HMN FINANCIAL INC - FORM 10-K - EX-13 - EXHIBIT 13

Attached files

file	filename
EX-32 - EXHIBIT 32 - HMN FINANCIAL INC	ex32.htm
EX-31.2 - EXHIBIT 31.2 - HMN FINANCIAL INC	ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - HMN FINANCIAL INC	ex31-1.htm
EX-23 - EXHIBIT 23 - HMN FINANCIAL INC	ex23.htm
EX-21 - EXHIBIT 21 - HMN FINANCIAL INC	ex21.htm
EX-10.11 - EXHIBIT 10.11 - HMN FINANCIAL INC	ex10-11.htm
10-K - FORM 10-K - HMN FINANCIAL INC	hmnf20170216_10k.htm

Exhibit 13

Financial Highlights	1
Letter to Shareholders and Clients	2
Board of Directors	4
Five-year Consolidated Financial Highlights	5
Management Discussion and Analysis	6
Consolidated Financial Statements	27
Notes to Consolidated Financial Statements	31
Report of Independent Registered Public Accounting Firm	66
Other Financial Data	64
Selected Quarterly Financial Data	66
Common Stock Information	68
Corporate and Shareholder Information	Inside Back Cover
Directors and Officers	Inside Back Cover

HMN Financial, Inc. and Home Federal Savings Bank are headquartered in Rochester, Minnesota. Home Federal Savings Bank operates twelve full service offices in Minnesota located in Albert Lea, Austin, Eagan, Kasson (2), La Crescent, Rochester (4), Spring Valley and Winona; one full service office in Marshalltown, Iowa; and three loan origination offices in Minnesota located in Sartell, Owatonna, and Mankato and one loan origination office in Delafield, Wisconsin.

FINANCIAL HIGHLIGHTS

	At or For the Year Ended
Operating Results:	December 31,						Percentage
(Dollars in thousands, except per share data)	2016			2015			Change
Total interest income	$	27,349			21,453			27.5	%
Total interest expense		1,593			1,507			5.7
Net interest income		25,756			19,946			29.1
Provision for loan losses		(645	)		(164	)		(293.3	)
Net interest income after provision for loan losses		26,401			20,110			31.3
Fees and service charges		3,427			3,316			3.3
Loan servicing fees		1,108			1,046			5.9
Gain on sales of loans		2,618			1,964			33.3
Other non-interest income		1,048			1,327			(21.0	)
Total non-interest income		8,201			7,653			7.2
Total non-interest expense		24,130			23,196			4.0
Income before income tax expense		10,472			4,567			129.3
Income tax expense		4,122			1,611			155.9
Net income		6,350			2,956			114.8
Preferred stock dividends		0			(108	)		100.0
Net income available to common shareholders	$	6,350			2,848			123.0

Per Common Share Information:
Earnings per common share and common share equivalents
Basic	$	1.52			0.69
Diluted		1.34			0.61
Stock price (for the year)
High	$	18.55			12.92
Low		10.81			10.18
Close		17.50			11.55
Book value per common share		16.91			15.54
Closing price to book value		103.49	%		74.32	%

Financial Ratios:
Return on average assets		0.96	%		0.50	%		92.0	%
Return on average stockholders' equity		8.71			4.27			104.0
Net interest margin		4.11			3.56			15.4
Operating expenses to average assets		3.66			3.92			(6.6	)
Average stockholders’ equity to average assets		11.07			11.70			(5.4	)
Stockholders’ equity to total assets at year end		11.13			10.83			2.8
Non-performing assets to total assets		0.57			0.97			(41.2	)
Efficiency ratio		71.06			84.05			(15.5	)

Balance Sheet Data:	December 31,						Percentage
(Dollars in thousands)	2016			2015			Change
Total assets	$	682,023			643,161			6.0	%
Securities available for sale		78,477			111,974			(29.9	)
Loans held for sale		2,009			3,779			(46.8	)
Loans receivable, net		551,171			463,185			19.0
Deposits		592,811			559,387			6.0
Federal Home Loan Bank advances and other borrowings		7,000			9,000			(22.2	)
Stockholders’ equity		75,919			69,645			9.0
Home Federal Savings Bank regulatory capital ratios:
Common equity tier 1 capital		13.42	%		14.08	%		(4.7	)%
Tier 1 leverage		11.55			11.46			0.8
Tier 1 risk-based capital		13.42			14.08			(4.7	)
Total risk-based capital		14.68			15.35			(4.4	)

Letter to Shareholders and Clients

I am very proud to present you with our 2016 Annual Report. It reflects the hard work of a very dedicated group of employees and the patronage shown by our many loyal clients.

Net income for the year was $6.4 million and the return on stockholders' equity was 8.71%. While I am pleased with these bottom line results, I am especially pleased with the significant changes our balance sheet has undergone throughout the year, which I believe has positioned us to become a more profitable bank in the years to come.

While our total assets grew $39 million, or 6.1% during the year, our gross loan portfolio grew over $87 million, or 18.5%, during the same period. Most importantly, we grew in all four of the major loan categories – single family residential, commercial real estate, commercial business, and consumer, for the first time in over eight years. This growth was funded in part by a corresponding reduction in our lower-yielding investment portfolio. The asset growth and composition changes resulted in a $5.8 million increase in net interest income from the prior year.

Growth in deposits was another bright spot as the overall average deposits grew over $62 million in 2016 with all deposit account types showing growth during the year. Almost $43 million of the average deposit growth was related to the acquisitions we made during the past eighteen months, with the remaining growth related to organic deposit growth at our existing branches.

In April of 2016, we acquired certain assets and liabilities of the Albert Lea branch of Deerwood Bank. We were fortunate to find a branch in one of our existing markets that we could purchase without incurring significant increases in our overhead expense. The integration of client portfolios went very smoothly and the transition to servicing these deposits out of our existing branch facility helped make this office one of the largest community banks in that market.

2016 also marked the first full year of operation of the branches we acquired in Kasson, Minnesota in August of the prior year. This purchase has proven to be well timed and a very good fit for our Bank. Our new Kasson employees have done a remarkable job of transitioning their client base to Home Federal.

Other divisions of our Bank reported strong operating results as well. Our residential mortgage lending operation generated sales into the secondary market of $89.1 million in 2016 and recognized $2.1 million in gains on the sale of these loans. Our Small Business Administration (SBA) and United States Department of Agriculture (USDA) lenders also sold over $7.5 million in loans during the year recognizing a gain on sale of $0.5 million. Finally, Home Federal Investments Services, our wholly owned Bank subsidiary that offers our clients investment products and advice, reported record revenues and income for the year as well.

These results are due in large part to a major staffing upgrade we embarked on over the past three years. Our surveys of businesses and individuals in the markets we serve found that a growing number of prospective clients are disappointed with what they view as a general decline in the experience and authority levels of management at their local bank. For them, access to an experienced local manager, who has been given the authority to make a decision, is an important factor in determining where they choose to bank. We responded by training our local managers to offer all types and categories of Bank products while recruiting and retaining new talent where needed. While this staffing structure might be more expensive than the more common centralized approach, we are confident that it is an important point of differentiation in today’s competitive marketplace.

Our focus on credit quality continued during the year. Non-performing assets declined $2.3 million, or 37%, to $3.9 million at year-end. Our past due ratio as of year-end was less than 1%, while our reserve for problem loans was 1.80% of net total loans. Our improved asset quality positioned us to record a credit provision for loan loss during the year of $0.6 million.

At HMN, we believe our Company and our employees have a responsibility to give back to the local communities we serve. To that end, our employees collectively donated over 5,000 hours to local community service projects and nonprofits in 2016. Furthermore, Home Federal Savings Bank contributed almost $200,000 to various community projects, non-profits, and charities during the year.

I believe that our work in 2016 has positioned HMN to continue to grow and prosper in the coming years. Thank you for your support in making that happen.

Best Regards,

Brad Krehbiel

President/CEO

Board of Directors


	Dr. Hugh Smith Chairman of the Board	Bradley Krehbiel President and CEO




Allen Berning	Michael Bue	Bernard Nigon	Dr. Wendy Shannon


	Dr. Patricia Simmons	Mark Utz	Hans Zietlow

FIVE-YEAR CONSOLIDATED FINANCIAL HIGHLIGHTS


Selected Operations Data:	Year Ended December 31,
(Dollars in thousands, except per share data)	2016			2015			2014			2013			2012
Total interest income	$	27,349			21,453			20,613			22,983			30,816
Total interest expense		1,593			1,507			1,211			3,289			7,139
Net interest income		25,756			19,946			19,402			19,694			23,677
Provision for loan losses		(645	)		(164	)		(6,998	)		(7,881	)		2,544
Net interest income after provision for loan losses		26,401			20,110			26,400			27,575			21,133
Fees and service charges		3,427			3,316			3,458			3,513			3,325
Loan servicing fees		1,108			1,046			1,058			1,029			964
Gain on sales of loans		2,618			1,964			1,828			2,102			3,574
Other non-interest income		1,048			1,327			940			668			1,127
Total non-interest income		8,201			7,653			7,284			7,312			8,990
Total non-interest expense		24,130			23,196			21,403			22,623			24,670
Income before income tax expense		10,472			4,567			12,281			12,264			5,453
Income tax expense (benefit)		4,122			1,611			4,902			(14,406	)⁽¹⁾		132
Net income		6,350			2,956			7,379			26,670			5,321
Preferred stock dividends and discount		0			(108	)		(1,710	)		(2,068	)		(1,861	)
Net income available to common shareholders	$	6,350			2,848			5,669			24,602			3,460

Basic earnings per common share	$	1.52			0.69			1.40			6.15			0.88
Diluted earnings per common share		1.34			0.61			1.23			5.71			0.86

⁽¹⁾ Relates to the elimination of the deferred tax asset valuation reserve at December 31, 2013.

Selected Financial Condition Data:	December 31,
(Dollars in thousands, except per share data)	2016			2015			2014			2013			2012
Total assets	$	682,023			643,161			577,426			648,622			653,327
Securities available for sale		78,477			111,974			137,834			107,956			85,891
Loans held for sale		2,009			3,779			2,076			1,502			2,584
Loans receivable, net		551,171			463,185			365,113			384,615			454,045
Deposits		592,811			559,387			496,750			553,930			514,951
FHLB advances and other borrowings		7,000			9,000			0			0			70,000
Stockholders’ equity		75,919			69,645			76,013			85,675			60,834
Book value per common share		16.91			15.54			14.77			13.49			8.02

Number of full service offices		13			13			11			11			12
Number of loan origination offices⁽²⁾		3			3			2			1			1

Key Ratios: ⁽³⁾
Stockholders’ equity to total assets at year end		11.13	%		10.83	%		13.16	%		13.21	%		9.31	%
Average stockholders’ equity to average assets		11.07			11.70			13.25			10.77			8.81
Return on stockholders’ equity
(ratio of net income to average equity)		8.71			4.27			9.12			42.22			8.94
Return on assets
(ratio of net income to average assets)		0.96			0.50			1.21			4.55			0.79

⁽²⁾ The Company opened a 4^th loan origination office in Mankato, Minnesota on January 1, 2017.

⁽³⁾Average balances were calculated based upon amortized cost without the market value impact of ASC 320.

^{See accompanying notes to consolidated financial statements.}

This Annual Report, other reports filed by the Company with the Securities and Exchange Commission, and the Company’s proxy statement may contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intend,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to growing our core deposit relationships and loan balances, enhancing the financial performance and profitability of our core banking operations, improving credit quality, reducing non-performing assets, and generating improved financial results (including profitability); the adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for maintenance thereof; improvements in loan production; changes in the size of the Bank’s loan portfolio; the amount of the Bank’s non-performing assets and the appropriateness of the allowance therefor; anticipated future levels of the provision for loan losses; future losses on non-performing assets; the amount and composition of interest-earning assets; the amount and composition of interest-bearing liabilities; the availability of alternate funding sources; the payment of dividends by HMN; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer trust preferred securities held by the Bank; the ability of the Bank to pay dividends to HMN; the ability of HMN to pay the principal and interest payments on its third party note payable; the ability to remain well capitalized; and compliance by the Bank with regulatory standards generally (including the Bank’s status as “well-capitalized”) and other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement.

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 (FHLB); technological, computer-related or operational difficulties; results of litigation; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; international economic developments; the Company’s access to and adverse changes in securities markets; the market for credit related assets; the future operating results, financial condition, cash flow requirements and capital spending priorities of the Company and the Bank; the availability of internal and, as required, external sources of funding; acquisition integration costs; our ability to attract and retain employees; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filing on Forms 10-K and 10-Q with the Securities and Exchange Commission. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

All statements in this Annual Report, including forward-looking statements, speak only as of the date hereof, and we undertake no duty to update any of the forward-looking statements after the date of this Annual Report.

Overview

HMN Financial, Inc. (HMN or the Company) is the stock savings bank holding company for Home Federal Savings Bank (the Bank), which operates community banking and loan production offices in Minnesota, Iowa and Wisconsin. The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and other borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and composition of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company's net earnings are also affected by the generation of non-interest income, which consists primarily of gains from the sale of loans and real estate owned, fees for servicing loans, commissions on the sale of uninsured investment products, and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of salaries and benefits, occupancy expenses, provisions for loan losses, deposit insurance, amortization expense on mortgage servicing assets, data processing costs and income taxes. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single-family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings.

Critical Accounting Estimates

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

Allowance for Loan Losses and Related Provision

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

The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income and by receiving recoveries of previously charged off loans. The Company decreases its allowance by crediting the provision for loan losses. The current year activity in the allowance resulted in a credit to the loan loss provision. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio that have not been specifically identified. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.

Income Taxes

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

The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relate to the allowance for loan and real estate losses and state net operating loss carryforwards. For income tax purposes, only net charge-offs are deductible, not the entire provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies, and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the Company’s cumulative net income in the prior three year period, the ability to implement tax planning strategies to accelerate taxable income recognition, and the probability that taxable income will be generated in future periods. The Company could not currently identify any negative evidence. It is possible that future conditions may differ substantially from those anticipated in determining that no valuation allowance was required on deferred tax assets and adjustments may be required in the future.

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

Accounting for Loans Acquired in a Business Combination

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

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

Subsequent to the acquisition date, the methods utilized to estimate the required allowance for loan losses for these loans is similar to originated loans. See “Note 2 Acquisitions” and “Note 6 Allowance for Loan Losses and Credit Quality Information” in the Notes to Consolidated Financial Statements for more information regarding acquired loans.

Results of Operations

Comparison of 2016 with 2015

Net income was $6.4 million for 2016, an increase of $3.4 million compared to net income of $3.0 million for 2015. Net income available to common shareholders was $6.4 million for 2016, an increase of $3.6 million compared to net income available to common shareholders of $2.8 million for 2015. Diluted earnings per share for the year ended December 31, 2016 was $1.34, an increase of $0.73 per share compared to diluted earnings per share of $0.61 for the year ended December 31, 2015. The increase in net income for 2016 is due primarily to a $5.9 million increase in interest income as a result of an increase in the average interest-earning assets and a change in the composition of the average interest-earning assets held between the periods. Gain on sales of loans increased $0.7 million due to an increase in single family mortgage loan production and sales between the periods. The provision for loan losses decreased $0.5 million between the periods due to improvements in the credit quality of the commercial loan portfolio. These increases in income were partially offset by a $1.0 million increase in compensation expense due to annual increases in compensation and an increase in the number of employees related to the increased loan production. Income tax expense increased $2.5 million because of the increase in pre-tax income between the periods.

Net Interest Income

Net interest income was $25.8 million for 2016, an increase of $5.9 million, or 29.1%, from $19.9 million for 2015. Interest income was $27.3 million for 2016, an increase of $5.8 million, or 27.5%, from $21.5 million for 2015. Interest income increased between the periods because of an increase in the average interest-earning assets and a change in the composition of the average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets increased $67.3 million between the periods, the average interest-earning assets held in higher yielding loans increased $120.4 million and the amount of average interest-earning assets held in lower yielding cash and investments decreased $53.1 million between the periods. The yield on average interest-earning assets was also enhanced by $2.2 million, or 30 basis points, due to loan prepayment penalties, yield adjustments recognized on purchased loans, and interest payments received on non-accruing and previously charged off loans during 2016. Due to the decreasing amounts of interest payments receive on previously charged off loans that are available for recapture, the yield adjustments to interest income are anticipated to decrease significantly in 2017 from those experienced in 2016. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred because of an increase in loan originations and a reduction in loan payoffs between the periods. Average outstanding loans also increased $18.6 million between the periods as a result of the acquisitions that occurred in the third quarter of 2015 and the second quarter of 2016. The average yield earned on interest-earning assets was 4.36% for 2016, an increase of 53 basis points from 3.83% for 2015.

Interest expense was $1.6 million for 2016, an increase of $0.1 million, or 5.7%, compared to $1.5 million for 2015. Interest expense increased because of an increase in the average outstanding interest-bearing liabilities. The average rate paid on interest-bearing liabilities decreased 1 basis point between the periods because of the change in the composition of the average interest-bearing liabilities. While the average interest-bearing liabilities increased $62.9 million between the periods, the average amount held in lower rate checking and money market accounts increased $58.0 million and the average amount held in higher rate certificates of deposits and other borrowings increased $4.9 million between the periods. The increase in the average outstanding deposits between the periods was primarily due to the $42.9 million increase that occurred as a result of the acquisitions that occurred in the third quarter of 2015 and the second quarter of 2016. The average interest rate paid on interest-bearing liabilities was 0.28% for 2016 compared to 0.29% for 2015. Net interest margin (net interest income divided by average interest-earning assets) for 2016 was 4.11%, an increase of 55 basis points compared to 3.56% for 2015.

The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Non-accruing loans have been included in the average outstanding loan balance in the table as loans carrying a zero yield.

	Year Ended December 31,
	2016								2015								2014
(Dollars in thousands)	Average Outstanding Balance		Interest Earned/ Paid			Average Yield/ Rate			Average Outstanding Balance		Interest Earned/ Paid			Average Yield/ Rate			Average Outstanding Balance		Interest Earned/ Paid			Average Yield/ Rate
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities	$	1,631		58			3.56	%	$	3,274		116			3.54	%	$	3,726		164			4.40	%
Other marketable securities		84,528		1,289			1.52			130,806		1,881			1.44			119,484		1,269			1.06
Loans held for sale		3,046		126			4.14			2,507		87			3.47			1,557		58			3.73
Loans receivable, net^{(1) (2)}		513,974		25,774			5.01			394,086		19,302			4.90			369,571		18,929			5.12
FHLB stock		770		6			0.78			734		4			0.54			778		4			0.51
Other, including cash equivalents		23,337		96			0.41			28,544		63			0.22			79,373		189			0.24
Total interest-earning assets	$	627,286		27,349			4.36		$	559,951		21,453			3.83		$	574,489		20,613			3.59

Interest-bearing liabilities:
NOW accounts	$	85,440		50			0.06	%	$	76,136		17			0.02	%	$	71,666		14			0.02	%
Passbooks		71,728		62			0.09			55,273		42			0.08			47,200		32			0.07
Money market accounts		164,522		366			0.22			153,441		347			0.23			162,207		414			0.26
Certificate accounts		100,942		524			0.52			96,600		528			0.55			110,256		739			0.67
Brokered deposits		0		0			0.00			0		0			0.00			830		12			1.45
FHLB advances and other borrowings		9,374		591			6.30			9,225		573			6.21			0		0			0.00
Total interest-bearing liabilities	$	432,006							$	390,675							$	392,159
Noninterest checking		145,450								124,342								125,767
Other non-interest-bearing liabilities		1,434								985								924
Total interest-bearing liabilities and noninterest-bearing deposits	$	578,890		1,593			0.28	%	$	516,002		1,507			0.29	%	$	518,850		1,211			0.23	%
Net interest income				25,756								19,946								19,402
Net interest rate spread							4.08	%							3.54	%							3.35	%
Net earning assets	$	48,396							$	43,949							$	55,639
Net interest margin							4.11	%							3.56	%							3.38	%
Average interest-earning assets to average interest-bearing liabilities and noninterest-bearing deposits				108.36	%							108.52	%							110.72	%

⁽¹⁾ Tax exempt income was not significant; therefore, the yield was not presented on a tax equivalent basis for any of the years presented.

⁽²⁾ Calculated net of deferred loan fees, loan discounts, loans in process and loss reserves.

Net interest margin increased to 4.11% in 2016 from 3.56% in 2015 primarily because of a change in the composition of average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. The increases in the average yields earned was due to having larger average balances of higher earning loans and smaller average balances of lower earning cash and investments during 2016 when compared to 2015. The yield on average interest-earning assets was also enhanced $2.2 million, or 30 basis points, in 2016 due to loan prepayment penalties, yield adjustments recognized on purchased loans, and interest payments received on non-accruing and previously charged off loans. Average net earning assets increased from $43.9 million in 2015 to $48.4 million in 2016. The $4.5 million increase in net earning assets is due primarily to the net income earned in 2016.

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It quantifies the changes in interest income and interest expense related to changes in the average outstanding balances (volume) and those changes caused by fluctuating interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by current volume).

	Year Ended December 31,
	2016 vs. 2015									2015 vs. 2014
	Increase (Decrease) Due to									Increase (Decrease) Due to
(Dollars in thousands)	Volume ⁽¹⁾			Rate⁽¹⁾			Total Increase (Decrease)			Volume ⁽¹⁾			Rate⁽¹⁾			Total Increase (Decrease)
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities	$	(58	)		0			(58	)		(20	)		(28	)		(48	)
Other marketable securities		(665	)		73			(592	)		120			492			612
Loans held for sale		19			20			39			36			(7	)		29
Loans receivable, net		5,824			648			6,472			1,175			(802	)		373
Cash equivalents		(12	)		45			33			(121	)		(5	)		(126	)
FHLB stock		0			2			2			0			0			0
Total interest-earning assets	$	5,108			788			5,896			1,190			(350	)		840
Interest-bearing liabilities:
NOW accounts	$	1			32			33			1			1			2
Passbooks		12			8			20			5			5			10
Money market accounts		18			1			19			20			(86	)		(66	)
Certificates of deposit		26			(30	)		(4	)		(104	)		(107	)		(211	)
Brokered deposits		0			0			0			(12	)		0			(12	)
FHLB advances and other borrowings		16			2			18			0			573			573
Total interest-bearing liabilities		73			13			86			(90	)		386			296
Increase (decrease) in net interest income	$	5,035			775			5,810			1,280			(736	)		544

⁽¹⁾ For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate.

The following table sets forth the weighted average yields on the Company's interest-earning assets, the weighted average interest rates on interest-bearing liabilities and the interest rate spread between the weighted average yields and rates as of the date indicated. Non-accruing loans have been included in the average outstanding loan balances in the table as loans carrying a zero yield.

At December 31, 2016
Weighted average yield on:			Weighted average rate on:
Securities available for sale:
Mortgage-backed and related securities	3.51	%	NOW accounts	0.07	%
Other marketable securities	1.34		Passbooks	0.08
Loans held for sale	4.65		Money market accounts	0.24
Loans receivable, net	4.69		ICS/CDARS	0.28
Federal Home Loan Bank stock	0.50		Certificates of deposit	0.61
Other interest-earnings assets	0.75		Federal Home Loan Bank advances and other borrowings	6.50
Combined weighted average yield on interest-earning assets	4.14		Combined weighted average rate on interest-bearing liabilities	0.27
			Interest rate spread	3.87

Provision for Loan Losses

The provision for loan losses was ($0.6) million for the year ended December 31, 2016, a decrease of $0.4 million, from ($0.2) million for the year ended December 31, 2015. The provision for loan losses decreased between the periods primarily because of the decrease in the reserve percentages applied to certain risk rated loan categories as a result of an internal analysis performed. Total non-performing assets were $3.9 million at December 31, 2016, a decrease of $2.3 million, or 37.4%, from $6.2 million at December 31, 2015. Non-performing loans decreased $0.9 million and foreclosed and repossessed assets decreased $1.4 million during 2016.

A reconciliation of the allowance for loan losses for 2016 and 2015 is summarized as follows:


(Dollars in thousands)	2016			2015
Balance at January 1	$	9,709			8,332
Provision		(645	)		(164	)
Charge offs:
Commercial		(180	)		(69	)
Commercial real estate		(67	)		0
Consumer		(108	)		(105	)
Single-family		(66	)		(19	)
Recoveries		1,260			1,734
Balance at December 31	$	9,903			9,709

Specific allowance	$	988			1,009
General allowance		8,915			8,700
	$	9,903			9,709

The allowance for loan losses increased in 2016 when compared to 2015 primarily because of the increase in the loan portfolio between the periods.

Non-Interest Income

Non-interest income was $8.2 million for the year ended December 31, 2016, an increase of $0.5 million from $7.7 million for the year ended December 31, 2015.

The following table presents the components of non-interest income:


	Year ended December 31,						Percentage Increase (Decrease)
(Dollars in thousands)	2016		2015		2014		2016/2015			2015/2014
Fees and service charges	$	3,427		3,316		3,458		3.3	%		(4.1	)%
Loan servicing fees		1,108		1,046		1,058		5.9			(1.1	)
Gain on sales of loans		2,618		1,964		1,828		33.3			7.4
Other non-interest income		1,048		1,327		940		(21.0	)		41.2
Total non-interest income	$	8,201		7,653		7,284		7.2			5.1

The increase in non-interest income is primarily related to the $0.7 million increase in the gain on sales of loans due to an increase in single family loan originations and sales between the periods. Fees and service charges increased $0.1 million between the periods due primarily to an increase in debit card income. Loan servicing fees increased $0.1 million due to an increase in the loans serviced for others between the periods. These increases were partially offset by a $0.3 million decrease in other non-interest income because of a decrease in the gains realized on acquisitions between the periods.

Non-Interest Expense

Non-interest expense was $24.1 million for the year ended December 31, 2016, an increase of $0.9 million from $23.2 million for the year ended December 31, 2015. The following table presents the components of non-interest expense:

	Year ended December 31,								Percentage Increase (Decrease)
(Dollars in thousands)	2016			2015		2014			2016/2015			2015/2014
Compensation and benefits	$	14,764			13,733		13,332			7.5	%		3.0	%
(Gains) losses on real estate owned		(596	)		218		(1,194	)		(373.4	)		118.3
Occupancy and equipment		4,041			3,722		3,691			8.6			0.8
Data processing		1,161			1,020		1,011			13.8			0.9
Professional services		1,257			1,108		1,216			13.4			(8.9	)
Other		3,503			3,395		3,347			3.2			1.4
Total non-interest expense	$	24,130			23,196		21,403			4.0			8.4

Compensation expense increased $1.0 million between the periods due to annual increases in compensation and an increase in the number of employees between the periods because of the increased loan production. Occupancy and equipment expense increased $0.3 million because of increased software and equipment expenses. Other non-interest expense increased $0.1 million due primarily to an increase in loan related expenses as a result of the increase in loans originated between the periods. Data processing expense increased $0.1 million between the periods due to increased mobile and on-line banking costs. Other professional expenses increased $0.1 million primarily due to expenses related to the acquisition that occurred in the second quarter of 2016. These increases in non-interest expenses were partially offset by a $0.8 million increase in the gains on real estate owned between the periods primarily because of the gains that were recognized on the sale of two commercial properties during 2016.

Income Taxes

The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates, as previously discussed. Income tax expense was $4.1 million for the year ended December 31, 2016, an increase of $2.5 million, from $1.6 million for the year ended December 31, 2015. The increase in income tax expense between the periods is primarily related to the increase in pre-tax income in 2016 when compared to 2015.

Net Income Available to Common Shareholders

Net income available to common shareholders was $6.4 million for 2016, an increase of $3.6 million from the $2.8 million net income available to common shareholders for 2015. Basic earnings per common share for the year ended December 31, 2016 was $1.52, an increase of $0.83 from the basic earnings per common share of $0.69 for the year ended December 31, 2015. Diluted earnings per common share for the year ended December 31, 2016 was $1.34, an increase of $0.73 from diluted earnings per common share of $0.61 for the year ended December 31, 2015. Net income available to common shareholders and the basic and diluted earnings per common share increased primarily because of the increase in net income and a reduction in the dividends required to be paid on the outstanding Fixed Rate Cumulative Perpetual Preferred Stock Series A (the “Preferred Stock”) between the periods. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends were required to be paid on the Preferred Stock after that date.

Comparison of 2015 with 2014

Net income was $3.0 million for 2015, a decrease of $4.4 million, from $7.4 million for 2014. Net income available to common shareholders was $2.8 million for the year ended December 31, 2015, a decrease of $2.9 million, from net income available to common shareholders of $5.7 million for 2014. Diluted earnings per common share for the year ended December 31, 2015 was $0.61, a decrease of $0.62 compared to the diluted earnings per common share of $1.23 for the year ended December 31, 2014. The decrease in net income in 2015 is due primarily to a $6.8 million decrease in the credit provision for loan losses between the periods. The decrease in the credit provision was primarily because there was more commercial loan growth and fewer recoveries of previously charged off loans in 2015 when compared to 2014. Net income also decreased $1.4 million due to the change in the losses recognized on real estate owned between the periods. The increased losses in 2015 as compared to 2014 were primarily due to a large gain realized on the sale of a commercial property in 2014. These decreases in net income were partially offset by a $0.5 million increase in net interest income due to increases in outstanding loan balances and a $3.3 million decrease in income tax expense as a result of the decreased pre-tax income between the periods.

Net interest income was $19.9 million for 2015, an increase of $0.5 million, or 2.8%, from $19.4 million for 2014. Interest income was $21.5 million for 2015, an increase of $0.9 million, or 4.1%, from $20.6 million for 2014. Interest income increased between the periods primarily because of a change in the composition of average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. While the average interest-earning assets decreased $14.5 million between the periods, the average interest-earning assets held in higher yielding loans increased $25.5 million and the amount held in lower yielding cash and investments decreased $40.0 million between the periods. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred primarily because of an increase in loan originations and a reduction in loan payoffs between the periods. The Company also acquired $24.1 million of loans through an acquisition that occurred in the third quarter of 2015. The average yield earned on interest-earning assets was 3.83% for 2015, an increase of 24 basis points from 3.59% for 2014.

Interest expense was $1.5 million for the year ended December 31, 2015, an increase of $0.3 million, or 24.4%, from $1.2 million for 2014. Interest expense increased primarily because of the change in the composition of the average interest-bearing liabilities held, which resulted in an increase in the average rate paid between the periods. While the average interest-bearing liabilities decreased $2.8 million between the periods, the average amount held in higher rate advances and other borrowings increased $9.3 million, the average amount held in higher rate certificates of deposit decreased $14.5 million, and the average amount held in other lower rate checking and money market deposits increased $2.4 million between the periods. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Preferred Stock. Interest expense increases related to borrowing costs were partially offset by the lower interest rates paid on deposit accounts between the periods as a result of the low interest rate environment that continued to exist in 2015. The average interest rate paid on interest-bearing liabilities was 0.29% for 2015, an increase of 6 basis points from the 0.23% average interest rate paid in 2014. Net interest margin (net interest income divided by average interest-earning assets) for 2015 was 3.56%, an increase of 18 basis points, compared to 3.38% for 2014.

Net interest margin increased to 3.56% in 2015 from 3.38% in 2014 primarily because of a change in the composition of the average interest-earning assets held, which resulted in an increase in the average yields earned between the periods. The increases in the average yields earned due to having larger average balances of higher earning loans and smaller average balances of lower earning cash and investments was partially offset by an increase in the average rates paid on the average interest-bearing liabilities held between the periods. The increase in the average rates paid was primarily due to the $10.0 million holding company note payable that was funded in the first quarter of 2015 in connection with the redemption of all of the remaining Preferred Stock. Average net earning assets decreased $11.7 million to $43.9 million in 2015 compared to $55.6 million for 2014 primarily because the proceeds of the $10.0 million note payable that was funded in the first quarter of 2015 were used to redeem outstanding Preferred Stock.

The provision for loan losses was ($0.2 million) for the year ended December 31, 2015, an increase of $6.8 million, from ($7.0 million) for the year ended December 31, 2014. The credit provision for loan losses decreased primarily because there was more commercial loan growth, fewer credit rating upgrades, and fewer recoveries of previously charged off loans in 2015 when compared to 2014. The decrease in non-performing loans relates primarily to a commercial real estate development relationship that was upgraded to performing status during 2015 due to the improved financial performance of the project as a result of increased lot sales.

The allowance for loan losses increased in 2015 when compared to 2014 primarily because of the $99.3 million increase in the loan portfolio between the periods.

Non-interest income was $7.7 million for the year ended December 31, 2015, an increase of $0.4 million, compared to $7.3 million for the year ended December 31, 2014. The increase is primarily related to a gain of $0.3 million that was recognized on an acquisition that occurred in the third quarter of 2015. Gain on sales of loans increased $0.1 million, or 7.4%, between the periods primarily because of an increase in single-family loan originations and sales. Other non-interest income increased $0.1 million primarily due to an increase in income related to the sale of non-insured investment products. These increases in non-interest income were partially offset by a $0.1 million decrease in fees and service charges primarily because of a decrease in retail and commercial overdraft fees between the periods.

Non-interest expense was $23.2 million for the year ended December 31, 2015, an increase of $1.8 million, or 8.4%, from $21.4 million for the same period in 2014. Losses on real estate owned increased $1.4 million between the periods primarily because of a $1.0 million gain that was recognized on the sale of a single commercial property in 2014. Compensation expense increased $0.4 million between the periods primarily because of an increase in the expenses related to restricted stock awards and increased incentive accruals due to increased loan production. These increases in non-interest expense were partially offset by a decrease of $0.1 million in deposit insurance costs due primarily to a decrease in insurance rates between the periods.

The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities. Income tax expense was $1.6 million for the year ended December 31, 2015, a decrease of $3.3 million from $4.9 million for the same period in 2014. The decrease in income tax expense between the periods is primarily related to the decrease in pre-tax income in 2015 when compared to 2014.

Net income available to common shareholders was $2.8 million for 2015, a decrease of $2.9 million from the $5.7 million net income available to common shareholders in 2014. Basic earnings per common share for the year ended December 31, 2015 was $0.69, a decrease of $0.71 from the basic earnings per common share of $1.40 for the year ended December 31, 2014. Diluted earnings per common share for the year ended December 31, 2015 was $0.61, a decrease of $0.62 from diluted earnings per common share of $1.23 for the year ended December 31, 2014. The net income available to common shareholders and the basic and diluted earnings per common share decreased primarily because of the decrease in net income between the periods that was partially offset by a reduction in the dividends paid on the outstanding Preferred Stock. On February 17, 2015 the Company redeemed the final 10,000 shares of its outstanding Preferred Stock and, as a result, no dividends were required to be paid on the Preferred Stock after that date.

Financial Condition

Loans Receivable, Net

The following table sets forth the information on the Company's loan portfolio in dollar amounts and percentages before deductions for deferred fees and discounts and allowances for losses as of the dates indicated:

	December 31,
	2016						2015						2014					2013					2012
(Dollars in thousands)	Amount			Percent			Amount			Percent			Amount		Percent			Amount		Percent			Amount		Percent
Real Estate Loans:
One-to-four family	$	103,255			18.41	%	$	90,945			19.24	%	$	69,841		18.70	%	$	76,467		19.31	%	$	97,037		20.40	%
Multi-family		36,777			6.56			12,324			2.61			15,700		4.20			8,113		2.05			11,756		2.47
Commercial		230,955			41.18			196,926			41.65			163,365		43.73			178,486		45.06			220,721		46.39
Construction or development		31,348			5.59			38,103			8.05			12,603		3.37			7,851		1.98			12,430		2.61
Total real estate loans		402,335			71.74			338,298			71.55			261,509		70.00			270,917		68.40			341,944		71.87
Other Loans:
Consumer Loans:
Automobile		3,036			0.54			2,885			0.61			1,124		0.30			971		0.25			623		0.13
Home equity line		40,476			7.22			38,980			8.24			36,832		9.86			36,178		9.13			36,521		7.68
Home equity		16,302			2.91			14,782			3.13			12,420		3.33			11,629		2.94			11,390		2.39
Recreational vehicles		7,553			1.35			2,650			0.56			0		0.00			0		0.00			0		0.00
Other		5,916			1.05			5,118			1.08			4,549		1.22			4,645		1.17			5,441		1.15
Total consumer loans		73,283			13.07			64,415			13.62			54,925		14.71			53,423		13.49			53,975		11.35
Commercial business loans		85,176			15.19			70,106			14.83			57,122		15.29			71,709		18.11			79,854		16.78
Total other loans		158,459			28.26			134,521			28.45			112,047		30.00			125,132		31.60			133,829		28.13
Total loans		560,794			100.00	%		472,819			100.00	%		373,556		100.00	%		396,049		100.00	%		475,773		100.00	%
Less:
Unamortized discounts		20						16						14					33					33
Net deferred loan (costs) fees		(300	)					(91	)					97					0					87
Allowance for losses		9,903						9,709						8,332					11,401					21,608
Total loans receivable, net	$	551,171					$	463,185					$	365,113				$	384,615				$	454,045

In 2016, the Company’s loan portfolio increased because of an increase in the loan originations as a result of an improving economy and an increase in lending staff. The loan portfolio also increased $6.0 million as a result of the acquisition that occurred in the second quarter of 2016. Because of the enhanced lending staff and the improving economic conditions projected, it is anticipated that the size of our overall loan portfolio will continue to increase in 2017.

Single family real estate loans were $103.3 million at December 31, 2016, an increase of $12.4 million, compared to $90.9 million at December 31, 2015. Mortgage loan originations increased in 2016 as a result of additional mortgage lending staff and an increased emphasis on originating shorter term and adjustable rate mortgage loans that were placed into the portfolio. The majority of the longer term mortgage loans that were originated during the year continued to be sold into the secondary market and were not placed in the loan portfolio in order to manage the Company’s interest rate risk position. The increased origination of loans placed into the loan portfolio was the primary reason for the increase in the single family loan portfolio during 2016.

Multi-family real estate loans were $36.8 million at December 31, 2016, an increase of $24.5 million, compared to $12.3 million at December 31, 2015. The increase in multi-family real estate loans in 2016 is primarily the result of the $16.6 million in multi-family construction loans where the construction phase was completed and the loan was reclassified as a multi-family real estate loan. The origination of multi-family loans also increased between the periods.

Commercial real estate loans were $231.0 million at December 31, 2016, an increase of $34.1 million, compared to $196.9 million at December 31, 2015. Commercial business loans were $85.2 million at December 31, 2016, an increase of $15.1 million, compared to $70.1 million at December 31, 2015. Increased commercial loan production as a result of increased demand for commercial loans resulted in an increase in the commercial business and commercial real estate loan portfolios in 2016.

Construction or development loans were $31.3 million at December 31, 2016, a decrease of $6.8 million, compared to $38.1 million at December 31, 2015. The decrease was the net result of the following activity during 2016: $26.0 million in new construction loans originated, $2.7 million in advances on existing loans, $5.8 million in loans paid-off, and $29.7 million in loans moved to a permanent loan classification because the construction phase was completed.

Home equity lines of credit were $40.5 million at December 31, 2016, an increase of $1.5 million, compared to $39.0 million at December 31, 2015. The open-end home equity lines are generally written with an adjustable rate and a 10 year draw period which requires interest only payments followed by a 10 year repayment period which fully amortizes the outstanding balance. Closed-end home equity loans are written with fixed or adjustable rates with terms up to 15 years. Home equity loans were $16.3 million at December 31, 2016, an increase of $1.5 million, compared to $14.8 million at December 31, 2015. The increase in the open-end equity lines and closed-end equity loans is related primarily to an increase in originations between the periods.

Recreational vehicle loans were $7.6 million at December 31, 2016, an increase of $4.9 million, compared to $2.7 million at December 31, 2015. These loans have been made primarily to finance the recreational vehicle sales of a single dealer within the Bank’s market area and the increase in balances between the periods is due to an increase in originations.

Allowance for Loan Losses

The determination of the allowance for loan losses and the related provision is a critical accounting policy of the Company that is subject to significant estimates, as previously discussed. The current level of the allowance for loan losses is a result of management’s assessment of the risks within the portfolio based on the information obtained through the credit evaluation process. The Company utilizes a risk-rating system on non-homogenous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to adjust the allowance balance on the basis of these reviews.

Management actively monitors asset quality and, when appropriate, charges off loans against the allowance for loan losses. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the size of the allowance for loan losses.

The allowance for loan losses was $9.9 million, or 1.77% of gross loans at December 31, 2016, compared to $9.7 million, or 2.05% of gross loans at December 31, 2015. The allowance for loan losses increased primarily due to an $88.0 million increase in the loan portfolio between the periods. The increase in the allowance due to loan growth was partially offset by a decrease in the allowance due to lower reserve percentages being used for certain risk rated commercial loans between the periods as a result of an internal analysis of the most recent charge-off history that was performed during the year. The decrease in the allowance as a percentage of outstanding loans, from 2.05% of gross loans at December 31, 2015 to 1.77% of gross loans at December 31, 2016, reflects the improved credit quality of the loan portfolio between the periods.

The following table reflects the activity in the allowance for loan losses and selected statistics:

	December 31,
(Dollars in thousands)	2016			2015			2014			2013			2012
Balance at beginning of year	$	9,709			8,332			11,401			21,608			23,888
Provision for losses		(645	)		(164	)		(6,998	)		(7,881	)		2,544
Charge-offs:
Single family		(66	)		(19	)		(92	)		(200	)		(63	)
Consumer		(108	)		(105	)		(131	)		(484	)		(1,071	)
Commercial business		(180	)		(69	)		(55	)		(651	)		(2,464	)
Commercial real estate		(67	)		0			(936	)		(3,711	)		(5,719	)
Recoveries		1,260			1,734			5,143			2,720			4,493
Net recoveries (charge-offs)		839			1,541			3,929			(2,326	)		(4,824	)
Balance at end of year	$	9,903			9,709			8,332			11,401			21,608
Year-end allowance for loan losses as a percent of year end gross loan balance		1.77	%		2.05	%		2.23	%		2.88	%		4.54	%
Ratio of net loan (recoveries) charge-offs to average loans outstanding		(0.16	)		(0.36	)		(1.02	)		0.53			0.91

The following table reflects the allocation of the allowance for loan losses:

	December 31,
	2016						2015						2014						2013						2012
	Allocated Allowance as a % of Loan Category			Percent of Loans in Each Category to Total Loans			Allocated Allowance as a % of Loan Category			Percent of Loans in Each Category to Total Loans			Allocated Allowance as a % of Loan Category			Percent of Loans in Each Category to Total Loans			Allocated Allowance as a % of Loan Category			Percent of Loans in Each Category to Total Loans			Allocated Allowance as a % of Loan Category			Percent of Loans in Each Category to Total Loans
Single family		1.15	%		18.41	%		1.09	%		19.24	%		1.57	%		18.70	%		2.13	%		19.31	%		2.91	%		20.40	%
Commercial real estate		1.66			53.33			2.46			52.31			2.62			51.30			3.32			49.09			5.55			51.47
Consumer		2.20			13.07			1.86			13.62			1.84			14.71			2.07			13.49			2.12			11.35
Commercial business		2.53			15.19			2.05			14.83			2.11			15.29			3.08			18.11			5.08			16.78
Total		1.77			100.00	%		2.05			100.00	%		2.23			100.00	%		2.88			100.00	%		4.54			100.00	%

The allocated reserve percentages for commercial real estate decreased in 2016 due to the general improvement in the credit quality of the commercial real estate portfolio. The allocation of the allowance for loan losses for single family, commercial, and consumer loans increased due to an increase in the outstanding balances and changes in the types of loans held in these categories between the periods.

Allowance for Real Estate Losses

Real estate properties acquired or expected to be acquired through loan foreclosures are initially recorded at fair value less estimated selling costs. Management periodically performs valuations and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs. The balance in the allowance for real estate losses was $0.7 million at December 31, 2016 and $0.8 million at December 31, 2015.

Non-performing Assets

Loans are reviewed at least quarterly and if the collectability of any loan is doubtful, it is placed on non-accrual status. Loans are placed on non-accrual status when either principal or interest is 90 days or more past due, unless, in the judgment of management, the loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. Restructured loans include the Bank's troubled debt restructurings (TDRs) that involved forgiving a portion of interest or principal or making a loan at a rate materially less than the market rate to borrowers whose financial condition has deteriorated. Foreclosed and repossessed assets include assets acquired in settlement of loans. Total non-performing assets were $3.9 million at December 31, 2016, a decrease of $2.3 million, or 37.4%, from $6.2 million at December 31, 2015. Non-performing loans decreased $0.9 million and foreclosed and repossessed assets decreased $1.4 million during 2016. The following table sets forth the amounts and categories of non-performing assets (non-accrual loans and foreclosed and repossessed assets) in the Company’s portfolio:

	December 31,
(Dollars in thousands)	2016			2015			2014			2013			2012
Non-performing loans:
Single family	$	916			1,655			1,564			1,602			2,492
Commercial real estate		1,384			1,694			8,750			14,549			25,543
Consumer		630			786			486			737			300
Commercial business		343			46			120			608			1,640
Total		3,273			4,181			10,920			17,496			29,975
Foreclosed and repossessed assets:
Single family		0			48			50			0			1,595
Commercial real estate		611			1,997			3,053			6,898			9,000
Consumer		16			0			0			0			0
Total		627			2,045			3,103			6,898			10,595
Total non-performing assets	$	3,900		$	6,226		$	14,023		$	24,394		$	40,570
Total as a percentage of total assets		0.57	%		0.97	%		2.43	%		3.76	%		6.21	%
Total non-performing loans	$	3,273		$	4,181		$	10,920		$	17,496		$	29,975
Total as a percentage of total loans receivable, net		0.59	%		0.90	%		2.99	%		4.55	%		6.60	%
Allowance for loan losses to non-performing loans		302.56	%		232.22	%		76.30	%		65.17	%		72.09	%

Gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $0.6 million for 2016, $0.4 million for 2015, and $0.9 million for 2014. The amounts that were included in interest income on a cash basis for these loans were $0.4 million, $0.2 million, and $0.2 million, respectively.

At December 31, 2016, 2015 and 2014, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.3 million, $2.5 million, and $9.4 million, respectively. Had the loans performed in accordance with their original terms throughout 2016, 2015, and 2014, the Company would have recorded gross interest income of $0.6 million, $0.4 million, and $0.9 million, respectively. During 2016, 2015 and 2014 the Company recorded gross interest income of $0.4 million, $0.2 million, and $0.3 million, respectively.

For the loans that were modified in 2016, $0.2 million were unclassified and performing, and $1.7 million were non-performing at December 31, 2016. The increase in TDRs in 2016 relates primarily to one commercial relationship totaling $1.3 million that was downgraded from performing to non-performing status and was restructured during the year. Of the loans that were modified in 2016 and outstanding at December 31, 2016, $1.3 million related to loans secured by commercial real estate and $0.4 million related to first or second mortgages on single family property, and the remaining modifications related to other consumer or commercial business loans.

For the loans that were modified in 2015, $0.5 million were unclassified and performing, and $0.7 million were non-performing at December 31, 2015. The decrease in TDRs in 2015 relates primarily to a group of commercial development loans totaling $6.0 million that were upgraded to performing status and met the criteria to be removed from TDR classification during the year. Of the loans that were modified in 2015 and outstanding at December 31, 2015, $0.8 million related to loans secured by first or second mortgages on single family properties, and the remaining modifications related to other consumer or commercial business loans.

For the loans that had been modified in 2014, $0.1 million were unclassified and performing and $0.1 million were non-performing at December 31, 2014. The decrease in TDRs in 2014 relates primarily to two related commercial development loans totaling $3.5 million that were charged down to $2.5 million and paid off during the year. TDRs also decreased during the year by $1.4 million due to the paydown of six loans in an unrelated commercial development, as well as $1.0 million due to the payoff of a loan for another unrelated commercial development. Of the loans that were modified in 2014 and outstanding at December 31, 2014, $0.2 million related to loans secured by first or second mortgages on single family properties, and the remaining modifications related to other consumer loans.

The following table sets forth the amount of TDRs in the Company’s portfolio:

	December 31,
(Dollars in thousands)	2016		2015		2014		2013		2012
Single family	$	448		647		368		840		3,540
Commercial real estate		1,774		725		7,956		14,781		24,702
Consumer		709		732		571		697		1,814
Commercial business		369		415		555		1,074		1,614
Total TDRs		3,300		2,519		9,450		17,392		31,670

TDRs on accrual status		1,297		1,618		7,414		3,780		7,125
TDRs on non-accrual status		2,003		901		2,036		13,612		24,545
Total	$	3,300		2,519		9,450		17,392		31,670

In addition to the TDRs and the non-performing loans set forth in the table above of all non-performing assets, the Company may identify other potential problem loans. Potential problem loans are loans that are not in non-performing status, however, there are circumstances present to create doubt as to the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that the Company expects losses to occur but that management recognized a higher degree of risk associated with these loans. The level of potential problem loans is another predominant factor in determining the relative level of the allowance for loan losses. There were no potential problem loans identified by the Company as of December 31, 2016. The four loan relationships that are reported as potential problem loans at December 31, 2015 were $6.0 million in loans to two unrelated trucking companies and $0.5 million in loans secured by agricultural assets to two unrelated individuals. The three loan relationships reported as potential problem loans at December 31, 2014 were a $3.8 million loan to an educational institution, a $0.6 million loan to a small manufacturing business, and three loans totaling $0.3 million to a golf course.

Liquidity and Capital Resources

The Company attempts to manage its liquidity position so that the funding needs of borrowers and depositors are met timely and in a cost effective manner. Asset liquidity is the ability to convert assets to cash through the maturity or sale of the asset. Liability liquidity is the ability of the Bank to obtain retail, internet, or brokered deposits or to borrow funds from third parties such as the FHLB or the Federal Reserve Bank of Minneapolis.

The primary investing activities are the origination of loans and the purchase of securities. Principal and interest payments on loans and securities, along with the proceeds from the sale of loans held for sale, are the primary sources of cash for the Bank. Additional cash can be obtained by selling securities from the available for sale portfolio or by selling loans or mortgage servicing rights. Unpledged securities could also be pledged and used as collateral for additional borrowings with the FHLB or Federal Reserve Bank of Minneapolis to generate additional cash.

The primary financing activity is the attraction of retail and internet deposits. The Bank has the ability to borrow additional funds from the FHLB or Federal Reserve Bank of Minneapolis by pledging additional securities or loans, subject to applicable borrowing base and collateral requirements. See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on additional advances that could be drawn based upon existing collateral levels with the FHLB and the Federal Reserve Bank of Minneapolis.

The Bank's most liquid assets are cash and cash equivalents, which consist of short-term highly liquid investments with original maturities of less than three months that are readily convertible to known amounts of cash and interest-bearing deposits. The level of these assets is dependent on the operating, financing and investing activities during any given period.

Cash and cash equivalents at December 31, 2016 were $27.6 million, a decrease of $12.2 million, compared to $39.8 million at December 31, 2015. Net cash provided by operating activities during 2016 was $25.5 million. The Company conducted the following major investing activities during 2016: principal payments and maturity proceeds received on securities available for sale and FHLB stock were $139.2 million, purchases of securities available for sale and FHLB stock were $106.8 million, and the proceeds from the sale of premises and other real estate were $2.4 million. The Company also purchased premises and equipment of $1.6 million. Net loans receivable increased $89.6 million due primarily to increased loan originations. The Company completed a branch acquisition and received $6.1 million in net cash in connection with the transaction. Net cash used by investing activities during 2016 was $50.4 million. The Company conducted the following major financing activities during 2016: deposits increased $14.5 million, received proceeds from borrowings of $45.0 million and repaid borrowings of $47.0 million. Net cash provided by financing activities was $12.6 million for 2016.

The Bank has certificates of deposits from customers with outstanding balances of $57.8 million that mature during 2017. Based upon past experience, management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits that do not renew will be replaced with deposits from other customers or FHLB advances. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits.

The Bank has deposits of $61.9 million in checking and money market accounts of four customers that have individual relationship balances greater than $5.0 million. These funds may be withdrawn at any time, however, management anticipates that the majority of these deposits will remain on deposit with the Bank over the next twelve months. If these deposits are withdrawn, it is anticipated that they would be funded with available cash or replaced with deposits from other customers or FHLB advances. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits.

Dividends from the Bank have been the Company’s primary source of cash. The Bank is restricted under applicable federal banking law from paying dividends to the Company without prior notice to and non-objection of the applicable regulator. During 2016, the Bank paid dividends to the Company of $3.0 million and at December 31, 2016, the Company had $3.3 million in cash and other assets that could readily be turned into cash.

On February 17, 2015, the Company redeemed the final 10,000 shares of outstanding Preferred Stock. The Preferred Stock redemption was funded through a $10.0 million term loan to HMN from an unrelated third party that was evidenced by a promissory note. The interest payments on the note are due quarterly. The principal balance of the note bears interest at a rate of 6.50% and is payable in consecutive annual installments of $1.0 million on each December 15, beginning December 15, 2015, with the balance due on December 15, 2021.

The Company’s primary use of cash is the payment of principal and interest on the third party note payable and holding company level expenses, including the payment of director and management fees, legal expenses, and other regulatory costs. The Company does not anticipate that it will have on a stand-alone basis adequate liquid resources to make future interest and principal payments on its third party note payable and fund the Company-level expenses. The Company plans to continue to fund its liquidity needs through dividends from the Bank or by obtaining external capital. Provided that no default or event of default has occurred and is continuing, the Company may also, at its option, elect to defer payment of one installment of principal on the third party note payable otherwise due prior to the maturity date, in which event such installment will become due and payable on the maturity date.

Contractual Obligations and Commercial Commitments

The Company has certain obligations and commitments to make future payments under existing contracts. At December 31, 2016, the aggregate contractual obligations (excluding bank deposits) and commercial commitments were as follows:


	Payments Due by Period
(Dollars in thousands)	Total		Less than 1 Year		1-3 Years		4-5 Years		More than 5 Years
Contractual Obligations:
Total borrowings	$	7,000		1,000		2,000		4,000		0
Annual rental commitments under non- cancellable operating leases		5,856		843		1,452		1,380		2,181
Total contractual obligations	$	12,856		1,843		3,452		5,380		2,181

	Amount of Commitments Expiring by Period
Other Commercial Commitments:
Commercial lines of credit	$	50,229	26,523	9,282	9,414	5,010
Commitments to lend		31,831	9,797	4,736	7,220	10,078
Standby letters of credit		1,902	1,575	327	0	0
Total other commercial commitments	$	83,962	37,895	14,345	16,634	15,088

Regulatory Capital Requirements

Effective January 1, 2015 the capital requirements of the Company and the Bank were changed to implement the regulatory requirements of the Basel III capital reforms. The Basel III requirements, among other things, (i) apply a strengthened set of capital requirements to the Bank (the Company is exempt, pursuant to the Small Bank Holding Company Policy Statement (Policy Statement) described below), including requirements relating to common equity as a component of core capital, (ii) implement a “capital conservation buffer” against risk and a higher minimum tier 1 capital requirement, and (iii) revise the rules for calculating risk-weighted assets for purposes of such requirements. The rules made corresponding revisions to the prompt corrective action framework and include the capital ratios and buffer requirements which will be phased in incrementally, with full implementation scheduled for January 1, 2019. Failure by the Bank to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, both the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Management believes that, as of December 31, 2016, the Bank’s capital ratios were in excess of those quantitative capital ratio standards set forth under the prompt corrective action regulations. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can further adjust the requirement to be “well-capitalized” in the future. See “Note 17 Regulatory Capital” of the Notes to Consolidated Financial Statements for a table which reflects the Bank’s capital compared to these capital requirements.

In the second quarter of 2015, the FRB amended its Policy Statement, which exempted small bank holding companies from the above capital requirements, by raising the asset size threshold for determining applicability from $500 million to $1 billion. The Policy Statement was also expanded to include savings and loan holding companies that meet the Policy Statement’s qualitative requirements for exemption. The Company met the qualitative exemption requirements, and therefore, is exempt from the above capital requirements.

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

If the Company raises capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders and, if issued at less than the Company’s book value would dilute the per share book value of the Company’s common stock, dilute the Company’s earnings per share, and could result in a change of control of the Company and the Bank. New investors may also have rights, preferences and privileges senior to the Company’s current stockholders, which may adversely impact the Company’s current stockholders. The Company’s ability to raise additional capital through the issuance of equity securities, if deemed prudent, will depend on, among other factors, conditions in the capital markets at that time, which are outside of its control, and on the Company’s financial performance and plans. Accordingly, the Company may not be able to raise additional capital, if deemed prudent, on favorable economic terms, or other terms acceptable to it. If the Bank cannot satisfactorily address its capital needs as they arise, the Bank’s ability to maintain or expand its operations, maintain compliance with the regulatory capital requirements, to operate without additional regulatory or other restrictions, and its operating results, could be materially adversely affected.

Dividends

The declaration of dividends is subject to, among other things, the Company's financial condition and results of operations, the Bank's compliance with regulatory capital requirements and other regulatory restrictions, tax considerations, industry standards, economic conditions, general business practices and other factors. The Company has not made any dividend payments to common stockholders during the three year period ending December 31, 2016.

Under applicable federal banking laws and regulations, no dividends can be declared or paid by the Bank to the Company without notice to and non-objection from the applicable banking regulator. There is no assurance that the Bank and the Company would satisfy the applicable regulatory requirements necessary to effect any such dividends. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders. Further, any determination as to whether, when and in what amount to declare and pay any such dividends would be subject to the discretion of the boards of directors of the Bank and the Company and would depend on numerous factors including the results of operations, financial conditions, growth plans, and cash flow requirements of the Company and the Bank.

Impact of Inflation and Changing Prices

The impact of inflation is reflected in the increased cost of operations. Unlike most industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

New Accounting Pronouncements

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

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

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

In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this ASU affect all entities that measure credit losses on financial instruments including loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial asset that has a contractual right to receive cash that is not specifically excluded. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this ASU replace the incurred loss impairment methodology required in current GAAP with a methodology that reflects expected credit losses that requires consideration of a broader range of reasonable and supportable information to estimate credit losses. The amendments in this ASU will affect entities to varying degrees depending on the credit quality of the assets held by the entity, the duration of the assets held, and how the entity applies the current incurred loss methodology. The amendments in this ASU, for public business entities that are U. S. Securities and Exchange Commission (SEC) filers, are effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. All entities may adopt the amendments in the ASU early as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Amendments should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Management is in the process of evaluating the impact that the adoption of this ASU in the first quarter of 2020 will have on the Company’s consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The amendments in this ASU affect all entities that are required to present a statement of cash flows under Topic 230 and address the following eight specific cash flow issues: debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies; distributions received from equity method investees; beneficial interest in securitization transactions; and separately identifiable cash flows and application of the predominance principle. This ASU is intended to reduce diversity in practice and is effective for public business entities that are U. S. Securities and Exchange Commission (SEC) filers for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. Upon adoption, the amendments should be applied using a retrospective transition method to each period presented. The adoption of this ASU in the first quarter of 2018 is not anticipated to have a material impact on the Company’s consolidated financial statements.

Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure.

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

The Company utilizes a model that uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities under different interest rate changes.

The following table discloses the projected changes in market value to the Company’s interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on December 31, 2016.

	Market Value
(Dollars in thousands)
Basis point change in interest rates		-100		0		+100			+200
Total market-risk sensitive assets	$	686,536		673,175			660,259			647,134
Total market-risk sensitive liabilities		582,820		541,354			503,943			471,842
Off-balance sheet financial instruments		(256	)	0			(16	)		15
Net market risk	$	103,972		131,821			156,332			175,277
Percentage change from current market value		(21.13	%)	0.00	%		18.59	%		32.97	%

The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that were determined by management based upon their review of historical prepayment speeds and decay rates. Fixed rate loans were assumed to prepay at annual rates of between 2% and 40%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 7% and 53%, depending on the note rate and the period to maturity. Mortgage-backed securities were projected to have prepayments based upon the underlying collateral securing the instrument. All loan prepayments vary based on the note rate and period to maturity of the individual loans. Certificate accounts were assumed not to be withdrawn until maturity. Passbook and money market accounts were assumed to decay at annual rates of 19% and 7%, respectively. Non-interest checking and NOW accounts were assumed to decay at annual rates of 4% and 14%, respectively. Commercial non-interest checking and NOW accounts were assumed to decay at annual rates of 17% and 9%, respectively. Commercial MMDA accounts were assumed to decay at annual rates of 23%.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the interest spread) will remain constant over the interest changes disclosed in the table. Changes in interest spread could impact projected market value changes. Certain assets, such as ARMs, have features that restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets that are approaching their lifetime interest rate caps or floors could be different from the values calculated in the table. Certain liabilities, such as certificates of deposit, have fixed rates that restrict interest rate changes until maturity. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may also decrease in the event of a substantial sustained increase in interest rates.

Asset/Liability Management

The Company's management reviews the impact that changing interest rates will have on the net interest income projected for the twelve months following December 31, 2016 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on net interest income during the 12 month period ending December 31, 2017 of immediate interest rate changes called rate shocks:

(Dollars in thousands)
Rate Shock in Basis Points	Net Interest Change			Percent Change
+200	$	2,859			11.15	%
+100		1,408			5.49
0		0			0.00
-100		(1,441	)		(5.62	)

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

In an attempt to manage its exposure to changes in interest rates, management closely monitors interest rate risk. The Company has an Asset/Liability Committee that meets frequently to discuss changes in the interest rate risk position and projected profitability. The Committee makes adjustments to the asset-liability position of the Bank that are reviewed by the Board of Directors of the Bank. This Committee also reviews the Bank's portfolio, formulates investment strategies and oversees the timing and implementation of transactions as intended to assure attainment of the Bank's objectives in an effective manner. In addition, the Board reviews, on a quarterly basis, the Bank's asset/liability position, including simulations of the effect on the Bank's capital of various interest rate scenarios.

In managing its asset/liability mix, the Bank may, at times, depending on the relationship between long and short-term interest rates, market conditions and consumer preference, place more emphasis on managing net interest margin than on better matching the interest rate sensitivity of its assets and liabilities in an effort to enhance net interest income. Management believes that the increased net interest income resulting from a mismatch in the maturity of its asset and liability portfolios can, in certain situations, provide high enough returns to justify the increased exposure to sudden and unexpected changes in interest rates.

To the extent consistent with its interest rate spread objectives, the Bank attempts to manage its interest rate risk and has taken a number of steps to restructure its balance sheet in order to better match the maturities of its assets and liabilities. In the past, more long term fixed rate loans were placed into the single family loan portfolio. In recent years, the Bank has focused its 30 year fixed rate single family residential lending program on loans that are saleable to third parties and generally places only adjustable rate or shorter term fixed rate loans that meet certain risk characteristics into its loan portfolio. In addition, a significant portion of the Bank’s commercial loan production continues to be in adjustable rate loans that re-price every one, two, or three years.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business. See “Note 18 Financial Instruments with Off-Balance Sheet Risk” in the Notes to Consolidated Financial Statements for additional information. Management believes that the Company has sufficient liquidity to satisfy its off-balance sheet obligations.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)	December 31, 2016			December 31, 2015

ASSETS
Cash and cash equivalents	$	27,561			39,782
Securities available for sale:
Mortgage-backed and related securities (amortized cost $993 and $2,237)		1,005			2,283
Other marketable securities (amortized cost $78,846 and $110,092)		77,472			109,691
		78,477			111,974

Loans held for sale		2,009			3,779
Loans receivable, net		551,171			463,185
Accrued interest receivable		2,626			2,254
Real estate, net		611			2,045
Federal Home Loan Bank stock, at cost		770			691
Mortgage servicing rights, net		1,604			1,499
Premises and equipment, net		8,223			7,469
Goodwill		802			0
Core deposit intangible, net		454			393
Prepaid expenses and other assets		1,768			1,417
Deferred tax asset, net		5,947			8,673
Total assets	$	682,023			643,161

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits	$	592,811			559,387
Other borrowings		7,000			9,000
Accrued interest payable		236			242
Customer escrows		1,011			830
Accrued expenses and other liabilities		5,046			4,057
Total liabilities		606,104			573,516

Commitments and contingencies
Stockholders’ equity:
Serial-preferred stock: ($.01 par value) authorized 500,000 shares; issued shares 0		0			0
Common stock ($.01 par value): authorized 16,000,000; issued shares 9,128,662		91			91
Additional paid-in capital		50,566			50,388
Retained earnings, subject to certain restrictions		86,886			80,536
Accumulated other comprehensive loss		(820	)		(214	)
Unearned employee stock ownership plan shares		(2,223	)		(2,417	)
Treasury stock, at cost 4,639,739 and 4,645,769 shares		(58,581	)		(58,739	)
Total stockholders’ equity		75,919			69,645
Total liabilities and stockholders’ equity	$	682,023			643,161

See accompanying notes to consolidated financial statements.

Consolidated Statements of COMPREHENSIVE INCOME

Years ended December 31 (Dollars in thousands, except per share amounts)	2016			2015			2014
Interest income:
Loans receivable	$	25,900			19,389			18,987
Securities available for sale:
Mortgage-backed and related		58			116			164
Other marketable		1,289			1,881			1,269
Cash equivalents		96			63			189
Other		6			4			4
Total interest income		27,349			21,453			20,613

Interest expense:
Deposits		1,002			934			1,211
Federal Home Loan Bank advances and other borrowings		591			573			0
Total interest expense		1,593			1,507			1,211
Net interest income		25,756			19,946			19,402
Provision for loan losses		(645	)		(164	)		(6,998	)
Net interest income after provision for loan losses		26,401			20,110			26,400

Non-interest income:
Fees and service charges		3,427			3,316			3,458
Loan servicing fees		1,108			1,046			1,058
Gain on sales of loans		2,618			1,964			1,828
Other		1,048			1,327			940
Total non-interest income		8,201			7,653			7,284

Non-interest expense:
Compensation and benefits		14,764			13,733			13,332
(Gains) losses on real estate owned		(596	)		218			(1,194	)
Occupancy and equipment		4,041			3,722			3,691
Data processing		1,161			1,020			1,011
Professional services		1,257			1,108			1,216
Other		3,503			3,395			3,347
Total non-interest expense		24,130			23,196			21,403
Income before income tax expense		10,472			4,567			12,281
Income tax expense		4,122			1,611			4,902
Net income		6,350			2,956			7,379
Preferred stock dividends		0			(108	)		(1,710	)
Net income available to common shareholders	$	6,350			2,848			5,669
Other comprehensive (loss) income, net of tax		(606	)		204			256
Comprehensive income available to common shareholders	$	5,744			3,052			5,925
Basic earnings per common share	$	1.52			0.69			1.40
Diluted earnings per common share	$	1.34			0.61			1.23

See accompanying notes to consolidated financial statements.

Consolidated Statements of Stockholders’ Equity

												Accumulated			Unearned
												Other			Employee						Total
						Additional						Comprehensive			Stock						Stock-
	Preferred			Common		Paid-in			Retained			Income			Ownership			Treasury			holders’
(Dollars in thousands)	Stock			Stock		Capital			Earnings			(Loss)			Plan			Stock			Equity
Balance, December 31, 2013	$	26,000			91		51,175			72,211			(674	)		(2,804	)		(60,324	)		85,675
Net income										7,379												7,379
Other comprehensive income													256									256
Redemption of preferred stock		(16,000	)																			(16,000	)
Stock compensation tax benefits							1															1
Restricted stock awards							(1,262	)											1,262			0
Amortization of restricted stock awards							240															240
Preferred stock dividends										(1,785	)											(1,785	)
Earned employee stock ownership plan shares							53									194						247
Balance, December 31, 2014	$	10,000			91		50,207			77,805			(418	)		(2,610	)		(59,062	)		76,013
Net income										2,956												2,956
Other comprehensive income													204									204
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							447															447
Preferred stock dividends										(225	)											(225	)
Earned employee stock ownership plan shares							57									193						250
Balance, December 31, 2015	$	0			91		50,388			80,536			(214	)		(2,417	)		(58,739	)		69,645
Net income										6,350												6,350
Other comprehensive loss													(606	)								(606	)
Stock compensation expense							79															79
Restricted stock awards							(158	)											158			0
Amortization of restricted stock awards							177															177
Earned employee stock ownership plan shares							80									194						274
Balance, December 31, 2016	$	0			91		50,566			86,886			(820	)		(2,223	)		(58,581	)		75,919

See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31 (Dollars in thousands)	2016			2015			2014
Cash flows from operating activities:
Net income	$	6,350			2,956			7,379
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses		(645	)		(164	)		(6,998	)
Depreciation		850			706			576
Amortization of premiums (discounts), net		47			(3	)		18
Amortization of deferred loan fees		(1,011	)		(964	)		(340	)
Amortization of core deposit intangible		92			28			0
Amortization of purchased loan fair value adjustments		(529	)		(657	)		0
Amortization of mortgage servicing rights		601			555			517
Capitalized mortgage servicing rights		(706	)		(547	)		(316	)
Deferred income tax expense		3,128			1,722			4,566
Securities losses (gains), net		10			(6	)		0
(Gains) losses on sales of real estate and premises		(596	)		218			(1,194	)
Gain on sales of loans		(2,618	)		(1,964	)		(1,828	)
Proceeds from sales of loans held for sale		99,121			78,278			56,040
Disbursements on loans held for sale		(79,783	)		(69,941	)		(41,557	)
Amortization of restricted stock awards		177			447			240
Amortization of unearned ESOP shares		194			193			194
Earned ESOP shares priced above original cost		80			57			53
Stock option compensation expense		79			0			1
(Increase) decrease in accrued interest receivable		(265	)		(346	)		240
(Decrease) increase in accrued interest payable		(9	)		137			(53	)
Increase in other assets		(323	)		(239	)		(444	)
Increase (decrease) in other liabilities		999			302			(265	)
Other, net		270			52			515
Net cash provided by operating activities		25,513			10,820			17,344
Cash flows from investing activities:
Proceeds from sales of securities available for sale		20			10,951			0
Principal collected on securities available for sale		1,245			1,694			2,148
Proceeds collected on maturity of securities available for sale		136,145			175,070			125,000
Purchases of securities available for sale		(104,968	)		(144,069	)		(157,004	)
Purchase of Federal Home Loan Bank stock		(1,879	)		(2,152	)		0

Redemption of Federal Home Loan Bank stock		1,800		2,238		7
Proceeds from sales of real estate and premises		2,369		1,127		4,816
Net (increase) decrease in loans receivable		(89,570	)	(80,447	)	13,455
Gain on acquisition		0		(289	)	0
Acquisition payment (net of cash acquired)		6,080		4,816		0
Purchases of premises and equipment		(1,607	)	(803	)	(847	)
Net cash used by investing activities		(50,365	)	(31,864	)	(12,425	)
Cash flows from financing activities:
Increase (decrease) in deposits		14,468		15,375		(57,182	)
Redemption of preferred stock		0		(10,000	)	(16,000	)
Dividends paid to preferred stockholders		0		(225	)	(5,964	)
Proceeds from borrowings		45,000		65,000		0
Repayment of borrowings		(47,000	)	(56,000	)	0
Increase in customer escrows		163		42		175
Net cash provided (used) by financing activities		12,631		14,192		(78,971	)
Decrease in cash and cash equivalents		(12,221	)	(6,852	)	(74,052	)
Cash and cash equivalents, beginning of year		39,782		46,634		120,686
Cash and cash equivalents, end of year	$	27,561		39,782		46,634
Supplemental cash flow disclosures:
Cash paid for interest	$	1,599		1,358		1,264
Cash paid for income taxes		436		191		0
Supplemental noncash flow disclosures:
Loans transferred to loans held for sale		15,002		8,125		13,243
Transfer of loans to real estate		591		110		142

See accompanying notes to consolidated financial statements.

Notes to Consolidated Financial Statements

December 31, 2016, 2015 and 2014

NOTE 1 Description of the Business and Summary of Significant Accounting Policies

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production facilities in Minnesota, Iowa, and Wisconsin. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OIA), which does business as Home Federal Investment Services and offers financial planning products and services, and HFSB Property Holdings, LLC (HPH), which is currently inactive, but has acted in the past as an intermediary for the Bank in holding and operating certain foreclosed properties.

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

The Company evaluated subsequent events through the filing date of our annual 10-K with the Securities and Exchange Commission on March 10, 2017.

Use of Estimates

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates.

An estimate that is particularly susceptible to change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is appropriate to cover probable losses inherent in the portfolio at the date of the balance sheet. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require changes to the allowance based on their judgment about information available to them at the time of their examination.

Cash and Cash Equivalents

The Company considers highly liquid investments with original maturities of three months or less to be cash equivalents.

Securities

Securities are accounted for according to their purpose and holding period. The Company classifies its debt and equity securities in one of three categories:

Trading Securities

Securities held principally for resale in the near term are classified as trading securities and are recorded at their fair values. Unrealized gains and losses on trading securities are included in other income.

Securities Held to Maturity

Securities that the Company has the positive intent and ability to hold to maturity are reported at cost and adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities held to maturity reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established.

Securities Available for Sale

Securities available for sale consist of securities not classified as trading securities or as securities held to maturity. They include securities that management intends to use as part of its asset/liability strategy or that may be sold in response to changes in interest rates, changes in prepayment risk, or similar factors. Unrealized gains and losses, net of income taxes, are reported as a separate component of stockholders’ equity until realized. Gains and losses on the sale of securities available for sale are determined using the specific identification method and recognized on the trade date. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized losses on securities available for sale reflecting a decline in value judged to be other than temporary are charged to income and a new cost basis is established.

Management monitors the investment security portfolio for impairment on an individual security basis and has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves analyzing the length of time and extent to which the fair value has been less than the amortized cost basis, the market liquidity for the security, the financial condition and near-term prospects of the issuer, expected cash flows, and the Company's intent and ability to hold the investment for a period of time sufficient to recover the temporary loss, including determining whether it is more-likely-than-not that the Company will be required to sell the security prior to recovery. To the extent it is determined that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized.

Loans Held for Sale

Mortgage loans originated or purchased which are intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net fees and costs associated with acquiring or originating loans held for sale are deferred and included in the basis of the loan in determining the gain or loss on the sale of the loans. Gains on the sale of loans are recognized on the settlement date. Net unrealized losses are recognized through a valuation allowance by charges to income.

Loans Receivable, net

Loans receivable, net, are carried at amortized cost. Loan origination fees received, net of certain loan origination costs, are deferred as an adjustment to the carrying value of the related loans, and are amortized into income using the interest method over the estimated life of the loans.

Premiums and discounts on purchased participation loans are amortized into interest income using the interest method over the period to contractual maturity, adjusted for estimated prepayments.

The allowance for loan losses is based on a periodic analysis of the loan portfolio and is maintained at an amount considered to be appropriate by management to provide for probable losses inherent in the loan portfolio as of the balance sheet dates. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, actual and anticipated changes in the size of the portfolios, national and regional economic conditions (such as unemployment data, loan delinquencies, local economic conditions, demand for single-family homes, demand for commercial real estate and building lots), loan portfolio composition, historical loss experience, and observations made by the Company's ongoing internal audit and regulatory exam processes. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties or other collateral securing classified loans. Appraisals on collateral dependent commercial real estate and commercial business loans are obtained when it is determined that the borrower’s risk profile has deteriorated and the loan is classified as impaired. Subsequent new third party appraisals of properties securing impaired commercial real estate and commercial business loans are prepared at least every two years. For all land development loan types, a new third party appraisal is prepared on an annual basis where current activity is not consistent with the assumptions made in the most recent third party appraisal. Non-performing residential and consumer home equity loans and home equity lines may have a third party appraisal or an internal evaluation completed depending on the size of the loan and location of the property. These appraisals, or internal valuations, are generally completed when a residential or consumer home equity loan or home equity line of credit becomes 120 days past due and are typically updated after possession of the property is obtained. Valuations are reviewed on a quarterly basis and adjustments are made to the allowance for loan losses for temporary impairments and charge-offs are taken when the impairment is determined to be permanent. The fair market value of the properties for all loan types are adjusted for estimated selling costs in order to determine the net realizable value of the properties. The allowance for loan losses is established for known problem loans, as well as for loans which are not currently known to require an allowance. Loans are charged off to the extent they are deemed to be uncollectible. The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans are typically based on the appraised value of the property less estimated selling costs. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income and decreases its allowance by crediting the provision for loan losses. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio that have not been specifically identified.

Interest income is recognized on an accrual basis except when collectability is in doubt. When loans are placed on a non-accrual basis, generally when the loan is 90 days past due, previously accrued but unpaid interest is reversed from income. If the ultimate collectability of a loan is in doubt and the loan is placed in nonaccrual status, the cost recovery method is used and cash collected is applied to first reduce the principal outstanding. Generally, the Company returns a loan to accrual status when all delinquent interest and principal becomes current under the terms of the loan agreement and collectability of remaining principal and interest is no longer doubtful. Previously collected interest payments that were applied to principal when the loan was classified as non-accrual are recorded as interest income using the effective yield method over the estimated life of the loan, including expected renewal terms.

All impaired loans are valued at the present value of expected future cash flows discounted at the loan's initial effective interest rate. The fair value of the collateral of an impaired collateral-dependent loan or an observable market price, if one exists, may be used as an alternative to discounting. If the value of the impaired loan is less than the recorded investment in the loan, the impaired amount is charged off. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all loans which are on non-accrual, delinquent as to principal and interest for 90 days or greater, or restructured in a troubled debt restructuring (TDR) involving a modification of terms. All non-accruing loans are reviewed for impairment on an individual basis.

Included in loans receivable, net, are certain loans that have been modified in order to maximize collection of the loan balances. The Company evaluates all loan modifications and if the Company, for legal or economic reasons related to the borrower's financial difficulties, grants a concession compared to the original terms and conditions of the loan that the Company would not otherwise consider, the modified loan is considered a TDR and is classified as an impaired loan. If the TDR loan was performing (accruing) prior to the modification, it typically will remain accruing after the modification as long as it continues to perform according to the modified terms. If the TDR loan was non-performing (non-accruing) prior to the modification, it will remain non-accruing after the modification for a minimum of six months. If the loan performs according to the modified terms for a minimum of six months, it typically will be returned to accruing status. In general, there are two conditions in which a TDR loan is no longer considered to be a TDR and potentially not classified as impaired. The first condition is whether the loan is refinanced with terms that reflect normal market terms for the type of credit involved. The second condition is whether the loan is repaid or charged off.

Purchased Loans Acquired Through Business Combinations

Purchased loans acquired in a business combination, including loans that have evidence of deterioration of credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments, are initially recorded at fair value as determined by the present value of expected future cash flows with no valuation allowance. The difference between the undiscounted cash flows expected at acquisition and the investment in the loan is an accretable yield adjustment and is recognized as interest income using the effective yield method over the life of the loan. Contractually required payments for principal and interest that exceed the undiscounted cash flows expected at acquisition is a nonaccretable difference and is not recognized as a yield adjustment, loss accrual, or a valuation allowance. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through an adjustment of the yield on the loan over its remaining life. Decreases in expected cash flows after the loan is acquired are recognized as an impairment and charged to the provision for loan losses.

Transfers of Financial Assets and Participating Interests

Transfers of an entire financial asset or a participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

The transfer of a participating interest in an entire financial asset must also meet the definition of a participating interest. A participating interest in a financial asset has all of the following characteristics: (1) from the date of transfer, it must represent a proportionate (pro rata) ownership interest in the financial asset, (2) from the date of transfer, all cash flows received, except any cash flows allocated as any compensation for servicing or other services performed, must be divided proportionately among participating interest holders in the amount equal to their share ownership, (3) the rights of each participating interest holder must have the same priority, and (4) no party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to do so.

Real Estate, net

Real estate acquired through loan foreclosure or deed in lieu of foreclosure, is initially recorded at its fair value less estimated selling costs. Third party appraisals are obtained as soon as practical after obtaining possession of the property. Valuations are reviewed quarterly by management and an allowance for losses is established if the carrying value of a property exceeds its fair value less estimated selling costs.

Mortgage Servicing Rights, net

Mortgage servicing rights are capitalized at fair value and amortized in proportion to, and over the period of, estimated net servicing income. The Company evaluates its capitalized mortgage servicing rights for impairment each quarter. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. Any impairment is recognized through a valuation allowance.

Premises and Equipment, net

Land is carried at cost. Office buildings, improvements, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is computed on a straight-line basis over estimated useful lives of 5 to 40 years for office buildings and improvements and 3 to 10 years for furniture and equipment.

Goodwill

The Company records goodwill for acquisition amounts paid in excess of the net assets purchased. Goodwill is not amortized, but is tested for impairment at least annually or more frequently if there are indications of impairment.

Core Deposit Intangible, net

The Company records the estimated fair value of the deposit base acquired in an acquisition as a core deposit intangible asset. The recorded amount is amortized on a straight line basis over the estimated life of the deposits acquired.

Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of

The Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Stock Based Compensation

The Company recognizes the grant-date fair value of stock option and restricted stock awards issued as compensation expense, amortized over the vesting period.

Employee Stock Ownership Plan (ESOP)

The Company has an ESOP that borrowed funds from the Company and purchased shares of HMN common stock. The Company makes quarterly principal and interest payments on the ESOP loan. As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral based on the proportion of debt service paid in the year and then allocated to eligible employees. The Company accounts for its ESOP in accordance with ASC 718, Employers' Accounting for Employee Stock Ownership Plans. Accordingly, the shares pledged as collateral are reported as unearned ESOP shares in stockholders' equity. As shares are determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations.

Income Taxes

Deferred tax assets and liabilities are recognized for future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. A valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax asset is subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence regarding the ultimate realizability of deferred tax assets.

Earnings per Common Share

Basic earnings per common share excludes dilution and is computed by dividing the income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that shared in the earnings of the entity.

Comprehensive Income

Comprehensive income is defined as the change in equity during a period from transactions and other events from non-owner sources. Comprehensive income is the total of net income and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale.

Segment Information

The amount of each segment item reported is the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an enterprise’s general-purpose financial statements and allocations of revenues, expenses and gains or losses are included in determining reported segment profit or loss if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets that are included in the measure of the segment’s assets that are used by the chief operating decision maker are reported for that segment.

New Accounting Pronouncements

Derivative Financial Instruments

The Company uses derivative financial instruments in order to manage the interest rate risk on residential loans held for sale and its commitments to extend credit for residential loans. The Company may also from time to time use interest rate swaps to manage interest rate risk. Derivative financial instruments include commitments to extend credit and forward mortgage loan sales commitments.

Reclassifications

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

NOTE 2 Acquisitions

The Company records purchased assets and liabilities at their fair market value at the time of purchase in accordance with the requirements of ASU 805 - Business Combinations. On April 8, 2016, the Bank completed the acquisition of loans and assumption of liabilities of the Deerwood Bank branch in Albert Lea, Minnesota. The transaction increased the Bank’s assets by $19.0 million, including increases in loans, cash, goodwill, and core deposit intangible of $11.9 million, $6.1 million, $0.8 million, and $0.2 million, respectively. The Bank also assumed deposit liabilities of $19.0 million. The acquired loans and deposits are being serviced from Home Federal’s existing branch location at 143 West Clark Street, Albert Lea, Minnesota.

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

Determining the estimated fair value of the acquired assets and assumed liabilities required the Bank to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of those determinations related to the fair valuation of the loans acquired, which management considers to be a critical accounting estimate that involves significant estimates and assumptions. The fair value of the loans purchased was based on the present value of the expected cash flows. Periodic principal and interest cash flows were adjusted for expected losses and prepayments, then discounted to determine the present value and summed to arrive at the estimated fair value. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and other factors, such as prepayments. In accordance with GAAP, there was no carry-over of previously established allowances for loan losses established on the seller’s records. As a result, standard industry coverage ratios with regard to the allowance for credit losses are less meaningful after the acquisitions. The purchased loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC topic 310-30 (purchased credit impaired (PCI)) and loans that do not meet this criteria, which are accounted for under ASC topic 310-20 (performing). PCI loans have experienced a deterioration of credit quality from origination to acquisition for which it is probable that the Bank will not be able to collect all contractually required principal and interest payments on the loan. Subsequent decreases in the expected cash flows require the Bank to evaluate the need for additions to the allowance for credit losses. Subsequent improvements in expected cash flows generally result in a reduction of previously established allowance for credit losses or the recognition of additional interest income over the remaining lives of the loans.

NOTE 3 Other Comprehensive (Loss) Income

The components of other comprehensive (loss) income and the related tax effects were as follows:

	For the years ended December 31,
	2016									2015						2014
(Dollars in thousands)	Before Tax			Tax Effect			Net of Tax			Before Tax		Tax Effect		Net of Tax		Before Tax		Tax Effect			Net of Tax
Securities available for sale:
Gross unrealized (losses) gains arising during the period.	$	(1,016	)		(404	)		(612	)		344		137		207		38		(218	)		256
Less reclassification of net (losses) gains included in net income		(10	)		(4	)		(6	)		6		3		3		0		0			0
Net unrealized (losses) gains arising during the period		(1,006	)		(400	)		(606	)		338		134		204		38		(218	)		256
Other comprehensive (loss) income	$	(1,006	)		(400	)		(606	)		338		134		204		38		(218	)		256

The tax effect in 2014 includes the impact of the reversal of certain deferred tax asset valuation reserve components that reversed in 2014 as a result of the changes that occurred in the investment portfolio during the year.

NOTE 4 Securities Available for Sale

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

(Dollars in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses			Fair value
December 31, 2016
Mortgage-backed securities:
Federal Home Loan Mortgage Corporation (FHLMC)	$	327		10		0			337
Federal National Mortgage Association (FNMA)		295		7		0			302
Collateralized mortgage obligations:
FHLMC		371		0		(5	)		366
		993		17		(5	)		1,005
Other marketable securities:
U.S. Government agency obligations		74,979		16		(1,079	)		73,916
Municipal obligations		2,819		0		(20	)		2,799
Corporate obligations		290		2		0			292
Corporate preferred stock		700		0		(350	)		350
Corporate equity		58		57		0			115
		78,846		75		(1,449	)		77,472
	$	79,839		92		(1,454	)		78,477

December 31, 2015
Mortgage-backed securities:
FHLMC	$	728		31		0			759
FNMA		725		22		0			747
Collateralized mortgage obligations:
FHLMC		742		2		(1	)		743
Other		42		0		(8	)		34
		2,237		55		(9	)		2,283
Other marketable securities:
U.S. Government agency obligations		105,003		68		(129	)		104,942
Municipal obligations		3,991		18		(7	)		4,002
Corporate obligations		340		0		(6	)		334
Corporate preferred stock		700		0		(350	)		350
Corporate equity		58		5		0			63
		110,092		91		(492	)		109,691
	$	112,329		146		(501	)		111,974

In 2016, the Company sold $20,000 of available for sale securities and recognized a loss of $10,000 on the sales.

In 2015, the Company sold $11.0 million of available for sale securities and recognized a gain of $6,000 on the sales. The Company did not sell any available for sale securities and did not recognize any gains or losses on investments in 2014.

The following table presents the amortized cost and estimated fair value of securities available for sale at December 31, 2016, based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates. Actual maturities may differ from the maturities in the following table because obligors may have the right to call or prepay obligations with or without call or prepayment penalties:

(Dollars in thousands)	Amortized Cost		Fair Value
Due one year or less	$	15,561		15,358
Due after one year through five years		63,144		62,282
Due after five years through ten years		263		261
Due after ten years		813		461
No stated maturity		58		115
Total	$	79,839		78,477

The allocation of mortgage-backed securities in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds.

The following table shows the gross unrealized losses and fair values for the securities available for sale portfolio aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2016 and 2015:

	Less Than Twelve Months							Twelve Months or More							Total
(Dollars in thousands)	# of Investments		Fair Value		Unrealized Losses			# of Investments		Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
December 31, 2016
Collateralized mortgage obligations:
FNMA		1	$	262		(3	)		1	$	104		(2	)	$	366		(5	)
Other marketable securities:
U.S. Government agency obligations		13		63,896		(1,079	)		0		0		0			63,896		(1,079	)
Municipal obligations		14		2,327		(19	)		2		214		(1	)		2,541		(20	)
Corporate preferred stock		0		0		0			1		350		(350	)		350		(350	)
Total temporarily impaired securities		28	$	66,485		(1,101	)		4	$	668		(353	)	$	67,153		(1,454	)


December 31, 2015
Collateralized mortgage obligations:
FNMA		1	$	346		(1	)		0	$	0		0		$	346		(1	)
Other		2		34		(8	)		0		0		0			34		(8	)
Other marketable securities:
U.S. Government agency obligations		9		44,878		(129	)		0		0		0			44,878		(129	)
Municipal obligations		12		2,010		(7	)		0		0		0			2,010		(7	)
Corporate obligations		1		334		(6	)		0		0		0			334		(6	)
Corporate preferred stock		0		0		0			1		350		(350	)		350		(350	)
Total temporarily impaired securities		25	$	47,602		(151	)		1	$	350		(350	)	$	47,952		(501	)

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss. The unrealized losses on U.S. Government agency obligations are the result of changes in interest rates. The unrealized losses reported for the corporate preferred stock at December 31, 2016 relates to a single trust preferred security that was issued by the holding company of a small community bank. Typical of most trust preferred issuances, the issuer has the ability to defer interest payments for up to five years with interest payable on the deferred balance. In September 2014, the issuer paid all deferred interest that was due and all payments were current as of September 30, 2014. Since January 2015, the issuer has deferred its scheduled interest payments as allowed by the terms of the security agreement. The issuer’s subsidiary bank has generated modest net income amounts over the past several years and met the regulatory requirements to be considered “well capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at December 31, 2016. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

NOTE 5 Loans Receivable, Net

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

(Dollars in thousands)	2016			2015
Residential real estate loans:
Single family conventional	$	103,125			90,587
Single family FHA		92			206
Single family VA		38			152
		103,255			90,945
Commercial real estate:
Lodging		43,285			27,428
Retail/office		53,935			45,097
Nursing home/health care		8,185			9,183
Land developments		24,240			21,272
Golf courses		1,560			4,163
Restaurant/bar/café		5,851			5,854
Alternative fuel plants		0			2,205
Warehouse		26,630			18,337
Construction:
Single family builder		21,944			15,152
Multi-family		2,610			18,865
Commercial real estate		6,794			4,086
Manufacturing		15,743			11,585
Churches/community service		10,199			8,195
Multi-family		36,777			12,324
Other		41,327			43,607
		299,080			247,353
Consumer:
Autos		3,036			2,885
Home equity line		40,476			38,980
Home equity		16,302			14,782
Other – secured		2,048			2,031
Recreational vehicles		7,553			2,650
Land/lots		2,362			1,144
Other – unsecured		1,506			1,943
		73,283			64,415

Commercial business		85,176			70,106
Total loans		560,794			472,819
Less:
Unamortized discounts		20			16
Net deferred loan costs		(300	)		(91	)
Allowance for loan losses		9,903			9,709
Total loans receivable, net	$	551,171			463,185
Commitments to originate or purchase loans	$	47,220			27,184
Commitments to deliver loans to secondary market	$	9,595			8,071
Weighted average contractual rate of loans in portfolio		4.45	%		4.54	%

Included in total commitments to originate or purchase loans are fixed rate loans aggregating $29.6 million and $22.3 million as of December 31, 2016 and 2015, respectively. The interest rates on these loan commitments ranged from 2.75% to 5.125% at December 31, 2016 and from 3.00% to 5.49% at December 31, 2015.

The aggregate amount of loans to executive officers and directors of the Company was $0.2 million, $2.7 million and $2.8 million at December 31, 2016, 2015 and 2014, respectively. During 2016, there was no activity on loans to executive officers and directors other than the $2.5 million in loans that were reclassified during the period due to a change in borrower classification. During 2015, repayments on loans to executive officers and directors were $0.1 million, new loans to executive officers and directors totaled $0.2 million, and loans closed or paid off were $0.2 million. During 2014, repayments on loans to executive officers and directors were $0.1 million, new loans to executive officers and directors totaled $0.2 million, sales of executive officer and director loans were $0.2 million, and loans reclassified were $0.2 million. All loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated parties.

At December 31, 2016, 2015 and 2014, the Company was servicing loans for others with aggregate unpaid principal balances of approximately $425.5 million, $391.9 million and $379.7 million, respectively.

The Company originates residential, commercial real estate and other loans primarily in Minnesota, Wisconsin, and Iowa. At December 31, 2016 and 2015, the Company had in its portfolio single-family residential loans located in the following states:

	2016					2015
(Dollars in thousands)	Amount		Percent of Total			Amount		Percent of Total
Iowa	$	4,470		4.3	%	$	5,387		5.9	%
Minnesota		87,135		84.4			75,417		82.9
Missouri		1,206		1.2			918		1.0
Wisconsin		8,779		8.5			7,956		8.8
Other states		1,665		1.6			1,267		1.4
Total	$	103,255		100.0	%	$	90,945		100.0	%
Amounts under one million dollars in both years are included in “Other states”.

At December 31, 2016 and 2015, the Company had in its portfolio commercial real estate loans located in the following states:

	2016					2015
(Dollars in thousands)	Amount		Percent of Total			Amount		Percent of Total
Alabama	$	1,902		0.7	%	$	2,056		0.8	%
Florida		3,781		1.3			3,738		1.5
Idaho		3,529		1.2			3,678		1.5
Indiana		2,189		0.7			4,608		1.9
Iowa		1,973		0.7			1,106		0.4
Minnesota		213,983		71.5			184,670		74.7
North Carolina		2,926		1.0			4,203		1.7
North Dakota		8,447		2.8			7,979		3.2
Tennessee		1,036		0.3			260		0.1
Wisconsin		57,512		19.2			31,918		12.9
Other states		1,802		0.6			3,137		1.3
Total	$	299,080		100.0	%	$	247,353		100.0	%
Amounts under one million dollars in both years are included in “Other states”.

NOTE 6 Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:

(Dollars in thousands)	Single Family			Commercial Real Estate			Consumer			Commercial Business			Total
Balance, December 31, 2013	$	1,628			6,458			1,106			2,209			11,401

Provision for losses	$	(440	)		(3,518	)		(4	)		(3,036	)		(6,998	)
Charge-offs		(92	)		(936	)		(131	)		(55	)		(1,214	)
Recoveries		0			3,020			38			2,085			5,143
Balance, December 31, 2014	$	1,096			5,024			1,009			1,203			8,332

Provision for losses	$	(105	)		(427	)		254			114			(164	)
Charge-offs		(19	)		0			(105	)		(69	)		(193	)
Recoveries		18			1,481			42			193			1,734
Balance, December 31, 2015	$	990			6,078			1,200			1,441			9,709

Provision for losses	$	262			(1,788	)		481			400			(645	)
Charge-offs		(66	)		(67	)		(108	)		(180	)		(421	)
Recoveries		0			730			40			490			1,260
Balance, December 31, 2016	$	1,186			4,953			1,613			2,151			9,903

Allocated to:
Specific reserves	$	223			296			370			120			1,009
General reserves		767			5,782			830			1,321			8,700
Balance, December 31, 2015	$	990			6,078			1,200			1,441			9,709

Allocated to:
Specific reserves	$	235			248			434			71			988
General reserves		951			4,705			1,179			2,080			8,915
Balance, December 31, 2016	$	1,186			4,953			1,613			2,151			9,903

Loans receivable at December 31, 2015:
Individually reviewed for impairment	$	2,203			2,204			977			415			5,799
Collectively reviewed for impairment		88,742			245,149			63,438			69,691			467,020
Ending balance	$	90,945			247,353			64,415			70,106			472,819

Loans receivable at December 31, 2016:
Individually reviewed for impairment	$	1,107			1,880			940			643			4,570
Collectively reviewed for impairment		102,148			297,200			72,343			84,533			556,224
Ending balance	$	103,255			299,080			73,283			85,176			560,794

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

December 31, 2016

Classified

Unclassified

(Dollars in thousands)

Special

Mention

Substandard

Doubtful

Loss

Total

Total Loans

Single family

457

2,130

2,661

100,594

103,255

Commercial real estate:

Real estate rental and leasing

1,577

3,156

4,733

148,610

153,343

Other

1,702

7,187

8,889

136,848

145,737

Consumer

531

110

299

940

72,343

73,283

Commercial business:

Transportation industry

4,065

6,444

10,509

Other

3,973

2,916

6,889

67,778

74,667

7,709

19,985

184

299

28,177

532,617

560,794

	December 31, 2015
	Classified										Unclassified
(Dollars in thousands)	Special Mention		Substandard		Doubtful		Loss		Total		Total		Total Loans
Single family	$	189		2,889		55		0		3,133		87,812		90,945
Commercial real estate:
Real estate rental and leasing		1,910		4,827		0		0		6,737		118,639		125,376
Other		917		9,473		0		0		10,390		111,587		121,977
Consumer		0		639		52		286		977		63,438		64,415
Commercial business:
Transportation industry		4,082		18		0		0		4,100		5,249		9,349
Other		841		1,515		0		0		2,356		58,401		60,757
	$	7,939		19,361		107		286		27,693		445,126		472,819

Classified loans represent special mention, performing substandard, and non-performing loans categorized as substandard, doubtful and loss. Loans classified as special mention are loans that have potential weaknesses that, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. Loans classified as substandard are loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Substandard loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have the weaknesses of those classified as substandard, with additional characteristics that make collection in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. A loan classified as loss is considered uncollectible and of such little value that continuance as an asset on the balance sheet is not warranted. Loans classified as substandard or doubtful require the Bank to perform an analysis of the individual loan and charge off any loans, or portion thereof, that are deemed uncollectible.

The aging of past due loans at December 31, 2016 and 2015 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
2016
Single family	$	342		158		179		679		102,576		103,255		0
Commercial real estate:
Real estate rental and leasing		0		0		0		0		153,343		153,343		0
Other		0		0		0		0		145,737		145,737		0
Consumer		412		117		140		669		72,614		73,283		0
Commercial business:
Transportation industry		0		0		0		0		10,509		10,509		0
Other		85		0		274		359		74,308		74,667		0
	$	839		275		593		1,707		559,087		560,794		0

2015
Single family	$	490		130		799		1,419		89,526		90,945		0
Commercial real estate:
Real estate rental and leasing		0		0		0		0		125,376		125,376		0
Other		0		289		0		289		121,688		121,977		0
Consumer		330		262		119		711		63,704		64,415		0
Commercial business:
Transportation industry		0		0		0		0		9,349		9,349		0
Other		45		0		0		45		60,712		60,757		0
	$	865		681		918		2,464		470,355		472,819		0

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a TDR. The following table summarizes impaired loans and related allowances for the years ended December 31, 2016 and 2015:

December 31, 2016

(Dollars in thousands)

Recorded

Investment

Unpaid

Principal

Balance

Related

Allowance

Average

Recorded

Investment

Interest

Income

Recognized

Loans with no related allowance recorded:

Single family

217

567

Commercial real estate:

Real estate rental and leasing

122

Other

1,771

Consumer

312

449

Commercial business:

Other

274

356

Loans with an allowance recorded:

Single family

890

235

1,022

Commercial real estate:

Real estate rental and leasing

389

Other

1,814

248

1,856

229

Consumer

628

644

434

553

Commercial business:

Other

369

921

423

Total:

Single family

1,107

235

1,589

Commercial real estate:

Real estate rental and leasing

122

429

Other

1,840

3,585

248

1,885

326

Consumer

940

956

434

1,002

Commercial business:

Other

643

1,277

504

4,570

7,047

988

5,409

459

	December 31, 2015
(Dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Loans with no related allowance recorded:
Single family	$	1,251		1,251		0		943		60
Commercial real estate:
Real estate rental and leasing		44		184		0		46		7
Other		25		1,706		0		5,462		96
Consumer		475		476		0		387		10
Commercial business:
Other		0		79		0		36		0

Loans with an allowance recorded:
Single family		952		952		223		1,045		14
Commercial real estate:
Real estate rental and leasing		0		0		0		3		0
Other		2,135		2,135		296		1,920		32
Consumer		502		519		370		448		20
Commercial business:
Other		415		967		120		429		20

Total:
Single family		2,203		2,203		223		1,988		74
Commercial real estate:
Real estate rental and leasing		44		184		0		49		7
Other		2,160		3,841		296		7,382		128
Consumer		977		995		370		835		30
Commercial business:
Other		415		1,046		120		465		20
	$	5,799		8,269		1,009		10,719		259

At December 31, 2016, 2015 and 2014, non-accruing loans totaled $3.3 million, $4.2 million and $10.9 million, respectively, for which the related allowance for loan losses was $0.8 million, $0.7 million and $0.8 million, respectively. Non-accruing loans for which no specific allowance has been recorded because management determined that the value of the collateral was sufficient to repay the loan totaled $0.7 million, $1.4 million and $8.0 million at December 31, 2016, 2015, and 2014, respectively. Had the loans performed in accordance with their original terms, the Company would have recorded gross interest income on the loans of $0.6 million, $0.5 million and $0.9 million in 2016, 2015 and 2014, respectively. For the years ended December 31, 2016, 2015, and 2014, the Company recognized interest income on these loans of $0.4 million, $0.3 million and $0.2 million, respectively. All of the interest income that was recognized for non-accruing loans was recognized using the cash basis method of income recognition. Non-accrual loans also include some of the loans that have had terms modified in a TDR.

The following table summarizes non-accrual loans at December 31, 2016 and 2015:

Dollars in thousands)	2016		2015
Single family	$	916		1,655
Commercial real estate:
Real estate rental and leasing		41		44
Other		1,343		1,650
Consumer		630		786
Commercial business:
Other		343		46
	$	3,273		4,181

Included in loans receivable, net, are certain loans that have been modified in order to maximize collection of loan balances. If the Company, for legal or economic reasons related to the borrower’s financial difficulties, grants a concession compared to the original terms and conditions of the loan, the modified loan is considered a troubled debt restructuring (TDR).

At December 31, 2016, 2015 and 2014, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $3.3 million, $2.5 million and $9.4 million, respectively. Had these loans been performing in accordance with their original terms throughout 2016, 2015, and 2014, the Company would have recorded gross interest income of $0.6 million, $0.4 million and $0.9 million, respectively. During 2016, 2015 and 2014, the Company recognized interest income of $0.4 million, $0.2 million and $0.3 million, respectively, on these loans. For the loans that were modified in 2016, $0.2 million were classified and performing, and $1.7 million were non-performing at December 31, 2016.

The following table summarizes TDRs at December 31, 2016 and 2015:

(Dollars in thousands)	2016		2015
Single family	$	448		647
Commercial real estate:
Other		1,774		725
Consumer		709		732
Commercial business:
Other		369		415
	$	3,300		2,519

As of December 31, 2016, the Bank had commitments to lend an additional $0.4 million to a borrower who has TDR and non-accrual loans. These additional funds are for the construction of single family homes with a maximum loan-to-value ratio of 75%. These loans are secured by the home under construction. There were commitments to lend additional funds of $1.5 million to this same borrower at December 31, 2015.

TDR concessions can include reduction of interest rates, extension of maturity dates, forgiveness of principal and/or interest due, or acceptance of real estate or other assets in full or partial satisfaction of the debt. Loan modifications are not reported as TDRs after 12 months if the loan was modified at a market rate of interest for comparable risk loans, and the loan is performing in accordance with the terms of the restructured agreement. All loans classified as TDRs are considered to be impaired.

When a loan is modified as a TDR, there may be a direct, material impact on the loans within the Consolidated Balance Sheets, as principal balances may be partially forgiven. The financial effects of TDRs are presented in the following table and represent the difference between the outstanding recorded balance pre-modification and post-modification, for the periods ending December 31, 2016 and 2015:

	Year ended December 31, 2016						Year ended December 31, 2015
(Dollars in thousands)	Number of Contracts		Pre- modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment		Number of Contracts		Pre- modification Outstanding Recorded Investment		Post- modification Outstanding Recorded Investment
Troubled debt restructurings:
Single family		4	$	251		263		4	$	476		478
Commercial real estate:
Other		1		1,274		1,274		1		209		209
Consumer		18		382		384		21		527		530
Commercial business:
Other		2		257		201		1		44		44
Total		25	$	2,164		2,122		27	$	1,256		1,261

Loans that were restructured within the 12 months preceding December 31, 2016 and 2015 and defaulted during the year are presented in the table below:

	Year ended December 31, 2016				Year ended December 31, 2015
(Dollars in thousands)	Number of Contracts		Outstanding Recorded Investment		Number of Contracts		Outstanding Recorded Investment
Troubled debt restructurings that subsequently defaulted:
Commercial real estate:
Other		1	$	183		0	$	0
Consumer		1		4		0		0
Total		2	$	187		0	$	0

The Company considers a loan to have defaulted when it becomes 90 or more days past due under the modified terms, when it is placed in non-accrual status, when it becomes other real estate owned, or when it becomes non-compliant with some other material requirement of the modification agreement.

Loans that were non-accrual prior to modification remain non-accrual for at least six months following modification. Non-accrual TDR loans that have performed according to the modified terms for six months may be returned to accruing status. Loans 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 allocated allowance for TDRs was $0.6 million, or 6.2%, of the total $9.9 million in allowance for loan losses at December 31, 2016, and $0.5 million, or 5.2%, of the total $9.7 million in allowance for loan losses at December 31, 2015.

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

The following is additional information with respect to loans acquired through acquistions:

(Dollars in thousands)	Contractual Principal Receivable			Accretable Difference			Carrying Amount
Purchased Performing Loans:
Balance at December 31, 2015	$	18,539			(459	)		18,080
Loans acquired during the period		11,772			(211	)		11,561
Change due to payments/refinances		(13,413	)		340			(13,073	)
Change due to loan charge-off		(156	)		(2	)		(158	)
Balance at December 31, 2016	$	16,742			(332	)		16,410

(Dollars in thousands)

Contractual

Principal

Receivable

Non-Accretable

Difference

Carrying

Amount

Purchased Credit Impaired Loans:

Balance at December 31, 2015

555

(162

)

393

Loans acquired during the period

329

(37

)

292

Change due to payments/refinances

(449

)

147

(302

)

Balance at December 31, 2016

435

(52

)

383

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

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

NOTE 7 Accrued Interest Receivable

Accrued interest receivable at December 31 is summarized as follows:

(Dollars in thousands)	2016		2015
Securities available for sale	$	400		422
Loans receivable		2,226		1,832
	$	2,626		2,254

NOTE 8 Intangible Assets

The Company’s intangible assets consist of core deposit intangibles, goodwill, and mortgage servicing rights. A summary of mortgage servicing rights activity for 2016 and 2015 is as follows:

(Dollars in thousands)	2016			2015
Mortgage servicing rights:
Balance, beginning of year	$	1,499			1,507
Originations		706			547
Amortization		(601	)		(555	)
Balance, end of year		1,604			1,499
Valuation reserve		0			0
Mortgage servicing rights, net	$	1,604			1,499
Fair value of mortgage servicing rights	$	2,952			2,590

All of the single family loans sold where the Company continues to service the loans are serviced for Federal National Mortgage Association (FNMA) under the individual loan sale program. The following is a summary of the risk characteristics of the loans being serviced for FNMA at December 31, 2016:

(Dollars in thousands)	Loan Principal Balance		Weighted Average Interest Rate			Weighted Average Remaining Term (months)		Number of Loans
Original term:
30 year fixed rate	$	235,933		4.07	%		305		1,953
15 year fixed rate		110,377		3.12			140		1,163
Adjustable rate		57		2.75			293		2

The gross carrying amount of intangible assets and the associated accumulated amortization at December 31, 2016 and 2015 are presented in the following table. Amortization expense for intangible assets was $0.7 million, $0.6 million, and $0.5 million for the years ended December 31, 2016, 2015, and 2014, respectively.

	Gross					Unamortized
	Carrying		Accumulated			Intangible
(Dollars in thousands)	Amount		Amortization			Assets
December 31, 2016
Mortgage servicing rights	$	3,954		(2,350	)		1,604
Core deposit intangible		574		(120	)		454
Goodwill		802		0			802
Total	$	5,330		(2,470	)		2,860

December 31, 2015
Mortgage servicing rights	$	3,739		(2,240	)		1,499
Core deposit intangible		421		(28	)		393
Total	$	4,160		(2,268	)		1,892

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

(Dollars in thousands)	Mortgage Servicing Rights		Core Deposit Intangible		Total Amortizing Intangible Assets
Year ended December 31,
2017	$	440		99		539
2018		350		99		449
2019		297		99		396
2020		215		99		314
2021		162		47		209
Thereafter		140		11		151
	$	1,604		454		2,058

No amortization expense relating to goodwill is recorded as generally accepted accounting principles do not allow goodwill to be amortized, but require that it be tested for impairment at least annually, or sooner, if there are indications that impairment may exist.

Projections of amortization are based on asset balances and the interest rate environment that existed at December 31, 2016. The Company®€™s actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

NOTE 9 Real Estate

A summary of real estate at December 31, 2016 and 2015 is as follows:

	2016								2015
(Dollars in thousands)	Residential		Commercial & Other			Total			Residential			Commercial & Other			Total
Real estate in judgment subject to redemption	$	0		0			0			110			0			110
Real estate acquired through foreclosure		0		1,245			1,245			0			2,269			2,269
Real estate acquired through deed in lieu of foreclosure		0		28			28			0			465			465
		0		1,273			1,273			110			2,734			2,844
Allowance for losses		0		(662	)		(662	)		(62	)		(737	)		(799	)
	$	0		611			611			48			1,997			2,045

NOTE 10 Premises and Equipment

A summary of premises and equipment at December 31, 2016 and 2015 is as follows:

(Dollars in thousands)	2016			2015
Land	$	2,021			2,021
Office buildings and improvements		9,666			8,930
Furniture and equipment		12,478			12,714
		24,165			23,665
Accumulated depreciation		(15,942	)		(16,196	)
	$	8,223			7,469

NOTE 11 Deposits

Deposits and their weighted average interest rates at December 31, 2016 and 2015 are summarized as follows:

			2016								2015
(Dollars in thousands)			Weighted Average Rate			Amount		Percent of Total			Weighted Average Rate			Amount		Percent of Total
Noninterest checking				0.00	%	$	158,024		26.7	%		0.00	%	$	151,737		27.1	%
NOW accounts				0.07			92,670		15.6			0.04			82,425		14.7
Savings accounts				0.08			74,238		12.5			0.09			66,421		11.9
Money market accounts				0.25			165,179		27.9			0.22			159,959		28.6
							490,111		82.7						460,542		82.3
Certificates by rate:
0	-	0.99%					79,628		13.4						85,391		15.3
1		1.99%					22,958		3.9						12,611		2.3
2	-	2.99%					0		0.0						733		0.1
3	-	3.99%					114		0.0						110		0.0
Total certificates				0.61			102,700		17.3			0.53			98,845		17.7
Total deposits				0.20		$	592,811		100.0	%		0.17		$	559,387		100.0	%

At December 31, 2016 and 2015, the Company had $172.6 million and $183.0 million, respectively, of deposit accounts with balances of $250,000 or more. At December 31, 2016 and 2015, the Company had no certificate accounts that had been acquired through a broker.

Certificates had the following maturities at December 31, 2016 and 2015:


			2016					2015
(Dollars in thousands)			Amount		Weighted Average Rate			Amount		Weighted Average Rate
Remaining term to maturity
1	-	6 months	$	32,418		0.36	%	$	36,040		0.44	%
7	-	12 months		25,424		0.45			26,019		0.37
13	-	36 months		36,111		0.81			28,706		0.65
Over 36 months				8,747		1.18			8,080		1.05
			$	102,700		0.61		$	98,845		0.53

At December 31, 2016 and 2015, the Company had pledged mortgage loans and mortgage-backed and related securities with an amortized cost of approximately $17.4 million and $28.0 million, respectively, as collateral for certain deposits. An additional $1.0 million of letters of credit from the Federal Home Loan Bank (FHLB) were pledged at December 31, 2016 and 2015 as collateral on certain Bank deposits.

Interest expense on deposits is summarized as follows for the years ended December 31, 2016, 2015 and 2014:

Dollars in thousands)	2016		2015		2014
NOW accounts	$	50		17		14
Savings accounts		62		42		32
Money market accounts		366		347		414
Certificates		524		528		751
	$	1,002		934		1,211

NOTE 12 FHLB Advances and Other Borrowings

The Bank had no outstanding advances from the FHLB or borrowings from the Federal Reserve Bank of Minneapolis as of December 31, 2016 or December 31, 2015. At December 31, 2016 it had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $105.7 million. The Bank had the ability to draw additional borrowings of $104.7 million from the FHLB, based upon the mortgage loans and securities that were pledged at December 31, 2016, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of $85.8 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2016, subject to approval from the Board of Governors of the Federal Reserve System (FRB).

At December 31, 2015 the Bank had collateral pledged to the FHLB consisting of FHLB stock, mortgage loans, and investments with a borrowing capacity of approximately $96.3 million. The Bank had the ability to draw additional borrowings of $95.3 million from the FHLB, based upon the mortgage loans and securities that were pledged as of December 31, 2015, subject to a requirement to purchase FHLB stock. The Bank also had the ability to draw additional borrowings of $73.5 million from the Federal Reserve Bank of Minneapolis, based upon the loans that were pledged to them as of December 31, 2015, subject to approval from the FRB.

On December 15, 2014, the Company entered into a Loan Agreement with an unrelated third party, providing for a term loan of up to $10.0 million that was evidenced by a promissory note (the Note) with an interest rate of 6.50% per annum. The principal balance of the Note is payable in consecutive equal annual installments of $1.0 million on each anniversary of the date of the Loan Agreement, commencing on December 15, 2015, with the balance due on December 15, 2021. Provided that no default or event of default has occurred and is continuing, the Company may, at its option, elect to defer the payment of one installment of principal on the Note otherwise due prior to the maturity date, in which event such installment will become due and payable on the maturity date. The Company may voluntarily prepay the Note in whole or in part without penalty and the Company has prepaid $1.0 million of principal on the Note in addition to the required annual payments. The outstanding loan balance was $7.0 million at December 31, 2016 and $9.0 million at December 31, 2015.

NOTE 13 Income Taxes

Income tax expense for the years ended December 31, 2016, 2015 and 2014 is as follows:

(Dollars in thousands)	2016		2015			2014
Current:
Federal	$	939		(87	)		262
State		55		(24	)		74
Total current		994		(111	)		336
Deferred:
Federal		2,322		1,393			3,753
State		806		329			813
Total deferred		3,128		1,722			4,566
Income tax expense	$	4,122		1,611			4,902

The reasons for the difference between the expected income tax expense utilizing the federal corporate tax rate of 34% and the actual income tax expense are as follows:

(Dollars in thousands)	2016			2015			2014
Expected federal income tax expense	$	3,560			1,553			4,176
Items affecting federal income tax:
State income taxes, net of federal income tax deduction		622			259			698
Tax exempt interest		(16	)		(44	)		(45	)
Other, net		(44	)		(157	)		73
Income tax expense	$	4,122			1,611			4,902

The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31:

Dollars in thousands)	2016		2015
Deferred tax assets:
Allowances for loan and real estate losses	$	4,186		4,169
Deferred compensation costs		262		235
Deferred ESOP loan asset		704		710
Nonaccruing loan interest		313		361
Federal net operating loss carryforward		0		1,805
State net operating loss carryforward		1,366		2,255
Alternative minimum tax credit carryforward		118		500
Capitalized other real estate owned expenses		56		530
Net unrealized loss on securities available for sale		542		142
Other		91		155
Total gross deferred tax assets		7,638		10,862

Deferred tax liabilities:
Deferred loan fees		100		247
Premises and equipment basis difference		126		139
Originated mortgage servicing rights		636		594
Federal tax liability on state net operating loss carryforwards		676		779
Core deposit intangible		74		105
Other		79		325
Total gross deferred tax liabilities		1,691		2,189
Net deferred tax assets	$	5,947		8,673

The Company has no federal net operating loss carryforwards and $14.3 million of state net operating loss carryforwards at December 31, 2016 that expire beginning in 2023.

Retained earnings at December 31, 2016 included approximately $8.8 million for which no provision for income taxes was made. This amount represents allocations of income to bad debt deductions for tax purposes. Reduction of amounts so allocated for purposes other than absorbing losses will create income for tax purposes, which will be subject to the then-current corporate income tax rate.

The Company considers the determination of the deferred tax asset amount and the need for any valuation reserve to be a critical accounting policy that requires significant judgment. The Company has, in its judgment, made reasonable assumptions and considered both positive and negative evidence relating to the ultimate realization of deferred tax assets. Positive evidence includes the cumulative net income generated over the prior three year period and the probability that taxable income will be generated in future periods. Negative evidence includes the current general business and economic environments. Based upon this evaluation, the Company determined that no valuation allowance was required with respect to the net deferred tax assets at December 31, 2016 and 2015.

NOTE 14 Employee Benefits

All eligible full-time employees of the Bank that were hired prior to 2002 were included in a noncontributory retirement plan sponsored by the Financial Institutions Retirement Fund (FIRF). The Home Federal Savings Bank (Employer #8006) plan participates in the Pentegra Defined Benefit Plan for Financial Institutions (the Pentegra DB Plan). The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes under the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan.

The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan, contributions made by a participating employer may be used to provide benefits to participants of other participating employers.

Effective September 1, 2002, the accrual of benefits for existing participants was frozen and no new enrollments were permitted into the plan. The actuarial present value of accumulated plan benefits and net assets available for benefits relating to the Bank's employees was not available at December 31, 2016 because such information is not accumulated for each participating institution. As of June 30, 2016, the Pentegra DB Plan valuation report reflected that the Bank was obligated to make a contribution totaling $0.2 million which was expensed in 2016 and paid in the first quarter of 2017.

Funded status (market value of plan assets divided by funding target) as of July 1 for the 2016, 2015, and 2014 plan years were 97.09%, 96.01%, and 97.98%, respectively. Market value of plan assets reflects contributions received through June 30, 2016.

Total employer contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $163.1 million, $190.8 million, and $136.5 million for the plan years ended June 30, 2015, 2014 and 2013, respectively. The Bank®€™s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan. There is no funding improvement plan or rehabilitation plan as part of this multi-employer plan.

The following contributions were paid by the Bank during the fiscal years ending December 31:

(Dollars in thousands)
2016				2015			2014
Date Paid	Amount			Date Paid	Amount		Date Paid	Amount
10/15/16	$	33	*	10/15/2015	$	42	10/15/2014	$	46
				12/30/2015		151	12/30/2014		164
Total	$	33			$	193		$	210

*- An additional contribution of $119,000 was accrued at December 31, 2016 and paid in the first quarter of 2017.

The Company has a qualified, tax-exempt savings plan with a deferred feature qualifying under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). All employees who have attained 18 years of age are eligible to participate in the 401(k) Plan. Participants are permitted to make contributions to the 401(k) Plan equal to the lesser of 50% of their annual salary or the maximum allowed by law, which was $18,000 for 2016 and 2015 and $17,500 for 2014. The Company matches 25% of each participant®€™s contributions up to a maximum of 8% of their annual salary. Participant contributions and earnings are fully and immediately vested. The Company’s contributions are vested on a three year cliff basis, are expensed annually, and were $0.2 million in 2016 and 2015 and $0.1 million in 2014.

The Company has adopted an Employee Stock Ownership Plan (the ESOP) that meets the requirements of Section 4975(e)(7) of the Internal Revenue Code and Section 407(d)(6) of ERISA and, as such, the ESOP is empowered to borrow in order to finance purchases of the common stock of HMN. The ESOP borrowed $6.1 million from the Company to purchase 912,866 shares of common stock in the initial public offering of HMN in 1994. As a result of a merger with Marshalltown Financial Corporation (MFC), the ESOP borrowed $1.5 million in 1998 to purchase an additional 76,933 shares of HMN common stock to account for the additional employees and avoid dilution of the benefit provided by the ESOP. The ESOP debt requires quarterly payments of principal plus interest at 7.52%. The Company has committed to make quarterly contributions to the ESOP necessary to repay the loans including interest. The Company contributed $0.5 million in 2016, 2015, and 2014.

As the debt is repaid, ESOP shares that were pledged as collateral for the debt are released from collateral based on the proportion of debt service paid in the year and then allocated to eligible employees. The Company accounts for its ESOP in accordance with ASU 718, Employers' Accounting for Employee Stock Ownership Plans. Accordingly, the shares pledged as collateral are reported as unearned ESOP shares in stockholders' equity. As shares are determined to be ratably released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per common share computations. ESOP compensation expense was $0.3 million for each of the years ending December 31, 2016, 2015 and 2014.

All employees of the Bank are eligible to participate in the ESOP after they attain age 18 and complete one year of service during which they worked at least 1,000 hours. A summary of the ESOP share allocation is as follows for the years ended December 31:

	2016			2015			2014
Shares held by participants beginning of the year		334,277			336,024			347,887
Shares allocated to participants		24,377			24,317			24,317
Shares distributed to participants		(18,784	)		(26,064	)		(36,180	)
Shares held by participants end of year		339,870			334,277			336,024

Unreleased shares beginning of the year		304,123			328,440			352,757
Shares released during year		(24,377	)		(24,317	)		(24,317	)
Unreleased shares end of year		279,746			304,123			328,440
Total ESOP shares end of year		619,616			638,400			664,464
Fair value of unreleased shares at December 31	$	4,895,555			3,512,621			4,072,656

In March 2001, the HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan) was adopted by the Company. In April 2009, this plan was superseded by the HMN Financial, Inc. 2009 Equity and Incentive Plan (2009 Plan) and options or restricted shares were no longer awarded from the 2001 Plan. As of December 31, 2016, all outstanding options issued under the 2001 Plan have expired.

The purpose of the 2009 Plan is to provide key personnel and advisors with an opportunity to acquire a proprietary interest in the Company. The opportunity to acquire a proprietary interest in the Company is intended to aid in attracting, motivating and retaining key personnel and advisors, including non-employee directors, and to align their interests with those of the Company’s stockholders. 350,000 shares of HMN common stock were initially available for distribution under the 2009 Plan in either restricted stock or stock options, subject to adjustment for future stock splits, stock dividends and similar changes to the capitalization of the Company. Additionally, shares of restricted stock that are awarded are counted as 1.2 shares for purposes of determining the total shares available for issuance under the 2009 Plan. As of December 31, 2016, there were 15,000 vested and 34,229 unvested options under the 2009 Plan that remain unexercised. These options expire 10 years from the date of grant and have a weighted average exercise price of $9.25.

A summary of activities under all plans for the past three years is as follows:

												Unvested options
	Shares Available For Grant			Unvested Restricted Shares Outstanding			Options Outstanding			Award Value/ Weighted Average Exercise Price		Number			Weighted Average Grant Date Fair Value		Vesting Period (in years)
2001 Plan
December 31, 2013		0			0			45,540		$	28.21		0
Forfeited/expired		0			0			(30,540	)		27.33		0
December 31, 2014		0			0			15,000			30.00		0
Forfeited/expired		0			0			(15,000	)		30.00		0
December 31, 2015		0			0			0			0.00		0
December 31, 2016		0			0			0			0.00		0

2009 Plan
December 31, 2013		121,053			101,806			15,000		$	4.77		3,000		$	4.41
Granted January 7, 2014		(28,627	)		23,856			0			N/A		0					3
Granted May 27, 2014		(26,561	)		22,134			0			N/A		0					3
Forfeited/expired		30,540			0			0					0
Vested		0			(62,938	)		0					(3,000	)		4.41
December 31, 2014		96,405			84,858			15,000			4.77		0
Granted January 27, 2015		(11,903	)		9,919			0			N/A		0					3
Granted April 28, 2015		(3,158	)		2,632			0			N/A		0					1
Granted June 8, 2015		(398	)		332			0			N/A		0					1
Forfeited/expired		395			(329	)		0					0
Forfeited/expired		15,000			0			0					0
Vested		0			(58,526	)		0					0
December 31, 2015		96,341			38,886			15,000			4.77		0
Granted January 26, 2016		(4,087	)		3,406			0			N/A		0					3
Granted January 26, 2016		(34,229	)		0			34,229			11.21		34,229			4.04		3
Granted April 26, 2016		(3,149	)		2,624			0			N/A		0					1
Vested		0			(24,320	)		0					0
December 31, 2016		54,876			20,596			49,229			9.25		34,229			4.04
Total all plans		54,876			20,596			49,229		$	9.25		34,229		$	4.04

The following table summarizes information about stock options outstanding at December 31, 2016:

Date of Grant	Exercise Price		Number Outstanding		Weighted Average Remaining Contractual Life in Years		Number Exercisable		Number Unexercisable		Unrecognized Compensation Expense		Weighted Average Years Over Which Unrecognized Compensation will be Recognized
May 6, 2009	$	4.77		15,000		2.4		15,000		0	$	0		N/A
January 26, 2016	$	11.21		34,229		9.1		0		34,229		59,528		2.1
				49,229				15,000		34,229	$	59,528

The Company will issue shares from treasury stock upon the exercise of outstanding options.

In accordance with ASC 718, the Company recognized compensation expense relating to the stock options granted in 2016 over the vesting period. The amount of the expense was determined under the fair value method. There were no options granted in 2015 or 2014.

The fair value for each option grant is estimated on the date of the grant using a Black Scholes option valuation model. The assumptions used in determining the fair value of the options granted during 2016 are as follows:

	2016
Risk-free interest rate		2.10	%
Expected life (in years)		10
Expected volatility		22.83	%
Expected dividends		0.00	%

NOTE 15 Earnings per Common Share

The following table reconciles the weighted average shares outstanding and net income for basic and diluted earnings per common share:

	Year ended December 31,
(Dollars in thousands, except per share data)	2016		2015			2014
Weighted average number of common shares outstanding used in basic earnings per common share calculation		4,180,994		4,127,453			4,060,404

Net dilutive effect of :
Options and warrants		553,386		513,505			507,856
Restricted stock awards		13,367		34,959			55,783
Weighted average number of common shares outstanding adjusted for effect of dilutive securities		4,747,747		4,675,917			4,624,043

Net income	$	6,350		2,956			7,379
Dividends on preferred stock		0		(108	)		(1,710	)
Net income available to common shareholders	$	6,350		2,848			5,669
Basic earnings per common share	$	1.52		0.69			1.40
Diluted earnings per common share	$	1.34		0.61			1.23

NOTE 16 Stockholders' Equity

The Company did not repurchase any shares of its common stock or pay any dividends on its common stock during 2016, 2015 or 2014.

The Company's certificate of incorporation authorizes the issuance of up to 500,000 shares of preferred stock, and on December 23, 2008, the Company completed the sale of 26,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (Preferred Stock) to the United Stated Department of Treasury (Treasury). The Preferred Stock had a liquidation value of $1,000 per share and a related warrant was also issued to purchase 833,333 shares of HMN common stock at an exercise price of $4.68 per share (the Warrant). The transaction was part of the Treasury®€™s Capital Purchase Program under the Emergency Economic Stabilization Act of 2008.

On February 17, 2015, the Company redeemed the final 10,000 shares of the outstanding Preferred Stock. On May 21, 2015, the Treasury sold the Warrant at an exercise price of $4.68 to three unaffiliated third party investors for an aggregate purchase price of $5.7 million. Two of the investors received a warrant to purchase 277,777.67 shares and one investor received a warrant to purchase 277,777.66 shares. All of the warrants were still outstanding as of December 31, 2016 and may be exercised at any time prior to their expiration date of December 23, 2018. The Company received no proceeds from this transaction and it had no effect on the Company®€™s capital, financial condition or results of operations.

In order to grant a priority to eligible accountholders in the event of future liquidation, the Bank, at the time of conversion to a stock savings bank, established a liquidation account equal to its regulatory capital as of September 30, 1993. In the event of future liquidation of the Bank, an eligible accountholder who continues to maintain their deposit account shall be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account will decrease as the balance of eligible accountholders is reduced subsequent to the conversion, based on an annual determination of such balance.

NOTE 17 Regulatory Capital

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

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

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

At December 31, 2016 and 2015, the Bank's capital amounts and ratios are presented for actual capital, required capital and excess capital including amounts and ratios in order to qualify as being well capitalized under the prompt corrective action regulations:

	Actual					Required to be Adequately Capitalized					Excess Capital					To Be Well Capitalized Under Prompt Corrective Action Provisions
(Dollars in thousands)	Amount		Percent of Assets⁽¹⁾			Amount		Percent of Assets⁽¹⁾			Amount		Percent of Assets⁽¹⁾			Amount		Percent of Assets⁽¹⁾
December 31, 2016
Common equity tier 1 capital	$	77,634		13.42	%	$	26,032		4.50	%	$	51,602		8.92	%	$	37,601		6.50	%
Tier 1 leverage		77,634		11.55			26,876		4.00			50,758		7.55			33,595		5.00
Tier 1 risk-based capital		77,634		13.42			34,709		6.00			42,925		7.42			46,278		8.00
Total risk-based capital		84,900		14.68			46,278		8.00			38,622		6.68			57,848		10.00

December 31, 2015
Common equity tier 1 capital	$	71,520		14.08	%	$	22,854		4.50	%	$	48,666		9.58	%	$	33,012		6.50	%
Tier 1 leverage		71,520		11.46			24,971		4.00			46,549		7.46			31,213		5.00
Tier 1 risk-based capital		71,520		14.08			30,473		6.00			41,047		8.08			40,630		8.00
Total risk-based capital		77,934		15.35			40,630		8.00			37,304		7.35			50,788		10.00

⁽¹⁾ Based upon the Bank's adjusted total assets for the purpose of the Tier 1 leverage capital ratio and risk-weighted assets for the purpose of the risk-based capital ratios.

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

Management believes that, as of December 31, 2016, the Bank’s capital ratios were in excess of those quantitative capital ratio standards applicable on that date, set forth under the prompt corrective action regulations, including the capital conservation buffer described above. However, there can be no assurance that the Bank will continue to maintain such status in the future. The Office of the Comptroller of the Currency has extensive discretion in its supervisory and enforcement activities, and can further adjust the requirement to be well-capitalized in the future.

NOTE 18 Financial Instruments with Off-Balance Sheet Risk

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of these instruments reflect the extent of involvement by the Company.

The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contract amount of these commitments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments.

	December 31, Contract Amount
(Dollars in thousands)	2016		2015
Financial instruments whose contract amount represents credit risk:
Commitments to originate, fund or purchase loans:
Single family mortgages	$	7,587		4,292
Commercial real estate mortgages		33,953		18,834
Non-real estate commercial loans		420		1,310
Undisbursed balance of loans closed		39,841		44,082
Unused lines of credit		100,893		96,354
Letters of credit		1,902		1,077
Total commitments to extend credit	$	184,596		165,949
Forward commitments	$	9,595		8,071

Commitments to extend credit are agreements to lend to a customer, at the customer’s request, as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the loan type and on management's credit evaluation of the borrower. Collateral consists primarily of residential and commercial real estate and personal property.

Forward commitments represent commitments to sell loans to a third party following the closing of the loan and are entered into in the normal course of business by the Bank.

The Bank issued standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit outstanding expire over the next 26 months and totaled $1.9 million at December 31, 2016 and $1.0 million at December 31, 2015. The letters of credit are collateralized primarily with commercial real estate mortgages. Draws on standby letters of credit would be initiated by the secured party under the terms of the underlying obligation. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

	Payments Due by Period
(Dollars in thousands)	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Contractual Obligations:
Total borrowings	$	7,000		1,000		2,000		4,000		0
Annual rental commitments under non-cancellable operating leases		5,856		843		1,452		1,380		2,181
	$	12,856		1,843		3,452		5,380		2,181

	Amount of Commitments Expiring by Period
Other Commercial Commitments:
Commercial lines of credit	$	50,229	26,523	9,282	9,414	5,010
Commitments to lend		31,831	9,797	4,736	7,220	10,078
Standby letters of credit		1,902	1,575	327	0	0
	$	83,962	37,895	14,345	16,634	15,088

NOTE 19 Derivative Instruments and Hedging Activities

The Company originates single-family residential loans for sale into the secondary market and enters into commitments to sell those loans in order to mitigate the interest rate risk associated with holding the loans until they are sold. The Company accounts for its commitments in accordance with ASC 815, Accounting for Derivative Instruments and Hedging Activities.

The Company had commitments outstanding to extend credit to future borrowers that had not closed prior to the end of the year, which is referred to as its mortgage pipeline. As commitments to originate loans enter the mortgage pipeline, the Company generally enters into commitments to sell the loans into the secondary market. The commitments to originate and sell loans are derivatives that are recorded at fair value. As a result of marking these derivatives to fair value for the period ended December 31, 2016, the Company recorded an increase in other liabilities of $11,000, an increase in other assets of $30,000 and a net gain on the sale of loans of $19,000. As a result of marking these derivatives to fair value for the period ended December 31, 2015, the Company recorded a decrease in other liabilities of $7,000, an increase in other assets of $20,000 and a net gain on the sale of loans of $27,000.

As of December 31, 2016 and 2015, the current commitments to sell loans held for sale are derivatives that do not qualify for hedge accounting. The loans held for sale that are not hedged are recorded at the lower of cost or market. As a result of marking these loans for the period ended December 31, 2016, the Company recorded a decrease in other liabilities of $14,000 and a net gain on the sale of loans of $14,000. As a result of marking these loans for the period ended December 31, 2015, the Company recorded an increase in other liabilities of $3,000, and a net loss on the sales of loans of $3,000.

NOTE 20 Fair Value Measurement

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

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

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

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

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

	Carrying Value at December 31, 2016
*(Dollars in thousands)*	Total		Level 1		Level 2		Level 3
Securities available for sale	$	78,477		0		78,477		0
Mortgage loan commitments		66		0		66		0
Total	$	78,543		0		78,543		0

	Carrying Value at December 31, 2015
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Securities available for sale	$	111,974		0		111,974		0
Mortgage loan commitments		36		0		36		0
Total	$	112,010		0		112,010		0

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write downs of individual assets. For assets measured at fair value on a nonrecurring basis in 2016 and 2015 that were still held at December 31, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at December 31, 2016 and 2015.

	Carrying Value at December 31, 2016
*(Dollars in thousands)*	Total		Level 1		Level 2		Level 3		Year Ended December 31, 2016 Total gains (losses)
Loans held for sale	$	2,009		0		2,009		0		14
Mortgage servicing rights, net		1,604		0		1,604		0		0
Loans ⁽¹⁾		3,582		0		3,582		0		(380	)
Real estate, net⁽²⁾		611		0		611		0		(197	)
Total	$	7,806		0		7,806		0		(563	)

	Carrying Value at December 31, 2015
(Dollars in thousands)	Total		Level 1		Level 2		Level 3		Year Ended December 31, 2015 Total gains (losses)
Loans held for sale	$	3,779		0		3,779		0		(3	)
Mortgage servicing rights, net		1,499		0		1,499		0		0
Loans ⁽¹⁾		4,790		0		4,790		0		(373	)
Real estate, net⁽²⁾		2,045		0		2,045		0		(262	)
Total	$	12,113		0		12,113		0		(638	)

⁽¹⁾Represents carrying value and related specific reserves on loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.

⁽²⁾Represents the fair value and related losses on foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

NOTE 21 Fair Value of Financial Instruments

ASC 825, Disclosures about Fair Values of Financial Instruments, requires disclosure of the estimated fair values of the Company's financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value estimates are made as of December 31, 2016 and 2015 based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. The estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based only on existing financial instruments without attempting to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.

The estimated fair value of the Company's financial instruments are shown below. Following the table, there is an explanation of the methods and assumptions used to estimate the fair value of each class of financial instruments.

December 31, 2016

December 31, 2015

Fair value hierarchy

(Dollars in thousands)

Carrying

amount

Estimated

fair value

Level 1

Level 2

Level 3

Contract

amount

Carrying

Amount

Estimated

fair value

Contract

amount

Financial assets:

Cash and cash equivalents

27,561

39,782

Securities available for sale

78,477

111,974

Loans held for sale

2,009

3,779

Loans receivable, net

551,171

552,395

463,185

458,539

FHLB stock

770

691

Accrued interest receivable

2,626

2,254

Financial liabilities:

Deposits

592,811

593,297

559,387

558,731

FHLB advances and other
borrowings

7,000

7,018

9,000

Accrued interest payable

236

242

Off-balance sheet financial
instruments:

Commitments to extend credit

184,596

165,949

Commitments to sell loans

(22

)

(22

)

9,595

(26

)

(26

)

8,071

Cash and Cash Equivalents

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

Securities Available for Sale

The fair values of securities were based upon quoted market prices.

Loans Held for Sale

The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity.

Loans Receivable

The fair values of loans receivable were estimated for groups of loans with similar characteristics. The fair value of the loan portfolio, with the exception of the adjustable rate portfolio, was calculated by discounting the scheduled cash flows through the estimated maturity using anticipated prepayment speeds and using discount rates that reflect the credit and interest rate risk inherent in each loan portfolio. The fair value of the adjustable loan portfolio was estimated by grouping the loans with similar characteristics and comparing the characteristics of each group to the prices quoted for similar types of loans in the secondary market.

FHLB Stock

The carrying amount of FHLB stock approximates its fair value.

Accrued Interest Receivable

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

Deposits

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

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

FHLB Advances and Other Borrowings

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

Accrued Interest Payable

The carrying amount of accrued 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.

NOTE 22 HMN Financial, Inc. Financial Information (Parent Company Only)

The following are the condensed financial statements for the parent company only as of December 31, 2016 and 2015 and for the years ended December 31, 2016, 2015 and 2014.

Dollars in thousands)	2016			2015			2014
Condensed Balance Sheets
Assets:
Cash and cash equivalents	$	3,314			2,564
Investment in subsidiaries		78,108			74,565
Prepaid expenses and other assets		44			33
Deferred tax asset, net		756			1,000
Total assets	$	82,222			78,162
Liabilities and Stockholders' Equity:
Other borrowed money	$	7,000			9,000
Accrued expenses and other liabilities		(697	)		(483	)
Total liabilities		6,303			8,517
Common stock		91			91
Additional paid-in capital		50,566			50,388
Retained earnings		86,886			80,536
Net unrealized losses on securities available for sale		(820	)		(214	)
Unearned employee stock ownership plan shares		(2,223	)		(2,417	)
Treasury stock, at cost, 4,639,739 and 4,645,769 shares		(58,581	)		(58,739	)
Total stockholders' equity		75,919			69,645
Total liabilities and stockholders' equity	$	82,222			78,162
Condensed Statements of Income
Interest income	$	0			1			1
Interest expense		(589	)		(571	)		0
Equity income of subsidiaries		7,148			3,629			7,644
Compensation and benefits		(264	)		(269	)		(233	)
Occupancy		(30	)		(30	)		(24	)
Data processing		(6	)		(6	)		(6	)
Professional services		(138	)		(119	)		(165	)
Other		(329	)		(216	)		(374	)
Income before income tax benefit		5,792			2,419			6,843
Income tax benefit		(558	)		(537	)		(536	)
Net income	$	6,350			2,956			7,379
Condensed Statements of Cash Flows
Cash flows from operating activities:
Net income	$	6,350			2,956			7,379
Adjustments to reconcile net income to cash used by operating activities:
Equity income of subsidiaries		(7,148	)		(3,629	)		(7,644	)
Deferred income tax benefit (expense)		244			22			(92	)
Earned employee stock ownership shares priced above original cost		80			57			53
Stock option compensation		79			0			1
Amortization of restricted stock awards		177			447			240
Decrease in unearned ESOP shares		194			193			194
Decrease (increase) in other assets		(11	)		(23	)		69
Decrease in other liabilities		(214	)		(692	)		(420	)
Other, net		(1	)		1			0
Net cash used by operating activities		(250	)		(668	)		(220	)
Cash flows from investing activities:
Decrease in loans receivable, net		0			900			100
Net cash provided by investing activities		0			900			100
Cash flows from financing activities:
Redemption of preferred stock		0			(10,000	)		(16,000	)
Dividends to preferred stockholders		0			(225	)		(5,964	)
Proceeds from borrowings		0			10,000			0
Repayments of borrowings		(2,000	)		(1,000	)		0
Dividends received from Bank		3,000			3,000			22,500
Net cash provided by financing activities		1,000			1,775			536
Increase in cash and cash equivalents		750			2,007			416
Cash and cash equivalents, beginning of year		2,564			557			141
Cash and cash equivalents, end of year	$	3,314			2,564			557

NOTE 23 Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. HMN, the holding company, did not meet the quantitative thresholds for a reportable segment and therefore is included in the “Other” category. The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets, and return on average equity. Each corporation is managed separately with its own officers and board of directors.

The following table sets forth certain information about the reconciliations of reported net income and assets for each of the Company’s reportable segments.

(Dollars in thousands)	Home Federal Savings Bank		Other			Eliminations			Consolidated Total

At or for the year ended December 31, 2016:
Interest income – external customers	$	27,349		0			0			27,349
Non-interest income – external customers		8,201		0			0			8,201
Intersegment interest income		0		1			(1	)		0
Intersegment non-interest income		210		7,148			(7,358	)		0
Interest expense		1,004		589			0			1,593
Non-interest expense		23,572		768			(210	)		24,130
Income tax expense (benefit)		4,680		(558	)		0			4,122
Net income		7,148		6,350			(7,148	)		6,350
Total assets		681,257		82,222			(81,456	)		682,023

At or for the year ended December 31, 2015:
Interest income – external customers	$	21,453		0			0			21,453
Non-interest income – external customers		7,653		0			0			7,653
Intersegment interest income		0		1			(1	)		0
Intersegment non-interest income		204		3,629			(3,833	)		0
Interest expense		937		571			(1	)		1,507
Non-interest expense		22,760		640			(204	)		23,196
Income tax expense (benefit)		2,148		(537	)		0			1,611
Net income		3,629		2,956			(3,629	)		2,956
Total assets		642,151		78,162			(77,152	)		643,161

At or for the year ended December 31, 2014:
Interest income – external customers	$	20,613		0			0			20,613
Non-interest income – external customers		7,284		0			0			7,284
Intersegment interest income		0		2			(2	)		0
Intersegment non-interest income		180		7,644			(7,824	)		0
Interest expense		1,213		0			(2	)		1,211
Non-interest expense		20,781		802			(180	)		21,403
Income tax expense (benefit)		5,438		(536	)		0			4,902
Net income		7,644		7,379			(7,644	)		7,379
Total assets		576,397		76,221			(75,192	)		577,426

OTHER FINANCIAL DATA

The following tables set forth certain information as to the Bank’s Federal Home Loan Bank (FHLB) advances.

	Year Ended December 31,
(Dollars in thousands)	2016		2015		2014
Maximum Balance:
FHLB advances	$	15,500		16,000		0
FHLB short-term advances		15,500		16,000		0
Average Balance:
FHLB advances		468		551		0
FHLB short-term advances		468		551		0

See “Note 12 Federal Home Loan Bank (FHLB) Advances and Other Borrowings” in the Notes to Consolidated Financial Statements for more information on the Bank’s FHLB advances and other borrowings.

SELECTED QUARTERLY FINANCIAL DATA

(Dollars in thousands, except per share data)

December 31, 2016

September 30, 2016

June 30, 2016

Selected Operations Data (3 months ended):

Interest income

6,711

6,954

7,159

Interest expense

420

404

395

Net interest income

6,291

6,550

6,764

Provision for loan losses

(374

)

381

Net interest income after provision for loan losses

6,665

6,470

6,383

Non-interest income:

Fees and service charges

874

901

873

Loan servicing fees

296

280

271

Gain on sales of loans

770

656

705

Other

257

310

253

Total non-interest income

2,197

2,147

2,102

Non-interest expense:

Compensation and benefits

3,748

3,723

3,598

(Gains) losses on real estate owned

(161

)

(11

)

(75

)

Occupancy and equipment

1,047

998

1,006

Data processing

308

299

281

Professional services

386

252

368

Other

877

940

855

Total non-interest expense

6,205

6,201

6,033

Income before income tax expense

2,657

2,416

2,452

Income tax expense

973

1,002

974

Net income

1,684

1,414

1,478

Preferred stock dividends

Net income available to common stockholders

1,684

1,414

1,478

Basic earnings per common share

0.40

0.34

0.35

Diluted earnings per common share

0.35

0.30

0.31

Financial Ratios:

Return on average assets⁽¹⁾

0.99

0.84

0.91

Return on average common equity⁽¹⁾

8.93

7.55

8.23

Average equity to average assets

11.07

11.10

11.07

Net interest margin⁽¹⁾⁽²⁾

3.89

4.10

4.36

(Dollars in thousands)

Selected Financial Condition Data:

Total assets

682,023

685,667

653,385

Securities available for sale:

Mortgage-backed and related securities

1,005

1,306

1,641

Other marketable securities

77,472

78,810

73,924

Loans held for sale

2,009

5,879

3,159

Loans receivable, net

551,171

540,583

530,425

Deposits

592,811

592,243

563,060

FHLB advances and other borrowings

7,000

9,000

Stockholders’ equity

75,919

74,834

73,337

⁽¹⁾ Annualized

⁽²⁾ Net interest income divided by average interest-earning assets

March 31, 2016		December 31, 2015			September 30, 2015			June 30, 2015			March 31, 2015
6,525			6,109			5,390			5,070			4,884
374			393			397			391			326
6,151			5,716			4,993			4,679			4,558
(732	)		75			(56	)		(183	)		0
6,883			5,641			5,049			4,862			4,558

779			827			863			844			782
261			268			262			257			261
487			536			613			530			285
228			330			493			236			268
1,755			1,961			2,231			1,867			1,596

3,695			3,448			3,299			3,540			3,448
(349	)		97			168			65			(112	)
990			981			936			926			879
273			267			254			268			231
251			325			273			293			217
831			878			1,039			708			770
5,691			5,996			5,969			5,800			5,433
2,947			1,606			1,311			929			721
1,173			516			491			344			260
1,774			1,090			820			585			461
0			0			0			0			(108	)
1,774			1,090			820			585			353
0.43			0.26			0.20			0.14			0.09
0.38			0.23			0.18			0.13			0.08

1.12	%		0.69	%		0.53	%		0.42	%		0.33	%
10.12			6.19			4.77			3.50			2.60
11.11			11.70			11.91			12.30			12.62
4.09			3.80			3.44			3.56			3.42



638,156			643,161			618,917			564,001			565,487

1,984			2,283			7,080			2,115			2,471
103,844			109,691			138,258			123,326			151,674
4,467			3,779			5,153			5,968			2,663
490,260			463,185			432,174			368,110			360,370
551,506			559,387			531,586			481,476			483,323
9,000			9,000			10,000			10,000			10,000
71,687			69,645			68,710			67,494			66,775

COMMON STOCK INFORMATION

The common stock of the Company is listed on the Nasdaq Stock Market (Nasdaq) under the symbol HMNF. As of December 31, 2016, the Company had 9,128,662 shares of common stock issued and 4,639,739 shares in treasury stock. As of December 31, 2016, there were 572 stockholders of record and 1,036 estimated beneficial stockholders. The following table presents the stock price information for the Company as furnished by Nasdaq for each quarter for the last two fiscal years. On February 13, 2017, the last reported sale price of shares of our common stock on the Nasdaq was $18.50 per share. The Company has not paid a dividend on its common stock during the two year period ending December 31, 2016 and no common stock dividends are anticipated to be paid in 2017. See “Liquidity and Capital Resources – Dividends” in the “Management Discussion and Analysis” section of this annual report for a description of restrictions on the ability of the Company and the Bank to pay dividends.

For the Quarter Ended

December 31,

2016

September 30,

2016

June 30,

2016

March 31,

2016

December 31,

2015

September 30,

2015

June 30,

2015

March 31,

2015

HIGH

18.55

15.00

14.44

11.80

12.06

12.61

12.92

LOW

13.58

13.25

11.25

10.81

11.06

10.88

10.18

11.46

17.50

14.16

13.58

11.26

11.55

11.51

11.79

12.10

The following graph and table compares the total cumulative stockholders’ return on the Company’s common stock to the NASDAQ U.S. Stock Index (“NASDAQ Composite”), which includes all NASDAQ traded stocks of U.S. companies, and the SNL Bank NASDAQ Index. The graph and table assume that $100 was invested on December 31, 2011 and that all dividends were reinvested.

Index	12/31/11		12/31/12		12/31/13		12/31/14		12/31/15		12/31/16
HMN Financial, Inc.		100.00		179.30		545.97		640.50		596.59		903.93
NASDAQ Composite		100.00		117.45		164.57		188.84		201.98		219.89
SNL Bank NASDAQ Index		100.00		119.19		171.31		177.42		191.53		265.56

HMN Financial, Inc.

1016 Civic Center Drive NW

Rochester, MN 55901

(507) 535-1200

Annual Meeting

The annual meeting of shareholders will

be held on Tuesday, April 25, 2017 at

10:00 a.m. (Central Time) at the

Rochester Golf and Country Club, 3100

West Country Club Road, Rochester, Minnesota.

Legal Counsel

Faegre Baker Daniels LLP

2200 Wells Fargo Center

90 South Seventh Street

Minneapolis, MN 55402-3901

Independent Registered Public Accounting Firm

CliftonLarsonAllen LLP

220 South Sixth Street, Suite 300

Minneapolis, MN 55402-1436

Investor Information and Form 10-K

HMN’s Form 10-K, filed with the

Securities and Exchange Commission,

is available without charge

upon written request from:

HMN Financial, Inc.

Attn: Cindy Hamlin, Investor Relations

1016 Civic Center Drive NW

Rochester, MN 55901

or at www.hmnf.com

Transfer Agent and Registrar

Inquiries regarding change of address,

transfer requirements, and lost certificates

should be directed to HMN’s transfer

agent:

Wells Fargo Bank, N.A.

Shareowner Services

1110 Centre Pointe Curve, Suite 101

MAC N9173-010

Mendota Heights, MN 55120

www.wellsfargo.com/shareownerservices

(800) 468-9716

Directors

Dr. Hugh C. Smith

Chairman of the Board

HMN and Home Federal Savings Bank

Retired Professor of Medicine, Mayo

Clinic College of Medicine and

Consultant in Cardiovascular Division,

Mayo Clinic

Allen J. Berning

Chief Executive Officer

Ambient Clinical Analytics

Michael A. Bue

Retired President and Chief Executive

Officer

Security State Bank of Lewiston

Bradley C. Krehbiel

President and Chief Executive Officer

HMN and Home Federal Savings Bank

Bernard R. Nigon

Retired Audit Partner with RSM US LLP

(formerly McGladrey & Pullen, LLP)

Dr. Wendy S. Shannon

Assistant Professor, Winona State University

Dr. Patricia S. Simmons

Retired Professor of Pediatric and Adolescent

Medicine, Mayo Clinic College of Medicine

Mark E. Utz

Attorney at law, Wendland Utz, Ltd.

Hans K. Zietlow

Director of Real Estate for Kwik Trip, Inc.

Executive Officers Who Are Not

Directors

Jon J. Eberle

Senior Vice President, Chief Financial Officer

and Treasurer of HMN and Executive Vice

President, Chief Financial Officer and

Treasurer of Home Federal Savings Bank

Susan K. Kolling

Senior Vice President

HMN and Home Federal Savings Bank

Lawrence D. McGraw

Executive Vice President and

Chief Operating Officer

Home Federal Savings Bank

Branch Offices of Bank

Albert Lea

143 West Clark Street

Albert Lea, MN 56007

(507) 379-2551

Austin

201 Oakland Avenue West

Austin, MN 55912

(507) 434-2500

Eagan

2805 Dodd Road, Suite 160

Eagan, MN 55121

(651) 405-2000

Kasson

203 West Main
Kasson, MN 55944

(507) 634-7022

502 South Mantorville Avenue
Kasson, MN 55944

(507) 634-4141

La Crescent

208 South Walnut

La Crescent, MN 55947

(507) 895-9200

Marshalltown

303 West Main Street

Marshalltown, IA 50158

(641) 754-6198

Rochester

1201 South Broadway

Rochester, MN 55901

(507) 536-2416

1016 Civic Center Drive NW

Rochester, MN 55901

(507) 535-1309

100 1^st Avenue Bldg., Suite 200

Rochester, MN 55902

(507) 280-7256

2048 Superior Drive NW, Suite 400

Rochester, MN 55901

(507) 226-0800

Spring Valley

715 North Broadway

Spring Valley, MN 55975

(507) 346-9709

Winona

175 Center Street

Winona, MN 55987

(507) 453-6460

Loan Production Offices

Sartell

50 14^th Ave E, Suite 100
Sartell, MN 56377

(320) 654-4020

Owatonna

1850 Austin Road, Suite 103

Owatonna, MN 55060
(507) 413-6420

Mankato

100 Warren Street, Suite 300
Mankato, MN 56001

(507) 455-0174

Delafield

3960 Hillside Drive, Suite 206
Delafield, WI 53018

(262) 337-9511

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