HMN Financial Inc.
Annual Report 2017

Plain-text annual report

1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 • www.hmnf.com 2017 ANNUAL REPORT 2017_AnnualReport_full.indd 1 2/6/2018 1:02:18 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 ..................................................................................................................................... 25 Notes to Consolidated Financial Statements ....................................................................................................................... 29 Report of Independent Registered Public Accounting Firm ............................................................................................... 63 Other Financial Data ........................................................................................................................................................... 64 Common Stock Information................................................................................................................................................ 65 Selected Quarterly Financial Data ...................................................................................................................................... 66 Inside Back Cover Corporate and Shareholder Information ................................................................................................... Inside Back Cover Directors and Officers .............................................................................................................................. HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal Savings Bank operates 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; two loan origination offices in Minnesota located in Sartell and Owatonna; and one loan origination office in Delafield, Wisconsin. At or For the Year Ended December 31, Percentage 2017 2016 Change 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 ................................................................................ $ 27,680 1,797 25,883 (523) 26,406 3,354 1,202 2,138 960 7,654 25,254 8,806 4,402 4,404 Per Common Share Information: Earnings per common share and common share equivalents: Basic ........................................................................................... $ Diluted ....................................................................................... 1.04 0.90 Stock price (for the year): High ........................................................................................... $ Low ............................................................................................ Close .......................................................................................... Book value per common share .......................................................... Closing price to book value ............................................................... 19.45 16.60 19.10 17.97 106.29% 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 .................................................................................. 0.63% 5.52 3.86 3.62 11.43 11.18 0.52 75.30 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 1.52 1.34 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 1.2% 12.8 0.5 18.9 0.0 (2.1) 8.5 (18.3) (8.4) (6.7) 4.7 (15.9) 6.8 (30.6) (34.4)% (36.6) (6.1) (1.1) 3.3 0.4 (8.8) 6.0 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 .............................................................. December 31, Percentage 2017 2016 Change 722,685 77,472 1,837 585,931 635,601 0 80,818 12.45% 10.68 12.45 13.71 682,023 78,477 2,009 551,171 592,811 7,000 75,919 13.42 % 11.55 13.42 14.68 6.0% (1.3) (8.6) 6.3 7.2 (100.0) 6.5 (7.2)% (7.5) (7.2) (6.6) 1 LETTER TO SHAREHOLDERS AND CLIENTS I am pleased to present you with our 2017 Annual Report. Our focus during the year to improve core balance sheet and earnings growth is reflected throughout this report. Balance Sheet By year-end 2017, total assets had grown by $41 million. This growth was comprised primarily of increases in our highest yielding assets- mortgage and commercial real estate loans. By design, our investment portfolio remained level throughout the year as management worked to deploy excess liquidity. It is important to note that this loan growth reflects loans made and serviced directly by Home Federal, and not loans purchased from third party originators. While we regularly participate with other community banks, the outstanding balances of participations purchased declined $8.5 million during the year to $20.1 million. We believe organic loan growth offers us the best opportunity to develop long-term multi-product relationships with our clients. Deposits also exhibited growth during the year with commercial accounts leading the way increasing by $35.9 million. Retail accounts over the same period grew by $6.9 million. This growth can be attributed to management’s efforts to solicit more local deposits and the improving financial condition of our commercial clients. We have also experienced success in attracting new clients with special affiliation accounts like our Jubilee Program, for clients 55 and older and obtaining larger deposit relationships by providing insurance coverage for deposits over FDIC limits using the insured cash sweep (ICS) and Certificate of Deposit Account Registry Service (CDARS) programs offered through a third party vendor. During the year, we prepaid the remaining $7 million balance of the $10 million term loan secured in 2014 to repurchase the remaining HMN Preferred shares issued in connection with the Troubled Asset Relief Program (TARP). At a rate of 6.5%, this obligation represented our single most expensive source of funds and was an excellent opportunity to deploy excess balance sheet liquidity and capital of the Company. In spite of our growth, our capital level remains strong. While it might appear to some that we hold more capital than is necessary, I firmly believe that our disciplined approach to capital planning will position our Company to capitalize on growth opportunities as they arise- in good times or in bad-, prudently fund organic growth and weather adverse economic conditions when they arise. Income Statement Net income for 2017 was $4.4 million, a decline of $2.0 million from 2016. The decline in income between the periods is partially because of the $1.1 million increase in income tax expense as a result of tax reform legislation that was enacted in the fourth quarter of 2017. The decline relating to our core operating results was centered in lower commercial loan sale gains- a result of increased competition from conventional lenders- and a decline in gain on sale of non-performing assets. It is important to note that as our asset quality has improved, the opportunities to recognize yield enhancements as problem assets are collected have diminished as well. These assets include our own recession-era legacy assets as well as purchased assets that are collected in excess of our book value. The continuing low interest rate environment caused a 0.23% decline in our yield on average earning assets. Fortunately, the aforementioned loan growth along with a nominal increase in our cost of funds enabled us to report higher net interest income compared with the prior year. Asset Quality Non-performing asset levels remained flat during the year- further evidence of our improved asset quality and more normalized operations. Our past due ratio as of year-end remained very low at 0.30%, while our reserve for problem loans remained a healthy 1.57% of total loans. Our improved asset quality allowed us to record a reverse provision for loan losses during the year of $0.5 million. 2 Markets I continue to be pleased by our growth in nearly all of our markets. While some of this growth can be attributed to the overall improvement in the economy, we believe it is a reflection of our approach to community banking, one which empowers qualified managers to make local decisions in their own markets. Late in the year, we announced plans to open our first new branch in over ten years. Located in Owatonna, Minnesota, this branch is the logical next step for our Business Development Office we established there in 2015. We are using this opportunity to utilize the latest developments in a branch floor plan design and technology while continuing to meet the market’s sales and service expectations. The pricing expectations of community banks contemplating a sale increased dramatically throughout the year. While acquisitions remain an important component of our growth strategy, we must remain disciplined in our approach to deal pricing. During the year, our acquisitions team considered a number of potential acquisition opportunities in new markets. Unfortunately, we were unable to negotiate the terms and conditions we felt necessary to ensure sufficient earnings accretion and the enhancement in long-term shareholder value. We continue to aggressively look for new opportunities for growth through acquisition. Summary As I review this annual report, I am particularly pleased with the increase in the core operating results of the Bank. It is a reflection of our commitment to enhancing long-term franchise and shareholder value- a commitment to doing what is in the long-term best interest of our Company and its shareholders. I want to thank each and every one of you for your support over the past year and especially thank our dedicated employees and board members for their work in helping to accomplish our mission. 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 2017 27,680 1,797 25,883 (523) 26,406 3,354 1,202 2,138 960 7,654 25,254 8,806 4,402(1) 4,404 0 Year Ended December 31, 2015 2016 2014 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 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) 2013 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 ) (2) 26,670 (2,068 ) shareholders .............................................. $ 4,404 6,350 2,848 5,669 24,602 Basic earnings per common share ............... $ Diluted earnings per common share ............ 1.04 0.90 1.52 1.34 0.69 0.61 1.40 1.23 6.15 5.71 (1) Relates to the decrease in the Company’s net deferred tax asset as a result of the reduction in the corporate federal tax rate from 34% to 21% in the fourth quarter of 2017. (2) Relates to the elimination of the deferred tax asset valuation reserve at December 31, 2013. Selected Financial Condition Data: (Dollars in thousands, except per share data) Total assets ........................................................... $ 722,685 682,023 643,161 577,426 648,622 78,477 111,974 137,834 107,956 77,472 Securities available for sale .................................. Loans held for sale ............................................... 1,502 2,009 1,837 Loans receivable, net ............................................ 585,931 551,171 463,185 365,113 384,615 Deposits ................................................................ 635,601 592,811 559,387 496,750 553,930 Federal Home Loan Bank advances and other December 31, 2015 2,076 3,779 2014 2016 2013 2017 borrowings ......................................................... Stockholders’ equity ............................................. Book value per common share ............................. 0 80,818 17.97 7,000 75,919 16.91 9,000 69,645 15.54 0 76,013 14.77 0 85,675 13.49 Number of full service offices .............................. Number of loan origination offices ...................... 13 3 13 3 13 3 11 2 11 1 Key Ratios: (3) Stockholders’ equity to total assets at year end .... Average stockholders’ equity to average assets ... Return on stockholders’ equity (ratio of net 11.18% 11.43 11.13% 11.07 10.83% 11.70 13.16% 13.25 13.21% 10.77 income to average equity) .................................. 5.52 8.71 4.27 9.12 42.22 Return on assets (ratio of net income to average assets) ................................................................. 0.63 0.96 0.50 1.21 4.55 (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 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 the financial performance of our core banking operations, maintaining credit quality, reducing non-performing assets, and generating improved financial results (including profitability); the extent of the positive impact of the lower federal tax rate on future earnings; 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 of the Bank’s non- performing assets and the 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 of yield enhancements to non-accruing and relating purchased loans; the amount and composition of non- interest and 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 of the trust preferred securities held by the Bank; the ability of the Bank to pay dividends to HMN; the ability to remain well capitalized; the impact of new accounting pronouncements, and compliance by the Bank with regulatory standards the Bank’s status as “well- generally 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 standard, directive or requirement. regulatory (including such 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 6 regulation and enforcement; possible legislative and regulatory changes, including additional changes to 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 competitive developments such as shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company’s loan and investment portfolios; changes in costs associated with alternate funding sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank (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; 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 (SEC). 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, 2017. 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  MANAGEMENT DISCUSSION AND ANALYSIS professional affected by changes in interest rates, the volume and 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 compensation and benefits, occupancy and equipment expenses, provisions for loan losses, insurance, services, 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 deposit 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, 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 7 its for the loan non-homogeneous loss allowance for the non-homogeneous has established separate processes to determine the appropriateness of its loan homogeneous single family and consumer loan portfolios and portfolios. The determination of the allowance on the homogeneous single family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance for all non-performing loans. The determination of the allowance 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 identified credit are assigned 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 relates to the allowance for loan and real estate losses. For tax purposes only the net charge-offs are deductible while the entire provision for loan losses is used to determine book income. A deferred tax asset is created because of the timing difference of when the expense is recognized for book and tax purposes. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies, and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of the deferred 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 Results of Operations Comparison of 2017 with 2016 Net income was $4.4 million for 2017, a decrease of $2.0 million compared to net income of $6.4 million for 2016. Diluted earnings per share for the year ended December 31, 2017 was $0.90, a decrease of $0.44 per share compared to diluted earnings per share of $1.34 for the year ended December 31, 2016. The decrease in net income for 2017 is due primarily to a $0.5 million decrease in the gain on sales of loans because of a decrease in commercial government guaranteed loan sales and a $0.5 million decrease in the gains on real estate owned because of fewer sales between the periods. Net income also decreased $0.4 million due to an increase in other non-interest expenses primarily related to advertising expenses, $0.3 million due to an increase in income tax expense, $0.2 million because of an increase in compensation and benefits and $0.1 million due to an increase in the loan loss provision between the periods. The increase in income tax expense is due primarily to the $1.1 million decrease in the Company’s net deferred tax asset as a result of the reduction in the corporate federal tax rate in connection with the enactment of the Tax Cuts and Jobs act in the fourth quarter of 2017. These decreases in net income were partially offset by an increase in net interest income of $0.1 million 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. Net Interest Income Net interest income was $25.9 million for 2017, an increase of $0.1 million, or 0.5%, from $25.8 million for the same period of 2016. Interest income was $27.7 million for 2017, an increase of $0.4 million, or 1.2%, from $27.3 million for the same period of 2016. Interest income increased $2.4 million 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 a 6 basis point increase in the average yields earned between the periods. While the average interest-earning assets increased $43.2 million between the periods, the average interest-earning assets held in higher yielding loans increased $58.8 million and the amount of average interest- earning assets held in lower yielding cash and investments decreased $15.6 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 occurred because of an increase in loan originations and a reduction in loan payoffs between the periods. The increase in interest income as a result of these items was partially offset by a decrease in interest income as a result of recognizing a lower amount of yield income enhancements between decreased $2.1 million due to a decrease in the amount of yield enhancements recognized from loan prepayment penalties, yield adjustments on purchased loans, and the interest payments received on non-accruing and previously the periods. Interest  MANAGEMENT DISCUSSION AND ANALYSIS charged off commercial real estate loans. This resulted in a 29 basis point decrease in the average yield between the periods. It is anticipated that the yield enhancements relating to these items will be lower in subsequent periods as the pool of non-accruing and purchased loans continues to decline. The average yield earned on interest-earning assets was 4.13% for 2017, a decrease of 23 basis points from 4.36% for 2016. The decrease in the average yield earned on interest-earning assets is primarily related to the decrease in yield enhancements recognized between the periods. accounts. This increase was partially offset by a decrease in the interest paid on other borrowings due to a decrease in the average borrowings outstanding between the periods. The average non-interest and interest-bearing liabilities increased $34.6 million between the periods, the average amount held in lower rate checking, savings, and money market accounts increased $10.4 million, the average amount held in higher rate premium money market accounts increased $22.5 million, and the average amount held in higher rate borrowings and certificates of deposit increased $1.7 million between the periods. Interest expense was $1.8 million for 2017, an increase of $0.2 million, or 12.8%, compared to $1.6 million for 2016. The average interest rate paid on non-interest and interest- bearing liabilities was 0.29% for 2017, an increase of 1 basis point from 0.28% for 2016. The average rate paid increased between the periods due to an increase in the rates paid on certain money market and certificate of deposit 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. Year Ended December 31, Average Outstanding Balance 2017 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2016 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2015 Interest Earned/ Paid Average Yield/ Rate (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 ......................... $ 2,524 74,035 1,905 57 1,103 94 573,894 26,274 12 874 17,214 140 670,446 27,680 Interest-bearing liabilities: NOW accounts .............................................. $ Passbooks ...................................................... Money market accounts ................................ Certificate accounts ...................................... FHLB advances and other borrowings ......... Total interest-bearing liabilities .................... $ Noninterest checking .................................... Other non-interest-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 .................... 77 63 560 770 327 87,416 76,592 179,675 106,006 6,335 456,024 156,149 1,279 613,452 1,797 25,883 56,994 2.26% $ 1.49 4.93 4.58 1.37 0.81 4.13 $ 0.09% $ 0.08 0.31 0.73 5.16 $ 0.29% $ 3.84% $ 3.86% 1,631 3,046 58 84,528 1,289 126 513,974 25,774 6 770 23,337 96 627,286 27,349 50 62 366 524 591 85,440 71,728 164,522 100,942 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 6.30 $ 0.28% $ 4.08% $ 4.11% 3,274 2,507 116 130,806 1,881 87 394,086 19,302 4 734 28,544 63 559,951 21,453 17 42 347 528 573 76,136 55,273 153,441 96,600 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 6.21 0.29 % 3.54 % 3.56 % 109.29% 108.36% 108.52% (1) Tax exempt income was not material; 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. 9  MANAGEMENT DISCUSSION AND ANALYSIS Net interest margin decreased 25 basis points to 3.86% in 2017 from 4.11% in 2016 primarily because of a $2.1 million, or 29 basis point decrease the yield enhancements recognized between the periods. Average net earning assets increased from $48.4 million in 2016 to $57.0 million in 2017. The $8.6 million increase in net earning assets is due to the net income earned in 2017 adjusted for non-cash items including the expenses incurred related to deferred tax asset changes and depreciation. in The following table presents the dollar amount of changes interest to changes income and interest expense for major in 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). in Year Ended December 31, 2017 vs. 2016 Increase (Decrease) Due to 2016 vs. 2015 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 ........................................... FHLB advances and other borrowings ................. Total interest-bearing liabilities ....................... Increase (decrease) in net interest income ................ $ 32 (160) (47) 3,091 (25) 1 2,892 3 4 39 77 (275) (152) 3,044 (33) (26) 15 (2,591) 69 5 (2,561) 24 (3) 155 169 11 356 (2,917) (1) (186) (32) 500 44 6 331 27 1 194 246 (264) 204 127 (58) (665) 19 5,824 (12) 0 5,108 1 12 18 26 16 73 5,035 0 73 20 648 45 2 788 32 8 1 (30) 2 13 775 (58) (592) 39 6,472 33 2 5,896 33 20 19 (4) 18 86 5,810 (1) For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate. The following table sets forth the weighted average 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, 2017 Weighted average rate on: Mortgage-backed and related securities ................................. 2.04% NOW accounts .............................................................................. 0.05% Other marketable securities .................................................... 1.61 Loans held for sale ...................................................................... 5.06 Loans receivable, net .................................................................. 4.78 Federal Home Loan Bank stock ................................................. 1.50 Other interest-earnings assets ..................................................... 1.50 Combined weighted average yield on interest-earning assets .... 4.27 Passbooks ...................................................................................... 0.08 Money market accounts ................................................................ 0.38 Certificates of deposit ................................................................... 0.94 Combined weighted average rate on interest-bearing liabilities .. 0.30 Interest rate spread ........................................................................ 3.97 10  MANAGEMENT DISCUSSION AND ANALYSIS Provision for Loan Losses The provision for loan losses was ($0.5) million for the year ended December 31, 2017, an increase of $0.1 million, from ($0.6) million for the year ended December 31, 2016. The provision for loan losses increased between the periods primarily because of the increase in the reserves required on certain commercial loans due to a deterioration of their credit quality. A reconciliation of the allowance for loan losses for 2017 and 2016 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 ........................................................................................................................................................ $ 2017 2016 9,903 (523) (311) (50) (288) (6) 586 9,311 1,073 8,238 9,311 9,709 (645) (180) (67) (108) (66) 1,260 9,903 988 8,915 9,903 Non-Interest Income Non-interest income was $7.7 million for the year ended December 31, 2017, a decrease of $0.5 million, from $8.2 million for the year ended December 31, 2016. 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, 2016 2017 3,354 1,202 2,138 960 7,654 3,427 1,108 2,618 1,048 8,201 Percentage Increase (Decrease) 2015 2017/2016 2016/2015 3,316 1,046 1,964 1,327 7,653 (2.1)% 8.5 (18.3) (8.4) (6.7) 3.3 % 5.9 33.3 (21.0 ) 7.2 The decrease in non-interest income is primarily related to the $0.5 million decrease in the gain on sales of loans due to a decrease in commercial government guaranteed loan sales between the periods. Fees and service charges decreased $0.1 million between the periods due primarily to a decrease in overdraft fees. Other non-interest income decreased $0.1 million because of a decrease in the revenue earned on the sale of uninsured investment products between the periods. These decreases in non-interest income were partially offset by a $0.1 million increase in loan servicing fees earned due to an increase in the loans being serviced for others between the periods. Non-Interest Expense Non-interest expense was $25.3 million for the year ended December 31, 2017, an increase of $1.2 million, from $24.1 million for the year ended December 31, 2016. 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, 2016 2017 15,007 (72) 4,068 1,106 1,285 3,860 25,254 14,764 (596) 4,041 1,161 1,257 3,503 24,130 Percentage Increase (Decrease) 2015 2017/2016 2016/2015 13,733 218 3,722 1,020 1,108 3,395 23,196 1.6% 87.9 0.7 (4.7) 2.2 10.2 4.7 7.5% (373.4) 8.6 13.8 13.4 3.2 4.0 11  MANAGEMENT DISCUSSION AND ANALYSIS Gains on real estate owned decreased $0.5 million between the periods due to the gains that were recognized on the sale of two commercial properties in 2016. Other non-interest expense increased $0.4 million primarily due to an increase in advertising expense between the periods. Compensation expense increased $0.2 million between the periods due to normal annual salary increases. Occupancy and equipment expense increased slightly because of increased software and equipment expenses. Professional services expense increased slightly due to an increase in legal expenses between the periods. These increases in non-interest expense were partially offset by a $0.1 million decrease in data processing expense due to a decrease in debit card costs between the periods. 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. Income tax expense was $4.4 million for the year ended December 31, 2017, an increase of $0.3 million, from $4.1 million for the year ended December 31, 2016. The increase in income tax expense is due primarily to the $1.1 million decrease in the Company’s net deferred tax asset as result of the reduction in the corporate federal tax rate in connection with the enactment of the Tax Cuts and Jobs Act in the fourth quarter of 2017. The increase in income tax expense as a result of the tax law change was partially offset by a decrease in income tax expense due to a decrease in pre-tax income between the periods. 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 was 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. 12 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. 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 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.  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 increase 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 was due primarily to the net income earned in 2016. 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. 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 increase in non-interest income was 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 was $24.1 million for the year ended December 31, 2016, an increase of $0.9 million from $23.2 million the year ended December 31, 2015. 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 for 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. The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates. 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 was primarily related to the increase in pre-tax income in 2016 when compared to 2015. 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 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. 13  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: December 31, 2015 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent 2016 2014 2013 2017 Single family .................................... $ 107,005 17.99% $103,255 18.41% $ 90,945 19.24% $ 69,841 18.70% $ 76,467 19.31% 4.81 Multi-family ..................................... 28,649 Commercial ...................................... 259,024 43.55 7.81 Construction or development ........... 46,444 Total real estate loans ............. 441,122 74.16 2.61 12,324 196,926 41.65 38,103 8.05 338,298 71.55 6.56 36,777 230,955 41.18 31,348 5.59 402,335 71.74 4.20 15,700 163,365 43.73 12,603 3.37 261,509 70.00 8,113 2.05 178,486 45.06 7,851 1.98 270,917 68.40 Other Loans: Consumer Loans: Automobile .................................. 2,894 Home equity line ......................... 36,869 Home equity ................................ 15,823 Recreational vehicles................... 13,181 5,000 Other ............................................ 0.49 6.20 2.66 2.21 0.84 Total consumer loans .............. 73,767 12.40 Commercial business loans.............. 79,909 13.44 Total other loans ..................... 153,676 25.84 Total loans ............................... 594,798 100.00% 560,794 100.00% 472,819 100.00% 373,556 100.00% 396,049 100.00% 0.61 8.24 3.13 0.56 1.08 64,415 13.62 70,106 14.83 134,521 28.45 0.54 7.22 2.91 1.35 1.05 73,283 13.07 85,176 15.19 158,459 28.26 0.30 9.86 3.33 0.00 1.22 54,925 14.71 57,122 15.29 112,047 30.00 971 0.25 36,178 9.13 11,629 2.94 0 0.00 4,645 1.17 53,423 13.49 71,709 18.11 125,132 31.60 2,885 38,980 14,782 2,650 5,118 3,036 40,476 16,302 7,553 5,916 1,124 36,832 12,420 0 4,549 Less: Unamortized discounts .................... Net deferred loan (costs) fees .......... Allowance for losses ........................ 19 (463) 9,311 Total loans receivable, net ...... $ 585,931 20 (300) 9,903 $551,171 16 (91) 9,709 $463,185 14 97 8,332 $365,113 33 0 11,401 $384,615 fewer there were The increase in the loan portfolio in 2017 was primarily because than originations. Based on current economic conditions and the projected loan origination and prepayment amounts, it is anticipated that our overall loan portfolio growth will be less in 2018 than the growth experienced in 2017. loan prepayments Single family real estate loans were $107.0 million at December 31, 2017, an increase of $3.7 million, compared to $103.3 million at December 31, 2016. The mortgage loan portfolio increased in 2017 due to 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 were sold into the secondary market and were not placed in the loan portfolio in order to manage the Company’s interest rate risk position. Multi-family real estate loans were $28.6 million at December 31, 2017, a decrease of $8.2 million, compared to $36.8 million at December 31, 2016. The decrease in multi-family real estate loans is primarily because newly originated loans were less than the $15.6 million in loans that were paid off or transferred to other loan categories during 2017. Commercial real estate loans were $259.0 million at December 31, 2017, an increase of $28.0 million, compared to $231.0 million at December 31, 2016. Commercial real 14 estate loan balances increased in 2017 as loan originations exceeded loan payoffs during the year. Commercial business loans were $79.9 million at December 31, 2017, a decrease of $5.3 million, compared to $85.2 million at December 31, 2016. The decrease in commercial business loans is because there were more loan payoffs in 2017 when compared to 2016. Construction or development loans were $46.4 million at December 31, 2017, an increase of $15.1 million, compared to $31.3 million at December 31, 2016. The increase was primarily related to an increase in multi-family and commercial construction loans between the periods. The increase was the result of the following activity during 2017: $26.8 million in new construction loans originated, $13.2 million in paid off loans, $9.7 million in advances on existing loans and $8.2 million of loans moved to a permanent loan classification upon completion of a project. Home equity lines of credit were $36.9 million at December 31, 2017, a decrease of $3.6 million, compared to $40.5 million at December 31, 2016. The open-end home equity 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 $15.8 million at December 31, 2017, a decrease of $0.5 million, compared  MANAGEMENT DISCUSSION AND ANALYSIS to $16.3 million at December 31, 2016. The decrease in the open-end equity lines and closed-end equity loans is related primarily to an increase in loan payoffs as borrowers continued to refinance their homes and roll outstanding equity loan balances into their first mortgage. Recreational vehicle loans were $13.2 million at December 31, 2017, an increase of $5.6 million, compared to $7.6 million at December 31, 2016. 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. 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-homogeneous 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 $9.3 million, or 1.57% of gross loans at December 31, 2017, compared to $9.9 million, or 1.77% of gross loans at December 31, 2016. The allowance for loan losses decreased primarily due the lower reserve percentages used for certain risk rated commercial loans as a result of an internal analysis of the most recent charge-off history that was performed during the year. This decrease was partially offset by an increase in reserves due to a $34 million increase in the loan portfolio during the year, as well as increased specific reserves for non- performing commercial loans. 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 (charge-offs) recoveries ............................................................. Balance at end of year ............................................................................... $ Year end allowance for loan losses as a percent of year end gross loan 2017 2016 December 31, 2015 2014 2013 9,903 (523) (6) (288) (311) (50) 586 (69) 9,311 9,709 (645) (66) (108) (180) (67) 1,260 839 9,903 8,332 (164) 11,401 (6,998) (19) (105) (69) 0 1,734 1,541 9,709 (92) (131) (55) (936) 5,143 3,929 8,332 21,608 (7,881) (200) (484) (651) (3,711) 2,720 (2,326) 11,401 balance .................................................................................................. 1.57 % 1.77% 2.05% 2.23% 2.88% Ratio of net loan recoveries (charge-offs) to average loans outstanding ............................................................................................ (0.01) 0.16 0.36 1.02 (0.53) 15  MANAGEMENT DISCUSSION AND ANALYSIS The following table reflects the allocation of the allowance for loan losses: 2017 2016 December 31, 2015 2014 2013 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 18.41% 1.15% 53.33 1.66 13.07 2.20 2.53 15.19 1.77 100.00% Category 19.24% 1.09% 52.31 2.46 13.62 1.86 2.05 14.83 2.05 100.00% Category 18.70% 1.57% 51.30 2.62 14.71 1.84 2.11 15.29 2.23 100.00% Category 2.13 % 3.32 2.07 3.08 2.88 100.00% 19.31% 49.09 13.49 18.11 Single family ........................ Commercial real estate ......... Consumer .............................. Commercial business ............ Total ................................. 0.84% 1.52 2.21 2.14 1.57 17.99% 56.17 12.40 13.44 100.00% The allocated reserve percentages for single family, commercial real estate, and commercial business loans decreased in 2017 due to the general improvement in the credit quality of these loan portfolios. The allocation of the allowance for loan losses for 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. There was no allowance for real estate losses at December 31, 2017 and the balance of the allowance was $0.7 million at December 31, 2016. 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 $3.8 million at December 31, 2017, a decrease of $0.1 million, or 3.3%, from $3.9 million at December 31, 2016. loans decreased $0.1 million and Non-performing foreclosed and repossessed assets were the same between the periods. 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: 16  MANAGEMENT DISCUSSION AND ANALYSIS (Dollars in thousands) Non-performing loans: 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 .... 2017 2016 December 31, 2015 2014 2013 949 1,364 553 278 3,144 0 627 0 627 3,771 0.52 % $ 3,144 0.54 % 296.11 % 916 1,384 630 343 3,273 0 611 16 627 3,900 1,655 1,694 786 46 4,181 48 1,997 0 2,045 6,226 1,564 8,750 486 120 10,920 50 3,053 0 3,103 14,023 3,273 0.57 % $ 0.59 % 302.56 % 4,181 0.97% $ 0.90% 232.22% 10,920 2.43% $ 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% Gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $0.3 million, $0.6 million and $0.4 million for the years ended December 31, 2017, 2016 and 2015, respectively. The amounts that were included in interest income on a cash basis for these loans were $0.1 million, $0.4 million and $0.2 million, respectively. At December 31, 2017, 2016 and 2015, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.0 million, $3.3 million and $2.5 million, respectively. Had the loans performed in accordance with their original terms throughout 2017, 2016 and 2015, the Company would have recorded gross interest income of $0.4 million, $0.6 million and $0.4 million, respectively. During 2017, 2016 and 2015 the Company recorded gross interest income of $0.2 million, $0.4 million and $0.2 million, respectively. For the loans that were modified in 2017, $0.6 million were unclassified and performing and $0.4 million were non- performing at December 31, 2017. The decrease in TDRs in 2017 relates primarily to one commercial relationship totaling $0.5 million that had performed according to the restructured terms and met the criteria to be upgraded to non-TDR status during the year. Of the loans that were modified in 2017 and outstanding at December 31, 2017, $0.8 million related to loans secured by first or second mortgages on a single family property and the remaining modifications related to other consumer or commercial business loans. 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 related 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, $0.4 million related to first or second mortgages on a 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 related 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. 17  MANAGEMENT DISCUSSION AND ANALYSIS The following table sets forth the amount of TDRs in the Company’s portfolio: (Dollars in thousands) 2017 2016 December 31, 2015 2014 2013 Single family ............................................................. $ Commercial real estate ............................................. Consumer .................................................................. Commercial business ................................................ Total TDRs ........................................................... $ TDRs on accrual status ............................................. $ TDRs on non-accrual status ...................................... Total ...................................................................... $ 685 1,210 758 391 3,044 1,129 1,915 3,044 448 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 In addition to the TDRs and the non-performing loans set forth in the previous table 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 was one potential problem loan relationship totaling $7.5 million identified by the Company as of December 31, 2017. These loans are secured primarily by multi-family properties and other business assets. There were no potential problem loans identified by the Company as of December 31, 2016. The four loan relationships that were 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. 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 18 additional borrowings with the FHLB or Federal Reserve Bank of Minneapolis to generate additional cash. The primary financing activity is the attraction of retail, commercial, and internet deposits. The Bank also has the ability to borrow additional funds from the FHLB or Federal Reserve Bank of Minneapolis by pledging additional securities or loans, subject to applicable borrowing base and collateral requirements. See “Note 12 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, 2017 were $37.6 million, an increase of $10.0 million, compared to $27.6 million at December 31, 2016. Net cash provided by operating activities during 2017 was $17.0 million. The Company conducted investing activities during 2017: principal payments and maturity proceeds received on securities available for sale and FHLB stock were $25.0 million; purchases of securities available for sale and FHLB stock were $24.0 million; and the proceeds from the sale of premises and other real estate were $0.3 million. The Company also purchased premises and equipment of $1.0 million and net loans receivable increased $43.2 million. Net cash used by investing activities during 2017 was $42.9 million. The Company conducted the following major financing activities during 2017: repaid borrowings of $106.2 million, received proceeds from borrowings of $99.2 million, and deposits increased $42.8 million. Net cash provided by financing activities was $35.9 million for 2017.  MANAGEMENT DISCUSSION AND ANALYSIS The Bank has certificates of deposits from customers with outstanding balances of $65.6 million that mature during 2018. 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 $77.0 million in checking and money market accounts of six 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 2017, the Bank paid dividends to the Company of $6.0 million and at December 31, 2017, the Company had $2.1 million in cash and other assets that could readily be turned into cash. The Company’s primary use of cash is the payment of holding company level expenses including the payment of director and management fees, legal expenses, and other regulatory costs. The Company plans to continue to fund its liquidity needs through dividends from the Bank, or if deemed prudent, by obtaining external capital. Contractual Obligations and Commercial Commitments The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2017, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: (Dollars in thousands) Contractual Obligations: Annual rental commitments under non-cancellable Total Less than 1 Year 1-3 Years 4-5 Years More than 5 Years Payments Due by Period operating leases ................................................................ $ Total contractual obligations ....................................... $ 5,740 5,740 888 888 1,740 1,740 1,679 1,679 1,433 1,433 Other Commercial Commitments: Commercial lines of credit.................................................... $ Commitments to lend ............................................................ Standby letters of credit ........................................................ Total other commercial commitments ......................... $ 53,691 39,965 1,867 95,523 25,433 13,691 1,546 40,670 17,175 994 321 18,490 11,033 13,110 0 24,143 50 12,170 0 12,220 Amount of Commitments Expiring by Period 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 19 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, 2017, 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 the enforcement activities, and can risk weightings further adjust other and  MANAGEMENT DISCUSSION AND ANALYSIS 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. 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, 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 the Company’s 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 regulatory 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 has not made any dividend payments to common stockholders during the three year period ending December 31, 2017. restrictions, 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 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 board of directors of both 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 May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014- 09, Revenue from Contracts with Customers (Topic 606), with an original effective date for annual reporting periods beginning after December 15, 2016. In August 2015, the FASB issued ASU 2015-14, which deferred the effective date of ASU 2014-09 to annual and interim reporting periods in fiscal years beginning after December 15, 2017. This ASU is a converged standard between the FASB and the International Accounting Standards Board (IASB) that provides a single comprehensive revenue recognition model for all contracts with customers across transactions and industries. The primary objective of the ASU is revenue recognition that represents the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. In March, April, May and December of 2016 and February and September of 2017, the FASB also issued ASU 2016-08, 2016-10, 2016- 12, 2016-20, 2017-05, and 2017-13, respectively, related to Topic 606. The amendments in these subsequently issued 20  MANAGEMENT DISCUSSION AND ANALYSIS ASUs do not change the core principles of the previously issued guidance, but instead provide more clarity and implementation guidance for certain aspects of the original ASU. The Company has completed its assessment of which revenue sources are within the scope of this ASU and evaluated the applicable contracts to assess and quantify accounting methodology changes resulting from the adoption of the standard. Based on this assessment, the adoption of this ASU and the related amendments in the first quarter of 2018 did not have a material impact on the Company’s consolidated financial statements. 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 did not 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 Generally Accepted Accounting Principles (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, 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 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 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 21  MANAGEMENT DISCUSSION AND ANALYSIS insurance claims; proceeds from 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; transactions; and in securitization beneficial 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 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 did not have a material impact on the Company’s consolidated financial statements. interest the FASB In January 2017, issued ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments – Equity Method and Joint Ventures (Topic 323). The amendments in the ASU add and amend SEC paragraphs pursuant to the SEC staff announcement at the September 22, 2016 and November 17, 2016 Emerging Issues Task Force (EITF) meetings. The September announcement is about the disclosure of the impact that recently issued accounting standards will have on the financial statements of a registrant when such standards are adopted in a future period. The announcement applies to ASU 2014-09, Revenue from Contracts with Customers (Topic 606); ASU 2016-02, Leases (Topic 842); and ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments and to any subsequent amendments to these ASUs that are issued prior to their adoption. The November announcement made amendments to conform the SEC Observer comment on accounting for tax benefits resulting from investments in qualified affordable housing projects to the guidance issued in Accounting Standards Update No. 2014-01, Investments-Equity Method and Joint Ventures (Topic 323); Accounting for Investments in Qualified Affordable Housing Projects. This ASU is intended to improve transparency and is effective for public business entities upon issuance. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements other than to enhance the disclosures on the effects of new accounting pronouncements as they move closer to adoption. the FASB issued ASU 2017-04, In January 2017, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this ASU were issued to address concerns over the cost and 22 complexity of the two-step goodwill impairment test and resulted in the removal of the second step of the test. The amendments require an entity to apply a one-step quantitative test and record the amount of goodwill impairment as the excess of a reporting unit’s carrying amount over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The new guidance does not amend the optional qualitative assessment of goodwill impairment. This ASU is intended to reduce the cost and complexity of the two-step goodwill impairment test and is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years with early adoption permitted for testing performed after January 1, 2017. Upon adoption, the amendments should be applied on a prospective basis and the entity is required to disclose the nature of and reason for the change in accounting principle upon transition. The Company early adopted this ASU in the fourth quarter of 2017 in order to reduce the complexity of the goodwill impairment calculation. The adoption of this ASU in the fourth quarter of 2017 did not have any impact on the Company’s consolidated financial statements. the FASB incorporated in market pricing on In March 2017, issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount as discounts continue to be amortized to maturity. This ASU is intended to more closely align the amortization period of premiums and discounts to expectations the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates and prices securities to maturity when the coupon is below market rates. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument. This ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 with early adoption permitted. Upon adoption, the amendments should be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity should provide disclosures about a change in accounting principles. 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.  MANAGEMENT DISCUSSION AND ANALYSIS the FASB issued ASU 2017-09, In May 2017, Compensation- Stock Compensation (Topic 718). The amendments in this ASU provide clarity about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The ASU is effective for all entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years with early adoption permitted. The adoption of this ASU in the first quarter of 2018 did not have any impact on the Company’s consolidated financial statements. In February 2018, the FASB issued ASU 2018-01, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this ASU require a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the newly enacted federal corporate income tax rate. The amount of the reclassification is the difference between the historical corporate income tax rate and the newly enacted 21 percent corporate income tax rate. This ASU is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in any interim period, for public business entities such as the Company for reporting periods for which financial statement have not yet been issued. The Company opted to early adopt this ASU as of December 31, 2017. The impact on the December 31, 2017 financial statements was a $157,600 reclassification between other comprehensive income and retained earnings for the stranded tax effects as a result of the change in the federal corporate tax rate. 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, 2017. (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 0 +100 +200 726,656 625,420 (184) 101,420 714,097 584,839 0 129,258 701,330 549,618 (8) 151,720 687,808 518,471 4 169,333 (21.54%) 0.00 % 17.38% 31.00% Market Value (the Model Assumptions) The preceding table was prepared utilizing the following assumptions regarding prepayment and decay ratios that were determined by management based upon its review of historical prepayment speeds and decay rates. Fixed rate loans were assumed to prepay at annual rates of between 2% and 42%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 6% and 48%, 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. Retail money market and passbook accounts were assumed to decay at annual rates of 2% and 18%, respectively. Retail non-interest checking and negotiable order of withdrawal (NOW) accounts were assumed to decay at annual rates of 12% and 14%, respectively. Commercial non-interest checking and NOW accounts were assumed to decay at annual rates of 27% and 32%, respectively. Commercial money market demand accounts (MMDAs) were assumed to decay at annual rates of between 1% and 31%. 23  MANAGEMENT DISCUSSION AND ANALYSIS 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, 2017 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on net interest income during the twelve month period ending December 31, 2018 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 3,089 1,536 0 (1,644) 11.35 % 5.65 0.00 (6.04 ) 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 loans that are anticipated to re-price to higher interest rates in the next twelve months than there are deposits that would re- price. 24 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. 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 loan significant portion of production is in short term fixed rate loans or adjustable rate loans that re-price every one, two, or three years. the Bank’s commercial 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 CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, December 31, 2017 2016 ASSETS Cash and cash equivalents ................................................................................................ $ Securities available for sale: Mortgage-backed and related securities (amortized cost $5,148 and $993) ................. Other marketable securities (amortized cost $73,653 and $78,846) ............................ 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 .............................................................................................................. 37,564 27,561 5,068 72,404 77,472 1,837 585,931 2,344 627 817 1,724 8,226 802 355 1,314 3,672 722,685 635,601 0 146 1,147 4,973 641,867 1,005 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 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 4,631,124 and 4,639,739 shares .................................................. Total stockholders’ equity ............................................................................................ Total liabilities and stockholders’ equity ......................................................................... $ 91 50,623 91,448 (957) (2,030) (58,357) 80,818 722,685 91 50,566 86,886 (820) (2,223) (58,581) 75,919 682,023 See accompanying notes to consolidated financial statements. 25 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. 2017 2016 2015 26,368 25,900 19,389 57 1,103 140 12 27,680 1,470 327 1,797 25,883 (523) 26,406 3,354 1,202 2,138 960 7,654 15,007 (72) 4,068 1,106 1,285 3,860 25,254 8,806 4,402 4,404 0 4,404 (137) 4,267 1.04 0.90 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 26 CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Dollars in thousands) Balance, December 31, 2014............................... $ 10,000 91 Additional Preferred Common Paid-in Capital Stock Stock Net income ...................................................... Other comprehensive income ......................... Redemption of preferred stock ....................... (10,000) Restricted stock awards .................................. Restricted stock awards forfeiture .................. Amortization of restricted stock awards ......... Preferred stock dividends ............................... Earned employee stock ownership plan Unearned Accumulated Employee Plan Other (Loss) Total Stock- Stock Retained Comprehensive Ownership Treasury holders’ Earnings Equity (2,610) (59,062) 76,013 50,207 77,805 2,956 2,956 204 (10,000) 0 0 447 (225) (332) 9 447 332 (9) Stock (225) (418) 204 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 ............................. $ Net income ..................................................... Other comprehensive income ...................... Reclassification of certain income tax effects from accumulated other comprehensive income ............................. Stock compensation expense ........................ Restricted stock awards ............................... Stock awards withheld for tax withholding................................................ Amortization of restricted stock awards .... Earned employee stock ownership plan shares ......................................................... Balance, December 31, 2017 ............................. $ 0 91 57 50,388 80,536 6,350 (214) (606) 79 (158) 177 80 0 91 50,566 86,886 4,404 193 250 (2,417) (58,739) 69,645 6,350 (606) 79 0 177 158 (820) 21 194 274 (2,223) (58,581) 75,919 4,404 21 158 (158) 41 (278) 147 147 0 91 50,623 91,448 (957) 278 (54) 0 41 0 (54) 147 193 340 (2,030) (58,357) 80,818 See accompanying notes to consolidated financial statements. 27 CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31 (Dollars in thousands) Cash flows from operating activities: 2017 2016 2015 Net income .............................................................................................................................. $ Adjustments to reconcile net income to cash provided by operating activities: 4,404 6,350 Provision for loan losses .................................................................................................. Depreciation ..................................................................................................................... Amortization of (discounts) premiums, 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 ........................................................................................... Reclassification of certain income tax effects from accumulated other comprehensive income .......................................................................................................................... Securities losses (gains), net ............................................................................................ Gain on sale of premises .................................................................................................. (Gains) losses on sales of real estate owned .................................................................... 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 ................................................................................ Decrease (increase) in accrued interest receivable .......................................................... (Decrease) increase in accrued interest payable .............................................................. Decrease (increase) in other assets................................................................................... (Decrease) increase 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 owned ................................................................................ Net increase in loans receivable ............................................................................................. Gain on acquisition .................................................................................................................. Acquisition payment (net of cash acquired) ........................................................................... Proceeds from sale of premises ............................................................................................... Purchases of premises and equipment ..................................................................................... Net cash used by investing activities ...................................................................... Cash flows from financing activities: Increase in deposits .................................................................................................................. Redemption of preferred stock ................................................................................................ Stock awards withheld for tax withholding ............................................................................. Dividends paid to preferred stockholders ................................................................................ Proceeds from borrowings ....................................................................................................... Repayment of borrowings ........................................................................................................ Increase in customer escrows .................................................................................................. Net cash provided by financing activities ............................................................... Increase (decrease) in cash and cash equivalents ................................................... Cash and cash equivalents, beginning of year ............................................................................. Cash and cash equivalents, end of year ........................................................................................ $ Supplemental cash flow disclosures: Cash paid for interest ............................................................................................................... $ Cash paid for income taxes ...................................................................................................... Supplemental noncash flow disclosures: Loans transferred to loans held for sale ................................................................................... Loans held for sale transferred to loans ................................................................................... Transfer of loans to real estate ................................................................................................. See accompanying notes to consolidated financial statements. (523) 949 (3) (240) 99 (85) 555 (675) 2,105 158 0 (8) (72) (2,138) 90,127 (78,751) 147 193 147 41 282 (91) 417 (62) 67 17,043 0 953 20,100 (20,035) (3,999) 3,952 309 (43,194) 0 0 8 (1,011) (42,917) 42,794 0 (54) 0 99,200 (106,200) 137 35,877 10,003 27,561 37,564 1,887 1,879 9,211 164 253 (645) 850 47 (1,011) 92 (529) 601 (706) 3,128 0 10 0 (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 0 (1,607) (50,365) 14,468 0 0 0 45,000 (47,000) 163 12,631 (12,221) 39,782 27,561 1,599 436 15,002 0 591 2,956 (164) 706 (3) (964) 28 (657) 555 (547) 1,722 0 (6) 0 218 (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 0 (803) (31,864) 15,375 (10,000) 0 (225) 65,000 (56,000) 42 14,192 (6,852) 46,634 39,782 1,358 191 8,125 0 110 28  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2017, 2016 and 2015 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 (SEC) on March 9, 2018. 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 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 29  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 classified as third party impaired. Subsequent new 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 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 the impairment 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. 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 30  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 more, 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. 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 31  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014- 09, Revenue from Contracts with Customers (Topic 606), with an original effective date for annual reporting periods beginning after December 15, 2016. In August 2015, the FASB issued ASU 2015-14, which deferred the effective date of ASU 2014-09 to annual and interim reporting periods in fiscal years beginning after December 15, 2017. This ASU is a converged standard between the FASB and the International Accounting Standards Board (IASB) that provides a single comprehensive revenue recognition model for all contracts with customers across transactions and industries. The primary objective of the ASU is revenue recognition that represents the transfer of promised goods 32  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. In March, April, May and December of 2016 and February and September of 2017, the FASB also issued ASU 2016-08, 2016-10, 2016- 12, 2016-20, 2017-05, and 2017-13, respectively, related to Topic 606. The amendments in these subsequently issued ASUs do not change the core principles of the previously issued guidance, but instead provide more clarity and implementation guidance for certain aspects of the original ASU. The Company has completed its assessment of which revenue sources are within the scope of this ASU and evaluated the applicable contracts to assess and quantify the accounting methodology changes resulting from adoption of the standard. Based on this assessment, the adoption of this ASU and the related amendments in the first quarter of 2018 did not have a material impact on the Company’s consolidated financial statements. 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 did not 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, 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 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 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. 33  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS insurance claims; proceeds from 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 diversity in practice and is effective for public business entities 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 did not have a material impact on the Company’s consolidated financial statements. interest the FASB issued ASU 2017-03, In January 2017, Accounting Changes and Error Corrections (Topic 250) and Investments – Equity Method and Joint Ventures (Topic 323). The amendments in the ASU add and amend SEC paragraphs pursuant to the SEC staff announcement at the September 22, 2016 and November 17, 2016 Emerging Issues Task Force (EITF) meetings. The September announcement is about the disclosure of the impact that recently issued accounting standards will have on the financial statements of a registrant when such standards are adopted in a future period. The announcement applies to ASU 2014-09, Revenue from Contracts with Customers (Topic 606); ASU 2016-02, Leases (Topic 842); and ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments and to any subsequent amendments to these ASUs that are issued prior to their adoption. The November announcement made amendments to conform the SEC Observer comment on accounting for tax benefits resulting from investments in qualified affordable housing projects to the guidance issued in Accounting Standards Update No. 2014-01, Investments-Equity Method and Joint Ventures (Topic 323); Accounting for Investments in Qualified Affordable Housing Projects. This ASU is intended to improve transparency and is effective for public business entities upon issuance. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements other than to enhance the disclosures on the effects of new accounting pronouncements as they move closer to adoption. 34 the FASB issued ASU 2017-04, In January 2017, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this ASU were issued to address concerns over the cost and complexity of the two-step goodwill impairment test and resulted in the removal of the second step of the test. The amendments require an entity to apply a one-step quantitative test and record the amount of goodwill impairment as the excess of a reporting unit’s carrying amount over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The new guidance does not amend the optional qualitative assessment of goodwill impairment. This ASU is intended to reduce the cost and complexity of the two-step goodwill impairment test and is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years with early adoption permitted for testing performed after January 1, 2017. Upon the amendments should be applied on a adoption, prospective basis and the entity is required to disclose the nature of and reason for the change in accounting principle upon transition. The Company early adopted this ASU in the fourth quarter of 2017 in order to reduce the complexity of the goodwill impairment calculation. The adoption of this ASU in the fourth quarter of 2017 did not have any impact on the Company’s consolidated financial statements. the FASB incorporated in market pricing on In March 2017, issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount as discounts continue to be amortized to maturity. This ASU is intended to more closely align the amortization period of premiums and discounts to expectations the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates and prices securities to maturity when the coupon is below market rates. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument. This ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 with early adoption permitted. Upon adoption, the amendments should be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity should provide disclosures about a change in accounting principles. The adoption of this ASU  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements. the FASB In May 2017, issued ASU 2017-09, Compensation- Stock Compensation (Topic 718). The amendments in this ASU provide clarity about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The ASU is effective for all entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years with early adoption permitted. The adoption of this ASU in the first quarter of 2018 did not have any impact on the Company’s consolidated financial statements. In February 2018, the FASB issued ASU 2018-01, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this ASU require a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the newly enacted federal corporate income tax rate. The amount of the reclassification is the difference between the historical corporate income tax rate and the newly enacted 21 percent corporate income tax rate. This ASU is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in any interim period, for public business entities such as the Company for reporting periods for which financial statement have not yet been issued. The Company opted to early adopt this ASU as of December 31, 2017. The impact on the December 31, 2017 financial statements was a $157,600 reclassification between other comprehensive income and retained earnings for the stranded tax effects as a result of the change in the federal corporate tax rate. 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 year have been reclassified to conform to the current year presentation. NOTE 2 Acquisitions The Company records purchased assets and liabilities at their fair market value at the time of purchase in accordance - Business requirements of ASU 805 with the 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 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. 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 35  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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. 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 gains (losses) arising Before Tax 2017 Tax Effect For the years ended December 31, 2016 Tax Effect Before Tax Net of Tax Net of Tax Before Tax 2015 Tax Effect Net of Tax during the period ....................................... $ 33 12 21 (1,016) (404) (612) 344 137 207 Less reclassification of net (losses) gains included in net income .............................. 0 0 0 (10) (4) (6) 6 3 3 Net unrealized gains (losses) arising during the period .................................................. 33 12 21 (1,006) (400) (606) 338 134 204 Reclassification of certain income tax effects from accumulated other comprehensive income ............................. Other comprehensive (loss) income .............. $ 0 33 (158) 170 158 (137) 0 (1,006) 0 (400) 0 (606) 0 338 0 134 0 204 NOTE 4 Securities Available for Sale A summary of securities available for sale at December 31, 2017 and 2016 is as follows: (Dollars in thousands) December 31, 2017 Mortgage-backed securities: Federal Home Loan Mortgage Corporation (FHLMC) ..................... $ Federal National Mortgage Association (FNMA) ............................... Collateralized mortgage obligations: FNMA ....................................................................................................... Other marketable securities: U.S. Government agency obligations .................................................... Municipal obligations ............................................................................. Corporate obligations ............................................................................. Corporate preferred stock ..................................................................... Corporate equity ..................................................................................... $ December 31, 2016 Mortgage-backed securities: FHLMC ..................................................................................................... $ FNMA ....................................................................................................... Collateralized mortgage obligations: FNMA ....................................................................................................... Other marketable securities: U.S. Government agency obligations ....................................................... Municipal obligations ............................................................................... Corporate obligations ................................................................................ Corporate preferred stock ......................................................................... Corporate equity ....................................................................................... Amortized cost Gross unrealized gains Gross unrealized losses Fair value 91 4,834 223 5,148 69,962 2,699 234 700 58 73,653 78,801 327 295 371 993 74,979 2,819 290 700 58 78,846 79,839 2 1 0 3 0 2 0 0 99 101 104 10 7 0 17 16 0 2 0 57 75 92 0 (78) (5) (83) (1,201) (8) (1) (140) 0 (1,350) (1,433) 0 0 (5) (5) (1,079) (20) 0 (350) 0 (1,449) (1,454) 93 4,757 218 5,068 68,761 2,693 233 560 157 72,404 77,472 337 302 366 1,005 73,916 2,799 292 350 115 77,472 78,477 $ 36  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company did not sell any available for sale securities and did not recognize any gains or losses on investments in 2017. In 2016, the Company sold $20,000 of available for sale securities and recognized a loss of $10,000 on the sales. In 2015, the Company sold $11.0 million of available for sale securities and recognized a gain of $6,000 on the sales. The following table presents the amortized cost and estimated fair value of securities available for sale at December 31, 2017, based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates. Actual maturities may differ from the maturities in the following table because obligors may have the right to call or prepay obligations with or without call or prepayment penalties: (Dollars in thousands) Due one year or less ........................................ $ Due after one year through five years ............. Due after five years through ten years ............ Due after ten years ........................................... No stated maturity ........................................... Total ........................................................ $ Amortized Cost Fair Value 1,188 73,706 1,752 669 157 77,472 1,202 74,950 1,780 811 58 78,801 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, 2017 and 2016: (Dollars in thousands) December 31, 2017 Mortgage backed securities: Less Than Twelve Months Fair Value # of Investments Unrealized Losses Twelve Months or More Total # of Investments Fair Value Unrealized Losses Fair Value Unrealized Losses FNMA ................................................... 2 $ 4,703 (78) Collateralized mortgage obligations: FNMA ................................................... 1 218 (5) 0 $ 0 0 0 0 $ 4,703 0 218 (78) (5) Other marketable securities: U.S. Government agency obligations ....................................... Municipal obligations ......................... Corporate obligations ......................... Corporate preferred stock ................. Total temporarily impaired securities .......................................... December 31, 2016 Collateralized mortgage obligations: 2 14 1 0 9,819 2,268 233 0 (163) (8) (1) 0 12 0 0 1 58,942 0 0 560 (1,038) 0 0 (140) 68,761 2,268 233 560 (1,201) (8) (1) (140) 20 $ 17,241 (255) 13 $ 59,502 (1,178) $ 76,743 (1,433) FNMA ................................................... 1 $ 262 (3) 1 $ 104 (2) $ 366 (5) Other marketable securities: U.S. Government agency obligations ........................................ Municipal obligations ........................... Corporate preferred stock ..................... Total temporarily impaired securities ........................................... 13 14 0 63,896 2,327 0 (1,079) (19) 0 0 2 1 0 214 350 0 (1) (350) 63,896 2,541 350 (1,079) (20) (350) 28 $ 66,485 (1,101) 4 $ 668 (353) $ 67,153 (1,454) 37  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, 2017 relates to a single trust preferred security that was issued by the holding company of a small community bank. As of December 31, 2017 all payments were current on the trust preferred security and the issuer’s subsidiary bank was considered to be “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, 2017. 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 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. receive all principal and NOTE 5 Loans Receivable, Net A summary of loans receivable at December 31, 2017 and 2016, is as follows: (Dollars in thousands) Residential real estate loans: Single family conventional ....................... $ Single family FHA .................................... Single family VA ...................................... Commercial real estate: Lodging ..................................................... Retail/office ............................................... Nursing home/health care ......................... Land developments ................................... Golf courses .............................................. Restaurant/bar/café ................................... Warehouse ................................................. Construction: Single family ........................................ Multi-family ......................................... Commercial real estate ......................... Manufacturing ........................................... Churches/community service .................... Multi-family .............................................. Other .......................................................... Consumer: Autos ......................................................... Home equity line ....................................... Home equity .............................................. Other – secured ......................................... Recreational vehicles ................................ Land/lots ................................................... Other – unsecured ..................................... Commercial business ..................................... Total loans ............................................ Less: 2017 2016 106,881 88 36 107,005 55,675 64,780 7,352 21,058 1,112 5,929 25,891 23,090 11,649 11,705 22,136 12,734 28,649 42,357 334,117 2,894 36,869 15,823 1,911 13,181 1,587 1,502 73,767 79,909 594,798 103,125 92 38 103,255 43,285 53,935 8,185 24,240 1,560 5,851 26,630 21,944 2,610 6,794 15,743 10,199 36,777 41,327 299,080 3,036 40,476 16,302 2,048 7,553 2,362 1,506 73,283 85,176 560,794 Unamortized discounts ............................. Net deferred loan costs ............................. Allowance for loan losses ......................... Total loans receivable, net .................... $ 19 (463) 9,311 585,931 20 (300) 9,903 551,171 Commitments to originate or purchase loans ............................................................ $ 24,692 47,220 Commitments to deliver loans to secondary market ......................................................... $ 5,629 9,595 Weighted average contractual rate of loans in portfolio .................................................. 4.56% 4.45% 38  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Included in total commitments to originate or purchase loans are fixed rate loans aggregating $18.1 million and $29.6 million as of December 31, 2017 and 2016, respectively. The interest rates on these loan commitments ranged from 3.375% to 5.210% at December 31, 2017 and from 2.75% to 5.125% at December 31, 2016. The aggregate amount of loans to executive officers and directors of the Company was $0.1 million, $0.2 million and $2.7 million at December 31, 2017, 2016 and 2015, respectively. There was no activity during 2017 and 2016 on loans to executive officers and directors other than the $0.1 million and $2.5 million in loans that were reclassified during the respective periods 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 paid off 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, 2017, 2016 and 2015, the Company was servicing loans for others with aggregate unpaid principal balances of approximately $471.4 million, $425.5 million and $391.9 million, respectively. The Company originates residential, commercial real estate and other loans primarily in Minnesota, Wisconsin, and Iowa. At December 31, 2017 and 2016, the Company had in its portfolio single family residential loans located in the following states: 2017 2016 Percent of Total (Dollars in thousands) Amount 3,605 Iowa ................................. $ Minnesota ........................ 90,345 1,841 Missouri ........................... 9,894 Wisconsin ........................ 1,320 Other states ...................... Total ............................ $ 107,005 Amount 4,470 87,135 1,206 8,779 1,665 100.0% $ 103,255 3.4% $ 84.4 1.7 9.3 1.2 Percent of Total 4.3% 84.4 1.2 8.5 1.6 100.0% Amounts under one million dollars in both years are included in “Other states”. At December 31, 2017 and 2016, the Company had in its portfolio commercial real estate loans located in the following states: (Dollars in thousands) Alabama ........................................................................................................ $ Florida ........................................................................................................... Idaho ............................................................................................................. Indiana .......................................................................................................... Iowa .............................................................................................................. Minnesota ..................................................................................................... North Carolina .............................................................................................. North Dakota ................................................................................................ Ohio .............................................................................................................. Pennsylvania ................................................................................................. Tennessee ..................................................................................................... Wisconsin ..................................................................................................... Other states ................................................................................................... Total ......................................................................................................... $ 2017 Amount Percent of Total 2016 Amount Percent of Total 1,742 2,790 3,371 3,374 4,755 232,991 5,996 1,093 1,680 2,056 0 72,510 1,759 334,117 0.5 % $ 0.9 1.0 1.0 1.4 69.8 1.8 0.3 0.5 0.6 0.0 21.7 0.5 100.0 % $ 1,902 3,781 3,529 2,189 1,973 213,983 2,926 8,447 0 0 1,036 57,512 1,802 299,080 0.7% 1.3 1.2 0.7 0.7 71.5 1.0 2.8 0.0 0.0 0.3 19.2 0.6 100.0% Amounts under one million dollars in both years are included in “Other states”. 39  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 Allowance for Loan Losses and Credit Quality Information The allowance for loan losses is summarized as follows: 8,332 (164) (193) 1,734 9,709 (645) (421) 1,260 9,903 (523) (655) 586 9,311 988 8,915 9,903 1,073 8,238 9,311 4,570 556,224 560,794 4,274 590,524 594,798 (Dollars in thousands) Balance, December 31, 2014......................................... $ Provision for losses ................................................... $ Charge-offs ............................................................... Recoveries ................................................................. Balance, December 31, 2015......................................... $ Provision for losses ................................................... $ Charge-offs ............................................................... Recoveries ................................................................. Balance, December 31, 2016......................................... $ Provision for losses.................................................. $ Charge-offs .............................................................. Recoveries ................................................................ Balance, December 31, 2017 ....................................... $ Allocated to: Specific reserves ................................................... $ General reserves ................................................... Balance, December 31, 2016......................................... $ Allocated to: Specific reserves .................................................. $ General reserves ................................................. Balance, December 31, 2017 ....................................... $ Loans receivable at December 31, 2016: Single Family Commercial Real Estate Consumer Commercial Business Total 1,096 5,024 1,009 1,203 (105 ) (19 ) 18 990 262 (66 ) 0 1,186 (280 ) (6 ) 0 900 235 951 1,186 192 708 900 (427 ) 0 1,481 6,078 (1,788 ) (67 ) 730 4,953 (75 ) (50 ) 245 5,073 248 4,705 4,953 441 4,632 5,073 254 (105) 42 1,200 481 (108) 40 1,613 263 (288) 42 1,630 434 1,179 1,613 263 1,367 1,630 114 (69) 193 1,441 400 (180) 490 2,151 (431) (311) 299 1,708 71 2,080 2,151 177 1,531 1,708 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 Loans receivable at December 31, 2017: Individually reviewed for impairment ............. $ Collectively reviewed for impairment .............. Ending balance ................................................... $ 1,523 105,482 107,005 1,364 332,753 334,117 880 72,887 73,767 507 79,402 79,909 40  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes the amount of classified and unclassified loans at December 31, 2017 and 2016: December 31, 2017 Classified Unclassified (Dollars in thousands) Single family ............................................... $ Commercial real estate: Special Mention Substandard Doubtful 44 2,154 77 Loss Total 0 2,275 Total Total Loans 104,730 107,005 Real estate rental and leasing ............... Other ....................................................... Consumer .................................................... Commercial business: 5,022 9,135 0 Transportation industry ....................... Other ....................................................... $ 116 5,665 20,015 3,813 4,257 631 1,002 4,504 16,361 0 0 119 0 0 163 0 0 130 0 0 130 8,835 13,392 880 1,118 10,169 36,669 166,342 175,177 145,548 158,940 73,767 72,887 9,089 7,971 60,651 70,820 558,129 594,798 December 31, 2016 Classified Unclassified (Dollars in thousands) Special Mention Substandard Doubtful Loss Total Total 457 2,130 74 0 2,661 100,594 Total Loans 103,255 Single family ................................................ $ Commercial real estate: Real estate rental and leasing .................. Other ........................................................ Consumer ..................................................... Commercial business: Transportation industry ........................... Other ........................................................ $ 1,577 1,702 0 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 0 0 299 4,733 8,889 940 4,065 6,889 28,177 148,610 136,848 72,343 153,343 145,737 73,283 6,444 67,778 532,617 10,509 74,667 560,794 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. 41  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The aging of past due loans at December 31, 2017 and 2016 is summarized as follows: (Dollars in thousands) 2017 30-59 Days 60-89 Days Past Due 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 ........................................................ $ 2016 Single family ................................................. $ Commercial real estate: Real estate rental and leasing .................... Other ......................................................... Consumer ....................................................... Commercial business: Transportation industry ............................. Other ......................................................... $ 727 294 669 1,690 105,315 107,005 0 0 734 0 34 1,495 0 0 117 0 0 411 0 0 235 0 0 1,086 175,177 158,940 72,681 175,177 158,940 73,767 0 180 1,084 0 214 2,990 9,089 70,606 591,808 9,089 70,820 594,798 342 158 179 679 102,576 103,255 0 0 412 0 85 839 0 0 117 0 0 275 0 0 140 0 274 593 0 0 669 153,343 145,737 72,614 153,343 145,737 73,283 0 359 1,707 10,509 74,308 559,087 10,509 74,667 560,794 0 0 0 0 0 0 0 0 0 0 0 0 0 0 42  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, 2017 and 2016: (Dollars in thousands) Loans with no related allowance recorded: December 31, 2017 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 ................................................................................ 415 35 25 414 0 415 51 1,682 414 0 Loans with an allowance recorded: Single family ........................................................................ Commercial real estate: Real estate rental and leasing ........................................ Other ................................................................................ Consumer ............................................................................. Commercial business: Other ................................................................................ 1,108 1,108 0 1,304 466 0 1,304 483 507 1,358 0 0 0 0 0 192 0 441 263 177 414 38 26 406 100 878 155 1,715 457 443 Total: Single family ........................................................................ Commercial real estate: Real estate rental and leasing ........................................ Other ................................................................................ Consumer ............................................................................. Commercial business: Other ................................................................................ $ 1,523 1,523 192 1,292 35 1,329 880 507 4,274 51 2,986 897 1,358 6,815 0 441 263 177 1,073 193 1,741 863 543 4,632 24 0 96 7 0 31 0 0 14 22 55 0 96 21 22 194 43  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) Loans with no related allowance recorded: Single family ......................................................................... $ Commercial real estate: Real estate rental and leasing ........................................... Other ................................................................................. Consumer .............................................................................. Commercial business: December 31, 2016 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 217 217 40 26 312 122 1,771 312 0 0 0 0 0 567 40 29 449 81 Other ................................................................................. 274 356 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 At December 31, 2017, 2016 and 2015, non-accruing loans totaled $3.2 million, $3.3 million and $4.2 million, respectively, for which the related allowance for loan losses was $0.9 million, $0.8 million and $0.7 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 $0.4 million, $0.7 million and $1.4 million at December 31, 2017, 2016 and 2015, respectively. Had the non-accruing loans performed in accordance with their original terms, the Company would have recorded gross interest income on the loans of $0.3 million, $0.6 million and $0.4 million in 2017, 2016 and 2015, respectively. For the years ended December 31, 2017, 2016 and 2015, the Company recognized interest income on these loans of $0.1 million, $0.4 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. 44  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes non-accrual loans at December 31, 2017 and 2016: The following table summarizes TDRs at December 31, 2017 and 2016: (Dollars in thousands) Single family ................................................... $ Commercial real estate: Real estate rental and leasing ...................... Other............................................................ Consumer ......................................................... Commercial business: Other............................................................ $ 2017 2016 949 916 35 1,329 553 278 3,144 41 1,343 630 343 3,273 (Dollars in thousands) Single family ................................................... $ Commercial real estate: Other ............................................................ Consumer ......................................................... Commercial business: Other ............................................................ $ 2017 2016 685 448 1,210 758 391 3,044 1,774 709 369 3,300 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 TDR. At December 31, 2017, 2016 and 2015, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.0 million, $3.3 million and $2.5 million, respectively. Had these loans been performing in accordance with their original terms throughout 2017, 2016 and 2015, the Company would have recorded gross interest income of $0.4 million, $0.6 million and $0.4 million, respectively. During 2017, 2016 and 2015, the Company recognized interest income of $0.2 million, $0.4 million and $0.2 million, respectively, on these loans. For the loans that were modified in 2017, $0.7 million are classified and performing and $0.4 million were non- performing at December 31, 2017. As of December 31, 2017, the Bank had commitments to lend an additional $0.8 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 $0.4 million to this same borrower at December 31, 2016. 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, 2017 and 2016: (Dollars in thousands) Troubled debt restructurings: Single family ............................................... Commercial real estate: Other........................................................ Consumer ..................................................... Commercial business: Other........................................................ Total ............................................................. Year ended December 31, 2017 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts Year ended December 31, 2016 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts 3 $ 0 15 1 19 $ 282 0 588 416 1,286 514 0 591 116 1,221 4 $ 251 1 18 2 25 $ 1,274 382 257 2,164 263 1,274 384 201 2,122 45  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loans that were restructured within the 12 months preceding December 31, 2017 and 2016 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, 2017 Outstanding Recorded Investment Number of Contracts Year ended December 31, 2016 Outstanding Recorded Investment Number of Contracts Other................................................................................................ Consumer ............................................................................................. Total ..................................................................................................... 0 $ 1 1 $ 0 65 65 1 $ 1 2 $ 183 4 187 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 acquisitions: (Dollars in thousands) Purchased Performing Loans: Balance at December 31, 2014 ........... $ Contractual Principal Receivable Accretable Difference Net Carrying Amount 0 0 0 Loans acquired during the period .. $ Change due to 24,215 (793) 23,422 payments/refinances .................... Balance at December 31, 2015 ........... $ (5,676) 18,539 334 (5,342) (459) 18,080 Loans acquired during the period .. $ Change due to 11,772 (211) 11,561 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) Change due to payments/refinances ................. $ Transferred to foreclosed assets . Change due to loan charge-off .... Balance at December 31, 2017 ......... $ (6,594) (2) (18) 10,128 101 (6,493) (2) (18) (231) 9,897 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 reserves for TDRs was $0.9 million, or 9.8%, of the total $9.3 million in allowance for loan losses at December 31, 2017, and $0.6 million, or 6.2%, of the total $9.9 million in allowance for loan losses at December 31, 2016. 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 46  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) Purchased Credit Impaired Loans: Balance at December 31, 2014 ........... $ Contractual Principal Receivable Non- Accretable Difference Net Carrying Amount 0 0 0 Loans acquired during the period .. $ Change due to payments/refinances ................... Change due to loan charge-off ....... Balance at December 31, 2015 ........... $ 1,134 (497) 637 (260) (319) 555 48 287 (162) (212) (32) 393 Loans acquired during the period .. $ Change due to payments/refinances ................... Balance at December 31, 2016 ........... $ 329 (37) 292 (449) 435 147 (52) (302) 383 Change due to payments/refinances ................. $ Balance at December 31, 2017 ......... $ (33) 402 13 (39) (20) 363 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, 2017 was $0.4 million. No material provision for loan losses was recognized during the period ended December 31, 2017 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 .............................................. $ 2017 2016 352 1,992 2,344 400 2,226 2,626 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 2017 and 2016 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 ............ $ 2017 2016 1,604 675 (555) 1,724 0 1,724 3,196 1,499 706 (601) 1,604 0 1,604 2,952 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, 2017: (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 .................. $266,560 15 year fixed rate .................. 102,957 55 Adjustable rate ...................... 4.07% 3.10 3.25 306 2,119 136 1,084 2 281 The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2017 and 2016 are presented in the following table. Amortization expense for intangible assets was $0.7 million, $0.7 million and $0.6 million for the years ended December 31, 2017, 2016 and 2015, respectively. Gross Carrying Accumulated Intangible Amount Amortization Assets Unamortized (Dollars in thousands) December 31, 2017 Mortgage servicing rights ............................... $ 4,244 574 Core deposit intangible ... Goodwill ............................ 802 Total .................................. $ 5,620 (2,520 ) (219 ) 0 (2,739 ) December 31, 2016 Mortgage servicing rights ................................ $ 3,954 Core deposit intangible ...... 574 802 Goodwill ............................ Total ................................... $ 5,330 (2,350 ) (120 ) 0 (2,470 ) 1,724 355 802 2,881 1,604 454 802 2,860 The following amortization expense for amortizing intangible assets: the estimated future indicates table (Dollars in thousands) Year ended December 31, 2018 .......................................... $ 2019 .......................................... 2020 .......................................... 2021 .......................................... 2022 .......................................... Thereafter ................................. $ Mortgage Servicing Rights Core Deposit Intangible Total Amortizing Intangible Assets 438 378 305 256 191 156 1,724 99 99 99 47 11 0 355 537 477 404 303 202 156 2,079 47  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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, 2017. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions. NOTE 9 Real Estate A summary of real estate at December 31, 2017 and 2016 is as follows: 2017 2016 (Dollars in thousands) Residential Commercial & Other Total Residential Commercial & Other Total Real estate in judgment subject to redemption ........... $ Real estate acquired through foreclosure ................... Real estate acquired through deed in lieu of foreclosure .............................................................. Allowance for losses ................................................... Real estate, net ............................................................ $ 40 0 0 40 0 40 173 414 0 587 0 587 213 414 0 627 0 627 0 0 0 0 0 0 0 1,245 28 1,273 (662 ) 611 0 1,245 28 1,273 (662) 611 NOTE 10 Premises and Equipment A summary of premises and equipment at December 31, 2017 and 2016 is as follows: (Dollars in thousands) Land ................................................................. $ Office buildings and improvements ................ Furniture and equipment ................................. Accumulated depreciation ............................... $ 2017 2016 2,021 9,844 12,507 24,372 (16,146) 8,226 2,021 9,666 12,478 24,165 (15,942 ) 8,223 48  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 Deposits Deposits and their weighted average interest rates at December 31, 2017 and 2016 are summarized as follows: (Dollars in thousands) Noninterest checking ................... NOW accounts ............................ Savings accounts ......................... Money market accounts .............. Certificates by rate: 0-0.99% ....................................... 1-1.99% ....................................... 2-2.99% ....................................... 3-3.99% ....................................... Total certificates .......................... Total deposits .............................. Weighted Average Rate 2017 Amount Percent of Total Weighted Average Rate 2016 Amount Percent of Total 0.00% $ 0.05 0.08 0.40 0.94 0.30 $ 172,007 90,599 75,255 186,937 524,798 58,444 43,691 8,550 118 110,803 635,601 27.1 % 14.3 11.8 29.4 82.6 9.2 6.9 1.3 0.0 17.4 100.0 % 0.00 % $ 0.07 0.08 0.25 0.61 0.20 $ 158,024 92,670 74,238 165,179 490,111 79,628 22,958 0 114 102,700 592,811 26.7% 15.6 12.5 27.9 82.7 13.4 3.9 0.0 0.0 17.3 100.0% At December 31, 2017 and 2016, the Company had $204.2 million and $172.6 million, respectively, of deposit accounts with balances of $250,000 or more. At December 31, 2017 and 2016, the Company had no certificate accounts that had been acquired through a broker. Certificates had the following maturities at December 31, 2017 and 2016: (Dollars in thousands) Remaining term to maturity 1-6 months ........................................................................................... $ 7-12 months ......................................................................................... 13-36 months ....................................................................................... Over 36 months ................................................................................... $ 2017 2016 Amount Weighted Average Rate Amount Weighted Average Rate 28,133 37,439 39,382 5,849 110,803 0.54% $ 0.95 1.14 1.28 0.94 $ 32,418 25,424 36,111 8,747 102,700 0.36% 0.45 0.81 1.18 0.61 At December 31, 2017 and 2016, the Company had pledged mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $18.9 million and $17.4 million, respectively, as collateral for certain deposits. An additional $1.0 million letter of credit from the Federal Home Loan Bank (FHLB) was pledged at December 31, 2016 as collateral on certain Bank deposits. This letter of credit matured in August of 2017 and was not renewed. 49  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Interest expense on deposits is summarized as follows for the years ended December 31, 2017, 2016 and 2015: (Dollars in thousands) NOW accounts ......................................................................................... $ Savings accounts ...................................................................................... Money market accounts ........................................................................... Certificates ................................................................................................ $ 2017 2016 2015 77 63 560 770 1,470 50 62 366 524 1,002 17 42 347 528 934 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, 2017 or December 31, 2016. At December 31, 2017 it had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $106.3 million, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of $77.9 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2017, subject to approval from the Board of Governors of the Federal Reserve System (FRB). At December 31, 2016 it had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with an available borrowing capacity of approximately $104.7 million, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of $85.8 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2016, 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 was 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. The Company had the option to voluntarily prepay the Note in whole or in part without penalty. The Company made the scheduled $1.0 million principal payment on December 15, 2015, a $2.0 million payment on December 15, 2016, and on August 31, 2017 paid off the remaining principal balance of $7.0 million. There was no outstanding loan balance at December 31, 2017 and the loan balance was $7.0 million at December 31, 2016. NOTE 13 Income Taxes Income tax expense for the years ended December 31, 2017, 2016 and 2015 is as follows: (Dollars in thousands) Current: Federal ...................................... $ State .......................................... Total current ........................ Deferred: Federal ...................................... State .......................................... Total deferred ...................... Income tax expense ..................... $ 2017 2016 2015 2,287 10 2,297 1,412 693 2,105 4,402 939 55 994 2,322 806 3,128 4,122 (87) (24) (111) 1,393 329 1,722 1,611 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 income tax deduction ............... Tax exempt interest ..................... Change in federal tax rate ........... Other, net ..................................... Income tax expense ........................ $ 2017 2016 2015 2,994 3,560 1,553 529 (16) 1,062 (167) 4,402 622 (16) 0 (44) 4,122 259 (44) 0 (157) 1,611 50  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: Allowances for loan and real estate losses ...... $ Deferred compensation costs ........................... Deferred ESOP loan asset ................................ Nonaccruing loan interest ................................ State net operating loss carryforward .............. Alternative minimum tax credit 2017 2016 2,602 166 487 221 824 4,186 262 704 313 1,366 carryforward .................................................. 175 118 Net unrealized loss on securities available for sale ................................................................ Other................................................................. Total gross deferred tax assets .................... 372 92 4,939 542 147 7,638 Deferred tax liabilities: Deferred loan fees ............................................ Premises and equipment basis difference ........ Originated mortgage servicing rights .............. Federal tax liability on state net operating loss carryforwards ......................................... Other................................................................. Total gross deferred tax liabilities ............... Net deferred tax assets ................................ $ 37 380 482 280 88 1,267 3,672 100 126 636 676 153 1,691 5,947 The Company has no loss carryforwards and $8.7 million of state net operating loss carryforwards at December 31, 2017 that expire beginning in 2023. federal net operating On December 22, 2017 the Tax Cuts and Jobs Act became law. Among other things, this law reduced the corporate tax rate for the Company from 34% to 21% effective January 1, 2018. In accordance with current accounting guidelines, this change in the tax rate was reflected as an adjustment to the Company’s deferred tax items at December 31, 2017. The net result of this adjustment was to reduce the Company’s net deferred tax asset by $1.1 million with a corresponding increase to income tax expense in the fourth quarter of 2017. included Retained earnings at December 31, 2017 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 the deferred tax assets. Positive evidence includes cumulative net income generated over the prior three year period and the probability that taxable income will be generated in future periods. Based upon this evaluation, the Company determined that no valuation allowance was required with respect to the net deferred tax assets at December 31, 2017 and 2016. 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 have been 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, 2017 because such information is not accumulated for each participating institution. As of June 30, 2017, the Pentegra DB Plan valuation report reflected that the Bank was obligated to make a contribution totaling $0.1 million which was paid and expensed in 2017. Funded status (market value of plan assets divided by funding target) as of July 1 for the 2017, 2016, and 2015 plan years were 95.45%, 97.09% and 96.01%, respectively. Market value of plan assets reflects contributions received through June 30, 2017. Total employer contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $153.2 million, $163.1 million and $190.8 million for the plan years ended June 30, 2017, 2016 and 2015, 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. 51  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following contributions were paid by the Bank during the fiscal years ending December 31: (Dollars in thousands) 2017 Date Paid 1/6/2017 ......................... $ 10/15/2017 ..................... 12/27/2017 ..................... Total .............................. $ Amount Date Paid Amount Date Paid Amount 2016 2015 119 (1) 27 99 245 10/15/16 $ $ 0 33 0 33 10/15/2015 12/30/2015 $ $ 0 42 151 193 (1) The contribution relates to the 2016 plan year and was accrued at December 31, 2016. 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 2017, 2016 and 2015. 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 2017, 2016 and 2015. 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 to 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 2017, 2016 and 2015. 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. 52 ESOP compensation expense was $0.4 million for 2017 and $0.3 million for both 2016 and 2015. 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 beginning of the year ................. Shares allocated to participants .... Shares distributed to participants . Shares held by participants end of 2017 2016 2015 339,870 334,277 336,024 24,317 24,317 (26,064) (7,052 ) 24,377 (18,784) year ............................................ 357,135 339,870 334,277 Unreleased shares beginning of the year ...................................... Shares released during year .......... Unreleased shares end of year ...... Total ESOP shares end of year ..... Fair value of unreleased shares at 279,746 304,123 328,440 (24,317 ) (24,317) (24,377) 255,429 279,746 304,123 612,564 619,616 638,400 December 31 .............................. $ 4,878,694 4,895,555 3,512,621 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, 2017, all outstanding options under the 2001 Plan have expired. In April of 2017, the 2009 Plan was superseded by the HMN Financial, Inc. 2017 Equity Incentive Plan (2017 Plan) and options or restricted shares were no longer awarded from the 2009 Plan. As of December 31, 2017 there were 26,409 vested and 22,820 unvested options outstanding under the 2009 Plan. These options expire 10 years from the date of grant and have an average exercise price of $9.25. There were also 14,881 shares of restricted stock previously granted to current employees that as of December 31, 2017 remain unvested. The 43,712 ungranted shares remaining in the 2009 Plan were transferred to the 2017 Plan upon its adoption and are available for grant under that plan.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS their interests with The purpose of the 2017 Plan is to attract and retain the best available personnel for positions of responsibility with the Company, to provide additional incentives to them and align the Company’s stockholders, and to thereby promote the Company’s long- term business success. 375,000 shares of HMN common stock were initially available for distribution under the 2017 Plan in either restricted stock or options, subject to adjustment for future stock splits, stock dividends and those of the Company. to capitalization of similar changes Additionally, shares of restricted stock that are awarded are counted as 1.5 shares for purposes of determining the total shares available for issuance under the 2017 Plan. As of December 31, 2017, there were no options outstanding under the 2017 Plan. There were 2,280 shares of restricted stock granted to current employees during 2017 that remain unvested at December 31, 2017. 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 (in years) Number 2001 Plan December 31, 2014........................................... Forfeited/expired ......................................... December 31, 2015........................................... December 31, 2016........................................... December 31, 2017 .......................................... 2009 Plan December 31, 2014........................................... Granted January 27, 2015 ............................ Granted April 28, 2015 ................................ Granted June 8, 2015 ................................... Forfeited/expired .......................................... Transferred from 2001 Plan ......................... Vested........................................................... December 31, 2015........................................... Granted January 26, 2016 ............................ Granted January 26, 2016 ............................ Granted April 26, 2016 ................................ Vested........................................................... December 31, 2016........................................... Granted January 31, 2017 ......................... Transferred to 2017 Plan .......................... Vested .......................................................... December 31, 2017 .......................................... 0 0 0 0 0 96,405 (11,903) (3,158) (398) 395 15,000 0 96,341 (4,087) (34,229) (3,149) 0 54,876 (11,164) (43,712) 0 0 2017 Plan April 25, 2017 .................................................. Granted May 5, 2017 ...................................... Transferred from 2009 Plan .......................... December 31, 2017 .......................................... 375,000 (3,420) 43,712 415,292 0 0 0 0 0 15,000 $ (15,000) 0 0 0 30.00 30.00 0.00 0.00 0.00 0 0 0 0 0 84,858 9,919 2,632 332 (329) 0 (58,526) 38,886 3,406 0 2,624 (24,320) 20,596 9,303 0 (15,018) 14,881 15,000 $ 0 0 0 0 0 0 15,000 0 34,229 0 0 49,229 0 0 0 49,229 $ 2,280 0 2,280 0 0 0 0 0 0 0 0 0 0 0 0 34,229 0 0 34,229 4.04 4.04 (11,409) 22,820 $ 4.04 4.04 4.77 N/A N/A N/A 4.77 N/A 11.21 N/A 9.25 N/A N/A 9.25 N/A N/A 0 3 1 1 3 3 1 3 1 Total all plans .................................................. 415,292 17,161 49,229 $ 9.25 22,820 $ 4.04 53  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes information about stock options outstanding at December 31, 2017: Date of Grant May 6, 2009 ......................................... $ January 26, 2016 .................................. $ Exercise Price 4.77 11.21 Weighted Average Remaining Contractual Life in Years 1.4 8.1 Number Outstanding 15,000 34,229 49,229 Number Number Unexercisable Unrecognized Compensation Expense Exercisable 15,000 11,409 26,409 0 $ 22,820 22,820 $ 0 18,062 18,062 Weighted Average Years Over Which Unrecognized Compensation will be Recognized N/A 1.1 The Company will issue shares from treasury stock upon the exercise of outstanding options. The assumptions used in determining the fair value of the options granted during 2016 are as follows: In accordance with ASC 718, the Company recognizes compensation expense relating to stock options over the vesting period. The amount of the expense was determined under the fair value method. The fair value for each option grant is estimated on the date of the grant using the Black Scholes option valuation method. There were no options granted in 2017 or 2015. Risk-free interest rate ............................................................ Expected life (in years) .......................................................... Expected volatility ................................................................. Expected dividends ................................................................ 2016 2.10% 10 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 earnings per 2017 Year ended December 31, 2016 2015 common share calculation ............................................................................................. 4,215,899 4,180,994 4,127,453 Net dilutive effect of : Options and warrants ..................................................................................................... Restricted stock awards ................................................................................................. 640,410 11,662 553,386 13,367 513,505 34,959 Weighted average number of common shares outstanding adjusted for effect of dilutive securities ........................................................................................................... 4,867,971 4,747,747 4,675,917 Net income .......................................................................................................................... $ Dividends on preferred stock ............................................................................................. Net income available to common shareholders ................................................................. $ Basic earnings per common share ...................................................................................... $ Diluted earnings per common share ................................................................................... $ 4,404 0 4,404 1.04 0.90 6,350 0 6,350 1.52 1.34 2,956 (108) 2,848 0.69 0.61 54  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16 Stockholders' Equity The Company did not repurchase any shares of its common stock in the open market or pay any dividends on its common stock during 2017, 2016 or 2015. The Company did purchase 2,968 shares of common stock from employees to pay the income taxes on net exchanges of vested restricted stock in 2017. 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 the Emergency Economic Purchase Program under 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, 2017 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 The Company and the Bank are subject to 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 capital ratios and buffer requirements which are being phased in incrementally, with full 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. from The FRB amended its Policy Statement, to exempt small the above capital bank holding companies 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 the Policy and 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. 55  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2017 and 2016, the Bank's capital amounts and ratios are presented for actual capital, required capital and excess capital including amounts and ratios in order to qualify as being well capitalized under the prompt corrective action regulations: Actual Required to be Adequately Capitalized Excess Capital To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Percent of Assets(1) Amount Percent of Assets(1) Amount Percent of Assets(1) Amount Percent of Assets(1) (Dollars in thousands) December 31, 2017 Common equity Tier 1 capital .......... $ Tier 1 leverage .................................... Tier 1 risk-based capital .................... Total risk-based capital ..................... 76,279 76,279 76,279 83,957 12.45% $ 27,561 28,569 10.68 36,748 12.45 48,997 13.71 4.50% $ 48,718 47,710 4.00 6.00 39,531 34,960 8.00 7.95% $ 39,810 35,711 6.68 48,997 6.45 61,246 5.71 6.50 % 5.00 8.00 10.00 December 31, 2016 Common equity Tier 1 capital .............. $ Tier 1 leverage ...................................... Tier 1 risk-based capital ....................... Total risk-based capital ........................ 77,634 77,634 77,634 84,900 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 (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. 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 2017, the capital conservation buffer was 1.25%. 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, 2017, 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. 56  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 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, 2017, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: Payments Due by Period Less than 1 Year 1-3 Years 4-5 Years More than 5 Years Total (Dollars in thousands) Contractual Obligations: Annual rental (Dollars in thousands) Financial instruments whose contract amount represents credit risk: Commitments to originate, fund or purchase loans: Single family .......................................... $ Commercial real estate ........................... Non-real estate commercial .................... Undisbursed balance of loans closed ..... Unused lines of credit ............................. Letters of credit ...................................... Total commitments to extend credit ................ $ Forward commitments ..................................... $ December 31, Contract Amount 2016 2017 commitments under non-cancellable operating leases .............. $ 5,740 888 1,740 1,679 1,433 Total contractual obligations ............. $ 5,740 888 1,740 1,679 1,433 3,792 12,968 6,495 44,712 103,811 1,867 173,645 5,629 7,587 33,953 420 39,841 100,893 1,902 184,596 9,595 Amount of Commitments Expiring by Period Other Commercial Commitments: Commercial lines of credit ............................... $53,691 25,433 17,175 11,033 Commitments to lend ........ 39,965 13,691 Standby letters of credit .... 1,867 1,546 Total other 50 994 13,110 12,170 0 321 0 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 34 months and totaled $1.9 million at December 31, 2017 and December 31, 2016. The letters of credit are collateralized 57 commercial commitments ......... $95,523 40,670 18,490 24,143 12,220 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 Company had commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the year, which is referred to as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, the Company generally enters into commitments to sell the secondary market. The commitments to originate and sell loans are derivatives that are recorded at fair value. The marking of these derivatives to fair value for the periods ended December 31, 2017 and December 31, 2016 did not have a material impact on the Company’s consolidated financial statements. loans into the  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS the current As of December 31, 2017 and 2016, 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. The marking of these loans for the periods ended December 31, 2017 and December 31, 2016 did not have a material impact on the Company’s consolidated financial statements. 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 liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access. Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. 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, 2017 and 2016. (Dollars in thousands) Securities available for sale .............................................................. $ Mortgage loan commitments ............................................................ Total .................................................................................................... $ Total Level 1 Level 2 Level 3 77,472 28 77,500 0 0 0 77,472 28 77,500 Carrying Value at December 31, 2017 (Dollars in thousands) Securities available for sale ................................................................. $ Mortgage loan commitments ............................................................... Total ..................................................................................................... $ Total Level 1 Level 2 Level 3 78,477 66 78,543 0 0 0 78,477 66 78,543 Carrying Value at December 31, 2016 0 0 0 0 0 0 58  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 2017 and 2016 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, 2017 and 2016. Carrying Value at December 31, 2017 (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 1,837 1,724 3,201 627 7,389 0 0 0 0 0 1,837 1,724 3,201 627 7,389 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 Level 2 Level 3 2,009 1,604 3,582 611 7,806 0 0 0 0 0 2,009 1,604 3,582 611 7,806 Year Ended December 31, 2017 Total gains (losses) 0 0 0 0 0 1 0 (413) 0 (412) Year Ended December 31, 2016 Total gains (losses) 0 0 0 0 0 14 0 (380) (197) (563) (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, 2017 and 2016 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. 59  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. (Dollars in thousands) Financial assets: December 31, 2017 Fair value hierarchy December 31, 2016 Carrying amount Estimated fair value Level 1 Level 2 Level 3 Contract amount Carrying amount Estimated fair value Contract amount 37,564 37,564 Cash and cash equivalents .................... $ 37,564 77,472 77,472 Securities available for sale .................. 1,837 1,837 Loans held for sale ................................ Loans receivable, net ............................ 585,931 585,494 817 FHLB stock ........................................... 2,344 Accrued interest receivable ................... 817 2,344 77,472 1,837 585,494 817 2,344 27,561 78,477 2,009 27,561 78,477 2,009 551,171 552,395 770 2,626 770 2,626 Financial liabilities: Deposits ................................................. 635,601 635,905 0 Other borrowings .................................. 146 Accrued interest payable ....................... 0 146 635,905 0 146 592,811 593,297 7,018 236 7,000 236 Off-balance sheet financial instruments: Commitments to extend credit .............. Commitments to sell loans.................... 28 (11) 28 (11) 173,645 5,629 66 (22) 66 184,596 9,595 (22) 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. 60  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, 2017 and 2016 and for the years ended December 31, 2017, 2016 and 2015. (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, 4,631,124 and 4,639,739 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 ................................................................................... Earned employee stock ownership shares priced above original cost ................... Stock option compensation .................................................................................... Amortization of restricted stock awards ................................................................ Decrease in unearned ESOP shares ....................................................................... 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 ........................................................................... Stock awards withheld for tax withholding ................................................................ Proceeds from borrowings .......................................................................................... Repayments of borrowings ......................................................................................... Dividends received from Bank ................................................................................... Net cash (used) provided by financing activities ....................................................... (Decrease) increase in cash and cash equivalents ...................................................... Cash and cash equivalents, beginning of year ................................................................ Cash and cash equivalents, end of year ........................................................................... $ 61 2017 2016 2015 2,057 77,006 1,867 141 81,071 0 253 253 91 50,623 91,448 (957) (2,030) (58,357) 80,818 81,071 0 (306) 4,878 (257) (30) (6) (130) (319) 3,830 (574) 4,404 3,314 78,108 1,159 756 83,337 7,000 418 7,418 91 50,566 86,886 (820 ) (2,223 ) (58,581 ) 75,919 83,337 0 (589 ) 7,148 (264 ) (30 ) (6 ) (138 ) (329 ) 5,792 (558 ) 6,350 4,404 6,350 (4,878) 615 147 41 147 193 (6) (866) 0 (203) 0 0 0 0 (54) 0 (7,000) 6,000 (1,054) (1,257) 3,314 2,057 (7,148 ) 244 80 79 177 194 (11 ) (214 ) (1 ) (250 ) 0 0 0 0 0 0 (2,000 ) 3,000 1,000 750 2,564 3,314 1 (571 ) 3,629 (269 ) (30 ) (6 ) (119 ) (216 ) 2,419 (537 ) 2,956 2,956 (3,629 ) 22 57 0 447 193 (23 ) (692 ) 1 (668 ) 900 900 (10,000 ) (225 ) 0 10,000 (1,000 ) 3,000 1,775 2,007 557 2,564  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, 2017: Interest income – external customers .............................................. $ Non-interest income – external customers ...................................... 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, 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 .......................................................................................... 27,680 7,654 210 1,491 24,722 4,976 4,879 722,532 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 0 0 4,879 306 742 (574) 4,404 79,254 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 (5,089) 0 (210) 0 (4,879) (79,101) 0 0 (1) (7,358) 0 (210) 0 (7,148) (81,456) 0 0 (1) (3,833) (1) (204) 0 (3,629) (77,152) 27,680 7,654 0 1,797 25,254 4,402 4,404 722,685 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 62 63 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: 2017 Year Ended December 31, 2016 2015 FHLB advances .......................................................................................... $ FHLB short-term advances ........................................................................ Average Balance: FHLB advances .......................................................................................... FHLB short-term advances ........................................................................ 18,800 18,800 1,693 1,693 15,500 15,500 468 468 16,000 16,000 551 551 See “Note 12 FHLB Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and other borrowings. 64 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, 2017, the Company had 9,128,662 shares of common stock issued and 4,631,124 shares in treasury stock. As of December 31, 2017, there were 507 stockholders of record and 1,067 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 9, 2018, 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, 2017 and no common stock dividends are anticipated to be paid in 2018. 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, 2017 September 30, 2017 June 30, 2017 March 31, 2017 December 31, 2016 September 30, 2016 June 30, 2016 March 31, 2016 HIGH ........ $ LOW ......... CLOSE ..... 19.45 17.80 19.10 18.95 16.61 17.85 18.50 16.60 17.55 18.70 17.48 18.05 18.55 13.58 17.50 15.00 13.25 14.16 14.44 11.25 13.58 11.80 10.81 11.26 For the Quarter Ended 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, 2012 and that all dividends were reinvested. Index HMN Financial, Inc. .................................... Nasdaq Composite Index ............................ SNL Bank Nasdaq Index ............................. 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 100.00 100.00 100.00 304.50 140.12 143.73 357.21 160.78 148.86 332.73 171.97 160.70 504.13 187.22 222.81 12/31/17 550.23 242.71 234.58 Period Ending 65  December 31, 2017 September 30, 2017 June 30, 2017 6,767 435 6,332 59 6,273 837 296 610 216 1,959 3,641 0 953 311 302 1,002 6,209 2,023 1,636 387 0.09 0.08 7,255 493 6,762 (581) 7,343 848 299 521 241 1,909 3,642 (65) 1,050 243 307 1,082 6,259 2,993 1,213 1,780 0.42 0.37 0.21% 1.88 11.43 3.64 0.99% 8.78 11.43 3.92 722,685 5,068 72,404 1,837 585,931 635,601 0 80,818 716,610 5,450 72,901 2,594 583,057 628,971 0 80,632 6,999 461 6,538 269 6,269 845 306 488 267 1,906 3,780 (1) 1,026 260 417 957 6,439 1,736 712 1,024 0.24 0.21 0.60% 5.19 11.51 3.98 725,183 613 78,034 2,061 590,259 634,101 7,000 78,723 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 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 ..................................................................... $ 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 (end of period): 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, 2017 December 31, 2016 September 30, 2016 June 30, 2016 March 31, 2016 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 0.35 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 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 0.43 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 6,659 408 6,251 (270) 6,521 824 301 519 236 1,880 3,944 (6) 1,039 292 259 819 6,347 2,054 841 1,213 0.29 0.25 0.73% 6.35 11.49 3.91 680,981 797 77,751 2,430 565,040 591,376 7,000 77,400 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 0.40 0.35 0.99% 8.93 11.07 3.89 682,023 1,005 77,472 2,009 551,171 592,811 7,000 75,919 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 0.34 0.30 0.84% 7.55 11.10 4.10 685,667 1,306 78,810 5,879 540,583 592,243 9,000 74,834 67 This page intentionally left blank HMN FINANCIAL, INC. 1016 Civic Center Drive NW Rochester, MN 55901 (507) 535-1200 ANNUAL MEETING The annual meeting of shareholders will be held on Tuesday, April 24, 2018 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: Equiniti Trust Company EQ Shareowner Services 1110 Centre Pointe Curve, Suite 101 Mendota Heights, MN 55120 www.shareowneronline.com (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 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 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 2017 ANNUAL REPORT 2017_AnnualReport_full.indd 1 2/6/2018 1:02:18 PM 

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