HMN Financial Inc.
Annual Report 2019

Plain-text annual report

1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 • www.hmnf.com 2019 ANNUAL REPORT TABLE OF CONTENTS 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 ...................................................................................................................................... 22 Notes to Consolidated Financial Statements ....................................................................................................................... 26 Report of Independent Registered Public Accounting Firm ................................................................................................ 54 Other Financial Data ........................................................................................................................................................... 55 Selected Quarterly Financial Data ....................................................................................................................................... 56 Common Stock Information ................................................................................................................................................ 58 Corporate and Shareholder Information .................................................................................................... Inside Back Cover Directors and Officers ............................................................................................................................... Inside Back Cover HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal Savings Bank operates twelve full service offices in Minnesota located in Albert Lea, Austin, Eagan, Kasson, La Crescent, Owatonna, Rochester (4), Spring Valley and Winona, one full service office in Marshalltown, Iowa, and one full service office in Pewaukee, Wisconsin. The Bank also operates a loan origination office in Sartell, Minnesota. At or For the Year Ended December 31, 2019 2018 Percentage 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 ............................................................................... $ 31,890 3,339 28,551 (1,216 ) 29,767 3,100 1,278 2,941 1,136 8,455 27,105 11,117 3,324 7,793 Per Common Share Information: Earnings per common share and common share equivalents: Basic ......................................................................................... $ Diluted ...................................................................................... 1.69 1.68 Stock price (for the year): High .......................................................................................... $ Low .......................................................................................... Close ........................................................................................ Book value per common share ........................................................ Closing price to book value ............................................................. 23.34 19.01 21.01 19.13 109.83 % 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 ................................................................................ 1.05 % 8.74 4.04 3.67 12.06 11.91 0.34 73.25 30,381 2,233 28,148 (649) 28,797 3,330 1,255 2,095 1,034 7,714 25,387 11,124 2,888 8,236 1.89 1.71 21.90 18.05 19.62 17.19 114.14% 1.14% 9.88 4.03 3.51 11.52 11.67 0.43 70.79 5.0% 49.5 1.4 (87.4) 3.4 (6.9) 1.8 40.4 9.9 9.6 6.8 (0.1) 15.1 (5.4) (7.9)% (11.5) 0.2 4.6 4.7 2.1 (20.9) 3.5 Balance Sheet Data: (Dollars in thousands) Total assets ...................................................................................... $ Securities available for sale ............................................................. Loans held for sale .......................................................................... Loans receivable, net ....................................................................... Deposits ........................................................................................... 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, 2019 2018 Percentage Change 777,639 107,592 3,606 596,392 673,870 92,648 712,315 79,859 3,444 586,688 623,352 83,147 13.21 % 10.89 13.21 14.46 13.26 % 11.00 13.26 14.52 9.2% 34.7 4.7 1.7 8.1 11.4 (0.4)% (1.0) (0.4) (0.4) 1 LETTER TO SHAREHOLDERS AND CLIENTS I am very pleased with the financial performance that HMN Financial, Inc. (HMN) reported for 2019. Our dedicated staff worked very hard to execute our strategic plan and improve the financial performance and asset quality of the bank. As of year-end, total assets had increased over $65 million since last year. While net loans increased approximately $10 million, new commercial loan production exceeded $90 million for the year while mortgage loan production exceeded $150 million - both substantial increases over the previous year’s levels. Most importantly, deposits rose over $50 million during the year which can be attributed to a number of initiatives: • • • In October 2018, we purchased an existing branch facility in Pewaukee, Wisconsin, fully aware that deed restrictions would prevent us from opening a branch there for twelve months. We used this time to update both the interior and exterior of the facility and implemented the latest technology in order to reduce the number of employees needed to operate the branch. This way, production staff is able to spend more time out in the community meeting with prospective clients and serving existing ones. During the year, we also recruited a number of excellent local community bankers to staff the office. We opened a full service branch in October 2019 and have been very pleased with the support of the local community and the performance of the branch. In early 2019, we commenced construction of an expansion to our drive-up branch facility in Kasson, Minnesota. Once again, we utilized the latest technology and completely remodeled the original floorplan in order to operate the branch as efficiently as possible. In September 2019, we closed on the sale of our downtown branch location in Kasson to another local business which allowed us to consolidate all of our operations into a single convenient location for that market. The community response has been very positive as evidenced by the deposit growth that we experienced during the year - in large part due to our efforts to ensure that our original main street storefront was not abandoned but repurposed. In the second half of 2018, a number of new product and marketing initiatives were launched in order to increase organic deposit growth. The implementation of these initiatives resulted in a substantial increase in the number of new retail and commercial deposit accounts opened in 2019 compared to the previous year’s results. While pleased with the organic deposit growth we experienced in 2019, we continue to look for acquisition targets that will grow the asset size of the bank, enhance our franchise value and improve our financial performance. During this past year we analyzed a number of acquisition opportunities and aggressively pursued some of those opportunities but ultimately, we determined not to go forward with any acquisitions in 2019. We are very sensitive to the potential dilution an acquisition could have on our common shareholders and will continue to remain disciplined in our approach to valuing and pursuing acquisition targets. Another area of focus this past year was the management of our net interest margin. Maintaining net interest margins was a challenge in 2019 due to the Federal Open Market Committee’s decision to reduce the Federal Funds rate by 75 basis points during the year which resulted in a corresponding decrease in the Prime interest rate. The decrease in the Prime interest rate resulted in fierce pricing competition on loans for quality borrowers which resulted in lower loan rates while deposit costs fell more slowly. Fortunately, our net interest margin for the year held steady from the previous year at 4.04%. Once again, our asset quality improved with past due loans declining to just 19 basis points of total loans at year-end. During the year, we were able to move a number of our weakest, but performing, commercial loan relationships out of the bank. We believe this proactive approach capitalized on the fierce competition for loan growth in our markets and left our bank in a better position should economic conditions deteriorate. 2 The capital positions of both the bank and HMN remain very strong when compared to our peers. Over the past several years we have strategically deployed excess capital to repurchase preferred stock, repay outstanding debt, and repurchase common stock warrants. All of this was accomplished while continuing to maintain adequate liquidity and capital at HMN to ensure that it remains a source of strength for the bank. After considering HMN’s capital positon, our Board of Directors has approved a stock repurchase plan which provides management the ability to repurchase up to $6 million of outstanding HMN common stock. Repurchases of common stock could support the stock price, if needed, and return excess capital to our shareholders should it not be needed to support anticipated growth. Management and the Board will continue to evaluate the most prudent use of our capital resources on a quarterly basis. We appreciate your interest in HMN and thank you for your continued support of our mission. Best Regards, Bradley Krehbiel President/CEO 3 BOARD OF DIRECTORS Dr. Hugh Smith Chairman of the Board Bradley Krehbiel President and CEO Dr. Wendy Shannon Vice Chair Allen Berning Michael Bue Sequoya Borgman Bernard Nigon 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 .......................................................... Net income ................................................................ Preferred stock dividends and discount ..................... Net income available to common shareholders ......... $ 2019 31,890 3,339 28,551 (1,216) 29,767 3,100 1,278 2,941 1,136 8,455 27,105 11,117 3,324 7,793 0 7,793 Year Ended December 31, 2017 2018 30,381 2,233 28,148 (649) 28,797 3,330 1,255 2,095 1,034 7,714 25,387 11,124 2,888 8,236 0 8,236 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 4,404 (645 ) 2015 2016 27,349 21,453 1,593 1,507 25,756 19,946 (164) 26,401 20,110 3,427 3,316 1,108 1,046 2,618 1,964 1,048 1,327 8,201 7,653 24,130 23,196 10,472 4,567 4,122 1,611 6,350 2,956 (108) 6,350 2,848 0 Basic earnings per common share ............................. $ Diluted earnings per common share .......................... 1.69 1.68 1.89 1.71 1.04 0.90 1.52 1.34 0.69 0.61 (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. 2019 Selected Financial Condition Data: (Dollars in thousands, except per share data) Total assets ........................................................................... $ 777,639 Securities available for sale .................................................. 107,592 3,606 Loans held for sale ............................................................... Loans receivable, net ............................................................ 596,392 Deposits ................................................................................ 673,870 Federal Home Loan Bank advances and other borrowings .. 0 Stockholders’ equity ............................................................. 92,648 19.13 Book value per common share ............................................. 2018 712,315 79,859 3,444 586,688 623,352 0 83,147 17.19 At December 31, 2017 722,685 77,472 1,837 585,931 635,601 0 80,818 17.97 2016 682,023 78,477 2,009 551,171 592,811 7,000 75,919 16.91 2015 643,161 111,974 3,779 463,185 559,387 9,000 69,645 15.54 Number of full service offices(2)............................................ Number of loan origination offices(2) .................................... 14 1 14 2 13 3 13 3 13 3 Key Ratios: (3) Stockholders’ equity to total assets at year end .................... Average stockholders’ equity to average assets ................... Return on stockholders’ equity (ratio of net income to 11.91 % 11.67 % 11.18 % 11.13 % 10.83 % 12.06 11.70 11.07 11.43 11.52 average equity) .................................................................. Return on assets (ratio of net income to average assets) ...... 8.74 1.05 9.88 1.14 5.52 0.63 8.71 0.96 4.27 0.50 (2) In 2019, converted Wisconsin loan origination office to a full service office and consolidated the two Kasson offices into one location. (3) Average balances were calculated based upon amortized cost without the market value impact of ASC 320. See accompanying notes to consolidated financial statements. 5 MANAGEMENT DISCUSSION AND ANALYSIS the allowance the appropriateness of This Annual Report, other reports filed by HMN Financial, Inc. (HMN or the Company) with the Securities and Exchange Commission (SEC), 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, maintaining net interest margins, reducing non-performing assets, and generating improved financial results (including profitability); the adequacy and amount of available liquidity and capital resources to Home Federal Savings Bank (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 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 relating to non-accruing and 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 anticipated results of litigation and our assessment of the impact on our financial statements; 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 generally (including the Bank’s status as “well-capitalized”) and other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement. 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 from 6 adequacy and marketability of real estate and other collateral securing loans to borrowers; federal and state regulation and enforcement; possible legislative and regulatory changes, including 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 continued 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 traditional and alternate funding sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank (FHLB); technological, computer-related or operational difficulties, including those from any third party cyberattack; 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 economic and 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 “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. laws; domestic international 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 is the stock savings bank holding company for the Bank, which operates community banking and loan production offices in Minnesota, Iowa and Wisconsin. The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and other borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and composition of interest-earning assets and interest-bearing MANAGEMENT DISCUSSION AND ANALYSIS 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, data processing costs, professional services, deposit insurance, amortization expense on mortgage servicing assets, advertising expenses, and income taxes. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply 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. 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 for the the non-homogeneous to determine loss allowance for the has established separate processes appropriateness of its loan homogeneous and non-homogeneous loan portfolios. The determination of the allowance on the homogeneous single family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance for all non-performing loans. The determination of the allowance commercial, commercial real estate and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company's own loss experience and are assigned identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans, or portions thereof, that are deemed uncollectible. loans without to all The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. reviewed periodically and any The estimates are adjustments are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income and by receiving recoveries of previously charged off loans. The Company decreases its allowance by crediting the provision for loan losses and recording loan charge offs. 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. 7 Litigation Estimates related to litigation are inherently subjective and the ultimate resolution of any litigation may be different than current management estimates. See “Note 18 Commitments and Contingencies” for further information. Results of Operations Comparison of 2019 with 2018 Net income was $7.8 million for 2019, a decrease of $0.4 million, or 5.4%, compared to net income of $8.2 million for 2018. Diluted earnings per share for the year ended December 31, 2019 was $1.68, a decrease of $0.03 per share compared to diluted earnings per share of $1.71 for the year ended December 31, 2018. The decrease in net income between the periods was because of a $1.7 million increase in non-interest expenses primarily related to increased compensation and professional services expense and a $0.4 million increase in income tax expense. These decreases in net income were partially offset by a $0.8 million increase in the gain on sales of loans, a $0.6 million decrease in the loan loss provision, and a $0.5 million increase in net interest income due to an increase in the average interest- earning assets between the periods. Net Interest Income Net interest income was $28.6 million for 2019, an increase of $0.5 million, or 1.4%, from $28.1 million for the same period of 2018. Interest income was $31.9 million for 2019, an increase of $1.5 million, or 5.0%, from $30.4 million for the same period of 2018. Interest income increased primarily because of the increase in the average yield earned on interest-earning assets between the periods. The average yield earned on interest-earning assets was 4.51% for 2019, an increase of 16 basis points from 4.35% for 2018. The increase in the average yield is primarily related to the increase in the average prime rate between the periods. Interest expense was $3.3 million for 2019, an increase of $1.1 million, or 49.5%, compared to $2.2 million in 2018. The average interest rate paid on interest-bearing liabilities and non-interest-bearing deposits was 0.52% for 2019, an increase of 17 basis points from 0.35% for 2018. The increase in interest paid on interest-bearing liabilities was primarily because of a lag in the timing of the market’s response in lowering deposit pricing when the federal funds rate decreased in the second half of 2019. Interest expense also increased as a result of an increase in the average federal funds rate between the periods. 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 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 U.S. generally accepted accounting principles (GAAP), 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 positive evidence considered includes the Company’s cumulative net income in the prior three year period, the ability to implement tax planning strategies to accelerate taxable income recognition, and the probability that taxable income will be generated in future periods. The Company could not currently identify any negative evidence. It is possible that future conditions may differ substantially from those anticipated in determining that no valuation allowance was required on deferred tax assets and adjustments may be required in the future. 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 MANAGEMENT DISCUSSION AND ANALYSIS The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Non-accruing loans have been included in the average outstanding loan balance in the table as loans carrying a zero yield. Average Outstanding Balance 2019 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2018 Interest Earned/ Paid Average Yield/ Rate Average Outstanding Balance 2017 Interest Earned/ Paid Average Yield/ Rate Year Ended December 31, (Dollars in thousands) Interest-earning assets: Securities available for sale: Mortgage-backed and related securities ... $ Other marketable securities ...................... Loans held for sale ......................................... Loans receivable, net(1) (2) .............................. FHLB stock and other earning assets including cash equivalents .......................... Total interest-earning assets .......................... $ Interest-bearing liabilities: Checking accounts ......................................... $ Passbooks ....................................................... Money market accounts ................................. Certificate accounts ....................................... FHLB advances and other borrowings .......... Total interest-bearing liabilities ..................... $ Noninterest checking ..................................... Other noninterest-bearing liabilities .............. Total interest-bearing liabilities and noninterest-bearing deposits ....................... $ Net interest income ........................................ Net interest rate spread .................................. Net earning assets .......................................... $ Net interest margin ........................................ Average interest-earning assets to average interest-bearing liabilities and noninterest- bearing deposits ........................................... 15,308 343 67,075 1,157 125 589,521 29,662 2,959 2.24 % $ 1.72 4.22 5.03 8,550 197 70,827 1,138 89 586,664 28,446 1,765 2.30 % $ 1.61 5.04 4.85 2,524 57 74,035 1,103 94 573,894 26,274 1,905 603 31,679 706,542 31,890 1.90 4.51 $ 511 30,567 698,373 30,381 1.67 4.35 $ 152 18,088 670,446 27,680 103 96,387 79,587 63 177,587 1,171 121,914 1,995 7 287 475,762 163,420 2,057 641,239 3,339 28,551 65,303 0.11 % $ 0.08 0.66 1.64 2.54 $ 0.52 % $ 3.99 % $ 4.04 % 62 86,750 61 77,630 865 199,202 114,243 1,243 2 140 477,965 156,482 1,534 635,981 2,233 28,148 62,392 0.07 % $ 0.08 0.43 1.09 1.71 $ 0.35 % $ 4.00 % $ 4.03 % 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 56,994 110.18 % 109.81 % 109.29 % 2.26 % 1.49 4.93 4.58 0.84 4.13 0.09 % 0.08 0.31 0.73 5.16 0.29 % 3.84 % 3.86 % (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 costs, loan discounts, loans in process and loss reserves. Net interest margin (net interest income divided by average interest-earning assets) for 2019 was 4.04%, an increase of 1 basis point compared to 4.03% for 2018. The increase in the net interest margin is primarily related to the increase in interest income as a result of the increase in the average yield earned on the interest-earning assets between the periods. Average net earning assets increased from $62.4 million in 2018 to $65.3 million in 2019. The $2.9 million increase in the net earning assets in 2019 is due primarily to the net income earned in 2019 that was partially offset by the purchase of premises and equipment. 9 MANAGEMENT DISCUSSION AND ANALYSIS interest income and The following table presents the dollar amount of changes in interest expense for major components of interest-earning assets and interest-bearing liabilities. It quantifies the changes in interest income and the average interest expense related outstanding balances (volume) and those changes caused by to changes in 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). Year Ended December 31, 2019 vs. 2018 Increase (Decrease) Due to 2018 vs. 2017 Increase (Decrease) Due to Volume (1) Rate (1) Total Increase Volume (1) Rate (1) Total Increase (Decrease) (Dollars in thousands) Interest-earning assets: Securities available for sale: Mortgage-backed and related securities .......................................... $ Other marketable securities ............... Loans held for sale ................................. Loans receivable, net ............................. Other ....................................................... Total interest-earning assets .............. $ Interest-bearing liabilities: Checking accounts ................................. $ Passbooks ............................................... Money market accounts ......................... Certificates of deposit ............................ FHLB advances and other borrowings .. Total interest-bearing liabilities ........ $ Increase in net interest income ................... $ 156 (60) 60 105 17 278 1 2 (21) 53 3 38 240 (10) 79 (24) 1,111 75 1,231 40 0 327 699 2 1,068 163 146 19 36 1,216 92 1,509 41 2 306 752 5 1,106 403 136 (48) (7) 806 102 989 6 0 37 79 (325) (203) 1,192 4 83 2 1,366 257 1,712 (21 ) (2 ) 268 394 0 639 1,073 140 35 (5) 2,172 359 2,701 (15) (2) 305 473 (325) 436 2,265 (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, 2019 Weighted average rate on: Mortgage-backed and related securities .............................. 2.13 % Checking accounts ........................................................................ 0.13 % Other marketable securities ................................................. 1.72 Loans held for sale ................................................................... 3.99 Loans receivable, net ............................................................... 4.79 FHLB stock and other interest-earning assets ......................... 1.71 Combined weighted average yield on interest-earning assets . 4.22 Passbook accounts ........................................................................ 0.08 Money market accounts ................................................................ 0.65 Certificates of deposit ................................................................... 1.84 Combined weighted average rate on interest-bearing liabilities .. 0.56 Interest rate spread ........................................................................ 3.66 Provision for Loan Losses The provision for loan losses was ($1.2) million for 2019, a decrease of $0.6 million compared to the ($0.6) million provision for loan losses for 2018. The credit provision amount for the period was primarily the result of the increase in net recoveries received during 2019 when compared to the same period of 2018. The net recoveries, combined with the changes in the credit reserve amounts required on the existing portfolio, resulted in a reduction of the overall provision for loan losses between the periods. 10 MANAGEMENT DISCUSSION AND ANALYSIS A reconciliation of the allowance for loan losses for 2019 and 2018 is summarized as follows: (Dollars in thousands) Balance beginning of period ..................................................................................................................................... $ Provision ................................................................................................................................................................... Charge offs: Single family ........................................................................................................................................................ Consumer ............................................................................................................................................................. Commercial business ........................................................................................................................................... Recoveries ................................................................................................................................................................ Balance at December 31, .......................................................................................................................................... $ Allocated to: General allowance .................................................................................................................................................... $ Specific allowance .................................................................................................................................................... $ 2019 2018 8,686 $ (1,216 ) (1 ) (107 ) (880 ) 2,082 8,564 $ 7,839 725 8,564 9,311 (649) (24) (226) (270) 544 8,686 7,892 794 8,686 Non-Interest Income Non-interest income was $8.5 million for the year ended December 31, 2019, an increase of $0.8 million, or 9.6%, from $7.7 million for the year ended December 31, 2018. 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 ......................... $ 2019 Year ended December 31, 2018 3,100 1,278 2,941 1,136 8,455 3,330 1,255 2,095 1,034 7,714 Percentage Increase (Decrease) 2017 2019/2018 2018/2017 3,354 1,202 2,138 960 7,654 (6.9)% 1.8 40.4 9.9 9.6 (0.7)% 4.4 (2.0) 7.7 0.8 Gain on sales of loans increased $0.8 million between the periods primarily because of an increase in single family loan sales. Other non-interest income increased $0.1 million due primarily to an increase in the gains recognized on equity securities between the periods. Loan servicing fees increased slightly due to an increase in single family loan servicing fees earned between the periods. These increases were partially offset by a decrease of $0.2 million in fees and service charges due to a decrease in commitment fees and late charges earned on loans between the periods. Non-Interest Expense Non-interest expense was $27.1 million for the year ended December 31, 2019, an increase of $1.7 million, or 6.8%, from $25.4 million for the year ended December 31, 2018. The following table presents the components of non-interest expense: (Dollars in thousands) Compensation and benefits ........................... $ Occupancy and equipment ............................ Data processing.............................................. Professional services ..................................... Other .............................................................. Total non-interest expense ............................. $ 2019 Year ended December 31, 2018 15,659 4,442 1,263 1,573 4,168 27,105 14,728 4,304 1,270 1,137 3,948 25,387 Percentage Increase (Decrease) 2017 2019/2018 2018/2017 15,007 4,068 1,106 1,285 3,788 25,254 6.3 % 3.2 (0.6 ) 38.3 5.6 6.8 (1.9)% 5.8 14.8 (11.5) 4.2 0.5 Compensation and benefits expense increased $0.9 million primarily because of annual salary increases, the opening of a new branch location, and an increase in the compensation paid as a result of the increased mortgage loan production the periods. Professional services expense between increased $0.4 million between the periods due primarily to an increase in legal expenses relating to a bankruptcy litigation claim. Other non-interest expense increased $0.2 million due to an increase in mortgage loan servicing expenses because of the increase in serviced loans that were refinanced between the periods. Occupancy and equipment costs increased $0.1 million between the periods due to an increase in depreciation and maintenance costs. 11 MANAGEMENT DISCUSSION AND ANALYSIS 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 $3.3 million for the year ended December 31, 2019, an increase of $0.4 million from $2.9 million for the year ended December 31, 2018. Income tax expense increased between the periods because of an increase in the effective tax rate. The effective tax rate increased primarily because of a change in the deductibility of certain expenses between the periods. Interest expense was $2.2 million for 2018, an increase of $0.4 million, or 24.3%, from $1.8 million for 2017. The average interest rate paid on non-interest and interest- bearing liabilities was 0.35% for 2018, an increase of 6 basis points from 0.29% paid in 2017. The increase in the interest paid on non-interest and interest-bearing liabilities was primarily because of the 100 basis point increase in the federal funds rate which increased the cost of deposits between the periods and a $22.5 million increase in the average non-interest and interest-bearing liabilities held between the periods. Comparison of 2018 with 2017 Net income was $8.2 million for 2018, an increase of $3.8 million, or 87.0%, compared to net income of $4.4 million for 2017. Diluted earnings per share for the year ended December 31, 2018 was $1.71, an increase of $0.81 per share compared to diluted earnings per share of $0.90 for the year ended December 31, 2017. The increase in net income for 2018 is due primarily to a $2.2 million increase in net interest income and a $1.5 million decrease in income tax expense between the periods. Net interest income increased primarily because of the higher interest income earned on loans and cash balances as a result of the 100 basis point increase in the federal funds rate between the periods. The decrease in income tax expense is primarily because of the enactment of the Tax Cuts and Jobs Act of 2017 (the Act) on December 22, 2017 which required the Company to record $1.1 million in additional income tax expense in the fourth quarter of 2017 and reduced the Company’s federal income tax rate in 2018. Net Interest Income Net interest income was $28.1 million for 2018, an increase of $2.2 million, or 8.8%, from $25.9 million for the same period of 2017. Interest income was $30.4 million for 2018, an increase of $2.7 million, or 9.8%, from $27.7 million for the same period of 2017. Interest income increased primarily because of the higher interest amounts earned on loans and cash balances as a result of the 100 basis point increase in the federal funds rate between the periods and a $27.9 million increase in the average interest-earning assets held between the periods. Interest income also increased $0.5 million because of a change in the amount of yield enhancements recognized on purchased and non-accruing loans between the periods. The average yield earned on interest-earning assets was 4.35% for 2018, an increase of 22 basis points from 4.13% for 2017. The average yield earned on interest-earning assets increased 8 basis points as a result of the change in yield enhancements recognized between the periods. Net interest margin for 2018 was 4.03%, an increase of 17 basis points, compared to 3.86% for 2017. The increase in the net interest margin is primarily related to the increase in interest income which is primarily due to the increase in the average yields earned on the average interest-earning assets held between the periods. Average net earning assets increased from $57.0 million in 2017 to $62.4 million in 2018. The $5.4 million increase in the net earning assets in 2018 is due primarily to the net income earned in 2018 that was partially offset by the purchase of fixed assets and warrants. Provision for Loan Losses The provision for loan losses was ($0.6) million for the year ended December 31, 2018, a decrease of $0.1 million, from ($0.5) million for the year ended December 31, 2017. The provision for loan losses decreased between the periods primarily because of the improved credit quality of the loan the payoff of certain non-performing portfolio and commercial loans which resulted in a decrease in the reserves required between the periods. Non-Interest Income Non-interest income was $7.7 million for the year ended December 31, 2018, the same as for the year ended December 31, 2017. Other non-interest income increased $0.1 million primarily because of an increase in the revenue earned on the sale of uninsured investment products between the periods. Loan servicing fees increased $0.1 million between the periods due to an increase in the single family loans being serviced. These increases in non-interest income were offset by a decrease in the gain on sales of loans due to a decrease in single family loan originations and sales between the periods. Fees and service charges decreased slightly between the periods primarily because of a decrease in overdraft fees. 12 MANAGEMENT DISCUSSION AND ANALYSIS Non-Interest Expense Non-interest expense was $25.4 million for the year ended December 31, 2018, an increase of $0.1 million, or 0.5%, from $25.3 million for the year ended December 31, 2017. Occupancy and equipment expense increased $0.2 million because of increases in depreciation and real estate tax expenses. Data processing costs increased $0.2 million primarily because of an increase in mobile and on-line banking costs between the periods. Other non-interest expense increased $0.2 million between the periods due to an increase in the fraud losses incurred on deposit accounts and an increase in deposit insurance rates. These increases in non-interest expense were partially offset by a $0.3 million decrease in compensation and benefits expense primarily because of a decrease in employees between the periods. Professional services expense decreased $0.2 million between the periods primarily because of a decrease in legal expenses. Income Taxes Income tax expense was $2.9 million for the year ended December 31, 2018, a decrease of $1.5 million, from $4.4 million for the year ended December 31, 2017. The decrease in income tax expense is due primarily to the enactment of the Act which required the Company to record $1.1 million in additional income tax expense in the fourth quarter of 2017 and reduced the Company’s federal income tax rate in 2018. 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 costs/fees and discounts and the allowance for losses as of the dates indicated: 2019 Amount Percent 2018 Amount Percent December 31, 2017 Amount Percent 2016 Amount Percent 2015 Amount Percent (Dollars in thousands) Real Estate Loans: Single family .................. $ 120,064 19.86 % $ 110,698 18.61 % $ 107,005 17.99 % $ 103,255 18.41 % $ 90,945 19.24 % Multi-family ................... 48,663 8.05 Commercial .................... 270,410 44.74 Construction or 28,649 4.81 259,024 43.55 50,150 8.43 257,036 43.21 12,324 2.61 196,926 41.65 36,777 6.56 230,955 41.18 development ................ 31,122 5.15 Total real estate loans 470,259 77.80 28,944 4.87 446,828 75.12 46,444 7.81 441,122 74.16 31,348 5.59 402,335 71.74 38,103 8.05 338,298 71.55 Other Loans: Consumer Loans: 2,608 Automobile ................... Home equity line ........... 28,004 Home equity .................. 16,422 Recreational vehicles .... 17,266 Other.............................. 5,649 0.43 4.63 2.72 2.86 0.93 Total consumer loans 69,949 11.57 Commercial business 2,483 32,273 16,733 16,226 4,817 0.42 5.42 2.81 2.73 0.81 72,532 12.19 2,894 36,869 15,823 13,181 5,000 0.49 6.20 2.66 2.21 0.84 73,767 12.40 3,036 40,476 16,302 7,553 5,916 0.54 7.22 2.91 1.35 1.05 73,283 13.07 2,885 38,980 14,782 2,650 5,118 0.61 8.24 3.13 0.56 1.08 64,415 13.62 loans ............................. 64,227 10.63 Total other loans ........ 134,176 22.20 Total loans 79,909 13.44 153,676 25.84 $ 604,435 100.00 % $ 594,856 100.00 % $ 594,798 100.00 % $ 560,794 100.00 % $ 472,819 100.00 % 70,106 14.83 134,521 28.45 75,496 12.69 148,028 24.88 85,176 15.19 158,459 28.26 Less: Unamortized discounts .. Net deferred loan costs .. Allowance for losses ...... Total loans receivable, 15 (536 ) 8,564 17 (535 ) 8,686 19 (463) 9,311 20 (300) 9,903 16 (91 ) 9,709 net .............................. $ 596,392 $ 586,688 $ 585,931 $ 551,171 $ 463,185 The modest growth in the loan portfolio in 2019 was primarily because the growth experienced in commercial and single family real estate loans was offset by a decrease in other loan categories. Based on current economic conditions and loan origination and prepayment amounts, it is anticipated that any growth in the overall loan portfolio will be limited in 2020. the projected Single family real estate loans were $120.1 million at December 31, 2019, an increase of $9.4 million, compared to $110.7 million at December 31, 2018. The single family loan portfolio increased in 2019 due to an increase in the single family loans that were originated due to the low interest rate environment and an increased emphasis on originating shorter term and adjustable rate mortgage loans that were placed into the portfolio. The majority of the longer term mortgage loans that were originated during the year 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. 13 MANAGEMENT DISCUSSION AND ANALYSIS Multi-family real estate loans were $48.7 million at December 31, 2019, a decrease of $1.5 million, compared to $50.2 million at December 31, 2018. The decrease in multi-family real estate loans in 2019 is primarily the result of having an increase in loan payoffs and fewer originations in 2019. Commercial real estate loans were $270.4 million at December 31, 2019, an increase of $13.4 million, compared to $257.0 million at December 31, 2018. The increase in commercial real estate loans is primarily due to an increase in the originations of these types of loans in 2019. Construction or development loans were $31.1 million at December 31, 2019, an increase of $2.2 million, compared to $28.9 million at December 31, 2018. The increase in construction loans is primarily related to the $21.8 million in new construction loans and the $4.1 million in advances on existing loans. These increases were partially offset by the $10.2 million in paid off loans and the $13.5 million of loans on construction projects that were completed during the year and were moved to a permanent classification. Home equity lines of credit were $28.0 million at December 31, 2019, a decrease of $4.3 million, compared to $32.3 million at December 31, 2018. The open-end home equity lines are generally written with an adjustable rate and a two to ten year draw period which requires interest only payments followed by a ten year repayment period which fully amortizes the outstanding balance. Home equity loans were $16.4 million at December 31, 2019, a decrease of $0.3 million, compared to $16.7 million at December 31, 2018. Closed-end home equity loans are written with fixed or adjustable rates with terms up to fifteen years. The decrease in the open-end equity lines and closed-end equity loans is primarily the result of an increase in the payoffs of open- ended home equity lines of credit. The increased payoffs are the result of borrowers’ continued preference to obtain a fixed rate closed-equity loan or to refinance their first mortgage and roll their outstanding open-end equity loan balances into their new home loan. Recreational vehicle loans were $17.3 million at December 31, 2019, an increase of $1.1 million, compared to $16.2 million at December 31, 2018. 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 the balance between the periods is due to loan originations exceeding principal repayments during 2019. Commercial business loans were $64.2 million at December 31, 2019, a decrease of $11.3 million, compared to $75.5 million at December 31, 2018. The decrease in commercial business loans in 2019 is because loan payoffs exceeded loan originations during the year, with some of the payoffs related to the Bank’s initiative to maintain the credit quality of the loan portfolio. 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 $8.6 million, or 1.42% of gross loans at December 31, 2019, compared to $8.7 million, or 1.46% of gross loans at December 31, 2018. The allowance for loan losses decreased primarily because of a decrease in the reserve percentages applied to certain classified commercial loans. These percentages were reduced based on a historical loss analysis that was performed during the year. This decrease was partially offset by an increase in reserves as a result of an increase in outstanding balances and a change in the composition of the loan portfolio between the periods. 14 MANAGEMENT DISCUSSION AND ANALYSIS The following table reflects the activity in the allowance for loan losses and selected statistics: (Dollars in thousands) Balance at beginning of year ................................................................................. $ Provision for losses ........................................................................................... Charge-offs: Single family ................................................................................................ Commercial real estate ................................................................................. Consumer ...................................................................................................... Commercial business .................................................................................... Recoveries ......................................................................................................... Net recoveries (charge-offs) ......................................................................... Balance at end of year ........................................................................................... $ Year end allowance for loan losses as a percent of year end gross loan balance . Ratio of net loan recoveries (charge-offs) to average loans outstanding .............. Allowance as a percent of total assets at year end ................................................ 2019 2018 December 31, 2017 2016 2015 8,686 (1,216) (1) 0 (107) (880) 2,082 1,094 8,564 1.42% 0.18 1.10 9,311 (649) 9,903 (523) 9,709 (645) 8,332 (164) (24) 0 (226) (270) 544 24 8,686 1.46% 0.00 1.22 (6) (50) (288) (311) 586 (69) 9,311 1.57% (0.01) 1.29 (66) (67) (108) (180) 1,260 839 9,903 1.77% 0.16 1.45 (19) 0 (105) (69) 1,734 1,541 9,709 2.05% 0.36 1.51 The following table reflects the allocation of the allowance for loan losses: 2019 2018 December 31, 2017 2016 2015 Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Allocated Allowance as a % of Loan Category Percent of Loans in Each Category to Total Loans Single family ....................... Commercial real estate ....... Consumer ............................ Commercial business .......... Total .................................... 0.71 % 1.44 2.15 1.78 1.42 19.86 % 57.94 11.57 10.63 100.00 % 0.75 % 18.61 % 1.45 2.24 1.80 1.46 56.51 12.19 12.69 100.00 % 0.84 % 17.99 % 1.52 2.21 2.14 1.57 56.17 12.40 13.44 100.00 % 1.15 % 18.41 % 1.66 2.20 2.53 1.77 53.33 13.07 15.19 100.00 % 1.09 % 19.24 % 2.46 1.86 2.05 2.05 52.31 13.62 14.83 100.00 % The allocated allowance percentages for all loan categories decreased in 2019 primarily because of an improvement in the credit quality of the loans held in the various portfolios. 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, 2019 or December 31, 2018. 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 15 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 $2.7 million at December 31, 2019, a decrease of $0.4 million, or 13.9%, from $3.1 million at December 31, 2018. Non- performing loans decreased $0.6 million and foreclosed and repossessed assets increased $0.2 million during 2019. The decrease in the non-performing loans between the periods was primarily the result of the reclassification of a $1.3 million non-performing the manufacturing industry to an accruing loan during 2019. This decrease in non-performing loans was partially offset by a $0.6 million increase in non-accruing loans related to a loan in the trucking industry that was reclassified as non- accruing during the year. relationship loan in MANAGEMENT DISCUSSION AND ANALYSIS The following table sets forth the amounts and categories of non-performing assets in the Company’s portfolio: (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 ........ 2019 2018 December 31, 2017 2016 2015 617 184 659 621 2,081 166 414 0 580 2,661 730 1,311 489 148 2,678 0 414 0 414 3,092 949 1,364 553 278 3,144 0 627 0 627 3,771 916 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 2,081 0.34 % $ 0.35 % 411.25 % 2,678 0.43 % $ 0.46 % 324.27 % 3,144 0.52 % $ 0.54 % 296.11 % 3,273 0.57 % $ 0.59 % 302.56 % 0.97 % 4,181 0.90 % 232.22 % Gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $0.2 million for the year ended December 31, 2019, and $0.3 million for the years ended December 31, 2018 and 2017. The amounts that were included in interest income on a cash basis for these loans were $0.1 million for each of the three years. At December 31, 2019, 2018 and 2017, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $2.5 million, $2.5 million and $3.0 million, respectively. Had the loans performed in accordance with their original terms throughout 2019, 2018 and 2017, the Company would have recorded gross interest income of $0.2 million, $0.3 million and $0.4 million, respectively. During 2019, 2018 and 2017 the Company recorded gross interest income of $0.1 million, $0.2 million and $0.2 million, respectively. For the loans that were modified in 2019, $0.1 million were classified and performing and $0.5 million were non- performing at December 31, 2019. Total TDRs of $2.5 million remained the same at December 31, 2019 when compared to December 31, 2018. During 2019, several single family and retail consumer TDRs paid off and were replaced by new TDRs. Of the loans that were modified in 2019 and outstanding at December 31, 2019, $0.5 million related to first or second mortgages on single-family properties, and the remaining modifications related to other consumer loans. For the loans that were modified in 2018, $0.4 million were classified and performing and $1.2 million were non- performing at December 31, 2018. The decrease in TDRs in 2018 related primarily to several retail consumer TDRs that were paid or charged off during the year, as well as one commercial business loan that was charged off. Of the loans that were modified in 2018 and outstanding at December 31, 2018, $1.1 million related to loans secured by commercial real estate, $0.4 million related to first or second mortgages on single family properties and the remaining modifications related to other consumer or commercial business loans. For the loans that were modified in 2017, $0.6 million were classified and performing and $0.4 million were non- performing at December 31, 2017. The decrease in TDRs in 2017 related 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 single family properties and the remaining modifications related to other consumer or commercial business loans. 16 MANAGEMENT DISCUSSION AND ANALYSIS The following table sets forth the amount of TDRs in the Company’s portfolio: (Dollars in thousands) Single family ................................................................................... $ Commercial real estate .................................................................... Consumer ........................................................................................ Commercial business ...................................................................... Total TDRs ................................................................................. $ TDRs on accrual status ................................................................... $ TDRs on non-accrual status ............................................................ Total ............................................................................................ $ 2019 2018 December 31, 2017 2016 2015 623 983 745 114 2,465 1,770 695 2,465 636 1,110 522 208 2,476 1,018 1,458 2,476 685 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 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 were no potential problem loans identified by the Company as of December 31, 2019 or 2018. There was one potential problem loan relationship totaling $7.5 million identified by the Company as of December 31, 2017, however, the issues with the loan improved in 2018 and it did not progress to a problem loan status. Liquidity and Capital Resources The Company manages 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. The primary financing activity is the attraction of retail, commercial, and internet deposits. The Bank also has the ability to borrow funds from the FHLB or Federal Reserve 17 Bank of Minneapolis based on the collateral value of the loans pledged, subject to applicable borrowing base and collateral requirements. See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on the advances that could be drawn based upon existing collateral levels with the FHLB and the Federal Reserve Bank of Minneapolis. Unpledged securities could also be pledged and used as collateral for additional borrowings with the FHLB or 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, 2019 were $44.4 million, an increase of $23.7 million, compared to $20.7 million at December 31, 2018. Net cash provided by operating activities during 2019 was $15.2 million. The Company conducted investing activities during 2019: purchases of securities available for sale and FHLB stock were $55.5 million; principal payments and maturity proceeds received on securities available for sale and FHLB stock were $29.3 million; and the proceeds from the sale of premises and other real estate were $0.2 million. Net loans receivable increased $14.7 million and the Company also purchased premises and equipment of $2.2 million. Net cash used by investing activities during 2019 was $42.9 million. The Company conducted the following major financing activities during 2019: deposits increased $50.5 million; received and repaid borrowings of $26.0 million; customer escrows increased $1.0 million; and withheld stock of $0.1 million to cover taxes due on vested stock awards. Net cash provided by financing activities was $51.4 million for 2019. MANAGEMENT DISCUSSION AND ANALYSIS The Bank has certificates of deposits from customers with outstanding balances of $82.5 million that mature during 2020. 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 $60.4 million in checking and money market accounts of five 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 advances from the FHLB. 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 2019, the Bank paid dividends to the Company of $5.0 million and at December 31, 2019, the Company had $7.7 million in cash. The Company’s primary use of cash is the payment of holding company level expenses including the payment of legal expenses and director and management fees, 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, 2019, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows: (Dollars in thousands) Contractual Obligations: Annual rental commitments under non- cancellable operating leases ................................. $ Total contractual obligations ......................... $ Total Less than 1 Year 1-3 Years 4-5 Years More than 5 Years Payments Due by Period 4,266 4,266 887 887 1,829 1,829 1,536 1,536 14 14 Other Commercial Commitments: Commercial lines of credit ...................................... $ Commitments to lend .............................................. Standby letters of credit .......................................... Total other commercial commitments ........... $ 63,322 22,757 2,810 88,889 23,742 8,716 2,108 34,566 27,240 2,668 702 30,610 12,340 4,090 0 16,430 0 7,283 0 7,283 Amount of Commitments Expiring by Period Regulatory Capital Requirements The Company and the Bank are subject to the Basel III regulatory capital requirements. The Basel III requirements, among other things, (i) apply a set of capital requirements to the Bank (the Company is exempt, pursuant to the Small (Policy Bank Holding Company Policy Statement 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 minimum Tier 1 capital requirement, and (iii) set forth 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 fully phased in as of 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 its 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. 18 MANAGEMENT DISCUSSION AND ANALYSIS The Policy Statement of the FRB exempts small bank and savings and loan holding companies with assets less than $3 billion from the above capital requirements. The Company currently meets the qualitative exemption requirements, and therefore, is exempt from the above capital requirements. Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios 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. 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. On January 1, 2019, the capital conservation buffer amount increased to the fully phased in amount of 2.50%. Management believes that, as of December 31, 2019, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the current 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 OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well- capitalized” in the future. See “Note 17 Regulatory Capital” of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to these capital requirements. 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 in 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 operations, the Bank's compliance with regulatory capital requirements and other tax considerations, industry standards, economic conditions, anticipated asset growth, 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, 2019 but will continue to evaluate the best use of the Company’s capital based on the factors identified above. restrictions, regulatory Under applicable federal banking laws and regulations, no dividends can be declared or paid by the Bank to the Company without notice to and non-objection from the applicable banking regulator. There is no assurance that the Bank and the Company would satisfy the applicable regulatory requirements necessary to effect any such dividends. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its 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, asset growth plans and the 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. 19 MANAGEMENT DISCUSSION AND ANALYSIS New Accounting Pronouncements Note 1 of the Notes to Consolidated Financial Statements discusses recently issued accounting pronouncements that we will be required to adopt. Also discussed is our these new accounting expectation of pronouncements will have on our consolidated financial statements. impact the 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. 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 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 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 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, 2019. (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 Market Value -200 -100 $ $ 790,627 752,616 198 37,813 (64.50 )% 781,112 703,845 90 77,177 (27.55)% 0 767,305 660,785 0 106,520 +100 +200 753,086 622,784 (132) 130,434 739,106 590,543 (246) 148,809 0.00 % 22.45% 39.70% (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 51%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 5% and 61%, 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 demand accounts (MMDAs) and passbook accounts were assumed to decay at annual rates of 9% and 6%, respectively. Retail non-interest and interest-bearing checking accounts were assumed to decay at annual rates of 8% and 11%, respectively. Commercial non-interest and interest-bearing checking accounts were assumed to decay at annual rates of 10% and 19%, respectively. Commercial MMDAs were assumed to decay at annual rates of between 0% and 30%. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the interest spread) will remain constant over the interest changes disclosed in the table. Changes in interest spread could impact projected market value changes. Certain assets, such as ARMs, have features that restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets that are approaching their lifetime interest rate caps or floors could be different from the values calculated in the table. Certain liabilities, such as certificates of deposit, have fixed rates that restrict interest rate changes until maturity. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from the those assumed foregoing table. The ability of many borrowers to service their debt may also decrease in the event of a substantial increase in interest rates. in calculating 20 MANAGEMENT DISCUSSION AND ANALYSIS 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, 2019 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, 2020 of immediate interest rate changes called rate shocks: (Dollars in thousands) Rate Shock in Basis Points +200 +100 0 -100 -200 $ Net Interest Change Percent Change 1,927 962 0 (1,068) (2,284) 7.04 % 3.52 0.00 (3.90 ) (8.35 ) The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the preceding 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 preceding 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. In managing the Company’s 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 the attainment of the Bank's objectives in an effective manner. In addition, each quarter the Board reviews the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios. In managing its asset/liability composition, the Bank may, at times, depending on the relationship between long-term 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 structure its balance sheet 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. A significant portion of the Bank’s commercial loan production continues to be in adjustable rate loans that reprice every one, two, or three years. Off-Balance Sheet Arrangements The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business. See “Note 18 Commitments and Contingencies” in the Notes to Consolidated Financial Statements information. Management believes that the Company has sufficient liquidity to satisfy its off-balance sheet obligations. for additional 21 CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, December 31, 2019 2018 ASSETS Cash and cash equivalents ............................................................................................... $ Securities available for sale: Mortgage-backed and related securities (amortized cost $54,777 and $8,159) ........... Other marketable securities (amortized cost $52,751 and $73,222) ............................ Equity securities .............................................................................................................. 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 .................................................................................................... Prepaid expenses and other assets ................................................................................... Deferred tax asset, net ..................................................................................................... Total assets ........................................................................................................... $ LIABILITIES AND STOCKHOLDERS’ EQUITY Deposits ........................................................................................................................... $ Accrued interest payable ................................................................................................. Customer escrows ........................................................................................................... Accrued expenses and other liabilities ............................................................................ Total liabilities ...................................................................................................... 44,399 20,709 54,851 52,741 107,592 167 3,606 596,392 2,251 580 854 2,172 10,515 802 156 6,451 1,702 777,639 673,870 420 2,413 8,288 684,991 8,023 71,836 79,859 121 3,444 586,688 2,356 414 867 1,855 9,635 802 255 2,668 2,642 712,315 623,352 346 1,448 4,022 629,168 Commitments and contingencies Stockholders’ equity: Serial-preferred stock ($.01 par value): authorized 500,000 shares; issued 0 ......................................................................... 0 0 Common stock ($.01 par value): authorized 16,000,000 shares; issued 9,128,662 ...................................................... Additional paid-in capital ................................................................................................ Retained earnings, subject to certain restrictions ............................................................ Accumulated other comprehensive gain (loss) ................................................................ Unearned employee stock ownership plan shares ........................................................... Treasury stock, at cost 4,284,840 and 4,292,838 shares .................................................. Total stockholders’ equity .................................................................................... Total liabilities and stockholders’ equity .............................................................. $ 91 40,365 107,547 46 (1,643) (53,758) 92,648 777,639 91 40,090 99,754 (1,096) (1,836) (53,856) 83,147 712,315 See accompanying notes to consolidated financial statements. 22 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 .................................................................... Other .......................................................................................... Total interest income .............................................................. Interest expense: Deposits ...................................................................................... 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 ........................................................ Occupancy and equipment ......................................................... Data processing .......................................................................... Professional services .................................................................. Other .......................................................................................... Total non-interest expense ...................................................... Income before income tax expense ..................................... Income tax expense ........................................................................... Net income .............................................................................. Other comprehensive income (loss), 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. 2019 2018 2017 29,787 28,535 26,368 343 1,157 603 31,890 3,332 7 3,339 28,551 (1,216) 29,767 3,100 1,278 2,941 1,136 8,455 15,659 4,442 1,263 1,573 4,168 27,105 11,117 3,324 7,793 1,142 8,935 1.69 1.68 197 1,138 511 30,381 2,231 2 2,233 28,148 (649 ) 28,797 3,330 1,255 2,095 1,034 7,714 14,728 4,304 1,270 1,137 3,948 25,387 11,124 2,888 8,236 (69 ) 8,167 1.89 1.71 57 1,103 152 27,680 1,470 327 1,797 25,883 (523) 26,406 3,354 1,202 2,138 960 7,654 15,007 4,068 1,106 1,285 3,788 25,254 8,806 4,402 4,404 (137) 4,267 1.04 0.90 23 CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Additional Accumulated Other Unearned Employee Stock Total Stock- Common Paid-in Capital Stock Retained Comprehensive Ownership Treasury holders’ Earnings Income (Loss) Equity Stock Plan (Dollars in thousands) 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 ............................ $ Net income ................................................... Other comprehensive loss ............................ Reclassification due to adjustments for equity securities as required by ASU 2016-01 ...................................................... Stock warrants purchased ............................ Exercise of stock warrants ........................... Exercise of stock options ............................. Tax benefits of exercised stock options ....... Stock compensation expense ....................... Restricted stock awards................................ Amortization of restricted stock awards ...... Earned employee stock ownership plan shares.......................................................... Balance, December 31, 2018 ............................ $ Net income .................................................. 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, 2019 .......................... $ 91 50,566 86,886 4,404 (820) (2,223) 21 (58,581) 75,919 4,404 21 158 (158) 41 (278) 147 278 (54) 0 41 0 (54) 147 91 147 50,623 91,448 8,236 (957) (69) 193 (2,030) 340 (58,357) 80,818 8,236 (69) 70 (70) 99,754 7,793 (1,096) 1,142 194 (1,836) 4,168 145 188 0 (6,453) 0 0 64 17 0 134 400 (53,856) 83,147 7,793 1,142 1 0 143 (45) (45) 187 91 (6,453) (4,168) (145) 64 17 (188) 134 206 40,090 1 (143) 187 230 91 40,365 107,547 46 193 (1,643) 423 (53,758) 92,648 See accompanying notes to consolidated financial statements. 24 CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31 (Dollars in thousands) Cash flows from operating activities: Net income ................................................................................................................ $ Adjustments to reconcile net income to cash provided by operating activities: Provision for loan losses ...................................................................................... Depreciation ......................................................................................................... Amortization of premiums (discounts), net ......................................................... Amortization of deferred loan fees ...................................................................... Amortization of core deposit intangible ............................................................... Amortization of purchased asset 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 loss .......................................................................................... Securities (gains) losses, net ................................................................................. Loss (gain) on sale of premises ............................................................................ Gains on real estate owned, net ............................................................................ 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 compensation expense ................................................................................ Decrease (increase) in accrued interest receivable .............................................. Increase (decrease) in accrued interest payable ................................................... Decrease (increase) in other assets ....................................................................... Decrease in other liabilities .................................................................................. Other, net .............................................................................................................. Net cash provided by operating activities ....................................................... Cash flows from investing activities: Principal collected on securities available for sale ................................................... Proceeds collected on maturity of securities available for sale ................................ Purchases of securities available for sale ................................................................. Purchase of Federal Home Loan Bank stock............................................................ Redemption of Federal Home Loan Bank stock ...................................................... Proceeds from sales of real estate owned ................................................................. Net increase in loans receivable ............................................................................... Proceeds from sale of premises ................................................................................ Purchases of premises and equipment ...................................................................... Net cash used by investing activities ............................................................... Cash flows from financing activities: Increase (decrease) in deposits ................................................................................. Warrants purchased ................................................................................................... Stock awards withheld for tax withholding .............................................................. Excess tax benefit from options exercised ............................................................... Proceeds from borrowings ........................................................................................ Repayment of borrowings ......................................................................................... Increase in customer escrows ................................................................................... Net cash provided (used) 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 owned, net ............................................................... Right to use assets and lease obligations .................................................................. See accompanying notes to consolidated financial statements. 2019 2018 2017 7,793 (1,216) 1,129 3 (91) 99 (41) 780 (1,097) 496 0 (46) 24 0 (2,941) 124,858 (115,861) 187 193 230 1 105 74 693 (199) 28 15,201 2,867 25,400 (54,427) (1,040) 1,053 0 (14,765) 195 (2,232) (42,949) 50,518 0 (45) 0 26,001 (26,001) 965 51,438 23,690 20,709 44,399 3,265 2,911 6,253 0 166 4,505 8,236 (649) 1,078 16 (260) 99 (70) 551 (682) 1,084 0 36 11 (80) (2,095) 88,649 (76,489) 134 194 206 17 (12) 200 (1,343) (1,024) 2 17,809 1,914 310 (4,888) (322) 272 367 (11,483) 0 (2,497) (16,327) (12,249) (6,453) 0 64 6,801 (6,801) 301 (18,337) (16,855) 37,564 20,709 2,034 4,264 11,642 0 74 0 4,404 (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 17,043 953 20,100 (20,035) (3,999) 3,952 309 (43,194) 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 0 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2019, 2018 and 2017 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 6, 2020. 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. An estimate that is particularly susceptible to change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is appropriate to cover probable losses inherent in the portfolio at the date of the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies, as an integral part of the their examination process, periodically 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. review tax consequences attributable 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. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state to 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. Estimates related to litigation are inherently subjective and the ultimate resolution of any litigation may be different than current management estimates. See “Note 18 Commitments and Contingencies” for further information. 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 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 that are for premiums and discounts recognized in interest income using the interest method with discounts amortized over the period to maturity and premiums amortized to the earliest call date. 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, in prepayment risk, or similar factors. changes 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 interest method with the discounts amortized over the period to maturity and premiums amortized to the earliest call date. Unrealized income using 26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 impaired, an deemed impairment loss is recognized. to be other-than-temporarily Equity Securities Equity securities are carried at their fair market value with any changes during the period recognized in other income on the consolidated statements of comprehensive income. Loans Held for Sale Mortgage loans originated 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 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 materially 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 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 taken when the impairment is 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. 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 is 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. 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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, the borrower has consistently made the required payments for a period of six months, and the 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 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 when the loan is refinanced with terms that reflect normal market terms for the type of credit involved and performs according to the modified terms for a period of at least one year. The second condition is when the loan is repaid or charged off. 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 of 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. Mortgage Servicing Rights, net Mortgage servicing rights are capitalized at their fair value and amortized in proportion to, and over the period of, estimated net servicing income. The Company evaluates its capitalized mortgage servicing rights for impairment each quarter. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. Any impairment is recognized through a valuation allowance. 28 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Premises and Equipment, net Land is carried at cost. Office buildings, improvements, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is computed on a straight-line basis over their 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. The Company is no longer subject to federal or state income tax examinations by tax authorities for years before 2016. Earnings per Common Share Basic earnings per common share excludes dilution and is computed by dividing the income available to common shareholders 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. 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS financial losses on the current New Accounting Pronouncements In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (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 instruments and other credit 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 loss methodology. The amendments in this ASU, for public business entities that are filers with the SEC, were originally effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. On November 26, 2019, the FASB issued ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments – Credit Losses which delayed the implementation date of ASU 2016-13 for small SEC reporting companies, such as HMN, from the first quarter of 2020 to the first quarter of 2023. All entities may adopt the amendments in the ASU early as of the fiscal years beginning after December 15, 2018, including 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. The Company has not early adopted this ASU. Management has accumulated the charge off the appropriate life of loan loss percentages for the various loan categories, has identified several key metrics to help identify and project anticipated changes in the credit quality of our loan portfolio upon enactment, and is in the process of evaluating the determination of potential qualitative reserve amounts and the impact that the adoption of this ASU will have on the Company’s consolidated financial statements when it is adopted in the first quarter of 2023. interim periods within information necessary to calculate incurred In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU apply to all entities that are required, under existing GAAP, to make 30 disclosures about recurring or nonrecurring fair value measurements and modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including the consideration of costs and benefits. The ASU removed, modified, and added various disclosure requirements in Topic 820. The amendments also eliminate at a minimum from the phrase an entity shall disclose at a minimum to promote the appropriate exercise of discretion by entities when considering fair value measurement disclosures and to clarify that materiality is an appropriate consideration of entities and their auditor when evaluating disclosure requirements. The amendments in the ASU are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. An entity is permitted to early adopt the implementation of any removed or modified disclosures upon issuance of the ASU and delay adoption of the additional disclosures until their effective date. The Company has not opted to early adopt any portion of this ASU and the adoption in the first quarter of 2020 did not have a material impact on the Company’s consolidated financial statements. Derivative Financial Instruments The Company uses derivative financial instruments in order to manage the interest rate risk on residential loans held for sale and its commitments to extend credit for residential loans. The Company may also from time to time use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments. Reclassifications Certain amounts in the consolidated financial statements for the prior year have been reclassified to conform to the current year presentation. to NOTE 2 Revenue Recognition Effective January 1, 2018, the Company adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent amendments the ASU (collectively, “ASC 606”), which (1) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (2) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as securities and premises and equipment. The majority of the Company’s revenues come from interest income on loans and securities that are outside the scope of ASC 606. The Company’s services that fall within the scope of ASC 606 are presented on the income statement within non-interest income and are recognized as revenue as the Company satisfies its performance obligation to the customer. Services within the scope of ASC 606 include fees and service charges on deposit accounts, ATM and debit card interchange income, safe deposit box rental fees, check printing charges and income earned on the sale of uninsured investment products. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company, using a modified retrospective transition approach, determined that there was no cumulative effect adjustment to retained earnings as a result of adopting the new standard, nor did the standard have a material impact on our consolidated financial statements relating to the timing or amounts of revenue recognized. All of the Company’s revenue from contracts with customers within the scope of ASC 606 is recognized within non-interest income. The following table presents the Company’s sources of non-interest income for the years ended December 31, 2019 and 2018. Sources of revenue outside the scope of ASC 606 are noted as such. (Dollars in thousands) Non-interest income: Fees and service charges on deposit accounts ................................................ $ Other fees and service charges................ Debit card interchange fees ..................... Gain on sale of loans (1) ........................... Loan servicing fees (1) ............................. Uninsured investment product sales ....... Other ........................................................ Total non-interest income ............................ (1) Not within the scope of ASC 606. Year ended December 31, 2019 2018 1,257 433 1,410 2,941 1,278 909 227 8,455 1,308 585 1,437 2,095 1,255 870 164 7,714 A description of the Company’s revenue categories that are accounted for under ASC 606 is as follows: Fees and Service Charges on Deposit Accounts The Company earns fees from deposit customers for transaction-based, account maintenance, and overdraft services. Transaction-based fees, which include services such as ATM use fees, wire transfer fees, check cashing fees, stop payment charges, statement rendering, ACH fees, and other deposit related fees, are recognized at the time the transaction is executed or when the Company fulfills the customer’s request. Account maintenance fees, which relate primarily to monthly maintenance, are earned over the course of a month, representing the period over which the Company satisfies the performance obligation. Overdraft fees are recognized at the point in time that the overdraft occurs. Service charges on deposits are withdrawn from the customer’s account balance. Other Fees and Service Charges Other fees and service charges consist of revenues that are both within the scope of and outside the scope of ASC 606. Other fees and service charges within the scope of ASC 606 consist of fees for the rental of safe deposit boxes and check printing charges. Revenues for these fees are recognized at the point the service is provided or the fee is incurred by the customer. Other fees and service charges outside the scope of ASC 606 consist of loan commitment fees and late charges on loans. Debit Card Interchange Fees The Company earns interchange fees from debit card holder transactions conducted through various payment networks. transactions are Interchange from cardholder recognized daily, concurrently with transaction the processing services provided by an outsourced technology solution and are presented on a net basis. fees Uninsured Investment Product Sales Commission revenues on the sale of uninsured investment products may be recognized up front on the sale date of the investment or monthly over a period of years depending on the product being sold. The commissions on investment sales are recognized when the product sale is completed or monthly for trailer fees in accordance with the customer agreement. Any subsequent commission adjustments are recognized upon our receipt of notification from the investment companies concerning matters necessitating such adjustments. Profit-sharing contingent commissions are recognized when determinable, which is generally when such commissions are received from the investment companies. Other Other consists of revenues that are both within the scope of and outside the scope of ASC 606. Other income within the scope of ASC 606 consists of gains and losses on asset sales. Other income outside the scope of ASC 606 consists of gains and losses on equity securities and rental income on buildings. 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 Other Comprehensive Income (Loss) The components of other comprehensive income (loss) and the related tax effects were as follows: 2019 Before Tax Tax Net Effect of Tax For the years ended December 31, 2018 2017 Before Tax Effect Tax Net of Tax Before Tax Effect Tax Net of Tax (Dollars in thousands) Securities available for sale: Unrealized gains (losses) arising during the period .............................. $ 1,585 443 1,142 (94 ) (25) (69) 33 12 21 Reclassification of certain income tax effects from accumulated other comprehensive income(1) .................. 0 Other comprehensive income (loss) ... $ 1,585 0 443 0 1,142 0 (94 ) 0 (25) 0 (69) 0 33 (158) 170 158 (137) (1) The reclassification in 2017 relates to the change in the tax rate that occurred because of the enactment of the Tax Cuts and Jobs Act in the fourth quarter of 2017. NOTE 4 Securities Available for Sale A summary of securities available for sale at December 31, 2019 and 2018 is as follows: (Dollars in thousands) December 31, 2019 Mortgage-backed securities: Federal National Mortgage Association (FNMA) .................... $ Federal Home Loan Mortgage Corporation (FHLMC) .......... Collateralized mortgage obligations: FNMA ............................................................................................ Other marketable securities: U.S. Government agency obligations ......................................... Municipal obligations .................................................................. Corporate obligations .................................................................. Corporate preferred stock .......................................................... $ December 31, 2018 Mortgage-backed securities: FNMA ............................................................................................ $ FHLMC .......................................................................................... Collateralized mortgage obligations: FNMA ............................................................................................ Other marketable securities: U.S. Government agency obligations ............................................ Municipal obligations .................................................................... Corporate obligations ..................................................................... Corporate preferred stock .............................................................. $ Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value 46,604 8,004 169 54,777 49,974 1,969 108 700 52,751 107,528 3,886 4,074 199 8,159 69,971 2,378 173 700 73,222 81,381 47 88 4 139 39 7 0 0 46 185 0 0 0 0 0 1 0 0 1 1 (65) 0 0 (65) (21) 0 0 (35) (56) (121) (117) (10) (9) (136) (1,236) (10) (1) (140) (1,387) (1,523) 46,586 8,092 173 54,851 49,992 1,976 108 665 52,741 107,592 3,769 4,064 190 8,023 68,735 2,369 172 560 71,836 79,859 The Company did not sell any available for sale securities and did not recognize any gains or losses on securities available for sale in 2019, 2018 or 2017. 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the amortized cost and estimated fair value of securities available for sale at December 31, 2019, 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 ........................................................................................................................... Total ........................................................................................................................................ $ Amortized Cost Fair Value 46,931 44,262 14,991 1,344 107,528 46,962 44,308 15,011 1,311 107,592 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, 2019 and 2018: (Dollars in thousands) December 31, 2019 Mortgage backed securities: # of Less Than Twelve Months Fair Value Unrealized Losses Investments # of Twelve Months or More Fair Value Unrealized Losses Investments Total Fair Value Unrealized Losses FNMA .............................................. 4 $ 12,143 (65 ) 0 $ 0 0 $ 12,143 (65) Other marketable securities: U.S. Government agency obligations ..................................... Corporate preferred stock ............ Total temporarily impaired securities ....................................... December 31, 2018 Mortgage backed securities: FNMA .............................................. FHLMC ............................................ Collateralized mortgage obligations: 0 0 0 0 0 0 4 19,972 665 1 (21) 19,972 665 (35) (21) (35) 4 $ 12,143 (65 ) 5 $ 20,637 (56) $ 32,780 (121) 0 0 $ 1 4,060 0 (10 ) 2 $ 3,769 0 0 (117) $ 3,769 0 4,060 (117) (10) FNMA .............................................. 0 0 0 1 190 (9) 190 (9) Other marketable securities: U.S. Government agency obligations ...................................... Municipal obligations ...................... Corporate obligations ....................... Corporate preferred stock ................ Total temporarily impaired securities ........................................ 0 3 0 0 0 498 0 0 0 (2 ) 0 0 14 68,735 8 1,467 172 1 560 1 (1,236) 68,735 (8) 1,965 172 (1) 560 (140) (1,236) (10) (1) (140) 4 $ 4,558 (12 ) 27 $ 74,893 (1,511) $ 79,451 (1,523) 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 impaired securities other than the corporate preferred stock are the result of changes in interest rates. The unrealized losses reported for the corporate preferred stock at December 31, 2019 relates to a single trust preferred security that was issued by the holding company of a small community bank. As of December 31, 2019 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, 2019. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods. 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The aggregate amount of loans to executive officers and directors of the Company was $0.1 million at December 31, 2019, 2018 and 2017. The entire balance for all three years represents a Home Equity Line of Credit for one executive officer and there has been no activity on the line of credit during 2019, 2018 or 2017. All loans to executive officers and directors are 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, 2019, 2018 and 2017, the Company was servicing loans for others with aggregate unpaid principal balances of $505.7 million, $480.6 million and $471.4 million, respectively. The Company originates residential, commercial real estate and other loans primarily in Minnesota, Wisconsin and Iowa. At December 31, 2019 and 2018, the Company had in its portfolio single family residential loans located in the following states: 2019 2018 Percent of Total Amount (Dollars in thousands) Iowa ......................... $ 1,937 Minnesota ................ 107,607 8,483 Wisconsin ................ Other states (1) .......... 2,037 Amount 1.6 % $ 2,778 98,505 89.6 8,105 7.1 1,310 1.7 Percent of Total 2.5 % 89.0 7.3 1.2 Total .................... $ 120,064 100.0 % $ 110,698 100.0 % (1) Amounts under two million dollars in both years are included in “Other states”. NOTE 5 Loans Receivable, Net A summary of loans receivable at December 31, 2019 and 2018, is as follows: (Dollars in thousands) Residential real estate loans: 2019 2018 Single family conventional .................... $ 119,805 259 Single family government guaranteed ... 120,064 110,580 118 110,698 Commercial real estate: Lodging .................................................. Retail/office ............................................ Nursing home/health care ...................... Land developments ................................ Golf courses ........................................... Restaurant/bar/café ................................ Warehouse .............................................. Construction: 58,643 71,730 7,767 13,167 1,597 6,752 32,064 Single family ..................................... Multi-family ...................................... Commercial real estate ...................... Manufacturing ........................................ Churches/community service ................. Multi-family ........................................... Other ....................................................... 23,256 1,858 6,008 20,027 10,156 48,663 48,507 350,195 Consumer: Autos ...................................................... Home equity line .................................... Home equity ........................................... Recreational vehicles ............................. Land/lots ................................................. Other – secured ...................................... Other – unsecured .................................. 2,608 28,004 16,422 17,266 3,358 1,195 1,096 69,949 64,227 Total loans ......................................... 604,435 Commercial business .................................. 45,259 69,539 3,712 18,865 397 8,196 34,634 20,442 4,931 3,571 22,029 11,103 50,150 43,302 336,130 2,483 32,273 16,733 16,226 2,145 1,423 1,249 72,532 75,496 594,856 Less: Unamortized discounts........................... Net deferred loan costs........................... Allowance for loan losses ...................... 15 (536 ) 8,564 Total loans receivable, net ................. $ 596,392 17 (535) 8,686 586,688 Commitments to originate or purchase loans .......................................................... $ 38,157 13,183 Commitments to deliver loans to secondary market ...................................... $ 10,098 7,289 Weighted average contractual rate of loans in portfolio ................................................ 4.75 % 4.83% Included in total commitments to originate or purchase loans are fixed rate loans aggregating $19.0 million and $11.0 million as of December 31, 2019 and 2018, respectively. The interest rates on these loan commitments ranged from 3.00% to 5.65% at December 31, 2019 and from 4.125% to 6.375% at December 31, 2018. 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2019 and 2018, the Company had in its portfolio commercial real estate loans located in the following states: (Dollars in thousands) Florida ............................................................................ $ Idaho .............................................................................. Illinois ............................................................................ Indiana ........................................................................... Iowa ............................................................................... Minnesota ...................................................................... North Carolina ............................................................... Ohio ............................................................................... Wisconsin ...................................................................... Other states(1) ................................................................. Total .......................................................................... $ 2019 2018 Amount Percent of Total Amount Percent of Total 6,520 2,980 2,513 2,691 6,794 244,572 4,624 2,140 73,122 4,239 350,195 1.9 % $ 0.9 0.7 0.8 1.9 69.8 1.3 0.6 20.9 1.2 100.0 % $ 4,795 3,171 851 3,031 7,563 238,397 5,442 1,566 67,196 4,118 336,130 1.4 % 0.9 0.2 0.9 2.3 70.9 1.6 0.5 20.0 1.3 100.0 % (1) Amounts under two million dollars in both years are included in “Other states”. NOTE 6 Allowance for Loan Losses and Credit Quality Information The allowance for loan losses is summarized as follows: (Dollars in thousands) Balance, December 31, 2016 ........................... $ Provision for losses ..................................... $ Charge-offs .................................................. Recoveries ................................................... Balance, December 31, 2017 ........................... $ Provision for losses ..................................... $ Charge-offs .................................................. Recoveries ................................................... Balance, December 31, 2018 ........................... $ Provision for losses .................................... $ Charge-offs ................................................ Recoveries .................................................. Balance, December 31, 2019 ......................... $ Allocated to: Specific reserves ......................................... $ General reserves .......................................... Balance, December 31, 2018 ........................... $ Allocated to: Specific reserves ........................................ $ General reserves ........................................ Balance, December 31, 2019 ......................... $ Loans receivable at December 31, 2018: Individually reviewed for impairment ........ $ Collectively reviewed for impairment ........ Ending balance ............................................ $ Loans receivable at December 31, 2019: Individually reviewed for impairment .... $ Collectively reviewed for impairment ..... Ending balance .......................................... $ Single Family Commercial Real Estate Consumer Commercial Business Total 1,186 4,953 1,613 2,151 263 (288) 42 1,630 202 (226) 16 1,622 (29) (107) 21 1,507 172 1,450 1,622 119 1,388 1,507 856 71,676 72,532 976 68,973 69,949 (431) (311) 299 1,708 (386) (270) 310 1,362 297 (880) 361 1,140 73 1,289 1,362 93 1,047 1,140 303 75,193 75,496 735 63,492 64,227 (280) (6) 0 900 (44) (24) 1 833 25 (1) 0 857 98 735 833 62 795 857 (75 ) (50 ) 245 5,073 (421 ) 0 217 4,869 (1,509 ) 0 1,700 5,060 451 4,418 4,869 451 4,609 5,060 1,226 109,472 110,698 1,311 334,819 336,130 974 119,090 120,064 1,166 349,029 350,195 35 9,903 (523) (655) 586 9,311 (649) (520) 544 8,686 (1,216) (988) 2,082 8,564 794 7,892 8,686 725 7,839 8,564 3,696 591,160 594,856 3,851 600,584 604,435 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes the amount of classified and unclassified loans at December 31, 2019 and 2018: (Dollars in thousands) Single family ................................. $ Commercial real estate: Real estate rental and leasing Other ......................................... Consumer ..................................... Commercial business ................... $ (Dollars in thousands) Single family .................................. $ Commercial real estate: Real estate rental and leasing .... Other .......................................... Consumer ....................................... Commercial business ..................... $ December 31, 2019 Classified Unclassified Special Mention Substandard Doubtful Loss Total Total 1,118 1,765 35 0 2,918 117,146 Total Loans 120,064 3,489 4,451 0 5,710 14,768 9,114 5,253 842 2,516 19,490 0 0 69 0 104 0 0 65 0 65 12,603 9,704 976 8,226 34,427 179,899 147,989 68,973 56,001 570,008 192,502 157,693 69,949 64,227 604,435 December 31, 2018 Classified Unclassified Special Mention Substandard Doubtful Loss Total Total 150 1,771 40 0 1,961 108,737 Total Loans 110,698 5,564 4,879 0 6,647 17,240 4,805 5,118 709 2,761 15,164 0 0 41 0 81 0 0 106 0 106 10,369 9,997 856 9,408 32,591 185,195 130,569 71,676 66,088 562,265 195,564 140,566 72,532 75,496 594,856 Classified loans represent special mention, substandard (performing and non-performing), and non-performing loans categorized as 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 essentially uncollateralized and/or considered uncollectible and of such little value that continuance as an asset on the balance sheet may not be 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. 36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The aging of past due loans at December 31, 2019 and 2018 is summarized as follows: (Dollars in thousands) 2019 30-59 Days Past Due 60-89 Days Past Due 90 Days or More Past Due Total Past Due Current Loans Total Loans Loans 90 Days or More Past Due and Still Accruing Single family .............................................. $ Commercial real estate: Real estate rental and leasing .............. Other ...................................................... Consumer ................................................... Commercial business ................................ $ 2018 Single family ............................................... $ Commercial real estate: Real estate rental and leasing ................. Other ....................................................... Consumer .................................................... Commercial business .................................. $ 786 77 59 922 119,142 120,064 0 0 527 147 1,460 0 0 31 13 121 0 0 206 550 815 0 192,502 0 157,693 69,185 63,517 2,396 602,039 764 710 192,502 157,693 69,949 64,227 604,435 680 325 77 1,082 109,616 110,698 0 0 391 21 1,092 0 0 100 0 425 0 0 279 0 356 0 195,564 0 140,566 71,762 75,475 1,873 592,983 770 21 195,564 140,566 72,532 75,496 594,856 0 0 0 0 0 0 0 0 0 0 0 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, 2019 and 2018: (Dollars in thousands) Loans with no related allowance recorded: December 31, 2019 Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized Single family ....................................................................... $ Commercial real estate: Other ............................................................................... Consumer ............................................................................ 544 563 0 781 0 781 0 0 0 508 10 580 Loans with an allowance recorded: Single family ....................................................................... Commercial real estate: Real estate rental and leasing ....................................... Other ............................................................................... Consumer ............................................................................ Commercial business ......................................................... Total: 430 430 62 633 184 982 195 735 184 982 195 1,287 16 435 119 93 193 1,048 231 476 Single family ....................................................................... Commercial real estate: Real estate rental and leasing ....................................... Other ............................................................................... Consumer ............................................................................ Commercial business ......................................................... $ 974 993 62 1,141 184 982 976 735 3,851 184 982 976 1,287 4,422 16 435 119 93 725 193 1,058 811 476 3,679 33 0 26 3 0 71 14 24 36 0 71 40 24 171 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) Loans with no related allowance recorded: December 31, 2018 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 ............................................................................. 458 477 0 25 515 0 1,682 515 0 0 0 0 465 27 81 510 Loans with an allowance recorded: Single family ........................................................................ Commercial real estate: Real estate rental and leasing .......................................... Other ................................................................................ Consumer ............................................................................. Commercial business ........................................................... Total: 768 768 98 859 201 1,085 341 303 201 1,085 341 854 21 430 172 73 82 1,673 395 385 Single family ........................................................................ Commercial real estate: Real estate rental and leasing .......................................... Other ................................................................................ Consumer ............................................................................. Commercial business ........................................................... $ 1,226 1,245 98 1,324 201 1,110 856 303 3,696 201 2,767 856 854 5,923 21 430 172 73 794 109 1,754 905 385 4,477 21 0 106 14 5 7 0 9 13 26 7 106 23 13 175 At December 31, 2019, 2018 and 2017, non-accruing loans totaled $2.1 million, $2.7 million and $3.2 million, respectively, for which the related allowance for loan losses was $0.2 million, $0.7 million and $0.9 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 $0.8 million, $0.4 million and $0.4 million at December 31, 2019, 2018 and 2017, 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 $0.2 million, $0.3 million and $0.3 million in 2019, 2018 and 2017, respectively. For each of the years ended December 31, 2019, 2018 and 2017, the Company recognized interest income on these loans of $0.1 million. 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. 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, 2019, 2018 and 2017, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $2.5 million, $2.5 million and $3.0 million, respectively. Had these loans been performing in accordance with their original terms throughout 2019, 2018 and 2017, the Company would have recorded gross interest income of $0.2 million, $0.3 million and $0.4 million, respectively. During 2019, 2018 and 2017, the Company recognized interest income of $0.1 million, $0.2 million and $0.2 million, respectively, on these loans. For the loans that were modified in 2019, $0.1 million were classified and performing and $0.5 million were non- performing at December 31, 2019. The following table summarizes non-accrual loans at December 31, 2019 and 2018: The following table summarizes TDRs at December 31, 2019 and 2018: (Dollars in thousands) Single family ................................................ $ Commercial real estate: Real estate rental and leasing................... Other ........................................................ Consumer ...................................................... Commercial business.................................... $ 2019 2018 617 730 184 0 659 621 2,081 201 1,110 489 148 2,678 (Dollars in thousands) Single family ................................................ $ Commercial real estate: Other ........................................................ Consumer ...................................................... Commercial business.................................... $ 2019 2018 623 636 983 745 114 2,465 1,110 522 208 2,476 38 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2019, the Bank had commitments to lend an additional $0.8 million to a borrower who has a 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 $0.9 million to this same borrower at December 31, 2018. 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 ended December 31, 2019 and 2018: (Dollars in thousands) Troubled debt restructurings: Single family ......................................... Commercial real estate: Real estate rental and leasing ........... Other ................................................. Consumer .............................................. Commercial business ............................ Total ...................................................... Year ended December 31, 2019 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts Year ended December 31, 2018 Pre- modification Outstanding Recorded Investment Post- modification Outstanding Recorded Investment Number of Contracts 4 $ 215 220 2 $ 217 220 0 0 10 0 14 $ 0 0 371 0 586 0 0 371 0 591 1 2 10 1 16 $ 54 1,518 373 70 2,232 54 1,518 373 70 2,235 There were no loans that were restructured during the year ended December 31, 2019 that subsequently defaulted during the year. There was one consumer loan with a balance of $17,000 that was restructured during the year ended December 31, 2018 that subsequently defaulted during 2018. 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 may 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 $0.6 million, or 7.2%, of the total $8.6 million in allowance for loan losses at December 31, 2019, and $0.6 million, or 7.2%, of the total $8.7 million in allowance for loan losses at December 31, 2018. NOTE 7 Accrued Interest Receivable Accrued interest receivable at December 31 is summarized as follows: (Dollars in thousands) Securities available for sale .......................... $ Loans receivable ........................................... $ 2019 2018 378 1,873 2,251 381 1,975 2,356 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following amortization expense for amortizing intangible assets: the estimated future indicates table (Dollars in thousands) Year ended December 31, 2020 ...................................... $ 2021 ...................................... 2022 ...................................... 2023 ...................................... 2024 ...................................... Thereafter ............................. $ Mortgage Servicing Rights Core Deposit Intangible Total Amortizing Intangible Assets 505 455 402 330 251 229 2,172 99 47 10 0 0 0 156 604 502 412 330 251 229 2,328 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, 2019. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions. NOTE 9 Premises and Equipment A summary of premises and equipment at December 31, 2019 and 2018 is as follows: (Dollars in thousands) Land ............................................................. $ Office buildings and improvements ............ Furniture and equipment ............................. Accumulated depreciation ........................... $ 2019 2018 2,615 11,946 12,954 27,515 (17,000) 10,515 2,621 10,878 12,935 26,434 (16,799) 9,635 The increase in premises and equipment related primarily to the remodeling of branch facilities. NOTE 10 Leases On January 1, 2019, the Company adopted ASU 2016-02, Leases (Topic 842) and a $4.5 million right-of-use asset and an offsetting lease payment obligation liability were recorded on the consolidated balance sheet in other assets and other liabilities, respectively. 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 2019 and 2018 is as follows: (Dollars in thousands) Mortgage servicing rights, net: Balance, beginning of year .......................... $ Originations ................................................. Amortization ................................................ Balance, end of year .................................... Fair value of mortgage servicing rights ...... $ 2019 2018 1,855 1,097 (780) 2,172 3,390 1,724 682 (551) 1,855 3,901 All of the single family loans sold where the Company continues to service the loans are serviced for FNMA under the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced for FNMA at December 31, 2019: Loan Principal Balance Weighted Average Interest Rate Weighted Average Remaining Term (months) Number of Loans (Dollars in thousands) Original term: 30 year fixed rate .. $ 333,300 15 year fixed rate .. 93,869 45 Adjustable rate ...... 4.10 % 3.21 4.63 309 2,445 940 131 2 257 The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2019 and 2018 are presented in the following table. Amortization expense for intangible assets was $0.9 million for the year ended December 31, 2019, and $0.7 million for the years ended December 31, 2018 and 2017. (Dollars in thousands) December 31, 2019 Gross Carrying Accumulated Intangible Amount Amortization Assets Unamortized Mortgage servicing rights ................................ $ Core deposit intangibles .. Goodwill .......................... Total ................................. $ 4,968 574 802 6,344 (2,796) (418) 0 (3,214) December 31, 2018 Mortgage servicing rights ................................. $ Core deposit intangibles ..... Goodwill ............................. Total .................................... $ 4,526 574 802 5,902 (2,671) (319) 0 (2,990) 2,172 156 802 3,130 1,855 255 802 2,912 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS lease liabilities are Operating lease right-of-use assets represent our right to use an underlying asset during the lease term and operating lease liabilities represent our obligation to make lease payments arising from the lease. Right-of-use assets and lease operating commencement based on the present value of the remaining lease payments using a discount rate that represents the Company’s incremental borrowing rate at the lease commencement date. Because the Company only has operating leases and the right-of-use asset is offset by a lease payment obligation liability, the lease payments are the only amount that is recorded in occupancy expense in the consolidated statements of comprehensive income. recognized at The Company’s leases relate to office space and Bank branches with remaining lease terms between 32 and 64 months. Certain leases contain extension options which typically range from 3 to 10 years. Because these extension options are not considered reasonably certain of exercise, they are not included in the lease term. As of December 31, 2019, operating lease right-of-use assets and liabilities were $4.0 million. The table below summarizes our net lease cost: (Dollars in thousands) Operating lease cost ................................................... $ For the Year Ended December 31, 2019 889 The table below summarizes other information related to our operating leases: (Dollars in thousands) Cash paid for amounts included in the measurement of lease liabilities: Year Ended December 31, 2019 Operating cash flows from operating leases.......... $ 889 Weighted-average remaining lease term – operating leases, in years .......................................... Weighted-average discount rate – operating leases ... 4.7 2.19 % The table below summarizes the maturity of remaining lease liabilities: (Dollars in thousands) 2020 ............................................................................ $ 2021 ............................................................................ 2022 ............................................................................ 2023 ............................................................................ 2024 ............................................................................ 2025 and thereafter ..................................................... Total lease payments .................................................. Less: Interest............................................................... Present value of lease liabilities ................................. $ December 31, 2019 887 896 932 807 729 15 4,266 (221) 4,045 NOTE 11 Deposits Deposits and their weighted average interest rates at December 31, 2019 and 2018 are summarized as follows: (Dollars in thousands) Noninterest checking ................ Interest checking ....................... 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 2019 Amount Percent of Total Weighted Average Rate 2018 Amount Percent of Total 0.00 % $ 0.13 0.08 0.65 1.84 0.56 $ 183,350 96,341 80,054 187,517 547,262 22,499 38,097 61,936 4,076 126,608 673,870 27.2 % 14.3 11.9 27.8 81.2 3.3 5.7 9.2 0.6 18.8 100.0 % 0.00 % $ 0.10 0.08 0.56 1.32 0.43 $ 163,500 88,715 76,839 181,374 510,428 32,904 47,627 31,680 713 112,924 623,352 26.2 % 14.3 12.3 29.1 81.9 5.3 7.6 5.1 0.1 18.1 100.0 % 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2019 and 2018, the Company had $215.8 million and $182.0 million, respectively, of deposit accounts with balances at $250,000 or more. At December 31, 2019 and 2018, the Company had no certificate accounts that had been acquired through a broker. Certificates had the following maturities at December 31, 2019 and 2018: (Dollars in thousands) Remaining term to maturity 1-6 months ..................................................................... $ 7-12 months ................................................................... 13-36 months ................................................................. Over 36 months ............................................................. $ 2019 2018 Amount Weighted Average Rate Amount Weighted Average Rate 43,447 39,074 41,753 2,334 126,608 1.88 % $ 1.63 2.00 1.71 1.84 $ 39,004 36,711 33,941 3,268 112,924 1.23 % 1.29 1.46 1.44 1.32 At December 31, 2019 and 2018, the Company had pledged mortgage-backed and agency securities with an amortized cost of approximately $14.9 million and $17.9 million, respectively, as collateral for certain deposits. Interest expense on deposits is summarized as follows for the years ended December 31, 2019, 2018 and 2017: (Dollars in thousands) Checking accounts ................ $ Savings accounts .................. Money market accounts ........ Certificates ............................ $ 2019 2018 2017 103 63 1,171 1,995 3,332 62 61 865 1,243 2,231 77 63 560 770 1,470 NOTE 13 Income Taxes Income tax expense for the years ended December 31, 2019, 2018 and 2017 is as follows: (Dollars in thousands) Current: 2019 2018 2017 Federal ....................................... $ State ........................................... Total current ......................... 2,141 687 2,828 1,690 115 1,805 2,287 10 2,297 Deferred: Federal ....................................... State ........................................... Total deferred ....................... Income tax expense ....................... $ 256 240 496 3,324 234 849 1,083 2,888 1,412 693 2,105 4,402 The reasons for the difference between the expected income tax expense utilizing the federal corporate tax rate of 21% in 2019 and 2018, and 34% in 2017 and the actual income tax expense are as follows: (Dollars in thousands) Expected federal income tax 2019 2018 2017 expense ...................................... $ 2,334 2,336 2,994 Items affecting federal income tax: State income taxes, net of federal income tax deduction Change in federal tax rate ....... Other, net ................................. Income tax expense ..................... $ 852 0 138 3,324 559 0 (7) 2,888 529 1,062 (183) 4,402 NOTE 12 Federal Home Loan Bank (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, 2019 or December 31, 2018. At December 31, 2019 the Bank had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $181.2 million, subject to a requirement to purchase FHLB stock. The Bank also had the ability to borrow $65.3 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2019, subject to approval from the Board of Governors of the Federal Reserve System (FRB). At December 31, 2018 the Bank had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $167.6 million, subject to a requirement to purchase FHLB stock. The Bank also had the ability to borrow of $73.0 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2018, subject to approval from the FRB. 42 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: 2019 2018 Allowances for loan losses ........................... $ Deferred compensation costs ........................ Deferred ESOP loan asset ............................. Nonaccruing loan interest ............................. State net operating loss carryforward ........... Alternative minimum tax credit 2,394 158 453 78 42 2,428 154 473 185 160 carryforward................................................ 0 208 Net unrealized loss on securities available for sale ......................................................... Other .............................................................. Total gross deferred tax assets ................. 0 140 3,265 426 91 4,125 Deferred tax liabilities: Deferred loan costs ....................................... Premises and equipment basis difference ..... Originated mortgage servicing rights ........... Federal tax liability on state net operating 344 526 607 367 509 519 loss carryforwards ....................................... 9 34 Net unrealized gain on securities available for sale ......................................................... Other .............................................................. Total gross deferred tax liabilities ............ Net deferred tax assets .............................. $ 18 59 1,563 1,702 0 54 1,483 2,642 The Company has no federal and $0.8 million of state net operating loss carryforwards at December 31, 2019. 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 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, 2019 approximately $8.8 million for which no provision for income taxes was made. This amount represents allocations of income to bad debt deductions for tax purposes. Reduction of amounts so allocated for purposes other than absorbing losses will create income for tax purposes, which will be subject to the then-current corporate income tax rate. The Company considers the determination of the deferred tax asset amount and the need for any valuation reserve to be a critical accounting policy that requires significant judgment. The Company has, in its judgment, made reasonable assumptions and considered both positive and negative evidence relating to the ultimate realization of deferred the cumulative net income generated over the prior three year tax assets. Positive evidence includes period and the probability that taxable income will be generated in future periods. The Company could not currently identify any negative evidence. Based upon this evaluation, the Company determined that no valuation allowance was required with respect to the net deferred tax assets at December 31, 2019 and 2018. 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. 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, 2019 because such information is not accumulated for each participating institution. As of June 30, 2019, the Pentegra DB Plan valuation report reflected that the Bank was obligated to make a contribution totaling $0.3 million which was paid and expensed in 2019. Funded status (market value of plan assets divided by funding target) as of July 1 for the 2019, 2018 and 2017 plan years were 87.67%, 89.86% and 95.45%, respectively. Market value of plan assets reflects contributions received through June 30, 2019. Total employer contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $164.6 million, $367.1 million, and $153.2 million for the plan years ended June 30, 2018, 2017 and 2016, 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. 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following contributions were paid by the Bank during the fiscal years ending December 31: (Dollars in thousands) 2019 2018 Date Paid Amount 10/02/2019 ................ $ 12/23/2019 ................. Date Paid 29 10/11/2018 ................ $ 244 12/27/2018 ................ Amount Total .......................... $ 273 $ 2017 Date Paid 26 01/06/2017 .............. (1) $ 92 10/15/2017 .............. 12/27/2017 .............. $ 118 Amount 119 27 99 245 (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 $19,000 for 2019, $18,500 for 2018 and $18,000 for 2017, with additional “catch up” contributions allowed for employees over 50 years of age. 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 2019, 2018 and 2017. 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 2019, 2018 and 2017. 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 44 determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares and the shares become outstanding for earnings per common share computations. ESOP compensation expense was $0.5 million for 2019 and 2018, and $0.4 million for 2017. 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 .......... 340,237 357,135 339,870 2019 2018 2017 Shares allocated to participants ......................... 24,317 24,317 24,317 Shares distributed to participants ......................... (18,457 ) (41,215) (7,052) Shares held by participants end of year .......................... 346,097 340,237 357,135 Unreleased shares beginning of the year ........................... 231,112 255,429 279,746 (24,317) (24,317 ) (24,317) Shares released during year .. Unreleased shares end of year ............................................ 206,795 231,112 255,429 Total ESOP shares end of year ..................................... 552,892 571,349 612,564 Fair value of unreleased shares at December 31 ....... $ 4,344,763 4,534,417 4,878,694 In April 2009 the HMN Financial, Inc. 2009 Equity and Incentive Plan (2009 Plan) was adopted by the Company. In April 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, 2019 there were 34,229 vested options outstanding under the 2009 Plan. These options expire 10 years from the date of grant and have an average exercise price of $11.21. There were also 3,102 shares of restricted stock previously granted to current employees under the 2009 Plan that as of December 31, 2019 remained unvested. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 their interests with those of 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 similar changes to the capitalization of the Company. 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, 2019, there were no options outstanding under the 2017 Plan. There were 14,787 shares of restricted stock previously granted to current employees and directors under the 2017 Plan that remained unvested at December 31, 2019. A summary of activities under all plans for the past three years is as follows: Shares Available For Grant Unvested Restricted Shares Award Value/ Weighted Average Options Outstanding Outstanding Exercise Price Number Weighted Average Grant Date Fair Value Vesting Period (in years) Unvested options 34,229 $ 4.04 2009 Plan December 31, 2016 ............................. Granted January 31, 2017 .............. Transferred to 2017 Plan ................ Vested ............................................. December 31, 2017 ............................. Options Exercised .......................... Vested ............................................. December 31, 2018 ............................. Vested ............................................ December 31, 2019 ............................ 2017 Plan April 25, 2017 ..................................... Granted May 5, 2017 ..................... Transferred from 2009 Plan ........... December 31, 2017 ............................. Granted January 23, 2018 .............. Granted April 24, 2018 .................. Vested ............................................. December 31, 2018 ............................. Granted January 22, 2019 ........... Granted April 23, 2019 ................ Vested ............................................ December 31, 2019 ............................ 54,876 (11,164 ) (43,712 ) 0 0 0 0 0 0 0 375,000 (3,420 ) 43,712 415,292 (10,044 ) (792 ) 0 404,456 (12,971 ) (2,514 ) 0 388,971 20,596 9,303 0 (15,018) 14,881 0 (7,541) 7,340 (4,238) 3,102 0 2,280 0 2,280 6,696 528 (2,280) 7,224 8,647 1,676 (2,760) 14,787 49,229 $ 0 0 0 49,229 $ (15,000 ) 0 34,229 $ 0 34,229 $ 0 0 0 0 0 0 0 0 0 0 0 0 9.25 N/A N/A N/A 9.25 (11,409) 22,820 $ N/A 11.21 11.21 (11,410) 11,410 $ (11,410) 0 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 0 0 0 0 0 4.04 4.04 4.04 4.04 4.04 3 1 3 1 3 1 Total all plans .................................... 388,971 17,889 34,229 $ 11.21 0 $ 4.04 The following table summarizes information about stock options outstanding at December 31, 2019: Date of Grant Exercise Price Number Outstanding Weighted Average Remaining Contractual Life in Years Number Exercisable Number Unexercisable January 26, 2016 ..................... $ 11.21 34,229 34,229 6.1 34,229 34,229 0 0 The Company will issue shares from treasury stock upon the exercise of outstanding options. 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 2019, 2018 or 2017. 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 2019 Year ended December 31, 2018 2017 common share calculation ................................................................................................ 4,610,469 4,368,289 4,215,899 Net dilutive effect of : Options and warrants ........................................................................................................ Restricted stock awards..................................................................................................... 16,018 12,443 423,818 10,868 640,410 11,662 Weighted average number of common shares outstanding adjusted for effect of dilutive securities ............................................................................................................................ 4,638,930 4,802,975 4,867,971 Net income available to common shareholders .................................................................... $ Basic earnings per common share ......................................................................................... $ Diluted earnings per common share ...................................................................................... $ 7,793 1.69 1.68 8,236 1.89 1.71 4,404 1.04 0.90 NOTE 16 Stockholders' Equity 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 States Department of Treasury (Treasury). The Preferred Stock had a liquidation value of $1,000 per share and a related warrant was also issued to purchase 833,333 shares of HMN common stock at an exercise price of $4.68 per share (the Warrant). The transaction was part of the Treasury’s Capital Purchase Program under the Emergency Economic Stabilization Act of 2008. On February 17, 2015, the Company redeemed the final 10,000 shares of outstanding Preferred Stock. On May 21, 2015, the Treasury sold the Warrant at an exercise price of $4.68 per share to three unaffiliated third party investors for an aggregate purchase price of $5.7 million. In 2018, all of the outstanding Warrants were either exercised by the Warrant holder or repurchased by the Company. These Warrant transactions resulted in the Company issuing an additional 319,651 shares of common stock from treasury shares for Warrants that were exercised and paying $6.5 million in cash to repurchase the remaining Warrants. As a result of these transactions, the Company no longer has any obligations under the Warrant. On November 28, 2018, the Board of Directors announced a new share repurchase program, pursuant to which the Company may purchase shares of its common stock for an aggregate purchase price not to exceed $6 million. The share repurchase program does not obligate the Company to purchase any shares and has no set expiration date. No shares were repurchased in the open market by the Company in 2019 or 2018 under the share repurchase program. The Company did not pay any dividends on its common stock during 2019, 2018 or 2017. 46 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. such requirements. The NOTE 17 Regulatory Capital The Company and the Bank are subject to the Basel III regulatory capital requirements. The Basel III requirements, among other things, (i) apply a set of capital requirements to the Bank (the Company is exempt, pursuant to the Small (Policy Bank Holding Company Policy Statement 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) set forth rules for calculating risk-weighted assets for purposes of rules made corresponding revisions to the prompt corrective action framework and ratios and buffer requirements which are fully phased in as of 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 its 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. include capital NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The FRB amended its Policy Statement, to exempt small bank and savings and loan holding companies with assets less than $3 billion from the above capital requirements. The Company currently meets the qualitative exemption requirements, and therefore, is exempt from the above capital requirements. 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. At December 31, 2019 and 2018, 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: Amount (Dollars in thousands) December 31, 2019 Common equity Tier 1 capital ....... $ 83,525 Tier 1 leverage ................................. 83,525 Tier 1 risk-based capital ................ 83,525 Total risk-based capital .................. 91,438 Required to be Adequately Capitalized Amount Percent of Assets(1) Capital in Excess of Minimum Requirements To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Percent of Assets(1) Amount Percent of Assets(1) Actual Percent of Assets(1) 13.21 % $ 28,458 30,684 10.89 37,944 13.21 50,591 14.46 4.50 % $ 55,067 52,841 4.00 45,581 6.00 40,847 8.00 8.71 % $ 41,106 38,355 6.89 50,591 7.21 63,239 6.46 6.50 % 5.00 8.00 10.00 December 31, 2018 Common equity Tier 1 capital .......... $ 79,552 Tier 1 leverage .................................. 79,552 Tier 1 risk-based capital ................... 79,552 Total risk-based capital..................... 87,063 (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 13.26 % $ 26,988 28,923 11.00 35,983 13.26 47,978 14.52 8.76 % $ 38,982 36,154 7.00 47,978 7.26 59,972 6.52 4.50 % $ 52,564 50,629 4.00 43,569 6.00 39,085 8.00 6.50 % 5.00 8.00 10.00 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. On January 1, 2019, the capital conservation buffer amount increased to 2.50% and is fully phased in. Management believes that, as of December 31, 2019, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the current 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 adjust the requirement to be well-capitalized in the future. In addition, the Company must adhere to various U.S. Department of Housing and Urban Development (HUD) regulatory guidelines including required minimum capital and liquidity amounts to maintain their Federal Housing Administration approved status. Failure to comply with the HUD guidelines could result in withdrawal of this certification. As of December 31, 2019, the Company was in compliance with HUD guidelines. NOTE 18 Commitments and Contingencies The Company is a party to financial instruments with off- balance sheet risk in the normal course of business to meet 47 the financing needs of its customers. These financial instruments include all 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 Contract Amount December 31, 2019 2018 (Dollars in thousands) Financial instruments whose contract amount represents credit risk: Commitments to originate, fund or purchase loans: Single family ...................................... $ Commercial real estate ....................... Commercial business .......................... Undisbursed balance of loans closed . Unused lines of credit ......................... Letters of credit ................................... 6,081 7,620 6,320 19,183 782 11,354 23,749 30,070 107,767 107,438 2,608 Total commitments to extend credit ....... $ 178,804 146,978 7,289 Forward commitments ............................ $ 10,098 2,810 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS its From time to time, the Company is party to legal proceedings arising out of lending and deposit operations. The Company is, and expects to become, engaged in foreclosure proceedings, collection actions, and other litigation as part of its normal banking activities. Among the various current litigation matters, the Company is involved in a bankruptcy litigation claim where the bankruptcy trustee is attempting to recover $3.7 million related to the principal and interest payments made to the Bank prior to the bankruptcy filing of a former customer of the Bank. The Company examines each legal matter, and, in those situations where it determines that a particular legal matter presents loss contingencies that are both probable and reasonably estimable, establishes an appropriate accrual. In many situations, the Company is not able to estimate reasonably possible losses due to the preliminary nature of the legal matter, as well as a variety of other factors and uncertainties. For those legal matters where the Company is able to estimate a range of reasonably possible losses, management currently estimates that the aggregate range of losses from all of our outstanding litigation is from $0 to $1.2 million in excess of the amounts accrued, if any. This estimated aggregate range is based on an assessment of the information currently available to the Company and the actual aggregate losses could be higher. However, the Company does not believe these losses are probable to occur at this time. The Company reassesses all of its potential loss positions based on the available information each quarter and the estimated range of reasonably possible losses may change in the future. The Company typically vigorously pursues all available defenses related to litigation but may consider other alternatives, in situations where there is an opportunity to resolve a legal matter on terms that are considered to be favorable to the Company when considering the continued expense and distraction of defending against any particular legal action. including settlement, Based on the Company’s current understanding of all of the outstanding legal matters, management does not believe that judgments or settlements arising from any pending or threatened litigation, individually or in the aggregate, would have a material adverse effect on the consolidated financial condition or results of operations. However, litigation is unpredictable and the actual results of litigation cannot be determined with any certainty. Therefore, the ultimate aggregate resolution of any, or all, of the current outstanding legal matters could have a material adverse effect on the Company’s results of operations in the future. 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 the 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 32 months and totaled $2.8 million at December 31, 2019 and $2.6 million at December 31, 2018. The letters of credit are collateralized primarily with commercial real estate mortgages. Draws on standby letters of credit would be initiated by the secured party under the terms of the underlying obligation. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments. The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2019, 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 (Dollars in thousands) Total Contractual Obligations: Annual rental commitments under non-cancellable operating leases ....... $ 4,266 887 1,829 1,536 14 Total contractual obligations........ $ 4,266 887 1,829 1,536 14 Amount of Commitments Expiring by Period Other Commercial Commitments: Commercial lines of credit........................ $ 63,322 23,742 27,240 12,340 0 Commitments to lend 22,757 8,716 2,668 4,090 7,283 Standby letters of credit........................ 2,810 2,108 702 0 0 Total other commercial commitment ..... $ 88,889 34,566 30,610 16,430 7,283 48 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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, 2019 and December 31, 2018 did not have a material impact on the Company’s consolidated financial statements. loans into the the current As of December 31, 2019 and 2018, 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, 2019 and December 31, 2018 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 inputs are not available. These that observable 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, 2019 and 2018. (Dollars in thousands) Securities available for sale ............................... $ Equity securities .................................................. Mortgage loan commitments ............................. Total ..................................................................... $ Total Level 1 Level 2 Level 3 Carrying Value at December 31, 2019 107,592 167 14 107,773 0 0 0 0 107,592 167 14 107,773 (Dollars in thousands) Securities available for sale .................................. $ Equity securities ................................................... Mortgage loan commitments ................................ Total ...................................................................... $ Total 79,859 121 40 80,020 Carrying Value at December 31, 2018 Level 1 Level 2 Level 3 0 0 0 0 79,859 121 40 80,020 0 0 0 0 0 0 0 0 49 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 2019 and 2018 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, 2019 and 2018. Carrying Value at December 31, 2019 (Dollars in thousands) Loans held for sale ................................................ $ Mortgage servicing rights, net ............................. Impaired loans ...................................................... Real estate, net ...................................................... Total ....................................................................... $ Total Level 1 Level 2 Level 3 3,606 2,172 3,126 580 9,484 0 0 0 0 0 3,606 2,172 3,126 580 9,484 Carrying Value at December 31, 2018 (Dollars in thousands) Loans held for sale .................................................. $ Mortgage servicing rights, net ................................ Impaired loans ........................................................ Real estate, net ........................................................ Total ........................................................................ $ Total Level 1 Level 2 Level 3 3,444 1,855 2,902 414 8,615 0 0 0 0 0 3,444 1,855 2,902 414 8,615 Year Ended December 31, 2019 Total losses (40) 0 (28) 0 (68) Year Ended December 31, 2018 Total gains (losses) 45 0 (97) 0 (52) 0 0 0 0 0 0 0 0 0 0 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, 2019 and 2018 based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, risk characteristics of various financial instruments and other factors. The estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. conditions, economic current Fair value estimates are based only on existing financial instruments without attempting to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates. 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The estimated fair value of the Company's financial instruments is shown below. Following the table, there is an explanation of the methods and assumptions used to estimate the fair value of each class of financial instruments. December 31, 2019 Fair value hierarchy December 31, 2018 Carrying amount Estimated fair value Level 1 Level 2 Level 3 Contract amount Carrying amount Estimated fair value Contract amount (Dollars in thousands) Financial assets: Cash and cash equivalents ......... $ 44,399 Securities available for sale ....... 107,592 167 Equity securities ........................ Loans held for sale .................... 3,606 Loans receivable, net ................. 596,392 854 FHLB stock ............................... 2,251 Accrued interest receivable ....... 44,399 44,399 107,592 167 3,606 600,863 854 2,251 107,592 167 3,606 600,863 854 2,251 Financial liabilities: 20,709 79,859 121 3,444 20,709 79,859 121 3,444 586,688 578,978 867 2,356 867 2,356 Deposits ..................................... 673,870 420 Accrued interest payable ........... 673,945 420 673,945 420 623,352 623,439 346 346 Off-balance sheet financial instruments: Commitments to extend credit .. Commitments to sell loans ........ 14 (16 ) 14 (16) 178,804 10,098 40 (56) 40 146,978 7,289 (56) Cash and Cash Equivalents The carrying amount of cash and cash equivalents approximates their fair value. FHLB Stock The carrying amount of FHLB stock approximates its fair value. Securities Available for Sale The fair values of securities were based upon quoted market prices. Equity Securities The fair values of equity 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 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. The fair value disclosures for both the fixed and adjustable rate portfolios were adjusted to reflect the exit price amount anticipated to be received from the sale of the portfolio in an open market transaction as required upon adoption of ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities beginning in the first quarter of 2018. 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 disclosures for all of the deposits were adjusted to reflect the exit price amount anticipated to be received from the sale of the deposits in an open market transaction as required upon adoption of ASU 2016-01, (Subtopic 825-10) Financial Recognition and Measurement of Financial Assets and Financial Liabilities beginning in the first quarter of 2018. Instruments – Overall 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. 51 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, 2019 and 2018 and for the years ended December 31, 2019, 2018 and 2017. (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: Accrued expenses and other liabilities ..................................................................... $ Total liabilities ...................................................................................................... Common stock .......................................................................................................... Additional paid-in capital ......................................................................................... Retained earnings ...................................................................................................... Net unrealized gains (losses) on securities available for sale .................................. Unearned employee stock ownership plan shares .................................................... Treasury stock, at cost, 4,284,840 and 4,292,838 shares ......................................... Total stockholders' equity..................................................................................... Total liabilities and stockholders' equity .............................................................. $ Condensed Statements of Income Interest income (expense) ......................................................................................... $ Equity income of subsidiaries ................................................................................... Compensation and benefits ....................................................................................... Occupancy and equipment ........................................................................................ Data processing ......................................................................................................... Professional services ................................................................................................. Other .......................................................................................................................... Income before income tax expense (benefit) ....................................................... Income tax expense (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 .......................................................................... Decrease (increase) in other assets ........................................................................... Decrease in other liabilities ....................................................................................... Other, net ................................................................................................................... Net cash provided (used) by operating activities ................................................. Cash flows from financing activities: Warrants purchased ................................................................................................... Excess tax benefit from options exercised ............................................................... Stock awards withheld for tax withholding .............................................................. Repayments of borrowings ....................................................................................... Dividends received from Bank ................................................................................. Net cash provided (used) by financing activities ..................................................... Increase (decrease) in cash and cash equivalents ..................................................... Cash and cash equivalents, beginning of year .............................................................. Cash and cash equivalents, end of year ......................................................................... $ 2019 2018 2017 7,722 84,507 610 24 92,863 215 215 91 40,365 107,547 46 (1,643) (53,758) 92,648 92,863 21 8,627 (240) (30) (6) (131) (367) 7,874 81 7,793 1,534 79,737 2,014 95 83,380 233 233 91 40,090 99,754 (1,096) (1,836) (53,856) 83,147 83,380 0 8,800 (221) (30) (6) (124) (331) 8,088 (148) 8,236 7,793 8,236 (8,627) 71 230 1 187 193 1,404 (18) (1) 1,233 0 0 (45) 0 5,000 4,955 6,188 1,534 7,722 (8,800) 46 206 17 134 194 (146) (20) (1) (134) (6,453) 64 0 0 6,000 (389) (523) 2,057 1,534 (306) 4,878 (257) (30) (6) (130) (319) 3,830 (574) 4,404 4,404 (4,878) 615 147 41 147 193 (6) (866) 0 (203) 0 0 (54) (7,000) 6,000 (1,054) (1,257) 3,314 2,057 52 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, 2019: Interest income – external customers ............................................................ $ Non-interest income – external customers .................................................... Intersegment interest income .......................................................................... Intersegment non-interest income .................................................................. Interest expense ................................................................................................ Provision for loan losses .................................................................................. Non-interest expense ........................................................................................ Income tax expense .......................................................................................... Net income ........................................................................................................ Total assets ........................................................................................................ At or for the year ended December 31, 2018: Interest income – external customers ................................................................ $ Non-interest income – external customers ........................................................ Intersegment non-interest income ...................................................................... Interest expense .................................................................................................. Provision for loan losses .................................................................................... Non-interest expense .......................................................................................... Income tax expense (benefit) ............................................................................. Net income ......................................................................................................... Total assets ......................................................................................................... At or for the year ended December 31, 2017: Interest income – external customers ................................................................ $ Non-interest income – external customers ........................................................ Intersegment non-interest income ...................................................................... Interest expense .................................................................................................. Provision for loan losses .................................................................................... Non-interest expense .......................................................................................... Income tax expense (benefit) ............................................................................. Net income ......................................................................................................... Total assets ......................................................................................................... 31,890 8,455 0 234 3,360 (1,216) 26,565 3,243 8,627 777,083 30,381 7,714 222 2,233 (649) 24,897 3,036 8,800 710,281 27,680 7,654 210 1,491 (523) 24,722 4,976 4,879 722,532 0 0 21 8,627 0 0 774 81 7,793 92,863 0 0 8,800 0 0 712 (148 ) 8,236 83,380 0 0 4,879 306 0 742 (574 ) 4,404 79,254 0 0 (21) (8,861) (21) 0 (234) 0 (8,627) (92,307) 0 0 (9,022) 0 0 (222) 0 (8,800) (81,346) 0 0 (5,089) 0 0 (210) 0 (4,879) (79,101) 31,890 8,455 0 0 3,339 (1,216) 27,105 3,324 7,793 777,639 30,381 7,714 0 2,233 (649) 25,387 2,888 8,236 712,315 27,680 7,654 0 1,797 (523) 25,254 4,402 4,404 722,685 53 54 OTHER FINANCIAL DATA The following tables set forth certain information as to the Bank’s FHLB advances. (Dollars in thousands) Maximum Balance: 2019 Year Ended December 31, 2018 FHLB advances ......................................................................................................... $ FHLB short-term advances ....................................................................................... 13,800 13,800 Average Balance: FHLB advances ......................................................................................................... FHLB short-term advances ....................................................................................... 287 287 6,800 6,800 140 140 2017 18,800 18,800 1,693 1,693 See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and other borrowings. 55  December 31, 2019 September 30, 2019 June 30, 2019 7,861 914 6,947 236 6,711 795 321 1,106 294 2,516 4,163 1,158 338 492 1,193 7,344 1,883 647 1,236 0.27 0.27 7,998 906 7,092 (420) 7,512 820 324 845 238 2,227 3,849 1,142 319 428 1,009 6,747 2,992 916 2,076 0.45 0.45 0.64% 5.29 12.06 3.76 1.11% 9.10 12.07 3.97 777,639 763,228 54,851 52,741 3,606 596,392 673,870 92,648 22,187 62,665 7,819 583,102 659,608 91,190 8,299 829 7,470 (1,059 ) 8,529 785 318 611 307 2,021 3,737 1,081 305 381 1,063 6,567 3,983 1,121 2,862 0.62 0.62 1.60 13.10 12.01 4.35 722,767 7,435 72,469 5,912 595,757 623,510 88,811 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 ......................................................... 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 ........................................................................................... Stockholders’ equity ........................................................................ (1) Annualized (2) Net interest income divided by average interest-earning assets 56 SELECTED QUARTERLY FINANCIAL DATA March 31, 2019 December 31, 2018 September 30, 2018 June 30, 2018 March 31, 2018 7,732 690 7,042 27 7,015 700 315 379 297 1,691 3,910 1,061 301 272 903 6,447 2,259 640 1,619 0.35 0.35 7,797 650 7,147 (167) 7,314 909 314 483 242 1,948 3,652 1,062 331 264 997 6,306 2,956 604 2,352 0.51 0.51 7,970 587 7,383 (652) 8,035 870 343 489 234 1,936 3,574 1,073 310 326 931 6,214 3,757 1,045 2,712 0.62 0.56 7,456 526 6,930 295 6,635 785 297 679 293 2,054 3,678 1,072 334 298 931 6,313 2,376 649 1,727 0.40 0.35 0.91% 7.67 11.82 4.11 1.29% 11.24 11.52 4.06 1.47% 12.90 11.54 4.14 0.95 % 8.25 11.61 3.97 722,745 7,743 72,044 3,292 599,462 626,592 85,350 712,315 8,023 71,836 3,444 586,688 623,352 83,147 737,445 8,207 71,253 2,109 586,092 651,429 79,994 726,285 8,895 71,451 3,624 589,855 639,535 81,825 7,158 470 6,688 (125 ) 6,813 766 301 444 265 1,776 3,824 1,097 295 249 1,089 6,554 2,035 590 1,445 0.34 0.29 0.82 % 7.07 11.65 3.95 722,339 9,455 71,545 2,234 591,840 633,805 82,056 57 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, 2019, the Company had 9,128,662 shares of common stock issued and 4,284,840 shares in treasury stock. As of December 31, 2019, there were 462 stockholders of record and 992 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 5, 2020, the last reported sale price of shares of our common stock on the Nasdaq was $21.11 per share. The Company has not paid a dividend on its common stock during the two year period ending December 31, 2019. 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. 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 Nasdaq Bank Index. The graph and table assume that $100 was invested on December 31, 2014 and that all dividends were reinvested. Index HMN Financial, Inc. .................................. $ Nasdaq Composite ..................................... $ Nasdaq Bank .............................................. $ 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18 12/31/19 100.00 $ 100.00 $ 100.00 $ 93.15 $ 106.96 $ 107.08 $ 141.13 $ 116.45 $ 147.27 $ 154.03 $ 150.96 $ 155.68 $ 158.23 $ 146.67 $ 129.17 $ 169.44 200.49 160.44 58 This page intentionally left blank 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 28, 2020 at 10:00 a.m. (Central Time) at the Rochester Golf and Country Club, 3100 West Country Club Road, Rochester, Minnesota. LEGAL COUNSEL Faegre Drinker Biddle & Reath 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, a provider of clinical decision support products SEQUOYA S. BORGMAN Borgman Capital LLC, Founder and Managing Director MICHAEL A. BUE Retired President and Chief Executive Officer Marquette Bank Rochester 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 Vice Chair HMN and Home Federal Savings Bank Educational consultant, PTECH in Minnesota, Former Assistant Professor, Winona State University MARK E. UTZ Attorney at law, Wendland Utz, Ltd. Eagan 2805 Dodd Road, Suite 160 Eagan, MN 55121 (651) 405-2000 Kasson 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 Owatonna 1015 West Frontage Road, Suite 100 Owatonna, MN 55060 (507) 413-6420 Pewaukee 1870 Meadow Lane Pewaukee, WI 53072 (262) 337-9511 Rochester 1201 South Broadway Rochester, MN 55901 (507) 536-2416 1016 Civic Center Drive NW Rochester, MN 55901 (507) 535-1309 HANS K. ZIETLOW Former Director of Real Estate for Kwik Trip, Inc. 100 1st Avenue Bldg., Suite 200 Rochester, MN 55902 (507) 280-7256 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 THE 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 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 1016 Civic Center Drive NW Rochester, Minnesota 55901 507.535.1200 • www.hmnf.com 2019 ANNUAL REPORT 

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