.

The Company evaluated subsequent events through the
filing date of our annual 10-K with the Securities and
Exchange Commission on March 11, 2014.

the consolidated
is

Use of Estimates
financial statements,
In preparing
management
to make estimates and
assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet and revenues
and expenses for the period. Actual results could differ
from those estimates.

required

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
require changes to the allowance based on their judgment
about information available to them at the time of their
examination.

Cash and Cash Equivalents
The Company considers highly liquid investments with
original maturities of three months or less to be cash
equivalents.

Securities
Securities are accounted for according to their purpose
and holding period. The Company classifies its debt and
equity securities in one of three categories:

Trading Securities
Securities held principally for resale in the near term are
classified as trading securities and are recorded at their
fair values. Unrealized gains and losses on trading
securities are included in other income.

Securities Held to Maturity
Securities that the Company has the positive intent and
ability to hold to maturity are reported at cost and adjusted
for premiums and discounts that are recognized in interest
income using the interest method over the period to
maturity. Unrealized losses on securities held to maturity
reflecting a decline in value judged to be other than
temporary are charged to income and a new cost basis is
established.

Securities Available for Sale
Securities available for sale consist of securities not
classified as trading securities or as securities held to
maturity. They include securities that management intends
to use as part of its asset/liability strategy or that may be
sold in response to changes in interest rates, changes in
prepayment risk, or similar factors. Unrealized gains and
losses, net of income taxes, are reported as a separate
component of stockholders’ equity until realized. Gains
and losses on the sale of securities available for sale are
determined using the specific identification method and
recognized on the trade date. Premiums and discounts are
recognized in interest income using the interest method
over
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.

to maturity. Unrealized

the period

in place

identify securities

Management monitors the investment security portfolio
for impairment on an individual security basis and has a
that could
process
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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

deemed
impairment loss is recognized.

to be other-than-temporarily

impaired, an

Loans Held for Sale
loans originated or purchased which are
Mortgage
intended for sale in the secondary market are carried at the
lower of cost or estimated market value in the aggregate.
Net fees and costs associated with acquiring or originating
loans held for sale are deferred and included in the basis
of the loan in determining the gain or loss on the sale of
the loans. Gains on the sale of loans are recognized on the
settlement date. Net unrealized losses are recognized
through a valuation allowance by charges to income.

Loans Receivable, net
Loans receivable, net, are carried at amortized cost. Loan
origination fees received, net of certain loan origination
costs, are deferred as an adjustment to the carrying value
of the related loans, and are amortized into income using
the interest method over the estimated life of the loans.

Premiums and discounts on purchased loans are amortized
into interest income using the interest method over the
period to contractual maturity, adjusted for estimated
prepayments.

The allowance for 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 and building lots, loan
portfolio composition and historical loss experience. In
connection with the determination of the allowance for
loan losses, management obtains independent appraisals
for significant properties or other collateral securing
delinquent loans. The allowance for loan losses is
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
impaired loans. Such estimates, appraisals, evaluations
and cash flows may be subject to frequent adjustments
due to changing economic prospects of borrowers or
properties. The estimates are reviewed periodically and
adjustments, if any, are recorded in the provision for loan
losses in the periods in which the adjustments become
known.

Interest income is recognized on an accrual basis except
when collectability is in doubt. When loans are placed on
a non-accrual basis, generally when the loan is 90 days
past due, previously accrued but unpaid interest is
reversed from income. If the ultimate collectability of a
loan is in doubt and the loan is placed in nonaccrual
status, the cost recovery method is used and cash collected
is applied to first reduce the principal outstanding.
Generally, the Company returns a loan to accrual status
when all delinquent interest and principal becomes current
under the terms of the loan agreement and collectability of
remaining principal and interest is no longer doubtful.

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
impaired loan. If the TDR loan was performing (accruing)
prior to the modification, it 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 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.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 or deed in
lieu of foreclosure, is initially recorded at 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.

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.

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.

from collateral and allocated

Employee Stock Ownership Plan (ESOP)
The Company has an ESOP that borrowed funds from the
Company and purchased shares of HMN common stock.
The Company makes quarterly principal and interest
payments on the ESOP loan. As the debt is repaid, ESOP
shares that were pledged as collateral for the debt are
released
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.

tax consequences attributable

Income Taxes
Deferred tax assets and liabilities are recognized for the
future
temporary
differences between the financial statement carrying
amounts of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary
differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that
includes the enactment date. A valuation allowance is
required to be recognized if it is “more likely than not”
that the deferred tax asset will not be realized. The
determination of the realizability of the deferred tax asset
is subjective and dependent upon judgment concerning
management’s evaluation of both positive and negative
evidence regarding the ultimate realizability of deferred
tax assets.

Preferred Stock Dividends and Discount
The proceeds received from the preferred stock and
warrant issued to the U.S. Treasury were allocated
between the preferred stock and the warrant based on their
relative fair values at the time of issuance in accordance
with the requirements of ASC 470, Accounting for
Convertible Debt Issued with Stock Purchase Warrants.
Because of the increasing rate dividend feature of the
preferred shares,
the warrant was
the discount on
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.

Earnings (loss) per Common Share
Basic earnings (loss) per common share excludes dilution
and is computed by dividing the income available to
common stockholders by the weighted-average number of
common shares outstanding for the period. Diluted
earnings (loss) per common share reflects the potential
dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into
common stock or resulted in the issuance of common
stock that shared in the earnings of the entity. Options and
restricted stock awards are excluded from the earnings 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 income (loss) and other comprehensive
income (loss), which for the Company is comprised of
unrealized gains and losses on securities available for sale.

mortgage loan. Under the amendment, physical possession
occurs, upon either (1) the creditor obtaining legal title to
the residential real estate property upon completion of a
foreclosure or (2) the borrower conveying all interest in
the residential real estate property to the creditor to satisfy
that loan through completion of a deed in lieu of
foreclosure or through a similar legal agreement. The
ASU is intended to reduce diversity in practice and is
effective for public business entities for annual periods,
those annual periods,
and
beginning after December 15, 2014. The adoption of this
ASU in the first quarter of 2015 is not anticipated to have
a material
the Company’s consolidated
financial statements.

interim periods within

impact on

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
sales
extend credit and
commitments.

forward mortgage

loan

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

the

segment and assessing

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
its performance.
to
Adjustments and eliminations made in preparing an
enterprise’s general-purpose financial statements and
allocations of revenues, expenses and gains or losses are
included in determining reported segment profit or loss if
they are included in the measure of the segment’s profit or
loss that is used by the chief operating decision maker.
Similarly, only those assets that are included in the
measure of the segment’s assets that are used by the chief
operating decision maker are reported for that segment.

to derivatives

New Accounting Pronouncements
In January 2013, the FASB issued ASU 2013-01, Balance
Sheet (Topic 210). The objective of this ASU is to clarify
that the scope of ASU 2011-11, Balance Sheet (Topic
210), applies
including bifurcated
embedded derivatives, repurchase agreements and reverse
repurchase agreements, and securities borrowing and
securities lending transactions that are either offset in
accordance with Section 210-20-45 or Section 815-10-45
or are subject to a master netting arrangement or similar
agreement. This ASU is the final version of proposed
ASU 2011-11, Balance Sheet (Topic 210) which has been
deleted. An entity is required to apply the amendments for
fiscal years beginning on or after January 1, 2013, and
interim periods within those annual periods. The adoption
of this ASU in the first quarter of 2013 did not have any
financial
impact on
statements as it has no outstanding rights of setoff.

the Company’s consolidated

replace

In February 2013, the FASB issued ASU 2013-02, Other
Comprehensive Income (Topic 220). The amendments in
this ASU supersede and
the presentation
requirements of reclassifications out of accumulated other
comprehensive income in ASU’s 2011-05 (issued in June
2011) and 2011-12 (issued in December 2011) for all
public and private organizations. The amendments require
an entity
information about
reclassifications out of accumulated other comprehensive
income. For public entities, the amendments are effective
prospectively for reporting periods beginning after
December 15, 2012. The adoption of this ASU in the first
quarter of 2013 did not have a material impact on the
Company’s consolidated financial statements.

to provide additional

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 Other Comprehensive Loss
The components of other comprehensive loss and the related tax effects were as follows:

(Dollars in thousands)
Securities available for sale:
Gross unrealized losses arising during

Before
Tax

2013
Tax
Effect

For the years ended December 31,
2012
Tax
Effect

Before
Tax

of Tax

Net

Net
of Tax

Before
Tax

2011
Tax
Effect

Net
of Tax

the period ........................................... $ (1,272)

(647)

(625)

(520)

Less reclassification of net gains

included in net income .....................

Net unrealized losses arising during

the period ........................................... (1,272)
Other comprehensive loss ................... $ (1,272)

(647)
(647)

(625)
(625)

(520)
(520)

0
0

(520)

(70)

(520)
(520)

(70)
(70)

0
0

(70)

(70)
(70)

NOTE 3 Securities Available for Sale
A summary of securities available for sale at December 31, 2013 and 2012 is as follows:

Amortized
cost

Gross
unrealized
gains

Gross
unrealized
losses

Fair value

2,749
2,150
4,899

103,030
700
58
103,788
108,687

5,669
4,076

80
9,825

75,059
700
75,759
85,584

183
131
314

1
0
11
12
326

294
301

1
596

170
0
170
766

0
0
0

(637)
(420)
0
(1,057)
(1,057)

0
0

(4)
(455)
(459)
(459)

2,932
2,281
5,213

102,394
280
69
102,743
107,956

5,963
4,377

81
10,421

75,225
245
75,470
85,891

(Dollars in thousands)
December 31, 2013
Mortgage-backed securities:

FHLMC .............................................................................................. $
FNMA .................................................................................................

Other marketable securities:

U.S. Government agency obligations ................................................
Corporate preferred stock .................................................................
Corporate equity ................................................................................

December 31, 2012
Mortgage-backed securities:

FHLMC ................................................................................................ $
FNMA .................................................................................................

Collateralized mortgage obligations:

FNMA ..................................................................................................

Other marketable securities:

U.S. Government agency obligations ...................................................
Corporate preferred stock .....................................................................

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company did not sell any available for sale securities
and did not recognize any gains or losses on investments
in 2013, 2012, or 2011.

The following table presents amortized cost and estimated
fair value of securities available for sale at December 31,
2013 based upon contractual maturity adjusted for
scheduled
repayments of principal and projected
prepayments of principal based upon current economic
conditions and interest rates. Actual maturities may differ
from the maturities in the following table because obligors
may have the right to call or prepay obligations with or
without call or prepayment penalties:

(Dollars in thousands)
Due one year or less ................................................. $
Due after one year through five years .......................
Due after five years through ten years ......................
Due after ten years .....................................................

Amortized
Cost
77,995 77,645
29,903 29,929
33
349
Total .................................................................. $ 108,687 107,956

Fair
Value

31
758

The allocation of mortgage-backed securities in the table
above is based upon the anticipated future cash flow of the
securities using estimated mortgage prepayment speeds.

The following table shows the gross unrealized losses and fair values for the securities available for sale portfolio
aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss
position at December 31, 2013 and 2012:

(Dollars in thousands)

December 31, 2013
Other marketable

securities:
U.S. Government

Less Than Twelve Months
Fair
# of
Value
Investments

Unrealized
Losses

Twelve Months or More
Fair
Value

# of
Investments

Unrealized
Losses

Total

Fair Value

Unrealized
Losses

agency obligations.....

Corporate preferred

stock ...........................

Total temporarily

20 $ 93,390

(637)

0 $

93,390

280

(420)

280

(637)

(420)

impaired securities .......

20 $ 93,390

(637)

1 $

280

(420) $

93,670

(1,057)

December 31, 2012
Other marketable

securities:
U.S. Government

agency obligations ......

1 $ 4,996

Corporate preferred

stock ...........................

Total temporarily

impaired securities ..........

1 $ 4,996

(4)

0 $

4,996

(4)

245

(455)

245

(455)

1 $

245

(455) $

5,241

(459)

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 on U. S. Government agency
obligations are the result of changes in interest rates. The
unrealized losses reported for corporate preferred stock at
December 31, 2013 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 loan losses but still
met the regulatory requirements to be considered “well
capitalized” based on its most recent regulatory filing in
2013. Based on a review of the issuer, it was determined
that the trust preferred security was not other-than-
temporarily
impaired at December 31, 2013. The
Company does not intend to sell the preferred stock and
has the intent and ability to hold it for a period of time
sufficient to recover the temporary loss. Management
believes that the Company will receive all principal and
interest payments contractually due on the security and

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

Included in total commitments to originate or purchase
loans are fixed rate loans aggregating $26.3 million and
$5.4 million as of December 31, 2013 and 2012,
respectively. The interest rates on these loan commitments
ranged from 3.38% to 5.79% at December 31, 2013 and
from 2.50% to 5.50% at December 31, 2012.

The aggregate amounts of loans to executive officers and
directors of the Company was $3.1 million, $3.1 million
and $4.0 million at December 31, 2013, 2012 and 2011.
During 2013, repayments on loans to executive officers
and directors were $106,000, new loans to executive
officers and directors totaled $281,000, there were no
sales of executive officer and director loans and loans
closed or paid off were $146,000. During 2012,
repayments on loans to executive officers and directors
were $54,000, new loans to executive officers and
directors totaled $198,000, sales of executive officer and
director loans were $198,000, and net loans removed from
the executive officer listing due to change in status of the
officer or loan were $943,000. All loans were made in the
ordinary course of business on normal credit terms,
including interest rates and collateral, as those prevailing
at the time for comparable transactions with unrelated
parties and did not involve more than the normal risk of
collectability or present other unfavorable features.

At December 31, 2013, 2012, and 2011, the Company was
servicing loans for others with aggregate unpaid principal
balances of approximately $411.8 million, $428.2 million,
and $417.4 million, respectively.

The Company originates residential, commercial real
estate and other loans primarily in Minnesota and Iowa.
At December 31, 2013 and 2012, the Company had in its
portfolio single-family and multi-family residential loans
located in the following states:

2013

2012

(Dollars in thousands) Amount

Percent
of
Total

Amount

Iowa .............................. $ 3,793
Minnesota ..................... 69,219
Wisconsin .....................
1,770
Other states ...................
1,685

4.6%
91.1
2.4
1.9
Total ..................... $ 76,467 100.0% $ 97,037 100.0%

5.0% $ 4,503
88,364
90.5
2,319
2.3
1,851
2.2

Amounts under one million dollars in both years are included

in “Other states”.

NOTE 4 Loans Receivable, Net
A summary of loans receivable at December 31 is as
follows:

(Dollars in thousands)
Residential real estate loans:

2013

2012

1-4 family conventional ........................ $ 75,958
1-4 family FHA .....................................
464
1-4 family VA .......................................
45
76,467

96,512
479
46
97,037

Commercial real estate:

Lodging ................................................. 33,603
Retail/office .......................................... 42,490
Nursing home/health care .....................
6,558
Land developments ............................... 28,643
Golf courses ..........................................
6,574
Restaurant/bar/café ...............................
3,609
Alternative fuel plants ...........................
9,783
Warehouse ............................................
9,180
Construction:

1-4 family builder .............................
Multi-family ......................................
Commercial real estate ......................

7,299
0
552
Manufacturing ....................................... 11,344
Churches/community service ................
7,199
Multi-family ..........................................
8,113
Other ..................................................... 19,503
194,450

Consumer:

Autos .....................................................
971
Home equity line ................................... 36,178
Home equity .......................................... 11,629
Consumer – secured ..............................
1,070
Land/lot loans .......................................
1,827
Savings ..................................................
177
Mobile home .........................................
360
Consumer – unsecured ..........................
1,211
53,423

31,020
66,159
22,205
36,691
7,193
3,057
13,911
7,570

6,659
3,811
1,960
11,196
3,731
11,756
17,988
244,907

623
36,521
11,390
1,184
2,246
220
449
1,342
53,975

Commercial business ................................ 71,709
Total loans ......................................... 396,049

79,854
475,773

Less:

Unamortized discounts ..........................
33
Net deferred loan fees ...........................
0
Allowance for loan losses ..................... 11,401
Total loans receivable, net ................. $384,615

33
87
21,608
454,045

Commitments to originate or purchase

loans ....................................................... $ 39,507

5,392

Commitments to deliver loans to

secondary market .................................... $

2,025

7,046

Weighted average contractual rate of

loans in portfolio ....................................

4.71%

5.01%

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

At December 31, 2013 and 2012, the Company had in its
portfolio commercial real estate loans located in the
following states:

2013

2012

Percent
of
Total

(Dollars in thousands) Amount
Florida ......................... $
2,312
Idaho ...........................
3,936
Indiana ........................
5,023
Iowa ............................
1,267
Kansas .........................
0
Minnesota ................... 163,040
North Carolina ............
5,576
North Dakota...............
1,282
Wisconsin ................... 10,589
Other states .................
1,425

1.8%
1.8
2.7
1.1
0.4
85.7
2.9
0.0
3.3
0.3
Total .................... $194,450 100.0% $244,907 100.0%

Amount
4,458
4,348
6,461
2,732
1,014
209,935
7,161
0
8,091
707

1.2% $
2.0
2.6
0.6
0.0
83.9
2.9
0.7
5.4
0.7

Amounts under one million dollars in both years are included
in “Other states”.

NOTE 5 Allowance for Loan Losses and Credit Quality Information
The allowance for loan losses is summarized as follows:

(Dollars in thousands)
Balance, December 31, 2010 ............................................................ $

Provision for losses ......................................................................
Charge-offs ..................................................................................
Recoveries ....................................................................................
Balance, December 31, 2011 ............................................................

Provision for losses ......................................................................
Charge-offs ..................................................................................
Recoveries ....................................................................................
Balance, December 31, 2012 ............................................................

Provision for losses ....................................................................
Charge-offs .................................................................................
Recoveries ...................................................................................
Balance, December 31, 2013 .......................................................... $

Allocated to:

Specific reserves .......................................................................... $
General reserves ...........................................................................
Balance, December 31, 2012 ............................................................ $

Allocated to:

Specific reserves ......................................................................... $
General reserves .........................................................................
Balance, December 31, 2013 .......................................................... $

Loans receivable at December 31, 2012:

Individually reviewed for impairment ......................................... $
Collectively reviewed for impairment .........................................
Ending balance ............................................................................. $

Loans receivable at December 31, 2013:

Individually reviewed for impairment .................................... $
Collectively reviewed for impairment .....................................
Ending balance ........................................................................... $

1-4 Family

Commercial
Real Estate

Consumer

Commercial
Business

Total

24,590

11,785
(23,012)
259
13,622

3,864
(5,719)
1,821
13,588

(5,190)
(3,711)
1,771
6,458

2,591
10,997
13,588

2,403
4,055
6,458

28,195
216,712
244,907

17,190
177,260
194,450

924

15,169

482
(270)
23
1,159

686
(1,071)
372
1,146

347
(484)
97
1,106

537
609
1,146

382
724
1,106

1,823
52,152
53,975

917
52,506
53,423

2,930
(15,512)
2,802
5,389

(1,172)
(2,464)
2,300
4,053

(1,832)
(651)
639
2,209

1,114
2,939
4,053

589
1,620
2,209

2,395
77,459
79,854

1,281
70,428
71,709

42,828

17,278
(39,302)
3,084
23,888

2,544
(9,317)
4,493
21,608

(7,881)
(5,046)
2,720
11,401

4,813
16,795
21,608

3,778
7,623
11,401

37,100
438,673
475,773

21,276
374,773
396,049

2,145

2,081
(508)
0
3,718

(834)
(63)
0
2,821

(1,206)
(200)
213
1,628

571
2,250
2,821

404
1,224
1,628

4,687
92,350
97,037

1,888
74,579
76,467

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes the amount of classified and unclassified loans at December 31:

December 31, 2013

Classified

Unclassified

(Dollars in thousands)

1-4 family ............................................ $
Commercial real estate:

Special
Mention Substandard Doubtful Loss
6,987

322

738

Total

Total
Loans

8,047

68,420

76,467

Residential developments ..............
Other ...............................................

0
5,337

19,229
13,092

0
0

19,229
18,429

13,755
32,984
143,037 161,466

Consumer ............................................
Commercial business:

524

152

240

916

52,507

53,423

Construction industry ....................
Other ...............................................
$

0
1,419
7,494

401
6,433
46,666

0
0
474

0
0
240

401
7,852
54,874

5,933
57,523

6,334
65,375
341,175 396,049

December 31, 2012

Classified

Unclassified

(Dollars in thousands)

1-4 family ............................................. $
Commercial real estate:

Special
Mention Substandard Doubtful
33

13,915

1,004

Loss

Total

Total
Loans

14,952

82,085

97,037

Residential developments .................
Other ................................................

744
17,170

36,210
30,365

0
0

36,954
47,535

9,389
151,029

46,343
198,564

Consumer .............................................
Commercial business:

1,543

123

157

1,823

52,152

53,975

Construction industry .......................
Other ................................................

0
1,224
$ 20,142

320
12,628
94,981

0
134
290

0
0

320
13,986
157 115,570

2,346
63,202
360,203

2,666
77,188
475,773

Classified loans represent special mention, performing
substandard, and non-performing loans categorized as
substandard, doubtful and loss. Loans classified as special
mention are loans that have potential weaknesses that, if
left uncorrected, may result in deterioration of the
repayment prospects for the asset or in the Bank’s credit
position at some future date. Loans classified as
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. Loans
classified as substandard have a well-defined weakness or
weaknesses that jeopardize the liquidation of the debt.
Substandard loans are characterized by the distinct

possibility that the Bank will sustain some loss if the
deficiencies are not corrected. Loans classified as doubtful
have the weaknesses of those classified as substandard,
with additional characteristics that make collection in full
on the basis of currently existing facts, conditions and
values questionable, and there is a high possibility of loss.
A loan classified as loss is considered uncollectible and of
such little value that continuance as an asset on the
balance sheet is not warranted. Loans classified as
substandard or doubtful require the Bank to perform an
analysis of the individual loan and charge off any loans, or
portion thereof, that are deemed uncollectible.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The aging of past due loans at December 31 are summarized as follows:

(Dollars in thousands)
2013

30-59
Days Past
Due

60-89
Days Past
Due

90 Days
or More
Past Due

Total Past
Due

Current
Loans

Total
Loans

1,542

128

322

1,992

74,475

76,467

1-4 family ............................................ $
Commercial real estate:

Residential developments ..............
Other ...............................................

Consumer ............................................
Commercial business:

0
0

1,426
0

418

256

Construction industry ....................
Other ...............................................
$

0
800
2,760

1,934
104
3,848

0
0

0
0
379

1,426
0

31,558

32,984
161,466 161,466

731

52,692

53,423

1,934
904
6,987

4,400
64,471

6,334
65,375
389,062 396,049

1,172

240

1,412

95,625

97,037

2012

1-4 family ............................................. $
Commercial real estate:

Residential developments .................
Other ................................................

0
49

Consumer ...............................................

591

Commercial business:

Construction industry .......................
Other ................................................
$

45
1,441
3,298

0
0

0
106
426

0
289

79
7,467
7,835

0
338

46,343

46,343
198,226 198,564

671

53,304

53,975

124
9,014
11,559

2,542
68,174

2,666
77,188
464,214 475,773

0
7,423
7,423

Loans 90
Days or
More Past
Due
and Still
Accruing

0
0

0
0
0

0
0

At December 31, 2012, there was one commercial
business line of credit loan with an outstanding balance of
$7.4 million that was past due more than 90 days and still
accruing interest. This loan was considered to be in the

process of collection as funds to fully pay off the loan
were held in escrow at December 31, 2012 and were
received by the Company in January 2013.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Impaired loans include loans that are non-performing
(non-accruing) and loans that have been modified in a
table
restructuring. The
troubled debt

following

summarizes impaired loans and related allowances for the
years ended December 31, 2013 and 2012:

(Dollars in thousands)
Loans with no related allowance recorded:

December 31, 2013

Recorded
Investment

Unpaid
Principal
Balance

Allowance

Average
Recorded
Investment

Interest
Income
Recognized

1-4 family .................................................................. $
Commercial real estate:

Residential developments ....................................
Other .....................................................................
Consumer ..................................................................
Commercial business:

Construction industry ..........................................
Other .....................................................................

Loans with an allowance recorded:

1-4 family ..................................................................
Commercial real estate:

Construction industry ..........................................
Other .....................................................................

Total:
1-4 family ..................................................................
Commercial real estate:

Construction industry ..........................................
Other .....................................................................
$

8,257
52
487

93
0

1,800

7,994
888
429

0
1,188

13,636
52
491

296
0

1,844

12,725
888
429

0
1,984

0
0
0

0
0

1,304

9,122
350
350

91
7

404

2,417

2,260
143
382

0
589

12,414
1,977
1,057

29
1,647

1,888

1,932

404

3,721

16,251
940
916

93
1,188
21,276

26,361
940
920

296
1,984
32,433

2,260
143
382

0
589
3,778

21,536
2,327
1,407

120
1,654
30,765

81
55
12

2
0

54
202
14

0
36

135
257
26

2
36
494

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands)
Loans with no related allowance

recorded:
1-4 family ....................................... $
Commercial real estate:

Residential developments ...........
Other ..........................................
Consumer .......................................
Commercial business:

Construction industry .................
Other ..........................................

Loans with an allowance recorded:

1-4 family .......................................
Commercial real estate:

Residential developments ...........
Other ..........................................
Consumer .......................................
Commercial business:

Construction industry .................
Other ..........................................

Total:
1-4 family .......................................
Commercial real estate:

Residential developments ...........
Other ..........................................
Consumer .......................................
Commercial business:

Construction industry .................
Other ..........................................
$

Recorded
Investment

Unpaid
Principal
Balance

Related
Allowance

Average
Recorded
Investment

Interest Income
Recognized

December 31, 2012

1,617

10,714
640
393

102
34

15,530
640
400

1,038
534

3,070

3,114

14,061
2,780
1,430

74
2,185

16,545
3,133
1,430

74
2,936

4,687

4,731

24,775
3,420
1,823

176
2,219
37,100

32,075
3,773
1,830

1,112
3,470
46,991

0
0
0

0
0

571

1,669
921
537

62
1,053

571

1,669
921
537

62
1,053
4,813

2,973

10,744
2,669
390

235
1,252

3,638

14,514
3,973
1,301

146
3,515

6,611

25,258
6,642
1,691

381
4,767
45,350

386
22
26

0
0

242
10
85

0
48

127

628
32
111

0
48
946

At December 31, 2013, 2012 and 2011, non-accruing
loans totaled $17.5 million, $30.0 million and $34.0
million, respectively, for which the related allowance for
loan losses was $3.4 million, $3.9 million and $5.2
million, respectively. Non-accruing loans for which no
specific
because
management determined that the value of the collateral
was sufficient to repay the loan totaled $7.8 million, $10.3
million and $14.8 million, respectively. Had the loans
performed in accordance with their original terms, the
Company would have recorded gross interest income on

allowance

recorded

been

has

the loans of $1.8 million, $2.4 million and $3.2 million in
2013, 2012 and 2011, respectively. For the years ended
December 31, 2013, 2012 and 2011, the Company
recognized interest income on these loans of $0.1 million,
$0.5 million and $0.7 million, respectively. All of the
interest income that was recognized for non-accruing
loans was recognized using the cash basis method of
income recognition. Non-accrual loans also include some
of the loans that have had terms modified in a troubled
debt restructuring.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes non-accrual loans at
December 31:

following

The
restructurings at December 31:

table

summarizes

troubled

debt

(Dollars in thousands)
2013 2012
1-4 family ................................................. $ 1,602 2,492
Commercial real estate:

Residential developments ..................... 14,146 23,652
403 1,891
Other .....................................................
Consumer .................................................
300
737
Commercial business:

Construction industry ...........................
Other .....................................................

93
176
515 1,464
$ 17,496 29,975

(Dollars in thousands)
1-4 family ................................................ $
Commercial real estate:

2013 2012
909 3,600

Residential developments..................... 15,750 22,843
709 3,032
Other ....................................................
Consumer .................................................
713 1,814
Commercial business:

Construction industry ...........................
88
Other .................................................... 1,033 1,678
$ 19,229 33,055

115

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).

At December 31, 2013, 2012 and 2011, there were loans
included in loans receivable, net, with terms that had been
modified in a troubled debt restructuring totaling $19.2
million, $33.1 million and $29.2 million, respectively.
Had these loans been performing in accordance with their
original terms throughout 2013, 2012 and 2011, the
Company would have recorded gross interest income of
$1.8 million, $2.5 million and $2.5 million, respectively.
During 2013, 2012 and 2011, the Company recorded
interest income of $0.5 million, $0.9 million, and $0.6
million on these loans, respectively. For the loans that
were modified in 2013, $0.3 million are classified and
performing, and $0.8 million are non-performing at
December 31, 2013.

There were no material commitments to lend additional
funds to customers whose loans were restructured or
classified as non-accrual at December 31, 2013 or
December 31, 2012.

TDR concessions can include reduction of interest rates,
extension of maturity dates, forgiveness of 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 interest for
comparable risk loans, and the loan is 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 Consolidated
Balance Sheets, 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 periods ending December 31,
2013 and 2012:

(Dollars in thousands)
Troubled debt restructurings:
1-4 family .............................................
Commercial real estate:

Residential developments.................
Other ................................................
Consumer .............................................
Commercial business:

Construction industry .......................
Other ................................................
Total .....................................................

Year ended December 31, 2013
Pre-
modification
Outstanding
Recorded
Investment

Post-
modification
Outstanding
Recorded
Investment

Number of
Contracts

Year ended December 31, 2012
Pre-
modification
Outstanding
Recorded
Investment

Post-
modification
Outstanding
Recorded
Investment

Number of
Contracts

0
3
21

1
5
32

210

0
754
528

41
194
1,727

219

0
329
548

41
218
1,355

33 $

3,991

3,979

11
6
28

2
5
85 $

16,280
2,814
1,715

172
706
25,678

12,585
2,586
1,729

80
706
21,665

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Loans that were restructured within the 12 months preceding December 31, 2013 and 2012 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:

Construction industry .........................................................................
Other ..................................................................................................
Total .......................................................................................................

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.

for

least

six months

Loans that were non-accrual prior to modification remain
non-accrual
following
modification. Non-accrual TDR loans that have 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.

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 to general
reserves as needed. Loans that are not collateral dependent
may have additional reserves established if deemed
necessary. The allocated allowance for TDR’s was $2.9
million, or 25.6%, of the total $11.4 million in allowance
for loan losses at December 31, 2013, and $3.7 million, or
17.2%, of the total $21.6 million in allowance for loan
losses at December 31, 2012.

Year ended
December 31, 2013

Year ended
December 31, 2012

Number of
Contracts

Outstanding
Recorded
Investment

Number of
Contracts

Outstanding
Recorded
Investment

0
0
0

0 $

0
2
0

1
2
5 $

0
159
0

74
227
460

NOTE 7 Mortgage Servicing Rights, Net
A summary of mortgage servicing activity is as follows:

2013 2012

(Dollars in thousands)
Mortgage servicing rights:
Balance, beginning of year .................................... $1,732 1,485
568 979
Originations ...........................................................
Amortization ..........................................................
(592) (732)
Balance, end of year .............................................. 1,708 1,732
Valuation reserve ...................................................
0
Mortgage servicing rights, net ............................... $1,708 1,732
Fair value of mortgage servicing rights ................. $2,801 2,126

All of the single family loans sold where the Company
continues to service the loans are serviced for Federal
the
National Mortgage Association (FNMA) under
individual loan sale program. The following is a summary
of the risk characteristics of the loans being serviced for
FNMA at December 31, 2013:

Loan
Principal
Balance

Weighted
Average
Interest
Rate

Weighted
Average
Remaining
Term
(months)

Number
of
Loans

(Dollars in thousands)
Original term 30

year fixed rate ........ $203,957

4.36%

302 1,746

Original term 15

NOTE 6 Accrued Interest Receivable
Accrued
summarized as follows:

interest

receivable at December 31

year fixed rate ........ 120,461
202

Adjustable rate ..........

3.42
3.86

145 1,347
5
321

(Dollars in thousands)
2013 2012
Securities available for sale .................................... $ 338 332
Loans receivable .................................................... 1,615 1,686
$1,953 2,018

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The gross carrying amount of mortgage servicing rights
and the associated accumulated amortization at December
31, 2013 and 2012 are presented in the following table.
Amortization expense for mortgage servicing rights was
$0.6 million, $0.7 million, and $0.6 million for the years
ended December 31, 2013, 2012 and 2011, respectively.

Unamortized
Mortgage

Gross
Carrying Accumulated Servicing
Amount Amortization Rights

(Dollars in thousands)
December 31, 2013

Mortgage servicing

rights ........................... $ 3,638
Total............................ $ 3,638

(1,930 )
(1,930 )

1,708
1,708

December 31, 2012

Mortgage servicing

rights............................ $ 2,412
Total ............................ $ 2,412

(680 )
(680 )

1,732
1,732

NOTE 8 Real Estate
A summary of real estate at December 31 is as follows:

the estimated future
indicates
The following
amortization expense for amortized mortgage servicing
rights:

table

(Dollars in thousands)
Year ended December 31,
2014 .............................................................................. $
2015 ..............................................................................
2016 ..............................................................................
2017 ..............................................................................
2018 ..............................................................................
Thereafter .....................................................................
$

Mortgage
Servicing
Rights
420
401
354
262
158
113
1,708

Projections of amortization are based on asset balances
and the interest rate environment that existed at December
31, 2013. The Company’s actual experience may be
in
significantly different depending upon changes
mortgage interest rates and other market conditions.

(Dollars in thousands)
Real estate in judgment subject to

Residential

2013
Commercial
& Other

Total

Residential

2012
Commercial
& Other

Total

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 ............................
$

0
0
0
0

7,520

1,759

7,520

1,759

501

1,055

1,421

6,540

5,109

63
9,342
(2,444)
6,898

0
1,969
(374)
1,595

79
12,783
(3,783)
9,000

1,556

7,961

5,156

79
14,752
(4,157)
10,595

NOTE 9 Premises and Equipment
A summary of premises and equipment at December 31 is
as follows:

2013 2012
(Dollars in thousands)
Land ................................................................ $ 1,978 1,978
Office buildings and improvements ................ 8,490 8,725
Furniture and equipment ................................. 11,350 12,722
21,818 23,425
Accumulated depreciation ............................... (15,107) (16,252)
$ 6,711 7,173

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 Deposits
Deposits and their weighted average interest rates at December 31 are summarized as follows:

(Dollars in thousands)
Noninterest checking .............................
NOW accounts ......................................
Savings accounts ...................................
Money market accounts ........................

Certificates:
0-0.99% .................................................
1-1.99% .................................................
2-2.99% .................................................
3-3.99% .................................................
4-4.99% .................................................
Total certificates ....................................
Total deposits ........................................

2013

2012

Weight
Average
Rate

Amount

Percent
of Total

Weight
Average
Rate

Amount

Percent
of Total

0.00% $
0.03
0.07
0.28

0.80
0.26

169,362
70,407
44,823
139,818
424,410

85,705
38,456
4,798
561
0
129,520
553,930

30.6%
12.7
8.1
25.2
76.6

15.5
6.9
0.9
0.1
0.0
23.4
100.0%

0.00% $
0.02
0.12
0.33

1.08
0.48

101,198
71,472
42,691
111,000
326,361

90,103
81,143
15,063
2,263
18
188,590
514,951

19.6%
13.9
8.3
21.6
63.4

17.5
15.8
2.9
0.4
0.0
36.6
100.0%

At December 31, 2013 and 2012, the Company had
$294.3 million and $225.7 million, respectively, of
deposit accounts with balances of $100,000 or more. At

December 31, 2013 and 2012, the Company had $7.6
million and $15.9 million of certificate accounts,
respectively, that had been acquired through a broker.

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 ........................................................................................
$

2013

2012

Weighted
Average
Rate

Amount

Weighted
Average
Rate

Amount

43,618
43,462
35,542
6,898
129,520

0.84% $
0.64
0.86
1.14
0.80

73,451
48,782
60,498
5,859
188,590

1.10%
0.88
1.16
1.55
1.08

At December 31, 2013, mortgage loans and mortgage-
backed and related securities with an amortized cost of
approximately $18.9 million were pledged as collateral for
certain deposits. An additional $1.0 million of letters of
credit from the FHLB were pledged as collateral on Bank
deposits.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Interest expense on deposits is summarized as follows for the years ended December 31:

(Dollars in thousands)
NOW accounts ............................................................................................... $
Savings accounts ............................................................................................
Money market accounts .................................................................................
Certificates .....................................................................................................
$

2013

2012

2011

15
34
372
1,383
1,804

35
67
447
3,192
3,741

57
57
746
5,987
6,847

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
2013 ......................................................................................................... $
Lines of Credit – Federal Reserve/Federal Home Loan Bank ..................
$

Amount

2013

0
0
0

2012

Rate

Amount

Rate

0.00% $
0.00
0.00

70,000
0
70,000

4.77%
0.00
4.77

The reasons for the difference between expected income
tax (benefit) expense utilizing the federal corporate tax
rate of 34% and the actual income tax (benefit) expense
are as follows:

(Dollars in thousands)
Expected federal income tax

2013

2012 2011

(benefit) expense ........................... $ 4,170 1,854 (3,929)

Items affecting federal income tax:
State income taxes, net of federal

income tax expense (benefit) ....
Tax exempt interest .....................
(Decrease) increase in valuation

706
(69)

327
(86)

(645)
(123)

allowance .................................. (19,602) (1,878) 4,883
(186)
0

389
Income tax (benefit) expense ........... $(14,406)

Other, net .....................................

(85)
132

As of December 31, 2013, the Bank had no outstanding
advances from the FHLB and had collateral pledged to the
FHLB consisting of FHLB stock, mortgage loans, and
investments with unamortized principal balances of
approximately $104.4 million. The Bank has the ability to
draw additional borrowings of $103.5 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 $59.1 million from the Federal Reserve
Bank, based upon the loans that are currently pledged with
them, subject to approval from the Federal Reserve Board.

NOTE 12 Income Taxes
Income
December 31 is as follows:

tax (benefit) expense for

the years ended

(Dollars in thousands)
Current:

2013

2012 2011

Federal ......................................... $
State .............................................
Total current .............................

227
64
291

108
24
132

0
0
0

Deferred:

Federal ......................................... 3,554 1,598 (4,010)
State ............................................. 1,351
(873)
Total deferred ........................... 4,905 1,878 (4,883)
Change in valuation allowance ........ (19,602) (1,878) 4,883
Income tax (benefit) expense ........... $(14,406)
0

280

132

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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:

2013 2012

Allowances for loan and real estate losses .. $ 5,486 10,523
315
Deferred compensation costs ......................
717
Deferred ESOP loan asset ...........................
800
Nonaccruing loan interest ...........................
Federal net operating loss carry forward ..... 3,983 5,113
State net operating loss carry forward ......... 2,802 3,219
Alternative minimum tax credit

233
706
558

carryforward .............................................

700

Capitalized other real estate owned

expenses ................................................... 1,284

194

Net unrealized loss on securities available

for sale ......................................................
Other ...........................................................

0
265
Total gross deferred tax assets ................ 16,383 21,146

291
340

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 ...........................................................

123
312
155
707
247
Total gross deferred tax liabilities ........... 1,272 1,544
Net deferred tax assets ............................ 15,111 19,602
0 (19,602)

Valuation allowance ...................................

0
284
132
677
179

Deferred tax assets, net of valuation

allowance .............................................. $ 15,111

The Company has cumulative federal net operating loss
carryforwards of $16.2 million at December 31, 2013 that
expire beginning in 2029. The Company also has state net
operating loss carryforwards of $31.8 million at December
31, 2013 that expire beginning in 2023.

taxes was made. This amount

included
Retained earnings at December 31, 2013
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.

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
the
cumulative net income generated over the prior three year
period allowance and the probability that taxable income

tax assets. Positive evidence

includes

will be generated in future periods. Negative evidence
includes the general business and economic environment.
Based upon this evaluation, the Company determined that
no valuation allowance was required with respect to the
net deferred tax assets at December 31, 2013.

NOTE 13 Employee Benefits
All eligible full-time employees of the Bank that were
hired prior to 2002 were included in a 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 Financial Institutions (the
Pentegra DB Plan). The Pentegra DB Plan’s Employer
Identification Number is 13-5645888 and the Plan number
is 333. The Pentegra DB Plan operates as 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 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, 2013 because such information
is not accumulated for each participating institution. As of
June 30, 2013, the Pentegra DB Plan valuation report
reflected
to make a
the Bank was obligated
contribution
totaling $257,000 which was expensed
during 2013.

that

Funded status (market value of plan assets divided by
funding target) as of July 1 for the 2013, 2012 and 2011
plan years were 89.51%, 95.77% and 80.39%,
respectively. Market value of plan assets reflects any
contribution received through June 30, 2013.

Total employer contributions made to the Pentegra DB
Plan, as reported on Form 5500, equal $196,473,000,
$299,729,000 and $203,582,000 for the plan years ended
June 30, 2012, 2011 and 2010, 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.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following contributions were paid by the Bank during the fiscal years ending December 31,

(Dollars in thousands)

2013

Date Paid

Amount

10/15/2013 ................ $
12/30/2013 ................

Total ......................... $

Date Paid
1/09/2012
10/12/2012
12/31/2012

42
215

257

2012

Amount

Date Paid

Amount

2011

234**
38
134
406

10/14/2011

$
$

57
57

** - An additional contribution of $234,000 was accrued at December 31, 2011 and paid in the first quarter of 2012.

The Company has a qualified, tax-exempt savings plan
with a deferred feature qualifying under Section 401(k) of
the Internal Revenue Code (the 401(k) Plan). All
employees who have attained 18 years of age are eligible
to participate in the 401(k) Plan. Participants are permitted
to make contributions to the 401(k) Plan equal to the
lesser of 50% of the participant’s annual salary or the
maximum allowed by law, which was $17,500 for 2013,
$17,000 for 2012 and $16,500 for 2011. The Company
matches 25% of each participant’s contributions up to a
maximum of 8% of the participant’s annual salary.
Participant contributions and earnings are fully and
immediately vested. The Company’s contributions are
vested on a three year cliff basis, are expensed annually,
and were $160,000, $158,000 and $159,000, in 2013,
2012 and 2011, respectively.

The Company has adopted an Employee Stock Ownership
Plan (the ESOP) that meets the requirements of Section
4975(e)(7) of the Internal Revenue Code and Section
407(d)(6) of the Employee Retirement Income Security
Act of 1974, as amended (ERISA) and, as such, the ESOP
is empowered to borrow in order to finance purchases of
the common stock of HMN. The ESOP borrowed $6.1
million from the Company to purchase 912,866 shares of
common stock in the initial public offering of HMN. As a
result of a merger with Marshalltown Financial
Corporation (MFC), the ESOP borrowed $1.5 million to
purchase an additional 76,933 shares of HMN common
stock to account for the additional employees and avoid
dilution of the benefit provided by the ESOP. The ESOP
debt requires quarterly payments of principal plus interest
at 7.52%. The Company has committed to make quarterly
contributions to the ESOP necessary to repay the loans
including interest. The Company contributed $525,000 in
2013, $527,000 in 2012 and $525,000 in 2011.

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
expense was
computations. ESOP
$172,000, $68,000 and $58,000, respectively, for 2013,
2012 and 2011.

compensation

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:

2013

2012

2011

Shares allocated to

participants beginning of the
year ....................................... 350,539 339,991 335,453

Shares allocated to

participants ............................
Shares purchased .....................
Shares distributed to

24,317
9

24,378 24,317
42

2,353

participants ............................

(26,978)

(16,183) (19,821)

Shares allocated to

participants end of year ......... 347,887 350,539 339,991

Unreleased shares beginning

of the year ............................. 377,074 401,452 425,769
Shares released during year .....
(24,378) (24,317)
Unreleased shares end of year . 352,757 377,074 401,452
Total ESOP shares end of year 700,644 727,613 741,443
Fair value of unreleased shares

(24,317)

at December 31 ..................... $3,728,641 1,308,447 778,817

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, 2013, there were 45,540 vested
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 $28.21. As of December

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

31, 2013, all shares of restricted stock granted under the
2001 Plan have vested.

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
interests with those of the Company’s stockholders.
350,000 shares of HMN common stock were initially

available for distribution under the 2009 Plan in either
restricted stock or stock options, subject to adjustment for
future stock splits, stock dividends and similar changes to
the capitalization of the Company. Additionally, shares of
restricted stock that are awarded are counted as 1.2 shares
for purposes of determining the total shares available for
issuance under the 2009 Plan. As of December 31, 2013,
there were 12,000 vested and 3,000 unvested options
under the 2009 Plan that remain unexercised. These
options expire 10 years from the date of grant and have an
average exercise price of $4.77.

A summary of activities under all plans for the past three years is as follows:

Shares
available for
grant

Restricted
shares

Options

outstanding

Unvested options

Award value/
weighted
average
exercise
price

Number

Weighted
average grant
date fair
value

Vesting
Period

2001 Plan
December 31, 2010 ...........
Vested ...........................
December 31, 2011 ...........
Forfeited/expired ...........
Vested ...........................
December 31, 2012 ...........
December 31, 2013 ..........

2009 Plan
December 31, 2010 ...........

Granted January 27,

2011 ............................
Forfeited/expired ...........
Vested ...........................
December 31, 2011 ...........

Granted January 27,

2012 ............................
Forfeited ........................
Forfeited/expired ...........
Vested ...........................
December 31, 2012 ...........

Granted October 4,

2013 ............................
Forfeited .......................
Cancelled......................
Vested ...........................
December 31, 2013 ..........
Total all plans ..................

0
0
0
0
0
0
0

5,441
(5,441)
0
0
0
0
0

139,450
0
139,450
(93,910)

0
45,540
45,540

20.07
0
20.07
16.13
0
28.21
28.21

93,808 $
(21,292)
72,516
0
(72,516)
0
0

163,883

134,043

15,000

4.77

12,000

1.43
1.43
1.43
0
1.43
0
0

4.41

0
0
4.41
4.41

0
0
0
4.41
4.41

3 years

0
0
(3,000)
9,000

0
0
0
(3,000)
6,000

N/A
0
0
4.77

N/A
0
0
0
4.77

N/A

4.77
22.40

(3,000)
3,000
3,000 $

4.41
4.41
4.41

(93,600)
538
0
70,821

(43,236)
470
93,910
0
121,965

(37,531)
5,400
31,219

121,053
121,053

78,000

(448)
(48,825)
162,770

36,030

(392)
0

(50,075)
148,333

31,276
(4,500)

(73,303)
101,806
101,806

0
0
0
15,000

0
0
0
0
15,000

0
0
0
0
15,000
60,540

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Due to the Bank’s participation in the Treasury’s Capital
Purchase Program (CPP) (see discussion elsewhere in this
report), a portion of the vested restricted stock awards
granted to certain executives during the period that
Treasury held the preferred shares remain subject to
transfer restrictions if, and so long as, the Treasury does
not receive repayment of all of the financial assistance
provided under the CPP. In accordance with Treasury
policy, any such shares that would remain nontransferable
indefinitely were to be cancelled. Following the sale by
Treasury of the preferred shares to third party investors,
approximately 82% of the CPP financial assistance to the
Bank had been repaid, meaning that 25% of the shares
subject to these restricted stock awards that had vested in
2011, 2012 and 2013 remained nontransferable and

subject to possible cancellation. Based on an assessment
at the time that these shares were likely to remain
restricted indefinitely, they were cancelled during the first
half of 2013 and returned to the Bank as treasury stock,
and the number of shares cancelled were added back to
the total shares available for future equity awards under
the 2009 Plan. In light of the Company’s stock price
performance since these cancellations occurred, the value
that Treasury may be able to realize from the warrant to
acquire Company common stock it continues to hold as a
result of the CPP may be sufficient to enable all of the
CPP financial assistance to the Bank to be repaid, which
would eliminate ongoing transfer restrictions on the
restricted stock awards that vest in the future and the
obligation to cancel any such vested shares.

The following table summarizes information about stock options outstanding at December 31, 2013:

Weighted

Exercise Price
$

27.66
26.98
30.00
4.77

Weighted
Average
Remaining
Contractual Life
in Years
0.2
0.6
1.4
5.4

Number
Outstanding

15,540
15,000
15,000
15,000
60,540

Number
Exercisable

Number

Unexercisable

Unrecognized
Compensation
Expense

15,540
15,000
15,000
12,000
57,540

0
0
0
3,000
3,000

0
0
0
914
914

Average Years
Over Which
Unrecognized
Compensation
will be
Recognized
N/A
N/A
N/A
0.4

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 2013, 2012 or
2011.

The Company will issue shares from treasury stock 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 ASC 718, which replaced FAS No. 123 and
supersedes APB Opinion No. 25. In accordance with this
standard, the Company recognized compensation expense
in 2013, 2012 and 2011 relating to stock options over the
vesting period. The amount of
the expense was
determined under the fair value method.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 14 Earnings (Loss) per Common Share
The following table reconciles the weighted average shares outstanding and net income (loss) for basic and diluted earnings
(loss) per common share:

(Dollars in thousands, except per share data)
Weighted average number of common shares outstanding used in basic

2013

Year ended December 31,
2012

2011

earnings per common share calculation .......................................................

4,001,288

3,946,314

3,853,491

Net dilutive effect of :

Options .......................................................................................................
Restricted stock awards ..............................................................................

266,391
42,487

0
84,338

0
0

Weighted average number of common shares outstanding adjusted for

effect of dilutive securities ..........................................................................

4,310,166

4,030,652

3,853,491

Net income (loss) available to common shareholders .................................... $
Basic earnings (loss) per common share ........................................................ $
Diluted earnings (loss) per common share ..................................................... $

24,602
6.15
5.71

3,460
0.88
0.86

(13,376)
(3.47)
(3.47)

Options and restricted stock awards are excluded from the
loss per common 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
the 2011 loss per common share calculation.

NOTE 15 Stockholders' Equity
The Company did not repurchase any shares of its
common stock in the open market during 2013, 2012 or
2011. 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
environment.

The Company's certificate of incorporation authorizes the
issuance of up to 500,000 shares of preferred stock, and
on December 23, 2008, the Company completed the sale
of 26,000 shares of cumulative perpetual preferred stock
to the United States Treasury. The preferred stock has a
liquidation value of $1,000 per share and a related warrant
was also issued to purchase 833,333 shares of HMN
common stock at an exercise price of $4.68 per share. The
transaction was part of the United States Treasury’s
capital purchase program under the Emergency Economic
Stabilization Act of 2008. Under the terms of the sale, the
preferred shares were entitled to a quarterly cumulative
compounding dividend at a stated rate of 5% per annum
for each of the first five years of the investment, which
increased to 9% on February 15, 2014, until HMN
redeems the shares. The Company made all required
dividend payments to the Treasury on the outstanding
preferred stock in 2009 and 2010 but has deferred the last
thirteen quarterly dividend payments, beginning with the
February 15, 2011 dividend payment. The deferred
dividend payments have been accrued for payment in the
future and are being reported for the deferral period as a
preferred dividend requirement that is deducted from

income for financial statement purposes to arrive at the net
income (loss) available to common shareholders. Under
the terms of the certificate of designations for the
preferred stock, dividend payments may be deferred, but
the dividend is cumulative and compounds quarterly while
unpaid. In addition, since the Company failed to pay
dividends for six quarters, the Treasury had the right to
appoint two representatives to the Company’s board of
directors. Treasury did not exercise this right.

On February 8, 2013, the Treasury sold the preferred
stock issued by the Company to unaffiliated third party
investors in a private transaction for $18.8 million. The
Company received no proceeds from the sale and it had no
effect on the terms of the outstanding preferred stock,
including the Company’s obligation to satisfy accrued and
unpaid dividends prior to the payment of any dividend or
other distribution to holders of junior stock, including the
Company’s common stock, and an increase in the
dividend rate from 5% to 9%, commencing with the
dividend payment date of February 15, 2014. Further, the
sale of the preferred stock had no effect on the Company’s
capital, financial condition or results of operations.
Because of the sale, the Company generally is no longer
subject
the various executive compensation and
corporate governance requirements to which participants
in Treasury’s Capital Purchase Program were subject
while Treasury held the preferred stock. In addition, the
Company has been advised that the current holders of
substantially all of the preferred stock have entered into
agreements with the FRB pursuant to which they have
each agreed not to take actions, without the consent of the
FRB, which might be construed as exercising or
attempting to exercise a controlling influence over the
management or policies of the Company or the Bank,
including exercise of any right to elect any representatives
to the Company’s board of directors.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

the

terms of

the Company’s Supervisory
Under
Agreement with the FRB as described in Note 16, the
Company may not declare or pay any cash dividends, or
purchase or redeem any capital stock, without prior notice
to, and consent of, the FRB. Subject to the foregoing, 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.

Treasury continues to hold the warrant to purchase
833,333 shares of the Company’s common stock at an
exercise price of $4.68, which Treasury may sell in its
discretion, subject to applicable securities laws and the
Company’s right to repurchase the warrant at fair market
value under the terms of the Company’s agreements with
Treasury. The warrant may be exercised at any time over
its ten-year term and Treasury has agreed not to exercise
any voting rights received by acquiring common stock on
the exercise of the warrant. The discount on the common
stock warrant was amortized over the first five years the
preferred stock was outstanding. Both the preferred
securities and the warrant qualify as Tier 1 capital.

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 and IMCR
On July 21, 2011, the OTS was integrated into the OCC,
which became the Bank’s primary banking regulator, and
the primary banking regulator for the Company became
the FRB.

the

is subject

The Bank
to various regulatory capital
federal banking
requirements administered by
agencies. Failure to meet minimum capital requirements
can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Company's
financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective
action, the Bank must meet specific capital guidelines that
involve quantitative measures of the Bank's assets,
liabilities and certain off-balance sheet items as calculated
under regulatory accounting practices. The Bank's capital
amounts and classification are also subject to qualitative

judgments by the regulators about components, risk
weightings and other factors.

replaced

issues. This agreement

The Bank entered into a written Supervisory Agreement
with the OTS, effective February 22, 2011, that primarily
related to the Bank’s financial performance and credit
quality
the prior
memorandum of understanding that the Bank entered into
with its primary regulator on December 9, 2009. In
accordance with the agreement, the Bank submitted a two
year business plan in May of 2011 that the OCC accepted
with the expectation that the Bank would be in adherence
with the OCC’s Notification of Establishment of Higher
Minimum Capital Ratios, dated August 8, 2011, or IMCR,
which required the Bank to establish and maintain a
minimum core capital ratio of 8.50% by December 31,
2011. The IMCR is discussed more fully below. As
the Bank
the Supervisory Agreement,
required by
submitted updated two year business plans in January of
2012, 2013, and 2014. The Bank was required to operate
within the parameters of the business plan and was
required to monitor and submit periodic reports on its
compliance with the plan. The Bank also submitted
problem asset reduction plans at the same time that the
business plans were submitted. The Bank was required to
operate within the parameters of the problem asset plan
and was 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
the
documentation relating to the allowance for loan and lease
losses as required by the agreement. In addition, prior to
termination of the Bank Supervisory Agreement, as
described below, the Bank could not 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 renew or extend any
existing arrangement related to compensation or benefits
with any directors or officers, make any golden parachute
payments, or enter into any significant contracts with a
third party service provider without the consent of the
OCC. The Bank believes it was in compliance with all
requirements of the Supervisory Agreement at December
31, 2013.

improved

The OCC 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, the
to establish, and subsequently
Bank was required
maintain, core capital at least equal to 8.50% of adjusted
total assets. The Bank’s core capital to adjusted total
assets ratio improved to 12.22% at December 31, 2013.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

the

ratio

capital

and periodic

Effective February 11, 2014 the OCC terminated the
Supervisory Agreement and the IMCR to which the Bank
was a party or was subject. As a result, from February 11,
2014,
reporting
requirements, asset growth restrictions and significant
contract restrictions are no longer applicable to the Bank.
The dividend and compensation restrictions expressly set
forth in the Bank Supervisory Agreement also terminated,
although the Bank remains subject to generally applicable
limitations on dividends and certain compensation
arrangements under federal banking laws and regulations.

The Company also entered into a written Supervisory
Agreement with the OTS effective February 22, 2011.
This agreement replaced the prior memorandum of
understanding that the Company entered into with its
primary regulator on December 9, 2009. As required by
the Supervisory Agreement, the Company submitted
updated two year consolidated capital plans in January of
2012, 2013, and 2014. The Company must operate within
the parameters of the capital plan and is required to
monitor and submit periodic reports on its compliance

with the plan. In addition, without the consent of the FRB,
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 director or officer, or make any golden
parachute payments. The Company believes it was in
compliance with all requirements of its Supervisory
Agreement at December 31, 2013.

Quantitative measures established by regulations to ensure
capital adequacy require the Bank to maintain minimum
amounts and ratios (set forth in the following table) of
Tier I (Core) capital, and Risk-based capital (as defined in
the regulations) to total assets (as defined).

At December 31, 2013 and 2012, 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 action 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, 2013

Tier I or core capital ......... $
Tier I risk-based capital ...
Risk-based capital to risk-

77,848
77,848

12.22% $
19.51

25,478
15,963

4.00% $
4.00

52,370
61,885

8.22% $

15.51

31,847
23,944

5.00%
6.00

weighted assets ...............

82,916

20.78

31,926

8.00

50,990

12.78

39,907

10.00

December 31, 2012

Tier I or core capital ............ $
Tier I risk-based capital ......
Risk-based capital to risk-

63,212
63,212

9.68% $

14.23

26,123
17,770

4.00% $
4.00

37,089
45,442

5.68% $

10.23

32,653
26,655

5.00%
6.00

weighted assets ................

68,963

15.52

35,540

8.00

33,423

7.52

44,425

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.

implementing the changes required by the Dodd-Frank
Wall Street Reform and Consumer Protection Act of
2010. The new capital requirements are effective for the
Company beginning January 1, 2015, and among other
things, apply a strengthened set of capital requirements to
both the Bank and the Company and revise the rules for
calculating risk-weighted assets for purposes of such
requirements. The Company is still evaluating the impact
that these requirements will have on the Company’s and
Bank’s capital positions effective January 1, 2015.

Management believes that, as of December 31, 2013, the
Bank’s capital ratios were in excess of those quantitative
capital ratio standards set forth under
the prompt
corrective action regulations referenced above. 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.

The capital requirements of the Company and the Bank
will be affected by regulatory changes issued in July 2013
by the FRB, the FDIC and the OCC. The changes are to
establish an integrated regulatory capital framework for
implementing
the Basel Committee on Banking
Supervision’s Basel III regulatory capital reforms and

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 17 Financial Instruments with Off-Balance
Sheet Risk
The Company is a party to financial instruments with off-
balance sheet risk in the normal course of business to meet
the financing needs of its customers. These financial
instruments include commitments to extend credit. These
instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amounts recognized
in the balance sheet. The contract amounts of these
instruments reflect the extent of involvement by the
Company.

The Company's exposure to credit loss in the event of
nonperformance by the other party to the financial
instrument
is
represented by the contract amount of these commitments.
The Company uses the same credit policies in making
commitments as it does for on-balance sheet instruments.

to extend credit

for commitments

(Dollars in thousands)
Financial instruments whose contract amount

December 31,
Contract Amount
2013 2012

represents credit risk:
Commitments to originate, fund or purchase loans:
523 4,462
1-4 family mortgages .......................................... $
750
Commercial real estate mortgages ...................... 25,514
180
Non-real estate commercial loans ....................... 13,095
7,586 5,445
Undisbursed balance of loans closed ..................
Unused lines of credit .......................................... 79,136 76,582
1,017 1,910
Letters of credit ...................................................
$126,871 89,329
2,025 7,046
$

Total commitments to extend credit ...................
Forward commitments ........................................

Commitments to extend credit are agreements to lend to a
customer as long as there is no violation of any condition
established in the contract. Commitments generally have
fixed expiration dates or other termination clauses and
may require payment of a fee. Since a portion of the
commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily
represent future cash requirements. The Bank evaluates
each customer's creditworthiness on a case-by-case basis.
The amount of collateral obtained, if deemed necessary by
the Bank upon extension of credit, is based on the loan
type and on management's credit evaluation of the
borrower. Collateral consists primarily of residential and
commercial real estate and personal property.

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 12
months and totaled $1.0 million at December 31, 2013
and $1.9 million at December 31, 2012. 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 single-family residential loans
for sale into the secondary market and enters into
commitments to sell 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.
loans are
The commitments
derivatives that are recorded at fair value. As a result of
marking these derivatives to fair value for the period
ended December 31, 2013, the Company recorded a
decrease in other liabilities of $24,000, a decrease in other
assets of $26,000 and a net loss on the sales of loans of
$2,000.

to originate and sell

As of December 31, 2013, the current commitments to sell
loans held for sale are derivatives that do not qualify for
hedge accounting. 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 other liabilities of $6,000, and a net loss on the
sales of loans of $6,000.

NOTE 19 Fair Value Measurement
ASC 820, Fair Value Measurements, 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.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Level 3 – Valuation is generated from model-based
techniques that use significant assumptions not observable
in the market and are used only to the extent that
observable inputs are not available. These unobservable
assumptions reflect our own estimates of assumptions that
market participants would use in pricing the asset or
liability. Valuation techniques include use of option

pricing models, discounted cash flow models and similar
techniques.

The following
the
Company for which fair values are determined on a
recurring basis as of December 31, 2013 and 2012.

table summarizes

the assets of

(Dollars in thousands)
Securities available for sale ................................................................... $
Mortgage loan commitments .................................................................
Total ........................................................................................................ $

Carrying Value at December 31, 2013

Total

Level 1

Level 2

Level 3

107,956
2
107,958

0
0
0

107,956
2
107,958

(Dollars in thousands)
Securities available for sale ...................................................................... $
Mortgage loan commitments....................................................................
Total ......................................................................................................... $

Carrying Value at December 31, 2012

Total

Level 1

Level 2

Level 3

85,891
27
85,918

81
0
81

85,810
27
85,837

0
0
0

The Company may also be required, from time to time, to
measure certain other financial assets at fair value on a
nonrecurring basis in accordance with generally accepted
accounting principles. These adjustments to fair value
usually result from the application of the lower-of-cost-or-
market accounting or write-downs of individual assets.

For assets measured at fair value on a nonrecurring basis
in 2013 and 2012 that were still held at December 31, the
following
level of valuation
assumptions used to determine each adjustment and the
carrying value of the related individual assets or portfolios
at December 31, 2013 and 2012.

table provides

the

Carrying Value at December 31, 2013

(Dollars in thousands)
Loans held for sale .................................
Mortgage servicing rights ......................
Loans (1) ...................................................
Real estate, net (2) ....................................
Total ........................................................

Total

Level 1

Level 2

Level 3

1,502
1,708
17,498
6,898
27,606

0
0
0
0
0

1,502
1,708
17,498
6,898
27,606

Carrying Value at December 31, 2012

(Dollars in thousands)
Loans held for sale ...................................
Mortgage servicing rights ........................
Loans (1) ...................................................
Real estate, net (2) .....................................
Total .........................................................

Total

Level 1

Level 2

Level 3

2,584
1,732
32,287
10,595
47,198

0
0
0
0
0

2,584
1,732
32,287
10,595
47,198

Year Ended
December 31, 2013
Total gains (losses)

21
0
(1,728)
(429)
(2,136)

Year Ended
December 31, 2012
Total gains (losses)

15
0
(2,307)
(569)
(2,861)

0
0
0
0
0

(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.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 20 Fair Value of Financial Instruments
ASC 825, Disclosures about Fair Values of Financial
Instruments, requires disclosure of estimated fair values of
the Company's financial instruments, including assets,
liabilities and off-balance sheet items for which it is
practicable to estimate fair value. The fair value estimates
are made as of December 31, 2013 and 2012 based upon
relevant market information, if available, and upon the
characteristics of the financial instruments themselves.
Because no market exists for a significant portion of the
Company's financial instruments, fair value estimates are
based upon judgments regarding future expected loss
experience,
risk
characteristics of various financial instruments, and other
factors. The estimates are subjective in nature and involve
uncertainties and matters of significant judgment and
therefore cannot be determined with precision. Changes in
assumptions could significantly affect the estimates.

conditions,

economic

current

Fair value estimates are based only on existing financial
instruments without attempting to estimate the value of
anticipated future business or the value of assets and
liabilities that are not considered financial instruments. In
addition, the tax ramifications related to the realization of
the unrealized gains and losses can have a significant
effect on the fair value estimates and have not been
considered in any of the estimates.

The estimated fair value of the Company's financial
instruments are shown below. Following the table, there is
an explanation of the methods and assumptions used to
the fair value of each class of financial
estimate
instruments.

December 31, 2013

December 31, 2012

(Dollars in thousands)
Financial assets:

Carrying
amount

Estimated
fair value

Fair value hierarchy
Level

Level
3

Level
1

Cash and cash equivalents ................... $ 120,686
Securities available for sale .................
107,956
Loans held for sale ...............................
1,502
Loans receivable, net ...........................
384,615
Federal Home Loan Bank stock ..........
784
Accrued interest receivable ..................
1,953

120,686 120,686
107,956
1,502
388,263
784
1,953

107,956
1,502
388,263
784
1,953

Financial liabilities:

Deposits
Federal Home Loan Bank advances ....
Accrued interest payable ......................

553,930
0
146

Off-balance sheet financial instruments:

Commitments to extend credit .............
Commitments to sell loans...................

2
(22)

Contract
amount

Carrying
amount

Estimated
fair value

Contract
amount

83,660
85,891
2,584
454,045
4,063
2,018

83,660
85,891
2,584
459,177
4,063
2,018

514,951
70,000
247

514,951
71,623
247

126,871
2,025

27
(40)

89,329
7,046

Cash and Cash Equivalents
The carrying amount of cash and cash equivalents
approximates their fair value.

Securities Available for Sale
The fair values of securities were based upon quoted
market prices.

Loans Held for Sale
The fair values of loans held for sale were based upon
quoted market prices for loans with similar interest rates
and terms to maturity.

Loans Receivable
The fair values of loans receivable were estimated for
groups of loans with similar characteristics. The fair value
of the loan portfolio, with the exception of the adjustable
rate portfolio, was calculated by discounting the scheduled
cash
the estimated maturity using
anticipated prepayment speeds and using discount rates
that reflect the credit and interest rate risk inherent in each

through

flows

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.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Deposits
The fair value of demand deposits, savings accounts and
certain money market account deposits is the amount
payable on demand at the reporting date. The fair value of
fixed maturity certificates of deposit is estimated using the
rates currently offered for deposits of similar remaining
maturities. If the fair value of the fixed maturity
certificates of deposit is calculated at less than the
carrying amount, the carrying value of these deposits is
reported as the fair value.

The fair value estimate for deposits does not include the
benefit that results from the low cost funding provided by
the Company's existing deposits and long-term customer
relationships compared to the cost of obtaining different
sources of funding. This benefit is commonly referred to
as the core deposit intangible.

Federal Home Loan Bank Advances
The fair values of advances with fixed maturities are
estimated based on discounted cash flow analysis using as
discount rates the interest rates charged by the FHLB for
borrowings of similar remaining maturities.

Accrued Interest Payable
The carrying amount of accrued
interest payable
approximates its fair value since it is short-term in nature.

Commitments to Extend Credit
The fair values of commitments to extend credit are
estimated using the fees normally charged to enter into
similar agreements, taking into account the remaining
terms of the agreements and the present creditworthiness
of the counter parties.

Commitments to Sell Loans
The fair values of commitments to sell loans are estimated
using the quoted market prices for loans with similar
interest rates and terms to maturity.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 21 HMN Financial, Inc. Financial Information (Parent Company Only)
The following are the condensed financial statements for the parent company only as of December 31, 2013 and 2012 and
for the years ended December 31, 2013, 2012 and 2011.

(Dollars in thousands)
Condensed Balance Sheets
Assets:

Cash and cash equivalents .......................................................................... $
Investment in subsidiaries ..........................................................................
Loans receivable, net ..................................................................................
Prepaid expenses and other assets ..............................................................
Deferred tax asset, net ................................................................................
Total assets ............................................................................................. $

Liabilities and Stockholders' Equity:

Accrued expenses and other liabilities ....................................................... $
Total liabilities .......................................................................................
Serial preferred stock .................................................................................
Common stock ...........................................................................................
Additional paid-in capital ...........................................................................
Retained earnings .......................................................................................
Net unrealized losses on securities available for sale .................................
Unearned employee stock ownership plan shares ......................................
Treasury stock, at cost, 4,704,313 and 4,705,073 shares ............................
Total stockholders' equity ......................................................................
Total liabilities and stockholders' equity ................................................ $

Condensed Statements of Income (Loss)

Interest income ........................................................................................... $
Equity income (losses) of subsidiaries .......................................................
Compensation and benefits ........................................................................
Occupancy .................................................................................................
Data processing ..........................................................................................
Other ..........................................................................................................
Income (loss) before income tax expense (benefit) ...............................
Income tax (benefit) expense ....................................................................
Net income (loss) ................................................................................... $

Condensed Statements of Cash Flows
Cash flows from operating activities:

Net income (loss) ...................................................................................... $
Adjustments to reconcile net income (loss) to cash used by operating

activities:
Equity (income) losses of subsidiaries ...................................................
Deferred income tax benefit ...................................................................
Earned employee stock ownership shares priced below original cost ....
Stock option compensation ....................................................................
Cancellation of restricted stock awards ..................................................
Amortization of restricted stock awards .................................................
Decrease in unearned ESOP shares ........................................................
Increase in accrued expenses and other liabilities ..................................
(Increase) decrease in other assets ..........................................................
Other, net ...............................................................................................
Net cash used by operating activities .................................................

Cash flows from investing activities:

(Increase) decrease in loans receivable, net ...............................................
Net cash (used) provided by investing activities ....................................

Cash flows from financing activities:

Dividends received from Bank ...............................................................
Net cash used by financing activities .....................................................
(Decrease) increase in cash and cash equivalents ..................................
Cash and cash equivalents, beginning of year ................................................
Cash and cash equivalents, end of year .......................................................... $

2013

2012

2011

141
88,332
1,000
79
931
90,483

4,808
4,808
26,000
91
51,175
72,211

(674)
(2,804)
(60,324)
85,675
90,483

1
26,792

(235)
(24)
(6)
(498)

26,030

(640)

26,670

154
63,165
800
14
0
64,133

3,299
3,299
25,336
91
51,795
47,004
(49 )
(2,997 )
(60,346 )
60,834
64,133

3
6,220
(227 )
(24 )
(6 )
(513 )
5,453
132
5,321

4
(10,519)
(263)
(24)
(6)
(747)
(11,555)
0
(11,555)

26,670

5,321

(11,555)

(26,792)
(931)
(21)
4
(119)
202
193
47
(65)
(1)
(813)

(200)
(200)

1,000
1,000

(13)
154
141

(6,220 )
0
(162 )
7
0
233
194
65
22
0
(540 )

600
600

0
0
60
94
154

10,519
0
(81)
29
0
298
193
101
13
(1)
(484)

100
100

0
0
(384)
478
94

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 22 Business Segments
The Bank has been identified as a reportable operating
segment in accordance with the provisions of ASC 280.
HMN, the holding company, did not meet the quantitative
thresholds for a reportable segment and therefore is
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.

The following table sets forth certain information about the reconciliations of reported net income (loss) and assets for each
of the Company’s reportable segments.

(Dollars in thousands)
At or for the year ended December 31, 2013:

Interest income - external customers ................................................ $
Non-interest income - external customers ........................................
Intersegment interest income ............................................................
Intersegment non-interest income ....................................................
Interest expense ..................................................................................
Non-interest expense ..........................................................................
Income tax benefit .............................................................................
Net income ..........................................................................................
Total assets ..........................................................................................

At or for the year ended December 31, 2012:

Interest income - external customers .................................................... $
Non-interest income - external customers ............................................
Intersegment interest income ...............................................................
Intersegment non-interest income ........................................................
Interest expense ....................................................................................
Non-interest expense ............................................................................
Income tax expense .............................................................................
Net income ...........................................................................................
Total assets ...........................................................................................

At or for the year ended December 31, 2011:

Interest income - external customers .................................................... $
Non-interest income - external customers ............................................
Gain on limited partnerships ................................................................
Intersegment interest income ...............................................................
Intersegment non-interest income ........................................................
Interest expense ....................................................................................
Non-interest expense ............................................................................
Net loss ................................................................................................
Total assets ...........................................................................................

Home
Federal
Savings
Bank

22,983
7,312
0
182
3,290
22,039
(13,766)
26,795
647,679

30,816
8,990
0
186
7,143
24,077
0
6,228
653,315

39,541
6,863
6
0
186
11,139
28,689
(10,510)
790,115

Other

Eliminations

Consolidated
Total

0
0
1
26,792
0
766
(640)
26,667
90,483

0
0
4
6,220
0
779
132
5,313
64,135

0
0
0
4
(10,519)
0
1,049
(11,564)
59,005

0
0
(1)
(26,974)
(1)
(182)
0
(26,792)
(89,540)

0
0
(4)
(6,406)
(4)
(186)
0
(6,220)
(64,123)

0
0
0
(4)
10,333
(4)
(186)
10,519
(58,965)

22,983
7,312
0
0
3,289
22,623
(14,406)
26,670
648,622

30,816
8,990
0
0
7,139
24,670
132
5,321
653,327

39,541
6,863
6
0
0
11,135
29,552
(11,555)
790,155

Report of Independent Registered Public Accounting Firm

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,
2013 and 2012, and the related consolidated statements of comprehensive income (loss), stockholders’ equity, and cash
flows for each of the years in the three-year period ended December 31, 2013. 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, 2013 and 2012, and the results of their operations and their cash flows
for each of the years in the three-year period ended December 31, 2013, in conformity with U.S. generally accepted
accounting principles.

Minneapolis, Minnesota
March 11, 2014

OTHER FINANCIAL DATA

The following tables set forth certain information as to the Bank’s Federal Home Loan Bank (FHLB) advances.

(Dollars in thousands)
Maximum Balance:
FHLB advances ................................................................................. $
FHLB short-term advances ...............................................................
Average Balance:
FHLB advances .................................................................................
FHLB short-term advances ...............................................................

Year Ended December 31,
2012

2011

2013

70,000
70,000

30,329
30,329

70,000
70,000

70,000
39,317

122,500
52,500

92,542
22,604

2013

December 31,
2012

2011

(Dollars in thousands)
FHLB short-term advances ........... $
FHLB long-term advances ............
Total .............................................. $

Amount

Weighted
Average
Rate

Amount

0
0
0

0.00% $
0.00
0.00% $

70,000
0
70,000

4.77% $
0.00
4.77% $

0
70,000
70,000

0.00%
4.77
4.77%

Refer to Note 11 of the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances
and FRB borrowings.

December 31,
2013

September 30,
2013

June 30,
2013

5,144
378
4,766
(3,031)
7,797

912
257
289
0
170
1,628

3,492
(223)
795
188
209
1,512
5,973
3,452
(14,644)
18,096
(522)
17,574
4.37
3.93

5,729
404
5,325
(4,330)
9,655

929
267
433
0
194
1,823

3,009
(282)
867
172
313
1,207
5,286
6,192
158
6,034
(523)
5,511
1.38
1.27

5,787
1,115
4,672
(520)
5,192

883
257
702
0
145
1,987

2,980
(306)
826
190
325
1,310
5,325
1,854
55
1,799
(547)
1,252
0.32
0.30

12.23%

4.44%

106.72
10.77
3.37

38.17
10.54
4.10

1.21%

11.78
10.05
3.28

648,622

562,565

560,974

5,213
102,743
1,502
384,615
553,930
0
85,675

5,973
83,714
1,180
393,322
485,921
0
67,376

7,042
83,251
3,212
415,534
491,753
0
61,162

SELECTED QUARTERLY FINANCIAL DATA

(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 after provision for loan losses ..........................................

Noninterest income:

Fees and service charges ..................................................................................
Loan servicing fees ..........................................................................................
Gain on sales of loans ......................................................................................
Gain on sales of branch office ..........................................................................
Other noninterest income .................................................................................
Total noninterest income ..............................................................................

Noninterest expense:

Compensation and benefits ..............................................................................
(Gains) losses on real estate owned ..................................................................
Occupancy .......................................................................................................
Deposit insurance .............................................................................................
Data processing ................................................................................................
Other noninterest expense ................................................................................
Total noninterest expense .............................................................................
Income before income tax (benefit) expense ....................................................
Income tax (benefit) expense ...............................................................................
Net income .......................................................................................................
Preferred stock dividends and discount ............................................................
Net income (loss) available to common stockholders ...................................... $
Basic earnings (loss) per common share .............................................................. $
Diluted earnings (loss) per common share ........................................................... $
Financial Ratios:
Return on average assets(1) ...................................................................................
Return on average common equity(1) ...................................................................
Average equity to average assets .........................................................................
Net interest margin(1)(2).........................................................................................

(Dollars in thousands)
Selected Financial Condition Data:
Total assets ........................................................................................................... $
Securities available for sale:

Mortgage-backed and related securities ...........................................................
Other marketable securities ..............................................................................
Loans held for sale ...............................................................................................
Loans receivable, net ...........................................................................................
Deposits ...............................................................................................................
Federal Home Loan Bank advances .....................................................................
Stockholders’ equity ............................................................................................

(1) Annualized
(2) Net interest income divided by average interest-earning assets.

March 31, 2013

December 31, 2012

September 30, 2012

June 30, 2012

March 31, 2012

6,323
1,392
4,931
0
4,931

789
248
678
0
159
1,874

3,199
(19)
850
318
330
1,361
6,039
766
25
741
(476)
265
0.07
0.06

7,038
1,513
5,525
0
5,525

841
251
1,105
0
177
2,374

2,865
256
832
327
326
1,676
6,282
1,617
132
1,485
(469)
1,016
0.26
0.25

7,551
1,659
5,892
1,584
4,308

821
245
940
0
110
2,116

2,955
(172)
805
353
333
1,513
5,787
637
0
637
(467)
170
0.04
0.04

7,952
1,905
6,047
1,088
4,959

834
236
620
0
104
1,794

3,219
174
839
305
336
1,485
6,358
395
0
395
(464)
(69)
(0.02)
(0.02)

0.48%
4.90
9.82
3.34

0.93%
9.77
8.81
3.63

0.39%
4.20
8.58
3.82

0.23%
2.66
8.22
3.72

627,086

8,586
82,438
2,210
434,634
487,645
70,000
61,053

653,327

10,421
75,470
2,584
454,045
514,951
70,000
60,834

643,723

12,437
46,406
4,654
474,346
505,541
70,000
59,849

670,314

14,869
61,420
2,601
496,178
534,297
70,000
59,531

8,275
2,062
6,213
(128)
6,341

829
232
909
552
184
2,706

3,413
(77)
882
270
337
1,418
6,243
2,804
0
2,804
(461)
2,343
0.60
0.58

1.57%
19.32
8.14
3.53

706,409

17,597
70,358
3,279
538,069
568,237
70,000
59,465

COMMON STOCK INFORMATION

The common stock of the Company is listed on the Nasdaq Stock Market under the symbol HMNF. As of December 31,
2013, the Company had 9,128,662 shares of common stock issued and 4,704,313 shares in treasury stock. As of December
31, 2013, there were 573 stockholders of record and 1,020 estimated beneficial stockholders. The following table represents
the stock price information for the Company as furnished by Nasdaq for each quarter starting with the quarter ended
December 31, 2013 and regressing back to March 30, 2012. On February 4, 2014, the last reported sale price of shares of
our common stock on the Nasdaq Stock Market was $10.48 per share. The Company has not paid a dividend on its
common stock since 2008. Under the terms of the Supervisory Agreement that the Company entered into with the FRB
effective February 22, 2011, the Company may not declare or pay any cash dividend without prior notice to, and the
consent of, the FRB. Further, while dividends on the Company’s outstanding preferred stock are in arrears ($4.6 million at
February 15, 2014), no dividend may be paid on common stock of the Company. See “Management Discussion and
Analysis –Liquidity and Capital Resources- Dividends” and “Note 15 Stockholders’ Equity” in the Notes to the
Consolidated Financial Statements.

December 31,
2013

September 30,

2013

June 28,
2013

March 28,
2013

December 31,
2012

September 28,

2012

June 29,
2012

March 30,
2012

HIGH ................................. $
LOW ..................................
CLOSE ...............................

10.98
7.57
10.57

9.94
6.39
7.90

7.84
5.84
7.11

6.40
2.99
5.85

3.80
2.65
3.47

3.25
2.60
3.15

3.50
2.38
3.00

2.65
1.61
2.48

The following graph and table compares the total cumulative stockholders’ return on the Company’s common stock to the
NASDAQ U.S. Stock Index (“NASDAQ Composite”), which includes all NASDAQ traded stocks of U.S. companies, and
the SNL Bank NASDAQ Index. The graph and table assume that $100 was invested on December 31, 2008 and that all
dividends were reinvested.

Index
HMN Financial, Inc. ............................
NASDAQ Composite ...........................
SNL Bank NASDAQ Index .................

12/31/08
100.00
100.00
100.00

12/31/09
100.48
145.36
81.12

Period Ending

12/31/10
67.22
171.74
95.71

12/31/11
46.32
170.38
84.92

12/31/12
83.05
200.63
101.22

12/31/13
252.87
281.22
145.48

This page intentionally left blank

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 22, 2014 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
1110 Centre Pointe Curve, Suite 101
MAC N9173-010
Mendota Heights, MN 55120
www.wellsfargo.com/
shareownerservices
(800) 468-9716

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

Spring Valley
715 North Broadway
Spring Valley, MN 55975
(507) 346-9709

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) 226-080

DIRECTORS
DR. 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

ALLEN J. BERNING
Independent Consultant

MICHAEL J. FOGARTY
Vice President
C.O. Brown Agency, Inc.

KAREN L. HIMLE
Executive Vice President
DHR International

BRADLEY C. KREHBIEL
President and Chief Executive Officer
HMN and Home Federal Savings Bank

MALCOLM W. MCDONALD
Retired Senior Vice President
Space Center, Inc.

BERNARD R. NIGON
Retired Audit Partner with
McGladrey LLP

WENDY S. SHANNON
Assistant Professor
Winona State University

MARK E. UTZ
Attorney at law, Wendlund Utz, Ltd.

EXECUTIVE OFFICERS WHO ARE NOT
DIRECTORS

JON J. EBERLE
Senior Vice President,
Chief Financial Officer
and Treasurer of HMN and
Executive Vice President, Chief
Financial Officer and Treasurer of
Home Federal Savings Bank

DWAIN C. JORGENSEN
Senior Vice President
HMN and Home Federal Savings Bank

SUSAN K. KOLLING
Senior Vice President
HMN and Home Federal Savings Bank

LAWRENCE D. MCGRAW
Executive Vice President and
Chief Operating Officer
Home Federal Savings Bank