**Exhibit 13**

 

**FIVE - YEARCONSOLIDATED FINANCIAL HIGHLIGHTS**

 

**SelectedOperations Data:**

 
|                                                 |   | **Year Ended December 31,** |       |
|------------------------------------------------------|--------|----------------------------------|------------|
| **(Dollars in thousands, except per  share data)**   |   | **2003**                         |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Total  interest income                               |   | **$**                            | **44,937** | ** ** | 42,868 |   | 51,468 |   | 52,917 |   | 47,104 |   |
| Total  interest expense                              |   | **20,289**                       | ** ** | 21,295 |   | 30,444 |   | 33,001 |   | 28,911 |   |
| Net  interest income                                 |   | **24,648**                       | ** ** | 21,573 |   | 21,024 |   | 19,916 |   | 18,193 |   |
| Provision  for loan losses                           |   | **2,610**                        | ** ** | 2,376 |   | 1,150 |   | 180 |   | 240 |   |
| Net  interest income after provision for loan losses |   | **22,038**                       | ** ** | 19,197 |   | 19,874 |   | 19,736 |   | 17,953 |   |
| Fees  and service charges                            |   | **2,304**                        | ** ** | 1,723 |   | 1,563 |   | 1,297 |   | 848 |   |
| Mortgage  servicing fees                             |   | **998**                          | ** ** | 715 |   | 470 |   | 341 |   | 335 |   |
| Securities  gains (losses), net                      |   | **1,275**                        | ** ** | 422 |   | (671 | ) | (23 | ) | 122 |   |
| Gain  on sales of loans                              |   | **5,240**                        | ** ** | 3,077 |   | 2,934 |   | 1,216 |   | 1,932 |   |
| Earnings  (losses) in limited partnerships           |   | **(243**                         | **)**      | (659 | ) | (1,311 | ) | (121 | ) | 550 |   |
| Other  non-interest income                           |   | **681**                          | ** ** | 597 |   | 599 |   | 613 |   | 506 |   |
| Total  non-interest income                           |   | **10,255**                       | ** ** | 5,875 |   | 3,584 |   | 3,323 |   | 4,293 |   |
| Other  non-interest expense                          |   | **19,653**                       | ** ** | 17,849 |   | 15,749 |   | 12,559 |   | 11,895 |   |
| Total  non-interest expense                          |   | **19,653**                       | ** ** | 17,849 |   | 15,749 |   | 12,559 |   | 11,895 |   |
| Income  tax expense                                  |   | **4,038**                        | ** ** | 2,099 |   | 2,634 |   | 3,798 |   | 3,960 |   |
| Income  before minority interest                     |   | **8,602**                        | ** ** | 5,124 |   | 5,075 |   | 6,702 |   | 6,391 |   |
| Minority  interest                                   |   | **(3**                           | **)**      | (142 | ) | (383 | ) | 0 |   | 0 |   |
| Net  income                                          |   | **$**                            | **8,605**  | ** ** | 5,266 |   | 5,458 |   | 6,702 |   | 6,391 |   |
| Per  common share and common share equivalents:      |   |                             | ** ** |   |   |   |   |   |   |   |   |
| Basic                                                |   | **$**                            | **2.26**   | ** ** | 1.40 |   | 1.45 |   | 1.75 |   | 1.47 |   |
| Diluted                                              |   | **2.16**                         | ** ** | 1.32 |   | 1.37 |   | 1.69 |   | 1.41 |   |

 

**SelectedFinancial Condition Data:**

 
|                                                                          |   | **December 31,** |        |
|-------------------------------------------------------------------------------|--------|-----------------------|-------------|
| **(Dollars in thousands, except per  share data)**                            |   | **2003**              |        | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Total  assets                                                                 |   | **$**                 | **866,436** |   | 737,523 |   | 721,114 |   | 716,016 |   | 699,186 |   |
| Securities  available for sale                                                |   | **104,664**           |        | 121,397 |   | 119,895 |   | 139,206 |   | 173,477 |   |
| Loans  held for sale                                                          |   | **6,543**             |        | 15,127 |   | 68,018 |   | 7,861 |   | 4,083 |   |
| Loans  receivable, net                                                        |   | **688,951**           |        | 533,906 |   | 471,668 |   | 518,765 |   | 447,896 |   |
| Deposits                                                                      |   | **551,688**           |        | 432,951 |   | 421,843 |   | 421,691 |   | 400,382 |   |
| Federal  Home Loan Bank advances                                              |   | **203,900**           |        | 218,300 |   | 217,800 |   | 221,900 |   | 229,400 |   |
| Stockholders’  equity                                                    |   | **80,931**            |        | 76,065 |   | 72,161 |   | 66,626 |   | 64,561 |   |
|                                                                          |   |                  |        |   |   |   |   |   |   |   |   |
| Book  value per share                                                         |   | **17.93**             |        | 17.28 |   | 16.41 |   | 15.17 |   | 13.57 |   |
| Tangible  book value per share                                                |   | **16.23**             |        | 15.68 |   | 15.39 |   | 14.09 |   | 12.48 |   |
|                                                                          |   |                  |        |   |   |   |   |   |   |   |   |
| Number  of full service offices                                               |   | **12**                |        | 13 |   | 12 |   | 11 |   | 10 |   |
| Number  of mortgage origination offices                                       |   | **6**                 |        | 2 |   | 1 |   | 1 |   | 1 |   |
|                                                                          |   |                  |        |   |   |   |   |   |   |   |   |
| Key  Ratios(1)                                                                |   |                  |        |   |   |   |   |   |   |   |   |
| Stockholders’  equity to total assets at year end                        |   | **9.34**              | **%**       | 10.31 | % | 10.01 | % | 9.31 | % | 9.23 | % |
| Average  stockholders’ equity to average assets                          |   | **10.15**             |        | 10.66 |   | 9.91 |   | 9.56 |   | 10.13 |   |
| Return  on stockholders’ equity  (ratio of net income to average equity) |   | **10.85**             |        | 6.94 |   | 7.57 |   | 9.81 |   | 9.18 |   |
| Return  on assets  (ratio of net income to average assets)                    |   | **1.10**              |        | 0.74 |   | 0.75 |   | 0.94 |   | 0.93 |   |
| Dividend  payout ratio                                                        |   | **39.58**             |        | 57.63 |   | 39.71 |   | 27.22 |   | 24.11 |   |
|                                                                               |        |                       |             |  |  |  |  |  |  |  |  |  |

 

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(1)     Average balances were calculatedbased upon amortized cost without the market value impact of SFAS No. 115.

 

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**MANAGEMENT’SDISCUSSION AND ANALYSIS**

 

*ThisAnnual Report, other reports filed with the Securities and Exchange Commission,and HMN’s proxy statement may contain “forward-looking” statements that dealwith future results, plans or performance. In addition, the Company’smanagement may make such statements orally to the media, or to securitiesanalysts, investors or others. Forward-looking statements deal with mattersthat do not relate strictly to historical facts. The Company’s future resultsmay differ materially from historical performance and forward-lookingstatements about the Company’s expected financial results or other plans aresubject to a number of risks and uncertainties. These include but are notlimited to possible legislative changes and adverse economic, business andcompetitive developments such as shrinking interest margins; deposit outflows;reduced demand for financial services and loan products; changes in accounting policiesand guidelines, or monetary and fiscal policies of the federal government;changes in credit and other risks posed by the Company’s loan and investmentportfolios; technological, computer-related or operational difficulties;adverse changes in securities markets; results of litigation or othersignificant uncertainties.*

 

**OVERVIEW**

 

HMN Financial, Inc. (HMN orthe Company) is the stock savings bank holding company for Home Federal SavingsBank (the Bank) which operates community retail banking facilities and loanproduction offices in southern Minnesota and Iowa. Eagle Crest Capital Bank, adivision of Home Federal Savings Bank, provides private banking services to adiverse group of high net worth customers from offices in Edina and RochesterMinnesota. The earnings of the Company are primarily dependant on the Bank’snet interest income, which is the difference between interest earned on itsloans and investments, and the interest paid on interest-bearing liabilitiessuch as deposits and Federal Home Loan Bank (FHLB) advances. The differencebetween the average rate of interest earned on assets and the average rate paidon liabilities is the “interest rate spread”. Net interest income is producedwhen interest-earning assets equal or exceed interest-bearing liabilities andthere is a positive interest rate spread. The Company’s interest rate spreadhas been enhanced by the increased level of commercial loans placed inportfolio and the increased amount of lower rate deposit products such aschecking and money market accounts. Net interest income and net interest ratespread are affected by changes in interest rates, the volume and the mix ofinterest-earning assets and interest-bearing liabilities, and the level ofnon-performing assets. The Company’s net income is also affected by thegeneration of non-interest income, which consists primarily of gains or lossesfrom the sale of securities, gains from the sale of loans, and the generationof fees and service charges on deposit accounts. The Company’s non-interestincome has been enhanced by increased fees and service charges on depositaccounts. The Bank incurs expenses in addition to interest expense in the formof salaries and benefits, occupancy expenses, provisions for loan losses andamortization and valuation adjustments on mortgage servicing assets.

 

The earnings of financialinstitutions, such as the Bank, are significantly affected by prevailingeconomic and competitive conditions, particularly changes in interest rates,government monetary and fiscal policies, and regulations of various regulatoryauthorities. Lending activities are influenced by the demand for and supply ofsingle family and commercial properties, competition among lenders, the levelof interest rates and the availability of funds. Due to an anticipated increasein mortgage interest rates, we expect mortgage activity to slow in 2004.Deposit flows and costs of deposits are influenced by prevailing market ratesof interest on competing investments, account maturities and the levels ofpersonal income and savings.

 

**CriticalAccounting Policies**

 

Critical accounting policiesare those policies that the Company’s management believes are the mostimportant to understanding the Company’s financial condition and operatingresults. The Company has identified the following three policies as beingcritical because they require difficult, subjective, and/or complex judgmentsthat are inherently uncertain. Therefore, actual financial results could differsignificantly depending upon the estimates used.

 

***Allowance for Loan Losses and Related Provision***

 

The allowance for loanlosses is based on periodic analysis of the loan portfolio. In this analysis,management considers factors including, but not limited to, specificoccurrences of loan impairment, changes in the size of the portfolios, nationaland regional economic conditions, such as unemployment data, loan portfoliocomposition, loan delinquencies, local construction permits, development plans,local economic growth rates, historical experience and observations made by theCompany’s ongoing internal audit and regulatory exam processes. The allowancefor loan losses is established for known problem loans, as well as for loanswhich are not currently known to require specific allowances. Loans are chargedoff to the extent they are deemed to be uncollectible. The Company hasestablished separate processes to determine the adequacy of the loan lossallowance for its homogeneous and non-homogeneous loan portfolios. Thedetermination of the allowance for the nonhomogeneous commercial, commercialreal estate, and multi-family loan portfolios involves assigning standardizedrisk ratings and loss factors that are periodically reviewed. The loss factorsare estimated using a combination of the Company’s own loss experience andexternal industry data and are assigned to all loans without identified creditweaknesses. The Company also performs an individual analysis of impairment oneach non-performing loan that is based on the expected cash flows or the valueof the assets collateralizing the loans. The determination of the allowance onthe homogeneous single-family and consumer loan portfolios is calculated on apooled basis with individual determination of the allowance of allnon-performing loans.

 

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The adequacy of theallowance for loan losses is dependent upon management’s estimates of variablesaffecting valuation, appraisals of collateral, evaluations of performance andstatus, and the amounts and timing of future cash flows expected to be receivedon impaired loans. Such estimates, appraisals, evaluations and cash flows maybe subject to frequent adjustments due to changing economic prospects ofborrowers or properties. The estimates are reviewed periodically andadjustments, if any, are recorded in the provision for loan losses in theperiods in which the adjustments become known. The allowance is allocated toindividual loan categories based upon the relative risk characteristics of theloan portfolios and the actual loss experience. The Company increases itsallowance for loan losses by charging the provision for loan losses againstincome. The methodology for establishing the allowance for loan losses takesinto consideration probable losses that have been identified in connection withspecific loans as well as losses in the loan portfolio for which specificreserves are not required. Although management believes that the allowance forloan losses is maintained at an adequate amount to provide for probable loanlosses inherent in the portfolio as of the balance sheet dates, futureadjustments to the provision for loan losses may be necessary if conditionsdiffer substantially from those in the assumptions used to determine theallowance for loan losses.

 

***Mortgage Servicing Rights***

 

The Company recognizes as anasset the rights to service mortgage loans for others, which are referred to asmortgage servicing rights (MSRs). MSRs are capitalized at the relative fairvalue of the servicing rights on the date the mortgage loan is sold and arecarried at the lower of the capitalized amount, net of accumulatedamortization, or fair value. MSRs are capitalized and amortized in proportionto, and over the period of, estimated net servicing income. Each quarter theCompany evaluates its MSRs for impairment in accordance with Statement ofFinancial Accounting Standard (SFAS) No. 140. Loan type and interest rate are the predominant risk characteristics ofthe underlying loans used to stratify the MSRs for purposes of measuringimpairment. If temporary impairment exists, a valuation allowance isestablished for any excess of amortized cost over the current fair valuethrough a charge to income. If the Company later determines that all or aportion of the temporary impairment no longer exists, a reduction of thevaluation allowance is recorded as an increase to income.  The valuation of the MSRs is based onvarious assumptions including the estimated prepayment speeds and default ratesof the stratified portfolio. Changes in the mix of loans, interest rates,prepayment speeds, or default rates from the estimates used in the valuation ofthe mortgage servicing rights may have a material effect on the amortizationand valuation of MSRs. Although management believes that the assumptions usedand the values determined are reasonable, future adjustments may be necessaryif economic conditions differ substantially from the economic conditions in theassumptions used to determine the value of the MSRs. The Company does not formallyhedge its MSRs because they are hedged naturally by the Company’s originationvolume. Generally, as interest rates rise the origination volume declines andthe value of MSRs increases and as interest rates decline the originationvolume increases and the value of MSRs decreases.

 

***Income Taxes***

 

Deferred tax assets andliabilities are recognized for the future tax consequences attributable totemporary differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax basis. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. These calculations are based on many complexfactors including estimates of the timing of reversals of temporarydifferences, the interpretation of federal and state income tax laws, and adetermination of the differences between the tax and the financial reportingbasis of assets and liabilities. Actual results could differ significantly fromthe estimates and interpretations used in determining the current and deferredincome tax liabilities.

 

**Results ofOperations**

 

Net income was $8.6 millionfor the year ended December 31, 2003, compared to $5.3 million for theyear ended December 31, 2002. Basic earnings per share were $2.26 for theyear ended December 31, 2003, compared to $1.40 for the year endedDecember 31, 2002. Diluted earnings per common share for the year endedDecember 31, 2003 were $2.16, compared to $1.32 for the year endedDecember 31, 2002. Return on average assets was 1.10% and 0.74% and returnon average equity was 10.85% and 6.94% for the years ended December 31,2003 and 2002, respectively.

 

***Net Interest Income***

 

In comparing the year endedDecember 31, 2003 to the year ended December 31, 2002, net interestincome increased by $3.1 million to $24.6 million from $21.5 million in 2002.Interest income was $44.9 million for the year ended December 31, 2003, anincrease of $2.0 million, from $42.9 million for the same period in 2002.Interest income increased primarily because of an increase in interest-earningassets and because of a higher concentration of commercial and consumer loansin portfolio. The commercial and consumer loan portfolios increased by $148million between the periods.  During2003, the Company’s commercial and consumer loan portfolios continued toincrease and the

 

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percentage of loans in theseportfolios represented 61.7% of the Company’s outstanding loans atDecember 31, 2003, compared to 58.2% at December 31, 2002. Theincrease in interest-earning assets offsets the decrease in the interest ratesearned on the assets between the periods. Interest expense was $20.3 millionfor the year ended December 31, 2003, a decrease of $1.0 million, from the$21.3 million for the same period in 2002. Interest expense declined primarilybecause of a decrease in the rates paid on deposits and Federal Home Loan Bankadvances and because of a $45 million increase in the outstanding averagebalance of checking and money market accounts between the periods, whichgenerally have lower interest rates than other deposit accounts.

 

The following table presentsthe total dollar amount of interest income from average interest-earning assetsand the resultant yields, as well as the interest expense on averageinterest-bearing liabilities, expressed both in dollars and rates. Non-accruingloans have been included in the table as loans carrying a zero yield.

 
|                                                                     |   | **Year Ended December 31,**  |        |
|--------------------------------------------------------------------------|--------|-----------------------------------|-------------|
|                                                                     |   | **2003**                          |        | **2002** |   | **2001** |   |
| **(Dollars in thousands)**                                               |   | **Average  Outstanding  Balance** |        | **Interest  Earned/  Paid** |   | **Yield/  Rate** |   | **Average  Outstanding  Balance** |   | **Interest  Earned/  Paid** |   | **Yield/  Rate** |   | **Average  Outstanding  Balance** |   | **Interest  Earned/  Paid** |   | **Yield/  Rate** |   |
| **Interest-earning assets:**                                             |   |                              | ** **  |   | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities  available for sale:                                          |   |                              | ** **  |   | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed  and related securities                                  |   | **$**                             | **21,885**  | ** ** | **272** | ** ** | **1.24** | **%** | $ | 63,022 |   | 1,704 |   | 2.70 | % | $ | 71,230 |   | 3,867 |   | 5.43 | % |
| Other  marketable securities(1)                                          |   | **74,487**                        | ** **  | **2,387** | ** ** | **3.20** | ** ** | 60,973 |   | 2,420 |   | 3.97 |   | 38,106 |   | 2,248 |   | 5.90 |   |
| Loans  held for sale                                                     |   | **12,899**                        | ** **  | **748** | ** ** | **5.80** | ** ** | 22,485 |   | 1,587 |   | 7.06 |   | 54,009 |   | 3,764 |   | 6.97 |   |
| Loans  receivable, net(2)                                                |   | **602,653**                       | ** **  | **41,052** | ** ** | **6.81** | ** ** | 479,158 |   | 36,426 |   | 7.60 |   | 503,063 |   | 40,806 |   | 8.11 |   |
| Federal  Home Loan Bank stock                                            |   | **11,464**                        | ** **  | **349** | ** ** | **3.04** | ** ** | 12,086 |   | 349 |   | 2.89 |   | 12,245 |   | 537 |   | 4.38 |   |
| Other,  including cash equivalents                                       |   | **20,503**                        | ** **  | **129** | ** ** | **0.63** | ** ** | 37,831 |   | 382 |   | 1.01 |   | 16,715 |   | 246 |   | 1.47 |   |
| Total  interest-earning assets                                           |   | **$**                             | **743,891** | ** ** | **44,937** | ** ** | **6.04** | ** ** | $ | 675,555 |   | 42,868 |   | 6.35 |   | $ | 695,368 |   | 51,468 |   | 7.40 |   |
| **Interest-bearing liabilities:**                                        |   |                              | ** **  |   | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest  checking                                                    |   | **$**                             | **28,964**  | ** ** | **0** | ** ** | **0.00** | **%** | $ | 19,095 |   | 0 |   | 0.00 | % | $ | 13,055 |   | 0 |   | 0.00 | % |
| NOW  accounts                                                            |   | **46,277**                        | ** **  | **120** | ** ** | **0.26** | ** ** | 39,625 |   | 226 |   | 0.57 |   | 33,457 |   | 380 |   | 1.13 |   |
| Passbooks                                                                |   | **38,201**                        | ** **  | **91** | ** ** | **0.24** | ** ** | 35,847 |   | 241 |   | 0.67 |   | 32,707 |   | 455 |   | 1.39 |   |
| Money  market accounts                                                   |   | **73,800**                        | ** **  | **878** | ** ** | **1.19** | ** ** | 47,593 |   | 796 |   | 1.67 |   | 39,924 |   | 1,271 |   | 3.18 |   |
| Certificate  accounts                                                    |   | **286,238**                       | ** **  | **9,185** | ** ** | **3.21** | ** ** | 270,482 |   | 9,686 |   | 3.58 |   | 299,336 |   | 16,472 |   | 5.50 |   |
| Federal  Home Loan Bank advances                                         |   | **221,503**                       | ** **  | **10,015** | ** ** | **4.52** | ** ** | 215,623 |   | 10,346 |   | 4.80 |   | 221,891 |   | 11,866 |   | 5.35 |   |
| Other  interest-bearing liabilities                                      |   | **2,556**                         | ** **  | **0** | ** ** | **0.00** | ** ** | 1,544 |   | 0 |   | 0.00 |   | 1,220 |   | 0 |   | 0.00 |   |
| Total  interest-bearing liabilities                                      |   | **$**                             | **697,539** | ** ** | **20,289** | ** ** | **2.91** | ** ** | $ | 629,809 |   | 21,295 |   | 3.39 |   | $ | 641,590 |   | 30,444 |   | 4.75 |   |
| Net  interest income                                                     |   |                              |        | **24,648** | ** ** |   | ** ** |   |   | 21,573 |   |   |   |   |   | 21,024 |   |   |   |
| Net  interest rate spread                                                |   |                              |        |   |   | **3.13** | **%** |   |   |   |   | 2.96 | % |   |   |   |   | 2.65 | % |
| Net  earning assets                                                      |   | **$**                             | **46,352**  | ** ** |   | ** ** |   | ** ** | $ | 45,746 |   |   |   |   |   | $ | 53,778 |   |   |   |   |   |
| Net  interest margin                                                     |   |                              |        |   |   | **3.31** | **%** |   |   |   |   | 3.19 | % |   |   |   |   | 3.02 | % |
| Average  interest-earning assets to average interest-bearing liabilities |   |                              |        | **106.65** | **%** |   |   |   |   | 107.26 | % |   |   |   |   | 108.38 | % |   |   |

 

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(1)          Tax exempt income was not significant; therefore, the yield was notpresented on a tax equivalent basis. The tax-exempt income was $837,343 for2003, $315,093 for 2002 and $70,702 for 2001.

(2)          Calculated net of deferred loan fees, loan discounts, loans in processand loss reserve.

 

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Net interest marginincreased to 3.31% in 2003 compared to 3.19% for 2002 primarily because of theincreased focus on commercial and consumer loans and the increase in theoutstanding average balance of checking and money market accounts. Average netearning assets were $46.4 million in 2003 compared to $45.7 million for 2002.The Company has actively purchased its common stock in the open market and haspaid quarterly dividends to its stockholders, both of which reduce net interestearning assets. During 2003 and 2002 HMN paid $1.4 million and $1.5 million topurchase its common stock in the open market and paid dividends to stockholdersof $2.9 million and $2.6 million, respectively. The increase in net interestearning assets in 2003 is primarily the result of net income exceeding stockrepurchases, dividends on common stock, and fixed asset additions.

 

The followingschedule presents the dollar amount of changes in interest income andinterest expense for major components of interest-earning assets andinterest-bearing liabilities. It quantifies the changes in interest income andinterest expense related to changes in the average outstanding balances(volume) and those changes caused by fluctuating interest rates. For eachcategory 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 old volume).

 
|                                    |   | **Year Ended December 31,** |          |
|-----------------------------------------|--------|----------------------------------|---------------|
|                                    |   | **2003 vs. 2002**                |          |   |   | **2002 vs. 2001** |   |   |   |
| **(Dollars in thousands)**              |   | **Increase (Decrease)  Due to**  |          | **Total  Increase  (Decrease)** |   | **Increase (Decrease)  Due to** |   | **Total  Increase  (Decrease)** |   |
| **Volume(1)**                           |   | **Rate(1)**                      | **Volume(1)** |   | **Rate(1)** |
| Interest-earning  assets:               |   |                             |          |   |   |   | ** ** |   |   |   |   |   |   |
| Securities  available for sale:         |   |                             |          |   |   |   | ** ** |   |   |   |   |   |   |
| Mortgage-backed  and related securities |   | **$**                            | **(784**      | **)** | **(648** | **)** | **(1,432** | **)** | $ | (404 | ) | (1,759 | ) | (2,163 | ) |
| Other  marketable securities            |   | **591**                          | ** **    | **(620** | **)** | **(29** | **)** | 1,634 |   | (1,462 | ) | 172 |   |
| Loans  held for sale                    |   | **(592**                         | **)**         | **(247** | **)** | **(839** | **)** | (2,224 | ) | 47 |   | (2,177 | ) |
| Loans  receivable, net                  |   | **10,084**                       | ** **    | **(5,457** | **)** | **4,627** | ** ** | (1,887 | ) | (2,494 | ) | (4,381 | ) |
| Federal  Home Loan Bank stock           |   | **(18**                          | **)**         | **24** | ** ** | **6** | ** ** | (7 | ) | (180 | ) | (187 | ) |
| Other,  including cash equivalents      |   | **(136**                         | **)**         | **(128** | **)** | **(264** | **)** | 390 |   | (254 | ) | 136 |   |
| Total  interest-earning assets          |   | **$**                            | **9,145**     | ** ** | **(7,076** | **)** | **2,069** | ** ** | $ | (2,498 | ) | (6,102 | ) | (8,600 | ) |
| Interest-bearing  liabilities:          |   |                             |          |   |   |   | ** ** |   |   |   |   |   |   |
| NOW  accounts                           |   | **$**                            | **88**        | ** ** | **(194** | **)** | **(106** | **)** | $ | 79 |   | (233 | ) | (154 | ) |
| Passbooks                               |   | **17**                           | ** **    | **(168** | **)** | **(151** | **)** | 48 |   | (261 | ) | (213 | ) |
| Money  market accounts                  |   | **702**                          | ** **    | **(622** | **)** | **80** | ** ** | 277 |   | (752 | ) | (475 | ) |
| Certificates                            |   | **585**                          | ** **    | **(1,084** | **)** | **(499** | **)** | (1,468 | ) | (5,319 | ) | (6,787 | ) |
| Federal  Home Loan Bank advances        |   | **287**                          | ** **    | **(617** | **)** | **(330** | **)** | (328 | ) | (1,192 | ) | (1,520 | ) |
| Total  interest-bearing liabilities     |   | **$**                            | **1,679**     | ** ** | **(2,685** | **)** | **(1,006** | **)** | $ | (1,392 | ) | (7,757 | ) | (9,149 | ) |
| Net  interest income                    |   |                             |          |   |   | **$** | **24,648** | ** ** |   |   |   |   | $ | 21,573 |   |
|                                         |        |                                  |               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

5

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The following table setsforth the weighted average yields on the Company’s interest-earning assets, theweighted average interest rates on interest-bearing liabilities and theinterest rate spread between the weightedaverage yields and rates as of the date indicated. Non-accruing loans have beenincluded in the table as loans carrying a zero yield.

 

**At December 31, 2003**

 
| Weighted  average yield on:                                     |   |   |   |
|-----------------------------------------------------------------|--------|--------|--------|
| Securities  available for sale:                                 |   |   |   |
| Mortgage-backed  and related securities                         |   | 3.52   | %      |
| Other  marketable securities                                    |   | 2.86   |   |
| Loans  held for sale                                            |   | 5.56   |   |
| Loans  receivable, net                                          |   | 6.41   |   |
| Federal  Home Loan Bank stock                                   |   | 3.00   |   |
| Other  interest-earning assets                                  |   | 0.66   |   |
| Combined  weighted average yield on interest-earning assets     |   | 5.82   |   |
| Weighted  average rate on:                                      |   |   |   |
| NOW  accounts                                                   |   | 0.39   | %      |
| Passbooks                                                       |   | 0.20   |   |
| Money  market accounts                                          |   | 1.23   |   |
| Certificates                                                    |   | 3.11   |   |
| Federal  Home Loan Bank advances                                |   | 4.33   |   |
| Other  interest bearing liabilities                             |   | 0.02   |   |
| Combined  weighted average rate on interest-bearing liabilities |   | 2.63   |   |
| Interest  rate spread                                           |   | 3.19   |   |

 

***Provision For Loan Losses***

 

The provision for loanlosses is recorded to bring the allowance for loan losses to a level deemedappropriate by management based on factors disclosed in the critical accountingpolicy previously discussed. The provision for loan losses for the year endedDecember 31, 2003 was $2.6 million compared to $2.4 million for the yearended December 31, 2002. The provision increased primarily because of theadditional $33 million in growth experienced in the commercial and consumerloan portfolios in 2003. Commercial and consumer loans generally require alarger provision due to the greater inherent credit risk of these loans. Theprovision also increased because of increases in specific consumer loanreserves and increased instances of personal bankruptcies which resulted in anincrease in non-accruing loans of $1.2 million between the periods. The Companyincurred $494,000 of net loan charge-offs in 2003 compared to $1.3 million ofnet loan charge-offs in 2002.

 

***Non-Interest Income***

 

Non-interest income was$10.3 million for the year ended December 31, 2003, an increase of $4.4million, from $5.9 million for the same period in 2002. The following tablepresents the components of non-interest income:

 
|                            |   |                             |       |                    |   |     |   | **Percentage** |       |
|---------------------------------|--------|----------------------------------|------------|-------------------------|--------|----------|--------|----------------|------------|
|                            |   | **Year Ended December 31,** |       | **Increase (Decrease)** |   |
| **(Dollars  in thousands)**     |   | **2003**                         |       | **2002**                |   | **2001** |   | **2003/2002**  |       | **2002/2001** | ** ** |
| Fees  and service charges       |   | **$**                            | **2,304**  | ** **              | 1,723  |     | 1,563  |           | **33.7**   | **%** | 10.2 | % |
| Mortgage  servicing fees        |   | **998**                          | ** ** | 715                     |   | 470      |   | **39.6**       | ** ** | 52.1 |   |
| Securities  gains (losses), net |   | **1,275**                        | ** ** | 422                     |   | (671     | )      | **202.1**      | ** ** | 162.9 |   |
| Gain  on sales of loans         |   | **5,240**                        | ** ** | 3,077                   |   | 2,934    |   | **70.3**       | ** ** | 4.9 |   |
| Losses  in limited partnerships |   | **(243**                         | **)**      | (659                    | )      | (1,311   | )      | **63.1**       | ** ** | 49.7 |   |
| Other  non-interest income      |   | **$**                            | **681**    | ** **              | 597    |     | 599    |           | **14.1**   | ** ** | (0.3 | ) |
| Total  non-interest income      |   | **$**                            | **10,255** | ** **              | 5,875  |     | 3,584  |           | **74.6**   | ** ** | 63.9 |   |

 

6

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Fees and service chargesearned for the year ended December 31, 2003 increased by $581,000 fromthose earned in 2002, primarily due to the increased fees generated from anoverdraft protection program that was implemented in the second quarter of2003. The Company also increased the charges for some services and developedmore retail and commercial checking account relationships during 2003, whichcreated more fee income opportunities. The Company will continue to focus ondeposit growth in checking and money market accounts to increase fee incomeopportunities and decrease its cost of funds.

 

Mortgage servicing feesincreased by $283,000 for the year ended December 31, 2003. The increasewas due to the increased number of single-family loans that were serviced forothers. The lower mortgage interest rates in 2003 resulted in increased loanoriginations and the majority of these loans were sold on the secondarymortgage market with the servicing rights retained.

 

Gains on the sale ofsecurities increased by $853,000 for the year ended December 31, 2003 asinvestments were sold to fund a portion of the consumer and commercial loangrowth that was experienced. The ability to realize gains on the sale ofsecurities is dependent on the type of securities in the securities portfolioand on changes in the general interest rate environment. The Company was ableto recognize gains on both its debt and equity security portfolios in thedeclining interest rate conditions that existed during 2003.

 

Gains on the sale ofsingle-family loans increased by $2.2 million for the year endedDecember 31, 2003. Low mortgage rates during 2003 resulted in highersingle-family loan originations than in 2002 as consumers took advantage of thelow interest rates to purchase a home or refinance their existing home mortgage.The majority of the fixed rate single-family loans originated were sold in thesecondary mortgage market in order to reduce interest rate risk, increasenon-interest income, and provide funding for the commercial and consumer loangrowth.  The Company expects mortgageinterest rates to trend higher in 2004, which will result in lowersingle-family loan originations and less gain on sales of loans.

 

Losses from limitedpartnerships decreased by $416,000 for the year ended December 31, 2003primarily because of lower losses on an investment in a limited partnershipthat invested in mortgage servicing rights. Generally, as interest rates risethe value of fixed rate mortgage servicing rights increases and as interestrates fall the value of mortgage servicing rights declines due to changes inthe anticipated cash flows caused by prepayments on the loans being serviced.During 2003 and 2002, declines in interest rates on single-family mortgagescaused the Company to recognize losses on its investment in the mortgageservicing limited partnership. This partnership was dissolved in the secondquarter of 2003. For more information on investments in limited partnershipsrefer to Notes 1 and 9 of the Notes to Consolidated Financial Statements.

 

Other non-interest incomeconsists primarily of fees and commissions earned on the sale of financialplanning and insurance products and the gains and losses from the sale ofassets.  For the year endedDecember 31, 2003, other non-interest income was $681,000, compared to$597,000 for 2002. The change in other non-interest income is principally dueto increases in the gains recognized on the sale of assets as the Company soldthree former branch locations in 2003.

 

***Non-Interest Expense***

 

Non-interest expense for theyear ended December 31, 2003 was $19.7 million, compared to $17.8 millionfor the year ended in 2002. The following table presents the components ofnon-interest expense:

 
|                                                                                          |   | **Year Ended December 31,** |       | **Percentage  Increase (Decrease)** |   |
|-----------------------------------------------------------------------------------------------|--------|----------------------------------|------------|-------------------------------------|--------|
| **(Dollars in thousands)**                                                                    |   | **2003**                         |       | **2002**                            |   | **2001** |   | **2003/2002** |   | **2002/2001** |   |
| Compensation  and benefits                                                                    |   | **$**                            | **8,676**  |                                | 8,013  |   | 7,915 | ** ** | **8.3** | **%** | 1.2 | % |
| Occupancy                                                                                     |   | **3,424**                        |       | 3,110                               |   | 2,239 | ** ** | **10.1** | ** ** | 38.9 |   |
| Federal  deposit insurance premiums                                                           |   | **72**                           |       | 74                                  |   | 80 | ** ** | **(2.7** | **)** | (7.5 | ) |
| Advertising                                                                                   |   | **393**                          |       | 522                                 |   | 426 | ** ** | **(24.7** | **)** | 22.5 |   |
| Data  processing                                                                              |   | **1,109**                        |       | 1,107                               |   | 964 | ** ** | **0.2** | ** ** | 14.8 |   |
| Amortization  of mortgage servicing rights, net of valuation adjustments and servicing  costs |   | **1,982**                        |       | 1,166                               |   | 758 | ** ** | **70.0** | ** ** | 53.8 |   |
| Other                                                                                         |   | **3,997**                        |       | 3,857                               |   | 3,367 | ** ** | **3.6** | ** ** | 14.6 |   |
| Total  non-interest expense                                                                   |   | **$**                            | **19,653** |                                | 17,849 |   | 15,749 | ** ** | **10.1** | ** ** | 13.3 |   |

 

7

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Non-interest expenseincreased by $1.8 million in 2003 primarily because of an increase of $816,000in the amortization of mortgage servicing rights which was caused by the largenumber of loan prepayments during the year. Because of the low interest ratesin 2003, many loans that were being serviced by the Bank were refinanced.  When a serviced loan was paid off, theremaining value of the right to service that loan was recorded as additionalamortization expense in the month in which the loan was repaid. Compensationand benefits expense increased by $663,000 primarily because of an increase inthe number of employees, annual payroll cost increases, and costs related to aseparation agreement with a former executive officer. Occupancy expenseincreased by $314,000 due to the increased costs associated with operating andmaintaining additional facilities in 2003, including loan production officesopened in Byron, Stewartville, and St. Cloud, Minnesota, as well as West DesMoines, Iowa.

 

***Income Taxes***

 

The Company considers thecalculation of current and deferred income taxes to be a critical accountingpolicy that is subject to significant estimates.  Actual results could differ significantly from the estimates andinterpretations used in determining the current and deferred income taxliabilities. During 2003 and 2002 the Company recorded income tax expense of$4.0 million and $2.1 million, respectively. The change in income tax expenseis the result of changes in taxable income and an increase in the Company’seffective tax rate between the years. The increased effective tax rate wascaused primarily by lower state tax deductions as a percentage of income in2003 when compared to 2002. Refer to Note 16 of the Notes to ConsolidatedFinancial Statements for additional information relating to income taxes.

 

**COMPARISONOF 2002 WITH 2001**

 

Net income for the yearended December 31, 2002 was $5.3 million, compared to $5.5 million for2001. Basic earnings per share were $1.40 for the year ended December 31,2002, compared to $1.45 for 2001. Diluted earnings per share were $1.32 for theyear ended December 31, 2002, compared to $1.37 for 2001. Return on averageassets was 0.74% and 0.75% and return on average equity was 6.94% and 7.57% for2002 and 2001, respectively.

 

In comparing the year endedDecember 31, 2002 to the year ended December 31, 2001, net interestincome increased by $549,000 primarily because interest rates declined to agreater degree on FHLB advances and deposits than on interest earning assets.The provision for loan losses increased $1.2 million due to certain loans thatdeteriorated in 2002 and were charged off. The provision also increased becauseof increases in the commercial and consumer loan portfolios which generallyrequire a larger provision due to the greater inherent credit risk of theseloans. Non-interest income increased by $2.3 million primarily due to increasedgains recognized on the sale of securities and lower losses from a limitedpartnership that invests in mortgage servicing rights. Non-interest expenseincreased by $2.1 million primarily due to increased occupancy, other operatingcosts and amortization expense on mortgage servicing rights.

 

Net interest income for theyear ended December 31, 2002 was $21.6 million, an increase of $549,000,from $21.0 million during 2001. Interest income was $42.9 million for the yearended December 31, 2002, a decrease of $8.6 million, from $51.5 millionfor the same period in 2001. Interest income declined by $3.7 million due to areduction in interest rates on investments and $2.4 million due to a reductionin interest rates on loans. During 2001 and 2002 the Federal Reserve decreasedthe Federal Funds interest rate twelve times and interest rates on treasuryinstruments with maturities of two years and longer generally decreased. TheWall Street Journal prime rate decreased from 9.50% at the beginning of 2001 to4.75% at the end of 2001 and decreased another 50 basis points in the fourthquarter of 2002.  These decreasesresulted in a lower rate environment in 2002 when compared to 2001. As aresult, loans with rates that were indexed to prime, such as commercial loansand consumer lines of credit, earned less interest income and funds generatedfrom fixed rate loans that prepaid during the year were reinvested in loans atlower rates.  Interest income decreasedby $2.5 million due to a decrease in the average outstanding interest earningassets. Interest expense was $21.3 million for the year ended December 31,2002, a decrease of $9.1 million, from the $30.4 million for 2001. Interestexpense declined by $6.6 million due to a decrease in the general interestrates paid on deposits and by $1.2 million due to decreased rates paid on FHLBadvances. Interest expense also decreased by $1.4 million due to a decline inthe average outstanding balance of deposits and Federal Home Loan Bankadvances.

 

Net interest margin was3.19% and 3.02% and average net earning assets were $47.3 million and $55.0million for the years ended December 31, 2002 and 2001, respectively.

 

The provision for loanlosses for 2002 was $2.4 million, compared to $1.2 million for 2001. Theprovision for loan losses increased due to the deterioration of certain loansthat were charged off during 2002 and due to the $115 million in growth thatwas experienced in the commercial and consumer loan portfolios which generallyrequire a larger provision due to the greater inherent credit risk of theseloans. The provision also increased because of increases in specific loanreserves, as well as a slowing economy which resulted in an increase innon-accruing loans of $1.1 million. HMN incurred $1.4 million of loancharge-offs during 2002 and it recovered $34,000 of loans previouslycharged-off. HMN incurred $516,000 of loan charge-offs during 2001 and itrecovered $6,000 of loans previously charged-off.

 

Non-interest income was $5.9million for 2002, compared to $3.6 million for 2001. Fees and service chargesearned for the year ended December 31, 2002 increased by

 

8

----

 

$160,000 from fees andservice charges earned in 2001, primarily due to increased fees and servicecharges on an increased number of deposit accounts.

 

Mortgage servicing feesincreased by $245,000 and $129,000 for the years ended December 31, 2002and December 31, 2001, respectively. The increases were primarily due tothe increased number of single-family loans that were serviced for others. Thelower mortgage interest rates in 2002 and 2001 resulted in increased loanoriginations and loan sales at the Bank and the servicing rights on all ofthese loans were retained.

 

The ability to realize gainson the sale of securities is dependent on the type of securities in thesecurities portfolio and upon changes in the general interest rate environment.Interest rates in general were declining in 2002 and the opportunity to sellinvestments at a gain was present. Consequently, the Company recognized$422,000 in gains on the sale of securities for the year endedDecember 31, 2002, an increase of $1.1 million over 2001’s net losses. Theincrease in securities gains is primarily because the Bank recognizedimpairment losses of $1.0 million on its securities portfolio in 2001. Theselosses resulted in a net loss on the sale of securities of $671,000 for 2001.

 

In order to reduce itsinterest rate risk and increase its other non-interest income, the Bank, whichoriginates all of its 1-4 family loans at its retail facilities, sold many ofits originated or refinanced fixed rate 1-4 family loans in 2002 and 2001. Themortgage banking business operated by Home Federal Mortgage Services, LLC(HFMS) also sold the majority of their mortgage origination and loan brokerageactivity. The origination and brokerage activity at HFMS decreased by $604.4million in 2002 from 2001 production levels as the operations were being phaseddown throughout the first half of the year and production stopped completely inthe third quarter of 2002. The lower interest rate environment in 2002 causedloan originations at the Bank to increase by $40.1 million. For the year endedDecember 31, 2002, HMN recognized $3.1 million of net gain on the sale of$274.6 million of primarily single-family mortgage loans. The Bank accountedfor $2.9 million of the net gain on sale on $184.6 million of loans sold. HFMSaccounted for $262,000 of the net gain on sale on $90.0 million of loans sold.For the year ended December 31, 2001, HMN recognized $2.9 million of netgain on the sale of $724.2 million of primarily single-family mortgage loans.The Bank accounted for $2.1 million of the net gain on sale on $136.2 millionof loans sold and HFMS accounted for $842,000 of the net gain on sale on $588.1million of loans sold. During 2002 and 2001 HFMS brokered $26.9 million and$349.6 million of loans, respectively, from correspondent lenders at lowerprofit margins than its other brokerage and origination activity. Thesignificant increase in loan volume from these correspondents during 2001 andcarrying over into 2002 resulted in the Company incurring pair off fees becauseloans were not delivered into their forward sales commitments on a timelybasis. The pair off fees resulted in a lower gain on sale of loans for HFMS asa percentage of loans sold. The lower profit margins coupled with theadditional costs relating to processing the increased loan volume resulted inHFMS generating losses for 2002 and 2001.

 

For the years endedDecember 31, 2002 and 2001, HMN recognized net losses of $659,000 and $1.3million, respectively, from its limited partnership investments. A majorportion of HMN’s investment in limited partnerships resided in a partnershipthat owned mortgage servicing rights. Generally, as interest rates rise thevalue of fixed rate mortgage servicing rights increases and as interest ratesfall the value of mortgage servicing rights declines due to changes in theanticipated cash flows caused by prepayments on the loans being serviced. During2002 and 2001 significant declines in interest rates on single-family mortgagescaused HMN to recognize losses on its investment in the mortgage servicinglimited partnership.

 

Non-interest expensesincreased by $2.1 million from 2001 to 2002 primarily due to an $870,000increase in occupancy expense caused by the three additional facilitiesmaintained during 2002 and a full year of expenses associated with facilitychanges that occurred in 2001. Amortization of mortgage servicing rightsincreased by $407,000 because of increased amortization on loans that prepaidduring the year and because the number of loans being serviced increased.Because of the lower interest rates in 2002 many loans that were being servicedby the Bank were refinanced.  When a servicedloan was paid off, the remaining value of the right to service that loan wasrecorded as additional amortization expense in the month in which the loan wasrepaid. Compensation and benefits expense increased by $99,000 in 2002, despitethe decrease in compensation expense at the mortgage banking operation, as theBank hired more employees to staff the additional retail facilities that wereopened during the year. Data processing expenses increased by $143,000 due tothe increased number of customers and the costs of various services offered tocustomers. Other expenses increased by $490,000 primarily due to $175,000 invaluation reserves recorded on other assets and increased expenses related toadditional facilities and increased loan activity. Other expenses decreased by$180,000 due to decreased goodwill amortization relating to the adoption ofStatement of Financial Accounting Standards (SFAS) No. 142. See Notes 1 and 11of the Notes to Consolidated Financial Statements for additional information relatingto goodwill amortization.

 

During 2002 and 2001 HMNrecorded income tax expense of $2.1 million and $2.6 million, respectively. Thechange in income tax expense between the years is primarily the result ofchanges in taxable income between the years and state tax planning implementedduring 2002.

 

9

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**FinancialCondition**

 

***Loans Receivable, Net***

 

The following table setsforth the information on the Company’s loan portfolio in dollar amounts and inpercentages (before deductions for loans in process, deferred fees anddiscounts and allowances for losses) as of the dates indicated.

 
|                         |   | **December 31,** |        |
|------------------------------|--------|-----------------------|-------------|
|                         |   | **2003**              |        | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| **(Dollars in thousands)**   |   | **Amount**            |        | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| **Real Estate Loans:**       |   |                  | ** **  |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four  family          |   | **$**                 | **144,315** | ** ** | **20.37** | **%** | $ | 151,566 |   | 27.72 | % | $ | 215,448 |   | 44.73 | % | $ | 312,888 |   | 59.43 | % | $ | 344,674 |   | 70.95 | % |
| Multi-family                 |   | **31,540**            | ** **  | **4.45** | ** ** | 15,766 |   | 2.88 |   | 14,369 |   | 2.98 |   | 12,090 |   | 2.30 |   | 8,489 |   | 1.75 |   |
| Commercial                   |   | **199,124**           | ** **  | **28.10** | ** ** | 130,417 |   | 23.85 |   | 70,768 |   | 14.69 |   | 61,654 |   | 11.71 |   | 43,894 |   | 9.04 |   |
| Construction  or development |   | **95,346**            | ** **  | **13.45** | ** ** | 61,336 |   | 11.22 |   | 46,977 |   | 9.75 |   | 20,211 |   | 3.84 |   | 16,046 |   | 3.30 |   |
| Total  real estate           |   | **470,325**           | ** **  | **66.37** | ** ** | 359,085 |   | 65.67 |   | 347,562 |   | 72.15 |   | 406,843 |   | 77.28 |   | 413,103 |   | 85.04 |   |
| **Other Loans:**             |   |                  | ** **  |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer  Loans:             |   |                  | ** **  |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Automobile                   |   | **14,754**            | ** **  | **2.08** | ** ** | 11,062 |   | 2.02 |   | 6,624 |   | 1.38 |   | 6,363 |   | 1.21 |   | 4,532 |   | 0.94 |   |
| Home  equity line            |   | **54,193**            | ** **  | **7.64** | ** ** | 52,106 |   | 9.53 |   | 35,714 |   | 7.42 |   | 26,907 |   | 5.11 |   | 22,437 |   | 4.62 |   |
| Home  equity                 |   | **18,974**            | ** **  | **2.68** | ** ** | 23,760 |   | 4.35 |   | 26,440 |   | 5.49 |   | 28,144 |   | 5.35 |   | 17,349 |   | 3.57 |   |
| Mobile  home                 |   | **3,665**             | ** **  | **0.52** | ** ** | 4,534 |   | 0.83 |   | 5,456 |   | 1.13 |   | 4,921 |   | 0.93 |   | 791 |   | 0.16 |   |
| Other                        |   | **14,319**            | ** **  | **2.02** | ** ** | 4,959 |   | 0.91 |   | 4,897 |   | 1.02 |   | 4,561 |   | 0.87 |   | 3,127 |   | 0.64 |   |
| Total  consumer loans        |   | **105,905**           | ** **  | **14.94** | ** ** | 96,421 |   | 17.64 |   | 79,131 |   | 16.44 |   | 70,896 |   | 13.47 |   | 48,236 |   | 9.93 |   |
| Commercial  business loans   |   | **132,459**           | ** **  | **18.69** | ** ** | 91,260 |   | 16.69 |   | 54,940 |   | 11.41 |   | 48,760 |   | 9.25 |   | 24,435 |   | 5.03 |   |
| Total  other loans           |   | **238,364**           | ** **  | **33.63** | ** ** | 187,681 |   | 34.33 |   | 134,071 |   | 27.85 |   | 119,656 |   | 22.72 |   | 72,671 |   | 14.96 |   |
| Total  loans                 |   | **708,689**           | ** **  | **100.00** | **%** | 546,766 |   | 100.00 | % | 481,633 |   | 100.00 | % | 526,499 |   | 100.00 | % | 485,774 |   | 100.00 | % |
| Less:                        |   |                  | ** **  |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans  in process            |   | **11,298**            | ** **  |   |   | 6,826 |   |   |   | 4,692 |   |   |   | 2,953 |   |   |   | 2,771 |   |   |   |
| Unamortized  discounts       |   | **166**               | ** **  |   |   | 142 |   |   |   | 278 |   |   |   | 289 |   |   |   | 297 |   |   |   |
| Net  deferred loan fees      |   | **1,334**             | ** **  |   |   | 1,068 |   |   |   | 1,212 |   |   |   | 1,348 |   |   |   | 1,537 |   |   |   |
| Allowance  for losses        |   | **6,940**             | ** **  |   |   | 4,824 |   |   |   | 3,783 |   |   |   | 3,144 |   |   |   | 3,273 |   |   |   |
| Total  loans receivable, net |   | **$**                 | **688,951** | ** ** |   |   | $ | 533,906 |   |   |   | $ | 471,668 |   |   |   | $ | 518,765 |   |   |   | $ | 477,896 |   |   |   |

 

The Company continues toreduce interest rate risk and increase interest income by increasing itsinvestment in shorter term and generally higher yielding commercial real estateand commercial business loans and reducing its investment in longer termone-to-four family real estate loans. The Company intends to continue toincrease the size of its commercial real estate, commercial business andconsumer loan portfolios while maintaining the level of one-to-four familyloans held in portfolio.

 

The one-to-four family realestate loans were $144.3 million at December 31, 2003, a decrease of $7.3million, compared to $151.6 million at December 31, 2002. During 2003 loanprepayments on single-family loans increased as a result of the low interestrate environment and many loans that were in the loan portfolio atDecember 31, 2002 were refinanced and sold in the secondary mortgagemarket.  Some of these loans werereplaced in the portfolio with shorter term (10 year) fixed rate and adjustablerate loans during 2003. The

 

10

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increased prepayments andthe related loan sales were the principal cause of the decline in theone-to-four family loan portfolio during 2003.

 

Commercial real estate loanswere $199.1 million at December 31, 2003, an increase of $68.7 million,compared to $130.4 million at December 31, 2002. Commercial business loanswere $132.5 million at December 31, 2003, an increase of $41.2 million,compared to $91.3 million at December 31, 2002. The Company’s continuedemphasis on commercial real estate and commercial business loans resulted inthe origination or purchase of commercial real estate loans totaling $133.6million in 2003 and $70.7 million in 2002. Commercial business loans originatedor purchased were $142.6 million in 2003 compared to $101.0 million in 2002.The increased production and the Company’s continued focus in this area werethe principal reasons for the increase in commercial real estate and commercialbusiness loans in 2003.

 

Home equity line loans were$54.2 million at December 31, 2003, compared to $52.1 million atDecember 31, 2002. The open-end home equity lines are written with anadjustable rate with a term of 20 years, a 10 year draw period which requires“interest only” payments and a 10 year repayment period which fully amortizesthe outstanding balance.  Closed-endhome equity loans are written with fixed or adjustable-rates with terms up to15 years. Home equity loans were $19.0 million at December 31, 2003,compared to $23.8 million at December 31, 2002.  Due to the general decline in interest rates during 2003 and2002, many borrowers consolidated their debt and paid off open and closed homeequity loans when refinancing their first mortgage. The increased debtconsolidation into first mortgages was the principal reason for the slightdecline in the combined home equity and home equity line loan portfolios in2003.

 

***Allowances for Loan Losses***

 

The determination of theallowance for loan losses and the related provision is a critical accountingpolicy of the Company that is subject to significant estimates, as previouslydiscussed. The current level of the allowance for loan losses is a result ofmanagement’s assessment of the risks within the portfolio based on theinformation obtained through the credit evaluation process. The Companyutilizes a risk-rating system on non-homogenous commercial real estate andcommercial business loans that includes regular credit reviews to identify andquantify the risk in the commercial portfolio. Management conducts quarterlyreviews of the loan portfolio and evaluates the need to establish generalallowances on the basis of these reviews.

 

Management continues toactively monitor asset quality and to charge off loans against the allowancefor loan losses when appropriate. Although management believes it uses the bestinformation available to make determinations with respect to the allowance forloan losses, future adjustments may be necessary if economic conditions differsubstantially from the economic conditions in the assumptions used to determinethe size of the allowance for losses.

 

The allowance for loanlosses was $6.9 million, or 0.98%, of gross loans at December 31, 2003,compared to $4.8 million, or 0.88%, of gross loans at December 31, 2002.The following table reflects the activity in the allowance for loan losses andselected statistics:

 
|                                                                            |   | **December 31,** |       |
|---------------------------------------------------------------------------------|--------|-----------------------|------------|
| **(Dollars in thousands)**                                                      |   | **2003**              |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Balance  at the beginning of year                                               |   | **$**                 | **4,824**  | ** ** | 3,783 |   | 3,144 |   | 3,273 |   | 3,041 |   |
| Provision  for losses                                                           |   | **2,610**             | ** ** | 2,376 |   | 1,150 |   | 180 |   | 240 |   |
| Charge-offs:                                                                    |   |                  | ** ** |   |   |   |   |   |   |   |   |
| One-to-four  family                                                             |   | **(69**               | **)**      | (44 | ) | 0 |   | 0 |   | (1 | ) |
| Consumer                                                                        |   | **(226**              | **)**      | (310 | ) | (170 | ) | (59 | ) | (9 | ) |
| Commercial  business and real estate                                            |   | **(255**              | **)**      | (1,015 | ) | (347 | ) | (253 | ) | 0 |   |
| Recoveries                                                                      |   | **56**                | ** ** | 34 |   | 6 |   | 3 |   | 2 |   |
| Net  charge-offs                                                                |   | **(494**              | **)**      | (1,335 | ) | (511 | ) | (309 | ) | (8 | ) |
| Balance  at end of year                                                         |   | **$**                 | **6,940**  | ** ** | 4,824 |   | 3,783 |   | 3,144 |   | 3,273 |   |
| Year  end allowance for loan losses as a percent of year end gross loan balance |   | **0.98**              | **%**      | 0.88 | % | 0.79 | % | 0.60 | % | 0.69 | % |
| Ratio  of net loan charge-offs to average loans outstanding                     |   | **0.09**              | ** ** | 0.26 |   | 0.10 |   | 0.06 |   | 0.00 |   |
| Allowance  for loan losses as a percentage of total assets at year end          |   | **0.80**              | ** ** | 0.65 |   | 0.52 |   | 0.44 |   | 0.47 |   |

 

11

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

 
|                        |   | **December 31,**                                |       |
|-----------------------------|--------|------------------------------------------------------|------------|
|                        |   | **2003**                                             |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| **(Dollars in thousands)**  |   | **Allocated  allowance  as of %  of loan  category** |       | **Percent  of loans  in each  category  in 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** |   |
| Real estate loans:          |   |                                                 | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family          |   | **0.12**                                             | **%**      | **20.36** | **%** | 0.06 | % | 27.72 | % | 0.10 | % | 44.73 | % | 0.10 | % | 59.43 | % | 0.15 | % | 70.95 | % |
| Multi-family                |   | **1.34**                                             | ** ** | **4.45** | ** ** | 1.30 |   | 2.88 |   | 1.41 |   | 2.98 |   | 0.92 |   | 2.30 |   | 1.57 |   | 1.75 |   |
| Commercial real estate      |   | **1.42**                                             | ** ** | **28.10** | ** ** | 1.55 |   | 23.88 |   | 1.28 |   | 14.69 |   | 1.30 |   | 11.71 |   | 1.21 |   | 9.04 |   |
| Construction or development |   | **0.92**                                             | ** ** | **13.45** | ** ** | 0.97 |   | 11.22 |   | 1.19 |   | 9.75 |   | 2.02 |   | 3.84 |   | 1.44 |   | 3.30 |   |
| Consumer                    |   | **0.98**                                             | ** ** | **14.95** | ** ** | 0.56 |   | 17.63 |   | 0.71 |   | 16.44 |   | 0.58 |   | 13.47 |   | 1.40 |   | 9.93 |   |
| Commercial business         |   | **1.20**                                             | ** ** | **18.69** | ** ** | 1.48 |   | 16.67 |   | 2.44 |   | 11.41 |   | 2.72 |   | 9.25 |   | 1.19 |   | 5.03 |   |
| Total                       |   | **0.98**                                             | **%**      | **100.00** | **%** | 0.88 | % | 100.00 | % | 0.79 | % | 100.00 | % | 0.60 | % | 100.00 | % | 0.67 | % | 100.00 | % |

 

The allocation of theallowance for loan losses decreased in 2003 for commercial, construction ordevelopment, and commercial business loans primarily because management’soverall assessment of the risk of the individual loans in these categoriesimproved between the years. The allocated percentage for the consumer loansincreased in 2003 primarily because of increases in non-performing consumerloans between the periods.

 

***Allowance for Real Estate Losses***

 

Real estate propertiesacquired or expected to be acquired through loan foreclosures are initiallyrecorded at the lower of the related loan balance, less any specific allowancefor loss, or fair value less estimated selling costs. Valuations are periodicallyperformed by management and an allowance for losses is established if thecarrying value of a property exceeds its fair value less estimated sellingcosts. There was limited activity in the allowance for real estate lossesduring 2003 and 2002 and the balance of the allowance for real estate losseswas zero at December 31, 2003 and December 31, 2002.

 

***Non-performing Assets***

 

Loans are reviewed at leastquarterly and any loan whose collectibility is doubtful is placed onnon-accrual status. Loans are placed on non-accrual status when eitherprincipal or interest is 90 days or more past due, unless, in the judgment ofmanagement, 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 statusis charged against interest income. Subsequent payments are either applied tothe outstanding principal balance or recorded as interest income, depending onthe assessment of the ultimate collectibility of the loan. Restructured loans includethe Bank’s troubled debt restructurings which involved forgiving a portion ofinterest or principal on any loans or making loans at a rate materially lessthan the market rate. Foreclosed and repossessed assets include assets acquiredin settlement of loans.

 

Non-performing assets iscomprised of non-accrual loans, restructured loans, impaired securities,delinquent accounts receivable, real estate acquired through foreclosure, andrepossessed assets and totaled $5.0 million at December 31, 2003, comparedto $4.9 million at December 31, 2002. The $128,000 increase in non-performing assets in 2003 relates primarilyto a net increase of $1.2 million in non-accruing loans due primarily to anincrease in non-performing single-family loans of $482,000 and non-performingconsumer loans of $555,000. The increase in non-performing loans was almostcompletely offset by decreases of $655,000 in non-performing other assetscaused by the sale of a non-performing investment, and a decrease of $399,000in foreclosed and repossessed assets between the years.

 

The following table setsforth the amounts and categories of non-performing assets in the Company’sportfolio.

 

12

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|                                                 |   | **December 31,** |      |
|------------------------------------------------------|--------|-----------------------|-----------|
| **(Dollars in thousands)**                           |   | **2003**              |      | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Non-accruing loans:                                  |   |                  |      |   |   |   |   |   |   |   |   |
| Real estate:                                         |   |                  |      |   |   |   |   |   |   |   |   |
| One-to-four family                                   |   | **$**                 | **1,177** |   | 695 |   | 771 |   | 775 |   | 165 |   |
| Commercial real estate                               |   | **2,162**             |      | 1,719 |   | 187 |   | 0 |   | 0 |   |
| Consumer                                             |   | **1,050**             |      | 495 |   | 311 |   | 142 |   | 177 |   |
| Commercial business                                  |   | **186**               |      | 427 |   | 890 |   | 95 |   | 0 |   |
| Total                                                |   | **4,575**             |      | 3,336 |   | 2,159 |   | 1,012 |   | 342 |   |
| Accruing loans delinquent 90 days or more:           |   |                  |      |   |   |   |   |   |   |   |   |
| One-to-four family                                   |   | **114**               |      | 171 |   | 24 |   | 405 |   | 476 |   |
| Other assets                                         |   | **211**               |      | 866 |   | 1,390 |   | 0 |   | 0 |   |
| Foreclosed and repossessed assets:                   |   |                  |      |   |   |   |   |   |   |   |   |
| Real estate:                                         |   |                  |      |   |   |   |   |   |   |   |   |
| One-to-four family                                   |   | **73**                |      | 300 |   | 0 |   | 195 |   | 0 |   |
| Commercial real estate                               |   | **0**                 |      | 127 |   | 0 |   | 0 |   | 0 |   |
| Consumer                                             |   | **62**                |      | 107 |   | 155 |   | 0 |   | 0 |   |
| Commercial business                                  |   | **0**                 |      | 0 |   | 33 |   | 0 |   | 0 |   |
| Total                                                |   | **135**               |      | 534 |   | 188 |   | 195 |   | 0 |   |
| Total non-performing assets                          |   | **$**                 | **5,035** | ** ** | 4,907 |   | 3,761 |   | 1,612 |   | 818 |   |
| Total as a percentage of total assets                |   | **0.58**              | **%**     | 0.67 | % | 0.52 | % | 0.23 | % | 0.12 | % |
| Total non-performing loans                           |   | **$**                 | **4,689** | ** ** | 3,507 |   | 2,183 |   | 1,417 |   | 818 |   |
| Total as a percentage of total loans receivable, net |   | **0.68**              | **%**     | 0.66 | % | 0.46 | % | 0.27 | % | 0.17 | % |
| Allowance for loan losses to non-performing loans    |   | **147.99**            | **%**     | 134.60 | % | 173.29 | % | 221.87 | % | 400.29 | % |

 

For the year endedDecember 31, 2003, gross interest income which would have been recorded hadthe non-accruing loans been current in accordance with their original termsamounted to $458,473. The amounts that were included in interest income on acash basis for such loans during 2003 were $163,044.

 

In addition to thenon-performing assets set forth in the table above, as of December 31,2003 there were no loans with known information about the possible creditproblems of the borrowers or the cash flows of the secured properties that havecaused management to have concerns as to the ability of the borrowers to complywith present loan repayment terms which may result in the future inclusion ofsuch items in the non-performing asset categories. Management has consideredthe Bank’s non-performing and “of concern” assets in establishing its allowancefor loan losses.

 

***Mortgage Servicing Rights***

 

The capitalization andvaluation of mortgage servicing rights (MSR’s) is a critical accounting policyof the Company that is subject to significant estimates. MSR’s are valuedquarterly by an unrelated third party specializing in the valuation ofservicing rights and are reviewed by the Company’s management. The assumptionsused to value the MSR’s are based on loan types, note rates, default rates, andprepayment speeds, among other assumptions. Changes in the mix of loans,interest rates, default rates, or prepayment speeds may have a material effecton the amortization and valuation of MSR’s. Although management believes thatthe assumptions used and the values determined are reasonable based uponcurrent circumstances, adjustments may be necessary if future economicconditions differ substantially from the economic conditions in the assumptionsused to determine the value of the MSR’s. Refer to Notes 1 and 7 of the Notesto Consolidated Financial Statements for additional information relating toMSR’s.

 

13

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***Contractual Obligations and Commercial Commitments***

 

The Company has certainobligations and commitments to make future payments under contracts. AtDecember 31, 2003, the aggregate contractual obligations (excluding bankdeposits) and commercial commitments are as follows:

 
|                                                             |   | **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                                                 |   | $                                             | 203,900 |   | 33,000 |   | 10,000 |   | 60,000 |   | 100,900 |   |
| Annual rental commitments under  non-cancelable operating leases |   | 1,472                                         |    | 499 |   | 858 |   | 115 |   | 0 |   |
|                                                             |   | $                                             | 205,372 |   | 33,499 |   | 10,858 |   | 60,115 |   | 100,900 |   |
|                                                             |   |                                          |    |   |   |   |   |   |   |   |   |
|                                                             |   | **Amount of Commitment-Expiration by Period** |    |
| Other Commercial Commitments:                                    |   |                                          |    |   |   |   |   |   |   |   |   |
| Commercial lines of credit                                       |   | $                                             | 25,612  |   | 18,058 |   | 7,448 |   | 91 |   | 15 |   |
| Commitments to lend                                              |   | 101,090                                       |    | 29,572 |   | 53,843 |   | 2,617 |   | 15,058 |   |
| Standby letters of credit                                        |   | 2,028                                         |    | 813 |   | 1,215 |   | 0 |   | 0 |   |
|                                                             |   | $                                             | 128,730 |   | 48,443 |   | 62,506 |   | 2,708 |   | 15,073 |   |

 

***Regulatory Capital Requirements***

 

As a result of the FederalDeposit Insurance Corporation Improvement Act of 1991 (FDICIA), banking andthrift regulators are required to take prompt regulatory action againstinstitutions which are undercapitalized. FDICIA requires banking and thriftregulators to categorize institutions as “well capitalized,” “adequatelycapitalized,” “undercapitalized,” “significantly undercapitalized,” or“critically undercapitalized”. A savings institution will be deemed to be wellcapitalized if it: (i) has a total risk-based capital ratio of 10% or greater,(ii) has a Tier 1 (core) risk-based capital ratio of 6% or greater, (iii) has aleverage (core) ratio of 5% or greater, and (iv) is not subject to any order orwritten directive by the Office of Thrift Supervision (OTS) to meet andmaintain a specific capital level for any capital measure. Management believesthat, as of December 31, 2003, the Bank met all of the capitalrequirements to which it was subject and is well capitalized based on theregulatory definition described above. Refer to Note 20 of the Notes toConsolidated Financial Statements for a table which reflects the Bank’s capitalcompared to its capital requirements.

 

**Liquidityand Capital Resources**

 

The Company manages itsliquidity position to ensure that the funding needs of borrowers and depositorsare met timely and in the most cost effective manner. Asset liquidity is theability to convert assets to cash through the maturity or sale of the asset.Liability liquidity is the ability of the Bank to attract retail or brokereddeposits or to borrow funds from third parties such as the FHLB.

 

The primary investingactivities are the origination of loans and the purchase of securities.Principal and interest payments on loans and securities along with the proceedsfrom the sale of loans held for sale are the primary sources of cash for theCompany. Additional cash can be obtained by selling securities from theavailable for sale portfolio or by selling loans. Loans could also besecuritized and used as collateral for additional borrowings with the FHLB togenerate additional cash.

 

The primary financingactivity is the attraction of retail and brokered deposits. The Bank has theability to borrow additional funds from the FHLB by pledging additionalsecurities or loans. Refer to Note 14 of the Notes to Consolidated FinancialStatements for more information on additional advances that could be drawn uponbased on existing collateral levels with the FHLB. Information on outstandingadvance maturities and related early call features is also included in Note 14.

 

The Company anticipates thatits liquidity requirements for 2004 will be similar to the cash flows itexperienced in 2003 with the following exceptions: net increase in loansreceivable is anticipated to be $125 million; net decrease in customer escrowsis anticipated to be $21 million; the funds provided from deposits and/or FHLBadvances are anticipated to be $86 million; and the funds provided by securitysales and/or principal collections on securities are anticipated to be $34million.

 

The Company’s most liquidassets are cash and cash equivalents, which consist of short-term highly liquidinvestments with original maturities of less than three months that are readilyconvertible to known amounts of cash and interest-bearing deposits. The levelof these assets is dependent on the operating, financing, and investingactivities during any given period.

 

14

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Cash and cash equivalents atDecember 31, 2003 were $30.5 million, an increase of $2.8 million,compared to $27.7 million at December 31, 2002. Net cash provided byoperating activities during 2003 was $24.1 million. The Company conducted thefollowing major investing activities during 2003: proceeds from the sale ofsecurities available for sale were $50.4 million, principal received onpayments and maturities of securities available for sale was $40.9 million,purchases of securities available for sale were $76.4 million, and net loansreceivable increased by $161.5 million. HMN spent $1.0 million for the purchaseof equipment and updating its premises, and received $1.2 million from the saleof real estate and old branch facilities. Net cash used by investing activitiesduring 2003 was $144.6 million. HMN conducted the following major financingactivities during 2003: purchase of treasury stock of $1.4 million, received$1.4 million from the exercise of HMN common stock options, paid $2.9 millionin dividends to HMN stockholders, proceeds from FHLB advances totaled $161.0million, repayments of FHLB advances totaled $175.4 million, and increase indeposits were $118.8 million. Net cash provided by financing activities was$123.3 million.

 

The Company has certificatesof deposit with outstanding balances of $167.2 million that mature during 2004.Based upon past experience, management anticipates that the majority of thedeposits will renew for another term. The Company believes that deposits whichdo not renew will be replaced with deposits from a combination of othercustomers or brokers. FHLB advances or the sale of securities could also beused to replace unanticipated outflows of deposits. Management does notanticipate that it will have a liquidity problem due to maturing deposits.

 

The Company has $33.0million of FHLB advances that mature in 2004 and it has $100.9 million of FHLBadvances with maturities beyond 2004 that have call features that may beexercised by the FHLB during 2004. If the call features are exercised, theCompany has the option of requesting any advance otherwise available to itpursuant to the credit policy of the FHLB. Since the Company has the ability torequest another advance to replace the advance that is being called, managementdoes not anticipate that it will have a liquidity problem due to advances beingcalled by the FHLB during 2004.

 

The credit policy of theFHLB may change such that the current collateral pledged to secure the advancesis no longer acceptable or the formulas for determining the excess pledgedcollateral may change. If this were to happen the Bank may not have additionalcollateral to pledge to secure the existing advances which could cause the FHLBadvances to become a liquidity problem during 2004.

 

On February 24, 2004,HMN’s Board of Directors authorized the extension of the stock repurchaseprogram to August 26, 2005. The plan authorizes HMN torepurchase up to 350,000 shares of its commonstock in the open market.

 

***Dividends***

 

The declaration of dividendsare subject to, among other things, the Company’s financial condition andresults of operations, the Bank’s compliance with its regulatory capitalrequirements, tax considerations, industry standards, economic conditions,regulatory restrictions, general business practices and other factors. Refer toNote 19 of the Notes to Consolidated Financial Statements for information onregulatory limitations on dividends from the Bank to the Company and additionalinformation on dividends. The payment of dividends is dependant upon theCompany having adequate cash or other assets that can be converted to cash topay dividends to its stockholders. The Company does not anticipate a liquidityproblem in 2004 relating to the payment of dividends.

 

***Merger and Acquisitions***

 

From time to time managementreviews the possibility of acquiring or merging with different companies thatwould complement the business conducted by the Company. The Company’s Board ofDirectors has adopted the policy of not disclosing to the public its intent toacquire or merge until a formal definitive agreement has been signed by allparties involved with the transaction, except as otherwise required by law.

 

***Impact of Inflation and Changing Prices***

 

The impact of inflation isreflected in the increased cost of operations. Unlike most industrialcompanies, nearly all of the assets and liabilities of the Company are monetaryin nature. As a result, interest rates have a greater impact on the Company’sperformance than do the effects of general levels of inflation. Interest ratesdo not necessarily move in the same direction or to the same extent as theprices of goods and services.

 

***New Accounting Pronouncement***

 

The Financial AccountingStandards Board (FASB) issued a revised Interpretation No. 46, *Consolidation of Variable Interest Entities*(FIN46) that addresses consolidation by business enterprises of variable interestentities that have certain characteristics. It requires a business enterprise thathas a controlling interest in a variable interest entity (as defined by FIN 46)to include the assets, liabilities, and results of the activities of thevariable interest entity in the consolidated financial statements of thebusiness enterprise. The impact of adopting FIN 46 on the Company’s financialcondition and results of operation will not be material.

 

15

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**Market Risk**

 

Market risk is the risk of loss from adverse changes in market pricesand rates. The Company’s market risk arises primarily from interest rate riskinherent in its investing, lending and deposit taking activities. Managementactively monitors and manages its interest rate risk exposure.

 

The Company’s profitabilityis affected by fluctuations in interest rates. A sudden and substantial changein interest rates may adversely impact the Company’s earnings to the extentthat the interest rates borne by assets and liabilities do not change at thesame speed, to the same extent, or on the same basis. The Company monitors theprojected changes in net interest income that occur if interest rates were tosuddenly change up or down. The Rate Shock Table located in the Asset/LiabilityManagement section of this report discloses the Company’s projectedchanges in net interest income based upon immediate interest rate changescalled rate shocks.

 

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

 

The management of theCompany believes that over the next twelve months interest rates couldconceivably fluctuate in a range of 200 basis points up or 100 basis pointsdown from where the rates were at December 31, 2003. The following tablediscloses the projected changes in market value to the Company’sinterest-earning assets and interest-bearing liabilities based upon incremental100 basis point changes in interest rates from interest rates in effect onDecember 31, 2003.

 
| **Other than trading portfolio  (Dollars in thousands)  Basis point change in interest rates** |     | **Market Value** |    |
|------------------------------------------------------------------------------------------------|----------|------------------|---------|
|                                                                                           | **-100** |             | **0**   |   | **+100** |   | **+200** |   |
| Total market risk sensitive assets                                                             |     | $                | 884,037 |   | 868,534 |   | 851,556 |   | 835,089 |   |
| Total market risk sensitive liabilities                                                        |     | (803,381         | )       | (790,192 | ) | (779,336 | ) | (772,416 | ) |
| Off-balance sheet financial instruments                                                        |     | 858              |    | 0 |   | (252 | ) | (569 | ) |
| Net market risk                                                                                |     | $                | 81,514  |   | 78,342 |   | 71,968 |   | 62,104 |   |
| Percentage change from current market value                                                    |     | 4.05             | %       | 0.00 | % | (8.14 | )% | (20.73 | )% |

 

The preceding table wasprepared utilizing the following assumptions (the Model Assumptions) regardingprepayment and decay ratios which were determined by management based upontheir review of historical prepayment speeds and future prepayment projections.Fixed rate loans were assumed to prepay at annual rates of between 7% and 48%,depending on the note rate and the period to maturity. Adjustable ratemortgages (ARMs) were assumed to prepay at annual rates of between 11% and 17%,depending on the note rate and the period to maturity. Growing Equity Mortgage(GEM) loans were assumed to prepay at annual rates of between 7% and 20%depending on the note rate and the period to maturity. Mortgage-backedsecurities and Collateralized Mortgage Obligations (CMOs) were projected tohave prepayments based upon the underlying collateral securing the instrumentand the related cash flow priority of the CMO tranche owned. Certificateaccounts were assumed not to be withdrawn until maturity. Passbook and moneymarket accounts were assumed to decay at an annual rate of 20%. Non-interestchecking and NOW accounts were assumed to decay at an annual rate of 19%.Commercial NOW and MMDA accounts were assumed to decay at an annual rate of40%. FHLB advances were projected to be called at the first call date where theprojected interest rate on similar remaining term advances exceeded theinterest rate on the callable advance. Refer to Note 14 of the Notes toConsolidated Financial Statements for more information on call provisions ofthe FHLB advances.

 

Certain shortcomings areinherent in the method of analysis presented in the foregoing table. Theinterest rates on certain types of assets and liabilities may fluctuate inadvance of changes in market interest rates, while interest rates on othertypes of assets and liabilities may lag behind changes in market interestrates. The model assumes that the difference between the current interest ratebeing earned or paid compared to a treasury instrument or other interest indexwith a similar term to maturity (the Interest Spread) will remain constant overthe interest changes disclosed in the table. Changes in Interest Spread couldimpact projected market value changes. Certain assets, such as ARMs, havefeatures which restrict changes in interest rates on a short-term basis andover the life of the assets. The market value of the interest-bearing assetsthat are approaching their lifetime interest rate caps could be different fromthe values calculated in the table. In the event of a change in interest rates,prepayment and early withdrawal levels may deviate significantly from thoseassumed in calculating the foregoing table. The ability of many borrowers toservice their debt may decrease in the event of a substantial sustainedinterest rate increase.

 

16

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***Asset/Liability Management***

 

The Company’s managementreviews the impact that changing interest rates will have on its net interestincome projected for the twelve months following December 31, 2003 todetermine if its current level of interest rate risk is acceptable. Thefollowing table projects the estimated impact on net interest income ofimmediate interest rate changes called rate shocks.

 
| **Rate Shock  in Basis Points** |   | **Net  Interest  Income** |       | **Percentage  Change** |   |
|---------------------------------|--------|---------------------------|------------|------------------------|--------|
| +200                            |   |                      | 31,972,000 |                   | 13.12  | % |
| +100                            |   |                      | 30,929,000 |                   | 9.43   | % |
| 0                               |   |                      | 28,263,000 |                   | 0.00   | % |
| -100                            |   |                      | 25,672,000 |                   | (9.17  | )% |

 

The preceding table wasprepared utilizing the Model Assumptions regarding prepayment and decay ratioswhich were determined by management based upon their review of historicalprepayment speeds and future prepayment projections prepared by third parties.

 

Certain shortcomings areinherent in the method of analysis presented in the foregoing table. In theevent of a change in interest rates, prepayment and early withdrawal levelswould likely deviate significantly from those assumed in calculating theforegoing table. The ability of many borrowers to service their debt maydecrease in the event of a substantial increase in interest rates and couldimpact net interest income.

 

In an attempt to manage itsexposure to changes in interest rates, management closely monitors interestrate risk. The Company has an Asset/Liability Committee which meets frequentlyto discuss changes made to the interest rate risk position and projectedprofitability. The Committee makes adjustments to the asset/liability positionof the Bank which are reviewed by the Board of Directors of the Bank. ThisCommittee also reviews the Bank’s portfolio, formulates investment strategiesand oversees the timing and implementation of transactions to assure attainmentof the Bank’s objectives in the most effective manner. In addition, the Boardreviews on a quarterly basis the Bank’s asset/liability position, includingsimulations of the effect on the Bank’s capital of various interest rate scenarios.

 

Inmanaging its asset/liability mix, the Bank, at times, depending on therelationship between long and short-term interest rates, market conditions andconsumer preference, may place more emphasis on managing net interest marginthan on better matching the interest rate sensitivity of its assets andliabilities in an effort to enhance net interest income. Management believesthat the increased net interest income resulting from a mismatch in thematurity of its asset and liability portfolios can, during periods of decliningor stable interest rates, provide high enough returns to justify the increasedexposure to sudden and unexpected increases in interest rates.

 

To the extent consistentwith its interest rate spread objectives, the Bank attempts to reduce itsinterest rate risk and has taken a number of steps to restructure its assetsand liabilities. The Bank has primarily focused its fixed rate one-to-fourfamily residential lending program on loans that are saleable to third partiesand only places fixed rate loans that meet certain risk characteristics intoits loan portfolio. The Bank does place into portfolio adjustable ratesingle-family loans that reprice over a one-year, three year or five-yearperiod. The Bank’s commercial loan production has primarily been in adjustablerate loans and the fixed rate commercial loans placed in portfolio have beenshorter-term loans, usually with maturities of five years or less, in order tolower the Company’s interest rate risk exposure.

 

17

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**CONSOLIDATEDBALANCE SHEETS**

 
| **December ****31****,****2003****and****2002**                                 |   | **2003**        |            | **2002**    |        |
|--------------------------------------------------------------------------------------|--------|-----------------|-----------------|-------------|-------------|
|                                                                                 |   |            | ** **      |        |        |
| **ASSETS**                                                                           |   |            | ** **      |        |        |
| Cash and cash equivalents                                                            |   | **$**           | **30,496,823**  | ** **  | 27,729,007  |   |
| Securities available for sale:                                                       |   |            | ** **      |        |        |
| Mortgage-backed and related securities (amortized cost $13,707,005  and $51,677,294) |   | **13,048,718**  | ** **      | 51,895,832  |        |
| Other marketable securities (amortized cost $91,035,285 and  $67,282,379)            |   | **91,615,047**  | ** **      | 69,501,417  |        |
|                                                                                 |   | **104,663,765** |            | 121,397,249 |        |
| Loans held for sale                                                                  |   | **6,542,824**   | ** **      | 15,126,509  |        |
| Loans receivable, net                                                                |   | **688,951,119** | ** **      | 533,905,652 |        |
| Accrued interest receivable                                                          |   | **3,462,221**   | ** **      | 3,050,636   |        |
| Real estate, net                                                                     |   | **73,271**      | ** **      | 426,691     |        |
| Federal Home Loan Bank stock, at cost                                                |   | **10,004,400**  | ** **      | 11,880,500  |        |
| Mortgage servicing rights, net                                                       |   | **3,447,843**   | ** **      | 2,691,031   |        |
| Premises and equipment, net                                                          |   | **12,110,151**  | ** **      | 12,875,816  |        |
| Investment in limited partnerships                                                   |   | **617,042**     | ** **      | 862,666     |        |
| Goodwill                                                                             |   | **3,800,938**   | ** **      | 3,800,938   |        |
| Core deposit intangible                                                              |   | **447,474**     | ** **      | 561,331     |        |
| Prepaid expenses and other assets                                                    |   | **1,818,156**   | ** **      | 3,214,792   |        |
| Total assets                                                                         |   | **$**           | **866,436,027** | ** **  | 737,522,818 |   |
|                                                                                 |   |            | ** **      |        |        |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                        |   |            | ** **      |        |        |
| Deposits                                                                             |   | **$**           | **551,687,995** | ** **  | 432,951,462 |   |
| Federal Home Loan Bank advances                                                      |   | **203,900,000** | ** **      | 218,300,000 |        |
| Accrued interest payable                                                             |   | **766,837**     | ** **      | 849,427     |        |
| Customer escrows                                                                     |   | **22,457,671**  | ** **      | 707,213     |        |
| Accrued expenses and other liabilities                                               |   | **6,952,600**   | ** **      | 7,614,406   |        |
| Deferred tax liabilities                                                             |   | **26,300**      | ** **      | 1,456,600   |        |
| Total liabilities                                                                    |   | **785,791,403** | ** **      | 661,879,108 |        |
| Commitments and contingencies                                                        |   |            | ** **      |        |        |
| Minority interest                                                                    |   | **(286,433**    | **)**           | (420,846    | )           |
| Stockholders’ equity:                                                           |   |            | ** **      |        |        |
| Serial preferred stock: ($.01 par value)                                             |   |            |            |        |        |
| Authorized 500,000 shares; issued and outstanding none                               |   | **0**           | ** **      | 0           |        |
| Common stock ($.01 par value):                                                       |   |            |            |        |        |
| Authorized 11,000,000; issued shares 9,128,662                                       |   | **91,287**      | ** **      | 91,287      |        |
| Additional paid-in capital                                                           |   | **57,863,726**  | ** **      | 58,885,279  |        |
| Retained earnings, subject to certain restrictions                                   |   | **85,364,657**  | ** **      | 79,660,481  |        |
| Accumulated other comprehensive income (loss)                                        |   | **(50,725**     | **)**           | 1,575,577   |        |
| Unearned employee stock ownership plan shares                                        |   | **(4,738,084**  | **)**           | (4,931,385  | )           |
| Treasury stock, at cost 4,616,010 and 4,722,856 shares                               |   | **(57,599,804** | **)**           | (59,216,683 | )           |
| Total stockholders’ equity                                                      |   | **80,931,057**  | ** **      | 76,064,556  |        |
| Total liabilities and stockholders’ equity                                      |   | **$**           | **866,436,027** | ** **  | 737,522,818 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

18

----

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

 
| **Years  ended****December 31,  2003, 2002 and 2001**                                   |   | **2003**       |           | **2002**   |       | **2001**   |       |
|----------------------------------------------------------------------------------------------|--------|----------------|----------------|------------|------------|------------|------------|
|                                                                                         |   |           | ** **     |       |       |       |       |
| Interest income:                                                                             |   |           | ** **     |       |       |       |       |
| Loans receivable                                                                             |   | **$**          | **41,800,039** | ** ** | 38,011,750 |       | 44,569,397 |   |
| Securities available for sale:                                                               |   |           | ** **     |       |       |       |       |
| Mortgage-backed and related                                                                  |   | **272,253**    | ** **     | 1,704,248  |       | 3,867,079  |       |
| Other marketable                                                                             |   | **2,386,590**  | ** **     | 2,420,317  |       | 2,248,383  |       |
| Cash equivalents                                                                             |   | **128,948**    | ** **     | 382,021    |       | 246,449    |       |
| Other                                                                                        |   | **349,150**    | ** **     | 349,214    |       | 536,619    |       |
| Total interest income                                                                        |   | **44,936,980** | ** **     | 42,867,550 |       | 51,467,927 |       |
| Interest expense:                                                                            |   |           | ** **     |       |       |       |       |
| Deposits                                                                                     |   | **10,274,188** | ** **     | 10,949,802 |       | 18,578,348 |       |
| Federal Home Loan Bank advances and other borrowed money                                     |   | **10,014,865** | ** **     | 10,345,102 |       | 11,865,682 |       |
| Total interest expense                                                                       |   | **20,289,053** | ** **     | 21,294,904 |       | 30,444,030 |       |
| Net interest income                                                                          |   | **24,647,927** | ** **     | 21,572,646 |       | 21,023,897 |       |
| Provision for loan losses                                                                    |   | **2,610,000**  | ** **     | 2,376,000  |       | 1,150,000  |       |
| Net interest income after provision for loan losses                                          |   | **22,037,927** | ** **     | 19,196,646 |       | 19,873,897 |       |
| Non-interest income:                                                                         |   |           | ** **     |       |       |       |       |
| Fees and service charges                                                                     |   | **2,304,090**  | ** **     | 1,723,117  |       | 1,563,031  |       |
| Mortgage servicing fees                                                                      |   | **998,200**    | ** **     | 715,074    |       | 470,081    |       |
| Securities gains (losses), net                                                               |   | **1,274,537**  | ** **     | 422,346    |       | (670,958   | )          |
| Gain on sales of loans                                                                       |   | **5,240,442**  | ** **     | 3,077,294  |       | 2,934,317  |       |
| Losses in limited partnerships                                                               |   | **(243,305**   | **)**          | (659,378   | )          | (1,311,568 | )          |
| Other                                                                                        |   | **681,518**    | ** **     | 596,117    |       | 598,625    |       |
| Total non-interest income                                                                    |   | **10,255,482** | ** **     | 5,874,570  |       | 3,583,528  |       |
| Non-interest expense:                                                                        |   |           | ** **     |       |       |       |       |
| Compensation and benefits                                                                    |   | **8,675,596**  | ** **     | 8,012,953  |       | 7,914,452  |       |
| Occupancy                                                                                    |   | **3,423,745**  | ** **     | 3,109,548  |       | 2,239,152  |       |
| Federal deposit insurance premiums                                                           |   | **72,524**     | ** **     | 74,108     |       | 79,714     |       |
| Advertising                                                                                  |   | **392,833**    | ** **     | 521,898    |       | 426,357    |       |
| Data processing                                                                              |   | **1,109,098**  | ** **     | 1,107,248  |       | 963,958    |       |
| Amortization of mortgage servicing rights, net of valuation  adjustments and servicing costs |   | **1,982,337**  | ** **     | 1,165,762  |       | 758,352    |       |
| Other                                                                                        |   | **3,997,243**  | ** **     | 3,857,117  |       | 3,366,698  |       |
| Total noninterest expense                                                                    |   | **19,653,376** | ** **     | 17,848,634 |       | 15,748,683 |       |
| Income before income tax expense                                                             |   | **12,640,033** | ** **     | 7,222,582  |       | 7,708,742  |       |
| Income tax expense                                                                           |   | **4,037,800**  | ** **     | 2,099,200  |       | 2,634,385  |       |
| Income before minority interest                                                              |   | **8,602,233**  | ** **     | 5,123,382  |       | 5,074,357  |       |
| Minority interest                                                                            |   | **(3,014**     | **)**          | (142,274   | )          | (383,259   | )          |
| Net income                                                                                   |   | **$**          | **8,605,247**  | ** ** | 5,265,656  |       | 5,457,616  |   |
| Basic earnings per share                                                                     |   | **$**          | **2.26**       | ** ** | 1.40       |       | 1.45       |   |
| Diluted earnings per share                                                                   |   | **$**          | **2.16**       | ** ** | 1.32       |       | 1.37       |   |

 

**CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME**

 
| Net income                                                                   |   | **$**          | **8,605,247** | ** ** | 5,265,656 |      | 5,457,616 |   |
|------------------------------------------------------------------------------|--------|----------------|---------------|------------|-----------|-----------|-----------|--------|
| Other comprehensive income, net of tax:                                      |   |           | ** **    |       |      |      |      |
| Unrealized gains (losses) on hedging  valuation                              |   | **0**          | ** **    | (35,795    | )         | 35,795    |      |
| Less: minority interest in hedging  valuation                                |   | **0**          | ** **    | (21,950    | )         | 21,950    |      |
| Net unrealized gains (losses) on hedging  valuation                          |   | **0**          | ** **    | (13,845    | )         | 13,845    |      |
| Unrealized gains on securities:                                              |   |           | ** **    |       |      |      |      |
| Unrealized holding gains (losses) arising  during period                     |   | **(801,965**   | **)**         | 1,494,824  |      | 1,988,754 |      |
| Less: reclassification adjustment for gains  (losses) included in net income |   | **824,337**    | ** **    | 273,146    |      | (402,150  | )         |
| Net unrealized gains (losses) on securities                                  |   | **(1,626,302** | **)**         | 1,221,678  |      | 2,390,904 |      |
| Other comprehensive income (loss)                                            |   | **(1,626,302** | **)**         | 1,207,833  |      | 2,404,749 |      |
| Comprehensive income                                                         |   | **$**          | **6,978,945** | ** ** | 6,473,489 |      | 7,862,365 |   |

 

*See accompanyingnotes to consolidated financial statements.*

 

19

----

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

 
|                                        |   | **Common  Stock** |       | **Additional  Paid-In  Capital** |           | **Retained  Earnings** |           | **Accumulated  Other  Comprehensive  Income (Loss)** |        | **Unearned  Employee  Stock  Ownership  Plan  Shares** |           | **Unearned  Compensation  Restricted  Stock Awards** |       | **Treasury  Stock** |            | **Total  Stockholders’  Equity** |           |
|---------------------------------------------|--------|-------------------|------------|----------------------------------|----------------|------------------------|----------------|------------------------------------------------------|-------------|--------------------------------------------------------|----------------|------------------------------------------------------|------------|---------------------|-----------------|---------------------------------------|----------------|
| Balance, December 31, 2000             |   | $                 | 91,287     |                             | 59,584,176     |                   | 73,380,588     |                                                 | (2,037,005  | )                                                      | (5,318,067     | )                                                    | (9,800     | )                   | (59,065,531     | )                                     | 66,625,648     |   |
| Net income                                  |   |              |       |                             |           | 5,457,616              |           |                                                 |        |                                                   |           |                                                 |       |                |            | 5,457,616                             |           |
| Other comprehensive income                  |   |              |       |                             |           |                   |           | 2,404,749                                            |        |                                                   |           |                                                 |       |                |            | 2,404,749                             |           |
| Treasury stock purchases                    |   |              |       |                             |           |                   |           |                                                 |        |                                                   |           |                                                 |       | (1,584,152          | )               | (1,584,152                            | )              |
| Employee stock options exercised            |   |              |       | (712,140                         | )              |                   |           |                                                 |        |                                                   |           |                                                 |       | 1,358,339           |            | 646,199                               |           |
| Tax benefits of exercised stock options     |   |              |       | 191,695                          |           |                   |           |                                                 |        |                                                   |           |                                                 |       |                |            | 191,695                               |           |
| Tax benefit of restricted stock awards      |   |              |       | 2,479                            |           |                   |           |                                                 |        |                                                   |           |                                                 |       |                |            | 2,479                                 |           |
| Amortization of restricted stock awards     |   |              |       |                             |           |                   |           |                                                 |        |                                                   |           | 2,450                                                |       |                |            | 2,450                                 |           |
| Earned employee stock ownership plan shares |   |              |       | 102,572                          |           |                   |           |                                                 |        | 193,321                                                |           |                                                 |       |                |            | 295,893                               |           |
| Dividends paid                              |   |              |       |                             |           | (1,881,226             | )              |                                                 |        |                                                   |           |                                                 |       |                |            | (1,881,226                            | )              |
| Balance, December 31, 2001             |   | $                 | 91,287     |                             | 59,168,782     |                   | 76,956,978     |                                                 | 367,744     |                                                   | (5,124,746     | )                                                    | (7,350     | )                   | (59,291,344     | )                                     | 72,161,351     |   |
| Net income                                  |   |              |       |                             |           | 5,265,656              |           |                                                 |        |                                                   |           |                                                 |       |                |            | 5,265,656                             |           |
| Other comprehensive income                  |   |              |       |                             |           |                   |           | 1,207,833                                            |        |                                                   |           |                                                 |       |                |            | 1,207,833                             |           |
| Treasury stock purchases                    |   |              |       |                             |           |                   |           |                                                 |        |                                                   |           |                                                 |       | (1,496,111          | )               | (1,496,111                            | )              |
| Employee stock options exercised            |   |              |       | (699,641                         | )              |                   |           |                                                 |        |                                                   |           |                                                 |       | 1,570,772           |            | 871,131                               |           |
| Tax benefits of exercised stock options     |   |              |       | 272,534                          |           |                   |           |                                                 |        |                                                   |           |                                                 |       |                |            | 272,534                               |           |
| Amortization of restricted stock awards     |   |              |       |                             |           |                   |           |                                                 |        |                                                   |           | 7,350                                                |       |                |            | 7,350                                 |           |
| Earned employee stock ownership plan shares |   |              |       | 143,604                          |           |                   |           |                                                 |        | 193,361                                                |           |                                                 |       |                |            | 336,965                               |           |
| Dividends paid                              |   |              |       |                             |           | (2,562,153             | )              |                                                 |        |                                                   |           |                                                 |       |                |            | (2,562,153                            | )              |
| Balance, December 31, 2002             |   | $                 | 91,287     |                             | 58,885,279     |                   | 79,660,481     |                                                 | 1,575,577   |                                                   | (4,931,385     | )                                                    | 0          |                | (59,216,683     | )                                     | 76,064,556     |   |
| Net income                                  |   |              | ** ** |                             | ** **     | **8,605,247**          | ** **     |                                                 | ** **  |                                                   | ** **     |                                                 | ** ** |                | ** **      | **8,605,247**                         | ** **     |
| Other comprehensive loss                    |   |              |       |                             |           |                   | ** **     | **(1,626,302**                                       | **)**       |                                                   | ** **     |                                                 | ** ** |                | ** **      | **(1,626,302**                        | **)**          |
| Treasury stock purchases                    |   |              |       |                             |           |                   | ** **     |                                                 | ** **  |                                                   | ** **     |                                                 | ** ** | **(1,384,560**      | **)**           | **(1,384,560**                        | **)**          |
| Employee stock options exercised            |   |              |       | **(1,578,979**                   | **)**          |                   | ** **     |                                                 | ** **  |                                                   | ** **     |                                                 | ** ** | **3,001,439**       | ** **      | **1,422,460**                         | ** **     |
| Tax benefits of exercised stock options     |   |              | ** ** | **376,969**                      | ** **     |                   | ** **     |                                                 | ** **  |                                                   | ** **     |                                                 | ** ** |                | ** **      | **376,969**                           | ** **     |
| Earned employee stock ownership plan shares |   |              | ** ** | **180,457**                      | ** **     |                   | ** **     |                                                 | ** **  | **193,301**                                            | ** **     |                                                 | ** ** |                | ** **      | **373,758**                           | ** **     |
| Dividends paid                              |   |              |       |                             |           | **(2,901,071**         | **)**          |                                                 | ** **  |                                                   | ** **     |                                                 | ** ** |                | ** **      | **(2,901,071**                        | **)**          |
| Balance, December 31, 2003             |   | **$**             | **91,287** | ** **                       | **57,863,726** | ** **             | **85,364,657** | ** **                                           | **(50,725** | **)**                                                  | **(4,738,084** | **)**                                                | **0**      | ** **          | **(57,599,804** | **)**                                 | **80,931,057** | ** ** |

 

*Seeaccompanying notes to consolidated financial statements.*

 

20

----

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| **Years  ended****December 31,  2003, 2002 and 2001**                                   |   | **2003**         |           | **2002**     |       | **2001**     |       |
|----------------------------------------------------------------------------------------------|--------|------------------|----------------|--------------|------------|--------------|------------|
| Cash flows from operating activities:                                                        |   |             | ** **     |         |       |         |       |
| Net income                                                                                   |   | **$**            | **8,605,247**  | ** **   | 5,265,656  |         | 5,457,616  |   |
| Adjustments to reconcile net income to cash provided (used) by  operating activities:        |   |             | ** **     |         |       |         |       |
| Provision for loan losses                                                                    |   | **2,610,000**    | ** **     | 2,376,000    |       | 1,150,000    |       |
| Depreciation                                                                                 |   | **1,549,997**    | ** **     | 1,460,636    |       | 1,037,897    |       |
| Amortization of premiums, net                                                                |   | **652,344**      | ** **     | 501,945      |       | 107,719      |       |
| Amortization of deferred loan fees                                                           |   | **(690,176**     | **)**          | (672,993     | )          | (513,671     | )          |
| Amortization of goodwill                                                                     |   | **0**            | ** **     | 0            |       | 180,036      |       |
| Amortization of core deposit intangible                                                      |   | **113,857**      | ** **     | 124,178      |       | 108,854      |       |
| Amortization of mortgage servicing rights, net of valuation  adjustments and servicing costs |   | **1,982,337**    | ** **     | 1,165,762    |       | 758,352      |       |
| Capitalized mortgage servicing rights                                                        |   | **(2,522,231**   | **)**          | (1,956,845   | )          | (1,458,321   | )          |
| Deferred income taxes                                                                        |   | **(540,900**     | **)**          | (158,700     | )          | (821,600     | )          |
| Securities losses (gains), net                                                               |   | **(1,274,537**   | **)**          | (422,346     | )          | 670,958      |       |
| (Gain) loss on sale of premises                                                              |   | **(185,630**     | **)**          | 85,434       |       | 0            |       |
| Loss (gain) on sales of real estate                                                          |   | **115,710**      | ** **     | (1,254       | )          | (17,293      | )          |
| Gain on sales of loans                                                                       |   | **(5,240,442**   | **)**          | (3,077,294   | )          | (2,934,317   | )          |
| Proceeds from sales of loans held for sale                                                   |   | **297,862,680**  | ** **     | 283,485,340  |       | 753,564,329  |       |
| Disbursements on loans held for sale                                                         |   | **(280,633,930** | **)**          | (221,645,865 | )          | (809,722,094 | )          |
| Principal collected on loans held for sale                                                   |   | **11,521**       | ** **     | 120,621      |       | 179,020      |       |
| Amortization of restricted stock awards                                                      |   | **0**            | ** **     | 7,350        |       | 2,450        |       |
| Amortization of unearned ESOP Shares                                                         |   | **193,301**      | ** **     | 193,361      |       | 193,321      |       |
| Earned employee stock ownership shares priced above original cost                            |   | **180,457**      | ** **     | 143,604      |       | 102,572      |       |
| Decrease (increase) in accrued interest receivable                                           |   | **(411,585**     | **)**          | 458,192      |       | 802,919      |       |
| Decrease in accrued interest payable                                                         |   | **(82,590**      | **)**          | (168,029     | )          | (558,065     | )          |
| Equity losses of limited partnerships                                                        |   | **243,305**      | ** **     | 659,378      |       | 1,311,568    |       |
| Equity losses of minority interest                                                           |   | **(3,014**       | **)**          | (142,274     | )          | (383,259     | )          |
| Decrease (increase) in other assets                                                          |   | **680,227**      | ** **     | 126,663      |       | (1,937,860   | )          |
| Increase in other liabilities                                                                |   | **663,785**      | ** **     | 629,031      |       | 2,890,551    |       |
| Other, net                                                                                   |   | **178,627**      | ** **     | 366,903      |       | (60,665      | )          |
| Net cash provided (used) by operating activities                                             |   | **24,058,360**   | ** **     | 68,924,454   |       | (49,888,983  | )          |
| Cash flows from investing activities:                                                        |   |             | ** **     |         |       |         |       |
| Proceeds from sales of securities available for sale                                         |   | **50,372,919**   | ** **     | 18,036,553   |       | 19,135,721   |       |
| Principal collected on securities available for sale                                         |   | **30,938,152**   | ** **     | 25,481,396   |       | 24,062,724   |       |
| Proceeds collected on maturity of securities available for sale                              |   | **10,000,000**   | ** **     | 19,900,000   |       | 13,695,000   |       |
| Purchases of securities available for sale                                                   |   | **(76,410,791**  | **)**          | (63,173,006  | )          | (34,461,933  | )          |
| Proceeds from sales of loans receivable                                                      |   | **0**            | ** **     | 0            |       | 12,156       |       |
| Purchase of Federal Home Loan Bank stock                                                     |   | **(768,900**     | **)**          | 0            |       | 0            |       |
| Redemption of Federal Home Loan Bank stock                                                   |   | **2,645,000**    | ** **     | 364,500      |       | 0            |       |
| Net decrease (increase) in loans receivable                                                  |   | **(161,455,973** | **)**          | (69,313,264  | )          | 44,264,172   |       |
| Proceeds from sale of mortgage servicing rights                                              |   | **0**            | ** **     | 33,032       |       | 0            |       |
| Proceeds from sale of premises and equipment                                                 |   | **416,354**      | ** **     | 655,465      |       | 0            |       |
| Proceeds from sale of real estate                                                            |   | **740,194**      | ** **     | 151,453      |       | 316,797      |       |
| Purchases of premises and equipment                                                          |   | **(1,046,235**   | **)**          | (4,281,615   | )          | (2,438,943   | )          |
| Net cash (used) provided by investing activities                                             |   | **(144,569,280** | **)**          | (72,145,486  | )          | 64,585,694   |       |
| Cash flows from financing activities:                                                        |   |             | ** **     |         |       |         |       |
| Increase in deposits                                                                         |   | **118,784,449**  | ** **     | 10,925,976   |       | 334,938      |       |
| Purchase of treasury stock                                                                   |   | **(1,384,560**   | **)**          | (1,496,111   | )          | (1,584,152   | )          |
| Stock options exercised                                                                      |   | **1,422,460**    | ** **     | 871,131      |       | 646,199      |       |
| Dividends to stockholders                                                                    |   | **(2,901,071**   | **)**          | (2,562,153   | )          | (1,881,226   | )          |
| Proceeds from Federal Home Loan Bank advances                                                |   | **161,000,000**  | ** **     | 10,000,000   |       | 267,700,000  |       |
| Repayment of Federal Home Loan Bank advances                                                 |   | **(175,400,000** | **)**          | (9,500,000   | )          | (271,800,000 | )          |
| Minority interest in subsidiaries                                                            |   | **7,000**        | ** **     | 0            |       | 125,000      |       |
| Increase (decrease) in customer escrows                                                      |   | **21,750,458**   | ** **     | (308,357     | )          | 365,222      |       |
| Net cash provided (used) by financing activities                                             |   | **123,278,736**  | ** **     | 7,930,486    |       | (6,094,019   | )          |
| Increase in cash and cash equivalents                                                        |   | **2,767,816**    | ** **     | 4,709,454    |       | 8,602,692    |       |
| Cash and cash equivalents, beginning of year                                                 |   | **27,729,007**   | ** **     | 23,019,553   |       | 14,416,861   |       |
| Cash and cash equivalents, end of year                                                       |   | **$**            | **30,496,823** | ** **   | 27,729,007 |         | 23,019,553 |   |
| Supplemental cash flow disclosures:                                                          |   |             | ** **     |         |       |         |       |
| Cash paid for interest                                                                       |   | **$**            | **20,371,643** | ** **   | 21,462,933 |         | 31,002,095 |   |
| Cash paid for income taxes                                                                   |   | **2,141,000**    | ** **     | 1,952,500    |       | 3,713,121    |       |
| Supplemental noncash flow disclosures:                                                       |   |             | ** **     |         |       |         |       |
| Loans transferred to loans held for sale                                                     |   | **3,741,477**    | ** **     | 4,669,139    |       | 2,172,128    |       |
| Transfer of loans to real estate                                                             |   | **769,584**      | ** **     | 628,233      |       | 86,123       |       |
| Transfer of real estate to loans                                                             |   | **47,802**       | ** **     | 0            |       | 0            |       |

 

*Seeaccompanying notes to consolidated financial statements.*

 

21

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**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

*December31, 2003, 2002 and 2001*

 

**NOTE 1  Description of the Business and Summary ofSignificant Accounting Policies**

 

HMN Financial, Inc. (HMN orthe Company) is a stock savings bank holding company that owns 100 percent ofHome Federal Savings Bank (the Bank). The Bank has a community bankingphilosophy and operates retail banking facilities in Minnesota and Iowa. TheBank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OAI)which offers financial planning products and services and Home Federal Holding,Inc. (HFH) which is the holding company for Home Federal REIT, Inc. (HFREIT)which invests in real estate loans acquired from the Bank. HMN has anotherwholly owned subsidiary, Security Finance Corporation (SFC) which acts as anintermediary for the Bank in transacting like kind property exchanges for Bankcustomers. The Bank has a 51% owned subsidiary, Home Federal Mortgage Services,LLC (HFMS), which was a mortgage banking and mortgage brokerage businesslocated in Brooklyn Park, Minnesota. HFMS’s brokerage and production activitystopped during the third quarter of 2002 and the company is in the process ofbeing dissolved. The Bank has an 80% owned subsidiary, Federal Title Services,LLC (FTS), which performs mortgage title services for Bank customers.

 

The consolidated financialstatements included herein are for HMN, SFC, the Bank and the Bank’sconsolidated entities, OIA, HFH, HFREIT, HFMS, and FTS. All significantintercompany accounts and transactions have been eliminated in consolidation.

 

***Use of Estimates   ***In preparing the consolidated financialstatements, management is required to make estimates and assumptions thataffect the reported amounts of assets and liabilities as of the date of thebalance sheet and revenues and expenses for the period. Actual results coulddiffer from those estimates.

 

Estimates that areparticularly susceptible to change relate to the determination of the allowancefor loan losses and the valuation of mortgage servicing rights.

 

Management believes that theallowance for loan losses is adequate to cover probable losses inherent in theportfolio at the date of the balance sheet. While management uses availableinformation to recognize losses on loans, future additions to the allowance maybe necessary based on changes in economic conditions. In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the allowance for loan losses. Such agencies may requireadditions to the allowance based on their judgment about information availableto them at the time of their examination.

 

Mortgage servicing rightsare stratified by loan type and note rate and are valued quarterly usingprepayment and default rate assumptions. While management believes that theassumptions used and the values determined are reasonable, future adjustmentsmay be necessary if economic conditions differ substantially from the economicconditions in the assumptions used to determine the value of the mortgageservicing rights.

 

***Cash and Cash Equivalents   ***The Company considers highly liquidinvestments with original maturities of three months or less to be cashequivalents.

 

***Securities   ***Securities are accounted for according totheir purpose and holding period. The Company classifies its debt and equitysecurities in one of three categories:

 

*TradingSecurities *Securities held principally for resale in thenear term are classified as trading securities and are recorded at their fairvalues. Unrealized gains and losses on trading securities are included in otherincome.

 

*SecuritiesHeld to Maturity *Securities that the Company has the positiveintent and ability to hold to maturity are reported at cost and adjusted forpremiums and discounts that are recognized in interest income using theinterest method over the period to maturity. Unrealized losses on securitiesheld to maturity reflecting a decline in value judged to be other thantemporary are charged to income.

 

*SecuritiesAvailable for Sale *Securities available for sale consist ofsecurities not classified as trading securities or as securities held tomaturity. They include securities that management intends to use as part of itsasset/liability strategy or that may be sold in response to changes in interestrate, changes in prepayment risk, or similar factors. Unrealized gains andlosses, net of income taxes, are reported as a separate component ofstockholders’ equity until realized. Gains and losses on the sale of securitiesavailable for sale are determined using the specific identification method andrecognized on the trade date. Premiums and discounts are recognized in interestincome using the interest method over the period to maturity. Unrealized losseson securities available for sale reflecting a decline in value judged to beother than temporary are charged to income.

 

***Loans Held for Sale   ***Mortgage loans originated or purchased whichare intended for sale in the secondary market are carried at the lower of costor estimated market value in the aggregate. Net fees and costs associated withacquiring and/or originating loans held for sale are deferred and included inthe basis of the loan in determining the gain or loss on the sale of the loans.Gains are recognized on the settlement date. Net unrealized losses arerecognized through a valuation allowance by charges to income.

 

***Loans Receivable,Net   ***Loans receivable, net are considered long-term investments and,accordingly, are carried at amortized cost. Loan origination fees received, netof certain loan origination costs, are deferred as an adjustment to thecarrying value of the related loans, and are amortized into income using theinterest method over the estimated life of the loans.

 

Premiums and discounts onloans are amortized into interest income using the interest method over theperiod to contractual maturity, adjusted for estimated prepayments.

 

The allowance for loanlosses is maintained at an amount considered adequate by management to providefor probable losses inherent in the loan portfolio as of the balance sheetdates. The allowance for loan losses is based on periodic analysis of the loanportfolio by management. In this analysis, management considers factorsincluding, but not limited to, specific occurrences which include loanimpairment, changes in the size of the portfolios, general economic conditions,loan portfolio composition and historical experience.  In connection with the determination of the allowance for loanlosses, management obtains independent

 

22

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appraisals for significant properties. The allowance for loan losses is established for known problem loans aswell as for loans which are not currently known to require specific allowances.Loans are charged off to the extent they are deemed to be uncollectible. Theadequacy of the allowance for loan losses is dependent upon management’sestimates of variables affecting valuation, appraisals of collateral,evaluations of performance and status, and the amounts and timing of futurecash flows expected to be received on impaired loans. Such estimates,appraisals, evaluations and cash flows may be subject to frequent adjustmentsdue to changing economic prospects of borrowers or properties. The estimatesare reviewed periodically and adjustments, if any, are recorded in theprovision for loan losses in the periods in which the adjustments become known.

 

Interest income is recognized on an accrual basis except when collectibility is in doubt. When loansare placed on a non-accrual basis, generally when the loan is 90 days past due,previously accrued but unpaid interest is reversed from income. Interest issubsequently recognized as income to the extent cash is received when, inmanagement’s judgment, principal is collectible.

 

All impaired loans are valued at the present value of expected future cash flows discountedat the loan’s initial effective interest rate. The fair value of the collateralof an impaired collateral-dependent loan or an observable market price, if oneexists, may be used as an alternative to discounting. If the value of theimpaired loan is less than the recorded investment in the loan, impairment willbe recognized through the allowance for loan losses. A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect all amounts due according to the contractualterms of the loan agreement.  Impairedloans include all loans which are delinquent as to principal and interest for120 days or greater and all loans that are restructured in a troubled debtrestructuring involving a modification of terms. All portfolio loans arereviewed for impairment on an individual basis.

 

***Mortgage Servicing Rights   ***Mortgage servicing rights are capitalized andamortized in proportion to, and over the period of, estimated net servicingincome. HMN evaluates quarterly its capitalized mortgage servicing rights forimpairment. Loan type and note rate are predominant risk characteristics of theunderlying loans used to stratify capitalized mortgage servicing rights forpurposes of measuring impairment. Any impairment is recognized through avaluation allowance.

 

***Real Estate, Net   ***Real estate acquired through loanforeclosures are initially recorded at the lower of the related loan balance,less any specific allowance for loss, or fair value less estimated sellingcosts. Valuations are periodically performed by management and an allowance forlosses is established if the carrying value of a property exceeds its fairvalue less estimated selling costs.

 

***Premises and Equipment   ***Land is carried at cost. Office buildings,improvements, furniture and equipment are carried at cost less accumulateddepreciation.

 

Depreciation is computed on a straight-line basis over estimated useful lives of 5 to 40 yearsfor office buildings and improvements and 3 to 10 years for furniture andequipment.

 

***Impairment of Long-Lived Assets and for Long-Lived Assets to BeDisposed Of   ***HMN reviews long-lived assets and certain identifiable intangibles forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable.

 

***Investment in Limited Partnerships   ***HMN has investments in limited partnershipswhich invest in mortgage servicing assets, the common stock of other financialinstitutions and low to moderate income housing projects which generate taxcredits for HMN. HMN accounts for the earnings or losses from the limitedpartnerships on the equity method.

 

***Intangible Assets   ***Goodwill resulting from acquisitions is notamortized but is tested for impairment annually in accordance with therequirements of SFAS No. 142, *Goodwill andOther Intangible Assets.*Deposit base intangibles are amortized onan accelerated basis as the deposits run off. HMN reviews the recoverability ofthe carrying value of these assets annually or whenever an event occursindicating that they may be impaired.

 

***Stock-Based Compensation   ***Effective January 1, 1996, HMN adopted SFASNo. 123, *Accounting for Stock-BasedCompensation.*It elected to continue using the accounting methodsprescribed by Accounting Principles Board (APB) Opinion No. 25 and relatedinterpretations which measure compensation cost using the intrinsic valuemethod.  See Note 17 for additionalinformation relating to stock based compensation. Had compensation cost forHMN’s stock-based plan been determined in accordance with the fair value methodrecommended by SFAS No. 123, HMN’s net income and earnings per share would havebeen adjusted to the pro forma amounts indicated below:

 
|                                                                                                                                                    |   | **2003**   |          | **2002** |      | **2001** |      |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|---------------|----------|-----------|----------|-----------|
| Net income:                                                                                                                                             |   |       |          |     |      |     |      |
| As reported                                                                                                                                             |   | **$**      | **8,605,247** |     | 5,265,656 |     | 5,457,616 |   |
| Deduct: Total stock-based employee compensation expense (benefit)  determined under fair value based method for all awards, net of related tax  effects |   | **44,935** | ** **    | 42,960   |      | (6,805   | )         |
| Pro forma                                                                                                                                               |   | **$**      | **8,560,312** |     | 5,222,696 |     | 5,464,421 |   |
| Earnings per common share:                                                                                                                              |   |       | ** **    |     |      |     |      |
| As reported:                                                                                                                                            |   |       | ** **    |     |      |     |      |
| Basic                                                                                                                                                   |   | **$**      | **2.26**      |     | 1.40      |     | 1.45      |   |
| Diluted                                                                                                                                                 |   | **2.16**   | ** **    | 1.32     |      | 1.37     |      |
| Pro forma:                                                                                                                                              |   |       | ** **    |     |      |     |      |
| Basic                                                                                                                                                   |   | **2.25**   | ** **    | 1.39     |      | 1.45     |      |
| Diluted                                                                                                                                                 |   | **2.15**   | ** **    | 1.31     |      | 1.37     |      |

 

***Income Taxes   ***Deferred tax assets and liabilities arerecognized for the future tax consequences attributable to temporarydifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date.

 

23

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***Earnings per Share   ***Basic earnings per share (EPS) excludesdilution and is computed by dividing income available to common stockholders bythe weighted-average number of common shares outstanding for the period.Diluted EPS reflects the potential dilution that could occur if securities orother contracts to issue common stock were exercised or converted into commonstock or resulted in the issuance of common stock that shared in the earningsof the entity. See Note 18 for disclosure of EPS calculations.

 

***Comprehensive Income   ***Comprehensive income is defined as the changein equity during a period from transactions and other events from nonownersources. Comprehensive income is the total of net income and othercomprehensive income, which for HMN is comprised of unrealized gains and losseson securities available for sale and unrealized gains and losses on hedgingvaluations qualifying for cash flow hedge accounting treatment pursuant to SFASNo. 133.

 

***Segment Information   ***The amount of each segment item reported isthe measure reported to the chief operating decision maker for purposes ofmaking decisions about allocating resources to the segment and assessing itsperformance. Adjustments and eliminations made in preparing an enterprise’sgeneral-purpose financial statements and allocations of revenues, expenses andgains or losses are included in determining reported segment profit or loss ifthey are included in the measure of the segment’s profit or loss that is usedby the chief operating decision maker. Similarly, only those assets that areincluded in the measure of the segment’s assets that are used by the chiefoperating decision maker are reported for that segment.

 

***New Accounting Standards   ***In April 2003, the FASB issued SFAS No. 149, *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities.*This Statement amends and clarifiesfinancial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts (collectivelyreferred to as derivatives) and for hedging activities under FASB Statement No.133, *Accounting for Derivative Instrumentsand Hedging Activities.*This Statement is effective prospectivelyfor contracts entered into or modified after June 30, 2003, except for thoseprovisions of the Statement that relate to Statement 133 Implementation Issuesthat have been effective for fiscal quarters that began prior to June 15, 2003,which should continue to be applied in accordance with their respectiveeffective dates. The impact of adopting SFAS No. 149 on HMN’s financialcondition and results of operations was not material.

 

In May 2003, the FASB issuedSFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity.*ThisStatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. It requires that an issuer classify a financial instrument that iswithin its scope as a liability (or an asset in some circumstances). Many ofthose instruments were previously classified as equity. This Statement iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003, however, the effective date has been delayedunder certain conditions. The impact of adopting SFAS No. 150 on HMN’sfinancial condition and results of operations was not material.

 

In December 2003, the FASBissued a revised SFAS No. 132, *Employers’Disclosures about Pensions and Other Postretirement Benefits.*ThisStatement revises employers’ disclosures about pension plans and otherpostretirement benefit plans. It requires additional disclosures to those inthe original Statement 132 about the assets, obligations, cash flow, and netperiodic benefit cost of defined benefit pension plans and other definedbenefit postretirement plans. This Statement is effective for financialstatements with fiscal years ending after December 15, 2003. The impact ofadopting SFAS was not material. See Note 17 for the related employee benefitsdisclosure.

 

In December 2003, the FASBissued a revised Interpretation No. 46, *Consolidationof Variable Interest Entities*(FIN 46). FIN 46 addresses consolidation by business enterprises of variableinterest entities that have certain characteristics. It requires a businessenterprise that has a controlling interest in a variable interest entity (asdefined by FIN 46) to include the assets, liabilities, and results of theactivities of the variable interest entity in the consolidated financialstatements of the business enterprise. FIN 46 applies to a public entity thatis not a small business issuer no later than the end of the first reportingperiod that ends after March 15, 2004. The impact of adopting FIN 46 on HMN’sfinancial condition and results of operations will not be material.

 

***Derivative Financial Instruments   ***HMN uses derivative financial instruments inorder to manage the interest rate risk on residential loans held for sale andits commitments to extend credit for residential loans. HMN also uses interestrate swaps to manage interest rate risk. Derivative financial instrumentsinclude commitments to extend credit and forward mortgage loan salescommitments. See Note 22 for additional information concerning these derivativefinancial instruments.

 

***Reclassifications   ***Certain amounts in the consolidated financialstatements for prior years have been reclassified to conform with the currentyear presentation.

 

**NOTE 2  Other Comprehensive Income**

 

There was no hedgingvaluation for the year ended December 31, 2003. The gross unrealized holdinglosses on securities for the year ended December 31, 2003 was $1,241,000, theincome tax benefit would have been $439,000 and therefore, the net loss was$802,000. The gross reclassification adjustment for the year ended December 31,2003 was $1,274,000, the income tax expense would have been $450,000 andtherefore, the net reclassification adjustment was $824,000. The grossunrealized losses in hedging valuation for the year ended December 31, 2002 was$45,000, the income tax benefit would have been $9,000 and therefore, the netloss was $36,000. The gross minority interest in hedging valuation for the yearended December 31, 2002 was $22,000. The gross unrealized holding gains onsecurities for the year ended December 31, 2002 was $2,283,000, the income taxexpense would have been $788,000 and therefore, the net gain was $1,495,000.The gross reclassification adjustment in the year ended December 31, 2002 was$422,000, the income tax expense would have been $149,000 and therefore, thenet reclassification adjustment was $273,000.

 

24

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**NOTE 3  Securities Available for Sale**

 

A summary of securities availablefor sale at December 31, 2003 and 2002 is as follows:

 
|                                   |   | **Amortized  cost** |            | **Gross  unrealized  gains** |        | **Gross  unrealized  losses** |          | **Fair  value** |            |
|----------------------------------------|--------|---------------------|-----------------|------------------------------|-------------|-------------------------------|---------------|-----------------|-----------------|
| *December 31, 2003:*                   |   |                |            |                         |        |                          |          |            |            |
| Mortgage-backed securities:            |   |                |            |                         |        |                          |          |            |            |
| FHLMC                                  |   | **$**               | **421,818**     |                         | **19,938**  | ** **                    | **0**         | ** **      | **441,756**     | ** ** |
| GNMA                                   |   | **31,715**          | ** **      | **1,621**                    | ** **  | **3**                         | ** **    | **33,333**      | ** **      |
| Collateralized mortgage obligations:   |   |                |            |                         |        |                          |          |            |            |
| FHLMC                                  |   | **4,697,157**       | ** **      | **1,618**                    | ** **  | **266,403**                   | ** **    | **4,432,372**   | ** **      |
| FNMA                                   |   | **8,556,315**       | ** **      | **14,262**                   | ** **  | **429,320**                   | ** **    | **8,141,257**   | ** **      |
|                                   |   | **13,707,005**      |            | **37,439**                   | ** **  | **695,726**                   | ** **    | **13,048,718**  | ** **      |
| Other marketable securities:           |   |                |            |                         |        |                          |          |            |            |
| U.S. Government and agency obligations |   | **86,658,130**      | ** **      | **929,527**                  | ** **  | **0**                         | ** **    | **87,587,657**  | ** **      |
| Corporate debt                         |   | **177,155**         | ** **      | **0**                        | ** **  | **6,765**                     | ** **    | **170,390**     | ** **      |
| Corporate equity                       |   | **4,200,000**       | ** **      | **0**                        | ** **  | **343,000**                   | ** **    | **3,857,000**   | ** **      |
|                                   |   | **91,035,285**      |            | **929,527**                  | ** **  | **349,765**                   | ** **    | **91,615,047**  | ** **      |
|                                   |   | **$**               | **104,742,290** |                         | **966,966** | ** **                    | **1,045,491** | ** **      | **104,663,765** | ** ** |
| *December 31, 2002:*                   |   |                |            |                         |        |                          |          |            |            |
| Mortgage-backed securities:            |   |                |            |                         |        |                          |          |            |            |
| FHLMC                                  |   | $                   | 1,507,799       |                         | 84,778      |                          | 0             |            | 1,592,577       |   |
| FNMA                                   |   | 140,791             |            | 2,859                        |        | 0                             |          | 143,650         |            |
| GNMA                                   |   | 53,582              |            | 2,399                        |        | 0                             |          | 55,981          |            |
| Collateralized mortgage obligations:   |   |                |            |                         |        |                          |          |            |            |
| FHLMC                                  |   | 18,707,714          |            | 181,933                      |        | 1,277                         |          | 18,888,370      |            |
| FNMA                                   |   | 19,048,094          |            | 84,734                       |        | 134,270                       |          | 18,998,558      |            |
| Other                                  |   | 12,219,314          |            | 112,263                      |        | 114,881                       |          | 12,216,696      |            |
|                                   |   | 51,677,294          |            | 468,966                      |        | 250,428                       |          | 51,895,832      |            |
| Other marketable securities:           |   |                |            |                         |        |                          |          |            |            |
| U.S. Government and agency obligations |   | 61,417,086          |            | 2,168,825                    |        | 25,928                        |          | 63,559,983      |            |
| Corporate debt                         |   | 1,061,140           |            | 16,548                       |        | 0                             |          | 1,077,688       |            |
| Corporate equity                       |   | 4,804,153           |            | 199,593                      |        | 140,000                       |          | 4,863,746       |            |
|                                   |   | 67,282,379          |            | 2,384,966                    |        | 165,928                       |          | 69,501,417      |            |
|                                   |   | $                   | 118,959,673     |                         | 2,853,932   |                          | 416,356       |            | 121,397,249     |   |

 

Proceeds from securitiesavailable for sale which were sold during 2003 were $50,372,919, resulting ingross gains of $1,353,885 and gross losses of $79,348. Proceeds from securitiesavailable for sale which were sold during 2002 were $18,036,553, resulting ingross gains of $456,946 and gross losses of $34,600. Proceeds from securitiesavailable for sale which were sold during 2001 were $19,135,721, resulting ingross gains of $349,563 and gross losses of $521. The Company also recognizedlosses of $1,020,000 resulting from other than temporary impairments ofsecurities in 2001.

 

The following tableindicates amortized cost and estimated fair value of securities available forsale at December 31, 2003 based upon contractual maturity adjusted forscheduled repayments of principal and projected prepayments of principal basedupon current economic conditions and interest rates. Actual maturities maydiffer from the maturities in the following table because obligors may have theright to call or prepayobligations with or without call or prepayment penalties:

 
|                                   |   | **Amortized  cost** |        | **Fair  value** |        |
|----------------------------------------|--------|---------------------|-------------|-----------------|-------------|
|                                   |   |                |        |            |        |
| Due less than one year                 |   | $                   | 20,409,718  |            | 20,570,137  |   |
| Due after one year through five years  |   | 78,312,100          |        | 78,468,608      |        |
|                                   |   |                |        |            |        |
| Due after five years through ten years |   | 1,464,103           |        | 1,414,191       |        |
| Due after ten years                    |   | 356,369             |        | 353,829         |        |
| No stated maturity                     |   | 4,200,000           |        | 3,857,000       |        |
| Total                                  |   | $                   | 104,742,290 |            | 104,663,765 |   |

 

The allocation of mortgage-backed securities and collateralizedmortgage obligations in the table above is based upon the anticipated futurecash flow of the securities using estimated mortgage prepayment speeds.

 

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The following table shows the gross unrealized losses and fair values for thesecurities available for sale portfolio aggregated by investment category andlength of time that individual securities have been in a continuous unrealizedloss position, at December 31, 2003.

 
|                                  |   | **Less than  twelve months** |   | **Twelve  months or more** |   | **Total**       |   |
|---------------------------------------|--------|------------------------------|--------|----------------------------|--------|-----------------|--------|
| **(Dollars in thousands)**            |   | **Fair  Value**              |   | **Unrealized  Losses**     |   | **Fair  Value** |   | **Unrealized  Losses** |   | **Fair  Value** |   | **Unrealized  Losses** |   |
|                                  |   |                         |   |                       |   |            |   |   |   |   |   |   |   |
| Mortgage backed securities:           |   |                         |   |                       |   |            |   |   |   |   |   |   |   |
| Collateralized mortgage obligations   |   | $                            | 12,338 |                       | (695   | )               | 0      |   | 0 |   | 12,338 |   | (695 | ) |
| Other marketable securities:          |   |                         |   |                       |   |            |   |   |   |   |   |   |   |
| Corporate debt                        |   | 0                            |   | 0                          |   | 170             |   | (7 | ) | 170 |   | (7 | ) |
| Corporate equity                      |   | 0                            |   | 0                          |   | 3,157           |   | (343 | ) | 3,157 |   | (343 | ) |
| Total temporarily impaired securities |   | $                            | 12,338 |                       | (695   | )               | 3,327  |   | (350 | ) | 15,665 |   | (1,045 | ) |

 

**NOTE 4  Loans Receivable, Net**

 

A summary of loansreceivable at December 31 is as follows:

 
|                                             |   | **2003**        |            | **2002**    |        |
|--------------------------------------------------|--------|-----------------|-----------------|-------------|-------------|
| Residential real estate loans:                   |   |            | ** **      |        |        |
| 1-4 family conventional                          |   | **$**           | **187,821,158** | ** **  | 174,232,528 |   |
| 1-4 family FHA                                   |   | **692,690**     | ** **      | 306,815     |        |
| 1-4 family VA                                    |   | **382,107**     | ** **      | 128,911     |        |
|                                             |   | **188,895,955** |            | 174,668,254 |        |
| 5 or more family                                 |   | **54,877,999**  | ** **      | 29,903,411  |        |
|                                             |   | **243,773,954** |            | 204,571,665 |        |
| Commercial real estate:                          |   |            | ** **      |        |        |
| Lodging                                          |   | **39,464,818**  | ** **      | 37,188,951  |        |
| Retail/office                                    |   | **54,770,096**  | ** **      | 40,648,853  |        |
| Nursing home/health care                         |   | **5,545,180**   | ** **      | 2,250,556   |        |
| Land developments                                |   | **53,374,516**  | ** **      | 22,587,781  |        |
| Golf courses                                     |   | **26,938,649**  | ** **      | 11,282,148  |        |
| Restaurant, bar, café                       |   | **3,400,084**   | ** **      | 3,279,726   |        |
| Gaming                                           |   | **0**           | ** **      | 1,204,980   |        |
| Warehouse                                        |   | **7,577,813**   | ** **      | 6,203,530   |        |
| Manufacturing                                    |   | **5,950,639**   | ** **      | 5,806,968   |        |
| Other                                            |   | **29,529,814**  | ** **      | 24,201,130  |        |
|                                             |   | **226,551,609** |            | 154,654,623 |        |
| Other loans:                                     |   |            | ** **      |        |        |
| Autos                                            |   | **14,754,042**  | ** **      | 11,061,725  |        |
| Home equity line                                 |   | **54,192,801**  | ** **      | 52,105,686  |        |
| Home equity                                      |   | **18,973,890**  | ** **      | 23,760,135  |        |
| Consumer – secured                          |   | **12,030,495**  | ** **      | 2,700,204   |        |
| Commercial business                              |   | **132,459,066** | ** **      | 91,119,446  |        |
| Savings                                          |   | **494,227**     | ** **      | 533,695     |        |
| Mobile home                                      |   | **3,665,206**   | ** **      | 4,534,353   |        |
| Consumer – unsecured                        |   | **1,794,226**   | ** **      | 1,724,858   |        |
| Total other loans                                |   | **238,363,953** | ** **      | 187,540,102 |        |
| Total loans                                      |   | **708,689,516** | ** **      | 546,766,390 |        |
| Less:                                            |   |            | ** **      |        |        |
| Unamortized discounts                            |   | **166,364**     | ** **      | 142,439     |        |
| Net deferred loan fees                           |   | **1,334,284**   | ** **      | 1,068,297   |        |
| Allowance for losses                             |   | **6,939,602**   | ** **      | 4,824,217   |        |
| Loans in process                                 |   | **11,298,147**  | ** **      | 6,825,785   |        |
|                                             |   | **$**           | **688,951,119** |        | 533,905,652 | ** ** |
| Weighted average contractual interest rate       |   | **6.20**        | **%**           | 6.97        | %           |
| Commitments to originate, fund or purchase loans |   | **$**           | **69,547,706**  | ** **  | 80,999,893  |   |
| Commitments to deliver loans to secondary market |   | **7,077,725**   | ** **      | 61,711,741  |        |
| Loans serviced for others                        |   | **483,620,394** | ** **      | 337,490,407 |        |

 

Included in totalcommitments to originate or purchase loans are fixed rate loans aggregating$20,037,650 and $44,943,293 as of December 31, 2003 and 2002, respectively. Theinterest rates on these commitments ranged from 4.75% to 8.50% at December 31,2003 and from 4.75% to 7.88% at December 31, 2002.

 

At December 31, 2003 and2002, loans on nonaccrual status totaled $4,574,950 and $3,336,046,respectively. Had the loans performed in accordance with their original termsthroughout 2003, HMN would have recorded gross interest income of $458,473 forthese loans. Interest income of $163,044 has been recorded on these loans forthe year ended December 31, 2003.

 

At December 31, 2003 and2002 there were no loans included in loans receivable, net, with terms that hadbeen modified in a troubled debt restructuring.

 

There were no materialcommitments to lend additional funds to customers whose loans were classifiedas restructured or nonaccrual at December 31, 2003.

 

At December 31, 2003, 2002and 2001, the recorded investment in loans that are considered to be impairedwas $4,689,162, $3,507,418 and $2,183,483 for which the related allowance forcredit losses was $1,045,495, $904,840 and $637,233, respectively. The averageinvestment in impaired loans during 2003, 2002 and 2001 was $4,801,109,$3,005,743 and $1,385,071, respectively. For the years ended December 31, 2003,2002, and 2001, HMN recognized interest income on impaired loans of $163,044,$551,542 and $125,040, respectively. All of the interest income that wasrecognized for impaired loans was recognized using the cash basis method ofincome recognition.

 

The aggregate amounts ofloans to executive officers and directors of HMN was $1,038,119, $8,861,210 and$1,324,983, at December 31, 2003, 2002 and 2001, respectively. During 2003repayments on loans to executive officers and directors were $7,891,091, newloans to executive officers and directors totaled $490,500, and sales ofexecutive officer and director loans totaled $422,500. During 2002 repaymentson loans to executive officers and directors aggregated $871,573, loansoriginated aggregated $8,897,300, and loans removed from the executive officerand director listing due to a change in status of the officer or director were$5,000. All loans were made in the ordinary course of business on normal creditterms, including interest rates and collateral, as those prevailing at the timefor comparable transactions with unrelated parties.

 

At December 31, 2003, 2002and 2001, HMN was servicing real estate loans for others with aggregate unpaidprincipal balances of approximately $483,620,394, $337,490,407 and$234,911,618, respectively.

 

26

----

 

HMN originates residential,commercial real estate and other loans primarily in southern Minnesota andIowa. HMN has also purchased loans from a third party broker located in thesoutheastern United States. At December 31, 2003 and 2002, HMN owned single familyand multi-family residential loans located in the following states:

 
|           |   | **2003**        |            | **2002**              |       |
|----------------|--------|-----------------|-----------------|-----------------------|------------|
|           |   | **Amount**      |            | **Percent  of Total** |       | **Amount** |   | **Percent  of Total** |   |
| Alabama        |   | **$**           | **2,084,425**   | ** **            | **0.9**    | **%** | $ | 3,967,366 |   | 1.9 | % |
| Arizona        |   | **1,559,579**   | ** **      | **0.6**               | ** ** | 0 |   | 0.0 |   |
| Colorado       |   | **1,794,321**   | ** **      | **0.7**               | ** ** | 416,455 |   | 0.2 |   |
| Florida        |   | **5,206,942**   | ** **      | **2.2**               | ** ** | 4,277,451 |   | 2.1 |   |
| Georgia        |   | **7,338,911**   | ** **      | **3.0**               | ** ** | 16,004,376 |   | 7.8 |   |
| Illinois       |   | **3,914,175**   | ** **      | **1.6**               | ** ** | 5,753,548 |   | 2.8 |   |
| Iowa           |   | **16,106,426**  | ** **      | **6.6**               | ** ** | 13,819,533 |   | 6.8 |   |
| Massachusetts  |   | **2,647,058**   | ** **      | **1.1**               | ** ** | 2,217,054 |   | 1.1 |   |
| Minnesota      |   | **178,051,169** | ** **      | **73.0**              | ** ** | 135,894,338 |   | 66.4 |   |
| North Carolina |   | **3,243,818**   | ** **      | **1.3**               | ** ** | 6,099,133 |   | 3.0 |   |
| South Carolina |   | **4,335,467**   | ** **      | **1.8**               | ** ** | 4,040,068 |   | 2.0 |   |
| Texas          |   | **5,826,905**   | ** **      | **2.4**               | ** ** | 0 |   | 0.0 |   |
| Wisconsin      |   | **4,977,308**   | ** **      | **2.0**               | ** ** | 3,324,013 |   | 1.6 |   |
| Other states   |   | **6,687,450**   | ** **      | **2.8**               | ** ** | 8,758,330 |   | 4.3 |   |
| Total          |   | **$**           | **243,773,954** | ** **            | **100.0**  | **%** | $ | 204,571,665 |   | 100.0 | % |

 

Amounts under one milliondollars are included in “Other states”.

 

At December 31, 2003 and2002, HMN owned commercial real estate loans located in the following states:

 
|         |   | **2003**        |            | **2002**              |       |
|--------------|--------|-----------------|-----------------|-----------------------|------------|
|         |   | **Amount**      |            | **Percent  of Total** |       | **Amount** |   | **Percent  of Total** |   |
| Alabama      |   | **$**           | **0**           | ** **            | **0.0**    | **%** | $ | 3,216,316 |   | 2.1 | % |
| Arizona      |   | **12,967,520**  | ** **      | **5.7**               | ** ** | 12,099,641 |   | 7.8 |   |
| Colorado     |   | **3,255,512**   | ** **      | **1.4**               | ** ** | 1,719,175 |   | 1.1 |   |
| Connecticut  |   | **2,481,462**   | ** **      | **1.1**               | ** ** | 0 |   | 0.0 |   |
| Iowa         |   | **14,390,247**  | ** **      | **6.4**               | ** ** | 8,237,520 |   | 5.3 |   |
| Minnesota    |   | **168,828,643** | ** **      | **74.5**              | ** ** | 121,301,043 |   | 78.5 |   |
| Missouri     |   | **4,447,653**   | ** **      | **2.0**               | ** ** | 0 |   | 0.0 |   |
| Montana      |   | **2,186,326**   | ** **      | **1.0**               | ** ** | 2,260,264 |   | 1.5 |   |
| Nebraska     |   | **947,905**     | ** **      | **0.4**               | ** ** | 969,127 |   | 0.6 |   |
| Oregon       |   | **0**           | ** **      | **0.0**               | ** ** | 1,204,980 |   | 0.8 |   |
| South Dakota |   | **8,499,929**   | ** **      | **3.8**               | ** ** | 0 |   | 0.0 |   |
| Texas        |   | **3,459,878**   | ** **      | **1.5**               | ** ** | 3,583,300 |   | 2.3 |   |
| Utah         |   | **1,848,385**   | ** **      | **0.8**               | ** ** | 0 |   | 0.0 |   |
| Wisconsin    |   | **3,238,149**   | ** **      | **1.4**               | ** ** | 63,257 |   | 0.0 |   |
| Total        |   | **$**           | **226,551,609** | ** **            | **100.0**  | **%** | $ | 154,654,623 |   | 100.0 | % |
|              |        |                 |                 |                       |            |  |  |  |  |  |  |  |  |

 

**NOTE 5  Allowance forLoan Losses**

 

Theallowance for loan losses is summarized as follows:

 
| Balance, December 31, 2000 |   | $             | 3,143,746     |       |
|----------------------------|--------|---------------|---------------|------------|
| Provision for losses       |   | 1,150,000     |          |
| Charge-offs                |   | (516,337      | )             |
| Recoveries                 |   | 5,703         |          |
| Balance, December 31, 2001 |   | 3,783,112     |          |
| Provision for losses       |   | 2,376,000     |          |
| Charge-offs                |   | (1,369,241    | )             |
| Recoveries                 |   | 34,346        |          |
| Balance, December 31, 2002 |   | 4,824,217     |          |
| Provision for losses       |   | **2,610,000** | ** **    |
| Charge-offs                |   | **(550,580**  | **)**         |
| Recoveries                 |   | **55,965**    | ** **    |
| Balance, December 31, 2003 |   | **$**         | **6,939,602** | ** ** |

 

**NOTE 6  Accrued Interest Receivable**

 

Accrued interest receivableat December 31 is summarized as follows:

 
|                          |   | **2003**      |          | **2002**  |      |
|-------------------------------|--------|---------------|---------------|-----------|-----------|
| Securities available for sale |   | **$**         | **609,913**   |      | 388,705   |   |
| Loans receivable              |   | **2,852,308** |          | 2,661,931 |      |
|                          |   | **$**         | **3,462,221** |      | 3,050,636 |   |

 

**NOTE 7  Investment in Mortgage Servicing Rights**

 

A summary of mortgageservicing activity is as follows:

 
|                           |   | **2003**       |          | **2002**   |      |
|--------------------------------|--------|----------------|---------------|------------|-----------|
| Mortgage servicing rights      |   |           |          |       |      |
| Balance, beginning of year     |   | **$**          | **2,701,031** | ** ** | 1,922,736 |   |
| Originations                   |   | **2,522,231**  | ** **    | 1,956,845  |      |
| Sales                          |   | **0**          | ** **    | (41,532    | )         |
| Amortization                   |   | **(1,775,419** | **)**         | (1,137,018 | )         |
| Balance, end of year           |   | **3,447,843**  | ** **    | 2,701,031  |      |
| Valuation reserve              |   |           | ** **    |       |      |
| Balance, beginning of year     |   | **(10,000**    | **)**         | (19,100    | )         |
| Additions                      |   | **(800,000**   | **)**         | (213,000   | )         |
| Reductions                     |   | **810,000**    | ** **    | 222,100    |      |
| Balance, end of year           |   | **0**          | ** **    | (10,000    | )         |
| Mortgage servicing rights, net |   | **$**          | **3,447,843** | ** ** | 2,691,031 |   |

 

Mortgage servicing costs,which include professional services related to valuing mortgage servicingrights and guarantee fees on securitized mortgage loans, were $216,917 and$29,344, respectively, in 2003 and 2002.

 

All of the loans beingserviced were single family loans serviced for FNMA under the mortgage-backedsecurity program or the individual loan sale program. The following is asummary of the risk characteristics of the loans being serviced at December 31,2003:

 
|                             |   | **Loan  Principal  Balance** |        | **Weighted  Average  Interest  Rate** |   | **Weighted  Average  Remaining  Term** |   | **Number  of  Loans** |   |
|----------------------------------|--------|------------------------------|-------------|---------------------------------------|--------|----------------------------------------|--------|-----------------------|--------|
| Original term 30 year fixed rate |   | $                            | 184,135,459 |                                  | 5.99   | %                                      | 347    |                  | 1,675  |   |
| Original term 15 year fixed rate |   | 245,332,910                  |        | 5.39                                  |   | 168                                    |   | 2,915                 |   |
| Seven year balloon               |   | 121,796                      |        | 5.75                                  |   | 61                                     |   | 1                     |   |
| Adjustable rate                  |   | 9,772,175                    |        | 4.95                                  |   | 344                                    |   | 84                    |   |
|                                  |        |                              |             |                                       |        |                                        |        |                       |        |  |

 

**NOTE 8  Real Estate**

 

A summary of real estate atDecember 31 is as follows:

 
|                                          |   | **2003**   |       | **2002**   |    |
|-----------------------------------------------|--------|------------|------------|------------|---------|
| In-substance foreclosures                     |   | **$**      | **73,271** | ** ** | 127,000 |   |
| Real estate in judgment subject to redemption |   | **0**      | ** ** | 89,691     |    |
| Real estate acquired through foreclosure      |   | **0**      | ** ** | 210,000    |    |
|                                          |   | **73,271** |       | 426,691    |    |
| Allowance for losses                          |   | **0**      | ** ** | 0          |    |
|                                          |   | **$**      | **73,271** |       | 426,691 |   |

 

27

----

 

**NOTE 9  Investment in Limited Partnerships**

 

Investments in limitedpartnerships at December 31 were as follows:

 
| **Primary partnership activity**       |   | **2003**    |        | **2002** |    |
|----------------------------------------|--------|-------------|-------------|----------|---------|
| Mortgage servicing rights              |   | **$**       | **0**       |     | 349,577 |   |
| Common stock of financial institutions |   | **421,671** |        | 289,398  |    |
| Low to moderate income housing         |   | **195,371** |        | 223,691  |    |
|                                   |   | **$**       | **617,042** |     | 862,666 |   |

 

During 2003 HMN’sproportionate loss from the mortgage servicing partnership was $349,577, itsproportionate share of gains from the common stock investments in financialinstitutions was $132,273 and its proportionate loss on low income housing was$26,000.  During 2003 HMN received lowincome housing credits totaling $84,000 which were credited to current incometax benefits.

 

During 2002 HMN’sproportionate loss from the mortgage servicing partnership was $642,364, itsproportionate share of gains from the common stock investments in financialinstitutions was $23,442 and its proportionate loss on low income housing was$40,456.  During 2002 HMN received lowincome housing credits totaling $84,000 which were credited to current incometax benefits.

 

During 2003, the limitedpartnership that invested in mortgage servicing rights was dissolved and HMNrequested the general partner of the limited partnership that invests in thecommon stock of financial institutions to liquidate its investment in thatpartnership effective December 31, 2003.

 

**NOTE 10  Intangible Assets**

 

The gross carrying amount ofintangible assets and the associated accumulated amortization at December 31,2003 and December 31, 2002 are presented in the table below. Amortizationexpense for intangible assets was $1,889,276 and $1,261,196 for the years endedDecember 31, 2003 and December 31, 2002, respectively.

 
|                         |   | **Gross  Carrying  Amount** |          | **Accumulated  Amortization** |           | **Valuation  Adjustment** |       | **Unamortized  Intangible  Assets** |          |
|------------------------------|--------|-----------------------------|---------------|-------------------------------|----------------|---------------------------|------------|-------------------------------------|---------------|
| *December 31, 2003*          |   |                        |          |                          |           |                      |       |                                |          |
| Amortized intangible assets: |   |                        |          |                          |           |                      |       |                                |          |
| Mortgage servicing rights    |   | **$**                       | **4,308,468** | ** **                    | **(860,625**   | **)**                     | **0**      | ** **                          | **3,447,843** | ** ** |
| Core deposit intangible      |   | **1,567,000**               | ** **    | **(1,119,526**                | **)**          | **0**                     | ** ** | **447,474**                         | ** **    |
| Total                        |   | $                           | **5,875,468** | ** **                    | **(1,980,151** | **)**                     | **0**      | ** **                          | **3,895,317** | ** ** |
|                         |   |                        |          |                          |           |                      |       |                                |          |
| *December 31, 2002*          |   |                        |          |                          |           |                      |       |                                |          |
| Amortized intangible assets: |   |                        |          |                          |           |                      |       |                                |          |
| Mortgage servicing rights    |   | $                           | 4,370,652     |                          | (1,669,621     | )                         | (10,000    | )                                   | 2,691,031     |   |
| Core deposit intangible      |   | 1,567,000                   |          | (1,005,669                    | )              | 0                         |       | 561,331                             |          |
| Total                        |   | $                           | 5,937,652     |                          | (2,675,290     | )                         | (10,000    | )                                   | 3,252,362     |   |

 

The following tableindicates the estimated future amortization expense for amortized intangibleassets:

 
|                    |   | **Mortgage  Servicing  Rights** |      | **Core  Deposit  Intangible** |    | **Total** |      |
|-------------------------|--------|---------------------------------|-----------|-------------------------------|---------|-----------|-----------|
| Year ended December 31, |   |                            |      |                          |    |      |      |
| 2004                    |   | $                               | 1,020,432 |                          | 113,857 |      | 1,134,289 |   |
| 2005                    |   | 680,700                         |      | 113,857                       |    | 794,557   |      |
| 2006                    |   | 497,096                         |      | 113,857                       |    | 610,953   |      |
| 2007                    |   | 361,742                         |      | 105,903                       |    | 467,645   |      |
| 2008                    |   | 243,444                         |      | 0                             |    | 243,444   |      |
|                         |        |                                 |           |                               |         |           |           |  |

 

Projections of amortizationare based on existing asset balances and the existing interest rate environmentas of December 31, 2003. HMN’s actual experiences may be significantlydifferent depending upon changes in mortgage interest rates and other marketconditions.

 

28

----

 

**NOTE 11  “Adjusted” Earnings SFAS No. 142Transitional Disclosure**

 

Effective January 1, 2002,the amortization of goodwill was discontinued. The table below reconcilesreported earnings for 2003, 2002 and 2001 to “adjusted” earnings, whichexcludes goodwill amortization.

 
|                              |   | **Year**                     |           | **Year**                     |      | **Year ended  December 31, 2001** |      |
|-----------------------------------|--------|------------------------------|----------------|------------------------------|-----------|-----------------------------------|-----------|
|                              |   | **Ended  December 31, 2003** |           | **Ended  December 31, 2002** |      | **Reported  Earnings**            |      | **Goodwill  Amortization** |   | **Adjusted  Earnings** |   |
|                              |   |                         | ** **     |                         |      |                              |      |   |   |   |   |
| Income before income tax expense  |   | **$**                        | **12,640,033** | ** **                   | 7,222,582 |                              | 7,708,742 |   | 180,036 |   | 7,888,778 |   |
| Income tax expense                |   | **4,037,800**                | ** **     | 2,099,200                    |      | 2,634,385                         |      | 0 |   | 2,634,385 |   |
| Income before minority interest   |   | **8,602,233**                | ** **     | 5,123,382                    |      | 5,074,357                         |      | 180,036 |   | 5,254,393 |   |
| Minority interest                 |   | **(3,014**                   | **)**          | (142,274                     | )         | (383,259                          | )         | 0 |   | (383,259 | ) |
| Net income                        |   | **$**                        | **8,605,247**  | ** **                   | 5,265,656 |                              | 5,457,616 |   | 180,036 |   | 5,637,652 |   |
| Earnings per common share         |   | **$**                        | **2.26**       | ** **                   | 1.40      |                              | 1.45      |   | 0.05 |   | 1.50 |   |
| Diluted earnings per common share |   | **$**                        | **2.16**       | ** **                   | 1.32      |                              | 1.37      |   | 0.05 |   | 1.42 |   |

 

**NOTE 12  Premises and Equipment**

 

A summary of premises andequipment at December 31 is as follows:

 
|                              |   | **2003**       |           | **2002**   |       |
|-----------------------------------|--------|----------------|----------------|------------|------------|
| Land                              |   | **$**          | **1,338,943**  | ** ** | 1,399,741  |   |
| Office buildings and improvements |   | **9,376,782**  | ** **     | 9,712,405  |       |
| Furniture and equipment           |   | **9,875,743**  | ** **     | 9,325,853  |       |
|                              |   | **20,591,468** |           | 20,437,999 |       |
| Less accumulated depreciation     |   | **8,481,317**  | ** **     | 7,562,183  |       |
|                              |   | **$**          | **12,110,151** |       | 12,875,816 |   |

 

**NOTE 13  Deposits**

 

Deposits and their weightedaverage interest rates at December 31 are summarized as follows:

 
|                  |   | **2003**                   |       | **2002**        |            |
|-----------------------|--------|----------------------------|------------|-----------------|-----------------|
|                  |   | **Weighted  average rate** |       | **Amount**      |            | **Percent of  total** |   | **Weighted  average rate** |   | **Amount** |   | **Percent of  total** |   |
| Noninterest checking  |   | **0.00**                   | **%**      | **$**           | **37,629,054**  | ** ** | **6.8** | **%** | 0.00 | % | $ | 28,173,034 |   | 6.5 | % |
| NOW accounts          |   | **0.39**                   | ** ** | **61,270,853**  | ** **      | **11.1** | ** ** | 0.30 |   | 43,508,898 |   | 10.1 |   |
| Savings accounts      |   | **0.20**                   | ** ** | **35,882,917**  | ** **      | **6.5** | ** ** | 0.35 |   | 41,032,871 |   | 9.5 |   |
| Money market accounts |   | **1.23**                   | ** ** | **91,314,858**  | ** **      | **16.6** | ** ** | 1.16 |   | 49,510,654 |   | 11.4 |   |
|                  |   |                       |       | **226,097,682** |            | **41.0** | ** ** |   | ** ** | 162,225,457 |   | 37.5 |   |
| Certificates:         |   |                       | ** ** |            | ** **      |   | ** ** |   |   |   |   |   |   |
| 1-1.99%               |   |                       | ** ** | **57,153,099**  | ** **      | **10.4** | ** ** |   |   | 23,002,684 |   | 5.3 |   |
| 2-2.99%               |   |                       | ** ** | **103,449,915** | ** **      | **18.8** | ** ** |   |   | 72,161,515 |   | 16.7 |   |
| 3-3.99%               |   |                       | ** ** | **71,691,188**  | ** **      | **13.0** | ** ** |   |   | 75,444,893 |   | 17.4 |   |
| 4-4.99%               |   |                       | ** ** | **76,315,958**  | ** **      | **13.8** | ** ** |   |   | 74,817,691 |   | 17.3 |   |
| 5-5.99%               |   |                       | ** ** | **16,621,295**  | ** **      | **3.0** | ** ** |   |   | 23,719,214 |   | 5.5 |   |
| 6-6.99%               |   |                       | ** ** | **246,042**     | ** **      | **0.0** | ** ** |   |   | 1,468,058 |   | 0.3 |   |
| 7-7.99%               |   |                       | ** ** | **112,816**     | ** **      | **0.0** | ** ** |   |   | 111,950 |   | 0.0 |   |
| Total certificates    |   | **3.11**                   | ** ** | **325,590,313** | ** **      | **59.0** | ** ** | 3.42 |   | 270,726,005 |   | 62.5 |   |
| Total deposits        |   | **2.09**                   | ** ** | **$**           | **551,687,995** | ** ** | **100.0** | **%** | 2.34 |   | $ | 432,951,462 |   | 100.0 | % |

 

At December 31, 2003 and2002 HMN had $117,733,801 and $61,353,755, respectively, of deposit accountswith balances at $100,000 or more. At December 31, 2003 and 2002, HMN had $66,003,390 and $11,203,358 of certificateaccounts, respectively, that were acquired through a broker.

 

29

----

 

Certificates had thefollowing maturities at December 31:

 
|                            |   | **2003**                   |        | **2002**                    |       |
|---------------------------------|--------|----------------------------|-------------|-----------------------------|------------|
| **Remaining  term to maturity** |   | **Amount  (in thousands)** |        | **Weighted  average  rate** |       | **Amount  (in thousands)** |   | **Weighted  average  rate** |   |
| 1-6 months                      |   | **$**                      | **97,354**  | ** **                  | **2.81**   | **%** | $ | 87,070 |   | 2.70 | % |
| 7-12 months                     |   | **69,890**                 | ** **  | **2.73**                    | ** ** | 27,310 |   | 2.92 |   |
| 13-36 months                    |   | **112,265**                | ** **  | **3.19**                    | ** ** | 136,382 |   | 3.88 |   |
| Over 36 months                  |   | **46,081**                 | ** **  | **3.61**                    | ** ** | 19,964 |   | 4.10 |   |
|                            |   | **$**                      | **325,590** |                        | **3.03**   | ** ** | $ | 270,726 |   | 3.42 |   |

 

At December 31, 2003mortgage loans and mortgage-backed and related securities with an amortizedcost of approximately $56,976,000 were pledged as collateral for certaindeposits and $650,000 of letters of credit from the Federal Home Loan Bank(FHLB) were pledged as additional collateral on Bank deposits.

 

Interest expense on depositsis summarized as follows for the years ended December 31:

 
|             |   | **2003**      |           | **2002**   |       | **2001**   |       |
|------------------|--------|---------------|----------------|------------|------------|------------|------------|
| NOW              |   | **$**         | **211,736**    | ** ** | 181,073    |       | 315,149    |   |
| Savings Accounts |   | **90,421**    | ** **     | 241,397    |       | 454,628    |       |
| Money Market     |   | **437,645**   | ** **     | 589,406    |       | 897,875    |       |
| Certificates     |   | **9,534,386** | ** **     | 9,937,926  |       | 16,910,696 |       |
|             |   | **$**         | **10,274,188** |       | 10,949,802 |       | 18,578,348 |   |

 

**NOTE 14  Federal Home Loan Bank Advances**

 

Fixed and variable rateFederal Home Loan Bank advances consisted of the following at December 31, 2003and 2002:

 
|                  |   | **2003**        |            | **2002**   |       |
|-----------------------|--------|-----------------|-----------------|------------|------------|
| **Year of  Maturity** |   | **Amount**      |            | **Rate**   |       | **Amount** |   | **Rate** |   |
| 2003                  |   |            |            |       |       | $ | 64,400,000 |   | 3.20 | % |
| 2004                  |   | **$**           | **33,000,000**  | ** ** | **5.01**   | **%** | 33,000,000 |   | 5.01 |   |
| 2005                  |   | **10,000,000**  | ** **      | **2.69**   | ** ** | 10,000,000 |   | 2.69 |   |
| 2007                  |   | **40,000,000**  | ** **      | **2.91**   | ** ** | 0 |   | 0.00 |   |
| 2008                  |   | **20,000,000**  | ** **      | **3.83**   | ** ** | 90,000,000 |   | 5.40 |   |
| 2010                  |   | **10,000,000**  | ** **      | **6.48**   | ** ** | 10,000,000 |   | 6.48 |   |
| 2011                  |   | **10,900,000**  | ** **      | **4.81**   | ** ** | 10,900,000 |   | 4.81 |   |
| 2013                  |   | **80,000,000**  | ** **      | **4.75**   | ** ** | 0 |   | 0.00 |   |
|                  |   | **203,900,000** |            | **4.33**   | ** ** | 218,300,000 |   | 4.59 |   |
| Lines of Credit       |   | **0**           | ** **      | **0.00**   | ** ** | 0 |   | 0.00 |   |
|                  |   | **$**           | **203,900,000** |       | 4.33       | ** ** | $ | 218,300,000 |   | 4.59 |   |

 

Many of the advances listedabove have call provisions which allow the FHLB to request that the advance bepaid back or refinanced at the rates then being offered by the FHLB.As of December 31, 2003, HMN had advances from the FHLB with the following callfeatures:

 
| **Year of  Maturity** |   | **Callable  Quarterly  in Year 2004** |        | **Callable  Quarterly  in Year 2005** |       |
|-----------------------|--------|---------------------------------------|-------------|---------------------------------------|------------|
| 2004                  |   | $                                     | 15,000,000  |                                  | 0          |   |
| 2008                  |   | 10,000,000                            |        | 0                                     |       |
| 2010                  |   | 0                                     |        | 10,000,000                            |       |
| 2011                  |   | 10,900,000                            |        | 0                                     |       |
| 2013                  |   | 80,000,000                            |        | 0                                     |       |
|                  |   | $                                     | 115,900,000 |                                  | 10,000,000 |   |

 

At December 31, 2003 theadvances from the FHLB were collateralized by the Bank’s FHLB stock andmortgage loans with unamortized principal balances of $313.4 million. The Bankhas the ability to draw additional borrowings of $9.7 million based upon the mortgage loans that are currently pledged subject to a requirement to purchaseFHLB stock.

 

**NOTE 15  Other Borrowed Money**

 

HMN had a $2,500,000revolving line of credit established with a bank that was not drawn at December31, 2002. The line of credit expired on November 15, 2003 and was renewed inthe first quarter of 2004.

 

30

----

 

**NOTE 16  Income Taxes**

 

Income tax expense (benefit)for the years ended December 31 is as follows:

 
|           |   | **2003**      |          | **2002**   |      | **2001**  |      |
|----------------|--------|---------------|---------------|------------|-----------|-----------|-----------|
| Current:       |   |          |          |       |      |      |      |
| Federal        |   | **$**         | **4,080,500** | ** ** | 2,223,300 |      | 2,773,200 |   |
| State          |   | **498,200**   | ** **    | 34,600     |      | 682,785   |      |
| Total current  |   | **4,578,700** | ** **    | 2,257,900  |      | 3,455,985 |      |
| Deferred:      |   |          | ** **    |       |      |      |      |
| Federal        |   | **(506,200**  | **)**         | 1,400      |      | (638,000  | )         |
| State          |   | **(34,700**   | **)**         | (160,100   | )         | (183,600  | )         |
| Total deferred |   | **(540,900**  | **)**         | (158,700   | )         | (821,600  | )         |
|           |   | **$**         | **4,037,800** |       | 2,099,200 |      | 2,634,385 |   |

 

The reasons for the difference between “expected” income tax expense utilizing thefederal corporate tax rate of 34% and the actual income tax expense are asfollows:

 
|                                                                 |   | **2003**     |          | **2002**   |      | **2001** |      |
|----------------------------------------------------------------------|--------|--------------|---------------|------------|-----------|----------|-----------|
| Federal expected income tax expense                                  |   | **$**        | **4,297,600** | ** ** | 2,455,700 |     | 2,621,000 |   |
| Items affecting federal income tax:                                  |   |         | ** **    |       |      |     |      |
| Dividend received deduction                                          |   | **(26,100**  | **)**         | (145,200   | )         | (108,200 | )         |
| Non deductible portion of minority interest loss                     |   | **0**        | ** **    | 72,800     |      | 130,300  |      |
| State income taxes, net of federal income tax benefit                |   | **249,700**  | ** **    | 21,700     |      | 329,500  |      |
| Reduction of tax rate due to employee stock ownership plan dividends |   | **(160,500** | **)**         | (149,100   | )         | (313,000 | )         |
| Low income housing credits                                           |   | **(84,000**  | **)**         | (84,000    | )         | (84,000  | )         |
| Tax exempt interest                                                  |   | **(284,600** | **)**         | (107,000   | )         | (24,200  | )         |
| Other, net                                                           |   | **45,700**   | ** **    | 34,300     |      | 82,985   |      |
|                                                                 |   | **$**        | **4,037,800** |       | 2,099,200 |     | 2,634,385 |   |

 

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

 
|                                                                                  |   | **2003**      |          | **2002**   |       |
|---------------------------------------------------------------------------------------|--------|---------------|---------------|------------|------------|
| Deferred tax assets:                                                                  |   |          | ** **    |       |       |
| Allowances for loan and real estate losses                                            |   | **$**         | **2,453,000** | ** ** | 1,705,300  |   |
| Investment in limited partnership                                                     |   | **0**         | ** **    | 164,500    |       |
| Discounts on assets and liabilities acquired from Marshalltown  Financial Corporation |   | **400**       | ** **    | 900        |       |
| Deferred compensation and pension costs                                               |   | **181,500**   | ** **    | 176,100    |       |
| Impairment losses on securities available for sale                                    |   | **0**         | ** **    | 157,900    |       |
| Net unrealized loss on market value adjustments to securities  available for sale     |   | **27,800**    | ** **    | 0          |       |
| Mark to market on forward sales commitments                                           |   | **0**         | ** **    | 85,500     |       |
| Total gross deferred tax assets                                                       |   | **2,662,700** | ** **    | 2,290,200  |       |
| Valuation allowance                                                                   |   | **0**         | ** **    | 0          |       |
| Net deferred tax assets                                                               |   | **2,662,700** | ** **    | 2,290,200  |       |
| Deferred tax liabilities:                                                             |   |          | ** **    |       |       |
| Tax bad debt reserve over base year                                                   |   | **0**         | ** **    | 213,500    |       |
| Premium on assets acquired from Marshalltown Financial Corporation                    |   | **158,100**   | ** **    | 199,200    |       |
| Net unrealized gain on market value adjustments to securities  available for sale     |   | **0**         | ** **    | 861,600    |       |
| FHLB stock                                                                            |   | **0**         | ** **    | 285,000    |       |
| Deferred loan fees and costs                                                          |   | **458,600**   | ** **    | 400,500    |       |
| Premises and equipment basis difference                                               |   | **852,800**   | ** **    | 809,800    |       |
| Originated mortgage servicing rights                                                  |   | **1,218,700** | ** **    | 954,700    |       |
| Other                                                                                 |   | **800**       | ** **    | 22,500     |       |
| Total gross deferred tax liabilities                                                  |   | **2,689,000** | ** **    | 3,746,800  |       |
| Net deferred tax liabilities                                                          |   | **$**         | **(26,300**   | **)**      | (1,456,600 | ) |

 

Retained earnings atDecember 31, 2003 included approximately $8,800,000 for which no provision forincome taxes was made. This amount represents allocations of income to bad debtdeductions for tax purposes. Reduction of amounts so allocated for purposesother than absorbing losses will create income for tax purposes, which will besubject to the then-current corporate income tax rate. The Company has, in itsjudgment, made reasonable assumptions relating to the realization of deferredtax assets. Based upon these assumptions, the Company has determined that novaluation allowance is required with respect to the deferred tax assets.

 

31

----

 

**NOTE 17  Employee Benefits**

 

Prior to 2002, all eligible full-time employees of the Bank wereincluded in a noncontributory retirement plan sponsored by the FinancialInstitutions Retirement Fund (FIRF). Effective September 1, 2002 the Bank frozethe accrual of benefits for existing participants and no new enrollments arepermitted into the plan. The actuarial present value of accumulated planbenefits and net assets available for benefits relating to the Bank’s employeesis not available at December 31, 2003 because such information is notaccumulated for each participating institution. As of June 30, 2003, the FIRFvaluation report reflected that the Bank was obligated to make a contributionfor the plan year ending June 30, 2003 totaling $36,014. The contribution was$20,575 in 2002 and no contribution was required in 2001 because the retirementplan benefits had been reduced and the plan was fully funded.

 

HMN 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 attained18 years of age are eligible to participate in the Plan. Participants arepermitted to make contributions to the 401(k) Plan equal to the lesser of 50%of the participant’s annual salary or the maximum allowed by law, which was$12,000 for 2003. HMN matches 25% of each participant’s contributions up to amaximum of 8% of the participant’s annual salary. Employee contributions above8% are not matched by HMN. Participant contributions and earnings are fully andimmediately vested. HMN’s contributions made prior to January 1, 2002 arevested on a five year cliff basis and contributions made after December 31,2001 are vested on a three year cliff basis. HMN’s matching contributions tothe 401(k) plan are expensed when made and they totaled  $113,843, $76,005 and $71,200 in 2003, 2002and 2001, respectively.

 

HMN adopted an EmployeeStock Ownership Plan (the ESOP) which met the requirements of Section(e)(7) ofthe Internal Revenue Code and Section 407(d)(6) of the Employee RetirementIncome Security Act of 1974, as amended (ERISA) and, as such the ESOP wasempowered to borrow in order to finance purchases of the common stock of HMN.The ESOP borrowed $6,085,770 from HMN to purchase 912,866 shares of commonstock in the initial public offering of HMN. As a result of a merger withMarshalltown Financial Corporation (MFC), the ESOP borrowed $1,476,000 topurchase 76,933 shares of HMN common stock to provide the employees from MFCwith an ESOP benefit. The ESOP debt requires quarterly payments of principalplus interest at 7.52%. HMN has committed to make quarterly contributions tothe ESOP necessary to repay the loan including interest. HMN contributed$525,224 for each of the years 2003, 2002 and 2001.

 

As the debt is repaid, ESOPshares that were pledged as collateral for the debt are committed to bereleased from collateral and allocated to active employees basedon the proportion of debt service paid in the year. HMN accounts for its ESOPin accordance with Statement of Position 93-6, *Employers’Accounting for Employee Stock Ownership Plans.*Accordingly, theshares pledged as collateral are reported as unearned ESOP shares instockholders’ equity. As shares are determined to be ratably released fromcollateral, HMN reports compensation expense equal to the current market priceof the shares, and the shares become outstanding for earnings per sharecomputations. ESOP compensation benefit expense was $472,108, $418,700 and$365,921 respectively, for 2003, 2002 and 2001.

 

All employees of the Bank are eligible to participate in the ESOP after they attainage 21 and complete one year of service during which they worked at least 1,000hours. A summary of the ESOP share allocation is as follows for the yearsended:

 
|                                                   |   | **2003**    |           | **2002**   |       | **2001** |      |
|--------------------------------------------------------|--------|-------------|----------------|------------|------------|----------|-----------|
| Shares allocated to participants beginning of the year |   | **$**       | **245,031**    |       | 233,697    |     | 246,710   |   |
| Shares allocated to participants                       |   | **24,317**  | ** **     | 24,317     |       | 24,317   |      |
| Shares purchased with dividends from allocated shares  |   | **10,638**  | ** **     | 8,485      |       | 7,884    |      |
| Shares distributed to participants                     |   | **(4,398**  | **)**          | (21,468    | )          | (45,214  | )         |
| Shares allocated to participants end of year           |   | **275,588** | ** **     | 245,031    |       | 233,697  |      |
|                                                   |   |        |           |       |       |     |      |
| Unreleased shares beginning of the year                |   | **620,430** | ** **     | 644,747    |       | 669,064  |      |
| Shares released during year                            |   | **(24,317** | **)**          | (24,317    | )          | (24,317  | )         |
| Unreleased shares end of year                          |   | **596,113** | ** **     | 620,430    |       | 644,747  |      |
| Total ESOP shares end of year                          |   | **$**       | **871,701**    |       | 865,461    |     | 878,444   |   |
| Fair value of unreleased shares at December 31         |   | **$**       | **14,479,585** | ** ** | 10,435,633 |     | 9,987,131 |   |

 

In June of 1995, HMN as partof a Recognition and Retention Plan (RRP) awarded 126,729 shares of restrictedcommon stock to its officers and directors. The shares vested over a five yearperiod and were issued from treasury stock. In April 1997, 3,000 shares of restrictedcommon stock were awarded to a director. Those shares vested over a five yearperiod beginning in 1998. Compensation and benefit expense related to therestricted stock was $0, $7,350 and $2,450, respectively for 2003, 2002 and2001.

 

In June 1995, HMN adoptedthe 1995 Stock Option and Incentive Plan (the SOP). During 1995, optionsexercisable for 821,569 shares of HMN common stock were granted to certainofficers and directors at an exercise price of $9.211 per share. In December1996, options exercisable for 1,500 shares of common stock were granted tocertain officers at an exercise price of $12.089. In April 1997, options for18,000 shares of common stock were granted to a director at an exercise priceof $13.007. In April 1999, options for 80,000 shares of common stock weregranted to an officer and directors at an exercise price of $11.50. In April2000, options for 30,000 shares were granted to directors at an exercise priceof $11.25. In April of 2002, options for 15,000 shares were granted to adirector at an exercise price of $16.25. All options issued under this planvest over a five year period and expire 10 years from the grant date.

 

In March 2001, HMN adoptedthe HMN Financial, Inc. 2001 Omnibus Stock Plan (2001 Plan). The purpose of the2001 Plan was to promote the interests of HMN and its stockholders by providingkey personnel with an opportunity to acquire a proprietary interest in HMN andreward them for achieving a high level of corporate performance and therebydevelop a stronger incentive to put forth maximum effort for the success andgrowth of HMN. The total number of shares of HMN common stock available fordistribution under the 2001 Plan in either restricted stock or stock optionswas

 

32

----

 

400,000 subject to adjustment for future stock splits, stock dividendsand similar changes to the capitalization of HMN. In April 2002, HMN awarded212,410 options at $16.13 per share which vest starting in April of 2008through 2012.

 

The fair value of the options granted under the SOP were $1.85, $2.59,$4.11, $6.08, $5.55 and $4.49 for 2002, 2000, 1999, 1998, 1997, and 1995,respectively, and $1.43 for 2002 under the 2001 Plan. A summary of stock optionactivities under both plans are detailed as follows:

 
|                                   |   | **Options  available for  grant** |   | **Options  outstanding** |   | **Weighted  average  exercise price** |   |
|----------------------------------------|--------|-----------------------------------|--------|--------------------------|--------|---------------------------------------|--------|
| *1995 Stock Option and Incentive Plan* |   |                              |   |                     |   |                                  |   |
| December 31, 1998                      |   | 111,799                           |   | 727,246                  |   | $                                     | 9.308  |   |
| Exercised                              |   |                              |   | (49,516                  | )      | 9.211                                 |   |
| Forfeited                              |   | 6,848                             |   | (6,848                   | )      | 9.211                                 |   |
| Granted April 27, 1999                 |   | (80,000                           | )      | 80,000                   |   | 11.500                                |   |
| December 31, 1999                      |   | 38,647                            |   | 750,882                  |   | 9.549                                 |   |
| Exercised                              |   |                              |   | (91,742                  | )      | 9.211                                 |   |
| Forfeited                              |   | 750                               |   | (750                     | )      | 12.089                                |   |
| Granted May 23, 2000                   |   | (30,000                           | )      | 30,000                   |   | 11.250                                |   |
| December 31, 2000                      |   | 9,397                             |   | 688,390                  |   | 9.665                                 |   |
| Exercised                              |   |                              |   | (171,271                 | )      | 9.211                                 |   |
| Forfeited                              |   | 15,000                            |   | (15,000                  | )      | 11.500                                |   |
| December 31, 2001                      |   | 24,397                            |   | 502,119                  |   | 9.765                                 |   |
| Exercised                              |   |                              |   | (109,871                 | )      | 9.211                                 |   |
| Granted April 23, 2002                 |   | (15,000                           | )      | 15,000                   |   | 16.250                                |   |
| December 31, 2002                      |   | 9,397                             |   | 407,248                  |   | 10.154                                |   |
| Exercised                              |   |                              |   | (228,493                 | )      | 9.211                                 |   |
| December 31, 2003                      |   | 9,397                             |   | 178,755                  |   | 11.358                                |   |
|                                   |   |                              |   |                     |   |                                  |   |
| *2001 Omnibus Stock Plan*              |   |                              |   |                     |   |                                  |   |
| December 31, 2001                      |   | 400,000                           |   |                     |   |                                  |   |
| Granted April 16, 2002                 |   | (212,410                          | )      | 212,410                  |   | 16.130                                |   |
| December 31, 2002                      |   | 187,590                           |   | 212,410                  |   | 16.130                                |   |
| Forfeited                              |   | 16,447                            |   | (16,447                  | )      | 16.130                                |   |
| December 31, 2003                      |   | 204,037                           |   | 195,963                  |   | 16.130                                |   |
| Total both plans                       |   | 213,434                           |   | 374,718                  |   | 13.854                                |   |
|                                        |        |                                   |        |                          |        |                                       |        |  |

 

The following tablesummarizes information about stock options outstanding at December 31, 2003:

 
| **Options  Outstanding** |   | **Options  Exercisable** |   |
|--------------------------|--------|--------------------------|--------|
| **Exercise  price**      |   | **Number  outstanding**  |   | **Weighted  average  remaining contractual  life in years** |   | **Number** |   | **Price** |   |
| $                        | 9.211  |                     | 50,755 |   | 1.4 |   | 50,755 |   | $ | 9.211 |   |
| 13.007                   |   | 18,000                   |   | 3.3 |   | 18,000 |   | 13.007 |   |
| 11.500                   |   | 65,000                   |   | 5.3 |   | 52,000 |   | 11.500 |   |
| 11.250                   |   | 30,000                   |   | 6.4 |   | 18,000 |   | 11.250 |   |
| 16.250                   |   | 15,000                   |   | 8.4 |   | 3,000 |   | 16.250 |   |
| 16.130                   |   | 195,963                  |   | 8.3 |   | 0 |   | 16.130 |   |
|                     |   | 374,718                  |   |   |   | 141,755 |   |   |   |
|                          |        |                          |        |  |  |  |  |  |  |  |  |

 

HMN uses the intrinsic value method as described in APB Opinion No. 25 and relatedinterpretations to account for its stock incentive plans. Accordingly, nocompensation cost has been recognized for the option plans. Proceeds from stockoptions exercised are credited to common stock and additional paid-in capital.There are no charges or credits to expense with respect to the granting orexercise of options since the options were issued at fair value on therespective grant dates. Had compensation cost for HMN’s stock-based plan beendetermined in accordance with the fair value method recommended by SFAS No.123, HMN’s net income and earnings per share would have been adjusted to thepro forma amounts indicated below:

 
|                                                                                                                                                    |   | **2003** |          | **2002** |      | **2001** |      |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------------|----------|-----------|----------|-----------|
| Net income:                                                                                                                                             |   |     |          |     |      |     |      |
| As reported                                                                                                                                             |   | **$**    | **8,605,247** |     | 5,265,656 |     | 5,457,616 |   |
| Deduct: total stock-based employee compensation expense (benefit)  determined under fair value based method for all awards, net of related tax  effects |   | 44,935   |          | 42,960   |      | (6,805   | )         |
| Pro forma                                                                                                                                               |   | **$**    | **8,560,312** |     | 5,222,696 |     | 5,464,421 |   |
| Earnings per common share:                                                                                                                              |   |     |          |     |      |     |      |
| As reported:                                                                                                                                            |   |     |          |     |      |     |      |
| Basic                                                                                                                                                   |   | **$**    | **2.26**      |     | 1.40      |     | 1.45      |   |
| Diluted                                                                                                                                                 |   | **2.16** |          | 1.32     |      | 1.37     |      |
| Pro forma:                                                                                                                                              |   |     |          |     |      |     |      |
| Basic                                                                                                                                                   |   | **2.25** |          | 1.39     |      | 1.45     |      |
| Diluted                                                                                                                                                 |   | **2.15** |          | 1.31     |      | 1.37     |      |

 

The preceding disclosed proforma effects of applying SFAS No. 123 to compensation costs may not berepresentative of the effects on reported pro forma net income for futureyears.

 

The fair value for eachoption grant is estimated on the date of the grant using the Option DesignerModel. The model incorporated the following assumptions for each year of grant:

 
|                    |   | **2002** |   | **2000** |   | **1999** |   | **1998**  |   | **1997**  |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|-----------|--------|-----------|--------|
| Risk-free interest rate |   | 5.20     | %      | 6.49     | %      | 5.59     | %      | 6.80      | %      | 6.21      | %      |
| Expected life           |   | 9  years |   | 9  years |   | 9  years |   | 10  years |   | 10  years |   |
| Expected volatility     |   | 13.00    | %      | 15.60    | %      | 30.00    | %      | 18.00     | %      | 18.00     | %      |
| Expected dividends      |   | 4.5      | %      | 3.0      | %      | 2.1      | %      | None      |   | None      |   |

 

33

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**NOTE 18  Earnings per Share**

 

The following tablereconciles the weighted average shares outstanding and the income available tocommon shareholders used for basic and diluted EPS:

 
|                                                                                                      |   | **Year Ended  December 31,** |          |
|-----------------------------------------------------------------------------------------------------------|--------|------------------------------|---------------|
|                                                                                                      |   | **2003**                     |          | **2002** |   | **2001** |   |
| Weighted average number of common shares outstanding used in basic  earnings per common share calculation |   | **3,812,213**                |          | 3,767,216 |   | 3,761,115 |   |
| Net dilutive effect of:                                                                                   |   |                         |          |   |   |   |   |
| Options                                                                                                   |   | **169,171**                  |          | 217,576 |   | 212,854 |   |
| Restricted stock awards                                                                                   |   | **0**                        |          | 36 |   | 509 |   |
| Weighted average number of shares outstanding adjusted for effect of  dilutive securities                 |   | **3,981,384**                |          | 3,984,828 |   | 3,974,478 |   |
| Income available to common shareholders                                                                   |   | **$**                        | **8,605,247** |   | 5,265,656 |   | 5,457,616 |   |
| Basic earnings per common share                                                                           |   | **$**                        | **2.26**      |   | 1.40 |   | 1.45 |   |
| Diluted earnings per common share                                                                         |   | **$**                        | **2.16**      |   | 1.32 |   | 1.37 |   |

 

**NOTE 19  Stockholders’ Equity**

 

HMN repurchased 86,600 sharesof its common stock in the open market during 2003, 92,300 shares during 2002and 105,200 shares during 2001 for $1,384,560, $1,496,111 and $1,584,152,respectively. The shares were placed in treasury stock.

 

HMN declared and paiddividends as follows:

 
| **Record date**   |   | **Payable  date**  |   | **Dividend  per share** |   | **Dividend  Payout Ratio** |   |
|-------------------|--------|--------------------|--------|-------------------------|--------|----------------------------|--------|
| February 22, 2001 |   | March 8, 2001      |   | $                       | 0.12   |                       | 29.27  | % |
| May 24, 2001      |   | June 11, 2001      |   | $                       | 0.12   |                       | 30.00  | % |
| August 28, 2001   |   | September 11, 2001 |   | $                       | 0.14   |                       | 43.75  | % |
| November 23, 2001 |   | December 12, 2001  |   | $                       | 0.14   |                       | 28.00  | % |
| February 21, 2002 |   | March 7, 2002      |   | $                       | 0.14   |                       | 100.00 | % |
| May 23, 2002      |   | June 10, 2002      |   | $                       | 0.18   |                       | 36.00  | % |
| August 27, 2002   |   | September 10, 2002 |   | $                       | 0.18   |                       | 56.25  | % |
| November 22, 2002 |   | December 11, 2002  |   | $                       | 0.18   |                       | 81.82  | % |
| February 21, 2003 |   | March 7, 2003      |   | $                       | 0.18   |                       | 64.29  | % |
| May 22, 2003      |   | June 9, 2003       |   | $                       | 0.18   |                       | 50.00  | % |
| August 28, 2003   |   | September 11, 2003 |   | $                       | 0.20   |                       | 38.46  | % |
| November 28, 2003 |   | December 17, 2003  |   | $                       | 0.20   |                       | 26.32  | % |

 

On January 28, 2004 HMNdeclared a cash dividend of $0.20 per share payable on March 8, 2004, tostockholders of record on February 20, 2004. The annualized dividend payoutratios for 2003, 2002 and 2001 were 39.58%, 57.63% and 31.90%, respectively.

 

HMN’s certificate ofincorporation authorizes the issuance of up to 500,000 shares of preferredstock, but to date no shares have been issued.

 

In order to grant a priorityto eligible accountholders in the event of future liquidation, the Bank, at thetime of conversion established a liquidation account equal to its regulatorycapital as of September 30, 1993. In the event of future liquidation of theBank, an eligible accountholder who continues to maintain their deposit accountshall be entitled to receive a distribution from the liquidation account. Thetotal amount of the liquidation account will be decreased as the balance ofeligible accountholders are reduced subsequent to the conversion, based on anannual determination of such balance.

 

The Bank may not declare orpay a cash dividend to HMN without filing a capital distribution applicationwith the OTS if the total amount of the dividends for the year exceeds theBank’s net income for the year plus the Bank’s retained net income for thepreceding two years. Additional limitations on dividends declared or paid on,or repurchases of, the Bank’s capital stock are tied to the Bank’s level ofcompliance with its regulatory capital requirements.

 

**NOTE 20  Federal Home Loan Bank Investment andRegulatory Capital Requirements**

 

The Bank, as a member of theFederal Home Loan Bank System, is required to hold a specified number of sharesof capital stock, which is carried at cost, in the Federal Home Loan Bank ofDes Moines. The Bank has met the requirements as of December 31, 2003.

 

The Bank is subject tovarious regulatory capital requirements administered by the federal banking agencies.Failure to meet minimum capital requirements can initiate certain mandatory andpossibly additional discretionary actions by regulators that, if undertaken,could have a direct material effect on HMN’s financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Bank must meet specific capital guidelines that involvequantitative measures of the Bank’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.The Bank’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.

 

Quantitative measuresestablished by regulations to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios (set forth in the following table) of TierI or Core capital, and Risk-based capital (as defined in the regulations) tototal assets (as defined). Management believes, as of December 31, 2003, that theBank meets all capital adequacy requirements to which it is subject.

 

Management believes thatbased upon the Bank’s capital calculations at December 31, 2003 and otherconditions consistent with the Prompt Corrective Actions Provisions of the OTSregulations, the Bank would be categorized as well capitalized.

 

34

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At December 31, 2003 theBank’s capital amounts and ratios are also presented for actual capital,required capital, and excess capital, including amounts and ratios in order toqualify as being well capitalized under the Prompt Corrective Actionsregulations:

 
|                                       |   | **Actual** |   | **Required  to  be Adequately  Capitalized** |   | **Excess  Capital** |   | **To Be Well  Capitalized  Under Prompt  Corrective Actions  Provisions** |   |
|--------------------------------------------|--------|------------|--------|----------------------------------------------|--------|---------------------|--------|---------------------------------------------------------------------------|--------|
| **(in thousands)**                         |   | **Amount** |   | **Percent of  Assets (1)**                   |   | **Amount**          |   | **Percent of  Assets (1)**                                                |   | **Amount** |   | **Percent of  Assets (1)** |   | **Amount** |   | **Percent of  Assets (1)** |   |
| Bank stockholder’s equity             |   | $          | 73,279 |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |   |
| Less:                                      |   |       |   |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |
| Goodwill and other intangibles             |   | 4,249      |   |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |
| Tier I or core capital                     |   | 69,030     |   |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |
| Tier I capital to adjusted total assets    |   |       |   | 8.03                                         | %      | $                   | 34,366 |                                                                      | 4.00   | % | $ | 34,664 |   | 4.03 | % | $ | 42,957 |   | 5.00 | % |
| Tier I capital to risk-weighted assets     |   |       |   | 10.19                                        | %      | $                   | 27,088 |                                                                      | 4.00   | % | $ | 41,942 |   | 6.19 | % | $ | 40,633 |   | 6.00 | % |
| Plus:                                      |   |       |   |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |
| Allowable allowance for loan losses        |   | 5,901      |   |                                         |   |                |   |                                                                      |   |   |   |   |   |   |   |   |   |
| Risk-based capital                         |   | $          | 74,931 |                                         |   |                | $      | 54,177                                                                    |   |   |   | $ | 20,754 |   |   |   | $ | 67,721 |   |   |   |
| Risk-based capital to risk-weighted assets |   |       |   | 11.06                                        | %      |                |   | 8.00                                                                      | %      |   |   | 3.06 | % |   |   | 10.00 | % |

 

----

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

 

**NOTE 21  Financial Instruments with Off-Balance SheetRisk**

 

HMN is a party to financialinstruments with off-balance sheet risk in the normal course of business tomeet the financing needs of its customers. These financial instruments includecommitments to extend credit. These instruments involve, to varying degrees,elements of credit and interest rate risk in excess of the amounts recognizedin the balance sheet. The contract amounts of these instruments reflect theextent of involvement by HMN.

 

HMN’s exposure to creditloss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit is represented by the contractamount of these commitments. HMN uses the same credit policies in makingcommitments as it does for on-balance sheet instruments.

 
|                                                                 |   | **Contract amount** |        |
|----------------------------------------------------------------------|--------|---------------------|-------------|
| **(in thousands)**                                                   |   | **2003**            |        | **2002** |   |
| Financial  instruments whose contract amount represents credit risk: |   |                |        |   |   |
| Commitments  to extend credit                                        |   | **$**               | **238,291** |   | 215,285 |   |
| Commitment  of counter party to purchase loans                       |   | **7,078**           |        | 61,712 |   |
|                                                                      |        |                     |             |  |  |  |

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since a portion of the commitments are expected to expire without being drawnupon, the total commitment amounts do not necessarily represent future cashrequirements. The Bank evaluates each customer’s creditworthiness on acase-by-case basis. The amount of collateral obtained, if deemed necessary bythe Bank upon extension of credit, is based on the loan type and onmanagement’s credit evaluation of the borrower. Collateral consists primarilyof residential and commercial real estate and personal property.

 

Commitments of a counterparty to purchase loans represents commitments to sell loans to FNMA and areentered into in the normal course of business by the Bank.

 

35

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**NOTE 22  Derivative Instruments and HedgingActivities**

 

HMN originates and purchasessingle family residential loans for sale into the secondary market and entersinto commitments to sell or securitize those loans in order to mitigate theinterest rate risk associated with holding the loans until they are sold. HMNadopted SFAS No. 133, *Accounting forDerivative Instruments and Hedging Activities,*in the first quarterof 2001. At the beginning of the second quarter of 2001, certain commitments tosell loans held for sale were designated as a cash flow hedge of a forecastedtransaction and were accounted for in accordance with SFAS No. 133 with noineffectiveness recognized in the income statement. In the second quarter of2002 cash flow hedge accounting was discontinued because HMN ceased deliveringloans under a mortgage backed security program. The mortgage banking operationsin the Brooklyn Park location were eliminated in 2002 and some of the activitywas moved to other branches within HMN.

 

HMN hascommitments outstanding to extend credit to future borrowers that had notclosed prior to the end of the quarter, which is referred to as its mortgagepipeline. As commitments to originate loans enter the mortgage pipeline, HMNgenerally enters into commitments to sell the loans into the secondary market.The commitments to originate and sell loans are derivatives that are recordedat market value. As a result of marking these derivatives to market for theperiod ended December 31, 2003, HMN recorded a decrease in other assets of$689,313, a decrease in other liabilities of $690,504, and a net gain on thesale of loans of $1,191.

 

The current commitments tosell loans held for sale are derivatives that do not qualify for hedgeaccounting. As a result, these derivatives are marked to market. The loans heldfor sale that are not hedged are recorded at the lower of cost or market. As aresult of marking these loans, HMN recorded an increase in loans held for saleof $15,219, a decrease in other liabilities of $243,246, and a net gain on thesale of loans of $258,465.

 

**NOTE 23  Fair Value of Financial Instruments**

 

SFAS No. 107, *Disclosures about Fair Values of FinancialInstruments,*requires disclosure of estimated fair values of HMN’sfinancial instruments, including assets, liabilities and off-balance sheetitems for which it is practicable to estimate fair value. The fair valueestimates are made as of December 31, 2003 and 2002 based upon relevant marketinformation, if available, and upon the characteristics of the financialinstruments themselves. Because no market exists for a significant portion ofHMN’s financial instruments, fair value estimates are based upon judgmentsregarding future expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors. Theestimates are subjective in nature and involve uncertainties and matters ofsignificant judgment and therefore cannot be determined with precision. Changesin assumptions could significantly affect the estimates.

 

Fair value estimates arebased only on existing financial instruments without attempting to estimate thevalue of anticipated future business or the value of assets and liabilitiesthat are not considered financial instruments. In addition, the taxramifications related to the realization of the unrealized gains and losses canhave a significant effect on the fair value estimates and have not beenconsidered in any of the estimates.

 

The estimated fair value ofHMN’s financial instruments are shown below. Following the table, there is anexplanation of the methods and assumptions used to estimate the fair value ofeach class of financial instruments.

 
|                                      |   | **December 31,**     |       |
|-------------------------------------------|--------|----------------------|------------|
|                                      |   | **2003**             |       | **2002** |   |
| **(in thousands)**                        |   | **Carrying  amount** |       | **Estimated  fair value** |   | **Contract  amount** |   | **Carrying  amount** |   | **Estimated  fair value** |   | **Contract  amount** |   |
| Financial  assets:                        |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash  and cash equivalents                |   | **$**                | **30,497** | ** ** | **30,497** |   |   |   | 27,729 |   | 27,729 |   |   |   |
| Securities  available for sale            |   | **104,664**          | ** ** | **104,664** |   |   |   | 121,397 |   | 121,397 |   |   |   |
| Loans  held for sale                      |   | **6,543**            | ** ** | **6,560** |   |   |   | 15,127 |   | 15,127 |   |   |   |
| Loans  receivable, net                    |   | **688,951**          | ** ** | **695,454** |   |   |   | 533,906 |   | 558,625 |   |   |   |
| Federal  Home Loan Bank stock             |   | **10,004**           | ** ** | **10,004** |   |   |   | 11,881 |   | 11,881 |   |   |   |
| Accrued  interest receivable              |   | **3,462**            | ** ** | **3,462** |   |   |   | 3,051 |   | 3,051 |   |   |   |
| Financial  liabilities:                   |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                  |   | **551,688**          | ** ** | **554,936** |   |   |   | 432,951 |   | 437,490 |   |   |   |
| Federal  Home Loan Bank advances          |   | **203,900**          | ** ** | **213,256** |   |   |   | 218,300 |   | 222,109 |   |   |   |
| Accrued  interest payable                 |   | **767**              | ** ** | **767** |   |   |   | 849 |   | 849 |   |   |   |
| Off-balance  sheet financial instruments: |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Commitments  to extend credit             |   | **16**               | ** ** | **16** | ** ** | **238,291** |   | 706 |   | 706 |   | 215,285 |   |
| Commitments  to sell loans                |   | **(14**              | **)**      | **(14** | **)** | **7,078** |   | (947 | ) | (947 | ) | 61,712 |   |
|                                           |        |                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

36

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***Cash and Cash Equivalents ***The carrying amount of cash and cashequivalents approximates their fair value.

 

***Securities Available for Sale ***The fair values of securities were based uponquoted market prices.

 

***Loans Held for Sale ***The fair values of loans held for sale werebased upon quoted market prices for loans with similar interest rates and termsto maturity.

 

***Loans Receivable ***The fair values of loans receivable wereestimated for groups of loans with similar characteristics. The fair value ofthe loan portfolio, with the exception of the adjustable rate portfolio, wascalculated by discounting the scheduled cash flows through the estimatedmaturity using anticipated prepayment speeds and using discount rates thatreflect the credit and interest rate risk inherent in each loan portfolio. Thefair value of the adjustable loan portfolio was estimated by grouping the loanswith similar characteristics and comparing the characteristics of each group tothe prices quoted for similar types of loans in the secondary market.

 

***Federal Home Loan Bank Stock ***The carrying amount of FHLB stockapproximates its fair value.

 

***Accrued Interest Receivable ***The carrying amount of accrued interestreceivable approximates its fair value since it is short-term in nature anddoes not present unanticipated credit concerns.

 

***Deposits ***Under SFAS No. 107, the fair value ofdeposits with no stated maturity such as checking, savings and money marketaccounts, is equal to the amount payable on demand. The fair value ofcertificates of deposit is based on the discounted value of contractual cashflows using as discount rates the rates that were offered by HMN as of December31, 2003 and 2002 for deposits with maturities similar to the remainingmaturities of the existing certificates of deposit.

 

The fair value estimate fordeposits does not include the benefit that results from the low cost fundingprovided by HMN’s existing deposits and long-term customer relationshipscompared to the cost of obtaining different sources of funding. This benefit iscommonly referred to as the core deposit intangible.

 

***Federal Home Loan Bank Advances ***The fairvalues of advances with fixed maturities are estimated based on discounted cashflow analysis using as discount rates the interest rates charged by the FHLB atDecember 31, 2003 and 2002 for borrowings of similar remaining maturities.

 

***Accrued Interest Payable ***The carrying amount of accrued interestpayable approximates its fair value since it is short-term in nature.

 

***Commitments to Extend Credit ***The fair values of commitments to extend creditfor 2003 and 2002 are estimated using the fees normally charged to enter intosimilar agreements, taking into account the remaining terms of the agreementsand the present creditworthiness of the counter parties.

 

***Commitments to Sell Loans ***The fair values of commitments to sell loansfor 2003 and 2002 are estimated using the quoted market prices for loans withsimilar interest rates and terms to maturity.

 

**NOTE 24  Commitments and Contingencies**

 

The Bank entered into twoguaranty agreements with third parties in order for Home Federal MortgageServices, LLC (HFMS) to secure loan purchase agreements. Under the agreements,the Bank guaranteed to satisfy and discharge all obligations of HFMS arisingfrom transactions entered into between HFMS and the third parties if HFMSfailed to fulfill its obligations. The agreements are in effect until theobligations of HFMS are fully satisfied and the Bank’s guaranty is limited to acombined maximum of $3 million. No liability has been recorded in theconsolidated financial statements of HMN for these guarantees and HMN is notaware of any outstanding obligations of HFMS to either of the third partieswith whom a guarantee exists. HFMS ceased doing business with both thirdparties in 2002. There is the possibility that the Bank would be required topurchase loans that were previously sold to the third parties by HFMS prior to2002 if the loans did not meet the requirements in the loan purchaseagreements. If this were to occur, the proceeds from the subsequent sale ofthese loans would enable the Bank to recover a portion of the amounts paidunder the guaranty. 

 

The Bank issued standbyletters of credit which guarantee the performance of customers to thirdparties. The standby letters of credit outstanding at December 31, 2003 expireover the next two years and totaled approximately $2.5 million at December 31,2003 and $1.2 million at December 31, 2002. The letters of credit werecollateralized primarily with commercial real estate mortgages. Since theconditions under which the Bank is required to fund the standby letters ofcredit may not materialize, the cash requirements are expected to be less thanthe total outstanding commitments.

 

37

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**NOTE 25  HMN Financial, Inc. Financial Information(Parent Company Only)**

 

The following are thecondensed financial statements for the parent company only as of December 31,2003 and 2002 and for the years ended December 31, 2003, 2002 and 2001.

 
|                                                         |   | **2003**        |           | **2002**    |       | **2001**  |      |
|--------------------------------------------------------------|--------|-----------------|----------------|-------------|------------|-----------|-----------|
| **Condensed Balance Sheets**                                 |   |            |           |        |       |      |      |
| **Assets:**                                                  |   |            |           |        |       |      |      |
| Cash  and cash equivalents                                   |   | **$**           | **5,929,858**  |        | 447,420    |      |      |   |
| Securities  available for sale                               |   | **0**           |           | 1,490,500   |       |      |      |
| Loans  receivable from subsidiaries                          |   | **0**           |           | 4,700,000   |       |      |      |
| Loans  receivable, net                                       |   | **110,000**     |           | 1,601,383   |       |      |      |
| Investment  in subsidiaries                                  |   | **73,337,245**  |           | 66,479,330  |       |      |      |
| Investment  in limited partnerships                          |   | **421,671**     |           | 289,398     |       |      |      |
| Accrued  interest receivable                                 |   | **5,620**       |           | 21,168      |       |      |      |
| Prepaid  expenses and other assets                           |   | **1,318,313**   |           | 1,270,981   |       |      |      |
| Deferred  tax asset                                          |   | **33,600**      |           | 0           |       |      |      |
| Total  assets                                                |   | **$**           | **81,156,307** |        | 76,300,180 |      |      |   |
| Liabilities  and Stockholders’ Equity                   |   |            |           |        |       |      |      |
| Accrued  expenses and other liabilities                      |   | **$**           | **225,250**    |        | 198,724    |      |      |   |
| Deferred  tax liability                                      |   | **0**           |           | 36,900      |       |      |      |
| Total  liabilities                                           |   | **225,250**     |           | 235,624     |       |      |      |
| Serial  preferred stock                                      |   | **0**           |           | 0           |       |      |      |
| Common  stock                                                |   | **91,287**      |           | 91,287      |       |      |      |
| Additional  paid-in capital                                  |   | **57,863,726**  |           | 58,885,279  |       |      |      |
| Retained  earnings                                           |   | **85,364,657**  |           | 79,660,481  |       |      |      |
| Net  unrealized loss (gain) on securities available for sale |   | **(50,725**     | )              | 1,575,577   |       |      |      |
| Unearned  employee stock option plan shares                  |   | **(4,738,084**  | )              | (4,931,385  | )          |      |      |
| Treasury  stock, at cost, 4,616,010 and 4,722,856 shares     |   | **(57,599,804** | )              | (59,216,683 | )          |      |      |
| Total  stockholders’ equity                             |   | **80,931,057**  |           | 76,064,556  |       |      |      |
| Total  liabilities and stockholders’ equity             |   | **$**           | **81,156,307** |        | 76,300,180 |      |      |   |
|                                                         |   |            |           |        |       |      |      |
| **Condensed Statements of Income**                           |   |            |           |        |       |      |      |
| Interest  income                                             |   | **$**           | **193,334**    |        | 365,202    |      | 651,478   |   |
| Interest  expense                                            |   | **0**           |           | 0           |       | (14,557   | )         |
| Securities  gains (losses), net                              |   | **301,006**     |           | 118,238     |       | (130,344  | )         |
| Equity  earnings of subsidiaries                             |   | **8,361,418**   |           | 5,095,784   |       | 5,282,142 |      |
| Equity  earnings (losses) of limited partnerships            |   | **132,273**     |           | 23,441      |       | (19,568   | )         |
| Other  income                                                |   | **0**           |           | 15,514      |       | 0         |      |
| Compensation  and benefits                                   |   | **(42,100**     | )              | (44,250     | )          | (48,601   | )         |
| Occupancy                                                    |   | **(6,005**      | )              | (6,000      | )          | (6,324    | )         |
| Advertising                                                  |   | **(2,500**      | )              | 0           |       | 0         |      |
| Data  processing                                             |   | **(1,200**      | )              | (1,200      | )          | (2,722    | )         |
| Mortgage  servicing                                          |   | **(8,009**      | )              | (1,459      | )          | 0         |      |
| Other                                                        |   | **(481,770**    | )              | (523,314    | )          | (458,788  | )         |
| Income  before income tax expense                            |   | **8,446,447**   |           | 5,041,956   |       | 5,252,716 |      |
| Income  tax benefit                                          |   | **(158,800**    | )              | (223,700    | )          | (204,900  | )         |
| Net  income                                                  |   | **$**           | **8,605,247**  |        | 5,265,656  |      | 5,457,616 |   |

 

38

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|                                                                           |   | **2003**       |          | **2002**   |      | **2001**   |      |
|--------------------------------------------------------------------------------|--------|----------------|---------------|------------|-----------|------------|-----------|
| **Condensed Statements of Cash Flows**                                         |   |           |          |       |      |       |      |
| Cash  flows from operating activities:                                         |   |           |          |       |      |       |      |
| Net  income                                                                    |   | **$**          | **8,605,247** |       | 5,265,656 |       | 5,457,616 |   |
| Adjustments  to reconcile net income to cash provided by operating activities: |   |           |          |       |      |       |      |
| Equity  earnings of subsidiaries                                               |   | **(8,361,418** | )             | (5,095,784 | )         | (5,282,142 | )         |
| Equity  (earnings) losses in limited partnership                               |   | **(132,273**   | )             | (23,441    | )         | 19,568     |      |
| Amortization  of premiums, net                                                 |   | **0**          |          | 31,028     |      | 0          |      |
| Securities  (gains) losses, net                                                |   | **(301,006**   | )             | (118,238   | )         | 130,344    |      |
| Deferred  income taxes                                                         |   | **(3,200**     | )             | 257,600    |      | (171,800   | )         |
| Earned  employee stock ownership shares priced above original cost             |   | **180,457**    |          | 143,604    |      | 102,572    |      |
| Decrease  in restricted stock awards                                           |   | **0**          |          | 7,350      |      | 2,450      |      |
| Decrease  in unearned ESOP shares                                              |   | **193,301**    |          | 193,361    |      | 193,321    |      |
| Decrease  in accrued interest receivable                                       |   | **15,548**     |          | 98,659     |      | 88,983     |      |
| Increase  in accrued expenses and other liabilities                            |   | **26,526**     |          | 199,219    |      | 41,073     |      |
| Decrease  (increase) in other assets                                           |   | **330,037**    |          | (944,817   | )         | 51,583     |      |
| Other,  net                                                                    |   | **0**          |          | 1          |      | 0          |      |
| Net  cash provided by operating activities                                     |   | **553,219**    |          | 14,198     |      | 633,568    |      |
| Cash  flows from investing activities:                                         |   |           |          |       |      |       |      |
| Proceeds  from sales of securities available for sale                          |   | **1,601,007**  |          | 6,296,788  |      | 3,634,968  |      |
| Purchases  of securities available for sale                                    |   | **0**          |          | 0          |      | (2,688,600 | )         |
| Decrease  (increase) in loans receivable, net                                  |   | **1,491,383**  |          | (1,601,383 | )         | 0          |      |
| Decrease  of investments in subsidiaries                                       |   | **0**          |          | 0          |      | 1,096,972  |      |
| Net  decrease (increase) in loans receivable from subsidiaries                 |   | **4,700,000**  |          | (3,985,118 | )         | 3,745,510  |      |
| Net  cash provided by investing activities                                     |   | **7,792,390**  |          | 710,287    |      | 5,788,850  |      |
| Cash  flows from financing activities:                                         |   |           |          |       |      |       |      |
| Purchase  of treasury stock                                                    |   | **(1,384,560** | )             | (1,496,111 | )         | (1,584,152 | )         |
| Stock  options exercised                                                       |   | **1,422,460**  |          | 871,131    |      | 646,199    |      |
| Dividends  to stockholders                                                     |   | **(2,901,071** | )             | (2,562,153 | )         | (1,881,226 | )         |
| Decrease  in other borrowed money                                              |   | **0**          |          | 0          |      | (750,000   | )         |
| Net  cash used by financing activities                                         |   | **(2,863,171** | )             | (3,187,133 | )         | (3,569,179 | )         |
| Increase  (decrease) in cash and cash equivalents                              |   | **5,482,438**  |          | (2,462,648 | )         | 2,853,239  |      |
| Cash  and cash equivalents, beginning of year                                  |   | **447,420**    |          | 2,910,068  |      | 56,829     |      |
| Cash  and cash equivalents, end of year                                        |   | **$**          | **5,929,858** |       | 447,420   |       | 2,910,068 |   |

 

39

----

 

**NOTE 26  Business Segments**

 

The Bank has been identifiedas a reportable operating segment in accordance with the provisions of SFAS No.131.  SFC and HMN, the holding company,did not meet the quantitative thresholds for a reportable segment and thereforeare not included in the “Other” category. Prior to 2003, Home Federal MortgageServices, (HFMS) was reported as a separate business segment. HFMS is in theprocess of being dissolved and its segmented information for earlier years hasbeen included in the “Home Federal Savings Bank” category to conform with thecurrent year presentation.

 

HMN evaluates performanceand allocates resources based on the segment’s net income, return on averageassets and return on average equity. Each corporation is managed separatelywith its own officers and board of directors.

 

The following table setsforth certain information about the reconciliations of reported net income andassets for each of HMN’s reportable segments.

 
| **(Dollars in thousands)**                                                                    |   | **Home  Federal****Savings  Bank** |       | **Other**  |       | **Eliminations** |       | **Consolidated****Total** |       |
|-----------------------------------------------------------------------------------------------|--------|------------------------------------|------------|------------|------------|------------------|------------|---------------------------|------------|
| **At or for the year ended December 31, 2003:**                                               |   |                               |       |       |       |             |       |                      |       |
| Interest  income – external customers                                                    |   | **$**                              | **44,775** | ** ** | **162**    | ** **       | **0**      | ** **                | **44,937** | ** ** |
| Non-interest  income – external customers                                                |   | **10,198**                         | ** ** | **301**    | ** ** | **0**            | ** ** | **10,499**                | ** ** |
| Earnings  (losses) on limited partnerships                                                    |   | **(376**                           | **)**      | **132**    | ** ** | **0**            | ** ** | **(244**                  | **)**      |
| Intersegment  interest income                                                                 |   | **28**                             | ** ** | **31**     | ** ** | **(59**          | **)**      | **0**                     | ** ** |
| Intersegment  non-interest income                                                             |   | **868**                            | ** ** | **8,361**  | ** ** | **(9,229**       | **)**      | **0**                     | ** ** |
| Interest  expense                                                                             |   | **20,348**                         | ** ** | **0**      | ** ** | **(59**          | **)**      | **20,289**                | ** ** |
| Amortization  of mortgage servicing rights and net valuation adjustments and servicing  costs |   | **2,298**                          | ** ** | **8**      | ** ** | **(324**         | **)**      | **1,982**                 | ** ** |
| Other  non-interest expense                                                                   |   | **17,456**                         | ** ** | **542**    | ** ** | **(327**         | **)**      | **17,671**                | ** ** |
| Income  tax expense (benefit)                                                                 |   | **4,200**                          | ** ** | **(162**   | **)**      | **0**            | ** ** | **4,038**                 | ** ** |
| Minority  interest                                                                            |   | **(3**                             | **)**      | **0**      | ** ** | **0**            | ** ** | **(3**                    | **)**      |
| Net  income                                                                                   |   | **8,584**                          | ** ** | **8,599**  | ** ** | **(8,578**       | **)**      | **8,605**                 | ** ** |
| Goodwill                                                                                      |   | **3,801**                          | ** ** | **0**      | ** ** | **0**            | ** ** | **3,801**                 | ** ** |
| Total  assets                                                                                 |   | **860,220**                        | ** ** | **81,182** | ** ** | **(74,966**      | **)**      | **866,436**               | ** ** |
| Net  interest margin                                                                          |   | **3.30**                           | **%**      | **NM**     | ** ** | **NM**           | ** ** | **3.31**                  | **%**      |
| Return  on average assets                                                                     |   | **1.08**                           | ** ** | **NM**     | ** ** | **NM**           | ** ** | **1.10**                  | ** ** |
| Return  on average realized common equity                                                     |   | **11.88**                          | ** ** | **NM**     | ** ** | **NM**           | ** ** | **10.85**                 | ** ** |
|                                                                                          |   |                               |       |       |       |             |       |                      |       |
| At  or for the year ended December 31, 2002:                                                  |   |                               |       |       |       |             |       |                      |       |
| Interest  income – external customers                                                    |   | $                                  | 42,550     |       | 318        |             | 0          |                      | 42,868     |   |
| Non-interest  income – external customers                                                |   | 6,401                              |       | 134        |       | 0                |       | 6,535                     |       |
| Earnings  (losses) on limited partnerships                                                    |   | (683                               | )          | 23         |       | 0                |       | (660                      | )          |
| Intersegment  interest income                                                                 |   | 517                                |       | 47         |       | (564             | )          | 0                         |       |
| Intersegment  non-interest income                                                             |   | 305                                |       | 5,168      |       | (5,473           | )          | 0                         |       |
| Interest  expense                                                                             |   | 21,859                             |       | 0          |       | (564             | )          | 21,295                    |       |
| Amortization  of mortgage servicing rights and net valuation adjustments and servicing  costs |   | 1,364                              |       | 1          |       | (199             | )          | 1,166                     |       |
| Other  non-interest expense                                                                   |   | 16,643                             |       | 583        |       | (543             | )          | 16,683                    |       |
| Income  tax expense (benefit)                                                                 |   | 2,368                              |       | (269       | )          | 0                |       | 2,099                     |       |
| Minority  interest                                                                            |   | (142                               | )          | 0          |       | 0                |       | (142                      | )          |
| Net  income                                                                                   |   | 4,728                              |       | 5,269      |       | (4,731           | )          | 5,266                     |       |
| Goodwill                                                                                      |   | 3,801                              |       | 0          |       | 0                |       | 3,801                     |       |
| Total  assets                                                                                 |   | 732,769                            |       | 76,436     |       | (71,682          | )          | 737,523                   |       |
| Net  interest margin                                                                          |   | 3.13                               | %          | NM         |       | NM               |       | 3.19                      | %          |
| Return  on average assets                                                                     |   | 0.75                               |       | NM         |       | NM               |       | 0.74                      |       |
| Return  on average realized common equity                                                     |   | 8.33                               |       | NM         |       | NM               |       | 6.94                      |       |
|                                                                                          |   |                               |       |       |       |             |       |                      |       |
| At  or for the year ended December 31, 2001:                                                  |   |                               |       |       |       |             |       |                      |       |
| Interest  income – external customers                                                    |   | $                                  | 51,040     |       | 428        |             | 0          |                      | 51,468     |   |
| Non-interest  income – external customers                                                |   | 4,573                              |       | 323        |       | 0                |       | 4,896                     |       |
| Earnings  (losses) on limited partnerships                                                    |   | (1,292                             | )          | (20        | )          | 0                |       | (1,312                    | )          |
| Intersegment  interest income (expense)                                                       |   | 2,800                              |       | 225        |       | (3,025           | )          | 0                         |       |
| Intersegment  non-interest income                                                             |   | (246                               | )          | 5,282      |       | (5,036           | )          | 0                         |       |
| Interest  expense                                                                             |   | 33,453                             |       | 16         |       | (3,025           | )          | 30,444                    |       |
| Amortization  of mortgage servicing rights and net valuation adjustments and servicing  costs |   | 758                                |       | 0          |       | 0                |       | 758                       |       |
| Other  non-interest expense                                                                   |   | 14,565                             |       | 1,002      |       | (576             | )          | 14,991                    |       |
| Income  tax expense (benefit)                                                                 |   | 2,852                              |       | (218       | )          | 0                |       | 2,634                     |       |
| Minority  interest                                                                            |   | (383                               | )          | 0          |       |             |       | (383                      | )          |
| Net  income                                                                                   |   | 4,480                              |       | 5,438      |       | (4,460           | )          | 5,458                     |       |
| Total  assets                                                                                 |   | 768,318                            |       | 72,547     |       | (119,751         | )          | 721,114                   |       |
| Net  interest margin                                                                          |   | 2.97                               | %          | NM         |       | NM               |       | 3.02                      | %          |
| Return  on average assets                                                                     |   | 0.69                               |       | NM         |       | NM               |       | 0.75                      |       |
| Return  on average realized common equity                                                     |   | 9.24                               |       | NM         |       | NM               |       | 7.57                      |       |

 

NM – Not meaningful

 

40

----

 

**INDEPENDENTAUDITOR’S REPORT**

 

 

*The Boardof Directors*

 

*HMNFinancial, Inc.*

 

*Rochester,Minnesota:*

 

We have audited theaccompanying consolidated balance sheets of HMN Financial, Inc. andsubsidiaries (the Company) as of December 31, 2003 and 2002, and the relatedconsolidated statements of income, comprehensive income, stockholders’ equity,and cash flows for each of the years in the three-year period ended December31, 2003. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the United States ofAmerica. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of HMN Financial, Inc. andsubsidiaries as of December 31, 2003 and 2002, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2003, in conformity with accounting principles generallyaccepted in the United States of America.

 

As discussed in note 1 tothe consolidated financial statements, the Company adopted the provisions ofthe Financial Accounting Standards Board’s Statement of Financial AccountingStandards No. 142, *Goodwill and OtherIntangible Assets,*as of January 1, 2002.

 

 
|                      | /s/ KPMG LLP |   |
|---------------------------|--------------|--------|
|                      |
| *Minneapolis,  Minnesota* |
| *March  12, 2004*         |

 

41

----

 

**SELECTEDQUARTERLY FINANCIAL DATA**

 
| **(Dollars in thousands, except per share data)**                        |   | **December 31,****2003** |       | **September 30,****2003** |       | **June 30,****2003** |       |
|--------------------------------------------------------------------------|--------|--------------------------|------------|---------------------------|------------|----------------------|------------|
| Selected  Operations Data *(3 months ended):*                            |   |                     |       |                      |       |                 |       |
| Interest  income                                                         |   | **$**                    | **11,922** | ** **                | **11,507** | ** **           | **11,036** | ** ** |
| Interest  expense                                                        |   | **5,165**                | ** ** | **5,065**                 | ** ** | **5,108**            | ** ** |
| Net  interest income                                                     |   | **6,757**                | ** ** | **6,442**                 | ** ** | **5,928**            | ** ** |
| Provision  for loan losses                                               |   | **710**                  | ** ** | **545**                   | ** ** | **490**              | ** ** |
| Net  interest income after provision for loan losses                     |   | **6,047**                | ** ** | **5,897**                 | ** ** | **5,438**            | ** ** |
| Noninterest  income:                                                     |   |                     |       |                      |       |                 |       |
| Fees  and service charges                                                |   | **691**                  | ** ** | **626**                   | ** ** | **555**              | ** ** |
| Mortgage  servicing fees                                                 |   | **282**                  | ** ** | **261**                   | ** ** | **239**              | ** ** |
| Securities  gains (losses), net                                          |   | **41**                   | ** ** | **417**                   | ** ** | **225**              | ** ** |
| Gain  on sales of loans                                                  |   | **648**                  | ** ** | **1,601**                 | ** ** | **1,526**            | ** ** |
| Earnings  (losses) in limited partnerships                               |   | **70**                   | ** ** | **10**                    | ** ** | **31**               | ** ** |
| Other  noninterest income                                                |   | **167**                  | ** ** | **179**                   | ** ** | **115**              | ** ** |
| Total  noninterest income                                                |   | **1,899**                | ** ** | **3,094**                 | ** ** | **2,691**            | ** ** |
| Noninterest  expense:                                                    |   |                     |       |                      |       |                 |       |
| Compensation  and benefits                                               |   | **2,283**                | ** ** | **2,085**                 | ** ** | **2,028**            | ** ** |
| Occupancy                                                                |   | **1,025**                | ** ** | **806**                   | ** ** | **769**              | ** ** |
| Federal  deposit insurance premiums                                      |   | **18**                   | ** ** | **18**                    | ** ** | **18**               | ** ** |
| Advertising                                                              |   | **115**                  | ** ** | **92**                    | ** ** | **101**              | ** ** |
| Data  processing                                                         |   | **238**                  | ** ** | **311**                   | ** ** | **290**              | ** ** |
| Amortization  of mortgage servicing rights and net valuation adjustments |   | **277**                  | ** ** | **(193**                  | **)**      | **1,108**            | ** ** |
| Other  noninterest expense                                               |   | **974**                  | ** ** | **1,211**                 | ** ** | **867**              | ** ** |
| Total  noninterest expense                                               |   | **4,930**                | ** ** | **4,330**                 | ** ** | **5,181**            | ** ** |
| Income  before income tax expense                                        |   | **3,016**                | ** ** | **4,661**                 | ** ** | **2,948**            | ** ** |
| Income  tax expense                                                      |   | **874**                  | ** ** | **1,621**                 | ** ** | **918**              | ** ** |
| Income  before minority interest                                         |   | **2,142**                | ** ** | **3,040**                 | ** ** | **2,030**            | ** ** |
| Minority  interest                                                       |   | **(3**                   | **)**      | **0**                     | ** ** | **0**                | ** ** |
| Net  income                                                              |   | **$**                    | **2,145**  | ** **                | **3,040**  | ** **           | **2,030**  | ** ** |
| Basic  earnings per share                                                |   | **$**                    | **0.55**   | ** **                | **0.79**   | ** **           | **0.54**   | ** ** |
| Diluted  earnings per share                                              |   | **$**                    | **0.53**   | ** **                | **0.76**   | ** **           | **0.52**   | ** ** |
| Financial  Ratios:                                                       |   |                     |       |                      |       |                 |       |
| Return  on average assets(1)                                             |   | **1.03**                 | **%**      | **1.53**                  | ** ** | **1.06**             | ** ** |
| Return  on average equity(1)                                             |   | **10.45**                | ** ** | **15.12**                 | ** ** | **10.45**            | ** ** |
| Average  equity to average assets                                        |   | **10.15**                | ** ** | **10.27**                 | ** ** | **10.34**            | ** ** |
| Dividend  payout ratio                                                   |   | **26.32**                | ** ** | **38.46**                 | ** ** | **50.00**            | ** ** |
| Net  interest margin(1)(2)                                               |   | **3.39**                 | ** ** | **3.41**                  | ** ** | **3.24**             | ** ** |

 
| **(Dollars in thousands)**              |   |        |        |        |        |        |        |
|-----------------------------------------|--------|-------------|-------------|-------------|-------------|-------------|-------------|
| Selected  Financial Condition Data:     |   |        |        |        |        |        |        |
| Total  assets                           |   | **$**       | **866,436** | ** **  | **807,043** | ** **  | **785,910** | ** ** |
| Securities  available for sale:         |   |        |        |        |        |        |        |
| Mortgage-backed  and related securities |   | **13,049**  | ** **  | **16,327**  | ** **  | **21,121**  | ** **  |
| Other  marketable securities            |   | **91,615**  | ** **  | **72,201**  | ** **  | **84,510**  | ** **  |
| Loans  held for sale                    |   | **6,543**   | ** **  | **17,634**  | ** **  | **13,855**  | ** **  |
| Loans  receivable, net                  |   | **688,951** | ** **  | **645,715** | ** **  | **606,931** | ** **  |
| Deposits                                |   | **551,688** | ** **  | **490,088** | ** **  | **463,185** | ** **  |
| Federal  Home Loan Bank advances        |   | **203,900** | ** **  | **229,300** | ** **  | **235,300** | ** **  |
| Stockholders’  equity              |   | **80,931**  | ** **  | **79,467**  | ** **  | **77,522**  | ** **  |
|                                         |        |             |             |             |             |             |             |  |

 

----

(1)Annualized

(2)Net interestincome divided by average interest-earning assets.

 

42

----

 
| **(Dollars in thousands, except per share data)**                        |   | **March 31,  2003** |   | **December  31,  2002** |   | **September  30,  2002** |   | **June 30,  2002** |   | **March 31,  2002** |   |
|--------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|--------------------------|--------|--------------------|--------|---------------------|--------|
| Selected  Operations Data *(3 months ended):*                            |   | **10,472**          |   | 10,583                  |   | 10,633                   |   | 10,511             |   | 11,141              |   |
| Interest  income                                                         |   | **4,951**           |   | 5,203                   |   | 5,173                    |   | 5,228              |   | 5,691               |   |
| Interest  expense                                                        |   | **5,521**           |   | 5,380                   |   | 5,460                    |   | 5,283              |   | 5,450               |   |
| Net  interest income                                                     |   | **865**             |   | 575                     |   | 771                      |   | 310                |   | 720                 |   |
| Provision  for loan losses                                               |   | **4,656**           |   | 4,805                   |   | 4,689                    |   | 4,973              |   | 4,730               |   |
| Net  interest income after provision for loan losses                     |   |                |   |                    |   |                     |   |               |   |                |   |
| Noninterest  income:                                                     |   | **432**             |   | 511                     |   | 418                      |   | 390                |   | 404                 |   |
| Fees  and service charges                                                |   | **216**             |   | 193                     |   | 184                      |   | 177                |   | 160                 |   |
| Mortgage  servicing fees                                                 |   | **592**             |   | 0                       |   | 377                      |   | 27                 |   | 19                  |   |
| Securities  gains (losses), net                                          |   | **1,465**           |   | 1,102                   |   | 432                      |   | 498                |   | 1,044               |   |
| Gain  on sales of loans                                                  |   | **(354**            | )      | (455                    | )      | (531                     | )      | (52                | )      | 379                 |   |
| Earnings  (losses) in limited partnerships                               |   | **220**             |   | 65                      |   | 123                      |   | 151                |   | 258                 |   |
| Other  noninterest income                                                |   | **2,571**           |   | 1,416                   |   | 1,003                    |   | 1,191              |   | 2,264               |   |
| Total  noninterest income                                                |   |                |   |                    |   |                     |   |               |   |                |   |
| Noninterest  expense:                                                    |   | **2,278**           |   | 2,006                   |   | 1,987                    |   | 2,069              |   | 1,951               |   |
| Compensation  and benefits                                               |   | **824**             |   | 899                     |   | 801                      |   | 726                |   | 683                 |   |
| Occupancy                                                                |   | **19**              |   | 18                      |   | 18                       |   | 19                 |   | 20                  |   |
| Federal  deposit insurance premiums                                      |   | **85**              |   | 104                     |   | 129                      |   | 146                |   | 143                 |   |
| Advertising                                                              |   | **271**             |   | 283                     |   | 273                      |   | 287                |   | 264                 |   |
| Data  processing                                                         |   |                |   |                    |   |                     |   |               |   |                |   |
| Amortization  of mortgage servicing rights and net valuation adjustments |   | **791**             |   | 281                     |   | 502                      |   | 171                |   | 211                 |   |
| Other  noninterest expense                                               |   | **944**             |   | 1,031                   |   | 845                      |   | 1,108              |   | 873                 |   |
| Total  noninterest expense                                               |   | **5,212**           |   | 4,622                   |   | 4,555                    |   | 4,526              |   | 4,145               |   |
| Income  before income tax expense                                        |   | **2,015**           |   | 1,599                   |   | 1,137                    |   | 1,638              |   | 2,849               |   |
| Income  tax expense                                                      |   | **625**             |   | 462                     |   | 312                      |   | 485                |   | 840                 |   |
| Income  before minority interest                                         |   | **1,390**           |   | 1,137                   |   | 825                      |   | 1,153              |   | 2,009               |   |
| Minority  interest                                                       |   | **0**               |   | (1                      | )      | (67                      | )      | (115               | )      | 41                  |   |
| Net  income                                                              |   | **1,390**           |   | 1,138                   |   | 892                      |   | 1,268              |   | 1,968               |   |
| Basic  earnings per share                                                |   | **0.37**            |   | 0.30                    |   | 0.24                     |   | 0.34               |   | 0.53                |   |
| Diluted  earnings per share                                              |   | **0.36**            |   | 0.28                    |   | 0.22                     |   | 0.32               |   | 0.50                |   |
| Financial  Ratios:                                                       |   |                |   |                    |   |                     |   |               |   |                |   |
| Return  on average assets(1)                                             |   | **0.76**            |   | 0.62                    |   | 0.51                     |   | 0.72               |   | 1.11                |   |
| Return  on average equity(1)                                             |   | **7.21**            |   | 5.81                    |   | 4.58                     |   | 6.75               |   | 10.92               |   |
| Average  equity to average assets                                        |   | **10.59**           |   | 10.66                   |   | 10.66                    |   | 10.44              |   | 10.21               |   |
| Dividend  payout ratio                                                   |   | **64.29**           |   | 81.82                   |   | 56.25                    |   | 36.00              |   | 100.00              |   |
| Net  interest margin(1)(2)                                               |   | **3.20**            |   | 3.09                    |   | 3.29                     |   | 3.17               |   | 3.23                |   |

 
| **(Dollars in thousands)**              |   |        |   |    |   |    |   |    |   |    |   |
|-----------------------------------------|--------|-------------|--------|---------|--------|---------|--------|---------|--------|---------|--------|
| Selected  Financial Condition Data:     |   | **761,399** |   | 737,523 |   | 719,469 |   | 693,723 |   | 718,781 |   |
| Total  assets                           |   |        |   |    |   |    |   |    |   |    |   |
| Securities  available for sale:         |   | **15,049**  |   | 51,896  |   | 61,882  |   | 65,565  |   | 65,533  |   |
| Mortgage-backed  and related securities |   | **83,982**  |   | 69,501  |   | 46,811  |   | 67,053  |   | 73,849  |   |
| Other  marketable securities            |   | **12,999**  |   | 15,127  |   | 14,419  |   | 12,305  |   | 25,854  |   |
| Loans  held for sale                    |   | **577,542** |   | 533,906 |   | 508,036 |   | 470,292 |   | 448,976 |   |
| Loans  receivable, net                  |   | **448,083** |   | 432,951 |   | 422,347 |   | 399,530 |   | 414,024 |   |
| Deposits                                |   | **219,300** |   | 218,300 |   | 214,300 |   | 214,300 |   | 217,800 |   |
| Federal  Home Loan Bank advances        |   | **74,894**  |   | 76,065  |   | 75,180  |   | 73,757  |   | 73,283  |   |
| Stockholders’  equity              |   |        |   |    |   |    |   |    |   |    |   |

 

43

----

 

**OTHERFINANCIAL DATA**

 

The following table setsforth the maximum month-end balance and average balance of FHLB advances.

 
|                                          |   | **Year Ended December 31,** |        |
|-----------------------------------------------|--------|-----------------------------|-------------|
| **(Dollars in thousands)**                    |   | **2003**                    |        | **2002** |   | **2001** |   |
| Maximum  Balance:                             |   |                        |        |   |   |   |   |
| Federal  Home Loan Bank advances              |   | **$**                       | **241,800** |   | 218,300 |   | 240,900 |   |
| Federal  Home Loan Bank short-term borrowings |   | **69,400**                  |        | 64,400 |   | 38,000 |   |
| Average  Balance:                             |   |                        |        |   |   |   |   |
| Federal  Home Loan Bank advances              |   | **221,510**                 |        | 215,673 |   | 221,890 |   |
| Federal  Home Loan Bank short-term borrowings |   | **41,169**                  |        | 36,290 |   | 20,470 |   |
|                                               |        |                             |             |  |  |  |  |  |

 

The following table setsforth certain information as to the Bank’s FHLB advances.

 
|                                             |   | **December 31,** |        |
|--------------------------------------------------|--------|------------------|-------------|
|                                             |   | **2003**         |        | **2002** |   | **2001** |   |
| **(Dollars in thousands)**                       |   | **Amount**       |        | **Weighted  Average****Rate** |   | **Amount** |   | **Weighted  Average****Rate** |   | **Amount** |   | **Weighted  Average****Rate** |   |
| Federal  Home Loan Bank short-term borrowings    |   | **$**            | **33,000**  | ** ** | **5.01** | % | 64,400 |   | 3.20 | % | 9,500 |   | 4.42 | % |
| Other  Federal Home Loan Bank long-term advances |   | **170,900**      | ** **  | **4.20** |   | 153,900 |   | 5.17 |   | 208,300 |   | 4.76 |   |
| Total                                            |   | **$**            | **203,900** | ** ** | **4.33** |   | 218,300 |   | 4.59 |   | 217,800 |   | 4.75 |   |

 

Refer to Note 14 of theNotes to Consolidated Financial Statements for more information on the Bank’sFHLB advances.

 

**COMMON STOCKINFORMATION**

 

The common stock of HMNFinancial, Inc. is listed on the Nasdaq Stock Market under the symbol: HMNF.The common stock outstanding is 9,128,662 shares of which 4,616,010 shares arein treasury stock at December 31, 2003. As of December 31, 2003 there were 696 stockholders of record and 865estimated beneficial stockholders. The following table represents the stockprice information for HMN Financial, Inc. as furnished by Nasdaq for eachquarter starting in December 31, 2003 and regressing back to March 31, 1998.

 
|   |   | **Dec. 31,  2003** |       | **Sept. 30,  2003** |       | **June 30,  2003** |       | **March 31,  2003** |      | **Dec. 31,  2002** |   | **Sept. 30,  2002** |   | **June 28,  2002** |   | **March 29,  2002** |   |
|--------|--------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|-----------|--------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|
| HIGH   |   | **$**              | **24.70**  | ** **          | **21.63**  | ** **         | **20.04**  | ** **          | **16.82** |               | 18.14  |                | 19.31  |               | 20.25  |                | 16.17  |   |
| LOW    |   | **20.00**          | ** ** | **19.36**           | ** ** | **15.85**          | ** ** | **15.55**           |      | 15.78              |   | 16.50               |   | 15.90              |   | 15.24               |   |
| CLOSE  |   | **24.29**          | ** ** | **21.50**           | ** ** | **19.40**          | ** ** | **16.05**           |      | 16.82              |   | 17.46               |   | 19.06              |   | 16.05               |   |
|        |        |                    |            |                     |            |                    |            |                     |           |                    |        |                     |        |                    |        |                     |        |  |

 
|   |   | **Dec. 31,  2001** |   | **Sept. 28,  2001** | ** ** | **June 29,  2001** | ** ** | **March 30,  2001** | ** ** | **Dec. 29,  2000** | ** ** | **Sept. 29,  2000** | ** ** | **June 30,  2000** | ** ** | **March 31,  2000** | ** ** |
|--------|--------|--------------------|--------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| HIGH   |   | $                  | 15.85  |                | 17.10      |               | 17.15      |                | 15.06      |               | 13.25      |                | 13.88      |               | 11.75      |                | 12.13      |   |
| LOW    |   | 13.27              |   | 14.35               |       | 13.50              |       | 13.00               |       | 12.31              |       | 10.88               |       | 10.13              |       | 9.63                |       |
| CLOSE  |   | 15.49              |   | 15.10               |       | 17.10              |       | 14.75               |       | 13.06              |       | 12.44               |       | 11.00              |       | 10.13               |       |
|        |        |                    |        |                     |            |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |  |

 
|   |   | **Dec. 31,  1999** |   | **Sept. 30,  1999** | ** ** | **June 30,  1999** | ** ** | **March 31,  1999** | ** ** | **Dec. 31,  1998** | ** ** | **Sept. 30,  1998** | ** ** | **June 30,  1998** | ** ** | **March 31,  1998** | ** ** |
|--------|--------|--------------------|--------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| HIGH   |   | $                  | 12.75  |                | 13.50      |               | 13.13      |                | 13.50      |               | 14.75      |                | 16.06      |               | 20.67      |                | 21.33      |   |
| LOW    |   | 10.88              |   | 11.88               |       | 10.50              |       | 11.38               |       | 10.38              |       | 13.25               |       | 15.50              |       | 17.50               |       |
| CLOSE  |   | 11.25              |   | 12.25               |       | 11.63              |       | 11.38               |       | 11.75              |       | 14.50               |       | 15.88              |       | 20.00               |       |
|        |        |                    |        |                     |            |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |  |

 

44

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**CORPORATEAND SHAREHOLDER INFORMATION**

 

**HMN F****INANCIAL****, I****NC****.**

 

1016 Civic Center Drive NWRochester, MN 55901(507) 535-1200

 

**A****NNUAL****M****EETING**

 

The annual meeting ofshareholders will be held on Tuesday, April 27, 2004 at 10:00 a.m. (CentralTime) at theRochester Golf and Country Club,3100 W. Country Club Road,Rochester, Minnesota.

 

**L****EGAL****C****OUNSEL**

 

Faegre &Benson LLP2200 Wells Fargo Center90 South Seventh St.Minneapolis, MN55402-3901

 

**I****NDEPENDENT****A****UDITORS**

 

KPMG LLP4200 Wells Fargo Center90 South Seventh St.Minneapolis, MN 55402-3900

 

**I****NVESTOR****I****NFORMATION AND****F****ORM****10-K**

 

Additional information andHMN’s Form 10-K, filed with the Securities and Exchange Commission is availablewithout charge upon request from:

 

HMN Financial, Inc.Attn: Investor Relations1016 Civic Center Drive NWRochester, MN  55901

 

**T****RANSFER****A****GENT****& R****EGISTRAR**

 

Inquiries regarding change ofaddress, transfer requirements, and lost certificates should be directed to thetransfer agent.

 

Wells Fargo Bank, N.A.Shareowner Services161 North Concord ExchangeSouth St. Paul, MN 55075www.wellsfargo.com/shareownerservices(800) 468-9716

 

**D****IRECTORS**

 

TIMOTHY R. GEISLER

*HMN andHome Federal Savings BankChairman of the BoardUnit Manager Foundation AccountingMayo Foundation*

 

MICHAEL MCNEIL

*HMNPresident and Home Federal Savings Bank President and CEO*

 

ROGER P.WEISE

*RetiredChairman, President and Chief Executive OfficerHMN and Home Federal Savings Bank*

 

DUANE D. BENSON

*RetiredExecutive DirectorMinnesota Business Partnership*

 

ALLAN R. DEBOER

*RetiredChief Executive OfficerRCS of Rochester*

 

MAHLON C. SCHNEIDER

*Senior VicePresident External Affairs and General CounselHormel Foods Corporation*

 

SUSAN K. KOLLING

*Senior VicePresidentHome Federal Savings Bank*

 

MICHAEL J. FOGARTY

*Chairman C.O.Brown Agency, Inc.*

 

**E****XECUTIVE****O****FFICERS**

 

MICHAEL MCNEIL

*President*

 

JON J. EBERLE

*Senior VicePresident,Chief Financial Officer and Treasurer*

 

DWAIN C. JORGENSEN

*Senior VicePresident*

 

**B****RANCH****O****FFICES OF****B****ANK**

 

**Albert Lea**

143 West Clark St.

Albert Lea, MN 56007

(507) 377-3330

 

**Austin**

201 Oakland Avenue West

Austin, MN 55912

(507) 433-2355

 

**LaCrescent**

208 South Walnut

LaCrescent, MN 55947

(507) 895-4090

 

**Marshalltown**

303 West Main Street

Marshalltown, IA 50158

(515) 754-6000

 

**Rochester**

Crossroads Shopping Center

1201 South Broadway

Rochester, MN 55901

(507) 289-4025

 

1016 Civic Center Dr. NW

Rochester, MN 55901

(507) 285-1707

 

3900 55th St. NW

Rochester, MN 55901

(507) 535-3460

 

**SpringValley**

715 North Broadway

Spring Valley, MN 55975

(507) 346-7345

 

**Toledo**

1301 S. County Road

Toledo, IA 52342

(515) 484-5141

 

**Winona**

175 Center Street

Winona, MN 55987

(507) 454-4912

 

1475 Service Road

Winona, MN  55987

(507) 454-9660

 

**E****AGLE****C****REST****C****APITAL****B****ANK****,****A DIVISION OF****H****OME****F****EDERAL****S****AVINGS****B****ANK**

 

5201 Eden Ave., Ste 170

Edina, MN  55436

(952) 848-5360

 

1016 Civic Center Dr. N.W.

Rochester, MN  55901

(507) 535-1280

 

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