hmnf20160201_10q.htm

 UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

[X]     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2016

OR

 

[   ]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________ to _________

 

Commission File Number 0-24100

 

HMN FINANCIAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

41-1777397

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

     

1016 Civic Center Drive N.W., Rochester, MN

 

55901

(Address of principal executive offices)

 

(ZIP Code)

     

Registrant's telephone number, including area code:

 

(507) 535-1200

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒          No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

     Yes ☒          No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 Large accelerated filer ☐   

 Accelerated filer ☐

 Non-accelerated filer ☐

 Smaller reporting company ☒

(Do not check if a smaller reporting company)          

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐          No ☒

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

 

Class

 

Outstanding at April 21, 2016

 

Common stock, $0.01 par value

    4,486,299  

 

 

 
1

 

 

HMN FINANCIAL, INC.

CONTENTS

 

    Page
PART I – FINANCIAL INFORMATION  
   

 

Item 1:

Financial Statements

 
     
 

Consolidated Balance Sheets at March 31, 2016 and December 31, 2015

3

     
 

Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2016 and 2015

4

     
 

Consolidated Statement of Stockholders' Equity for the Three Month Period Ended March 31, 2016

5

     
 

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015

6

     
 

Notes to Consolidated Financial Statements

7

     

Item 2:

Management's Discussion and Analysis of Financial Condition and Results of Operations

26

     

Item 3:

Quantitative and Qualitative Disclosures About Market Risk

36

     

Item 4:

Controls and Procedures

37

     

PART II – OTHER INFORMATION

 
     

Item 1:

Legal Proceedings

38

     

Item 1A:

Risk Factors

38

     

Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

38

     

Item 3:

Defaults Upon Senior Securities

38

     

Item 4:

Mine Safety Disclosures

38

     

Item 5:

Other Information

38

     

Item 6:

Exhibits

38

     

Signatures

39

 

 
2

 

 

PART I – FINANCIAL INFORMATION

Item 1 : Financial Statements

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

 

                   
   

March 31,

   

December 31,

   

(Dollars in thousands)

 

2016

   

2015

   
   

(unaudited)

           

Assets

                 

Cash and cash equivalents

  $ 13,766       39,782    

Securities available for sale:

                 

Mortgage-backed and related securities (amortized cost $1,938 and $2,237)

    1,984       2,283    

Other marketable securities (amortized cost $104,016 and $110,092)

    103,844       109,691    
      105,828       111,974    
                   

Loans held for sale

    4,467       3,779    

Loans receivable, net

    490,260       463,185    

Accrued interest receivable

    2,134       2,254    

Real estate, net

    1,668       2,045    

Federal Home Loan Bank stock, at cost

    770       691    

Mortgage servicing rights, net

    1,456       1,499    

Premises and equipment, net

    7,583       7,469    

Core deposit intangible

    374       393    

Prepaid expenses and other assets

    1,268       1,417    

Deferred tax asset, net

    8,582       8,673    

Total assets

  $ 638,156       643,161    
                   

Liabilities and Stockholders’ Equity

                 

Deposits

  $ 551,506       559,387    

Other borrowings

    9,000       9,000    

Accrued interest payable

    230       242    

Customer escrows

    1,558       830    

Accrued expenses and other liabilities

    4,175       4,057    

Total liabilities

    566,469       573,516    

Commitments and contingencies

                 

Stockholders’ equity:

                 

Serial preferred stock ($.01 par value):

                 

Authorized 500,000 shares; issued shares 0

    0       0    

Common stock ($.01 par value):

                 

Authorized 16,000,000; issued shares 9,128,662

    91       91    

Additional paid-in capital

    50,380       50,388    

Retained earnings, subject to certain restrictions

    82,310       80,536    

Accumulated other comprehensive loss

    (76 )     (214 )  

Unearned employee stock ownership plan shares

    (2,368 )     (2,417 )  

Treasury stock, at cost 4,642,363 and 4,645,769 shares

    (58,650 )     (58,739 )  

Total stockholders’ equity

    71,687       69,645    

Total liabilities and stockholders’ equity

  $ 638,156       643,161    

 


 See accompanying notes to consolidated financial statements.

 

 
3

 

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(unaudited)

 

       

Three Months Ended

March 31,

 
(Dollars in thousands, except per share data)       2016       2015  

Interest income:

                 

Loans receivable

  $ 6,094       4,354  

Securities available for sale:

               

Mortgage-backed and related

    20       28  

Other marketable

    372       486  

Cash equivalents

    38       15  

Other

    1       1  

Total interest income

    6,525       4,884  
                   

Interest expense:

               

Deposits

    226       248  

Other borrowings

    148       78  

Total interest expense

    374       326  

Net interest income

    6,151       4,558  

Provision for loan losses

    (732 )     0  

Net interest income after provision for loan losses

    6,883       4,558  
                   

Non-interest income:

               

Fees and service charges

    779       782  

Loan servicing fees

    261       261  

Gain on sales of loans

    487       285  

Other

    228       268  

Total non-interest income

    1,755       1,596  
                   

Non-interest expense:

               

Compensation and benefits

    3,695       3,448  

Gain on real estate owned

    (349 )     (112 )

Occupancy and equipment

    990       879  

Data processing

    273       231  

Professional services

    251       217  

Other

    831       770  

Total non-interest expense

    5,691       5,433  

Income before income tax expense

    2,947       721  

Income tax expense

    1,173       260  

Net income

    1,774       461  

Preferred stock dividends

    0       (108 )

Net income available to common shareholders

  $ 1,774       353  

Other comprehensive income, net of tax

  $ 138       395  

Comprehensive income attributable to common shareholders

  $ 1,912       748  
Basic earnings per common share   $ 0.43       0.09  
Diluted earnings per common share   $ 0.38       0.08  

 

 See accompanying notes to consolidated financial statements.

 

 
4

 

 

 HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders' Equity 

For the Three Month Period Ended March 31, 2016

(unaudited)

 

                                   

Unearned

                 
                                   

Employee

                 
                           

Accumulated

   

Stock

           

Total

 
           

Additional

           

Other

   

Ownership

           

Stock-

 
   

Common

   

Paid-In

   

Retained

   

Comprehensive

   

Plan

   

Treasury

   

Holders’

 

(Dollars in thousands)

 

Stock

   

Capital

   

Earnings

   

Income/(Loss)

   

Shares

   

Stock

   

Equity

 

Balance, December 31, 2015

  $ 91       50,388       80,536       (214 )     (2,417 )     (58,739 )     69,645  

Net income

                    1,774                               1,774  

Other comprehensive income

                            138                       138  

Stock compensation expense

            20                                       20  

Restricted stock awards

            (89 )                             89       0  

Amortization of restricted stock awards

            49                                       49  

Earned employee stock ownership plan shares

            12                       49               61  

Balance, March 31, 2016

  $ 91       50,380       82,310       (76 )     (2,368 )     (58,650 )     71,687  

 

See accompanying notes to consolidated financial statements.

 

 
5

 

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

 

   

Three Months Ended

March 31,

 

(Dollars in thousands)

 

2016

   

2015

 

Cash flows from operating activities:

               

Net income

  $ 1,774       461  

Adjustments to reconcile net income to cash provided by operating activities:

               

Provision for loan losses

    (732 )     0  

Depreciation

    195       161  

Amortization of (discounts) premiums, net

    (8 )     6  

Amortization of deferred loan fees

    (383 )     (31 )

Amortization of core deposit intangible

    19       0  

Amortization of other purchased loan fair value adjustments

    (171 )     0  

Amortization of mortgage servicing rights and servicing costs

    132       143  

Capitalized mortgage servicing rights

    (89 )     (84 )

Gain on sales of real estate and premises

    (349 )     (112 )

Gain on sales of loans

    (487 )     (285 )

Proceeds from sale of loans held for sale

    16,494       12,061  

Disbursements on loans held for sale

    (12,303 )     (12,027 )

Amortization of restricted stock awards

    49       67  

Amortization of unearned ESOP shares

    49       48  

Earned employee stock ownership shares priced above original cost

    12       16  

Stock option compensation expense

    20       0  

Decrease (increase) in accrued interest receivable

    120       (228 )

(Decrease) increase in accrued interest payable

    (12 )     72  

Decrease in other assets

    205       50  

Increase in other liabilities

    77       209  

Other, net

    16       9  

Net cash provided by operating activities

    4,628       536  

Cash flows from investing activities:

               

Principal collected on securities available for sale

    307       409  

Proceeds collected on maturities of securities available for sale

    56,020       18,000  

Purchases of securities available for sale

    (49,968 )     (34,070 )

Purchase of Federal Home Loan Bank stock

    (79 )     0  

Redemption of Federal Home Loan Bank stock

    0       86  

Proceeds from sales of real estate

    1,305       221  

Net (increase) decrease in loans receivable

    (30,779 )     4,431  

Purchases of premises and equipment

    (309 )     (99 )

Net cash used by investing activities

    (23,503 )     (11,022 )

Cash flows from financing activities:

               

Decrease in deposits

    (7,869 )     (13,428 )

Redemption of preferred stock

    0       (10,000 )

Dividends to preferred stockholders

    0       (225 )

Proceeds from borrowings

    0       13,000  

Repayment of borrowings

    0       (3,000 )

Increase in customer escrows

    728       441  

Net cash used by financing activities

    (7,141 )     (13,212 )

Decrease in cash and cash equivalents

    (26,016 )     (23,698 )

Cash and cash equivalents, beginning of period

    39,782       46,634  

Cash and cash equivalents, end of period

  $ 13,766       22,936  

Supplemental cash flow disclosures:

               

Cash paid for interest

  $ 387       254  

Cash paid for income taxes

    156       135  

Supplemental noncash flow disclosures:

               

Loans transferred to loans held for sale

    4,408       342  

Transfer of loans to real estate

    591       0  

 

See accompanying notes to consolidated financial statements.

 

 
6

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

 

(1) HMN Financial, Inc.

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 offers financial planning products and services, and HFSB Property Holdings, LLC (HPH), which is currently inactive, but has acted 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.

 

Certain amounts in the consolidated financial statements for the prior year have been reclassified to conform to the current year presentation.

 

(2) Basis of Preparation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of comprehensive income, consolidated statement of stockholders' equity and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles. However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The results of operations for the three-month period ended March 31, 2016 are not necessarily indicative of the results which may be expected for the entire year.

 

(3) New Accounting Standards

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this ASU require, among other things, equity investments to be measured at fair value with changes in fair value recognized in net income and that public business entities use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. The amendments also require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. In addition, the amendments also eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The amendments should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The amendments in the ASU create Topic 842, Leases, and supersede the leases requirements in Topic 840, Leases. The objective of this ASU is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. The main difference between previous GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The amendment requires a lessee to recognize in the statement of financial position a liability to make lease payments (the lease liability) and the right-of-use asset representing its right to use the underlying asset for the lease term. The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply that will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified. The amendments in the ASU, for public business entities, are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The adoption of this ASU in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

 
7

 

 

In March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation (Topic 718). The amendments in this ASU affect all entities that issue share-based payment awards to their employees. The amendments are intended to simplify the accounting for share-based payment transactions including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments in this ASU, for public business entities, are effective for fiscal years beginning after December 15, 2016, including interim periods within those annual periods. Amendments should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. The adoption of this ASU in the first quarter of 2017 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

(4) Fair Value Measurements

ASC 820, Fair Value Measurements, establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

 

Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

 

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

 

The following table summarizes the assets of the Company for which fair values are determined on a recurring basis as of March 31, 2016 and December 31, 2015.

 

   

Carrying value at March 31, 2016

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 105,828       0       105,828       0  

Mortgage loan commitments

    93       0       93       0  

Total

  $ 105,921       0       105,921       0  
                                 
   

Carrying value at December 31, 2015

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 111,974       0       111,974       0  

Mortgage loan commitments

    36       0       36       0  

Total

  $ 112,010       0       112,010       0  
                                 

 

 
8

 

 

There were no transfers between Levels 1, 2, or 3 during the three months ended March 31, 2016.

 

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 that were still held at March 31, 2016 and December 31, 2015, 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 March 31, 2016 and December 31, 2015.

 

               
   

Carrying value at March 31, 2016

         

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Three months ended

March 31, 2016

total gains (losses)

 

Loans held for sale

  $ 4,467       0       4,467       0       16  

Mortgage servicing rights, net

    1,456       0       1,456       0       0  

Loans(1)

    4,555       0       4,555       0       (65 )

Real estate, net(2)

    1,668       0       1,668       0       (253 )

Total

  $ 12,146       0       12,146       0       (302 )
               
   

Carrying value at December 31, 2015

         

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Year ended

December 31, 2015 total gains (losses)

 

Loans held for sale

  $ 3,779       0       3,779       0       3  

Mortgage servicing rights, net

    1,499       0       1,499       0       0  

Loans(1)

    4,790       0       4,790       0       (373 )

Real estate, net(2)

    2,045       0       2,045       0       (262 )

Total

  $ 12,113       0       12,113       0       (632 )

 

(1)

Represents carrying value and related write-downs of loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.

 

(2)

Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

 

(5) Fair Value of Financial Instruments

Generally accepted accounting principles require interim reporting period disclosure about the fair value of financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value hierarchy level for each asset and liability, as defined in note 5, have been included in the following table for March 31, 2016 and December 31, 2015. The fair value estimates are made 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, current economic conditions, risk characteristics of various financial instruments and other factors. The estimated fair value of the Company’s financial instruments as of March 31, 2016 and December 31, 2015 are shown below.

 

 
9

 

 

            March 31, 2016     December 31, 2015  
                    Fair value hierarchy                           Fair value hierarchy        
(Dollars in thousands)  

Carrying

amount

   

Estimated

fair value

    Level 1     Level 2   Level 3  

Contract

amount

   

Carrying

amount

   

Estimated

fair value

    Level 1     Level 2   Level 3   Contract amount  

Financial assets:

                                                                                   
Cash and cash equivalents   $ 13,766       13,766       13,766                         39,782       39,782       39,782                    

Securities available for sale

    105,828       105,828               105,828                 111,974       111,974               111,974            

Loans held for sale

    4,467       4,467               4,467                 3,779       3,779               3,779            

Loans receivable, net

    490,260       487,952               487,952                 463,185       458,539               458,539            

Federal Home Loan Bank stock

    770       770               770                 691       691               691            

Accrued interest receivable

    2,134       2,134               2,134                 2,254       2,254               2,254            

Financial liabilities:

                                                                                   

Deposits

    551,506       551,206               551,206                 559,387       558,731               558,731            

Other borrowings

    9,000       9,022               9,022                 9,000       9,000               9,000            

Accrued interest payable

    230       230               230                 242       242               242            

Off-balance sheet financial instruments:

                                                                                   
Commitments to extend credit     93       93                         199,870       36       36                         165,949  
Commitments to sell loans     (73 )     (73 )                       11,546       (26 )     (26 )                       8,071  

 

Cash and Cash Equivalents

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

 

Securities Available for Sale

The fair values of securities were based upon quoted market prices for identical or similar instruments in active markets.

 

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, net

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.

 

Federal Home Loan Bank Stock

The carrying amount of Federal Home Loan Bank (FHLB) stock approximates its fair value.

 

Accrued Interest Receivable

The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns.

 

Deposits

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

 

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

 

Other Borrowings

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

 

 
10

 

 

Accrued Interest Payable

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

 

Commitments to Extend Credit

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

 

Commitments to Sell Loans

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

 

(6) Other Comprehensive Income

Other comprehensive income is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income, which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income and the related tax effects were as follows:

 

   

For the period ended March 31,

 

(Dollars in thousands)

 

2016

   

2015

 

Securities available for sale:

 

Before tax

   

Tax effect

   

Net of tax

   

Before tax

   

Tax effect

   

Net of tax

 

Net unrealized gains arising during the period

  $ 229       91       138       655       260       395  

Other comprehensive income

  $ 229       91       138       655       260       395  

 

 
11

 

  

(7) Securities Available For Sale

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 March 31, 2016 and December 31, 2015.

 

   

Less Than Twelve Months

   

Twelve Months or More

   

Total

 
(Dollars in thousands)   # of Investments    

Fair Value

    Unrealized Losses     # of Investments    

Fair Value

    Unrealized Losses    

Fair Value

   

Unrealized Losses

 

March 31, 2016

                                                               

Collateralized mortgage
obligations:

                                                               

Federal National Mortgage Association (FNMA)

    1     $ 345       (3 )     0     $ 0       0     $ 345       (3 )

Other

    2       34       (7 )     0       0       0       34       (7 )

Other marketable securities:

                                                               

U.S. Government agency obligations

    2       9,996       (4 )     0       0       0       9,996       (4 )

Municipal obligations

    5       549       (3 )     0       0       0       549       (3 )

Corporate preferred stock

    0       0       0       1       350       (350 )     350       (350 )

Total temporarily impaired securities

    10     $ 10,924       (17 )     1     $ 350       (350 )   $ 11,274       (367 )

 

   

Less Than Twelve Months

   

Twelve Months or More

   

Total

 

(Dollars in thousands)

 

# of Investments

   

Fair Value

   

Unrealized Losses

   

# of Investments

   

Fair Value

   

Unrealized Losses

   

Fair Value

   

Unrealized Losses

 

December 31, 2015

                                                               

Collateralized mortgage obligations:

                                                               

Federal National Mortgage Association(FNMA)

    1     $ 346       (1 )     0     $ 0       0     $ 346       (1 )

Other

    2       34       (8 )     0       0       0       34       (8 )

Other marketable securities:

                                                               

U.S. Government agency obligations

    9       44,878       (129 )     0       0       0       44,878       (129 )

Municipal obligations

    12       2,010       (7 )     0       0       0       2,010       (7 )

Corporate obligations

    1       334       (6 )     0       0       0       334       (6 )

Corporate preferred stock

    0       0       0       1       350       (350 )     350       (350 )

Total temporarily impaired securities

    25     $ 47,602       (151 )     1     $ 350       (350 )   $ 47,952       (501 )

 

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss.

 

The unrealized losses reported for corporate preferred stock over twelve months at March 31, 2016 relates to a single trust preferred security that was issued by the holding company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In September 2014, the issuer paid all previously deferred interest that was due and all payments were current as of September 30, 2014. Since January 2015, the issuer has deferred its scheduled interest payment as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses in the past due to increased provisions for loan losses but had a modest net income in 2015 and continued to meet the regulatory requirements to be considered “well capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at March 31, 2016. The Company does not intend to sell the trust preferred security 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 securities and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities and the deferral of interest by the issuer. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

 

 
12

 

 

A summary of securities available for sale at March 31, 2016 and December 31, 2015 is as follows:

 

(Dollars in thousands)

 

Amortized

cost

   

Gross unrealized

gains

   

Gross unrealized

losses

   

Fair value

 

March 31, 2016

                               

Mortgage-backed securities:

                               

Federal Home Loan Mortgage Corporation (FHLMC)

  $ 605       18       0       623  

Federal National Mortgage Association (FNMA)

    610       26       0       636  

Collateralized mortgage obligations:

                               

FHLMC

    682       12       (3 )     691  

Other

    41       0       (7 )     34  
      1,938       56       (10 )     1,984  

Other marketable securities:

                               

U.S. Government agency obligations

    99,980       122       (4 )     100,098  

Municipal obligations

    2,962       29       ( 3 )     2,988  

Corporate obligations

    316       16       0       332  

Corporate preferred stock

    700       0       (350 )     350  

Corporate equity

    58       18       0       76  
      104,016       185       (357 )     103,844  
    $ 105,954       241       (367 )     105,828  

 

(Dollars in thousands)

 

Amortized

cost

   

Gross unrealized

gains

   

Gross unrealized

losses

   

Fair value

 

December 31, 2015

                               

Mortgage-backed securities:

                               

Federal Home Loan Mortgage Corporation (FHLMC)

  $ 728       31       0       759  

Federal National Mortgage Association (FNMA)

    725       22       0       747  

Collateralized mortgage obligations:

                               

FHLMC

    742       2       (1 )     743  

Other

    42       0       (8 )     34  
      2,237       55       (9 )     2,283  

Other marketable securities:

                               

U.S. Government agency obligations

    105,003       68       (129 )     104,942  

Municipal obligations

    3,991       18       (7 )     4,002  

Corporate obligations

    340       0       (6 )     334  

Corporate preferred stock

    700       0       (350 )     350  

Corporate equity

    58       5       0       63  
      110,092       91       (492 )     109,691  
    $ 112,329       146       (501 )     111,974  

 

The following table indicates amortized cost and estimated fair value of securities available for sale at March 31, 2016 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.

 

 
13

 

 

 

(Dollars in thousands)

 

Amortized

Cost

   

Fair

Value

 

Due less than one year

  $ 20,914       20,961  

Due after one year through five years

    83,849       84,005  

Due after five years through ten years

    402       405  

Due after ten years

    731       381  

No stated maturity

    58       76  

Total

  $ 105,954       105,828  
                 

 

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 allocation of other marketable securities that have call features is based on the anticipated cash flows to the call date if it is anticipated that the security will be called, or to the maturity date if it is not anticipated to be called.

 

(8) Loans Receivable, Net

A summary of loans receivable at March 31, 2016 and December 31, 2015 is as follows:

 

(Dollars in thousands)

 

March 31,

2016

   

December 31, 2015

 

1-4 family

  $ 95,247       90,945  

Commercial real estate:

               

Real estate rental and leasing

    145,224       125,376  

Other

    122,241       121,977  
      267,465       247,353  

Consumer

    66,782       64,415  

Commercial business:

               

Transportation industry

    9,440       9,349  

Other

    60,551       60,757  
      69,991       70,106  

Total loans

    499,485       472,819  

Less:

               

Unamortized discounts

    18       16  

Net deferred loan costs

    (156 )     (91 )

Allowance for loan losses

    9,363       9,709  

Total loans receivable, net

  $ 490,260       463,185  

 

 
14

 

 

 

(9) Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:

 

(Dollars in thousands)   1-4 Family    

Commercial

Real Estate

    Consumer     Commercial Business     Total  

Balance, December 31, 2015

  $ 990       6,078       1,200       1,441       9,709  

Provision for losses

    60       (823 )     184       (153 )     (732 )

Charge-offs

    0       0       (7 )     0       (7 )

Recoveries

    0       182       18       193       393  

Balance, March 31, 2016

  $ 1,050       5,437       1,395       1,481       9,363  
                                         

Balance, December 31, 2014

  $ 1,096       5,024       1,009       1,203       8,332  

Provision for losses

    (5 )     34       23       (52 )     0  

Charge-offs

    0       0       (18 )     0       (18 )

Recoveries

    0       64       8       32       104  

Balance, March 31, 2015

  $ 1,091       5,122       1,022       1,183       8,418  
                                         

Allocated to:

                                       

FAS 114 reserves

  $ 223       296       370       120       1,009  

General reserves

    767       5,782       830       1,321       8,700  

Balance, December 31, 2015

  $ 990       6,078       1,200       1,441       9,709  
                                         

Allocated to:

                                       

FAS 114 reserves

  $ 225       254       389       116       984  

General reserves

    825       5,183       1,006       1,365       8,379  

Balance, March 31, 2016

  $ 1,050       5,437       1,395       1,481       9,363  
                                         

Loans receivable at December 31, 2015:

                                       

Individually reviewed for impairment

  $ 2,203       2,204       977       415       5,799  

Collectively reviewed for impairment

    88,742       245,149       63,438       69,691       467,020  

Ending balance

  $ 90,945       247,353       64,415       70,106       472,819  

Loans receivable at March 31, 2016:

                                       

Individually reviewed for impairment

  $ 1,774       2,326       1,041       397       5,538  

Collectively reviewed for impairment

    93,473       265,139       65,741       69,594       493,947  

Ending balance

  $ 95,247       267,465       66,782       69,991       499,485  
                                         

 

 
15

 

 

The following table summarizes the amount of classified and unclassified loans at March 31, 2016 and December 31, 2015:

 

      March 31, 2016   
      Classified      Unclassified          
(Dollars in thousands)   Special Mention     Substandard     Doubtful     Loss     Total     Total    

Total

Loans

 

1-4 family

  $ 379       2,718       53       0       3,150       92,097       95,247  

Commercial real estate:

                                                       

Real estate rental and leasing

    704       6,529       0       0       7,233       137,991       145,224  

Other

    630       9,509       0       0       10,139       112,102       122,241  
                                                         

Consumer

    0       714       51       276       1,041       65,741       66,782  

Commercial business:

                                                       

Transportation industry

    1,154       3,085       0       0       4,239       5,201       9,440  

Other

    837       1,303       0       0       2,140       58,411       60,551  
    $ 3,704       23,858       104       276       27,942       471,543       499,485  
                                                         

 

    December 31, 2015  
    Classified     Unclassified          
(Dollars in thousands)   Special Mention     Substandard     Doubtful     Loss     Total     Total    

Total

Loans

 

1-4 family

  $ 189       2,889       55       0       3,133       87,812       90,945  

Commercial real estate:

                                                       

Real estate rental and leasing

    1,910       4,827       0       0       6,737       118,639       125,376  

Other

    917       9,473       0       0       10,390       111,587       121,977  
                                                         

Consumer

    0       639       52       286       977       63,438       64,415  

Commercial business:

                                                       

Transportation industry

    4,082       18       0       0       4,100       5,249       9,349  

Other

    841       1,515       0       0       2,356       58,401       60,757  
    $ 7,939       19,361       107       286       27,693       445,126       472,819  
                                                         

 

 

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.

 

 

 
16

 

 

The aging of past due loans at March 31, 2016 and December 31, 2015 are summarized as follows:

 

(Dollars in thousands)

 

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

 

March 31, 2016

                                                       

1-4 family

  $ 461       240       247       948       94,299       95,247       0  

Commercial real estate:

                                                    0  

Real estate rental and leasing

    0       0       0       0       145,224       145,224       0  

Other

    92       0       185       277       121,964       122,241       0  
                                                         

Consumer

    302       120       111       533       66,249       66,782       0  

Commercial business:

                                                       

Transportation industry

    16       0       0       16       9,424       9,440       0  

Other

    41       0       0       41       60,510       60,551       0  
    $ 912       360       543       1,815       497,670       499,485       0  
                                                         
December 31, 2015                                                        

1-4 family

  $ 490       130       799       1,419       89,526       90,945       0  

Commercial real estate:

                                                       

Real estate rental and leasing

    0       0       0       0       125,376       125,376       0  

Other

    0       289       0       289       121,688       121,977       0  
                                                         

Consumer

    330       262       119       711       63,704       64,415       0  

Commercial business:

                                                       

Transportation industry

    0       0       0       0       9,349       9,349       0  

Other

    45       0       0       45       60,712       60,757       0  
    $ 865       681       918       2,464       470,355       472,819       0  

 

 
17

 

 

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring (TDR). The following table summarizes impaired loans and related allowances as of March 31, 2016 and December 31, 2015:

 

   

March 31, 2016

 

December 31, 2015

 

(Dollars in thousands)

 

Recorded Investment

   

Unpaid Principal Balance

   

Related Allowance

     

Recorded Investment

   

Unpaid Principal Balance

   

Related Allowance

 

Loans with no related allowance recorded:

                                                 

1-4 family

  $ 695       695       0         1,251       1,251       0  

Commercial real estate:

                                                 

Real estate rental and leasing

    43       178       0         44       184       0  

Other

    26       1,682       0         25       1,706       0  

Consumer

    502       503       0         475       476       0  

Commercial business:

                                                 

Other

    0       66       0         0       79       0  
                                                   

Loans with an allowance recorded:

                                                 

1-4 family

    1,079       1,079       225         952       952       223  

Commercial real estate:

                                                 

Real estate rental and leasing

    0       0       0         0       0       0  

Other

    2,257       2,257       254         2,135       2,135       296  

Consumer

    539       556       389         502       519       370  

Commercial business:

                                                 

Other

    397       949       116         415       967       120  
                                                   

Total:

                                                 

1-4 family

    1,774       1,774       225         2,203       2,203       223  

Commercial real estate:

                                                 

Real estate rental and leasing

    43       178       0         44       184       0  

Other

    2,283       3,939       254         2,160       3,841       296  

Consumer

    1,041       1,059       389         977       995       370  

Commercial business:

                                                 

Other

    397       1,015       116         415       1,046       120  
    $ 5,538       7,965       984         5,799       8,269       1,009  
                                                   

 

 
18

 

  

The following table summarizes the average recorded investment and interest income recognized on impaired loans during the three months ended March 31, 2016 and 2015:

 

   

March 31, 2016

   

March 31, 2015

 

(Dollars in thousands)

 

Average

Recorded

Investment

   

Interest Income Recognized

   

Average

Recorded

Investment

   

Interest Income Recognized

 

Loans with no related allowance recorded:

                               

1-4 family

  $ 973       6       744       3  

Commercial real estate:

                               

Real estate rental and leasing

    44       1       48       2  

Other

    26       161       7,304       100  

Consumer

    489       1       367       0  

Commercial business:

                               

Other

    0       0       68       0  
                                 

Loans with an allowance recorded:

                               

1-4 family

    1,016       3       1,170       22  

Commercial real estate:

                               

Real estate rental and leasing

    0       0       8       0  

Other

    2,196       7       1,837       7  

Consumer

    521       3       337       2  

Commercial business:

                               

Other

    406       4       467       5  
                                 

Total:

                               

1-4 family

    1,989       9       1,914       25  

Commercial real estate:

                               

Real estate rental and leasing

    44       1       56       2  

Other

    2,222       168       9,141       107  

Consumer

    1,010       4       704       2  

Commercial business:

                               

Other

    406       4       535       5  
    $ 5,671       186       12,350       141  

 

At March 31, 2016 and December 31, 2015, non-accruing loans totaled $3.9 million and $4.2 million, respectively, for which the related allowance for loan losses was $0.7 million and $0.7 million, respectively. All of the interest income recognized for non-accruing loans was recognized using the cash basis method of income recognition. 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 and $1.4 million, at March 31, 2016 and December 31, 2015, respectively. Non-accrual loans also include certain loans that have had terms modified in a TDR.

 

The non-accrual loans at March 31, 2016 and December 31, 2015 are summarized as follows:

(Dollars in thousands)

 

March 31, 2016

   

December 31, 2015

 
                 

1-4 family

  $ 1,229     $ 1,655  

Commercial real estate:

               

Real estate rental and leasing

    44       44  

Other

    1,778       1,650  

Consumer

    809       786  

Commercial business:

               

Other

    45       46  
    $ 3,905     $ 4,181  
                 

 

 
19

 

 

At March 31, 2016 and December 31, 2015, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $2.6 million and $2.5 million, respectively. For the loans that were restructured in the first quarter of 2016, $31,000 were classified but performing and $75,000 were non-performing at March 31, 2016. There was one $9,000 loan that was restructured in the first quarter of 2015 that was classified but performing at March 31, 2015.

 

The following table summarizes troubled debt restructurings at March 31, 2016 and December 31, 2015:

 

      March 31, 2016              December, 31, 2015  

(Dollars in thousands)

 

Accruing

   

Non-Accrual

   

Total

   

Accruing

   

Non-Accrual

   

Total

 

1-4 Family

  $ 544       98       642       547       100       647  

Commercial real estate

    504       211       715       511       214       725  

Consumer

    233       577       810       191       541       732  

Commercial business

    352       45       397       369       46       415  
    $ 1,633       931       2,564       1,618       901       2,519  
                                                 

 

As of March 31, 2016, the Bank had commitments to lend an additional $1.1 million to a borrower who has TDR and non-accrual loans. These additional funds are for the construction of 1-4 family homes with a maximum loan-to-value ratio of 75%. These loans are secured by the home under construction. At December 31, 2015, there were commitments to lend additional funds of $1.5 million to this same borrower.

 

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 for the entire 12-month period. All loans classified as TDRs are considered to be impaired.

 

When a loan is modified in 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 three-months ended March 31, 2016 and March 31, 2015.

 

   

Three Months Ended

March 31, 2016

   

Three Months Ended

March 31, 2015

 
(Dollars in thousands)   Number of Contracts     Pre-Modification Outstanding Recorded Investment     Post-Modification Outstanding Recorded Investment     Number of Contracts     Pre-Modification Outstanding Recorded Investment     Post-Modification Outstanding Recorded Investment  
Troubled debt restructurings:                                                

Consumer

    6     $ 106       107       1     $ 9     $ 9  

 

There were no loans that were restructured within the 12 months preceding March 31, 2016 and March 31, 2015 that defaulted during the three months ended March 31, 2016 and March 31, 2015.

 

 
20

 

 

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 on non-accrual status 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 accrual status. Loans that were accruing prior to modification remain on accrual status after the modification as long as the loan continues to perform under the new terms.

 

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 reserves for TDRs were $0.5 million, or 5.3%, of the total $9.4 million in loan loss reserves at March 31, 2016 and $0.5 million, or 5.2%, of the total $9.7 million in loan loss reserves at December 31, 2015.

 

The following is additional information with respect to loans acquired through the Kasson State Bank acquisition:

 

(Dollars in thousands)

 

Contractual

Principal

Receivable

   

Accretable

Difference

   

Net Carrying Amount

 

Purchased performing loans:

                       

Balance at December 31, 2015

  $ 18,539       (459 )     18,080  

Change due to payments/refinances

    (2,597 )     71       (2,526 )

Transferred to foreclosed assets

    0       0       0  

Change due to loan charge-off

    (2 )     0       (2 )

Balance at March 31, 2016

  $ 15,940       (388 )     15,552  
                         

 

(Dollars in thousands)

 

Contractual

Principal

Receivable

   

Non-

Accretable

Difference

   

Net Carrying Amount

 

Purchased credit impaired loans:

                       

Balance at December 31, 2015

  $ 555       (162 )     393  

Change due to payments/refinances

    (142 )     100       (42 )

Transferred to foreclosed assets

    0       0       0  

Change due to loan charge-off

    0       0       0  

Balance at March 31, 2016

  $ 413       (62 )     351  

 

As a result of the Kasson State Bank acquisition, the Company has loans for which there was at acquisition evidence of deterioration of credit quality since origination and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount of those loans as of March 31, 2016 was $0.4 million.

 

No provision for loan losses was recognized during the period ended March 31, 2016 related to acquired loans as there was no significant change to the credit quality of those loans.

 

(10) Intangible Assets        

The Company’s intangible assets consist of core deposit intangibles and mortgage servicing rights. A summary of mortgage servicing activity is as follows:

 

(Dollars in thousands)

 

Three Months ended

March 31, 2016

   

Twelve Months ended

December 31, 2015

   

Three Months ended

March 31, 2015

 

Balance, beginning of period

  $ 1,499       1,507       1,507  

Originations

    89       547       84  

Amortization

    (132 )     (555 )     (143 )

Balance, end of period

  $ 1,456       1,499       1,448  

Fair value of mortgage servicing rights

  $ 2,427       2,590       2,508  

 

 

 
21

 

 

 

All of the 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 March 31, 2016.

 

            Weighted     Weighted          
    Loan     Average     Average          
    Principal     Interest     Remaining     Number  
(Dollars in thousands)   Balance     Rate     Term (months)     of Loans  

Original term 30 year fixed rate

  $ 218,770       4.20

%

    301       1,853  

Original term 15 year fixed rate

    107,390       3.21       138       1,190  

Adjustable rate

    58       4.38       302       2  

 

The gross carrying amount of intangible assets and the associated accumulated amortization at March 31, 2016 and 2015 is presented in the following table. Amortization expense for intangible assets was $151,000 and $143,000 for the three months ended March 31, 2016 and 2015, respectively.

 

   

March 31, 2016

 
   

Gross

           

Unamortized

 
   

Carrying

   

Accumulated

   

Intangible

 

(Dollars in thousands)

 

Amount

   

Amortization

   

Assets

 

Mortgage servicing rights

  $ 3,749       (2,293 )     1,456  

Core deposit intangible

    420       (46 )     374  

Total

  $ 4,169       (2,339 )     1,830  

 

 

   

March 31, 2015

 
   

Gross

           

Unamortized

 
   

Carrying

   

Accumulated

   

Intangible

 

(Dollars in thousands)

 

Amount

   

Amortization

   

Assets

 

Mortgage servicing rights

  $ 3,587       (2,139 )     1,448  

Total

  $ 3,587       (2,139 )     1,448  
                         

 

The following table indicates the estimated future amortization expense for intangible assets:

 

(Dollars in thousands)

 

Mortgage Servicing Rights

   

Core Deposit Intangible

   

Total Intangible Assets

 

Year ending December 31,

                       

2016

  $ 333       56       389  

2017

    369       74       443  

2018

    279       74       353  

2019

    220       74       294  

2020

    131       74       205  

Thereafter

    124       22       146  

Total

  $ 1,456       374       1,830  
                         

 

 

Projections of amortization are based on existing asset balances and the existing interest rate environment as of March 31, 2016. The Company’s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

 

 
22

 

 

(11) Earnings per Common Share

The following table reconciles the weighted average shares outstanding and the earnings available to common shareholders used for basic and diluted earnings per common share:

 

   

Three months ended March 31,

 

(Dollars in thousands, except per share data)

 

2016

   

2015

 

Weighted average number of common shares outstanding used in basic earnings per common share calculation

    4,166,003       4,096,985  

Net dilutive effect of:

               

Restricted stock awards, options and warrants

    514,245       574,665  

Weighted average number of shares outstanding adjusted for effect of dilutive securities

    4,680,248       4,671,650  

Income available to common shareholders

  $ 1,774       353  

Basic earnings per common share

  $ 0.43       0.09  

Diluted earnings per common share

  $ 0.38       0.08  
                 

 

(12) Regulatory Capital and Oversight

Effective January 1, 2015 the capital requirements of the Bank were changed to implement the regulatory requirements of the Basel III capital reforms. The Basel III requirements, among other things, (i) apply a strengthened set of capital requirements to the Bank (the Company is exempt, pursuant to the Small Bank Holding Company Policy Statement (Policy Statement) described below), including requirements relating to common equity as a component of core capital, (ii) implement a “capital conservation buffer” against risk and a higher minimum tier 1 capital requirement, and (iii) revise the rules for calculating risk-weighted assets for purposes of such requirements. The rules made corresponding revisions to the prompt corrective action framework and include new capital ratios and buffer requirements which will be phased in incrementally, with full implementation scheduled for January 1, 2019. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of 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.

 

The Federal Reserve Bank amended its Policy Statement, to exempt small bank holding companies from the above capital requirements, by raising the asset size threshold for determining applicability from $500 million to $1 billion. The Policy Statement was also expanded to include savings and loan holding companies that meet the Policy Statement’s qualitative requirements for exemption. The Company met the qualitative exemption requirements, and therefore, is exempt from the above capital requirements.

 

Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Common Equity Tier 1 capital to risk weighted assets (as defined in the regulations), Tier 1 capital to adjusted total assets (as defined in the regulations), Tier 1 capital to risk weighted assets (as defined in the regulations), and total capital to risk weighted assets.

 

The Bank’s average total assets for the first quarter of 2016 were $635.7 million, its adjusted total assets were $632.4 million, and its risk-weighted assets were $535.6 million. The following table presents the Bank’s capital amounts and ratios at March 31, 2016 for actual capital, required capital and excess capital, including ratios in order to qualify as being well capitalized under the revised Prompt Corrective Actions regulations.

 

 
23

 

 

 

 

 

 

 

 

   

Actual

   

Required to be

Adequately Capitalized

   

Excess Capital

   

To Be Well Capitalized Under Prompt Corrective Action Provisions(1)

 

(Dollars in thousands)

 

Amount

   

Percent of Assets(2)

   

Amount

   

Percent of Assets (2)

   

Amount

   

Percent of Assets(2)

   

Amount

   

Percent of Assets(2)

 

Bank stockholder’s equity

  $ 76,672                                                          
Plus:                                                                

Net unrealized loss on certain securities available for sale

    76                                                          

Less:

                                                               

Goodwill and other intangibles

    224                                                          

Disallowed servicing and tax assets

    3,016                                                          

Common equity tier I capital

    73,508                                                          

Common equity tier I capital ratio

            13.73 %   $ 24,101       4.50 %   $ 49,407       9.23 %   $ 34,812       6.50 %

Tier I capital

    73,508                                                          

Tier I capital leverage ratio

            11.62 %   $ 25,297       4.00 %   $ 48,211       7.62 %   $ 31,622       5.00 %

Tier I risk-based capital ratio

            13.73 %   $ 32,134       6.00 %   $ 41,374       7.73 %   $ 42,845       8.00 %

Plus:

Allowable allowance for loan losses

    6,743                                                          

Risk-based capital

  $ 80,251                                                          

Total risk-based capital ratio

            14.98 %   $ 42,845       8.00 %   $ 37,406       6.98 %   $ 53,557       10.00 %

 

(1) Under the final rules, revised requirements will be phased in commencing January 1, 2015, as described above.

(2) Based upon the Bank’s adjusted total assets for the purpose of the Tier I or core capital ratios and risk-weighted assets for the purpose of the risk-based capital ratios.

 

Beginning in 2016, the Bank must maintain a capital conservation buffer composed of common equity tier 1 capital above its minimum risk-based capital requirements in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. For 2016, the capital conservation buffer is 0.625%. The buffer amount will increase incrementally each year until 2019 when the entire 2.50% capital conservation buffer will be fully phased in.

 

Management believes that, as of March 31, 2016, 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.

 

(13) 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 (the “Preferred Stock”) to the U.S. Department of the 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.

 

 
24

 

 

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 to three unaffiliated third party investors for an aggregate purchase price of $5.7 million. Two of the investors received a warrant to purchase 277,777.67 shares and one investor received a warrant to purchase 277,777.66 shares. All of the warrants were still outstanding as of March 31, 2016 and may be exercised at any time prior to their expiration date of December 23, 2018. The Company received no proceeds from this transaction and it had no effect on the Company’s capital, financial condition or results of operations.

 

(14) Other Borrowings

On December 15, 2014, the Company entered into a Loan Agreement with an unrelated third party, providing for a term loan of up to $10.0 million that was evidenced by a promissory note (the Note) with an interest rate of 6.50% per annum. The principal balance of the loan is payable in consecutive equal annual installments of $1.0 million on each anniversary of the date of the Loan Agreement, commencing on December 15, 2015, with the balance due on December 15, 2021. Provided that no default or event of default has occurred and is continuing, the Company may, at its option, elect to defer payment of one installment of principal on the Note otherwise due prior to the maturity date, in which event such installment will become due and payable on the maturity date. The Company may voluntarily prepay the Note in whole or in part without penalty. The outstanding loan balance was $9.0 million at March 31, 2016 and December 31, 2015.

 

(15) Commitments and Contingencies

The Bank issues standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at March 31, 2016 were approximately $3.2 million, expire over the next 34 months, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

 

(16) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. HMN did not meet the quantitative thresholds for determining reportable segments 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 equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

 

The following table sets forth certain information about the reconciliations of reported profit 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 quarter ended March 31, 2016:

                               

Interest income - external customers

  $ 6,525       0       0       6,525  

Non-interest income - external customers

    1,755       0       0       1,755  

Intersegment non-interest income

    53       1,969       (2,022 )     0  

Interest expense

    226       148       0       374  

Non-interest expense

    5,561       183       (53 )     5,691  

Income tax expense (benefit)

    1,309       (136 )     0       1,173  

Net income

    1,969       1,774       (1,969 )     1,774  

Total assets

    637,104       80,868       (79,816 )     638,156  

At or for the quarter ended March 31, 2015:

                               

Interest income - external customers

  $ 4,884       0       0       4,884  

Non-interest income - external customers

    1,596       0       0       1,596  

Intersegment non-interest income

    51       591       (642 )     0  

Interest expense

    248       78       0       326  

Non-interest expense

    5,305       179       (51 )     5,433  

Income tax expense (benefit)

    387       (127 )     0       260  

Net income

    591       461       (591 )     461  

Total assets

    564,427       76,760       (75,700 )     565,487  

 

 
25

 

 

HMN FINANCIAL, INC.

 

Item 2:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-looking Information

 

Safe Harbor Statement 

This quarterly report and other reports filed by the Company with the Securities and Exchange Commission 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 increasing our core deposit relationships, improving credit quality, reducing non-performing assets, and generating improved financial results (including profitability); the adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for maintenance thereof; improvements in loan production; changes in the size of the Bank’s loan portfolio; the amount of the Bank’s non-performing assets and the appropriateness of the allowance therefor; our ability to integrate the Deerwood Bank branch and other acquired operations; anticipated future levels of the provision for loan losses; future losses on non-performing assets; the amount and composition of interest-earning assets; the amount and composition of interest bearing liabilities; the availability of alternate funding sources; the payment of dividends by HMN; the future outlook for the Company; the amount of dividends paid by the Federal Home Loan Bank (FHLB) on its stock; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; the ability of the Bank to pay dividends to HMN; the ability of HMN to pay the principal and interest payments on its third party note payable; the ability to remain well capitalized; and compliance by the Bank with regulatory standards generally (including the Bank’s status as “well capitalized”) and other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement.

 

 
26

 

 

A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate and other collateral securing loans to borrowers; federal and state regulation and enforcement; possible legislative and regulatory changes, including additional changes to regulatory capital rules; the ability of the Bank to comply with other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard or requirement; adverse economic, business and competitive developments such as shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company’s loan and investment portfolios; changes in costs associated with alternate funding sources, including changes in collateral advance rates and policies of the FHLB; technological, computer-related or operational difficulties; results of litigation; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments; the Company’s access to and adverse changes in securities markets; the market for credit related assets; the future operating results, financial condition, cash flow requirements and capital spending priorities of the Company and the Bank; the availability of internal and, as required, external sources of funding; acquisition integration costs; our ability to attract and retain employees; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filing on Forms 10-K with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

 

All statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and we undertake no duty to update any of the forward-looking statements after the date of this quarterly report on Form 10-Q.

 

General

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 liabilities, and the level of non-performing assets. The Company's net earnings are also affected by the generation of non-interest income, which consists primarily of gains from the sale of loans and real estate owned, fees for servicing loans, commissions on the sale of uninsured investment products, and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy and equipment expenses, provisions for loan losses, deposit insurance, amortization expense on mortgage servicing assets, data processing costs, fees for professional services, 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 consolidated 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.

 

 
27

 

 

Allowance for Loan Losses and Related Provision

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

 

The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual 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 allowance is also credited for recoveries received on previously charged off loans. The activity in the allowance in the first quarter of 2016 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.

 

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.

 

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

 

 
28

 

 

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

 

Accounting for Loans Acquired in a Business Combination

Loans acquired in a business combination are initially recorded at their acquisition date fair values. The fair values of the purchased loans are based on the present value of the expected cash flows, including principal, interest and prepayments. Periodic principal and interest cash flows are adjusted for expected losses and prepayments, then discounted to determine the present value and summed to arrive at the estimated fair value. Fair value estimates involve assumptions and judgments as to credit risk, interest rate risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Purchased loans are divided into loans with evidence of credit quality deterioration, which are accounted for under ASC topic 310-30 (purchased credit impaired (PCI)), and loans that do not meet this criteria, which are accounted for under ASC topic 310-20 (performing). PCI loans have experienced a deterioration of credit quality from origination to acquisition for which it is probable that the Bank will not be able to collect all principal and interest payments on the loan. In the assessment of credit quality, numerous assumptions, interpretations and judgments must be made, based on internal and third-party credit quality information and ultimately the determination as to the probability that all contractual cash flows will not be able to be collected. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved.

 

Subsequent to the acquisition date, the Bank continues to estimate the amount and timing of cash flows expected to be collected on PCI loans. The present value of any decreases in expected cash flows after the acquisition date will generally result in an impairment charge recorded as a provision for loan losses, resulting in an increase to the allowance for loan losses. Increases in expected cash flows will generally result in a recovery of any previously recorded allowance for loan losses, to the extent applicable, and/or a reclassification from the nonaccretable difference to accretable yield, which will be recognized prospectively. For acquired performing loans, the difference between the acquisition date fair value and the contractual amounts due at the acquisition date represents the fair value adjustment. Fair value adjustments may be discounts or premiums to a loan's cost basis and are accreted or amortized into interest income over the loan's remaining life using the level yield method.

 

Subsequent to the acquisition date, the methods utilized to estimate the required allowance for loan losses for these loans is similar to originated loans. See “Note 9 Allowance for Loan Losses and Credit Quality Information” in the Notes to Consolidated Financial Statements for more information regarding acquired loan disclosures.

 

Acquisition

On April 8, 2016, the Bank completed the acquisition of loans, totaling approximately $12 million, and deposits, totaling approximately $19 million, related to the Deerwood Bank branch in Albert Lea, Minnesota. The acquired loans and deposits are being serviced from Home Federal’s existing branch location at 143 West Clark Street, Albert Lea, Minnesota.

 

 
29

 

 

RESULTS OF OPERATIONS FOR THE QUARTER ENDED MARCH 31, 2016 COMPARED TO THE QUARTER ENDED MARCH 31, 2015

 

Net Income

Net income was $1.8 million for the first quarter of 2016, an increase of $1.3 million compared to net income of $0.5 million for the first quarter of 2015. Net income available to common shareholders was $1.8 million for the first quarter of 2016, an increase of $1.4 million from the net income available to common shareholders of $0.4 million for the first quarter of 2015. Diluted earnings per common share for the first quarter of 2016 was $0.38, an increase of $0.30 from diluted earnings per common share of $0.08 for the first quarter of 2015. The increase in net income between the periods was due primarily to the $1.6 million increase in net interest income due to an increase in the average interest-earning assets and yields earned between the periods. Net income also increased $0.7 million because of a decrease in the provision for loan losses between the periods. The decrease in the provision for loan losses reflects the general improvement in the credit quality of the commercial loan portfolio and the increased recoveries received on previously charged off loans in the first quarter of 2016 when compared to the same period of 2015. These increases in net income were partially offset by a $0.9 million increase in income tax expense due to the increased pre-tax income between the periods.

 

Net Interest Income

Net interest income was $6.1 million for the first quarter of 2016, an increase of $1.5 million, or 34.9%, compared to $4.6 million for the first quarter of 2015. Interest income was $6.5 million for the first quarter of 2016, an increase of $1.6 million, or 33.6%, from $4.9 million for the first quarter of 2015. Interest income increased between the periods primarily because of an increase in the outstanding average interest-earning assets and a change in the composition of the average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets increased $64.8 million between the periods, the average interest-earning assets held in higher yielding loans increased $108.3 million and the amount of average interest-earning assets held in lower yielding cash and investments decreased $43.5 million between the periods. The yield on average interest-earning assets was also enhanced by $0.5 million due to the interest payments received on non-accruing and previously charged off commercial real estate loans that were paid off in the first quarter of 2016. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred because of an increase in loan originations and a reduction in loan payoffs between the periods. The Company also acquired $24.1 million of loans through an acquisition that occurred in the third quarter of 2015. The average yield earned on interest-earning assets was 4.34% for the first quarter of 2016, an increase of 67 basis points from 3.67% for the first quarter of 2015.

 

Interest expense was $0.4 million for the first quarter of 2016, an increase of $0.1 million, or 14.7%, compared to $0.3 million for the first quarter of 2015. Interest expense increased primarily because of an increase in the average interest-bearing liabilities between the periods. The average rate paid between the periods remained the same due to a change in the composition of the average interest-bearing liabilities. While the average interest-bearing liabilities increased $69.3 million between the periods, the amount held in lower rate checking and money market accounts increased $62.3 million and the amount held in higher rate certificates of deposits and other borrowings increased $7.0 million between the periods. The increase in the average outstanding deposits between the periods was primarily the result of the $47.3 million in deposits acquired through an acquisition that occurred in the third quarter of 2015. The increase in the interest paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Fixed Rate Cumulative Perpetual Preferred Stock, Series A of HMN (the “Preferred Stock”). Interest expense increases related to borrowing costs were partially offset by the lower interest rates paid on deposit accounts between the periods as a result of the low interest rate environment that continued to exist during the first quarter of 2016. The average interest rate paid on interest-bearing liabilities was 0.27% for both the first quarter of 2016 and the first quarter of 2015.

 

Net interest margin (net interest income divided by average interest-earning assets) for the first quarter of 2016 was 4.09%, an increase of 67 basis points, compared to 3.42% for the first quarter of 2015. Net interest margin increased between the periods primarily because the yields earned on interest-earning assets increased more than the rates paid on interest-bearing liabilities. The increase in the yields earned on interest-earning assets was primarily because of an increase in the outstanding average interest-earning assets and a change in the composition of the average interest-earning assets held. The yield on average interest-earning assets was also enhanced by $0.5 million due to the interest payments received on non-accruing and previously charged off commercial real estate loans that were paid off in the first quarter of 2016.

 

 
30

 

 

A summary of the Company’s net interest margin for the three-month periods ended March 31, 2016 and 2015 is as follows:

 

   

For the three-month period ended

 
   

March 31, 2016

   

March 31, 2015

 

(Dollars in thousands)

 

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate

   

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate

 

Interest-earning assets:

                                               

Securities available for sale

  $ 97,362       392       1.62

%

  $ 146,715       515       1.42

%

Loans held for sale

    2,104       24       4.59       1,489       8       2.09  

Mortgage loans, net

    96,526       1,009       4.20       69,545       736       4.29  

Commercial loans, net

    307,653       4,250       5.56       238,932       2,948       5.00  

Consumer loans, net

    65,485       811       4.98       53,466       661       5.02  

Cash equivalents

    34,890       38       0.44       28,998       15       0.21  

Federal Home Loan Bank stock

    694       1       0.58       774       1       0.50  

Total interest-earning assets

    604,714       6,525       4.34       539,919       4,884       3.67  
                                                 

Interest-bearing liabilities and non-interest bearing deposits:

                                               

NOW accounts

    83,221       11       0.05       76,997       3       0.02  

Savings accounts

    67,664       15       0.09       47,597       7       0.06  

Money market accounts

    158,920       87       0.22       149,955       97       0.26  

Certificates

    98,430       113       0.46       95,736       141       0.60  

Advances and other borrowings

    9,000       148       6.61       4,811       78       6.58  

Total interest-bearing liabilities

    417,235                       375,096                  

Non-interest checking

    142,760                       115,678                  

Other non-interest bearing escrow deposits

    1,138                       1,044                  

Total interest-bearing liabilities and non-interest bearing deposits

  $ 561,133       374       0.27     $ 491,818       326       0.27  

Net interest income

          $ 6,151                     $ 4,558          

Net interest rate spread

                    4.07

%

                    3.40

%

Net interest margin

                    4.09

%

                    3.42

%

 

Provision for Loan Losses

The provision for loan losses was ($0.7 million) for the first quarter of 2016, a decrease of $0.7 million compared to the provision for loan losses of $0 for the first quarter of 2015. The provision decreased in the first quarter of 2016 primarily because of a general improvement in the credit quality of the commercial loan portfolio which resulted in a decrease in the required reserve percentages on these loans and an increase in the recoveries received on previously charged off loans during the first quarter of 2016 when compared to the first quarter of 2015.

 

A reconciliation of the Company’s allowance for loan losses for the first quarters of 2016 and 2015 is as follows:

 

(Dollars in thousands)

 

2016

   

2015

 

Balance at January 1,

  $ 9,709     $ 8,332  

Provision

    (732 )     0  

Charge offs:

               

Consumer

    (7 )     (18 )

Recoveries

    393       104  

Balance at March 31,

  $ 9,363     $ 8,418  
                 

General allowance

  $ 8,379     $ 7,489  

Specific allowance

    984       929  
    $ 9,363     $ 8,418  

 

 
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Non-Interest Income

Non-interest income was $1.8 million for the first quarter of 2016, an increase of $0.2 million, or 10.0%, from $1.6 million for the first quarter of 2015. Gain on sales of loans increased $0.2 million between the periods primarily due to an increase in the gains recognized on the sale of commercial government guaranteed loans. Other non-interest income decreased slightly between the periods primarily because of a decrease in the fees earned on the sale of uninsured investment products.

 

Non-Interest Expense

Non-interest expense was $5.7 million for the first quarter of 2016, an increase of $0.3 million, or 4.75%, from $5.4 million for the first quarter of 2015. Compensation and benefits expense increased $0.2 million between the periods primarily because of an increase in wages and incentive accruals between the periods due to the increased number of branches being operated and increased loan originations. Occupancy and equipment expense increased $0.1 million between the periods because of increases in non-capitalized software and equipment expenses. Other operating expense increased $0.1 million primarily due to increased charitable contributions and lending expenses associated with the increase in loans originated between the periods. Data processing expense increased slightly because of an increase in mobile banking and on-line banking costs due to increased customer activity between the periods. Professional services expense increased marginally due to costs related to the Deerwood Bank branch acquisition. These increases in expense were partially offset by an increase of $0.2 million in the gain on real estate owned due to increased sales activity between the periods.

 

Income Taxes

Income tax expense was $1.2 million for the first quarter of 2016, an increase of $0.9 million from $0.3 million for the first quarter of 2015. The increase in income tax expense between the periods is primarily related to the increase in pre-tax income in the first quarter of 2016 when compared to the first quarter of 2015.

 

Net Income Available to Common Shareholders

The net income available to common shareholders was $1.8 million for the first quarter of 2016, an increase of $1.4 million from the $0.4 million income available to common shareholders in the first quarter of 2015. The net income available to common shareholders increased primarily because of the increase in the net income between the periods and a reduction in the dividends paid on the outstanding Preferred Stock. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends are required to be paid on the Preferred Stock after that date.

 

 
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FINANCIAL CONDITION

Non-Performing Assets

The following table summarizes the amounts and categories of non-performing assets in the Bank’s portfolio and loan delinquency information as of the end of the two most recently completed quarters.

 

   

March 31,

   

December 31,

 

(Dollars in thousands)

 

2016

   

2015

 

Non-Performing Loans:

               

One-to-four family real estate

  $ 1,229     $ 1,655  

Commercial real estate

    1,822       1,694  

Consumer

    809       786  

Commercial business

    45       46  

Total

    3,905       4,181  
                 

Foreclosed and Repossessed Assets:

               

One-to-four family real estate

    591       48  

Commercial real estate

    1,077       1,997  

Total non-performing assets

  $ 5,573     $ 6,226  

Total as a percentage of total assets

    0.87

%

    0.97

%

Total non-performing loans

  $ 3,905     $ 4,181  

Total as a percentage of total loans receivable, net

    0.80

%

    0.90

%

Allowance for loan losses to non-performing loans

    239.77

%

    232.22

%

                 

Delinquency Data:

               

Delinquencies (1)

               

30+ days

  $ 1,005     $ 993  

90+ days

    0       0  

Delinquencies as a percentage of loan and lease portfolio (1)

               

30+ days

    0.20

%

    0.21

%

90+ days

    0.00

%

    0.00

%

(1) Excludes non-accrual loans.

 

Total non-performing assets were $5.6 million at March 31, 2016, a decrease of $0.6 million, or 9.7%, from $6.2 million at December 31, 2015. Non-performing loans decreased $0.2 million and foreclosed and repossessed assets decreased $0.4 million during the first quarter of 2016.

 

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 regulatory restrictions, tax considerations, industry standards, economic conditions, general business practices and other factors. The Company has not made any dividend payments to common stockholders during the three year period ending March 31, 2016.

 

LIQUIDITY AND CAPITAL RESOURCES 

For the quarter ended March 31, 2016, the net cash provided by operating activities was $4.6 million. The Company collected $56.3 million in principal repayments and maturities on securities during the quarter. It received $1.3 million in proceeds from the sale of real estate and $0.7 million related to increases in customer escrows. The Company had a net decrease in deposit balances of $7.9 million during the quarter. It also purchased $50.0 million in securities and $0.1 million in FHLB stock, paid out $0.3 million for premises and equipment, and loans receivable increased $30.8 million.

 

 
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The Company has certificates of deposits with outstanding balances of $57.8 million that come due over the next 12 months. Based upon past experience, management anticipates that the majority of the deposits will renew for another term. The Company believes that cash outflows from deposits that do not renew will be replaced with a combination of other customer’s deposits or FHLB advances. FRB borrowings or proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits.

 

The Company had three deposit customers with aggregate deposits greater than $5.0 million as of March 31, 2016. The $43.1 million in funds held by these customers may be withdrawn at any time, but management anticipates that the majority of these deposits will not be withdrawn from the Bank over the next twelve months. If these deposits are withdrawn, it is anticipated that they would be replaced with deposits from other customers or FHLB advances. FRB borrowings or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.

 

The Company had the ability to borrow $96.0 million from the FHLB at March 31, 2016 based on the collateral value of the loans pledged. The credit policy of the FHLB relating to the collateral value of the loans collateralizing the available line of credit with the FHLB may change such that the current collateral pledged to secure future advances is no longer acceptable or the formulas for determining the excess pledged collateral may change. The FHLB could also reduce the amount of funds it will lend to the Bank. It is not anticipated that the Bank will need to find alternative funding sources in the next twelve months to replace the available borrowings from the FHLB. However, if needed, excess collateral currently pledged to the FHLB could be pledged to the FRB and the Bank could borrow additional funds from the FRB based on the increased collateral levels or obtain additional deposits.

 

The Company’s primary source of cash is dividends from the Bank. At March 31, 2016, the Company had $3.1 million in cash and other assets that could readily be turned into cash. The primary use of cash by the Company is the payment of operating expenses and the principal and interest amounts on the third party note payable.

 

The Company also serves as a source of capital, liquidity, and financial support to the Bank. Depending upon the operating performance of the Bank and the Company’s other liquidity and capital needs, including Company level expenses and the payment of principal and interest on the Company’s outstanding note payable, the Company may find it prudent, subject to prevailing capital market conditions and other factors, to raise additional capital through issuance of its common stock or other equity securities. Additional capital would also potentially permit the Company to implement a strategy of growing Bank assets. Depending on the circumstances, if it were to raise capital, the Company may deploy it to the Bank for general banking purposes, or may retain some or all of it for use by the Company.

 

If the Company were to raise 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 a price less than the Company’s book value, would dilute the per share book value of the Company’s common stock, 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 its control, and on the Company’s financial performance and plans.

 

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.

 

 
34

 

 

The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located in the following Asset/Liability Management section of this report discloses the Company’s projected changes in net interest income based upon immediate interest rate changes called rate shocks. The Company utilizes a model that uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities under different interest rate changes.

 

The following table discloses the projected changes in the market value of 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 March 31, 2016.

 

   

Market Value

 
(Dollars in thousands)                                

Basis point change in interest rates

    -100       0    

+100

   

+200

 

Total market risk sensitive assets

  $ 635,302       624,222       611,596       597,595  

Total market risk sensitive liabilities

    562,353       526,850       503,723       482,787  

Off-balance sheet financial instruments

    (668 )     0       (111 )     (154 )

Net market risk

  $ 73,617       97,372       107,984       114,962  
Percentage change from current market value     (24.40 )%     0.00       10.90       18.06  
                                 

 

The preceding table was prepared utilizing a model using the following assumptions (the Model Assumptions) regarding prepayment and decay ratios, that were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 5% to 68%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 18% and 138%, depending on the note rate and the period to maturity. Mortgage-backed securities were projected to have prepayments based upon the underlying collateral securing the instrument. Certificate accounts were assumed not to be withdrawn until maturity. Passbook accounts and money market accounts were assumed to decay at an annual rate of 6% and 8%, respectively. Retail checking accounts were assumed to decay at an annual rate of 3%. Commercial checking accounts and money market accounts were assumed to decay at annual rates of 7% and 12%, respectively. Callable investments were projected to be called at the first call date where the projected interest rate on similar remaining term instruments exceeded the interest rate on the callable advance or investment.

 

Certain shortcomings are inherent in the method of analysis presented in the above 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 which 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 could be different from the values disclosed in the table. Certain liabilities, such as certificates of deposit, have fixed rates that restrict interest rate changes until maturity. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may also decrease in the event of a substantial sustained increase in interest rates.

 

 
35

 

 

Asset/Liability Management

The Company’s management reviews the impact that changing interest rates will have on its net interest income projected for the next twelve months 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 March 31, 2017 of immediate interest rate changes called rate shocks:

  

(Dollars in thousands)

 

Rate Shock in Basis Points

   

Projected Change in Net Interest Income

   

Percentage Change

 

+200

    $ 2,599       11.04 %

+100

      1,316       5.59  
0       0       0.00  
-100       (1,312 )     (5.58 )

 

The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may decrease in the event of a substantial increase in interest rates and could impact net interest income. The increase in interest income in a rising rate environment is primarily because there are more adjustable rate loans that would re-price to higher interest rates than there are deposits that would re-price in the next twelve months.

 

In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee that meets frequently to discuss changes in the interest rate risk position and projected profitability. This Committee makes adjustments to the asset-liability position of the Bank, that are reviewed by the Board of Directors of the Bank. This Committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions as intended to assure 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 restructure its balance sheet in order to better match the maturities of its assets and liabilities. In the past, more long-term fixed rate loans were placed into the single family loan portfolio. In recent years, the Bank has continued to focus 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.

 

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

 

 
36

 

 

Item 4: Controls and Procedures

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the Company’s management, including the principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

Changes in internal controls. There was no change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 
37

 

 

HMN FINANCIAL, INC.

 

PART II - OTHER INFORMATION

 

ITEM 1.     Legal Proceedings.

 

From time to time, the Company is party to legal proceedings arising out of its lending and deposit operations. The Company is, and expects to become, engaged in a number of foreclosure proceedings and other collection actions as part of its collection activities. Based on our current understanding of these pending legal proceedings, management does not believe that judgements or settlements, if any and if determined adversely to the Company, arising from pending legal matters individually or in the aggregate, would have a material adverse effect on the consolidated financial position, operating results or cash flows of the Company. Litigation is often unpredictable and the actual results of litigation cannot be determined with any certainty.

 

ITEM 1A.      Risk Factors.

 

There have been no material changes to the Company’s risk factors contained in its Annual Report on Form 10-K for the year ended December 31, 2015. For a further discussion of our Risk Factors, see Part I, Item 1.A. of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

 

ITEM 2.     Unregistered Sales of Equity Securities and Use of Proceeds.

 

None. 

 

ITEM 3.     Defaults Upon Senior Securities.

 

None.

 

ITEM 4.     Mine Safety Disclosures.

 

Not applicable.

 

ITEM 5.     Other Information.

 

None.

 

ITEM 6.     Exhibits.

 

          Incorporated by reference to the index to exhibits included with this report immediately following           the signature page.

 

 
38

 

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

 

 

 

 HMN FINANCIAL, INC.

 

    Registrant  

 

 

 

 

 Date:   May 6, 2016                                 

 

/s/ Bradley Krehbiel

 

 

 

Bradley Krehbiel, President and Chief Executive Officer

 

 

 

(Principal Executive Officer)

 

 

 

 

 

 

 

 

 

 

 

 

 

 Date:   May 6, 2016                                 

 

/s/ Jon Eberle

 

 

 

Jon Eberle, Senior Vice President and Chief Financial Officer

 

 

 

(Principal Financial Officer)

 

 

 

 
39

 

 

HMN FINANCIAL, INC.

INDEX TO EXHIBITS

FOR FORM 10-Q

 

         

Sequential

         

Page Numbering

     

Reference

Where Attached

Regulation

   

to Prior

Exhibits Are

S-K

   

Filing or

Located in This

Exhibit

   

Exhibit

Form 10-Q

Number

 

Document Attached Hereto

Number

Report

           

31.1

 

Rule 13a-14(a)/15d-14(a) Certification of CEO

31.1

Filed Electronically

         

31.2

 

Rule 13a-14(a)/15d-14(a) Certification of CFO

31.2

Filed Electronically

         

32

 

Section 1350 Certifications of CEO and CFO

32

Filed Electronically

         

101

 

Financial statements from the Quarterly Report on Form 10-Q of the Company for the period ended March 31, 2016, filed with the SEC on May 6, 2016, formatted in Extensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheet at March 31, 2016 and December 31, 2015, (ii) the Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2016 and 2015, (iii) the Consolidated Statement of Stockholders’ Equity for the Three Month Period Ended March 31, 2016, (iv) the Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015, and (v) Notes to Consolidated Financial Statements.

101

Filed Electronically

 

40