HMN Financial Inc.
Annual Report 2016

Plain-text annual report

1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 • www.hmnf.com 2016 Annual Report 2016_AnnualReport_full.indd 1 2/15/2017 1:19:39 PM 1 Financial Highlights ............................................................................................................................................................ 2 Letter to Shareholders and Clients ...................................................................................................................................... 4 Board of Directors ............................................................................................................................................................... 5 Five-year Consolidated Financial Highlights ...................................................................................................................... Management Discussion and Analysis ................................................................................................................................ 6 Consolidated Financial Statements ..................................................................................................................................... 27 Notes to Consolidated Financial Statements ....................................................................................................................... 31 Report of Independent Registered Public Accounting Firm ................................................................................................ 64 Other Financial Data ........................................................................................................................................................... 65 Selected Quarterly Financial Data ....................................................................................................................................... 66 Common Stock Information ................................................................................................................................................ 68 Corporate and Shareholder Information ..................................................................................................... Inside Back Cover Directors and Officers ................................................................................................................................ Inside Back Cover HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal Savings Bank operates twelve full service offices in Minnesota located in Albert Lea, Austin, Eagan, Kasson (2), La Crescent, Rochester (4), Spring Valley and Winona; one full service office in Marshalltown, Iowa; and three loan origination offices in Minnesota located in Sartell, Owatonna, and Mankato and one loan origination office in Delafield, Wisconsin. Per Common Share Information: Earnings per common share and common share equivalents Basic ................................................................................................ $ Diluted ............................................................................................. 1.52 1.34 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 ............................................................................. Other non-interest income ....................................................................... Total non-interest income ................................................................ Total non-interest expense ............................................................... Income before income tax expense ......................................................... Income tax expense ................................................................................. Net income ....................................................................................... Preferred stock dividends ................................................................ Net income available to common shareholders ............................... $ Stock price (for the year) High ................................................................................................. $ Low .................................................................................................. Close ................................................................................................ Book value per common share ................................................................ Closing price to book value ..................................................................... Financial Ratios: Return on average assets ......................................................................... Return on average stockholders’ equity .................................................. Net interest margin .................................................................................. Operating expenses to average assets ...................................................... Average stockholders’ equity to average assets ...................................... Stockholders’ equity to total assets at year end ....................................... Non-performing assets to total assets ...................................................... Efficiency ratio ........................................................................................ Balance Sheet Data: (Dollars in thousands) Total assets .............................................................................................. $ Securities available for sale ..................................................................... Loans held for sale .................................................................................. Loans receivable, net ............................................................................... Deposits ................................................................................................... Federal Home Loan Bank advances and other borrowings ..................... Stockholders’ equity ................................................................................ Home Federal Savings Bank regulatory capital ratios: Common equity tier 1 capital .......................................................... Tier 1 leverage ................................................................................. Tier 1 risk-based capital................................................................... Total risk-based capital .................................................................... 1 At or For the Year Ended December 31, Percentage 2016 2015 Change 27,349 1,593 25,756 (645) 26,401 3,427 1,108 2,618 1,048 8,201 24,130 10,472 4,122 6,350 0 6,350 18.55 10.81 17.50 16.91 103.49% 0.96% 8.71 4.11 3.66 11.07 11.13 0.57 71.06 21,453 1,507 19,946 (164) 20,110 3,316 1,046 1,964 1,327 7,653 23,196 4,567 1,611 2,956 (108) 2,848 0.69 0.61 12.92 10.18 11.55 15.54 74.32% 0.50% 4.27 3.56 3.92 11.70 10.83 0.97 84.05 27.5% 5.7 29.1 (293.3) 31.3 3.3 5.9 33.3 (21.0) 7.2 4.0 129.3 155.9 114.8 100.0 123.0 92.0% 104.0 15.4 (6.6) (5.4) 2.8 (41.2) (15.5) December 31, Percentage 2016 2015 Change 682,023 78,477 2,009 551,171 592,811 7,000 75,919 13.42% 11.55 13.42 14.68 643,161 111,974 3,779 463,185 559,387 9,000 69,645 14.08% 11.46 14.08 15.35 6.0% (29.9) (46.8) 19.0 6.0 (22.2) 9.0 (4.7)% 0.8 (4.7) (4.4) LETTER TO SHAREHOLDERS AND CLIENTS I am very proud to present you with our 2016 Annual Report. It reflects the hard work of a very dedicated group of employees and the patronage shown by our many loyal clients. Net income for the year was $6.4 million and the return on average stockholders’ equity was 8.71%. While I am pleased with these bottom line results, I am especially pleased with the significant changes our balance sheet has undergone throughout the year, which I believe has positioned us to become a more profitable bank in the years to come. While our total assets grew $39 million, or 6.1% during the year, our gross loan portfolio grew over $87 million, or 18.5%, during the same period. Most importantly, we grew in all four of the major loan categories – single family residential, commercial real estate, commercial business, and consumer, for the first time in over eight years. This growth was funded in part by a corresponding reduction in our lower-yielding investment portfolio. The asset growth and composition changes resulted in a $5.8 million increase in net interest income from the prior year. Growth in deposits was another bright spot as the overall average deposits grew over $62 million in 2016 with all deposit account types showing growth during the year. Almost $43 million of the average deposit growth was related to the acquisitions we made during the past eighteen months, with the remaining growth related to organic deposit growth at our existing branches. In April of 2016, we acquired certain assets and liabilities of the Albert Lea branch of Deerwood Bank. We were fortunate to find a branch in one of our existing markets that we could purchase without incurring significant increases in our overhead expense. The integration of client portfolios went very smoothly and the transition to servicing these deposits out of our existing branch facility helped make this office one of the largest community banks in that market. 2016 also marked the first full year of operation of the branches we acquired in Kasson, Minnesota in August of the prior year. This purchase has proven to be well timed and a very good fit for our Bank. Our new Kasson employees have done a remarkable job of transitioning their client base to Home Federal. Other divisions of our Bank reported strong operating results as well. Our residential mortgage lending operation generated sales into the secondary market of $89.1 million in 2016 and recognized $2.1 million in gains on the sale of these loans. Our Small Business Administration (SBA) and United States Department of Agriculture (USDA) lenders also sold over $7.5 million in loans during the year recognizing a gain on sale of $0.5 million. Finally, Home Federal Investments Services, our wholly owned Bank subsidiary that offers our clients investment products and advice, reported record revenues and income for the year as well. These results are due in large part to a major staffing upgrade we embarked on over the past three years. Our surveys of businesses and individuals in the markets we serve found that a growing number of prospective clients are disappointed with what they view as a general decline in the experience and authority levels of management at their local bank. For them, access to an experienced local manager, who has been given the authority to make a decision, is an important factor in determining where they choose to bank. We responded by training our local managers to offer all types and categories of Bank products while recruiting and retaining new talent where needed. While this staffing structure might be more expensive than the more common centralized approach, we are confident that it is an important point of differentiation in today’s competitive marketplace. Our focus on credit quality continued during the year. Non-performing assets declined nearly $2.3 million, or 37%, to $3.9 million at year-end. Our past due ratio as of year-end was less than 1%, while our reserve for problem loans was 1.80% of net total loans. Our improved asset quality positioned us to record a credit provision for loan loss during the year of $0.6 million. 2 At HMN, we believe our Company and our employees have a responsibility to give back to the local communities we serve. To that end, our employees collectively donated over 5,000 hours to local community service projects and nonprofits in 2016. Furthermore, Home Federal Savings Bank contributed almost $200,000 to various community projects, non-profits, and charities during the year. I believe that our work in 2016 has positioned HMN to continue to grow and prosper in the coming years. Thank you for your support in making that happen. Best Regards, Brad Krehbiel President/CEO 3 BOARD OF DIRECTORS Dr. Hugh Smith Chairman of the Board Bradley Krehbiel President and CEO Allen Berning Michael Bue Bernard Nigon Dr. Wendy Shannon Dr. Patricia Simmons Mark Utz Hans Zietlow 4 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 after provision for loan losses ........................................................... Fees and service charges ...................................... Loan servicing fees .............................................. Gain on sales of loans .......................................... Other non-interest income .................................... Total non-interest income ............................. Total non-interest expense ............................ Income before income tax expense ...................... Income tax expense (benefit) ............................... Net income .................................................... Preferred stock dividends and discount ......... Net income available to common 2016 27,349 1,593 25,756 (645) 26,401 3,427 1,108 2,618 1,048 8,201 24,130 10,472 4,122 6,350 0 Year Ended December 31, 2014 2013 2015 21,453 1,507 19,946 (164) 20,110 3,316 1,046 1,964 1,327 7,653 23,196 4,567 1,611 2,956 (108) 20,613 1,211 19,402 (6,998) 26,400 3,458 1,058 1,828 940 7,284 21,403 12,281 4,902 7,379 (1,710) 22,983 3,289 19,694 (7,881) 27,575 3,513 1,029 2,102 668 7,312 22,623 12,264 (14,406) (1) 26,670 (2,068) 2012 30,816 7,139 23,677 2,544 21,133 3,325 964 3,574 1,127 8,990 24,670 5,453 132 5,321 (1,861) shareholders ................................................ $ 6,350 2,848 5,669 24,602 3,460 Basic earnings per common share ................. $ Diluted earnings per common share .............. 1.52 1.34 0.69 0.61 1.40 1.23 6.15 5.71 0.88 0.86 (1) Relates to the elimination of the deferred tax asset valuation reserve at December 31, 2013. 2016 Selected Financial Condition Data: (Dollars in thousands, except per share data) Total assets .......................................................... $ 682,023 643,161 577,426 648,622 653,327 85,891 78,477 111,974 137,834 107,956 Securities available for sale .................................. Loans held for sale ............................................... 2,584 1,502 2,009 Loans receivable, net ............................................ 551,171 463,185 365,113 384,615 454,045 Deposits ................................................................ 592,811 559,387 496,750 553,930 514,951 70,000 7,000 FHLB advances and other borrowings ................. 60,834 75,919 Stockholders’ equity ............................................. 8.02 16.91 Book value per common share ............................. 0 85,675 13.49 0 76,013 14.77 9,000 69,645 15.54 December 31, 2014 2,076 3,779 2013 2015 2012 Number of full service offices .............................. Number of loan origination offices(2) ................... 13 3 13 3 11 2 11 1 12 1 Key Ratios: (3) Stockholders’ equity to total assets at year end .... Average stockholders’ equity to average assets ... Return on stockholders’ equity 11.13% 11.07 10.83% 11.70 13.16% 13.25 13.21% 10.77 9.31% 8.81 (ratio of net income to average equity) ......... 8.71 4.27 9.12 42.22 8.94 Return on assets (ratio of net income to average assets) .......... 0.96 0.50 1.21 4.55 0.79 (2) The Company opened a 4th loan origination office in Mankato, Minnesota on January 1, 2017. (3) Average balances were calculated based upon amortized cost without the market value impact of ASC 320. See accompanying notes to consolidated financial statements. 5  MANAGEMENT DISCUSSION AND ANALYSIS the results financial improved 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 safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward- looking terminology as “expect,” “intend,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to growing our core deposit relationships and loan balances, enhancing financial performance and profitability of our core banking operations, improving credit quality, reducing non-performing assets, and generating (including profitability); the adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for maintenance thereof; improvements in loan production; changes in the size of the Bank’s loan portfolio; the amount the the Bank’s non-performing assets and of appropriateness of the allowance therefor; anticipated future levels of the provision for loan losses; future losses on non-performing assets; the amount and composition of interest-earning assets; the amount and composition of interest-bearing liabilities; the availability of alternate funding sources; the payment of dividends by HMN; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; the ability of the Bank to pay dividends to HMN; the ability of HMN to pay the principal and interest payments on its third party note payable; the ability to remain well capitalized; and compliance by the Bank with regulatory standards generally (including the Bank’s status as “well-capitalized”) and 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), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement. from A number of factors could cause actual results to differ materially the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate and other collateral securing loans to borrowers; federal and state regulation and enforcement; possible legislative and regulatory changes, including additional changes to 6 regulatory capital rules; the ability of the Bank to comply with other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard or requirement; adverse economic, business and interest competitive developments such as shrinking 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 (FHLB); technological, computer-related or operational difficulties; results of litigation; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments; the Company’s access to and adverse changes in securities markets; the market for credit related assets; the future operating results, financial condition, cash flow requirements and capital spending priorities of the Company and the Bank; the availability of internal and, as required, external sources of funding; acquisition integration costs; our ability to attract and retain employees; 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 filing 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, 2016. 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 banking and loan production offices in Minnesota, Iowa and Wisconsin. The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and other borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and  MANAGEMENT DISCUSSION AND ANALYSIS composition 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 and real estate owned, fees for servicing loans, commissions on the sale of uninsured investment products, 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 expense on mortgage servicing assets, data processing costs 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 Critical Accounting Estimates Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company’s financial condition and operating results. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company’s financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used. Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio and 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. In this analysis, 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 delinquencies, local economic conditions, demand for single-family homes, demand for commercial real estate and building lots, loan portfolio composition and historical loss experience and observations made by the Company's ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the 7 for consumer the non-homogeneous loan the single-family loss allowance for and its appropriateness of homogeneous loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance on the homogeneous single- family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance for all non-performing loans. The determination of the allowance 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 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 portions thereof, that are deemed uncollectible. loans without to all 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 adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. 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 its allowance for loan losses by charging the provision for loan losses against income and by receiving recoveries of previously charged off loans. The Company decreases its allowance by crediting the provision for loan losses. The current year activity in the allowance resulted in a credit to the loan loss provision. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio 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 those anticipated in determining the allowance for loan losses and adjustments may be required in the future. loss experience. The Company increases  MANAGEMENT DISCUSSION AND ANALYSIS to 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. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities. The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relate to the allowance for loan and real estate losses and state net operating loss carryforwards. For income tax purposes, only net charge-offs are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective judgment and and dependent upon management’s 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 the Company’s cumulative net income in the prior three year period, the ability to implement tax planning strategies to accelerate taxable income recognition, and the probability that taxable income will be generated in future periods. The Company could not currently identify any negative evidence. It is possible that future conditions may differ substantially from those anticipated in determining that no valuation allowance was required on deferred tax assets and adjustments may be required in the future. tax assets. Positive evidence includes 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 those estimated. that are significantly different from 8 Accounting for Loans Acquired in a Business Combination Loans acquired in a business combination are initially recorded at their acquisition date fair values. The fair values of the purchased loans are based on the present value of the expected cash flows, including principal, interest and prepayments. Periodic principal and interest cash flows are adjusted for expected losses and prepayments, then discounted to determine the present value and summed to arrive at the estimated fair value. Fair value estimates involve assumptions and judgments as to credit risk, interest rate risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Purchased loans are divided into loans with evidence of credit quality deterioration, which are accounted for under Accounting Standards Codification (ASC) topic 310- 30 (purchased credit impaired (PCI)) and loans that do not meet this criteria, which are accounted for under ASC topic 310-20 (performing). PCI loans have experienced a to deterioration of credit quality acquisition for which it is probable that the Bank will not be able to collect all principal and interest payments on the loan. In the assessment of credit quality, numerous assumptions, interpretations and judgments must be made, based on internal and third-party credit quality information and ultimately the determination as to the probability that all contractual cash flows will not be able to be collected. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. from origination Subsequent to the acquisition date, the Bank continues to estimate the amount and timing of cash flows expected to be collected on PCI loans. The present value of any decreases in expected cash flows after the acquisition date will generally result in an impairment charge recorded as a provision for loan losses, resulting in an increase to the allowance for loan losses. Increases in expected cash flows will generally result in a recovery of any previously recorded allowance for loan losses, to the extent applicable, and/or a reclassification from the nonaccretable difference to accretable yield, which will be recognized prospectively. For acquired performing loans, the difference between the acquisition date fair value and the contractual amounts due at the acquisition date represents the fair value adjustment. Fair value adjustments may be discounts or premiums to a loan's cost basis and are accreted or amortized into interest income over the loan's remaining life using the level yield method. is similar Subsequent to the acquisition date, the methods utilized to estimate the required allowance for loan losses for these loans loans. See “Note 2 Acquisitions” and “Note 6 Allowance for Loan Losses and Credit Quality Information” in the Notes to Consolidated Financial Statements for more information regarding acquired loans. to originated  MANAGEMENT DISCUSSION AND ANALYSIS Results of Operations Comparison of 2016 with 2015 Net income was $6.4 million for 2016, an increase of $3.4 million compared to net income of $3.0 million for 2015. Net income available to common shareholders was $6.4 million for 2016, an increase of $3.6 million compared to net income available to common shareholders of $2.8 million for 2015. Diluted earnings per share for the year ended December 31, 2016 was $1.34, an increase of $0.73 per share compared to diluted earnings per share of $0.61 for the year ended December 31, 2015. The increase in net income for 2016 is due primarily to a $5.9 million increase in interest income as a result of an increase in the average interest-earning assets and a change in the composition of the average interest-earning assets held between the periods. Gain on sales of loans increased $0.7 million due to an increase in single family mortgage loan production and sales between the periods. The provision for loan losses decreased $0.5 million between the periods due to improvements in the credit quality of the commercial loan portfolio. These increases in income were partially offset by a $1.0 million increase in compensation expense due to annual increases in compensation and an increase in the number of employees related to the increased loan production. Income tax expense increased $2.5 million because of the increase in pre-tax income between the periods. Net Interest Income Net interest income was $25.8 million for 2016, an increase of $5.9 million, or 29.1%, from $19.9 million for 2015. Interest income was $27.3 million for 2016, an increase of $5.8 million, or 27.5%, from $21.5 million for 2015. Interest income increased between the periods because of an increase in the average interest-earning assets and a change in the composition of the average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets increased $67.3 million between the periods, the average interest-earning assets held in higher yielding loans increased $120.4 million and the amount of average interest-earning assets held in lower yielding cash and investments decreased $53.1 million between the periods. The yield on average interest-earning assets was also enhanced by $2.2 million, or 30 basis points, due to loan prepayment penalties, yield adjustments recognized on purchased loans, and interest payments received on non- accruing and previously charged off loans during 2016. Due to the decreasing amounts of interest payments receive on previously charged off loans that are available for recapture, the yield adjustments to interest income are anticipated to decrease significantly in 2017 from those experienced in 2016. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred because of an increase in loan originations and a reduction in loan payoffs between the periods. Average outstanding loans also increased $18.6 million between the periods as a result of the acquisitions that occurred in the third quarter of 2015 and the second quarter of 2016. The average yield earned on interest-earning assets was 4.36% for 2016, an increase of 53 basis points from 3.83% for 2015. Interest expense was $1.6 million for 2016, an increase of $0.1 million, or 5.7%, compared to $1.5 million for 2015. Interest expense increased because of an increase in the average outstanding interest-bearing liabilities. The average rate paid on interest-bearing liabilities decreased 1 basis point between the periods because of the change in the composition of the average interest-bearing liabilities. While the average interest-bearing liabilities increased $62.9 million between the periods, the average amount held in lower rate checking and money market accounts increased $58.0 million and the average amount held in higher rate certificates of deposits and other borrowings increased $4.9 million between the periods. The increase in the average outstanding deposits between the periods was primarily due to the $42.9 million increase that occurred as a result of the acquisitions that occurred in the third quarter of 2015 and the second quarter of 2016. The average interest rate paid on interest-bearing liabilities was 0.28% for 2016 compared to 0.29% for 2015. Net interest margin (net interest income divided by average interest-earning assets) for 2016 was 4.11%, an increase of 55 basis points compared to 3.56% for 2015. 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. 9  MANAGEMENT DISCUSSION AND ANALYSIS Average Outstanding Balance 2016 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2015 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2014 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 .......................... $ Other marketable securities ............ Loans held for sale .......................... Loans receivable, net(1) (2) ............... FHLB stock ..................................... Other, including cash equivalents .. Total interest-earning assets ........... $ 1,631 84,528 3,046 58 1,289 126 513,974 25,774 6 770 23,337 96 627,286 27,349 Interest-bearing liabilities: NOW accounts ................................ $ Passbooks ........................................ Money market accounts .................. Certificate accounts ........................ Brokered deposits ........................... FHLB advances and other borrowings ................................... Total interest-bearing liabilities ...... $ Noninterest checking ...................... Other noninterest-bearing liabilities ...................................... 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 ........................................ 50 62 366 524 0 591 85,440 71,728 164,522 100,942 0 9,374 432,006 145,450 1,434 578,890 1,593 25,756 48,396 3.56 % $ 1.52 4.14 5.01 0.78 0.41 4.36 $ 0.06 % $ 0.09 0.22 0.52 0.00 6.30 $ 0.28% $ 4.08% $ 4.11% 3,274 130,806 2,507 116 1,881 87 394,086 19,302 4 734 28,544 63 559,951 21,453 17 42 347 528 0 573 76,136 55,273 153,441 96,600 0 9,225 390,675 124,342 985 516,002 1,507 19,946 43,949 3.54% $ 1.44 3.47 4.90 0.54 0.22 3.83 $ 0.02% $ 0.08 0.23 0.55 0.00 6.21 $ 0.29% $ 3.54% $ 3.56% 4.40 % 1.06 3.73 5.12 0.51 0.24 3.59 0.02 % 0.07 0.26 0.67 1.45 0 0.00 3,726 119,484 1,557 164 1,269 58 369,571 18,929 4 778 79,373 189 574,489 20,613 14 32 414 739 12 71,666 47,200 162,207 110,256 830 0 392,159 125,767 924 518,850 1,211 19,402 55,639 0.23% 3.35 % 3.38 % 108.36% 108.52% 110.72% (1) Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis for any of the years presented. (2) Calculated net of deferred loan fees, loan discounts, loans in process and loss reserves. 10  MANAGEMENT DISCUSSION AND ANALYSIS Net interest margin increased to 4.11% in 2016 from 3.56% in 2015 primarily because of a change in the composition of average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. The increases in the average yields earned was due to having larger average balances of higher earning loans and smaller average balances of lower earning cash and investments during 2016 when compared to 2015. The yield on average interest-earning assets was also enhanced $2.2 million, or 30 basis points, in 2016 due to loan prepayment penalties, yield adjustments recognized on purchased loans, and interest payments received on non-accruing and previously charged off loans. Average net earning assets increased from $43.9 million in 2015 to $48.4 million in 2016. The $4.5 million increase in net earning assets is due primarily to the net income earned in 2016. 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 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 current volume). to changes in Year Ended December 31, 2016 vs. 2015 Increase (Decrease) Due to 2015 vs. 2014 Increase (Decrease) Due to Volume (1) Rate(1) Total Increase (Decrease) Volume (1) Total Increase (Decrease) Rate(1) (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 of deposit ........................................... Brokered deposits ................................................. FHLB advances and other borrowings ................. Total interest-bearing liabilities ....................... Increase (decrease) in net interest income ................ $ (58) (665) 19 5,824 (12) 0 5,108 1 12 18 26 0 16 73 5,035 0 73 20 648 45 2 788 32 8 1 (30) 0 2 13 775 (58) (592) 39 6,472 33 2 5,896 33 20 19 (4) 0 18 86 5,810 (20) 120 36 1,175 (121) 0 1,190 1 5 20 (104) (12) 0 (90) 1,280 (28) 492 (7) (802) (5) 0 (350) 1 5 (86) (107) 0 573 386 (736) (48) 612 29 373 (126) 0 840 2 10 (66) (211) (12) 573 296 544 (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. 11  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, 2016 Weighted average rate on: Mortgage-backed and related securities ...................... 3.51% NOW accounts ............................................................... 0.07% Other marketable securities ......................................... 1.34 Passbooks ...................................................................... 0.08 Loans held for sale .......................................................... 4.65 Money market accounts ................................................. 0.24 ICS/CDARS................................................................... 0.28 Loans receivable, net ....................................................... 4.69 Certificates of deposit .................................................... 0.61 Federal Home Loan Bank stock ...................................... 0.50 Other interest-earnings assets .......................................... 0.75 Federal Home Loan Bank advances and other Combined weighted average yield on interest- borrowings ................................................................. 6.50 earning assets .............................................................. 4.14 Combined weighted average rate on interest- bearing liabilities........................................................ Interest rate spread ......................................................... 0.27 3.87 Provision for Loan Losses The provision for loan losses was ($0.6) million for the year ended December 31, 2016, a decrease of $0.4 million, from ($0.2) million for the year ended December 31, 2015. The provision for loan losses decreased between the periods primarily because of the decrease in the reserve percentages applied to certain risk rated loan categories as a result of an internal analysis performed. Total non-performing assets were $3.9 million at December 31, 2016, a decrease of $2.3 million, or 37.4%, from $6.2 million at December 31, 2015. Non-performing loans decreased $0.9 million and foreclosed and repossessed assets decreased $1.4 million during 2016. A reconciliation of the allowance for loan losses for 2016 and 2015 is summarized as follows: (Dollars in thousands) Balance at January 1 ................................................................................................................................. $ Provision ................................................................................................................................................... Charge offs: Commercial ........................................................................................................................................... Commercial real estate .......................................................................................................................... Consumer .............................................................................................................................................. Single-family ....................................................................................................................................... Recoveries ................................................................................................................................................. Balance at December 31 ........................................................................................................................... $ Specific allowance .................................................................................................................................... $ General allowance ..................................................................................................................................... $ 2016 2015 9,709 (645) (180) (67) (108) (66) 1,260 9,903 988 8,915 9,903 8,332 (164 ) (69 ) 0 (105 ) (19 ) 1,734 9,709 1,009 8,700 9,709 12  MANAGEMENT DISCUSSION AND ANALYSIS The allowance for loan losses increased in 2016 when compared to 2015 primarily because of the increase in the loan portfolio between the periods. Non-Interest Income Non-interest income was $8.2 million for the year ended December 31, 2016, an increase of $0.5 million from $7.7 million for the year ended December 31, 2015. 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 ................................................... Other non-interest income ............................................. Total non-interest income ......................................... $ Year ended December 31, 2015 2014 2016 Percentage Increase (Decrease) 2016/2015 2015/2014 3,427 1,108 2,618 1,048 8,201 3,316 1,046 1,964 1,327 7,653 3,458 1,058 1,828 940 7,284 3.3% 5.9 33.3 (21.0) 7.2 (4.1)% (1.1) 7.4 41.2 5.1 The increase in non-interest income is primarily related to the $0.7 million increase in the gain on sales of loans due to an increase in single family loan originations and sales between the periods. Fees and service charges increased $0.1 million between the periods due primarily to an increase in debit card income. Loan servicing fees increased $0.1 million due to an increase in the loans serviced for others between the periods. These increases were partially offset by a $0.3 million decrease in other non-interest income because of a decrease in the gains realized on acquisitions between the periods. Non-Interest Expense Non-interest expense was $24.1 million for the year ended December 31, 2016, an increase of $0.9 million from $23.2 million for the year ended December 31, 2015. The following table presents the components of non-interest expense: (Dollars in thousands) Compensation and benefits ........................................... $ (Gains) losses on real estate owned ............................... Occupancy and equipment ............................................ Data processing ............................................................. Professional services ..................................................... Other ............................................................................. Total non-interest expense ........................................ $ Year ended December 31, 2015 2014 2016 Percentage Increase (Decrease) 2016/2015 2015/2014 14,764 (596) 4,041 1,161 1,257 3,503 24,130 13,733 218 3,722 1,020 1,108 3,395 23,196 13,332 (1,194) 3,691 1,011 1,216 3,347 21,403 7.5 % 3.0% (373.4 ) 8.6 13.8 13.4 3.2 4.0 118.3 0.8 0.9 (8.9) 1.4 8.4 Compensation expense increased $1.0 million between the periods due to annual increases in compensation and an increase in the number of employees between the periods because of the increased loan production. Occupancy and equipment expense increased $0.3 million because of increased software and equipment expenses. Other non- interest expense increased $0.1 million due primarily to an increase in loan related expenses as a result of the increase in loans originated between the periods. Data processing expense increased $0.1 million between the periods due to increased mobile and on-line banking costs. Other professional expenses increased $0.1 million primarily due to expenses related to the acquisition that occurred in the second quarter of 2016. These increases in non-interest expenses were partially offset by a $0.8 million increase in the gains on real estate owned between the periods primarily because of the gains that were recognized on the sale of two commercial properties during 2016. 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, as previously discussed. Income tax expense was $4.1 million for the year ended December 31, 2016, an increase of $2.5 million, from $1.6 million for the year ended December 31, 2015. The increase in income tax expense between the periods is primarily related to the increase in pre-tax income in 2016 when compared to 2015. Net Income Available to Common Shareholders Net income available to common shareholders was $6.4 million for 2016, an increase of $3.6 million from the $2.8 million net income available to common shareholders for 2015. Basic earnings per common share for the year ended December 31, 2016 was $1.52, an increase of $0.83 from the basic earnings per common share of $0.69 for the year 13  MANAGEMENT DISCUSSION AND ANALYSIS ended December 31, 2015. Diluted earnings per common share for the year ended December 31, 2016 was $1.34, an increase of $0.73 from diluted earnings per common share of $0.61 for the year ended December 31, 2015. Net income available to common shareholders and the basic and diluted earnings per common share increased primarily because of the increase in net income and a reduction in the dividends required to be paid on the outstanding Fixed Rate Cumulative Perpetual Preferred Stock Series A (the “Preferred Stock”) between the periods. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends were required to be paid on the Preferred Stock after that date. Comparison of 2015 with 2014 Net income was $3.0 million for 2015, a decrease of $4.4 million, from $7.4 million for 2014. Net income available to common shareholders was $2.8 million for the year ended December 31, 2015, a decrease of $2.9 million, from net income available to common shareholders of $5.7 million for 2014. Diluted earnings per common share for the year ended December 31, 2015 was $0.61, a decrease of $0.62 compared to the diluted earnings per common share of $1.23 for the year ended December 31, 2014. The decrease in net income in 2015 is due primarily to a $6.8 million decrease in the credit provision for loan losses between the periods. The decrease in the credit provision was primarily because there was more commercial loan growth and fewer recoveries of previously charged off loans in 2015 when compared to 2014. Net income also decreased $1.4 million due to the change in the losses recognized on real estate owned between the periods. The increased losses in 2015 as compared to 2014 were primarily due to a large gain realized on the sale of a commercial property in 2014. These decreases in net income were partially offset by a $0.5 million increase in net interest income due to increases in outstanding loan balances and a $3.3 million decrease in income tax expense as a result of the decreased pre-tax income between the periods. Net interest income was $19.9 million for 2015, an increase of $0.5 million, or 2.8%, from $19.4 million for 2014. Interest income was $21.5 million for 2015, an increase of $0.9 million, or 4.1%, from $20.6 million for 2014. Interest income increased between the periods primarily because of a change in the composition of average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets decreased $14.5 million between the periods, the average interest-earning assets held in higher yielding loans increased $25.5 million and the amount held in lower yielding cash and investments decreased $40.0 million between the periods. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which 14 in increase loan occurred primarily because of an originations and a reduction in loan payoffs between the periods. The Company also acquired $24.1 million of loans through an acquisition that occurred in the third quarter of 2015. The average yield earned on interest-earning assets was 3.83% for 2015, an increase of 24 basis points from 3.59% for 2014. Interest expense was $1.5 million for the year ended December 31, 2015, an increase of $0.3 million, or 24.4%, from $1.2 million for 2014. Interest expense increased primarily because of the change in the composition of the average interest-bearing liabilities held, which resulted in an increase in the average rate paid between the periods. While the average interest-bearing liabilities decreased $2.8 million between the periods, the average amount held in higher rate advances and other borrowings increased $9.3 million, the average amount held in higher rate certificates of deposit decreased $14.5 million, and the average amount held in other lower rate checking and money market deposits increased $2.4 million between the periods. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Preferred Stock. Interest expense increases related to borrowing costs were partially offset by the lower interest rates paid on deposit accounts between the periods as a result of the low interest rate environment that continued to exist in 2015. The average interest rate paid on interest-bearing liabilities was 0.29% for 2015, an increase of 6 basis points from the 0.23% average interest rate paid in 2014. Net interest margin (net interest income divided by average interest-earning assets) for 2015 was 3.56%, an increase of 18 basis points, compared to 3.38% for 2014. Net interest margin increased to 3.56% in 2015 from 3.38% in 2014 primarily because of a change in the composition of the average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. The increases in the average yields earned due to having larger average balances of higher earning loans and smaller average balances of lower earning cash and investments was partially offset by an increase in the average rates paid on the average interest-bearing liabilities held between the periods. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Preferred Stock. Average net earning assets decreased $11.7 million to $43.9 million in 2015 compared to $55.6 million for 2014 primarily because the proceeds of the $10.0 million note payable that was funded in the first quarter of 2015 were used to redeem outstanding Preferred Stock.  MANAGEMENT DISCUSSION AND ANALYSIS The provision for loan losses was ($0.2 million) for the year ended December 31, 2015, an increase of $6.8 million, from ($7.0 million) for the year ended December 31, 2014. The credit provision for loan losses decreased primarily because there was more commercial loan growth, fewer credit rating upgrades, and fewer recoveries of previously charged off loans in 2015 when compared to 2014. The decrease in non- performing loans relates primarily to a commercial real estate development relationship that was upgraded to performing status during 2015 due to the improved financial performance of the project as a result of increased lot sales. The allowance for loan losses increased in 2015 when compared to 2014 primarily because of the $99.3 million increase in the loan portfolio between the periods. Non-interest income was $7.7 million for the year ended December 31, 2015, an increase of $0.4 million, compared to $7.3 million for the year ended December 31, 2014. The increase is primarily related to a gain of $0.3 million that was recognized on an acquisition that occurred in the third quarter of 2015. Gain on sales of loans increased $0.1 million, or 7.4%, between the periods primarily because of an increase in single-family loan originations and sales. Other non-interest income increased $0.1 million primarily due to an increase in income related to the sale of non- insured investment products. These increases in non- interest income were partially offset by a $0.1 million decrease in fees and service charges primarily because of a decrease in retail and commercial overdraft fees between the periods. Non-interest expense was $23.2 million for the year ended December 31, 2015, an increase of $1.8 million, or 8.4%, from $21.4 million for the same period in 2014. Losses on real estate owned increased $1.4 million between the periods primarily because of a $1.0 million gain that was recognized on the sale of a single commercial property in increased $0.4 million 2014. Compensation expense between the periods primarily because of an increase in the expenses related to restricted stock awards and increased incentive accruals due to increased loan production. These increases in non-interest expense were partially offset by a decrease of $0.1 million in deposit insurance costs due primarily to a decrease in insurance rates between the periods. 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 $1.6 million for the year ended December 31, 2015, a decrease of $3.3 million from $4.9 million for the same period in 2014. The decrease in income tax expense between the periods is primarily related to the decrease in pre-tax income in 2015 when compared to 2014. Net income available to common shareholders was $2.8 million for 2015, a decrease of $2.9 million from the $5.7 million net income available to common shareholders in 2014. Basic earnings per common share for the year ended December 31, 2015 was $0.69, a decrease of $0.71 from the basic earnings per common share of $1.40 for the year ended December 31, 2014. Diluted earnings per common share for the year ended December 31, 2015 was $0.61, a decrease of $0.62 from diluted earnings per common share of $1.23 for the year ended December 31, 2014. The net income available to common shareholders and the basic and diluted earnings per common share decreased primarily because of the decrease in net income between the periods that was partially offset by a reduction in the dividends paid on the outstanding Preferred Stock. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends were required to be paid on the Preferred Stock after that date. 15  MANAGEMENT DISCUSSION AND ANALYSIS 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: (Dollars in thousands) Real Estate Loans: 2016 Amount Percent 2015 December 31, 2014 2013 2012 Amount Percent Amount Percent Amount Percent Amount Percent One-to-four family ..................... $ 103,255 18.41% $ 90,945 19.24% $ 69,841 18.70% $ 76,467 19.31% $ 97,037 20.40% Multi-family ............................... 36,777 6.56 Commercial ................................ 230,955 41.18 Construction or development ..... 31,348 5.59 Total real estate loans ....... 402,335 71.74 2.47 12,324 196,926 41.65 163,365 43.73 178,486 45.06 220,721 46.39 38,103 2.61 338,298 71.55 261,509 70.00 270,917 68.40 341,944 71.87 2.61 15,700 8.05 12,603 2.05 11,756 1.98 12,430 3.37 4.20 8,113 7,851 Other Loans: Consumer Loans: Automobile ............................ 3,036 Home equity line ................... 40,476 Home equity .......................... 16,302 Recreational vehicles............. 7,553 Other ...................................... 5,916 0.54 7.22 2.91 1.35 1.05 Total consumer loans ........ 73,283 13.07 Commercial business loans........ 85,176 15.19 Total other loans ............... 158,459 28.26 Total loans ......................... 560,794 100.00% 472,819 100.00% 373,556 100.00% 396,049 100.00% 475,773 100.00% 0.13 7.68 2.39 0.00 1.15 64,415 13.62 54,925 14.71 53,423 13.49 53,975 11.35 70,106 14.83 57,122 15.29 71,709 18.11 79,854 16.78 134,521 28.45 112,047 30.00 125,132 31.60 133,829 28.13 0.61 1,124 8.24 36,832 3.13 12,420 0.56 0 4,549 1.08 0.30 971 9.86 36,178 3.33 11,629 0 0.00 4,645 1.22 0.25 623 9.13 36,521 2.94 11,390 0.00 0 5,441 1.17 2,885 38,980 14,782 2,650 5,118 Less: Unamortized discounts .............. Net deferred loan (costs) fees .... Allowance for losses .................. 20 (300) 9,903 Total loans receivable, net $ 551,171 16 (91) 9,709 $ 463,185 14 97 8,332 $ 365,113 33 0 11,401 $ 384,615 33 87 21,608 $ 454,045 In 2016, the Company’s loan portfolio increased because of an increase in the loan originations as a result of an improving economy and an increase in lending staff. The loan portfolio also increased $6.0 million as a result of the acquisition that occurred in the second quarter of 2016. Because of the enhanced lending staff and the improving economic conditions projected, it is anticipated that the size of our overall loan portfolio will continue to increase in 2017. Single family real estate loans were $103.3 million at December 31, 2016, an increase of $12.4 million, compared to $90.9 million at December 31, 2015. Mortgage loan originations increased in 2016 as a result of additional mortgage lending staff and an increased emphasis on originating shorter term and adjustable rate mortgage loans that were placed into the portfolio. The majority of the longer term mortgage loans that were originated during the year continued to be 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 increased origination of loans placed into the loan portfolio was the primary reason for the increase in the single family loan portfolio during 2016. Multi-family real estate loans were $36.8 million at December 31, 2016, an increase of $24.5 million, compared to $12.3 million at December 31, 2015. The increase in multi-family real estate loans in 2016 is primarily the result of the $16.6 million in multi-family construction loans where the construction phase was completed and the loan was reclassified as a multi-family real estate loan. The origination of multi-family loans also increased between the periods. Commercial real estate loans were $231.0 million at December 31, 2016, an increase of $34.1 million, compared to $196.9 million at December 31, 2015. Commercial business loans were $85.2 million at December 31, 2016, an increase of $15.1 million, compared to $70.1 million at December 31, 2015. Increased commercial loan production as a result of increased demand for commercial loans resulted in an increase in the commercial business and commercial real estate loan portfolios in 2016. Construction or development loans were $31.3 million at December 31, 2016, a decrease of $6.8 million, compared to $38.1 million at December 31, 2015. The decrease was the net result of the following activity during 2016: $26.0 million in new construction loans originated, $2.7 million in advances on existing loans, $5.8 million in loans paid- off, and $29.7 million in loans moved to a permanent loan classification because the construction phase was completed. Home equity lines of credit were $40.5 million at December 31, 2016, an increase of $1.5 million, compared to $39.0 million at December 31, 2015. The open-end home equity 16  MANAGEMENT DISCUSSION AND ANALYSIS lines are generally 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 $16.3 million at December 31, 2016, an increase of $1.5 million, compared to $14.8 million at December 31, 2015. The increase in the open-end equity lines and closed-end equity loans is related primarily to an increase in originations between the periods. Recreational vehicle loans were $7.6 million at December 31, 2016, an increase of $4.9 million, compared to $2.7 million at December 31, 2015. These loans have been made primarily to finance the recreational vehicle sales of a single dealer within the Bank’s market area and the increase in balances between the periods is due to an increase in originations. Allowance for Loan Losses The determination of the allowance for loan losses and the related provision is a critical accounting policy of the Company that is subject to significant estimates, as previously discussed. The current level of the allowance for loan losses is a result of management’s assessment of the risks within the portfolio based on the information obtained through the credit evaluation process. The Company utilizes a risk-rating system on non-homogenous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to adjust the allowance balance on the basis of these reviews. 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 to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the size of the allowance for loan losses. The allowance for loan losses was $9.9 million, or 1.77% of gross loans at December 31, 2016, compared to $9.7 million, or 2.05% of gross loans at December 31, 2015. The allowance for loan losses increased primarily due to an $88.0 million increase in the loan portfolio between the periods. The increase in the allowance due to loan growth was partially offset by a decrease in the allowance due to lower reserve percentages being used for certain risk rated commercial loans between the periods as a result of an internal analysis of the most recent charge-off history that was performed during the year. The decrease in the allowance as a percentage of outstanding loans, from 2.05% of gross loans at December 31, 2015 to 1.77% of gross loans at December 31, 2016, reflects the improved credit quality of the loan portfolio between the periods. 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: Single family ................................................................................ Consumer ...................................................................................... Commercial business.................................................................... Commercial real estate ................................................................. Recoveries ......................................................................................... Net recoveries (charge-offs) ......................................................... Balance at end of year ........................................................................... $ Year-end allowance for loan losses as a percent of year end gross 2016 2015 December 31, 2014 2013 2012 9,709 (645) (66) (108) (180) (67) 1,260 839 9,903 8,332 (164) 11,401 (6,998) 21,608 (7,881) 23,888 2,544 (19) (105) (69) 0 1,734 1,541 9,709 (92) (131) (55) (936) 5,143 3,929 8,332 (200) (484) (651) (3,711) 2,720 (2,326) 11,401 (63) (1,071) (2,464) (5,719) 4,493 (4,824) 21,608 loan balance ........................................................................................ 1.77% 2.05 % 2.23 % 2.88 % 4.54% Ratio of net loan (recoveries) charge-offs to average loans outstanding ......................................................................................... (0.16) (0.36) (1.02) 0.53 0.91 17  MANAGEMENT DISCUSSION AND ANALYSIS The following table reflects the allocation of the allowance for loan losses: 2016 2015 December 31, 2014 2013 2012 Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Percent of Loans in Each Category to Total Loans Category 1.09% 2.46 1.86 2.05 2.05 19.24% 52.31 13.62 14.83 100.00% Category 1.57% 2.62 1.84 2.11 2.23 18.70% 51.30 14.71 15.29 100.00% Category 2.13% 3.32 2.07 3.08 2.88 19.31% 49.09 13.49 18.11 100.00% Category 2.91% 5.55 2.12 5.08 4.54 20.40% 51.47 11.35 16.78 100.00% Single family .................. Commercial real estate ... Consumer ....................... Commercial business ..... Total ..................... 1.15% 1.66 2.20 2.53 1.77 18.41 % 53.33 13.07 15.19 100.00 % The allocated reserve percentages for commercial real estate decreased in 2016 due to the general improvement in the credit quality of the commercial real estate portfolio. The allocation of the allowance for loan losses for single family, commercial, and consumer loans increased due to an increase in the outstanding balances and changes in the types of loans held in these categories between the periods. Allowance for Real Estate Losses Real estate properties acquired or expected to be acquired through loan foreclosures are initially recorded at fair value less estimated selling costs. Management periodically performs valuations and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. The balance in the allowance for real estate losses was $0.7 million at December 31, 2016 and $0.8 million at December 31, 2015. Non-performing Assets Loans are reviewed at least quarterly and if the collectability of any loan is doubtful, it is placed on non-accrual status. Loans are placed on non-accrual status when either principal or interest is 90 days or more past due, unless, in the judgment of management, the loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. Restructured loans include the Bank's troubled debt restructurings (TDRs) 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 condition has deteriorated. Foreclosed and repossessed assets include assets acquired in settlement of loans. Total non-performing assets were $3.9 million at December 31, 2016, a decrease of $2.3 million, or 37.4%, from $6.2 million at December 31, 2015. Non-performing loans decreased $0.9 million and foreclosed and repossessed assets decreased $1.4 million during 2016. The following table sets forth the amounts and categories of non-performing assets (non-accrual loans and foreclosed and repossessed assets) in the Company’s portfolio: 18  MANAGEMENT DISCUSSION AND ANALYSIS (Dollars in thousands) Non-performing loans: 2016 2015 December 31, 2014 2013 2012 Single family ............................................................ $ Commercial real estate ............................................. Consumer ................................................................. Commercial business ............................................... Total ..................................................................... Foreclosed and repossessed assets: Single 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 ..... 916 1,384 630 343 3,273 0 611 16 627 $ 3,900 0.57 % $ 3,273 0.59 % 302.56 % 1,655 1,694 786 46 4,181 48 1,997 0 2,045 6,226 $ 0.97 % 4,181 $ 0.90 % 232.22 % 1,564 8,750 486 120 10,920 50 3,053 0 3,103 14,023 $ 2.43% 10,920 $ 2.99% 76.30% 1,602 14,549 737 608 17,496 0 6,898 0 6,898 24,394 $ 3.76 % 17,496 $ 4.55 % 65.17 % 2,492 25,543 300 1,640 29,975 1,595 9,000 0 10,595 40,570 6.21% 29,975 6.60% 72.09% Gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $0.6 million for 2016, $0.4 million for 2015, and $0.9 million for 2014. The amounts that were included in interest income on a cash basis for these loans were $0.4 million, $0.2 million, and $0.2 million, respectively. At December 31, 2016, 2015 and 2014, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.3 million, $2.5 million, and $9.4 million, respectively. Had the loans performed in accordance with their original terms throughout 2016, 2015, and 2014, the Company would have recorded gross interest income of $0.6 million, $0.4 million, and $0.9 million, respectively. During 2016, 2015 and 2014 the Company recorded gross interest income of $0.4 million, $0.2 million, and $0.3 million, respectively. For the loans that were modified in 2016, $0.2 million were unclassified and performing, and $1.7 million were non- performing at December 31, 2016. The increase in TDRs in 2016 relates primarily to one commercial relationship totaling $1.3 million that was downgraded from performing to non-performing status and was restructured during the year. Of the loans that were modified in 2016 and outstanding at December 31, 2016, $1.3 million related to loans secured by commercial real estate and $0.4 million related to first or second mortgages on single family property, and the remaining modifications related to other consumer or commercial business loans. For the loans that were modified in 2015, $0.5 million were unclassified and performing, and $0.7 million were non- performing at December 31, 2015. The decrease in TDRs in 2015 relates primarily to a group of commercial development loans totaling $6.0 million that were upgraded to performing status and met the criteria to be removed from TDR classification during the year. Of the loans that were modified in 2015 and outstanding at December 31, 2015, $0.8 million related to loans secured by first or second mortgages on single family properties, and the remaining modifications related to other consumer or commercial business loans. For the loans that had been modified in 2014, $0.1 million were unclassified and performing and $0.1 million were non-performing at December 31, 2014. The decrease in TDRs in 2014 relates primarily to two related commercial development loans totaling $3.5 million that were charged down to $2.5 million and paid off during the year. TDRs also decreased during the year by $1.4 million due to the paydown of six in an unrelated commercial development, as well as $1.0 million due to the payoff of a loan for another unrelated commercial development. Of the loans that were modified in 2014 and outstanding at December 31, 2014, $0.2 million related to loans secured by first or second mortgages on single family properties, and the remaining modifications related to other consumer loans. loans 19  MANAGEMENT DISCUSSION AND ANALYSIS The following table sets forth the amount of TDRs in the Company’s portfolio: (Dollars in thousands) 2016 2015 December 31, 2014 2013 2012 Single family ............................................................. $ Commercial real estate .............................................. Consumer .................................................................. Commercial business ................................................ Total TDRs ........................................................... TDRs on accrual status ............................................. TDRs on non-accrual status ...................................... Total ...................................................................... $ 448 1,774 709 369 3,300 1,297 2,003 3,300 647 725 732 415 2,519 1,618 901 2,519 368 7,956 571 555 9,450 7,414 2,036 9,450 840 14,781 697 1,074 17,392 3,780 13,612 17,392 3,540 24,702 1,814 1,614 31,670 7,125 24,545 31,670 In addition to the TDRs and the non-performing loans set forth in the table above of all non-performing assets, the Company may identify other potential problem loans. 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 problem loans is another predominant factor in determining the relative level of the allowance for loan losses. There were no potential problem loans identified by the Company as of December 31, 2016. The four loan relationships that are reported as potential problem loans at December 31, 2015 were $6.0 million in loans to two unrelated trucking companies and $0.5 million in loans secured by agricultural assets to two unrelated individuals. The three loan relationships reported as potential problem loans at December 31, 2014 were a $3.8 million loan to an educational institution, a $0.6 million loan to a small manufacturing business, and three loans totaling $0.3 million to a golf course. Liquidity and Capital Resources The Company attempts to manage its liquidity position so that the funding needs of borrowers and depositors are met timely and in a 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 obtain retail, internet, or brokered deposits or to borrow funds from third parties such as the FHLB or the Federal Reserve Bank of Minneapolis. 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 Bank. 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 20 additional borrowings with the FHLB or Federal Reserve Bank of Minneapolis 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 Federal Reserve Bank of Minneapolis by pledging additional securities or loans, to applicable borrowing base and collateral subject requirements. See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in 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 Federal Reserve Bank of Minneapolis. The Bank'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. the following major Cash and cash equivalents at December 31, 2016 were $27.6 million, a decrease of $12.2 million, compared to $39.8 million at December 31, 2015. Net cash provided by operating activities during 2016 was $25.5 million. The Company conducted investing activities during 2016: principal payments and maturity proceeds received on securities available for sale and FHLB stock were $139.2 million, purchases of securities available for sale and FHLB stock were $106.8 million, and the proceeds from the sale of premises and other real estate were $2.4 million. The Company also purchased premises and equipment of $1.6 million. Net loans receivable increased $89.6 million due primarily to increased loan originations. The Company completed a branch acquisition and received $6.1 million in net cash in connection with the transaction. Net cash used by investing activities during 2016 was $50.4 million. The Company conducted the following major financing activities during 2016: deposits increased $14.5 million, from borrowings of $45.0 million and repaid borrowings of $47.0 received proceeds  MANAGEMENT DISCUSSION AND ANALYSIS million. Net cash provided by financing activities was $12.6 million for 2016. Company had $3.3 million in cash and other assets that could readily be turned into cash. The Bank has certificates of deposits from customers with outstanding balances of $57.8 million that mature during 2017. Based upon past experience, management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits that do not renew will be replaced with deposits from other customers or FHLB advances. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits. The Bank has deposits of $61.9 million in checking and money market accounts of four customers that have individual relationship balances greater than $5.0 million. These funds may be withdrawn at any time, however, management anticipates that the majority of these deposits will remain on deposit with the Bank over the next twelve months. 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. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits. 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. During 2016, the Bank paid dividends to the Company of $3.0 million and at December 31, 2016, the On February 17, 2015, the Company redeemed the final 10,000 shares of outstanding Preferred Stock. The Preferred Stock redemption was funded through a $10.0 million term loan to HMN from an unrelated third party that was evidenced by a promissory note. The interest payments on the note are due quarterly. The principal balance of the note bears interest at a rate of 6.50% and is payable in consecutive annual installments of $1.0 million on each December 15, beginning December 15, 2015, with the balance due on December 15, 2021. The Company’s primary use of cash is the payment of principal and interest on the third party note payable and holding company level expenses, including the payment of director and management fees, legal expenses, and other regulatory costs. The Company does not anticipate that it will have on a stand-alone basis adequate liquid resources to make future interest and principal payments on its third party note payable and fund the Company-level expenses. The Company plans to continue to fund its liquidity needs through dividends from the Bank or by obtaining external capital. Provided that no default or event of default has occurred and is continuing, the Company may also, at its option, elect to defer payment of one installment of principal on the third party note payable otherwise due prior to the maturity date, in which event such installment will become due and payable on the maturity date. Contractual Obligations and Commercial Commitments The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2016, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: (Dollars in thousands) Contractual Obligations: Total borrowings ....................................................... $ Annual rental commitments under non-cancellable Payments Due by Period Total Less than 1 Year 1-3 Years 4-5 Years More than 5 Years 7,000 1,000 2,000 4,000 0 operating leases ...................................................... Total contractual obligations ................................. $ 5,856 12,856 843 1,843 1,452 3,452 1,380 5,380 2,181 2,181 Other Commercial Commitments: Commercial lines of credit ........................................ $ Commitments to lend ................................................ Standby letters of credit ............................................ Total other commercial commitments ................... $ 50,229 31,831 1,902 83,962 26,523 9,797 1,575 37,895 9,282 4,736 327 14,345 9,414 7,220 0 16,634 5,010 10,078 0 15,088 Amount of Commitments Expiring by Period 21  MANAGEMENT DISCUSSION AND ANALYSIS Regulatory Capital Requirements Effective January 1, 2015 the capital requirements of the Company and the Bank were changed to implement the regulatory requirements of the Basel III capital reforms. The Basel III requirements, among other things, (i) apply a strengthened set of capital requirements to the Bank (the Company is exempt, pursuant to the Small Bank Holding Company Policy Statement (Policy Statement) described below), including requirements relating to common equity as a component of core capital, (ii) implement a “capital conservation buffer” against risk and a higher minimum tier 1 capital requirement, and (iii) revise the rules for calculating risk-weighted assets for purposes of such requirements. The rules made corresponding revisions to the prompt corrective action framework and include the capital ratios and buffer requirements which will be phased in incrementally, with full implementation scheduled for January 1, 2019. Failure by the Bank 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, both the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, factors. Management believes that, as of December 31, 2016, 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 the requirement to be “well-capitalized” in the future. See “Note 17 Regulatory Capital” of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to these capital requirements. risk weightings further adjust other and In the second quarter of 2015, the FRB amended its Policy Statement, which exempted small bank holding companies from the above capital requirements, by raising the asset size threshold for determining applicability from $500 million to $1 billion. The Policy Statement was also expanded to include savings and loan holding companies that meet the Policy Statement’s qualitative requirements for exemption. The Company met the qualitative exemption requirements, and therefore, is exempt from the above capital requirements. 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 potential Company-level expenses and the payment of principal and interest payments on the third party note payable, the 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. Additional capital would 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 Bank cannot satisfactorily address its capital needs as they arise, the Bank’s ability to maintain or expand its operations, maintain compliance with the regulatory capital requirements, to operate without additional regulatory or other restrictions, and its operating results, could be materially adversely affected. 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 regulatory capital requirements and other tax considerations, industry standards, economic conditions, general business practices and other factors. The Company to common has not made any dividend payments stockholders during the three year period ending December 31, 2016. restrictions, regulatory 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. There is no assurance that the Bank and the Company would satisfy the applicable regulatory requirements necessary to effect any such dividends. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its 22  MANAGEMENT DISCUSSION AND ANALYSIS stockholders. 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 conditions, growth plans, and cash flow requirements of the Company and the Bank. Impact of Inflation and Changing Prices The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. New Accounting Pronouncements In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this ASU require, among other things, equity investments to be measured at fair value with changes in fair value recognized in net income and that public business entities use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. The amendments also require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. In addition, the amendments also eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The amendments should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The amendments in the ASU create Topic 842, Leases, and supersede the lease requirements in Topic 840, Leases. The objective of this ASU is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. The main difference between previous GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The amendment requires a lessee to recognize in the statement of financial position a liability to make lease payments (the lease liability) and the right-of-use asset representing its right to use the underlying asset for the lease term. The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply that will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless is modified. The the amendments in the ASU, for public business entities that are U. S. Securities and Exchange Commission (SEC) filers, are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The adoption of this ASU in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements. lease the income including the FASB transactions In March 2016, issued ASU 2016-09, Compensation – Stock Compensation (Topic 718). The amendments in this ASU affect all entities that issue share- based payment awards to their employees. The amendments are intended to simplify the accounting for share-based payment tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments in this ASU, for public business entities, are effective for fiscal years beginning after December 15, 2016, including interim periods within those annual periods. Amendments should be applied using a modified retrospective transition method by means of a cumulative- effect adjustment to equity as of the beginning of the period in which the guidance is adopted. The adoption of this ASU in the first quarter of 2017 is not anticipated to have a material impact on the Company’s consolidated financial statements. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this ASU affect all entities that measure credit losses on financial instruments including loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial asset that has a contractual right to receive cash that is not specifically excluded. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this ASU replace the incurred loss impairment methodology required in 23  MANAGEMENT DISCUSSION AND ANALYSIS current GAAP with a methodology that reflects expected credit losses that requires consideration of a broader range of reasonable and supportable information to estimate credit losses. The amendments in this ASU will affect entities to varying degrees depending on the credit quality of the assets held by the entity, the duration of the assets held, and how the entity applies the current incurred loss methodology. The amendments in this ASU, for public business entities that are U. S. Securities and Exchange Commission (SEC) filers, are effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. All entities may adopt the amendments in the ASU early as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Amendments should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Management is in the process of evaluating the impact that the adoption of this ASU in the first quarter of 2020 will have on the Company’s consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The amendments in this ASU affect all entities that are required to present a statement of cash flows under Topic 230 and address the following eight specific cash flow issues: debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of the settlement of corporate-owned life insurance policies; distributions received from equity method investees; beneficial transactions; and in securitization separately identifiable cash flows and application of the predominance principle. This ASU is intended to reduce for public diversity business entities that are U. S. Securities and Exchange insurance claims; proceeds from in practice and is effective interest Commission (SEC) filers for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. Upon adoption, the amendments should be applied using a retrospective transition method to each period presented. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements. 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 following 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. 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, 2016. Market Value (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 ........................................ -100 686,536 582,820 (256) 103,972 (21.13)% 0 673,175 541,354 0 131,821 0.00% +100 660,259 503,943 (16 ) 156,332 18.59 % +200 647,134 471,842 15 175,277 32.97% 24  MANAGEMENT DISCUSSION AND ANALYSIS (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 decay rates. Fixed rate loans were assumed to prepay at annual rates of between 2% and 40%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 7% and 53%, depending on the note rate and the period to maturity. Mortgage-backed securities were projected to have prepayments based upon the underlying collateral securing the instrument. All loan prepayments vary based on the note rate and period to maturity of the individual loans. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at annual rates of 19% and 7%, respectively. Non-interest checking and NOW accounts were assumed to decay at annual rates of 4% and 14%, respectively. Commercial non-interest checking and NOW accounts were assumed to decay at annual rates of 17% and 9%, respectively. Commercial MMDA accounts were assumed to decay at annual rates of 23%. 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 liabilities, such as table. Certain 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. the in Asset/Liability Management The Company's management reviews the impact that changing interest rates will have on the net interest income projected for the twelve months following December 31, 2016 to determine if its current level of interest rate risk is 25 acceptable. The following table projects the estimated impact on net interest income during the 12 month period ending December 31, 2017 of immediate interest rate changes called rate shocks: (Dollars in thousands) Rate Shock in Basis Points +200 +100 0 -100 $ Net Interest Change Percent Change 2,859 1,408 0 (1,441) 11.15% 5.49 0.00 (5.62) The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. The increase in interest income in a rising rate environment is because there are more adjustable rate loans that would re-price to higher interest rates in the next twelve months than there are deposits that would re-price. 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 as intended to assure attainment of the Bank's objectives in an 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. 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. See “Note 18 Financial Instruments with Off-Balance Sheet Risk” in the Notes to Consolidated information. for Financial Management believes that the Company has sufficient liquidity to satisfy its off-balance sheet obligations. Statements additional MANAGEMENT DISCUSSION AND ANALYSIS 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 long term fixed rate loans were placed into the single family loan portfolio. In recent years, the Bank has focused its 30 year fixed rate single family residential lending program on loans that are saleable to third parties and generally places only adjustable rate or shorter term fixed rate loans that meet certain risk characteristics into its loan portfolio. In addition, a significant portion of loan production continues to be in adjustable rate loans that re- price every one, two, or three years. the Bank’s commercial 26 CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, December 31, 2016 2015 ASSETS Cash and cash equivalents ................................................................................................ $ Securities available for sale: Mortgage-backed and related securities 27,561 39,782 (amortized cost $993 and $2,237) ............................................................................. 1,005 2,283 Other marketable securities (amortized cost $78,846 and $110,092) ................................................................... 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 ........................................................................................... Goodwill ........................................................................................................................... Core deposit intangible, net .............................................................................................. Prepaid expenses and other assets .................................................................................... Deferred tax asset, net ...................................................................................................... Total assets ................................................................................................................ $ LIABILITIES AND STOCKHOLDERS’ EQUITY Deposits ............................................................................................................................ $ Other borrowings ............................................................................................................. Accrued interest payable .................................................................................................. Customer escrows ............................................................................................................ Accrued expenses and other liabilities ............................................................................. Total liabilities .......................................................................................................... 77,472 78,477 2,009 551,171 2,626 611 770 1,604 8,223 802 454 1,768 5,947 682,023 592,811 7,000 236 1,011 5,046 606,104 109,691 111,974 3,779 463,185 2,254 2,045 691 1,499 7,469 0 393 1,417 8,673 643,161 559,387 9,000 242 830 4,057 573,516 Commitments and contingencies Stockholders’ equity: Serial-preferred stock: ($.01 par value) authorized 500,000 shares; issued shares 0 ............................................................... 0 0 Common stock ($.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 4,639,739 and 4,645,769 shares .................................................. Total stockholders’ equity ......................................................................................... Total liabilities and stockholders’ equity ......................................................................... $ 91 50,566 86,886 (820) (2,223) (58,581) 75,919 682,023 91 50,388 80,536 (214 ) (2,417 ) (58,739 ) 69,645 643,161 See accompanying notes to consolidated financial statements. 27 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years ended December 31 (Dollars in thousands, except per share amounts) Interest income: Loans receivable ............................................................................. $ Securities available for sale: Mortgage-backed and related ...................................................... Other marketable ......................................................................... Cash equivalents ............................................................................. Other ............................................................................................... Total interest income ................................................................... Interest expense: Deposits .......................................................................................... Federal Home Loan Bank advances and other borrowings ............ 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 ..................................................................... Other ............................................................................................... Total non-interest income ........................................................... Non-interest expense: Compensation and benefits ............................................................ (Gains) losses on real estate owned ................................................ Occupancy and equipment .............................................................. Data processing............................................................................... Professional services ....................................................................... Other ............................................................................................... Total non-interest expense .......................................................... Income before income tax expense ......................................... Income tax expense ............................................................................ Net income .................................................................................. Preferred stock dividends ................................................................... Net income available to common shareholders ........................... $ Other comprehensive (loss) income, net of tax .................................. Comprehensive income available to common shareholders ............... $ Basic earnings per common share ...................................................... $ Diluted earnings per common share ................................................... $ See accompanying notes to consolidated financial statements. 2016 2015 2014 25,900 19,389 18,987 58 1,289 96 6 27,349 1,002 591 1,593 25,756 (645) 26,401 3,427 1,108 2,618 1,048 8,201 14,764 (596) 4,041 1,161 1,257 3,503 24,130 10,472 4,122 6,350 0 6,350 (606) 5,744 1.52 1.34 116 1,881 63 4 21,453 934 573 1,507 19,946 (164 ) 20,110 3,316 1,046 1,964 1,327 7,653 13,733 218 3,722 1,020 1,108 3,395 23,196 4,567 1,611 2,956 (108 ) 2,848 204 3,052 0.69 0.61 164 1,269 189 4 20,613 1,211 0 1,211 19,402 (6,998 ) 26,400 3,458 1,058 1,828 940 7,284 13,332 (1,194 ) 3,691 1,011 1,216 3,347 21,403 12,281 4,902 7,379 (1,710 ) 5,669 256 5,925 1.40 1.23 28 CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Additional Preferred Common Paid-in Capital Stock Stock 91 51,175 Retained Earnings 72,211 7,379 Accumulated Other Comprehensive Income (Loss) (674) Unearned Employee Stock Total Stock- Ownership Treasury holders’ Plan Stock Equity (Dollars in thousands) Balance, December 31, 2013...................... $ 26,000 Net income ............................................. Other comprehensive income ................ Redemption of preferred stock .............. Stock compensation tax benefits ........... Restricted stock awards ......................... Amortization of restricted stock awards ................................................. Preferred stock dividends ...................... Earned employee stock ownership plan shares ........................................... (16,000) Balance, December 31, 2014...................... $ 10,000 91 Net income ............................................. Other comprehensive income ................ Redemption of preferred stock .............. Restricted stock awards ......................... Restricted stock awards forfeiture ......... Amortization of restricted stock awards ................................................. Preferred stock dividends ...................... Earned employee stock ownership plan shares ........................................... Balance, December 31, 2015 .................... $ Net income ............................................ Other comprehensive loss ................... Stock compensation expense ............... Restricted stock awards ...................... Amortization of restricted stock awards ................................................ Earned employee stock ownership plan shares ......................................... Balance, December 31, 2016 .................... $ (10,000) 0 91 0 91 1 (1,262) 240 53 50,207 (332) 9 447 57 50,388 79 (158) 177 80 50,566 256 (418) 204 (214) (606) (1,785) 77,805 2,956 (225) 80,536 6,350 (2,804) (60,324) 1,262 194 (2,610) (59,062) 332 (9) 193 (2,417) (58,739) 158 85,675 7,379 256 (16,000) 1 0 240 (1,785) 247 76,013 2,956 204 (10,000) 0 0 447 (225) 250 69,645 6,350 (606) 79 0 177 274 75,919 86,886 (820) 194 (2,223) (58,581) See accompanying notes to consolidated financial statements. 29 CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31 (Dollars in thousands) Cash flows from operating activities: 2016 2015 2014 Net income .................................................................................................................. $ Adjustments to reconcile net income to cash provided by operating activities: 6,350 2,956 7,379 Provision for loan losses ........................................................................................ Depreciation ........................................................................................................... Amortization of premiums (discounts), net ........................................................... Amortization of deferred loan fees ........................................................................ Amortization of core deposit intangible ................................................................ Amortization of purchased loan fair value adjustments ........................................ Amortization of mortgage servicing rights ............................................................ Capitalized mortgage servicing rights ................................................................... Deferred income tax expense ................................................................................. Securities losses (gains), net .................................................................................. (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 ................................................................ Earned ESOP shares priced above original cost .................................................... Stock option compensation expense ...................................................................... (Increase) decrease in accrued interest receivable ................................................. (Decrease) increase in accrued interest payable .................................................... Increase in other assets ........................................................................................... Increase (decrease) in other liabilities .................................................................... Other, net ................................................................................................................ Net cash provided by operating activities ......................................................... Cash flows from investing activities: Proceeds from sales of securities available for sale ................................................... Principal collected on securities available for sale ..................................................... Proceeds collected on maturity of securities available for sale .................................. Purchases of securities available for sale ................................................................... Purchase of Federal Home Loan Bank stock ............................................................. Redemption of Federal Home Loan Bank stock ........................................................ Proceeds from sales of real estate and premises ......................................................... Net (increase) decrease in loans receivable ............................................................... Gain on acquisition ..................................................................................................... Acquisition payment (net of cash acquired) .............................................................. Purchases of premises and equipment ........................................................................ Net cash used by investing activities ................................................................. Cash flows from financing activities: Increase (decrease) in deposits ................................................................................... Redemption of preferred stock ................................................................................... Dividends paid to preferred stockholders ................................................................... Proceeds from borrowings .......................................................................................... Repayment of borrowings ........................................................................................... Increase in customer escrows ..................................................................................... Net cash provided (used) by financing activities .............................................. Decrease in cash and cash equivalents .............................................................. Cash and cash equivalents, beginning of year ................................................................ Cash and cash equivalents, end of year ........................................................................... $ Supplemental cash flow disclosures: Cash paid for interest .................................................................................................. $ Cash paid for income taxes ......................................................................................... Supplemental noncash flow disclosures: Loans transferred to loans held for sale ...................................................................... Transfer of loans to real estate .................................................................................... See accompanying notes to consolidated financial statements. (645) 850 47 (1,011) 92 (529) 601 (706) 3,128 10 (596) (2,618) 99,121 (79,783) 177 194 80 79 (265) (9) (323) 999 270 25,513 20 1,245 136,145 (104,968) (1,879) 1,800 2,369 (89,570) 0 6,080 (1,607) (50,365) 14,468 0 0 45,000 (47,000) 163 12,631 (12,221) 39,782 27,561 1,599 436 15,002 591 (164 ) 706 (3 ) (964 ) 28 (657 ) 555 (547 ) 1,722 (6 ) 218 (1,964 ) 78,278 (69,941 ) 447 193 57 0 (346 ) 137 (239 ) 302 52 10,820 10,951 1,694 175,070 (144,069 ) (2,152 ) 2,238 1,127 (80,447 ) (289 ) 4,816 (803 ) (31,864 ) 15,375 (10,000 ) (225 ) 65,000 (56,000 ) 42 14,192 (6,852 ) 46,634 39,782 1,358 191 8,125 110 (6,998 ) 576 18 (340 ) 0 0 517 (316 ) 4,566 0 (1,194 ) (1,828 ) 56,040 (41,557 ) 240 194 53 1 240 (53 ) (444 ) (265 ) 515 17,344 0 2,148 125,000 (157,004 ) 0 7 4,816 13,455 0 0 (847 ) (12,425 ) (57,182 ) (16,000 ) (5,964 ) 0 0 175 (78,971 ) (74,052 ) 120,686 46,634 1,264 0 13,243 142 30  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2016, 2015 and 2014 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, Iowa, and Wisconsin. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OIA), which does business as Home Federal Investment Services and offers financial planning products and services, and HFSB Property Holdings, LLC (HPH), which is currently inactive, but has acted in the past 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 10, 2017. the consolidated Use of Estimates In preparing financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. the date of An estimate that is particularly susceptible to change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is appropriate to cover probable losses inherent in the portfolio at the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require 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 the period to maturity. Unrealized losses on securities available for sale reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established. Management monitors the investment security portfolio for impairment on an individual security basis and has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves analyzing the length of time and extent to which the fair value has been less than the amortized cost basis, the market liquidity for the security, the financial condition and near-term prospects of the issuer, expected cash flows, and the Company's intent and ability to hold the investment for a period of time sufficient to recover the temporary loss, including determining whether it is more-likely-than-not 31  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS that the Company will be required to sell the security prior to recovery. To the extent it is determined that a security is deemed impaired, an impairment loss is recognized. to be other-than-temporarily Loans Held for Sale Mortgage loans originated or purchased which are intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net fees and costs associated with acquiring or originating loans held for sale are deferred and included in the basis of the loan in determining the gain or loss on the sale of the loans. Gains on the sale of loans are recognized on the settlement date. Net unrealized losses are recognized through a valuation allowance by charges to income. 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 participation 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 based on a periodic analysis of the loan portfolio and 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. In this analysis, 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 delinquencies, local economic conditions, demand for single-family homes, demand for commercial real estate and building lots), loan portfolio composition, historical loss experience, and observations made by the Company's ongoing internal audit and regulatory exam processes. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties or other collateral securing classified loans. Appraisals on collateral dependent commercial real estate and commercial business loans are obtained when it is determined that the borrower’s risk profile has deteriorated and the loan is third party impaired. Subsequent new classified as appraisals of properties securing impaired commercial real estate and commercial business loans are prepared at least every two years. For all land development loan types, a new third party appraisal is prepared on an annual basis where current activity is not consistent with the assumptions made in the most recent third party appraisal. Non-performing residential and consumer home equity loans and home equity lines may have a third party appraisal or an internal the impairment evaluation completed depending on the size of the loan and location of the property. These appraisals, or internal valuations, are generally completed when a residential or consumer home equity loan or home equity line of credit becomes 120 days past due and are typically updated after possession of the property is obtained. Valuations are reviewed on a quarterly basis and adjustments are made to the allowance for loan losses for temporary impairments and charge-offs are is taken when determined to be permanent. The fair market value of the properties for all loan types are adjusted for estimated selling costs in order to determine the net realizable value of the properties. 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 adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. 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. 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. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio that have not been specifically identified. 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. Previously collected interest payments that were applied to principal when the loan was classified as non-accrual are recorded as interest income using the effective yield method over the estimated life of the loan, including expected renewal terms. 32  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 (TDR) 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 TDR and is 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 market terms for the type of credit involved. The second condition is whether the loan is repaid or charged off. Purchased Loans Acquired Through Business Combinations Purchased loans acquired in a business combination, including loans that have evidence of deterioration of credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments, are initially recorded at fair value as determined by the present value of expected future cash flows with no valuation allowance. The difference between the undiscounted cash flows expected at acquisition and the investment in the loan is an accretable yield adjustment and is recognized as interest income using the effective yield method over the life of the loan. Contractually required payments for principal and interest that exceed the undiscounted cash flows expected at acquisition is a nonaccretable difference and is not recognized as a yield adjustment, loss accrual, or a valuation allowance. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through an adjustment of the yield on the loan over its remaining life. Decreases in expected cash flows after the loan is acquired are recognized as an impairment and charged to the provision for loan losses. Transfers of Financial Assets and Participating Interests Transfers of an entire financial asset or a participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. The transfer of a participating interest in an entire financial asset must also meet the definition of a participating interest. A participating interest in a financial asset has all of the following characteristics: (1) from the date of transfer, it must represent a proportionate (pro rata) ownership interest in the financial asset, (2) from the date of transfer, all cash flows received, except any cash flows allocated as any compensation for servicing or other services performed, must be divided proportionately among participating interest holders in the amount equal to their share ownership, (3) the rights of each participating interest holder must have the same priority, and (4) no party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to do so. Real Estate, net Real estate acquired through loan foreclosure or deed in lieu of foreclosure, is initially recorded at its fair value less estimated selling costs. Third party appraisals are obtained as soon as practical after obtaining possession of the property. 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. income. The Company evaluates Mortgage Servicing Rights, net Mortgage servicing rights are capitalized at fair value and amortized in proportion to, and over the period of, estimated net servicing 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. 33  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Premises and Equipment, net 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. Goodwill The Company records goodwill for acquisition amounts paid in excess of the net assets purchased. Goodwill is not amortized, but is tested for impairment at least annually or more frequently if there are indications of impairment. Core Deposit Intangible, net The Company records the estimated fair value of the deposit base acquired in an acquisition as a core deposit intangible asset. The recorded amount is amortized on a straight line basis over the estimated life of the deposits acquired. 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. Employee Stock Ownership Plan (ESOP) The Company has an ESOP that borrowed funds from the Company and purchased shares of HMN common stock. The Company makes quarterly principal and interest payments on the ESOP loan. As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral based on the proportion of debt service paid in the year and then allocated to eligible employees. The Company accounts for its ESOP in accordance with ASC 718, Employers' Accounting for Employee Stock Ownership Plans. Accordingly, the shares pledged as collateral are reported as unearned ESOP shares in stockholders' equity. As shares are determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations. Income Taxes Deferred tax assets and liabilities are recognized for future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities 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. Earnings per Common Share Basic earnings 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 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. Comprehensive Income Comprehensive income is defined as the change in equity during a period from transactions and other events from non-owner sources. Comprehensive income is the total of net income and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. Segment Information The amount of each segment item reported is the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an enterprise’s general- purpose financial 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. New Accounting Pronouncements In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this ASU require, among other things, equity investments to be measured at fair value with changes in fair value recognized in net income and that public business entities use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. The amendments also require an entity 34  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. In addition, the amendments also eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The amendments should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The amendments in the ASU create Topic 842, Leases, and supersede the lease requirements in Topic 840, Leases. The objective of this ASU is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. The main difference between previous GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The amendment requires a lessee to recognize in the statement of financial position a liability to make lease payments (the lease liability) and the right-of-use asset representing its right to use the underlying asset for the lease term. The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply that will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless is modified. The the amendments in the ASU, for public business entities that are U. S. Securities and Exchange Commission (SEC) filers, are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The adoption of this ASU in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements. lease the FASB issued ASU 2016-09, In March 2016, Compensation – Stock Compensation (Topic 718). The amendments in this ASU affect all entities that issue share- based payment awards to their employees. The amendments are intended to simplify the accounting for share-based the income including transactions tax payment consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments in this ASU, for public business entities, are effective for fiscal years beginning after December 15, 2016, including interim periods within those annual periods. Amendments should be applied using a modified retrospective transition method by means of a cumulative- effect adjustment to equity as of the beginning of the period in which the guidance is adopted. The adoption of this ASU in the first quarter of 2017 is not anticipated to have a material impact on the Company’s consolidated financial statements. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this ASU affect all entities that measure credit losses on financial instruments including loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial asset that has a contractual right to receive cash that is not specifically excluded. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this ASU replace the incurred loss impairment methodology required in current GAAP with a methodology that reflects expected credit losses that requires consideration of a broader range of reasonable and supportable information to estimate credit losses. The amendments in this ASU will affect entities to varying degrees depending on the credit quality of the assets held by the entity, the duration of the assets held, and how the entity applies the current incurred loss methodology. The amendments in this ASU, for public business entities that are U. S. Securities and Exchange Commission (SEC) filers, are effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. All entities may adopt the amendments in the ASU early as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Amendments should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Management is in the process of evaluating the impact that the adoption of this ASU in the first quarter of 2020 will have on the Company’s consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The amendments in this ASU affect all entities that are required to present a statement of cash flows under Topic 230 and address the following eight specific cash flow issues: debt prepayment or debt 35  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS interest insurance claims; proceeds from extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the the settlement of settlement of corporate-owned life insurance policies; distributions received from equity method investees; beneficial transactions; and in securitization separately identifiable cash flows and application of the predominance principle. This ASU is intended to reduce diversity in practice and is effective for public business entities that are U. S. Securities and Exchange Commission (SEC) filers for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. Upon adoption, the amendments should be applied using a retrospective transition method to each period presented. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements. Derivative Financial Instruments The Company uses derivative financial instruments in order to manage the interest rate risk on residential loans held for sale and its commitments to extend credit for residential loans. The Company may also from time to time use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments. Reclassifications Certain amounts in the consolidated financial statements for the prior years have been reclassified to conform to the current year presentation. the NOTE 2 Acquisitions The Company records purchased assets and liabilities at their fair market value at the time of purchase in accordance with - Business requirements of ASU 805 Combinations. On April 8, 2016, the Bank completed the acquisition of loans and assumption of liabilities of the Deerwood Bank branch in Albert Lea, Minnesota. The transaction increased the Bank’s assets by $19.0 million, including increases in loans, cash, goodwill, and core deposit intangible of $11.9 million, $6.1 million, $0.8 million, and $0.2 million, respectively. The Bank also assumed deposit liabilities of $19.0 million. The acquired loans and deposits are being serviced from Home Federal’s existing branch location at 143 West Clark Street, Albert Lea, Minnesota. On August 14, 2015, the Bank completed the acquisition of certain assets and assumption of certain liabilities of Kasson 36 State Bank. The transaction increased the Bank’s total assets by $52.8 million including increases in loans of $24.1 million, investments of $17.5 million, cash of $10.0 million, core deposit intangible of $0.4 million and other assets of $0.8 million. The Bank also assumed liabilities of $49.3 million, including $47.3 million of deposits and $2.0 million in other liabilities. Consideration paid was $3.2 million and a gain on the transaction of $0.3 million was recorded. The Bank continues to operate both of the former Kasson State Bank locations in Kasson, Minnesota acquired in the transaction as branches of Home Federal Savings Bank. Determining the estimated fair value of the acquired assets and assumed liabilities required the Bank to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of those determinations related to the fair valuation of the loans acquired, which management considers to be a critical accounting estimate that involves significant estimates and assumptions. The fair value of the loans purchased was based on the present value of the expected cash flows. Periodic principal and interest cash flows were adjusted for expected losses and prepayments, then discounted to determine the present value and summed to arrive at the estimated fair value. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and other factors, such as prepayments. In accordance with GAAP, there was no carry-over of previously established allowances for loan losses established on the seller’s records. As a result, standard industry coverage ratios with regard to the allowance for credit losses are less meaningful after the acquisitions. The purchased loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC topic 310-30 (purchased credit impaired (PCI)) and loans that do not meet this criteria, which are accounted for under ASC topic 310-20 (performing). PCI loans have experienced a deterioration of credit quality from origination to acquisition for which it is probable that the Bank will not be able to collect all contractually required principal and interest payments on the loan. Subsequent decreases in the expected cash flows require the Bank to evaluate the need for additions to the allowance for credit losses. Subsequent improvements in expected cash flows generally result in a reduction of previously established allowance for credit losses or the recognition of additional interest income over the remaining lives of the loans.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 Other Comprehensive (Loss) Income The components of other comprehensive (loss) income and the related tax effects were as follows: (Dollars in thousands) Securities available for sale: Gross unrealized (losses) gains arising Before Tax 2016 Tax Effect For the years ended December 31, 2015 Tax Effect Before Tax of Tax Net Net of Tax Before Tax 2014 Tax Effect Net of Tax during the period .............................. $ (1,016) (404) (612) 344 137 207 38 (218) 256 Less reclassification of net (losses) gains included in net income ........... (10) (4) (6) 6 3 3 0 0 0 Net unrealized (losses) gains arising during the period .............................. (1,006) Other comprehensive (loss) income .... $ (1,006) (400) (400) (606) (606) 338 338 134 134 204 204 38 38 (218) (218) 256 256 The tax effect in 2014 includes the impact of the reversal of certain deferred tax asset valuation reserve components that reversed in 2014 as a result of the changes that occurred in the investment portfolio during the year. NOTE 4 Securities Available for Sale A summary of securities available for sale at December 31, 2016 and 2015 is as follows: (Dollars in thousands) December 31, 2016 Mortgage-backed securities: Amortized cost Gross unrealized gains Gross unrealized losses Fair value Federal Home Loan Mortgage Corporation (FHLMC) ................. $ Federal National Mortgage Association (FNMA) ........................... Collateralized mortgage obligations: FHLMC ............................................................................................. Other marketable securities: U.S. Government agency obligations ............................................... Municipal obligations ....................................................................... Corporate obligations ....................................................................... Corporate preferred stock ................................................................ Corporate equity ............................................................................... $ December 31, 2015 Mortgage-backed securities: FHLMC ............................................................................................... $ FNMA ................................................................................................. Collateralized mortgage obligations: FHLMC ............................................................................................... Other ................................................................................................... Other marketable securities: U.S. Government agency obligations .................................................. Municipal obligations ......................................................................... Corporate obligations .......................................................................... Corporate preferred stock .................................................................... Corporate equity .................................................................................. $ 37 327 295 371 993 74,979 2,819 290 700 58 78,846 79,839 728 725 742 42 2,237 105,003 3,991 340 700 58 110,092 112,329 10 7 0 17 16 0 2 0 57 75 92 31 22 2 0 55 68 18 0 0 5 91 146 0 0 (5) (5) (1,079) (20) 0 (350) 0 (1,449) (1,454) 0 0 (1) (8) (9) (129) (7) (6) (350) 0 (492) (501) 337 302 366 1,005 73,916 2,799 292 350 115 77,472 78,477 759 747 743 34 2,283 104,942 4,002 334 350 63 109,691 111,974  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In 2016, the Company sold $20,000 of available for sale securities and recognized a loss of $10,000 on the sales. because obligors may have the right to call or prepay obligations with or without call or prepayment penalties: In 2015, the Company sold $11.0 million of available for sale securities and recognized a gain of $6,000 on the sales. The Company did not sell any available for sale securities and did not recognize any gains or losses on investments in 2014. The following table presents the amortized cost and estimated fair value of securities available for sale at December 31, 2016, 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 (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 .............................................. No stated maturity .............................................. Total ........................................................... $ Amortized Cost 15,561 63,144 263 813 58 79,839 Fair Value 15,358 62,282 261 461 115 78,477 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, 2016 and 2015: Less Than Twelve Months Fair Value # of Investments Unrealized Losses (Dollars in thousands) December 31, 2016 Collateralized mortgage Twelve Months or More Fair Value # of Investments Unrealized Losses Total Fair Value Unrealized Losses obligations: FNMA ................................ Other marketable securities: U.S. Government agency obligations ....................... Municipal obligations ....... Corporate preferred stock ................................. Total temporarily impaired securities ............................ December 31, 2015 Collateralized mortgage obligations: FNMA ................................ Other .................................. Other marketable securities: U.S. Government agency obligations ........................ Municipal obligations ......... Corporate obligations ......... Corporate preferred stock ... Total temporarily impaired 1 $ 262 (3 ) 1 $ 104 (2) $ 366 (5) 13 63,896 2,327 14 (1,079 ) (19 ) 0 2 0 214 0 63,896 2,541 (1) (1,079) (20) 0 0 0 1 350 (350) 350 (350) 28 $ 66,485 (1,101 ) 4 $ 668 (353) $ 67,153 (1,454) 1 $ 2 346 34 (1 ) (8 ) 9 44,878 2,010 334 0 12 1 0 (129 ) (7 ) (6 ) 0 0 $ 0 0 0 0 1 0 0 0 $ 0 346 34 (1) (8) 0 0 0 350 0 44,878 2,010 0 334 0 350 (350) (129) (7) (6) (350) securities ............................. 25 $ 47,602 (151 ) 1 $ 350 (350) $ 47,952 (501) 38  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 the corporate preferred stock at December 31, 2016 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 September 2014, the issuer paid all deferred interest that was due and all payments were current as of September 30, 2014. Since January 2015, the issuer has deferred its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has generated modest net income amounts over the past several years and met the regulatory requirements to be considered “well capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at December 31, 2016. 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 that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities. 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. NOTE 5 Loans Receivable, Net A summary of loans receivable at December 31, 2016 and 2015, is as follows: (Dollars in thousands) Residential real estate loans: 2016 2015 Single family conventional .......................... $ 103,125 Single family FHA ....................................... 92 Single family VA ......................................... 38 103,255 90,587 206 152 90,945 Commercial real estate: Lodging ........................................................ Retail/office .................................................. Nursing home/health care ............................ Land developments ...................................... Golf courses ................................................. Restaurant/bar/café ...................................... Alternative fuel plants .................................. Warehouse .................................................... Construction: 43,285 53,935 8,185 24,240 1,560 5,851 0 26,630 27,428 45,097 9,183 21,272 4,163 5,854 2,205 18,337 Single family builder ............................... Multi-family ............................................ Commercial real estate ............................ Manufacturing .............................................. Churches/community service ....................... Multi-family ................................................. Other ............................................................. 21,944 2,610 6,794 15,743 10,199 36,777 41,327 299,080 15,152 18,865 4,086 11,585 8,195 12,324 43,607 247,353 Consumer: Autos ............................................................ Home equity line .......................................... Home equity ................................................. Other – secured ............................................ Recreational vehicles ................................... Land/lots ...................................................... Other – unsecured ........................................ 3,036 40,476 16,302 2,048 7,553 2,362 1,506 73,283 2,885 38,980 14,782 2,031 2,650 1,144 1,943 64,415 Commercial business 85,176 Total loans ............................................... 560,794 70,106 472,819 Less: Unamortized discounts ................................ Net deferred loan costs ................................ Allowance for loan losses ............................ 20 (300 ) 9,903 Total loans receivable, net ....................... $ 551,171 Commitments to originate or purchase loans ... $ 47,220 Commitments to deliver loans to secondary 16 (91) 9,709 463,185 27,184 market ............................................................ $ 9,595 8,071 Weighted average contractual rate of loans in portfolio ......................................................... 4.45 % 4.54% 39  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Included in total commitments to originate or purchase loans are fixed rate loans aggregating $29.6 million and $22.3 million as of December 31, 2016 and 2015, respectively. The interest rates on these loan commitments ranged from 2.75% to 5.125% at December 31, 2016 and from 3.00% to 5.49% at December 31, 2015. The aggregate amount of loans to executive officers and directors of the Company was $0.2 million, $2.7 million and $2.8 million at December 31, 2016, 2015 and 2014, respectively. During 2016, there was no activity on loans to executive officers and directors other than the $2.5 million in loans that were reclassified during the period due to a change in borrower classification. During 2015, repayments on loans to executive officers and directors were $0.1 million, new loans to executive officers and directors totaled $0.2 million, and loans closed or paid off were $0.2 million. During 2014, repayments on loans to executive officers and directors were $0.1 million, new loans to executive officers and directors totaled $0.2 million, sales of executive officer and director loans were $0.2 million, and loans reclassified were $0.2 million. All loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated parties. At December 31, 2016, 2015 and 2014, the Company was servicing loans for others with aggregate unpaid principal balances of approximately $425.5 million, $391.9 million and $379.7 million, respectively. The Company originates residential, commercial real estate and other loans primarily in Minnesota, Wisconsin, and Iowa. At December 31, 2016 and 2015, the Company had in its portfolio single-family residential loans located in the following states: 2016 2015 (Dollars in thousands) Iowa ................................ $ Minnesota ....................... Missouri .......................... Wisconsin ....................... Other states ..................... Amount 4,470 87,135 1,206 8,779 1,665 Total ...................... $ 103,255 Percent of Total Amount 5,387 75,417 918 7,956 1,267 4.3 % $ 84.4 1.2 8.5 1.6 Percent of Total 5.9 % 82.9 1.0 8.8 1.4 100.0% $ 90,945 100.0 % Amounts under one million dollars in both years are included in “Other states”. At December 31, 2016 and 2015, the Company had in its portfolio commercial real estate loans located in the following states: 2016 2015 (Dollars in thousands) Alabama ............................................................................................... $ Florida .................................................................................................. Idaho .................................................................................................... Indiana ................................................................................................. Iowa ..................................................................................................... Minnesota ............................................................................................ North Carolina ..................................................................................... North Dakota........................................................................................ Tennessee ............................................................................................. Wisconsin ............................................................................................ Other states .......................................................................................... Total ............................................................................................. $ Amount Percent of Total Amount Percent of Total 1,902 3,781 3,529 2,189 1,973 213,983 2,926 8,447 1,036 57,512 1,802 299,080 0.7 % $ 1.3 1.2 0.7 0.7 71.5 1.0 2.8 0.3 19.2 0.6 100.0 % $ 2,056 3,738 3,678 4,608 1,106 184,670 4,203 7,979 260 31,918 3,137 247,353 0.8 % 1.5 1.5 1.9 0.4 74.7 1.7 3.2 0.1 12.9 1.3 100.0 % Amounts under one million dollars in both years are included in “Other states”. 40  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 Allowance for Loan Losses and Credit Quality Information The allowance for loan losses is summarized as follows: (Dollars in thousands) Balance, December 31, 2013 ........................................ $ Single Family 1,628 Commercial Real Estate Consumer Commercial Business Total 6,458 1,106 2,209 11,401 Provision for losses ................................................... $ Charge-offs ............................................................... Recoveries ................................................................. Balance, December 31, 2014 ........................................ $ Provision for losses ................................................... $ Charge-offs ............................................................... Recoveries ................................................................. Balance, December 31, 2015 ........................................ $ Provision for losses .................................................. $ Charge-offs .............................................................. Recoveries ................................................................ Balance, December 31, 2016 ....................................... $ Allocated to: Specific reserves ....................................................... $ General reserves ........................................................ Balance, December 31, 2015 ........................................ $ Allocated to: Specific reserves ...................................................... $ General reserves ...................................................... Balance, December 31, 2016 ....................................... $ Loans receivable at December 31, 2015: (440) (92) 0 1,096 (105) (19) 18 990 262 (66) 0 1,186 (3,518) (936) 3,020 5,024 (427) 0 1,481 6,078 (1,788) (67) 730 4,953 (4) (131) 38 1,009 254 (105) 42 1,200 481 (108) 40 1,613 (3,036) (55) 2,085 1,203 114 (69) 193 1,441 400 (180) 490 2,151 223 767 990 296 5,782 6,078 370 830 1,200 120 1,321 1,441 235 951 1,186 248 4,705 4,953 434 1,179 1,613 71 2,080 2,151 (6,998) (1,214) 5,143 8,332 (164) (193) 1,734 9,709 (645) (421) 1,260 9,903 1,009 8,700 9,709 988 8,915 9,903 Individually reviewed for impairment ....................... $ Collectively reviewed for impairment ....................... Ending balance .......................................................... $ 2,203 88,742 90,945 2,204 245,149 247,353 977 63,438 64,415 415 69,691 70,106 5,799 467,020 472,819 Loans receivable at December 31, 2016: Individually reviewed for impairment .................. $ Collectively reviewed for impairment ................... Ending balance ........................................................ $ 1,107 102,148 103,255 1,880 297,200 299,080 940 72,343 73,283 643 84,533 85,176 4,570 556,224 560,794 41  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes the amount of classified and unclassified loans at December 31, 2016 and 2015: December 31, 2016 Classified Unclassified (Dollars in thousands) Single family .......................................... $ Commercial real estate: Special Mention Substandard Doubtful Loss 2,130 457 74 Total Total Total Loans 0 2,661 100,594 103,255 Real estate rental and leasing ........... Other .................................................. Consumer ............................................... Commercial business: 1,577 1,702 0 Transportation industry ................... Other .................................................. $ 0 3,973 7,709 3,156 7,187 531 4,065 2,916 19,985 0 0 110 0 0 184 0 0 299 4,733 8,889 940 148,610 153,343 136,848 145,737 72,343 73,283 0 0 4,065 6,889 299 28,177 6,444 10,509 67,778 74,667 532,617 560,794 December 31, 2015 Classified Unclassified (Dollars in thousands) Single family ........................................... $ Commercial real estate: Special Mention Substandard Doubtful Loss 2,889 189 55 Total Total Total Loans 0 3,133 87,812 90,945 Real estate rental and leasing .............. Other ................................................... Consumer ................................................ Commercial business: 1,910 917 0 4,827 9,473 639 Transportation industry ....................... Other ................................................... $ 4,082 841 7,939 18 1,515 19,361 0 0 52 0 0 107 0 0 286 6,737 10,390 977 118,639 125,376 111,587 121,977 64,415 63,438 0 0 286 4,100 2,356 27,693 9,349 5,249 58,401 60,757 445,126 472,819 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. 42  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The aging of past due loans at December 31, 2016 and 2015 is summarized as follows: (Dollars in thousands) 2016 30-59 Days Past Due 60-89 Days Past Due 90 Days or More Past Due Total Past Due Current Loans Total Loans Loans 90 Days or More Past Due and Still Accruing Single family ...................................... $ Commercial real estate: Real estate rental and leasing ... Other .......................................... Consumer ........................................... Commercial business: Transportation industry ........... Other .......................................... $ 2015 Single family ....................................... $ Commercial real estate: Real estate rental and leasing ...... Other ........................................... Consumer ............................................ Commercial business: Transportation industry ............... Other ........................................... $ 0 0 0 0 0 0 0 0 0 0 0 0 0 0 342 158 179 679 102,576 103,255 0 0 412 0 85 839 0 0 117 0 0 275 0 0 140 0 274 593 0 153,343 153,343 0 145,737 145,737 73,283 72,614 669 0 359 10,509 10,509 74,667 74,308 1,707 559,087 560,794 490 130 799 1,419 89,526 90,945 0 0 330 0 45 865 0 289 262 0 0 681 0 0 119 0 0 918 0 125,376 125,376 289 121,688 121,977 64,415 711 63,704 0 45 9,349 9,349 60,757 60,712 2,464 470,355 472,819 43  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Impaired loans include loans that are non-performing (non- accruing) and loans that have been modified in a TDR. The following table summarizes impaired loans and related allowances for the years ended December 31, 2016 and 2015: (Dollars in thousands) Loans with no related allowance recorded: December 31, 2016 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized Single family ............................................................ $ Commercial real estate: Real estate rental and leasing ............................. Other .................................................................... Consumer ................................................................. Commercial business: 217 217 40 26 312 122 1,771 312 Other .................................................................... 274 356 0 0 0 0 0 567 40 29 449 81 Loans with an allowance recorded: Single family ............................................................ Commercial real estate: Real estate rental and leasing ............................. Other .................................................................... Consumer ................................................................. Commercial business: 890 890 235 1,022 0 1,814 628 0 1,814 644 0 248 434 389 1,856 553 Other .................................................................... 369 921 71 423 Total: Single family ............................................................ Commercial real estate: Real estate rental and leasing ............................. Other .................................................................... Consumer ................................................................. Commercial business: Other .................................................................... $ 1,107 1,107 235 1,589 40 1,840 940 643 4,570 122 3,585 956 1,277 7,047 0 248 434 71 988 429 1,885 1,002 504 5,409 15 0 97 13 18 17 0 229 13 57 32 0 326 26 75 459 44  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) Loans with no related allowance recorded: December 31, 2015 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized Single family ............................................................. $ Commercial real estate: Real estate rental and leasing ................................ Other ..................................................................... Consumer .................................................................. Commercial business: Other ..................................................................... 1,251 1,251 44 25 475 184 1,706 476 0 79 0 0 0 0 0 943 46 5,462 387 36 Loans with an allowance recorded: Single family ............................................................. Commercial real estate: Real estate rental and leasing ................................ Other ..................................................................... Consumer .................................................................. Commercial business: 952 952 223 1,045 0 2,135 502 0 2,135 519 0 296 370 3 1,920 448 Other ..................................................................... 415 967 120 429 Total: Single family ............................................................. Commercial real estate: Real estate rental and leasing ................................ Other ..................................................................... Consumer .................................................................. Commercial business: Other ..................................................................... $ 2,203 2,203 223 1,988 44 2,160 977 415 5,799 184 3,841 995 1,046 8,269 0 296 370 49 7,382 835 120 1,009 465 10,719 60 7 96 10 0 14 0 32 20 20 74 7 128 30 20 259 At December 31, 2016, 2015 and 2014, non-accruing loans totaled $3.3 million, $4.2 million and $10.9 million, respectively, for which the related allowance for loan losses was $0.8 million, $0.7 million and $0.8 million, respectively. Non-accruing loans for which no specific allowance has been recorded because management determined that the value of the collateral was sufficient to repay the loan totaled $0.7 million, $1.4 million and $8.0 million at December 31, 2016, 2015, and 2014, respectively. Had the loans performed in accordance with their original terms, the Company would have recorded gross interest income on the loans of $0.6 million, $0.5 million and $0.9 million in 2016, 2015 and 2014, respectively. For the years ended December 31, 2016, 2015, and 2014, the Company recognized interest income on these loans of $0.4 million, $0.3 million and $0.2 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 TDR. 45  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes non-accrual loans at December 31, 2016 and 2015: The following table summarizes TDRs at December 31, 2016 and 2015: (Dollars in thousands) Single family ............................................................. $ Commercial real estate: Real estate rental and leasing ................................ Other...................................................................... Consumer ................................................................... Commercial business: 2016 2015 916 1,655 (Dollars in thousands) Single family ............................................................ $ Commercial real estate: 41 1,343 630 44 1,650 786 Other ..................................................................... Consumer .................................................................. Commercial business: 2016 2015 448 647 1,774 709 725 732 Other...................................................................... $ 343 3,273 46 4,181 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, 2016, 2015 and 2014, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.3 million, $2.5 million and $9.4 million, respectively. Had these loans been performing in accordance with their original terms throughout 2016, 2015, and 2014, the Company would have recorded gross interest income of $0.6 million, $0.4 million and $0.9 million, respectively. During 2016, 2015 and 2014, the Company recognized interest income of $0.4 million, $0.2 million and $0.3 million, respectively, on these loans. For the loans that were modified in 2016, $0.2 million were classified and performing, and $1.7 million were non- performing at December 31, 2016. Other ..................................................................... $ 369 415 3,300 2,519 As of December 31, 2016, the Bank had commitments to lend an additional $0.4 million to a borrower who has TDR and non-accrual loans. These additional funds are for the construction of single family homes with a maximum loan- to-value ratio of 75%. These loans are secured by the home under construction. There were commitments to lend additional funds of $1.5 million to this same borrower at December 31, 2015. 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 TDRs 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 TDRs 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 TDRs 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, 2016 and 2015: Year ended December 31, 2016 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Year ended December 31, 2015 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts Number of Contracts 4 $ 251 263 4 $ 476 (Dollars in thousands) Troubled debt restructurings: Single family ....................................... Commercial real estate: Other ............................................... Consumer ............................................ Commercial business: Other ............................................... Total .................................................... 1 18 2 25 $ 1,274 382 257 2,164 1,274 384 201 2,122 1 21 1 27 $ 209 527 44 1,256 46 478 209 530 44 1,261  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loans that were restructured within the 12 months preceding December 31, 2016 and 2015 and defaulted during the year are presented in the table below: (Dollars in thousands) Troubled debt restructurings that subsequently defaulted: Commercial real estate: Year ended December 31, 2016 Outstanding Number of Contracts Recorded Investment Year ended December 31, 2015 Outstanding Number of Contracts Recorded Investment Other ............................................................. Consumer ........................................................ Total ................................................................ 1 1 2 $ $ 183 4 187 0 0 0 $ $ 0 0 0 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. Loans that were non-accrual prior to modification remain non-accrual for at least six months following modification. Non-accrual TDR loans that have performed according to the modified terms for six months may be returned to accruing status. Loans to modification remain on accrual status after the modification as long as the loan continues to perform under the new terms. that were accruing prior TDRs are reviewed for impairment following the same methodology as other impaired loans. For loans that are collateral dependent, the value of the collateral is reviewed and additional reserves may be added as needed. Loans that are not collateral dependent may have additional reserves established if deemed necessary. The allocated allowance for TDRs was $0.6 million, or 6.2%, of the total $9.9 million in allowance for loan losses at December 31, 2016, and $0.5 million, or 5.2%, of the total $9.7 million in allowance for loan losses at December 31, 2015. Loans acquired in a business combination are segregated into two types: purchased performing loans with a discount attributable at least in part to credit quality and PCI loans with evidence of significant credit deterioration. Purchased performing loans are accounted for in accordance with ASC 310-20 “Nonrefundable Fees and Other Costs” as these loans do not have evidence of credit deterioration since origination. PCI loans are accounted for in accordance with ASC 310-30 “Receivables – Loans and Debt Securities Acquired with Deteriorated Credit Quality” as they display significant credit deterioration since origination. In accordance with ASC 310-30, for PCI loans, the difference between contractually required payments at acquisition and the cash flows expected to be collected is referred to as the non-accretable difference. This amount is not recognized as a yield adjustment or as a loss accrual or a valuation allowance. Furthermore, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loans when there is a reasonable expectation about the amount and timing of such cash flows. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through an adjustment of the yield on the loan over its remaining estimated life. Decreases in expected cash flows are recognized immediately as an impairment through the provision for loan losses. The following is additional information with respect to loans acquired through acquistions: (Dollars in thousands) Purchased Performing Loans: Balance at December 31, 2015 ........... $ Contractual Principal Receivable Accretable Difference Carrying Amount 18,539 (459) 18,080 Loans acquired during the period .......................................... 11,772 (211) 11,561 Change due to payments/refinances ................. Change due to loan charge-off .... Balance at December 31, 2016 ......... $ (13,413 ) (156 ) 16,742 340 (13,073) (158) (332) 16,410 (2) (Dollars in thousands) Purchased Credit Impaired Loans: Balance at December 31, 2015 ........... $ Contractual Principal Receivable Non- Accretable Difference Carrying Amount 555 (162) 393 Loans acquired during the period .......................................... 329 (37) 292 Change due to payments/refinances ................. Balance at December 31, 2016 ......... $ (449 ) 435 147 (52) (302) 383 47  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As a result of acquisitions, the Company has PCI loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount of those loans as of December 31, 2016 was $0.4 million. The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2016 and 2015 are presented in the following table. Amortization expense for intangible assets was $0.7 million, $0.6 million, and $0.5 million for the years ended December 31, 2016, 2015, and 2014, respectively. (Dollars in thousands) December 31, 2016 Gross Unamortized Carrying Accumulated Intangible Amount Amortization Assets Mortgage servicing rights . $ Core deposit intangible ...... Goodwill .............................. Total ..................................... $ 3,954 574 802 5,330 (2,350) (120) 0 (2,470) December 31, 2015 Mortgage servicing rights .... $ Core deposit intangible ........ Total ..................................... $ 3,739 421 4,160 (2,240) (28) (2,268) 1,604 454 802 2,860 1,499 393 1,892 The following amortization expense for amortizing intangible assets: the estimated future indicates table (Dollars in thousands) Year ended December 31, 2017 ......................................... $ 2018 ......................................... 2019 ......................................... 2020 ......................................... 2021 ......................................... Thereafter ................................. $ Mortgage Servicing Rights Core Deposit Intangible Total Amortizing Intangible Assets 440 350 297 215 162 140 1,604 99 99 99 99 47 11 454 539 449 396 314 209 151 2,058 No amortization expense relating to goodwill is recorded as generally accepted accounting principles do not allow goodwill to be amortized, but require that it be tested for impairment at least annually, or sooner, if there are indications that impairment may exist. Projections of amortization are based on asset balances and the interest rate environment that existed at December 31, 2016. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions. No material provision for loan losses was recognized during the period ended December 31, 2016 related to acquired loans as there was no significant change to the credit quality of the loans. NOTE 7 Accrued Interest Receivable Accrued interest receivable at December 31 is summarized as follows: (Dollars in thousands) Securities available for sale ....................................... $ Loans receivable ........................................................ $ 2016 2015 400 2,226 2,626 422 1,832 2,254 NOTE 8 Intangible Assets The Company’s intangible assets consist of core deposit intangibles, goodwill, and mortgage servicing rights. A summary of mortgage servicing rights activity for 2016 and 2015 is as follows: (Dollars in thousands) Mortgage servicing rights: Balance, beginning of year ........................................ $ Originations ............................................................... Amortization .............................................................. Balance, end of year .................................................. Valuation reserve ....................................................... Mortgage servicing rights, net ................................... $ Fair value of mortgage servicing rights .................... $ 2016 2015 1,499 706 (601) 1,604 0 1,604 2,952 1,507 547 (555) 1,499 0 1,499 2,590 All of the single family loans sold where the Company continues to service the loans are serviced for Federal National Mortgage Association the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced for FNMA at December 31, 2016: (FNMA) under Loan Principal Balance Weighted Average Interest Rate Weighted Average Remaining Term (months) Number of Loans (Dollars in thousands) Original term: 30 year fixed rate ................. $235,933 15 year fixed rate ................. 110,377 57 Adjustable rate ..................... 4.07% 3.12 2.75 305 1,953 140 1,163 2 293 48  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 Real Estate A summary of real estate at December 31, 2016 and 2015 is as follows: (Dollars in thousands) Real estate in judgment subject to Residential 2016 Commercial & Other Total Residential 2015 Commercial & Other Total redemption........................................ $ Real estate acquired through foreclosure ........................................ Real estate acquired through deed in lieu of foreclosure ............................. Allowance for losses ........................... $ 0 0 0 0 0 0 0 0 110 0 110 1,245 1,245 0 2,269 2,269 28 1,273 (662) 611 28 1,273 (662) 611 0 110 (62) 48 465 2,734 (737) 1,997 465 2,844 (799) 2,045 NOTE 10 Premises and Equipment A summary of premises and equipment at December 31, 2016 and 2015 is as follows: 2016 (Dollars in thousands) 2,021 Land ......................................................................... $ 8,930 Office buildings and improvements ........................ Furniture and equipment ......................................... 12,478 12,714 24,165 23,665 Accumulated depreciation ....................................... (15,942) (16,196) 7,469 2,021 9,666 2015 8,223 $ 49  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 Deposits Deposits and their weighted average interest rates at December 31, 2016 and 2015 are summarized as follows: 2016 2015 Weighted Average Rate Percent of Total Weighted Average Rate Percent of Total (Dollars in thousands) Noninterest checking ..................................................... NOW accounts ............................................................... Savings accounts ............................................................ Money market accounts ................................................. Amount 0.00% $ 158,024 92,670 0.07 74,238 0.08 165,179 0.25 490,111 Certificates by rate: 0-0.99% .......................................................................... 1-1.99% .......................................................................... 2-2.99% .......................................................................... 3-3.99% .......................................................................... Total certificates ............................................................ Total deposits ................................................................. 79,628 22,958 0 114 102,700 $ 592,811 0.61 0.20 26.7% 15.6 12.5 27.9 82.7 13.4 3.9 0.0 0.0 17.3 100.0% Amount 0.00% $ 151,737 0.04 82,425 0.09 66,421 0.22 159,959 460,542 85,391 12,611 733 110 0.53 98,845 0.17 $ 559,387 27.1% 14.7 11.9 28.6 82.3 15.3 2.3 0.1 0.0 17.7 100.0% At December 31, 2016 and 2015, the Company had $172.6 million and $183.0 million, respectively, of deposit accounts with balances of $250,000 or more. At December 31, 2016 and 2015, the Company had no certificate accounts that had been acquired through a broker. Certificates had the following maturities at December 31, 2016 and 2015: (Dollars in thousands) Remaining term to maturity 1-6 months .............................................................................................. $ 7-12 months ............................................................................................ 13-36 months .......................................................................................... Over 36 months ....................................................................................... $ 2016 2015 Weighted Average Rate Amount Weighted Average Rate Amount 32,418 25,424 36,111 8,747 102,700 0.36% $ 0.45 0.81 1.18 0.61 $ 36,040 26,019 28,706 8,080 98,845 0.44% 0.37 0.65 1.05 0.53 At December 31, 2016 and 2015, the Company had pledged mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $17.4 million and $28.0 million, respectively, as collateral for certain deposits. An additional $1.0 million of letters of credit from the Federal Home Loan Bank (FHLB) were pledged at December 31, 2016 and 2015 as collateral on certain Bank deposits. 50  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Interest expense on deposits is summarized as follows for the years ended December 31, 2016, 2015 and 2014: (Dollars in thousands) NOW accounts ............................................................................................... $ Savings accounts ............................................................................................ Money market accounts ................................................................................. Certificates ..................................................................................................... $ 2016 2015 2014 50 62 366 524 1,002 17 42 347 528 934 14 32 414 751 1,211 NOTE 12 FHLB Advances and Other Borrowings The Bank had no outstanding advances from the FHLB or borrowings from the Federal Reserve Bank of Minneapolis as of December 31, 2016 or December 31, 2015. At December 31, 2016 it had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $105.7 million. The Bank had the ability to draw additional borrowings of $104.7 million from the FHLB, based upon the mortgage loans and securities that were pledged at December 31, 2016, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of the Federal Reserve Bank of $85.8 million from Minneapolis, based upon the loans that were pledged to them as of December 31, 2016, subject to approval from the Board of Governors of the Federal Reserve System (FRB). At December 31, 2015 the Bank had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $96.3 million. The Bank had the ability to draw additional borrowings of $95.3 million from the FHLB, based upon the mortgage loans and securities that were pledged as of December 31, 2015, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of $73.5 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2015, subject to approval from the FRB. On December 15, 2014, the Company entered into a Loan Agreement with an unrelated third party, providing for a term loan of up to $10.0 million that was evidenced by a promissory note (the Note) with an interest rate of 6.50% per annum. The principal balance of the Note is payable in consecutive equal annual installments of $1.0 million on each anniversary of the date of the Loan Agreement, commencing on December 15, 2015, with the balance due on December 15, 2021. Provided that no default or event of default has occurred and is continuing, the Company may, at its option, elect to defer the payment of one installment of principal on the Note otherwise due prior to the maturity date, in which event such installment will become due and payable on the maturity date. The Company may voluntarily prepay the Note in whole or in part without penalty and the Company has prepaid $1.0 million of principal on the Note the required annual payments. The in addition outstanding loan balance was $7.0 million at December 31, 2016 and $9.0 million at December 31, 2015. to NOTE 13 Income Taxes Income tax expense for the years ended December 31, 2016, 2015 and 2014 is as follows: (Dollars in thousands) Current: 2016 2015 2014 Federal ................................................. $ State ..................................................... Total current ................................... 939 55 994 (87) (24) (111) 262 74 336 Deferred: Federal ................................................. State ..................................................... Total deferred ................................. Income tax expense ................................ $ 2,322 806 3,128 4,122 1,393 329 1,722 1,611 3,753 813 4,566 4,902 The reasons for the difference between the expected income tax expense utilizing the federal corporate tax rate of 34% and the actual income tax expense are as follows: (Dollars in thousands) Expected federal income tax expense ..... $ Items affecting federal income tax: State income taxes, net of federal 2016 2015 2014 3,560 1,553 4,176 income tax deduction ....................... Tax exempt interest ............................. Other, net ............................................. Income tax expense ................................ $ 622 (16) (44) 4,122 259 (44) (157) 1,611 698 (45) 73 4,902 51  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: 2016 2015 Allowances for loan and real estate losses ........... $ Deferred compensation costs ................................ Deferred ESOP loan asset ..................................... Nonaccruing loan interest ..................................... Federal net operating loss carryforward ............... State net operating loss carryforward ................... Alternative minimum tax credit carryforward ...... Capitalized other real estate owned expenses ...... Net unrealized loss on securities available for sale ..................................................................... Other...................................................................... Total gross deferred tax assets ......................... 4,186 262 704 313 0 1,366 118 56 4,169 235 710 361 1,805 2,255 500 530 542 91 142 155 7,638 10,862 Deferred tax liabilities: Deferred loan fees ................................................ Premises and equipment basis difference ............. Originated mortgage servicing rights ................... Federal tax liability on state net operating loss carryforwards ..................................................... Core deposit intangible ......................................... Other...................................................................... Total gross deferred tax liabilities .................... Net deferred tax assets ..................................... $ 100 126 636 676 74 79 1,691 5,947 247 139 594 779 105 325 2,189 8,673 The Company has no loss carryforwards and $14.3 million of state net operating loss carryforwards at December 31, 2016 that expire beginning in 2023. federal net operating included Retained earnings at December 31, 2016 approximately $8.8 million for which no provision for income taxes was made. This amount 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 and the probability that taxable income will be generated in future periods. Negative evidence includes the current general business and economic environments. Based upon this evaluation, the Company determined that no valuation allowance was required with respect to the net deferred tax assets at December 31, 2016 and 2015. tax assets. Positive evidence includes NOTE 14 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 under the Employee Retirement Income Security Act of 1974, as amended (ERISA), 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 a 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, 2016 because such information is not accumulated for each participating institution. As of June 30, 2016, the Pentegra DB Plan valuation report reflected that the Bank was obligated to make a contribution totaling $0.2 million which was expensed in 2016 and paid in the first quarter of 2017. Funded status (market value of plan assets divided by funding target) as of July 1 for the 2016, 2015, and 2014 plan years were 97.09%, 96.01%, and 97.98%, respectively. Market value of plan assets reflects contributions received through June 30, 2016. Total employer contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $163.1 million, $190.8 million, and $136.5 million for the plan years ended June 30, 2015, 2014 and 2013, 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. 52  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following contributions were paid by the Bank during the fiscal years ending December 31: (Dollars in thousands) 2016 Date Paid 10/15/16 .................. $ Total ....................... $ Amount Date Paid Amount Date Paid Amount 2015 2014 33* 10/15/2015 12/30/2015 33 $ $ 42 10/15/2014 151 12/30/2014 193 $ $ 46 164 210 * An additional contribution of $119,000 was accrued at December 31, 2016 and paid in the first quarter of 2017. 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 their annual salary or the maximum allowed by law, which was $18,000 for 2016 and 2015 and $17,500 for 2014. The Company matches 25% of each participant’s contributions up to a maximum of 8% of their 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 $0.2 million in 2016 and 2015 and $0.1 million in 2014. 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 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 in 1994. As a result of a merger with Marshalltown Financial Corporation (MFC), the ESOP borrowed $1.5 million in 1998 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 $0.5 million in 2016, 2015, and 2014. As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral based on the proportion of debt service paid in the year and then allocated to eligible employees. 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 common share computations. ESOP compensation expense was $0.3 million for each of the years ending December 31, 2016, 2015 and 2014. 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 December 31: Shares held by participants 2016 2015 2014 beginning of the year ...................... 334,277 336,024 347,887 24,317 (36,180) Shares allocated to participants ......... Shares distributed to participants ...... Shares held by participants end of 24,377 (18,784) 24,317 (26,064) year ................................................. 339,870 334,277 336,024 Unreleased shares beginning of the year ................................................. 304,123 328,440 352,757 Shares released during year ............... (24,317) Unreleased shares end of year ........... 279,746 304,123 328,440 Total ESOP shares end of year .......... 619,616 638,400 664,464 Fair value of unreleased shares at (24,377) (24,317) December 31 ................................... $4,895,555 3,512,621 4,072,656 In March 2001, the HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan) was adopted by the Company. In April 2009, this plan was superseded by the HMN Financial, Inc. 2009 Equity and Incentive Plan (2009 Plan) and options or restricted shares were no longer awarded from the 2001 Plan. As of December 31, 2016, all outstanding options issued under the 2001 Plan have expired. 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 is intended to aid in attracting, motivating and retaining key personnel and advisors, including non-employee directors, and to 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 53  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS for purposes of determining the total shares available for issuance under the 2009 Plan. As of December 31, 2016, there were 15,000 vested and 34,229 unvested options under the 2009 Plan that remain unexercised. These options expire 10 years from the date of grant and have a weighted average exercise price of $9.25. A summary of activities under all plans for the past three years is as follows: Shares Available For Grant Unvested Restricted Shares Options Outstanding Outstanding Unvested options Award Value/ Weighted Average Exercise Price Weighted Average Grant Date Fair Value Vesting Period Number 2001 Plan December 31, 2013 ...................... Forfeited/expired ...................... December 31, 2014 ...................... Forfeited/expired ...................... December 31, 2015 ...................... December 31, 2016 ..................... 2009 Plan December 31, 2013 ...................... Granted January 7, 2014 .......... Granted May 27, 2014 ............. Forfeited/expired ...................... Vested ...................................... December 31, 2014 ...................... Granted January 27, 2015 ........ Granted April 28, 2015 ............ Granted June 8, 2015 ............... Forfeited/expired ...................... Forfeited/expired ...................... Vested ...................................... December 31, 2015 ...................... Granted January 26, 2016 ..... Granted January 26, 2016 ..... Granted April 26, 2016 .......... Vested ...................................... December 31, 2016 ..................... Total all plans ............................. 0 0 0 0 0 0 121,053 (28,627) (26,561) 30,540 0 96,405 (11,903) (3,158) (398) 395 15,000 0 96,341 (4,087) (34,229) (3,149) 0 54,876 54,876 0 0 0 0 0 0 45,540 $ (30,540) 15,000 (15,000) 0 0 28.21 27.33 30.00 30.00 0.00 0.00 0 0 0 0 0 0 101,806 23,856 22,134 0 (62,938) 84,858 9,919 2,632 332 (329) 0 (58,526) 38,886 3,406 0 2,624 (24,320) 20,596 20,596 15,000 $ 0 0 0 0 15,000 0 0 0 0 0 0 15,000 0 34,229 0 0 49,229 49,229 $ 4.77 N/A N/A 4.77 N/A N/A N/A 4.77 N/A 11.21 N/A 9.25 9.25 3,000 $ 0 0 0 (3,000 ) 0 0 0 0 0 0 0 0 0 34,229 0 0 34,229 34,229 $ 3 years 3 years 3 years 1 year 1 year 3 years 3 years 1 year 4.41 4.41 4.04 4.04 4.04 54  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes information about stock options outstanding at December 31, 2016: Date of Grant May 6, 2009 ............................ $ 4.77 January 26, 2016 ..................... $ 11.21 Exercise Price Number Outstanding 15,000 34,229 49,229 Weighted Average Remaining Contractual Life in Years 2.4 9.1 Number Exercisable 15,000 0 15,000 Number Unexercisable Unrecognized Compensation Expense 0 $ 34,229 34,229 $ 0 59,528 59,528 Weighted Average Years Over Which Unrecognized Compensation will be Recognized N/A 2.1 The Company will issue shares from treasury stock upon the exercise of outstanding options. In accordance with ASC 718, the Company recognized compensation expense relating to the stock options granted in 2016 over the vesting period. The amount of the expense was determined under the fair value method. There were no options granted in 2015 or 2014. The fair value for each option grant is estimated on the date of the grant using a Black Scholes option valuation model. The assumptions used in determining the fair value of the options granted during 2016 are as follows: Risk-free interest rate ............................................................ Expected life .......................................................................... Expected volatility ................................................................. Expected dividends ................................................................ 2016 2.10% 10 years 22.83% 0.00% NOTE 15 Earnings per Common Share The following table reconciles the weighted average shares outstanding and net income for basic and diluted earnings per common share: (Dollars in thousands, except per share data) Weighted average number of common shares outstanding used in basic 2016 Year ended December 31, 2015 2014 earnings per common share calculation ....................................................... 4,180,994 4,127,453 4,060,404 Net dilutive effect of : Options and warrants ................................................................................. Restricted stock awards .............................................................................. 553,386 13,367 513,505 34,959 507,856 55,783 Weighted average number of common shares outstanding adjusted for effect of dilutive securities .......................................................................... 4,747,747 4,675,917 4,624,043 Net income ..................................................................................................... $ Dividends on preferred stock ......................................................................... Net income available to common shareholders .............................................. $ Basic earnings per common share .................................................................. $ Diluted earnings per common share ............................................................... $ 6,350 0 6,350 1.52 1.34 2,956 (108) 2,848 0.69 0.61 7,379 (1,710 ) 5,669 1.40 1.23 55  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16 Stockholders' Equity The Company did not repurchase any shares of its common stock or pay any dividends on its common stock during 2016, 2015 or 2014. 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 Fixed Rate Cumulative Perpetual Preferred Stock, Series A (Preferred Stock) to the United Stated Department of Treasury (Treasury). The Preferred Stock had 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 Warrant). The transaction was part of the Treasury’s Capital Purchase Program under the Emergency Economic Stabilization Act of 2008. On February 17, 2015, the Company redeemed the final 10,000 shares of the outstanding Preferred Stock. On May 21, 2015, the Treasury sold the Warrant at an exercise price of $4.68 to three unaffiliated third party investors for an aggregate purchase price of $5.7 million. Two of the investors received a warrant to purchase 277,777.67 shares and one investor received a warrant to purchase 277,777.66 shares. All of the warrants were still outstanding as of December 31, 2016 and may be exercised at any time prior to their expiration date of December 23, 2018. The Company received no proceeds from this transaction and it had no effect on the Company’s capital, financial condition or results of operations. 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 17 Regulatory Capital Effective January 1, 2015 the capital requirements of the Company and the Bank were changed to implement the regulatory requirements of the Basel III capital reforms. The Basel III requirements, among other things, (i) apply a strengthened set of capital requirements to the Bank (the Company is exempt, pursuant to the Small Bank Holding Company Policy Statement (Policy Statement) described below), including requirements relating to common equity as a component of core capital, (ii) implement a “capital conservation buffer” against risk and a higher minimum tier 1 capital requirement, and (iii) revise the rules for calculating risk-weighted assets for purposes of such requirements. The rules made corresponding revisions to the prompt corrective action framework and include the new capital ratios and buffer requirements which will be phased implementation scheduled for January 1, 2019. 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 their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. incrementally, with full in from The FRB amended its Policy Statement, to exempt small bank holding companies the above capital requirements, by raising the asset size threshold for determining applicability from $500 million to $1 billion. The Policy Statement was also expanded to include savings and the Policy Statement’s qualitative requirements for exemption. The Company met the qualitative exemption requirements, and therefore, is exempt from the above capital requirements. loan holding companies that meet Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table and defined in the regulation) of Common Equity Tier 1 capital to risk weighted assets, Tier 1 capital to adjusted total assets, Tier 1 capital to risk weighted assets, and total capital to risk weighted assets. 56  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2016 and 2015, 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 Amount Percent of Assets(1) Required to be Adequately Capitalized Percent of Assets(1) Amount Excess Capital Amount Percent of Assets(1) To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Percent of Assets(1) (Dollars in thousands) December 31, 2016 Common equity tier 1 capital ........................... $ 77,634 77,634 77,634 84,900 Tier 1 leverage ................ Tier 1 risk-based capital . Total risk-based capital .. 13.42 % $ 26,032 26,876 11.55 34,709 13.42 46,278 14.68 4.50% $ 51,602 50,758 4.00 42,925 6.00 38,622 8.00 8.92% $ 37,601 33,595 7.55 46,278 7.42 57,848 6.68 6.50% 5.00 8.00 10.00 December 31, 2015 Common equity tier 1 capital ............................ $ 71,520 71,520 71,520 77,934 Tier 1 leverage ................. Tier 1 risk-based capital ... Total risk-based capital .... 14.08 % $ 22,854 24,971 11.46 30,473 14.08 40,630 15.35 4.50% $ 48,666 46,549 4.00 41,047 6.00 37,304 8.00 9.58% $ 33,012 31,213 7.46 40,630 8.08 50,788 7.35 6.50% 5.00 8.00 10.00 (1) Based upon the Bank’s adjusted total assets for the purpose of the Tier 1 leverage capital ratio and risk-weighted assets for the purpose of the risk- based capital ratios. Beginning in 2016, the Bank must maintain a capital conservation buffer composed of common equity tier 1 capital above its minimum risk-based capital requirements in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. For 2016, the capital conservation buffer is 0.625%. The buffer amount will increase incrementally each year until 2019 when the entire 2.50% capital conservation buffer will be fully phased in. Management believes that, as of December 31, 2016, the Bank’s capital ratios were in excess of those quantitative capital ratio standards applicable on that date, set forth under the prompt corrective action regulations, including the capital conservation buffer described above. However, there can be no assurance that the Bank will continue to maintain such status in the future. The Office of the Comptroller of the Currency has extensive discretion in its supervisory and enforcement activities, and can further adjust the requirement to be well-capitalized in the future. 57  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18 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 commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of these instruments reflect the extent of involvement by the Company. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contract amount of these commitments. The Company uses in making commitments as it does for on-balance sheet instruments. the same credit policies collateralized primarily with commercial real estate mortgages. Draws on standby letters of credit would be initiated by the secured party under the terms of the underlying obligation. 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. The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2016, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: Payments Due by Period (Dollars in thousands) Contractual Obligations: Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years December 31, Contract Amount 2016 2015 Total borrowings ............... $ 7,000 1,000 2,000 4,000 Annual rental commitments 0 under non-cancellable operating leases ................ 5,856 843 1,452 1,380 2,181 $12,856 1,843 3,452 5,380 2,181 (Dollars in thousands) Financial instruments whose contract amount represents credit risk: Commitments to originate, fund or purchase 7,587 loans: Single family mortgages .................................. $ 4,292 Commercial real estate mortgages ................... 33,953 18,834 1,310 Non-real estate commercial loans .................... Undisbursed balance of loans closed ............... 39,841 44,082 Unused lines of credit ....................................... 100,893 96,354 1,077 Letters of credit ................................................ Total commitments to extend credit ..................... $ 184,596 165,949 8,071 Forward commitments .......................................... $ 9,595 1,902 420 Commitments to extend credit are agreements to lend to a customer, at the customer’s request, 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 following the closing of the loan 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 26 months and totaled $1.9 million at December 31, 2016 and $1.0 million at December 31, 2015. The letters of credit are 58 Amount of Commitments Expiring by Period Other Commercial Commitments: Commercial lines of credit ................................. $50,229 26,523 9,282 9,414 5,010 Commitments to lend ........ 31,831 9,797 4,736 7,220 10,078 0 Standby letters of credit ..... 1,902 1,575 $83,962 37,895 14,345 16,634 15,088 327 0 NOTE 19 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 into loans 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 the secondary market. The to sell commitments to originate and sell loans are derivatives that are recorded at fair value. As a result of marking these derivatives to fair value for the period ended December 31, 2016, the Company recorded an increase in other liabilities of $11,000, an increase in other assets of $30,000 and a net gain on the sale of loans of $19,000. As a result of marking these derivatives to fair value for the period ended December 31, 2015, the Company recorded a decrease in  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS other liabilities of $7,000, an increase in other assets of $20,000 and a net gain on the sale of loans of $27,000. liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: As of December 31, 2016 and 2015, 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 for the period ended December 31, 2016, the Company recorded a decrease in other liabilities of $14,000 and a net gain on the sale of loans of $14,000. As a result of marking these loans for the period ended December 31, 2015, the Company recorded an increase in other liabilities of $3,000, and a net loss on the sales of loans of $3,000. NOTE 20 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 Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access. Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of December 31, 2016 and 2015. Carrying Value at December 31, 2016 (Dollars in thousands) Securities available for sale ....................................................... $ Mortgage loan commitments ..................................................... Total ............................................................................................ $ Total Level 1 78,477 66 78,543 Level 3 Level 2 0 0 0 78,477 66 78,543 Carrying Value at December 31, 2015 (Dollars in thousands) Securities available for sale .......................................................... $ 111,974 Mortgage loan commitments ........................................................ 36 Total ............................................................................................. $ 112,010 Total Level 1 Level 2 Level 3 0 0 0 111,974 36 112,010 0 0 0 0 0 0 59  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 2016 and 2015 that were still held at December 31, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at December 31, 2016 and 2015. Carrying Value at December 31, 2016 (Dollars in thousands) Loans held for sale ...................................................... $ Mortgage servicing rights, net ................................... Loans (1) ........................................................................ Real estate, net (2) ......................................................... Total ............................................................................. $ Total Level 1 2,009 1,604 3,582 611 7,806 Level 3 Level 2 0 0 0 0 0 2,009 1,604 3,582 611 7,806 Carrying Value at December 31, 2015 (Dollars in thousands) Loans held for sale ........................................................ $ Mortgage servicing rights, net ....................................... Loans (1) ........................................................................ Real estate, net (2) .......................................................... Total .............................................................................. $ Total Level 1 Level 2 Level 3 3,779 1,499 4,790 2,045 12,113 0 0 0 0 0 3,779 1,499 4,790 2,045 12,113 Year Ended December 31, 2016 Total gains (losses) 0 0 0 0 0 14 0 (380) (197) (563) Year Ended December 31, 2015 Total gains (losses) 0 0 0 0 0 (3) 0 (373) (262) (638) (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 on foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets. NOTE 21 Fair Value of Financial Instruments ASC 825, Disclosures about Fair Values of Financial Instruments, requires disclosure of the 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, 2016 and 2015 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 conditions, economic current factors. The estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based only on existing financial instruments without attempting to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates. 60  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The estimated fair value of the Company's financial instruments are shown below. Following the table, there is an explanation of the methods and assumptions used to estimate the fair value of each class of financial instruments. December 31, 2016 Fair value hierarchy December 31, 2015 Carrying amount Estimated fair value Level 1 Level 2 Level 3 Contract amount Carrying amount Estimated fair value Contract amount (Dollars in thousands) Financial assets: Cash and cash equivalents .......... $ 27,561 Securities available for sale ........ 78,477 Loans held for sale ...................... 2,009 Loans receivable, net .................. 551,171 FHLB stock ................................. 770 Accrued interest receivable ......... 2,626 27,561 27,561 78,477 2,009 552,395 770 2,626 78,477 2,009 552,395 770 2,626 3,779 39,782 39,782 111,974 111,974 3,779 463,185 458,539 691 2,254 691 2,254 Financial liabilities: Deposits ....................................... 592,811 FHLB advances and other borrowings ............................... Accrued interest payable ............. 7,000 236 593,297 593,297 559,387 558,731 7,018 236 7,018 236 9,000 242 9,000 242 Off-balance sheet financial instruments: Commitments to extend credit .... Commitments to sell loans.......... 66 (22 ) 66 (22) 184,596 9,595 36 (26) 36 165,949 8,071 (26) Cash and Cash Equivalents The carrying amount of cash and cash equivalents approximates their fair value. Securities Available for Sale The fair values of securities were based upon quoted market prices. Loans Held for Sale The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity. Loans Receivable The fair values of loans receivable were estimated for groups of loans with similar characteristics. The fair value of the loan portfolio, with the exception of the adjustable rate portfolio, was calculated by discounting the scheduled cash flows through the estimated maturity using anticipated prepayment speeds and using discount rates that reflect the credit and interest rate risk inherent in each loan portfolio. The fair value of the adjustable loan portfolio was estimated by grouping the loans with similar characteristics and comparing the characteristics of each group to the prices quoted for similar types of loans in the secondary market. FHLB Stock The carrying amount of FHLB stock approximates its fair value. Accrued Interest Receivable The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns. Deposits The fair value of demand deposits, savings accounts and certain money market account deposits is 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. 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. FHLB Advances and Other Borrowings The fair values of advances and borrowings 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 approximates its fair value since it is short-term in nature. interest payable 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. 61  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 22 HMN Financial, Inc. Financial Information (Parent Company Only) The following are the condensed financial statements for the parent company only as of December 31, 2016 and 2015 and for the years ended December 31, 2016, 2015 and 2014. (Dollars in thousands) Condensed Balance Sheets Assets: Cash and cash equivalents .......................................................................................... $ Investment in subsidiaries ........................................................................................... Prepaid expenses and other assets .............................................................................. Deferred tax asset, net ................................................................................................. Total assets ......................................................................................................... $ Liabilities and Stockholders' Equity: Other borrowed money ............................................................................................... $ Accrued expenses and other liabilities ....................................................................... Total liabilities ................................................................................................... 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, 4,639,739 and 4,645,769 shares ........................................... Total stockholders' equity .................................................................................. Total liabilities and stockholders' equity ........................................................... $ Condensed Statements of Income Interest income ............................................................................................................ $ Interest expense ........................................................................................................... Equity income of subsidiaries ..................................................................................... Compensation and benefits ......................................................................................... Occupancy ................................................................................................................... Data processing ........................................................................................................... Professional services ................................................................................................... Other............................................................................................................................ Income before income tax benefit ..................................................................... Income tax benefit ...................................................................................................... Net income ......................................................................................................... $ Condensed Statements of Cash Flows Cash flows from operating activities: Net income ................................................................................................................. $ Adjustments to reconcile net income to cash used by operating activities: Equity income of subsidiaries ................................................................................ Deferred income tax benefit (expense) .................................................................. Earned employee stock ownership shares priced above original cost ................... Stock option compensation .................................................................................... Amortization of restricted stock awards ................................................................ Decrease in unearned ESOP shares ....................................................................... Decrease (increase) in other assets ......................................................................... Decrease in other liabilities .................................................................................... Other, net ................................................................................................................ Net cash used by operating activities ................................................................ Cash flows from investing activities: Decrease in loans receivable, net ........................................................................... Net cash provided by investing activities .......................................................... Cash flows from financing activities: Redemption of preferred stock ............................................................................... Dividends to preferred stockholders ...................................................................... Proceeds from borrowings ..................................................................................... Repayments of borrowings .................................................................................... Dividends received from Bank .............................................................................. Net cash provided by financing activities .............................................................. Increase in cash and cash equivalents .................................................................... Cash and cash equivalents, beginning of year ................................................................ Cash and cash equivalents, end of year ........................................................................... $ 62 2016 2015 2014 3,314 78,108 44 756 82,222 7,000 (697) 6,303 91 50,566 86,886 (820) (2,223) (58,581) 75,919 82,222 0 (589) 7,148 (264) (30) (6) (138) (329) 5,792 (558) 6,350 2,564 74,565 33 1,000 78,162 9,000 (483) 8,517 91 50,388 80,536 (214) (2,417) (58,739) 69,645 78,162 1 (571) 3,629 (269) (30) (6) (119) (216) 2,419 (537) 2,956 6,350 2,956 (7,148) 244 80 79 177 194 (11) (214) (1) (250) 0 0 0 0 0 (2,000) 3,000 1,000 750 2,564 3,314 (3,629) 22 57 0 447 193 (23) (692) 1 (668) 900 900 (10,000) (225) 10,000 (1,000) 3,000 1,775 2,007 557 2,564 1 0 7,644 (233 ) (24 ) (6 ) (165 ) (374 ) 6,843 (536 ) 7,379 7,379 (7,644 ) (92 ) 53 1 240 194 69 (420 ) 0 (220 ) 100 100 (16,000 ) (5,964 ) 0 0 22,500 536 416 141 557  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 23 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 and assets for each of the Company’s reportable segments. (Dollars in thousands) Home Federal Savings Bank Other Eliminations Consolidated Total At or for the year ended December 31, 2016: Interest income – external customers .............................................. $ Non-interest income – external customers ...................................... Intersegment interest income ........................................................... Intersegment non-interest income ................................................... Interest expense ................................................................................. Non-interest expense ......................................................................... Income tax expense (benefit) ............................................................ Net income ......................................................................................... Total assets ......................................................................................... At or for the year ended December 31, 2015: Interest income – external customers .................................................. $ Non-interest income – external customers .......................................... Intersegment interest income .............................................................. Intersegment non-interest income ....................................................... Interest expense ................................................................................... Non-interest expense ........................................................................... Income tax expense (benefit) .............................................................. Net income .......................................................................................... Total assets .......................................................................................... At or for the year ended December 31, 2014: Interest income – external customers .................................................. $ Non-interest income – external customers .......................................... Intersegment interest income .............................................................. Intersegment non-interest income ....................................................... Interest expense ................................................................................... Non-interest expense ........................................................................... Income tax expense (benefit) .............................................................. Net income .......................................................................................... Total assets .......................................................................................... 27,349 8,201 0 210 1,004 23,572 4,680 7,148 681,257 21,453 7,653 0 204 937 22,760 2,148 3,629 642,151 20,613 7,284 0 180 1,213 20,781 5,438 7,644 576,397 0 0 1 7,148 589 768 (558) 6,350 82,222 0 0 1 3,629 571 640 (537) 2,956 78,162 0 0 2 7,644 0 802 (536) 7,379 76,221 0 0 (1) (7,358) 0 (210) 0 (7,148) (81,456) 0 0 (1) (3,833) (1) (204) 0 (3,629) (77,152) 0 0 (2) (7,824) (2) (180) 0 (7,644) (75,192) 27,349 8,201 0 0 1,593 24,130 4,122 6,350 682,023 21,453 7,653 0 0 1,507 23,196 1,611 2,956 643,161 20,613 7,284 0 0 1,211 21,403 4,902 7,379 577,426 63 64 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: Year Ended December 31, 2016 2015 2014 FHLB advances ........................................................................................ $ FHLB short-term advances ...................................................................... 15,500 15,500 Average Balance: FHLB advances ........................................................................................ FHLB short-term advances ...................................................................... 468 468 16,000 16,000 551 551 0 0 0 0 See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and other borrowings. 65  December 31, 2016 September 30, 2016 June 30, 2016 6,711 420 6,291 (374) 6,665 874 296 770 257 2,197 3,748 (161) 1,047 308 386 877 6,205 2,657 973 1,684 0 1,684 0.40 0.35 6,954 404 6,550 80 6,470 901 280 656 310 2,147 3,723 (11) 998 299 252 940 6,201 2,416 1,002 1,414 0 1,414 0.34 0.30 0.99% 8.93 11.07 3.89 0.84% 7.55 11.10 4.10 682,023 1,005 77,472 2,009 551,171 592,811 7,000 75,919 685,667 1,306 78,810 5,879 540,583 592,243 9,000 74,834 7,159 395 6,764 381 6,383 873 271 705 253 2,102 3,598 (75 ) 1,006 281 368 855 6,033 2,452 974 1,478 0 1,478 0.35 0.31 0.91 % 8.23 11.07 4.36 653,385 1,641 73,924 3,159 530,425 563,060 9,000 73,337 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 ........... Non-interest income: Fees and service charges ................................................... Loan servicing fees ........................................................... Gain on sales of loans ....................................................... Other ................................................................................. Total non-interest income ............................................. Non-interest expense: Compensation and benefits ............................................... (Gains) losses on real estate owned ................................... Occupancy and equipment ................................................ Data processing ................................................................. Professional services ......................................................... Other ................................................................................. Total non-interest expense ............................................ Income before income tax expense ................................... Income tax expense ............................................................... Net income ........................................................................ Preferred stock dividends .................................................. Net income available to common stockholders ................. $ Basic earnings per common share ......................................... $ Diluted earnings 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 ................................................................................ FHLB advances and other borrowings .................................. Stockholders’ equity ............................................................. (1) Annualized (2) Net interest income divided by average interest-earning assets 66  March 31, 2016 December 31, 2015 September 30, 2015 June 30, 2015 March 31, 2015 6,525 374 6,151 (732) 6,883 779 261 487 228 1,755 3,695 (349) 990 273 251 831 5,691 2,947 1,173 1,774 0 1,774 0.43 0.38 1.12% 10.12 11.11 4.09 638,156 1,984 103,844 4,467 490,260 551,506 9,000 71,687 6,109 393 5,716 75 5,641 827 268 536 330 1,961 3,448 97 981 267 325 878 5,996 1,606 516 1,090 0 1,090 0.26 0.23 0.69% 6.19 11.70 3.80 5,390 397 4,993 (56) 5,049 863 262 613 493 2,231 3,299 168 936 254 273 1,039 5,969 1,311 491 820 0 820 0.20 0.18 0.53% 4.77 11.91 3.44 5,070 391 4,679 (183) 4,862 844 257 530 236 1,867 3,540 65 926 268 293 708 5,800 929 344 585 0 585 0.14 0.13 0.42% 3.50 12.30 3.56 643,161 618,917 564,001 2,283 109,691 3,779 463,185 559,387 9,000 69,645 7,080 138,258 5,153 432,174 531,586 10,000 68,710 2,115 123,326 5,968 368,110 481,476 10,000 67,494 4,884 326 4,558 0 4,558 782 261 285 268 1,596 3,448 (112) 879 231 217 770 5,433 721 260 461 (108) 353 0.09 0.08 0.33% 2.60 12.62 3.42 565,487 2,471 151,674 2,663 360,370 483,323 10,000 66,775 67 COMMON STOCK INFORMATION The common stock of the Company is listed on the Nasdaq Stock Market (Nasdaq) under the symbol HMNF. As of December 31, 2016, the Company had 9,128,662 shares of common stock issued and 4,639,739 shares in treasury stock. As of December 31, 2016, there were 572 stockholders of record and 1,036 estimated beneficial stockholders. The following table presents the stock price information for the Company as furnished by Nasdaq for each quarter for the last two fiscal years. On February 13, 2017, the last reported sale price of shares of our common stock on the Nasdaq was $18.50 per share. The Company has not paid a dividend on its common stock during the two year period ending December 31, 2016 and no common stock dividends are anticipated to be paid in 2017. See “Liquidity and Capital Resources – Dividends” in the “Management Discussion and Analysis” section of this annual report for a description of restrictions on the ability of the Company and the Bank to pay dividends. December 31, 2016 September 30, 2016 For the Quarter Ended March 31, 2016 December 31, 2015 June 30, 2016 September 30, 2015 June 30, 2015 March 31, 2015 HIGH ........... $ LOW ............ CLOSE ........ 18.55 13.58 17.50 15.00 13.25 14.16 14.44 11.25 13.58 11.80 10.81 11.26 12.06 11.06 11.55 12.06 10.88 11.51 12.61 10.18 11.79 12.92 11.46 12.10 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, 2011 and that all dividends were reinvested. Index HMN Financial, Inc. ........................... NASDAQ Composite .......................... SNL Bank NASDAQ Index ................ 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15 100.00 100.00 100.00 179.30 117.45 119.19 545.97 164.57 171.31 640.50 188.84 177.42 596.59 201.98 191.53 12/31/16 903.93 219.89 265.56 68 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 25, 2017 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 CliftonLarsonAllen LLP 220 South Sixth Street, Suite 300 Minneapolis, MN 55402-1436 INVESTOR INFORMATION AND FORM 10-K HMN’s Form 10-K, filed with the Securities and Exchange Commission, is available without charge upon written request from: HMN Financial, Inc. Attn: Cindy Hamlin, 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 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 Chief Executive Officer Ambient Clinical Analytics MICHAEL A. BUE Retired President and Chief Executive Officer Security State Bank of Lewiston BRADLEY C. KREHBIEL President and Chief Executive Officer HMN and Home Federal Savings Bank BERNARD R. NIGON Retired Audit Partner with RSM US LLP (formerly McGladrey & Pullen, LLP) DR. WENDY S. SHANNON Assistant Professor, Winona State University DR. PATRICIA S. SIMMONS Retired Professor of Pediatric and Adolescent Medicine, Mayo Clinic College of Medicine MARK E. UTZ Attorney at law, Wendland Utz, Ltd. HANS K. ZIETLOW Director of Real Estate for Kwik Trip, Inc. 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 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 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 Kasson 203 West Main Kasson, MN 55944 (507) 634-7022 502 South Mantorville Avenue Kasson, MN 55944 (507) 634-4141 La Crescent 208 South Walnut La Crescent, 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 100 1st Avenue Bldg., Suite 200 Rochester, MN 55902 (507) 280-7256 2048 Superior Drive NW, Suite 400 Rochester, MN 55901 (507) 226-0800 Spring Valley 715 North Broadway Spring Valley, MN 55975 (507) 346-9709 Winona 175 Center Street Winona, MN 55987 (507) 453-6460 LOAN PRODUCTION OFFICES Sartell 50 14th Ave E, Suite 100 Sartell, MN 56377 (320) 654-4020 Owatonna 1850 Austin Road, Suite 103 Owatonna, MN 55060 (507) 413-6420 Mankato 100 Warren Street, Suite 300 Mankato, MN 56001 (507) 455-0174 Delafield 3960 Hillside Drive, Suite 206 Delafield, WI 53018 (262) 337-9511 1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 • www.hmnf.com 2016 Annual Report 2016_AnnualReport_full.indd 1 2/15/2017 1:19:39 PM 

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