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EX-31.1 - EXHIBIT 31.1 - HMN FINANCIAL INCex31-1.htm
EX-31.2 - EXHIBIT 31.2 - HMN FINANCIAL INCex31-2.htm
EX-32 - EXHIBIT 32 - HMN FINANCIAL INCex32.htm
EX-3.1 - EXHIBIT 3.1 - HMN FINANCIAL INCex3-1.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 September 30, 2015

 

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 October 20, 2015

Common stock, $0.01 par value

 

4,482,893

  

 
1

 

  

HMN FINANCIAL, INC.

 

CONTENTS

 

PART I - FINANCIAL INFORMATION  

 

 

 

 

 

Page

 

Item 1:  

 

Financial Statements

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets at September 30, 2015 and December 31, 2014

3

 

 

 

 

 

 

 

 

Consolidated Statements of Comprehensive Income for the Three Months and Nine Months Ended September 30, 2015 and 2014

4

 

 

 

 

 

 

 

 

Consolidated Statement of Stockholders' Equity for the Nine-Month Period Ended September 30, 2015 

5

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014

6

 

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements

7

 

 

 

 

 

 

 Item 2: 

 

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

25

 

 

 

 

 

 

 Item 3:

 

Quantitative and Qualitative Disclosures about Market Risk

37

 

 

 

 

 

 

 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

 

   

September 30,

   

December 31,

 

(Dollars in thousands)

 

2015

   

2014

 
   

(unaudited)

         

Assets

               

Cash and cash equivalents

  $ 10,359       46,634  

Securities available for sale:

               

Mortgage-backed and related securities (amortized cost $6,979 and $2,755)

    7,080       2,909  

Other marketable securities (amortized cost $138,254 and $135,772)

    138,258       134,925  
      145,338       137,834  
                 

Loans held for sale

    5,153       2,076  

Loans receivable, net

    432,174       365,113  

Accrued interest receivable

    2,162       1,713  

Real estate, net

    2,504       3,103  

Federal Home Loan Bank stock, at cost

    691       777  

Mortgage servicing rights, net

    1,446       1,507  

Premises and equipment, net

    7,426       6,982  

Core deposit intangible

    411       0  

Prepaid expenses and other assets

    1,040       1,157  

Deferred tax asset, net

    10,213       10,530  

Total assets

  $ 618,917       577,426  
                 

Liabilities and Stockholders’ Equity

               

Deposits

  $ 531,586       496,750  

Other borrowings

    10,000       0  

Accrued interest payable

    252       93  

Customer escrows

    1,274       788  

Accrued expenses and other liabilities

    7,095       3,782  

Total liabilities

    550,207       501,413  

Commitments and contingencies

               

Stockholders’ equity:

               

Serial preferred stock ($.01 par value): authorized 500,000 shares; issued and outstanding shares 0 and 10,000

    0       10,000  

Common stock ($.01 par value): authorized 16,000,000; issued shares 9,128,662

    91       91  

Additional paid-in capital

    50,314       50,207  

Retained earnings, subject to certain restrictions

    79,446       77,805  

Accumulated other comprehensive income (loss), net of tax

    63       (418 )

Unearned employee stock ownership plan shares

    (2,465 )     (2,610 )

Treasury stock, at cost 4,645,769 and 4,658,323 shares

    (58,739 )     (59,062 )

Total stockholders’ equity

    68,710       76,013  

Total liabilities and stockholders’ equity

  $ 618,917       577,426  
                 

 

See accompanying notes to consolidated financial statements.

 

 
3

 

  

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(unaudited)

 

      Three Months Ended       Nine Months Ended  
      September 30,        September 30,  
(Dollars in thousands, except per share data)     2015       2014       2015       2014  
Interest income:                                

Loans receivable

  $ 4,860       4,669       13,751       14,398  

Securities available for sale:

                               

Mortgage-backed and related

    35       38       87       131  

Other marketable

    468       378       1,455       889  

Cash equivalents

    26       45       48       157  

Other

    1       1       3       3  

Total interest income

    5,390       5,131       15,344       15,578  
                                 

Interest expense:

                               

Deposits

    231       297       705       937  

Federal Home Loan Bank advances

    0       0       1       0  

Other borrowings

    166       0       408       0  

Total interest expense

    397       297       1,114       937  

Net interest income

    4,993       4,834       14,230       14,641  

Provision for loan losses

    (56 )     (989 )     (239 )     (4,777 )

Net interest income after provision for loan losses

    5,049       5,823       14,469       19,418  
                                 

Non-interest income:

                               

Fees and service charges

    863       903       2,489       2,627  

Mortgage servicing fees

    262       263       778       787  

Gain on sales of loans

    613       804       1,428       1,480  

Gain on acquisition

    289       0       289       0  

Other

    204       224       708       710  

Total non-interest income

    2,231       2,194       5,692       5,604  
                                 

Non-interest expense:

                               

Compensation and benefits

    3,299       3,193       10,285       9,944  

Losses (gains) on real estate owned

    168       (78 )     121       (1,130 )

Occupancy

    936       896       2,741       2,654  

Deposit insurance

    125       74       269       328  

Data processing

    254       240       753       735  

Other

    1,187       1,100       3,031       3,055  

Total non-interest expense

    5,969       5,425       17,200       15,586  

Income before income tax expense

    1,311       2,592       2,961       9,436  

Income tax expense

    491       1,054       1,095       3,736  

Net income

  $ 820       1,538       1,866       5,700  

Preferred stock dividends

    0       (360 )     (108 )     (1,417 )

Net income for common shareholders

    820       1,178       1,758       4,283  

Other comprehensive income (loss), net of tax

    275       (70 )     481       302  

Comprehensive income attributable to common shareholders

  $ 1,095       1,108       2,239       4,585  

Basic earnings per common share

  $ 0.20       0.29       0.43       1.06  

Diluted earnings per common share

  $ 0.18       0.25       0.38       0.93  
                                 

 

See accompanying notes to consolidated financial statements. 

 

 
4

 

  

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders' Equity

For the Nine-Month Period Ended September 30, 2015

(unaudited)

 

                                                               
                                           

Unearned

                 
                                           

Employee

                 
                                   

Accumulated

   

Stock

           

Total

 
   

Serial

           

Additional

           

Other

   

Ownership

           

Stock-

 
   

Preferred

   

Common

   

Paid-in

   

Retained

   

Comprehensive

   

Plan

   

Treasury

   

Holders’

 

(Dollars in thousands)

 

Stock

   

Stock

   

Capital

   

Earnings

   

Income (Loss)

   

Shares

   

Stock

   

Equity

 

Balance, December 31, 2014

  $ 10,000       91       50,207       77,805       (418 )     (2,610 )     (59,062 )     76,013  

Net income

                            1,866                               1,866  

Other comprehensive income

                                    481                       481  

Redemption of preferred stock

    (10,000 )                                                     (10,000 )

Restricted stock awards

                    (332 )                             332       0  

Restricted stock awards forfeiture

                    9                               (9 )     0  

Amortization of restricted stock awards

                    387                                       387  

Dividends on preferred stock

                            (225 )                             (225 )

Earned employee stock ownership plan shares

                    43                       145               188  

Balance, September 30, 2015

  $ 0       91       50,314       79,446       63       (2,465 )     (58,739 )     68,710  
                                                                 

 

See accompanying notes to consolidated financial statements. 

 

 
5

 

 


 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

   

Nine Months Ended

September 30,

 

(Dollars in thousands)

 

2015

   

2014

 

Cash flows from operating activities:

               

Net income

  $ 1,866       5,700  

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

               

Provision for loan losses

    (239 )     (4,777 )

Depreciation

    516       416  

Amortization of (discounts) premiums, net

    (10 )     7  

Amortization of deferred loan fees

    (194 )     (175 )

Amortization of core deposit intangible

    9       0  

Amortization of purchased loan market adjustments

    (112 )     0  

Amortization of mortgage servicing rights and servicing costs

    427       385  

Capitalized mortgage servicing rights

    (366 )     (219 )

Loss (gain) on sales of real estate

    121       (1,130 )

Gain on sales of loans

    (1,428 )     (1,480 )

Proceeds from sale of loans held for sale

    55,995       42,724  

Disbursements on loans held for sale

    (50,952 )     (29,032 )

Amortization of restricted stock awards

    387       176  

Amortization of unearned ESOP shares

    145       145  

Earned employee stock ownership shares priced above original cost

    43       37  

Stock option compensation

    0       1  

(Increase) decrease in accrued interest receivable

    (254 )     167  

Increase (decrease) in accrued interest payable

    148       (46 )

Decrease in other assets

    195       170  

Increase in other liabilities

    3,252       3,508  

Other, net

    33       388  

Net cash provided by operating activities

    9,582       16,965  

Cash flows from investing activities:

               

Principal collected on securities available for sale

    1,257       1,726  

Proceeds collected on maturities of securities available for sale

    118,570       55,000  

Purchases of securities available for sale

    (109,070 )     (89,000 )

Purchase of Federal Home Loan Bank Stock

    (119 )     0  

Redemption of Federal Home Loan Bank Stock

    205       7  

Proceeds from sales of real estate and premises

    772       4,382  

Net (increase) decrease in loans receivable

    (49,252 )     11,898  

Gain on acquisition

    (289 )     0  

Acquisition of Kasson State Bank (net of cash acquired)

    4,816       0  

Purchases of premises and equipment

    (570 )     (538 )

Net cash used by investing activities

    (33,680 )     (16,525 )

Cash flows from financing activities:

               

Decrease in deposits

    (12,438 )     (49,024 )

Redemption of preferred stock

    (10,000 )     (10,000 )

Dividends to preferred stockholders

    (225 )     (5,604 )

Proceeds from borrowings

    41,000       0  

Repayment of borrowings

    (31,000 )     0  

Increase in customer escrows

    486       679  

Net cash used by financing activities

    (12,177 )     (63,949 )

Decrease in cash and cash equivalents

    (36,275 )     (63,509 )

Cash and cash equivalents, beginning of period

    46,634       120,686  

Cash and cash equivalents, end of period

  $ 10,359       57,177  

Supplemental cash flow disclosures:

               

Cash paid for interest

  $ 954       983  

Cash paid for income taxes

    191       0  

Supplemental noncash flow disclosures:

               

Transfer of loans to real estate

    110       142  

Loans transferred to loans held for sale

    6,701       11,954  
                 

 

See accompanying notes to consolidated financial statements. 

 

 
6

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

 

September 30, 2015 and 2014

 

(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 acts as an intermediary for the Bank in holding and operating certain foreclosed properties.

 

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

 

(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 nine-month period ended September 30, 2015 are not necessarily indicative of the results which may be expected for the entire year.

 

(3) Derivative Instruments and Hedging Activities

The Company had commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the quarter. The Company intends to sell these commitments, which are referred to as its mortgage pipeline. As commitments to originate or purchase loans enter the mortgage pipeline, the Company generally enters into commitments to sell the mortgage pipeline into the secondary market on a firm commitment or best efforts basis. The commitments to originate, purchase or sell loans on a firm commitment basis are derivatives and are recorded at market value. As a result of marking to market the mortgage pipeline and the related firm commitments to sell at September 30, 2015, the Company recorded an increase in other assets of $76,000, an increase in other liabilities of $9,000 and a gain included in the gain on sales of loans of $67,000.

 

The current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. As a result, these derivatives are marked to market and the related loans held for sale are recorded at the lower-of-cost-or-market. As of and for the nine months ended September 30, 2015, the Company recorded an increase in other liabilities of $75,000 and a loss included in the gain on sales of loans of $75,000.

 

(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.

 

 
7

 

  

The following table summarizes the assets and liabilities of the Company for which fair values are determined on a recurring basis as of September 30, 2015 and December 31, 2014.

 

   

Carrying value at September 30, 2015

 
                         

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 145,338       0       145,338       0  

Mortgage loan commitments

    93       0       93       0  

Total

  $ 145,431       0       145,431       0  
                                 

 

   

Carrying value at December 31, 2014

 
                         

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 137,834       0       137,834       0  

Mortgage loan commitments

    16       0       16       0  

Total

  $ 137,850       0       137,850       0  
                                 

 

There were no transfers between Levels 1, 2, or 3 during the three or nine-month periods ended September 30, 2015.

 

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis in the third quarter of 2015 that were still held at September 30, 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 September 30, 2015 and December 31, 2014.

 

   

Carrying value at September 30, 2015

                 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Three months ended

September 30, 2015

Total gains (losses)

   

Nine months ended

September 30, 2015

Total gains (losses)

 

Loans held for sale

  $ 5,153       0       5,153       0       83       75  

Mortgage servicing rights

    1,446       0       1,446       0       0       0  

Loans (1)

    9,848       0       9,848       0       39       (203 )

Real estate, net (2)

    2,504       0       2,504       0       (200 )     (200 )

Total

  $ 18,951       0       18,951       0       (78 )     (328 )
                                                 

 

   

Carrying value at December 31, 2014

         

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Year ended

December 31, 2014 Total gains (losses)

 

Loans held for sale

  $ 2,076       0       2,076       0       (1 )

Mortgage servicing rights

    1,507       0       1,507       0       0  

Loans (1)

    11,882       0       11,882       0       532  

Real estate, net (2)

    3,103       0       3,103       0       (134 )

Total

  $ 18,568       0       18,568       0       397  
                                         

 

(1)

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

(2)

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

 

(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 4, have been included in the following table for September 30, 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 September 30, 2015 and December 31, 2014 are shown below.

 

 
8

 

  

   

September 30, 2015

   

December 31, 2014

 
                   

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

  $ 10,359       10,359       10,359                         46,634       46,634       46,634                    

Securities available for sale

    145,338       145,338               145,338                 137,834       137,834               137,834            

Loans held for sale

    5,153       5,153               5,153                 2,076       2,076               2,076            

Loans receivable, net

    432,174       430,694               430,694                 365,113       364,509               364,509            

Federal Home Loan Bank stock

    691       691               691                 777       777               777            

Accrued interest receivable

    2,162       2,162               2,162                 1,713       1,713               1,713            

Financial liabilities:

                                                                                   

Deposits

    531,586       531,310               531,310                 496,750       496,494               496,494            

Other borrowings

    10,000       10,025               10,025                 0       0                            

Accrued interest payable

    252       252               252                 93       93               93            

Off-balance sheet financial
instruments:

                                                                                   

Commitments to extend credit

    93       93                         234,591       16       16                         141,578  

Commitments to sell loans

    (114 )     (114 )                       11,061       (30 )     (30 )                       3,279  

 

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 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.

 

Federal Home Loan Bank Stock

The carrying amount of FHLB stock approximates its fair value.

 

Accrued Interest Receivable

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

 

Deposits

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

 

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

 

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 Federal Home Loan Bank for borrowings of similar remaining maturities.

 

 
9

 

 

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 (Loss)

Other comprehensive income (loss) is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income (loss) is the total of net income and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income (loss) and the related tax effects for the quarter and nine-months ended September 30, 2015 and 2014 were as follows:

       
       
   

For the three months ended September 30,

 

(Dollars in thousands)

 

2015

   

2014

 

Securities available for sale:

 

Before tax

   

Tax effect

   

Net of tax

   

Before tax

   

Tax effect

   

Net of tax

 

Net unrealized gains (losses) arising during the period

  $ 458       183       275       (234 )     (164 )     (70 )

Other comprehensive income (loss)

  $ 458       183       275       (234 )     (164 )     (70 )

 

 

   

For the nine months ended September 30,

 

(Dollars in thousands)

 

2015

   

2014

 

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

  $ 798       317       481       317       15       302  

Other comprehensive income

  $ 798       317       481       317       15       302  
                                                 

 

(7) Securities Available For Sale

The following table shows the gross unrealized losses and fair value 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 September 30, 2015 and December 31, 2014.

 

   

September 30, 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

 

Mortgage backed securities:

                                                               

Federal National Mortgage Association (FNMA)

    6     $ 51       (1 )     0     $ 0       0       51       (1 )

Collateralized mortgage obligations:

                                                               

FNMA

    2       522       (2 )     0       0       0       522       (2 )

Other marketable securities:

                                                               

U.S. Government agency obligations

    1       5,005       (2 )     0       0       0       5,005       (2 )

Municipal obligations

    14       2,168       (6 )     0       0       0       2,168       (6 )

Corporate debt

    1       337       (4 )     0       0       0       337       (4 )

Corporate preferred stock

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

Corporate equity

    1       52       (6 )     0       0       0       52       (6 )

Total temporarily impaired securities

    25     $ 8,135       (21 )     1     $ 350       (350 )   $ 8,485       (371 )

 

   

December 31, 2014

 
   

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

 

Other marketable securities:

                                                               

U.S. Government agency obligations

    22     $ 104,453       (551 )     1     $ 4,970       (50 )   $ 109,423       (601 )

Corporate preferred stock

    0       0       0       1       420       (280 )     420       (280 )

Total temporarily impaired securities

    22     $ 104,453       (551 )     2     $ 5,390       (330 )   $ 109,843       (881 )

  

 
10

 

 

 

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 September 30, 2015 related 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. In January 2015, the issuer began to defer its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has incurred operating losses due to increased provisions for loan losses but still met the regulatory requirements to be considered “well capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at September 30, 2015. 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 security 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.

 

A summary of securities available for sale at September 30, 2015 and December 31, 2014 is as follows:

 

           

Gross unrealized

   

Gross unrealized

         
(Dollars in thousands)   Amortized cost     gains     losses     Fair value  
September 30, 2015:                                

Mortgage-backed securities:

                               

Federal Home Loan Mortgage Corporation (FHLMC)

  $ 1,382       45       0       1,427  

FNMA

    2,598       41       (1 )     2,638  

Government National Mortgage Association (GNMA)

    40       0       0       40  
                                 

Collateralized mortgage obligations:

                               

FHLMC

    1,285       9       0       1,294  

FNMA

    1,625       9       (2 )     1,632  

GNMA

    49       0       0       49  
      6,979       104       (3 )     7,080  

Other marketable securities:

                               

U.S. Government agency obligations

    133,151       355       (2 )     133,504  

Municipal obligations

    4,004       17       (6 )     4,015  

Corporate debt

    341       0       (4 )     337  

Corporate preferred stock

    700       0       (350 )     350  

Corporate equity

    58       0       (6 )     52  
      138,254       372       (368 )     138,258  
    $ 145,233       476       (371 )     145,338  
                                 

 

 

 
11

 

 

           

Gross unrealized

   

Gross unrealized

         

(Dollars in thousands)

  Amortized cost     gains     losses     Fair value  
December 31, 2014:                                

Mortgage-backed securities:

                               

FHLMC

  $ 1,418       90       0       1,508  

FNMA

    1,337       64       0       1,401  
      2,755       154       0       2,909  

Other marketable securities:

                               

U.S. Government agency obligations

    135,014       31       (601 )     134,444  

Corporate preferred stock

    700       0       (280 )     420  

Corporate equity

    58       3       0       61  
      135,772       34       (881 )     134,925  
    $ 138,527       188       (881 )     137,834  
                                 

 

The following table indicates amortized cost and estimated fair value of securities available for sale at September 30, 2015 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.

 

(Dollars in thousands)

 

Amortized

Cost

   

Fair

Value

 

Due less than one year

  $ 8,180       8,228  

Due after one year through five years

    132,979       133,376  

Due after five years through ten years

    3,038       3,051  

Due after ten years

    978       631  

No stated maturity

    58       52  

Total

  $ 145,233       145,338  

 

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 September 30, 2015 and December 31, 2014 is as follows:

 

(Dollars in thousands)

 

September 30,

2015

   

December 31, 2014

 

1-4 family

  $ 82,227       69,841  

Commercial real estate:

               

Residential developments

    29,074       19,960  

Other

    207,045       171,708  
      236,119       191,668  

Consumer

    62,855       54,925  

Commercial business:

               

Construction industry

    7,210       7,121  

Other

    52,616       50,001  
      59,826       57,122  

Total loans

    441,027       373,556  

Less:

               

Unamortized discounts

    14       14  

Net deferred loan costs

    53       97  

Allowance for loan losses

    8,786       8,332  

Total loans receivable, net

  $ 432,174       365,113  
                 

 

 
12

 

 

(9) Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses for the three and nine months ended September 30, 2015 and 2014 is summarized as follows:

 

(Dollars in thousands)

 

1-4 Family

   

Commercial

Real Estate

   

Consumer

   

Commercial Business

   

Total

 
For the three months ended September 30, 2015:                                        

Balance, June 30, 2015

  $ 1,011       5,278       1,162       951       8,402  

Provision for losses

    117       (462 )     25       264       (56 )

Charge-offs

    (19 )     0       (39 )     (1 )     (59 )

Recoveries

    1       435       7       56       499  

Balance, September 30, 2015

  $ 1,110       5,251       1,155       1,270       8,786  
                                         
For the nine months ended September 30, 2015:                                        

Balance, December 31, 2014

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

Provision for losses

    30       (415 )     191       (45 )     (239 )

Charge-offs

    (19 )     0       (66 )     (6 )     (91 )

Recoveries

    3       642       21       118       784  

Balance, September 30, 2015

  $ 1,110       5,251       1,155       1,270       8,786  
                                         

Allocated to:

                                       

Specific reserves

  $ 270       370       307       127       1,074  

General reserves

    826       4,654       702       1,076       7,258  

Balance, December 31, 2014

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

Allocated to:

                                       

Specific reserves

  $ 220       259       353       79       911  

General reserves

    890       4,992       802       1,191       7,875  

Balance, September 30, 2015

  $ 1,110       5,251       1,155       1,270       8,786  
                                         

Loans receivable at December 31, 2014:

                                       

Individually reviewed for impairment

  $ 1,867       9,728       806       555       12,956  

Collectively reviewed for impairment

    67,974       181,940       54,119       56,567       360,600  

Ending balance

  $ 69,841       191,668       54,925       57,122       373,556  

Loans receivable at September 30, 2015:

                                       

Individually reviewed for impairment

  $ 1,862       7,589       917       402       10,770  

Collectively reviewed for impairment

    80,365       228,530       61,938       59,424       430,257  

Ending balance

  $ 82,227       236,119       62,855       59,826       441,027  
                                         

 

(Dollars in thousands)

 

1-4 Family

   

Commercial

Real Estate

   

Consumer

   

Commercial Business

   

Total

 
For the three months ended September 30, 2014:                                        

Balance, June 30, 2014

  $ 2,085       3,823       1,164       1,624       8,696  

Provision for losses

    (489 )     14       (16 )     (498 )     (989 )

Charge-offs

    0       0       (15 )     (55 )     (70 )

Recoveries

    0       229       10       47       286  

Balance, September 30, 2014

  $ 1,596       4,066       1,143       1,118       7,923  
                                         
For the nine months ended September 30, 2014:                                        

Balance, December 31, 2013

  $ 1,628       6,458       1,106       2,209       11,401  

Provision for losses

    60       (3,588 )     83       (1,332 )     (4,777 )

Charge-offs

    (92 )     (936 )     (75 )     (56 )     (1,159 )

Recoveries

    0       2,132       29       297       2,458  

Balance, September 30, 2014

  $ 1,596       4,066       1,143       1,118       7,923  

 

 
13

 

 

The following table summarizes the amount of classified and unclassified loans at September 30, 2015 and December 31, 2014:

   

September 30, 2015

 
   

Classified

   

Unclassified

         

(Dollars in thousands)

 

Special Mention

   

Substandard

   

Doubtful

   

Loss

   

Total

   

Total

   

Total Loans

 

1-4 family

  $ 191       2,556       55       0       2,802       79,425       82,227  

Commercial real estate:

                                                       

Residential developments

    0       6,842       0       0       6,842       22,232       29,074  

Other

    3,158       12,744       0       0       15,902       191,143       207,045  

Consumer

    0       568       89       260       917       61,938       62,855  

Commercial business:

                                                       

Construction industry

    48       185       0       0       233       6,977       7,210  

Other

    4,653       1,567       14       0       6,234       46,382       52,616  
    $ 8,050       24,462       158       260       32,930       408,097       441,027  
                                                         

 

   

December 31, 2014

 
   

Classified

   

Unclassified

         

(Dollars in thousands)

 

Special Mention

   

Substandard

   

Doubtful

   

Loss

   

Total

   

Total

   

Total Loans

 

1-4 family

  $ 0       2,493       207       0       2,700       67,141       69,841  

Commercial real estate:

                                                       

Residential developments

    323       9,960       0       0       10,283       9,677       19,960  

Other

    7,376       8,792       0       0       16,168       155,540       171,708  

Consumer

    0       489       55       261       805       54,120       54,925  

Commercial business:

                                                       

Construction industry

    0       439       0       0       439       6,682       7,121  

Other

    4,255       1,156       0       0       5,411       44,590       50,001  
    $ 11,954       23,329       262       261       35,806       337,750       373,556  

 

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 considered uncollectible and of such little value that continuance as an asset on the balance sheet is not warranted. Loans classified as substandard or doubtful require the Bank to perform an analysis of the individual loan and charge off any loans, or portion thereof, that are deemed uncollectible.

 

 
14

 

 

The aging of past due loans at September 30, 2015 and December 31, 2014 is 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

 

September 30, 2015

                                                       

1-4 family

  $ 915       318       714       1,947       80,280       82,227       0  

Commercial real estate:

                                                       

Residential developments

    0       0       0       0       29,074       29,074       0  

Other

    0       0       0       0       207,045       207,045       0  

Consumer

    306       290       147       743       62,112       62,855       0  

Commercial business:

                                                       

Construction industry

    0       0       0       0       7,210       7,210       0  

Other

    263       20       15       298       52,318       52,616       0  
    $ 1,484       628       876       2,988       438,039       441,027       0  
                                                         

December 31, 2014

                                                       

1-4 family

  $ 413       673       841       1,927       67,914       69,841       0  

Commercial real estate:

                                                       

Residential developments

    0       0       0       0       19,960       19,960       0  

Other

    0       0       0       0       171,708       171,708       0  

Consumer

    550       176       131       857       54,068       54,925       0  

Commercial business:

                                                       

Construction industry

    0       0       0       0       7,121       7,121       0  

Other

    136       0       0       136       49,865       50,001       0  
    $ 1,099       849       972       2,920       370,636       373,556       0  

 

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 September 30, 2015 and December 31, 2014:

   

September 30, 2015

   

December 31, 2014

 

(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

  $ 995       995       0       755       755       0  

Commercial real estate:

                                               

Residential developments

    5,215       7,558       0       7,416       10,040       0  

Other

    500       645       0       48       216       0  

Consumer

    410       411       0       463       464       0  

Commercial business:

                                               

Construction industry

    0       102       0       80       198       0  

Other

    14       14       0       0       0       0  

Loans with an allowance recorded:

                                               

1-4 family

    867       867       220       1,112       1,112       270  

Commercial real estate:

                                               

Residential developments

    1,684       1,684       233       1,522       1,522       240  

Other

    190       190       26       742       743       130  

Consumer

    507       524       353       343       360       307  

Commercial business:

                                               
Construction industry     0       0       0       0       0       0  

Other

    388       939       79       475       1,026       127  

Total:

                                               

1-4 family

    1,862       1,862       220       1,867       1,867       270  

Commercial real estate:

                                               

Residential developments

    6,899       9,242       233       8,938       11,562       240  

Other

    690       835       26       790       959       130  

Consumer

    917       935       353       806       824       307  

Commercial business:

                                               

Construction industry

    0       102       0       80       198       0  

Other

    402       953       79       475       1,026       127  
    $ 10,770       13,929       911       12,956       16,436       1,074  
                                                 

 

 
15

 

 

The following tables summarize average recorded investment and interest income recognized on impaired loans during the three and nine months ended September 30, 2015 and 2014.

 

   

For the three months ended September 30, 2015

   

For the nine months ended September 30, 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

  $ 989       1       866       32  

Commercial real estate:

                               

Residential developments

    5,884       97       6,480       287  

Other

    501       8       388       22  

Consumer

    363       1       365       5  

Commercial business:

                               

Construction industry

    3       0       36       0  

Other

    20       0       10       1  

Loans with an allowance recorded:

                               

1-4 family

    968       3       1,069       10  

Commercial real estate:

                               

Residential developments

    1,705       6       1,540       24  

Other

    192       0       330       0  

Consumer

    531       2       434       16  

Commercial business:

                               

Construction industry

    0       0       0       0  

Other

    397       4       432       13  

Total:

                               

1-4 family

    1,957       4       1,935       42  

Commercial real estate:

                               

Residential developments

    7,589       103       8,020       311  

Other

    693       8       718       22  

Consumer

    894       3       799       21  

Commercial business:

                               

Construction industry

    3       0       36       0  

Other

    417       4       442       14  
    $ 11,553       122       11,950       410  
                                 

 

 
16

 

 

 

   

For the three months ended September 30, 2014

   

For the nine months ended September 30, 2014

 

(Dollars in thousands)

 

Average Recorded Investment

   

Interest Income Recognized

   

Average Recorded Investment

   

Interest Income Recognized

 

Loans with no related allowance recorded:

                               

1-4 family

  $ 234       3       352       6  

Commercial real estate:

                               

Residential developments

    7,691       102       7,688       112  

Other

    51       5       51       5  

Consumer

    456       8       468       10  

Commercial business:

                               

Construction industry

    86       0       89       0  

Other

    0       0       0       0  

Loans with an allowance recorded:

                               

1-4 family

    1,606       6       1,651       13  

Commercial real estate:

                               

Residential developments

    1,153       0       3,521       0  

Other

    866       9       874       24  

Consumer

    489       3       479       9  

Commercial business:

                               

Construction industry

    0       0       0       0  

Other

    981       8       990       23  

Total:

                               

1-4 family

    1,840       9       2,003       19  

Commercial real estate:

                               

Residential developments

    8,844       102       11,209       112  

Other

    917       14       925       29  

Consumer

    945       11       947       19  

Commercial business:

                               

Construction industry

    86       0       89       0  

Other

    981       8       990       23  
    $ 13,613       144       16,163       202  
                                 

 

At September 30, 2015 and December 31, 2014, non-accruing loans totaled $9.1 million and $10.9 million, respectively, for which the related allowance for loan losses was $0.6 million and $0.8 million, respectively. All of the interest income that was recognized for non-accruing loans was recognized using the cash basis method of income recognition. Non-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 $6.7 million and $8.0 million at September 30, 2015 and December 31, 2014, respectively. Non-accrual loans also include certain loans that have had terms modified in a TDR.

 

The non-accrual loans at September 30, 2015 and December 31, 2014 are summarized as follows:

 

(Dollars in thousands)

 

September 30, 2015

   

December 31, 2014

 
                 

1-4 family

  $ 1,621     $ 1,564  

Commercial real estate:

               

Residential developments

    6,382       8,483  

Other

    235       267  

Consumer

    797       486  

Commercial business:

               

Construction industry

    0       80  

Other

    17       40  
    $ 9,052     $ 10,920  
                 

 

At September 30, 2015 and December 31, 2014 there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $7.8 million and $9.4 million, respectively. For the loans that were restructured in the third quarter of 2015, $74,000 were classified but performing and $26,000 were non-performing at September 30, 2015. There were no loans modified in the third quarter of 2014.

 

 
17

 

 

The following table summarizes TDRs at September 30, 2015 and December 31, 2014:

 

   

September 30, 2015

   

December 31, 2014

 

(Dollars in thousands)

 

Accrual

   

Non-Accrual

   

Total

   

Accrual

   

Non-Accrual

   

Total

 

1-4 family

  $ 241       361       602       303       65       368  

Commercial real estate

    971       5,216       6,187       979       6,977       7,956  

Consumer

    121       470       591       320       251       571  

Commercial business

    385       2       387       434       121       555  
    $ 1,718       6,049       7,767       2,036       7,414       9,450  
                                                 

 

There were no material commitments to lend additional funds to customers whose loans were restructured or classified as nonaccrual at September 30, 2015 or December 31, 2014.

 

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 as a TDR, there may be a direct, material impact on the loans within the balance sheet, as principal balances may be partially forgiven. The financial effects of TDRs are presented in the following tables and represent the difference between the outstanding recorded balance pre-modification and post-modification, for the three month and nine month periods ended September 30, 2015 and 2014.

 

             
   

Three Months Ended

September 30, 2015

   

Nine Months Ended

September 30, 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:

                                               

1-4 family

    1     $ 46     $ 46       2     $ 358     $ 358  

Consumer

    4       53       54       11       365       367  

Total

    5     $ 99     $ 100       13     $ 723     $ 725  

 

             
   

Three Months Ended

September 30, 2014

   

Nine Months Ended

September 30, 2014

 

(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:

                                               

1-4 family

    0     $ 0     $ 0       2     $ 760     $ 760  

Consumer

    0       0       0       4       155       140  

Total

    0     $ 0     $ 0       6     $ 915     $ 900  

 

 
18

 

 

There were no loans restructured in the 12 months preceding September 30, 2015 that defaulted in the three and nine months ended September 30, 2015. Loans that were restructured within the 12 months preceding September 30, 2014 that defaulted during the three and nine month periods ended September 30, 2014 are presented in the following table:

 

   

Three Months Ended

September 30, 2014

   

Nine Months Ended

September 30, 2014

 

(Dollars in thousands)

 

Number of Contracts

   

Outstanding Recorded Investment

   

Number of Contracts

   

Outstanding Recorded Investment

 

Troubled debt restructurings that subsequently defaulted:

                               

1-4 family

    0     $ 0       1     $ 640  

Total

    0     $ 0       1     $ 640  

 

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 was $0.4 million, or 4.5%, of the total $8.8 million in loan loss reserves at September 30, 2015 and $0.4 million, or 5.1%, of the total $8.3 million in loan loss reserves at December 31, 2014.

 

Loans acquired in a business combination are segregated into two types: purchased performing loans with a discount attributable at least in part to credit quality and purchased credit impaired (PCI) loans with evidence of significant credit deterioration. Purchased performing loans are accounted for in accordance with ASC 310-20 “Nonrefundable Fees and Other Costs” as these loans do not have evidence of credit deterioration since origination. PCI loans are accounted for in accordance with ASC 310-30 “Receivables – Loans and Debt Securities Acquired with Deteriorated Credit Quality” as they display significant credit deterioration since origination. In accordance with ASC 310-30, for PCI loans, the difference between contractually required payments at acquisition and the cash flows expected to be collected is referred to as the non-accretable difference. This amount is not recognized as a yield adjustment or as a loss accrual or a valuation allowance. Furthermore, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loans when there is a reasonable expectation about the amount and timing of such cash flows. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through an adjustment of the yield on the loan over its remaining estimated life. Decreases in expected cash flows are recognized immediately as an impairment through the provision for loan losses.

 

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

 

(Dollars in thousands)

 

Contractual Principal Receivable

   

Accretable Difference

   

Carrying Amount

 

Purchased Performing Loans:

                       

Balance at August 15, 2015:

  $ 24,215       (793 )     23,422  

Change due to payments/refinances

    (1,730 )     122       (1,608 )

Transferred to foreclosed assets

    0       0       0  

Change due to loan charge-off

    0       0       0  

Balance at September 30, 2015

  $ 22,485       (671 )     21,814  
                         

 

 

 
19

 

 

(Dollars in thousands)

 

Contractual Principal Receivable

   

Non-Accretable Difference

   

Carrying Amount

 

Purchased Credit Impaired Loans:

                       

Balance at August 15, 2015:

  $ 1,134       (497 )     637  

Change due to payments/refinances

    (16 )     0       (16 )

Transferred to foreclosed assets

    0       0       0  

Change due to loan charge-off

    0       0       0  

Balance at September 30, 2015

  $ 1,118       (497 )     621  
                         

 

As a result of the Kasson State Bank acquisition, the Company has PCI loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount of those loans as of September 30, 2015 was $0.6 million.

 

No provision for loan losses was recognized during the period ended September 30, 2015 related to acquired loans as there was no significant change to the credit quality of those loans.

 

(10) Investment in Mortgage Servicing Rights

A summary of mortgage servicing rights activity is as follows:

 

(Dollars in thousands)

 

Nine Months ended

September 30, 2015

   

Twelve Months ended

December 31, 2014

   

Nine Months ended

September 30, 2014

 

Mortgage servicing rights:

                       

Balance, beginning of period

  $ 1,507       1,708       1,708  

Originations

    366       316       219  

Amortization

    (427 )     (517 )     (385 )

Balance, end of period

  $ 1,446       1,507       1,542  

Fair value of mortgage servicing rights

  $ 2,579       2,562       2,661  
                         

 

All of the loans being serviced are single family loans serviced for the FNMA under the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced at September 30, 2015.

 

(Dollars in thousands)  

Loan Principal

Balance

   

Weighted Average

Interest Rate

   

Weighted Average Remaining Term

(months)

    Number of Loans  

Original term 30 year fixed rate

  $ 210,023       4.24       299       1,813  

Original term 15 year fixed rate

    107,843       3.25       139       1,205  

Adjustable rate

    59       4.38       308       2  

 

(11) Intangible Assets

The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2015 and 2014 is presented in the table below. Amortization expense for intangible assets was $436,000 and $385,000 respectively, for the nine-month periods ended September 30, 2015 and 2014.

 

   

September 30, 2015

 
   

Gross

                 

(Dollars in thousands)

 

Carrying

Amount

   

Accumulated Amortization

   

Unamortized Intangible Assets

 

Mortgage servicing rights

  $ 3,736       (2,290 )     1,446  

Core deposit intangible

    420       (9 )     411  

Total

  $ 4,156       (2,299 )     1,857  
                         

 

 
20

 

 

 

   

September 30, 2014

 
   

Gross

                 

(Dollars in thousands)

 

Carrying

Amount

   

Accumulated Amortization

   

Unamortized
Intangible Assets

 

Mortgage servicing rights

  $ 3,597       (2,055 )     1,542  

Total

  $ 3,597       (2,055 )     1,542  
                         

 

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

 

(Dollars in thousands)

 

Mortgage
Servicing
Rights

   

Core

Deposit
Intangible

   

Total

 

Year ended December 31,

                       

2015

  $ 111       19       130  

2016

    414       74       488  

2017

    335       74       409  

2018

    243       74       317  

2019

    182       74       256  

Thereafter

    161       96       257  

Total

  $ 1,446       411       1,857  
                         

 

Projections of amortization are based on existing asset balances and the existing interest rate environment as of September 30, 2015. The Company's actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

 

(12) 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 share:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands, except per share data)

 

2015

   

2014

   

2015

   

2014

 

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

    4,142       4,067       4,118       4,053  

Net dilutive effect of:

                               

Options

    505       520       514       499  

Restricted stock awards

    26       62       40       57  

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

    4,673       4,649       4,672       4,609  

Income available to common shareholders

  $ 820       1,178       1,758       4,283  

Basic earnings per common share

  $ 0.20       0.29       0.43       1.06  

Diluted earnings per common share

  $ 0.18       0.25       0.38       0.93  
                                 

 

(13) Regulatory Capital and Regulatory Oversight

Effective January 1, 2015 the capital requirements of the Company and the Bank were changed to implement the regulatory requirements of the Basel III capital reforms. The new requirements, among other things, (i) apply a strengthened set of capital requirements to both the Company and the Bank, including new 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 new rules made corresponding revisions to the prompt corrective action framework and include the 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, both the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

 
21

 

 

In the second quarter of 2015, the Board of Governors of the Federal Reserve System amended its Small Bank Holding Company Policy Statement (Policy Statement), which exempted small bank holding companies from the above capital requirements, by raising the asset size threshold for determining applicability from $500 million to $1 billion. The Policy Statement was also expanded to include savings and loan holding companies that meet the Policy Statement’s qualitative requirements for exemption. The Company met the qualitative exemption requirements, and therefore, is exempt from the above holding company 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), Tier 1 capital to risk weighted assets, and total capital to risk weighted assets.

 

On September 30, 2015, the Bank’s tangible assets were $607.7 million, its adjusted total assets were $603.3 million, and its risk-weighted assets were $491.7 million. The following table presents the Bank’s capital amounts and ratios at September 30, 2015 for actual capital, required capital, and excess capital, including ratios in order to qualify as being well capitalized under the prompt corrective actions regulations.

 

   

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

  $ 73,531                                                          
Plus:                                                                

Net unrealized gain on certain securities available for sale

    (63 )                                                        

Less:

                                                               

Goodwill and other intangibles

    165                                                          

Disallowed servicing and tax assets

    4,217                                                          

Common equity tier I capital

    69,086                                                          

Common equity tier I capital ratio

            14.05 %   $ 22,126       4.50 %   $ 46,960       9.55 %   $ 31,960       6.50 %

Tier I capital

    69,086                                                          

Tier I capital to adjusted total assets (leverage ratio)

            11.45 %   $ 24,131       4.00 %   $ 44,955       7.45 %   $ 30,164       5.00 %

Tier I capital to risk-weighted assets

            14.05 %   $ 29,501       6.00 %   $ 39,585       8.05 %   $ 39,335       8.00 %
Plus:                                                                

Allowable allowance for loan losses

    6,211                                                          

Risk-based capital

  $ 75,297             $ 39,335             $ 35,962             $ 49,169          

Risk-based capital to risk- weighted assets

            15.31 %             8.00 %             7.31 %             10.00 %

 

(1) Under the recently issued final rules, revised requirements began to be phased in on January 1, 2015, as described above.

(2) Based upon the Bank’s adjusted total assets for the purpose of leverage ratio and risk-weighted assets for the purpose of the risk-based capital ratios.

 

 

Management believes that, as of September 30, 2015, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the current prompt corrective action regulations described above. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well-capitalized” in the future.

 

(14) Preferred Stock

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 United States 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 United States Treasury’s Capital Purchase Program under the Emergency Economic Stabilization Act of 2008.

 

In 2014, the Company redeemed 16,000 shares of Preferred Stock and on February 17, 2015, the Company redeemed the remaining 10,000 shares of outstanding Preferred Stock.

 

 
22

 

 

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 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 material effect on the Company’s capital, financial condition or results of operations.

 

(15) Other Borrowings

The Company funded the Preferred Stock redemption on February 17, 2015 with a $10.0 million term loan to HMN from an unrelated third party that was evidenced by a promissory note. The principal balance of the note bears interest at a rate of 6.50% and is payable in consecutive annual installments of $1.0 million on each December 15, beginning December 15, 2015, with the balance due on December 15, 2021. The Company may elect to prepay the note at any time without penalty and may also elect, upon written notice to the lender, to defer one principal payment on the note prior to the maturity date provided that the note is not in default. If a payment is deferred, it would become due and payable in full on the maturity date.

 

(16) Commitments and Contingencies

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at September 30, 2015 were approximately $3.2 million, expire over the next eighteen 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.

 

(17) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. HMN, OIA and HFH did not meet the quantitative thresholds for determining reportable segments and, therefore, are 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.

 

 
23

 

 

The following table sets forth certain information about the reconciliation 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 nine months ended September 30, 2015:

                         

Interest income - external customers

  $ 15,344       0       0       15,344  

Non-interest income - external customers

    5,692       0       0       5,692  

Intersegment interest income

    0       1       (1 )     0  

Intersegment non-interest income

    153       2,318       (2,471 )     0  

Interest expense

    707       408       (1 )     1,114  

Other non-interest expense

    16,887       466       (153 )     17,200  

Income tax expense

    1,516       (421 )     0       1,095  

Net income

    2,318       1,866       (2,318 )     1,866  

Total assets

    617,870       78,354       (77,307 )     618,917  
                                 

At or for the nine months ended September 30, 2014:

                         

Interest income - external customers

  $ 15,578       0       0       15,578  

Non-interest income - external customers

    5,604       0       0       5,604  

Intersegment interest income

    0       1       (1 )     0  

Intersegment non-interest income

    135       5,923       (6,058 )     0  

Interest expense

    938       0       (1 )     937  

Other non-interest expense

    15,135       586       (135 )     15,586  

Income tax expense

    4,098       (362 )     0       3,736  

Net income

    5,923       5,700       (5,923 )     5,700  

Total assets

    593,474       80,873       (79,914 )     594,433  

At or for the quarter ended September 30, 2015:

                         

Interest income - external customers

  $ 5,390       0       0       5,390  

Non-interest income - external customers

    2,231       0       0       2,231  

Intersegment non-interest income

    51       1,007       (1,058 )     0  

Interest expense

    231       166       0       397  

Other non-interest expense

    5,832       188       (51 )     5,969  

Income tax expense

    657       (166 )     0       491  

Net income

    1,007       820       (1,007 )     820  

Total assets

    617,870       78,354       (77,307 )     618,917  
                           

At or for the quarter ended September 30, 2014:

                         

Interest income - external customers

  $ 5,131       0       0       5,131  

Non-interest income - external customers

    2,194       0       0       2,194  

Intersegment interest income

    45       1,608       (1,653 )     0  

Intersegment non-interest income

                         

Interest expense

    297       0       0       297  

Other non-interest expense

    5,283       187       (45 )     5,425  

Income tax expense

    1,171       (117 )     0       1,054  

Net income

    1,608       1,538       (1,608 )     1,538  

Total assets

    593,474       80,873       (79,914 )     594,433  

 

 

 
24

 

 

Item 2:

HMN FINANCIAL, INC.

MANAGEMENT'S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-looking Information

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, becoming more efficient and generating improved financial results; 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 improvement 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 Kasson State Bank operations; expectations of future taxable income and its impact on the need to establish a valuation reserve against our net deferred tax asset; anticipated future levels of the provision for loan losses; future losses on non-performing assets; the amount and mix of interest-earning assets; the amount and mix 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 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 under revised capital rules; and compliance by the Bank with regulatory standards generally (including the Bank’s status as “well-capitalized”) and other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement.

 

A number of factors could cause actual results to differ materially 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 Federal Home Loan Bank; 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; unanticipated acquisition integration costs and other difficulties in assimilating the recently acquired Kasson State Bank operations; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filings on Forms 10-K and 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 and Part II, Item 1A of its subsequently filed Quarterly Reports on Form 10-Q.

 

All statements in this quarterly report on 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.

 

 
25

 

 

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 mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company's net income is also affected by the generation of non-interest income, which consists primarily of gains or losses from the sale of securities, gains from the sale of loans, fees for servicing mortgage loans, and the generation of fees and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses, and amortization of mortgage servicing assets. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings.

 

Critical Accounting Estimates

Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company’s financial condition and operating results. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company’s financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used.

 

Allowance for Loan Losses and Related Provision

The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local economic growth rates, historical 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 of all non-performing loans. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company's own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans or portion thereof that are deemed uncollectable.

 

Purchased loans are not included in the periodic analysis to determine the allowance for loan losses. At the time of purchase, these loans are reviewed to determine their estimated fair value and appropriate credit reserves are established. These loans are recorded net of the related reserve on the balance sheet and subsequent charge offs on these loans are recorded through the provision for loan losses to the extent that the charge off exceeds the previously established reserve. Loans that are considered impaired at the time of purchase (purchase credit impaired), and purchased loans that subsequently become impaired, are periodically reviewed to determine the adequacy of the established credit reserves and any additional reserves required would be recorded through the provision for loan losses.

 

 
26

 

 

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 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 and decreases its allowance for loan losses by charging or crediting the provision for loan losses against income. 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 probable losses in the loan portfolio for which additional specific reserves are not required. 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 date, 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 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 whether the deferred tax assets are realizable 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 realization of deferred tax assets. Positive evidence includes the Company’s cumulative net income in the prior three year period and the probability that taxable income will be generated in future periods. Negative evidence includes the general business and economic environment. The determination that a valuation reserve was not required at September 30, 2015 was based primarily upon the existence of a three-year cumulative net income and expectations of future taxable income. It is possible that future conditions may differ substantially from those anticipated in determining the valuation allowance on deferred tax assets and adjustments may be required in future periods.

 

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.

 

Acquisition

On August 14, 2015, the Bank completed the acquisition of certain assets and assumption of certain liabilities of Kasson State Bank. The transaction increased the Bank’s total assets $52.8 million including increases in loans of $24.1 million, investments of $17.5 million, cash of $10.0 million, core deposit intangible of $0.4 million and other assets of $0.8 million. The Bank also assumed liabilities of $49.3 million including $47.3 million of deposits and $2.0 million in other liabilities. Consideration paid was $3.2 million and a gain on the transaction of $0.3 million was recorded during the quarter. The Bank continues to operate both of the Kasson State Bank locations in Kasson, Minnesota acquired in the transaction as branches of Home Federal Savings Bank.

 

 
27

 

 

RESULTS OF OPERATIONS FOR THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2015 COMPARED TO THE SAME PERIODS ENDED SEPTEMBER 30, 2014

 

Net Income

Net income was $0.8 million for the third quarter of 2015, a decrease of $0.7 million compared to net income of $1.5 million for the third quarter of 2014. Net income available to common shareholders was $0.8 million for the third quarter of 2015, a decrease of $0.4 million from the net income available to common shareholders of $1.2 million for the third quarter of 2014. Diluted earnings per common share for the third quarter of 2015 was $0.18, a decrease of $0.07 from diluted earnings per common share of $0.25 for the third quarter of 2014. The decrease in net income for the third quarter of 2015 is due primarily to a $0.9 million increase in the provision for loan losses between the periods. The increase in the provision was primarily because there was more commercial loan growth and fewer credit rating upgrades in the third quarter of 2015 when compared to the third quarter of 2014. The loss on sale of real estate owned increased $0.2 million between the periods due to the write down of a commercial property as a result of obtaining an updated appraisal of the property. Gain on sales of loans decreased $0.2 million due to a decrease in the gains recognized on the sale of commercial government guaranteed loans between the periods. These decreases in net income were partially offset by a $0.6 million decrease in income tax expense due to the decreased income between the periods.

 

Net income was $1.9 million for the nine-month period ended September 30, 2015, a decrease of $3.8 million, or 67.3%, compared to net income of $5.7 million for the nine-month period ended September 30, 2014. The net income available to common shareholders was $1.8 million for the nine-month period ended September 30, 2015, a decrease of $2.5 million, or 59.0%, compared to the net income available to common shareholders of $4.3 million for the same period of 2014. Diluted earnings per common share for the first nine months of 2015 was $0.38, a decrease of $0.55 per share compared to the diluted earnings per common share of $0.93 for the same period in 2014. The decrease in net income for the first nine months of 2015 as compared to the same period of 2014 is due primarily to a $4.5 million increase in the provision for loan losses. The increase in the provision was primarily because there was more commercial loan growth and fewer credit rating upgrades in the first nine months of 2015 when compared to the first nine months of 2014. The loss on sale of real estate owned increased $1.3 million due primarily to a large gain realized on the sale of a commercial property in the first nine months of 2014. Net interest income decreased $0.4 million between the periods primarily because of a decrease in the average interest-earning assets between the periods. Compensation and benefits increased $0.3 million between the periods primarily because of increased expenses related to restricted stock awards. These decreases in net income were partially offset by a $2.6 million decrease in income tax expense due to the decreased income between the periods.

 

Net Interest Income

Net interest income was $5.0 million for the third quarter of 2015, an increase of $0.2 million, or 3.3%, compared to $4.8 million for the third quarter of 2014. Interest income was $5.4 million for the third quarter of 2015, an increase of $0.3 million, or 5.0%, from $5.1 million for the same period of 2014. Interest income increased between the periods primarily because of a change in the mix of average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets decreased $3.8 million between the periods, the average interest-earning assets held in lower yielding cash and investments decreased $38.2 million and the amount of average interest-earning assets held in higher yielding loans increased $34.4 million. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred primarily because of increased commercial loan originations between the periods and also because of the acquisition of loans from Kasson State Bank in the third quarter of 2015. The average yield earned on interest-earning assets was 3.72% for the third quarter of 2015, an increase of 21 basis points from 3.51% for the third quarter of 2014.

 

 
28

 

 

Interest expense was $0.4 million for the third quarter of 2015, an increase of $0.1 million, or 33.7%, compared to $0.3 million for the third quarter of 2014. Interest expense increased primarily because of the change in the mix of the average interest-bearing liabilities held, which resulted in an increase in the average rate paid between the periods. While the average interest-bearing liabilities increased $8.0 million between the periods, the amount held in higher rate borrowings increased $10.0 million, the average interest-bearing liabilities held in higher rate certificates of deposits decreased $11.1 million, and the amount of interest-bearing liabilities held in other lower rate deposit accounts increased $9.1 million. The increase in the average interest-bearing liabilities as a result of the deposits assumed in the Kasson State Bank transaction was almost entirely offset by decreases in the average deposit balances held between the periods by several large deposit customers due to changes in the cash needs of the customers. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Preferred Stock. Interest expense increases related to borrowing costs were partially offset by the lower interest rates paid on money market accounts and certificates of deposits between the periods. The decreased rates paid on these accounts were the result of the low interest rate environment that continued to exist during the third quarter of 2015. The average interest rate paid on interest-bearing liabilities was 0.30% for the third quarter of 2015, an increase of 7 basis points from the 0.23% average interest rate paid in the third quarter of 2014.

 

Net interest margin (net interest income divided by average interest-earning assets) for the third quarter of 2015 was 3.44%, an increase of 13 basis points, compared to 3.31% for the third quarter of 2014.

 

Net interest income was $14.2 million for the first nine months of 2015, a decrease of $0.4 million, or 2.8%, from $14.6 million for the same period of 2014. Interest income was $15.3 million for the nine-month period ended September 30, 2015, a decrease of $0.2 million, or 1.5%, from $15.5 million for the same period of 2014. Interest income decreased between the periods primarily because of a decrease in the average interest-earning assets held between the periods. This decrease was partially offset by an increase in average yields earned as a result of the change in the mix of assets held. While the average interest-earning assets decreased $34.0 million between the periods, the average interest-earning assets held in lower yielding cash and investment decreased $38.6 million and the amount of average interest-earning assets held in higher yielding loans increased $4.6 million between the periods. The increase in the average outstanding loans between the periods was primarily the result of an increase in loan originations between the periods. The average yield earned on interest-earning assets was 3.75% for the first nine months of 2015, an increase of 17 basis points from 3.58% for the same period of 2014.

 

Interest expense was $1.1 million for the nine-month period ended September 30, 2015, an increase of $0.2 million, or 18.9%, from $0.9 million for the same period in 2014. Interest expense increased primarily because of the change in the mix of the average interest-bearing liabilities held, which resulted in an increase in the average rate paid between the periods. While the average interest-bearing liabilities decreased $22.5 million between the periods, the amount held in higher rate borrowings increased $8.7 million, the average interest-bearing liabilities held in higher rate certificates of deposits decreased $19.0 million, and the amount of interest-bearing liabilities held in other lower rate deposit accounts decreased $12.2 million between the periods. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining outstanding Preferred Stock. Interest expense increases related to borrowing costs were partially offset by the lower interest rates paid on money market accounts and certificates of deposits between the periods. The decreased rates paid on these accounts were the result of the low interest rate environment that continued to exist during the first nine months of 2015. The average interest rate paid on interest-bearing liabilities was 0.30% for the first nine months of 2015, an increase of 6 basis points from the 0.24% average interest rate paid in the first nine months of 2014.

 

Net interest margin (net interest income divided by average interest earning assets) for the first nine months of 2015 was 3.47%, an increase of 11 basis points, compared to 3.36% for the first nine months of 2014.

 

 
29

 

 

A summary of the Company’s net interest margin for the three and nine-month periods ended September 30, 2015 and September 30, 2014 is as follows:

 

   

For the three-month period ended

 
   

September 30, 2015

   

September 30, 2014

 

(Dollars in thousands)

 

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate (2)

   

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate (2)

 

Interest-earning assets:

                                               

Securities available for sale

  $ 131,232       503       1.52

%

  $ 137,503       416       1.20

%

Loans held for sale

    3,633       36       3.93       2,253       21       3.70  

Mortgage loans, net (1)

    78,820       817       4.11       70,580       835       4.69  

Commercial loans, net (1)

    259,587       3,273       5.00       237,404       3,106       5.19  

Consumer loans, net (1)

    57,040       734       5.11       54,378       707       5.16  

Cash equivalents

    44,358       26       0.23       76,224       45       0.23  

Federal Home Loan Bank stock

    691       1       0.57       777       1       0.51  

Total interest-earning assets

    575,361       5,390       3.72       579,119       5,131       3.51  
                                                 

Interest-bearing liabilities:

                                               

NOW accounts

    72,995       4       0.02       70,311       3       0.02  

Savings accounts

    58,008       12       0.08       47,953       8       0.07  

Money market accounts

    154,904       84       0.22       171,329       107       0.25  

Certificates

    96,886       131       0.54       108,029       179       0.66  

Advances and other borrowings

    10,000       166       6.59       0       0       0.00  

Total interest-bearing liabilities

    392,793                       397,622                  

Non-interest checking

    138,571                       125,751                  

Other non-interest bearing deposits

    1,190                       1,200                  

Total interest-bearing liabilities and non-interest bearing deposits

  $ 532,554       397       0.30     $ 524,573       297       0.23  

Net interest income

            4,993                     $ 4,834          

Net interest rate spread

                    3.42

%

                    3.28

%

Net interest margin

                    3.44

%

                    3.31

%

 


(1) Average balances of loans include non-accrual loans

(2) Annualized

 

 


   

For the nine-month period ended

 
   

September 30, 2015

   

September 30, 2014

 

(Dollars in thousands)

 

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate(2)

   

Average

Outstanding

Balance

   

Interest

Earned/

Paid

   

Yield/

Rate(2)

 

Interest-earning assets:

                                               

Securities available for sale

  $ 139,851       1,542       1.47

%

  $ 120,632       1,020       1.13

%

Loans held for sale

    2,485       60       3.23       1,520       45       3.96  

Mortgage loans, net (1)

    73,063       2,292       4.19       73,572       2,483       4.51  

Commercial loans, net (1)

    247,586       9,346       5.05       244,197       9,777       5.35  

Consumer loans, net (1)

    54,273       2,053       5.06       53,563       2,093       5.22  

Cash equivalents

    29,699       48       0.22       87,474       157       0.24  

Federal Home Loan Bank stock

    733       3       0.55       779       3       0.51  

Total interest-earning assets

    547,690       15,344       3.75       581,737       15,578       3.58  
                                                 

Interest-bearing liabilities:

                                               

NOW accounts

    75,139       12       0.02       70,861       11       0.02  

Savings accounts

    51,706       27       0.07       47,259       24       0.07  

Money market accounts

    150,582       261       0.23       163,319       307       0.25  

Certificates

    95,282       405       0.57       113,200       583       0.69  

Brokered deposits

    0       0       0.00       1,109       12       1.45  

Advances and other borrowings

    8,665       409       6.31       0       0       0.00  

Total interest-bearing liabilities

    381,374                       395,748                  

Non-interest checking

    120,526                       128,759                  

Other non-interest bearing deposits

    1,044                       983                  

Total interest-bearing liabilities and non-interest bearing deposits

  $ 502,944       1,114       0.30     $ 525,490       937       0.24  

Net interest income

            14,230                     $ 14,641          

Net interest rate spread

                    3.45

%

                    3.34

%

Net interest margin

                    3.47

%

                    3.36

%

                                                 

 

(1) Average balances of loans include non-accrual loans

(2) Annualized

 
30

 

 

 

Provision for Loan Losses

The provision for loan losses was ($0.1) million for the third quarter of 2015, an increase in the provision of $0.9 million, compared to ($1.0) million for the third quarter of 2014. The provision for loan losses was ($0.2) million for the first nine months of 2015, an increase of $4.6 million, from ($4.8) million for the same nine-month period of 2014. The increase in the provision in the third quarter and the first nine months of 2015 was primarily because there was more commercial loan growth and fewer credit rating upgrades in the third quarter and first nine months of 2015 when compared to the same periods of 2014.

 

A reconciliation of the Company’s allowance for loan losses for the three and nine-month periods ended September 30, 2015 and September 30, 2014 is summarized as follows:

 

   

Three months ended September 30,

 

(Dollars in thousands)

 

2015

   

2014

 

Balance at June 30,

  $ 8,402     $ 8,696  

Provision

    (56 )     (989 )

Charge offs:

               

Consumer

    (39 )     (15 )

Commercial business

    (1 )     (55 )

One-to-four family real estate

    (19 )     0  

Recoveries

    499       286  

Balance at September 30,

  $ 8,786     $ 7,923  
                 

Allocated to:

               

General allowance

  $ 7,875     $ 6,651  

Specific allowance

    911       1,272  
    $ 8,786     $ 7,923  
                 

 

   

Nine months ended September 30,

 

(Dollars in thousands)

 

2015

   

2014

 

Balance at January 1,

  $ 8,332     $ 11,401  

Provision

    (239 )     (4,777 )

Charge offs:

               

One-to-four family

    (19 )     (92 )

Consumer

    (66 )     (75 )

Commercial business

    (7 )     (56 )

Commercial real estate

    0       (936 )

Recoveries

    785       2,458  

Balance at September 30,

  $ 8,786     $ 7,923  

 

 

Non-Interest Income

Non-interest income was $2.2 million for the third quarter of 2015, the same as for the third quarter of 2014. The Company recognized a gain of $0.3 million related to the Kasson State Bank acquisition that was completed in the third quarter of 2015. This increase in non-interest income was offset by a $0.2 million decrease in the gain on sales of loans between the periods and a decrease in fees and other income of $0.1 million between the periods. The decrease in the gain on sales of loans was primarily related to a decrease in the gains recognized on the sale of commercial government guaranteed loans between the periods due to a decrease in originations of these types of loans in the third quarter of 2015 when compared to the same period of 2014.

 

Non-interest income was $5.7 million for the first nine months of 2015, an increase of $0.1 million, or 1.6%, from $5.6 million for the same period in 2014. The Bank recognized a gain of $0.3 million in connection with the acquisition of Kasson State Bank that was completed in the third quarter of 2015. This increase in non-interest income was offset by a $0.1 million decrease on the gain on sales of loans between the periods. The decrease in the gain on sales of loans was primarily related to a decrease in the gains recognized on the sale of commercial government guaranteed loans due to a decrease in originations of these types of loans between the periods.

 

 
31

 

 

Non-Interest Expense

Non-interest expense was $6.0 million for the third quarter of 2015, an increase of $0.6 million, or 10.0%, from $5.4 million for the same period of 2014. The loss on sale of real estate owned increased $0.2 million between the periods due to the write down of a commercial property as a result of obtaining an updated appraisal of the property. Compensation and benefits expense increased $0.1 million primarily because of an increase in incentive accruals due to increased commercial loan production. Other non-interest expenses increased $0.1 million between the periods primarily because of an increase in expenses related to the increased loan production and costs associated with a new travel club that was established in the third quarter of 2015. Deposit insurance expense increased $0.1 million between the periods due to the increase in the Bank’s assets between the periods.

 

Non-interest expense was $17.2 million for the first nine months of 2015, an increase of $1.6 million, or 10.4%, from $15.6 million for the same period in 2014. The loss on sale of real estate owned increased $1.3 million between the periods primarily because of a $1.0 million gain that was recognized on the sale of single commercial property in the first nine months of 2014. Compensation and benefits increased $0.3 million between the periods primarily because of increased expenses related to restricted stock awards and increased incentive accruals due to increased loan originations.

 

Income Tax Expense

Income tax expense was $0.5 million for the third quarter of 2015, a decrease of $0.6 million, from $1.1 million for the third quarter of 2014. Income tax expense was $1.1 million for the first nine months of 2015, a decrease of $2.6 million, from $3.7 million for the same period in 2014. The decrease in income tax expense between the periods is primarily related to the decrease in income in the third quarter and first nine months of 2015 when compared to the same periods of 2014.

 

Net Income Available to Common Shareholders

Net income available to common shareholders was $0.8 million for the third quarter of 2015, a decrease of $0.4 million from the $1.2 million net income available to common shareholders in the third quarter of 2014. The net income available to common shareholders was $1.8 million for the first nine months of 2015, a decrease of $2.5 million from the $4.3 million net income available to common shareholders in the same period of 2014. The net income available to common shareholders decreased primarily because of the decrease in net income between the periods that was partially offset by a reduction, or in the case of the third quarter period, elimination, of the dividends required to be paid on the outstanding Preferred Stock. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends were required to be paid on the Preferred Stock after that date.

 

 
32

 

 

FINANCIAL CONDITION

Non-Performing Assets

The following table summarizes the amounts and categories of non-performing assets, which consist of non-performing loans and foreclosed and repossessed assets, in the Bank’s portfolio and loan delinquency information as of the end of the two most recently completed quarters and December 31, 2014.

 

   

September 30,

   

June 30,

   

December 31,

 

(Dollars in thousands)

 

2015

   

2015

   

2014

 

Non-Performing Loans:

                       

One-to-four family real estate

  $ 1,621     $ 1,807     $ 1,564  

Commercial real estate

    6,617       7,999       8,750  

Consumer

    801       743       486  

Commercial business

    42       11       120  

Total

    9,081       10,560       10,920  
                         

Foreclosed and Repossessed Assets:

                       

One-to-four family real estate

    110       0       50  

Commercial real estate

    2,394       2,730       3,053  

Total non-performing assets

  $ 11,585     $ 13,290     $ 14,023  

Total as a percentage of total assets

    1.87

%

    2.36

%

    2.43

%

Total non-performing loans

  $ 9,081     $ 10,560     $ 10,920  

Total as a percentage of total loans receivable, net

    2.10

%

    2.87

%

    2.99

%

Allowance for loan losses to non-performing loans

    96.75

%

    79.57

%

    76.30

%

                         

Delinquency Data:

                       

Delinquencies (1)

                       

30+ days

  $ 1,778     $ 1,382     $ 1,682  

90+ days

    0       0       0  

Delinquencies as a percentage of loan portfolio (1)

                       

30+ days

    0.40

%

    0.36

%

    0.45

%

90+ days

    0.00

%

    0.00

%

    0.00

%

                         

(1) Excludes non-accrual loans.

 

Total non-performing assets were $11.6 million at September 30, 2015, a decrease of $1.7 million, or 12.8%, from $13.3 million at June 30, 2015. Non-performing loans decreased $1.5 million and foreclosed and repossessed assets decreased $0.2 million during the third quarter of 2015. The non-performing loan and foreclosed and repossessed asset activity for the quarter was as follows:

            

(Dollars in thousands)                    

Non-performing loans

       

Foreclosed and repossessed assets

       

June 30, 2015

  $ 10,560  

June 30, 2015

  $ 2,730  

Classified as non-performing

    940  

Other foreclosures/repossessions

    239  

Charge offs

    (51 )

Real estate sold

    (401 )

Principal payments received

    (2,073 )

Net gain on sale of assets

    32  

Classified as accruing

    (185 )

Write downs

    (206 )

Transfer to real estate owned

    (110 )

Transfer from non-performing loans

    110  

September 30, 2015

  $ 9,081  

September 30, 2015

  $ 2,504  
                   

 

The decrease in non-performing loans during the third quarter of 2015 relates primarily to principal payments received during the period. Of the $2.1 million in principal payments received, $0.6 million related to the payoff of four construction loans as a result of home sales and $1.2 million related to the payments received on a commercial development loan from lot sale proceeds.

 

Total non-performing assets were $11.6 million at September 30, 2015, a decrease of $2.4 million, or 17.4%, from $14.0 million at December 31, 2014. Non-performing loans decreased $1.8 million and foreclosed and repossessed assets decreased $0.6 million during the first nine months of 2015. The non-performing loan and foreclosed and repossessed asset activity for the first nine months of 2015 was as follows:

 

 
33

 

 

(Dollars in thousands)                  

Non-performing loans

       

Foreclosed and repossessed asset activity

       

January 1, 2015

  $ 10,920  

January 1, 2015

  $ 3,103  

Classified as non-performing

    3,091  

Other foreclosures/repossessions

    239  

Charge offs

    (83 )

Real estate sold

    (809 )

Principal payments received

    (4,537 )

Net gain on sale of assets

    200  

Classified as accruing

    (200 )

Write downs

    (339 )

Transfer to real estate owned

    (110 )

Transfer from non-performing loans

    110  

September 30, 2015

  $ 9,081  

September 30, 2015

  $ 2,504  
                   

 

The decrease in      non-performing loans during the first nine months of 2014 relates primarily to principal payments received. Of the $4.5 million in principal payments received during the period, $2.5 million related to construction loans to residential builders where the construction had been completed and the borrower paid off the loan from the home sale proceeds and $1.2 million related to the payments received on a commercial development loan from lot sale proceeds.

 

The following table summarizes the number of lending relationships and types of commercial real estate loans that were non-performing as of the end of the two most recently completed quarters and December 31, 2014.

 

(Dollars in thousands)

 

Property Type

# of

relationships

Principal Amount of Loans at

September 30,

2015

# of

relationships

Principal Amount of Loans at

June 30,

2015

# of

relationships

Principal Amount of Loans at

December 31,

2014

Developments/land

  3 $ 6,617   3 $ 7,999   3 $ 8,750

 

The decrease in the non-performing commercial real estate loans from June 30, 2015 is due primarily to principal payments received on construction and development loans during the quarter as a result of various building lot sales.

 

 

LIQUIDITY AND CAPITAL RESOURCES

For the nine months ended September 30, 2015, the net cash provided by operating activities was $9.6 million. The Company collected $118.6 million from the maturities of securities, $1.3 million from principal repayments on securities, and $0.8 million in proceeds from the sale of real estate. The Company purchased securities of $109.1 million and purchased premises and equipment of $0.6 million. The Company purchased $0.1 million in Federal Home Loan Bank Stock (FHLB) and sold FHLB stock of $0.2 million. Net loans receivable increased $49.3 million due primarily to increased loan originations and also because of the loans purchased in connection with the Kasson State Bank acquisition. The Company recorded a gain on the Kasson State Bank acquisition of $0.3 million and received net cash of $4.8 million in connection with the transaction. The Company had a net decrease in deposit and customer escrow balances of $11.9 million, redeemed $10.0 million of outstanding Preferred Stock, and paid $0.2 million in Preferred Stock dividends. The Company received proceeds from borrowings of $41.0 million and repaid $31.0 million in borrowings during the period.

 

The Company has certificates of deposits with outstanding balances of $63.5 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 deposits that do not renew will be replaced with deposits from other customers or FHLB advances. Federal Reserve Bank 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 September 30, 2015. The $47.0 million in funds held by these customers may be withdrawn at any time and management anticipates that the majority of these deposits will be maintained at 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. Federal Reserve borrowing or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.

 

 
34

 

 

The Company had the ability to borrow $89.7 million from the FHLB at September 30, 2015, 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.

 

On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock after redeeming 16,000 shares in 2014. These redemptions reduced the amount of dividends paid on the Preferred Stock and increased interest expense in the first nine months of 2015 when compared to the same period of 2014 as the redemption was funded by a $10.0 million holding company note payable to an unrelated third party.  

 

The Company’s primary source of cash is dividends from the Bank. At September 30, 2015, the Company had $3.8 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 principal and interest on the third party note payable. The interest payments on the note payable are due quarterly and a principal payment of $1.0 million is due on December 15, 2015.

 

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 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. 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 could dilute the ownership interests of existing stockholders, dilute the Company’s earnings per share 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, borrowing, and deposit taking activities. Management actively monitors and manages its interest rate risk exposure.

 

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

 

 
35

 

 

The following table discloses the projected changes in market value to the Company’s interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on September 30, 2015.

 

         
Other than trading portfolio     Market Value  
                                 
(Dollars in thousands)                                
Basis point change in interest rates     100       0     +100     +200  

Total market risk sensitive assets

  $ 615,624       605,201       589,072       574,556  

Total market risk sensitive liabilities

    530,948       498,636       478,995       460,493  

Off-balance sheet financial instruments

    (610 )     0       58       182  

Net market risk

  $ 85,286       106,565       110,019       113,881  

Percentage change from current market value

    (19.97

)%

    0.00

%

    3.24

%

    6.87

%

                                 

 

The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios, which 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 4% to 58%, 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 were assumed to decay at an annual rate of 6% and retail money market accounts were assumed to decay at an annual rate of 8%. Non-interest checking and NOW accounts were assumed to decay at an annual rate of 3%. Commercial NOW accounts and MMDA accounts were assumed to decay at an annual rate of 7% and 12%, respectively. Commercial non-interest checking accounts were assumed to decay at an annual rate of 7%. Callable investments were projected to be called at the first call date where the projected interest rate on similar remaining term advances exceeded the interest rate on the callable advance or investment.

 

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the Interest Spread) will remain constant over the interest changes disclosed in the table. Changes in Interest Spread could impact projected market value changes. Certain assets, such as ARMs, have features 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 which are approaching their lifetime interest rate caps could be different from the values disclosed in the table. 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 decrease in the event of a substantial sustained interest rate increase.

 

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 annual impact on net interest income during the 12 month period ending September 30, 2016 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

    $ 2,063       9.88

%

+100

      1,003       4.80  
  0       0       0.00  
  -100       (1,811 )     (8.67 )

 

 

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 more loans than deposits are scheduled to reprice in the next twelve months.

 

 
36

 

 

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 which meets frequently to discuss changes in the interest rate risk position and projected profitability. The Committee makes adjustments to the asset/liability position of the Bank, which 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 to assure attainment of the Board's objectives in the most 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 mix, 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 fixed rate loans were placed into the single family loan portfolio. Over the past several years, the Bank has primarily focused its fixed rate one-to-four family residential lending program on loans that are saleable to third parties and generally placed only those fixed rate loans that met certain risk characteristics into its loan portfolio. The Bank’s commercial loan production continues to emphasize adjustable rate loans with minimum interest rate floors; however, a majority of the commercial portfolio is comprised of fixed rate loans with an average maturity of less than five years.

 

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than commitments to originate, fund, and sell loans in the ordinary course of business.

 

Item 3: Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

 

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 judgments 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, 2014 and Forms 10-Q for the quarters ended March 31, 2015 and June 30, 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, 2014 and Form 10-Q for the quarters ended March 31, 2015 and June 30, 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: November 4, 2015

By:

/s/ Bradley Krehbiel

 

 

 

 Bradley Krehbiel, President and Chief Executive Officer

 

 

 

(Principal Executive Officer)

 

 

 

 

 

 

 Date: November 4, 2015 

By:

/s/ Jon Eberle

 

 

 

 Jon Eberle

 

 

 

 Senior Vice President, Chief Financial Officer, and Treasurer

 

    (Principal Financial Officer)  

 

 

 
39

 

 

HMN FINANCIAL, INC.

INDEX TO EXHIBITS

FOR FORM 10-Q

 

       

Sequential

       

Page Numbering

Regulation

   

Where Attached

S-K

   

Exhibits Are

Exhibit

   

Located in This

Number

 

Document Attached Hereto

Form 10-Q Report

         

3.1

 

Amended and Restated Certificate of Incorporation

Filed Electronically

       

31.1

 

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

Filed Electronically

       

31.2

 

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

Filed Electronically

       

32

 

Section 1350 Certifications of CEO and CFO

Filed Electronically

       

101

 

Financial statements from the Quarterly Report on Form 10-Q of the Company for the period ended September 30, 2015, filed with the SEC on November 4, 2015, formatted in Extensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at September 30, 2015 and December 31, 2014, (ii) the Consolidated Statements of Comprehensive Income for the Three Month and Nine Month Periods Ended September 30, 2015 and 2014, (iii) the Consolidated Statement of Stockholders’ Equity for the Nine Month Period Ended September 30, 2015, (iv) the Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014, and (v) Notes to Consolidated Financial Statements.

Filed Electronically

 

40